1. To the attention of potential investors / partners
DLSS - the absolute return strategy
May, 2010 HFT @ EM
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.
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3. EM is a source of not only Alpha but high Beta also
MSCI EM Free Index vs
MSCI World Free Index,
1988 - 2009
1. High potential for EM equities
MSCI BRIC Index vs
growth is combined with risk of
MSCI EM Free Index,
significant losses. Buy & Hold
1995 - 2009
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.
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3
4. EM stocks tend to stay volatile during relatively quiet times
Between ‘LB’ and ‘Greece’ RTSI formed several waves with a magnitude 10-20%
top
RTS Index
top
top top
top top
bottom
bottom bottom
bottom bottom
Signs show local price extremes – optimal
bottom points for market position changes
2009 October November December January February 2010
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.
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5. Active Long-Short 1: Beta can be converted into Alpha
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
Russian equity market is a volatility champion can be converted into
advantage by development and
1000
RTSI usage of financial products
% Ultimate profitability KOSPI implying short selling of assets
BOVESPA in falling market conditions.
MSCI EMF
MEXBOL
BUX 2. Ultimate profitability (UP, %
S&P500 per year) is a theoretical
concept measuring upside limit
for returns from active asset
management (buying and short
selling with no leverage).
100
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
Systemic shift, days
Buy & Hold strategy.
10
-10d' -8d' -6d' -4d' -2d' 0 +2d' +4d' +6d' +8d' +10d'
5
6. Active Long-Short 2: Profitability depends on Frequency
Ultimate profitability dependence on frequency
100 000 1. UP is a characteristic of a particular
market / instrument (rather than that of a
Average annual ultimate
strategy or a manager’s investment style).
profitability, % The figure leftwards describes Russian
equity market as a whole (index).
2. This theoretical curve, however, doesn’t
10 000 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
-1.7281
y = 270293x frequency of trading;
2
R = 0.9975 (C) The market liquidity or number of
1 000
contracts/lots tradable within certain
period of time, - it quickly falls on smaller
time frames.
Minimal distance between price 3. For more details on the Ultimate
tops & bottoms, % of price Profitability concept and its implications
100 for an investing in the EM see the thesis
0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% “Market ultimate profitability”, Аlexei
Kazakov and Мaria Plotnikova, proceedings
Minimal distance between price tops & bottoms (as % of price) of ”Econophysics, New Economics and
serves as a variable determining the scale of market process Complexity – ENEC 2010” international
consideration and - indirectly - the frequency of trading. conference.
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7. Back-testing of DLSS on RTS Index future - 1
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 Period RTSI RTSI DLSS DLSS
August'05 13% 11%
Profitable trades 40.9%
Largest loss, % of Net Profit 0.80% 4Q2005 28% 90%
Largest consec.loss, % of Net Profit 1.39% 1Q2006 27% 119%
Ratio avg. win/avg. loss 2.26
2Q2006 4% 132%
Profit factor 1.56
Sharpe Ratio 3.03 3Q2006 4% 50%
Return Retracement Ratio 290.4 4Q2006 23% 70% 27% 868%
K-Ratio 8.50
1Q2007 1% 72%
2Q2007 (2%) 14%
In the context of this presentation DLSS is an 3Q2007 9% 23%
algorithm intensively tested on RTSI and RTSI 4Q2007 11% 20% 8% 160%
futures canned and live data. While the best
1Q2008 (10%) 19%
results (the biggest return and the smallest
drawdown) are registered on tiny time frames – 2Q2008 12% 7%
which is in full accordance with figure on previous 3Q2008 (47%) 115%
slide – the final version is approved for work on 4Q2008 (48%) (72%) 300% 993%
bigger time frames – to ensure there is sufficient 1Q2009 9% 75%
market liquidity to reverse $1 mn position in less 2Q2009 43% 79%
than a minute. Some of the results are shown
3Q2009 27% 49%
above and on the right. As a rule of thumb, the
bigger portfolio – the more decent results are 4Q2009 15% 129% 14% 427%
achievable with DLSS (though they are still much 1Q2010 9% 52%
better than just Buy&Hold approach can produce).
… Apr-May'10 (5%) 80%
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8. Back-testing of DLSS on RTS Index future - 2
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).
10000 4
Relative performance
1000 3
RTSI DLSS
100 2
10 1
Strategy / lefthand semilog. scale
RTSI, normalised / righthand scale
1 0
03.08.2005
21.10.2005
18.01.2006
05.04.2006
23.06.2006
30.08.2006
09.11.2006
29.01.2007
26.04.2007
16.07.2007
28.09.2007
11.12.2007
28.02.2008
21.05.2008
07.07.2008
15.08.2008
01.10.2008
17.11.2008
26.12.2008
18.02.2009
06.04.2009
20.05.2009
02.07.2009
14.08.2009
23.09.2009
02.11.2009
11.12.2009
02.02.2010
22.03.2010
04.05.2010
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9. 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).
Industrial breakdown of some ETF replicating the structures of MSCI national indices
NYSE Financial Industrial Consumer Telecommu Consumer Business
ETF ticker Service Materials Goods nication Hardware Energy Service Utilities 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-exJapan EPP 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
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.
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11. Markets (in)Efficiency Ranking Procedure
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.
4
Rank
Markets
3
prospective markets
to use the algorithmic
2 long-short strategies*
1
Efficient **
0
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
-1
Inefficient **
-2
-3
* estimate
** according to the original ranking methodology
-4
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12. Three levels of Investment Process
* Key know-how elements
Macro-Risks
Assessment Portfolio of Selected
Instruments & Strategies
Evaluation
Results
- Macro Themes / Risks
Identification / Diversification
Asset Price Algorithmic Text
Model Strategy
I
Choice of Strategies
& Instruments
- Market Price Model for - Selected Strategies
Certain Types of Assets* Intensive Back-Testing*
Instruments Instruments Access Strategy I
Pre-selection Selection to the Markets Implementation
- Credit Quality - Evaluation of the - Market Data Collection - Asset Allocation
Market Efficiency Test* & Research
- Strategy Running*
- Market Cap & Liquidity
- Global / Local Broker
- Evaluation of Strategy - Results & Contribution
- Ultimate Profitability* Back-Testing Results - Time Zones issues Analysis; Reporting
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13. Fund manager – key facts
Alexei Kazakov, PhD
20+ years in macro-economics
15+ years in market research
7+ years in portfolio design & management
e-mail: alexei.e.kazakov@gmail.ru
Public profile at LinkedIn: http://ru.linkedin.com/in/alexeikazakov
14. 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.
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