RETHINKING THE EFFICIENT FRONTIER

December 6, 2010

The efficient frontier sounds like something out of Star Trek , but it is actually an investment/asset allocation concept put forth by those who believe in Modern
Portfolio Theory. The general idea is that components of a portfolio should be selected based on what they do to the portfolio’s overall risk and reward profile, not o
their own merits. Taken further, one can calculate the best possible mix of portfolio components to arrive at the highest possible return with the lowest possible risk
(in terms of volatility or standard deviation of returns). That intersection of the best possible return with the lowest risk is the ‘efficient frontier’ point, while the entire
graph of various return and risk levels at varying asset allocation amounts can also be called the efficient frontier, or efficient frontier graph.

Efficient Frontier Graph from cmegroup.com, Past performance is not necessarily indicative of future resuts

Those who start researching managed futures are apt to run into efficient frontier graphs such as the one above from the CME’s website, because it graphically
shows what those of us in the managed futures industry have been harping about for years… that adding managed futures to an overall portfolio can actually
increase returns while decreasing risk. (maybe the tagline for the industry should be: Managed Futures…. the efficient frontier)

The CME hasn’t updated their image since February of 2008, unfortunately (not sure what their 2300 employees are doing with the Billions in revenue they take in)
but we’re happy to help out and give the updated picture (through Oct. 2010 and using the DJ/Credit Suisse Managed Futures index instead of the CISDM index)

Past performance is not necessarily indicative of future resuts

Source: Stocks = S&P 500/MSCI World Index ex USA, Bonds = Citi World Govt. Bond Index, Managed Futures = DJ/Credit Suisse Managed Futures Index
The Efficient Frontier is Flawed

Now – for all the nice things we’ve said about the efficient frontier (and how nice it makes managed futures look), there are some problems with it. Chief among
those problems is that it uses past history to derive an optimal asset allocation mix for the future, where correlations and risk profiles may change drastically from
what has happened in the past (see 2008 as an example). To see just how risk/reward profiles can change, check out the graph below which plots the 1994-2007
risk/reward points of major asset classes, as well as the updated risk/reward plots for the same asset classes 3 years later after having lived through the financial
crisis. You can see that all of the asset classes besides managed futures shifted lower (less return) and to the right (more risk). That kind of shift, and the fact that a
of the asset classes shifted together, can wreak havoc on a model based on the assumption that the future risk/reward profile for an asset class will remain in line
with historical norms.

Past performance is not necessarily indicative of future resuts

Stocks = 60% S&P 500 /40% MSCI World Index ex USA, Bonds= Citi World Bond Index, Commodities = GSCI, Hedge Funds = DJ/Credit Suisse Hedge Index, Real Estate =
MSCI REIT Index, Managed Futures = DJ Credit Suisse Managed Futures Index

The second major issue for the efficient frontier is that it uses just a single measure for risk – considering risk as equal to the volatility, or standard deviation, of
returns. We have covered in past newsletters when criticizing the Sharpe ratio how this can be a mistake. For one, not all volatility is bad. Would you complain abou
an up month 5 times the average month? But more importantly, considering just volatility ignores other important risk factors, chief among those in our opinion bein
the maximum drawdown. Considering just the standard deviation of returns (the second moment for any statisticians out there), also makes a very big assumption
that the returns you are analyzing are normally distributed (and will continue to be so).

Financial Returns are not Normally Distributed

Now, normally distributed is a statistical term meaning that any observations we see in a data set will be in a bell curve shape, with roughly 68% of the data points
being 1 standard deviation above or below the average, and 95% being within 2 standard deviations of the average, and virtually no data points outside of 3
standard deviations above or below the average (just .027%).

Problem is - financial market returns are not normally distributed. If 2008 didn’t teach us that, consider the double digit sigma move during the flash crash on May 6
of this year, or the mother of all normal distribution killing moves - Black Monday in October of 1987. Using a normal distribution curve, there was a 1 in a trillion
chance of prices being down more than 6% on 10/21/87, yet they fell -20% in a singled session.

Nassim Taleb, author of the fabulous book Black Swan separates normally distributed and non-normally distributed by saying that which belongs to normally
distributed curves exists in mediocristan, and everything else exists in a place called extremistan. Unfortunately for the efficient frontier and any financial models
assuming a normal curve - we live in extremistan!

Take the distribution of wealth as compared to the distribution of human height as an example. Consider that the tallest human ever recorded was 8’ 11”, or about
1.6 times the average, and 10 standard deviations outside of the average.

Now consider Bill Gates and his net worth of about $54 Billion. How tall do you think a person would have to be so that they are as much over the average in heigh
as Bill Gates is over the average in wealth? 10ft tall? 50? 1000? Would you believe 1.6 million feet, or 303 miles, tall… which is about the length of Lake Michigan.
That is how much greater Bill Gates wealth is than the average American. He should literally not exist in a world which is normally distributed, being thousands of
standard deviations above the average. But he does exist, and those $54 Billion are really his, making it painfully obvious for those of us down there within a few
standard deviations of the mean that we are in fact in extremistan.

More Efficient Frontiers?

So if we do live in extremistan where there is more to risk than normal distribution assuming volatility, shouldn’t there be more to the efficient frontier? Couldn’t we
also generate an efficient frontier based on the other risk factors such as the maximum drawdown and volatility of down months only? What about the third and
fourth moments of the function describing the returns, with graphs showing return over skew and return over kurtosis.

We decided to see what these efficient frontier derivatives would look like and ran the numbers to plot the returns over risk as measured alternatively with downside
volatility, skew, kurtosis, and maximum drawdown; of a traditional portfolio with varying levels of managed futures allocations.

The traditional portfolio started with 60% stocks (comprised of 66% US stocks and 33% foreign stocks) and 40% bonds, and added a 10% allocation to managed
futures at each level by reducing stocks and bonds by 5% each.

Source: Stocks = 60% S&P 500/40% MSCI World Index ex USA, Bonds = Citi World Govt. Bond Index, Managed Futures = BarclayHedge CTA Index. Past performance is not
neccessarily indicative of future results.

Downside Standard Deviation Efficient Frontier

Maximum Drawdown Efficient Frontier

Skew Efficient Frontier

Kurtosis Efficient Frontier

As you can see from the alternative efficient frontier graphs above, changing your definition of risk can and does change the optimal percentage allocations. In eac
case but Kurtosis, the different methods of defining risk actually increase the allocation to managed futures above what we saw in the traditionally run efficient
frontier analysis. As for Kurtosis, we were unsure how to analyze the results in all honesty. A large positive kurtosis reading means the presence of positive outliers
which – all else being equal – are preferable. And we definitely want to avoid negative kurtosis readings, but is a high kurtosis reading at the expense of return
preferable? Would you accept a lower overall return in exchange for more positive outliers? We didn’t think so, and went with an analysis which theorized that the
optimal Kurtosis based efficient frontier would be the point of maximum return and positive kurtosis.

Pulling it all together, we averaged each of the 4 alternative efficient frontier optimal portfolio mixes with the updated traditionally run 40/20/40
stocks/bonds/managed futures mix based on return over standard deviation. The result, an optimal portfolio mix of 32/12/56 based on the 5 different risk
measures.

Stocks Bonds MF

Normal 40% 20% 40%

Downside
Vol 30% 10% 60%

Max Dd 25% 5% 70%

Skew 25% 5% 70%

Kurtosis 40% 20% 40%

Averages 32% 12% 56%

The non-traditional portfolio:

If you are asking right about now, what about other asset classes – how do they fit into the optimal portfolio mix? Pat yourself on the back. The exercise above is
nice, but what about investors real portfolios containing more than just stocks,bonds, and managed futures. What about real estate, long only commodities (GLD, fo
example), and hedge funds? How do they fit into the mix?

To see how each of these fit into the efficient frontier model (yes, the same one we’ve identified as flawed), we ran a version of the efficient frontier analysis to
calculate an optimal portfolio considering all of these different asset classes – and have shared the results below:

* Managed Futures = BarclayHedge CTA Index, Bonds = Citi Govt Bond Index, Hedge Funds = Dow Jones/Credit Suisse Hedge Index, Commodities – GSCI,Rea
Estate = MSCI REIT Index, World Stocks = MCSI World Index (ex USA), US Stocks = S&P 500 Index

You will see a surprising result…. Absolutely no allocation to either US or International Stocks, nor long only commodities. All three are simply too volatile for the
efficient frontier model which values return per unit of risk above all else. Double digit losing months as stocks and long only commodities are apt to have make
them unattractive to the efficient frontier model, which tells us better returns with lower risk (as measured by volatility) are achievable via an absolute return portfolio
of hedge funds and managed futures – with a good chunk of bonds as an income producer.

Now, of course, this is a backwards looking analysis; and the only certainty is that tomorrow won’t look like today. A more realistic portfolio built to handle the
uncertainties of the future would likely have some stock exposure, and perhaps even some long commodity exposure. But we can use the numbers and graphs
above as a general guide to realize that bonds alone are not likely to remove the volatility from a portfolio. Additions of absolute return vehicles such as managed
futures and hedge funds have the ability to lower portfolio risk (again, as measured by volatility – and in the case of managed futures… as measured by several
other measures as well) while also increasing return.

Jeff Malec
IMPORTANT RISK DISCLOSURE

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Feature | Month in Review |

Month in Review : Mid Month reversal hurts managed futures

Economic and Geo-political news made for a volatile environment in November which made for large price swings in most Commodity and Stock Index futures. The
main headline was news of sovereign debt problems in Ireland which aided in a re-allocation of investment equity out of Euro backed instruments and into that had
low to no exposure to the region. News of military turmoil on the Korean peninsula also played a key role for price discovery in several sectors as the event led to
uneasiness about demand issues popping up in the strong growing region in the world. QEII by the FOMC also remained in the headlines as the Fed took several
shot across the bow not only from politicians in the U.S. but several key allies indicating that they were not satisfied the new round of bond purchases would aid in
any kind of job growth or help cure the ails of global economic growth. Economic data not only in the U.S., but in several regions continued to show signs that
sustained growth was taking hold with data from the manufacturing sector in Europe and Asia hitting multi-year highs. Overall, the news aided metals the most as
the hard asset attraction and manufacturing growth sparked a strong rally for most of the complex. Silver +14.58% led the charge followed by Palladium +8.68%,
Copper +2.15% and Gold +1.95%. Platinum -2.38% was the sector laggard.

The Energy complex was aided by the turn of events in the Korean tug of war along with seasonal support from higher winter demand for most areas of the sector.
There was also brief supply tightness on the east coast of the U.S. for gasoline that aided the rally as well. RBOB Gasoline +5.73% was the main beneficiary
followed by Heating Oil +2.76% and Crude Oil +2.39%. Burdensome supplies continued to hamper Natural Gas -1.99%.

Market activity in currency futures for November reflected the change of risk appetite by many inventors as the turmoil in Europe regarding Irish debt problems led t
a large inflow of risk capital into the U.S. Dollar Index +4.92%. The Euro -6.81% took the brunt of the penalty, but British Pound -2.93% and Swiss Franc -1.92%
also were under pressure. Japanese Yen -3.86% folded under pressure from tension on the Korean peninsula.

The string of strong monthly performances ended in November for larger cap indices as investor aversion to anything that could be affected by the debt problems in
Europe or the uneasy situation in Asia were re-allocated to perceived safe havens. The small cap arena benefitted from the changing psychology in the marketplac
along with ideas that the sector was benefitting from a better economic sector in the U.S. The scoreboard for the month had Russell 2000 futures +3.46%, Mid-Cap
400 futures +2.95%, S&P 500 futures near steady, NASDAQ futures -0.24% and Dow futures -0.72%.

Most sectors in the Food and Grain complex underperformed as the changing world circumstances sparked ideas that demand in the near term could subside until
some of the issues could be worked out. The appreciation by the U.S. Dollar and some slowing in the export markets made for a tricky trade as well, although coole
weather aided a rally in the livestock complex. Lean Hogs +5.15%, Live Cattle +4.49% and Soybeans were the lone bright spots. Wheat -8.82% felt the most
pressure followed by Corn -8.57%, Sugar -5.39%, OJ -5.11%, Cotton -2.58%, Coffee-2.02% and Cocoa -0.92%.

Managed Futures

For most multi market managers November started out looking like the glory days of 2008 when market trends picked one direction and never looked back for
several months. Unfortunately, reality set in during the second ½ of the month as markets reversed and nearly every multi-market manager we track including both
short-term and long-term programs ended up posting a loss for the month. However, considering the recent run up experienced by most of these programs the
monthly losses are not as painful as the numbers portray.

Despite the difficulties of most, there are a couple managers that are in the black this month, including Futures Truth MS4 at +1.54% and Mesirow Financial
Commodities Low Volatility at +0.03%. Futures Truth has had a little more success as the program has counter-trend analysis that has given short signals in
markets like cotton and bonds that are reverting to the mean. In comparison, many trend followers gave back profits in these markets over the last few weeks of
November (See today’s blog post for an update on December so far).

The remainder of multi-market traders are in the red including Mesirow Financial Commodities Absolute Return -0.09%, Dighton Capital Limited Aggressive -0.08%
Sequential Capital Management -0.11%, Accela Capital Management Global Diversified -0.28%, DMH -0.65%, Futures Truth SAM 101 -0.97%, Robinson Langley
Capital -1.67%, Quantum Leap Capital -1.58%, APA Strategic Diversification -1.68%, Auctos Capital Management Global Diversified -1.84%, Integrated Managed
Futures Global Concentrated -1.91%, GT Capital -2.09%, Applied Capital Systems -3.89%, Hoffman Asset -3.75%, Covenant Capital Aggressive -4.39%, 2100
Xenon Managed Futures (2X) -5.31%, Clarke Worldwide -5.39%, APA Modified -5.55%, Dominion Capital Management -5.94%, Clarke Global Magnum -5.75%,
and Clarke Global Basic -10.77%.

Short-term stock index traders had a positive month of trading with Paskewitz Asset Management Contrarian 3X St. Index up +0.59%, while Roe Capital
Management posting positive numbers in the Jefferson Index +2.05% and Monticello Spread +0.36% programs.

Currency trader P/E Investments – Standard Program was down for the month at -3.20%.
For option trading managers, the fight to end the recent 3 month slide came to an end for several managers but not for others. Leading the way for November was
Liberty Funds Group Diversified Option Strategy +5.21%. Liberty implements a premium collection strategy with a directional futures hedging overlay that has
struggled over the past few months. We’ll be looking forward to see what they are able to produce for December.

Others posting gains for November include: FCI OSS +3.22%, White River Group +2.61%, Clarity Capital +2.59%, and HB Capital +2.20%, and Crescent Bay BVP
+1.66%. Option traders in the red are as follows: Cervino Diversified -0.43%, Cervino Diversified 2x -0.81%, FCI CPP -0.93%, Crescent Bay PSI -0.94%, ACE SIP
-5.50%, ACE DCP -19.33%.

Specialty market managers were led by gold trading specialists Cervio Gold +0.79%. Cervino launched their Gold strategy in November 2009 and has averaged a
estimated +16.02% annual return with a maximum 5.63% drawdown. Any investors looking for gold exposure outside of GLD or owning gold bars/coins should
consider giving Cervino a look. AFB Forty Eighter Gold Options ended -0.92%

Agriculture specialists ended mixed after a strong run up in October. Estimates include NDX Shadrach +0.78%, NDX Abednego +0.25%, Oak Investment Group -
4.70% and Rosetta Capital -7.15%.

Spread trading specialist, Emil Van Essen, ended down -4.02%. The current drawdown has now extended to over 10% presenting an opportunity to jump into the
program a possible discount. View our blog posting from 12/3/10 outlining the opportunity here.

Trading Systems

Unfortunately, day trading systems couldn’t turn their luck around in November. They continue to be hurt by reversals in the markets. Swing systems didn’t fare
much better. In October, the swing systems held through the choppiness and benefited when the markets moved in their direction. In November, the choppy action
remained but this time swing systems were getting stopped out before any definitive move occurred. But there were still some systems that got it right and produce
profitable results.

On the swing system side, MoneyBeans S, which trades the SoyBeans contract, continued to build on its success from last month and finished with a profit of
$1,255.00. Most of the time Moneybeans would get long and take profit and reverse short and then reverse its position again. This worked really well because
Moneybeans ended up buying the lows and selling the highs the majority of the time in November. Other systems that finished up for the month were Jaws US 400
at $65.00, Bounce ERL at $90.00, Polaris ES at $317.50, Waugh Swing ES at $652.50, and Bam 90 Single Contract ES at $2,405.00.

Unlike Moneybeans which seemed to always buy the low and sell the high there were some swing systems that bought the high and sold the low consistently
throughout November. AG Mechwarrior struggled quite a bit when the eMini S&P 500 market would reverse direction because it was causing AG Mechwarrior to
buy the highs and sell the lows. The week after Thanksgiving, AG Mechwarrior got short and for a moment it looked like the eMini S&P 500 market would continue
to go lower. But the market reversed and went straight up. Unfortunately, once the market made a new high AG Mechwarrior reversed long and the market promptl
reversed direction and went back down. For the month AG Mechwarrior lost -$3,075.00. Other results in the red included Jaws 60 US at -$341.25, Waugh CTO ER
at -$820.00, TurningPoint ES at -$980.00, Bam 90 M Squared at -$1,684.72, TurningPoint X2 at -$1,960.00, Bam 90 ES at -$2,292.50, MoneyMaker at -$2,520.00
Strategic ES at -$4,760.07, and Strategic v2 SP at -$22, 052.98.

Day trading systems continued their struggles in November. Many were hurt by the lack of continuation in the markets and were caught the wrong way when the
markets turned. But there were some positive signs, Upperhand ES has been hurt a lot by the sudden reversals in market direction and towards the end of the
month, the market didn’t reversed and continued the move and as a result Upperhand finished strong, but unfortunately it wasn’t enough to overcome the losses it
sustained earlier on in the month. Upperhand lost -$1,137.50 during the month of November. Other results in the red included Waugh ERL at -$100.00, Compass
ES at -$147.50, Compass SP at -$350.00, and Clipper ERL at -$510.00.

PSI! ERL and Bounce MOC ERL took the biggest steps in the right direction. Both systems finished with profits for the month and both did it very differently. Bounc
MOC only made one trade last month and it was a long trade on the 18th. PSI ERL made 4 trades and all were long trades. The best trade was on the 24th when it
got long early on and the market continue to rally upwards throughout the day. For the month PSI ERL made $30.00 and BounceMOC EMD made $35.00 and
BounceMOC ERL made $345.00.

IMPORTANT RISK DISCLOSURE

Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect
investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex
programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance
based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the
individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes
proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client
accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The
actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market
behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques.
Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this
website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION
IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE
FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED
BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY
PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO
HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE
ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS
WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN
GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION
OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.
Feature | Month in Review |

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