Smith Barney Potomac Futures Fund L.P.
Notes to Financial Statements
June 30, 2005
(Unaudited)
In the normal course of its business, the Partnership either directly or through its investment in the Master, is party to financial instruments with off-balance sheet risk, including derivative financial instruments and derivative commodity instruments. These financial instruments may include forwards, futures and options, whose values are based upon an underlying asset, index, or reference rate, and generally represent future commitments to exchange currencies or cash flows, to purchase or sell other financial instruments at specific terms at specified future dates, or, in the case of derivative commodity instruments, to have a reasonable possibility to be settled in cash, through physical delivery or with another financial instrument. These instruments may be traded on an exchange or over-the-counter ("OTC"). Exchange-traded instruments are standardized and include futures and certain option contracts. OTC contracts are negotiated between contracting parties and include forwards and certain options.
Each of these instruments is subject to various risks similar to those related to the underlying financial instruments including market and credit risk. In general, the risks associated with OTC contracts are greater than those associated with exchange-traded instruments because of the greater risk of default by the counterparty to an OTC contract.
Market risk is the potential for changes in the value of the financial instruments traded by the Partnership/Master due to market changes, including interest and foreign exchange rate movements and fluctuations in commodity or security prices. Market risk is directly impacted by the volatility and liquidity in the markets in which the related underlying assets are traded.
Credit risk is the possibility that a loss may occur due to the failure of a counterparty to perform according to the terms of a contract. Credit risk with respect to exchange-traded instruments is reduced to the extent that an exchange or clearing organization acts as a counterparty to the transactions. The Partnership's/Master's risk of loss in the event of counterparty default is typically limited to the amounts recognized as unrealized appreciation in the statements of financial condition and not represented by the contract or notional amounts of the instruments. The Partnership, through its investment in the Master, has credit risk and concentration risk because the sole counterparty or broker with respect to the Master's assets is CGM.
The General Partner monitors and controls the Partnership's/Master's risk exposure on a daily basis through financial, credit and risk management monitoring systems, and accordingly believes that it has effective procedures for evaluating and limiting the credit and market risks to which the Partnership/Master is subject. These monitoring systems allow the General Partner to statistically analyze actual trading results with risk-adjusted performance indicators and correlation statistics. In addition, on-line monitoring systems provide account analysis of futures, forward and option positions by sector, margin requirements, gain and loss transactions and collateral positions.
The majority of these instruments mature within one year of June 30, 2005. However, due to the nature of the Partnership's/Master's business, these instruments may not be held to maturity.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Liquidity and Capital Resources
The Partnership does not engage in the sale of goods or services. Its only assets are its investment in the Master and cash. The Master does not engage in the sale of goods or services. Because of the low margin deposits normally required in commodity futures trading, relatively small price movements may result in substantial losses to the Partnership. While substantial losses could lead to a substantial decrease in liquidity, no such losses occurred in the second quarter of 2005.
The Partnership's capital consists of capital contributions, as increased or decreased by its investment in the Master, expenses, interest income, redemptions of Redeemable Units and distributions of profits, if any.
For the six months ended June 30, 2005, Partnership capital increased 28.9% from $154,682,645 to $199,329,012. This increase was attributable to a net gain from operations of $11,984,489 coupled with the additional sales of 25,384.3906 Redeemable units of Limited Partnership Interest totaling $42,260,000, which was partially offset by the redemption of 5,767.6989 Redeemable Units of Limited Partnership Interest totaling $9,598,122. Future redemptions can impact the amount of funds available for investment in commodity contract positions in subsequent periods.
The Master's capital consists of the capital contributions of the partners as increased or decreased by realized and/or unrealized gains or losses on commodity futures trading, expenses, interest income, redemptions of Units and distributions of profits, if any.
For the six months ended June 30, 2005, Master's capital increased 5.9% from $283,959,300 to $300,648,584. This increase was attributable to a net gain from operations of $29,198,776 coupled with the additional sales of 307,582.8470 units totaling $307,113,300, which was partially offset by the redemption of 33,167.7228 units totaling $32,916,124 and distribution of interest totaling $2,747,368 to the limited partners of the Master. Future redemptions can impact the amount of funds available for investments in commodity contract positions in subsequent periods.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
All commodity interests (including derivative financial instruments and derivative commodity instruments) are used for trading purposes. The commodity interests are recorded on trade date and open contracts are recorded in the statements of financial condition at fair value on the last business day of the period, which represents market value for those commodity interests for which market quotations are readily available or other measures of fair value deemed appropriate by management of the General Partner for those commodity interests and foreign currencies for which market quotations are not readily available. Investments in commodity interests denominated in foreign currencies are translated into U.S. dollars at the exchange rates prevailing on the last business day of the period. Realized gains (losses) and changes in unrealized values on open positions are recognized in the period in which the contract is closed or the changes occur and are included in net gains (losses) on trading of commodity interests.
The value of the Partnership's investment in the Master reflects the Partnership's proportional interest in the partners' capital of the Master. All of the income and expenses and unrealized and realized gains and losses from the commodity transactions of the Master are allocated pro rata among the investors at the time of such determination.
Foreign currency contracts are those contracts where the Partnership/Master agrees to receive or deliver a fixed quantity of foreign currency for an agreed-upon price on an agreed future date. Foreign currency contracts are valued daily, and the Partnership's/Master's net equity therein, representing unrealized gain or loss on the contracts as measured by the difference between the forward foreign
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exchange rates at the dates of entry into the contracts and the forward rates at the reporting date, is included in the statements of financial condition. Realized gains (losses) and changes in unrealized values on foreign currency contracts are recognized in the period in which the contract is closed or the changes occur and are included in the Statements of Income and Expenses and Partners' capital.
Results of Operations
During the Partnership's second quarter of 2005 the net asset value per Redeemable unit increased 11.9% from $1,610.06 to $1,801.96 as compared to a decrease of 12.7% in the second quarter of 2004. The Partnership experienced a net trading gain before brokerage commissions and related fees in the second quarter of 2005 of $24,374,848. Gains were primarily attributable to the trading of commodity futures in currencies and non-U.S. interest rates and were partially offset by losses in energy, U.S. interest rates, metals and indices. The Partnership experienced a net trading loss before brokerage commissions and related fees in the second quarter of 2004 of $14,968,381. Losses were primarily attributable to the trading of commodity futures in currencies, U.S. and non-U.S. interest rates, indices and metals and were partially offset by gains in energy.
Results in the second quarter of 2005 reflect improved trading conditions for the trend-following strategies of the Advisor. April appeared to be a transition period as macro-economic trends emerged in financial markets and continued strong through May and June. Commodity trading was unprofitable as markets experienced wide rapid swings in broad ranges.
Lower interest rates in the Europe and the U.S. were the primary drivers of profitability for the quarter and had a concomitant impact on strengthening the U.S. dollar to recent highs versus the Euro, British pound and Swiss franc. The fixed income markets shrugged off another rate increase by the U.S. Federal Reserve driven by lower inflation reports, weak European markets, and improved productivity. Lower interest rates and strong currency trends provided substantial profits for the Advisor's positions. However, volatility in the global equity markets as a result of inflationary concerns and weak earnings reports in April produced net losses in stock index trading for the quarter.
A combination of lower inflation expectations and increased supplies disrupted prior trends and resulted in losses in the sectors for the Partnership's Advisor. Overall, the Partnership had a successful quarter taking advantage of trends that were available and avoiding serious consequences in the more treacherous markets.
During the Partnership's six months ended June 30, 2005 the net asset value per Redeemable unit increased 6.0% from $1,699.79 to $1,801.96 as compared to an increase of 0.3% for the six months ended June 30, 2004. The Partnership experienced a net trading gain before brokerage commissions and related fees during the six months ended June 30, 2005 of $18,020,882. Gains were primarily attributable to the trading of commodity futures in currencies, energy, U.S. and non-U.S. interest rates and metals and were partially offset by losses in indices. The Partnership experienced a net trading gain before brokerage commissions and related fees for the six months ended June 30, 2004 of $7,574,920. Gains were primarily attributable to the trading of commodity futures in currencies, energy, U.S. and non-U.S. interest rates, and were partially offset by losses in indices and metals.
Commodity futures markets are highly volatile. The potential for broad and rapid price fluctuations increases the risks involved in commodity trading, but also increases the possibility of profit. The profitability of the Partnership (and the Master) depends on the existence of major price trends and the ability of the Advisor to correctly identify those price trends. Price trends are influenced by, among other things, changing supply and demand relationships, weather, governmental, agricultural, commercial and trade programs and policies, national and international political and economic events and changes in interest rates. To the extent that market trends exist and the Advisor is able to identify them, the Partnership (and the Master) expects to increase capital through operations.
Interest income on 80% of the Partnership's daily average equity allocated to it by the Master was earned at a 30-day U.S. Treasury bill rate determined weekly by CGM based on the average non-competitive yield on 3-month U.S. Treasury bills maturing in 30 days. CGM may continue to maintain the Master's assets in cash and/or place all of the Master's assets in 90-day Treasury bills and pay the Partnership 80% of the interest earned on the Treasury bills purchased. CGM will retain 20% of any interest earned on Treasury bills. Interest income allocated from the Master for the three and six months
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ended June 30, 2005 increased by $724,263 and $1,293,867, respectively as compared to the unallocated amount earned directly for the corresponding period in 2004. The increase in interest income is primarily due to higher net assets and higher interest rates during the three and six months ended June 30, 2005 as compared to the corresponding periods in 2004.
Brokerage commissions are calculated on the Partnership's adjusted net asset value on the last day of each month and are affected by trading performance, additions and redemptions. Accordingly, they must be analyzed in relation to the fluctuations in the monthly net asset values. Commissions and fees for the three and six months ended June 30, 2005 increased by $955,339 and $1,626,528, respectively as compared to the corresponding periods in 2004. The increase in brokerage commissions and fees is due to higher net assets during the three and six months ended June 30, 2005 as compared to the corresponding periods in 2004.
Management fees are calculated as a percentage of the Partnership's net asset value as of the end of each month and are affected by trading performance, additions and redemptions. Management fees for the three and six months ended June 30, 2005 increased by $311,870 and $536,160, respectively as compared to the corresponding periods in 2004. The increase in management fees is due to higher net assets during the three and six months ended June 30, 2005 as compared to the corresponding periods in 2004.
Incentive fees are based on the new trading profits generated by the Advisor at the end of the quarter as defined in the advisory agreements between the Partnership, the General Partner and the Advisor. There were no incentive fees earned for the three and six months ended June 30, 2005 as well as the three months ended June 30, 2004. Trading performance for the six months ended June 30, 2004 resulted in incentive fees of $3,973,895.
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Item. 3 Quantitative and Qualitative Disclosures about Market Risk
All of the Partnership's assets are subject to the risk of trading loss through its investment in the Master. The Master is a speculative commodity pool. The market sensitive instruments held by it are acquired for speculative trading purposes, and all or substantially all of the Master's assets are subject to the risk of trading loss. Unlike an operating company, the risk of market sensitive instruments is integral, not incidental, to the Master's main line of business.
Market movements result in frequent changes in the fair market value of the Master's open positions and, consequently, in its earnings and cash flow. The Master's market risk is influenced by a wide variety of factors, including the level and volatility of interest rates, exchange rates, equity price levels, the market value of financial instruments and contracts, the diversification effects among the Master's open positions and the liquidity of the markets in which it trades.
The Master rapidly acquires and liquidates both long and short positions in a wide range of different markets. Consequently, it is not possible to predict how a particular future market scenario will affect performance, and the Master's past performance is not necessarily indicative of its future results.
Value at Risk is a measure of the maximum amount which the Master could reasonably be expected to lose in a given market sector. However, the inherent uncertainty of the Master's speculative trading and the recurrence in the markets traded by the Master of market movements far exceeding expectations could result in actual trading or non-trading losses far beyond the indicated Value at Risk or the Master's experience to date (i.e., "risk of ruin"). In light of the foregoing as well as the risks and uncertainties intrinsic to all future projections, the inclusion of the quantification in this section should not be considered to constitute any assurance or representation that the Master's losses in any market sector will be limited to Value at Risk or by the Master's attempts to manage its market risk.
Exchange maintenance margin requirements have been used by the Master as the measure of its Value at Risk. Maintenance margin requirements are set by exchanges to equal or exceed the maximum losses reasonably expected to be incurred in the fair value of any given contract in 95%-99% of any one-day interval. Maintenance margin has been used rather than the more generally available initial margin, because initial margin includes a credit risk component, which is not relevant to Value at Risk.
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The following table indicates the trading Value at Risk associated with the Master's open positions by market category as of June 30, 2005 and the highest, lowest and average values during the three months ended June 30, 2005. All open position trading risk exposures of the Master have been included in calculating the figures set forth below. As of June 30, 2005, the Master's total capitalization was $300,648,584.
June 30, 2005
(Unaudited)
| | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Three Months ended June 30, 2005 |
| Market Sector | | Value at Risk | | % of Total
Capitalization | | High
Value at Risk | | Low
Value at Risk | | Average
Value at Risk* |
| Currencies: | |
| — OTC | | $ | 13,085,240 | | | | 4.35 | % | | $ | 13,884,561 | | | $ | 12,052,514 | | | $ | 13,199,334 | |
| Energy | | | 3,209,075 | | | | 1.07 | % | | | 3,461,280 | | | | 2,683,050 | | | | 3,174,452 | |
| Interest Rates U.S. | | | 1,678,600 | | | | 0.56 | % | | | 3,410,050 | | | | 427,501 | | | | 1,781,138 | |
| Interest Rates Non-U.S. | | | 6,899,504 | | | | 2.29 | % | | | 10,351,655 | | | | 3,337,092 | | | | 8,500,614 | |
| Metals | | | | | | | | | | | | | | | | | | | | |
| — OTC | | | 551,275 | | | | 0.18 | % | | | 640,325 | | | | 222,525 | | | | 442,406 | |
| Indices | | | 8,106,203 | | | | 2.70 | % | | | 8,106,203 | | | | 1,443,204 | | | | 4,824,330 | |
| Total | | $ | 33,529,897 | | | | 11.15 | % | | | | | | | | | | | | |
|
| |
| * Average of Month-end Values at Risk |
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Item 4. Controls and Procedures
The General Partner of the Partnership, with the participation of the General Partner's Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) with respect to the Partnership within 90 days of the filing date of this quarterly report, and based on this evaluation, has concluded that these disclosure controls and procedures are effective. Additionally, there were no significant changes in the Partnership's internal controls or in other factors that could significantly affect these controls subsequent to the date of this evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The following information supplements and amends our discussion set forth under Item 3, "Legal Proceedings" in the Partnership's Annual Report on Form 10-K for the year ended December 31, 2004 and under Part II, Item 1, "Legal Proceedings" in the Partnership's Quarterly Report on Form 10-Q for the quarter ended March 31, 2005.
Enron-Related Civil Actions
On June 13, 2005, Citigroup announced a settlement of the Enron class action litigation (Newby, et al. v. Enron Corp., et al.) currently pending in the United States District Court for the Southern District of Texas, Houston Division. This settlement resolves all claims against Citigroup brought on behalf of the class of purchasers of publicly traded equity and debt securities issued by Enron and Enron-related entities between September 9, 1997 and December 2, 2001. The settlement, which involves a pre-tax payment of $2.0 billion to the settlement class, is fully covered by Citigroup's existing litigation reserves. It is subject to approval by the Board of Regents of the University of California (the lead plaintiff), The Citigroup Board and the District Court in Texas.
Mutual Funds
On May 31, 2005, Citigroup announced that Smith Barney Fund Management LLC and Citigroup Global Markets completed a settlement with the SEC resolving an investigation by the SEC into matters relating to arrangements between certain Smith Barney mutual funds, an affiliated transfer agent and an unaffiliated sub-transfer agent. Under the terms of the settlement, Citigroup agreed to pay fines totaling $208.1 million. The settlement in which Citigroup neither admitted nor denied any wrongdoing or liability, includes allegations of willful misconduct by Smith Barney Fund Management LLC and Citigroup Global Markets in failing to disclose aspects of the transfer agent arrangements to certain mutual fund investors.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
For the three months ended June 30, 2005, there were additional sales of 9,345.8413 Redeemable Units of Limited Partnership totaling $15,343,000. The Redeemable Units were issued in reliance upon applicable exemptions from registration under Section 4(2) of the Securities Act of 1933, as amended, and Section 506 of Regulation D promulgated thereunder.
Proceeds from the sale of additional Redeemable Units are used in the trading of commodity interests including futures contracts, options and forwards contracts.
The following chart sets forth the purchases of Redeemable Units by the Partnership.
| | | | | | | | | | | | | | | | | | |
| Period | | (a) Total Number
of Shares
(or Units) Purchased* | | (b) Average
Price Paid per
Share (or Unit)** | | (c) Total Number
of Shares (or Units)
Purchased as Part
of Publicly Announced
Plans or Programs | | (d) Maximum Number
(or Approximate
Dollar Value) of Shares
(or Units) that
May Yet Be
Purchased Under the
Plans or Programs |
April 1, 2005 -
April 30, 2005 | | | 799.1868 | | | $ | 1,614.57 | | | | N/A | | | | N/A | |
May 1, 2005 -
May 31, 2005 | | | 2,265.2357 | | | $ | 1,687.16 | | | | N/A | | | | N/A | |
June 1, 2005 -
June 30, 2005 | | | 612.5297 | | | $ | 1,801.96 | | | | N/A | | | | N/A | |
| Total | | | 3,676.9522 | | | $ | 1,701.23 | | | | N/A | | | | N/A | |
|
| |
| * Generally, Limited Partners are permitted to redeem their Redeemable Units as of the end of each month on 10 days' notice to the General Partner. Under certain circumstances, the General Partner can compel redemption but to date the General Partner has not exercised this right. Purchases of Redeemable Units by the Partnership reflected in the chart above were made in the ordinary course of the Partnership's business in connection with effecting redemptions for Limited Partners. |
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| |
| ** Redemptions of Redeemable Units are effected as of the last day of each month at the Net Asset Value per Redeemable Unit as of that day. |
Item 3. Defaults Upon Senior Securities – None
Item 4. Submission of Matters to a Vote of Security Holders – None
Item 5. Other Information – None
Item 6. Exhibits
The exhibits required to be filed by Item 601 of Regulation S-1 are incorporated herein by reference to the exhibit index of the Annual Report on Form 10-K for the period ended December 31, 2004.
Exhibit - 31.1 - Rule 13a-14(a)/15d-14(a) Certification
(Certification of President and Director)
Exhibit – 31.2 – Rule 13a-14(a)/15d-14(a) Certification
(Certification of Chief Financial Officer and Director)
Exhibit – 32.1 – Section 1350 Certification
(Certification of President and Director).
Exhibit – 32.2 – Section 1350 Certification
(Certification of Chief Financial Officer and Director).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | | | | | |
| SMITH BARNEY POTOMAC FUTURES FUND L.P. |
| By: | | Citigroup Managed Futures LLC
(General Partner) |
| By: | | /s/ David J. Vogel
David J. Vogel,
President and Director |
| Date: August 9, 2005 |
| By: | | /s/ Daniel R. McAuliffe, Jr.
Daniel R. McAuliffe, Jr.
Chief Financial Officer and Director |
| Date: August 9, 2005 |
|
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