Dow Jones LSP Position Sizing Indexes

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1 Introducing the SM Dow Jones LSP Position Sizing es Introduction On April 26, 2011, Dow Jones es, a leading global index provider, and LSP Partners LLC, a risk management research consulting firm, announced an agreement to develop and cobrand an index family utilizing a proprietary strategy created by LSP Partners founder and CEO, Ralph Vince. Ralph Vince has been recognized as an expert in position sizing, which is an alternative method of portfolio construction and risk management. Position sizing refers to the dollar amount of capital that is allocated to a particular security within a portfolio. By specifying the amount invested, position sizing also seeks to identify this security s risk exposure. Ralph has published five books on investment risk management (see Appendix A), as well as many research papers published by various industry magazines and professional web sites. His most recent book, The Leverage Space Trading Model, describes the Leverage Space Portfolio strategy ( LSP strategy ), which was designed to improve risk-return characteristics of an equity portfolio using his proprietary position sizing method. Dow Jones es has collaborated with LSP Partners LLC to incorporate the LSP theory and strategy into a fully automated indexing application. This indexing approach can be applied to equity portfolios of any size or composition. Leverage Space Portfolio Theory In 1980, Ralph introduced the Optimal f formula, which calculated the fraction of total capital that should be invested in any one stock. Over the succeeding 30 years, he expanded his research to stock portfolios and created the LSP strategy. At its heart, the LSP strategy s objective is to maximize the probability of positive performance, rather than seeking to maximize profits. It employs a risk-control process focused on the management of drawdown 1, as well as capital preservation. Compared to a buy-andhold strategy, the LSP strategy aims for more consistent returns with lower risk and much faster recoveries from drawdowns. According to Ralph, the LSP strategy is designed to address a vital question facing every investor: How much do I invest in a stock portfolio? This essential aspect of the investment process is wholly in the investor s control, and for many may be the only aspect that is. The meaning of leverage in LSP does not refer to borrowing capital to invest, which is the usual definition. In Ralph Vince s lexicon, leverage means using cash reserves to enlarge stock positions when the market is declining and stocks tend to be attractively priced. And space in LSP refers to the continuum from each stock s original buy-in price to the current price, whether higher or lower. When scaled to an entire stock portfolio, space means the relationship of the capital stake to the investment commitment and the relationships of each stock to all the other components. Core Mechanics of the Dow Jones LSP Position Sizing Family Each Dow Jones LSP Position Sizing consists of a basket of component stocks usually an existing index but it could be any random grouping and a cash component (representing a liquid short-term fixed income instrument). At the time the component stock is first added to the basket, the index s algorithm calculates the optimal initial allocation as a fraction of the total portfolio (which is always less than 100%, with remaining balance allocated to the cash component). Once the initial allocation is established, one of two things can trigger index rebalancing and reallocation between the stock and cash components: 1. If the price increases, the stock is liquidated as the price reaches its upside target, which the algorithm calculates based on the buy-in price. The proceeds are allocated to the cash component. A new component is selected from the designated pool and added to the index. The initial weight of that new stock is determined by the relative size of the cash reserve and the total value of the portfolio. 2. If the stock price declines to its downside target, the index s algorithm increases the allocation to the stock at the expense of the cash component. Simultaneously, the program automatically resets (lowers) the upside target in accordance with increasing a component s overall value and its weight in the index. This process is repeated for subsequent stock price declines to its lower downside targets. When eventually that

2 stock s price reverses and reaches its recent upside price target, the stock is again liquidated, the proceeds are allocated to cash and the new stock is selected and added to the index. On the base date of the index, all component stocks are equally weighted. The initial stock allocations are modest and calculated as a fraction of the maximum capital that could be allocated to the stocks in the index. Each Dow Jones LSP Position Sizing starts out with a significant cash component allocation to allow for enlarging stock positions in the index to counteract a price decline scenario. The cash allocation is dynamic and fluctuates depending on the price action of stocks in the index. (See Chart 1). The index is expected to need only a fraction of available capital to achieve its objective which is to close out each stock at its upside target price and thus for the index portfolio to measure positive returns in most cases. The Concept of Risk The Dow Jones LSP Position Sizing es are designed as measures to minimize risk, where risk is defined and measured as drawdown, also known as risk of ruin. This risk becomes known each time when a new component stock is added to the index. It is equal to the total amount of capital to be attributed to the component stock, both initially (which is relatively small) and potentially in the future (which increases the amount at risk, although at lower price levels). Basically, the indexes are designed to be risk averse in bull markets and risk-seeking in bear markets. Why Is Drawdown Important? Drawdown significantly reduces a portfolio s performance in the long run because it requires great positive price movement and time to recover. For example, a 20% drawdown would require a 25% price recovery to the breakeven level, which can take up to 2.3 years assuming a 10% compounded annual growth rate (CAGR). Examples are in the accompanying table (See Table 1). Chart 1. Historical* Weight of the Cash Component of the Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 (01/01/ /31/2011) % Cash (Weight%) 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 12/31/01 2/28/02 4/30/02 6/30/02 8/31/02 10/31/02 12/31/02 2/28/03 4/30/03 6/30/03 8/31/03 10/31/03 12/31/03 2/28/04 4/30/04 6/30/04 8/31/04 10/31/04 12/31/04 2/28/05 4/30/05 6/30/05 8/31/05 10/31/05 12/31/05 2/28/06 4/30/06 6/30/06 8/31/06 10/31/06 12/31/06 2/28/07 4/30/07 6/30/07 8/31/07 10/31/07 12/31/07 2/28/08 4/30/08 6/30/08 8/31/08 10/31/08 12/31/08 2/28/09 4/30/09 6/30/09 8/31/09 10/31/09 12/31/09 2/28/10 4/30/10 6/30/10 8/31/10 10/31/10 12/31/10 2/28/11 4/30/11 6/30/11 8/31/11 10/31/11 12/31/11 2

3 Table 1. Stock Price Dynamics of Recovery from Drawdown Price Action Price Required Price back to Breakeven (%) Required Recovery Time to Breakeven Level at 10% CAGR (Years) Initial Price $ % 0 Price Decline 20% $ % 2.3 Price Decline 30% $ % 3.8 Price Decline 50% $ % 7.3 Price Decline 70% $ % 12.6 Price Decline 75% $ % 14.6 Another illustration of the severe consequences of drawdowns was modeled using historical data for the Dow Jones U.S. Large-Cap Total Stock Market. Each component s maximum drawdown point (peak to trough) during the financial crisis was calculated, and then in Chart 2 the model captured each stock s percent change in price one year after the drawdown trough. The red line (zero line) represents the breakeven point for all 750 stocks in this index. As is clear, one year after their respective drawdowns the vast majority of the index s components fell below their respective breakeven points. Chart 2. Maximum Drawdown: Dow Jones U.S. Large Cap Total Stock Market s components ( ) 2 Maximum Drawdown 0.00% % % % % % % % % % % 60.0% 40.00% 20.00% 0.00% % % P/L 1 Year After Drawdown % % % 3

4 The Dow Jones LSP Position Sizing es are designed to reduce the time of recovery from drawdown as much as possible, and thereby generate positive performance. In backtesting*, the Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 fell 33.25% by February 2009, but recovered to breakeven seven months later. By contrast, the S&P 500 fell 50.95% and had not fully recovered as of January 2012, 35 months after the market bottomed out. (See Table 2). Table 2. Maximum Drawdown: Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P Maximum Drawdown Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 Maximum Drawdown Peak Date Trough Date Recovery Date Drawdown Duration (months) Recovery Duration (months) 1 Year After Trough Required Back to Peak % May 2008 Feb 2009 Sep % - S&P % Oct 2007 Feb % 12.26% Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 The Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 is the first of the initial suite of Dow Jones LSP Position Sizing indexes. Its components are the biggest (by market capitalization) five stocks in each of the ten Dow Jones es industry groups: 1. Oil & Gas 2. Basic Materials 3. Industrials 4. Consumer Goods 5. Health Care 6. Consumer Services 7. Telecommunications 8. Utilities 9. Financials 10. Technology The index s selection criteria was designed to provide diversification by sector. 4

5 Chart 3. Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P 500 (01/01/ /31/2011*) 2 20, Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P , Dow Jones LSP Sizing Equal Sector U.S. Large-Cap 50 S&P , , , , , , , , /01/02 4/01/02 7/01/02 10/01/02 1/01/03 4/01/03 7/01/03 10/01/03 1/01/04 4/01/04 7/01/04 10/01/04 1/01/05 4/01/05 7/01/05 10/01/05 1/01/06 4/01/06 7/01/06 10/01/06 1/01/07 4/01/07 7/01/07 10/01/07 1/01/08 4/01/08 7/01/08 10/01/08 1/01/09 4/01/09 7/01/09 10/01/09 1/01/10 4/01/10 7/01/10 10/01/10 1/01/11 4/01/11 7/01/11 10/01/11 The Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 (based on a review of backtested data) shows higher total returns and lower risk vs. the S&P 500 (Tables 3, 4 and 5). Table 3. Performance: Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P Performance Annualized Return 3-Year 5-Year 10-Year Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap % 5.23% 5.55% S&P % -0.25% 2.92% 5

6 Table 4. Risk: Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P Risk Annualized Risk 3-Year 5-Year 10-Year Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap % 13.58% 11.39% S&P % 18.88% 15.93% Table 5. Annualized Sharpe Ratio: Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap 50 vs. S&P Risk-Adjusted Return Annualized Sharpe Ratio 3-Year 5-Year 10-Year Dow Jones LSP Position Sizing Equal Sector U.S. Large-Cap S&P Conclusion The Dow Jones LSP Position Sizing es intend to increase the probability of positive performance through all market conditions. The means for reaching this goal include allocating capital dynamically between cash and stock components, taking disciplined action when component stocks have reached their upside targets, and minimizing the recovery time from drawdowns. The embedded risk mitigation feature and significant cash reserve are designed so the Dow Jones LSP Position Sizing es can measure a conservative long-term investment strategy. Appendix A Books by Ralph Vince Vince, Ralph. Portfolio Management Formulas. New York: John Wiley, 1990 Vince, Ralph. The Mathematics of Money Management. New York: John Wiley, 1992 Vince, Ralph. The New Money Management. New York: John Wiley, 1995 Vince, Ralph. The Handbook of Portfolio Mathematics. New York: John Wiley, 2007 Vince, Ralph. The Leverage Space Trading Model. New York: John Wiley,

7 For more information on the Dow Jones LSP Position Sizing es SM, or call U.S ; Asia ; Europe Learn more at CME Group Services LLC All rights reserved. "Dow Jones es", the marketing name of CME Group Services LLC ("CME es"), is a trademark of Dow Jones Trademark Holdings LLC. "Dow Jones", "Dow Jones es", "DJ" and all other index names for the Dow Jones-branded indexes listed above are service marks of Dow Jones Trademark Holdings, LLC ("Dow Jones"), and have been licensed for use by CME es. LSP is a service mark of LSP Partners, LLC. The Dow Jones LSP es are published pursuant to an agreement between CME es and LSP Partners, LLC. "CME" is a trademark of Chicago Mercantile Exchange Inc. "S&P", "Standard & Poor's", and "S&P 500" are service marks and/or trademarks of and proprietary to Standard & Poor s Financial Services LLC. All information provided by CME es is impersonal and not tailored to the needs of any person, entity or group of persons. Investment products based on the Dow Jonesbranded indexes listed above are not sponsored, endorsed, sold or promoted by Dow Jones, CME es or their respective affiliates and none of Dow Jones, CME es or any of their respective affiliates make any representation regarding the advisability of investing in such products. Inclusion of a company, bond or futures contract in any of the indexes in these materials does not in any way reflect an opinion of Dow Jones, CME es or any of their respective affiliates on the investment merits of such company, bond or futures contract. None of Dow Jones, CME es or any of their respective affiliates is providing investment advice in connection with these indexes. All information in these materials is provided "as is". CME es, Dow Jones and their respective affiliates do not make any representation regarding the accuracy or completeness of these materials, the content of which may change without notice, and each of CME es, Dow Jones and their respective affiliates disclaim liability related to these materials. Redistribution, reproduction and/or photocopying in whole or in part is prohibited without written permission. 1 Maximum Drawdown is defined as the peak-trough decline. A drawdown is usually quoted as the percentage between the peak and the trough. Maximum drawdown is the maximum loss that a product ever incurred during a specific time period. 2 Data sources: Dow Jones es and Thomson One/Thomson-Reuters. *To the extent information for any index for the period prior to its initial calculation date is made available, any such information will be back-tested (i.e., calculations of how the indexes might have performed during that time period if the indexes had existed). Any comparisons, assertions and conclusions regarding the performance of the indexes during the time period prior to the initial calculation date will be based on back-testing. Back-tested performance information is purely hypothetical and is provided solely for informational purposes. Back-tested performance does not represent actual performance, and should not be interpreted as an indication of actual performance. Past performance is also not indicative of future results. performance is not the same as fund performance as it does not reflect management and other fees. 7