Commodities: What Investors Need to Know by Nathan Rowader, Director of Investments & Senior Market Strategist

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1 Commodities: What Investors Need to Know by Nathan Rowader, Director of Investments & Senior Market Strategist Complexity and volatility have led many to steer clear of this asset class. But the picture is changing with easier access and new strategies. Inside: The dynamics of global demand Commodities vs. stocks and bonds The evolution of commodity investment vehicles Comparing long/short with long-only strategies Understanding roll yield It s easy to understand why sophisticated institutional investors have been diversifying into commodities for some years now. Virtually everything we buy or consume ultimately traces back to these basic resources. Their supplies are limited, and continued population and economic growth is producing a secular shift toward rising demand. As an asset class, commodities have historically exhibited unique characteristics, including low correlations with other asset classes and inflation-hedging abilities. Many institutional investors have significantly increased their exposure to commodities in recent years. 1 The Harvard Endowment, for example, has boosted its target portfolio allocation to commodities from 6% in 1995 to 14% in All told, approximately $134 billion in net new capital flowed into commodities in 2009 and 2010 an estimated three-quarters of it from institutional investors. 3 Still, individual investors and their advisors have generally shied away from commodities because of their high volatility and the difficulty of understanding the various investment options, not to mention the arcane technical aspects of commodity investing and trading. Although commodities do represent a vast global market, they make up just 1.6% of mutual fund and exchange-traded fund (ETF) assets. 4 Recently, however, commodities have become more accessible to the average investor as commodity mutual funds and exchange-traded funds have come onto the scene. However, some of these strategies have pitfalls and challenges, including a lack of diversity and downside protection. Fortunately, recent developments include new tools and strategies that help investors to manage volatility by investing both long and short. Other innovations have been aimed at capitalizing on return components unique to the world of commodities. As investors look for ways to cope with an uncertain global investment climate that may be shifting toward lower returns, many are pondering alternatives to traditional style box investing. Those seeking different sources of return and diversification should give commodities a closer look.

2 The Basics Not just oil and gold While investors often think of commodities in terms of oil and gold the commodities that tend to generate the most attention the universe of investable commodities is broad, ranging from agricultural products to industrial metals. They can be categorized as soft are likely to increase over the long term given the growing demand. Benefits of standardization. Commodities retain similar characteristics regardless of origin or seller. From the standpoint of valuation and trading, a bushel of wheat is largely the same FIGURE 1 Commodities in the S&P GSCI, by Type as of December 2012 Hard Commodities Soft Commodities Energy Industrial Metals Precious Metals Agriculture Livestock Brent Crude Oil Aluminum Gold Chicago Wheat Cocoa Feeder Cattle Crude Oil Copper Silver Corn Coffee Lean Hogs Gas Oil Lead Soybeans Cotton Live Cattle Heating Oil Nickel Wheat Sugar Natural Gas Zinc RBOB Gasoline Sources: S&P/Dow Jones Indices, Forward Rising standards of living and consumption in the developing world will likely exert upward pressure on commodity prices. commodities those that are grown and hard commodities those that are extracted from the ground (Figure 1). Despite the diversity of their supply, demand and pricing dynamics, commodities share certain characteristics. Building blocks of global expansion. Commodity investing is likely to become increasingly prominent as populations grow and emerging markets develop. China and India alone could substantially increase the demand for commodities of all kinds if they continue to grow at the torrid pace exhibited during the past decade. Together, they represent one-third of the world s population, and both are rapidly industrializing. 5 Consider that, at present, the average Chinese person consumes less than three barrels of oil per year, and the average Indian, one. Meanwhile, the average American consumes an estimated 22 barrels of oil per year. 6 It stands to reason that rising standards of living and consumption in the developing world will exert upward pressure on commodity prices. Return potential. Basic materials are limited in supply, which suggests that commodity prices whether it is grown in Kansas or Russia. It makes little difference whether a pound of copper is mined in Chile or Zambia. Besides allowing commodities to be traded globally at consistent prices, this also contributes to the overall size and liquidity of the market. Capital preservation features. Commodities differ from stocks and bonds in that they are tied to a physical asset. A barrel of oil might be volatile in price, but it is unlikely to ever be worthless, as stocks or bonds can sometimes become. This ability to act as a store of value also means that commodities tend to increase in value during inflationary times, as discussed below. Traditional ways to invest Direct physical investment. Because of the cost of buying, selling, transporting, storing and valuing physical commodities, this is not an option for most financial investors. Industrial producers and users make up the vast majority of those who choose to physically hold commodities. 2 Commodities: What Investors Need to Know

3 Virtually all commodity mutual funds employ a systematically-based investment strategy that uses an index. Commodity-related stocks. Some investors look for exposure via commodity-related stocks, meaning companies involved in the extraction, growing, storing, transporting or processing of various commodities. However, commodityrelated stocks have historically tended to behave more like stocks than commodities. 7 Moreover, they are already represented in many portfolios, meaning a portfolio with an additional allocation to commodity-related stocks would likely be overweight in those kinds of companies. Commodity futures contracts. Commodity derivatives have a long history dating back to the trading of rice futures in 18th century Japan. 8 Futures contracts are liquid, easy to value and are traded globally. They resemble a yield curve with varying prices and dates of maturity ( expiry ). As contracts approach expiry, investors must roll them into new contracts if they do not want to take delivery on the commodity. The role of commodity futures indices Commodity price indices date back to 1934, when the U.S. Bureau of Labor Statistics began compiling a daily spot price index at the request of the U.S. Department of the Treasury. 9 A number of commodity futures indices have since been introduced (Figure 2). A boon for investors. Indices allow tracking of price movements for the overall asset class and specific commodities. They also facilitate broad diversification within the asset class. Due to U.S. Internal Revenue Service rules on the tax treatment of investment income for mutual funds, virtually all commodity mutual funds employ a systematically-based investment strategy that uses an index. Many variations. By no means are all commodity indices constructed alike. The commonly used indices vary in their number of sectors or sub-indices. They also differ substantially in the weighting of sectors, which may be based on commodity production and/or liquidity, as well as in sector constraints. While the indices tend to be highly correlated, they are remarkably different in their risk and return characteristics. A leaning to long-only. The most commonly used indices are long-only. More recently, long/short indices have emerged as an alternative, in response to concerns with the historically high volatility and sometimes sizable drawdowns exhibited by the asset class. Nearby contracts. Most indices assume investment in nearby futures contracts and roll those contracts back as they expire. As discussed below, the focus on nearby contracts may have performance implications for mutual funds that replicate those indices. Investors should note, however, that the performance of commodity indices may not be matched by results of commodity mutual funds, as they may use varying methods in seeking to replicate an index. FIGURE 2 Selected Commodity Indices as of December 2012 Index Inception Date Current Construction CRB BLS Spot Indices commodities in 6 sectors (backfilled to 1957; earlier versions date back as far as 1934) S&P GSCI Index 1991 (backfilled to Jan 1970) 24 commodity futures in 6 sectors Production-based weighting of sectors Dow Jones UBS Commodity Index 1991 (backfilled to Jan 1970) 22 commodities in 5 sectors Production and liquidity-based sector weighting subject to weighting restrictions applied annually such that no related group of commodities constitutes more than 33% of the index and no single commodity constitutes more than 15% or less than 2% of the index. Sources: Standard & Poor s, Forward Commodities: What Investors Need to Know 3

4 Historical Advantages and Challenges Distinct benefits vs. stocks and bonds Historical data suggest that commodities potential for portfolio diversification may be their most important benefit. While there is no guarantee that commodities will continue to exhibit the same performance patterns they have displayed in the past, a large body of historical data suggests the asset class may have unique characteristics. Broad diversification potential. Commodities and commodity futures have reacted differently than other asset classes to economic factors and to changes in the stock and bond markets. Historically, they have shown low correlation with FIGURE 3 stock and bond returns (Figure 3). Significantly, historical data show that while commodities have tended to underperform stock and bond markets when their prices are rising, commodities have delivered positive overall performance in both rising and declining stock and bond price environments (Figure 4). This suggests that diversifying with commodities may have the potential to enhance nearly any asset allocation model possibly the most important benefit of the asset class. Correlation of Returns Among Asset Classes January 1, 1988 March 20, 2013 Commodities U.S. Stocks International Stocks Emerging Market Stocks U.S. Bonds Commodities 1.00 U.S. Stocks International Stocks Emerging Market Stocks U.S. Bonds to to to to 0.00 Less than 0 Source: Morningstar NOTE: Except as otherwise noted, asset classes and indices referenced in figures throughout are as follows: Commodities S&P GSCI; U.S. Stocks S&P 500; International Stocks MSCI EAFE; Emerging Market Stocks MSCI Emerging Markets; U.S. Bonds Barclays Capital U.S. Aggregate Bonds Past performance is no guarantee of future results. FIGURE 4 Impact of Changes in Stock and Bond Prices on Asset Class Returns January 1, 1970 December 31, 2012 Asset Class No. of Months Annualized Return (%) No. of Months Annualized Return (%) Asset Class No. of Months Annualized Return (%) No. of Months Annualized Return (%) Rising Stocks Falling Stocks Rising Bonds Falling Bonds U.S. Stocks U.S. Stocks Int l Stocks Int l Stocks Emerging Stocks Emerging Stocks U.S. Bonds U.S. Bonds Commodities Commodities Source: Standard & Poor s, MSCI, Barclays Capital, Forward. NOTE: Number of months varies among asset classes due to varying index time horizons. Past performance is no guarantee of future results. 4 Commodities: What Investors Need to Know

5 A possible hedge against inflation. Commodities have historically been highly sensitive to inflation, rising as consumer prices increase. Between January 1, 1970 and December 31, 2012, commodities produced a substantially higher return than U.S. stocks and bonds during periods of inflation (Figure 5). Of course, commodities also tend to fall in deflationary times. But it is worth noting that of the 504 months from 1970 through 2012, the Consumer Price Index (CPI) only declined in 9% of months. Potential for increased risk-adjusted returns. Viewed in terms of annualized absolute returns, commodity index performance has surpassed that of stocks and bonds for the past 40 years, albeit with higher volatility. The seminal analysis of the asset class, the Gorton/Rouwenhorst study, published by the Yale Center of Finance in 2005, concludes that baskets of fully-collateralized commodity futures have historically offered about the same return, risk premium and Sharpe ratio as U.S. equities. 10 Our analysis shows that, because of their low correlation with other asset classes, commodities may enhance portfolio returns (Figure 6). FIGURE 5 Impact of Consumer Price Changes on Asset Class Returns January 1, 1976 December 31, 2012 Total No. of Months Annualized Average Return Total No. of Months Asset Class Inflationary (CPI > 5%) All Other Periods Annualized Average Return U.S. Stocks % % U.S. Bonds % % Commodities % % FIGURE 6 Impact of Adding Commodities on Portfolio Returns January 1, 1970 December 31, 2012 Asset Class Base Case Including Commodities (Long-Only) U.S. Stocks 60% 47.30% U.S. Bonds 40% 14.60% Commodities 0% 38.10% Annualized Return 10.45% 11.52% Standard Deviation 11.10% 13.10% Source: Morningstar NOTE: Except as otherwise noted, asset classes and indices referenced in figures throughout are as follows: Commodities S&P GSCI; U.S. Stocks S&P 500; U.S. Bonds Barclays U.S. Aggregate Bond Past performance is no guarantee of future results. Commodities: What Investors Need to Know 5

6 Risks and barriers Historically high volatility. Since 1970, the commodity asset class has exhibited an annualized standard deviation of 20.0%, less than the 23.8% recorded for emerging market stocks, but significantly greater than the 15.5% figure for U.S. stocks. During the same time period, the S&P GSCI had 17 drawdowns greater than 20% with eight of them occurring in the last decade (Figure 7). Although it is uncertain whether this pattern of high volatility will persist in the future, it is often seen as a major drawback for investors in long-only commodity investments. On the other may also be affected by events affecting the financial services sector. Difficulty of access. Historically, investing through commodity trading advisors (CTAs) who offer managed futures accounts was the only way to gain exposure to commodity-based investment strategies. Generally packaging investments as private funds, CTAs typically charge a management fee, performance fee and operating expenses. Managed futures can only be transacted by financial advisors with specialized FIGURE 7 Historical Volatility of the S&P GSCI January 1, 1970 December 31, 2012 It has been demonstrated that the volatility of commodities may be mitigated and even capitalized upon by a long/ short approach. Valuation (in U.S. Dollars) 28,283 17,154 10,405 6,311 3,828 2,322 1, Bull & Bear Markets Defined as -20/+20% Reversals in S&P GSCI Total Return Gain During Bull Markets Mean 94% 617 Days Median 73% 337 Days Loss During Bear Markets Mean -30% 276 Days Median -27% 118 Days Shaded areas represent -20% reversals in S&P GSCI Total Return Source: Ned Davis Research Past performance is no guarantee of future results. hand, it has been demonstrated that high volatility can be mitigated, and even capitalized upon, by a long/short approach. A range of risk factors. Beyond the usual risks associated with any investment, commodities investments are subject to additional risks such as events or market factors that result in price fluctuations in underlying commodities such as energy, metals or agricultural products. The value of investments in commodity-linked securities licensing. While CTAs represent more than $337 billion in assets, a large share of the commodities market, 11 and have enabled investors to use hedge-style systematic and long/short strategies, their higher expenses and licensing requirements have been off-putting to many investors. Beyond that, some CTAs who invest in commodities also include financial futures and currencies in their investment mix. 6 Commodities: What Investors Need to Know

7 Recent Advances in Commodity Investing The rise of commodity mutual funds and ETFs/ETNs Commodity mutual funds have proliferated, but the vast majority of them employ long-only strategies. A growing trend. Commodity mutual funds have been available since 1997, but have gained steam in the last decade. ETFs and ETNs (exchangetraded notes) have emerged more recently and grown rapidly. From January 1, 2003 to December 31, 2012 alone, commodity mutual funds and ETFs/ETNs grew from $2 billion to more than $168 billion in assets under management. 12 How commodity mutual funds work. Virtually all commodity mutual funds seek to replicate an index. This should be a plus for investors, in that use of a well-constructed index provides diversified exposure to the asset class, potentially helping to dampen volatility. Additionally, many commodity funds invest assets in structured notes that are tied to an index. As a result of federal tax law and other restrictions on investing in commodity-related instruments, commodity mutual funds have certain characteristics that are different than other mutual funds. Many commodity mutual funds may hold a portion of their assets in a wholly owned offshore subsidiary, which is a response to U.S. Internal Revenue Service (IRS) regulations and constraints relating to tax treatment of mutual funds. Mutual funds vs. ETFs/ETNs. Both vehicles provide high liquidity as well as transparency of holdings and the underlying strategy. But while all mutual funds track a broadly diversified commodities index, ETFs and ETNs most often track a single commodity, such as gold, although some may track a broad index. An emerging concern is the significant tracking error ETFs and ETNs can sometimes experience, due to the fact that they are typically traded in secondary markets. 13 Finally, certain commodity ETFs are structured in a way that results in issuance of taxable partnership income, which can complicate tax planning and filing. 14 RISKS There are risks involved with investing, including loss of principal. Past performance does not guarantee future results, share prices will fluctuate and you may have a gain or loss when you redeem shares. Exposure to the commodities markets may subject a fund to greater volatility than investing in traditional securities. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as natural disasters and international economic, political and regulatory developments. Derivative instruments involve risks different from those associated with investing directly in securities and may cause, among other things, increased volatility and transaction costs or a fund to lose more than the amount invested. Investing in exchange-traded funds (ETFs) will subject a fund to substantially the same risks as those associated with the direct ownership of the securities or other property held by the ETFs. Mortgage and asset-backed securities are debt instruments that are secured by interests in pools of mortgage loans or other financial instruments. Mortgage-backed securities are subject to, among other things, prepayment and extension risks. Investing in a non-diversified fund involves the risk of greater price fluctuation than a more diversified portfolio. Alternative strategies typically are subject to increased risk and loss of principal. Consequently, investments such as mutual funds which focus on alternative strategies are not suitable for all investors. Diversification and asset allocation do not assure profit or protect against loss. Commodities: What Investors Need to Know 7

8 Use of long/short strategies to temper volatility Historically, long/short indices have captured much of the upside return in commodities with about two-thirds the volatility of long-only indices. A problem-solving innovation. A number of long/ short indices have been created in response to the high volatility of commodities. These indices generally use momentum measures to help determine whether the index will take a long or short position in each individual commodity. They do, however, vary widely in their construction, utilizing differing sector categories and weightings. Long/short index strategies were once available only through hedge funds, but have recently become available in mutual fund form. To date, however, only three mutual funds using a pure, long/short commodity-focused approach have been introduced. 15 Track record. Historically, long/short indices have captured much of the upside return in commodities while reducing some of the downside (Figure 8). Overall, they have functioned with approximately two-thirds the volatility of long-only indices. 16 They have also provided more downside protection during certain periods. During the financial crisis that began in 2008, for example, two long-only indices, the DJ UBS Commodity Index and the S&P GSCI, experienced their largest drawdowns ever, falling -54.3% and -67.6%, respectively. During the same period, two long/short commodity indices, the CS MOVERS Index and the BNP Millennium Index, dropped by only -29.1% and -26.9%, respectively. 17 Of course, there is no guarantee that commodity investments will continue to perform as they have in the past, but the record suggests that long/short strategies may have certain advantages over a long-only approach. FIGURE 8 Performance of Long-Only vs. Long/Short Indices January 1, 2008 December 31, 2012 Long-Only Indices 1 Year 3 Year 5 Year Max Drawdown Standard Deviation Sharpe Ratio S&P GSCI 0.08% 2.54% -8.12% DJ UBS Commodity -1.06% 0.07% -5.17% Long/Short Indices CS MOVERS % -9.98% 2.92% Millenium Long/Short Commodities % -7.78% 2.68% Barclays CORALS -6.23% -4.86% -0.34% JPMorgan C-IGAR Long/Short % -3.24% 1.97% S&P CTI % % -7.36% Morningstar Long/Short Commodity % 0.09% 1.79% Source: Morningstar Past performance is no guarantee of future results. Managing the impact of roll yield What is roll yield? When futures contracts reach expiry, investors must do one of the following: take delivery on the physical commodity, as stated in the contract (or make delivery, in the case of a short contract), financially close out the position or roll the expiring contract into a new one. This creates a yield curve comparable to that characteristic of bond markets. As futures contracts approach maturity, their prices will tend to converge to the expected future spot price of the contract (Figure 9). In a backwardated commodity futures market, contracts trade at higher prices as they approach maturity. The opposite is a contango market, one in which futures contract prices are above the expected future spot price, indicating that the price will decline as expiry draws closer. The shape of the curve is affected by supply and demand. 8 Commodities: What Investors Need to Know

9 FIGURE 9 Conceptual Representation of the Futures Curve $ Contango Backwardation Source: Forward Spot 3 Month 6 Month 9 Month Time to Expiry Roll yield can be a significant contributor to total commodity returns, but can also lower returns in contango markets. Roll yield (also known as roll return ) is realized when investors roll existing contracts approaching expiry into new contracts. Roll yield is one component of the return on commodity investments, and may be either a positive contributor, if the market is in backwardation, or a negative contributor if the market has been in contango. A double-edged sword. Roll yield can be a significant contributor to total returns from commodity investing, but it can also lower returns if a market has shifted into contango. A breakdown of S&P GSCI return components shows that over the past decade, roll yield has been a negative return factor overall (Figure 10). Some have attributed this to the fact that most of the major commodity futures indices mainly invest in nearby contracts. The demand exerted for short-term contracts tends to raise their prices, potentially resulting in losses as contract prices converge toward the expected spot price over time. FIGURE 10 Components of the S&P GSCI Return January 1, 1970 March 31, 2012 Annualized Returns Spot Return 4.40% Source The difference between initial purchase price and subsequent sale of a futures contract. Roll Return -0.74% Profit or loss achieved through the convergence toward an expected spot price as a contract approaches expiry. Collateral Return 5.74% Futures contracts are leveraged, requiring only a fractional cash deposit to gain the desired exposure. Most indices assume the remainder is invested in cash instruments such as 3-month Treasury bills. Total Return 9.40% Source: Standard & Poor s, Forward Past performance is no guarantee of future results. Commodities: What Investors Need to Know 9

10 A new-generation strategy. In an effort to reduce the likelihood of negative roll yield, some index providers have developed enhanced index components that aim to achieve positive roll yield. They operate by positioning the underlying commodity at varying points on the futures curve, based on the momentum of changes in the curve. Such a strategy may be combined with a long/short approach, as in the CS MOVERS Enhanced strategy referenced in the figure below, in an effort to maximize investor return per unit of risk (Figure 11). The differential between the CS MOVERS and CS MOVERS Enhanced strategies is entirely attributable to index enhancements seeking positive roll yield. FIGURE 11 Growth of $100 in Selected Commodity Indices January 1, 1970 March 31, 2013 CS MOVERS Enhanced $958 CS MOVERS $715 S&P 500 $178 S&P GSCI $174 Source: Bloomberg, Credit Suisse, Standard & Poor s, Dow Jones Conclusion At a time when many investors are still operating with financial models based on 10% returns but may now find themselves earning closer to 5%, alternative asset classes are garnering more attention than ever. Still, the world of commodities remains unfamiliar and even intimidating to many investors. While investors are wise to be cautious, given the historical volatility and idiosyncratic features of this asset class, they should give some thought to: Its unique potential for delivering diversification, increased portfolio alpha and preservation of value in times of inflation. The emergence of new investment options that may help reduce the volatility and complexity of commodity investing. The rising global demand for commodities as developing nations rapidly grow and industrialize. Together, these factors make a strong case for considering commodities investing now. 10 Commodities: What Investors Need to Know

11 Definition of Terms Alpha is a coefficient measuring risk-adjusted performance. A basket is a single unit of at least 15 stocks that are used in program trading. Backwardation occurs when a futures contract will trade at a higher price as it approaches expiration compared to when the contract is farther away from expiration. Rolling into less expensive futures contracts allows the trader to profit from the rise in a futures price as it nears expiration. Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Contango is a situation that occurs in a futures market where the prices for future delivery are higher than the prices for immediate (or nearer) delivery. A derivative is a security whose price is dependent upon or derived from one or more underlying assets. Drawdown is the gradual decline in the price of a security or other investment between its high and low over a given period. Exchange-traded funds (ETFs) are index-based products that allow investors to buy or sell shares of entire portfolios of stock in a single security. It is a type of investment vehicle whose objective is to achieve the same return as a particular market. Similar to an index fund, it invests primarily in the securities of companies included in a selected market index. Futures is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold, are known as liquid. A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Sharpe ratio is a ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate such as that of the 10-year U.S. Treasury bond from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. Spot price is the current price at which a particular commodity can be bought or sold at a specified time and place. Standard deviation is the most common measure of statistical dispersion, measuring how widely spread the values in a data set are. If many data points are close to the mean, then the standard deviation is small; if many data points are far from the mean, then the standard deviation is large. If all the data values are equal, then the standard deviation is zero. A structured note is a debt obligation that also contains an embedded derivative component with characteristics that adjust the security s risk/return profile. The return performance of a structured note will track that of the underlying debt obligation and the derivative embedded within it. Tracking error is a divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of a hedge or mutual fund that did not work as effectively as intended, creating an unexpected profit or loss instead. Transparency is the extent to which investors have ready access to any required financial information about a company such as price levels, market depth and audited financial reports. Yield curve is a line that plots the interest rates, at a set point in time, of bonds with equal credit quality, but differing maturity dates. Index Definitions Barclays Aggregate Bond Index represents securities that are U.S. domestic, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with components for government and corporate securities, mortgage pass-through securities and asset backed securities. Barclays CORALS Index is based on a systematic and quantitative allocation strategy which uses fundamental forecasts and market technical signals to determine the optimal monthly weight of each individual commodity. BNP Millennium Commodity Index is a quantitative strategy designed to generate positive returns through dynamic allocation across a diversified commodity universe. CRB BLS Spot indices (or Commodity Research Bureau/Bureau of Labor Statistics Indices) are a group of indices that measure the overall direction of commodity sectors. The CRB was designed to isolate and reveal the directional movement of prices in overall commodity trades. Credit Suisse Momentum and Volatility Enhanced Return Strategy (MOVERS) Index focuses on the global commodities market using a universe of 24 S&P GSCI sub-indices. The Index seeks positive absolute returns at bullish and at bearish points in the commodity cycle for each of the S&P GSCI single commodity sub-indices. Dow Jones UBS Commodity Index is composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a date for the delivery of the underlying physical commodity. JPMorgan C-IGAR (Commodity Investable Global Asset Rotator) Long-Short Index is a pure long-short strategy, which synthetically invests in up to 24 constituents (12 synthetic long positions and 12 synthetic short positions all equally weighted 1/12). Morningstar Long/Short Commodity Index is a fully collateralized commodity futures index that uses a momentum rule to determine if each commodity is held long, short or flat. MSCI EAFE (Morgan Stanley Capital International, Europe, Australia and Far East) Index is an unmanaged index of over 1,000 foreign common stock prices including the reinvestment of dividends. It is widely recognized as a benchmark for measuring the performance of international value funds. MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance in the global emerging markets. Russell 3000 Index is composed of the 3,000 largest U.S. companies as measured by market capitalization, and represents about 98% of the investable U.S. equity market. S&P 500 Index is a capitalization-weighted index of 500 stocks traded on the NYSE, AMEX and OTC exchanges, and is comprised of industrial, financial, transportation and utility companies. S&P CTI (Commodity Trends Indicator) Index is a diversified composite of traditional, physical global commodity futures that are highly traded and highly liquid. S&P GSCI Index Index serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. Index returns are for illustrative purposes only and do not represent actual performance of any securities. Index performance returns do not reflect any management fees, transaction costs or expenses. indices are unmanaged and one cannot invest directly in an index. Commodities: What Investors Need to Know 11

12 The new direction of investing The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward s investment solutions are built around the outcomes we believe investors need to be pursuing non-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of December 31, 2013, we manage $5.2 billion in a diverse product set offered to individual investors, financial advisors and institutions. 1. Institutions hope to find gold mine with commodities, Pensions & Investments, May 30, 2005; Funds boost private equity investing by 38%, Pensions & Investments, 02/07/11 2. Harvard Management Company, 12/31/11 3. Barclays, as reported in Institutional Investing to Drive Commodity Inflows, Pensions & Investments, 02/23/11 4. Strategic Insight, Morningstar, Forward, as of 05/31/13 5. CIA World Factbook China National Energy Administration, International Energy Agency, 12/31/12 7. Facts and Fantasies about Commodity Futures, by Gorton & Rouwenhorst. Yale ICF Working Paper No ; Forward, February Schaede, Ulrike. Forwards and futures in Tokugawa-period Japan: A new perspective on the Dojima rice market. Journal of Banking & Finance 13 (4-5): , November /31/ Facts and Fantasies about Commodity Futures, by Gorton & Rouwenhorst. Yale ICF Working Paper No , February BarclayHedge, Morningstar Inc., as of 03/31/ Strategic Insight, Morningstar Inc., Forward, 12/31/ /19/ Commodities ETFs can be taxing, Investment News, 01/30/ Morningstar Inc., Forward analysis, 12/31/ Forward, 12/31/ Dow Jones, Standard & Poor s, Credit Suisse, BNP Paribas, 12/31/12 You should consider the investment objectives, risks, charges and expenses of the Forward Funds carefully before investing. A prospectus with this and other information may be obtained by calling (800) or by downloading one from It should be read carefully before investing. RISKS Performance in the commodity indices should not be considered reflective of the performance of any of the Forward Funds. The information presented in this report was developed internally or obtained from sources that Forward believes to be reliable, but Forward cannot guarantee its accuracy or completeness. All expressions of opinion are subject to change without notice. This information should not be relied upon by the reader as research or investment advice regarding any securities. Forward is a registered investment advisor. The views expressed contain certain forward-looking statements. Forward believes these forward-looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. This material represents an assessment of the market at a particular time and is not a guarantee of future results. Nathan Rowader is a registered representative of ALPS Distributors, Inc. Forward Funds are distributed by Forward Securites, LLC Forward Management, LLC. All rights reserved. All other registered trademarks or copyrights are the property of their respective organizations. 101 California Street 16th Floor San Francisco, CA (888) FSD