Frequently Asked Questions About Managed Futures and Funds

What are managed futures?
Managed futures are a type of alternative investment established to trade in global futures, options and forex markets in which successful performance does not depend on continued upward movement in traditional equity or bond markets. Unlike other futures accounts, however, in a managed futures account a professional trader known as a commodities trading advisor (CTA) is responsible for determining what trades to make and when, pursuant to a power-of-attorney or limited trading authorization.

Who should invest in managed futures?
We believe that many investors, including individuals, corporations and institutional investors, can benefit from including managed futures in their portfolios because managed futures, as an asset class, can provide valuable diversification to a traditional portfolio of equities and fixed income investments.

Are managed futures suitable for everyone?
The simple answer is “No”. Although managed futures can provide badly needed portfolio diversification to many portfolios, only investors with risk capital who understand and can deal with the risks and rewards involved in trading futures should invest in managed futures.

Are managed futures a good short term investment?
Because futures markets tend to be cyclical, we recommend that investors hold a managed account, commodity pool or futures fund investment for at least two to three years and treat managed futures as a “core” investment instead of as a short term trading opportunity.

Can IRAs and other self directed plans invest in managed accounts, commodity pools and futures funds?
Yes. But an investor must ensure that his/her plan permits such investments. If the investor’s plan custodian does not accept alternative investments, he/she will have to open an account with another custodian that does.

Two plan custodians specializing in handling alternative assets are:

Millenium Trust Company LLC
820 Jorie Blvd.
Suite 420
Oak Brook, IL 60523

Northstar Trust Company
500 West Madison St
Suite 3630
Chicago, Il 60661

Is it true that futures trading is very risky?
Many people feel that futures trading is risky primarily because of the amount of leverage available to futures traders. For example, it only takes $4,000 in initial margins to trade a contract worth approximately $50,000 of the mini S&P 500, so the leverage available is 12:1. Because many investors who trade for themselves or use the services of a broker do not know how to take advantage of the leverage available or manage their risk exposure, they tend to lose money. That is why it makes sense to delegate responsibility for trading futures and forex to a registered CTA who follows the markets on a full-time basis and knows how to use leverage appropriately as part of an overall strategy for trading these markets. Furthermore, because managed futures are a separate asset class and are not correlated to traditional markets, portfolios including managed futures may be more diversified than those without managed futures. Comparisons of the futures indices to the S&P 500 and Nasdaq show that futures can actually reduce volatility and provide for more stable returns.

What is a hedge fund?
Hedge funds use a broad range of investment styles, strategies and techniques to trade different asset classes and financial instruments to try to make profits for their investors. Hedge fund managers provide expertise in managing risk and portfolio management and their returns are largely due to their talent and skill instead of general appreciation in the asset classes traded. Theoretically, hedge funds can generate positive returns independent of what happens in the stock and bond markets. Hedge fund managers often invest their own money in the funds they manage. Individual hedge funds tend to trade a limited number of strategies and many of them focus on just one strategy. Some of the strategies used by hedge fund managers include:

• Commodities and futures
• Distressed securities
• Equities - balanced long/short
• Equities - either long/short
• Equities- short
• Equities – trading
• International opportunistic
• International regional
• Industry sector
• Strategic block
• Relative value
• Convertible Arbitrage
• Statistical Arbitrage
• Mergers and reorganizations

Hedge funds are usually bought by sophisticated investors on a private placement basis. They are organized to provide investors with flow through tax treatment of profits/losses and limited liability. Hedge funds are usually organized and managed on a day-to-day basis by the traders responsible for implementing the fund’s strategies who are, in turn, paid management and incentive fees by the fund. Hedge fund managers are usually exempt from having to register with the SEC.

What is a Fund of Hedge Funds (FoF)?
A FoF invests in multiple underlying hedge funds in an attempt to achieve greater portfolio diversification and better returns by spreading investment risk over a number of managers and strategies. FoFs are generally structured as privately placed unregistered investment companies, although some FoFs register as investment companies with the SEC without registering under the Securities Act of 1933.

How are managed futures different from a hedge fund or FoF?
In answering this question it might be easier to point out the similarities between the managed futures, hedge funds and FoFs before discussing the differences. All of these investments provide:

• Diversification to a typical portfolio of stocks and bonds
• Professional investment management
• Access to different investment strategies, styles, and markets
• Returns that are highly dependent on the talent and skill of specific managers instead of general market appreciation.

In addition to these shared characteristics, managed futures offers greater accessibility, transparency, liquidity and security than most hedge funds and FoFs.

• Managed futures trading is more accessible to investors because it has lower commitment requirements than many other alternative investments.
Most alternative investments require a bigger capital commitment and offer far less liquidity than managed futures. Investors can open managed futures accounts and add additional capital to an account anytime they want. Most commodity pools and futures funds accept subscriptions from new investors and additional capital contributions from existing investors’ capital every month. Many hedge funds and FoFs, on the other hand, are closed to new investment once they raise enough capital to begin doing business or only accept new capital contributions annually or quarterly after they begin trading.

• Managed futures provide greater transparency than hedge funds and FoFs.
TraderSource, Inc. (TSI) will monitor the CTAs on PFG’s recommended list on a daily basis with the aid of a new risk monitoring platform that has been co-developed by TSI and PFG. This platform allows TSI to monitor every CTA on the list on a daily basis to ensure that their risk parameters have not been breached and values the open positions in every account. TSI also has detailed account access to every account through PFG’s Best Direct™ trading platform allowing it to monitor CTA “style drift” better.. PFG will also send statements to investors reporting all activity in managed futures accounts and monthly statements recapping all activity every month. Hedge funds and FoFs often trade exotic over-the-counter (OTC) instruments that can not be easily priced because they are traded in unregulated, non-public markets and many do not report trading activity to investors on a daily or monthly basis.

• Managed futures may have greater liquidity than hedge funds and FoFs.
Futures contracts are highly liquid and can usually be bought or sold in a matter of seconds. The only exception to this rule is when prices are very volatile and a contract trades through its daily price limit or stock prices trigger a “circuit breaker” between the equities markets and futures markets. Since the interbank currency market is one of the biggest markets in the world and is open 24/7, it is also incredibly liquid. Therefore, it is usually easy to open, roll or offset a futures contract or currency position. OTC derivative contracts, on the other hand, may be complicated and costly to close out early if a hedge fund manager needs to liquidate a position before it is due to expire.

• Managed futures may provide investors greater security than hedge funds and FoFs.
Capital invested in PFG managed futures accounts is all held in customer segregated funds account (Seg Account). CFTC Regulations prohibit FCMs from using Seg Account funds in the conduct of their business or commingling those funds with the FCM’s own funds. Therefore, Seg Accounts may provide greater security for customer assets than many bank or securities brokerage accounts used by hedge funds and FoFs.

Will adding managed futures diversify my customers’ portfolios?
It is impossible to answer this question because portfolio holdings and investment objectives vary from one customer to another. Modern Portfolio Theory suggests that a portfolio containing low correlated, positive performing investments usually produces better risk-adjusted returns than any of the portfolios underlying individual investments. Research indicates that managed futures have been negatively correlated to traditional portfolios of stocks and bonds when they experience prolonged losses, and positively correlated when they experience sustained gains. If that’s true, adding managed futures to a traditional portfolio of stocks and bonds should reduce overall volatility while improving overall returns.

While the theory about portfolio diversification sounds fine, how could adding an investment in managed futures impact a traditional portfolio? Contrary to popular belief, research shows that portfolios including managed futures generate higher returns and have less volatility than portfolios that do not include managed futures. The following chart shows the returns, volatility and Quick Sharpe Ratio for stocks, bonds, and managed futures from January 1990 through December 2003. As you can see from the data, managed futures generated a higher return than stocks and bonds and had lower volatility than stocks during that 14 year period.

Based on the data above, we can calculate returns in hypothetical portfolios allocating various amounts to stocks, bonds and managed futures, enabling us to compare the performance of portfolios including managed futures to those that do not. Consider the following three hypothetical portfolio allocations:

Based on the returns from January 1990 through December 2003, it is clear that hypothetical Portfolio C, the only portfolio including managed futures, generated the highest reward and had the lowest risk.

Note: This composite performance record is hypothetical and these trading advisors have not traded together in the manner shown in the composite. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any multi-advisor managed account or pool will or is likely to achieve a composite performance record similar to that shown. In fact, there are frequently sharp differences between a hypothetical composite performance record and the actual record subsequently achieved. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit or hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.

Will TSI monitor the performance of each CTA on the recommended list on a day-to-day basis? Yes.

How are gains and losses on futures trades taxed?
You should consult your tax advisor or preparer to determine how your gains and losses will be taxed. If you trade for yourself or have managed futures accounts, be sure you have all Forms 1099 provided by your FCM reporting trading profits/losses on Section 1256 contracts and interest or T-Bill discounts earned available when you prepare your tax return or meet with your tax advisor. If you invested in a pool or fund the CPO will send you a Form K-1 showing your share of profits/losses and other income that should be reported to the IRS.

As a general rule open positions will be marked-to-market as if the unrealized gains and losses were realized on the last day of the calendar year for individual accounts and the last day of the tax year for pools and funds. Marked-to-market unrealized gains/losses and realized gains/losses on 1256 contracts will be taxed on a 60%/40% basis as if 60% of the gains/losses are long term gains or losses and 40% are short term gains or losses.

Why do you keep talking about “Section 1256” contracts?
Because some futures interests like single stock futures contracts, narrow based indices and inter-bank foreign exchange contracts do not qualify for Section 1256 treatment and are taxed like securities.

This is not an offer to sell or a solicitation of any offer to purchase managed futures. It is intended for use only by FCMs, IBs, Broker-Dealers and their salespersons and should not be copied or distributed to any one else. This FAQ does not contain all the information necessary to make an investment decision. You should refer to the CTAs’ Disclosure Documents if you are considering investing in managed accounts or the offering memoranda for commodity pools or futures funds.