Summary

-Strategy MarketEthos Capital employs a multi-strategy approach in managing futures accounts in order to maximize return per unit risk. MarketEthos Capital applies multiple, non-correlated, positive expectation strategies to achieve a smoother portfolio equity curve. Currently, these strategies include statistical arbitrage and objective or mechanical technical trades. The first strategy employed by MarketEthos Capital is a statistical arbitrage pairs trading system. This strategy involves trades that match long and short positions in correlated securities, such as a yield curve spread involving different maturities of U.S. Treasury futures. With its statistical arbitrage systems, MarketEthos Capital seeks to profit from fluctuations within the spread between these correlated securities as opposed to the direction of either or both of the individual contracts. Its systems incorporate volatility-based hedge ratios so profitability is not correlated with, or dependent upon, the performance of the markets being traded. The non-correlation of MarketEthos Capital's trading program makes it an attractive diversifying component for investment portfolios that already include fixed income and/or equity market exposure. The second strategy used to manage customer accounts is a short-term countertrend system applied to broad-based equity index futures in the United States and Europe. Once an established trend is in place, the system will place limit orders to enter a countertrend position at what is often an overextended price zone. If the limit order is filled and a position is entered, a stop order is placed 6% away from the entry fill price. A limit order is also placed to exit the position. If either exit order is filled, the other one is cancelled. This system has an average holding time of 1.5 days and is also not correlated with the performance of the markets it trades. MarketEthos Capital makes extensive use of customized software in various aspects of its trading system research and execution. Current and potential strategies are simulated on a stand-alone basis and in portfolios combined with other strategies to quantify profitability and risk. MarketEthos Capital also uses these simulations to identify robust parameter sets for each strategy. Trades may be placed manually by a MarketEthos Capital trader or automatically by Rikou Systems trading software. Trades placed by the software are recorded in a database along with indicators present at the time of order entry. This database is then analyzed to compare actual trading results with simulated results for the same time period in order to verify performance and adjust slippage estimates for similar execution scenarios in that market. Also, the execution data allows testing of the recorded indicators to determine if they were useful in identifying advantageous trades. Correlation The pairs trading and index countertrend strategies are not correlated with each other, the performance of the markets they trade, or the performance of other managers or categories. Both systems rely on proprietary, quantitative models for their entry and exit levels, are equally likely to trade long or short positions, and are out of the market at times. This non-correlated performance ensures that adding the MarketEthos Capital trading program to a portfolio will add diversification and increase expected return per unit risk, regardless of the existing portfolio composition. Risk We believe that rigorous risk control is the most important factor in the long-term success of our firm. Our philosophy is to identify specific risks at various levels and address them, as well as building a solid foundation of business practices to best withstand unforeseen events. We evaluate many types of risk in conducting our trading business, which encompass the tactical, strategy, portfolio, and business levels. Tactical risk involves trade execution. In our pairs trading system, the tactical risk lies in executing the second leg of the spread trade after the first side is filled. In order to reduce the risk of prices moving away from our levels after one leg is filled, we cancel resting limit orders before known economic announcements are scheduled to be released. Once the first leg of our trade is filled, one of our traders or an automated system will move quickly to cross the market if appropriate, or continue to monitor the status of our limit order and update it if necessary. In our index countertrend system, there is little tactical risk as we rely on resting limit orders and stops. Strategy risk involves both expected fluctuations and the potential for infrequent, sudden moves in the market. Different strategies have different risk profiles, and each strategy must be evaluated to determine the appropriate method of risk control, which will include position sizing and may include stops and/or the purchase of protective options. The risk control for our pairs trading system consists of an exit target level that trails the price action and appropriate position sizing. At the time a trade is entered, the exit target level would close the position out for a profit. Each day the trade remains open, the exit target level moves toward the current price action, resulting in a smaller profit or a loss when the position is offset. A simulation of the pairs trading system using the same position sizing as the ME Standard Program experienced a maximum drawdown of 12.22% in the 11 year test period from January 3, 1995 through December 30, 2005. There were 3 other drawdowns between 10% and 12%. This is an acceptable level of routine fluctuation risk for the ME Standard Program. If a drawdown twice as large as the worst seen in those 11 years occurs, accounts will be down 24.44% which is acceptable risk for a low probability event on the ME Standard Program. Finally, a study of the largest potential 1 day absolute percentage equity changes using the ME Standard position sizing from August 18, 1988 through March 29, 2006 showed a largest change of 9.98% on April 5, 1994. The price movements from all days were evaluated regardless of whether the system would have had a position, as the goal was to identify the largest potential change during the period. Since 1995, the only potential 1 day change of more than 4% occurred on the day of the terrorist attacks on September 11, 2001, when there was a potential change of 6%. Again, the purpose of the study was to identify the largest potential 1 day changes, regardless of whether the system would have had a losing position, no position, or a winning position on that day. If there were to be a losing position on a day with twice the magnitude of the April 5, 1994 relative movement, which was the largest move in the test period of over 17 years, it would result in a 19.96% loss. That is an acceptable level of risk on the ME Standard Program, for a rare, extreme move. The risk control for our index countertrend system involves a stop order set 6% away from the entry price, and a target exposure of 200% of account equity if all contracts are long or short at the same time. A simulation of the index countertrend system using the same position sizing as the ME Standard Program experienced a maximum drawdown of 4.82% in the test period from May 1, 2003 through March 24, 2006. There were other drawdowns of 3.77%, 3.06%, and 2.94%. This is an acceptable level of routine fluctuation risk for the ME Standard Program. In a scenario where global markets have an extreme move which we faded in all contracts and were subsequently stopped out, that would result in a 12% loss of equity. No such events occurred during the test period, but effective risk control includes evaluating situations beyond the available data. If all markets had maximum positions and then a 15% gap occurred over a weekend, that would result in a 30% loss of equity on the ME Standard Program, which is acceptable for that specific scenario. Portfolio Risk involves addressing issues such as correlation between strategies and aggregate positions. The pairs trading system and the index countertrend system are not correlated with each other, and they trade different contracts and different product types, so there is not significant portfolio risk beyond the properties of each system. Business Risk involves issues such as emergency backup systems and the ability to trade and manage positions when key personnel are absent. We have the ability to trade from 3 sites in 2 cities. All locations have full trading and position management capabilities. We have battery backup power supplies, cell phones, and the ability to place orders over the phone. All 3 of our trading principals are capable of executing all necessary trades and managing positions and do so on a daily basis. Experience Faris P. Hitti, Managing Partner 15 years experience trading proprietary capital in futures, options, and equities both on exchange floors and electronically. 1991-1994: Options Trader, O'Connor / Swiss Bank / Morgan Stanley. 1995-1996: Options Marketmaker, Pacific Stock Exchange Options Floor. 1996-2005: Proprietary Equity and Equity Options Trader, Headwaters Capital. 2005-2006: Managing Partner, MarketEthos Capital. Sean Phelan, Partner 12 years experience in the financial markets, of which 10.5 years were spent in trading either in a marketmaking capacity, trading proprietary capital or managing client funds. Positions held include Assistant Stock Specialist for Pershing Trading Company on the Pacific Stock Exchange, Assistant Portfolio Manager for the emerging hedge fund Bellwether Partners LLC, and Proprietary Equity and Equity Options Trader for Headwaters Capital. Chris Kourakis, Partner 10 years experience in the trading industry in execution, proprietary trading, and money management. Worked as a Trading Assistant and Floor Manager on the Pacific Stock Exchange Options Floor with Faris Hitti, Cole Roesler & Associates, and Refco. Was a NASDAQ Marketmaker with New York Broker Inc. for two years and then joined Headwaters Capital as a Proprietary Equity and Equity Options Trader in 2002. Founded MarketEthos Capital with Faris Hitti, Sean Phelan, and Debra Hitti in 2005. Debra Hitti, Partner 5 years experience as a Proprietary Equity Trader with Headwaters Capital. Admitted to practice law in four states. Experience as an attorney in both the private and public sectors. Worked for the United States of America's General Services Administration for eight years as an attorney and Senior Real Estate Specialist.