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Non-Humans Beat High-Priced Fund Managers


Its $51 million TFS Small Cap Fund (TFSSX), a small-cap blend fund, has been having a tough time in the short run, losing 9.5% this year, but over three years it's up an average 8.4% a year, putting it in the top 3% of funds in its category in terms of performance. Over five years, it's in the top 1% as tracked by Morningstar, with an average annual return of 7.3%, versus the S&P 500's 0.3% gain.

TFS Small Cap's sister fund, the $1.8 billion TFS Market Neutral Fund (TFSMX), boasts a 6.7% average annual return over five years.

TFS Small Cap currently holds 428 stocks and has an annual turnover of a whopping 657%, according to Morningstar, meaning the fund has brand-new holdings about once every two months. Its top 10 stocks make up a mere 7% of the portfolio. Fund fees are a relatively high 1.78%.

By sector weighting, the fund is 22% industrials, 18% technology, 15% consumer cyclical, 12% health care and 11% financial services.

TFS funds' co-manager Yan Liu, who has a doctorate in economics and specializes in quantitative analysis and risk management, said in an interview that the current market volatility makes it harder for the computer models to identify good stocks because there is relatively little correlation between their real value as their share price performance is being swayed by the dramatic swings of the overall market.

But even if good stocks underperform in the short term, he says the computer models will eventually produce returns at their historic levels, of at least 6% to 7% annually over three to five years for TFS Small Cap. "Their performance is very consistent."

The small-cap fund depends on five separate computer models to crunch stock data, Liu said. For example, one examines financial statement data, another insider transactions, another share-buyback trends and one market-price imbalances, to name a few of the criteria.

Liu said the fund trades every day, throughout the day, because the models get updated constantly.

The top 10 stocks usually make up around 5% of the portfolio, but "it's very hard to tell why we hold a (particular) stock" as selection and buy-and-sell orders are driven solely by the computer models, he said. "So I cannot comment on individual stocks. We don't want too much human intervention."

Its selection process can result in what looks like some odd picks, at least to humans, as several recent purchases are of long-term underperformers with seemingly little chance of an immediate turnaround.

For example, the fund bought Lender Processing Services (LPS) within the past quarter. The company is one of the nation's largest processors of home-mortgage applications and foreclosures. Given that home sales are dormant and foreclosures aren't particularly lucrative, its growth prospects can't be good.

The fund also recently bought The Jones Group (JNY), an upscale clothing manufacturer and retailer that's the third-largest holding. Its stock performance is abysmal, with a loss of 39% this year, and an average annual loss of almost 17% over the past five years.

Here are five stocks that were either new acquisitions or top performers in the fund as of July 31:

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