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Iridian Opportunity Fund – 2nd Quarter 2010 Letter

Where are we?

It was three years ago in June-July of 2007 that the wheels began to come off the wagon of the US
economy. The Bear Stearns mortgage funds were shut down, and Countrywide Financial CEO Angelo
Mozilo confirmed on an earnings conference call that the residential real estate problem extended well
beyond subprime mortgages. The following month, macro funds hit a wall as they were forced to
deleverage. The equity market stumbled in July and August, rose to new highs in the fall of 2007, and
then entered a bear market of epic proportions. We have subsequently witnessed a truly awful 2008,
harkening back to the Great Depression, a major recovery in the market in the seven month period from
March 2009 through September 2009 (also reminiscent of the Great Depression), and a flat, range-bound
market since then.1 The resulting tally is an S&P 500 down more than 30%, not including dividends, over
the 36 months ending June 30, 2010.

Performance as of 6/30/10 1 year 2 years 3 years 5 years 10 years

S&P 500 cumulative

12.1% -19.5% -31.4% -13.5% -29.1%
returns before income

S&P 500 cumulative

14.4% -15.6% -26.6% -3.9% -14.8%
returns including income

S&P 500 annualized

18.78% 34.75% 30.70% 24.65% 21.98%
volatility

2
Opportunity Fund
cumulative returns, net of 1.1% 11.0% 28.9% 74.7% N/A
all fees and expenses

Opportunity Fund
6.0% 8.0% 8.2% 7.7% N/A
annualized volatility

Over the past 10 years, neither the S&P 500 nor any other equity market of a developed economy has
been a good investment. Of course market timing, that is the path, can make a difference for returns, but
the last three years has certainly demonstrated that not many investors can do this well, and over a ten
year period we suspect the record is not reassuring. As the chart above shows, what also matters
significantly is yield. We will return to this point later in this letter.

1
It has been a wide range of about 190 S&P points, but from October 1, 2009 to the end of June 2010 the S&P was essentially
unchanged, not including dividends.
2
Past performance is not a guarantee of future results. Please see final page for additional information on performance and
disclosures. 

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Asset Management LLC

The Opportunity Fund was up 1.4% in the second quarter net of fees and expenses. We are pleased that
we have made absolute returns on both our short and long book over the life of the Fund, are uncorrelated
to the S&P, and have generated our returns with 1/3 the volatility of the S&P. Currently we are running
the portfolio with a gross investment of about 175%, and we have positioned the portfolio to be
directionally unexposed to the market. Given the massive economic crosscurrents (Ben Bernanke’s
“unusual uncertainty”) we do not think it would be prudent to make a bet on the direction of the market.
We will stick to stock picking, even in this environment of high correlations.

We have consistently apportioned our letters among three lines of thought—a brief summary of the
macroeconomic picture, a presentation of a theme and/or stocks, and increasingly, the impact of micro
market dynamics, the action of the market itself, divorced from underlying economic fundamentals. We
hope that our letters, along with a generous helping of portfolio data we make available to clients, have
informed you with regard to those developments that bear upon the way in which we manage your money.
In this letter, we once again intend to follow this pattern. However, this time we have included a
significantly greater discussion on micro-market dynamics.

As evidenced by the May 6 meltdown, micro-market dynamics have become increasingly important to
understanding risk and to investing for return. There are several reasons why this is the case. First, over
short periods of time market moves have become increasingly dominated by the action of the market
itself, and not by company fundamentals. This may sound like circular logic, but there is a self-reinforcing
tendency of the market that is at work, which tends to accentuate short term moves. Second, the way in
which this exercise is carried out—one prominent example is high frequency trading—has created an
opportunity for those market players who engage in high frequency trading to extract a hidden tax on the
equity transactions of others, under the guise of providing liquidity. Furthermore, not only is there an
economic tax at issue, but as a result of the hyper-vigilance required to discern stock price movements
driven predominantly by market dynamics from those caused by fundamentals, the short term volatility
generated by such dynamics exerts a significant emotional tax on even the most mature fundamental
investor. As a result, when transacting, we need to be especially disciplined with respect to price limits
and stock valuation. Third, there is a growing chasm between the price action of both individual stocks
and the market over short periods of time, as influenced by players who have no knowledge or interest in
economic fundamentals, and the longer-term price action of stocks and markets as influenced by
underlying economic fundamentals. This dichotomy must impact return expectations. We will explore
each of these points in detail in the second half of this letter.

Macroeconomic recap

The best way to think about the macroeconomic environment we find ourselves in is to use the metaphor
of an earthquake. We are experiencing the aftershocks of a worldwide banking crisis that first struck in
2008. We highlighted this in our previous letter and it is the reason why we remained cautious throughout
2009.

Massive private losses in the Western economies have been socialized, leading to a sovereign debt crisis
throughout the Western economies. Here in the US, there is a debate between those who believe it is
imperative to drive growth with fiscal and monetary stimulus and those who hold that the line on budget
deficits must be drawn now. It is difficult to see how any meaningful fiscal stimulus will be possible in
the current political environment leading up to the election, but in his recent testimony before Congress,

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Federal Reserve Chairman Bernanke assured the audience that interest rates would remain low for quite
some time and that the Fed stood ready to react should the economy weaken.

In May and June, the equity markets seemed to be reflecting the concern that the United States, Western
Europe, and Chinese economies were all on shaky ground. The Chinese were trying to slow their red hot
economy and this was reflected in an equity market that had experienced in excess of a 20% bear market
decline. Western Europe was right in the middle of its sovereign debt storm, with the gloom there
reflected in markets that were down from the start of the year anywhere from the high single digits to
nearly 30%. And as the macroeconomic data in the United States weakened, the S&P 500 traded down
16% from its high and at one point was down over 8% for the year. Even so, the US seemed the place to
be as the dollar continued to strengthen and there was significant demand for Treasuries.

The narrative coming into July was around the probability of a double dip recession here in the United
States. A downward revision in first quarter GDP, a decline in the leading economic indicators, various
historically low levels of housing activity, a rollover in the ISM monthly survey, an unexpectedly weak
jobs report, soft consumer spending numbers, and an ECRI reading that was heading towards recession
levels all indicated that the US economic recovery did not seem to be self-sustaining. What we know is
that this “recovery” is historically weak, and that the macroeconomic data over the last three months
suggests that the recovery seems to be petering out. Whether we actually experience a negative GDP
reading sometime in the next three quarters or simply pass through a soft patch characterized by 1-2%
GDP growth, it is not going to feel good.

Notwithstanding the poor macroeconomic news, in the last two weeks we seem to be undergoing another
wrenching shift in sentiment—this one lifting the market—driven, it seems, by better news out of Europe
and good earnings here in the United States. A very public break at the meeting of the G-20 nations
between a US administration pushing for fiscal stimulus and its European allies espousing fiscal
constraint seems to have propped up the euro and provided a boost to European sentiment, at least out of
the UK and Germany. This has driven European equity markets higher, removed the specter of a systemic
event for the time being, and propelled the S&P higher. The risk trade is on again for the time being with
an 8% move in the S&P in 17 days. Only time will tell whether the deteriorating macroeconomic
environment in the United States will once again cast a pall over the market, whipsawing investors yet
again.

The chart below, taken from one of economist David Rosenberg’s daily letters, shows graphically just
how violent this whipsawing has been in 2010. There have been eight market moves this year of more
than 5% up or 5% down, typically within a matter of days or weeks. This is more than a choppy market.
From our viewpoint, it is a market spinning wildly out of control, and this instability has significant
implications for future market return expectations as well as our management of assets within such a
market.

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Asset Management LLC

Yield as a Theme

We often write about themes, and in addition to current themes including fruit, coffee, data mining, the
rush to 4G, telecommunications regulation, and the revolution in electronic payments, we have a theme of
a different sort to share with our clients. We have sought to take advantage of a unique environment
characterized by a low interest rate environment and spasms of elevated volatility, a rather rare
combination since one would not necessarily expect to have a low price of money coincide with great
volatility. To do so we have focused on yield. This has been achieved by using options in buy-write and
put-write strategies, by purchasing longs that conform to our catalyst driven approach and have above
average yields, by lending out long positions, and by avoiding shorts with above average dividends.

Following are three examples of the above. We are long TeeKay Offshore (ticker symbol TOO). TOO is
the largest owner of crude oil shuttle tankers in the world, with in excess of 50% of the world’s shuttle
tanker capacity. Shuttle tankers act in a taxi-like fashion, gathering crude oil from offshore production
platforms that are not linked to land by undersea pipelines. Shuttle tankers typically operate in deep water
environments, quite often of a harsh nature such as the North Sea, and more recently in offshore Brazil. In
addition, TOO has a growing fleet of Floating Production, Storage and Offloading vessels (FPSO’s),
crude oil floating storage units, and 11 Aframax-class crude oil tankers. As the name indicates, FPSO’s
enable production of crude oil, as well as storage and then offloading, more than likely, onto a shuttle
tanker.

TOO is a spinoff from TeeKay Corporation, in the form of a Master Limited Partnership (MLP), but has
chosen to be taxed as a corporation. TeeKay Corporation, through wholly owned and partially owned
entities, carries 10% of the world’s seaborne crude oil. As an MLP vehicle, TOO was established by
TeeKay Corporation to pay out its fixed stream, tax advantaged cash flows to investors. Beneficial tax
treatment of earnings assets at the TOO level allows TeeKay Corporation to “drop-down,” or sell assets
into TeeKay Offshore at prices that are accretive for TeeKay Offshore holders.

TOO offers investors both a yield and exciting growth prospects, and so returns can be a combination of
current yield expectations, increased distributions as the company adds assets, and an increase in the stock

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price reflecting a lower required yield on TOO’s prospects. On March 30, 2010, TOO stock was trading at
$19.92, and with a prospective $1.90 distribution going out twelve months, investors owning the stock
were staring at a 9.5% yield. The company has a stated goal of increasing distributions by at least 10% a
year. We believe this is conservative given the visibility that exists for drop-downs of assets from TeeKay
Corporation, and from growth opportunities in TOO’s various businesses. As for the former, there are
several FPSO’s that will be dropped into TOO over the next 36 months. As for the latter, TOO will be
taking delivery on four newly built shuttle tankers – two later this year and two in 2011. Furthermore, we
believe there are a growing number of opportunities in the FPSO market, aside from drop-downs.

Our second example is Textron, symbol TXT. We have been short Textron on and off for quite some time
now. Early on, our concerns were whether the finance subsidiary could sink the entire company. This
concern was compounded by the collapse of the business jet market, and the impact of that on Cessna. We
believe both concerns remain relevant catalysts, although we do not believe that the issues in the finance
subsidiary represent an existential threat.

We continue to believe that management is too aggressive in its guidance for Cessna deliveries, and in
general, the street is overly optimistic about a business jet recovery and business jet deliveries in 2011.
Furthermore, while the street reacted positively to the second quarter earnings release, the earnings beat
was not as great as the headline beat when adjusted for special items and a lower tax rate. On the earnings
conference call management was understandably cautious about business jet activity and noted that it saw
a slowing in June. In addition, management noted that the company’s industrial businesses will decline in
the second half of 2010 due to seasonality, and Bell’s operating margins will decline in the second half
because of mix. As a result, the guidance implies a second half earnings of $0.26 per share compared to a
consensus of $0.43.

We are short Textron at a cost in the low twenties. Originally we sold June $18 puts against the position
and collected $0.46 per share when they expired worthless, then sold July $18 puts against the position
and collected $0.49 per share when they expired worthless, and most recently sold August $17 puts
against the position at $0.84 per share and bought them back at $0.10 per share. We have collected $1.69
per share, or 8% on the current stock price over about three months, and additionally, we have a gain on
our average cost before taking into consideration the options proceeds.

Our third example is Clearwire, symbol CLWR. We occasionally have a chance to lend out our longs to
our prime broker, and we recently were able to do so on a portion of our Clearwire long position, initially
at a 15% rebate to us. We were happy to do so since there are no restrictions on our ability to transact in
the stock, and we continue to look for such opportunities.

The Hollow Market Revealed

Fifteen months ago, we coined the term “hollowed-out market” to describe what we believed was a
structurally unstable US equity market, where on the surface trading activity appears more or less normal,
but where in truth this activity only masks a profound absence of liquidity. We described five root causes
of this hollowing-out process in our April 2009 quarterly letter to investors – balance sheet deleveraging
throughout the private sector (firms and households), the death of securitization and the associated demise
of the shadow banking system, a betrayal of investors’ trust by both managers and regulators, misguided
regulatory/political responses here in the US and also in Europe, and the financial “innovations” of ETF’s,
dark liquidity pools, and trading algorithms – five root causes that we believe are just as relevant, just as
powerful, and just as destabilizing today as they were last April. In this quarterly letter we have much

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Asset Management LLC

more to say about the last of these five forces – the financial instruments, trading venues, and
programmatic trading strategies that have fundamentally altered what we call micro-market dynamics.
On May 6th we saw the hollow market revealed via the so-called “flash crash”, where liquidity throughout
US equity markets vanished in the time it takes to turn off a computer server running a high-frequency
trading algorithm.

S&P 500 Index, intraday chart, May 6, 2010

Source: Bloomberg

As we wrote to our investors that afternoon, we believe that it was the interaction of trading algorithms,
ETF’s, and decentralized venues that created the flash crash. Certainly the cause was not a “fat finger” or
a typo in a trade blotter, but neither is it correct to blame high-frequency trading in and of itself.
Here is what we wrote in the heat of the moment on May 6th:

Over the next few hours, you will read stories about a trading error at a major brokerage
firm “causing” this mini-crash. There are already stories about a $16 billion e-mini order
being placed in error. All of this may be true. We would argue, however, that these errors
or mistakes may be precipitating events, but they are a symptom, not a cause of the
temporary dislocation in US equity markets today between 2:30 and 3:00 pm.

We believe that the root cause of this dislocation was the interaction of three micro-market
factors that we have written about extensively in recent letters: high-frequency trading
(HFT) algorithms used by liquidity providers, buy-side trading algorithms used by major
institutional investors, and the rampant use of ETF instruments.

HFT algo’s work as a form of radar. Or maybe sonar is a better analogy. These liquidity
providers “ping” the quote depth with millions of indications of interest in order to identify
the fish (liquidity takers) at different depths in the water. Their goal is to hold exposure for
as short a period of time as possible, just long enough to unload that exposure to one of the
fish. These algo’s work best in a low volume and low volatility market that gently grinds
up.

HFT algo’s do not work at all when there are only sellers and no buyers, because there is
no one available for the algo to offload the exposure. But when there are no fish in the

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quote depth, the HFT algo’s just stop fishing. They simply turn off. As a result, all that
liquidity that everyone thinks exists in this hollow market simply vanishes.

Buy-side algo’s attempt to execute an order over a specified amount of time with a
specified price range, and they are evaluated on the basis of whether the execution price
was associated with appropriate liquidity. In other words, if the order is executed at the
volume-weighted average price over some period of time, then it is by definition a well-
executed order. That’s an over-simplification, to be sure, but there are only a handful of
variations on this general theme. The point is that when liquidity vanishes, these buy-side
algo’s can go nuts. Depending on how the parameters for executing the order were set,
they can continue to attempt to buy or sell regardless of the overall presence or lack of
liquidity.

ETF’s account for 30% of the dollar volume traded on US equity exchanges on any given
day. We believe that they dominate short-selling to a significantly greater degree. In fact,
my guess (and it’s only a guess) is that 80% of short positions are established with ETF’s.
If a hedge fund wants to get shorter immediately, the easiest way to do it is to use an ETF,
either by shorting a long ETF or going long a short ETF. All the better if you use a levered
ETF, which are terrible for buy-and-hold strategies but very effective for trading exposure
in a portfolio.

There are no liquidity constraints with short ETFs. Let me repeat that, with emphasis.
There. Are. No. Liquidity. Constraints. With. Short. ETFs. Unlike shorting an individual
stock, where you have to locate a borrow from your prime, I can go long as many shares of
a leveraged short ETF as I please. The executing broker, Goldman Sachs for example, then
turns around and shorts individual shares of the constituent stocks in the ETF (or buys puts
on the constituent stocks if they are selling me a levered short ETF, which results in the
options market maker shorting individual shares of the constituent stocks), and then
“redeems” those short shares at the end of the day with the ETF administrator to create the
ETF shares. The important point here is that market makers have an exemption from Reg
SHO, which requires a good locate on borrowed shares. So regardless of whether a borrow
actually exists, regardless of whether there is a real buyer for the shares being sold short,
massive shorting can take place through ETFs even in the absence of market liquidity.

Put these factors together and we think you have a coherent, structural explanation for
today’s dislocation. Either by accident or purposefully, a major sell order hits the market.
A large HFT algo sniffs this out and shuts down, cutting off a significant liquidity source.
As soon as one major HFT algo turns off, the others follow suit. Liquidity vanishes. But
the buy-side algo’s soldier on, some of them attempting to get execution regardless of
price. And everyone who is trying to get immediately shorter turns to ETF’s (or index puts,
which have exactly the same dynamic), which leads to naked short selling all the way
down the precipice.

What turned the market? If you ask me, the Plunge Protection Team lives on, but that’s an
email for another day.

The most important point to take from all this, however, is that we do not believe this
dislocation was a one-time event. So long as the micro-dynamics of the US equity market
are dominated by algo’s and ETF’s, we believe that the stage is set for a temporary but

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massive free fall at any point in time. All it takes is a triggering event … a liquidating
investment account, a corporate default, a Citi trading error, a Scud missile fired from
Lebanon, a Chinese banker saying the wrong thing about US Treasuries, a failed
Portuguese auction … the list goes on and on.

We have prepared our portfolio for a day like today, and it performed as we had hoped. We
also reacted quickly and, we believe, effectively, as the dislocation played out. Because we
do not believe this was a one-time event “caused” by a trading error, we maintain our
cautious portfolio position, and we remain vigilant for subsequent dislocations.

In this letter we intend to flesh out the observations made in the May 6th email and extend them to analyze
other, less extreme but no less important, changes in market dynamics. Not only do we believe that the
interaction of these now-dominant forms of equity trading can create the occasional flash crash, but we
also believe this interaction creates a pervasive tax or drag on investment returns. These pernicious
outcomes – one a rare but horrific event hitting the market as a whole, the other a mild but constant drain
on every individual trade within that market – are specific manifestations of the structural instability and
false liquidity that form a hollow market. At the conclusion of this letter we will discuss the specific
operational or tactical adjustments we are making to cope with this investment environment, as well as
why we believe that our investment strategy and process are well suited to generate absolute returns even
in (or perhaps especially in) a hollow market.

Hollow Market Outcome #1 – a constant, non-trivial chance of severe market dislocation

On May 10th, we had the opportunity to speak with the Chief Operating Officer of NYSE Euronext, Larry
Leibowitz. This was the day before he testified before the House Financial Services Committee on the
May 6th debacle.3 Leibowitz’s analysis for us and subsequent testimony to Congress included some rather
technical concepts such as Liquidity Refreshment Points (LRP’s) and order protection rules under Reg
NMS. But his fundamental assessment of the problem was amazingly blunt and completely non-technical:
“The markets are broken.”

What does it mean when the Chief Operating Officer of the NYSE says that this is a broken market? What
does it mean when he says that it is a hard sell to convince corporations of the benefits of issuing
publicly-traded stock? At its most basic level, it means that the prices of securities bear little or no
relationship to the fundamental economic reality of the corporations that issue those securities. It means
that price discovery, which is the fundamental goal of the open bid/ask system of a public exchange, is no
longer meaningful on terms that make sense to an investor whose decisions are based on fundamental
economic reality. It means that the US equity market is no longer an effective capital market, where
shares of stock represent an ownership interest in an economic entity with cash flows and assets, but is
more accurately conceptualized as a casino, where shares of stock are simply placeholders for money –
chips, if you will – representing nothing more than themselves.

All liquidity providers, whether it is a high-frequency trading (HFT) algorithm on Tradebot or a human
specialist at the NYSE, think of shares of stock as if they are chips at a casino. Their ostensible goal is to
make markets, to grease the wheels of investing, to hold either side of a trade only long enough to find a
fundamentally-oriented buyer or seller (a liquidity taker) on the other side of the trade. They are the
middleman, and their reward is the bid/ask spread. In a properly functioning capital market, liquidity

3
Leibowitz’s full statement can be found at: http://www.house.gov/apps/list/hearing/financialsvcs_dem/leibowitz_5.11.10.pdf

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providers should provide a minority share of overall market participation. Otherwise they are simply
churning stock from one middleman to another, which is ultimately a negative-sum game.

Today, however, HFT algorithms alone typically account for 60% of the dollar volume traded daily in US
markets. Institutional investors who would generally be considered liquidity takers are behaving more and
more like liquidity providers, as they increasingly adopt algorithmic trading strategies. ETF’s – which are
widely used by almost all market participants, even those who think of themselves as old-school
investors, and account for 30% or more of daily trading activity – are by their nature and construction one
or more steps removed from the classical capital markets definition of stock (i.e., fractional ownership of
a corporate entity) and so naturally lend themselves to a casino-style trading orientation. At times it feels
as if the entire market is one big game of roulette!

In the next section of this letter (Hollow Market Outcome #2 – a Tobin tax) we will explore how this vast
proliferation of liquidity providers can possibly generate enough profits to go around, especially as the
traditional source of liquidity provision profits – the bid/ask spread – has narrowed enormously in recent
years. Here we will examine the impact of this imbalance between liquidity provision and liquidity taking
on overall market stability.

In a properly functioning capital market, the more market participants the better. That is, a large number
of independent price-seekers, each with an exogenously-derived opinion regarding the intrinsic value of
the security in question, inexorably generates greater stability in price discovery behavior across the
market as a whole. This is the magic of the Invisible Hand. There is intriguing evidence, however, that the
exact opposite is true if market participants are neither independent nor interested in intrinsic value … in
other words, if they are liquidity providers rather than liquidity takers. Evidence to this effect comes from
the world of complex systems, of chaos and fractal theory, and it is here that we now turn.

Almost any modern network, regardless of its nature or field of application, is a complex system. Being a
complex system is not the same thing as being a complicated system, as “complexity” in this technical
sense refers to the stability or robustness of the system to various shocks and inputs. One critical element
in determining the stability of a complex system, whether we are talking about financial markets or
telecommunications networks or parliamentary elections, is the degree to which behaviors within the
system are “self-similar”. By self-similar we mean fractal-like, or appearing the same at various levels of
magnification. Broccoli is highly self-similar, for example, as the appearance of the entire stalk is similar
to that of each individual floret and each individual piece of each individual floret. Internet messages
demonstrate a high level of self-similarity along such dimensions as burst rates and packet sizes, so that
the patterns observable over a period of a few seconds look very much like the patterns observable over a
period of a few minutes.

For our purposes, the primary issue with self-similarity, or with fractal-like behavior in general, is that it
is not governed by the stochastic rules we are familiar with and typically assume apply to any given
system, as exemplified by the normal distribution and its most common representation, the bell curve.4
For example, early research on Internet traffic found that these networks were increasingly unstable the

4
A stochastic process, sometimes called a random process, is a description of the probability or likelihood distribution
associated with the random elements of any system. For example, the likelihood of flipping a fair coin heads 5 times in a row is
best described by a binomial distribution, which is in turn extremely well approximated by a normal distribution. Without
accurately specifying the stochastic or random process that underpins any system, it is extremely difficult to make accurate
predictions regarding the likely outputs of that system.

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more “self-similar” the messages were.5 Ethernet administrators found that if they attempted to use
control mechanisms designed from a normal distribution on a network dominated by self-similar
messages, the control mechanism would inevitably fail and the network would collapse. Benoit
Mandelbrot spent the latter part of his illustrious career demonstrating just how dangerous the
misapplication of standard stochastic processes could be if the underlying phenomenon were
characterized by fractal-like behavior, with his most famous examples being, of course, misapplications in
financial markets.6 More recently, Nassim Taleb has taken up Mandelbrot’s crusade for more accurate
stochastic specification in works such as Fooled by Randomness (2001, 2005) and The Black Swan
(2007).

The central question, then, is whether liquidity provision creates self-similar or fractal-like patterns in
equity market trading. In early June, Reginald Smith posted a paper on the open repository arXiv.org
titled “Is High-Frequency Trading Inducing Changes in Market Microstructure and Dynamics”.7 In it, he
applies wavelet analysis – which is a technique to identify structural data patterns over short periods of
time that replicate themselves over longer periods of time (think of it as finding the same feedback loop
on different time scales) – to the price histories of twelve large cap US stocks (Bank of America,
Microsoft, Citigroup, Intel, Proctor & Gamble, Cisco, GE, Apple, ITT, Genzyme, Church & Dwight, and
Gilead Sciences) from January 2002 through May 2009. The typical measure of wavelet analysis is
something called the Hurst exponent. If the Hurst exponent is equal to 0.5 then there is no self-similarity
or fractal-ness present in the data series. The closer the Hurst exponent gets to 1.0 the greater the degree
of self-similarity.

All stocks examined by Smith demonstrated some degree of self-similarity; that is, they all generated a
Hurst exponent greater than 0.5. More interestingly, however, the two stocks that we know are targets of
HFT algorithms by virtue of their high volume – Citigroup and Bank of America – show both the highest
Hurst exponent as well as an increase in the Hurst exponent over a time frame that coincides exactly with
the increase in use of HFT algorithms. In the graph below,8 for example, showing the Hurst calculations
for Citi, the vertical black lines represent the promulgation of Reg NMS in June 2005 and the initial
implementation compliance deadline of June 2006. The degree of self-similarity in Citi trading takes on a
new and sharply steeper trajectory with the approval and implementation of Reg NMS, which is largely
considered to be the seminal deregulatory event for opening traditional market making venues to
algorithm-based liquidity providers.

5
Leland et al, “On the Self-Similar Nature of Ethernet Traffic (extended version),” IEEE/ACM Transactions on Networking,
1994, 2:1, 125-151.
6
Notably, The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward, by Benoît Mandelbrot and Richard L.
Hudson (Basic Books: 2004).
7
http://arxiv.org/PS_cache/arxiv/pdf/1006/1006.5490v1.pdf
8
Smith, op. cit., pg. 13 

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Citigroup average Hurst exponent by month as calculated by the wavelet coefficient method

But what does it mean to have a Hurst exponent of 0.62,9 as in the case of Citi above? What we can say
with a great deal of confidence is that trading in Citi does not follow the precepts of traditional economic
theory known collectively as the Efficient Market Hypothesis. In an efficient market, a la Bachelier,
Markowitz, Black and Scholes, Merton, Fama, Samuelson, etc., the Hurst exponent must be 0.5. This is
the null hypothesis for Smith’s experiment, and since the lower confidence boundary is well above the
null hypothesis result of 0.5, Smith can surely claim that something is amiss here. Moreover, whatever
that something might be certainly seems to be related to the growth in algorithmic trading.

To Mandelbrot, the higher the Hurst exponent, the more that “the game is rigged.”10 In its most simple
form, this is what it means to fail the Efficient Market Hypothesis. It means that daily price movements in
Citi are increasingly divorced from both fundamental economic news regarding Citi and the “random
walk” around those price movements that an efficient market requires and creates. To quote Mandelbrot
again, it means that “the price will roam far; its motion will be persistent, like a mule intent on heading in
its own direction no matter what the rider does.”11 Ultimately the price behavior of Citi will revert to the
mean from a stochastic or random point of view, and ultimately the price behavior of Citi will respond to
the fundamental real economic fortunes of the company (the rider of the mule, to use Mandelbrot’s
analogy). But the higher the Hurst exponent, the more Citi’s price behavior will cluster away from where
it “should”, and the longer these clusters will persist.

Unfortunately, not only are algorithmic trading and liquidity provision responsible for a greater and
greater percentage of overall market activity, but their activity is concentrated in a smaller and smaller
number of stocks … like Citi and BofA. The most recent Abel Noser market liquidity study found that in
June the top twenty most actively traded US stocks were responsible for 29% of ALL market activity

9
The solid line in the graph is the most likely estimate, and the dotted lines show a 95% confidence interval on either side of
the most likely result.
10
Mandelbrot and Hudson, op. cit., pg. 187.
11
Ibid. 

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across 18,500 stocks, and the top 99 most actively traded US stocks were responsible for more than 50%
of all trades.

Source: Abel Noser

Three of the top four most actively traded stocks were ETF’s (Apple being the lone single-name stock in
the bunch), and the SPY ETF alone was responsible for 10% of all stock trading. All of these
concentration measures are up month-over-month and year-over-year. This is an accelerating
phenomenon.

Stitching these observations together, then, it appears that we have a market where trading is increasingly
concentrated in a few stocks, and where that trading increasingly does not follow the expected patterns of
an efficient market – neither in the reaction of prices to fundamental real economic activity nor in the
pattern of price randomness around a central tendency. As a result, what we have described as a hollow
market can equally well be described as a concentrated market divorced from fundamentals, with fractal-
like (i.e., self-similar, non-normally distributed) behavior.

Put simply, systems marked by concentrated, fractal-like phenomena are never robust. They may appear
to be stable for a period of time, perhaps a long period of time, but they do not follow the “rules” of
normal stochastic processes and are always pushed into a severe disequilibrium by what always turns out
to be, in retrospect, a surprisingly small stimulus. The prototypical example for such unexpected
outcomes in chaotic systems is the flapping of a butterfly’s wings in the Amazon ultimately causing a
tornado in Texas. While financial markets are perhaps not quite so sensitive to minute inputs, there is no
doubt that modern markets are extremely complex (again, in the technical sense of the word, which is
quite a different thing from being complicated), and are highly prone to outcomes that end up being
shockingly out of proportion to the initial incidents, through a series of cascading events that mimic
nothing more closely than a cartoon snowball hurtling down a mountain and picking up mass with every
roll.12 Proposed regulatory measures such as coordinated circuit breakers across all trading venues are not

12
For more on this topic, see anything written or said by Nassim Taleb in the past year. Questions regarding complex systems
are also at the heart of almost anything written by Malcolm Gladwell. The concept of cascading failures has been explored
most fully in research concerning power grids (see, for example, Ian Dobson et al, “Complex systems analysis of series of
blackouts: Cascading failure, critical points, and self-organization,” Chaos, vol. 17, 026103, June 2007), and more recently 

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only of minor utility in the face of this sort of structural weakness, they may actually be worse than
useless if they provide an illusion of control and preclude efforts to address the underlying source of
structural fragility: liquidity provision dominance.

The May 6th flash crash was not a once-in-a-hundred-lifetimes event as would be predicted by a normal
distribution, because it is not governed by a normal distribution. But as with all stochastic processes,
normal or not, these underlying random governors are utterly silent on what specific events or patterns
may precede an unlikely or long-tail event. So we are left with what is in many respects the worst of all
worlds: a non-trivial yet minute chance of a massive market dislocation at any given point in time, with
zero visibility into the proximate cause of that dislocation. Welcome to the Age of Anxiety, courtesy of
the hollow market.

Hollow Market Outcome #2 – a Tobin tax

In 1972 the economist James Tobin suggested a tax on all foreign currency transactions in order to
cushion the shocks resulting from the abandonment of the Bretton Woods regime. Since then, the notion
of a “Tobin tax” has come to refer to any tax on financial transactions or trades. While there has been
much talk in Washington about applying an overt Tobin tax on financial transactions in order to limit risk-
taking and to generate additional government revenues, we believe that there is already a covert Tobin tax
embedded in every equity trade that we make. Unfortunately, the proceeds from this tax do not go to some
governmental agency where – perhaps – some portion of the tax may be spent to support public goods.
No, with this tax, the proceeds only line the pockets of erstwhile market makers employing the latest and
greatest HFT algorithms.

Once again, it is the interaction of liquidity providing algorithms and liquidity taking algorithms that
creates the potential for this private sector Tobin tax. But while one partner in this it-takes-two-to-tango
argument – the use of HFT algorithms on the sell-side – has received a great deal of recent public
attention, the other dance partner – trading algorithm use by institutional money managers – deserves
some additional explication. In our last quarterly letter we described some of the organizational pressures
that have made algorithmic trading a dominant trade execution process on the buy-side. First, cost-cutting
initiatives throughout the money management industry have led to shrinking head counts on trading
desks, requiring an increased use of algorithms to manage orders.13 Second, performance reviews of both
managers and traders, particularly at larger vanilla funds, increasingly include externally evaluated order
execution metrics as part of that review.14 Since an after-the-fact evaluation of order execution can only
look at the prices paid by other market participants over a similar time frame for the same security (that is,
the evaluation software cannot get inside the head of the trader or manager at the time of the trade to see
what actually transpired in the decision making process), a successful trade is – by definition – one which
matches what other market participants achieved. There is a very simple way for a manager or trader to
guarantee that he or she will achieve this goal: use a Volume Weighted Average Pricing (VWAP)
algorithm.

across a range of socioeconomic systems marked by complexity. For a review, see Duncan Watts in the Boston Globe, “Too
Complex to Exist,” June 10, 2009, as well as his writings for the Harvard Business Review and other publications.
13
For example, Bloomberg Business News article July 6th,, 2010, “Schonfeld to Fire 50 Traders as Speed Curbs Profits”.
14
There are now many third party service providers for trade execution analysis. The most widely known include Abel Noser,
ITG, and Elkins McSherry. 

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The Advanced Execution Services (AES) group at Credit Suisse is, by many metrics, one of the most
active venues for buy-side use of algorithmic trading strategies. In a July 12th report,15 AES notes that use
of algorithms by their clients increased 18% in Q1 2010 over Q1 2009. Of the nine algorithms offered by
Credit Suisse (all of which are some trade-off of time, price, and volume), the plain vanilla VWAP
algorithm saw, by far, the largest increase in usage, with more than 40% greater use in Q1 2010 over the
same time period a year earlier. As AES describes this trend:

VWAP: Old Faithful Back in Fashion? Although not the most sophisticated strategy,
VWAP still holds an important place in a trader’s arsenal, especially for long-short funds.
This is because VWAP maintains delta- and factor-neutrality throughout a trade, even in
volatile markets. The VWAP algo will match the execution rates between buys and sells,
resisting the urge of more sophisticated algos to increase participation as markets move
favorably, thereby avoiding undesirable exposures from one side completing faster than the
other side.

A VWAP order will never embarrass you with its execution, because it is incapable of creating
“undesirable exposures” (to use Credit Suisse’s understated phrase) if the market changes course from one
minute to the other. In another era, the adage was “no one ever got fired for buying IBM.” In today’s asset
management world, no one ever got fired for using VWAP. It is always defensible, and this quality is just
as true for a long-only mutual fund manager as for a long-short trader.

The problem with using a VWAP-based trading algorithm to achieve a liquidity taking exposure is that it
creates predictable and observable buying patterns in the market. These patterns are completely
transparent to a modern HFT algorithm. Moreover, the typical effort made to hide these patterns – which
is always some variation of chopping up a large order into smaller pieces and then injecting those pieces
into the market according to a schedule determined by a sub-algorithm16 – only creates another sub-
pattern or code that is in turn inevitably cracked by the HFT algorithm. If the processing power available
to crack these codes were limited to the human brain, then any of these chopping-up sub-algorithms
would be sufficient to hide the pattern created by a VWAP order or one of its time-delineated kin. But
with the processing power available to even the more modest HFT algorithms, there is no hope –
absolutely no hope – of creating any trading pattern that is somehow invisible or untraceable.

And it’s not just VWAP with this inherent, unavoidable vulnerability. All of these buy-side algorithms are
programmed to buy a certain amount of stock within a certain amount of time, with the pace of that
behavior throttled forwards and backwards by factors such as volume and price limits. These algorithms
are well-publicized and documented, so that they can easily be reverse-engineered. But even if they were
maintained in total secrecy, even if they were randomly chosen for application to a given order, their
action creates a pattern, and a modern HFT algorithm – backed by terabytes of historical data, connection
speeds measured in millionths of a second, and sheer computing power that is greater than that of all the
human brains that have ever lived on this planet – is essentially god-like in its ability to detect and predict
patterns.

So what does this mean? It means that liquidity providers are no longer limited to bid/ask spreads as their
source of profits. It means that market making activity can become the functional equivalent of front-

15
Credit Suisse Portfolio Strategy report, North America Market Commentary, July 12, 2010, “AES Analysis” by Ana
Avramovic and Phil Mackintosh, “A Tactic for All Times: Algo Usage Growing.”
16
As trading algorithms are adopted by the buy-side, orders are chopped into small lots in a futile attempt to “hide” investor
intentions. In 2004 the average number of shares bought in a single trade on the NYSE was almost 800. Today the average
number of shares is less than 300. Source: NYSE-Euronext, nyx.com 

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running, as limit-order books are no longer held in confidence by market specialists, but are revealed to
any and all liquidity providers with a decent HFT algorithm.

This is not a complicated game. If I am a market maker, I am getting paid to take either side of a trade.
But if I am an algorithmic, unregulated market maker I can throttle my rate of liquidity provision up or
down as I please, depending on the conditions I see, as well as my holding period and my net exposure. In
the same way that a proficient card-counter playing blackjack will increase his or her bets when the deck
has more face cards in it than usual, so will I increase my exposure (defined either by amount or time) if a
market in a particular security is stacked in my favor. So, for example, if I see by 10am that there is a
VWAP buyer of 800,000 Walmart shares that day but volume is lower than usual, I know that this buyer
is going to be forced to buy lots of Walmart shares in the late afternoon because that’s what VWAP
requires. To take advantage of this I am going to accumulate exposure late morning and early afternoon,
and then start bidding up Walmart stock at 3pm (preferably 1-cent increments on 100 share orders) until
the VWAP buyer hits his limit. At that point I unload all of the exposure I have accumulated during the
day. The VWAP buyer is happy because his order was filled at a fraction of a penny below his limit, and I
am very happy because I have been paid a little by the venue for all the liquidity I “provided” this buyer,
and I have been paid a lot by the buyer because I know his price limit and order size.

It has become all too predictable for low volume in any given day to be associated with a late-afternoon
melt-up of the market, which is exactly what one would expect if the practice described above were
rampant. In the chart below we see how the price declines of late June were accompanied by high volume
(the green curves on the lower register) while the price increases of early July were associated with low
volume (the red curves).

S&P 500 e-mini price and volume, June 20 – July 14, 2010
Source: Bloomberg, as reported on ZeroHedge

Lately there have been several published accounts of well-documented examples of this functional
equivalent of front-running. Southeastern Asset Management, a well-respected value investor managing
over $30 billion in assets, has written a particularly instructive and thorough analysis of their experience
in this regard.17 But these published accounts are all individual examples of this practice. Is there evidence

17
We really cannot recommend SAM’s letter to the SEC highly enough. The title is “Comments & Analysis on Equity Market
Structure, Presentation to the Securities and Exchange Commission”, dated June 8, 2010. Among other places, the full
document may be found at: http://www.scribd.com/doc/33337467/Southeastern-Asset-Management-Report-to-SEC
 

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of widespread anticipation of limit-orders so as to create a Tobin tax on equity trades more generally? We
submit the following as prima facie evidence, albeit circumstantial, of ubiquitous manipulation.
Bid/ask spreads have collapsed over past 17 years, first from the change from pricing in eighths of a
dollar to sixteenths and then to pennies, subsequently from increased competition for order execution
from competing venues.

Source: Chordia, Tarun, Richard Roll and Avanidhar Subrahmanyam, 2008, “Liquidity and Market Efficiency”, Journal of Financial
Economics 87:2, 256, as reported in “Equity Trading in the 21st Century,” James J. Angel, Lawrence E. Harris, and Chester S. Spatt for
Knight Capital Group, February 23, 2010.

This collapse in spreads has continued in more recent years, and has occurred across trading venues …

Source: Public Rule 605 Reports from Thomson, Market orders 100-9999 shares, as reported in “Equity Trading in the 21st Century,” James
J. Angel, Lawrence E. Harris, and Chester S. Spatt for Knight Capital Group, February 23, 2010.

and is particularly notable in large cap stocks with high volumes, so that today the median bid/ask spread
for a large cap stock is just slightly more than 1 cent per share.

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Source: Knight Capital Group, as reported in “Equity Trading in the 21st Century,” James J. Angel, Lawrence E. Harris, and Chester S.
Spatt for Knight Capital Group, February 23, 2010.

Overall volume, however, has not kept pace with the decline in spreads. While volume on the NYSE has
roughly tripled since the mid-1990’s, bid/ask spreads are only 1/10th what they were then. Even
accounting for the rise of alternative venues, total US equity share volume is only estimated to have
tripled over the last nine years, and has declined significantly from its peak in 2008.18

NYSE Volume Index, monthly January, 1990 – July, 2010

Source: Bloomberg

In a traditional market structure, the profit pie available to market makers is simply the volume of trades
multiplied by the spread on those trades. On this basis, it seems clear that the profit pie for market makers
today is significantly smaller than it was even a few years ago, much less back in the 1990’s when there
was a 12 cent per share median bid/ask spread on trades. How, then, to explain the dominance of liquidity
provision in today’s market, where HFT trading has grown from essentially nothing pre-Reg NMS to 60-
70% of market activity in the past 5 years? How is it possible that independent HFT trading firms such as
Tradebot and Getco suggest that it has been years since they have had an unprofitable trading day? How is
it possible that the trading desks at most major US banks reported – not just stellar profits in Q1 – but the
absence of any days with a trading loss in that quarter?
18
Barclays Capital Equity Research, as reported in “Equity Trading in the 21st Century,” James J. Angel, Lawrence E. Harris,
and Chester S. Spatt for Knight Capital Group, February 23, 2010, pg. 7.

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To be sure, part of the answer is that liquidity providers are paid for their services by the exchanges. It is,
after all, difficult for a market maker to lose money. But even if one takes into account the total sum of
liquidity rebates paid out by the exchanges (which are, at most, about ½ cent per share for a roundtrip
liquidity transaction), it is impossible to support a system where the majority of volume participation is
accounted for by liquidity providers, on rebates and bid/ask spreads alone. The only way such a system
can exist, much less thrive and grow on the back of apparently immense profitability, is if the minority of
participants – the liquidity takers – are somehow providing massive subsidies to the market makers away
from the bid/ask spreads. We submit that the only possible vector for this subsidy is a perversion of the
limit-order book.

Just to be clear, we are not claiming that there is anything illegal under our current laws with what market
makers are doing with their HFT algorithms. This is not front-running in the traditional sense of the word,
where market makers steal (in the traditional sense of that word, too) information regarding the buying
intentions of market participants. But in a very real sense, this is stealing all the same. At the very least it
is the equivalent of trading on inside information. That this inside information was uncovered through the
use of pattern-recognition algorithms operating in broad daylight rather than through a human informant
operating secretly in the dark should not make a difference in the eyes of the law. But of course it does. If
the SEC cannot catch old-fashioned fraud a la Madoff, despite years of tips and flagrantly bogus results,
what chance do we have of SEC lawyers taking this new-fashioned fraud seriously? No, regulatory
agencies are hopelessly behind the times in their definition of what constitutes insider trading and front-
running. As a result we are treated to the circus of wiretaps on Raj Rajaratnam and the cast of clowns
around Galleon rather than a meaningful investigation of the state of market making today. The former is
entertaining, simple to understand, and threatens no institution that matters. It can make an Assistant US
Attorney’s career. The latter is boring, hard to grasp, and threatens every major banking and trading
institution in the country. It can get you fired. So we are left with something like Rick’s Café from
Casablanca, where not only is there a roulette wheel in the back room, but it is rigged. And not only is it
rigged, but the police chief is shocked, shocked to find that gambling is going on here. Welcome to the
Age of Corruption, courtesy of the hollow market.

Response #1 – Strategy for a hollow market

Our fundamental response to the hollow market, and one which we have written about at length in prior
letters, is to become more of an investor, not less. We believe that there are two fundamental aspects to
what it means to be an investor – applying a long(er)-term time horizon to exposures and having price
opinions that are exogenously-derived (i.e., value-based). We have taken conscious efforts to emphasize
or increase both aspects in our portfolio management, and in this letter we want to provide evidence to
document those efforts.

Over the past six quarters, ever since we started writing about the hollow market, we have dramatically
reduced the turnover within our portfolio and, as a result, equally dramatically increased the average
holding period of stocks in our portfolio. This behavior is most pronounced in our long portfolio, as the
charts below demonstrate.

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Opportunity Fund Quarterly Portfolio Turnover (x) 
Long Positions
1.7

1.5

1.3

1.1

0.9

0.7

0.5
Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010

Opportunity Fund Average Holding Period (mos) 
Long Positions
6

0
Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010

The short portfolio turnover multiple and average holding period shows a similar pattern, up until this
most recent quarter.

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Opportunity Fund Quarterly Portfolio Turnover (x)
4
3.5
3
2.5
2
Longs
1.5
Shorts
1
0.5
0
Q1  Q2  Q3  Q4  Q1  Q2 
2009 2009 2009 2009 2010 2010

Opportunity Fund Average Holding Period (mos) 
6

3
Longs
2 Shorts

0
Q1  Q2  Q3  Q4  Q1  Q2 
2009 2009 2009 2009 2010 2010

The reasons for the increase in short portfolio turnover in this most recent quarter are two-fold. First,
shorts actually worked in Q2, and they worked in the punctuated fashion that has always marked a well-
behaving short book. A good short-and-hold stock is a rare find, indeed, which means that – for a stock
picker – it is absolutely necessary to trade actively around your short positions, particularly when they are
working. Second, we made a more pronounced use of index puts and other hedging instruments in Q2, as
we sought to maintain a low net exposure without rashly throwing new short names into the portfolio to
replace names that we covered. As has always been our practice, we use these hedging instruments as a
place holder until new short positions emerge through our catalyst evaluation process, at which point we
replace the hedging exposure with single name stocks.19

19
It is worth noting that our hedge positions have generated a positive absolute return year-to-date, against an S&P 500 that, at
this writing, is back in positive territory for the year. This is our goal with the short book – to generate positive absolute returns
and not just relative gains – regardless of whether the investments are made in single name stocks or broad market hedges, and
it is a goal we have achieved over the five and a half year life of the Fund as well as most multi-quarter periods within that
span. The notable exception to this rule was the last 3 quarters of 2009, which we found to be the most difficult market for
shorting stocks we have ever endured. While there are still too many mindless “risk on” days that plague this market for us to 

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We believe that the constant presence of a small but non-trivial chance of systemic dislocation demands
this low net exposure, reinforced by market hedges until single name shorts take their place. But even
with a market that allows the possibility of effective short portfolio management, the downside to a low
net exposure – especially one that is unlevered (as we are) – is that an extremely high correlation of
returns across the market as a whole makes it more difficult to generate positive portfolio returns. We may
not lose our shirts in a sudden dislocation, but it certainly makes it more difficult to make money picking
stocks without also betting on overall market direction. In a future letter we will write at great length
about conceptions and misconceptions of correlation, and why rumors of the death of stock picking are
greatly exaggerated. Put simply, if you define stock picking as the absence of cross-correlated returns,
then yes, higher correlations are bad for stock picking. This is not how we define stock picking. But all
the same, we are clearly making a choice by running a low net exposure, and it is equally clearly a choice
in favor of caution.

Response #2 – tactics to minimize the Tobin tax

As the story goes, when the poker player in the Old West town learned that the saloon keeper was running
a crooked game, he continued to play. When asked why, he replied “Because it’s the only game in town.”
This is essentially the position we find ourselves in. But while there is no way to escape either the
constant danger of a severe market crash or the constant tax of market maker front-running, we are
constantly trying to mitigate both risks.

First, we are being more patient in establishing and exiting positions. The vast majority of buy-side
algorithms are designed to operate over a single trading day, which means that the adversarial HFT
algorithms are similarly focused on this time frame. It is the exceedingly rare catalyst which has a fuse of
only one or two days, which means from our perspective there is almost never a reason to rush into a
position. Also, perhaps the only positive aspect of increased volatility for a stock picker is that patience is
more apt to be rewarded by getting your price at some point in the future. Particularly when correlation of
returns is extremely high (more on this in a future letter) and +/- 5% moves in the overall market are
commonplace over relatively short time horizons, volatility tends to work in favor of slower position
entry/exit.

Second, we are using dark pools and block trades wherever possible. Dark pools are by no means immune
to the predation of HFT algorithms (and if regulators force disclosure of trades intraday rather than in
aggregate at the end of the day, then whatever refuge dark pools provide will be lost), but they do not so
easily allow the blasting of indications of actionable interest that create a sonar-like plumbing of the quote
depth. Block trades are a no-brainer. Almost by definition they are a meeting of the minds between two
liquidity takers, and so avoid the fun and games of HFT liquidity provision.

Third, we are avoiding algorithms, period, and we are relying more on our own experienced traders to
manage orders directly. It is all too easy to dismiss the role of human interaction and judgment in this era
of microsecond transaction speeds and algorithmic trading, but in fact we find that the network of
relationships that an effective trader possesses is both an effective defense against the most egregious
forms of front-running as well as the source of block trades that bypass liquidity algorithms entirely.
Hearing the phrase “we found a natural for that order” is music to our ears. These relationships with other

proclaim the return of a normal shorting environment, our experience year-to-date suggests that it is, at least, better than the
agonizingly hellish shorting environment of 2009.   

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traders are based on, if not trust, then at least a stable repeated game equilibrium marked by reciprocal
behavior. In other words, do right by our traders and they will do right by you. And vice versa. A good
trader knows when he is being taken advantage of, and conversely he knows who is watching his back.
Far from being a pure cost center that we can replace with a server or two, we believe that our human
traders save us a lot of money precisely because they interact effectively with other humans through tit-
for-tat behavior and reputational game-playing.

Fourth, we are setting extremely tight limits on all of our orders, and we are quick to cancel trades entirely
if volume is not up to par. Liquidity considerations are more important than ever in this market, despite
apparent improvements in liquidity levels since the depths of market despair in the winter of 2008-2009.
As we have written about for the past two years, liquidity is often a mirage, particularly in regards to
quote depth. Available volume and displayed quotes for large-cap stocks may have increased over the past
few years, but that is certainly not true for smaller stocks. And even for large-cap stocks, displayed quote
levels may be deep right around the best displayed offer, but they tend to evaporate completely at prices
beyond 6 cents from that offer. 20

We are under no illusions that these actions insulate us from the deleterious systemic consequences of a
hollow market. But we do believe that these steps make a difference, and we continue to explore ways in
which we can better protect our intellectual property from the in-broad-daylight theft perpetrated by HFT
algorithms and current market making structures.

A Final Point

We began this letter with the question “Where Are We?”, and we answered in terms of where the S&P
500 has ended up after three years of tribulation. To conclude this letter we want to answer the question in
terms of where WE – Jeff and Ben – are today. Since the summer of 2007 we have consistently made a
choice for caution in our portfolio management. Why? To quote from Mandelbrot’s (Mis)behavior of
Markets one last time:21

In the 1960’s, some old-timers on Wall Street – the men who remembered the trauma of
the 1929 Crash and the Great Depression – gave me a warning: “When we fade from this
business, something will be lost. That is the memory of 1929.” Because of that personal
recollection, they said, they acted with more caution than they otherwise might.
Collectively, their generation provided an in-built brake on the wildest forms of
speculation, an insurance policy against financial excess and consequent catastrophe. Their
memories provided a practical form of long-term dependence in the financial markets. Is it
any wonder that in 1987, when most of these men were gone and their wisdom forgotten,
the market encountered its first crash in nearly sixty years? Or that two decades later, we
would see the biggest bull market, and the worst bear market, in generations? Yet standard
financial theory holds that, in modeling markets, all that matters is today’s news and the
expectation of tomorrow’s news.

We would only add that there are all too few people in the markets today who remember 1987, much less
the Great Depression. Do our memories and expectations act as a brake on our behavior in the same
manner that Mandelbrot describes the “old-timers” in the 1960’s? Of course. We have no charts or graphs

20
Source: Knight Capital Group
21
Mandelbrot and Hudson, op. cit., pg. 185-186. 

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or game theoretical explanations to justify our choice for caution. It is simply who we are. And who we
will continue to be.

As always, we thank you for your continued confidence in our efforts.

Jeff Silver Ben Hunt

Managing Director Managing Director
Iridian Asset Management LLC Iridian Asset Management LLC
276 Post Road West 276 Post Road West
Westport, CT 06880 Westport, CT 06880
(203) 341-9054 (203) 341-9056
jsilver@iridan.com bhunt@iridian.com

07/30/10
 24 | P a g e

IRIDIAN Iridian
Asset Management LLC

This letter is intended for existing investors only, is for informational purposes only and is current
as of the date noted. It reflects the views of the Portfolio Managers at the time of this writing.
These views may have changed in response to changing circumstances and market conditions. If
you are not an investor in the Fund, you received this letter only because you have specifically
requested it for your review and not for further distribution.

Performance results shown reflect the net performance of the Iridian Opportunity Offshore Fund,
Ltd. and reflect the deduction of the highest management fee and highest incentive allocation/fee
that can be charged for the performance period represented as well as all current expenses,
custodial fees and transaction costs. Actual investor performance results may vary depending upon
different fee arrangements and timing of investments.

The S&P 500 Index: The Standard & Poor’s 500 Index represents 500 large U.S. companies in
leading industries. Benchmark returns reflect the reinvestment of dividends but do not reflect fees,
brokerage commissions or other expenses of investing. The comparative index is unmanaged and is
not directly investable.

Past performance is no guarantee of future results. There can be no assurance that the Investment
Manager will be able to achieve the desired results for the Fund. An investment in the Fund
involves a high degree of risk, including the risk of loss of the entire amount invested.

Specific investment information is provided for informational purposes only and should not be
deemed as a recommendation to purchase or sell any securities or investments mentioned. This
letter does not constitute an offer to sell or the solicitation of an offer to buy any interest in the
Fund. Fund interests are being offered to a limited number of qualified investors pursuant to a
Confidential Private Offering Memorandum. Accordingly, this document and the information
contained herein are qualified in their entirety by the more detailed information contained in the
Offering Memorandum.

07/30/10