HFT @ EM

To the attention of potential investors

/ partners

May, 2010

DLSS - the absolute return strategy

2

Resume

1. The problem. Y2008 stimulated a new search of attractive investments with adequately controlled credit and market risk. Many pension funds, charities and family offices worldwide

need more stable and higher returns. Some EMs, including Russia, evidence clear lack of such financial products at their local markets. This back-ground forms the demand for an Absolute Return strategies.

2. The solution. The Directional Long-Short Strategy (DLSS) is seen as a way of translating high equities volatility into an additional source of alpha. The Ultimate Profitability studies show that many EM, starting with Russia, are the most promising objects to

apply DLSS. Inefficiency Ranking procedure helps to reveal trading instruments which are the most

suitable for algorithmic trading.

3. The investment objectives. Investment objectives are: (1) to protect investors’

capital, (2) to achieve quarterly positive returns, (3) to provide positive extra-returns in the periods of the market downside volatility. Should these goals are achieved the product

can become the best in its class.

4. The investment process. Significant amount of research made in advance ensures the success. Multi-level investment process is used to make the market research findings to work. The distinctive feature is the intensive back-testing of fully automated strategies based on the original asset price model. As the DLSS implies high trading turnover, the major focus in operations is on the costs control. Starting with one strategy and one market, the project is aimed at a diversified portfolio of markets and strategies.

5. Fund manager – key facts. PhD with

20+ years in macro-economics, 15 years in the market research & strategy, 7 years in portfolio design & management, 2

years in management of UCITS III compliant fund. Regularly outperformed benchmarks in traditional

long-only multi-asset portfolios.

3

EM is a source of not only Alpha but high Beta also

3

MSCI EM Free Index vsMSCI World Free Index,

1988 - 2009

MSCI BRIC Index vsMSCI EM Free Index,

1995 - 2009

1. High potential for EM equities growth is combined with risk of significant losses. Buy & Hold strategy doesn’t provide reliable results and isn’t a solution for some types of investors.

2. National securities markets are highly correlated. Diversification within a given emerging market doesn’t help much in a crisis.

3. In a critical test the bonds do not offer 100% defense of capital at the falling market. Asset allocation approach isn’t a good-

for-all-time solution.

EM stocks tend to stay volatile during relatively quiet times

4

RTS Index

Signs show local price extremes – optimal points for market position changes

20102009 October November December January February

bottom

bottom

bottom

bottombottom

bottom

top

toptop

top

toptop

Each of these waves can be seen as a mini-bubble or mini-crisis (not necessarily economic one). In average there are 5-7 waves with a magnitude 15+ %

on Russian equity market annually.

Every year emerging markets universe becomes a birthplace for up to several dozens mini-crisis, depending on the definition. While some investors are ready to endure this EM characteristic (perceiving it as a country /

equity risk), the others may try to use this high volatility to make profits.

Between ‘LB’ and ‘Greece’ RTSI formed several waves with a magnitude 10-20%

Active Long-Short 1: Beta can be converted into Alpha

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Ultimate annual profitability,% for selected EM and US equity markets (in this diagram minimal distance between tops and bottoms equals 15%; Y1999-2004) 1. The inconvenience of

investing in volatile markets can be converted into advantage by development and usage of financial products implying short selling of assets in falling market conditions.

2.

Ultimate profitability (UP, % per year) is a theoretical concept measuring upside limit for returns from active asset management (buying and short selling with no leverage).

3. The total effect resulting from

the active short selling at the falling market is sizably bigger for the EM rather than for the DM, for instance for the US market,

both in the inter-

market comparisons (see the graph)

and in comparison with Buy & Hold strategy.

Russian equity market is a volatility champion

10

100

1000

-10d' -8d' -6d' -4d' -2d' 0 +2d' +4d' +6d' +8d' +10d'

RTSIKOSPIBOVESPAMSCI EMFMEXBOLBUXS&P500

%

Systemic shift, days

Ultimate profitability

Ultimate annual profitability,% for selected EM and US equity markets (in this diagram minimal distance between tops and bottoms equals 15%; Y1999-2004) 1. The inconvenience of

investing in volatile markets can be converted into advantage by development and usage of financial products implying short selling of assets in falling market conditions.

2.

Ultimate profitability (UP, % per year) is a theoretical concept measuring upside limit for returns from active asset management (buying and short selling with no leverage).

3. The total effect resulting from

the active short selling at the falling market is sizably bigger for the EM rather than for the DM, for instance for the US market,

both in the inter-

market comparisons (see the graph)

and in comparison with Buy & Hold strategy.

Russian equity market is a volatility champion

Active Long-Short 2: Profitability depends on Frequency

6

y = 270293x-1.7281

R2 = 0.9975

100

1 000

10 000

100 000

0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0%

Minimal distance between price tops & bottoms, % of price

Average annual ultimate profitability, %

Ultimate profitability dependence on frequency1. UP is a characteristic of a particular market / instrument (rather than that of a strategy or a manager’s investment style). The figure leftwards describes Russian equity market as a whole (index).

2. This theoretical curve, however, doesn’t discount many important practical things:(A) Principal difficulty of tops and bottoms real-time identification;(B) Trading costs which become more and more limiting factor with an increase in frequency of trading; (C) The market liquidity or number of contracts/lots tradable within certain period of time, -

it quickly falls on smaller time frames.

3. For more details on the Ultimate Profitability concept and its implications for an investing in the EM

see the thesis “Market ultimate

profitability”,

Аlexei

Kazakov

and

Мaria Plotnikova, proceedings of ”Econophysics, New Economics and Complexity –

ENEC 2010”

international conference.

Minimal distance between price tops & bottoms (as % of price) serves as a variable determining the scale of market process consideration and - indirectly - the frequency of trading.

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Back-testing of DLSS on RTS Index future - 1

…

7

The Directional Long-Short Strategy (DLSS) is a common name for a group of similar strategies basing on an original asset price model and implying taking long and short exposures in turn

at times when the price behaviour meets certain conditions. The strategies may vary in details depending on the time frame and size of portfolio they are designed for. Leverage and optimization aren’t used to maximize the investment results within particular periods or market states.

Strategy Analysis

Profitable trades 40.9%Largest loss, % of Net Profit 0.80%Largest consec.loss, % of Net Profit 1.39%Ratio avg. win/avg. loss 2.26Profit factor 1.56Sharpe Ratio 3.03Return Retracement Ratio 290.4K-Ratio 8.50

In the context of this presentation DLSS is an algorithm intensively tested on RTSI and RTSI futures canned and live data. While the best results (the biggest return and the smallest drawdown) are registered on tiny time frames –

which is in full accordance with figure on previous slide –

the final version is approved for work on bigger time frames –

to ensure there is sufficient market liquidity to reverse $1 mn position in less than a minute. Some of the results are shown above and on the right. As a rule of thumb, the bigger portfolio –

the more decent results are achievable with DLSS (though they are still much better than just Buy&Hold

approach can produce).

Period RTSI RTSI DLSS DLSSAugust'05 13% 11%4Q2005 28% 90%1Q2006 27% 119%2Q2006 4% 132%3Q2006 4% 50%4Q2006 23% 70% 27% 868%1Q2007 1% 72%2Q2007 (2%) 14%3Q2007 9% 23%4Q2007 11% 20% 8% 160%

1Q2008 (10%) 19%2Q2008 12% 7%3Q2008 (47%) 115%4Q2008 (48%) (72%) 300% 993%1Q2009 9% 75%2Q2009 43% 79%3Q2009 27% 49%4Q2009 15% 129% 14% 427%1Q2010 9% 52%Apr-May'10 (5%) 80%

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Back-testing of DLSS on RTS Index future - 2

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Historically, according to automated back-testing, $1 invested in the DLSS on August,3 2005 could bring $5490 by May,7 2010,

which means average annual return of 510%, CAGR during 4.76 years (full reinvestment, no tax & fees deductions, trading costs are discounted).

Relative performance

1

10

100

1000

10000

03.0

8.20

05

21.1

0.20

05

18.0

1.20

06

05.0

4.20

06

23.0

6.20

06

30.0

8.20

06

09.1

1.20

06

29.0

1.20

07

26.0

4.20

07

16.0

7.20

07

28.0

9.20

07

11.1

2.20

07

28.0

2.20

08

21.0

5.20

08

07.0

7.20

08

15.0

8.20

08

01.1

0.20

08

17.1

1.20

08

26.1

2.20

08

18.0

2.20

09

06.0

4.20

09

20.0

5.20

09

02.0

7.20

09

14.0

8.20

09

23.0

9.20

09

02.1

1.20

09

11.1

2.20

09

02.0

2.20

10

22.0

3.20

10

04.0

5.20

10

0

1

2

3

4

Strategy / lefthand semilog. scale

RTSI, normalised / righthand scale

DLSSRTSI

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Emerging markets-1: opportunities for country risks & investment stories diversification and higher liquidity

The bottleneck of the DLSS is the inverse relationship of the strategy returns and market liquidity.

One of possible ways to maintain high returns along with growing AuM is the inclusion of other markets liquid instruments in the portfolio. While index futures are used to get exposure to Russian equity market, index ETFs

may occur the most convenient instruments in many other cases (should the naked shorts are not under ban).

The structures of national stock markets/indexes reflects disequilibrium

of EM economic development. For a fund manager this situation provides an opportunity to play different

industrial stories at different phases of economic cycle and/or to compose a well-diversified portfolio with more stable performance.

Such diversification involves a lot of research and organizational work so within DLSS project it can be seen as the next stage of development.

Industrial breakdown of some ETF replicating the structures of MSCI national indices

ETFNYSE ticker

Financial Service

Industrial Materials

Consumer Goods

Telecommunication Hardware Energy

Consumer Service Utilities

Business Service

Emarkets EEM 24.13% 18.40% 4.63% 10.75% 12.31% 13.08% 2.81% 3.69%EAFE EFA 24.71% 15.55% 17.08% 8.14%Pacific-exJapanEPP 33.41% 19.53% 4.38% 4.34% 5.00%HongKong EWH 57.98% 7.21% 4.64% 14.35% 12.38%SKorea EWY 18.13% 21.48% 16.85% 4.69% 22.35%Brazil EWZ 14.46% 25.35% 4.87% 27.56% 4.84%SAfrica EZA 26.15% 31.61% 12.22% 10.36%

Mexico EWW 10.94% 22.35% 13.82% 35.94% 8.09%

Malaysia EWM 22.31% 18.66% 15.73% 11.28% 8.39%

Singapore EWS 53.47% 10.40% 10.79% 14.36% 7.17%Taiwan EWT 15.81% 7.13% 21.76% 4.61% 45.30% 2.51% 1.18%

Russia - 6.20% 11.30% 1.50% 12.90% 65.00% 3.20%Source: http://moneycentral.msn.com 03.11.2009

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Emerging markets-2: China case

DLSS Return (before costs)

vs. Buy&Hold Return, September-December 2009, Shanghai Future Exchange

Copper Future +116%(B&H +23%) Zink Future +99%(B&H +43%)

Nat.Rubber Future +89% (B&H +34%) Aluminium Future +33% (B&H+15%)

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Markets (in)Efficiency Ranking Procedure

-4

-3

-2

-1

0

1

2

3

4

X1 X6 X11 X16 X21 X26 X31 X36 X41 X46 X51 X56 X61 X66 X71 X76 X81 X86 X91 X96 X101 X106 X111 X116 X121 X126 X131

MarketsRank

Inefficient **

Efficient **

* estimate** according to the original ranking methodology

prospective markets to use the algorithmic long-short strategies*

Any High Frequency trading, including DLSS, needs an intensively

tested systemic approach, rather than a genius discretional trader. For this consideration and to suit the DLSS the Market (in)Efficiency

Ranking Procedure is used to define the market instruments suitable to make pairs with an algorithmic strategies.

Three levels of Investment Process

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* Key know-how elements

- Evaluation of the Market Efficiency Test*

- Evaluation of Strategy Back-Testing Results

- Market Data Collection & Research

- Global / Local Broker

- Time Zones issues

- Asset Allocation

- Strategy Running*

- Results & Contribution Analysis; Reporting

Instruments Pre-selection

Instruments Selection

Access to the Markets

Strategy Implementation

- Credit Quality

- Market Cap & Liquidity

- Ultimate Profitability*

- Macro Themes / Risks Identification / Diversification

Macro-Risks Assessment

- Selected Strategies Intensive Back-Testing*

Asset Price Model

Algorithmic Strategy

- Market Price Model for Certain Types of Assets*

I

Portfolio of Selected Instruments & Strategies Results

Evaluation

Choice of Strategies & Instruments

Text

I

Fund manager –

key facts

20+ years in macro-economics

15+ years in market research

7+ years in portfolio design & management

Alexei Kazakov, PhD

e-mail: alexei.e.kazakov@gmail.ru

Public profile at LinkedIn: http://ru.linkedin.com/in/alexeikazakov

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Disclaimer

The material contained herein is directed only at persons or entities in any jurisdiction or country where such information and the use thereof is not contrary to local law or regulation.

The information is for the sole use of the addressee, who is believed to be

a professional investor. Some of the products or product types are not suitable for retail investors.

The information contained herein including any expression of opinion is for information purposes only and is given on the understanding that anyone who acts on it, or changes her/his opinion thereon, does so entirely at their own risk.

While author believes that the information is correct at the date of this document, no warranty or representation is given to this effect and no responsibility can be accepted to any intermediaries or end users for any action taken on the basis of the information.

You should not make any assumptions about the future solely on the basis of information presented here. Remember, please, that past performance is not a reliable indicator of future performance.

This presentation may not be reproduced in any part or form without the express permission of author. To the extent that it is passed on, care must be taken to ensure that this is in a form which accurately reflects the information presented here and that it complies with the laws and regulations of any jurisdiction in which it is used.