Q:  What differentiates you from your peers?

A: I think we are unique primarily because of our investment process. Unlike many of our peers, our process is quantitative and objective which requires a unique skill set to build and execute it. Quantitative skills are a must, however, we also have to be patient and persistent because every trading strategy must be thoroughly evaluated qualitatively and then tested using historical market data before it will be implemented. Upon implementation, discipline is the key to avoid emotional trading decisions that can erode profits.

We also have high ethical standards in terms of how we manage our business, and we align our personal interests with those of our investors. For example, all of the owners of our firm are required to put at least 50% of their liquid net assets into the funds that we manage. Currently, the three founders of TFS actually have over 100% of their personal liquid assets invested with clients. The founders have invested borrowed money and this speaks both to our confidence and our incentive to add value.

In addition, we have voluntarily taken other steps to minimize conflicts of interest and to fulfill our fiduciary duty to shareholders. Specifically, we appointed a board of directors for the mutual fund with a majority of independent members, the owners and portfolio managers are restricted from trading in personal accounts and we have never engaged in soft dollar arrangements with brokerage firms.

Lastly, we do believe that our size is a competitive advantage. We are small and nimble and intend to stay that way by closing funds long before we have exhausted the capacity of our trading strategies.

Q:  What is your investment philosophy?

A: We believe that the best investment decisions are those made objectively with the help of carefully constructed quantitative models. We believe this process will eliminate emotional decision-making and will best capitalize on market inefficiencies. In addition, we think the capital markets are dynamic and therefore a commitment to ongoing research and development is vital to long-term success in this industry.

Another part of our philosophy is that we are risk averse. Most of our funds incorporate hedging techniques in an effort to reduce risk. In the case of the TFS Market Neutral Fund, its long positions are hedged by selling a different portfolio of securities short. We believe that hedged products are attractive because of their potential to produce capital appreciation in all market conditions, to lower volatility, and to reduce correlation to other traditional investment classes.

Q:  Why is it important to have market neutrality in the fund?

A: There are two ways that you can make money in the stock market. One is through general exposure to the stock market, or Beta, and the other is through superior stock selection, or Alpha. Funds with a high Beta, that move in tandem with the overall equity market, are readily available. Unfortunately, they also don’t add much value, or diversification benefit, to most portfolios. Our goal was to create a fund where the majority of the return was in the form of Alpha and that also had a low correlation to other equity investments. To achieve this, we had to greatly reduce the Beta exposure. In doing so, we believed we would create a product that would complement the more common high Beta funds and thereby smooth the portfolio growth curve of the average investor.

It’s worth emphasizing that the fund uses a static hedge, meaning that we don’t intend to alter our exposure to the market based on our expectations of the market’s overall performance. There are other long-short funds which, will increase their long exposure or reduce their short exposure in an effort to boost returns. We don’t do that because we believe a static hedge results in more predictable performance across all market conditions and less volatility. We manage the fund to have a slightly positive beta to the market.

Q:  What are the key elements of your investment strategy?

A: Our investment strategy is based Our investment strategy is based upon bottom-up quantitative models (factor models) that are built using variables that have historically been predictive of future stock performance. The process is very scientific in that we first perform qualitative research on a potential trading strategy. Then, we build historical data that can be used to run a trading simulation on a given model. In other words, we go back in time to simulate how a model would have performed. Though we are quantitative, the variables that drive our models are generally fundamental. We have looked at things such as management changes, earnings quality, and institutional ownership just to name a few. If we can determine through testing that we can produce alpha, then a new variable will enter into our trading logic for both the long and the short side. It’s a dynamic process and we are always validating the existing models and attempting to improve them.

Q:  Is your investment approach different for the long and the short side?

A: No, we use the same approach for the long and the short side. We read academic studies, journals and articles. We act as scientists and develop a hypothesis of what may, or may not, drive future stock performance. We collect and analyze that data, we challenge the hypothesis and come to a conclusion where we validate or reject the hypothesis.

For instance, it’s commonly considered a bullish strategy if a company announces a buyback of its stock shares. We can obtain historical data on all the times that a company has announced a buyback, model it, and try to see if that company has outperformed the market in the first week after its announcement, the first month, the first quarter, the first year, etc. We try to assess the commonly accepted wisdom that that it is a bullish signal. But do the numbers really validate that? As it turns out, we have not been able to validate that strategy. In this case, it seems that conventional wisdom was wrong.

Q:  What are the different factor models that you research?

A: Over the years, we’ve evaluated dozens of potential systems. A few that come to mind are the buyback strategy mentioned above, management changes, insider trading activity, seasonality, and various earnings related systems such as earnings momentum and quality.

Q:  How do you go about a situation where there is not enough coverage of the stock?

A: If we are constrained by the data such as is the case on some micro cap companies, we will try to alleviate that constraint by finding other sources of data. If data is simply not available then we just have to exclude the company from our back tests.