Should You Buy the Fund That Pays You to Own It?

Last Updated Feb 26, 2011 9:55 AM EST

I spend a lot of time here railing against the practices of many members of the mutual fund industry. But by no means is the industry full of scoundrels set upon ripping off their clients, and this week I'm pleased to profile a firm that works hard to do right by their investors.

Bridgeway funds have always stood slightly apart from the mutual fund industry at large. For starters, the firm has a rather strong social conscience, donating half of its advisory fee profits to charity each year. It also has a policy that no employee can earn more than seven times the lowest-paid employee. And the firm has a track record of taking its fiduciary duty quite seriously: it's been very quick to close funds; and most of its funds have shareholder-friendly performance fees, in which the firm is paid more when the funds outperform their benchmarks, and less when they underperform.

Those performance fees have led to another distinguishing characteristic for two of Bridgeway's funds: Bridgeway Micro-Cap Limited has an expense ratio of zero, while the recently reopened Bridgeway Aggressive Investors 1 has a negative 0.51 percent expense ratio -- it pays investors $5.10 for every $1,000 they have invested in it.

So what's going on here?

Bridgeway employs a quantitative approach to fund management, in which computer programs are used to select stocks that meet the firm's criteria. Like most quantitative managers, Bridgeway's funds got creamed in the 2008 market meltdown. Micro-Cap Limited lost nearly 42 percent that year, while Aggressive Investors 1 declined by 56 percent.

That performance, when combined with the firm's aggressive performance fee -- which is calculated on the fund's average assets over the trailing five years, instead of the more common three years -- has produced these odd expense ratios.

So should investors rush out to purchase these funds at what appear to be screaming bargains? Not so fast. While expenses are important, they're certainly not the sole criteria one should use in making an investment decision. Investors considering Bridgeway funds should also keep the following in mind:
  • Because of their management style Bridgeway's funds have higher-than-average portfolio turnover, which means that they're best held in tax-exempt accounts.
  • The funds have been extremely volatile, so if the notion of seeing the value of your investment decline by 50 percent or more in a given year gives you motion sickness, you're probably best served by sitting this ride out.
  • The funds are fairly specialized and are best-suited to fill out the fringes of an already diversified portfolio rather than serving as a core holding.
While those caveats might rule out a substantial investment in either fund for most investors, both funds, if nothing else, reinforce an important point. Investors typically spend a lot of time and effort poring over data -- past returns, tax efficiency, expense ratios, etc. -- to determine whether a fund is worthy of their hard-earned assets. And while those things are important, perhaps equally important -- but far less quantifiable -- is the character of the firm they're considering. It's easy to talk about how important your mutual fund clients are, but does the firm back up their talk with actions that demonstrate that they take their fiduciary duty seriously? There are a number of firms in the industry that meet that standard, and by all accounts Bridgeway is one of them.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.

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