Quantitative fund managers can be prickly sorts. Because so many of their strategies are hidden from view, it's easy to dismiss them when performance falters or crashes, like it did in 2007 to 2009. Managers can be sensitive to suggestions that their models are fallible.
But John Bogle Jr., manager of the Bogle Small Cap Growth Fund, is not like them. In many cases, he believes the criticisms levied at quants are valid. He is skeptical of back-testing, the much-touted practice for showing that a particular methodology worked well historically.
"Quant managers are very good at predicting the past," he says. And he thinks that quantitative investing got too popular in the last decade, so more money was chasing many of the same ideas that he had.
Bogle-yes, that Bogle, the son of Vanguard founder John "Jack" Bogle-has been through the investing version of a Category 5 hurricane. His strategy, which pairs earnings surprises, reasonable valuations and financial clarity, got smacked around for almost two years, and his investors abandoned him. From mid-2008 to late 2010, the fund was in tatters. Outflows equaled more than three-quarters of the fund's asset base.
"We had bad performance," Bogle concedes. "And as our performance declined, we lost business, and then we got into a death spiral of having to sell our positions to meet redemptions."
The results were not pretty. In 2007, the fund was down 5.6%, landing in the small-blend category's bottom 24%, according to Morningstar. In 2008, Bogle Small Cap Growth declined a staggering 48.2%, landing it in the group's cellar-dwelling 4%.
But over the last two years, Bogle has presided over a stunning turnaround. His fund is once again starting to show how well the models work. In 2009, the fund was up 45.7%, in the category's top 12%, and last year it was up 29%, landing in the group's top 16%.
What's more, inflows are starting to trickle in. November was the first month in more than two years where inflows outpaced outflows.
WHAT WENT WRONG
Bogle learned a few lessons along the way about investor psychology. Investors can be fickle, yanking out their investments right after a big loss and depositing them in frothy markets. Investor behavior is something of an obsession for the senior Bogle too. Namely, Bogle Sr. believes that seeking out active managers doesn't provide any competitive advantage.
The son has been in the family business for more than two decades. If his firm hasn't been as successful as his dad's, it's probably because quants haven't shaken their nerd image. "It's not a four-letter word," he insists.
Prior to launching his firm, Bogle ran the N/I Numeric Micro Cap Fund (the fund has since been dissolved), but he quit the fund shop abruptly in 1999 over a dispute with Numeric Investors' founder Langdon Wheeler. At his own shop in Newton, Mass., Bogle set to righting some of the problems he saw in the Numeric models he ran.
For much of the time that Bogle has managed his eponymous fund, he has managed to be in the top 25% of similar offerings. But his black box was no match for the bear market.
Much of the blame for the poor performance in 2007 and 2008 was due to the fact that quantitative models typically seek out stocks with reasonable valuations and good earnings growth prospects. In other words, both value and momentum characteristics.
In any other environment, that would be a winning combination, buying fast-growing companies selling on the cheap. However, during the bear market correlations converged so that all segments declined at the same time. There was no advantage to holding a stock with low price-to-sales ratios or several quarters of earnings surprises. The market simply didn't care.
A BETTER BLACK BOX
Bogle and his partner Keith Hartt, a quant veteran of Fidelity Investments, sift through 2,500 small-cap names. They are looking for stocks with three qualities. The first is a reasonable valuation based on price-to-sales and price-to-cash flows relative to its peer group. The next is earnings surprises or upward guidance. And the last is the quality of its financial reporting.
When Bogle and Hartt launched the firm in 1999, they were concerned about questionable accounting practices on the part of U.S. corporations. This was prior to the Enron debacle, which unraveled a whole decade's worth of accounting improprieties in U.S. businesses. But it was in the middle of the technology sector's astounding earnings leaps.
"In the mid-1990s, half of the firms would have positive earnings surprises and half would have earnings disappointments," Bogle says. "By the end of the decade, 80% of the firms were beating estimates. How could that be?"
They wanted to make sure that earnings were as accurate as possible, so they added this screen. They also give some weight to other metrics, such as firms actively buying back shares (a measure of value) and little to no short interest (hedge fund managers don't see long-term problems with the stock). "It adds a little at the margin," Bogle says.
The resulting portfolio is a collection of 150 to 175 names, which adhere to the sector weightings of the fund's benchmark, the Russell 2000. The individual names, however, are different.
The weighting of each name is a narrow band around one-sixth of a percent. Bogle and Hartt have equal convictions in all of their holdings. "There's not a huge amount of excess return from our No. 1 holding versus our number 150 holding," Bogle says.
Some managers are happy to talk about their holdings as if they were cherished children. Others guard the names in their portfolios like they might the secret recipe to Coca-Cola. Bogle's attitude is blasÃ©. "I don't want to get too attached to these stocks," he says. And that's for good reason. The average holding period of the fund is just eight months.
Coventry Health Care, a Bethesda, Md., managed healthcare company, posted estimate-beating financial results in the third quarter and is on pace to do so for the fourth quarter. Bogle also likes that the company has more cash on its balance sheet than other healthcare firms. The stock was up 8.7% last year.
Another favorite is R.R. Donnelly & Sons, the Chicago-based provider of print and related services. The company has conservative financial reporting, a very low valuation of 0.4 times price-to-sales and a 4.7 price-to-cash flow ratio. And the short interest in the stock is fairly low.
The firm has delivered earnings surprises too. "Its earnings trends are moderate," Bogle says. "But as a composite, it's an attractive stock." However, R.R. Donnelley was down 16.9% in 2010.
Then there's ReneSola, a Chinese-based maker of solar wafer technology. Positive earnings news and guidance drove the decision to add the stock to the portfolio. It was up 83% in 2010.
Another name in Bogle's portfolio is Kemet Corp., a Simpsonville, S.C., manufacturer of parts used in audio systems. The stock has a 0.7 times price-to-sales ratio, a seven times price-to-cash flow ratio and a 2.4 million share buyback program. Kemet returned an astounding 308% last year.
Bogle's black box paid off in 2009 and 2010. If he keeps this up, his father might have to change his opinion that managers can't beat the market.
Ilana Polyak is a regular contributor to Financial Planning.
John Bogle Jr.
Bogle Small Cap Growth
B.S., economics, computer science minor, Vanderbilt University; MBA, Vanderbilt University
Experience: President, Bogle Investment Management (1999-present); portfolio manager, Bogle Small Cap Growth (1999-present); managing director, Numeric Investors (1990-1999); vice president, State Street Bank (1983-1987)
Inception of fund: October 1999
Style: Small blend
Three-year performance as of Feb. 1, 2011: 3.1%
Five-year performance as of Feb. 1, 2011: -0.04%
Expense ratio: 1.35%
Front load: None
4.6% vs. S&P 500