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Why Long/Short Funds Hit a Rough Patch

Nadia Papagiannis, CFA

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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So you had still some pretty big macro headwinds and didn't know exactly where we'd fall. In fact, during the summer, you had a little scare that we were going to double dip into another recession. So, that seems to be off the table as far as a big nasty correction and double dip, but there are still a lot of macro headwinds that we're dealing with.

Papagiannis: So 2011 is a better year you think?

Lamensdorf: Should be. If the correlations don't pick up like they were in '08 and 2010, which I don't think they will because a lot of those macro drivers are more well known now, that it will provide a better backdrop for long/short strategy such as ours.

Papagiannis: But even if equity market rallies in 2011, are long/short funds expected to keep pace with equity market rallies?

Lamensdorf: Long/short strategies, in general, tend not to. Main underlying premise behind a long/short strategy is preservation of capital. You're trying to protect capital. So, in down markets, you should protect capital, not go down as much as long-only managers. In big up markets, you're also not going to keep up because you always have shorts on, which reduce volatility and add protection, but in big up markets or big bull markets, it drags you down so that's harder to keep up with the underlying equity markets.

Papagiannis: Cost of protection.

Lamensdorf: It's a cost of protection. So, over time, up markets, down markets, hopefully, you can keep up with the equity markets actually with less volatility, but in any given time period, if you have a big bull market three years in a row where the markets are up 25% in a row, long/short strategies are not to design to keep up with that.

What they are designed to do is, hopefully, protect you. So, when the markets were down in '08 big 37%, for instance, we were down about 10%. So we're able to give you a lot of protection, so we don't need to capture as much of the upside to generate as good returns or higher over time.

Papagiannis: So the goal of these funds is to outperform over a longer period of time, and in fact, your fund over the last three years has returned a positive 3.5% relative to a 2% to 3% decline in S&P 500 and also other long/short funds. So what sets you apart, what sets your fund apart from other long/short funds?

Lamensdorf: My background is just from an absolute return environment. My background is all from the long/short equity hedge fund side. So, in that environment, you are much more concerned with preservation of capital, risk mitigation, and then trying to generate strong risk-adjusted returns as opposed to competing with the S&P for any six-month timeframe.

That helped out a lot. We moved into a different environment in '08 where there's a lot of uncertainty, lot of volatility, the economy started to ratchet down a significant way, lot of risk to the whole financial system. The main thing to understand is risk management and that we'll always aim to protect capital and preserve capital, even at the risk that maybe the market bounces on us a little bit, but it's insurance to take off that tail risk.

That's exactly what happened in '08. At one point, we were over 50% net long, and then we got down to almost a market neutral type of posture for about four weeks, and that protected capital. But we didn't stay in that position too long. The market became really oversold. Companies started to trade at very cheap valuations. Then they started pre-announcing earnings for the fourth quarter. Then we moved back to more of a 30% net long type of exposure, where we normally are. It was where we typically – we've been in that mid 30s range for most of the last two years.

Another aspect where I think we differentiate ourselves from some of the other competitors is the ability to generate alpha, meaning our longs outperforming our shorts. That's a needed thing with any long/short strategy. You think about 2009, for instance. The market was up 26%. We averaged about 35% net long. If we didn't generate any alpha, we would have been up about 8% or 9% or about 35% of the return of the S&P.

We were up over 18%. The added extra 1,000 basis points is from the longs outperforming our shorts and generating that alpha. Each year we've been able to generate that alpha. Last year we didn't generate an alpha, and basically our return was in line with our net exposure to the market, and we talked earlier about why the macro environment made it more difficult on the long/short side.