Diversified Futures Fund II December 31, 1996 Annual Report [LOGO] DEAN WITTER DEAN WITTER Two World Trade Center 62nd Floor New York, NY 10048 Telephone (212) 392-8899 DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. ANNUAL REPORT 1996 Dear Limited Partner: This marks the eighth annual report for the Dean Witter Diversified Futures Fund II L.P. (the "Fund"). The Fund began the year at a Net Asset Value per Unit of $2,534.82 and finished 1996 at $2,412.41, reflecting a loss of 4.8%. The Fund has increased by 141.2% since it began trading in 1989 (a compound annualized return of 11.6%). Modest gains were recorded during January as short Japanese yen, German mark and Swiss franc positions profited from a downward move. A majority of these losses were offset by long positions in energy futures as gas and oil prices reversed lower after an upward move late in 1995. Significant losses were recorded in February as a result of a series of sharp trend reversals in the value of the Japanese yen and major European currencies. Additional losses were recorded in the energy markets, as a result of inconsistent price movement, and in global interest rate futures as a result of a sharp reversal in the previous upward move. Small gains were recorded in March from newly established long positions in the energy markets as oil and gas futures prices finished the month higher. Additional gains were recorded in the currency markets. Trading gains posted during April were recorded from short positions in the German mark and Swiss franc as the value of these currencies moved lower relative to the U.S. dollar. Smaller gains were recorded from trading in the agricultural and energy futures markets. Sharp trend reversals in a majority of the markets traded resulted in losses during May. The most significant losses were recorded in metals from long copper futures positions as prices moved dramatically lower on May 17 and 20. During June, global interest rate and stock index futures prices moved in a choppy pattern, resulting in losses for the Fund. Smaller losses were recorded in the agricultural markets. A portion of these losses was offset by gains from short copper futures positions as prices moved dramatically lower on news of significant losses in copper by Sumitomo Corporation. During July, long German mark and Swiss franc positions profited from an upward move in the value of these currencies relative to the U.S. dollar. Additional gains were recorded during July from long global interest rate futures positions. Trend reversals and choppy movement in the currency markets resulted in losses for the Fund during August. Smaller losses were recorded from trading in agricultural commodities and metals. Gains from long energy futures positions offset a portion of these losses. A strong upward move in global interest rate futures prices during September resulted in gains for the Fund's long positions. Additional gains were recorded in the energy markets as oil and gas prices continued to trend higher. Gains were recorded during October and November from long British pound positions as the value of the pound surged higher relative to the U.S. dollar. Additional gains were recorded as long global interest rate futures positions profited from a continued upward price trend. A small portion of these gains was offset by losses experienced during October in the energy markets, and during November as a result of choppy movement in agricultural futures prices. Losses were recorded during December as a result of sudden and dramatic reversal in global interest rate futures prices early in the month. Additional losses were recorded as the value of the British pound decreased sharply during the first week of December. The intermediate to long-term trend following trading methodology of the Fund's sole trading advisor, Dean Witter Futures & Currency Management Inc. ("DWFCM"), was hurt by price volatility in energies and agricultural commodities during much of 1996. This factor coupled with sharp trend reversals in currencies and global bond futures in February and December when positions in these areas were significant, resulted in overall losses for the year despite a better than 20% increase during the three month period September-November. While such results are frustrating, we remain confident in DWFCM's time tested methodology and in its ability to rebound as it has over previous long-term periods. Should you have any questions concerning this report, please feel free to contact Demeter Management Corporation at Two World Trade Center, 62nd Floor, New York, NY 10048, or your Dean Witter Account Executive. I hereby affirm, that to the best of my knowledge and belief, the information contained in this report is accurate and complete. Past performance is not a guarantee of future results. Sincerely, /s/ Mark J. Hawley Mark J. Hawley President Demeter Management Corporation General Partner DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. INDEPENDENT AUDITORS' REPORT The Limited Partners and the General Partner: We have audited the accompanying statements of financial condition of Dean Witter Diversified Futures Fund II L.P. (the "Partnership") as of December 31, 1996 and 1995 and the related statements of operations, changes in partners' capital, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Dean Witter Diversified Futures Fund II L.P. as of December 31, 1996 and 1995 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP February 17, 1997 New York, New York DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, --------------------- 1996 1995 ---------- ---------- $ $ ASSETS Equity in Commodity futures trading accounts: Cash 12,415,430 14,643,529 Net unrealized gain on open contracts 160,193 852,419 ---------- ---------- Total Trading Equity 12,575,623 15,495,948 Interest receivable (DWR) 42,043 54,267 ---------- ---------- Total Assets 12,617,666 15,550,215 ========== ========== LIABILITIES AND PARTNERS' CAPITAL LIABILITIES Redemptions payable 297,904 781,248 Accrued management fee (DWFCM) 31,538 38,862 Accrued brokerage fees (DWR) 15,137 116,587 Accrued transaction fees and costs 2,330 5,241 Accrued incentive fee (DWFCM) -- 3,299 ---------- ---------- Total Liabilities 346,909 945,237 ---------- ---------- PARTNERS' CAPITAL Limited Partners (4,982.521 and 5,657.751 Units, respectively) 12,019,867 14,341,357 General Partner (104 Units) 250,890 263,621 ---------- ---------- Total Partners' Capital 12,270,757 14,604,978 ---------- ---------- Total Liabilities and Partners' Capital 12,617,666 15,550,215 ========== ========== NET ASSET VALUE PER UNIT 2,412.41 2,534.82 ========== ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, -------------------------------- 1996 1995 1994 --------- ---------- --------- $ $ $ REVENUES Trading Profit (Loss): Realized 832,912 2,142,749 1,613,912 Net change in unrealized (692,226) (1,324,261) 861,395 --------- ---------- --------- Total Trading Results 140,686 818,488 2,475,307 Interest income (DWR) 502,812 738,238 562,625 --------- ---------- --------- Total Revenues 643,498 1,556,726 3,037,932 --------- ---------- --------- EXPENSES Brokerage fees (DWR) 1,004,389 1,522,301 1,502,699 Management fee (DWFCM) 383,830 507,434 500,900 Transaction fees and costs 82,386 132,583 129,572 Incentive fee (DWFCM) (2,590) (195,018) 51,320 --------- ---------- --------- Total Expenses 1,468,015 1,967,300 2,184,491 --------- ---------- --------- NET INCOME (LOSS) (824,517) (410,574) 853,441 ========= ========== ========= NET INCOME (LOSS) ALLOCATION: Limited Partners (811,786) (402,714) 839,933 General Partner (12,731) (7,860) 13,508 NET INCOME (LOSS) PER UNIT: Limited Partners (122.41) (75.58) 133.96 General Partner (122.41) (75.58) 133.96 STATEMENT OF CHANGES IN PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 UNITS OF PARTNERSHIP LIMITED GENERAL INTEREST PARTNERS PARTNER TOTAL ----------- ---------- ------- ---------- $ $ $ Partners' Capital, December 31, 1993 7,048.887 17,109,409 346,701 17,456,110 Net Income -- 839,933 13,508 853,441 Redemptions (556.592) (1,273,337) (88,728) (1,362,065) --------- ---------- ------- ---------- Partners' Capital, December 31, 1994 6,492.295 16,676,005 271,481 16,947,486 Net Loss -- (402,714) (7,860) (410,574) Redemptions (730.544) (1,931,934) -- (1,931,934) --------- ---------- ------- ---------- Partners' Capital, December 31, 1995 5,761.751 14,341,357 263,621 14,604,978 Net Loss -- (811,786) (12,731) (824,517) Redemptions (675.230) (1,509,704) -- (1,509,704) --------- ---------- ------- ---------- Partners' Capital, December 31, 1996 5,086.521 12,019,867 250,890 12,270,757 ========= ========== ======= ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 1996 1995 1994 ---------- ---------- ---------- $ $ $ CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) (824,517) (410,574) 853,441 Noncash item included in net income (loss): Net change in unrealized 692,226 1,324,261 (861,395) (Increase) decrease in operating assets: Interest receivable (DWR) 12,224 12,917 (30,869) Increase (decrease) in operating liabilities: Accrued management fee (DWFCM) (7,324) (5,406) (862) Accrued brokerage fees (DWR) (101,450) (16,216) (2,587) Accrued transaction fees and costs (2,911) 2,068 (426) Accrued incentive fee (DWFCM) (3,299) (210,269) (4,382) ---------- ---------- ---------- Net cash provided by (used for) operating activities (235,051) 696,781 (47,080) ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in redemptions payable (483,344) 412,306 171,494 Redemptions of units (1,509,704) (1,931,934) (1,362,065) ---------- ---------- ---------- Net cash used for financing activities (1,993,048) (1,519,628) (1,190,571) ---------- ---------- ---------- Net decrease in cash (2,228,099) (822,847) (1,237,651) Balance at beginning of period 14,643,529 15,466,376 16,704,027 ---------- ---------- ---------- Balance at end of period 12,415,430 14,643,529 15,466,376 ========== ========== ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION--Dean Witter Diversified Futures Fund II L.P. (the "Partnership") was organized to engage in the speculative trading of commodity futures contracts and futures related contracts including forward contracts on foreign currencies. The general partner is Demeter Management Corporation ("Demeter"). The commodity broker is Dean Witter Reynolds Inc. ("DWR"). The Trading Manager is Dean Witter Futures & Currency Management Inc. ("DWFCM"). DWR, DWFCM and Demeter are wholly-owned subsidiaries of Dean Witter, Discover & Co. ("DWD"). Demeter is required to maintain a 1% minimum interest in the equity of the Partnership and income (losses) are shared by the General and Limited Partners based upon their proportional ownership interests. BASIS OF ACCOUNTING--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the financial statements. REVENUE RECOGNITION--Commodity futures contracts and other commodity interests are open commitments until settlement date. They are valued at market and the resulting unrealized gains and losses are reflected in income. Monthly, DWR pays the Partnership interest income based upon 80% of the average daily Net Assets for the month at a rate equal to the average yield on 13-Week U.S. Treasury Bills issued during such month. For purposes of such interest payments, Net Assets do not include monies due the Partnership on forward contracts and other commodity interests, but not actually received. NET INCOME (LOSS) PER UNIT--Net income (loss) per Unit is computed using the weighted average number of units outstanding during the period. EQUITY IN COMMODITY FUTURES TRADING ACCOUNTS--The Partnership's asset "Equity in Commodity futures trading accounts" consists of cash on deposit at DWR to be used as margin for trading and the net asset or liability related to unrealized gains or losses on open contracts. The asset or liability related to the unrealized gains or losses on forward contracts is presented as a net amount because the Partnership has a master netting agreement with DWR. BROKERAGE FEES AND RELATED TRANSACTION FEES AND COSTS--Prior to September 1, 1996, the monthly brokerage fee was equal to 4/5 of 1% per month of the Partnership's adjusted month-end Net Assets, as defined in the Limited Partnership Agreement. DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) Effective September 1, 1996, brokerage commissions are accrued on a half-turn basis at 80% of DWR's published non-member rates, to a maximum of 13/20 of 1% per month inclusive of transaction fees and costs of the Partnership's month- end Net Assets (as defined in the Limited Partnership Agreement). Transaction fees and costs are accrued on a half-turn basis. OPERATING EXPENSES--The Partnership incurs a monthly management fee and may incur an incentive fee. Demeter and/or DWR bear all other operating expenses. INCOME TAXES--No provision for income taxes has been made in the accompanying financial statements, as partners are individually responsible for reporting income or loss based upon their respective share of the Partnership's revenues and expenses for income tax purposes. DISTRIBUTIONS--Distributions, other than on redemptions of Units, are made on a pro-rata basis at the sole discretion of Demeter. No distributions have been made to date. REDEMPTIONS--Limited Partners may redeem some or all of their Units at 100% of the Net Asset Value per Unit effective as of the last day of any calendar quarter upon five business days advance notice by redemption form to Demeter. DISSOLUTION OF THE PARTNERSHIP--The Partnership will terminate on December 31, 2025 or at an earlier date if certain conditions set forth in the Limited Partnership Agreement occur. 2. RELATED PARTY TRANSACTIONS Under its Customer Agreement with DWR, the Partnership pays a monthly brokerage fee to DWR as described in Note 1. The Partnership's cash is on deposit with DWR in commodity trading accounts to meet margin requirements as needed. DWR pays interest on these funds as described in Note 1. Demeter, on behalf of the Partnership and itself, has entered into a Management Agreement with DWFCM to make all trading decisions for the Partnership. Compensation to DWFCM by the Partnership consists of a management fee and an incentive fee as follows: MANAGEMENT FEE--The management fee is accrued daily at the rate of 1/4 of 1% per month of adjusted Net Assets, as defined in the Management Agreement, at each month-end. DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) INCENTIVE FEE--The Partnership will pay an annual incentive fee to DWFCM equal to 15% of the "Trading Profits", as defined in the Management Agreement, earned by the Partnership as of the end of each annual incentive period ending January 31. Such incentive fee is accrued in each month in which "Trading Profits" occur. In those months in which "Trading Profits" are negative, previous accruals, if any, during the incentive period will be reduced. 3. FINANCIAL INSTRUMENTS The Partnership trades futures and forward contracts in interest rates, stock indices, commodities, currencies, petroleum, and precious metals. Futures and forwards represent contracts for delayed delivery of an instrument at a specified date and price. Risk arises from changes in the value of these contracts and the potential inability of counterparties to perform under the terms of the contracts. There are numerous factors which may significantly influence the market value of these contracts, including interest rate volatility. At December 31, 1996 and 1995, open contracts were: CONTRACT OR NOTIONAL AMOUNT --------------------------- 1996 1995 ------------- ------------- $ $ EXCHANGE-TRADED CONTRACTS Financial Futures: Commitments to Purchase -- 68,504,000 Commitments to Sell -- -- Commodity Futures: Commitments to Purchase 2,026,000 32,009,000 Commitments to Sell 6,083,000 4,857,000 Foreign Futures: Commitments to Purchase 6,629,000 50,355,000 Commitments to Sell 11,748,000 3,536,000 OFF-EXCHANGE-TRADED FORWARD CURRENCY CONTRACTS Commitments to Purchase 33,150,000 49,215,000 Commitments to Sell 42,844,000 55,478,000 A portion of the amounts indicated as off-balance-sheet risk in forward currency contracts is due to offsetting forward commitments to purchase and to sell the same currency on the same date in the future. These commitments are economically offsetting, but are not offset in the forward market until the settlement date. The unrealized gains on open contracts are reported as a component of "Equity in Commodity futures trading accounts" on the Statements of Financial Condition and totaled $160,193 and $852,419 at December 31, 1996 and 1995, respectively. Of the $160,193 net unrealized gain on open contracts at December 31, 1996, $423,229 related to exchange-traded futures contracts and $(263,036) related to off- DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) exchange-traded forward currency contracts. Of the $852,419 net unrealized gain on open contracts at December 31, 1995, $1,413,016 related to exchange-traded futures contracts and $(560,597) related to off-exchange-traded forward currency contracts. Exchange-traded futures contracts held by the Partnership at December 31, 1996 and 1995 mature through June 1997 and September 1996, respectively. Off- exchange-traded forward currency contracts held by the Partnership at December 31, 1996 and 1995 mature through February 1997 and February 1996, respectively. The contract amounts in the above table represent the Partnership's extent of involvement in the particular class of financial instrument, but not the credit risk associated with counterparty nonperformance. The credit risk associated with these instruments is limited to the amounts reflected in the Partnership's Statements of Financial Condition. The Partnership also has credit risk because DWR acts as the futures commission merchant or the sole counterparty, with respect to most of the Partnership's assets. Exchange-traded futures contracts are marked to market on a daily basis, with variations in value settled on a daily basis. DWR, as the futures commission merchant for all of the Partnership's exchange-traded futures contracts, is required pursuant to regulations of the Commodity Futures Trading Commission to segregate from its own assets, and for the sole benefit of its commodity customers, all funds held by DWR with respect to exchange-traded futures contracts including an amount equal to the net unrealized gain on all open futures contracts, which funds totaled $12,838,659 and $16,056,545 at December 31, 1996 and 1995, respectively. With respect to the Partnership's off-exchange-traded forward currency contracts, there are no daily settlements of variations in value nor is there any requirement that an amount equal to the net unrealized gain on open forward contracts be segregated. With respect to those off-exchange-traded forward currency contracts, the Partnership is at risk to the ability of DWR, the counterparty on all of such contracts, to perform. For the years ended December 31, 1996 and 1995, the average fair value of financial instruments held for trading purposes was as follows: 1996 ---------------------- ASSETS LIABILITIES ---------- ----------- $ $ EXCHANGE-TRADED CONTRACTS: Financial Futures 15,923,000 8,572,000 Commodity Futures 7,188,000 5,152,000 Foreign Futures 22,067,000 8,118,000 OFF-EXCHANGE-TRADED FORWARD CURRENCY CONTRACTS 37,689,000 41,562,000 DEAN WITTER DIVERSIFIED FUTURES FUND II L.P. NOTES TO FINANCIAL STATEMENTS--(CONCLUDED) 1995 ---------------------- ASSETS LIABILITIES ---------- ----------- $ $ EXCHANGE-TRADED CONTRACTS: Financial Futures 25,157,000 13,498,000 Commodity Futures 13,763,000 6,544,000 Foreign Futures 28,482,000 9,500,000 OFF-EXCHANGE-TRADED FORWARD CURRENCY CONTRACTS 38,007,000 47,623,000 4. LEGAL MATTERS On September 6, 10, and 20, 1996, similar purported class actions were filed in the Superior Court of the State of California, County of Los Angeles, on behalf of all purchasers of interests in limited partnership commodity pools sold by DWR. Named defendants include DWR, Demeter, DWFCM, DWD (all such parties referred to hereafter as the "Dean Witter Parties"), the Partnership, certain other limited partnership commodity pools of which Demeter is the general partner, and certain trading advisors to those pools. Similar purported class actions were also filed on September 18 and 20, 1996 in the Supreme Court of the State of New York, New York County and on November 14, 1996 in the Superior Court of the State of Delaware, Newcastle County, against the Dean Witter Parties and certain trading advisors on behalf of all purchasers of interests in various limited partnership commodity pools, including the Partnership, sold by DWR. Generally, these complaints allege, among other things, that the defendants committed fraud, deceit, misrepresentation, breach of fiduciary duty, fraudulent and unfair business practices, unjust enrichment, and conversion in connection with the sale and operation of the various limited partnership commodity pools. The complaints seek unspecified amounts of compensatory and punitive damages and other relief. It is possible that additional similar actions may be filed and that, in the course of these actions, other parties could be added as defendants. The Dean Witter Parties believe that they and the Partnership have strong defenses to, and they will vigorously contest, the actions. Although the ultimate outcome of legal proceedings cannot be predicted with certainty, it is the opinion of management of the Dean Witter Parties that the resolution of the actions will not have a material adverse effect on the financial condition or the results of operations of any of the Dean Witter Parties or the Partnership. DEAN WITTER REYNOLDS INC. Two World Trade Center 62nd Floor New York, NY 10048 FIRST-CLASS MAIL ZIP + 4 PRESORT U.S. POSTAGE PAID BROOKLYN, NY PERMIT NO. 148