Somerset Exchange Fund
Annual Report
December 31, 1996
DEAR SHAREHOLDER
Somerset Exchange Fund, which closed on July 11, 1996, is comprised
of three main elements: the underlying equity portfolio of stocks
tendered by shareholders; positions in two privately placed
preferred stocks; and the loans which were used primarily to finance
the purchase of the preferred stocks and to meet the initial
expenses of the Fund. The equity portfolio, valued at $75.5 million
at the time of closing, is broadly diversified with 105 stocks
comprising 52 industries and 10 economic sectors. Compared with the
Standard & Poor's 500 Composite Index, the portfolio is moderately
underweighted in the energy and banking groups and has its largest
overweighting in health care. The portfolio's three largest equity
holdings at closing were UST, Inc., Medpartners/Mullikin, Inc. and
Watson Pharmaceuticals, Inc. In addition to the equity portfolio,
the Fund established positions in two preferred stocks: 476,786
shares of Banesto Holdings Corp. (10.50%, Series A), with a current
yield at closing of 8.89%, were purchased at a cost of $14.1
million, and 379,000 shares of Indosuez Holdings, S.C.A. (10.375%,
Series A), with a current yield at closing of 9.41%, were purchased
at a cost of $10.4 million. The preferred stocks represented 23.7%
of the Fund's net assets at the time of closing, and were expected
to generate approximately $558,650 in quarterly income.
<PAGE>
In order to finance the purchase of the preferred stocks and to meet
its start-up costs, a total of $28 million was borrowed from Merrill
Lynch International Bank Limited comprised of $25 million on a
3-month revolving facility and $3 million on a 1-year revolving
facility, both to be reset at 0.60% above their respective LIBOR
rates at each reset date. Since the preferred stocks pay fixed
quarterly dividends, we determined that it would be appropriate to
hedge the potential risk to the Fund of rising interest rates. This
was accomplished by entering into a "fixed rate for floating rate"
swap agreement with Goldman Sachs Financial Products U.S., L.P.,
whereby the Fund pays a fixed quarterly amount and receives a
floating rate amount based upon the prevailing 3-month LIBOR rate at
each reset date. The swap agreements entered into by the Fund were
effective as of July 15, 1996, and have a termination date of
July 15, 2001.
The closing of Somerset Exchange Fund coincided with the early
stages of a fairly significant correction in the US equity market,
as measured by Standard & Poor's 500 Composite Index, which declined
by 5.3% from July 1, 1996 to July 31, 1996. Beginning on August 1,
1996, however, the Fund (as well as the overall stock market) began
a significant rise which carried it to new highs by the early part
of October. The market remained relatively stable throughout
October, but regained its momentum in November, as the S&P 500 Index
posted a gain of +7.3% for the month. Heightened levels of
volatility affected the equity market late in the year, with the S&P
500 Index declining by -2.2% for the month of December.
Since the Fund's inception, 20 of the equity securities were
categorized as restricted, which requires the price of each security
to be discounted when computing the net asset value of the Fund. On
December 19, 1996, an additional eight equity positions were
reclassified as restricted securities. On December 31, 1996, the
combined value of restricted equity securities of $25.65 million was
equal to 32.3% of the Fund's net assets. The discount applied to
each security is usually between 5% and 25% of its market price. The
discounting formula provides for a gradual elimination of the
discount during the 24 months following the closing. The procedure
used to calculate each restricted security's discount includes
consideration of the following three factors: time remaining under
restriction; volatility of the stock, as compared to the overall
market, as measured by its beta coefficient; and size of the
position compared to the average daily volume of the stock. As a
result of this discounting process, the Fund's net asset value is
calculated two ways--with and without the discount. The Fund closed
on July 11, 1996 using valuations of contributed securities as of
the close of trading on July 10, 1996. Therefore, for purposes of
presenting performance data, the Fund uses a valuation as of July
10, 1996, the day prior to its commencement of operations. The
<PAGE>
discount applied on July 10 to take into account the lack of
liquidity of restricted securities is identical to that used on July
11. This is because the discount applied on July 11 was already
based upon the maximum potential remaining period for restricted
securities of two years. On July 10, 1996, the Fund's non-discounted
net asset value per share would have been $503.02 prior to the
deduction of offering costs and $500.00 after deduction of offering
costs. The fully discounted net asset value per share would have
been $470.12. On December 31, 1996, the Fund's discounted net asset
value was $516.04 per share; the net asset value with no discount
applied was $540.03 per share. On a non-discounted basis, the Fund's
net asset value had risen by +8.01% between July 10, 1996 and
December 31, 1996, and on a fully discounted basis by +9.77%. This
difference is explained primarily by the gradual reduction of the
time remaining in the discount periods for restricted securities.
For the period, the Fund's discounted net asset value of $516.04 has
risen 3.21% from the non-discounted net asset value of $500.00. From
July 10, 1996 through year-end, the Standard &Poor's 500 Composite
Index had advanced by 12.9% and the Standard & Poor's MidCap 400
Index had risen by +11.6%. Part of the Fund's underperformance was
attributable to the significant outperformance of large-capitalization
stocks combined with the Fund's relative overweighting in smaller-
capitalization issues. The rest is largely a function of the
performance of several of the highly weighted groups in the Fund
which had suffered significant setbacks since the Fund's inception,
including the health care, hospitals, gaming and tobacco groups.
As of December 31, 1996, the equity portfolio was valued at
$81,024,986, after discounting restricted stocks.
Between July 10, 1996 and year-end, advancing stocks in the Fund had
outnumbered declining issues by two-to-one. During this period, the
best performing stocks were Intel Corporation, 3Com Corp.,
International Business Machines Corp., COMPAQ Computer Corp.,
AFCCable Systems, Inc., and Genrad, Inc., all posting gains of 50%
or more. The worst performing stocks in the Fund were Cerplex Group,
Inc., Sunglass Hut International, Inc., Community Care of America,
Inc., Exogen, Inc., HEARx, Ltd., and Regis Corp. These had all
declined by 50% or more between July 10 and year-end. Among the best
performing industry groups through year-end 1996 were banking,
chemicals, communications equipment, computers-networking and
electronics. Those groups displaying the greatest negative returns
were gaming stocks, the entire health care sector (including
hospital management, long-term care, medical products and
specialized services), and specialty retailers.
<PAGE>
The Fund acquired several new positions as a result of spin-offs of
existing holdings since the closing date. These included 286 shares
of Imation Corp., a spin-off from Minnesota Mining & Manufacturing
Co., and 2,657 shares of Lucent Technologies, Inc. which was spun-
off from AT&T Corp. In addition, one of the Fund's holdings was
recently acquired by another company. This takeover was accomplished
via a stock swap, whereby an existing position in the Fund was
replaced by shares of the acquiring company. The Fund's position of
20,000 shares of Career Horizon's Inc. was replaced by 30,600 shares
of AccuStaff, Inc. in a 1.53-for-1 share stock swap. This
acquisition was completed on November 14, 1996. No equity trades of
any type were made by the Fund to date.
In Conclusion
Since its inception, the Fund has been quite successful in
diversifying the investment risk of its shareholders as evidenced by
the stability of its net asset value relative to the substantial
fluctuations in the market values of the Fund's underlying
securities.
We thank you for your continued investment in Somerset Exchange
Fund, and we look forward to reviewing our outlook and strategy with
you again in our next report to shareholders.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President
(Eric S. Mitofsky)
Eric S. Mitofsky
Vice President and Portfolio Manager
February 21, 1997
<PAGE>
THE BENEFITS AND RISKS OF LEVERAGING
Somerset Exchange Fund utilizes leverage through borrowings.
Investing borrowed money creates an opportunity for the Fund to be
more broadly invested and to earn higher investment returns.
However, investing borrowed money is a speculative technique that
creates risks, including the likelihood of greater net asset value
volatility. Interest rate fluctuations could negatively impact the
Fund's net asset value. In addition, if the income derived from
securities purchased with assets received from the borrowings is not
sufficient to cover the cost of leverage, the Fund's net income will
be less than if leverage had not been used. As prescribed by the
Investment Company Act of 1940, the Fund has specified asset
coverages of at least 300% with respect to any borrowing immediately
following any such borrowing. Loan agreements may contain other
requirements which could limit distributions or require the Fund to
dispose of portfolio investments on unfavorable terms if market
fluctuations or other factors reduce the required asset coverage to
less than the prescribed amount. In the event of a default, the
lender could elect to foreclose on any assets pledged as collateral
without regard to the tax or other consequences of such action on
either any shareholder who contributed a particular security or on
shareholders generally.
<TABLE>
SCHEDULE OF INVESTMENTS
<CAPTION>
Common Stock Shares Value
Sectors Industries Investments Held (Note 1a)
<S> <S> <S> <C> <C>
Basic Materials Aluminum ++MAXXAM Group, Inc. 64,000 $ 3,048,000
Chemicals duPont (E.I.) de Nemours & Co. 20,000 1,887,500
Chemicals--Diverse ++Airgas, Inc. 24,000 528,000
Paper & Forest Products Longview Fibre Co. 29,140 535,448
Capital Goods Electrical Equipment ++AFC Cable Systems, Inc. (a) 20,000 424,478
General Electric Co. 13,971 1,381,383
Honeywell, Inc. 5,715 375,761
Engineering & ++Jacobs Engineering Group, Inc. (a) 77,250 1,575,035
Construction
<PAGE>
Manufacturing Dover Corp. 6,900 346,725
Pollution Control World Fuel Services Corp. (a) 46,000 895,013
Consumer Cyclicals Auto Parts Bandag, Inc. (Class A) 6,200 283,650
Entertainment ++Pinnacle Systems, Inc. 60,000 630,000
Walt Disney Company (The) 29,000 2,019,125
Hotel/Motel ++Harrah's Entertainment, Inc. (a) 40,000 686,704
Household Furniture Bassett Furniture Industries, Inc. 12,000 294,000
& Appliances Leggett & Platt, Inc. 43,000 1,488,875
Leisure Time ++Grand Casinos, Inc. (a) 61,300 724,290
Office Equipment Alco Standard Corp. 10,000 516,250
& Supplies
Publishing--Newspaper Times Mirror Co. 11,330 563,668
Restaurants Bob Evans Farms, Inc. 50,000 675,000
++Boston Chicken, Inc. 30,000 1,076,250
Darden Restaurants, Inc. 18,605 162,794
McDonald's Corp. 4,255 192,539
Rainforest Cafe, Inc. (a) 15,000 295,097
Retail--General Casey's General Stores, Inc. (a) 15,000 261,393
Merchandise
Retail--Specialty Amplicon, Inc. 62,500 1,234,375
++Office Depot, Inc. 48,000 852,000
Regis Corp. 20,000 325,000
++Sunglass Hut International, Inc. (a) 12,000 77,102
Specialized Services AccuStaff, Inc. 30,600 646,425
Catalina Marketing Corporation 23,000 1,267,875
Service Corporation International (a) 12,000 308,285
Servicemaster L.P. 36,675 958,134
Textiles--Apparel Russell Corp. 19,900 592,025
Manufacturing St. John Knits, Inc. (a) 59,954 2,292,533
Consumer Staples Beverages--Soft Drink Coca-Cola Co. 13,800 726,225
PanAmerican Beverages, Inc. (Class A) 14,000 656,250
<PAGE>
Foods Archer-Daniels-Midland Co. 10,884 239,448
General Mills, Inc. 4,000 253,500
Heinz (H.J.) Co. 16,200 579,150
Ralston Purina Co. 6,000 440,250
Household Products Procter & Gamble Co. 11,081 1,191,207
Retail--Food Chains Albertson's, Inc. 7,500 267,187
++Safeway, Inc. 12,000 513,000
Smart & Final, Inc. (a) 60,000 1,157,382
Tobacco Philip Morris Companies, Inc. 13,671 1,539,696
UST, Inc. 100,000 3,237,500
Energy Oil--International Exxon Corp. 16,500 1,617,000
</TABLE>
<TABLE>
SCHEDULE OF INVESTMENTS (continued)
<CAPTION>
Common Stock Shares Value
Sectors Industries Investments Held (Note 1a)
<S> <S> <S> <C> <C>
Healthcare Healthcare-- Abbott Laboratories 37,685 $ 1,912,514
Diversified Johnson & Johnson Co. 19,600 975,100
Warner-Lambert Co. 5,500 412,500
Healthcare--Drugs Pfizer, Inc. 10,200 845,325
++Watson Pharmaceuticals, Inc. (a) 100,000 3,758,170
Healthcare--HMOs ++Medpartners/Mullikin, Inc. 13,600 285,600
++Medpartners/Mullikin, Inc. (a) 161,400 3,028,558
++Mid Atlantic Medical Services, Inc. 21,240 284,085
Healthcare-- ++Apria Healthcare Group, Inc. (a) 39,060 627,581
Miscellaneous ++Community Care of America, Inc. (a) 35,000 120,851
++Exogen, Inc. (a) 35,000 97,681
++HEALTHSOUTH Corporation (a) 28,000 908,684
++HEARx, Ltd. (a) 60,000 134,562
++Horizon/CMS Healthcare Corp. (a) 68,451 737,902
++OccuSystems, Inc. (a) 36,145 825,104
Hospital Management ++Tenet Healthcare Corp. 25,000 546,875
Medical Products ++Saint Jude Medical, Inc. (a) 50,000 1,907,605
<PAGE>
Interest Rate Banks--Money Center Chase Manhattan Corp. 5,000 446,250
Sensitive
Banks--Regional First Union Corporation 4,200 310,800
Northern Trust Corp. 18,900 685,125
PNC Bank Corp. 18,860 709,607
Wells Fargo & Company 2,100 566,475
Financial-- First USA, Inc. 29,982 1,038,127
Miscellaneous Forest City Enterprises, Inc. 22,000 1,331,000
Mercury Finance Company 37,000 453,250
Student Loan Marketing Association 4,110 382,744
Insurance--Brokers Marsh & McLennan Companies, Inc. 4,400 457,600
Insurance--Life John Alden Financial Corporation 11,536 213,416
Insurance--Multiline American International Group, Inc. 5,015 542,874
Insurance--Property Commerce Group, Inc. (a) 50,000 1,111,715
Savings & Loan Ahmanson (H.F) & Co. 50,400 1,638,000
CCB Financial Corp. 6,643 453,385
Miscellaneous Miscellaneous ++Imation Corp. 286 8,044
Minnesota Mining & Manufacturing Co. 2,860 237,022
Technology Communications-- ++MFS Communications Co., Inc. 9,176 500,092
Equipment
Computer Software ++Informix, Corp. 13,273 270,437
++Parametric Technology Company 7,000 359,625
++SunGard Data Systems, Inc. 8,100 319,950
Computer Systems ++3Com Corp. (a) 6,000 405,315
++COMPAQ Computer Corp. 6,300 467,775
++Cerplex Group, Inc. (a) 50,000 49,100
Hewlett-Packard Co. 16,000 804,000
International Business Machines Corp. 6,500 981,500
++Stratus Computer, Inc. (a) 10,000 224,984
Electronics-- ++Genrad, Inc. 25,000 581,250
Instruments
Electronics-- Intel Corporation 4,000 523,750
Semiconductors Motorola, Inc. (a) 31,500 1,790,224
++Solectron Corp. 9,750 520,406
Telecommunications AT&T Corp. 8,200 356,700
Lucent Technologies, Inc. 2,657 122,886
<PAGE>
Transportation Truckers ++Anuhco, Inc. (a) 34,221 240,184
Caliber Systems, Inc. 8,600 165,550
</TABLE>
<TABLE>
SCHEDULE OF INVESTMENTS (concluded)
<CAPTION>
Common Stock Shares Value
Sectors Industries Investments Held (Note 1a)
<S> <S> <S> <C> <C>
Utilities Electric Utilities Citizens Utilities Company (Class A) 25,806 $ 280,645
Telephone ALLTEL Corp. (a) 35,000 987,080
++C-TEC Corp. (Class B) 35,000 831,250
Telephone & Data Systems, Inc. 11,300 409,625
Preferred Stock Banks--Foreign Banesto Holdings Corp.
(10.50%, Series A) (ADR)*(a) 476,786 14,422,776
Indosuez Holdings, S.C.A.
(10.375%, Series A) (ADR)*(a) 379,000 10,422,500
Face
Amount
Short-Term Commercial Paper** General Motors Acceptance Corp.,
Investments 7.50% due 1/02/1997 1,939,000 1,938,192
Investments, at Value 107,808,454
Interest Rate Swaps (664,536)
Liabilities in Excess of Other Assets (27,828,820)
------------
Net Assets $ 79,315,098
============
<FN>
++Non-income producing security.
*American Depositary Receipts (ADR).
**Commercial Paper is traded on a discount basis; the interest rate
shown is the discount rate paid at the time of purchase by the Fund.
(a)Restricted securities as to resale. The value of the Fund's
investment in restricted securities was approximately $50,498,000,
representing 63.7% of net assets.
<PAGE>
Value as of
Acquisition Value as of 12/31/96
Issue Date+++ 7/11/96 (Note 1a)
Common Stock
3Com Corp. 7/11/1996 $ 273,000 $ 405,315
AFC Cable Systems, Inc. 7/11/1996 325,000 424,478
ALLTELL Corp. 7/11/1996 1,041,250 987,080
Anuhco, Inc. 7/11/1996 286,601 240,184
Apria Healthcare Group, Inc. 7/11/1996 1,122,975 627,581
Casey's General Stores, Inc. 7/11/1996 281,250 261,393
Cerplex Group, Inc. 7/11/1996 343,750 49,100
Commerce Group, Inc. 7/11/1996 1,075,000 1,111,715
Community Care of America, Inc. 7/11/1996 273,438 120,851
Exogen, Inc. 7/11/1996 288,750 97,681
Grand Casinos, Inc. 7/11/1996 1,478,863 724,290
HEALTHSOUTH Corporation 7/11/1996 973,000 908,684
HEARx, Ltd. 7/11/1996 367,500 134,562
Harrah's Entertainment, Inc. 7/11/1996 945,000 686,704
Horizon/CMS Healthcare Corp. 7/11/1996 855,638 737,902
Jacobs Engineering Group, Inc. 7/11/1996 2,018,156 1,575,035
Medpartners/Mullikin, Inc. 7/11/1996 3,086,775 3,028,558
Motorola, Inc. 7/11/1996 1,823,063 1,790,224
OccuSystems, Inc. 7/11/1996 1,125,013 825,104
Rainforest Cafe, Inc. 7/11/1996 395,625 295,097
Saint Jude Medical, Inc. 7/11/1996 1,653,125 1,907,605
Service Corporation
International 7/11/1996 336,000 308,285
Smart & Final, Inc. 7/11/1996 1,507,500 1,157,382
St. John Knits, Inc. 7/11/1996 2,682,942 2,292,533
Stratus Computer, Inc. 7/11/1996 261,250 224,984
Sunglass Hut International, Inc. 7/11/1996 237,000 77,102
Watson Pharmaceuticals,Inc. 7/11/1996 3,487,500 3,758,170
World Fuel Services Corp. 7/11/1996 828,000 895,013
29,372,964 25,652,612
----------- -----------
Preferred Stock Cost
Banesto Holdings Corp.
(10.50%, Series A) (ADR) 7/11/1996 14,121,115 14,422,776
Indosuez Holdings, S.C.A.
(10.375%, Series A) (ADR) 7/11/1996 10,418,170 10,422,500
24,539,285 24,845,276
----------- -----------
Total $53,912,249 $50,497,888
=========== ===========
<PAGE>
+++For Federal income tax purposes, the date the contributing
shareholder acquired the security represents the acquisition date.
See Notes to Financial Statements.
</TABLE>
<TABLE>
STATEMENT OF ASSETS AND LIABILITIES
<CAPTION>
As of December 31, 1996
<S> <S> <C> <C>
Assets: Investments, at value (cost at closing--$104,987,645) (Note 1a) $ 107,808,454
Cash 1,345
Dividends receivable 647,185
Deferred organization expenses (Note 1e) 276,838
-------------
Total assets 108,733,822
-------------
Liabilities: Loans (Note 5) 28,000,000
Interest rate swaps, at value (Notes 1b & 3) 664,536
Payables:
Interest on loans (Note 5) $ 444,538
Investment adviser (Note 2) 117,300
Interest rate swap contracts (Notes 1b & 3) 61,241
Administrator (Note 2) 39,100
Commitment fees 1,808 663,987
-------------
Accrued expenses and other liabilities 90,201
-------------
Total liabilities 29,418,724
-------------
Net Assets: Net assets $ 79,315,098
=============
Net Assets Capital stock $ 76,850,423
Consist of: Undistributed investment income--net 308,402
Unrealized appreciation on investments--net 2,156,273
-------------
Net assets--Equivalent to $516.04 per share based on
153,701 shares of beneficial interest outstanding $ 79,315,098
=============
See Notes to Financial Statements.
</TABLE>
<PAGE>
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Period July 11, 1996++ to December 31, 1996
<S> <S> <C> <C>
Investment Dividends $ 1,607,356
Income (Note 1d): Interest and amortization of discount earned 47,634
-------------
Total income 1,654,990
-------------
Expenses: Loan interest expense (Note 5) $ 846,239
Investment advisory fees (Note 2) 214,169
Interest rate swap expense (Notes 1b & 3) 126,527
Administrative fees (Note 2) 71,390
Professional fees 37,000
Amortization of organization expenses (Note 1e) 29,158
Printing and shareholder reports 7,000
Trustees' fees and expenses 6,588
Borrowing costs (Note 5) 3,383
Pricing fees 1,000
Registration fees (Note 1e) 1,000
Other 3,134
-------------
Total expenses 1,346,588
-------------
Investment income--net 308,402
-------------
Unrealized Gain Unrealized appreciation on investments--net 2,156,273
on Investments -------------
(Notes 1b & 3): Net Increase in Net Assets Resulting from Operations $ 2,464,675
=============
<FN>
++Commencement of Operations.
See Notes to Financial Statements.
</TABLE>
<PAGE>
<TABLE>
STATEMENT OF CHANGES IN NET ASSETS
<CAPTION>
For the Period
July 11, 1996++ to
Increase (Decrease) in Net Assets: December 31, 1996
<S> <S> <C>
Operations: Investment income--net $ 308,402
Unrealized appreciation on investments--net 2,156,273
-------------
Net increase in net assets resulting from operations 2,464,675
-------------
Beneficial Investments contributed 78,510,168
Interest Cash contributions 544,000
Transactions Selling commissions and offering expenses resulting from issuance of capital stock (2,203,745)
(Note 4): -------------
Net increase in net assets derived from beneficial interest transactions 76,850,423
-------------
Net Assets: Total increase in net assets 79,315,098
Beginning of period --
End of period* $ 79,315,098
-------------
<FN>
*Undistributed investment income--net $ 308,402
=============
++Commencement of Operations.
See Notes to Financial Statements.
</TABLE>
<PAGE>
<TABLE>
STATEMENT OF CASH FLOWS
<CAPTION>
For the Period July 11, 1996++ to December 31, 1996
<S> <S> <C>
Cash Provided by Net increase in net assets resulting from operations $ 2,464,675
Operating Adjustments to reconcile net increase in net assets
Activities: resulting from operations to net cash provided by
operating activities:
Increase in receivables (647,185)
Increase in other assets (276,838)
Increase in other liabilities 754,188
Unrealized gain on investments--net (2,156,273)
Amortization of discount (47,607)
-------------
Net cash provided by operating activities 90,960
-------------
Cash Used for Purchase of long-term securities (24,539,285)
Operating: Purchases of short-term investments (223,857,585)
Activities Proceeds from sales and maturities of short-term investments 221,967,000
-------------
Net cash used for financing activities (26,429,870)
-------------
Cash Provided by Cash receipts from issuance of capital shares 544,000
Financing Selling commissions and offering expenses from issuance of
Activities: capital shares (2,203,745)
Cash receipts from borrowings 28,000,000
-------------
Net cash provided by financing activities 26,340,255
-------------
Cash: Net increase in cash 1,345
Cash at beginning of period --
-------------
Cash at end of period $ l,345
=============
Cash Flow Cash paid for interest $ 466,987
Information: =============
Non-Cash Financing Capital shares issued in exchange for securities $ 78,510,168
Activities: =============
<FN>
++Commencement of Operations.
See Notes to Financial Statements.
</TABLE>
<PAGE>
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
The following per share data and ratios have been derived
from information provided in the financial statements. For the Period
July 11, 1996++ to
Increase (Decrease) in Net Asset Value: December 31, 1996
<S> <S> <C>
Per Share Net asset value, beginning of period $ 503.02
Operating Capital charge resulting from issuance of shares (3.02)
Performance: Net asset value, beginning of period, net of capital charges 500.00
-------------
Investment income--net 2.01
Unrealized gain on investments--net (including discount for
restricted securities) 14.03
-------------
Total from investment operations 16.04
-------------
Net asset value, end of period $ 516.04
=============
Total Investment Based on net asset value per share 2.59%
Return:** Based on net asset value, net of capital charge 3.21%
=============
Ratios to Average Expenses, excluding interest expense 1.05%*
Net Assets: =============
Expenses 3.78%*
=============
Investment income-net .87%*
=============
Supplemental Data: Net assets, end of period (in thousands) $ 79,315
=============
Portfolio turnover 0.00%
=============
Leverage: Amount of borrowings, end of period (in thousands) $ 28,000
=============
Average amount of borrowings outstanding during
the period (in thousands) $ 28,000
=============
Average amount of borrowings per share during the period $ 182.17
=============
<FN>
*Annualized.
**Aggregate total investment return.
++Commencement of Operations
See Notes to Financial Statements.
</TABLE>
<PAGE>
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies:
Somerset Exchange Fund (the "Fund") is a Delaware business trust
registered under the Investment Company Act of 1940 as a
diversified, closed-end management investment company. Investments
in the Fund were made by investors contributing publicly-traded
equity securities in exchange for shares of beneficial interest in
the Fund. Shares of beneficial interest will be illiquid unless and
until shareholders vote to convert the Fund into an open-end
investment company (or, if appropriate, an interval fund, which is a
closed-end investment company which makes scheduled periodic
repurchase offers, if at that time redemptions in kind are
permissible). No present market exists for the shares of beneficial
interest and none is expected to develop. The Fund will not be
listed on an exchange or otherwise be regularly traded. No provision
will be made initially for the Fund to provide liquidity through
cash tender offers or other means that may be available to closed-
end investment companies. The following is a summary of significant
accounting policies followed by the Fund.
(a) Valuation of securities--Securities for which market quotations
are readily available and which are not restricted securities,
including listed options and futures contracts, will be valued at
their current market values in the principal market on which such
securities are normally traded. The value of equity securities that
are not restricted securities and are listed on the New York or
American Stock Exchanges or listed on the NASDAQ National Market
System shall be the closing sale prices or, lacking any closing
price, the closing bid price. Equity securities that are not
restricted securities and are not listed on the New York or American
Stock Exchanges but that are listed on any other securities exchange
shall be valued as if listed on the New York Stock Exchange,
providing the close of trading coincides. If the close of trading on
such securities exchange does not coincide with the close of trading
on the New York Stock Exchange, the value shall be based on the
latest available price data at the time of determination of net
asset value. Unlisted readily marketable equity securities that are
not restricted securities shall be valued at the bid price in the
over-the-counter market.
<PAGE>
Merrill Lynch Asset Management, L.P. ("MLAM"), subject to the
supervision of the Trustees of the Fund, will generally value
restricted securities at discounts to the fair market value of
freely tradable securities of the same class. CTC Consulting, Inc.
may assist MLAM in the valuation of restricted securities. It is
expected that such discounts, which may vary with respect to
particular securities, will range initially between 5% and 25% of
the fair market value of freely tradable securities with such
discounts diminishing until the time the restricted securities
become freely tradable.
Pursuant to procedures authorized by the Trustees of the Fund, the
preferred stock holdings will be valued at fair value as determined
by MLAM or its designee, after consideration of all relevant
factors, data and information, which may include information from
various firms with knowledge of such issues, and the prices of
comparable preferred stock issues. Unlisted options and interest
rate and equity swaps will be valued at their fair values determined
in good faith by or on behalf of the Trustees of the Fund.
(b) Derivative financial instruments--The Fund may engage in various
portfolio strategies to seek to increase its return by hedging its
portfolio against adverse movements in the debt and equity markets.
Losses may arise due to changes in the value of the contract or if
the counterparty does not perform under the contract.
* Options--The Fund is authorized to write call options and purchase
put options. When the Fund writes an option, an amount equal to the
premium received by the Fund is reflected as an asset and an
equivalent liability. The amount of the liability is subsequently
marked to market to reflect the current market value of the option
written.
When a security is purchased or sold through an exercise of an
option, the related premium paid (or received) is added to (or
deducted from) the basis of the security acquired or deducted from
(or added to) the proceeds of the security sold. When an option
expires (or the Fund enters into a closing transaction), the Fund
realizes a gain or loss on the option to the extent of the premium
received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premium paid or received). The Fund
does not expect to sell securities contributed by shareholders upon
exercise of written call options and purchased put options.
Written and purchased options are non-income producing investments.
<PAGE>
* Financial futures contracts--The Fund may purchase or sell
financial futures contracts as a hedge against adverse changes in
interest rates and the stock market. A futures contract is an
agreement between two parties to buy and sell a security,
respectively, for a set price on a future date. Upon entering into a
contract, the Fund deposits and maintains as collateral such initial
margin as required by the exchange on which the transaction is
effected. Pursuant to the contract, the Fund agrees to receive from
or pay to the broker an amount of cash equal to the daily
fluctuation in value of the contract. Such receipts or payments are
known as variation margin and are recorded by the Fund as unrealized
gains or losses. When the contract is closed, the Fund records a
realized gain or loss equal to the difference between the value of
the contract at the time it was opened and the value at the time it
was closed.
* Interest rate swaps--The Fund is authorized to enter into interest
rate swaps and purchase or sell interest rate caps and floors. In an
interest rate swap, the Fund exchanges with another party their
respective commitments to pay or receive interest on a specified
notional principal amount. The purchase of an interest rate cap (or
floor) entitles the purchaser, to the extent that a specified index
exceeds (or falls below) a predetermined interest rate, to receive
payments of interest equal to the difference between the index and
the predetermined rate on a notional principal amount from the party
selling such interest rate cap (or floor).
(c) Income taxes--The Fund will be treated as a partnership for
federal income tax purposes. As a partnership for federal income tax
purposes, the Fund will not incur federal income tax liability.
Items of partnership income, gain, loss and deduction will pass
through to the shareholders as partners in the Fund.
(d) Security transactions and investment income--Interest income
(including amortization of discount) is recognized on the accrual
basis. Dividend income is recorded on the ex-dividend date. Realized
gains and losses on security transactions are determined on the
identified cost basis.
(e) Deferred organization expenses--Deferred organization expenses
are amortized on a straight-line basis over a five-year period.
(f) Distributions--Distributions of cash from investment income may
be made at least annually in such amounts as the Trustees of the
Fund may determine. Distributions of cash from realized capital
gains may be made at least annually in years in which such gains are
realized. The Fund does not offer a dividend reinvestment plan.
<PAGE>
2. Investment Advisory Agreement and Transactions with
Affiliates:
The Fund has entered into an Investment Advisory Agreement with
MLAM. The general partner of MLAM is Princeton Services, Inc.
("PSI"), an indirect wholly-owned subsidiary of Merrill Lynch & Co.,
Inc., ("ML & Co."), which is the limited partner.
MLAM is responsible for the management of the Fund's portfolio and
provides the necessary personnel, facilities, equipment and certain
other services necessary to the operation of the Fund. For such
services, the Fund pays a quarterly fee of 0.60%, on an annual
basis, of the Fund's average weekly net assets. For this purpose,
"average weekly net assets" means the average weekly value of the
total assets of the Fund minus the sum of (i) accrued liabilities of
the Fund, and (ii) any accrued and unpaid interest on outstanding
borrowings.
The Fund has also entered into an Administration Agreement with MLAM
whereby MLAM will provide or arrange for the provision of
administrative services (other than investment advice and related
portfolio activities) necessary for the operation of the Fund. Such
services include maintaining books and records and providing or
arranging for the provision of custody and transfer agency services.
For such services, the Fund pays a quarterly fee of 0.20%, on an
annual basis, of the Fund's average weekly net assets as defined
above.
MLAM has entered into a Sub-Administration Agreement with United
States Trust Company of New York ("US Trust") whereby US Trust may
provide information and advice relating to securities valuation and
portfolio activities. For such services, MLAM will pay US Trust a
quarterly fee of 0.05%, on an annual basis, of the Fund's average
weekly net assets as defined above. US Trust will be compensated
directly by MLAM out of the administration fee at no additional cost
to the Fund.
MLAM has entered into a Shareholder Servicing Agreement with US Trust
whereby US Trust will provide or arrange for the provision of
shareholder reporting services. For such services, MLAM will pay to
US Trust a quarterly fee of 0.15%, on an annual basis, of the Fund's
average weekly net assets, as defined above, multiplied by the
percentage of such assets (excluding any assets attributable to
borrowings by the Fund) attributable to shareholders of the Fund who
purchased their shares through a US Trust affiliate. US Trust will be
compensated directly by MLAM at no additional cost to the Fund.
Certain officers and/or trustees of the Fund are officers and/or
directors of MLAM, PSI, ML & Co., or USTrust.
<PAGE>
3. Investments:
Purchases of investments, excluding short-term securities,
for the period ended December 31, 1996 was $24,539,285.
Net unrealized gains (losses) as of December 31, 1996 were as
follows:
Unrealized
Gains (Losses)
Long-term investments $2,820,809
Interest rate swaps (664,536)
----------
Total $2,156,273
==========
The Fund has entered into the following interest rate swaps as of
December 31, 1996:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 5.535% Variable* 6.89% Fixed 7/15/2001
[FN]
*3-month LIBOR at reset date.
As of December 31, 1996, net unrealized appreciation for Federal
income tax purposes aggregated $73,373,324, of which $79,566,649
related to appreciated securities and $6,193,325 related to
depreciated securities. The aggregate cost of investments at
December 31, 1996 for Federal income tax purposes was $34,435,130.
4. Beneficial Interest Transactions:
For the period ended December 31, 1996, there were 153,701
outstanding shares. At December 31, 1996, total capital amounted to
$76,850,423.
5. Short-Term Borrowings:
On July 11, 1996, the Fund entered into a loan commitment in the
amount of $35,000,000 with Merrill Lynch International Bank Limited,
an indirect wholly-owned subsidiary of ML&Co. For this commitment,
the Fund pays .10% on any unused balance. For the period ended
December 31, 1996, the amount borrowed remained constant at
$28,000,000 and the daily weighted average interest rate was 6.34%.
For the period ended December 31, 1996, facility and commitment fees
aggregated approximately $3,383.
<PAGE>
<AUDIT-REPORT>
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Somerset Exchange Fund:
We have audited the accompanying statement of assets and
liabilities, including the schedule of investments, of Somerset
Exchange Fund as of December 31, 1996, the related statements of
operations, cash flows, changes in net assets, and the financial
highlights for the period July 11, 1996 (commencement of operations)
to December 31, 1996. These financial statements and the financial
highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial
statements and the financial highlights based on our audit.
We conducted our audit in accordance with generally accepted
auditing standards. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial
statements and the financial highlights are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements.
Our procedures included confirmation of securities owned at December
31, 1996 by correspondence with the custodian and broker. An audit
also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.
In our opinion, such financial statements and the financial
highlights present fairly, in all material respects, the financial
position of Somerset Exchange Fund as of December 31, 1996, the
results of its operations, its cash flows, the changes in its net
assets, and the financial highlights for the period July 11, 1996 to
December 31, 1996 in conformity with generally accepted accounting
principles.
Deloitte & Touche LLP
Princeton, New Jersey
February 21, 1997
</AUDIT-REPORT>
<PAGE>
CHANGE IN INVESTMENT POLICIES (unaudited)
In October 1996, Congress enacted legislation modernizing certain of
the federal securities laws and reducing regulation of registered
investment companies by state securities authorities. Consistent
with this legislation, the Board of Trustees of the Fund has
approved the elimination of two non-fundamental investment policies
adopted at the time of the Fund's offering to satisfy requirements
of two state securities authorities. One restriction related to a
limitation on investments in issuers where certain designated
individuals affiliated with the Fund owned more than 5% of the
securities of such issuer (Item C. on page 27 of the Fund's Private
Placement Memorandum dated February 14, 1996 (the "PPM")). The other
restriction related to the authority of the Fund to invest in
certain limited partnerships and interests in mineral programs (Item
D. on page 28 of the PPM). Neither restriction had any effect on
investments by the Fund.
OFFICERS AND TRUSTEES
Individual Trustees
Terry K. Glenn
Jack B. Sunderland
Stephen B. Swensrud
J. Thomas Touchton
David Fann (effective in 1997)
Officers
Terry K. Glenn, President
Norman R. Harvey, Senior Vice President
Donald C. Burke, Vice President
Eric S. Mitofsky, Vice President and Portfolio Manager
Robert E. Putney, III, Secretary
Gerald M. Richard, Treasurer
Somerset Exchange Fund
800 Scudders Mill Road
Plainsboro, New Jersey 08536
<PAGE>
Investment Adviser, Adviser Trustee and Administrator
Merrill Lynch Asset Management, L.P.
800 Scudders Mill Road
Plainsboro, New Jersey 08536
Sub-Administrator
United States Trust Company of New York
114 West 47th Street
New York, New York 10036
Custodian
The Chase Manhattan Bank, N.A.
Mutual Funds Service Division
770 Broadway
New York, New York 10003-9598
Transfer Agent
Chase Global Funds Services Company
73 Tremont Street
Boston, Massachusetts 02108-3913
Placement Agent
Merrill Lynch & Co.
Selected Dealer
UST Financial Services Corp.
Legal Counsel
Brown & Wood
Independent Auditors
Deloitte & Touche LLP
<PAGE>
Past performance results shown in this report should not be
considered a representation of future performance. The Fund has
leveraged its portfolio by investing borrowed money to seek the
opportunity for a more broadly invested portfolio and potentially
higher investment returns. However, leveraging may exaggerate
changes in the net asset value of the Fund's shares and in the yield
on the Fund's portfolio. Leveraging also exposes Fund shareholders
to the risk of potential adverse tax consequences in the event of
default or adverse market action. Statements and other information
herein are as dated and are subject to change.
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