Q:  What is the background of your company and the Long/Short Equity Fund? A : Highland Long/Short Equity Fund was launched in December 2006 as one of the specialty funds managed by Highland Capital Management, L.P. The fund has just reached its 3-year anniversary and has seen significant inflows in 2009 coming off strong performance in 2008. Additionally, we recently received our Morningstar rating of 4 stars. Q:  What are your investment objectives? A : Being a long/short equity mutual fund, we fall under the alternative investment umbrella. Our main objective is to deliver consistent, above-average total returns primarily through capital appreciation while also attempting to preserve capital and mitigate risk through hedging activities. Our secondary objective is to generate superior risk-adjusted returns compared to the equity markets over an entire market cycle. The funds overriding objective will always be capital preservation by aiming to protect the fund in down markets. We focus on mitigating risk through lower drawdowns in order to achieve returns that are less correlated and have lower volatility than the market. Q:  Would you illustrate this with some examples? A : In 2008, the S&P 500 Index was down 37% whereas our fund was down only 10.5%. And in calendar year 2009, the S&P 500 was up 26%, and our fund was up over 18%, capturing roughly 70% of the upside. This illustrates how our fund strategy is designed to generate solid risk-adjusted returns while mitigating losses on the downside. Thus, we attempt to stay protected on the downside, while capturing as much of the upside as we can. Q:  Could you explain how the long/short fund is different from the long-only fund? A : Long/short funds have been around for a while and they are mainly used by institutions and high net worth investors using hedge fund structures. On the retail side, this has been in vogue only for the last ten years and since many of these funds have been run by long-only managers, they have not fared particularly well. Most long/short funds in the retail space tend to run with relatively high net long exposure and that is primarily why they have not performed very well. Long/short is a strategy that involves both buying stocks, or going long, and shorting stocks. Unlike long-only mutual funds, long/short funds can use leverage, derivatives and short positions in an attempt to maximize returns and reduce risk regardless of market conditions. These types of funds are designed to generate a different risk/return profile than traditional equity and fixed income. When the markets are going down you might lose significantly in a long-only fund, whereas a long/short fund may give you better protection. By the same token, in strong uptrending markets, the long-only fund will normally outperform long/short funds as the shorts in the portfolio can act as a drag on performance. Q:  How do you translate your objectives to a strategy on the long and the short side? A : We always have short positions in the portfolio to create this type of risk return profile. This allows us to generate returns on our short positions in stocks if they go down and also gives the portfolio a cushion in down markets. Even though this may create a drag in an up market, it gives you better protection in a down market. The added short exposure also lowers the beta and the volatility of the portfolio compared to a traditional long-only mutual fund. We normally maintain a net long bias of between 20% and 60%, which can be changed if the situation calls for it. For instance, in 2008, when we started to see a lot of negative events occurring, we re-aligned the portfolio to roughly mimic a market neutral stance. This effectively allowed us to protect our capital in the third and fourth quarter of last year illustrating the flexibility that we have in this fund. Throughout 2009, on the other hand, the fund was on average about 40% net long. Q:  When do you use leverage and what is the maximum limit for that? A : As of the end of December 31, 2009, we were not using leverage. We look at our overall gross exposure, which typically ranges from 90% to 160%. Gross exposure is a calculation that adds your long exposure plus your short exposure, and shows how much of your balance sheet is at work. When the volatility in the market is relatively high, we use less gross exposure, to maintain the level of risk exposure we are comfortable with for the fund. The maximum net long position would be 100% net long, and the maximum gross exposure would be 200%. But again, we typically are between 20% and 60% net long. Q:  How do you select your positions in the portfolio? A : We look to construct the best risk adjusted portfolio over the entire capitalization spectrum in both value and growth stocks. We do not structure the portfolio along a specific index. On the long side, we generate potential ideas using value, growth, and technical screens. We also read industry publications, attend industry conferences, meet with management teams, and follow the current news and data flow for our positions and the market in general. From there, we dig deeper and look at the particular company’s valuation, growth prospects, underlying business model, industry dynamics and the recent trends in the business. If the company warrants further research, we then typically build our earnings and cash flow models and make further dynamic evaluations. We also talk to third party consultants, suppliers, competitors, and customers to get a third party view of the company. In this way, we try to find situations where we believe our view about the company’s prospects are different than the consensus. Ideally, if we find a growth company with a solid business model, strong barriers to entry, high incremental margins, strong secular tailwinds and are able to develop a variant view vs. the consensus, we would acquire it on the long side. On the short side, it is just the reverse. Some of the items we look for include companies that we believe might be at peak margins, companies whose estimates appear to be too aggressive in our opinion, companies where we believe the current growth rates are unsustainable, or where there are discrepancies between a company’s earnings growth and cash flow growth. If we find these types of characteristics in a company, we will look to potentially short the stock. Q:  Would you provide some examples? A : We are long a wireless communication tower company. They own wireless towers and rent space on the towers to wireless telecommunications companies like Verizon and AT&T to hoist their network equipment. Because of the tremendous growth in wireless data, the secular demand for space on these towers is very strong and that adds to the tailwind of the company’s growth. Additionally, zoning restrictions act as a formidable barrier of entry because of the limited spaces that are zoned for wireless towers. As a result, the wireless telecommunications companies are willing to sign long-term contracts with 3% to 5% annual price escalators and the cost of switching to another carrier is also prohibitive. This gives a lot of visibility to the revenue growth of a tower company. We also like the fact that their capital expenditures are miniscule, as they really only have to maintain the tower, which is just a large steel structure. Another compelling point to the investment is that the tower companies have very high incremental margins. In the case of the towers, roughly 85% of every new dollar in revenue falls to the bottom line. Lastly, the land on which the towers are constructed is very small, so that even a hefty increase in property tax would not affect their growth profile. On the short side, I can give you an example without getting too specific. When a company in the business services space showed a sudden spurt in earnings due to the transition from analog to digital television format, Wall Street analysts increased their long-term growth projections for the company. We had a different view and believed that this was a temporary phenomenon and that growth expectations had become too optimistic. We decided to short the stock with the thesis that earnings projections were too aggressive. Q:  How do you build your portfolio? A : We have about 60 to 100 positions with 40 to 50 positions on the long side and the balance on the short side. The portfolio is structured in such a way that a majority of our returns are usually generated by our longs outperforming our shorts, creating alpha, and the rest of the return is being generated through the beta of being net long the market. We are not thematic investors, so we do not try to determine where the macro-economy is headed and make investment decisions based on those views. Instead, we tend to be bottom-up stock pickers. We pick the stocks that we think are going to go up and short the stocks that we think are going to go down. We also pay attention to how much exposure we have in different sectors. So, if we get too net long in a sector, we try to change that either by reducing our longs in that sector or by putting on shorts in that sector to balance the exposure. Q:  What is your benchmark index? A : Even though we do not manage according to a benchmark in the traditional way a mutual fund manager would, we benchmark ourselves against the S&P 500 Index for comparison. However, because we are not a long-only equity fund, returns vs. the S&P 500 is only one aspect to consider when analyzing the fund. The second aspect to consider is the risk used to achieve those returns. We analyze the fund’s risk metrics vs. the benchmark by measuring the beta, standard deviation, drawdowns, and volatility. Q:  Do you have any market cap limitations? A : We do not have any limitations but in general, the majority of our portfolio is in the mid-cap area. We have investments in companies with market caps as small as $230 million to as high as $193 billion. As of December 31, 2009, 17% of our portfolio is invested in stocks with over $10B in market cap, 50% in companies with market caps between $2B and $10B, and the balance, 33%, is invested in small cap companies with market caps below $2B. Although we do have some positions under $1 billion, they make up a limited amount of the overall portfolio. Q:  How do you try to control or mitigate risks at the portfolio level? A : One of the advantages of running a long/short fund is that we typically always have a significant amount of short exposure, which inherently lowers the downside risk. As a result, we have less systemic risk than a traditional mutual fund. We also are very conscious of how net long we are on a beta adjusted basis, which would mean the more net long we are, the more market risk we have and vice versa. However, we can and do adjust our overall net long exposure one way or the other, but the adjustments are typically not large moves unless the environment changes dramatically. On the short side, we tend to have a tighter leash on our positions that are going against us than we do on the long side. With long positions, you can only lose 100%, but on shorts, you can lose multiples of one’s investment. We just don’t let the short positions run against us indefinitely. We have to have concrete catalysts on the short side, to better determine when an investment idea is proven right or wrong. We try to avoid having one or two short positions really hurt us in a significant way.