The Morningstar NEXUS Hedge Fund Replication Index Rule Book
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June 16, 2011
The Morningstar NEXUS Hedge Fund
Replication Index Rule Book
A New Standard for Hedge Fund Index Replication
Summary: This document describes the construction and
calculation of the Morningstar NEXUS Hedge Fund Replication
Index for which Morningstar is the Sponsor and Innocap
Investment Management Inc. is the Calculation Agent. The
Morningstar NEXUS Hedge Fund Replication Index aims at giving
an indication of the performance of a well diversified exposure to
hedge fund strategies, as proxied by the Morningstar Broad Hedge
Fund Index (MBHFI). The Morningstar NEXUS Hedge Fund
Replication Index is based on a sound hedge fund index replication
methodology that aims to replicate as closely as possible the
returns of the MBHFI.
©Innocap Investment Management inc. This document is confidential and is provided to you
solely for information purposes. Do not copy, quote or distribute. It does not constitute a business
offer or solicitation. Its content is based on information and models Innocap Investment
Management believes to be reliable. However, Innocap Investment Management cannot guarantee
the exactness and completeness of this document. Also, it shall not be used for any investment
decision. See the full disclosures and disclaimers in Section 7 of this document. To send
comments or for more information, please contact pierre.laroche@innocap.com or
sandrine.theroux@innocap.com.The Morningstar Innocap NEXUS Index Rule Book
Table of contents
1 Definitions................................................................................................................... 2
2 Overview of the Index ................................................................................................ 8
3 Calculation of the Index value .................................................................................... 9
4 Possible Exceptions regarding the calculation of the Index value............................ 15
5 Publication of the Index value .................................................................................. 17
6 Other contingencies .................................................................................................. 17
7 Disclosures and Disclaimers ..................................................................................... 18
8 Appendix to the Morningstar Nexus Hedge Fund Replication Index Rulebook: the
Nexus Hedge Fund Index Replication Model................................................................... 20
1 Definitions
Here are the main definitions used in this document.
Admissible Investor: any investor allowed by applicable laws and regulations to invest
in a given asset.
Ask Price: price at which a Reference Financial Instrument can be sold.
Asset: refers to a Financial Asset or a Real Asset.
Basket: linear combination of Reference Financial Instruments.
Bid Price: price at which a Reference Financial Instrument can be bought.
Business Day: a day that is simultaneously an Exchange Business Day and an Interbank
Market Trading Day in Relevant Countries.
Calculation Agent: entity responsible of the calculation of the Index. Unless section 4.6
of this Rule Book applies, Innocap acts as the Calculation Agent.
Closing Time: time of a Trading Day at which the Exchange closes (i.e. end of the
Exchange’s regular trading session, which excludes after hours or any other trading
outside of the regular trading session hours).
Computation Day: date on which the Index weights are computed (i.e. updated
according to the Nexus Replication Program), which will occur each Wednesday unless a
major force event or any major event as determined by the Calculation Agent occurs.
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Definitive Termination (applies to the Reference Index and to the Index): the
consequence of a decision by the Calculation Agent to definitively stop calculating and
publishing the Index.
Disrupted Day: as determined by the Calculation Agent, any Exchange Business Day or
Interbank Market Trading Day on which a Market Disruption Event has occurred.
Early Closure: the closure on any Exchange Business Day of any relevant Exchange at
least one hour prior to the earlier of (a) the actual Closing Time for the regular trading
session on such Exchange and (b) the submission deadline for orders to be entered into
the Exchange system for execution on any Index Value Calculation Day.
Exception (regarding the calculation of the Index value): modification of the usual
calculation methodology of the value of the Index, as described in Section 5 of this Rule
Book.
Exchange: an organized Financial Market or quotation system (or their substitute
Exchange when the usual Exchange has to be temporarily relocated) on which a
Reference Financial Instrument is traded.
Exchange Business Day: any day on which all relevant Exchanges or their substitutes
are open for normal trading during their respective regular trading session(s),
notwithstanding any Early Closure.
Factor-Based Replication Model: a statistical model that estimates the weightings of
explicative variables, the resulting collective variations of which explain as much as
possible the variations of an observable signal (or independent variable). For the
Morningstar Innocap NEXUS Index, the independent variable is the Reference Index and
the explicative variables are the Index Components.
Financial Instrument: a security (fundamental or derivative) that is traded on a
Financial Market.
Financial Market: an organized market (such as a stock exchange or a futures exchange)
or a so-called over-the-counter market (such as the markets for bond and forward
contracts) on which Admissible Investors can buy or sell Financial Instruments.
Hedge Fund (abbreviated by “HF”): refers to a basket of long and short positions on
one or more Assets.
Government Authority: any nation, state or government, any province or other political
subdivision thereof, any body, agency or ministry, any taxing, monetary, foreign
exchange or other authority, court, tribunal or other instrumentality and any other entity
exercising, executive, legislative, judicial, regulatory or administrative functions of or
pertaining to government.
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HF Strategy: a set of coherent investment objectives, approach, rules and trades that
determines the risk-return-liquidity profile of a HF. There are different ways to categorize
HF Strategies. In this document, unless otherwise stated, we adopt Innocap’s HF Strategy
classification.
Inception Date (of the Index): July 1, 2011, the first Index Value Calculation Day. On
that Inception Date, all prior Index Values are also calculated (hence creating the
simulated Index Value history).
Index (the): the Morningstar NEXUS Hedge Fund Replication Index or any index that
eventually replaces it. The Index Value Calculation details are provided in Sections 3 to 5
below.
Index Component: any return-generating factor that enters the NEXUS Replication
Model, as decided by the Calculation Agent.
Index Publication Day: the Business Day that follows an Index Value Calculation Day
if the Index Value Calculation Day is a business day. If the Index Value Calculation Day
is not a business day, then the following business day is not a Publication Day.
Index Sponsor: the entity that is responsible of publishing the Index value. Unless
section 6.2 of this Rule Book applies, Morningstar is the Index Sponsor.
Index Rulebook: this document (initial version February 4, 2011), which may be subject
to changes as jointly agreed between the Index Sponsor and the Calculation Agent.
Index Suspension Event: an event such that (1) the Index Sponsor’s and the Calculation
Agent’s obligations cannot be executed; or (2) the execution of their obligations is
delayed. Such events include (a) any act, law, rule, regulation, judgment, order, directive,
interpretation, decree or material legislative or administrative interference of any
Government Authority; (b) the occurrence of civil war, disruption, military action, unrest,
political insurrection, terrorist activity of any kind, riot, public demonstration and/or
protest, natural calamities such as tornados, earthquakes and typhoons or any other
financial or economic reasons or any other causes or impediments beyond such party’s
control; or (c) any expropriation, confiscation, requisition, nationalization or other action
taken or threatened by any Government Authority that deprives the Calculation Agent (or
any of its relevant affiliates), of all or substantially all of its assets in the relevant
jurisdiction.
Index Value Calculation Day: every Week Day, unless the Index Sponsor and/or the
Calculation Agent judge that some event do not allow the calculation of a valid Index
Value, in which case the Index Value Calculation Day will postponed to the nearest
possible Business Day.
Innocap: refers to Innocap Investment Management Inc., a portfolio management
corporation constituted under the laws of Canada and principally regulated by the
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Autorité des Marchés Financiers (securities regulatory authority of the province of
Quebec) and by the securities commissions (or the equivalent) of the other provinces of
Canada.
Innocap Global: refers to Innocap Global Investment Management Ltd, an investment
management advisory company domiciled in Malta and regulated by the Malta Financial
Services Authority.
Interbank Market: a “gré-à-gré” market (as opposed to an organized market) between
banks and other financial institutions (such as insurance companies, savings unions,
pension funds, government agencies and similar entities). Synomym of the so-called
“over-the-counter market”.
Interbank Market Trading Day: a day on which normal trading is simultaneously done
on the Interbank Markets in all Relevant Countries, as determined by the Calculation
Agent.
Long Position: ownership of an Asset following its purchase.
Market Disruption Event: means any event causing relevant Exchanges and/or
Interbank Market not to function normally (i.e. for which the market price formation
mechanism is malfunctioning in a way that market prices may not reflect the market
value) as determined by the Calculation Agent
Market Value: price of an Asset as determined on a well functioning market where a
sufficient number of competitive investors can trade under minimal restrictions as
determined by the Calculation Agent.
Modification: any possible change to the calculation, components and Reference
Financial Instruments relating to the Index, as defined in Section 4 of this Rule Book.
Possible Modifications to the Index include its termination.
NEXUS Replication Model: the Factor-based Replication Model referenced in the
version dated October 10, 2010 (10-10-10) of the document entitled “NEXUS: Overview,
Development and Technical Document” by Innocap Investment Management Inc. The
NEXUS Replication Model aims to replicate as closely as possible the Reference Index
by dynamically allocating capital among (i.e. estimating time-varying weights of) Index
Components.
Potential Reference Index Adjustment Event: means any of the following: (a) a
Reference Index Modification, (b) a Reference Index Disruption, or (c) a Successor
Reference Index.
Proxy Reference Currency Exchange Rate: the best possible approximation of a
Reference Currency Exchange Rate when the latter is not available, as determined by the
Calculation Agent.
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Proxy Reference Rate: the best possible approximation of a Reference Rate when the
latter is not available, as determined by the Calculation Agent.
Proxy Reference Value: the best possible approximation of a Reference Value when the
latter is not available, as determined by the Calculation Agent.
Real Asset: a tangible Asset that can be bought and/or sold.
Rebalancing (of the Index): any of the following, which could occur simultaneously: (1)
implementation of the trades on the Reference Financial Instruments trades following the
computation of their new weights within the Index, as per Section 4 of this Rule Book,
and/or (2) replacement of one or more Index Component, and/or (3) replacement of one
or more Reference Financial Instrument.
Rebalancing Day: the day on which Rebalancing of the Index is done, which should
occur on each Business Day that immediately follows the Computation Day unless the
Calculation Agent determines that the Rebalancing can not be implemented properly.
Reference Currency: the currency in which the value of the Index is stated. Unless
otherwise stated, the Reference Currency is the USA Dollar (USD).
Reference Currency Exchange Rate: the Market Value of a currency that is not the
Reference Currency. All Reference Currency Exchange Rates used in the Index Value
Calculation will be those of National Bank of Canada official rates coming from Reuters
closings at 3:15 PM NYC time on the Index Value Calculation Day. If, on any Index
Value Calculation Day, a given Reference Currency Exchange Rate is not available for
any reason or, if a Market Disruption Event occurs, the Reference Currency Exchange
Rate retained for that Index Value Calculation Day will be the Proxy Reference Currency
Exchange Rate.
Reference Financial Instrument: a Financial Instrument which is considered by the
Calculation Agent as being a good proxy of an Index Component. The Calculation Agent
may change any Reference Instrument if it considers that such a replacement would
improve the investable version of the Index. The respective values or rates (i.e. the
Reference Values, Reference Currency Exchange Rates and Reference Rates) of all
selected Reference Financial Instruments are used to calculate the value of the Index.
Reference Index Disruption: means that the index sponsor of a Reference Index fails to
calculate and announce a relevant Reference Index.
Reference Index: the Morningstar Broad Hedge Fund Index (MBHFI) or its replacement
if a termination event of the MBHFI occurs and the Calculation Agent, in its sole
discretion, deems such replacement index appropriate to replace the Reference Index.
Reference Market: a Financial Market on which a Reference Price is observed.
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Reference Index Modification: means that a relevant index sponsor for one of the
Reference Index announces that it will make a material change in the formula for or
method of calculating that Reference Index or in any other way materially modifies the
Reference Index (other than a modification prescribed in that formula or method to
maintain that Reference Index in the event of changes in constituent stocks and
capitalization and other routine events).
Reference Rate: best available measurement of the rate of return or interest rate –
expressed in the Reference Currency - of a given Reference Financial Instrument. All
Reference Rates used in the Index Value Calculation will be those of National Bank of
Canada official interest rates coming from Reuters closings at 3:15 PM NYC time on the
Index Value Calculation Day. If, on any Index Value Calculation Day, a given Reference
Rate is not available for any reason or, if a Market Disruption Event occurs, the
Reference Rate retained for that Index Value Calculation Day will be the Proxy
Reference Rate.
Reference Value: best available measurement, expressed in the Reference Currency, of
the Market Value of a Reference Financial Instrument. When the Market Value of a
Reference Financial Instrument is not expressed in the Reference Currency, it is
converted into the latter by using the National Bank of Canada official Reference
Currency Exchange Rate(s) coming from Reuters closings at 3:15 PM NYC time on the
Index Value Calculation Day.
Relevant Countries: USA, Canada, Germany, Japan, Australia and Singapore. This list
of Relevant Countries can be modified by the Calculation Agent at any time.
Short position: the result of short selling an asset (which means selling an asset and
simultaneously promising to subsequently buy it back).
Successor Reference Index: means a Reference Index that is (i) not calculated and
announced by its index sponsor but is calculated and announced by a successor sponsor
acceptable to the Calculation Agent, or (ii) replaced by a successor index using, in the
determination of the Calculation Agent, the same or a substantially similar formula for
and method of calculation as used in the calculation of that Reference Index.
USA: United States of America.
USD: the dollar or any other currency that replaces it as the official and legal currency in
the USA.
Week Day: every Mondays, Tuesdays, Wednesdays, Thursdays and Fridays.
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2 Overview of the Index
2.1 The Index aims to replicate as closely as possible the Reference Index by applying the
Nexus Replication Model to a set of Index Components.
2.2 The Index value is derived from the value of a basket of the Reference Financial
Instruments, which constitute proxies of the Index Components (see Sections 3 and 4 for
more details and the initial list of Reference Financial Instruments).
2.3 The Index value reflects the reinvestment of all investment gains and investment
revenues generated by the Reference Financial Instruments.
2.3 The initial set of Reference Financial Instruments is chosen to proxy as well as
possible the Index Components. Refer to Table 1 below for more details.
2.4 The Nexus replication Model, the Index Components and the Reference Financial
Instruments that underlie the Index are subject to change according to conditions
described in Section 4.
Table 1
Set of risky Reference Financial Instruments at the Index Inception Date
Reference Financial Currency Bloomberg Reference
Instrument Ticker Market*
E-mini S&P 500 Futures USD ES1 Index CME
E-mini MSCI Emerging Futures USD LLL1 Index CME
US 2YR Note Futures USD TU1 Comdty CBT
US 10YR Note Futures USD TY1 Comdty CBT
AU 3YR Bond Futures AUD YM1 Comdty SFE
AU 10YR Bond Futures AUD XM1 Comdty SFE
CAN 10YR Bond Futures CAD CN1 Comdty MSE
JPY 10YR Bond Futures JPY BJ1 Comdty SGX
GERMANY Bund Futures EUR RX1 Comdty EUX
USD/AUD USD AD1 Curncy CME
USD/CAD USD CD1 Curncy CME
USD/GBP USD BP1 Curncy CME
USD/JPY USD JY1 Curncy CME
Gold Futures USD GC1 Comdty CMX
Silver Futures USD SI1 Comdty CMX
Crude Oil Futures USD CL1 Comdty NYM
Natural Gas Futures USD NG1 Comdty NYM
Heating Oil Futures USD HO1 Comdty NYM
Wheat Futures USD W 1 Comdty CBT
Soybean Futures USD S 1 Comdty CBT
Copper Futures USD HG1 Comdty CMX
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* Meaning of the Reference Markets abbreviations: CME = Chicago Mercantile
Exchange; CBT = Chicago Board of Trade; SFE = Sidney Futures Exchange; MSE =
Montreal Stock Exchange; SGX = Singapore Exchange; EUX = Eurex Deutschland;
CMX = Commodity Exchange, Inc.; NYM = New York Mercantile Exchange.
3 Calculation of the Index value
Warning: This section describes as closely as possible the formulas and algorithms that
underlie the computer code that is used to calculate NHFIR’s value. This computer code is
contained in the following file of the Calculation Agent’s computer network server:
(S:\Gestion Alternative-R&D\S_Nexus). If there is a discrepancy between what follows and
the computer code, the latter is considered to be valid.
3.1 The value of the Index is expressed in the Reference Currency.
3.2 The value of the Index at the end of the calendar day that immediately precedes its
Inception Date is 1,000,000 units of the Reference Currency.
3.3 Unless the Calculation Agent decides otherwise, the following formula will be used
by the Calculation Agent to calculate the Index Value at the end of every Index Value
Calculation Day “t”, starting on the Inception Date (t = 1):
Indext 0 1,000,000
Number of Reference Financial Instruments ( NbrsRiskyRFI ) that were bought just
before Closing Time on each Relevant Exchange on the Index Inception Date
(first Rebalancing Date):
wi ,t*
NbrsRiskyRFI i ,t 0 Indext 0
RefFinInstrVal_RefCurri,t*
RefFi nInstrVal_R efCurri,t RefFinInst rVal_LocCu rri,t FX i,t
RefFinI nstr Val_RefCur ri,t means the Reference Value in Reference Currency on
the Index Value Calculation Day “t” of a risky Reference Financial Instrument.
Foreign exchange (if additional currencies are added, data source will also be
Bloomberg):
Cross-Currency Bloomberg Ticker
AUD/USD USDAUD F153 Curncy
CAD/USD USDCAD F153 Curncy
EUR/USD USDEUR F153 Curncy
JPY/USD USDJPY F153 Curncy
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Number of Reference Financial Instruments that are bought just before Closing
Time on each Relevant Exchange on each subsequent Rebalancing Date:
wi ,t*
NbrsRiskyRFI i ,t* 1BD Indext*
RefFinInstrVal_RefCurri,t*
Initial weights ( wi ,t* 0 ) are the following:
Reference Financial Initial weights ( wi ,t* 0 )
Instrument
E-mini S&P 500 Futures -6.74%
E-mini MSCI Emerging Futures 40.42%
US 2YR Note Futures 43.62%
US 10YR Note Futures 2.84%
AU 3YR Bond Futures -9.73%
AU 10YR Bond Futures -7.73%
CAN 10YR Bond Futures -4.75%
JPY 10YR Bond Futures -0.68%
GERMANY Bund Futures 6.90%
USD/AUD 10.77%
USD/CAD 2.00%
USD/GBP 8.22%
USD/JPY 0.44%
Gold Futures 2.46%
Silver Futures 1.44%
Crude Oil Futures 0.73%
Natural Gas Futures -1.38%
Heating Oil Futures 0.59%
Wheat Futures -0.37%
Soybean Futures 5.11%
Copper Futures 4.32%
Changes in weights derive from the Nexus Hedge Fund Index replication model as
described in the Appendix.
Initial Cash Breakdown:
BrokerBala nceAccount i 1,t 0 0.12 * Index t 0
Note: Where “i=1” refers to the Broker Balance Account expressed in the
Reference Currency.
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0.88 Indext 0 RiskyRFI _ CashInvestement t 0
TreasuryBills _ Bucket i ,t 0
2
where i=1,2
RiskyRFI _ CashInvest ement t 0
21
NbrsRiskyRFI
i 1
i ,t 0 RefFinI nstrVal_RefCur ri ,t 0 1(CashInvest ment ) i
1(CashInvestment ) is a binary function that is equal to :
o 1 if an investment (disinvestment) occurs in a Reference Financial
Instruments that requires a cash outlay (i.e. a fully funded instrument that is
not bought on margin) and that means that the investment in the Reference
Financial Instrument is made in cash and not on margin.
o 0 otherwise.
Description of the Cash policy: Initially, 12% of the Inception Date Index Value
is invested in the Broker Balance Account expressed in the Reference Currency
and 88% (minus the amount of cash that was used to invest in risky Reference
Financial Instruments) is invested in 2 buckets of Treasury Bills, 1 bucket with a
3-month maturity and one bucket with a 6-month maturity. Each 13 weeks, some
Treasury Bills come to maturity. At that time, the cash allocation is rebalanced
between the Broker Balance Account and the Treasury Bills to get back to the
12% / 88% allocation target. The remaining cash is reinvested in newly issues 6-
month Treasury Bills. When an investment (disinvestment) occurs in a Reference
Financial Instruments that requires a cash outlay (i.e. a fully funded instrument
that is not bought on margin), the cash used (received) is brokendown half and
half between the two Treasury Bills buckets.
Index Value Calculation:
IndexValue t
IndexValue t 1WD P&LRiskyRF I t P<reasur yBills t
P&LBr okerBalanc eAccount t , t 1
o Profit and loss on the risky Reference Financial Instruments:
If t t * 1BD
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P&LRiskyRFI t
21
RefFinInstrVal_RefCurri ,t
NbrsRiskyRFI
i 1
i , t* 1BD
RefFinI nstr Val_RefCur ri ,t 1WD
If t t * 1BD
P&LRiskyRFI t
21
RefFinInstrVal_RefCurri ,t
NbrsRiskyRFI
i 1
i ,t* 1BD
RefFinInstr Val_RefCur ri ,t 1WD
o Interest on the treasury bills account:
P<reasuryBills t
2
100 TBillsIssu e Pr icei
TreasuryBills _ Bucket
i 1
i ,t 1WD
TBillsMatu rityDate i TBillsIssu eDatei
3 if t is a Monday
1 if t is a Tuesday, a Wednesday, a Thursay or a Friday
TBillsIssue Pr icei means the price at which the Treasury bill for bucket “i”
was issued.
TBillsMaturityDate i means the date at which the Treasury bill for bucket “i”
come to maturity.
TBillsIssueDatei means the date at which the Treasury bill for bucket “i”
was issued.
Note: In the Index Value Calculation, the assumption is made that the
price of the treasury bills varies under the linear amortization formula.
o Interest on the broker balance account:
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P&LBrokerBalanceAccount t
ReferenceRatei,t
BrokerBalanceAccount i ,t 1WD 1i 1,2 ,3
365
2 * ReferenceRatei,t -1WD
5 BrokerBalanceAccount i ,t 2WD 1i 1,2 ,3 1t is a Monday
ReferenceR
365
ate
i ,t 2WD 1i 4 ,5
i 1 BrokerBalanceAccount i,t
365
2 * ReferenceRatei,t -1WD
BrokerBalanceAccount i ,t 3WD 1i 4 ,5 1t is a Monday
365
Where:
wi ,t*
is the weight of Reference Financial Instrument “i” at date “t*”. The
methodology used by the Calculation Agent to compute these weights is the
Nexus Replication Model, which is subject to change (i.e. Index Components,
Reference Financial Instruments and/or statistical or other mathematical models
may be replaced) without prior notice.
t* is “t” if Index Value Calculation Day “t” is a Computation Day or the closest
Computation Day preceding Index Value Calculation Day “t”.
-t* is the closest Computation Day preceding Index Value Calculation Day “t” if
date “t” is a Computation Day or is two Computation Day preceding Index Value
Calculation Day “t”.
RefFinInstrVal_LocCurri,t means the Reference Value in Local Currency on the
Index Value Calculation Day “t” of a risky Reference Financial Instrument.
WD means Monday, Tuesday, Wednesday, Thursday and Friday.
Here is the applicable JP Morgan Interest Schedule:
Balance Currency Reference Ratei
Account
Number (i)
1 USD Credit Balance: 28 Day T-Bill Rate – 0.50% (min 0%)
Debit Balance: J.P. Morgan Overnight Borrowing Rate + 0.50%
2 AUD Credit Balance: SFE AUD Deposit Rate – 0.50% (min 0%)
Debit Balance: SFE AUD Debit Rate + 0.50%
3 JPY Credit Balance: London Deposit Rate (LDR) – 0.50% (min 0%)
Debit Balance: J.P. Morgan Overnight Borrowing Rate + 0.50%
4 CAD Credit Balance: Canadian Deposit Rate – 0.50% (min 0%)
Debit Balance: Canadian Debit Rate + 0.50%
5 EUR Credit Balance: London Deposit Rate (LDR) – 0.50% (min 0%)
Debit Balance: J.P. Morgan Overnight Borrowing Rate + 0.50%
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Note: In the Index Value Calculation, the assumption is made that when P&L is
realized in another currency than the Reference Currency, the realized P&L is
immediately convert it back at the end of the day in the Reference Currency.
3.4 In order to provide an additional level of safety, Innocap Global will always run the
Rebalancing calculations in parallel with the Calculation Agent. Both entities will
compare their results and make the required adjustments, as defined in 5.6.1, if a material
difference is observed.
3.5 On any Computation Day, the Calculation Agent may decide – without prior notice -
to modify the Index Components and/or the Reference Financial Instruments and/or the
NEXUS Replication model.
3.6 Under normal circumstances, the Index is rebalanced once a week, on the
Rebalancing Day. If, in the opinion of the Calculation Agent, market conditions are such
that the Index Rebalancing cannot be implemented properly on the Rebalancing Day, the
Calculation Agent may in its sole discretion implement the Rebalancing over the number
of Business Days deemed necessary to implement such Rebalancing.
3.7 Under normal conditions, the Market Value of a Reference Financial Instrument is
measured by its settlement price as determined by the Reference Market when the latter is
an organized futures market. In other cases, it is the closing price (sometimes referred as
the fixing price) on the Reference Market or, if the latter is not available, (1) the volume
weighted average of all available Bid Prices and Ask Prices observed at the Closing Time
of the relevant Exchange(s), or if volume data is not available (2) the arithmetic average
of the Bid Price and the Ask Price as observed at the Closing Time of the relevant
Exchange(s).
3.8 If, on any Index Value Calculation Day, the Market Value of a Reference Financial
Instrument is not available for any reason or, if a Market Disruption Event occurs, the
Reference Value retained for that Index Value Calculation Day will be the Proxy
Reference Value.
3.9 If Innocap is unable to perform its duties and responsibilities as Calculation Agent, it
will be replaced by Innocap Global for as long as Innocap is in this situation. If Innocap
Global cannot assume these duties and responsibilities, then it will be replaced by
National Bank of Canada’s Treasury Department.
3.10 Under the circumstances described in section 5 of this Rule Book, the Calculation
Agent may temporarily or definitively suspend or modify the calculation of the Index.
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4 Possible Exceptions regarding the calculation of the Index value
4.1 General principle: the impact of any Modification to the calculation of the Index
value must be as small as possible so that the resulting modified value of the Index
should be as close as possible to the value that would have been obtained by following
the regular Index value calculation methodology and process.
4.2 Modifications to the calculations of the Index value will generally occur only under
exceptional circumstances. Exceptions and the resulting Modifications are defined in the
remainder of this section.
4.3 Modifications resulting from an event impacting the Reference Index:
4.3.1 Upon the occurrence of a Definitive Termination of the Reference Index, the
Calculation Agent will adjust the value and/or the components of the Index as it
deems appropriate. In effecting such adjustments, the Calculation Agent may
select another index to replace the Reference Index. If, in the opinion of the
Calculation Agent, no adjustments can be performed or no suitable replacement
index can be found, the Calculation Agent may decide to terminate the Index.
4.3.2 Upon the occurrence of a Potential Reference Index Adjustment Event, the
Calculation Agent shall take into account as it deems appropriate, any amendment,
correction or any potential adjustment of whatsoever nature relating to the
Potential Reference Index Adjustment Event and may select another index which
he deems suitable replace the Reference Index and will perform the necessary
adjustments to the Index.
4.3.3 Upon the occurrence of a Reference Index Suspension Event, the
Calculation Agent can suspend the Index Value Calculation until the end of the
Reference Index Suspension Event. If the Calculation Agent considers that the
Reference Index Suspension Event lasts over an unduly long period, it may
declare the Definitive Termination of the Index.
4.4 Modifications resulting from an event impacting the Reference Financial Instruments
and/or the Reference Values:
4.4.1 The Calculation Agent will make the necessary adjustments to the
calculation of the Index if one or more Reference Financial Instrument Values
is(are) derived from improper or misleading Market Value(s), as determined by
the Calculation Agent.
4.4.2 The Calculation Agent must take the appropriate action to adjust the
calculation of the Index value for (a) the temporary or permanent discontinuation
of listing and/or trading of any Reference Financial Instrument; or (b) the
temporary or permanent malfunction of any relevant Exchange.
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4.4.3 Any one or more of the Reference Financial Instruments may change as a
result of a change of the Reference Index. In this case, the Calculation Agent will
determine the new Reference Financial Instruments such that (a) the application
of NEXUS Replication Model on the modified Reference Financial Instruments
results in the smallest Tracking Error possible and (b) the calculation of the value
of the Index remains easily feasible.
4.4.4 In addition to the other dispositions included in this Rule Book, the
Calculation Agent can determine the best available proxy of the Reference Value
if the information source from which it is observed or estimated is temporarily or
permanently unavailable.
4.5 Modifications resulting from an event impacting the currency rates:
4.5.1 In the event that a Reference Currency Exchange Rate is not available, the
Calculation Agent will determine a proxy.
4.6 Modifications resulting from an event impacting the calculations of the weights
applied to the Reference Values:
4.6.1 In cases where the Rebalancing results obtained by the Calculation Agent
are materially different from the ones obtained by Innocap Global, the two entities
will determine the source of the discrepancy and make the adjustments they both
consider optimal in order to converge to the same fair results.
4.6.2 If, for any reason, the usual way to calculate the weights is not feasible for a
given Rebalancing, the Calculation Agent will apply the best possible
approximation of these weights, which includes a Modification to the NEXUS
Replication Model that is expected to produce the closest approximations of what
the weights would have been in other circumstances.
4.7 If, for whatever reason, there is a change in a Business Day, an Exchange Business
Day, an Interbank Market Trading Day, a Rebalancing Day or a Computation Day, the
Calculation Agent may in its sole discretion adjust accordingly the Index Value
calculation and/or the components and/or the Reference Financial Instruments related to
the Index.
4.8 The Calculation Agent may modify the Index value calculation or the Index
Components or call for the Definitive Termination of the Index following (a) the
adoption of, or change in any applicable law or regulation (including any tax law), or (b)
the promulgation of, or any change in the interpretation by any court, tribunal or
regulatory authority with competent jurisdiction of any applicable law or regulation
(including any action taken by a taxing authority), or (c) any other event such that it has
become illegal to hold, acquire or dispose of any Reference Financial Instrument.
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4.9 The nature and cause of any modification to the Index value calculation shall be
documented by the Index Sponsor and made publicly accessible as soon as possible.
4.10 If the Calculation Agent determines that, for whatever reason, it is no longer able to
compute a reliable estimation of the value of the Index, and if it determines that the
circumstances leading to this situation are likely to be permanent, then it may decide to
call for a Definitive Termination of the Index.
4.11 Definition of other Exceptions, Modifications to the calculation of the Index value
or motives for the Definitive Termination of the Index that are not expressly covered in
this section will be left to the sole discretion of the Calculation Agent. Such an event and
its impacts will be duly documented and made publicly accessible as soon as possible.
4.12 These Rules may be supplemented, amended in whole or in part, revised or
withdrawn at any time, at the sole discretion of the Calculation Agent. Supplements,
amendments, revisions and withdrawals may also lead to changes in the way the Index is
compiled or calculated or affect the Index in another way. All such decisions will be duly
documented and published as soon as possible. The Calculation Agent cannot incur any
liability for any losses resulting from supplementing, amending, revising or withdrawing
the Rules for the Index.
5 Publication of the Index value
5.1 Values of the Index will be published by the Index Sponsor on every Index
Publication Day.
5.2 Decisions to suspend or delay the publication of the Index or change of the Index
Sponsor shall be duly documented and made publicly available.
5.3 The Index Sponsor will stop publishing the Index if the Calculation Agent calls for its
Definitive Termination.
6 Other contingencies
6.1 The Calculation Agent and the Index Sponsor will aim to ensure the accuracy of the
composition, calculation, publication and adjustment of the Index in accordance with this
Rule Book. However, the Calculation Agent and the Index Sponsor may not be held
liable for (a) any inaccuracy in Reference Values or their information sources, (b) the
calculation and the publication of the Index, or (c) the information used to make
adjustments to the Index and/or the actual adjustments. Please also take note of the full
disclosures and disclaimers stated in Section 8 of this document.
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6.2 The Index Sponsor owns all intellectual and other property rights to the Index,
including its name and its composition. The Calculation Agent owns all intellectual and
other property rights in the Nexus Replication Model.
7 Disclosures and Disclaimers
7.1 General Disclosures and Disclaimers. This publication is intended for your personal
use only. Innocap believes that the information contained herein is reliable, but cannot
guarantee its accuracy or completeness considering its various sources. This publication
may not be reproduced, in whole or in part, in any way and under any circumstances,
prior to the obtaining of Innocap’s written approval. Any financial operation contains a
variety of risks and factors to consider. Before entering into an operation, it is
recommended to carefully examine all conditions, assess the risks and determine whether
it is appropriate for your financial needs and objectives in all respects. It is also
recommended to consult financial, legal and/or tax advisors before entering into a
transaction. Although past or anticipated returns may be stated in this publication,
Innocap Investment Management Inc. wishes to specify that such returns are not
necessarily indicative of future results. This document may also contain performance
simulation which are indicative only and might not reflect future performances. This
statement does not purport to describe all the risks associated with financial transactions
and should not be construed as advice on such transactions. The information and
opinions contained herein are for informational purposes only and are subject to change
depending on the market conditions and general conjuncture to which they relate. The
attached materials do not constitute and should not be construed as an offer or solicitation
to enter into any transaction in a jurisdiction where such offer would be unlawful under
the laws of that jurisdiction.
7.2 Accuracy of the Index. The Calculation Agent and the Index Sponsor will make
their reasonable effort to ensure the accuracy of the composition, calculation, publication
and adjustment of the Index value in accordance with the relevant rules or laws. The
information furnished by third parties is believed to be accurate and complete but the
Calculation Agent or the Index Sponsor did not perform audit to acknowledge this
information’s accuracy and completeness and neither can be held reliable for any
consequence if it is not the case.
7.3 Change in the methodology for calculation of the Index value. The Calculation
Agent and the Index Sponsor cannot be held liable for any modification or change in the
methodology used in calculating the Index value.
7.4 Suspension and interruption in the publication of the Index. The Calculation
Agent and the Index Sponsor are under no obligation to continue the calculation,
publication or dissemination of the Index and cannot be held liable for any suspension of
or interruption in the calculation of the Index.
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7.5 Index value. The Calculation Agent and the Index Sponsor decline any liability in
connection with the Index value at any given time. Neither the Calculation Agent nor the
Index Sponsor can be held liable for any loss whatsoever, directly or indirectly related to
the Index value.
7.6 Products derived from the Index. These Rules contain no provisions relating to any
product derived from the Index. Should any product derived from the Index be issued,
provisions relating to a possible liability with respect to such product will be dealt with in
a separate document.
7.7 Endorsement and sponsorship. At any time, the Index and/or any transaction linked
to the Index is not sponsored, endorsed, sold, or promoted by any of the Reference
Financial Instrument comprised in the Index or any of the Reference Instruments
sponsors and no Reference Financial Instrument sponsor makes any representation
(whether express or implied) either as to the results to be obtained from the use of the
relevant Reference Financial Instruments or the Index and/or the values of the Reference
Financial Instruments or of the Index. No Reference Financial Instrument or Reference
Financial Instrument sponsor shall be liable for any error in a Reference Financial
Instrument. No Reference Financial Instrument sponsor is making any representation
whatsoever, whether express or implied, as to the advisability of purchasing or assuming
any risk in connection with entering into any transaction. No Reference Financial
Instrument or Reference Financial Instrument sponsor shall have any liability for any act
or failure to act by the Index sponsor in connection with the calculation, adjustment or
maintenance of the Index. None of the Reference Financial Instruments, the Reference
Financial Instrument sponsors or their affiliates have any affiliation with or control over
the Index or any control over its computation, composition or publication.
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8 Appendix to the Morningstar Nexus Hedge Fund Replication
Index Rulebook: the Nexus Hedge Fund Index Replication Model
Overview: the Nexus Hedge Fund Index Replication Model (NHFIRM) uses a particles
filter to allocate between three factors: two equity factors and TreABSO factor, the latter
being a trend following factor. Section A1 of this appendix explains the TreABSO factor and
Section A2 explains the allocation between the three above mentioned factors. This
appendix describes the computer code and algorithms that are used to calculate NHFIR’s
value. This computer code is contained in the following file of the Calculation Agent’s
computer network server: (S:\Gestion Alternative-R&D\S_Nexus). If there is a discrepancy
between what follows and the computer code, the latter is considered to be valid.
A1: The TreABSO Factor
Overview: TreABSO is a quantitative asset allocation model aiming at generating a 11%1
annual return premium over the 1-month USD LIBOR rate with (1) a 15% annualized
volatility or less and (2) a controlled downside risk. The reference instruments used are 19
futures contracts and money market reference instruments. Figure A1 illustrates the
investment decision and market risk mitigation processes (which are interlaced). The
following steps are performed on a weekly basis (every Wednesday PM, NYC time).
Between each weekly rebalancing, the weights drift according to the evolution of market
returns, except if the stop-loss rule is hit (see Step 8). See Figure 1 for an illustration of the
TreABSO model.
Step 1: Level 1.1 weights (i.e. Allocation Model 1 – Optimization sub-Model)
Max w ( 1.1)
i ri
w
i
( 1.1)
i
Subject to the following constraints: the annualized standard
deviation of the resulting portfolio (estimated by using weekly
returns over the last 104 available weekly observations) is 4%,
w i(1.1) 1 , and w i(1.1) 2 , where: w i(1.1) is the weight of
i i
reference instrument i and ri is reference instrument i’s
average return over the last 104 available weekly observations.
1
ABSO aims to generate a 4% return premium over the 1-month USD LIBOR rate. When leveraged three
times, and assuming a 0.5%/year financing spread, this means that TreABSO aims a 11% return premium over
the 1-month USD LIBOR rate.
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Figure A1
Illustration of how the TreABSO Factor is constructed
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Step 2: Level 1.2 weights (i.e. Allocation Model 2 – TreABSO Filtering sub-Model)
This is a particles filtering model that can not be laid down
with a few formulas. We refer to line 1 to line 207 of the
MatLab code appearing in file S:\Gestion Alternative-
R&D\S_Nexus\Execution\Rebalancing\
WeightsCalc_TreABSO\2011-01-20\FrozenCode\libp_particle.m
on Innocap Investment Management Inc.’s server. The set of
resulting weights is denoted w i(1.2 ) .
Step 3: Integration of the two allocation models (model risk mitigation)
Min 2 r
w (M21.1) , w (M2.21)
Subject to the following constraint: w (M21.1) w (M2.21) 1 , and
where w (M21.1) and w (M2.21) are the weights of the two portfolios
resulting from Allocation Model 1 and Allocation Model 2
respectively and 2 r is the variance of the returns
(estimated over the last 104 available weekly observations) of
this portfolio of portfolios.
Step 4: Volatility rescaling (leverage weights coming out of step 2 so that the
resulting portfolio has a 4% annualized volatility)
4%
wi( 2.2 ) wi( 2.1 )
r
w i( 2.1) w (M21.1) w i(1.1) w (M2.21) w i(1.2 )
w
2
If ( 2.2 )
2 , wi( 2.2 ) wi( 2.,2 )
i
i wi( 2.2 )
i
Step 5: First conditional risk downscaling (expected tail loss constraint)
If w i( 2.2 ) ETL( 2.2 ) ETL * , then set w MM such that:
i ;i MM
1 w MM w i( 2.2 ) ETL( 2.2 ) ETL *
i
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Where ETL( 2.2 ) is the expected weekly tail loss at the 5%
confidence level (estimated over the last 104 available weekly
observations) of a portfolio applying the set of weights w ( 2.2 )
and ETL* is the target weekly ETL (set at 2.5%). Note that
after this step, w i( 3.1) 1 w MM w i( 2.1) , i MM and that the
total allocation to money market reference instruments and to
cash (denoted asset class MM) is w (MM 3.1)
w MM w (MM
2.1)
. At the
end of this step, w MM is reset to 0.
Step 6: Second conditional risk downscaling (implied volatility constraint)
If w IV j( 3.1 ) IV * , then set w MM such that:
( 3.1 )
j
j FI ,FX
1 w MM
w (j 3.1 ) IV j( 3.1 ) IV *
j FI ,FX
Where IV j( 3.1) is the centered and standardized value of the
annualized implied volatility (i.e. the observed IV value, less
the average IV , this difference being then divided by the
IV ’s standard deviation, both being estimated over the last
104 last Wednesdays) of asset class “j” to which we apply the
set of weights w (j3.1) and IV* is the weighted (using w (j3.1) )
implied volatility target (limit), set at 1.0. There are two asset
classes in TreABSO on which this implied volatility
constraint is applied: fixed income (denoted FI, which
includes all fixed income reference instruments, except
money market) and currencies (denoted FX). For example,
w (j3.1FI) is the sum of all fixed income weights (excluding
money market). Implied volatility of each asset classes are the
following:
FI: Merrill Lynch Option Estimate MOVE Index
(Bloomberg ticker: Move Index)
FX: Deutche Bank 1 Month Implied Volatility Index
(Bloomberg ticker: CVIX1I Index)
Implied volatility values used to compute the IVs are those
observed at the end of the preceding business day of each
rebalancing day. Note that after this step,
w i 1 w MM w i , i MM , and that the total
( 3.2 ) ( 3.1)
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allocation to money market and to cash is
w (MM
3.2 )
w
j FI ,FX ,C
3.1
j wj 3.2 w(MM3.1 ) . At the end of this step,
w MM is reset to 0.
Step 7: The final rebalanced weights (implemented on the rebalancing day)
TreABSO _ w i( Final ) 3 w i( 3.2 ) , i MM and w (MM
Final )
1 w
i MM
( Final )
i
Steps 1 to 5 describe how we calculate the ABSO weights.
Since TreABSO is ABSO to which a 3x leverage is applied,
the final step of the weekly rebalancing process consists in
multiplying by 3 all the non-money market weights.
Step 8: Ex post conditional market risk mitigation (stop-loss rule between each
rebalancing day)
The risky positions are all closed and all the capital invested
in money market reference instruments and cash if the
cumulative return since the last rebalancing day reaches -7.5%.
Risk taking resumes at the next rebalancing day according to
the above described Steps 1 to 7.
A2: Allocation among the factors
Overview: Once the TreABSO weights are computed, the NHFIRM uses a particles filter to
allocate between the TreABSO factor, two equity factors and a Money Market factor.
Step 9: Allocation to the factors using Innocap’s proprietary particles filter
Overview: NHFIRM’s goal is to track as closely as possible
the returns of the reference hedge fund index, using filtering
for estimating t , using the factors’ returns.
Calculation: The target return at period t ( TIRt ) is the
following function of the factor returns ( FR t( j ) ; j 1,..., p ):
TIR t FR t( p 1) w t( j ) FR t( j ) FR t( p 1)
p
j 1
For notation clarity, set t• t(1) … t( p ) and
H t FR t( p ) FR t( p 1) ,..., FR t( p ) FR t( p 1) .
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For the NHFIRM, we set p = 3 (but is subject to change as
described in this rulebook). The p+1 = 4 initial factors (which
are also subject to change as described in this index rulebook)
are:
The Money Market factor.
The TreABSO factor.
The S&P500 Index factor.
The MSCI Emerging Markets (Free) factor.
These factors are proxied by the reference instruments
described in this document.
Let’s now set yt RI t Rt( p 1) so that H t t should be close
to yt . The NHFIRM uses a particles filter to estimate the
weights’ values. The filter’s observation’s equation for yt is:
(1) yt H t t vt
where vt s has a centered Gaussian weighted-symmetric
probability distribution with parameters ( p s ) taking the
following values
p 0.45 , 1, s 0.04 . The distribution’s density is given
by:
1 p v
2 s s if v 0
f p s (v)
p
2
v
if v 0
s s
where ( x) e x 2
2 .
2
NHFIM’s filter’s transition equation is the following:
(2) t t 1 t( j ) j 1 2
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when t j , where t( j ) has distribution N (0, 2j I ) , and the
stochastic regime t =1 with probability 1 ,
1 e ( fvixt 0.20)
( fvixt 0.20)
and t 2 with probability e ,
1 e ( fvixt 0.20)
where 1 0.1 , 2 0.000001 and fvix is a 5-month moving
average of the VIX Index monthly level.
The implementation of NHFIRM’s particles filter firsts
consists in generating 10 … M 0 according to a uniform
distribution on (11) p . Given M particles 1t 1 … M t 1 ,
which are plausible values of t 1 , calculate as follows the
next generation of weights:
1. Generate independently new particles 1tt 1 … M tt 1 ,
each one according to the dynamics (1), i.e., generate j t with
distribution N (0 Qt ) and set j tt 1 j t 1 j t .
2. Evaluate the likelihoods j t f p yt H t j tt 1
with respect to observation yt and calculate the weights.
3. Select a sample of M particles 1t … M t from
1t t 1
… M tt 1 , each one independently.
The vector 1tt 1 … M tt 1 of the particles values are the
weights described in Section 3 of this index rulebook.
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