Somerset Exchange Fund
Annual Report
December 31, 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, December 31, 1998
DEAR SHAREHOLDER
Large-capitalization stocks continued to advance during the second
quarter of 1998, although at a much slower pace than during the
year's first quarter. Investor concerns regarding the impact of the
Asian financial and currency crises became apparent as increased
volatility led to a nearly 5% decline in the unmanaged Standard &
Poor's (S&P) 500 Index between mid-April and mid-June. The market's
recovery beginning in mid-June resulted from continued signs of a
moderating US economy, which led long-term bonds and stocks to rally
into the end of the month. However, unlike the year's first quarter,
in which the powerful gains of large stocks were mirrored by smaller-
capitalization benchmarks, market breadth had turned decidedly
negative during the second quarter. Both the unmanaged S&P MidCap
Index and S&P Small Cap Index had negative returns for the second
quarter of 1998.
All market segments declined early in the third quarter of 1998.
Renewed concerns regarding the situation in Asia, combined with
weakening earnings prospects for domestic companies, sent US
equities on a rapid descent through the end of July. Having reached
an all-time high of 1,186.75 on July 17, 1998, the S&P 500 Index
dropped more than 66 points by the end of the month. Fear of the
spreading economic crisis in many of the world's emerging markets
gripped investors in the United States as extreme levels of
volatility prevailed in the capital markets throughout August. The
S&P 500 Index declined by 14.58% in August, culminated by a 70-point
drop on August 31, 1998. This became the Index's worst one-month
decline since the crash of October 1987 and its ninth-largest one-
month decline since 1929. This brought the S&P 500 Index back to
957.28, nearly 230 points off its peak of July 17, 1998 and marking
its first close below 1,000 since January 30, 1998.
Despite a moderate recovery in September, the equity portfolio of
Somerset Exchange Fund decreased in value from $114.8 million to
$96.6 million during the year's third quarter, as declining stocks
outnumbered advancing stocks by a seven-to-two ratio, with only 23
of the Fund's equities showing positive results. The Fund's net
asset value per share declined by 16.79% during the third quarter,
by far the Fund's worst quarter since its inception on July 11,
1996. On the positive side, the Fund's holding of technology stocks
showed the strongest positive contribution to overall performance in
the third quarter as COMPAQ Computer Corporation, International
Business Machines Corporation and Intel Corporation all posted
double-digit returns. Pharmaceuticals also contributed solidly in
the third quarter as Watson Pharmaceutical, Warner-Lambert Company,
Abbott Laboratories and Johnson & Johnson all showed solid gains.
Three interest rate cuts by the US Federal Reserve Board beginning
on September 29, 1998 powered an explosive fourth-quarter rally in
US equities, resulting in an unprecedented fourth consecutive year
with annual returns in excess of 20% for the S&P 500 Index. The last
quarter of 1998 provided the best quarterly return for the S&P 500
Index since World War II, except for the first quarter of 1975.
However, one more round of selling, indicative of the ongoing
nervousness of investors, hit the equity market during early
October. This formed the base of a powerful rally as the Federal
Reserve Board surprised investors with an additional interest rate
cut on October 15, 1998, which catapulted the S&P 500 Index to a 42-
point rise that day. Coordinated interest rate cuts by central banks
around the world boosted equity markets globally and created the
backdrop for an extended seven-week advance off the October lows.
Investors displayed renewed confidence in the Federal Reserve
Board's ability to manage the global economic crisis after it
lowered interest rates for a third time on November 17, 1998. This
momentum carried the S&P 500 Index back to record-breaking territory
by the end of November, and to new highs by the end of the year.
During the fourth quarter of 1998, the Fund's equity portfolio
increased in value from $96.6 million to $117.6 million, more than
fully erasing the declines of the third quarter. The Fund's advance
was led by solid returns (in excess of 50%) by stocks in the
technology, healthcare and telecommunications sectors. Among the
best-performing stocks were Apria Healthcare Group Inc. (+104.3%),
FDX Corporation (+99.0%), Informix Corporation (+97.5%), Solectron
Corporation (+93.1%), Mid Atlantic Medical Services, Inc. (+80.5%)
and Chase Manhattan Corporation (+64.6%). Data processing and other
technology stocks such as Parametric Technology Corporation, Lucent
Technologies Inc., 3Com Corporation, NCR Corporation, International
Business Machines Corporation, Motorola, Inc., AFC Cable Systems,
Inc., Intel Corporation, Pinnacle Systems, Inc. and COMPAQ Computer
Corporation all posted returns in excess of 30% during the fourth
quarter. The managed care group within the healthcare sector
contributed solidly, as Mid Atlantic Medical Services, Inc.,
Medpartners, Inc. and HEALTHSOUTH Corporation rose in price by
80.5%, 61.5% and 47.0%, respectively. The Fund's advancing stocks
solidly outnumbered its declining stocks, with only 19 of the Fund's
holdings posting negative results for the fourth quarter of 1998.
This led to the Fund's best total return (+22.23% for the fourth
quarter of 1998), and its first outperformance of the S&P 500 Index
since the third quarter of 1997. As of year-end 1998, the Fund's
five-largest common stock holdings were Watson Pharmaceutical,
Abbott Laboratories, MAXXAM, Inc., UST Inc. and Washington Mutual,
Inc. Collectively, these five holdings were valued at $26.66 million
and represented 22.7% of the Fund's common stock portfolio.
Performance Results
The Fund's total return for the year ended December 31, 1998 was
+10.10%. Since inception (July 11, 1996) through December 31, 1998,
the Fund had a total return of +51.57%. The S&P 500 Index had total
returns of +28.58% and +98.73% for these same two periods,
respectively. In addition, the unmanaged S&P MidCap Index posted
total returns of +19.11% and +80.67% for the year ended December 31,
1998 and for the period July 11, 1996 to December 31, 1998,
respectively, and the S&P Small Cap Index had total returns of -
1.31% and +43.20% for the respective stated periods. Total returns
for the three indexes are provided for comparative purposes given
the Fund's extensive exposure to both the small- and mid-
capitalization sectors of the market.
Somerset Exchange Fund, December 31, 1998
Portfolio Matters
Several changes to the composition of the Fund's equity portfolio
occurred during the last half of 1998. One equity holding was
deleted from the Fund during the third quarter as a result of an all-
cash acquisition as Fortis Inc. (not a Fund holding) acquired Fund
holding John Alden Financial Corp. for $22.50 per share. The Fund
also completed its first sale of one of its original holdings during
the third quarter as 30,000 shares of Boston Chicken, Inc. were sold
on August 13, 1998 at a price of $1.03125 per share. Despite its
consistently negative performance since the Fund's inception,
several events led to our decision to unwind the position when we
did. On August 6, 1998, the company announced the results for its
second fiscal quarter, posting a larger-than-expected operating
loss. The company had a huge debt burden due on October 17, 1998,
which we believed it would be unable to roll over or extend, and had
been recently downgraded by Moody's Investors Service, Inc. Finally,
we feared a substantial loss of liquidity in the event that the
stock was delisted by the National Association of Securities
Dealers Automated Quotations, as had been threatened. During the
fourth quarter, acquisitions targeting two of the Fund's former
holdings were completed. Stratus Computer (10,000 shares) was
acquired in a stock-swap by Ascend Communications, Inc., with each
share of Stratus converting into 0.75 shares of Ascend on October
20, 1998. This resulted in the Fund's new position of 7,500 shares
of Ascend. Also, the acquisition of H.F. Ahmanson & Co. (50,400
shares) by Washington Mutual, Inc. via a stock-swap of 1.68
Washington Mutual shares for each share of Ahmanson was completed on
October 2, 1998. This resulted in the Fund adding 84,672 shares of
Washington Mutual. In addition, on October 1, 1998, Accustaff Inc.
changed its name to Modis Professional Services.
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 10.375% (379,000 shares with a quarterly dividend
of $0.64844 per share). The combined market value of the two
preferred stocks on December 31, 1998 was $24,634,366, and their
combined value on June 30, 1998 was $26,156,438. This represents a
decrease of $1,522,072 during the last six months of the year, which
reflects widening credit spreads between US Treasury bonds and all
other issues of lower credit quality.
At the Fund's inception, we initiated two loans in order to purchase
the $24 million in preferred stock as well as pay its initial
expenses. We borrowed $25 million 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. On its
second annual rollover, the rate on the remaining one-year loan of
$1 million was reset at 6.38125% (5.78125% plus 0.60% margin), a
decrease of 0.25% from the prior year's annual loan rate of 6.63125%
(6.03125% plus 0.60% margin). At the most recent reset date of
October 14, 1998, the $25 million quarterly loan was rolled over
with the interest rate reset at 5.9438% (a 0.60% margin is paid on
the loan as well), a decline of 0.3437% from the prior quarterly
rate.
The fixed-for-floating-rate swap agreements ($14 million notional
value) entered into with Goldman Sachs Financial Products (GSFP) are
still in place. The Fund pays a fixed rate of 6.89% (annualized) on
these agreements and receives payments based on the prevailing three-
month LIBOR rate. 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, 1998 reset of the swap, the rate the Fund received
from GSFP decreased to 5.348%, effectively identical to the interest
rate charged on the three-month loan. Thus, the interest rate swaps
are successfully insulating the Fund from changes in the interest
rates charged on its borrowed funds.
Allocation Methodology
The Board of Trustees has adopted the traditional allocation
methodology (the "traditional method") for tax purposes. Under the
traditional method, if the Fund disposes of a contributed security
where the fair market value of the security exceeded its adjusted
tax basis upon contribution (a "built-in-gain" security), gain
recognized on the transaction will be allocated to the contributing
shareholder to the extent of the built-in-gain on the security. Any
gain in excess of the built-in-gain allocated to the contributing
shareholder will be allocated among all shareholders. Any loss
recognized shall be allocated to noncontributing shareholders. The
total gain or loss allocated to any shareholder, including the
contributing shareholder, cannot exceed the total gain or loss
recognized by the Fund with respect to the disposition of the
security.
The adoption of the traditional method limits the tax impact of the
disposition of contributed securities to any given shareholder.
Accordingly, it provides increased flexibility for taking advantage
of economic opportunities in the unusual circumstances where the
disposition of a contributed security is desirable.
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 next
report to shareholders.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President
(Eric S. Mitofsky)
Eric S. Mitofsky
Senior Vice President and Portfolio Manager
February 16, 1999
Somerset Exchange Fund, December 31, 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 $ 3,672,000 3.2%
Chemicals du Pont (E.I.) de Nemours 40,000 2,122,500 1.8
Chemicals--Diverse ++Airgas, Inc. 24,000 214,500 0.2
Paper & Forest Longview Fibre Company 29,140 336,931 0.3
Products
Capital Goods Electrical ++AFC Cable Systems, Inc. 25,000 840,625 0.7
Equipment General Electric Company 27,942 2,851,830 2.5
Honeywell Inc. 5,715 430,411 0.4
Engineering & ++Jacobs Engineering Group Inc. 77,250 3,147,937 2.7
Construction
Manufacturing Dover Corporation 13,800 505,425 0.4
Pollution Control World Fuel Services Corporation 69,000 741,750 0.6
Consumer Auto Parts Bandag, Incorporated (Class A) 6,200 216,225 0.2
Cyclicals
Entertainment ++Pinnacle Systems, Inc. 60,000 2,145,000 1.9
The Walt Disney Company 87,000 2,610,000 2.3
Hotel/Motel ++Harrah's Entertainment, Inc. 40,000 627,500 0.5
Household Furniture Bassett Furniture Industries, Incorporated 12,000 286,500 0.3
& Appliances Leggett & Platt, Incorporated 86,000 1,892,000 1.6
Leisure Time ++Grand Casinos, Inc. 61,300 494,231 0.4
Office Equipment IKON Office Solutions, Inc. 10,000 85,625 0.1
& Supplies Unisource Worldwide, Inc. 5,000 36,250 0.0
Publishing--Newspaper The Times Mirror Company (Class A) 11,330 634,480 0.5
Restaurants Bob Evans Farms, Inc. 50,000 1,303,125 1.1
Darden Restaurants, Inc. 18,605 334,890 0.3
McDonald's Corporation 4,255 326,039 0.3
++Rainforest Cafe, Inc. 22,500 136,406 0.1
Retail--General Casey's General Stores, Inc. 30,000 390,937 0.3
Merchandise
Retail--Specialty Amplicon, Inc. 125,000 1,882,812 1.6
++Office Depot, Inc. 48,000 1,773,000 1.5
Regis Corporation 20,000 800,000 0.7
++Sunglass Hut International, Inc. 12,000 84,000 0.1
Specialized Services ++Catalina Marketing Corporation 23,000 1,572,625 1.4
++Modis Professional Services 30,600 443,700 0.4
Service Corporation International 12,000 456,750 0.4
The ServiceMaster Company 82,518 1,820,553 1.6
Textiles--Apparel Russell Corporation 19,900 404,219 0.4
Manufacturing St. Johns Knits, Inc. 59,954 1,558,804 1.3
Consumer Beverages-- The Coca-Cola Company 13,800 922,875 0.8
Staples Soft Drink Panamerican Beverages, Inc. (Class A)
(US Registered Shares) 28,000 610,750 0.5
Foods ++Agribrands International, Inc. 600 18,000 0.0
Archer-Daniels-Midland Company 11,999 206,233 0.2
General Mills, Inc. 4,000 311,000 0.3
H.J. Heinz Company 16,200 917,325 0.8
Ralston-Purina Group 18,000 582,750 0.5
Household Products The Procter & Gamble Company 22,162 2,023,668 1.7
Retail--Food Chains Albertson's, Inc. 7,500 477,656 0.4
++Safeway Inc. 24,000 1,462,500 1.3
Smart & Final Inc. 60,000 577,500 0.5
Tobacco Philip Morris Companies Inc. 41,013 2,194,196 1.9
UST Inc. 100,000 3,487,500 3.0
Energy Oil--International Exxon Corporation 33,000 2,413,125 2.1
</TABLE>
Somerset Exchange Fund, December 31, 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>
Healthcare Healthcare-- Abbott Laboratories 75,370 $ 3,693,130 3.2%
Diversified Johnson & Johnson 19,600 1,643,950 1.4
Warner-Lambert Company 16,500 1,240,594 1.1
Healthcare--Drugs Pfizer Inc. 20,400 2,558,925 2.2
++Watson Pharmaceutical 200,000 12,575,000 10.8
Healthcare--HMOs ++MedPartners, Inc. 175,000 918,750 0.8
++Mid Atlantic Medical Services, Inc. 21,240 208,418 0.2
Healthcare-- ++Apria Healthcare Group Inc. 39,060 349,099 0.3
Miscellaneous ++Concentra Managed Care, Inc. 36,145 386,300 0.3
++Exogen, Inc. 35,000 100,625 0.1
++HEALTHSOUTH Corporation 113,730 1,755,707 1.5
++HEARx, Ltd. 60,000 33,750 0.0
Hospital Management ++Tenet Healthcare Corporation 25,000 656,250 0.6
Medical Products ++St. Jude Medical, Inc. 50,000 1,384,375 1.2
Interest Rate Banks--Money Center The Chase Manhattan Corporation 10,000 680,625 0.6
Sensitive
Banks--Regional First Union Corporation 8,400 510,825 0.4
Northern Trust Corporation 18,900 1,650,206 1.4
PNC Bank Corp. 18,860 1,020,798 0.9
Wells Fargo Company 21,000 838,688 0.7
Financial-- Bank One Corporation 38,451 1,963,404 1.7
Miscellaneous Forest City Enterprises, Inc. 66,000 1,732,500 1.5
++Mercury Finance Company 37,000 1,665 0.0
SLM Holding Corporation 14,385 690,480 0.6
Insurance--Brokers Marsh & McLennan Companies, Inc. 13,200 771,375 0.7
Insurance--Multiline American International Group, Inc. 11,283 1,090,220 0.9
Insurance--Property The Commerce Group, Inc. 50,000 1,771,875 1.5
Savings & Loan CCB Financial Corporation 13,286 757,302 0.7
Washington Mutual, Inc. 84,672 3,233,412 2.8
Miscellaneous Miscellaneous ++Imation Corp. 286 5,005 0.0
Minnesota Mining and Manufacturing Company 2,860 203,417 0.2
Technology Computer Software ++Informix Corporation 13,273 131,071 0.1
++Parametric Technology Corporation 14,000 229,250 0.2
++Sungard Data Systems Inc. 16,200 642,938 0.6
Computer Systems ++3Com Corporation 6,000 268,875 0.2
++Ascend Communications, Inc. 7,500 493,125 0.4
++The Cerplex Group, Inc. 5,350 5,016 0.0
COMPAQ Computer Corporation 31,500 1,321,031 1.1
Hewlett-Packard Company 16,000 1,093,000 0.9
International Business Machines
Corporation 13,000 2,401,750 2.1
Electronics-- ++GenRad, Inc. 25,000 393,750 0.3
Instruments
Electronics-- Intel Corporation 8,000 948,500 0.8
Semiconductors Motorola, Inc. 31,500 1,923,469 1.7
++Solectron Corporation 19,500 1,812,281 1.6
Telecommunications AT&T Corp. 8,200 617,050 0.5
Lucent Technologies Inc. 5,314 584,540 0.5
++MCI WorldCom, Inc. 19,269 1,382,551 1.2
++NCR Corporation 512 21,376 0.0
Telecommuni- Utilities-- ALLTEL Corporation 35,000 2,093,437 1.8
cations Telecommunications ++Commonwealth Telephone Enterprises,
Inc. (Class B) 23,333 734,989 0.6
++RCN Corporation 70,000 1,238,125 1.1
Telephone and Data Systems, Inc. 11,300 507,794 0.4
Transportation Truckers ++FDX Corporation 6,880 612,320 0.5
++TransFinancial Holdings, Inc. 34,221 153,995 0.1
</TABLE>
Somerset Exchange Fund, December 31, 1998
<TABLE>
SCHEDULE OF INVESTMENTS (concluded)
<CAPTION>
Common Stock Shares Value Percent of
Sectors Industries Investments Held (Note 1a) Net Assets
<S> <S> <S> <C> <C> <C>
Utilities Utilities--Electric ++Citizens Utilities Company (Class B) 26,837 $ 218,049 0.2
Total Investments in Common Stock 117,639,610 101.3
Preferred Stock Banks--Foreign Banesto Holdings (10.50%, Series A)* 476,786 14,780,366 12.7
Indosuez Holdings (10.375%, Series A)* 379,000 9,854,000 8.5
Total Investments in Preferred Stock 24,634,366 21.2
Short-Term Commercial Paper** The CIT Group Holdings, Inc., 5.10% due
Securities 1/04/1999 $758,000 757,570 0.7
Total Investments in Short-Term Securities 757,570 0.7
Investments, at Value 143,031,546 123.2
Interest Rate Swaps (1,074,720) (0.9)
Liabilities in Excess of Other Assets (25,861,176) (22.3)
------------ ------
Net Assets $116,095,650 100.0%
============ ======
<FN>
++Non-income producing security.
*The security may be offered and sold to "qualified institutional
buyers" under Rule 144A of the Securities Act of 1933.
**Commercial Paper is traded on a discount basis; the interest rate
shown reflects the discount rate paid at the time of purchase by the
Fund.
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1998
<TABLE>
STATEMENT OF ASSETS AND LIABILITIES
<CAPTION>
As of December 31, 1998
<S> <S> <C> <C>
Assets: Investments, at value (cost--$102,321,258) (Note 1a) $143,031,546
Cash 557
Dividends receivable 657,336
Deferred organization expenses (Note 1e) 154,506
Prepaid expenses and other assets 1,824
------------
Total assets 143,845,769
------------
Liabilities: Loans (Note 5) 26,000,000
Interest rate swaps, at value (Notes 1b & 3) 1,074,720
Payables:
Interest on loans (Note 5) $ 356,569
Investment adviser (Note 2) 157,701
Interest rate swap contracts (Notes 1b & 3) 72,413
Administrator (Note 2) 52,567 639,250
------------
Accrued expenses and other liabilities 36,149
------------
Total liabilities 27,750,119
------------
Net Assets: Net assets $116,095,650
============
Net Assets Capital stock $ 76,129,973
Consist of: Undistributed investment income--net 1,064,311
Accumulated realized capital losses on investments--net (734,202)
Unrealized appreciation on investments--net 39,635,568
------------
Net assets--Equivalent to $760.86 per share based on 152,584
shares of beneficial interest outstanding $116,095,650
============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1998
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Year Ended December 31, 1998
<S> <S> <C> <C>
Investment Dividends $ 3,409,875
Income (Note 1d): Discount earned 25,518
------------
Total income 3,435,393
------------
Expenses: Loan interest expense (Note 5) $ 1,635,571
Investment advisory fees (Note 2) 651,354
Interest rate swap expense (Notes 1b & 3) 280,467
Administrative fees (Note 2) 217,120
Professional fees 62,484
Amortization of organization expenses (Note 1e) 61,166
Trustees' fees and expenses 13,758
Borrowing costs (Note 5) 9,125
Printing and shareholder reports 2,091
Other 4,491
------------
Total expenses 2,937,627
------------
Investment income--net 497,766
------------
Realized & Realized loss on investments--net (600,802)
Unrealized Change in unrealized appreciation on investments--net 10,716,120
Gain (Loss) ------------
on Investments Net Increase in Net Assets Resulting from Operations $ 10,613,084
- --Net (Notes 1b, ============
1d & 3):
See Notes to Financial Statements.
</TABLE>
<TABLE>
STATEMENTS OF CHANGES IN NET ASSETS
<CAPTION>
For the Year Ended
December 31,
Increase (Decrease) in Net Assets: 1998 1997
<S> <S> <C> <C>
Operations: Investment income--net $ 497,766 $ 490,814
Realized loss on investments--net (600,802) (133,399)
Change in unrealized appreciation on investments--net 10,716,120 26,763,175
------------ ------------
Net increase in net assets resulting from operations 10,613,084 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 (580,451) (140,000)
Interest ------------ ------------
Transactions Net decrease in net assets derived from beneficial
(Note 4): interest transactions (580,451) (140,000)
------------ ------------
Net Assets: Total increase in net assets 9,799,962 26,980,590
Beginning of year 106,295,688 79,315,098
------------ ------------
End of year* $116,095,650 $106,295,688
------------ ------------
<FN>
*Undistributed investment income--net $ 1,064,311 $ 799,216
============ ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1998
<TABLE>
STATEMENT OF CASH FLOWS
<CATION>
For the Year Ended December 31, 1998
<S> <S> <C>
Cash Provided Net increase in net assets resulting from operations $ 10,613,084
by Operating Adjustments to reconcile net increase in net assets resulting
Activities: from operations to net cash provided
by operating activities:
Increase in receivables (1,292)
Decrease in other assets 82,583
Decrease in payables (28,087)
Realized and unrealized gain on investments--net (10,115,318)
Amortization of discount (25,518)
------------
Net cash provided by operating activities 525,452
------------
Cash Used for Proceeds from sales of long-term investments 30,982
Investing Purchases of short-term investments (117,512,206)
Activities: Proceeds from sales and maturities of short-term investments 117,189,000
------------
Net cash used for investing activities (292,224)
------------
Cash Used for Distributions paid to shareholders (232,671)
Financing ------------
Activities: Net cash used for financing activities (232,671)
------------
Cash: Net increase in cash 557
Cash at beginning of year --
------------
Cash at end of year $ 557
============
Cash Flow Cash paid for interest $ 1,932,271
Information: ============
Non-Cash In-kind redemption of beneficial interest $ 580,451
Financing ============
Activities:
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1998
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
For the
Period
The following per share data and ratios have been derived For the July 11,
from information provided in the financial statements. Year Ended 1996++ to
December 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 3.29 3.18 2.01
Realized and unrealized gain on investments--net
(including discount for restricted securities) 66.62 173.25 14.03
-------- -------- --------
Total from investment operations 69.91 176.43 16.04
-------- -------- --------
Less dividends from investment income--net (1.52) -- --
-------- -------- --------
Net asset value, end of period $ 760.86 $ 692.47 $ 516.04
======== ======== ========
Total Investment Based on net asset value per share 10.10% 34.19% 2.59%+++
Return: ======== ======== ========
Based on net asset value, net of capital charge 10.10% 34.19% 3.21%+++
======== ======== ========
Ratios to Average Expenses, excluding interest expense .94% .94% 1.05%*
Net Assets: ======== ======== ========
Expenses 2.71% 3.13% 3.78%*
======== ======== ========
Investment income--net .46% .53% .87%*
======== ======== ========
Supplemental Net assets, end of period (in thousands) $116,096 $106,296 $ 79,315
Data: ======== ======== ========
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 $ 169.72 $ 175.89 $ 182.17
======== ======== ========
<FN>
++Commencement of operations.
+++Aggregate total investment return.
*Annualized.
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 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. The Fund's
financial statements are prepared in accordance with generally
accepted accounting principles which may require the use of
management accruals and estimates. 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.
(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.
Somerset Exchange Fund, December 31, 1998
(e) Deferred organization expenses--Deferred organization expenses
are amortized on a straight-line basis over a period not exceeding
five years. In accordance with Statement of Position 98-5, any
unamortized organization expenses will be expensed on the first day
of the next fiscal year beginning after December 15, 1998. This
charge will not have any material impact on the operations of the
Fund.
(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:
Sales of investments, excluding short-term securities, for the year
ended December 31, 1998 were $30,982.
Net realized losses for the year ended December 31, 1998 and net
unrealized gains (losses) as of December 31, 1998 were as follows:
Realized Unrealized
Losses Gains (Losses)
Long-term investments $ (600,802) $40,710,288
Interest rate swaps -- (1,074,720)
----------- -----------
Total $ (600,802) $39,635,568
=========== ===========
The Fund has entered into the following interest rate swaps as of
December 31, 1998:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 5.348% Variable* 6.89% Fixed 7/15/2001
[FN]
*3-month LIBOR at reset date.
As of December 31, 1998, net unrealized appreciation for Federal
income tax purposes aggregated $110,344,311, all of which related to
appreciated securities. The aggregate cost of investments at
December 31, 1998 for Federal income tax purposes was $32,687,235.
4. Beneficial Interest Transactions:
Shares issued and outstanding decreased by 919 and 198 for the years
ended December 31, 1998 and December 31, 1997, respectively, as a
result of in-kind redemptions.
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, 1998, the average amount borrowed was $26,000,000 and
the daily weighted average interest rate was 6.29%. For the year
ended December 31, 1998, facility and commitment fees aggregated
approximately $9,100.
Somerset Exchange Fund, December 31, 1998
<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, 1998, the related statements of
operations and cash flows for the year then ended, and changes in
net assets for the two-year period then ended, and the financial
highlights for the two-year period 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, 1998 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, 1998, 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 19, 1999
</AUDIT-REPORT>
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, December 31, 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
Robert E. Putney, III, Secretary
Donald C. Burke, 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
