TFS Market Neutral is beating the market with a fraction of the volatility. By Elizabeth Leary, Contributing Editor July 17, 2008 By and large, you're better off avoiding empty gimmickry of investments that overpromise, such as securities that guarantee they will never lose money (they usually don't make any, either) or funds that swear to double the market's gains (and that also happen to triple its losses).That said, TFS Market Neutral is an exception to the rule. That rare fund that has delivered precisely what it aspires to: market-beating returns with below-average volatility. From its inception in September 2004, through July 16, the fund, which invests primarily in small-company stocks, has gained 13% annualized, compared with 6% for the Russell 2000 small-company index. And it achieved those results with close to half of the index's volatility. TFS beat the index so easily because it did a better job of avoiding losses. Over the 34 rolling 12-month periods since the fund's inception (October 2004 through September 2005, November 2004 through October 2005, and so on), the Russell 2000 lost money in eight periods. TFS Market Neutral (symbol TFSMX) made money in all 34. The fund follows a straightforward long-short strategy. For every $3 invested long -- that is, betting on stocks going up -- the managers sell short $2 worth of stocks, betting that those stocks will lose value. Advertisement Computer models pick the stocks, but human creativity infuses the models. Co-founders Larry Eiben and twin brothers Kevin and Richard Gates, along with two other co-managers, rack their brains for "factors" currently driving stock performance. Management is hush-hush about these factors, but Eiben says that insider stock purchases might be a matter they consider. Team members back-test and refine factors, adding new ones to the computer and subtracting others as the mood of the stock market changes. "It's a never-ending battle for us," Eiben says. The research-intensive firm spends about $4 on research and development for every $1 it spends on executing investments and selling shares of its funds, he says. The result of all that labor is a wildly diversified fund with a heavy dose of tiny companies. At last report, TFS Market Neutral owned 671 stocks and had sold short 483 others. The fund trades frenetically, holding a position for less than three months, on average. Its complex investment process aside, it's tough not to love a fund that's up 6% year-to-date through July 16. That beats the Russell 2000 by 15 percentage points, Standard & Poor's 500-stock index by 20 points and the average long-short fund by nine points. Advertisement The biggest strike against TFS is its 2.48% expense ratio, which includes a hefty annual management fee of 2.25%. A point in the fund's favor is that all portfolio managers must invest at least 75% of their net worth in this fund or in TFS's other fund, a traditional small-cap offering. The managers say they will consider closing the fund to new investors once assets -- currently $271 million -- reach the $500-million to $700-million range.