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Applied Quantitative Strategy www.empiritrage.com

Volatility-Based Allocation (VBA)

Quantitative Research Team: Summary
Wesley R. Gray, PhD
[email protected]
 Diversification is an effective risk-management tool, but it does not do enough for the investor that is
intensely afraid of large drawdowns. We propose volatility-based allocation as an additional tool.
Tao Wang
[email protected]  Volatility-Based Allocation (VBA) is a two-signal model that is simple-to-implement, robust, and
historically generates a favorable risk/reward return profile.
Shenglan Zhang
[email protected]
1. The first indicator in VBA is the volatility regime signal, which simply identifies “Risk-On” and
Carl Kanner “Risk-Off” market regimes.
[email protected] 2. The second indicator in VBA is the long-term moving average signal, which invests when the
current price is above the 12-month MA, and invests in the risk-free rate otherwise.

 Over the March 1, 1986 to August 31, 2012 period, VBA generates a CAGR of 9.76% and a maximum
drawdown of 9.64% when applied to our 5 core assets classes: domestic equity, developed equity,
emerging equity, real estate, and long-term government bonds.

 Our volatility regime indicator outperforms the long-term moving average rule as a stand-alone risk
management tool.

 VBA (which combines the volatility regime indicator and the long-term moving average rule) dominates
the stand-alone long-term moving average.
PLEASE SEE THE DISLAIMER AND DISCLOSURES AT THE END OF THIS REPORT. The information set forth herein has been obtained or derived from sources believed by Empiritrage, LLC
(“Empiritrage”) to be reliable. Empiritrage does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does Empiritrage recommend that the
attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any
advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is subject to further review and revision.

T: +1.773.230.4727 | F: +1.888.517.5529 | 3830 Kelley Ave. Cleveland, OH 44114 | [email protected]

 Volatility Regime: Why does it matter?
As overall market volatility increases, risky assets tend to move in the same direction (correlations increase).

 During “Risk Off” periods, volatility increases, equities market tend to fall, while safe assets increase in
value. Increased correlations between risky assets keep diversification benefits to a minimum.

 During “Risk On” periods, volatility decays, equity markets rise, and safe assets decrease in value.
Correlations between risky assets decrease, which keep diversification benefits at a maximum.

 Diversification benefits are lower when correlations are high

 Diversification provides limited risk management because risky asset correlations have increased over
time.

 A good risk management system needs to predict “risk on” and “risk off” regimes—naïve
diversification does not work!

 Constructing the Volatility Regime Indicator:

1. Short term MA of VIX > Long term MA of VIX -----------------------> “Risk off”

2. Short term MA of VIX < Long term MA of VIX -----------------------> “Risk on”

 Underlying Alpha Driver: Risk asset markets react to spikes in VIX, but not enough
 “conservative bias” http://en.wikipedia.org/wiki/Conservatism_(belief_revision)

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 VBA System
VBA (Volatility-Based Allocation)
Step1: Volatility Regime

Step2: MA Rule

VBA Details
Step1: Volatility Regime

10-Day VIX MA > 30-Day VIX MA

No Yes

Risk-On Risk-Off

Step 2: MA Rule

S&P 500 Price > 12m MA

Yes No

S&P 500 Risk-Free

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 Volatility Regime Signal Over Time
 Volatility Regime signal is dynamic from 01/1986 through 10/2012.

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 Simulation Details
1. The VIX series is spliced with OEX data. We use VIX Index from January 1, 1990 through August 31,
2012. For the period from January 1, 1986 to December 31, 1989 we use the VXO Index.
2. The following 5 asset classes are used in the back-test (referred to as the “Core 5”):
a. FTSE NAREIT All Equity REITS Total Return Index—benchmark for REITs—FNERTR INDEX
b. MSCI EAFE Index—benchmark for investment in equity markets outside of U.S. and Canada—
NDDUEAFE INDEX
c. MSCI EEM Index—benchmark for investment in emerging markets—NDUEEGF INDEX
d. Merrill Lynch 7-10 year government bond index—ML1US10 INDEX
e. SP500 Index—SPXT INDEX
3. Simulation results are from March 1, 1986 through August 31, 2012.
4. Portfolios are rebalanced monthly.
5. We utilized long-term simple moving average rules as a risk-management technique. The benefits of long-
term MA rules as an effective risk-management tool was brought to the mainstream by Mebane Faber. We
analyze a 12-month moving average rule (MA (2,12)) that compares the 2 month simply moving average
(~40 days) and the 12 month simple moving averages (~250 days). The MA(2,12) rule is triggered if the 2
month MA goes below the 12 month MA. All MA rules are calculated off each asset class. When an MA
rule is triggered, proceeds earn risk-free rate of return (measured by US T-bill).
6. No transaction costs are included in any of our analysis. All results are gross of any transaction fees,
management fees, or any other fees that might be associated with executing the models in real-time.

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 VBA Simulated Performance

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 Outline
1. Benchmark Performance
2. VBA & Index Performance
a) SP500
b)EAFE
c) EEM
d)REIT
e) LTR
3. VBA & Core 5 Performance

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 Benchmark Statistics (3/1/1986-8/31/2012)
SP500 LTR KEY:
CAGR 9.79% 8.63%  SP500=S&P 500 Total Return
Standard Deviation 15.73% 6.52%  LTR = Merril Lynch 10-year U.S. Treasury Total
Downside Deviation 12.07% 3.81%
Return
Sharpe Ratio 0.39 0.61
Sortino Ratio (MAR=5%) 0.47 0.92  EAFE = EAFE Total Return
Worst Drawdown -50.21% -9.27%  REIT = All Equity REITS Total Return Index
Worst Month Return -21.58% -5.71%  EEM = MSCI Emerging Markets Index
Best Month Return 13.52% 8.73%  Core5_EW=Core5 equal-weight returns
Profitable Months 63.21% 67.61%

Summary Statistics* EAFE REIT EEM Core 5 EW

CAGR 6.92% 10.55% 12.40% 10.51%
Standard Deviation 18.24% 18.52% 24.61% 12.68%
Downside Deviation (MAR=5%) 12.66% 15.81% 18.82% 10.67%
Sharpe Ratio 0.25 0.43 0.45 0.55
Sortino Ratio (MAR=5%) 0.27 0.43 0.52 0.55
Worst Drawdown -56.68% -68.30% -61.44% -47.21%
Worst Month Return -20.18% -31.67% -28.91% -19.43%
Best Month Return 15.58% 31.02% 18.98% 13.48%
Profitable Months 58.81% 59.75% 61.64% 67.30%

 The typical story: decent returns, but scary drawdowns.

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 VBA S&P 500 Summary Statistics
Summary Statistics* VBA_SP500 Vol Regime_VIX(10,30)_SP500 MA(2,12)_SP500 SP500
CAGR 9.91% 10.60% 10.01% 9.79%
Standard Deviation 7.53% 10.20% 12.39% 15.73%
Downside Deviation (MAR=5%) 4.75% 7.81% 9.97% 12.16%
Sharpe Ratio 0.79 0.66 0.54 0.45
Sortino Ratio (MAR=5%) 1.00 0.72 0.56 0.48
Worst Drawdown -8.32% -26.21% -29.58% -50.21%
Worst Month Return -8.32% -10.90% -21.58% -21.58%
Best Month Return 13.52% 13.52% 13.52% 13.52%
Profitable Months 86.79% 80.82% 73.27% 63.21%
Rolling 5-Year Win % -- 44.02% 30.89% 48.65%
Rolling 10-Year Win % -- 65.83% 17.59% 42.71%
DrawDown Total -1418.27% -3671.68% -3382.63% -7131.59%
Correlation -- 0.732 0.602 0.474
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.05 0.21
p-value*** 0.0005 0.0000
3 Factor (FF) 0.05 0.21 -0.09 -0.07
p-value*** 0.0002 0.0000 0.0181 0.0721
4 Factor 0.04 0.24 -0.10 -0.04 0.09
p-value*** 0.0022 0.0000 0.0192 0.2496 0.0005
5 Factor 0.04 0.24 -0.10 -0.05 0.09 -0.07
p-value*** 0.0008 0.0000 0.0136 0.1896 0.0007 0.0525
***Italics denotes p-values significant at the 5% level; robust p-values

KEY:
 MA(2,12)_SP500 = Index with MA trading rule (2m vs. 12m)  The volatility regime indicator works;
 VBA_SP500 = Volatility regime indicator, then MA trading rule  VBA—volatility regime & MA signal—work
 Vol Regime_VIX (10,30)_SP500 = Volatility regime indicator, only
better.

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 VBA EAFE Summary Statistics
Summary Statistics* VBA_EAFE Vol Regime_VIX(10,30)_EAFE MA(2,12)_EAFE EAFE
CAGR 8.12% 9.86% 6.87% 6.92%
Standard Deviation 8.99% 12.94% 13.19% 18.24%
Downside Deviation (MAR=5%) 6.92% 9.79% 10.28% 12.66%
Sharpe Ratio 0.49 0.50 0.31 0.27
Sortino Ratio (MAR=5%) 0.47 0.54 0.29 0.30
Worst Drawdown -21.12% -38.04% -26.43% -56.68%
Worst Month Return -10.42% -14.46% -14.01% -20.18%
Best Month Return 10.62% 15.58% 14.06% 15.58%
Profitable Months 88.36% 79.87% 73.90% 58.81%
Rolling 5-Year Win % -- 40.15% 57.53% 50.97%
Rolling 10-Year Win % -- 30.15% 90.95% 69.85%
DrawDown Total -2600.71% -5610.14% -4273.89% -8351.48%
Correlation -- 0.689 0.684 0.493
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.04 0.13
p-value*** 0.0372 0.0000
3 Factor (FF) 0.04 0.13 0.02 0.00
p-value*** 0.0360 0.0001 0.5435 0.9240
4 Factor 0.03 0.15 0.02 0.02 0.08
p-value*** 0.0992 0.0001 0.6127 0.6298 0.0019
5 Factor 0.03 0.15 0.01 0.02 0.08 -0.05
p-value*** 0.0724 0.0001 0.7022 0.7280 0.0021 0.1798
***Italics denotes p-values significant at the 5% level; robust p-values

KEY:
 MA(2,12)_EAFE = Index with MA trading rule (2m vs. 12m)  The volatility regime indicator works;
 VBA_EAFE = Volatility regime indicator, then MA indicator  VBA—volatility regime & MA signal—work
 Vol Regime_VIX (10,30)_EAFE = Volatility regime indicator, only
better.

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 VBA EEM Summary Statistics
Summary Statistics* VBA_EEM Vol Regime_VIX(10,30)_EEM MA(2,12)_EEM EEM
CAGR 13.49% 15.18% 13.54% 12.40%
Standard Deviation 12.26% 16.97% 18.19% 24.61%
Downside Deviation (MAR=5%) 7.89% 12.53% 14.10% 18.80%
Sharpe Ratio 0.78 0.69 0.60 0.46
Sortino Ratio (MAR=5%) 1.07 0.85 0.69 0.54
Worst Drawdown -24.31% -45.64% -35.41% -61.44%
Worst Month Return -13.53% -17.49% -25.06% -28.91%
Best Month Return 15.59% 17.15% 18.98% 18.98%
Profitable Months 88.36% 80.50% 75.79% 61.64%
Rolling 5-Year Win % -- 49.03% 39.00% 47.88%
Rolling 10-Year Win % -- 62.81% 32.66% 71.36%
DrawDown Total -3336.07% -6077.38% -4725.16% -10809.94%
Correlation -- 0.712 0.668 0.491
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.08 0.17
p-value*** 0.0003 0.0000
3 Factor (FF) 0.08 0.16 0.12 0.05
p-value*** 0.0004 0.0001 0.0655 0.4738
4 Factor 0.08 0.18 0.11 0.07 0.06
p-value*** 0.0010 0.0001 0.0821 0.2547 0.1056
5 Factor 0.07 0.18 0.12 0.07 0.06 0.04
p-value*** 0.0020 0.0001 0.0739 0.2310 0.1061 0.3939
***Italics denotes p-values significant at the 5% level; robust p-values

KEY:
 MA(2,12)_EEM = Index with MA trading rule (2m vs. 12m)  The volatility regime indicator works;
 VBA_EEM = Volatility regime indicator, then MA indicator  VBA—volatility regime & MA signal—work
 Vol Regime_VIX (10,30)_EEM = Volatility regime indicator, only
better.

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 VBA REIT Summary Statistics
Summary Statistics* VBA_REIT Vol Regime_VIX(10,30)_REIT MA(2,12)_REIT REIT
CAGR 10.40% 12.64% 11.01% 10.55%
Standard Deviation 8.63% 12.15% 12.07% 18.52%
Downside Deviation (MAR=5%) 5.41% 7.49% 9.35% 15.81%
Sharpe Ratio 0.75 0.73 0.63 0.44
Sortino Ratio (MAR=5%) 0.98 1.02 0.68 0.44
Worst Drawdown -14.39% -24.63% -27.04% -68.30%
Worst Month Return -10.88% -17.31% -15.24% -31.67%
Best Month Return 10.39% 31.02% 10.39% 31.02%
Profitable Months 84.59% 78.62% 70.75% 59.75%
Rolling 5-Year Win % -- 37.07% 33.98% 42.47%
Rolling 10-Year Win % -- 42.21% 24.62% 31.66%
DrawDown Total -1807.35% -2789.50% -3585.71% -7157.83%
Correlation -- 0.693 0.710 0.459
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.06 0.12
p-value*** 0.0007 0.0000
3 Factor (FF) 0.05 0.12 0.14 0.13
p-value*** 0.0014 0.0003 0.0006 0.0073
4 Factor 0.05 0.13 0.14 0.13 0.02
p-value*** 0.0017 0.0002 0.0008 0.0063 0.4456
5 Factor 0.05 0.13 0.14 0.14 0.02 0.02
p-value*** 0.0022 0.0002 0.0008 0.0061 0.4498 0.5620
***Italics denotes p-values significant at the 5% level; robust p-values

KEY:
 MA(2,12)_REIT = Index with MA trading rule (2m vs. 12m)  The volatility regime indicator works;
 VBA_REIT = Volatility regime indicator, then MA indicator  VBA—volatility regime & MA signal—work
 Vol Regime_VIX (10,30)_REIT = Volatility regime indicator, only
better.

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 VBA LTR Summary Statistics
Summary Statistics* VBA_LTR Vol Regime_VIX(10,30)_LTR MA(2,12)_LTR LTR
CAGR 5.73% 6.13% 8.05% 8.63%
Standard Deviation 4.30% 4.48% 6.20% 6.52%
Downside Deviation (MAR=5%) 3.36% 3.38% 4.20% 4.08%
Sharpe Ratio 0.43 0.50 0.67 0.72
Sortino Ratio (MAR=5%) 0.20 0.32 0.71 0.86
Worst Drawdown -7.74% -7.74% -7.30% -9.27%
Worst Month Return -5.71% -5.71% -5.71% -5.71%
Best Month Return 5.22% 5.22% 8.73% 8.73%
Profitable Months 84.59% 82.08% 72.33% 67.61%
Rolling 5-Year Win % -- 20.85% 8.11% 5.79%
Rolling 10-Year Win % -- 2.01% 2.01% 0.00%
DrawDown Total -1185.14% -1185.14% -1458.99% -1546.69%
Correlation -- 0.951 0.670 0.633
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.01 -0.01
p-value** 0.1200 0.5131
3 Factor (FF) 0.01 0.00 -0.04 0.02
p-value** 0.1279 0.9542 0.2101 0.4846
4 Factor 0.01 0.01 -0.04 0.02 0.02
p-value** 0.2080 0.5966 0.1743 0.2960 0.1557
5 Factor 0.01 0.01 -0.04 0.02 0.02 0.00
p-value** 0.1867 0.6020 0.1767 0.3168 0.1555 0.8280

KEY:
 MA(2,12)_LTR = Index with MA trading rule (2m vs. 12m)  VBA, the volatility regime only, and MA rules
 VBA_LTR = Volatility regime indicator, then MA don’t work in the context of long-bonds.
 Vol Regime_VIX (10,30)_LTR = Volatility regime indicator, only

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 VBA Summary Statistics
Summary Statistics* VBA_Core 5 EW Vol Regime Only_Core 5 EW Core 5 EW_MA Core 5 EW
CAGR 9.76% 11.26% 10.37% 10.51%
Standard Deviation 5.28% 8.24% 8.30% 12.68%
Downside Deviation (MAR=5%) 3.57% 6.01% 6.72% 10.67%
Sharpe Ratio 1.07 0.88 0.77 0.55
Sortino Ratio (MAR=5%) 1.26 1.01 0.78 0.55
Worst Drawdown -9.64% -26.22% -18.96% -47.21%
Worst Month Return -4.86% -8.85% -11.90% -19.43%
Best Month Return 6.32% 13.48% 7.96% 13.48%
Profitable Months 87.42% 84.59% 71.38% 67.30%
Rolling 5-Year Win % -- 30.50% 27.80% 47.49%
Rolling 10-Year Win % -- 44.22% 15.58% 49.75%
DrawDown Total -1166.77% -2487.00% -1967.53% -5204.84%
Correlation -- 0.720 0.622 0.467
*Returns start in 03/1986 for this strategy.

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD
CAPM 0.05 0.12
p-value*** 0.0000 0.0000
3 Factor (FF) 0.05 0.12 0.03 0.03
p-value*** 0.0000 0.0000 0.1994 0.3362
4 Factor 0.04 0.14 0.03 0.05 0.06
p-value*** 0.0000 0.0000 0.2689 0.0606 0.0006
5 Factor 0.04 0.14 0.03 0.04 0.06 -0.01
p-value*** 0.0000 0.0000 0.2934 0.0760 0.0007 0.5697
***Italics denotes p-values significant at the 5% level; robust p-values

KEY:
 Core5_EW=Core5 equal-weight returns  The volatility regime indicator works;
 Core5 EW_MA = MA indicator applied on individual assets, then equal-weighted returns  VBA—volatility regime & MA signal—work
 Vol Regime_Only_Core5 EW = Volatility regime indicator applied to Core 5
 VBA_Core5 EW = Volatility regime indicator, then MA indicator, applied to the Core 5
better.

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 Annual Returns (3/1/1986-8/31/2012)
VBA_Core 5 EW Vol Regime Only_Core 5 EW Core 5 EW_MA Core 5 EW
1986 6.24% 6.40% 16.22% 16.41%
1987 26.14% 34.69% 3.04% 11.29%
1988 13.58% 21.18% 13.64% 21.68%
1989 19.29% 22.01% 23.49% 26.28%
1990 5.97% 7.88% -4.23% -8.46%
1991 6.68% 11.54% 19.34% 30.95%
1992 3.77% 4.28% 6.58% 6.05%
1993 10.77% 11.67% 25.74% 28.88%
1994 10.72% 10.94% 0.19% 0.48%
1995 14.89% 14.53% 17.14% 15.90%
1996 3.78% 4.16% 11.72% 14.19%
1997 8.09% 4.87% 13.32% 10.45%
1998 10.12% 15.47% 5.61% 2.90%
1999 16.73% 19.17% 17.70% 19.33%
2000 9.37% 4.84% 2.39% -3.51%
2001 5.80% 1.98% 6.63% -2.78%
2002 4.08% -2.93% -0.81% -4.81%
2003 12.81% 24.65% 23.43% 32.11%
2004 16.13% 16.13% 18.71% 18.92%
2005 1.52% 1.69% 13.39% 13.58%
2006 24.35% 24.44% 22.47% 22.46%
2007 17.18% 18.27% 10.81% 9.90%
2008 -8.08% -19.06% -2.94% -32.41%
2009 9.72% 29.50% 15.57% 31.77%
2010 7.38% 10.92% 8.65% 16.08%
2011 4.03% 1.61% -2.59% -1.57%
2012_YTD 3.66% 12.27% -0.77% 10.03%

 2008 is the only negative annual return.

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 Invested Growth (3/1/1986-8/31/2012)

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 Market Cycle Performance (3/1/1986-8/31/2012)

 VBA controls risk during bear markets and participates in bull markets.
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 Rolling CAGR Analysis (3/1/1986-8/31/2012)

 VBA delivers consistent results.

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 Drawdown Analysis (3/1/1986-8/31/2012)

 VBA controls risk; 36-month drawdowns are positive

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 ST Stress Test Analysis (3/1/1986-8/31/2012)

 VBA is not affected by major market stress events.

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 Rolling Drawdown Analysis (3/1/1986-8/31/2012)

 VBA consistently controls risk; Core5 EW strains during the 2008 Financial Crisis as correlations go to 1.
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 DISCLAIMER
The views expressed are the views of the authors and are subject to change at any time based on market and other conditions. This document shall not
constitute an offer to sell or the solicitation of any offer to buy any security and should not be construed as such. References to specific securities and
issuers are for illustrative purposes only and not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
While all the information prepared for this document is believed to be accurate, Empiritrage, LLC makes no express warranty as to the completeness or
accuracy, nor can it accept responsibility for errors appearing in the document.

Performance figures contained herein are unaudited and prepared by Empiritrage, LLC. They are intended for illustrative purposes only. Past performance
is not indicative of future results, which may vary.

There is a risk of substantial loss associated with trading commodities, futures, options and other financial instruments. Before trading, investors should
carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when
trading futures, commodities and/or granting/writing options one could lose the full balance of their account. It is also possible to lose more than the initial
deposit when trading futures and/or granting/writing options. All funds committed to such a trading strategy should be purely risk capital.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No
representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are
frequently sharp differences between hypothetical performance results and the actual results subsequently realized 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 in actual trading. For example,
the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual
trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date
first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the
future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not
necessarily recur. 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, all of which can adversely affect actual trading results. Hypothetical
performance results are presented for illustrative purposes only.

There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in
higher or lower than expected.

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1 December 2012 2012 © Empiritrage, LLC. All Rights Reserved.