Fighting Greek Fire with Fire: Volatility, Correlation, and Truth

Note: The following article is an excerpt from the Third Quarter 2011 Letter to Investors from Artemis Capital Management LLC published on September 30, 2011.

Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011

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Fighting Greek Fire with Fire: Volatility, Correlation, and Truth

The world economy is fighting a fearsome wildfire as the European sovereign debt crisis burns its way closer toward the tinderbox of a second global recession. The insolvency inferno has no prejudice and will fuse to the flesh of any asset class fueling a blistering spiral of correlation and volatility. The third quarter of 2011 was characterized by explosive movements in equity markets as the S&P 500 index declined -14% in the worst performance since the crash of 2008. Global indices officially entered bear market territory with the MSCI All-Country World Index down more than -20% since peaking in May. The 10-year US Treasury yield reached the lowest level on record in September as credit markets braced for an economic slowdown. Over the quarter implied volatility increased +96% as the VIX index climbed to 42.96. If you heeded the omens of variance markets earlier this year you were richly rewarded by this increase in volatility. A wildfire is blind and cruel in violently transforming the essence of any material to ash. In this sense the end-effect of fire is always correlation and volatility. The common method to extinguish a wildfire is by dousing it with water but what if this is not enough? Is it possible for fire to resist or spread through the addition of liquidity? Ironically in recorded history there is one such type of flame... Greek Fire. Greek Fire was the most feared weapon of the Byzantine Empire because water alone was powerless against its flames. The composition of the weapon is an ancient secret but modern scientists believe it was made with calcium phosphide (heating lime, bones, charcoal) which, upon contact with water, ignites spontaneously. Greek Fire was so difficult to extinguish that it was known to continue to burn even underneath bodies of water. The fire could fuse to any surface, including the sea, explode and spread uncontrollably. For this reason the ancient napalm was very effective in naval warfare and saved Constantinople from two Arab sieges. The guardians of the formula were so afraid it would fall into enemy hands that its secrets were eventually lost to time(1). For those who fought against Greek Fire a liquidity trap became a liquidity grave. In the new era of global interconnectedness liquidity alone is not enough to extinguish Europe's Greek Fire. The smoldering flames of default are spreading impervious to fiat money creation. The unintended consequences of unprecedented intervention in markets are culminating in higher cross-asset correlations and violent price gyrations. All we left have to show for our three year liquidity orgy is the most correlated period in modern finance. The propensity for erratic movements in DJIA daily lagged returns is at the most extreme levels in over nine decades of recorded data. We are trapped in a binary market governed by the flip of a macroeconomic coin with deflation on one side and government bail-outs on the other. In this hyper-correlated market many alpha generating strategies resemble directional volatility trades. The more global asset classes move in lockstep the more haphazardly the international response to the crisis has become. A currency war is raging as central banks alternate dousing sovereign insolvency flames with uncoordinated currency devaluation. Whether this is Brazil unexpectedly cutting rates by 50 basis points despite the highest inflation in six years or Switzerland pegging the Franc to the Euro to protect exports it is every man, woman, and central bank for itself. Every day we see new kinks in the armor of prior economic and political alliances that lay vulnerable to surrender in a vicious selfreinforcing cycle of devaluation. While public opposition grows to bail-out economics the Federal Reserve has very few credible stimulus options remaining to battle the inferno. Greek Fire in Europe threatens to ignite a global recession and if you haven't already noticed, your alpha is burning. There are no safe havens and to survive the flames of the next decade we must embrace and harness their nature. Fight fire with fire ...volatility with volatility In markets and in life, to find truth

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Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 Thoughts on Volatility - Omens and Intuition In my last letter I spoke at length about the abnormally steep volatility term-structure arguing it represented structural imbalances in risk driven by the unintended consequences of monetary policy ("Is Volatility Broken: Normalcy Bias and Abnormal Variance" Q1 2011). Earlier this year it was clear the volatility markets were bracing for a correction following the end of QE2. With this thesis in mind Artemis recommended shorting the long-end of the VIX futures curve where volatility of volatility ("VOV") was expensive and replacing that exposure with more sensitive volatility positions on the front of the curve where VOV was cheap. The strategy was extremely effective when equity markets collapsed and the VIX futures curve inverted while options skew flattened. What happens from here is much more difficult to understand. The consensus view is that volatility is mean reverting and when the VIX is above 40 and realized volatility is only at 30 the implied volatility premium is very expensive. Nonetheless my intuition tells me that given the current Euro-crisis, hyper-correlations, lack of remaining stimulus options, and structural fragility of markets there are enough catalysts for the VIX to break even higher in the next few months. Investors have a limited imagination regarding the potential for greater realized volatility. Historical realized volatility data of the DJIA going back to 1929 shows volatility climbed to 2008 highs a total of six times in the past eighty years. If options existed during the Great Depression we would have seen multiple observations of 50+ implied volatility levels from 1928 to 1933 (based on realized volatility calculated from DJIA returns). During the Black Monday crash of 1987 the VIX index would most likely have recorded levels above 100! That blows away the intra-day high of 89.53 reached on October 24, 2011 at the height to the last crash. A retest of volatility extremes last seen in 2008 and 1987 would require an uncontrolled default on Greek debt (similar to Lehman 2008) in combination with some kind of structural shock (similar to the flash crash in 2010). This is improbable but within the realm of possibility so look for signs of contagion that would spark realized and implied volatility to break the rules of power laws all over again.

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VIX Futures Curve (normalized by spot VIX / Jan 2011 to Sept 2011
1.70x
Vix Future / VIX spot

1.50x 1.30x 1.10x 0.90x 0.70x 0.50x

Jan-11 Feb-11 Mar-11 Apr-11

May-11

VXF7 VXF6 VXF5 VXF4 VXF3 VXF2

Jul-11

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Sep-11

VXF1

Volatility of VIX Futures Curve (Vol of Vol) (2008 to Present)

VIX Futures

With this uncertainty in mind the best course of action is to play both tails of the probability distribution. Global markets are now hyper-correlated and therefore asset selection is less important. Look for tail risk hedges in assets that exhibit low implied volatility relative to realized and cheap skew to the upside and downside. You can use this market schizophrenia to your advantage by entering long volatility tail positions on both sides of the return distribution during the peaks and the valleys of the market rollercoaster.

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07-Apr-11

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04-Feb-11

03-Dec-10

04-Oct-10 03-Aug-10 02-Jun-10 31-Mar-10 28-Jan-10 24-Nov-09 24-Sep-09 24-Jul-09 22-May- 23-Mar-09 20-Jan-09 14-Nov-08 16-Sep-08 16-Jul-08

VIX

VIX Futures

251 201 151 101 51 1

VIX VXF1 VXF2 VXF3 VXF4 VXF5 VXF6 VXF7

Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 Fire & Water / Volatility and Money From water comes life and from cash liquidity comes asset prices. Money itself is not immune to the laws of supply and demand and we can measure its volatility. Extremes in the volatility of the money supply, defined here as annualized monthly changes in M1 through M3, reflect important turning points in the US economy. To this effect we have never experienced a spike in M1 volatility as large as what was recorded in August 2011 without an ensuing recession. When the money supply is volatile the risk of a recession grows incrementally higher. The volatility of M1, defined as physical currency in circulation and checking deposits, typically spikes before the onset of a recession because market participants transfer risk assets back into physical cash (see graphic). In this sense, money is one of the only assets whereby volatility spikes occur in conjunction with high demand (US Treasury securities also come to mind). The evolution of cash volatility provides clues to the mystery of elevated global correlations. The volatility of the money supply has been climbing higher since the 1970s and the relationship between the volatility of M3 and M1 resembles an expanding sine wave or feedback loop (see chart). This is indicative of the fact increasingly violent shifts in the M1 physical cash supply are not matched by higher volatility in the broader M3 measurement that estimates credit creation and animal spirits(2). Therefore it takes vastly more liquidity today to rouse the shadow banking system but at the cost of higher potential for market dislocation. The ancient weapon of Greek Fire was deadly because its flames fused to the very liquidity used to fight it resulting in a larger blaze. Europe is a perfect example of this paradox. How can the EU provide unlimited liquidity to a stability fund backstopping most of southern Europe without threatening the sovereign credit of stronger member nations like France or Germany in the process? What happens if a member nation that serves as a pillar of that facility in calm markets is then forced to use it in times of market stress? In this self-feeding predicament excess liquidity during a contagion fuels further insolvency and is arguably the cause of, not the solution to, market disequilibrium.

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35 30

Volatility of Money Supply (annualized / 1971 to 2011)

Volatility of Money Supply

25 20 15 10 5 0

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Recession (Peak to Trough) Volatility of M1 Volatility of M2 Source: M1,M2 & M3 values from Shadow Government Statistics Volatility of M3

15 10
Difference Money Supply Volatility

Difference Annual M3 Volatility- M1 Volatility (annualized / 1971 to 2011)

5 0 -5 -10 -15 -20 -25

1972 1974 1976 1978 1979 1981 1983 1985 1986 1988 1990 1992 1993 1995 1997 1999 2000 2002 2004 2006 2007 2009 2011

Recession (Peak to Trough) Volatility of M3 - Volatility of M1

Source: M1,M2 & M3 values from Shadow Government Statistics

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Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011

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Assets to Ash - Correlation in the Greek Fire It is not a secret that we are experiencing some of the highest cross-asset correlations in market history rending traditional portfolio diversification futile. For example in this quarter we recorded the highest realized correlation readings ever for the 50 largest S&P 500 index stocks, S&P 500 sectors, Country ETFs, and in the CBOE S&P 500 Implied Correlation Index. We have yet to fully comprehend the extent to which bail-out economics, competitive currency devaluation, and unprecedented global monetary stimulus are contributing to what is now a decade long trend of higher correlation drift.
85
S&P 500 - 21 day Rolling Correlation Index S&P 500 Index Implied Correlation

75 65 55 45 35 25 15 5
Oct-05

Realized Correlation of 50 Largest Cap S&P 500 stocks (1 month rolling- 2005 to Present)

78 73 68 63 58 53 48 43 38 33
May-07

Implied Correlation of S&P 500 Index (12 month constant adjustement)

May-08

May-09

May-10

May-11

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Nov-07

Nov-08

Nov-09

Nov-10

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

120 100 80

Feb-05

Ranked 21 day Realized Correlations of 50 LargeCap Stocks in SPX (2005 to Present)

Feb-06

Feb-09

Feb-10

Feb-11

Feb-07

Feb-08

0.75 0.65 0.55 0.45 0.35 0.25

S&P 500 Sector Correlation

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2

Country ETF Correlation

21 day Realized Correlation

60 40 20 0 -20 -40 -60 -80 1 101 201 301 401 9/7/2011 (Highest Correlation at 0.82) 2008 Crash High (11/13/2008 - Correlation at 0.76) Bull Market Low (11/3/2006 - Correlation at 0.10) Ranking (Lowest to Highest) 501 601 701 801 901 1001 1101 1201

0.15 0.05

2000

2001

2002

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2005

2006

2007

2008

2009

2010

Volatility of the Fire If volatility is the heat of the fire correlations are the winds stirring the flames. The implied volatility of an index, such as the S&P 500, is more sensitive when the average correlations between the components of the index are greater. For example, if average correlation of index components rises from 0.35 to 0.70 the volatility of that index should be 45% more sensitive. Therefore as correlations have drifted higher over the past decade so has the volatility of volatility. To this effect volatility itself should be moving faster than ever before and it is. The volatility of the VIX index reached the highest level in history at the end of August (see graph) surpassing readings achieved during the 2008 financial crash and 2010 flash crash. The trend is troublesome for traditional portfolio management but presents opportunities for volatility as an asset class. Look to capitalize on higher volatility of volatility potential through timely execution of long vega/convexity positions on the tails of the return distribution.

270

21d Volatility of the VIX Index (2000 to Present)

Volatility of the VIX index (% annualized)

220

170

120

70

20

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2008

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2010

2011

Sep-11 Apr-11 Nov-10 Jun-10 Jan-10 Aug-09 Mar-09 Oct-08 May-08 Dec-07 Jul-07 Feb-07 Sep-06 Apr-06 Nov-05 Jun-05 Jan-05 Aug-04 Mar-04 Oct-03 May-03 Dec-02 Jul-02 Feb-02 Sep-01 Apr-01 Nov-00 Jun-00 Jan-00

Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 Everyone is a Volatility Trader

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It is becoming harder and harder to make money Hedge Fund Strategies 1-month Correlations from money. The alpha derived from active 0.9 (HFRX Equity Hedge, Relative Value, Event Driven / 2-day lag) management can be decomposed into two components 1) asset selection and; 2) volatility bias. 0.7 In highly correlated markets the asset selection component is negated and alpha becomes 0.5 increasingly driven by rising and falling vol. When this happens many classic hedge fund strategies 0.3 converge to simple synthetic volatility trades. This could be one reason why many high profile 0.1 managers including Druckenmiller and Soros are quitting the business while they are still ahead of the curve. For example strategies that rely upon mean -0.1 reversion such as traditional value investing, pairs trading, and statistical arbitrage become akin to -0.3 shorting volatility. The common retail strategy of buying a stock on dips and selling on strength is literally part of the process for synthetic replication of a variance swap (rebalanced to one share every day). Remove the asset selection component entirely and you are effectively shorting volatility. Likewise investment strategies that rely on trend following such as managed futures and global-macro are akin to going long volatility. This is one reason why, like everything else, hedge fund returns are becoming more correlated with one another (see graphic / HFRX indices).
Jul-09 Jul-08 Jul-10 Jul-11 Apr-09 Apr-08 Apr-10 Apr-11 Jan-08 Jan-09 Jan-10 Jan-11 Oct-08 Oct-09 Oct-10

Volatility and the Carry Trade When Greek Fire fuses to the sea the water itself becomes an extension of the flames. To this effect the daily performance of equity volatility and currencies is increasingly indistuinguisable. I understand that some volatility traders hate currencies on the basis that you never know when central banks will change the rules of the game. In today's markets currency trading and volatility trading are being played on the same court with the same unpredictable referees. We can best understand excessive correlation drift between equity vol and risk currencies as being driven by lower interest rates in developed economies that provide fuel to the carry trade fire. Since 2008 the VIX index and the JPY/AUD cross has moved in near perfect lockstep (see below) recording a 0.85 correlation. The trend is also noteceable in the correlation drift between the VIX index and a cross-section of "risk" currencies. Furthermore the correlation drift between the VSTOXX (European equity volatility) and the Euro/USD is also at historical extremes. The marriage of volatility and currency is a worrisome devlopment because it implies the equity risk premium is not about economic fundamentals but instead is a function of global central banks fueling leveraged carry trades.
90 80 20 70 60 40

VIX (lhs) vs. Japanese Yen/Aussie Dollar(rhs) Correlation = 0.85 since September 2008

0.6
0

3-month Correlation VSTOXX to Euro/USD

0.5 0.3 0.1 -0.1

3-month Correlation VIX to Risk Currencies

(AUD.USD; CAD.USD ; NZD.USD; AUD.JPY; EUR.CHF)

0.4 0.2
JPY/AUD

VIX index %

50 40 30 20

60 80

0 -0.3 -0.2 -0.5 -0.4 -0.6 -0.7 -0.9

100 10 0 120

Sep-11 Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 Mar-07 Sep-06 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 Mar-03 Sep-02 Mar-02 Sep-01 Mar-01 Sep-00 Mar-00

Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 Jan-08 Oct-07 Jul-07 Apr-07

Aug-11 Feb-11 Aug-10 Feb-10 Aug-09 Feb-09 Aug-08 Feb-08 Aug-07 Feb-07 Aug-06 Feb-06 Aug-05 Feb-05 Aug-04 Feb-04 Aug-03

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Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 40 years of Mean Reversion
0.5

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Negative Serial Correlation Positive Serial Correlation

Rolling 1yr Serial Correlation of daily lagged returns Dow Jones Industrial Average (1928 to 2011)
<0 Negative Daily Correlation >0 Positive Daily Correlation

0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4

10/9/1931 6mo Return = -51%

8/15/1971 US leaves gold standard

3/18/2004 6mo Return = -0.1% 9/30/2008 6mo Return = -37% 11/24/1964 6mo Return = +3% Lowest Negative Serial Correlation 8/11/2011 6mo Return = ??

1935

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1929

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The degree of up and down days in the DJIA is at the most extreme level in recorded history representing a pinnacle in an era of daily mean reversion. It only takes a casual observer of markets to see that the propensity for large-up days followed by large-down days seems particularly vicious in today's cycle. The excessive intra-day and day-to-day volatility is nauseating to professional and retail investors alike and multi-100 point swings in the DJIA are all too common. On a macro-level changes in the size and volatility of the money supply may be connected to a phenomenon called serial correlation drift. Modern derivative pricing theory is based on a conceptual idea that knowledge of past prices has no bearing on future returns (martingales). Despite this fact there is evidence that asset returns show signs of "serial correlation" whereby past returns are correlated (to some level) with future results. There are two forms of serial correlation 1) Negative serial correlation measures the propensity for today's return to be the opposite of yesterday's and rewards reversion to the mean strategies. For example an asset that alternates between being +1% and -1% every day demonstrates perfect negative serial correlation. 2) Positive serial correlation is associated with consecutive days of asset price movement in the same direction and rewards trend following models. Both forms of serial correlation can occur in up or down trending markets. We are going nowhere at the fastest pace in market history. The rolling one year serial correlation of daily lagged logarithmic returns in the DJIA reached a generational peak on May 25th, 1971. Less than three months later on August 15th, 1971 President Nixon surprised the international monetary system by cancelling the direct convertibility of the United States dollar to gold. After the "Nixon Shock" positive serial correlation in DJIA daily returns began a four decade decline. On August 11th, 2011 we reached the lowest levels of serial correlation in the 82 year history of the DJIA almost exactly 40 years to the day that Nixon abandoned the gold standard. 0.25 Is this a statistical coincidence? A random coin flip, whereby heads represent a +1% day on the market and tails a -1%, will also occasionally exhibit serial correlation extremes on a rolling one year basis. Despite this fact, this coin flip test, run over 100 years through 10,000 simulations shows nowhere near the serial correlation drift seen in the DJIA results and has much lower positive and negative extremes (see one sample simulation to the right). If DJIA serial correlation drift is real is it possible that monetary expansion has artificially rewarded stock market mean reversion strategies (such as value investing and buying on dips) for the past 40 years? If this is true does today represent the beginning of the new era of trend following and volatility?
Positive Serial
0.2 0.15 0.1 0.05 0
(Heads = +1% , Tails = -1%) <0 Negative Daily Correlation >0 Positive Daily Correlation

Rolling Correlation Random Coin Flips

Negative Serial

-0.05 -0.1 -0.15 -0.2

Year 17

Year 25

Year 33

Year 41

Year 49

Year 57

Year 65

Year 73

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Year 1

Year 9

2007

2010

Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011

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Smoke in the Panic Room As investors sought refuge from crashing markets many "safe haven" assets actually began to appear risky. At alternating times during the quarter confidence was shaken in established havens including the US dollar, US Treasury securities, Swiss Franc, and Gold. This was a stark reminder that "risk-free" is a myth. MBA programs teach their students to use the yield on US government debt as the "risk-free rate" of return in the capital asset pricing model. The only problem is now "risk-free" is rated AA+. In a bold decision on August 5th, Standard & Poor's announced that it lowered the United States' credit rating citing political risks and a rising debt burden. Prior to the downgrade US Treasury Bonds and the dollar were already losing value as partisan bickering over the debt ceiling raised the specter of an unthinkable US default. Counter intuitively this represented a buying opportunity. In August and September US Treasury securities rallied on recession fears and the yield on the 10 year fell 84 basis points to an all time low of 1.72% by September 22nd. Nonetheless our political risk is rapidly becoming credit risk. Over the past few years the Swiss Franc was a popular safe haven appreciating +28% against the Euro and +50% against the dollar since 2003 much to a chagrin of the people who export quality watches and chocolate. On September 6th in a surprise decision the Swiss National Bank devalued the Franc pegging it at 1.20x to the Euro resulting in an immediate +8.9% gain against the dollar. Evolution of Implied Volatility Surface for Investor Save Havens The new risks in supposedly "safe Third Quarter 2011 haven" currencies may encourage UUP ETF ($USD Index Bullish) - 120 Day Volatility Skew TLT 20+ US Treasury ETF- 120 Day Volatility Skew us all to become gold bugs, but June 24 to September 30, 2011 June 24 to Sept 30 2011 1.70x before you buy a shotgun and a 2.35x 1.60x 2.15x strongbox keep in mind that gold 1.50x 1.95x 1.40x 1.75x also took a beating this quarter. In 1.30x 1.55x 1.20x September the GLD ETF was 1.35x 1.15x 1.10x down -11.06% compared to -7.18% 0.95x 1.00x 0.75x 0.90x decline in the S&P 500 index. The 0.80x thesis for gold ownership is logical considering global competitive currency devaluation but it is always dangerous to be in the most % OTM % OTM crowded trade when the margin 0.00x 0.27x TLT 20+ US Treasury ETF - 5% OTM Vol Skew UUP 10% OTM Vol Skew comes due. In these markets gold -0.10x 0.25x -0.20x has behaved like a safe haven in 0.23x -0.30x 0.21x the good times, and a commodity -0.40x 0.19x -0.50x during the bad. This is -0.60x 0.17x Jun-11 Jul-11 Aug-11 Sep-11 Jun-11 Jul-11 Aug-11 Sep-11 disappointing if the objective is GLD ETF - 120 Day Volatility Skew FXF ETF (Swiss Franc Bullish) - 120 Day Volatility Skew true safe haven status. June 24 to September 30, 2011 June 24 to September 30, 2011 If recent history is any guide 1.25x 1.95x investors seeking shelter from 1.20x 1.75x 1.15x crisis are finding smoke in every 1.55x 1.10x 1.35x panic room. The global financial 1.05x 1.15x system seems poised for 1.00x 0.95x 0.95x monumental changes over the next decade and there is no telling if today's safe haven may be tomorrow's risk asset. To this effect the importance of volatility % OTM % OTM and convexity in a portfolio 0.20x 0.20x GLD 20% OTM Vol Skew FXF Swiss Franc 10% OTM Vol Skew shouldn't be underestimated 0.15x 0.15x 0.10x 0.10x because they offer protection 0.05x 0.05x 0.00x 0.00x against risks we don't yet know or -0.05x -0.05x -0.10x -0.15x -0.10x fully understand. -0.20x -0.15x
Implied Volatility / ATM Vol Ratio 24-Jun-11 08-Jul-11 22-Jul-11

Implied Vol / ATM Vol Ratio

05-Aug-11

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-20.0% -10.0% ATM 10.0% 20.0% 30.0% 40.0%

19-Aug-11

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5-Aug-11

50.0% 40.0% 30.0% 20.0% 15.0% 10.0% 5.0% ATM

02-Sep-11

26-Aug-11

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-10.0%

16-Sep-11

-15.0%

16-Sep-11

-20.0%

-30.0%

-30.0%

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-50%

30-Sep-11 -50%

Implied Volatility / ATM Vol Ratio

-40.0%

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Implied Volatility / ATM Vol Ratio

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16-Sep-11

02-Sep-11

16-Sep-11

30-Sep-11

Jun-11

Jul-11

Aug-11

Sep-11

Jun-11

Jul-11

30-Sep-11 -50%

-40.0%

Aug-11

-30.0%

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-20.0% -10.0% ATM 10.0% 20.0% 30.0% 40.0% 50.0%

05-Aug-11

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40.0% 30.0% 20.0% 10.0% ATM -10.0% -20.0% -30.0% -40.0%

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-50%

Sep-11

Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 Fighting Greek Fire with Fire Fight volatility with volatility and take advantage of the erratic movements in markets to strategically establish long tail risk positions on both sides of the return distribution in asset classes with competitively priced skew and vol. The strategy is effectively a global macro-straddle that is long volatility and convexity. As world draws closer to a second recession the unpredictable rising and falling tides of liquidity will either lift or sink all ships. Owning a small amount of volatility in both tails of the distribution gives the potential for exponential profits during the next deflationary crisis or shock-and-awe government intervention. The table to right presents a multi-asset comparison of volatility risk premiums that will serve as a starting point. For example during the next viscious short covering rally you may consider buying competitively priced far-OTM put options in emerging economies or Asian equities. In the event developed economies like the US and Europe fall back into recession there is little reason to believe equity volatility in China, Japan, South Africa, or Chile will be immune given trends in correlation. When equity markets are oversold protect against surprise monetary intervention using unloved farOTM call options on financials, high yield debt, and OTM puts on the Yen and US dollar index. With a small amount of risk capital you can win on both sides of the macroeconomic coin toss. Monetize Volatility of Volatility VIX options provide attractive opportunities for sophisticated investors to hedge against global contagion risk. Although the VIX index is currently elevated the skew, or spread between the local volatilities for VIX options (adjusted by historical standard deviation moves) is extremely flat. When the VIX index increases the option skew typically pancakes as volatility of volatility shifts from OTM calls to OTM puts reflecting higher probability of mean reversion (see chart). Hedgers can monetize this flat skew by executing a reverse ratio spread that will protect a portfolio in the event of cataclysmic decline in markets. To execute this trade sell OTM VIX calls at +1 or +2 standard deviations above the respective November or December VIX futures price and purchase 2x the number of further OTM calls. This "Euro-pocalypse" hedge will provide an exponential payoff in the event the VIX increases above 50+ but will otherwise result in a small loss of capital.
Volatility of VIX Futures as a ratio to ATM Vol

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Cross-Asset ETF Volatility Insurance Ratio Ratio = Avg. 12 Month Volatility Skew & Implied Vol / Historic Vol Higher Ratio = Higher Cost for Protection against Loss
SPY QQQ IWM ^VIX XLY XLP XLE XLF XLI XLK XLB XLU EFA EEM FXI EWH EWY EWA EWJ EWZ ECH EWW EZA EWG EWI EWP EWU TLT IEI IEF LQD HYG JNK PFF TIP BND AGG UUP FXC FXA FXF FXE FXS FXY GLD SLV USO GDX UNG DBA MOO DBB JJC 0.00x 0.20x 0.40x 0.60x

Exchange Traded Product

Domestic Equity Volatility Domestic Equity - Sectors Intl. Equity - Index Intl. Equity - Asia Intl. Equity - Americas & S. Africa Intl. Equity - Europe Domestic Fixed Income Currency Commodities

0.80x 1.00x Volatility Insurance Ratio

1.20x

1.40x

1.60x

Source: Ivolatility.com Ratio= Average of [(10% OTM Put Vol - 10% OTM Call Vol) / ATM Vol] and [1m Implied Vol/1m Historic Realized Vol]

1.40x 1.30x 1.20x 1.10x 1.00x 0.90x 0.80x 0.70x

Volatility Skew of the VIX Index (VIX options at 30 days to expiry)

Current Skew VIX@ 42 Average Skew Since 2004 Average Skew for 1yr Average Skew for 6mos Post-Lehman Sept16 2008
OTM VIX Puts OTM VIX Calls

0.60x VIX Strike Price Expressed as Standard Deviation of VIX future

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Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011 Volatility and Truth

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It is becoming harder for markets to deny the existential state of the global economy. The large banks that were too-big-tofail are now even bigger than before the crisis. Unemployment is an epidemic and will result in a lost generation for millions of Americans and Europeans. The middle class is under significant pressure with 14 million Americans officially out of work and another 16 million underemployed which in combination would form a state with the population of Texas. In Spain nearly half of the people under the age of 25 are unemployed and in Greece, Italy, and Ireland nearly a third. The number of unemployed youth in OECD countries is higher than at any time since the organization started collecting data in 1976(3). These are the lost children of the global economy. Things are likely to get worse before they get better. As we move closer to a second global recession it is highly questionable whether or not the European and domestic banking systems can withstand another systemic shock. The difference this time is that Main Street is ready to revolt against any new round of bail-out economics. A movement called Occupy Wall-Street that opposes corporate greed, financial bail-outs, and the political influence of banks is attracting hundreds of grass-roots followers and conducting protests in lower Manhattan and across the country. As I write this letter 700 people were just arrested for blocking traffic on the Brooklyn Bridge. This movement is spreading and has held demonstrations in Boston, St. Louis, Chicago, Philadelphia, and Los Angeles. The group is similar to protests across Europe including the indignados ("the outraged") movement in Spain and escalating strikes and sit-ins in Greece. A recent poll shows that two thirds of German's believe their parliament should block any more demands for euro bail-outs(4). The question we should ask ourselves is not whether policy makers can or cannot orchestrate another massive bail-out of the global banking system, but whether or not the citizens of developed countries are going to allow it. How this will end is impossible to predict, but in the next decade we are about to learn a lot more about volatility. Volatility as a concept is widely misunderstood. Volatility is not fear. Volatility is not the VIX index. Volatility is not a statistic or a standard deviation, Black-Scholes input, GARCH model, or any other number derived by abstract formula. Volatility is no different in markets than it is to life. Volatility is an instrument of truth. Regardless of how it is measured it reflects the difference between the world as we imagine it to be and the world that actually exists. It is the fire in Plato's cave that illuminates the shadows of reality for those chained to the darkness. It is as global as a violent revolution resulting in social change; or as personal as an exhilarating relationship with a complex woman who is very there and then inexplicably gone. Volatility hurts but is necessary for growth. In nature volatility is so fundamental that the trees of the great sequoia forest will not release their seeds without first sensing heat from wildfires. It is from the flames of change that we derive the potential for healthy resurrection and birth. In markets and in life if we don't recognize the truth in each moment, deny revolution, suppress volatility no matter how painful, we will not allow ourselves to prosper. Volatility is change and the world is changing. The truth is that Greece will default. The truth is that if our leaders continue to deny our problems history tells us the US will eventually default. These shocking events will hurt many people, markets will collapse, life savings will be lost, there will be violence, upheaval, and massive political change but you know what? The world will not end. When it is all said and done people will work, they will spend time with their children, they will cry, laugh, and love... life will go on. We will find a way to prosper if we relentlessly search for nothing but the truth, otherwise the truth will find us through volatility. Vive la vrit Vive le volatilit

Artemis Capital Investors, L.P. Christopher R. Cole, CFA Managing Partner and Portfolio Manager Artemis Capital Management, L.L.C.

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Artemis Capital Management, LLC | Letter to Investors Third Quarter 2011

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THIS IS NOT AN OFFERING OR THE SOLICITATION OF AN OFFER TO PURCHASE AN INTEREST IN ARTEMIS CAPITAL INVESTORS, L.P. (THE FUND). ANY SUCH OFFER OR SOLICITATION WILL ONLY BE MADE TO QUALIFIED INVESTORS BY MEANS OF A CONFIDENTIAL PRIVATE PLACEMENT MEMORANDUM (THE MEMORANDUM) AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW. AN INVESTMENT SHOULD ONLY BE MADE AFTER CAREFUL REVIEW OF THE FUNDS MEMORANDUM. THE INFORMATION HEREIN IS QUALIFIED IN ITS ENTIRETY BY THE INFORMATION IN THE MEMORANDUM. AN INVESTMENT IN THE FUND IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK. OPPORTUNITIES FOR WITHDRAWAL, REDEMPTION AND TRANSFERABILITY OF INTERESTS ARE RESTRICTED, SO INVESTORS MAY NOT HAVE ACCESS TO CAPITAL WHEN IT IS NEEDED. THERE IS NO SECONDARY MARKET FOR THE INTERESTS AND NONE IS EXPECTED TO DEVELOP. NO ASSURANCE CAN BE GIVEN THAT THE INVESTMENT OBJECTIVE WILL BE ACHIEVED OR THAT AN INVESTOR WILL RECEIVE A RETURN OF ALL OR ANY PORTION OF HIS OR HER INVESTMENT IN THE FUND. INVESTMENT RESULTS MAY VARY SUBSTANTIALLY OVER ANY GIVEN TIME PERIOD. CERTAIN DATA CONTAINED HEREIN IS BASED ON INFORMATION OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE, BUT WE CANNOT GUARANTEE THE ACCURACY OF SUCH INFORMATION. The General Partner has hired Unkar Systems, Inc. as NAV Calculation Agent and the reported rates of return are produced by Unkar for Artemis Capital Fund. Actual investor performance may differ depending on the timing of cash flows and fee structure. Past performance not indicative of future returns. Footnotes and Citations: Notes: Unless otherwise noted all % differences are taken on a logarithmic basis. Price changes an volatility measurements are calculated according to the following formula % Change = LN (Current Price / Previous Price) Greek Fire / from Madrid Skylitzes / public domain Flaming globe & Sequoia Tree photographs reproduced with rights from Istockphoto.com Liberty Leading the People by Eugne Delacroix / public domain. Security price data from Bloomberg and Yahoo Finance Implied volatility data from IVolatility.com Footnotes: (1) "Greek Fire" from Toxepedia.com http://toxipedia.org/display/toxipedia/Greek+Fire (2) The Federal Reserve ceased reporting M3 in March 2006. This report uses estimates of M3 provided by Shadow Government Statistics which uses Fed reporting of major M3 components and SGS modeling of missing components. See www.shadowstatistics.com for more information. (3) "It's grim down south" & "the jobless young Left Behind", The Economist September 10th, 2011 (4) "Angela Merkel denies euro bailout backlash was cause of election defeat" The Telegraph September 5th, 2011

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