Somerset Exchange Fund
FUND LOGO
Semi-Annual Report
June 30, 1998
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.
Printed on post-consumer recycled paper
Somerset Exchange Fund, June 30, 1998
DEAR SHAREHOLDER
For the quarter ended June 30, 1998, Somerset Exchange Fund had a
total return of -1.53%, the Fund's first negative quarterly return
since October 1997. For the six months ended June 30, 1998, the Fund
produced a total return of +8.25%. Based on its starting per share
net asset value of $503.02 on July 11, 1996 (before deduction of
offering costs), the Fund's total return since inception was +49.01%
through June 30, 1998. Net assets in Somerset Exchange Fund
decreased from $116.8 million on March 31, 1998 to $114.8 million on
June 30, 1998.
Concerns regarding the impact of the Asian financial crisis re-
emerged during the second quarter of 1998, producing mixed results
for the major US equity indexes. The unmanaged Standard & Poor's 500
Index (S&P500) posted a total return of +3.30% for the second
quarter, despite the increased volatility that led to a nearly 5%
decline between mid-April and mid-June. May was the S&P 500's only
negative month in the first half of 1998, and the first down month
for the Index since October 1997. Despite the S&P 500's modest rise
in the second quarter, gains were heavily concentrated in the very
largest stocks in the Index, and market breadth was decidedly
negative during the period. This occurred even though the Asian
crisis may potentially have a negative impact on the earnings of the
large multinational corporations that dominate the Index. Small-cap
and mid-cap stocks in the United States fared much worse than their
large-cap counterparts during the second quarter, even though they
are not as heavily exposed to events in Asia.
The stock market's advance resulted from continued signs of a
moderating US economy, which led long-term bonds and stocks to rally
into the end of June. Large-cap stocks once again benefited most
from this recovery (the S&P 500 reached a new high one day before
the end of June), while the small-cap sector finished the period
substantially below its mid-April highs. This pattern of returns had
a clear impact on the performance of Somerset Exchange Fund. While
the Fund underperformed the S&P 500 by 4.83 percentage points in the
second quarter, its total return of -1.53% was superior to that of
the S&P Mid Cap Index (which lost 2.14% during the same period) and
the S&P Small Cap Index (which lost 4.46%). For the six months ended
June 30, 1998, the Fund's total return of +8.25% was also closely
correlated with the S&P Mid Cap Index return of +8.63%, while the
S&P Small Cap Index returned +6.12% during the same period.
Portfolio Matters
Between March 31, 1998 and June 30, 1998, the Fund's equity
portfolio decreased in value from $117.3 million to $114.8 million,
as advancing stocks were outnumbered by declining stocks by a 3:2
ratio. Among the best-performing stocks were Cable Michigan, Inc.
(+53%), Cerplex Group, Inc. (+39%), ServiceMaster Company (+33%),
Lucent Technologies, Inc. (+30%), Watson Pharmaceuticals, Inc. (the
Fund's largest holding, +30%) and Warner-Lambert Company (+22%).
Contributing most to the Fund's performance was the pharmaceutical
group, with Abbott Laboratories, Johnson & Johnson, Pfizer, Inc. and
Warner-Lambert Company all showing positive returns for the quarter.
Chemicals also contributed positively to the Fund's returns, with
E.I. duPont de Nemours & Co. advancing by nearly 10%. The Fund's
worst-performing issue during the June quarter was Mercury Finance
Company, whose price fell by 82.67%. Other underperforming stocks
for the quarter included Boston Chicken, Inc. (-68.3%), Ikon Office
Solutions, Inc. (-57.9%), Exogen, Inc. (-46.5%), Amplicon, Inc.
(-45.8%) and Stratus Computer, Inc. (-42.6%). The combined market
value of Mercury, Boston Chicken, Ikon, and Exogen was under
$300,000 at the end of June, about 0.26% of the Fund's equity
portfolio, which limited the impact of their declines in the Fund's
net asset value.
Corporate restructurings led to three new equity holdings for the
Fund during the first half of 1998. First, FDX Corporation (the
former Federal Express Corp.) replaced Caliber Systems Inc. on
January 27, 1998 as each of the Fund's 8,600 shares of Caliber
Systems was converted into 0.8 shares of FDX, resulting in 6,880
shares of FDX Corp. for the Fund. Second, Ralston-Purina Company
spun off Agribrands International Inc. on April 17, 1998, resulting
in a position of 600 shares for the Fund. Finally, Aurora
Electronics Inc. acquired the Cerplex Group, Inc. on May 6, 1998,
resulting in 1.07 shares of Aurora Electronics Inc. for every share
of Cerplex Group, Inc. Upon completion of the acquisition, Aurora
Electronics Inc. changed its name to Cerplex Group, Inc.
There were a number of stock splits among Fund holdings in the first
half of 1998: SLM Holding Corp., COMPAQ Computer Corp., Rainforest
Cafe, Inc., Banc One Corporation, Casey's General Stores, Inc.,
Safeway Inc., Parametric Technology Company, Abbott Laboratories,
Chase Manhattan Corp., Leggett & Platt, Inc., Lucent Technologies,
Inc., Marsh & McLennan Companies, Inc., RCN Corporation and Warner-
Lambert Company.
One of the Fund's primary sources of income is the quarterly
dividend paid by the two preferred stocks, Banesto Holdings 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). The Fund received a
$312,891 Banesto Holdings dividend on June 10, 1998, and a $245,758
Indosuez Holdings dividend on July 1, 1998. In addition, the Fund
received $915,841.31 in common stock dividends during the second
quarter. Between March 31, 1998 and June 30, 1998, the price of the
Banesto Holdings preferred stock increased from $32.50 per share to
$33.00 per share, while the price of the Indosuez Holdings preferred
shares decreased from $27.75 per share to $27.50 per share. The
combined dollar value of the two preferred stocks on June 30 was
$26,156,438, an increase of $143,643 during the second quarter.
At the Fund's inception, two loans were initiated in order for the
Fund to purchase the $24 million in preferred stock as well as pay
its initial expenses. The Fund borrowed $25 million based upon the
3-month LIBOR rate and an additional $3 million on the 1-year LIBOR
rate. The $25 million loan has been rolled over quarterly since the
Fund's inception and on April 15, 1998, the rate was reset at
6.25625% (5.65625% plus 0.60% margin), an increase of 0.03125% from
the January 15 rate of 6.225% (5.625% plus 0.60% margin).
Somerset Exchange Fund, June 30, 1998
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 3-month LIBOR rate,
showed a similar adjustment. At the April 15, 1998 reset, the rate
the Fund received from GSFP increased to 5.65625%, which represents
an increase of 0.0625% from the prior rate effective on January 15,
1998 of 5.59375%. Thus, the interest rate swaps are accomplishing
their intended objective of insulating the Fund from changes in
interest rates 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 again in our
upcoming 1998 annual report to shareholders.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President
(Eric S. Mitofsky)
Eric S. Mitofsky
Senior Vice President and Portfolio Manager
August 17, 1998
Somerset Exchange Fund, June 30, 1998
<TABLE>
SCHEDULE OF INVESTMENTS
<CAPTION>
Common Stock Shares Value Percent of
Sectors Industries Investments Held (Note 1a) Net Assets
<S> <S> <S> <C> <C> <C>
Basic Materials Aluminum ++MAXXAM Inc. 64,000 $ 3,632,000 3.2%
Chemicals duPont (E.I.) de Nemours & Co. 40,000 2,985,000 2.6
Chemicals--Diverse ++Airgas, Inc. 24,000 345,000 0.3
Paper & Forest Longview Fibre Company 29,140 415,245 0.4
Products
Broadcasting Utilities-- ++Cable Michigan, Inc. 8,750 340,156 0.3
Telecommunications
Capital Goods Electrical Equipment ++AFC Cable Systems, Inc. 25,000 887,500 0.8
General Electric Co. 27,942 2,542,722 2.2
Honeywell, Inc. 5,715 477,560 0.4
Engineering & ++Jacobs Engineering Group, Inc. 77,250 2,481,656 2.2
Construction
Manufacturing Dover Corporation 13,800 472,650 0.4
Pollution Control World Fuel Services Corp. 69,000 1,194,563 1.0
Consumer Auto Parts Bandag, Inc. (Class A) 6,200 213,900 0.2
Cyclicals
Entertainment ++Pinnacle Systems, Inc. 60,000 1,942,500 1.7
Walt Disney Company (The) 29,000 3,046,813 2.7
Hotel/Motel ++Harrah's Entertainment, Inc. 40,000 930,000 0.8
Household Furniture Bassett Furniture Industries, Inc. 12,000 337,500 0.3
& Appliances Leggett & Platt, Inc. 86,000 2,150,000 1.9
Leisure Time ++Grand Casinos, Inc. 61,300 1,026,775 0.9
Office Equipment Ikon Office Solutions, Inc. 10,000 145,625 0.1
& Supplies Unisource Worldwide, Inc. 5,000 54,063 0.1
Publishing--Newspaper Times Mirror Co. (Series A) 11,330 712,374 0.6
Restaurants Bob Evans Farms, Inc. 50,000 1,059,375 0.9
++Boston Chicken, Inc. 30,000 47,813 0.0
Darden Restaurants, Inc. 18,605 295,354 0.3
McDonald's Corporation 4,255 293,595 0.3
++Rainforest Cafe, Inc. 22,500 312,188 0.3
Retail--General Casey's General Stores, Inc. 30,000 496,875 0.4
Merchandise
Retail--Specialty Amplicon, Inc. 125,000 1,625,000 1.4
++Office Depot, Inc. 48,000 1,515,000 1.3
Regis Corp. 20,000 591,250 0.5
++Sunglass Hut International, Inc. 12,000 132,750 0.1
Specialized Services ++AccuStaff, Inc. 30,600 956,250 0.8
++Catalina Marketing Corporation 23,000 1,194,563 1.0
Service Corporation International 12,000 514,500 0.5
ServiceMaster Company 55,012 2,093,894 1.8
Textiles--Apparel Russell Corporation 19,900 600,731 0.5
Manufacturing St. John Knits, Inc. 59,954 2,315,723 2.0
Consumer Staples Beverages--Soft Drink Coca-Cola Co. (The) 13,800 1,179,900 1.0
PanAmerican Beverages, Inc. (Class A)
(US$ Registered) 28,000 880,250 0.8
Foods ++Agribands International, Inc. 600 18,150 0.0
Archer-Daniels-Midland Company 11,428 221,418 0.2
General Mills, Inc. 4,000 273,500 0.2
Heinz (H.J.) Company 16,200 909,225 0.8
Ralston Purina Company 6,000 700,875 0.6
Household Products Procter & Gamble Company (The) 22,162 2,018,127 1.8
Retail--Food Chains Albertson's, Inc. 7,500 388,594 0.3
++Safeway Inc. 24,000 976,500 0.9
Smart & Final, Inc. 60,000 1,027,500 0.9
Tobacco Philip Morris Companies, Inc. 41,013 1,614,887 1.4
UST, Inc. 100,000 2,700,000 2.4
</TABLE>
Somerset Exchange Fund, June 30, 1998
<TABLE>
SCHEDULE OF INVESTMENTS (continued)
<CAPTION>
Common Stock Shares Value Percent of
Sectors Industries Investments Held (Note 1a) Net Assets
<S> <S> <S> <C> <C> <C>
Energy Oil--International Exxon Corp. 33,000 $ 2,353,313 2.1%
Healthcare Healthcare-- Abbott Laboratories 75,370 3,080,749 2.7
Diversified Johnson & Johnson 19,600 1,445,500 1.3
Warner-Lambert Company 16,500 1,144,687 1.0
Healthcare--Drugs Pfizer, Inc. 20,400 2,217,225 1.9
++Watson Pharmaceuticals, Inc. 200,000 9,337,500 8.1
Healthcare--HMOs ++Medpartners, Inc. 175,000 1,400,000 1.2
++Mid Atlantic Medical Services, Inc. 21,240 244,260 0.2
Healthcare-- ++Apria Healthcare Group, Inc. 39,060 261,214 0.2
Miscellaneous ++Concentra Managed Care Inc. 36,145 939,770 0.8
++Exogen, Inc. 35,000 100,625 0.1
++HEALTHSOUTH Corporation 113,730 3,035,169 2.6
++HEARx, Ltd. 60,000 93,750 0.1
Hospital Management ++Tenet Healthcare Corp. 25,000 781,250 0.7
Medical Products ++Saint Jude Medical, Inc. 50,000 1,840,625 1.6
Interest Rate Banks--Money Center Chase Manhattan Corp. 10,000 755,000 0.7
Sensitive
Banks--Regional First Union Corporation 8,400 489,300 0.4
Northern Trust Corporation 18,900 1,441,125 1.3
PNC Bank Corp. 18,860 1,014,904 0.9
Wells Fargo & Company 2,100 774,900 0.7
Financial-- Banc One Corporation 38,451 2,146,046 1.9
Miscellaneous Forest City Enterprises, Inc. 33,000 1,953,187 1.7
++Mercury Finance Company 37,000 4,810 0.0
SLM Holding Corp. 14,385 704,865 0.6
Insurance--Brokers Marsh & McLennan Companies, Inc. 13,200 797,775 0.7
Insurance--Life John Alden Financial Corporation 11,536 253,792 0.2
Insurance--Multiline American International Group, Inc. 7,522 1,098,212 1.0
Insurance--Property Commerce Group, Inc. 50,000 1,937,500 1.7
Savings & Loan Ahmanson (H.F.) & Company 50,400 3,578,400 3.1
CCB Financial Corp. 6,643 705,819 0.6
Miscellaneous Miscellaneous ++Imation Corp. 286 4,737 0.0
Minnesota Mining & Manufacturing
Company 2,860 235,056 0.2
Technology Communication ++WorldCom Inc. 19,269 933,342 0.8
Equipment
Computer Software ++Informix Corp. 13,273 104,940 0.1
++Parametric Technology Company 14,000 379,750 0.3
++SunGard Data Systems, Inc. 16,200 621,675 0.5
Computer Systems ++3Com Corporation 6,000 184,125 0.2
COMPAQ Computer Corp. 31,500 893,812 0.8
++Cerplex Group, Inc. 53,508 20,868 0.0
Hewlett-Packard Company 16,000 958,000 0.8
International Business Machines
Corporation 13,000 1,492,562 1.3
++Stratus Computer, Inc. 10,000 253,125 0.2
Electronics-- ++GenRad, Inc. 25,000 493,750 0.4
Instruments
Electronics-- Intel Corporation 8,000 593,000 0.5
Semiconductors Motorola, Inc. 31,500 1,655,719 1.4
++Solectron Corp. 19,500 820,219 0.7
Telecommunications AT&T Corp. 8,200 468,425 0.4
Lucent Technologies, Inc. 5,314 442,058 0.4
++NCR Corporation 512 16,640 0.0
</TABLE>
Somerset Exchange Fund, June 30, 1998
<TABLE>
SCHEDULE OF INVESTMENTS (concluded)
<CAPTION>
Common Stock Shares Held/ Value Percent of
Sectors Industries Investments Face Amount (Note 1a) Net Assets
<S> <S> <S> <C> <C> <C>
Telecommunications Utilities-- ++Commonwealth Telephone Enterprises,
Inc. (Class B) 23,333 $ 612,491 0.5%
Telecommunications ++RCN Corporation 70,000 1,351,875 1.2
Transportation Truckers ++FDX Corporation 6,880 431,720 0.4
++TransFinancial Holdings, Inc. 34,221 303,711 0.3
Utilities Electric Utilities ++Citizens Utilities Company (Class B) 26,837 258,304 0.2
Telephone ALLTEL Corporation 35,000 1,627,500 1.4
Telephone & Data Systems, Inc. 11,300 444,937 0.4
Total Investments in Common Stock 114,821,002 100.0
Preferred Stock Banks--Foreign Banesto Holdings Corp. (10.50%,
Series A) (ADR)* (a) 476,786 15,733,938 13.7
Indosuez Holdings, S.C.A. (10.375%,
Series A) (ADR)* (a) 379,000 10,422,500 9.1
Total Investments in Preferred Stock 26,156,438 22.8
Short-Term Commercial Paper** General Motors Acceptance Corp., 6.50%
Securities due 7/01/1998 $495,000 494,911 0.4
Total Investments in Short-Term
Securities 494,911 0.4
Investments, at Value 141,472,351 123.2
Interest Rate Swaps (748,056) (0.6)
Liabilities in Excess of Other Assets (25,900,473) (22.6)
------------ ------
Net Assets $114,823,822 100.0%
============ ======
<FN>
(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>
Somerset Exchange Fund, June 30, 1998
<TABLE>
STATEMENT OF ASSETS AND LIABILITIES
<CAPTION>
As of June 30, 1998
<S> <S> <C> <C>
Assets: Investments, at value (cost--$103,270,818) (Note 1a) $141,472,351
Cash 1,857
Dividends receivable 629,104
Deferred organization expenses (Note 1e) 215,672
Prepaid expenses and other assets 24,055
------------
Total assets 142,343,039
------------
Liabilities: Loans (Note 5) 26,000,000
Interest rate swaps, at value (Notes 1b & 3) 748,056
Payables:
Interest on loans (Note 5) $ 403,361
Investment adviser (Note 2) 173,973
Interest rate swap contracts (Notes 1b & 3) 59,446
Administrator (Note 2) 57,990 694,770
------------
Accrued expenses and other liabilities 76,391
------------
Total liabilities 27,519,217
------------
Net Assets: Net assets $114,823,822
============
Net Assets Capital stock $ 76,710,423
Consist of: Undistributed investment income--net 793,298
Accumulated realized capital losses on investments--net (133,376)
Unrealized appreciation on investments--net 37,453,477
------------
Net assets--Equivalent to $748.03 per share based on 153,502.52
shares of beneficial interest outstanding $114,823,822
============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 1998
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Six Months Ended June 30, 1998
<S> <S> <C> <C>
Investment Dividends $ 1,687,720
Income (Note 1d): Discount earned 10,599
------------
Total income 1,698,319
------------
Expenses: Loan interest expense (Note 5) $ 817,699
Investment advisory fees (Note 2) 335,598
Interest rate swap expense (Notes 1b & 3) 132,679
Administrative fees (Note 2) 111,867
Professional fees 30,118
Amortization of organization expenses (Note 1e) 28,289
Trustees' fees and expenses 6,363
Borrowing costs (Note 5) 4,525
Printing and shareholder reports 2,333
Other 2,095
------------
Total expenses 1,471,566
------------
Investment income--net 226,753
------------
Realized & Realized gain on investments--net 23
Unrealized Change in unrealized appreciation on investments--net 8,534,029
Gain on ------------
Investments Net Increase in Net Assets Resulting from Operations $ 8,760,805
- --Net (Notes ============
1b, 1d & 3):
See Notes to Financial Statements.
</TABLE>
<TABLE>
STATEMENTS OF CHANGES IN NET ASSETS
<CAPTION>
For the
Six Months For the
Ended Year Ended
June 30, December 31,
Increase (Decrease) in Net Assets: 1998 1997
<S> <S> <C> <C>
Operations: Investment income--net $ 226,753 $ 490,814
Realized gain (loss) on investments--net 23 (133,399)
Change in unrealized appreciation on investments--net 8,534,029 26,763,175
------------ ------------
Net increase in net assets resulting from operations 8,760,805 27,120,590
------------ ------------
Dividends to Investment income--net (232,671) --
Shareholders ------------ ------------
(Note 1f): Net decrease in net assets resulting from dividends to
shareholders (232,671) --
------------ ------------
Beneficial In-kind redemption of beneficial interest -- (140,000)
Interest ------------ ------------
Transactions Net decrease in net assets derived from beneficial
(Note 4): interest transactions -- (140,000)
------------ ------------
Net Assets: Total increase in net assets 8,528,134 26,980,590
Beginning of period 106,295,688 79,315,098
------------ ------------
End of period* $114,823,822 $106,295,688
------------ ------------
<FN>
*Undistributed investment income--net $ 793,298 $ 799,216
============ ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 1998
<TABLE>
STATEMENT OF CASH FLOWS
<CAPTION>
For the Six Months Ended June 30, 1998
<S> <S> <C>
Cash Provided by Net increase in net assets resulting from operations $ 8,760,805
Operating Adjustments to reconcile net increase in net assets resulting from
Activities: operations to net cash provided by operating activities:
Decrease in receivables 26,940
Increase in other assets (814)
Increase in payables 67,675
Realized and unrealized gain on investments--net (8,534,052)
Amortization of discount (10,600)
------------
Net cash provided by operating activities 309,954
------------
Cash Used for Proceeds from sales of long-term securities 39
Investing Purchases of short-term investments (47,548,465)
Activities: Proceeds from sales and maturities of short-term investments 47,473,000
------------
Net cash used for investing activities (75,426)
------------
Cash Used for Distribution paid to shareholders (232,671)
Financing ------------
Activities: Net cash used for financing activities (232,671)
------------
Cash: Net increase in cash 1,857
Cash at beginning of period --
------------
Cash at end of period $ 1,857
============
Cash Flow Cash paid for interest $ 932,786
Information: ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 1998
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
For the For the
Six For the Period
The following per share data and ratios have been derived Months Year July 11,
from information provided in the financial statements. Ended Ended 1996++ to
June 30, Dec. 31, Dec. 31,
Increase (Decrease) in Net Asset Value: 1998 1997 1996
<S> <S> <C> <C> <C>
Per Share Net asset value, beginning of period $ 692.47 $ 516.04 $ 503.02
Operating Capital charge resulting from issuance of shares -- -- (3.02)
Performance: -------- -------- --------
Net asset value, beginning of period, net of
capital charges 692.47 516.04 500.00
-------- -------- --------
Investment income--net 1.48 3.18 2.01
Realized and unrealized gain on investments--net
(including discount for restricted securities) 55.60 173.25 14.03
-------- -------- --------
Total from investment operations 57.08 176.43 16.04
-------- -------- --------
Less dividends from investment income--net (1.52) -- --
-------- -------- --------
Net asset value, end of period $ 748.03 $ 692.47 $ 516.04
======== ======== ========
Total Investment Based on net asset value per share 8.25%+++ 34.19% 2.59%+++
Return: ======== ======== ========
Based on net asset value, net of capital charge 8.25%+++ 34.19% 3.21%+++
======== ======== ========
Ratios to Average Expenses, excluding interest expense .94%* .94% 1.05%*
Net Assets: ======== ======== ========
Expenses 2.64%* 3.13% 3.78%*
======== ======== ========
Investment income--net .41%* .53% .87%*
======== ======== ========
Supplemental Data: Net assets, end of period (in thousands) $114,824 $106,296 $ 79,315
======== ======== ========
Portfolio turnover .00% .00% .00%
======== ======== ========
Leverage: Amount of borrowings outstanding, end of period
(in thousands) $ 26,000 $ 26,000 $ 28,000
======== ======== ========
Average amount of borrowings outstanding during
the period (in thousands) $ 26,000 $ 27,047 $ 28,000
======== ======== ========
Average amount of borrowings per share during
the period $ 169.38 $ 175.89 $ 182.17
======== ======== ========
<FN>
++Commencement of operations.
+++Aggregate total investment return.
*Annualized.
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 1998
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. These
unaudited financial statements reflect all adjustments which are, in
the opinion of management, necessary to a fair statement of the
results for the interim period presented. All such adjustments are
of a normal recurring nature. 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.
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 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.
* 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 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.
Somerset Exchange Fund, June 30, 1998
(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 period not exceeding
five years.
(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 gains for the six months ended June 30, 1998 and net
unrealized gains (losses) as of June 30, 1998 were as follows:
Realized Unrealized
Gains Gains (Losses)
Long-term investments $ 23 $38,201,533
Interest rate swaps -- (748,056)
----------- -----------
Total $ 23 $37,453,477
=========== ===========
The Fund has entered into the following interest rate swaps as of
June 30, 1998:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 5.65625% Variable* 6.89% Fixed 7/15/2001
[FN]
*3-month LIBOR at reset date.
As of June 30, 1998, net unrealized appreciation for Federal income
tax purposes aggregated $109,024,502, all of which related to
appreciated securities. The aggregate cost of investments at June
30, 1998 for Federal income tax purposes was $32,447,849.
4. Beneficial Interest Transactions:
For the six months ended June 30, 1998, shares issued and
outstanding remained constant and for the year ended December 31,
1997, decreased by 198 as a result of an in-kind redemption.
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 six months ended
June 30, 1998, the average amount borrowed was $26,000,000 and the
daily weighted average interest rate was 6.34%. For the six months
ended June 30, 1998, facility and commitment fees aggregated
approximately $4,500.
Somerset Exchange Fund, June 30, 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.
Somerset Exchange Fund, June 30, 1998
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
