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Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Former Highflyer Could Rise Again

Stocks in this article: BRAGX VFINX

NEW YORK ( TheStreet) -- Before the financial crisis, Bridgeway Aggressive Investors 1 (BRAGX) posted a remarkable record. From the time the fund launched in 1994 until October 2007, Bridgeway returned 21.0% annually, outdoing its mid blend competitors by more than 7 percentage points, according to Morningstar.

Then the roof collapsed. In 2008, the fund lost 56.2% and trailed 98% of peers. For the next three years, the results continued to be subpar. What caused the trouble?

Bridgeway's Chief Investment Officer John Montgomery attributes the poor record partly to the unusual market environment that prevailed during the financial crisis. He says that the fund could do better now that the Bridgeway portfolio managers have made adjustments and markets are calming.

Montgomery could be onto something. In 2012, his fund regained its winning ways, returning 21.6% and outdoing 89% of peers.

Bridgeway's struggle to revive is hardly unique. In the turmoil of 2008, many stock-picking systems failed. Dissatisfied with the results, angry investors dumped active managers and shifted to index funds, which aim to track benchmarks such as the S&P 500. But in recent months, markets have stabilized. Like Bridgeway Aggressive, many active managers have begun outdoing the index funds. If the market environment remains relatively steady, then Bridgeway and other active funds may do better and present a compelling reason for investors to abandon index funds.

To find the best investments, Bridgeway uses computer models that consider a host of variables, including stock values and market momentum. Some of the models favor stocks that are trending upward and have low prices. Montgomery says that the models failed in 2008 because investors ignored valuations, selling stocks of all kinds at once. "When people get scared, they just want out of the market," he says. "They don't care whether one stock is more attractive than another."

Montgomery says that growth funds like Bridgeway Aggressive did particularly poorly. This may have occurred because big hedge funds were forced to liquidate portfolios that were heavy with growth stocks. Under normal circumstances, some of the best performers are growth stocks that surprise Wall Street, delivering earnings that surpass the consensus. But as hedge funds sold growth holdings in 2008, stocks with earnings surprises lagged shares that were not beating estimates.

Montgomery says that the poor performance of his fund is connected to a measure known as correlation. When the stocks in a group such as the S&P 500 all move in unison, then the correlation is said to be 1.0. When the stocks do not move in lockstep, the correlation is 0.0.

Montgomery says that his fund can do well during periods when the correlation of the S&P 500 is near its normal level of 0.2 to 0.3. In such an environment, investors tend to favor one stock over another based on valuations and other factors. But when investors panic and sell everything, the correlation can top 0.5.

"When the correlations become high, investors do not care about the differences between companies," Montgomery says.

In the past, correlation spikes only occurred once every decade or two. Correlations soared during market collapses in 1946 and 1987. Then as the financial crisis unfolded, a series of spikes came in rapid succession.

The first peak appeared as mortgage markets froze in November 2008. Other spikes were triggered by the Greek debt crisis in May 2010 and the euro crisis in August 2011. Since then, correlations have returned to 0.3.

Many active funds performed poorly during the correlation spikes. For an indication of how active funds fared relative to the benchmarks, consider the performance of Vanguard Index 500 (VFINX), the first index mutual fund to track the S&P 500. During the past 15 years, the Vanguard fund returned 4.4% annually, compared to a return of 4.5% for the overall large blend category, a group that includes mainly active funds. But in 2008, Vanguard Index 500 topped large blend funds by 0.8 percentage points. The index fund also outpaced the group during the spike periods of 2010, 2011, and the first half of 2012. Then in the second half of 2012, correlations dropped, and Vanguard returned 5.9%, trailing the overall group, which returned 6.5%.

What happens if some unforeseen events send the markets into another tailspin? Montgomery says that his fund could again trail the benchmark. But he says that the margin of the underperformance should be less because Bridgeway has made some adjustments. "We expect to do better in future spikes than in the past," he says.

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