© 2009 Investment Technology Group, Inc.  All rights reserved.  Not to be reproduced or retransmitted without permission.Broker-dealer products and services offered by ITG Inc., member FINRA, SIPC. 091709-37177

Ian Domowitz, Managing Director

Transaction Costs and Portfolio Capacity Analysis

2

Capacity AnalysisAcademic Definitions and Industry Practice

The dependence between portfolio performance and size of fund

The study of ways to increase AUM for a target level of return

Identification of optimal turnover for every level of AUM

How to expand fund size while ‘remaining efficient’

Current investment strategy will lose 15 places in its ranking by growing to $5B

Based on a peer group of 746 names the fund will likely fall into the second quartile by growing to $6B

Growing to $3.5B, while keeping within first quartile, might be possible with careful liquidity planning

At a level of $2.5B, there is room to increase turnover

3

An Alternative View of Portfolio Capacity Analysis

General themes

ex ante versus ex post

strategy space underlying investment decisions

Fixed portfolio strategy

Determination of turnover and net returns jointly

Capacity

Conclusions

Ex post analysis

Ex ante analysis

4

Cost and Fixed Portfolio Strategies

Daily Market-Impact Costs for U.S. Indices Trade Lists up to $5 Billion

Comparative Market-Impact CostsUS Index Lists Trading One-Day VWAP $100M to $5B

(cost estimates as of August 31, 2006)

0

10

20

30

40

50

60

70

80

90

100

110

0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Dollar Volume Trading One-Day VWAP ($mil)

Da

ily

Ma

rke

t-Im

pa

ct

Co

st

(bp

s)

SP500 Equal Weight

SP500 Index Weight

R2000 Equal Weight

R2000 Index Weight

5

Past is Prologue“Optimal” Turnover

Optimal Turnover, Net Return Decrease with Higher AUM

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 120% 130% 140% 150%

Monthly Turnover Rate

Net

An

nu

al R

etu

rn

Net Return ($20B)

Net Return ($10B)

Net Return ($5B)

Net Return ($2B)

Paper Return

Optimal Turnover Rates for Different Levels of Assets Under Management

6

An Efficient Frontier for Turnover

The Turnover Efficient Frontier

0%

1%

2%

3%

4%

5%

6%

7%

0% 25% 50% 75% 100% 125% 150%

Monthly Turnover Rate

Ne

t A

nn

ua

l R

etu

rn

Net Return ($10B)

Net Return ($5B)

Net Return ($2B)

Turnover Efficient Frontier

Sub-Optimal turnover performance drag

(A) Optimal turnover $2B AUM

(C) Optimal turnover $5B

(B) Sub-Optimal turnover $5B AUM

7

Regional Weights in a Tangent PortfolioAugust 2008$500 Million

39

46

3

7

42

31

16 16

0

5

10

15

20

25

30

35

40

45

50

NorthAm.

LatinAm.

Europe Asia

paper

100%

Source: Investment Technology Group, Inc.

8

The Smoking GunOptimization and Costs

Net Portfolio Value(Non-Cost Aware)

0

10

20

30

40

50

60

Val

ue

($1m

ill)

Sharpe ratio = -1.10

Net Portfolio Value(Cost Aware)

0

10

20

30

40

50

60

Val

ue

(in

$1m

ill)

Sharpe ratio = 0.07

Non-Cost Aware

0%

100%

200%

300%

400%

500%

Tu

rno

ver

(%)

Cost Aware

0%

100%

200%

300%

400%

500%T

urn

ove

r (%

)

9

Turnover Determined

Return vs. realized turnover for different portfolio wealth

-0.40%

-0.35%

-0.30%

-0.25%

-0.20%

-0.15%

-0.10%

10% 20% 30% 40% 50% 60% 70% 80% 90%

realized monthly turnover

mon

thly

ret

urn

tau=0, wealth=$250mln tau=20, wealth=$250mln tau==50, wealth=$250mln

tau=0,wealth=$1bln tau=20, wealth=$1bln tau=50, wealth = $1bln

A250

A1000

10

Optimal Turnover RevisitedLevels Corresponding to Highest Net Return

Optimal Turnover for a Given tau and Portfolio Wealth

0%

5%

10%

15%

20%

25%

30%

35%

40%

250 500 1000 2000 5000Portfolio wealth, $mln

Tu

no

ve

r, %

pe

r m

on

th

-0.25%

-0.20%

-0.15%

-0.10%

-0.05%

0.00%

Re

turn

, % p

er

mo

nth

return optimal tau return tau=0 optimal turnoverturnover tau=0 turnover tau=50

11

Removing Turnover Constraints

The envelope curve which traverses all possible turnover levels for a $500mln fund and which passes through the highest net return

12

Trading Strategy and Turnover

Net return vs. realized turnover

-0.28%

-0.23%

-0.18%

-0.13%

-0.08%

-0.03%

0.02%

1% 2% 3% 4% 5% 6% 7% 8%

realized monthly turnover

mo

nth

ly r

etu

rn

$5Bn, tau=30, 1-day VWAP $5Bn, tau=30, 10% VolPart

$500mln, tau=50, 10% VolPArt $500mln, tau=50, 1-day VWAP

13

Two Lessons from the Analysis

Previous focus on turnover as a choice variable, and on its role as a proxy for implementation cost, is misplaced• Considering stock-specific transaction costs at the portfolio construction stage

enables higher turnover levels • Turnover levels are determined through the interaction of alpha predictions

and expected cost estimates• Managing at higher turnover levels allows for faster processing of new

information, and in conjunction with cost control, leads to superior net return

Limiting the strategy space within which portfolio strategy is formulated negatively impacts returns and reduces the capacity of a fund• Limiting that set of strategies also distorts capacity analysis and biases

capacity choice down, in general• There is particular importance to adding trading strategy to the strategy space

underlying the investment decision

14

Disclaimers

The information contained herein has been taken from trade and statistical services and other sources we deem reliable but we do not represent that such information is accurate or complete and it should not be relied upon as such.  No guarantee or warranty is made as to the reasonableness of the assumptions or the accuracy of the models or market data used by Investment Technology Group, Inc. or the actual results that may be achieved.  These materials are for informational purposes only, and are not intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product.  These materials do not provide any form of advice (investment, tax or legal).  Investment Technology Group, Inc. is not a registered investment adviser and does not provide investment advice or recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy.

Any opinions expressed herein reflect the judgment of the individual presenter as this date and do not necessarily reflect the opinions of Investment Technology Group, Inc. All information, analysis and terms set forth herein are indicative, based on, among other things, market conditions as of the time of this presentation, and are subject to change without notice.