The Expense-Free Mutual Fund

01/03/2011 1:43 pm EST

Focus: FUNDS

Russel Kinnel

Editor, Morningstar FundInvestor

The catch? It’s a volatile micro-cap offering with a lousy recent track record. But if BRMCX can return to prior form the potential reward is large, writes Russel Kinnel of Morningstar FundInvestor.  

Last month I wrote about how cheap Vanguard funds have become, but this time I have one that's cheaper than anything from Vanguard.

The Bridgeway Micro-Cap Limited Fund (BRMCX) has a 0% expense ratio.

The reason for the unheard-of expense ratio is the fund's very aggressive performance fees range. While many other funds have performance fees that raise or lower a fund’s management fee based on performance versus a benchmark, the Bridgeway fund has some unusual features. First, the fee adjustments are so large that they can wipe out the entire management fee—not half the management fee, which is more typical. Second, the fee is based on the fund’s average asset size for the trailing five years. Third, the fee is based on performance for the past five years rather than the standard three.

Put these factors together, and you get this crazy result. Because the performance fee is based on a larger asset size than the funds currently have, the performance-fee penalty is larger than all of the fees on the fund—not just the management fee. In addition, the key period of the funds’ underperformance was in the third quarter of 2008, so the performance penalty may well be around for a while. The funds are volatile enough that it’s possible they could have an equally extreme quarter of outperformance that would wipe out the performance penalty.

Ben Graham’s Cigar Butt
Now to the crux of the challenge for investors: The reason for the big performance penalties is that the fund has terrible five-year returns, so even if you get its services for free, is it a good investments? I don’t actually know if Ben Graham would have liked these funds, but they certainly seem like the sort of attractive cigar butt he liked. On the other hand, he didn’t pick stocks with the momentum-influenced style that Bridgeway employs.

Micro-Cap Limited actually has outperformed since it was launched in 1998, so if it reverts to form only with no expenses, you’d have a very nice relative performance. Most micro-cap funds charge 1.50% or more, though the three other micro-cap funds in the Morningstar 500 charge between 0.5% and 1.5%.

Look Elsewhere for Transparency
You could make an index-fund style case that even if manager John Montgomery merely manages to not subtract value, you’d still come out ahead after costs. The Bridgeway funds are kind of tough to own because they don’t disclose much about their strategies. In fact, we removed two other Bridgeway funds from our picks list because they were making some changes to their strategies in light of poor performance, and Micro-Cap Limited is also making some tweaks. Yet the proposition is different when there are no fees or even cash back as the hurdle rate becomes zero and merely requires that management not subtract value. If the funds should enjoy a great spurt that wipes out the performance penalty, you’d be in even better shape for having beaten the benchmark by something on the order of 1,000 basis points.

It will be interesting to see if investors respond to the bargain and buy the funds. Micro-Cap Limited has $23.5 million in assets today, and in the past it closed when assets hit $27 million. Thus, in more ways than one, this may be a limited-time opportunity.

[With small-cap stocks leading the rally, Richard Lehmann’s two suggested bargain plays on North American small fry are looking better by the day. Also last month, Dan Weiner recommended a red-hot small-cap fund—Editor.]

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