Thurman Smith, editor of Equity Fund Outlook, says a mutual fund that mimics long/short hedge funds’ strategies has been posting impressive returns.

TFS Market Neutral (TFSMX) is showing remarkable ability to counter the downside. If the market continues down, this fund could be a way to hold values, yet be in place with long positions to at least keep up with the market at the outset of the next turnaround.

At this long/short fund, the charter is to seek capital appreciation with low market correlation and lower volatility than would result from a long-only investment in the US equity market.

Over its 2.9 years, it returned 15.5%, annualized, vs. only 3.0% for the market. It gained 8.8% since the October high, a period in which the market declined 18.8%. “Market-neutral” means that a fund won’t move in step with the market because management balances a “long” portfolio with a “short” portfolio. However, TFS Market Neutral holds $3.00 in long positions for every $2.00 in short positions.

So, it is not surprising to see that in a rising market the fund rises, too. That structuring may not be strictly market-neutral, but since the market spends more time rising than falling, this deviation from purity is quite useful: It declined more than the market only once, in the July 20th- August 16th 2007 dip, a time when many other long/short operators were forced to liquidate positions.

Management informs me that they have refined their process to be less susceptible to what other players may be doing. Two pluses are that it keeps each short position well below 1% of assets (to help protect against blowups), and that the Richmond, Va.-based TFS principals have a large share of their own money in the fund.

Two reservations are that the approach leads to significant sector bets, which is unusual in a market-neutral fund, and that for both long and short positions, management leans heavily on small-cap and micro-cap stocks. High portfolio turnover has not generated much in the way of distributions, so the fund appears safe for taxable accounts.

TFS Market Neutral might be useful for any account willing to exchange only market returns in rising periods for controlled declines in market dips, and is OK with holding for six months to avoid a 2% redemption fee. Think of this choice as a way to at least keep up with the market when it turns around without taking on full market risk during a declining period.

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