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STATEMENT OF ADDITIONAL INFORMATION
THE FBR FAMILY OF FUNDS
FBR FINANCIAL SERVICES FUND
FBR SMALL CAP FINANCIAL FUND
FBR SMALL CAP GROWTH/VALUE FUND
JUNE 30, 1997
AS SUPPLEMENTED JANUARY 29, 1998
This Statement of Additional Information is not a Prospectus, but should be read
in conjunction with the Prospectus of The FBR Family of Funds, dated the same
date as the date hereof (the "Prospectus"). This Statement of Additional
Information is incorporated by reference in its entirety into the Prospectus.
Copies of the Prospectus may be obtained by writing to: The FBR Family of Funds,
Potomac Tower, 1001 Nineteenth Street North, Arlington, Virginia 22209, or by
telephoning toll-free 1-888-888-0025.
TABLE OF CONTENTS
INVESTMENT OBJECTIVES AND POLICIES. . . . . . . . . . . . . . . . . . 2
INVESTMENT LIMITATIONS AND RESTRICTIONS . . . . . . . . . . . . . . . 16
VALUATION OF PORTFOLIO SECURITIES . . . . . . . . . . . . . . . . . . 18
PERFORMANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
ADDITIONAL REDEMPTION INFORMATION . . . . . . . . . . . . . . . . . . 21
DIVIDENDS AND DISTRIBUTIONS . . . . . . . . . . . . . . . . . . . . . 22
TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
TRUSTEES AND OFFICERS . . . . . . . . . . . . . . . . . . . . . . . . 23
ADVISORY AND OTHER CONTRACTS. . . . . . . . . . . . . . . . . . . . . 26
ADDITIONAL INFORMATION. . . . . . . . . . . . . . . . . . . . . . . . 29
APPENDIX A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-1
FINANCIAL STATEMENTS. . . . . . . . . . . . . . . . . . . . . . . . . B-7
INVESTMENT ADVISER
FBR Fund Advisers, Inc.
DISTRIBUTORS
Friedman, Billings, Ramsey & Co., Inc.
FBR Direct, Inc.
ADMINISTRATOR
Bear Stearns Funds Management Inc.
ADMINISTRATION AND ACCOUNTING SERVICES/
TRANSFER AGENT
PFPC Inc.
CUSTODIAN
Custodial Trust Company
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STATEMENT OF ADDITIONAL INFORMATION
The FBR Family of Funds (the "Trust") is an open-end management investment
company. The Trust currently consists of four series of units of beneficial
interest ("shares"). The outstanding shares represent interests in the FBR
Financial Services Fund (the "Financial Services Fund"), FBR Small Cap Financial
Fund (the "Small Cap Financial Fund"), the FBR Information Technologies Fund
(the "Information Technologies Fund") and the FBR Small Cap Growth/Value Fund
(the "Growth/Value Fund") (collectively, the "Funds"). This Statement of
Additional Information relates to each fund, except FBR Information Technologies
Fund. Currently, shares of the Information Technologies Fund are not being
offered. Much of the information contained in this Statement of Additional
Information expands on subjects discussed in the Prospectus. Capitalized terms
not defined herein are used as defined in the Prospectus. No investment in
shares of the Funds should be made without first reading the Funds' Prospectus.
INVESTMENT OBJECTIVES AND POLICIES
ADDITIONAL FUND DESCRIPTIONS - FINANCIAL SERVICES FUND AND SMALL CAP FINANCIAL
FUND.
The Financial Services Fund and the Small Cap Financial Fund invest primarily
within the investment areas described below.
FINANCIAL SERVICES FUND. The Financial Services Fund invests in companies
providing financial services to consumers and industry. Companies in the
financial services group of industries include: commercial banks, savings and
loan associations, consumer and industrial finance companies, securities
brokerage companies, real estate-related companies, leasing companies and
holding companies for each of the foregoing, and a variety of firms in all
segments of the insurance field such as multi-line, property, casualty, and life
insurance.
The financial services area is currently undergoing relatively rapid change as
existing distinctions between financial service segments become less clear. For
instance, recent business combinations have included insurance, finance, and
securities brokerage under single ownership. Some primarily retail corporations
have expanded into securities and insurance fields. Moreover, the federal laws
generally separating commercial and investment banking are currently being
studied by Congress.
Banks, savings and loan associations, and finance companies are subject to
extensive governmental regulation which may limit both the amounts and types of
loans and other financial commitments they can make and the interest rates and
fees they can charge. The profitability of these groups is largely dependent on
the availability and cost of capital funds, and can fluctuate significantly when
interest rates change. In addition, general economic conditions are important
to the operations of these concerns, with exposure to credit losses resulting
from possible financial difficulties of borrowers potentially having an adverse
effect. Insurance companies are likewise subject to substantial governmental
regulation, predominantly at the state level, and may be subject to severe price
competition.
Commission regulations provide that the Fund may not invest more than 5% of its
assets in the securities of any one company that derives more than 15% of its
revenues from brokerage or investment management activities. These companies as
well as those deriving more than 15% of profits from brokerage and investment
management activities will be considered to be "principally engaged" in the
Fund's business activity.
SMALL CAP FINANCIAL FUND. The Small Cap Financial Fund invests in companies
providing financial services to consumers and industry with an emphasis on those
companies engaged in investing in real
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estate, usually through mortgage and other consumer-related loans. These
companies may also offer other financial services such as discount brokerage
services, insurance products, leasing services, and joint venture financing.
Investments may include mortgage banking companies, government-sponsored
enterprises, real estate investment trusts, consumer finance companies, and
similar entities, as well as savings and loan associations, savings banks,
building and loan associations, cooperative banks, commercial banks, and similar
depository institutions. The Fund may hold securities of U.S. depository
institutions whose customer deposits are insured by the Savings Association
Insurance Fund or the Bank Insurance Fund.
The residential real estate finance industry has changed rapidly over the last
decade and is expected to continue to change. Factors expected to continue
driving change among the smaller capitalization issues include regulatory
changes, consolidation, mutual conversion activity, management changes,
residential loan demand, credit trends, interest rate movements and new business
development.
The Fund will be influenced by, among other things, potential regulatory
changes, interest rate movements, the level of home mortgage demand, and
residential delinquency trends.
ADDITIONAL INFORMATION REGARDING FUND INVESTMENTS.
The following descriptions supplement the investment policies of each Fund set
forth in the Prospectus. Each Fund's investments in the following securities
and other financial instruments are subject to the investment policies and
limitations described in the Prospectus and this Statement of Additional
Information.
SHORT-TERM OBLIGATIONS. With respect to each Fund there may be times when, in
the opinion of the Adviser, adverse market conditions exist, including any
period during which it believes that the return on certain money market type
instruments would be more favorable than that obtainable through a Fund's normal
investment programs. Accordingly, for temporary defensive purposes, each Fund
may hold up to 100% of its total assets in cash and/or short-term obligations.
To the extent that a Fund's assets are so invested, they will not be invested so
as to meet its investment objective. The short-term instruments may include
high grade liquid debt securities such as variable amount master demand notes,
commercial paper, certificates of deposit, bankers' acceptances, repurchase
agreements which mature in less than seven days and obligations issued or
guaranteed by the U.S. Government, its agencies and instrumentalities. Bankers'
acceptances are instruments of the U.S. banks which are drafts or bills of
exchange "accepted" by a bank or trust company as an obligation to pay on
maturity. Money market instruments may carry fixed, variable, or floating
interest rates. A security's credit may be enhanced by a bank, insurance
company, or other entity. Some money market securities employ a trust or other
similar structure to modify the maturity, price characteristics, or quality of
financial assets so that they are eligible investments for money market funds.
If the structure does not perform as intended, adverse tax or investment
consequences may result.
CONVERTIBLE SECURITIES. The Funds may invest in all types of common stocks and
equivalents (such as convertible debt securities and warrants) and preferred
stocks. The Funds may invest in convertible securities which may offer higher
income than the common stocks into which they are convertible. The convertible
securities in which the Funds may invest consist of bonds, notes, debentures and
preferred stocks which may be converted or exchanged at a stated or determinable
exchange ratio into underlying shares of common stock. A Fund may be required
to permit the issuer of a convertible security to redeem the security, convert
it into the underlying common stock or sell it to a third party. Thus, a Fund
may not be able to control whether the issuer of a convertible security chooses
to convert that security. If the issuer
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chooses to do so, this action could have an adverse effect on the Fund's ability
to achieve its investment objectives.
ASSET-BACKED SECURITIES. Asset-backed securities include pools of mortgages,
loans, receivables or other assets. Payment of principal and interest may be
largely dependent upon the cash flows generated by the assets backing the
securities, and, in certain cases, supported by letters of credit, surety bonds,
or other credit enhancements. The value of asset-backed securities may also be
affected by the creditworthiness of the servicing agent for the pool, the
originator of the loans or receivables, or the financial institution(s)
providing the credit support.
STRUCTURED SECURITIES. Structured securities employ a trust or other similar
structure to modify the maturity, price characteristics or quality of financial
assets. For example, structural features can be used to modify the maturity of
a security or interest rate adjustment features can be used to enhance price
stability. If the structure does not perform as intended, adverse tax or
investment consequences may result. Neither the Internal Revenue Service
("IRS") nor any other regulatory authority has ruled definitively on certain
legal issues presented by structured securities. Future tax or other regulatory
determinations could adversely affect the value, liquidity or tax treatment of
the income received from these securities or the nature and timing of
distributions made by a Fund. The payment of principal and interest on
structured securities may be largely dependent on the cash flows generated by
the underlying financial assets.
VARIABLE OR FLOATING RATE SECURITIES. Variable or floating rate securities
provide for periodic adjustments of the interest rate paid. Variable rate
securities provide for a specific periodic adjustment in the interest rate,
while floating rate securities have interest rates that change whenever there is
a change in a designated benchmark rate. Some variable or floating rate
securities have put features.
SWAP AGREEMENTS. Swap agreements can be individually negotiated and structured
to include exposure to a variety of different types of investments or market
factors. Depending on their structure, swap agreements may increase or decrease
a Fund's exposure to long- or short-term interest rates (in the United States or
abroad), foreign currency values, mortgage securities, corporate borrowing
rates, or other factors such as security prices or inflation rates. Swap
agreements can take many different forms and are known by a variety of names.
The Funds are not limited to any particular form of swap agreement if the
Adviser determines it is consistent with a Fund's investment objective and
policies.
In a typical cap or floor agreement, one party agrees to make payments only
under specified circumstances, usually in return for payment of a fee by the
other party. For example, the buyer of an interest rate cap obtains the right
to receive payments to the extent that a specific interest rate exceeds an
agreed-upon level, while the seller of an interest rate floor is obligated to
make payments to the extent that a specified interest rate falls below an
agreed-upon level. An interest rate collar combines elements of buying a cap
and selling a floor.
Swap agreements will tend to shift a Fund's investment exposure from one type of
investment to another. For example, if a Fund agreed to exchange payments in
dollars for payments in foreign currency, the swap agreement would tend to
decrease the Fund's exposure to U.S. interest rates and increase its exposure to
foreign currency and interest rates. Caps and floors have an effect similar to
buying or writing options. Depending on how they are used, swap agreements may
increase or decrease the overall volatility of a Fund's investments and its
share price.
The most significant factor in the performance of swap agreements is the change
in the specific interest rate, currency, or other factors that determine the
amounts of payments due to and from a Fund. If a swap agreement calls for
payments by a Fund, the Fund must be prepared to make such payments when due.
In
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addition, if the counterparty's creditworthiness declined, the value of a swap
agreement would be likely to decline, potentially resulting in losses. Each
Fund expects to be able to eliminate its exposure under swap agreements whether
by assignment or other disposition, or by entering into an offsetting swap
agreement with the same party or a similarly creditworthy party.
Each Fund will maintain appropriate liquid assets in a segregated custodial
account to cover its current obligations under swap agreements. If a Fund
enters into a swap agreement on a net basis, it will segregate assets with a
daily value at least equal to the excess, if any, of the Fund's accrued
obligations under the swap agreement over the accrued amount the Fund is
entitled to receive under the agreement. If a Fund enters into a swap agreement
on other than a net basis, it will segregate assets with a value equal to the
full amount of the Fund's accrued obligations under the agreement.
INDEXED SECURITIES. The Funds may purchase securities whose prices are indexed
to the prices of other securities, securities indices, currencies, precious
metals or other commodities, or other financial indicators. Indexed securities
typically, but not always, are debt securities or deposits whose value at
maturity or coupon rate is determined by reference to a specific instrument or
statistic. Gold-indexed securities, for example, typically provide for a
maturity value that depends on the price of gold, resulting in a security whose
price tends to rise and fall together with gold prices. Currency-indexed
securities typically are short-term to intermediate-term debt securities whose
maturity values or interest rates are determined by reference to the values of
one or more specified foreign currencies, and may offer higher yields than U.S.
dollar-denominated securities of equivalent issuers. Currency-indexed
securities may be positively or negatively indexed; that is, their maturity
value may increase when the specified currency value increases, resulting in a
security that performs similarly to a foreign-denominated instrument, or their
maturity value may decline when foreign currencies increase, resulting in a
security whose price characteristics are similar to a put on the underlying
currency. Currency-indexed securities may also have prices that depend on the
value of a number of different foreign currencies relative to each other.
The performance of indexed securities depends to a great extent on the
performance of the security, currency, or other instrument to which they are
indexed, and may also be influenced by interest rate changes in the United
States and abroad. At the same time, indexed securities are subject to the
credit risks associated with the issuer of the security, and their values may
decline substantially if the issuer's creditworthiness deteriorates. Recent
issuers of indexed securities have included banks, corporations, and certain
U.S. Government agencies. Indexed securities may be more volatile than the
underlying instruments.
STRIPPED SECURITIES. The Funds may also purchase separately traded interest and
principal component parts of such obligations that are transferable through the
Federal book entry system, known as Separately Traded Registered Interest and
Principal Securities ("STRIPS") and Coupon Under Book Entry Safekeeping
("CUBES"). These instruments are issued by banks and brokerage firms and are
created by depositing U.S. Treasury notes and U.S. Treasury bonds into a special
account at a custodian bank; the custodian holds the interest and principal
payments for the benefit of the registered owner of the certificates or
receipts. The custodian arranges for the issuance of the certificates or
receipts evidencing ownership and maintains the register. Receipts include
Treasury Receipts ("TRs"), Treasury Investment Growth Receipts ("TIGRs") and
Certificates of Accrual on Treasury Securities ("CATS").
STRIPS, CUBES, TRs, TIGRs and CATS are sold as zero coupon securities, which
means that they are sold at a substantial discount and redeemed at face value at
their maturity date without interim cash payments of interest or principal.
This discount is amortized over the life of the security, and such amortization
will constitute the income earned on the security for both accounting and tax
purposes. Because of these features, these securities may be subject to greater
interest rate volatility than interest-
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paying U.S. Treasury obligations. Bonds issued by the Resolution Funding
Corporation (REFCORP) can also be stripped in this fashion. REFCORP Strips are
eligible investments for the Funds.
ZERO COUPON BONDS. The Funds are permitted to purchase zero coupon bonds. Zero
coupon bonds are purchased at a discount from the face amount because the buyer
receives only the right to receive a fixed payment on a certain date in the
future and does not receive any periodic interest payments. The effect of
owning instruments which do not make current interest payments is that a fixed
yield is earned not only on the original investment but also, in effect, on all
discount accretion during the life of the obligations. This implicit
reinvestment of earnings at the same rate eliminates the risk of being unable to
reinvest distributions at a rate as high as the implicit yields on the zero
coupon bond, but at the same time eliminates the holder's ability to reinvest at
higher rates in the future. For this reason, zero coupon bonds are subject to
substantially greater price fluctuations during periods of changing market
interest rates than are comparable securities which pay interest currently,
which fluctuation increases the longer the period of maturity. Although zero
coupon bonds do not pay interest to holders prior to maturity, U.S. Federal
income tax law requires a Fund to recognize as interest income a portion of the
bond's discount each year and this income must then be distributed to
shareholders along with other income earned by the Fund. To the extent that any
shareholders in a Fund elect to receive their dividends in cash rather than
reinvest such dividends in additional shares, cash to make these distributions
will have to be provided from the assets of the Fund or other sources such as
proceeds of sales of Fund shares and/or sales of portfolio securities. In such
cases, the Fund will not be able to purchase additional income producing
securities with cash used to make such distributions and its current income may
ultimately be reduced as a result.
REAL ESTATE-RELATED INSTRUMENTS. Real estate-related instruments include real
estate investment trusts, commercial and residential mortgage-backed securities,
and real estate financings. Real estate-related instruments are sensitive to
factors such as real estate values, property taxes, interest rates, cash flow of
underlying real estate assets, overbuilding, and the management skill and
creditworthiness of the issuer. Real estate-related instruments may also be
affected by tax and regulatory requirements, such as those relating to the
environment.
REPURCHASE AGREEMENTS. Under the terms of a repurchase agreement, a Fund
acquires securities from financial institutions or registered broker-dealers,
subject to the seller's agreement to repurchase such securities at a mutually
agreed upon date and price. The seller is required to maintain the value of
collateral held pursuant to the agreement at not less than the repurchase price
(including accrued interest). If the seller were to default on its repurchase
obligation or become insolvent, the Fund would suffer a loss to the extent that
the proceeds from a sale of the underlying portfolio securities were less than
the repurchase price, or to the extent that the disposition of such securities
by the Fund was delayed pending court action. Repurchase agreements are
considered to be loans by the staff of the Commission.
REVERSE REPURCHASE AGREEMENTS. As discussed in the Prospectus, each Fund may
borrow funds for temporary purposes by entering into reverse repurchase
agreements in accordance with the Fund's investment restrictions. Pursuant to
such agreements, a Fund would sell portfolio securities to financial
institutions such as banks and broker-dealers, and agree to repurchase the
securities at the mutually agreed-upon date and price. The Funds intend to
enter into reverse repurchase agreements only to avoid otherwise selling
securities during unfavorable market conditions to meet redemptions. At the
time a Fund enters into a reverse repurchase agreement, it will place in a
segregated custodial account assets consistent with the Fund's investment
restrictions having a value equal to the repurchase price (including accrued
interest), and will subsequently monitor the account to ensure that such
equivalent value is maintained. Such assets will include U.S. Government
securities or other liquid, high-grade debt securities. Reverse repurchase
agreements involve the risk that the market value of the securities sold by a
Fund may decline below the
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price at which the Fund is obligated to repurchase the securities. Reverse
repurchase agreements are considered to be borrowing by a Fund under the 1940
Act.
LOWER-RATED DEBT SECURITIES. The Funds may purchase lower-rated debt
securities, commonly referred to as "junk bonds" (those rated below the fourth
highest grade by a nationally recognized statistical ratings organization
("NRSRO") and unrated securities judged by the Adviser to be of equivalent
quality), that have poor protection with respect to the payment of interest and
repayment of principal, or that may be in default. These securities are often
considered to be speculative and involve greater risk of loss or price changes
due to changes in the issuer's capacity to pay. The market prices of
lower-rated debt securities may fluctuate more than those of higher-rated debt
securities and may decline significantly in periods of general economic
difficulty, which may follow periods of rising interest rates.
While the market for high-yield corporate debt securities has been in existence
for many years and has weathered previous economic downturns, the 1980s brought
a dramatic increase in the use of such securities to fund highly leveraged
corporate acquisitions and restructuring. Past experience may not provide an
accurate indication of future performance of the high-yield bond market,
especially during periods of economic recession.
The market for lower-rated debt securities may be thinner and less active than
that for higher-rated debt securities, which can adversely affect the prices at
which the former are sold. If market quotations are not available, lower-rated
debt securities will be valued in accordance with procedures established by the
Board of Trustees, including the use of outside pricing services. Judgment
plays a greater role in valuing high-yield corporate debt securities than is the
case for securities for which more external sources for quotations and last-sale
information are available. Adverse publicity and changing investor perceptions
may affect the ability of outside pricing services to value lower-rated debt
securities and the Fund's ability to sell these securities.
Since the risk of default is higher for lower-rated debt securities, the
Adviser's research and credit analysis are an especially important part of
managing securities of this type held by the Funds. In considering investments
for the Funds, the Adviser will attempt to identify those issuers of
high-yielding debt securities whose financial condition is adequate to meet
future obligations, has improved, or is expected to improve in the future. The
Adviser's analysis focuses on relative values based on such factors as interest
or dividend coverage, asset coverage, earnings prospects, and the experience and
managerial strength of the issuer.
A Fund may choose, at its expense or in conjunction with others, to pursue
litigation or otherwise exercise its right as security holder to seek to protect
the interests of security holders if it determines this to be in the best
interest of the Fund's shareholders.
ILLIQUID INVESTMENTS. Illiquid investments are investments that cannot be sold
or disposed of in the ordinary course of business, within seven days, at
approximately the prices at which they are valued. Under the supervision of the
Board of Trustees, the Adviser determines the liquidity of each Fund's
investments and, through reports from the Adviser, the Board of Trustees
monitors investments in illiquid instruments. In determining the liquidity of a
Fund's investments, the Adviser may consider various factors, including (1) the
frequency of trades and quotations, (2) the number of dealers and prospective
purchasers in the marketplace, (3) dealer undertakings to make a market, (4) the
nature of the security (including any demand or tender features), and (5) the
nature of the marketplace for trades (including the ability to assign or offset
a Fund's rights and obligations relating to the investment). Investments
currently considered by the Funds to be illiquid include repurchase agreements
not entitling the holder to payment of principal and interest within seven days.
Also, the Adviser may determine some over-the-counter options, restricted
securities and loans and other direct debt instruments, and swap agreements to
be illiquid. In the
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absence of market quotations, illiquid investments are priced at fair value as
determined in good faith by a committee appointed by the Board of Trustees. If
through a change in values, net assets, or other circumstances, a Fund were in a
position where more than 15% of its net assets were invested in illiquid
securities, it would seek to take appropriate steps to protect liquidity.
LOANS AND OTHER DIRECT DEBT INSTRUMENTS. Loans and other direct debt
instruments are interests in amounts owed by a corporate, governmental, or other
borrower to another party. They may represent amounts owed to lenders or
lending syndicates (loans and loan participation), to suppliers of goods or
services (trade claims or other receivables), or to other parties. Direct debt
instruments involve a risk of loss in case of default or insolvency of the
borrower and may offer less legal protection to the Funds in the event of fraud
or misrepresentation. In addition, loan participations involve a risk of
insolvency of the lending bank or other financial intermediary. Direct debt
instruments may also include standby financing commitments that obligate the
Funds to supply additional cash to the borrower on demand.
FOREIGN INVESTMENT. The Funds may invest in securities issued by foreign
branches of U.S. banks, foreign banks, or other foreign issuers, including
American Depositary Receipts ("ADRs") and securities purchased on foreign
securities exchanges and over-the-counter. Permissible investments include:
Eurodollar Certificates of Deposit ("ECDs") which are U.S. dollar denominated
certificates of deposit issued by branches of foreign and domestic banks located
outside the United States, Yankee Certificates of Deposit ("Yankee CDs") which
are certificates of deposit issued by a U.S. branch of a foreign bank
denominated in U.S. dollars and held in the United States, Eurodollar Time
Deposits ("ETDs") which are U.S. dollar-denominated deposits in a foreign branch
of a U.S. bank or a foreign bank, and Canadian Time Deposits ("CTDs") which are
U.S. dollar-denominated certificates of deposit issued by Canadian offices of
major Canadian Banks. Such investment may subject the Funds to significant
investment risks that are different from, and additional to, those related to
investments in obligations of U.S. domestic issuers or in U.S. securities
markets.
The value of securities denominated in or indexed to foreign currencies, and of
dividends and interest from such securities, can change significantly when
foreign currencies strengthen or weaken relative to the U.S. dollar. Foreign
securities markets generally have less trading volume and less liquidity than
U.S. markets, and prices on some foreign markets can be highly volatile. Many
foreign countries lack uniform accounting and disclosure standards comparable to
those applicable to U.S. companies, and it may be more difficult to obtain
reliable information regarding an issuer's financial condition and operations.
In addition, the costs of foreign investing, including withholding taxes,
brokerage commissions, and custodial costs, are generally higher than for U.S.
investments.
Foreign markets may offer less protection to investors than U.S. markets.
Foreign issuers, brokers, and securities markets may be subject to less
government supervision. Foreign branches of U.S. banks and foreign banks may be
subject to less stringent reserve requirements than those applicable to domestic
branches of U.S. banks. Foreign security trading practices, including those
involving the release of assets in advance of payment, may involve increased
risks in the event of a failed trade or the insolvency of a broker-dealer, and
may involve substantial delays. It may also be difficult to enforce legal
rights in foreign countries.
Investing abroad also involves different political and economic risks. Foreign
investments may be affected by actions of foreign governments adverse to the
interests of U.S. investors, including the possibility of expropriation or
nationalization of assets, confiscatory taxation, restrictions on U.S.
investment or on the ability to repatriate assets or convert currency into U.S.
dollars, or other government intervention. There may be a greater possibility
of default by foreign governments or foreign government-sponsored enterprises.
Investments in foreign countries also involve a risk of local political,
economic, or social
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instability, military action or unrest, or adverse diplomatic developments.
There is no assurance that the Adviser will be able to anticipate these
potential events or counter their effects.
The considerations noted above generally are intensified for investments in
developing countries. Developing countries may have relatively unstable
governments, economies based on only a few industries, and securities markets
that trade a small number of securities.
The Funds may invest in foreign securities that impose restrictions on transfer
within the U.S. or to U.S. persons. Although securities subject to transfer
restrictions may be marketable abroad, they may be less liquid than foreign
securities of the same class that are not subject to such restrictions.
FOREIGN CURRENCY TRANSACTIONS. Each Fund may conduct foreign currency
transactions on a spot (i.e., cash) basis or by entering into forward contracts
to purchase or sell foreign currencies at a future date and price. A Fund will
convert currencies on a spot basis from time to time, and investors should be
aware of the costs of currency conversion. Although foreign exchange dealers
generally do not charge a fee for conversion, they do realize a profit based on
the difference between the prices at which they are buying and selling various
currencies. Thus, a dealer may offer to sell a foreign currency to a Fund at
one rate, while offering a lesser rate of exchange should the Fund desire to
resell that currency to the dealer. Forward contracts are generally traded in
an interbank market conducted directly between currency traders (usually large
commercial banks) and their customers. The parties to a forward contract may
agree to offset or terminate the contract before its maturity, or may hold the
contract to maturity and complete the contemplated currency exchange.
Each Fund may use currency forward contracts for any purpose consistent with its
investment objective. The following discussion summarizes the principal
currency management strategies involving forward contracts that could be used by
the Funds. The Funds may also use swap agreements, indexed securities, and
options and futures contracts relating to foreign currencies for the same
purposes.
When a Fund agrees to buy or sell a security denominated in a foreign currency,
it may desire to "lock in" the U.S. dollar price of the security. By entering
into a forward contract for the purchase or sale, for a fixed amount of U.S.
dollars, of the amount of foreign currency involved in the underlying security
transaction, a Fund will be able to protect itself against an adverse change in
foreign currency values between the date the security is purchased or sold and
the date on which payment is made or received. This technique is sometimes
referred to as a "settlement hedge" or "transaction hedge." The Funds may also
enter into forward contracts to purchase or sell a foreign currency in
anticipation of future purchases or sales of securities denominated in foreign
currency, even if the specific investments have not yet been selected by the
Adviser.
The Funds may also use forward contracts to hedge against a decline in the value
of existing investments denominated in foreign currency. For example, if a Fund
owned securities denominated in pounds sterling, it could enter into a forward
contract to sell pounds sterling in return for U.S. dollars to hedge against
possible declines in the pound's value. Such a hedge, sometimes referred to as
a "position hedge," would tend to offset both positive and negative currency
fluctuations, but would not offset changes in security values caused by other
factors. A Fund could also hedge the position by selling another currency
expected to perform similarly to the pound sterling -- for example, by entering
into a forward contract to sell Deutschemarks or European Currency Units in
return for U.S. dollars. This type of hedge, sometimes referred to as a "proxy
hedge," could offer advantages in terms of cost, yield, or efficiency, but
generally would not hedge currency exposure as effectively as a simple hedge
into U.S. dollars. Proxy hedges may result in losses if the currency used to
hedge does not perform similarly to the currency in which the hedged securities
are denominated.
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A Fund may enter into forward contracts to shift its investment exposure from
one currency into another. This may include shifting exposure from U.S. dollars
to a foreign currency, or from one foreign currency to another foreign currency.
For example, if a Fund held investments denominated in Deutschemarks, the Fund
could enter into forward contracts to sell Deutschemarks and purchase Swiss
Francs. This type of strategy, sometimes known as a "cross-hedge," will tend to
reduce or eliminate exposure to the currency that is sold, and increase exposure
to the currency that is purchased, much as if the Fund had sold a security
denominated in one currency and purchased an equivalent security denominated in
another. Cross-hedges protect against losses resulting from a decline in the
hedged currency, but will cause a Fund to assume the risk of fluctuations in the
value of the currency it purchases.
Under certain conditions, Commission guidelines require mutual funds to set
aside appropriate liquid assets in a segregated custodial account to cover
currency forward contracts. As required by Commission guidelines, the Funds
will segregate assets to cover currency forward contracts, if any, whose purpose
is essentially speculative. The Funds will not segregate assets to cover
forward contracts entered into for hedging purposes, including settlement
hedges, position hedges, and proxy hedges.
Successful use of currency management strategies will depend on the Adviser's
skill in analyzing and predicting currency values. Currency management
strategies may substantially change a Fund's investment exposure to changes in
currency exchange rates, and could result in losses to the Fund if currencies do
not perform as the Adviser anticipates. For example, if a currency's value rose
at a time when the Adviser had hedged a Fund by selling that currency in
exchange for U.S. dollars, the Fund would be unable to participate in the
currency's appreciation. If the Adviser hedges currency exposure through proxy
hedges, the Fund could realize currency losses from the hedge and the security
position at the same time if the two currencies do not move in tandem.
Similarly, if the Adviser increases a Fund's exposure to a foreign currency, and
that currency's value declines, the Fund will realize a loss. There is no
assurance that the Adviser's use of currency management strategies will be
advantageous to a Fund or that it will hedge at an appropriate time.
FUTURES CONTRACTS. The Funds may enter into futures contracts, options on
futures contracts and stock index futures contracts and options thereon for the
purposes of remaining fully invested and reducing transaction costs. Futures
contracts provide for the future sale by one party and purchase by another party
of a specified amount of a specific security, class of securities, or an index
at a specified future time and at a specified price. A stock index futures
contract is a bilateral agreement pursuant to which two parties agree to take or
make delivery of an amount of cash equal to a specified dollar amount times the
difference between the stock index value at the close of trading of the
contracts and the price at which the futures contract is originally struck.
Futures contracts which are standardized as to maturity date and underlying
financial instrument are traded on national futures exchanges. Futures exchanges
and trading are regulated under the Commodity Exchange Act by the Commodity
Futures Trading Commission ("CFTC"), a U.S. Government agency.
Although futures contracts by their terms call for actual delivery and
acceptance of the underlying securities, in most cases the contracts are closed
out before the settlement date without the making or taking of delivery. Closing
out an open futures position is done by taking an opposite position ("buying" a
contract which has previously been "sold," or "selling" a contract previously
"purchased") in an identical contract to terminate the position. A futures
contract on a securities index is an agreement obligating either party to pay,
and entitling the other party to receive, while the contract is outstanding,
cash payments based on the level of a specified securities index. The
acquisition of put and call options on futures contracts will, respectively,
give the Funds the right (but not the obligation), for a specified price, to
sell or to purchase the underlying futures contract, upon exercise of the
option, at any time during the option period. Brokerage commissions are incurred
when a futures contract is bought or sold.
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Futures traders are required to make a good faith margin deposit in cash or U.S.
Government securities with a broker or custodian to initiate and maintain open
positions in futures contracts. A margin deposit is intended to assure
completion of the contract (delivery or acceptance of the underlying security)
if it is not terminated prior to the specified delivery date. Minimal initial
margin requirements are established by the futures exchange and may be changed.
Brokers may establish deposit requirements which are higher than the exchange
minimums. Initial margin deposits on futures contracts are customarily set at
levels much lower than the prices at which the underlying securities are
purchased and sold, typically ranging upward from less than 5% of the value of
the contract being traded.
After a futures contract position is opened, the value of the contract is marked
to market daily. If the futures contract price changes to the extent that the
margin on deposit does not satisfy margin requirements, payment of additional
"variation" margin will be required. Conversely, a change in the contract value
may reduce the required margin, resulting in a repayment of excess margin to the
contract holder. Variation margin payments are made to and from the futures
broker for as long as the contract remains open. A Fund expects to earn
interest income while its margin deposits are held pending performance on the
futures contract.
When interest rates are expected to rise or market values of portfolio
securities are expected to fall, a Fund can seek, through the sale of futures,
contracts to offset a decline in the value of its portfolio securities. When
interest rates are expected to fall or market values are expected to rise, a
Fund, through the purchase of such contracts, can attempt to secure better rates
or prices for the Fund than might later be available in the market when it
effects anticipated purchases.
A Fund's ability to effectively utilize futures trading depends on several
factors. First, it is possible that there will not be a perfect price
correlation between the futures contracts and their underlying stock index.
Second, it is possible that a lack of liquidity for futures contracts could
exist in the secondary market, resulting in an inability to close a futures
position prior to its maturity date. Third, the purchase of a futures contract
involves the risk that the Fund could lose more than the original margin deposit
required to initiate a futures transaction.
RESTRICTIONS ON THE USE OF FUTURES CONTRACTS. A Fund will only sell futures
contracts to protect securities it owns against price declines or purchase
contracts to protect against an increase in the price of securities it intends
to purchase. A Fund will not enter into futures contract transactions for
purposes other than bona fide hedging purposes to the extent that, immediately
thereafter, the sum of its initial margin deposits on open contracts exceeds 5%
of the market value of the Fund's total assets. In addition, the Fund will not
enter into futures contracts to the extent that the value of the futures
contracts held would exceed one third of the Fund's total assets. Futures
transactions will be limited to the extent necessary to maintain the Fund's
qualification as a regulated investment company.
The Trust, on behalf of each Fund, has undertaken to restrict its futures
contract trading as follows: first, a Fund will not engage in transactions in
futures contracts for speculative purposes; second, a Fund will not market its
funds to the public as commodity pools or otherwise as vehicles for trading in
the commodities futures or commodity options markets; third, a Fund will
disclose to all prospective shareholders the purpose of and limitations on its
commodity futures trading; fourth, a Fund will submit to the CFTC special calls
for information. Accordingly, registration as a commodities pool operator with
the CFTC is not required.
In addition to the margin restrictions discussed above, transactions in futures
contracts may involve the segregation of funds pursuant to requirements imposed
by the Commission. Under those requirements, where a Fund has a long position
in a futures contract, it may be required to establish a segregated account
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(not with a futures commission merchant or broker, except as may be permitted
under Commission rules) containing cash or certain liquid assets equal to the
purchase price of the contract (less any margin on deposit). For a short
position in futures or forward contracts held by a Fund, those requirements may
mandate the establishment of a segregated account (not with a futures commission
merchant or broker, except as may be permitted under Commission rules) with cash
or certain liquid assets that, when added to the amounts deposited as margin,
equal the market value of the instruments underlying the futures contracts (but
are not less than the price at which the short positions were established).
However, segregation of assets is not required if a Fund "covers" a long
position. For example, instead of segregating assets, a Fund, when holding a
long position in a futures contract, could purchase a put option on the same
futures contract with a strike price as high or higher than the price of the
contract held by the Fund. In addition, where a Fund takes short positions, or
engages in sales of call options, it need not segregate assets if it "covers"
these positions. For example, where the Fund holds a short position in a
futures contract, it may cover by owning the instruments underlying the
contract. A Fund may also cover such a position by holding a call option
permitting it to purchase the same futures contract at a price no higher than
the price at which the short position was established. Where the Fund sells a
call option on a futures contract, it may cover either by entering into a long
position in the same contract at a price no higher than the strike price of the
call option or by owning the instruments underlying the futures contract. A
Fund could also cover this position by holding a separate call option permitting
it to purchase the same futures contract at a price no higher than the strike
price of the call option sold by the Fund.
In addition, the extent to which a Fund may enter into transactions involving
futures contracts may be limited by the Internal Revenue Code's requirements for
qualification as a registered investment company and the Fund's intention to
qualify as such.
RISK FACTORS IN FUTURES TRANSACTIONS. Positions in futures contracts may be
closed out only on an exchange which provides a secondary market for such
futures. However, there can be no assurance that a liquid secondary market will
exist for any particular futures contract at any specific time. Thus, it may
not be possible to close a futures position. In the event of adverse price
movements, a Fund would continue to be required to make daily cash payments to
maintain the required margin. In such situations, if the Fund has insufficient
cash, it may have to sell portfolio securities to meet daily margin requirements
at a time when it may be disadvantageous to do so. In addition, the Fund may be
required to make delivery of the instruments underlying futures contracts it
holds. The inability to close options and futures positions also could have an
adverse impact on the ability to effectively hedge them. A Fund will minimize
the risk that it will be unable to close out a futures contract by only entering
into futures contracts which are traded on national futures exchanges and for
which there appears to be a liquid secondary market.
The risk of loss in trading futures contracts in some strategies can be
substantial, due both to the low margin deposits required, and the extremely
high degree of leverage involved in futures pricing. Because the deposit
requirements in the futures markets are less onerous than margin requirements in
the securities market, there may be increased participation by speculators in
the futures market which may also cause temporary price distortions. A
relatively small price movement in a futures contract may result in immediate
and substantial loss (as well as gain) to the investor. For example, if at the
time of purchase, 10% of the value of the futures contract is deposited as
margin, a subsequent 10% decrease in the value of the futures contract would
result in a total loss of the margin deposit, before any deduction for the
transaction costs, if the account were then closed out. A 15% decrease would
result in a loss equal to 150% of the original margin deposit if the contract
were closed out. Thus, a purchaser or sale of a futures contract may result in
losses in excess of the amount invested in the contract. However, because the
futures strategies engaged in by a Fund are only for hedging purposes, the
Adviser believes that the Fund is generally not subject to risks of loss
exceeding those that would be undertaken if, instead of the futures contract, it
had invested in the underlying financial instrument and sold it after the
decline.
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Utilization of futures transactions by a Fund involves the risk of imperfect or
no correlation where the securities underlying futures contract have different
maturities than the portfolio securities being hedged. It is also possible that
a Fund could both lose money on futures contracts and also experience a decline
in value of its portfolio securities. There is also the risk of loss by a Fund
of margin deposits in the event of bankruptcy of a broker with whom the Fund has
an open position in a futures contract or related option.
OPTIONS. The Funds may purchase and sell put and call options on their
portfolio securities to enhance investment performance and to protect against
changes in market prices.
COVERED CALL OPTIONS. A Fund may write covered call options on its securities
to realize a greater current return through the receipt of premiums than it
would realize on its securities alone. Such option transactions may also be
used as a limited form of hedging against a decline in the price of securities
owned by the Fund.
A call option gives the holder the right to purchase, and obligates the writer
to sell, a security at the exercise price at any time before the expiration
date. A call option is "covered" if the writer, at all times while obligated as
a writer, either owns the underlying securities (or comparable securities
satisfying the cover requirements of the securities exchanges), or has the right
to acquire such securities through immediate conversion of securities.
In return for the premium received when it writes a covered call option, a Fund
gives up some or all of the opportunity to profit from an increase in the market
price of the securities covering the call option during the life of the option.
The Fund retains the risk of loss should the price of such securities decline.
If the option expires unexercised, the Fund realizes a gain equal to the
premium, which may be offset by a decline in price of the underlying security.
If the option is exercised, the Fund realizes a gain or loss equal to the
difference between the Fund's cost for the underlying security and the proceeds
of sale (exercise price minus commissions) plus the amount of the premium.
A Fund may terminate a call option that it has written before it expires by
entering into a closing purchase transaction. A Fund may enter into closing
purchase transactions in order to free itself to sell the underlying security or
to write another call on the security, realize a profit on a previously written
call option, or protect a security from being called in an unexpected market
rise. Any profits from a closing purchase transaction may be offset by a
decline in the value of the underlying security. Conversely, because increases
in the market price of a call option will generally reflect increases in the
market price of the underlying security, any loss resulting from a closing
purchase transaction is likely to be offset in whole or in part by unrealized
appreciation of the underlying security owned by the Fund.
COVERED PUT OPTIONS. A Fund may write covered put options in order to enhance
its current return. Such options transactions may also be used as a limited
form of hedging against an increase in the price of securities that the Fund
plans to purchase. A put option gives the holder the right to sell, and
obligates the writer to buy, a security at the exercise price at any time before
the expiration date. A put option is "covered" if the writer segregates cash
and high-grade short-term debt obligations or other permissible collateral equal
to the price to be paid if the option is exercised.
In addition to the receipt of premiums and the potential gains from terminating
such options in closing purchase transactions, a Fund also receives interest on
the cash and debt securities maintained to cover the exercise price of the
option. By writing a put option, the Fund assumes the risk that it may be
required to purchase the underlying security for an exercise price higher than
its then current market value, resulting in a potential capital loss unless the
security later appreciates in value.
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A Fund may terminate a put option that it has written before it expires by a
closing purchase transaction. Any loss from this transaction may be partially
or entirely offset by the premium received on the terminated option.
PURCHASING PUT AND CALL OPTIONS. A Fund may also purchase put options to
protect portfolio holdings against a decline in market value. This protection
lasts for the life of the put option because the Fund, as a holder of the
option, may sell the underlying security at the exercise price regardless of any
decline in its market price. In order for a put option to be profitable, the
market price of the underlying security must decline sufficiently below the
exercise price to cover the premium and transaction costs that the Fund must
pay. These costs will reduce any profit the Fund might have realized had it
sold the underlying security instead of buying the put option.
A Fund may purchase call options to hedge against an increase in the price of
securities that the Fund wants ultimately to buy. Such hedge protection is
provided during the life of the call option since the Fund, as holder of the
call option, is able to buy the underlying security at the exercise price
regardless of any increase in the underlying security's market price. In order
for a call option to be profitable, the market price of the underlying security
must rise sufficiently above the exercise price to cover the premium and
transaction costs. These costs will reduce any profit the Fund might have
realized had it bought the underlying security at the time it purchased the call
option.
A Fund may also purchase put and call options to attempt to enhance its current
return.
OPTIONS ON FOREIGN SECURITIES. The Funds may purchase and sell options on
foreign securities if a Fund's Adviser believes that the investment
characteristics of such options, including the risks of investing in such
options, are consistent with the Fund's investment objectives. It is expected
that risks related to such options will not differ materially from risks related
to options on U.S. securities. However, position limits and other rules of
foreign exchanges may differ from those in the U.S. In addition, options
markets in some countries, many of which are relatively new, may be less liquid
than comparable markets in the U.S.
RISKS INVOLVED IN THE SALE OF OPTIONS. Options transactions involve certain
risks, including the risks that a Fund's Adviser will not forecast interest rate
or market movements correctly, that a Fund may be unable at times to close out
such positions, or that hedging transactions may not accomplish their purpose
because of imperfect market correlations. The successful use of these
strategies depends on the ability of a Fund's Adviser to forecast market and
interest rate movements correctly.
An exchange-listed option may be closed out only on an exchange which provides a
secondary market for an option of the same series. There is no assurance that a
liquid secondary market on an exchange will exist for any particular option or
at any particular time. If no secondary market were to exist, it would be
impossible to enter into a closing transaction to close out an option position.
As a result, a Fund may be forced to continue to hold, or to purchase at a fixed
price, a security on which it has sold an option at a time when its Adviser
believes it is inadvisable to do so.
Higher than anticipated trading activity or order flow or other unforeseen
events might cause The Options Clearing Corporation or an exchange to institute
special trading procedures or restrictions that might restrict a Fund's use of
options. The exchanges have established limitations on the maximum number of
calls and puts of each class that may be held or written by an investor or group
of investors acting in concert. It is possible that the Trust and other clients
of the Adviser may be considered such a group. These position limits may
restrict the Funds' ability to purchase or sell options on particular
securities.
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Options which are not traded on national securities exchanges may be closed out
only with the other party to the option transaction. For that reason, it may be
more difficult to close out unlisted options than listed options. Furthermore,
unlisted options are not subject to the protection afforded purchasers of listed
options by The Options Clearing Corporation.
Government regulations, particularly the requirements for qualification as a
"regulated investment company" under the Internal Revenue Code, may also
restrict the Funds' use of options.
SPECIAL EXPIRATION PRICE OPTIONS. The Funds may purchase over-the-counter
("OTC") puts and calls with respect to specified securities ("special expiration
price options") pursuant to which the Funds in effect may create a custom index
relating to a particular industry or sector that the Adviser believes will
increase or decrease in value generally as a group. In exchange for a premium,
the counterparty, whose performance is guaranteed by a broker-dealer, agrees to
purchase (or sell) a specified number of shares of a particular stock at a
specified price and further agrees to cancel the option at a specified price
that decreases straight line over the term of the option. Thus, the value of the
special expiration price option is comprised of the market value of the
applicable underlying security relative to the option exercise price and the
value of the remaining premium. However, if the value of the underlying
security increases (or decreases) by a prenegotiated amount, the special
expiration price option is canceled and becomes worthless. A portion of the
dividends during the term of the option are applied to reduce the exercise price
if the options are exercised. Brokerage commissions and other transaction costs
will reduce these Funds' profits if the special expiration price options are
exercised. A Fund will not purchase special expiration price options with
respect to more than 25% of the value of its net assets, and will limit premiums
paid for such options in accordance with state securities laws.
LEAPS. The Growth/Value Fund may purchase certain long-term exchange-traded
equity options called Long-Term Equity Anticipation Securities ("LEAPs"). LEAPs
provide a holder the opportunity to participate in the underlying securities'
appreciation in excess of a fixed dollar amount. The Growth/Value Fund will not
purchase these options with respect to more than 25% of the value of its net
assets.
LEAPs are long-term call options that allow holders the opportunity to
participate in the underlying securities' appreciation in excess of a specified
strike price, without receiving payments equivalent to any cash dividends
declared on the underlying securities. A LEAP holder will be entitled to
receive a specified number of shares of the underlying stock upon payment of the
exercise price, and therefore the LEAP will be exercisable at any time the price
of the underlying stock is above the strike price. However, if at expiration
the price of the underlying stock is at or below the strike price, the LEAP will
expire worthless.
SHORT SALES. Each Fund may seek to hedge investments or realize additional
gains through the use of short sales. Short sales are transactions in which a
Fund sells a security it does not own, in anticipation of a decline in the
market value of that security. To complete such a transaction, the Fund must
borrow the security to make delivery to the buyer. The Fund then is obligated
to replace the security borrowed by purchasing it at the market price at or
prior to the time of replacement. The price at such time may be more or less
than the price at which the security was sold by the Fund. Until the security
is replaced, the Fund is required to repay the lender any dividends or interest
that accrue during the period of the loan. To borrow the security, the Fund
also may be required to pay a premium, which would increase the cost of the
security sold. The net proceeds of the short sale will be retained by the
broker (or by the Fund's custodian in a special custody account), to the extent
necessary to meet margin requirements, until the short position is closed out.
A Fund also will incur transaction costs in effecting short sales.
A Fund will incur a loss as a result of the short sale if the price of the
security increases between the date of the short sale and the date on which the
Fund replaces the borrowed security. The Fund will realize a gain
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if the security declines in price between those dates. The amount of any gain
will be decreased, and the amount of any loss increased, by the amount of the
premium, dividends, interest or expenses the Fund may be required to pay in
connection with a short sale.
SECURITIES LENDING. Each Fund may lend its portfolio securities to
broker-dealers, banks or institutional borrowers of securities. A Fund must
receive a minimum of 100% collateral, plus any interest due in the form of cash
or U.S. Government securities. This collateral must be valued daily and should
the market value of the loaned securities increase, the borrower must furnish
additional collateral to the Fund. During the time portfolio securities are on
loan, the borrower will pay the Fund any dividends or interest paid on such
securities plus any interest negotiated between the parties to the lending
agreement. Loans will be subject to termination by the Fund or the borrower at
any time. While the Fund will not have the right to vote securities on loan, it
intends to terminate the loan and regain the right to vote if that is considered
important with respect to the investment. A Fund will only enter into loan
arrangements with broker-dealers, banks or other institutions which the Adviser
has determined are creditworthy under guidelines established by the Trustees.
Each Fund will limit its securities lending to 33 1/3% of total assets.
INVESTMENT COMPANY SECURITIES. Each Fund may invest up to 5% of its total
assets in the securities of any one investment company, but may not own more
than 3% of the outstanding securities of any one investment company or invest
more than 10% of its total assets in the securities of other investment
companies. The Adviser will waive its investment advisory fees as to all assets
invested in other investment companies. Because such other investment companies
employ an investment adviser, such investment by a Fund will cause shareholders
to bear duplicative fees, such as management fees, to the extent such fees are
not waived by the Adviser.
WHEN-ISSUED SECURITIES. Each Fund may purchase securities on a when-issued or
delayed delivery basis. These transactions are arrangements in which a Fund
purchases securities with payment and delivery scheduled for a future time.
When a Fund agrees to purchase securities on a when-issued basis, the Fund's
custodian must set aside cash or liquid portfolio securities equal to the amount
of that commitment in a separate account, and may be required to subsequently
place additional assets in the separate account to reflect any increase in the
Fund's commitment. Prior to delivery of when-issued securities, their value is
subject to fluctuation and no income accrues until their receipt. A Fund
engages in when-issued and delayed delivery transactions only for the purpose of
acquiring portfolio securities consistent with its investment objective and
policies, and not for investment leverage. In when-issued and delayed delivery
transactions, the Fund relies on the seller to complete the transaction; its
failure to do so may cause the Fund to miss a price or yield considered to be
advantageous.
INVESTMENT LIMITATIONS AND RESTRICTIONS
The following investment restrictions are fundamental with respect to each Fund
and may be changed only by a vote of a majority of the outstanding shares of the
Fund as defined in "Additional Information - Miscellaneous" of this Statement of
Additional Information).
EACH FUND MAY NOT:
1. Purchase or sell physical commodities unless acquired as a result of
ownership of securities or other instruments (but this shall not prevent a Fund
from purchasing or selling options and futures contracts or from investing in
securities or other instruments backed by physical commodities).
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2. Purchase or sell real estate unless acquired as a result of ownership of
securities or other instruments (but this shall not prevent a Fund from
investing in securities or other instruments backed by real estate or securities
of companies engaged in the real estate business). Investments by a Fund in
securities backed by mortgages on real estate or in marketable securities of
companies engaged in such activities are not hereby precluded.
3. Issue any senior security (as defined in the Investment Company Act of
1940, as amended (the "1940 Act")), except that (a) a Fund may engage in
transactions that may result in the issuance of senior securities to the extent
permitted under applicable regulations and interpretations of the 1940 Act or an
exemptive order; (b) a Fund may acquire other securities, the acquisition of
which may result in the issuance of a senior security, to the extent permitted
under applicable regulations or interpretations of the 1940 Act; (c) subject to
the restrictions set forth below, a Fund may borrow money as authorized by the
1940 Act.
4. Borrow money, except that (a) a Fund may enter into commitments to purchase
securities in accordance with its investment program, including when issued
securities and reverse repurchase agreements, provided that the total amount of
any such borrowing does not exceed 33 1/3% of the Fund's total assets; and (b) a
Fund may borrow money for temporary or emergency purposes in an amount not
exceeding 5% of the value of its total assets at the time when the loan is made.
Any borrowing representing more than 5% of a Fund's total assets must be repaid
before the Fund may make additional investments.
5. Lend any security or make any other loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, but this limitation does not
apply to purchases of publicly issued debt securities or to repurchase
agreements.
6. Underwrite securities issued by others, except to the extent that a Fund
may be considered an underwriter within the meaning of the Securities Act of
1933, as amended (the "1933 Act") in the disposition of restricted securities.
7. With respect to 75% (50%, with respect to the Growth/Value Fund) of its
total assets, purchase the securities of any issuer (other than securities
issued or guaranteed by the U.S. Government or any of its agencies or
instrumentalities) if, as a result, (a) more than 5% of the Fund's total assets
would be invested in the securities of that issuer, or (b) the Fund would hold
more than 10% of the outstanding voting securities of that issuer.
8. (a) With respect to the Financial Services Fund and the Small Cap Financial
Fund, purchase the securities of any issuer if, as a result, less than 25% of a
Fund's total assets would be invested in the securities of issuers principally
engaged in the financial services group of industries; and (b) with respect to
Growth/Value Fund, purchase the securities of an issuer if, as a result, more
than 25% of its total assets would be invested in the securities of companies
whose principal business activities are in the same industry. These limitations
do not apply to securities issued or guaranteed by the U.S. government or any of
its agencies or instrumentalities.
The following restrictions are not fundamental and may be changed without
shareholder approval:
1. No Fund will purchase or retain securities of any issuer if the officers or
Trustees of the Trust or the officers or directors of its investment adviser
owning beneficially more than one half of 1% of the securities of such issuer
together own beneficially more than 5% of such securities.
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2. No Fund will invest more than 10% of its total assets in the securities of
issuers which together with any predecessors have a record of less than three
years of continuous operation.
3. No Fund will invest more than 15% of its net assets in illiquid securities.
Illiquid securities are securities that are not readily marketable or cannot be
disposed of promptly within seven days and in the usual course of business at
approximately the price at which a Fund has valued them. Such securities
include, but are not limited to, time deposits and repurchase agreements with
maturities longer than seven days. Securities that may be resold under Rule
144A, securities offered pursuant to Section 4(2) of, or securities otherwise
subject to restrictions on resale under the 1933 Act ("Restricted Securities"),
shall not be deemed illiquid solely by reason of being unregistered. The Adviser
determines whether a particular security is deemed to be liquid based on the
trading markets for the specific security and other factors.
4. No Fund will purchase securities on margin except for short-term credits
necessary for clearance of portfolio transactions, provided that this
restriction will not be applied to limit the use of options, futures contracts
and related options, in the manner otherwise permitted by the investment
restrictions, policies and investment program of the Fund.
5. Each Fund may invest up to 5% of its total assets in the securities of any
one investment company, but may not own more than 3% of the securities of any
one investment company or invest more than 10% of its total assets in the
securities of other investment companies.
GENERAL. The policies and limitations listed above supplement those set forth
in the Prospectus. Unless otherwise noted, whenever an investment policy or
limitation states a maximum percentage of a Fund's assets that may be invested
in any security or other asset, or sets forth a policy regarding quality
standards, such standard or percentage limitation will be determined immediately
after and as a result of the Fund's acquisition of such security or other asset
except in the case of borrowing (or other activities that may be deemed to
result in the issuance of a "senior security" under the 1940 Act). Accordingly,
any subsequent change in values, net assets, or other circumstances will not be
considered when determining whether the investment complies with the Fund's
investment policies and limitations. If the value of a Fund's holdings of
illiquid securities at any time exceeds the percentage limitation applicable at
the time of acquisition due to subsequent fluctuations in value or other
reasons, the Trustees will consider what actions, if any, are appropriate to
maintain adequate liquidity.
The investment policies of a Fund may be changed without an affirmative vote of
the holders of a majority of the Fund's outstanding voting securities unless
(1) a policy is expressly deemed to be a fundamental policy of the Fund or (2) a
policy is expressly deemed to be changeable only by such majority vote.
VALUATION OF PORTFOLIO SECURITIES
Portfolio securities are valued at the last sale price on the securities
exchange or national securities market on which such securities primarily are
traded. Securities not listed on an exchange or national securities market, or
securities in which there were no transactions, are valued at the average of the
most recent bid and asked prices, except in the case of open short positions
where the asked price is used for valuation purposes. Bid price is used when no
asked price is available. Short-term investments are carried at amortized cost,
which approximates value. Any securities or other assets for which recent
market quotations are not readily available are valued at fair value as
determined in good faith by the Funds' Board of Trustees. Expenses and fees,
including the management fee and distribution and service fees, are accrued
daily and taken into account for the purpose of determining the net asset value
of the Funds' shares.
18
<PAGE>
Restricted securities, as well as securities or other assets for which market
quotations are not readily available, or are not valued by a pricing service
approved by the Board of Trustees, are valued at fair value as determined in
good faith by the Board of Trustees. The Board of Trustees will review the
method of valuation on a current basis. In making their good faith valuation of
restricted securities, the Trustees generally will take the following factors
into consideration: restricted securities which are, or are convertible into,
securities of the same class of securities for which a public market exists
usually will be valued at market value less the same percentage discount at
which purchased. This discount will be revised periodically by the Board of
Trustees if the Trustees believe that it no longer reflects the value of the
restricted securities. Restricted securities not of the same class as
securities for which a public market exists usually will be valued initially at
cost. Any subsequent adjustment from cost will be based upon considerations
deemed relevant by the Board of Trustees.
NEW YORK STOCK EXCHANGE CLOSINGS. The holidays (as observed) on which the New
York Stock Exchange is closed currently are: New Year's Day, Presidents' Day,
Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving and
Christmas Day.
PERFORMANCE
From time to time the "standardized yield," "dividend yield," "average annual
total return," "total return," and "total return at net asset value" of an
investment in Fund shares may be advertised. An explanation of how yields and
total returns are calculated and the components of those calculations are set
forth below.
Yield and total return information may be useful to investors in reviewing a
Fund's performance. A Fund's advertisement of its performance must, under
applicable Commission rules, include the average annual total returns for the
Fund for the 1, 5 and 10 year period (or the life of the Fund, if less) as of
the most recently ended calendar quarter. This enables an investor to compare
the Fund's performance to the performance of other funds for the same periods.
However, a number of factors should be considered before using such information
as a basis for comparison with other investments. An investment in a Fund is
not insured; its yield and total return are not guaranteed and normally will
fluctuate on a daily basis. When redeemed, an investor's shares may be worth
more or less than their original cost. Yield and total return for any given
past period are not a prediction or representation by the Trust of future yields
or rates of return on its shares. The yield and total returns of the Fund are
affected by portfolio quality, portfolio maturity, the type of investments the
Fund holds and operating expenses.
STANDARDIZED YIELD. A Fund's "yield" (referred to as "standardized yield") for
a given 30 day period for a class of shares is calculated using the following
formula set forth in rules adopted by the Commission that apply to all funds
that quote yields:
6
STANDARDIZED YIELD = 2 [(a-b + 1) - 1]
---
cd
The symbols above represent the following factors:
a = dividends and interest earned during the 30-day period.
b = expenses accrued for the period (net of any expense
reimbursements).
c = the average daily number of shares of that class outstanding
during the 30-day period that were entitled to receive
dividends.
19
<PAGE>
d = the maximum offering price per share of the class on the
last day of the period, adjusted for undistributed net
investment income.
The standardized yield for a 30 day period may differ from its yield for any
other period. The Commission formula assumes that the standardized yield for a
30 day period occurs at a constant rate for a six month period and is annualized
at the end of the six month period. This standardized yield is not based on
actual distributions paid by a Fund to shareholders in the 30 day period, but is
a hypothetical yield based upon the net investment income from the Fund's
portfolio investments calculated for that period. The standardized yield may
differ from the "dividend yield," described below.
DIVIDEND YIELD AND DISTRIBUTION RETURNS. From time to time a Fund may quote a
"dividend yield" or a "distribution return." Dividend yield is based on the
share dividends derived from net investment income during a stated period.
Distribution return includes dividends derived from net investment income and
from realized capital gains declared during a stated period. Under those
calculations, the dividends and/or distributions declared during a stated period
of one year or less (for example, 30 days) are added together, and the sum is
divided by the maximum offering price per share of Fund) on the last day of the
period.
DIVIDEND YIELD = DIVIDENDS + NUMBER OF DAYS (ACCRUAL PERIOD) X 365
-------------------
MAX. OFFERING PRICE
(LAST DAY OF PERIOD)
The maximum offering price for shares includes the maximum front-end sales
charge, if any.
From time to time similar yield or distribution return calculations may also be
made using the net asset value (instead of its respective maximum offering
price) at the end of the period.
TOTAL RETURNS. The "average annual total return" is an average annual
compounded rate of return for each year in a specified number of years. It is
the rate of return based on the change in value of a hypothetical initial
investment of $1,000 ("P" in the formula below) held for a number of years ("n")
to achieve an Ending Redeemable Value ("ERV"), according to the following
formula:
1n
(ERV) -1 = AVERAGE ANNUAL TOTAL RETURN
---
(P)
The cumulative "total return" calculation measures the change in value of a
hypothetical investment of $1,000 over an entire period of years. Its
calculation uses some of the same factors as average annual total return, but it
does not average the rate of return on an annual basis. Total return is
determined as follows:
(ERV)-1 = TOTAL RETURN
---
(P)
From time to time a Fund may also quote an "average annual total return at net
asset value" or a cumulative "total return at net asset value." It is based on
the difference in net asset value per share at the beginning and the end of the
period for a hypothetical investment in that class of shares (without
considering front-end or contingent sales charges) and takes into consideration
the reinvestment of dividends and capital gains distributions.
20
<PAGE>
PERFORMANCE COMPARISONS.
YIELD AND TOTAL RETURN. From time to time, performance information
for a Fund showing its average annual total return and/or yield may be included
in advertisements or in information furnished to present or prospective
shareholders and the ranking of those performance figures relative to such
figures for groups of mutual funds categorized by Lipper Analytical Services as
having the same investment objectives may be included in advertisements.
Total return and/or yield may also be used to compare the performance
of a Fund against certain widely acknowledged standards or indices for stock and
bond market performance. The Standard & Poor's Composite Index of 500 stocks
(the "S&P 500") is a market value-weighted and unmanaged index showing the
changes in the aggregate market value of 500 stocks relative to the base period
1941-43. The S&P 500 is composed almost entirely of common stocks of companies
listed on the New York Stock Exchange, although the common stocks of a few
companies listed on the American Stock Exchange or traded over-the-counter are
included. The 500 companies represented include 400 industrial, 60
transportation and 40 financial services concerns. The S&P 500 represents about
80% of the market value of all issues traded on the New York Stock Exchange.
The NASDAQ-OTC Price Index (the "NASDAQ Index") is a market
value-weighted and unmanaged index showing the changes in the aggregate market
value of approximately 3,500 stocks relative to the base measure of 100.00 on
February 5, 1971. The NASDAQ Index is composed entirely of common stocks of
companies traded over-the-counter and often through the National Association of
Securities Dealers Automated Quotations ("NASDAQ") system. Only those
over-the-counter stocks having only one market maker or traded on exchanges are
excluded.
The Shearson Lehman Government Bond Index (the "SL Government Index")
is a measure of the market value of all public obligations of the U.S. Treasury;
all publicly issued debt of all agencies of the U.S. Government and all
quasi-federal corporations; and all corporate debt guaranteed by the U.S.
Government. Mortgage backed securities, flower bonds and foreign targeted
issues are not included in the SL Government Index.
The Shearson Lehman Government/Corporate Bond Index (the "SL
Government/Corporate Index") is a measure of the market value of approximately
5,300 bonds with a face value currently in excess of $1.3 trillion. To be
included in the SL Government/Corporate Index, an issue must have amounts
outstanding in excess of $1 million, have at least one year to maturity and be
rated "Baa" or higher ("investment grade") by a nationally recognized
statistical rating agency.
Current yields or performance will fluctuate from time to time and are
not necessarily representative of future results. Accordingly, a Fund's yield
or performance may not provide for comparison with bank deposits or other
investments that pay a fixed return for a stated period of time. Yield and
performance are functions of quality, composition, and maturity, as well as
expenses allocated to the Fund.
21
<PAGE>
ADDITIONAL REDEMPTION INFORMATION
REDEMPTION IN KIND. Although each Fund intends to redeem shares in cash, each
Fund reserves the right under certain circumstances to pay the redemption price
in whole or in part by a distribution of securities from a Fund. To the extent
available, such securities will be readily marketable. Redemption in kind will
be made in conformity with applicable Commission rules, taking such securities
at the same value employed in determining NAV and selecting the securities in a
manner the Trustees determine to be fair and equitable. The Funds have elected
to be governed by Rule 18F-1 of the 1940 Act under which each Fund is obligated
to redeem shares for any one shareholder in cash only up to the lesser of
$250,000 or 1% of a Fund's net asset value during any 90-day period.
SUSPENSION OF REDEMPTIONS. The right of redemption may be suspended or the date
of payment postponed (a) during any period when the New York Stock Exchange is
closed (other than customary weekend and holiday closings), (b) when trading in
the markets a Fund ordinarily utilizes is restricted, or when an emergency
exists as determined by the Commission so that disposal of the Fund's
investments or determination of its net asset value is not reasonably
practicable, or (c) for such other periods as the Commission by order may permit
to protect Fund shareholders.
DIVIDENDS AND DISTRIBUTIONS
Each Fund ordinarily declares and pays dividends from its net investment income.
Each Fund distributes substantially all of its net investment income and net
capital gains, if any, to shareholders within each calendar year as well as on a
fiscal year basis to the extent required for the Fund to qualify for favorable
federal tax treatment.
The amount of distributions may vary from time to time depending on market
conditions and the composition of a Fund's portfolio.
For this purpose, the net income of a Fund, from the time of the immediately
preceding determination thereof, shall consist of all interest income accrued on
the portfolio assets of the Fund, dividend income, if any, income from
securities loans, if any, and realized capital gains and losses on the Fund's
assets, less all expenses and liabilities of the Fund chargeable against income.
Interest income shall include discount earned, including both original issue and
market discount, on discount paper accrued ratably to the date of maturity.
Expenses, including the compensation payable to the Adviser, are accrued each
day. The expenses and liabilities of a Fund shall include those appropriately
allocable to the Fund as well as a share of the general expenses and liabilities
of the Trust in proportion to the Fund's share of the total net assets of the
Trust.
TAXES
It is the policy of each Fund to seek to qualify for the favorable tax treatment
accorded regulated investment companies ("RICs") under Subchapter M of the IRS
Code (the "Code") for so long as such qualification is in the best interests of
its shareholders. By following such policy and distributing its income and
gains currently with respect to each taxable year, each Fund expects to
eliminate or reduce to a nominal amount the federal income and excise taxes to
which it may otherwise be subject.
In order to qualify as a RIC, a Fund must, among other things, (1) derive at
least 90% of its gross income from dividends, interest, payments with respect to
securities loans, and gains from the sale or other disposition of stock or
securities, foreign currencies or other income (including gains from options,
futures
22
<PAGE>
or forward contracts) derived with respect to its business of investing in
stock, securities or currencies, (2) derive less than 30% of its gross income
from the sale or other disposition of stock, securities, options, futures,
forward contracts, and certain foreign currencies (or options, futures, or
forward contracts on foreign currencies) held for less than three months, and
(3) diversify its holdings so that at the end of each quarter of its taxable
year (a) at least 50% of the market value of the Fund's assets is represented by
cash or cash items, U.S. Government securities, securities of other RICs and
other securities limited, in respect of any one issuer, to an amount not greater
than 5% of the value of the Fund's total assets and 10% of the outstanding
voting securities of such issuer, and (b) not more than 25% of the value of its
total assets is invested in the securities of any one issuer (other than U.S.
Government securities) or of two or more issuers that the Fund controls and that
are engaged in the same, similar, or related trades or businesses. These
requirements may restrict the degree to which a Fund may engage in short-term
trading and concentrate investments. If a Fund qualifies as a RIC, it will not
be subject to federal income tax on the part of its net investment income and
net realized capital gains, if any, that it distributes to shareholders with
respect to each taxable year within the time limits specified in the Code.
A non-deductible excise tax is imposed on RICs that do not distribute in each
calendar year an amount equal to 98% of their ordinary income for the year plus
98% of their capital gain net income for the 1-year period ending on October 31
of such calendar year. The balance of such income must be distributed during
the following calendar year. If distributions during a calendar year are less
than the required amount, the fund is subject to a non-deductible excise tax
equal to 4% of the deficiency.
Certain investment and hedging activities of a Fund, including transactions in
options, futures contracts, hedging transactions, forward contracts, straddles,
foreign currencies, and foreign securities, are subject to special tax rules.
In a given case, these rules may accelerate income to a Fund, defer losses to
the Fund, cause adjustments in the holding periods of the Fund's securities,
convert short-term capital losses into long-term capital losses, or otherwise
affect the character of the Fund's income. These rules could therefore affect
the amount, timing and character of distributions to shareholders. The Trust
will endeavor to make any available elections pertaining to such transactions in
a manner believed to be in the best interest of the Fund and its shareholders.
Each Fund will be required in certain cases to withhold and remit to the U.S.
Treasury 31% of taxable dividends paid to any shareholder who has failed to
provide a (or has provided an incorrect) tax identification number, or is
subject to withholding pursuant to a notice from the IRS for failure to properly
include on his or her income tax return payments of interest or dividends. This
"backup withholding" is not an additional tax, and any amounts withheld may be
credited against the shareholder's ultimate U.S. tax liability.
Information set forth in the Prospectus and this Statement of Additional
Information that relates to federal taxation is only a summary of certain key
federal tax considerations generally affecting purchasers of shares of the
Funds. No attempt has been made to present a complete explanation of the federal
tax treatment of a Fund or its shareholders, and this discussion is not intended
as a substitute for careful tax planning. Accordingly, potential purchasers of
shares of a Fund are urged to consult their tax advisers with specific reference
to their own tax circumstances. In addition, the tax discussion in the
Prospectus and this Statement of Additional Information is based on tax law in
effect on the date of the Prospectus and this Statement of Additional
Information; such laws and regulations may be changed by legislative, judicial
or administrative action, sometimes with retroactive effect.
23
<PAGE>
TRUSTEES AND OFFICERS
BOARD OF TRUSTEES.
Overall responsibility for management of the Trust rests with the Trustees, who
are elected by the shareholders of the Trust. The Trust is managed by the
Trustees in accordance with the laws of the State of Delaware. There are
currently five Trustees, three of whom are not "interested persons" of the Trust
within the meaning of that term under the 1940 Act ("Independent Trustee"). The
Trustees, in turn, elect the officers of the Trust to actively supervise its
day-to-day operations.
The Trustees of the Trust, their addresses, ages and their principal occupations
during the past five years are as follows:
<TABLE>
<CAPTION>
Position(s) Held Principal Occupation
Name, Address and Age With the Trust During Past 5 Years
- --------------------- ----------------- --------------------
<S> <C> <C>
Eric F. Billings, 44* Chairman, Trustee, Vice-Chairman and Director, FBR Fund Advisers, Inc.,
Potomac Tower Chief Financial Officer, Friedman, Billings, Ramsey & Co., Inc., Friedman,
1001 Nineteenth Street North Treasurer and Secretary Billings, Ramsey, Investment Management, Inc. and FBR
Arlington, Virginia 22209 Offshore Management Inc.
Thomas D. Eckert, 49 Trustee President, Mid-Atlantic Region, Pulte Home
Pulte Home North Corporation.
2100 Reston Parkway, Suite 450
Reston, Virginia 20191
Patrick J. Keeley, 48 Trustee Partner in the law firm of Fulbright & Jaworski,
Fulbright & Jaworski, L.L.P. L.L.P.
801 Pennsylvania Avenue, N.W.
Washington, D.C. 20004
C. Eric Brugel, 34* Trustee, President and Managing Director, Friedman, Billings, Ramsey & Co.,
Potomac Tower Assistant Secretary Inc.
1001 Nineteenth Street North
Arlington, VA 22209
Michael A. Willner, 40 Trustee President, Catalyst Advisers, Inc. from September
11521 Potomac Road 1996 to Present; President, Federal Filings, Inc.
Lorton, VA 22079 from July 1986 to July 1995
F. David Fowler, 63 Trustee Dean, The George Washington University School of
9450 Newbridge Drive Business and Public Management; Partner, KPMG Peat
Potomac, MD 20854 Marwick from October 1969 to June 1992.
</TABLE>
- ------------------------
* Messrs. Billings and Brugel are deemed to be "interested persons" of the
Trust under the 1940 Act.
24
<PAGE>
The Board of Trustees presently has an audit committee, a valuation committee,
and a nominating committee. The members of each committee are Messrs. Eckert,
Keeley, Willner and Fowler. The function of the audit committee is to recommend
independent auditors and review and report on accounting and financial matters.
The function of the valuation committee is to determine and monitor the value of
the Funds' assets. The function of the nominating committee is to nominate
persons to serve as disinterested trustees and trustees to serve on committees
of the Board.
REMUNERATION OF TRUSTEES AND CERTAIN EXECUTIVE OFFICERS.
Each Independent Trustee receives an annual retainer of $5,000 and a fee of
$1,000 for each regular meeting and $500 for each committee meeting attended,
plus expenses, and $250 for each telephonic meeting.
The officers of the Trust, their ages, addresses and principal occupations
during the past five years, are as follows:
<TABLE>
<CAPTION>
Position(s) Held Principal Occupation
Name, Address and Age With the Trust During Past 5 Years
- --------------------- ---------------- --------------------
<S> <C> <C>
Eric F. Billings, 44 Chairman, Trustee, Vice-Chairman and Director, FBR Fund Advisers,
Potomac Tower Chief Financial Officer, Treasurer Inc., Friedman, Billings, Ramsey & Co., Inc.,
1001 Nineteenth Street North and Secretary Friedman, Billings, Ramsey, Investment
Arlington, Virginia 22209 Management, Inc. and FBR Offshore Management Inc.
C. Eric Brugel, 34 Trustee, President and Assistant Managing Director, Friedman, billings, Ramsey &
Potomac Tower Secretary Co., Inc.
1001 Nineteenth Street North
Arlington, Virginia 22209
Frank J. Maresca, 38 Assistant Treasurer Managing Director of Bear, Stearns & Co. Inc.
245 Park Avenue since September 1994; Associate Director of Bear,
New York, NY 10167 Stearns & Co. Inc. from September 1993 to
September 1994; Executive Vice President of BSFM
since March 1992; Vice President of Bear, Stearns
& Co. Inc. from March 1992 to September 1993.
Vincent L. Pereira, 31 Assistant Secretary Associate Director of Bear, Stearns & Co. Inc.
245 Park Avenue since September 1995 and Vice President of BSFM
New York, New York 10167 since May 1993; Vice President to September 1995;
Assistant Vice President of Mitchell Hutchins
from October 1992 to May 1993; Senior
Relationship Manager of Mitchell Hutchins from
June 1988 to October 1992.
</TABLE>
25
<PAGE>
The mailing address of each of the officers of the Trust is Potomac Tower, 1001
Nineteenth Street North, Arlington, Virginia 22209.
The officers of the Trust receive no compensation directly from the Trust for
performing the duties of their offices.
ADVISORY AND OTHER CONTRACTS
INVESTMENT ADVISER.
FBR Fund Advisers, Inc. is the investment adviser to the Funds. The Adviser
directs the investment of the Funds' assets, subject at all times to the
supervision of the Trust's Board of Trustees. The Adviser continually conducts
investment research and supervision for the Funds and is responsible for the
purchase and sale of the Funds' investments.
The Adviser was organized as a Delaware corporation on September 30, 1996 and is
registered as an investment adviser under the 1940 Act. It is an affiliate of
Friedman, Billings, Ramsey & Co., Inc., Friedman, Billings, Ramsey Investment
Management, Inc. and FBR Offshore Management, Inc. Affiliates of the Adviser
manage approximately $200 million for numerous clients including individuals,
banks and thrift institutions, investment companies, pension and profit sharing
plans and trusts, estates and charitable organizations.
THE INVESTMENT ADVISORY AGREEMENT.
Unless sooner terminated, the Investment Advisory Agreement between the Adviser
and the Trust on behalf of the Funds (the "Investment Advisory Agreement")
provides that it will continue in effect as to each Fund for an initial two-year
term and for consecutive one-year terms thereafter, provided that such
continuance is approved at least annually by the Trustees or by vote of a
majority of the outstanding shares of a Fund (as defined under "Additional
Information"), and, in either case, by a majority of the Trustees who are not
parties to the Investment Advisory Agreement or interested persons (as defined
in the 1940 Act) of any party to the Investment Advisory Agreement, by votes
cast in person at a meeting called for such purpose.
The Investment Advisory Agreement is terminable as to a Fund at any time on 60
days' written notice without penalty by the Trustees, by vote of a majority of
the outstanding shares of the Fund, or by the Adviser. The Investment Advisory
Agreement also terminates automatically in the event of any assignment, as
defined in the 1940 Act.
The Investment Advisory Agreement provides that the Adviser shall not be liable
for any error of judgment or mistake of law or for any loss suffered by a Fund
in connection with the performance of services pursuant to the Investment
Advisory Agreement, except a loss resulting from a breach of fiduciary duty with
respect to the receipt of compensation for services or a loss resulting from
willful misfeasance, bad faith, or gross negligence on the part of the Adviser
in the performance of its duties, or from reckless disregard by it of its duties
and obligations thereunder.
Under the Investment Advisory Agreement, the Adviser may delegate a portion of
its responsibilities to a sub-adviser. In addition, the Investment Advisory
Agreement provides that the Adviser may render services through its own
employees or the employees of one or more affiliated companies that are
qualified to act as an investment adviser of a Fund and are under common control
with FBR as long as all such persons are functioning as part of an organized
group of persons, managed by authorized officers of the Adviser.
26
<PAGE>
PORTFOLIO TRANSACTIONS.
Pursuant to the Investment Advisory Agreement, the Adviser determines, subject
to the general supervision of the Trustees of the Trust, and in accordance with
each Fund's investment objective and restrictions, which securities are to be
purchased and sold by a Fund, and which brokers are to be eligible to execute
its portfolio transactions. Purchases from underwriters and/or broker-dealers
of portfolio securities include a commission or concession paid by the issuer to
the underwriter and/or broker-dealer and purchases from dealers serving as
market makers may include the spread between the bid and asked price. While
the Adviser generally seeks competitive spreads or commissions, a Fund may not
necessarily pay the lowest spread or commission available on each transaction,
for reasons discussed below.
Allocation of transactions to dealers is determined by the Adviser in its best
judgment and in a manner deemed fair and reasonable to shareholders. The
primary consideration is prompt execution of orders in an effective manner at
the most favorable price. Subject to this consideration, dealers who provide
supplemental investment research to the Adviser may receive orders for
transactions by the Trust. Information so received is in addition to and not in
lieu of services required to be performed by the Adviser and does not reduce the
investment advisory fees payable to the Adviser by a Fund. Such information may
be useful to the Adviser in serving both the Trust and other clients and,
conversely, such supplemental research information obtained by the placement of
orders on behalf of other clients may be useful to the Adviser in carrying out
its obligations to the Trust. The Trustees have authorized the allocation of
brokerage to affiliated broker-dealers on an agency basis to effect portfolio
transactions. The Trustees have adopted procedures incorporating the standards
of Rule 17e-1 under the 1940 Act, which require that the commission paid to
affiliated broker-dealers must be "reasonable and fair compared to the
commission, fee or other remuneration received, or to be received, by other
brokers in connection with comparable transactions involving similar securities
during a comparable period of time." At times, a Fund may also purchase
portfolio securities directly from dealers acting as principals, underwriters or
market makers. As these transactions are usually conducted on a net basis, no
brokerage commissions are paid by the Fund.
Investment decisions for a Fund are made independently from those made for the
other funds of the Trust or any other investment company or account managed by
the Adviser. Such other funds, investment companies or accounts may also invest
in the same securities in which a Fund invests. When a purchase or sale of the
same security is made at substantially the same time on behalf of a Fund and
another fund, investment company or account, the transaction will be averaged as
to price, and available investments allocated as to amount, in a manner which
the Adviser believes to be equitable to the Fund and such other fund, investment
company or account. In some instances, this investment procedure may affect the
price paid or received by a Fund or the size of the position obtained by the
Fund in an adverse manner relative to the result that would have been obtained
if only the Fund had participated in or been allocated such trades. To the
extent permitted by law, the Adviser may aggregate the securities to be sold or
purchased for a Fund with those to be sold or purchased for the other funds of
the Trust or for other investment companies or accounts in order to obtain best
execution. In making investment recommendations for the Trust, the Adviser will
not inquire or take into consideration whether an issuer of securities proposed
for purchase or sale by the Fund is a customer of the Adviser, its parents or
subsidiaries or affiliates and, in dealing with their commercial customers, the
Adviser, its subsidiaries, and affiliates will not inquire or take into
consideration whether securities of such customers are held by the Trust.
PORTFOLIO TURNOVER.
The portfolio turnover rate is calculated by dividing the lesser of each Fund's
purchases or sales of portfolio securities for the year by the monthly average
value of the portfolio securities. The calculation excludes all securities
whose maturities, at the time of acquisition, were one year or less.
27
<PAGE>
DISTRIBUTORS.
Friedman, Billings, Ramsey & Co., Inc., located at Potomac Tower, 1001
Nineteenth Street North, Arlington, Virginia 22209, and FBR Direct, Inc.,
located at the same address, each serves as a non-exclusive underwriter and
distributor (the "Distributors") of the Funds' shares pursuant to agreements
which are renewable annually. Each of the Distributors is entitled to receive
payments under the Funds' Distribution and Shareholder Servicing Plans described
below.
ADMINISTRATOR.
Under the terms of an Administration Agreement with the Trust on behalf of the
Funds, Bear Stearns Funds Management Inc. ("BSFM"), a wholly-owned subsidiary of
The Bear Stearns Companies Inc., generally supervises certain operations of the
Funds, subject to the overall authority of the Trust's Board of Trustees in
accordance with Delaware law.
From time to time, BSFM may waive receipt of its fees, which would have the
effect of lowering a Fund's expense ratio and increasing yield to investors at
the time such amounts are waived or assumed, as the case may be. The Funds will
not pay BSFM at a later time for any amounts it may waive.
Under the terms of an Administration and Accounting Services Agreement with the
Trust on behalf of the Funds, PFPC Inc. provides certain administration and
accounting services to the Funds.
CUSTODIAN AND TRANSFER AGENT.
Custodial Trust Company, 101 Carnegie Center, Princeton, New Jersey 08540, is
the Funds' custodian. PFPC Inc., Bellevue Corporate Center, 400 Bellevue
Parkway, Wilmington, Delaware 19809, is the Funds' transfer agent, dividend
disbursing agent and registrar (the "Transfer Agent"). The Transfer Agent also
provides certain administrative services to the Funds. Neither of them has any
part in determining the investment policies of the Funds or which securities are
to be purchased or sold by the Funds.
DISTRIBUTION PLAN.
Under a plan adopted by the Trust's Board of Trustees pursuant to Rule 12b-1
under the 1940 Act (the "Plan"), each Fund pays each Distributor for
distributing Fund shares and for providing personal services to, and/or
maintaining accounts of, Fund shareholders a fee at the annual rate of 0.25% of
the average daily net assets of the Fund shares for which it is the distributor
of record. Under the Plan, the Distributors may pay third parties in respect of
these services such amount as they may determine. The fees paid to the
Distributors under the Plan are payable without regard to actual expenses
incurred. The Trust understands that these third parties also may charge fees
to their clients who are beneficial owners of Fund shares in connection with
their client accounts. These fees would be in addition to any amounts which may
be received by them from the Distributors under the Plan.
In approving the Plan in accordance with the requirements of Rule 12b-1 under
the 1940 Act, the Trustees (including the Independent Trustees, being Trustees
who are not "interested persons", as defined by the 1940 Act, of the Trust and
have no direct or indirect financial interest in the operation of the Plan or in
any agreements related to the Plan) considered various factors and determined
that there is a reasonable likelihood that the Plan will benefit each Fund and
its shareholders. The Plan will continue in effect as to a Fund from year to
year if specifically approved annually (a) by the majority of such Fund's
outstanding voting shares or by the Board of Trustees and (b) by the vote of a
majority of the Independent Trustees. While the Plan remains in effect, the
Trust's Principal Financial Officer shall prepare and furnish to the
28
<PAGE>
Board of Trustees a written report setting forth the amounts spent by each Fund
under the Plan and the purposes for which such expenditures were made. The Plan
may not be amended to increase materially the amount to be spent for
distribution without shareholder approval and all material amendments to the
Plan must be approved by the Board of Trustees and by the Independent Trustees
cast in person at a meeting called specifically for that purpose. While the
Plan is in effect, the selection and nomination of the Independent Trustees
shall be made by those Independent Trustees then in office.
INDEPENDENT ACCOUNTANTS.
Arthur Andersen LLP, 8000 Tower Cresent Drive, Vienna, VA 22182, serves as
independent accountants to the Funds.
LEGAL COUNSEL.
Dechert Price & Rhoads, 1500 K Street, N.W., Washington, D.C. 20005 is the
counsel to the Trust.
EXPENSES.
Each Fund bears certain expenses relating to its operations; such expenses
include, but are not limited to, the following: taxes, interest, brokerage fees
and commissions, fees of the Trustees, Commission fees, state securities
qualification fees, costs of preparing and printing prospectuses for regulatory
purposes and for distribution to current shareholders, outside auditing and
legal expenses, advisory fees, fees and out-of-pocket expenses of the custodian,
administrators and transfer agent, certain insurance premiums, costs of
maintenance of the Fund's existence, costs of shareholders' reports and
meetings, and any extraordinary expenses incurred in the Fund's operation.
ADDITIONAL INFORMATION
DESCRIPTION OF SHARES.
The Trust is a Delaware business trust. The Delaware Trust Instrument
authorizes the Trustees to issue an unlimited number of shares, which are units
of beneficial interest, without par value. The Trust presently is authorized to
issue four series of shares, which represent interests in the FBR Small Cap
Financial Fund, the FBR Financial Services Fund, the FBR Information
Technologies Fund and the FBR Growth/Value Fund. The Trust's Trust Instrument
authorizes the Trustees to divide or redivide any unissued shares of the Trust
into one or more additional series by setting or changing in any one or more
aspects their respective preferences, conversion or other rights, voting power,
restrictions, limitations as to dividends, qualifications, and terms and
conditions of redemption.
Shares have no subscription or preemptive rights and only such conversion or
exchange rights as the Trustees may grant in their discretion. When issued for
payment as described in the Prospectus and this Statement of Additional
Information, the Trust's shares will be fully paid and non-assessable. In the
event of a liquidation or dissolution of the Trust, shares of a Fund are
entitled to receive the assets available for distribution belonging to the Fund,
and a proportionate distribution, based upon the relative asset values of the
respective funds of the Trust, of any general assets not belonging to any
particular fund which are available for distribution.
Shares of the Trust are entitled to one vote per share (with proportional voting
for fractional shares) on such matters as shareholders are entitled to vote. On
any matter submitted to a vote of the shareholders, all shares are voted
separately by individual series (funds), and whenever the Trustees determine
that the
29
<PAGE>
matter affects only certain series, may be submitted for a vote by only such
series, except (1) when required by the 1940 Act, shares are voted in the
aggregate and not by individual series; and (2) when the Trustees have
determined that the matter affects the interests of more than one series and
that voting by shareholders of all series would be consistent with the 1940 Act,
then the shareholders of all such series shall be entitled to vote thereon
(either by individual series or by shares voted in the aggregate, as the
Trustees in their discretion may determine). The Trustees may also determine
that a matter affects only the interests of one or more classes of a series, in
which case (or if required under the 1940 Act) such matter shall be voted on by
such class or classes. There will normally be no meetings of shareholders for
the purpose of electing Trustees unless and until such time as less than a
majority of the Trustees have been elected by the shareholders, at which time
the Trustees then in office will call a shareholders' meeting for the election
of Trustees. In addition, Trustees may be removed from office by a vote of the
holders of at least two-thirds of the outstanding shares of the Trust. A
meeting shall be held for such purpose upon the written request of the holders
of not less than 10% of the outstanding shares. Upon written request by ten or
more shareholders meeting the qualifications of Section 16(c) of the 1940 Act,
(i.e., persons who have been shareholders for at least six months, and who hold
shares having a net asset value of at least $25,000 or constituting 1% of the
outstanding shares) stating that such shareholders wish to communicate with the
other shareholders for the purpose of obtaining the signatures necessary to
demand a meeting to consider removal of a Trustee, the Trust will provide a list
of shareholders or disseminate appropriate materials (at the expense of the
requesting shareholders). Except as set forth above, the Trustees shall
continue to hold office and may appoint their successors.
Rule 18f-2 under the 1940 Act provides that any matter required to be submitted
to the holders of the outstanding voting securities of an investment company
such as the Trust shall not be deemed to have been effectively acted upon unless
approved by the holders of a majority of the outstanding shares of each Fund of
the Trust affected by the matter. For purposes of determining whether the
approval of a majority of the outstanding shares of a Fund will be required in
connection with a matter, a Fund will not be deemed to be affected by a matter
unless it is clear that the interests of each fund in the matter are identical,
or that the matter does not affect any interest of the fund. Under Rule 18f-2,
the approval of an investment advisory agreement or any change in investment
policy would be effectively acted upon with respect to a fund only if approved
by a majority of the outstanding shares of such fund. However, Rule 18f-2 also
provides that the ratification of independent public accountants, the approval
of principal underwriting contracts, and the election of Trustees may be
effectively acted upon by shareholders of the Trust voting without regard to
series.
SHAREHOLDER AND TRUSTEE LIABILITY.
The Delaware Business Trust Act provides that a shareholder of a Delaware
business trust shall be entitled to the same limitation of personal liability
extended to shareholders of Delaware corporations, and the Delaware Trust
Instrument provides that shareholders of the Trust shall not be liable for the
obligations of the Trust. The Delaware Trust Instrument also provides for
indemnification out of the trust property of any shareholder held personally
liable solely by reason of his or her being or having been a shareholder. The
Delaware Trust Instrument also provides that the Trust shall, upon request,
assume the defense of any claim made against any shareholder for any act or
obligation of the Trust, and shall satisfy any judgment thereon. Thus, the risk
of a shareholder incurring financial loss on account of shareholder liability is
considered to be extremely remote.
The Delaware Trust Instrument states further that no Trustee, officer, or agent
of the Trust shall be personally liable in connection with the administration or
preservation of the assets of a Fund or the conduct of the Trust's business; nor
shall any Trustee, officer, or agent be personally liable to any person for any
action or failure to act except for his own bad faith, willful misfeasance,
gross negligence, or
30
<PAGE>
reckless disregard of his duties. The Declaration of Trust also provides that
all persons having any claim against the Trustees or the Trust shall look solely
to the assets of the Trust for payment.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES.
As of June 20, 1997, the following persons held of record 5% or more of the
outstanding shares of the Funds. Financial Services Fund: FMT Co. Custodian IRA
Rollover Account (for the benefit of its customers), 64 Eisenhower Drive,
Middletown, N.Y. 10940 owned 60,698 shares (6.3%); Endeavour Capital Partners
LP, 555 Madison Avenue, New York, N.Y. 10022 owned 75,301 shares (7.8%); and
Charles Schwab & Co. (for the benefit of its customers), 101 Montgomery Street,
San Francisco, Ca. 94104 owned 100,865 shares (10.4%). Small Cap Financial
Fund: The Northern Trust Co. (for the benefit of its customers), P.O. Box
92956, Chicago, Ill. 60675 owned 43,087 shares (6.0%); FMT Co. Custodian IRA
Rollover Account (for the benefit of its customers), 64 Eisenhower Drive,
Middletown, N.Y. 10940 owned 60,863 shares (8.4%); and Charter Michigan Bancorp
Inc., 13606 Michigan Avenue, Dearborn, MI 48126 owned 39,463 shares (5.5%).
Growth/Value Fund: Bear Stearns Securities Corp., 1 Metrotech Center North,
Brooklyn, N.Y. 11201 owned 24,310 shares (13.3%); and Charles Schwab & Co., Inc.
(for the benefit of its customers), 101 Montgomery Street, San Francisco, Ca.
94104 owned 18,645 shares (10.2%).
MISCELLANEOUS.
As used in the Prospectus and in this Statement of Additional Information,
"assets belonging to a fund" means the consideration received by the Trust upon
the issuance or sale of shares of a fund, together with all income, earnings,
profits, and proceeds derived from the investment thereof, including any
proceeds from the sale, exchange, or liquidation of such investments, and any
funds or payments derived from any reinvestment of such proceeds and any general
assets of the Trust, which general liabilities and expenses are not readily
identified as belonging to a particular fund that are allocated to that fund by
the Trustees. The Trustees may allocate such general assets in any manner they
deem fair and equitable. It is anticipated that the factor that will be used by
the Trustees in making allocations of general assets to a particular fund of the
Trust will be the relative net asset value of each respective fund at the time
of allocation. Assets belonging to a particular fund are charged with the
direct liabilities and expenses in respect of that fund, and with a share of the
general liabilities and expenses of each of the funds not readily identified as
belonging to a particular fund, which are allocated to each fund in accordance
with its proportionate share of the net asset values of the Trust at the time of
allocation. The timing of allocations of general assets and general liabilities
and expenses of the Trust to a particular fund will be determined by the
Trustees and will be in accordance with generally accepted accounting
principles. Determinations by the Trustees as to the timing of the allocation
of general liabilities and expenses and as to the timing and allocable portion
of any general assets with respect to a particular fund are conclusive.
As used in the Prospectus and in this Statement of Additional Information, a
"vote of a majority of the outstanding shares" of a Fund means the affirmative
vote of the lesser of (a) 67% or more of the shares of the Fund present at a
meeting at which the holders of more than 50% of the outstanding shares of the
Fund are represented in person or by proxy, or (b) more than 50% of the
outstanding shares of the Fund.
The Trust is registered with the Commission as an open-end management investment
company. Such registration does not involve supervision by the Commission of
the management or policies of the Trust.
The Prospectus and this Statement of Additional Information omit certain of the
information contained in the Registration Statement filed with the Commission.
Copies of such information may be obtained from the Commission upon payment of
the prescribed fee.
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<PAGE>
THE PROSPECTUS AND THIS STATEMENT OF ADDITIONAL INFORMATION ARE NOT AN OFFERING
OF THE SECURITIES HEREIN DESCRIBED IN ANY STATE IN WHICH SUCH OFFERING MAY NOT
LAWFULLY BE MADE. NO SALESMAN, DEALER, OR OTHER PERSON IS AUTHORIZED TO GIVE
ANY INFORMATION OR MAKE ANY REPRESENTATION OTHER THAN THOSE CONTAINED IN THE
PROSPECTUS AND THIS STATEMENT OF ADDITIONAL INFORMATION.
32
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APPENDIX A
DESCRIPTION OF SECURITY RATINGS.
The nationally recognized statistical rating organizations (individually, an
"NRSRO") that may be utilized by the Adviser with regard to portfolio
investments for the Fund include Moody's Investors Service, Inc. ("Moody's"),
Standard & Poor's Corporation ("S&P"), Duff & Phelps, Inc. ("Duff"), Fitch
Investors Service, Inc. ("Fitch"), IBCA Limited and its affiliate, IBCA Inc.
(collectively, "IBCA"), and Thompson BankWatch, Inc. ("Thompson"). Set forth
below is a description of the relevant ratings of each such NRSRO. The NRSROs
that may be utilized by the Adviser and the description of each NRSRO's ratings
is as of the date of this Statement of Additional Information, and may
subsequently change.
LONG-TERM DEBT RATINGS (may be assigned, for example, to corporate and municipal
bonds).
Description of the five highest long-term debt ratings by Moody's (Moody's
applies numerical modifiers (E.G., 1, 2, and 3) in each rating category to
indicate the security's ranking within the category):
Aaa. Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
Aa. Bonds which are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high grade
bonds. They are rated lower than the best bonds because margins of protection
may not be as large as in Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other elements present which make
the long-term risk appear somewhat larger than in Aaa securities.
A. Bonds which are rated A possess many favorable investment attributes and are
to be considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment some time in the future.
Baa. Bonds which are rated Baa are considered as medium grade obligations,
I.E., they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba. Bonds which are rated Ba are judged to have speculative elements, I.E.,
their future cannot be considered as well assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded during both good and bad times in the future. Uncertainty of
position characterizes bonds in this class.
Description of the five highest long-term debt ratings by S&P (S&P may apply a
plus (+) or minus (-) to a particular rating classification to show relative
standing within that classification):
AAA. Debt rated AAA has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.
A-1
<PAGE>
AA. Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the higher rated issues only in small degree.
A. Debt rated A has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB. Debt rated BBB is regarded as having an adequate capacity to pay interest
and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
BB. Debt rated BB is regarded, on balance, as predominately speculative with
respect to capacity to pay interest and repay principal in accordance with the
terms of the obligation. While such debt will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or major
risk exposure to adverse conditions.
Description of the three highest long-term debt ratings by Duff:
AAA. Highest credit quality. The risk factors are negligible being only
slightly more than for risk-free U.S. Treasury debt.
AA+, AA, AA-. High credit quality protection factors are strong Risk is
modest but may vary slightly from time to time because of economic
conditions.
A+, A, A-. Protection factors are average but adequate. However, risk
factors are more variable and greater in periods of economic stress.
Description of the three highest long-term debt ratings by Fitch (plus or minus
signs are used with a rating symbol to indicate the relative position of the
credit within the rating category):
AAA. Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest
and repay principal, which is unlikely to be affected by reasonably
foreseeable events.
AA. Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong, although not quite as strong as bonds rated "AAA." Because bonds
rated in the "AAA" and "AA" categories are not significantly vulnerable to
foreseeable future developments, short-term debt of these issues is
generally rated "[-]+."
A. Bonds considered to be investment grade and of high credit quality.
The obligor's ability to pay interest and repay principal is considered to
be strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
IBCA's description of its three highest long-term debt ratings:
AAA. Obligations for which there is the lowest expectation of investment
risk. Capacity for timely repayment of principal and interest is
substantial. Adverse changes in business, economic or financial conditions
are unlikely to increase investment risk significantly.
A-2
<PAGE>
AA. Obligations for which there is a very low expectation of investment
risk. Capacity for timely repayment of principal and interest is
substantial. Adverse changes in business, economic, or financial
conditions may increase investment risk albeit not very significantly.
A. Obligations for which there is a low expectation of investment risk.
Capacity for timely repayment of principal and interest is strong, although
adverse changes in business, economic or financial conditions may lead to
increased investment risk.
SHORT-TERM DEBT RATINGS (may be assigned, for example, to commercial paper,
master demand notes, bank instruments, and letters of credit)
Moody's description of its three highest short-term debt ratings:
Prime-1. Issuers rated Prime-1 (or supporting institutions) have a superior
capacity for repayment of senior short-term promissory obligations. Prime-1
repayment capacity will normally be evidenced by many of the following
characteristics:
- Leading market positions in well-established industries.
- High rates of return on funds employed.
- Conservative capitalization structures with moderate reliance on debt
and ample asset protection.
- Broad margins in earnings coverage of fixed financial charges and high
internal cash generation.
- Well-established access to a range of financial markets and assured
sources of alternate liquidity.
Prime-2. Issuers rated Prime-2 (or supporting institutions) have a strong
capacity for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above but to a lesser
degree. Earnings trends and coverage ratios, while sound, may be more subject
to variation. Capitalization characteristics, while still appropriate, may be
more affected by external conditions. Ample alternate liquidity is maintained.
Prime-3. Issuers rated Prime-3 (or supporting institutions) have an acceptable
ability for repayment of senior short-term obligations. The effect of industry
characteristics and market compositions may be more pronounced. Variability in
earnings and profitability may result in changes in the level of debt protection
measurements and may require relatively high financial leverage. Adequate
alternate liquidity is maintained.
S&P's description of its three highest short-term debt ratings:
A-1. This designation indicates that the degree of safety regarding timely
payment is strong. Those issues determined to have extremely strong safety
characteristics are denoted with a plus sign (+).
A-2. Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated "A-1."
A-3
<PAGE>
A-3. Issues carrying this designation have adequate capacity for timely
payment. They are, however, more vulnerable to the adverse effects of
changes in circumstances than obligations carrying the higher designations.
Duff's description of its five highest short-term debt ratings (Duff
incorporates gradations of "1+" (one plus) and "1-" (one minus) to assist
investors in recognizing quality differences within the highest rating
category):
Duff 1+. Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to alternative sources
of funds, is outstanding, and safety is just below risk-free U.S. Treasury
short-term obligations.
Duff 1. Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection factors. Risk
factors are minor.
Duff 1-. High certainty of timely payment. Liquidity factors are strong
and supported by good fundamental protection factors. Risk factors are
very small.
Duff 2. Good certainty of timely payment. Liquidity factors and company
fundamentals are sound. Although ongoing funding needs may enlarge total
financing requirements, access to capital markets is good. Risk factors
are small.
Duff 3. Satisfactory liquidity and other protection factors qualify issue
as to investment grade.
Risk factors are larger and subject to more variation. Nevertheless, timely
payment is expected.
Fitch's description of its four highest short-term debt ratings:
F-1+. Exceptionally Strong Credit Quality. Issues assigned this rating
are regarded as having the strongest degree of assurance for timely
payment.
F-1. Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated
F-1+.
F-2. Good Credit Quality. Issues assigned this rating have a satisfactory
degree of assurance for timely payment, but the margin of safety is not as
great as for issues assigned F-1+ or F-1 ratings.
F-3. Fair Credit Quality. Issues assigned this rating have
characteristics suggesting that the degree of assurance for timely payment
is adequate, however, near-term adverse changes could cause these
securities to be rated below investment grade.
IBCA's description of its three highest short-term debt ratings:
A+. Obligations supported by the highest capacity for timely repayment.
A1. Obligations supported by a very strong capacity for timely repayment.
A2. Obligations supported by a strong capacity for timely repayment,
although such capacity may be susceptible to adverse changes in business,
economic or financial conditions.
A-4
<PAGE>
SHORT-TERM DEBT RATINGS. Thompson BankWatch, Inc. ("TBW") ratings are based
upon a qualitative and quantitative analysis of all segments of the organization
including, where applicable, holding company and operating subsidiaries.
TBW Ratings do not constitute a recommendation to buy or sell securities of any
of these companies. Further, TBW does not suggest specific investment criteria
for individual clients. The TBW Short-Term Ratings apply to commercial paper,
other senior short-term obligations and deposit obligations of the entities to
which the rating has been assigned. The TBW Short-Term Ratings apply only to
unsecured instruments that have a maturity of one year or less. The TBW
Short-Term Ratings specifically assess the likelihood of an untimely payment of
principal or interest.
TBW-1. The highest category; indicates a very high degree of likelihood that
principal and interest will be paid on a timely basis.
TBW-2. The second highest category; while the degree of safety regarding timely
repayment of principal and interest is strong, the relative degree of safety is
not as high as for issues rated "TBW-1."
TBW-3. The lowest investment grade category; indicates that while more
susceptible to adverse developments (both internal and external) than
obligations with higher ratings, capacity to service principal and interest in a
timely fashion is considered adequate.
TBW-4. The lowest rating category; this rating is regarded as non-investment
grade and, therefore, speculative.
DEFINITIONS OF CERTAIN MONEY MARKET INSTRUMENTS.
Commercial Paper. Commercial paper consists of unsecured promissory notes
issued by corporations. Issues of commercial paper normally have maturities of
less than nine months and fixed rates of return.
Certificates of Deposit. Certificates of Deposit are negotiable certificates
issued against funds deposited in a commercial bank or a savings and loan
association for a definite period of time and earning a specified return.
Bankers' Acceptances. Bankers' acceptances are negotiable drafts or bills of
exchange, normally drawn by an importer or exporter to pay for specific
merchandise, which are "accepted" by a bank, meaning, in effect, that the bank
unconditionally agrees to pay the face value of the instrument on maturity.
U.S. Treasury Obligations. U.S. Treasury Obligations are obligations issued or
guaranteed as to payment of principal and interest by the full faith and credit
of the U.S. Government. These obligations may include Treasury bills, notes and
bonds, and issues of agencies and instrumentalities of the U.S. Government,
provided such obligations are guaranteed as to payment of principal and interest
by the full faith and credit of the U.S. Government.
U.S. Government Agency and Instrumentality Obligations. Obligations issued by
agencies and instrumentalities of the U.S. Government include such agencies and
instrumentalities as the Government National Mortgage Association, the
Export-Import Bank of the United States, the Tennessee Valley Authority, the
Farmers Home Administration, the Federal Home Loan Banks, the Federal
Intermediate Credit Banks, the Federal Farm Credit Banks, the Federal Land
Banks, the Federal Housing Administration, the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation, and the Student Loan
Marketing Association. Some of these obligations, such as those of the
A-5
<PAGE>
Government National Mortgage Association are supported by the full faith and
credit of the U.S. Treasury; others, such as those of the Export-Import Bank of
the United States, are supported by the right of the issuer to borrow from the
Treasury; others, such as those of the Federal National Mortgage Association,
are supported by the discretionary authority of the U.S. Government to purchase
the agency's obligations; still others, such as those of the Student Loan
Marketing Association, are supported only by the credit of the instrumentality.
No assurance can be given that the U.S. Government would provide financial
support to U.S. Government-sponsored instrumentalities if it is not obligated to
do so by law. A Fund will invest in the obligations of such instrumentalities
only when the investment adviser believes that the credit risk with respect to
the instrumentality is minimal.
A-6
<PAGE>
FINANCIAL STATEMENTS
The financial statements (unaudited) contained in the Funds' semi-annual
report to shareholders dated April 30, 1997 are incorporated herein by
reference.
STATEMENT OF ASSETS AND LIABILITIES
December 16, 1996
<TABLE>
<CAPTION>
FBR Financial FBR Small Cap FBR Small Cap
Assets: Services Fund Financial Fund Growth/Value Fund
- ------- ------------- -------------- -----------------
<S> <C> <C> <C>
Cash in Bank . . . . . . . . . . . . . . . . . . . . . . . . . $ 33,333 $ 33,333 $ 33,334
Deferred organization expenses (Note 3). . . . . . . . . . . . 71,667 71,667 71,666
------------- -------------- -----------------
Total Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000 105,000 105,000
------------- -------------- -----------------
Liabilities --Organization expenses payable 71,667 71,667 71,666
------------- -------------- -----------------
Net Assets (as to each Fund, equivalent to $12.00 per share on $ 33,333 $ 33,333 $ 33,334
2,778 units of beneficial interest (no par value) outstanding ------------- -------------- -----------------
with an indefinite number of authorized shares of beneficial ------------- -------------- -----------------
interest) (Notes 1 and 2) . . . . . . . . . . . . . . . . . . .
Net Asset Value and Redemption Price $ 12.00 $ 12.00 $ 12.00
per share of beneficial interest (Note 4) . . . . . . . . . . . . . ------------- -------------- -----------------
------------- -------------- -----------------
</TABLE>
- -------------------------
(1) The FBR Family of Funds (the "Trust") is a registered open-end management
investment company organized under the laws of Delaware on April 30, 1996.
The Trust currently has four separate portfolios registered under the
Investment Company Act of 1940, as amended, of which the three portfolios
indicated above are expected to commence operations on or about January 2,
1997. To date, the Trust has not had any transactions other than those
relating to organizational matters and the sale of 2,778 shares of
beneficial interest each in FBR Financial Services Fund, FBR Small Cap
Financial Fund and FBR Small Cap Growth/Value Fund (collectively, the
"Funds") to Friedman, Billings, Ramsey and Co., Inc. (the "Distributor").
(2) FBR Fund Advisers, Inc. will serve as investment adviser (the "Adviser") to
the Funds. The Adviser, an affiliate of Friedman, Billings, Ramsey & Co.,
Inc., is entitled to receive annual advisory fees, which are paid monthly,
of 0.90% of the average daily net assets of each of the Funds. The Adviser
may periodically waive all or a portion of its advisory fee with respect to
the Funds.
The Trust has entered into a Distribution Agreement with the Distributor on
behalf of each of the Funds. Certain officers and/or Trustees of the Fund
are officers and/or directors of the Distributor.
(3) Deferred organization expenses will be amortized over a period from the
date each of the Funds commence operations not exceeding sixty months. In
the event that the Funds' initial shareholder or any transferee of the
Funds' initial shareholder redeems any of its original shares prior to the
end of the sixty month period, the proceeds of the redemption payable in
respect of such shares shall be reduced by the pro rata share (based on the
proportionate share of original shares outstanding at the time of
redemption) of the unamortized deferred organization expenses as of the
date of such redemption. In the event that the Funds are liquidated prior
to the end of the sixty month period, the Funds' initial shareholder or the
transferee of the Funds' initial shareholder shall bear the unamortized
deferred organization expenses.
(4) Shares held 90 days or less may be subject to a 1.00% redemption fee
(expressed as a percentage of redemption amount).
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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Trustees of
The FBR Family of Funds:
We have audited the accompanying statements of assets and liabilities of the FBR
Financial Services Fund, the FBR Small Cap Financial Fund, and the FBR Small Cap
Growth/Value Fund each of which is a series of The FBR Family of Funds (a
Delaware business trust, the "Trust") as of December 16, 1996. These financial
statements are the responsibility of the Trust's management. Our responsibility
is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform an 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 presentation. We believe
that our audit provides a reasonable basis for our opinion.
In our opinion, the statements of assets and liabilities referred to above
present fairly, in all material respects, the financial position of the FBR
Financial Services Fund, the FBR Small Cap Financial Fund, and the FBR Small Cap
Growth/Value Fund as of December 16, 1996, in conformity with generally accepted
accounting principles.
/s/Arthur Andersen LLP
Washington, D. C.
December 17, 1996
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