Portfolio Investment Opportunities in Managed Futures

Transcription

1 Portfolio Investment Opportunities in Managed Futures David M. Darst, CFA November 2011

2 Table of Contents Section 1 Section 2 Section 3 Section 4 Select Investment Advantages and Potential Risks of Managed Futures Summary of Managed Futures Investment Performance and Correlation Overview of the Investment Landscape Additional Sources & Disclosures 2

3 Singapore Toronto Sydney Section 1 Select Investment Advantages and Potential Risks of Managed Futures Source: Wikimedia Commons. 3

4 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Historical Background on Futures and Managed Futures Definition: Futures contracts are standardized contracts that allow for the delivery of an underlying commodity or financial instrument at a specified price on a stipulated future date. A futures contract obligates the buyer to purchase the underlying commodity or instrument, and the seller to sell it, unless the contract is sold, transferred, or closed out prior to the established settlement date. Leverage: Futures contracts involve a form of inherent leverage through the posting of initial, variation, and maintenance margin, which is a performance guarantee that the contract will be honored. Derivative Nature: Because futures prices are driven by and derived from the behavior of the underlying commodity or financial instrument, futures are considered derivative instruments. Regulation: The Commodity Futures Trading Commission (CFTC), created by the United States Congress in 1974, is responsible for regulating futures trading and markets. The mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets. Although recorded instances exist of the trading of rice futures in Japan during the 17 th century, exchange-based futures trading began in the United States during the middle of the 19 th century. In 1848, eighty-two Chicago merchants agreed on the need to establish a central trading exchange that would set an immediate and a future price for grain. In response, these merchants founded the Chicago Board of Trade (CBOT) at 101 South Water Street in Chicago, the world s first futures exchange. On March 13, 1851, the first contract was traded on this exchange, marking the inception of the futures industry. For more than one hundred years, the futures markets expanded in size and breadth, but remained focused solely on grains and agricultural commodities. Futures contracts provided farmers, ranchers, distributors, and others in the commodities markets with an efficient mechanism to help manage and hedge against the price volatility often experienced in agricultural markets. As time passed, the risk management benefits of the futures markets became apparent to other sectors of the economy, and beginning in the late 1970s and early 1980s, the industry began introducing contracts which created new futures products and markets for metals, energy, interest rates, currencies, and other financial instruments. During the late 1970s, a number of Commodity Trading Advisors (CTAs) were established, inaugurating the managed futures industry. CTAs are investment managers who use the global futures, options, and related markets as an investment medium to manage their clients assets. In the latter two decades of the twentieth century and on into the twenty-first, the managed futures industry has exhibited rapid growth, and as of the end of 2Q2011, it was estimated that futures trading advisors had approximately $300 billion under management globally. Many domestic and international corporations, financial institutions, trading firms, and securities broker-dealers are active participants in the managed futures marketplace. Hedgers rely on the futures markets to obtain protection against rising or falling prices, while speculators and traders seek to profit from their trading and investment strategies in the futures markets. Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department; Chicago Board of Trade. 4

5 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Distinguishing Between Commodities, Futures, and Managed Futures Global Currency Exchange Rates Instrument or Strategy Determinants of Investment Success Principal Means of Implementation Commodities Commodity selection Physical commodities (Purchased and sold by investors, hedgers, speculators, and traders) Prediction of price movements Costs and amounts of leverage Risk control behavior Options, futures, and swaps involving commodities Collateralized futures (futures contracts plus government securities posted as full or partial margin collateral) Futures Instrument selection Commodity futures Early-stage Wheat in Iowa (Purchased and sold by investors, hedgers, speculators, and traders) Prediction of price movements Costs and amounts of leverage Risk control behavior Financial futures Managed Futures Manager selection Financial futures (Managed by Commodity Trading Advisors (CTAs); also known as managed funds, Managed Futures Funds, or managed futures advisors, in partnerships subscribed to by investors) Manager trading skill Manager model construction Manager use of leverage Risk control systems and behavior Commodity futures Forwards and cash instruments Options, swaps, and swaptions Physical commodities Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 5

6 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Select Advantages of Managed Futures Traders on the Floor of the New York Mercantile Exchange Low Correlations with Many Other Asset Classes: Because of their generally low correlations of returns with many other conventional and alternative asset classes (including hedge funds), managed futures and Managed Futures Funds have tended to offer diversification opportunities that may have the potential to lower the standard deviation of returns and improve the risk-reward profile of an investment portfolio. Returns Generation in Varying Financial Conditions: Managed futures and Managed Futures Funds have the potential to generate attractive returns and may be suited to perform well in various economic and financial market scenarios. Favorable Performance During Periods of Financial Market Dislocation: On several occasions during periods of substantial turmoil or stress in financial markets, investment returns for Managed Futures have been favorable (please refer to page 24 for further information). Harvested Soybeans Source: United States Department of Agriculture. Exposure to a Broad Spectrum of Assets and Markets: Managed futures advisors may utilize futures contracts traded on many global exchanges involving typically underlying assets or indices, including equity indices, financial instruments, agricultural products, precious and nonferrous metals, currencies, and energy products, offering potential trading and investment opportunities across a broad spectrum of assets and markets. Disciplined Quantitative Underpinning to Approach: As a heavily quantitatively and computer-driven trading strategy, managed futures trading systems seek to identify and profit from price, volume, volatility, and covariance trends and anomalies across multiple time zones and in multiple markets. One differentiating factor among Managed Futures Funds is the degree to which a fund s strategy utilizes discretionary trading as substitutes for, or overlays and modifications of, the fund s underlying model and trading algorithms. Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 6

7 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Select Advantages of Managed Futures Source: Freeimages ( Asset Class Characteristics: Because Managed Futures: (i) offer the opportunity to establish with equal facility long and short positions; (ii) often employ stop-loss, trend-following, and/or mean-reverting trading disciplines; (iii) can incorporate leverage and interest income derivatives by means of margin and cash balances; and (iv) provide participation in a broad range of underlying markets, their potential investor liquidity, returns patterns, volatility profiles, correlations of returns, and skew and kurtosis characteristics, tend to be different from those of conventional asset classes (such as equities, fixed income securities, and cash) and from those of many alternative asset classes (such as hedge funds, private equity/venture capital, and real estate). Diversification: Managed Futures allow traders, investors, hedgers, and speculators to express views on, participate in, or oppose the movements of interest rates, equity indices, foreign exchange rates, and the prices of agricultural, metals, and energy products. Access and Exposure: Managed Futures may offer access and exposure to professional fund management in a wide variety of investment styles, trading methodologies, geographies, and underlying commodities and financial instruments. Source: Freeimages ( Protection: Through stop-loss disciplines and other systematic trading approaches, Managed Futures Funds tend to generate options-like returns with limitations on capital losses and anticipated participation in capital gains. Source: Morgan Stanley Smith Barney. 7

8 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Potential Investment Risks of Managed Futures Funds Reduced Liquidity and High Fee Levels: Substantial risks may be associated with investing, hedging, and speculating in Managed Futures Funds, including: (i) the possibility for an investor to lose all or a substantial portion of his or her investment capital; (ii) a limited ability to readily redeem partnership interests or units in a Managed Futures Fund; (iii) no established secondary market for Managed Futures Fund partnership interests or units; and (iv) the possibility for Managed Futures Funds high fees and expenses to potentially vitiate or negate portfolio profits or gains. Suitability: Managed futures are complicated and risky investment instruments that may be unsuitable for many investors. Commodity futures and financial futures trading itself is speculative, potentially volatile, and involves a high degree of leverage. Because managed futures investing is not well understood by mainstream individual investors, it is crucial that securities broker-dealer firms meet their suitability and disclosure obligations when recommending these products. (1) Capital Drawdowns: In certain sideways-trending, choppy, directionless market conditions in some or many of their underlying instruments, Managed Futures Funds returns patterns may be characterized by capital losses (drawdowns) and/or by high volatility, which may not be appropriate for all investors. Correlations Patterns: Correlations of returns for Managed Futures Funds with the returns on other asset classes may: (i) vary over time; (ii) change significantly during periods of increased market volatility; and/or (iii) be substantially affected by managers varying usage of leverage, derivatives, and short selling strategies and techniques. Possible Misapplication of Trading Disciplines: Given the fact that many Managed Futures Funds trading strategies tend to rely on: (i) trend following; (ii) momentum-based investment approaches; (iii) pattern recognition; (iv) stop-loss position unwinding; and (v) hedging disciplines, they may or may not be applied by their managers with an appropriately successful degree of discipline and insight under certain kinds of capital markets conditions and futures trading environments. Exposure to Systemic Threats: Although many futures exchanges reduce counterparty default risk through: (i) clearing institution guarantees; (ii) the setting of initial, maintenance, and variation margin conditions; and (iii) daily (and sometimes intraday) reconciliation of balances and debiting or crediting of margin collateral, Managed Futures Funds investment performance may be negatively affected by circumstances threatening the systemic reliability and integrity of such safeguards. Notes: 1. Adapted from remarks by Mary L. Shapiro, Former Vice Chairman of the National Association of Securities Dealers, and Chairperson, U.S. Securities and Exchange Commission Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 8

9 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Placing Managed Futures in an Investment Context Most of the returns, standard deviations of returns, and correlations of returns data associated with Managed Futures investment activity cover the time period from the mid- to late 1980s through the first decade of the 21 st century; to the degree that this specific time frame is not representative of the economic, financial, geopolitical, and/or systemic conditions in future years and groups of years, the analytical tools, trading methodologies, and absolute and relative investment results may deviate, perhaps sharply, from historical patterns. Stop loss-based trading strategies (and/or continuous delta hedging strategies) may limit a Managed Futures fund s portfolio losses, and tend to work most of the time, but not always, most notably in those cases where: (i) market conditions and/or manager misjudgments in a meaningful number of underlying instruments generate a sufficiently large number of repeated occurrences of being stopped out at a loss (colloquially termed getting whipsawed ); and/or (ii) market prices of a meaningful number of the fund s underlying investments experience significant price gaps and/or trading discontinuities resulting in actual realized prices that differ sharply from the manager s intended stoploss limits prices. Managed Futures-based investment and trading strategies and other algorithms which tend to have many of the trend-following and/or reversion-anticipating characteristics associated with statistical arbitrage, assume that markets are not random walk-like in nature and at the same time, raise the question of whether there are intrinsic sources of return beyond fixed-income like returns that are associated with: (i) commodities; (ii) commodity futures; (iii) financial instruments; and (iv) futures on financial instruments; as a result of such considerations, it tends to be difficult to make returns projections for Managed Futures as an asset class. Because of the dispersion of returns associated with first-quartile returns (i.e., the 25 th best manager out of a select universe of 100 managers) as compared with third-quartile returns (i.e., the 75 th best manager out of a select universe of 100 managers) special caution and care are particularly important in Managed Futures manager selection; manager evaluation criteria (1) include: (i) integrity and character; (ii) philosophy and approach; (iii) resource utilization; (iv) past investment performance; (v) risk management procedures and disciplines; (vi) correlations of returns with other Managed Futures managers and with other asset classes; (vii) fees and expenses; (viii) tax considerations; and (iv) operational and technical elements. Notes: 1. Please see page 207 in The Art of Asset Allocation. Second Edition, by David M. Darst, CFA (McGraw-Hill, 2008) for further details about and discussion of each of these criteria. Source: Morgan Stanley Smith Barney. 9

10 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Essential Differences Between Managed Futures and Other Asset Classes Set forth below are some of the essential reasons why the payoff profiles and patterns of returns of Managed Futures may be choppy and sometimes discontinuous in nature, differing from and exhibiting generally low levels of correlations with the returns of equities, fixed income securities, cash, and select other types of alternative investments: Scope of Activity Managed Futures Funds may participate in a wide variety of financial and commodity futures, forwards, and option markets, thereby gaining exposure to a broad opportunity set of underlying and derivative price movements. Long and Short Positions Managed Futures Fund managers may attempt to capitalize on price movements from a long position standpoint (with the expectation of benefiting from price increases in the underlying futures, forwards, or options contracts) and/or from a short position standpoint (with the expectation of benefiting from price declines in the underlying futures, forwards, or options contracts). Model-Driven Trading Managed Futures Fund managers attempt to identify and profit from sustained upward or downward price movements in specific kinds of futures, forwards, or options contracts; in many cases, such trend identification and trend-following investment techniques are developed and executed using computer-based, quantitatively driven models analyzing inputs including the amplitude and magnitude of behavior in: (i) prices; (ii) volume; (iii) explicit and implied volatility; (iv ) correlations with other instruments and with other forms of derivatives on a given instrument; (v) skewness; (vi) kurtosis; and (vii) other factors. Stop-Loss Disciplines Many Managed Futures Fund managers employ stop-loss disciplines to sell out (liquidate) long positions after they have declined a certain amount in price, or to buy back (cover) short positions after they have risen a certain amount in price; while such maneuvers may limit losses, they can be costly in the aggregate during choppy market conditions, which may recurrently trigger stop-loss orders. Use of Leverage Losses and/or gains may be magnified by the inherent leverage in futures trading, combined with Managed Futures Funds policies regarding the use of greater or lesser amounts of leverage for specific positions and market conditions. Source: Morgan Stanley Smith Barney. 10

11 Diversification Liquidity Volatility Quantification Budgeting Leverage Modeling SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Select Risk Management Strategies Pursued by Managed Futures Advisors Having an appropriate balance of contracts among a variety of: (i) underlying commodities and financial instruments; (ii) maturities and contract expirations; and (iii) countries, counterparties, time zones, exchanges, and settlement and delivery mechanisms. Taking into account the differing degrees of liquidity associated with: (i) specific position sizes; (ii) primary and non-primary trading marketplaces; (iii) exchange- and non exchange- based order handling mechanisms; and (iv) hedging and investment activity in related physical, spot, cash, forward, swap, and other derivatives markets. Using levels of and trends in historical and implied volatility to influence and inform trading, speculation, investment, price discovery, risk definition, risk assumption, and risk transference activity. Constructing, stress-testing, modifying, and applying appropriate: (i) mean absolute deviation, variance, covariance, range, and shortfall analysis; (ii) t-tests, F-tests, and chi-square tests; (iii) Roy s safety-first rule and Sharpe ratios; and (iv) efficient frontier, mean variance optimization, value-at-risk (VaR), and other tools to measure actual historical risk and potential future risk. Aggregating risks of various kinds and at multiple levels to detect and respond to portfolio risk. Remaining aware of the extent, magnitude, diversity, costs, and forms of borrowing and lending activity, and the degree to which leverage may subject the portfolio to rollover, counterparty, and systemic exposure. Building, constructing, and developing a profound understanding of the algorithms, powers, and limitations of the software and hardware behind the valuation, trading, loss limitation, and other models utilized in the identification and implementation of trading and investment systems. Source: Morgan Stanley Smith Barney and adaptations of Managing Risk for Managed Futures, Schweser Study Program,

12 Beef Cattle Feed Lot in Oklahoma The 10 states in the US with the largest cattle populations are Texas, Missouri, Oklahoma, Nebraska, South Dakota, Montana, Kansas, Iowa, Kentucky, and Florida. Source: United States Department of Agriculture. SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Special Considerations Associated with Managed Futures Funds Tax Reporting (1) : Many managed futures investments are structured as limited partnerships which may involve tax reporting procedures via the IRS Partnership Form 1065, so-called Schedule K-1. Because the IRS generally classifies each year s returns from Managed Futures trading as 40% short term and 60% long term, investors may be subject to more favorable (or less favorable) tax treatment on such investments compared to certain other asset classes. Liquidity: The units of such private placements tend to be relatively illiquid, as there is no established trading market for them, although investors may be able to redeem their units at specified intervals (such as once a month, once a quarter, or according to some other given time interval) or at the discretion of the general partner of the Managed Futures Fund. Minimum Net Worth and Income Requirements: With the exception of a small number of publicly traded entities that can be purchased by non-accredited investors, Managed Futures Funds are typically offered as private placements and have investor minimum net worth and minimum income requirements intended to ensure that only accredited investors or qualified eligible persons purchase such funds. Documentation Requirements: Prior to investing in private Managed Futures Funds, qualified investors must receive a Private Placement Memorandum for the Fund, which contains the information needed to evaluate the potential investment and provide important disclosures regarding risks, conflicts of interest, sales restrictions, fees and expenses. Single-Manager vs. Multiple-Manager Risk: In view of the relatively high standard deviations of returns that may be associated with any single Managed Futures Fund manager, allocations to Managed Futures Funds may be implemented using a Fund of Funds approach and/or a broadly diversified group of managers and strategies. Notes: 1. The information contained herein is not intended as tax, legal, or investment advice, and may not be suitable for all investors. Investors should consult their own tax, legal, investment, or other advisors to determine such suitability. If Managed Futures investments are held in a qualified investment account, such as an IRA, tax reporting is generally not required. Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department 12

13 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Fees and Expenses Associated with Managed Futures Funds Level and Complexity of Fees: Managed Futures Funds typically have fee structures that may be higher and more complex than fee structures usually associated with many conventional equity or fixed income funds and other pooled vehicles. Multiple Fees: Managed Futures Fund managers may in many cases be compensated through multiple fees, which could include one or more of: (i) a flat management fee, which may be based on the total assets under management for the fund; (ii) an incentive fee, which may be based on the performance of the individual manager; (iii) a commission fee based on the net asset value of the account or fund; (iv) transaction costs or brokerage fees; (v) an administrative fee, which may apply to all investors; (vi) redemption fees upon the sale of partnership interests; and (vii) in the case of Managed Futures funds of funds, additional layers of fees may apply. Fees in Relation to Aggregate Positions: Fees can also be examined in proportion to the dollar value of positions held via the use of leverage, as the dollar value of futures positions held by a fund is typically much larger than actual fund assets, while fees charged to a fund are based solely on fund assets. Redemption fees may also apply in certain circumstances. Variations on Fees: Fees and fee structures may differ: (i) from fund to fund; (ii) from manager to manager; and (iii) when offset by credits associated with the level of interest rates earned on collateral positions and cash balances. Fee Review: Prospective investors should carefully review the stated fee structures of specific Managed Futures Funds and fund managers. Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department; Chicago Board of Trade. 13

14 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Investment Approaches of Managed Futures Funds Select Contracts for Futures Contracts on U.S. Exchanges Corn (CBOT) Contract Size: 5,000 bushels Price Quote: Cents and ¼ cent per bushel Contract Months: Mar, May, Jul, Sep, Dec Soybeans (CBOT) Contract Size: 5,000 bushels Price Quote: Cents and ¼ cent per bushel Contract Months: Jan, Mar, May, Jul, Aug, Sep, Nov Copper (COMEX) Contract Size: 25,000 pounds Price Quote: Cents per pound Contract Months: The current calendar month and the next 23 consecutive months and any Mar, May, Jul, Sep, Dec falling within 60 month period beginning with current month Crude Oil (NYMEX) Contract Size: 1,000 barrels Price Quote: Dollars and Cents per barrel Contract Months: 60 consecutive months plus long-dated futures Orange Juice (ICE) Contract Size: 15,000 pounds Price Quote: Cents and 5/100 cents per pound Contract Months: Jan, Mar, May, Jul, Sep, Nov Source: Chicago Board of Trade; New York Mercantile Exchange; Chicago Mercantile Exchange; Commodity Exchange of New York. Investment approaches may be categorized by: (i) convergent versus divergent strategies; (ii) broad-based versus price-based trading systems; and (iii) systematic versus discretionary trading systems. While Managed Futures Funds advisors and CTAs may not necessarily employ and may not be limited to these investment approaches or trading strategies, the latter two investment approaches tend to be prevalent within the managed futures industry: (i) a systematic trend-following and counter trend-following investment approach; and (ii) a discretionary or fundamental investment approach. Systematic Investment Approach Managers who pursue a technical or systematic trend-following or counter trend-following approach utilize quantitative, computer-based trading models and strategies to identify opportunities to capitalize on what are believed to be upward or downward market trends. Trendfollowing managers hope to achieve positive absolute returns by making opportunistic trades that focus on meaningful and sustained directional moves in equities, bonds, currencies, commodities, or other futures, forwards, or options contracts. Some manager styles seek to take advantage of market trends lasting over short periods of time (perhaps hours or days), while other manager styles attempt to take advantage of market trends of intermediate- or longer-term duration (perhaps weeks or months). Technical trend-following advisors may rely solely on quantitative inputs and strategies, and may or may not allow qualitative or fundamental factors to affect their investment decisions. Approximately 80% of Managed Futures Funds advisors and CTAs pursue some type of systematic trend-following or counter trend-following investment approach. Discretionary Investment Approach Managers who pursue a discretionary or fundamental approach may utilize quantitative trading models and strategies, while also taking into consideration fundamental factors such as supply and demand data, macroeconomic indicators, geopolitical forces, and other qualitative influences in an effort to anticipate and predict market directions and movements for equities, bonds, currencies, commodities, or other futures, forwards, or options contracts and derivative instruments included within the portfolio. Some managers may utilize fundamental data with the intention of taking advantage of qualitative market judgments about trading opportunities lasting over short periods of time (perhaps hours or days) while other managers may attempt to take advantage of qualitative market judgments about trading opportunities lasting over intermediate- or longer-trading periods (perhaps weeks or months). Approximately 20% of Managed Futures Funds advisors and CTAs pursue some type of discretionary or fundamental investment approach. Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 14

15 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Select Insights Into Managed Futures Returns Patterns Oil Rig in the Gulf of Mexico Factors Influencing Capital Drawdowns: Managed Futures Funds tend to exhibit very low positive returns or negative returns (drawdowns): (i) during periods of sharp and severe price reversals of previously established trends; (ii) during periods of choppy, sideways, trendless price movements in their main areas of investment focus (due in large part to the fact that many Managed Futures Funds essentially have a long position in volatility or are essentially long the equivalent of an options straddle position, i.e., a long put option plus a long call option); (iii) when portfolio emphasis is placed on sectors that move against the manager s long or short positions; and (iv) when a substantial majority of markets are all in a relatively quiet state, with limited profit opportunities for managers to attempt to exploit. Unusual Price Behavior: It is relatively unusual, but not impossible, for many markets and sectors (including currencies, interest rates, energy, metals, and equities) across many regions to experience an essentially trendless environment. Determinants of the Use of Leverage: The degree of leverage employed by Managed Futures Funds tends to be a function of: (i) manager risk tolerance and risk control procedures; (ii) the strategy, trading disciplines, and objectives of the fund itself and its primary investor base; (iii) price, volume, volatility, covariance, and investor behavior characteristics affecting the main groups of underlying futures in the funds areas of emphasis; (iv) the degree of conviction that the fund manager has about present and future price trends and risk/reward opportunities; and (v) regulatory, internal, and counterparty leverage limits. Elements of Success in Managed Futures Trading: Success in managed futures trading requires skill in: (i) the timing of purchase and sale decisions; (ii) the style of trading and investment implementation; and (iii) the selection and weighting of areas of investment focus. Other success factors include the manner in which risk is assumed and managed, the time frame of the investment activity, and a sufficient degree of both amplitude and duration in the price movements of the underlying instruments. Costs of Stop-Loss Disciplines: Stop-loss trading disciplines may protect principal, yet can incur costs that may be small individually but substantial in the aggregate in trendless market environments; in such circumstances, Managed Futures Funds may experience a series of relatively defined losses resulting from being stopped out repeatedly after initially establishing long or short positions. Post-Drawdown Capital Recovery: Although there is no guarantee that future results will resemble past performance, intervals of trendless market behavior have tended to give way to sustained market moves in many sectors, with substantial capital drawdowns in many cases followed by periods of meaningfully positive investment returns (please refer to page 25 for eighteen instances of such outcomes). Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 15

16 Pit Traders at the Chicago Mercantile Exchange Oil Rig in the North Sea SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Managed Futures Funds Compared With Hedge Funds Key Distinctions Markets Traded Managed Futures Funds tend to focus on the futures, forwards, and options markets, while Hedge Funds tend to trade across the equity, fixed income, and derivatives markets. Investment Approach Many Managed Futures Funds investment approaches rely to a meaningful degree on systematic, technical trend-following, while most Hedge Fund managers tend to utilize one or more of a range of investment styles such as: (i) market neutral; (ii) convertible, fixed income, risk arbitrage, or capital structure arbitrage; (iii) distressed investing; (iv) global macro strategies; and (v) other approaches. Performance Characteristics While both Managed Futures Funds and Hedge Funds have in the past exhibited the ability to generate attractive investment returns across many, but not all, market environments, Managed Futures Funds have historically tended to perform better on an absolute and relative basis during periods of equity market weakness, whereas Hedge Funds have historically tended to perform better on an absolute and relative basis during periods of equity market strength. Investor Transparency The majority of Managed Futures Funds generally allow for full transparency, for the fund manager and the general partners, into underlying positions and daily independent pricing, whereas the majority of Hedge Funds generally provide limited transparency and monthly pricing. Skewness and Kurtosis Managed Futures Funds tend to have a higher degree of positive skewness of monthly returns and a lower degree of kurtosis of monthly returns than Hedge Funds (please refer to pages 30 and 32 for more details concerning the concepts of skewness and kurtosis). Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. 16

17 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Trend Characteristics and Underlying Drivers of Managed Futures Late-stage Wheat in Minnesota Underlying Instrument Trend Persistence Characteristics Selected Influences on Returns Patterns Agricultural Futures Moderate Supply and Demand Conditions Meteorological and Climate Conditions Currency Futures High Interest Rate Movements Economic Trends Trade and Capital Flows Geopolitical Events Energy Futures Moderate Supply Forces Demand Forces Geopolitical Forces Equity Futures Moderate Economic Trends Drilling for Oil in a Texas Field Fundamental and Valuation Trends Psychological/Technical/Liquidity Trends Interest Rate Futures High Monetary and Fiscal Policy Inflationary/Deflationary Forces Economic Trends Metals (Base) Futures Low Supply and Demand Conditions Infrastructure and Capacity Conditions Metals (Precious) Futures Low Inflationary/Deflationary Forces Supply and Demand Conditions Geopolitical Conditions The phrase trend persistence characteristics refers to the past tendency for prices of the underlying instrument to continue moving generally in the same direction for some period of time once established. Many Managed Futures industry participants and investment strategists maintain that the greater degree of perceived uncertainty in a given market the more likely that trend characteristics should be high. Source: Morgan Stanley Smith Barney. 17

18 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Evolution of the Futures Markets Composition of Traded Futures Markets (1) Interest Rates 14% Currencies 5% (2) Lumber & Energy 1% Metals 8% Agriculturals 13% Energy 7% Interest Rates 26% Metals 16% Agriculturals 64% Stock Indices 23% Currencies 24% (2) Volume of Contracts Traded Volume of Contracts Traded Sectors Volume (MM) Agriculturals 59.1 Metals 15.0 Interest Rates 12.5 Currencies 4.2 Lumber & Energy 1.2 Total 92.1 Sectors Volume (MM) Interest Rates 2,555.9 Currencies 2,350.9 Stock Indices 2,324.6 Agriculturals 1,245.9 Metals Energy Total 9,928.9 Source: Futures Industry Association; Morgan Stanley Smith Barney Managed Futures Department. Notes: 1. Includes domestic and international contracts traded on U.S. exchanges. 2. Due to the scope and size of the Interbank foreign exchange (FX) market, a significant amount of currency trading activity is executed through Interbank counterparties and is not included in these data. 18

19 SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Actively Traded Futures and Options Contracts in the U.S. Chicago Skyline Number of Futures and Options Contracts Traded on All U.S. Exchanges Chicago Board of Trade (CBOT) 3,000 2,466 2,500 1,963 2,000 1,500 1,365 1,521 1,135 1, Source Commodity Futures Trading Commission. Volume of Futures Contracts Traded on All U.S. Exchanges Traders at the Chicago Board of Trade (CBOT) celebrate upon completing 2003 s record annual trading volume of 454 million contracts. Source: Chicago Board of Trade. Million 4,000 3,474 3,500 3,079 3,103 3,000 2,706 2,416 2,500 1,920 2,000 1,518 1,500 1,225 1,004 1, Source: Commodity Futures Trading Commission. 19

20 Old World Map SELECT INVESTMENT ADVANTAGES AND POTENTIAL RISKS OF MANAGED FUTURES Total Global Assets Under Management in Managed Futures YTD (1) Global Assets Under Management in Managed Futures $ U.S. Billion World Map 250 Global assets under management in Managed Futures have grown from approximately $300 million in 1980 to approximately $300 billion as of the end of Q The Earth from Space (1) Source: BarclayHedge, Ltd. Notes: 1. Data are as of 2Q

21 The New York Mercantile Exchange (NYMEX) New York Mercantile Exchange Clearing Member Firms ABN AMRO Clearing Chicago LLC J.P. Morgan Securities LLC ADM Investor Services, Inc. Macquarie Futures USA Inc. Advantage Futures, LLC Marex North America LLC Barclays Capital Inc. MBF Clearing Corp. BMO Capital Markets Corp. Merrill Lynch, Pierce, Fenner & Smith Inc. BNP Paribas Prime Brokerage, Inc. MF Global Inc. BNY Mellon Clearing, LLC Mizuho Securities USA Inc. BOCI Commodities and Futures Limited Morgan Stanley & Co. LLC BP Corporation North America, Inc. Newedge USA, LLC Citigroup Global Markets Inc. Penson Financial Services, Inc. Credit Suisse Securities (USA) LLC Phillip Futures Inc. Crossland, LLC Proxima Clearing, LLC Deutsche Bank Securities Inc. Rand Financial Services Inc. Dorman Trading, L.L.C. RBC Capital Markets LLC Enskilda Futures Limited RBS Securities Inc. FCStone, L.L.C. R.J. O'Brien & Associates, LLC Gelber Group, LLC Rosenthal Collins Group, L.L.C. GETCO, LLC Santander Investment Securities Inc. Goldman, Sachs & Co. Term Commodities, Inc. Goldman Sachs Execution & Clearing, L.P. Timber Hill LLC HSBC Securities (USA) Inc. TradeLink L.L.C. Jefferies Bache, LLC UBS Securities LLC Jump Trading, LLC Vision Financial Markets LLC Source: CME Group Section 2 Summary of Managed Futures Investment Performance and Correlation The London Metal Exchange (LME) The London Metal Market and Exchange Company was founded in 1877, but its history traces back to the Royal Exchange, which opened in It was at the Royal Exchange where the tradition of the Ring (which can still be found on the LME logo) was born. A merchant with metal to sell would draw a circle on the floor and call out a willingness to make a trade, and other traders would assemble around the circle and make their bids. 21

22 Year Morgan Stanley Smith Barney Annual Total Returns for Select Indices Barclay CTA (1) Index S&P 500 Index MSCI EAFE Index 10-Year U.S. Treas. Bond U.S. Treas. Bill (90-Day) % 32.5% 22.6% -0.1% 11.9% % -4.9% -2.3% 5.4% 15.0% % 21.5% -1.9% 33.5% 11.3% % 22.6% 23.7% 2.9% 8.9% % 6.3% 7.4% 14.3% 10.0% % 31.7% 56.2% 27.3% 7.8% % 18.7% 69.4% 19.7% 6.2% % 5.3% 24.6% -3.2% 5.9% % 16.6% 28.3% 6.4% 6.8% % 31.7% 10.5% 16.4% 8.6% % -3.1% -23.4% 6.8% 7.9% % 30.5% 12.1% 17.2% 5.8% % 7.6% -12.2% 6.5% 3.6% % 10.1% 32.6% 11.8% 3.1% % 1.3% 7.8% -7.8% 4.2% % 37.6% 11.2% 23.7% 5.8% % 23.0% 6.0% 0.1% 5.3% % 33.4% 1.8% 11.3% 5.2% % 28.6% 20.0% 12.9% 5.1% % 21.0% 27.0% -8.4% 4.7% % -9.1% -14.2% 14.5% 6.0% % -11.9% -21.4% 4.0% 4.1% % -22.1% -15.9% 14.7% 1.7% % 28.7% 38.6% 1.3% 1.1% % 10.9% 20.2% 4.9% 1.2% % 4.9% 13.5% 2.0% 3.0% % 15.8% 26.3% 1.4% 4.8% % 5.5% 11.2% 9.8% 4.7% % -37.0% -43.4% 20.3% 1.8% % 26.5% 31.8% -9.9% 0.2% % 15.1% 7.8% 8.1% 0.1% Investment performance of the Barclay CTA Index may be more volatile than investment performance for other indices represented above. There is no guarantee that an investment of this type will achieve its objectives and investors may suffer losses. SUMMARY OF MANAGED FUTURES INVESTMENT PERFORMANCE AND CORRELATION Annual Total Return Performance for the Barclay CTA Index and Select Other Indices Annual Return (%) (20) (40) (60) Barclay CTA Index (1) Source: Morgan Stanley Smith Barney ; Factset; Bloomberg LLC; BarclayHedge, Ltd. S&P 500 Index 10-Year U.S. Treasury Bond U.S. Treasury Bill (90-Day) (2) (3) Notes: 1. Performance data are net of fees for the Barclay CTA Index only; the Barclay CTA Index is an industry benchmark of representative performance of Commodity Trading Advisors. As of late 2011, there are 565 programs included in the calculation of the Barclay CTA Index. To qualify for inclusion in the CTA Index, an advisor must have four years of prior performance history. Please refer to page 23 for additional details concerning the Barclay CTA Index for Managed Futures. 2. The 10-Year U.S. Treasury Bond is represented by the Citigroup 10-Year Treasury Note Index. 3. The U.S. Treasury Bill (90-Day) is represented by the Citigroup 3-Month Treasury Bill Index. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. 22

23 SUMMARY OF MANAGED FUTURES INVESTMENT PERFORMANCE AND CORRELATION Select Managed Futures Indices Performance The Barclay CTA Index is a leading industry benchmark of representative performance of commodity trading advisors. There are currently 565 programs included in the calculation of the Barclay CTA Index for the year 2011, which is unweighted and rebalanced at the beginning of each year. To qualify for inclusion in the CTA Index, an advisor must have four years of prior performance history. Additional programs introduced by qualified advisors are not added to the Index until after their second year. These restrictions, which offset the high turnover rates of trading advisors as well as their artificially high short-term performance records, ensure the accuracy and reliability of the Barclay CTA Index. Source: BarclayHedge, Ltd. Barclay CTA Index Index Level 35,000 30,000 25,000 20,000 15,000 10,000 5, Source: Bloomberg, LLC. Barclay CTA Indices - Annual Total Return (%), All Barclay CTA Index Returns Are Expressed Net of Fees (23-Year) CAGR Barclay CTA Index Sub Indices (1) Agricultural Traders Index (2) Currency Traders Index (3) Discretionary Traders Index (4) Diversified Traders Index (5) Financial & Metals Traders Index (6) Systemic Traders Index Source: Morgan Stanley Smith Barney ; Bloomberg, LLC. Notes: 1. The Barclay Agricultural Traders Index is an equal-weighted composite of managed programs that trade agricultural markets, such as grains, meats, foods. In 2011, 29 agricultural programs were included in the index. 2. The Barclay Currency Traders Index is an equal-weighted composite of managed programs that trade currency futures and/or cash forwards in the interbank market. In 2011, 117 currency programs were included in the index. 3. The Barclay Discretionary Traders Index is an equal-weighted composite of managed programs whose approach is at least 65% discretionary or judgmental. In 2011, 150 discretionary programs were included in the index. 4. The Barclay Diversified Traders Index is an equal-weighted composite of managed programs that trade a diversified portfolio. In 2011, 360 diversified programs were included in the index. 5. The Barclay Financial & Metals Traders Index is an equal-weighted composite of managed programs that trade primarily financial or financial and metals. In 2011, 98 financial/metals programs were included in the index. 6. The Barclay Systematic Traders Index is an equal-weighted composite of managed programs whose approach is at least 95% systematic. In 2011, 457 systematic programs were included in the index. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. 23

24 SUMMARY OF MANAGED FUTURES INVESTMENT PERFORMANCE AND CORRELATION Managed Futures Returns During Financial Market Dislocations Performance of the Barclay CTA Index vs. the S&P 500 Index During Select Periods of Financial Market Uncertainty Comparative Investment Performance During Periods of Perceived Crisis Period (1) Number of Months Event S&P 500 Index (Total Return) Barclay CTA Index Barclay CTA Index vs. S&P 500 Index Fourth Quarter U.S. Stock Market Crash % 13.77% 36.30% Third Quarter Invasion of Kuwait by Iraq % 15.82% 29.57% Third Quarter Russian Debt Default, LTCM Crisis -9.95% 8.95% 18.90% November December U.S. Presidential Election Uncertainty -7.43% 8.90% 16.33% September October Terrorist Attacks on United States Soil -6.32% 4.40% 10.72% October July Enron and Worldcom Bankruptcies % 7.49% 18.86% August October Bear Market Bottom and High Yield Bond Market Turbulance -2.39% 0.27% 2.66% January December Technology Bubble Bursts, U.S. Recession % 22.22% 59.82% January March War in Iraq, SARS Crisis, Geopolitical Uncertainty -3.15% 0.73% 3.88% July December Widespread Global Credit / Mortgage Crisis % 20.07% 57.93% September December Financial Institutions in U.S. Face Liquidity Crunch % 6.46% 35.36% Source: Morgan Stanley Smith Barney ; Morgan Stanley Smith Barney Managed Futures Department. Notes: 1. The select periods are used for illustrative purposes and may not correspond with the precise starting and ending dates surrounding the suggested events or periods of perceived crisis. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. 24

25 SUMMARY OF MANAGED FUTURES INVESTMENT PERFORMANCE AND CORRELATION Review of Drawdowns of 5% or More in the Barclay CTA Index 1980 September 2011 Barclay CTA Index Drawdowns of 5% or More January September 2011 Average Historical Drawdown (9.18%) Average Duration in Months 4.5 Number of Drawdowns 18 % Positive 12-month Periods Following a Drawdown Average 12-month Return Following a Drawdown 100% 21.20% Review of Drawdowns of 5% or More in the Barclay CTA Index September 2011 Drawdown Performance Number of Months Recovery (Months) Peak Trough Succeeding 12 Month Return (15.66%) 4 9 Jun 1989 Oct % (15.46%) 9 4 Mar 1986 Dec % (11.09%) 4 3 Jul 1984 Nov % (10.10%) 5 3 Dec 1991 May % (9.81%) 1 1 May 1984 Jun % (9.50%) 10 4 Oct 1990 Aug % (9.19%) 2 2 Jul 1985 Sep % (9.12%) 1 2 Jun 1982 Jul % (9.05%) 1 3 Jan 1983 Feb % (8.52%) 3 1 Sep 1982 Dec % (8.50%) 1 2 May 1983 Jun % (8.35%) 4 2 Dec 1987 Apr % (8.23%) 1 10 Jun 1988 Jul % (7.74%) 5 15 Mar 2004 Aug % (6.74%) 6 2 Oct 2001 Apr % (6.47%) 4 1 Feb 1985 Jun % (6.13%) 7 13 Jul 1993 Feb % (5.63%) 13 5 Jun 1999 Jul % Average (9.18%) % Source: Morgan Stanley Smith Barney Managed Futures Department. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. 25