Non-Humans Beat High-Priced Fund Managers

BOSTON ( TheStreet) -- What's the best way to excise emotions -- fear, greed -- when choosing to buy or sell stocks or other securities? For starters, get rid of humans and let computers take over.

That type of investing, used by so-called quantitative hedge funds, received a black eye after Goldman Sachs ( GS) said it was shuttering its once-esteemed Global Alpha quantitative hedge fund for poor performance.

Ever since, investors have been wondering if the computer-driven stock-picking model can't hack it in the wildly volatile stock market of late. But there's no evidence of that, as quantitative funds' average 0.64% return this year through August has outperformed the S&P 500 Index of the largest U.S. stocks, which is down 2.9%.

Quant funds can invest in a wide range of securitities or commodities, but they're typically rapid-fire traders. They tend to do well in the small-cap sector; hence their assets under management remain relatively small.

Quantitative hedge funds held about $560 billion in assets at the end of the second quarter, an increase of $52 billion since the start of the year, with inflows making up about $29 billion of that, according to Hedge Fund Research.

Joe Mezrich, head of quantitative research at Nomura Securities, said "quants are actually doing better than fundamental investors. There is a perception that quants have lost it, but it's actually not true. The returns are decent."

The Goldman Sachs situation, which includes the winding down of the once $12 billion Global Alpha fund, coincident with the so-called retirement of the head of the firm's quantitative strategies group, may have prompted that perception. "I would say the Goldman episode is an isolated example" unique to that firm, said Mezrich.

An example of a successful "quant shop" is TFS Capital of West Chester, Pa. It has built a series of proprietary quantitative models designed to exploit market inefficiencies and uses them to manage two mutual funds and two hedge funds.

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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Entegris ( ENTG), the largest fund holding at 1% of total assets, makes products for the handling and transport of critical, sensitive materials used in the manufacture of semiconductors and hard-disk drives. Its earnings are tied closely to the health of the largest computer chip makers.

Entegris shares are up 3% this year, and 64% over the past 12 months, giving it a market value of $1 billion. It has an average annual return of 12% over the past three years.


Lender Processing Services ( LPS), the second-largest fund holding at 0.7%, is the leading mortgage processor with 50% of the market for residential mortgages by dollar volume. Most of the nation's biggest banks with mortgage divisions are its customers.

Its services cover virtually every stage of the mortgage lending process, from origination through default and foreclosure.

Its shares are down 45% this year, and 50% over the past 12 months, giving it a market value of $1.4 billion. It has an average annual loss of 22% over the past three years.

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Dice Holdings ( DHX) is an employment-services firm specializing in Internet job boards, mainly for the financial-services and health-care industries, through its Dice.com, eFinancialCareers.com and AllHealthcareJobs.com Web sites.

It earns a fee from job postings and had about 4 million visitors to its Web site last year. Given that both financial services and health care are slow right now, Dice has looked to expand its offerings into technology- and government-job postings.

Its shares are down 30% this year, but up 38% over the past 12 months, giving it a market valuation of $670 million. Over the past three years it has an average annual return of 13%.


Cash America International ( CSH) owns nearly 450 pawnshops under various names in the U.S. and Europe. The stores lend money on the security of pledged goods, which makes it look like a good play in a recession.

Its shares are up 65% this year, and 88% over the past 12 months, giving it a market value of $1.8 billion. Its shares have an average annual return of 10% over five years.

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Helix Energy Solutions ( HLX) provides underwater construction, maintenance and salvage services to the offshore natural gas and oil industry in the Gulf of Mexico.

This company's shares could rocket if the government decides to expedite the permitting process for new projects in the Gulf. It slowed the process due to an environmental review of oil production there after the BP ( BP) oil spill in April 2010.

It works on offshore infrastructure construction projects involving pipelines, production platforms and subsea production systems.

The company's shares are up 35% this year and 62% over the past 12 months, giving it a market value of $1.8 billion. But over the past five years, its shares have declined 15%, on average, annually.
Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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