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By Nadia Papagiannis, CFA | 01-03-2013 01:00 PM

Following the Smart Money to Alpha

TFS' Eric Newman, whose team earned Alternative Managers of the Year honors, says watching for insider signals mainly in small caps allowed their fund to pull in the best absolute return in its category in 2012.

Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I am the director of alternative fund research for Morningstar, and today I have with me Eric Newman, one of the portfolio managers for TFS Market Neutral Fund, ticker symbol TFSMX.

Eric, thank you being with us today.

Eric Newman: Thanks, Nadia.

Papagiannis: Your fund was nominated and won the first ever Alternative Fund Manager of the Year award. Congratulations.

Newman: Thanks.

Papagiannis: Eric, so your fund is a market-neutral fund. Could you briefly describe its strategy?

Newman: Sure. TFS Market Neutral fund is a quantitative fund. We take long positions and short positions. We maintain a constant ratio of those longs and shorts in the equity piece. So for every dollar in the fund, we have a $1 long and $0.67 short. So what that means is that we're not really trying to make money by timing the market and we're not trying to wake up one day and say, "Oh, we think the market is going to rise the next month, so let's change our ratio." We're really trying to make money on the spreads between those longs and shorts.

Papagiannis: And your fund concentrates on smaller-cap stocks?

Newman: Yes, we concentrate on smaller caps. That's not because we're experts in small caps, but that's because that's where we find the alpha, that's where we find the inefficiencies in the market. We run separate quantitative factors, and so, we have nine factors that are running in the fund right now. Many of those do have a long side and a short side which hedge each other. Some can be long-only or short-only.

Papagiannis: And what types of factors are you looking for?

Newman: We have three main categories, or buckets of factors. One of them is financial statement analysis. This is using data that's provided by the company, typically on a quarterly filing. These are things that fundamental managers would look at. So we could be looking at earnings, or quality of earnings, or assets and those types of things.

The second category is what we call, following the smart money or the smart people. This could be signals from management. So if you see all of the insiders are buying the stock of the company and they weren't doing that for the last five years, well, that means something. It could be an increase in dividend. It could also be informed traders and other asset classes. So, for example, you can look at the CDS market or the bond market. If there are changes there, an increase or decrease in price, does that signal that the equity is going to move?

The third category are imbalances in the market. So do you think there is going to be too much demand or not enough demand over a period of time? An example of that, people talked a lot just recently at the end of the year about tax-loss harvesting. So people who are selling positions not because they have any fundamental reason to do so, but because they want to lock in taxable gains or losses to offset gains. Those are inefficiencies we think we can find, we can back test them over a long period of time, and see if they are actually durable, if they actually have worked well for many, many years. And if so, we can put those in the fund.

We try to find these sort of separate types of models, separate nine models in the fund that have low correlation to each other. And then of course, we also want to have a low correlation and a low beta to the overall markets. The market is getting much more correlated. It's much harder to find to sort of stumble into low correlation. It used to be you could buy a small-cap fund, a large-cap fund, and an international fund, and they would have low correlation to each other. That's not really true anymore. And so, we think it's important to have strategies that are built from the ground up to have low correlation and that's what we try offer with our alternative funds.

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