Somerset Exchange Fund
Annual Report
December 31, 1997
Somerset Exchange Fund, December 31, 1997
DEAR SHAREHOLDER
Although significantly higher levels of volatility became a
characteristic of the US equity market during the second half of 1997,
the year ended December 31, 1997 became the third straight year in which
the unmanaged Standard & Poor's 500 Index (S&P 500) produced a total
return in excess of 20%. From a longer-term perspective, 1997 became the
seventh straight year in which the S&P 500 produced positive total
returns. The market's recent fluctuations have, to some extent,
overshadowed the exceptional performance of the US equity market over
the last three years. For the three-year period ended December 31, 1997,
the S&P 500 Index had a total return of +125.56%. Somerset Exchange Fund
began operations on July 11, 1996, the mid-point of this remarkable
three-year stretch. As such, the total returns produced by the Fund have
been quite generous as well. Many of the Fund's holdings performed
extraordinarily well in 1997, and provided the intended diversification
to the Fund's shareholders which served to offset the severe setbacks
suffered by other Fund holdings. The Fund's net asset value per share
increased from $516.04 on December 31, 1996 to $692.47 on December 31,
1997. (The Fund's net asset value has been calculated without the
discount, since the discounting process was eliminated during the 12-
month period ended December 31, 1997.) The Fund's total return for the
six months ended December 31, 1997 was +13.99%, compared
to the +10.59% total return for the S&P 500 for the same period.
The Fund's total return for 1997 was +34.19%, which actually exceeded
the +33.36% total return of the S&P 500. Since inception (July 11, 1996)
through December 31, 1997, the Fund had a total return of +37.66%,
compared to the +54.56% total return for the S&P 500 for the same
period.
The third quarter of 1997 continued the remarkable string of returns
that had been produced by the Fund in May and June. For the three months
from May through July, the Fund produced monthly total returns of
+7.09%, +7.70% and +8.74%, respectively, the Fund's three best months of
operation. The last five months of 1997 were a much more tenuous period
for the Fund, as well as for the market as a whole. Concerns regarding
incipient inflationary pressures and faster-than-expected economic
growth, coupled with the unraveling financial and currency markets in
Asia, produced some extraordinarily volatile days and weeks during the
latter part of 1997. As inflationary concerns abated in September, the
Fund had a monthly total return of +6.33%. However, the full impact of
the Asian crisis was felt in the United States during October,
culminating in the biggest one-day point declines in history for both
the Dow Jones Industrial Average and S&P 500 on October 27. Although the
S&P 500 lost nearly 65 points that day, the rebound on the following day
saw the Index regain much of that loss, as the S&P 500 climbed by nearly
45 points, and posted only a modest loss of 3.30% for the month of
October. The Fund had a total return of -3.56% for October. Concerns
regarding the situation in Asia appeared to be muted during November,
and this momentum continued into December as long-term interest rates
continued their descent toward, and finally through, the 6% level. With
the background of a strong bond market rally, the overall US equity
market continued its upward surge in December, and the Fund produced a
total return of +4.15%.
Portfolio Matters
Net assets in Somerset Exchange Fund increased from $93.4 million on
June 30, 1997 to $106.3 million on December 31, 1997. Part of the
increase in the Fund's net asset value between the end of 1996 and July
11, 1997 was the elimination of the discount which had been applied to
the prices of the restricted securities prior to that date. On December
31, 1996, the Fund's discounted net asset value per share was quoted at
a 4.08% discount to the non-discounted net asset value. This discount
was phased out, so that by July 11, 1997 the discount was entirely
eliminated. Therefore, by July 31, 1997 the Fund had fully recouped the
4.08% discount that had been applied to the restricted securities at the
end of 1996.
During the second half of 1997, the Fund's holdings of common stocks
increased in value from $94.1 million to $106.2 million. During the
third quarter, gains in the Fund's equity portfolio were very broad-
based, as advancing stocks outnumbered declining stocks by a three-to-
one ratio. In the third quarter, the Fund's overall performance was
powered by stocks such as COMPAQ Computer Corp. (+88%), Pinnacle
Systems, Inc. (+71%), John Alden Financial Corporation (+48%), Caliber
Systems, Inc. (+46%), Commonwealth Telephone Enterprises, Inc. (+43%)
and Watson Pharmaceuticals Inc. (+41%). This broad advance was not
repeated in the fourth quarter because many of the Fund's technology
stocks and smaller-capitalization holdings were under severe pressure.
Imation Corp., Informix Corp., 3Com Corporation, COMPAQ Computer Corp.,
Intel Corporation, Stratus Computer Inc., Motorola, Inc. and NCR
Corporation all fell by at least 20% during the fourth quarter, as
advancing stocks were roughly equal in number to declining stocks.
Among the best-performing stocks in the Fund during the second half of
1997 were AT&T Corp., H. F. Ahmanson & Company, Watson Pharmaceuticals,
Inc., CCB Financial Corp., Northern Trust Corporation, World Fuel
Services Corp., Pinnacle Systems, Inc., and COMPAQ Computer Corp., all
of which advanced by at least 40% during this six-month period.
Among the worst-performing stocks in the Fund during the second half of
1997 was Mercury Finance Company, which was beset by allegations of
financial fraud during the early part of 1997 when its market value
plunged by 90%. Boston Chicken, Inc. has seen its market value drop by
roughly 75% since early 1997, as its earnings continually fell short of
analyst expectations. Other stocks that were under pressure during the
latter part of 1997 were Informix Corp., Airgas, Inc., Cerplex Goup,
Inc., Smart & Final, Inc. and St. Johns Knit, Inc. Each of these stocks
had declined by at least 25% during the six-month period ended December
31, 1997. Fortunately, many of the Fund's worst-performing stocks were
among its most lightly weighted positions. Mercury Finance Company,
Informix Corp. and Cerplex Group, Inc. combined amounted to roughly .25%
of the portfolio's equity value at June 30, 1997. Therefore, the
continuing poor performance of these companies has had little impact on
the overall performance of the Fund. The equity portfolio's 12.9%
appreciation during the last half of 1997 compares very favorably with
the price performance of the S&P 500, which advanced by 9.6% in this
period.
At year-end 1997, the Fund's largest common stock holdings were Watson
Pharmaceuticals Inc., MedPartners/Mulliken, Inc., UST, Inc., Ahmanson
(H.F.) & Company and HealthSouth Corporation. Collectively, these five
holdings were valued at $20,626,532, or 19.4% of the common stock
portfolio.
Several changes to the composition of the Fund's equity portfolio
occurred during the last half of 1997, a result of mergers and
acquisitions involving its constituents. Community Care of America Inc.,
of which the Fund held 35,000 shares, was the target of an all-cash
takeover during the third quarter of 1997. On September 26, 1997,
Integrated Health Services closed its $4 per share takeover of Community
Care, prior to which the shares were transferred back to the
contributing shareholder. Also in the third quarter of the year, Anuhco
Inc. changed its name to TransFinancial Holdings, Inc., OccuSystems Inc.
was acquired by Concentra Managed Care Inc. in a one-for-one share swap
(so that 36,145 shares of OccuSystems were converted into 36,145 shares
of Concentra), Student Loan Marketing Association completed its
reorganization, where shares of the Government-sponsored organization
were converted on a one-for-one basis into shares of the new Delaware-
chartered holding company, SLM Holding Corp., and 26,637 shares of
Citizens Utilities Company Class A shares were converted on a one-for-
one basis into Class B shares of the company.
A major restructuring of C-TEC Corp., of which the Fund held 35,000
shares, occurred on October 1, 1997. In this complex reorganization,
shareholders of C-TEC Corp. received one share of RCN Corp. for every
share of C-TEC held and one share of Cable Michigan Inc. for every four
shares of C-TEC held. Shares of the original company were then converted
on a 4:5 basis into Commonwealth Telephone Enterprises, Inc. Thus, the
original 35,000 shares of C-TEC held by the Fund resulted in the new
positions of 35,000 shares of RCN Corp., 8,750 shares of Cable Michigan
Inc. and 23,333 shares of Commonwealth Telephone Enterprises,
Inc. Also completed during the fourth quarter was the merger between
CMS/Horizon Healthcare Corp. and HealthSouth Corp. In the transaction
completed on October 30, 1997, each share of CMS/Horizon Healthcare was
converted into .843 shares of HealthSouth. For the Fund, its 68,451
shares of CMS/Horizon Healthcare were converted into 57,730 shares of
HealthSouth Corp. Combined with its existing position of 56,000 shares,
the Fund holds 113,730 shares of HealthSouth Corp., which has become the
fifth highest weighting in the Fund. Apria Healthcare Group, Inc. had
been the target of a cash plus stock takeover bid valued at
approximately $18 per share, but ultimately declined the offer and
continued to pursue other merger or acquisition options.
One of the Fund's primary sources of income is the quarterly dividend
paid by the two preferred stocks, Banesto Holdings Corp. 10.50% (476,786
shares with a quarterly dividend of $0.65625 per share) and Indosuez
Holdings S.C.A. 10.375% (379,000 shares with a quarterly dividend of
$0.64844 per share). During 1997, the Fund received a total of
$2,234,598 in cash from preferred stock dividends. The combined dollar
value of the two preferred stocks on June 30, 1997 was $25,322,063, and
their combined value on December 31, 1997 was $26,191,590, an increase
of $869,527 during the last six months of the year. This was a
reflection of the strong rally in the US Treasury bond market during
this period. Total dividend income from the Fund's common stock
portfolio (plus American depositary receipts) was $1,083,859.
At the Fund's inception (July 11, 1996), two loans were initiated in
order for the Fund to purchase the $24 million in preferred stock as
well as pay its initial expenses: $25 million was borrowed based upon
the three-month London Interbank Offered Rate (LIBOR), and $3 million
was borrowed on the one-year LIBOR rate. The $25 million loan has been
rolled over quarterly since inception, but sufficient cash balances were
available to allow the Fund to pay down $2 million of the $3 million
annual loan on July 11, 1997, its one-year anniversary. The remaining $1
million was reset, based upon the prevailing one-year LIBOR rate of
6.63125% (6.03125% plus 0.60% margin), which represented a 0.22%
reduction from the prior annual rate. The $2 million reduction of the
12-month loan will save the Fund $132,625 in interest expense during the
next year. However, the $2 million will still be available to the Fund
should its borrowing needs increase, and the Fund will pay an additional
$2,000 as a commitment fee (0.10% annually) on the unused portion of the
loan facility, which has been increased from $7 million to $9 million.
At the most recent reset date of October 14, 1997, the $25 million loan
was rolled over with the interest rate left unchanged at 5.75% (a 0.60%
margin is paid on the loan as well).
The fixed-for-floating-rate swap agreements entered into with Goldman
Sachs Financial Products (GSFP), on a notional amount of $24 million
whereby the Fund pays a fixed rate of 6.89% (annualized) and receives
payments based on the prevailing three-month LIBOR rate, are still in
place. Both the $25 million loan facility and the interest-rate swap
agreements are reset on a quarterly basis, and both have shown similar
rate adjustments at each reset period. At the October 15, 1997 reset of
the swap, the rate the Fund received from GSFP increased to 5.75781%,
effectively identical to the interest rate charged on the three-month
loan. Thus, the interest rate swaps are accomplishing their intended
goal of insulating the Fund from changes in the interest rate being
charged on its borrowed funds. However, interest rate swaps do not
insulate the Fund from changes in the value of its preferred stock
holdings, which may fluctuate as a result of changes in interest rates
or other factors.
In Conclusion
We thank you for your investment in Somerset Exchange Fund, and we look
forward to sharing our investment outlook with you in our semi-annual
1998 report to shareholders.
Sincerely,
/S/TERRY K. GLENN
Terry K. Glenn
President
/S/ERIC S. MITOFSKY
Eric S. Mitofsky
Senior Vice President and Portfolio Manager
February 18, 1998
<TABLE>
<CAPTION>
Somerset Exchange Fund, December 31, 1997
SCHEDULE OF INVESTMENTS
Percent
Common Stock Shares Value of
Sectors Industries Investments Held (Note 1a) Net Assets
<S> <C> <C> <C> <C> <C>
Basic Materials Aluminum +MAXXAM Inc. 64,000 $2,792,000 2.6%
Chemicals duPont (E.I.) de Nemours & Co. 40,000 2,402,500 2.3
Chemicals -- Diverse +Airgas, Inc. 24,000 336,000 0.3
Paper & Forest Products Longview Fibre Company 29,140 442,564 0.4
Broadcasting Utilities -- +Cable Michigan, Inc. 8,750 199,063 0.2
Telecommunications
Capital Goods Electrical Equipment AFC Cable Systems, Inc. 25,000 743,750 0.7
General Electric Co. 27,942 2,050,244 1.9
Honeywell, Inc. 5,715 391,478 0.4
Engineering & +Jacobs Engineering Group, Inc. 77,250 1,960,219 1.8
Construction
Manufacturing Dover Corporation 13,800 498,525 0.5
Pollution Control World Fuel Services Corp. 69,000 1,449,000 1.4
Consumer Cyclicals Auto Parts Bandag, Inc. (Class A) 6,200 296,825 0.3
Entertainment +Pinnacle Systems, Inc. 60,000 1,462,500 1.4
Walt Disney Company (The) 29,000 2,872,813 2.7
Hotel/Motel +Harrah's Entertainment, Inc. 40,000 755,000 0.7
Household Furniture Bassett Furniture Industries, Inc. 12,000 360,000 0.3
& Appliances Leggett & Platt, Inc. 43,000 1,800,625 1.7
Leisure Time +Grand Casinos, Inc. 61,300 835,212 0.8
Office Equipment Ikon Office Solutions, Inc. 10,000 281,250 0.3
& Supplies Unisource Worldwide, Inc. 5,000 71,250 0.1
Publishing -- Newspaper Times Mirror Co. (Series A) 11,330 696,795 0.7
Restaurants Bob Evans Farms, Inc. 50,000 1,106,250 1.0
+Boston Chicken, Inc. 30,000 193,125 0.2
Darden Restaurants, Inc. 18,605 232,562 0.2
McDonald's Corporation 4,255 203,176 0.2
+Rainforest Cafe, Inc. 15,000 495,000 0.5
Retail -- General Casey's General Stores, Inc. 15,000 380,625 0.4
Merchandise
Retail -- Specialty Amplicon, Inc. 125,000 2,062,500 1.9
+Office Depot, Inc. 48,000 1,149,000 1.1
Regis Corp. 20,000 502,500 0.5
+Sunglass Hut International, Inc. 12,000 75,750 0.1
Specialized Services +AccuStaff, Inc. 30,600 703,800 0.7
+Catalina Marketing Corporation 23,000 1,063,750 1.0
Service Corporation International 12,000 443,250 0.4
Servicemaster Company 55,012 1,609,101 1.5
Textiles -- Apparel Russell Corporation 19,900 528,594 0.5
Manufacturing St. John Knits, Inc. 59,954 2,398,160 2.3
Consumer Staples Beverages -- Soft Drink Coca-Cola Co. (The) 13,800 919,425 0.9
PanAmerican Beverages, Inc. (Class A) 28,000 913,500 0.9
Foods Archer-Daniels-Midland Company 11,428 247,845 0.2
General Mills, Inc. 4,000 286,500 0.3
Heinz (H.J.) Company 16,200 823,162 0.8
Ralston Purina Company 6,000 557,625 0.5
Household Products Procter & Gamble Company (The) 22,162 1,768,805 1.7
Retail -- Food Chains Albertson's, Inc. 7,500 355,312 0.3
+Safeway Inc. 12,000 759,000 0.7
Smart & Final, Inc. 60,000 1,080,000 1.0
Tobacco Philip Morris Companies, Inc. 41,013 1,858,402 1.7
UST, Inc. 100,000 3,693,750 3.5
Energy Oil -- International Exxon Corp. 33,000 2,019,187 1.9
Healthcare Healthcare -- Abbott Laboratories 37,685 2,470,723 2.3
Diversified Johnson & Johnson 19,600 1,291,150 1.2
Warner-Lambert Company 5,500 682,000 0.6
Healthcare -- Drugs Pfizer, Inc. 20,400 1,521,075 1.4
+Watson Pharmaceuticals, Inc. 200,000 6,487,500 6.1
Healthcare -- HMOs +Medpartners/Mullikin, Inc. 175,000 3,915,625 3.7
+Mid Atlantic Medical Services, Inc. 21,240 270,810 0.3
Healthcare -- +Apria Healthcare Group, Inc. 39,060 524,869 0.5
Miscellaneous +Concentra Managed Care Inc. 36,145 1,219,894 1.1
+Exogen, Inc. 35,000 140,000 0.1
+HEALTHSOUTH Corporation 113,730 3,156,007 3.0
+HEARx, Ltd. 60,000 93,750 0.1
Hospital Management +Tenet Healthcare Corp. 25,000 828,125 0.8
Medical Products +Saint Jude Medical, Inc. 50,000 1,525,000 1.4
Interest Rate Banks -- Money Center Chase Manhattan Corp. 5,000 547,500 0.5
Sensitive
Banks -- Regional First Union Corporation 8,400 430,500 0.4
Northern Trust Corporation 18,900 1,318,275 1.2
PNC Bank Corp. 18,860 1,076,199 1.0
Wells Fargo & Company 2,100 712,819 0.7
Financial -- Banc One Corporation 34,956 1,898,548 1.8
Miscellaneous Forest City Enterprises, Inc. 33,000 1,918,125 1.8
+Mercury Finance Company 37,000 23,125 0.0
SLM Holding Corp. 4,110 571,804 0.5
Insurance -- Brokers Marsh & McLennan Companies, Inc. 8,800 656,150 0.6
Insurance -- Life John Alden Financial Corporation 11,536 276,864 0.3
Insurance -- Multiline American International Group, Inc. 7,522 818,017 0.8
Insurance -- Property Commerce Group, Inc. 50,000 1,631,250 1.5
Savings & Loan Ahmanson (H.F.) & Company 50,400 3,373,650 3.2
CCB Financial Corp. 6,643 714,122 0.7
Miscellaneous Miscellaneous +Imation Corp. 286 4,576 0.0
Minnesota Mining & Manufacturing Company 2,860 234,699 0.2
Technology Communication +WorldCom, Inc. 19,269 582,887 0.5
Equipment
Computer Software +Informix Corp. 13,273 63,047 0.1
+Parametric Technology Company 7,000 331,625 0.3
+SunGard Data Systems, Inc. 16,200 502,200 0.5
Computer Systems +3Com Corporation 6,000 209,625 0.2
COMPAQ Computer Corp. 15,750 888,891 0.8
+Cerplex Group, Inc. 50,000 22,500 0.0
Hewlett-Packard Company 16,000 1,000,000 0.9
International Business Machines Corporation 13,000 1,359,312 1.3
+Stratus Computer, Inc. 10,000 378,125 0.4
Electronics -- +GenRad, Inc. 25,000 754,687 0.7
Instruments
Electronics -- Intel Corporation 8,000 562,000 0.5
Semiconductors Motorola, Inc. 31,500 1,797,469 1.7
+Solectron Corp. 19,500 810,469 0.8
Telecommunications AT&T Corp. 8,200 502,250 0.5
Lucent Technologies, Inc. 2,657 212,228 0.2
+NCR Corporation 512 14,240 0.0
Percent
Common Stock Shares Held/ Value of
Sectors Industries Investments Face Amount (Note 1a) Net Assets
Telecommunications Utilities -- +Commonwealth Telephone Enterprises, Inc.
Telecommunications (Class B) 23,333 583,325 0.5
+RCN Corporation 35,000 1,198,750 1.1
Transportation Truckers Caliber Systems, Inc. 8,600 418,712 0.4
+TransFinancial Holdings, Inc. 34,221 305,850 0.3
Utilities Electric Utilities Citizens Utilities Company (Class B) 26,637 256,385 0.2
Telephone ALLTEL Corporation 35,000 1,437,187 1.3
Telephone & Data Systems, Inc. 11,300 526,156 0.5
Preferred Stock Banks -- Foreign Banesto Holdings Corp. (10.50%, Series A)
(ADR)* (a) 476,786 15,674,340 14.7
Indosuez Holdings, S.C.A. (10.375%,
Series A) (ADR)* (a) 379,000 10,517,250 9.9
Short-Term Commercial Paper** General Motors Acceptance Corp., 6.75%
Investments due 1/02/1998 $409,000 408,847 0.4
Investments, at Value 132,778,377 124.9
Interest Rate Swaps (674,160) (0.6)
Liabilities in Excess of Other Assets (25,808,529) (24.3)
------------ -------
Net Assets $106,295,688 100.00%
============ =======
(a) The security may be offered and sold to "qualified institutional buyers" under Rule 144A of the Securities
Act of 1933.
+ 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.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF ASSETS AND LIABILITIES
As of December 31, 1997
<S> <C> <C> <C>
Assets: Investments, at value (cost -- $103,184,769) (Note 1a) $132,778,377
Dividends receivable 656,044
Deferred organization expenses (Note 1e) 215,672
Prepaid expenses and other assets 23,241
-------------
Total assets 133,673,334
-------------
Liabilities: Loans (Note 5) 26,000,000
Interest rate swaps, at value (Notes 1b & 3) 674,160
Payables:
Interest on loans (Note 5) $380,419
Investment adviser (Note 2) 157,426
Interest rate swap contracts (Notes 1b & 3) 64,796
Administrator (Note 2) 52,482 655,123
-------------
Accrued expenses and other liabilities 48,363
-------------
Total liabilities 27,377,646
-------------
Net Assets: Net assets $106,295,688
=============
Net Assets Capital stock $76,710,423
Consist of: Undistributed investment income -- net 799,216
Accumulated realized capital losses on investments -- net (133,399)
Unrealized appreciation on investments -- net 28,919,448
-------------
Net assets -- Equivalent to $692.47 per share based on 153,503
shares of beneficial interest outstanding $106,295,688
=============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS
For the Year Ended December 31, 1997
<S> <C> <C> <C>
Investment Dividends $3,321,017
Income (Note 1d): Discount earned 66,542
------------
Total income 3,387,559
------------
Expenses: Loan interest expense (Note 5) $1,748,784
Investment advisory fees (Note 2) 553,861
Interest rate swap expense (Notes 1b & 3) 274,834
Administrative fees (Note 2) 184,626
Amortization of organization expenses (Note 1e) 61,166
Professional fees 55,770
Trustees' fees and expenses 9,660
Borrowing costs (Note 5) 8,044
------------
Total expenses 2,896,745
------------
Investment income -- net 490,814
------------
Realized & Unrealized Realized loss on investments -- net (133,399)
Gain (Loss) on Change in unrealized appreciation on investments -- net 26,763,175
Investments -- Net ------------
(Notes 1b, 1d & 3): Net Increase in Net Assets Resulting from Operations $27,120,590
============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
For the
For the Period
Year July 11,
Ended 1996+ to
December 31, December 31,
1997 1996
Increase (Decrease) in Net Assets:
<S> <C> <C> <C>
Operations: Investment income -- net $490,814 $308,402
Realized loss on investments -- net (133,399) --
Change in unrealized appreciation on investments -- net 26,763,175 2,156,273
------------- -------------
Net increase in net assets resulting from operations 27,120,590 2,464,675
------------- -------------
Beneficial Interest Investments contributed -- 78,510,168
Transactions (Note 4): Cash contributions -- 544,000
Selling commissions and offering expenses resulting from issuance of
capital stock -- (2,203,745)
In-kind redemption of beneficial interest (140,000) --
------------- -------------
Net increase (decrease) in net assets derived from beneficial interest
transactions (140,000) 76,850,423
------------- -------------
Net Assets: Total increase in net assets 26,980,590 79,315,098
Beginning of period 79,315,098 --
------------- -------------
End of period* $106,295,688 79,315,098
------------- -------------
* Undistributed investment income -- net $799,216 $308,402
============= =============
+ Commencement of operations.
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF CASH FLOWS
For the Year Ended December 31, 1997
<S> <C> <C>
Cash Provided by Net increase in net assets resulting from operations $27,120,590
Operating Activities: Adjustments to reconcile net increase in net assets resulting from operations
to net cash provided by operating activities:
Increase in receivables (8,859)
Decrease in other assets 37,925
Decrease in payables (50,702)
Realized and unrealized gain on investments -- net (26,629,776)
Amortization of discount (66,542)
-------------
Net cash provided by operating activities 402,636
-------------
Cash Provided by Purchases of short-term investments (301,453,981)
Investing Activities: Proceeds from sales and maturities of short-term investments 303,050,000
-------------
Net cash provided by investing activities 1,596,019
-------------
Cash Used for Cash payments on borrowings (2,000,000)
Financing Activities: -------------
Net cash used for financing activities (2,000,000)
-------------
Cash: Net decrease in cash (1,345)
Cash at beginning of year 1,345
-------------
Cash at end of year $--
=============
Cash Flow Information: Cash paid for interest $2,084,182
=============
Non-Cash Financing In-kind redemption of beneficial interest $140,000
Activities: =============
See Notes to Financial Statements.
</TABLE>
<TABLE>
<CAPTION>
FINANCIAL HIGHLIGHTS
For the
For the Period
Year July 11,
The following per share data and ratios have been derived Ended 1996+ to
from information provided in the financial statements. December 31, December 31,
1997 1996
Increase (Decrease) in Net Asset Value:
<S> <C> <C> <C>
Per Share Operating Net asset value, beginning of period $516.04 $503.02
Performance: Capital charge resulting from issuance of shares -- (3.02)
-------- --------
Net asset value, beginning of period, net of capital charges 516.04 500.00
-------- --------
Investment income -- net 3.18 2.01
Realized and unrealized gain on investments -- net (including discount
for restricted securities) 173.25 14.03
-------- --------
Total from investments operations 176.43 16.04
-------- --------
Net asset value, end of period $692.47 $516.04
======== ========
Total Investment Based on net asset value per share 34.19% 2.59%++
Return: ======== ========
Based on net asset value, net of capital charge 34.19% 3.21%++
======== ========
Ratios to Average Expense, excluding interest expense .94% 1.05%*
Net Assets: ======== ========
Expenses 3.13% 3.78%*
======== ========
Investment income -- net .53% .87%*
======== ========
Supplemental Data: Net assets, end of period (in thousands) $106,296 $79,315
======== ========
Portfolio turnover 0.00% 0.00%
======== ========
Leverage: Amount of borrowings outstanding, end of period (in thousands) $26,000 $28,000
======== ========
Average amount of borrowings outstanding during the period (in thousands) $27,047 $28,000
======== ========
Average amount of borrowings per share during the period $175.89 $182.17
======== ========
* Annualized.
+ Commencement of operations.
++ Aggregate total investment return.
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1997
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 are 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
is not listed on an exchange or otherwise regularly traded. No provision
is 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, including listed options and futures contracts,
are valued at their current market values in the principal market on
which such securities are normally traded. The value of equity
securities that are listed on the New York or American Stock Exchanges
or listed on the NASDAQ National Market System are at the closing sale
prices or, lacking any closing price, the closing bid price. Equity
securities that are not listed on the New York or American Stock
Exchanges but that are listed on any other securities exchange are
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 is based on the latest available price data at
the time of determination of net asset value. Unlisted readily
marketable equity securities are valued at the bid price in the over-
the-counter market. Short-term securities are valued at amortized cost,
which approximates market value.
Effective July 11, 1997, the discount to fair market value of restricted
securities was removed pursuant to an amendment to Securities and
Exchange Commission regulations. The amendment, which became effective
April 29, 1997, effectively changed the holding period of restricted
securities from two years to one year.
Pursuant to procedures authorized by the Trustees of the Fund, the
preferred stock holdings are valued at fair value as determined by MLAM
or its designee, after consideration of all relevant factors, data and
information, which 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 are 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 engages in vari-
ous 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.
[bullet] 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.
[bullet] 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.
[bullet] 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 is treated as a partnership for federal
income tax purposes. As a partnership for federal income tax purposes,
the Fund does not incur federal income tax liability. Items of
partnership income, gain, loss and deduction 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 are
made at least annually in such amounts as the Trustees of the Fund
determine. Distributions of cash from realized capital gains are made at
least annually in years in which such gains are realized in such amounts
as the Trustees of the Fund determine. The Fund may retain such
investment income and realized capital gains in the early years. The
Fund does not offer a dividend reinvestment plan.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with Merrill
Lynch Asset Management, L.P. (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 provides or arranges 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 on 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 provides
information and advice relating to securities valuation and portfolio
activities. For such services, MLAM pays 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 is 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 pays 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 is 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, or US Trust.
3. Investments:
Net realized and unrealized gains (losses) as of December 31, 1997 were
as follows:
Realized Unrealized
Losses Gains (Losses)
Long-term investments $(133,399) $29,593,608
Interest rate swaps -- (674,160)
------------ ------------
Total $(133,399) $28,919,448
============ ============
The Fund has entered into the following interest rate swaps as of
December 31, 1997:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 5.75781% Variable* 6.89% Fixed 7/15/2001
* 3-month LIBOR at reset date.
As of December 31, 1997, net unrealized appreciation for Federal income
tax purposes aggregated $100,419,152, all of which related to
appreciated securities. The aggregate cost of investments at December
31, 1997 for Federal income tax purposes was $32,361,785.
4. Beneficial Interest Transactions:
For the year ended December 31, 1997, shares issued and outstanding
decreased by 198 as a result of an in-kind redemption and for the year
ended December 31, 1996 increased by 153,701 from the issuance of
shares.
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 year ended December 31,
1997, the maximum amount borrowed was $28,000,000, the average amount
borrowed was approximately $27,047,000, and the daily weighted average
interest rate was 6.47%. For the year ended December 31, 1997, facility
and commitment fees aggregated approximately $8,000.
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, 1997, the related statements of operations and cash flows
for the year then ended, and changes in net assets and the financial
highlights for the year then ended and 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 audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements 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, 1997 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 audits provide a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights
present fairly, in all material respects, the financial position of
Somerset Exchange Fund as of December 31, 1997, the results of its
operations, the changes in its net assets, its cash flows, and the
financial highlights for the respective stated periods in conformity
with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
February 23, 1998
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.
OFFICERS AND TRUSTEES
Individual Trustees
Terry K. Glenn
Jack B. Sunderland
Stephen B. Swensrud
J. Thomas Touchton
David Fann
Officers
Terry K. Glenn, President
Norman R. Harvey, Senior Vice President
Eric S. Mitofsky, Senior Vice President and Portfolio Manager
Donald C. Burke, Vice President
Robert E. Putney, III, Secretary
Gerald M. Richard, Treasurer
Somerset Exchange Fund
800 Scudders Mill Road
Plainsboro, NJ 08536
Investment Adviser, Adviser Trustee and Administrator
Merrill Lynch Asset Management, L.P.
800 Scudders Mill Road
Plainsboro, NJ 08536
(609) 282-2800
Sub-Administrator
United States Trust Company of New York
114 West 47th Street
New York, NY 10036
Custodian
The Chase Manhattan Bank, N.A.
Mutual Funds Service Division
770 Broadway
New York, NY 10003-9598
Transfer Agent
Chase Global Funds Services Company
73 Tremont Street
Boston, MA 02108-3913
Placement Agent
Merrill Lynch & Co.
Selected Dealer
UST Financial Services Corp.
Legal Counsel
Brown & Wood LLP
Independent Auditors
Deloitte & Touche LLP
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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