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By Nadia Papagiannis, CFA | 01-12-2011 04:15 PM

Why Long/Short Funds Hit a Rough Patch

Increased correlations made it difficult for long/short funds to make money in 2010, according to Jonathan Lamensdorf, portfolio manager of Highland Long/Short Equity.

Securities mentioned in this video
HEOAX Highland Long/Short Equity A

Nadia Papagiannis: Hello. My name is Nadia Papagiannis, Alternative Investment Strategist here at Morningstar. Today, I have with me Jonathan Lamensdorf, Portfolio Manager of the Highland Long/Short Equity Fund, ticker symbol HEOAX.

Jonathan, thanks for visiting us today.

Jonathan Lamensdorf: Thank you for inviting me.

Papagiannis: Jonathan, in 2010 the average long/short fund gained less than 5% relative to the S&P's 15% claim. Why do you think 2010 was a challenging year for long/short funds and what is the outlook for 2011?

Lamensdorf: 2010, the macro environment caused the correlations between stocks to be extremely high. Normally the correlations between stocks run in the 40% or 50% range. In 2008 as well as 2010 the correlations moved as high as 80%. What that makes it hard for a long/short strategy is to make money between your longs outperforming your shorts.

So, it was more of a macro-driven environment as opposed to a stock pickers' environment, which makes it hard for a long/short strategy to generate the needed alpha to make good returns.

Papagiannis: So in all stocks, when one stock was going up, all stocks were going up conversely?

Lamensdorf: Right. When they were going down, they were all going down. There was no differentiation between this company is a good company versus this company is a weak company, and that separates itself by the stock going up and one going down.

In fact, the market had so many corrections that one month anything that was cyclical and have weak fundamentals would go down, and then that would be the winner of the next month because everyone thought, "Hey, we're coming out of the recession."

Towards the end of the year, the correlations started to fall. So, by the end of the year, the correlations started to fall and it was easier to generate that spread between your longs and shorts.

Papagiannis: There was more disparity.

Lamensdorf: More disparity between individual companies, which has continued as we moved into this year, and hopefully, we'll be in a more normalized type of environment and will be a much better backdrop for long/short strategies going forward.

Papagiannis: Were there any other macroeconomic headwinds?

Lamensdorf: Sure. I mean we're still – '09 we didn't know if it was a Fed-induced rally, if we were really coming out the recession or not. So you still have the European sovereign debt issues which are still around, you still had China which is still around, as well as you had talking to company management teams, everything wasn't on solid footing as much.

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