Somerset Exchange Fund
Semi-Annual Report
June 30, 2000
The investment objective of Somerset Exchange Fund is to generate
long-term returns measured on an after-tax basis (i.e., taking into
account taxes payable by shareholders on the Fund's investment
income and realized gains) from a diversified portfolio of equity
securities.
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, 2000
DEAR SHAREHOLDER
The Fund's total return for the first six months ended June 30, 2000
was -2.76%. Since inception (July 11, 1996) through June 30, 2000,
the Fund had a total return of +47.91%. Net assets in Somerset
Exchange Fund declined 2.78% during the first half of 2000 from
$113,416,787 on December 31, 1999 to $110,258,959 on June 30, 2000.
This decline was accounted for by a combination of two factors.
First was the loss in value of the Fund's common stock portfolio,
which was valued at $116,261,635 on December 31 1999, but had
declined 1.89% to $114,435,144 by June 30, 2000. During the same
period, the unmanaged Standard & Poor's 500 Index lost approximately
1.00%. The second factor was the declining value of the Fund's
qualifying assets, two privately placed preferred stocks purchased
at the Fund's inception. Collectively, these two holdings suffered a
decline of nearly $2 million between December 31, 1999 (with a
combined value of $22,562,169) and June 30, 2000 (combined value of
$20,682,507). Thus, the decline in the Fund's net assets was
accounted for about equally by the declining value of the preferred
stocks and the declines in the value of the common stock portfolio.
In the Fund's common stock portfolio, declining issues outnumbered
advancing issues by about a 3:2 ratio during the first six months of
2000. Although Intel Corporation was the Fund's best-performing
stock in this period with a 62% gain, the health care group provided
the Fund with its biggest performance gains, as six of the Fund's
top 10 performers came from this sector. The best-performing
companies within this group were Mid Atlantic Medical Services, Inc.
(+62%), Watson Pharmaceuticals, Inc. (+50%), St. Jude Medical, Inc.
(+49%), Pfizer Inc. (+48%), Caremark RX, Inc. (+35%) and HEALTHSOUTH
Corporation (+33.7%).
On the downside, 20 of the Fund's holdings lost a minimum of one-
third of their value in the first six months of 2000. Among these
were many high-profile stocks that revealed earnings disappointments
during this period. Included in this list were: Parametric
Technology Corporation, which declined by 59% in the first half of
2000; The Procter & Gamble Company, which posted a decline of 48%;
Motorola, Inc. posted a 41% decline for the period; AT&T Corp. saw
its stock price reduced by 38%; and E.I. du Pont de Nemours and
Company posted a 34% decline.
The Fund's five-largest common stock holdings at the end of the
second quarter were: Watson Pharmaceuticals, Inc., Pinnacle Systems,
Inc., Pfizer Inc., General Electric Company and The Walt Disney
Company. Collectively, the Fund's holdings of these five companies
had a value of almost $29.1 million at June 30, 2000, and these
positions accounted for just over 25% of the Fund's common stock
portfolio.
Portfolio Matters
At the Fund's inception (July 11, 1996), we initiated two loans for
the Fund to purchase $24 million in preferred stock as well as to
pay the Fund's 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 loan on July 11, 1997, its one-year
anniversary, and to pay down an additional $500,000 in the second
quarter of 1999. On its third annual rollover, the rate on the
remaining one-year loan of $500,000 was reset to 6.38125% (5.78125%
plus 0.60% margin), which left the interest rate unchanged.
We anticipate that the Fund will have sufficient liquidity to allow
for the repayment of the remainder of the annual loan in the near
future. At its second quarter reset on March 15, 2000, the $25
million quarterly loan was rolled over with an interest rate at
6.88125%, an increase of 0.25% (a 0.60% margin is paid on this loan
as well) compared with its prior rate. The Fund also entered into a
fixed-for-floating interest rate swap agreement with Goldman Sachs
Financial Products (GSFP) at inception, on a notional amount of $24
million. The purpose of the swap transaction was to seek to insulate
the Fund from the potentially damaging impact on income of rising
short-term interest rates arising from the Fund's large borrowings
based on these short-term interest rates. It is not anticipated that
the swaps will act as a hedge against a decline in the principal
value of the preferred stocks resulting from an increase in long-
term interest rates. In this structure, 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.
Two stock splits occurred during the first quarter of 2000. Pinnacle
Systems, Inc. split 2-for-1 on March 27, 2000, increasing the Fund's
shares from 120,000 to 240,000. Solectron Corporation split 2-for-1
on March 9, 2000, increasing the Fund's shares from 39,000 to
78,000. There were an additional three stock splits during the
year's second quarter. The Chase Manhattan Corporation split 3-for-2
on June 12, 2000, increasing the Fund's shares from 10,000 to
15,000. Motorola, Inc. split 3-for-1 on June 2, increasing the
Fund's shares from 31,500 to 94,500, and General Electric Co. split
3-for-1 on May 8, 2000, increasing the Fund's shares from 27,942 to
83,826.
The Fund held 22,500 shares of Rainforest Cafe prior to its expected
acquisition by Landry's Seafood on April 26, 2000. Prior to the
merger's expected closing date, the shares of Rainforest Cafe were
sent back to the contributing shareholder since the merger was
structured as a combination of cash and shares of the acquiring
company. However, subsequent to the expected closing date, the
company cancelled the planned shareholder vote in response to stiff
opposition to the merger by several large shareholders. On December
31, 1999, the value of the Fund's shares of Rainforest Cafe was
$89,287, which accounts for nearly 5% of the overall decline in the
value of the equity portfolio during the first half of 2000.
Sincerely
(Terry K. Glenn)
Terry K. Glenn
President
(Eric S. Mitofsky)
Eric S. Mitofsky
Senior Vice President and Portfolio Manager
August 14, 2000
Somerset Exchange Fund, June 30, 2000
<TABLE>
SCHEDULE OF INVESTMENTS (in US dollars)
<CAPTION>
Common Stock Shares Percent of
Sectors Industries Investments Held Value Net Assets
<S> <S> <S> <C> <C> <C>
Basic Aluminum ++MAXXAM Inc. 64,000 $ 1,136,000 1.0%
Materials
Chemicals E.I. du Pont de Nemours and Company 40,000 1,750,000 1.6
Chemicals--Diverse ++Airgas, Inc. 24,000 136,500 0.1
Paper & Forest Products Longview Fibre Company 29,140 322,361 0.3
Capital Electrical Equipment General Electric Company 83,826 4,442,778 4.0
Goods Honeywell International Inc. 10,715 360,962 0.3
Engineering & ++Jacobs Engineering Group Inc. 77,250 2,525,109 2.3
Construction
Manufacturing Dover Corporation 13,800 559,763 0.5
Tyco International Ltd. 25,000 1,184,375 1.1
Pollution Control World Fuel Services Corporation 69,000 595,125 0.5
Consumer Auto Parts Bandag, Incorporated (Class A) 6,200 142,600 0.1
Cyclicals
Entertainment ++Pinnacle Systems, Inc. 240,000 5,396,250 4.9
The Walt Disney Company 87,000 3,376,687 3.1
Hotel/Motel ++Harrah's Entertainment, Inc. 40,000 837,500 0.8
++Park Place Entertainment Corporation 61,300 747,094 0.7
Household Furniture Bassett Furniture Industries,
& Appliances Incorporated 12,000 150,000 0.1
Leggett & Platt, Incorporated 86,000 1,419,000 1.3
Leisure Time ++Lakes Gaming Inc. 15,325 134,094 0.1
Office Equipment & IKON Office Solutions, Inc. 10,000 38,750 0.0
Supplies
Publishing--Newspaper Tribune Company 28,325 991,375 0.9
Restaurants Bob Evans Farms, Inc. 50,000 746,875 0.7
Darden Restaurants, Inc. 18,605 302,331 0.3
McDonald's Corporation 8,510 280,298 0.3
Retail--General Casey's General Stores, Inc. 30,000 311,250 0.3
Merchandise
Retail--Specialty Amplicon, Inc. 125,000 1,187,500 1.1
++Office Depot, Inc. 72,000 450,000 0.4
Regis Corporation 30,000 375,000 0.3
++Sunglass Hut International, Inc. 12,000 98,625 0.1
Specialized Services ++Catalina Marketing Corporation 23,000 2,346,000 2.1
++Modis Professional Services, Inc. 30,600 271,575 0.2
Service Corporation International 12,000 38,250 0.0
The ServiceMaster Company 82,518 938,642 0.9
Textiles--Apparel Russell Corporation 19,900 398,000 0.4
Manufacturing
Consumer Beverages--Soft Drink The Coca-Cola Company 13,800 792,638 0.7
Staples Panamerican Beverages, Inc. (Class A) 28,000 418,250 0.4
(US Registered Shares)
Foods ++Agribrands International, Inc. 600 25,162 0.0
Archer-Daniels-Midland Company 12,598 123,618 0.1
General Mills, Inc. 8,000 306,000 0.3
H.J. Heinz Company 16,200 708,750 0.7
Ralston-Purina Group 18,000 358,875 0.3
Household Products ++Energizer Holdings, Inc. 6,000 109,500 0.1
The Procter & Gamble Company 22,162 1,268,775 1.2
Retail--Food Chains Albertson's, Inc. 7,500 249,375 0.2
++Safeway Inc. 24,000 1,083,000 1.0
++Smart & Final Inc. 60,000 461,250 0.4
Tobacco Philip Morris Companies Inc. 41,013 1,089,408 1.0
UST Inc. 100,000 1,468,750 1.3
Energy Oil--International Exxon Mobil Corporation 33,000 2,590,500 2.4
</TABLE>
Somerset Exchange Fund, June 30, 2000
<TABLE>
SCHEDULE OF INVESTMENTS (continued) (in US dollars)
<CAPTION>
Common Stock Shares Percent of
Sectors Industries Investments Held Value Net Assets
<S> <S> <S> <C> <C> <C>
Healthcare Healthcare--Diversified Abbott Laboratories 75,370 $ 3,358,676 3.1%
Johnson & Johnson 19,600 1,996,750 1.8
Healthcare--Drugs Pfizer Inc. 106,575 5,115,600 4.7
++Watson Pharmaceuticals, Inc. 200,000 10,750,000 9.7
Healthcare--HMOs ++Caremark Rx, Inc. 175,000 1,192,187 1.1
++Mid Atlantic Medical Services, Inc. 21,240 286,740 0.3
Healthcare-- ++Apria Healthcare Group Inc. 39,060 478,485 0.4
Miscellaneous ++HEALTHSOUTH Corporation 113,730 817,434 0.8
++HEARx, Ltd. 6,000 22,125 0.0
Hospital Management ++Tenet Healthcare Corporation 25,000 675,000 0.6
Medical Products ++St. Jude Medical, Inc. 50,000 2,293,750 2.1
Interest Banks--Money Center The Chase Manhattan Corporation 15,000 690,937 0.6
Rate
Sensitive Banks--Regional First Union Corporation 8,400 208,425 0.2
Northern Trust Corporation 37,800 2,459,363 2.2
PNC Bank Corp. 18,860 884,063 0.8
Wells Fargo Company 21,000 813,750 0.7
Financial-- Bank One Corporation 38,451 1,021,355 0.9
Miscellaneous Forest City Enterprises, Inc. (Class A) 66,000 2,202,750 2.0
++MFN Financial Corporation 108 668 0.0
MFN Financial Corporation (Series A)
(Warrants) (a) 126 32 0.0
MFN Financial Corporation (Series B)
(Warrants) (a) 126 32 0.0
MFN Financial Corporation (Series C)
(Warrants) (a) 126 32 0.0
SLM Holding Corporation 14,385 538,538 0.5
Insurance--Brokers Marsh & McLennan Companies, Inc. 13,200 1,378,575 1.3
Insurance--Multiline American International Group, Inc. 14,103 1,657,102 1.5
Insurance--Property The Commerce Group, Inc. 50,000 1,475,000 1.3
Savings & Loan CCB Financial Corporation 13,286 491,582 0.5
Washington Mutual, Inc. 84,672 2,444,904 2.2
Miscellaneous Miscellaneous ++Imation Corp. 286 8,401 0.0
Minnesota Mining and Manufacturing
Company (3M) 2,860 235,950 0.2
Technology Computer Software ++Informix Corporation 13,273 98,718 0.1
++Parametric Technology Corporation 14,000 154,000 0.1
++Sungard Data Systems Inc. 16,200 502,200 0.5
Computer Systems ++3Com Corporation 6,000 345,750 0.3
++Agilent Technologies, Inc. 6,102 450,022 0.4
++The Cerplex Group, Inc. 5,350 1,016 0.0
Compaq Computer Corporation 31,500 805,219 0.7
Hewlett-Packard Company 16,000 1,998,000 1.8
International Business Machines
Corporation 26,000 2,848,625 2.6
Electronics-- ++GenRad, Inc. 25,000 225,000 0.2
Instruments
Electronics-- Intel Corporation 16,000 2,139,000 1.9
Semiconductors Motorola, Inc. 94,500 2,746,406 2.5
++Solectron Corporation 78,000 3,266,250 3.0
Telecommunications AT&T Corp. 12,300 388,987 0.4
Lucent Technologies Inc. 23,003 1,362,928 1.2
++NCR Corporation 512 19,936 0.0
++WorldCom, Inc. 28,903 1,325,925 1.2
Telecommuni- Utilities-- ALLTEL Corporation 35,000 2,167,812 2.0
cations Telecommunications ++Commonwealth Telephone Enterprises,
Inc. (Class B) 23,333 1,108,318 1.0
++RCN Corporation 70,000 1,771,875 1.6
Telephone and Data Systems, Inc. 11,300 1,132,825 1.0
</TABLE>
Somerset Exchange Fund, June 30, 2000
<TABLE>
SCHEDULE OF INVESTMENTS (concluded) (in US dollars)
Common Stock Shares Held/ Percent of
Sectors Industries Investments Face Amount Value Net Assets
<S> <S> <S> <C> <C> <C>
Transportation Truckers ++FedEx Corp. 13,760 $ 522,880 0.5%
++TransFinancial Holdings, Inc. 34,221 51,332 0.0
Utilities Utilities--Electric ++Citizens Communications Company 26,637 459,488 0.4
Total Investments in Common Stock 114,435,238 103.8
Preferred Banks--Foreign Banesto Holdings (10.50%, Series A)* 476,786 11,681,257 10.6
Stock Indosuez Holdings (10.375%, Series A)* 379,000 9,001,250 8.1
Total Investments in Preferred Stock 20,682,507 18.7
Short-Term Commercial Paper** General Motors Acceptance Corp., 7.13%
Investments due 7/03/2000 $646,000 645,616 0.6
Total Investments in Short-Term
Securities 645,616 0.6
Total Investments, at Value 135,763,361 123.1
Unrealized Appreciation on Interest
Rate Swaps 16,320 0.0
Liabilities in Excess of Other Assets (25,520,722) (23.1)
------------ ------
Net Assets $110,258,959 100.0%
============ ======
(a)Warrants entitle the Fund to purchase a predetermined number of
shares of common stock and are non-income producing. The purchase
price and number of shares are subject to adjustment under certain
conditions until the expiration date.
++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, June 30, 2000
<TABLE>
STATEMENT OF ASSETS AND LIABILITIES
<CAPTION>
As of June 30, 2000
<S> <S> <C> <C>
Assets: Investments, at value (cost--$97,630,673) $135,763,361
Unrealized appreciation on interest rate swaps 16,320
Cash 456
Dividends receivable 641,759
Prepaid expenses and other assets 23,968
------------
Total assets 136,445,864
------------
Liabilities: Loans 25,500,000
Payables:
Interest on loans $ 404,044
Investment adviser 163,486
Administrator 54,496
Interest rate swap contracts 26,675
Commitment fees 2,402 651,103
------------
Accrued expenses and other liabilities 35,802
------------
Total liabilities 26,186,905
------------
Net Assets: Net assets $110,258,959
============
Net Assets Capital stock $ 73,543,421
Consist of: Undistributed investment income--net 1,299,974
Accumulated realized capital losses on investments--net (2,726,187)
Accumulated distributions in excess of realized capital
gains on investments--net (7,257)
Unrealized appreciation on investments--net 38,149,008
------------
Net assets--Equivalent to $739.09 per share based on 149,183 shares of
beneficial interest outstanding $110,258,959
============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 2000
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Six Months Ended June 30, 2000
<S> <S> <C> <C>
Investment Dividends $ 1,762,468
Income: Discount earned 15,483
------------
Total income 1,777,951
------------
Expenses: Loan interest expense $ 869,134
Investment advisory fees 327,889
Administrative fees 109,296
Interest rate swap expense 79,513
Professional fees 44,698
Trustees' fees and expenses 7,998
Borrowing costs 4,803
Printing and shareholder reports 4,136
Other 1,631
------------
Total expenses 1,449,098
------------
Investment income--net 328,853
------------
Realized & Realized loss on investments--net (316,835)
Unrealized Change in unrealized appreciation on investments--net (3,161,969)
Loss on ------------
Investments Net Decrease in Net Assets Resulting from Operations $ (3,149,951)
--Net: ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 2000
<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: 2000 1999
<S> <S> <C> <C>
Operations: Investment income--net $ 328,853 $ 397,081
Realized loss on investments--net (316,835) (1,675,150)
Change in unrealized appreciation on investments--net (3,161,969) 1,675,409
------------ ------------
Net increase (decrease) in net assets resulting from operations (3,149,951) 397,340
------------ ------------
Distributions to Investment income--net (242,018) (248,253)
Shareholders: In excess of realized gain on investments--net -- (7,257)
------------ ------------
Net decrease in net assets resulting from distributions to
shareholders (242,018) (255,510)
------------ ------------
Beneficial In-kind redemption of beneficial interest (78,750) (2,507,802)
Interest ------------ ------------
Transactions:
Net Assets: Total decrease in net assets (3,470,719) (2,365,972)
Beginning of period 113,729,678 116,095,650
------------ ------------
End of period* $110,258,959 $113,729,678
============ ============
*Undistributed investment income--net $ 1,299,974 $ 1,213,139
============ ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 2000
<TABLE>
STATEMENT OF CASH FLOWS
<CAPTION>
For the Six Months Ended June 30, 2000
<S> <S> <C>
Cash Provided Net decrease in net assets resulting from operations $ (3,149,951)
by Operating Adjustments to reconcile net decrease in net assets resulting
Activities: from operations to net cash provided
by operating activities:
Decrease in receivables 21,953
Increase in payables 14,977
Realized and unrealized loss on investments--net 3,478,804
Amortization of discount (15,426)
------------
Net cash provided by operating activities 350,357
------------
Cash Used for Proceeds from sales and maturities of short-term investments 64,569,000
Investing Purchases of short-term investments (64,677,351)
Activities: ------------
Net cash used for investing activities (108,351)
------------
Cash Used for Distributions paid to shareholders (242,018)
Financing ------------
Activities: Net cash used for financing activities (242,018)
------------
Cash: Net decrease in cash (12)
Cash at beginning of period 468
------------
Cash at end of period $ 456
============
Cash Flow Cash paid for interest $ 852,704
Information: ============
Non-Cash In-kind redemption of beneficial interest $ 78,750
Financing ============
Activities:
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 2000
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
For the For the
Six Period
Months For the July 11,
The following per share data and ratios have been derived Ended Year Ended 1996++ to
from information provided in the financial statements. June 30, December 31, Dec. 31,
Increase (Decrease) in Net Asset Value: 2000 1999 1998 1997 1996
<S> <S> <C> <C> <C> <C> <C>
Per Share Net asset value, beginning of period $ 761.82 $ 760.86 $ 692.47 $ 516.04 $ 503.02
Operating Capital charge resulting from issuance
Performance: of shares -- -- -- -- (3.02)
-------- -------- -------- -------- --------
Net asset value, beginning of period,
net of capital charges 761.82 760.86 692.47 516.04 500.00
-------- -------- -------- -------- --------
Investment income--net 2.20 2.78 3.29 3.18 2.01
Realized and unrealized gain (loss)
on investments--net (including discount
for restricted securities) (23.31) (.14) 66.62 173.25 14.03
-------- -------- -------- -------- --------
Total from investments operations (21.11) 2.64 69.91 176.43 16.04
-------- -------- -------- -------- --------
Less distributions:
Investment income--net (1.62) (1.63) (1.52) -- --
In excess of realized gain on
investments--net -- (.05) -- -- --
-------- -------- -------- -------- --------
Total distributions (1.62) (1.68) (1.52) -- --
-------- -------- -------- -------- --------
Net asset value, end of period $ 739.09 $ 761.82 $ 760.86 $ 692.47 $ 516.04
======== ======== ======== ======== ========
Total Investment Based on net asset value per share (2.76%)+++ .36% 10.10% 34.19% 2.59%+++
Return: ======== ======== ======== ======== ========
Based on net asset value, net of
capital charge (2.76%)+++ .36% 10.10% 34.19% 3.21%+++
======== ======== ======== ======== ========
Ratios to Average Expenses, excluding interest expense .91%* 1.09% .94% .94% 1.05%*
Net Assets: ======== ======== ======== ======== ========
Expenses 2.64%* 2.78% 2.71% 3.13% 3.78%*
======== ======== ======== ======== ========
Investment income--net .60%* .35% .46% .53% .87%*
======== ======== ======== ======== ========
Supplemental Net assets, end of period (in thousands) $110,259 $113,730 $116,096 $106,296 $ 79,315
Data: ======== ======== ======== ======== ========
Portfolio turnover .00% .00% .00% .00% .00%
======== ======== ======== ======== ========
Leverage: Amount of borrowings outstanding, end of
period (in thousands) $ 25,500 $ 25,500 $ 26,000 $ 26,000 $ 28,000
======== ======== ======== ======== ========
Average amount of borrowings outstanding
during the period (in thousands) $ 25,500 $ 25,766 $ 26,000 $ 27,047 $ 28,000
======== ======== ======== ======== ========
Average amount of borrowings per share
during the period $ 170.86 $ 170.67 $ 169.72 $ 175.89 $ 182.17
======== ======== ======== ======== ========
++Commencement of operations.
+++Aggregate total investment return.
*Annualized.
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, June 30, 2000
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 accounting
principles generally accepted in the United States of America, which
may require the use of management accruals and estimates. 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 that 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
Merrill Lynch Investment Managers, L.P. ("MLIM") 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 investment strategies to increase or decrease the level of
risk to which the Fund is exposed more quickly and efficiently than
transactions in other types of instruments. 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 generally 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).
Somerset Exchange Fund, June 30, 2000
(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) 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. Distributions of
cash in excess of realized capital gains are due primarily to
differing tax treatments for post-October losses. 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
MLIM. The general partner of MLIM is Princeton Services, Inc.
("PSI"), an indirect wholly-owned subsidiary of Merrill Lynch & Co.,
Inc. ("ML & Co."), which is the limited partner.
MLIM 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 .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 MLIM
whereby MLIM 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 .20%, on an
annual basis, of the Fund's average weekly net assets as defined
above.
MLIM has entered into a Sub-Administration Agreement with United
States Trust Company of New York ("US Trust") whereby US Trust
agrees to provide information and advice relating to securities
valuation and portfolio activities. For such services, MLIM pays US
Trust a quarterly fee of .05%, on an annual basis, of the Fund's
average weekly net assets as defined above. US Trust is compensated
directly by MLIM out of the administration fee at no additional cost
to the Fund.
MLIM 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, MLIM pays to US
Trust a quarterly fee of .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 MLIM at no additional cost to the Fund.
Certain officers and/or trustees of the Fund are officers and/or
directors of MLIM or PSI.
3. Investments:
Net realized losses for the six months ended June 30, 2000 and net
unrealized gains as of June 30, 2000 were as follows:
Realized Unrealized
Losses Gains
Long-term investments $ (316,835) $38,132,688
Interest rate swaps -- 16,320
----------- -----------
Total $ (316,835) $38,149,008
=========== ===========
The Fund has entered into the following interest rate swaps as of
June 30, 2000:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 6.88125% Variable* 6.89% Fixed 7/15/2001
*3-month LIBOR at reset date.
As of June 30, 2000, net unrealized appreciation for Federal income
tax purposes aggregated $104,251,092, all of which related to
appreciated securities. The aggregate cost of investments at June
30, 2000 for Federal income tax purposes was $31,512,269.
4. Beneficial Interest Transactions:
Shares issued and outstanding decreased by approximately 104 and
3,297 for the six months ended June 30, 2000 and the year ended
December 31, 1999, 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 six months ended
June 30, 2000, the average amount borrowed was $25,500,000 and the
daily weighted average interest rate was 6.84%. For the six months
ended June 30, 2000, facility and commitment fees aggregated
approximately $4,800.
Somerset Exchange Fund, June 30, 2000
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 that 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, 2000
OFFICERS AND TRUSTEES
Individual Trustees
Terry K. Glenn
M. Colyer Crum
Laurie Simon Hodrick
Jack B. Sunderland
Stephen B. Swensrud
J. Thomas Touchton
Fred G. Weiss
Arthur Zeikel
Officers
Terry K. Glenn, President
Robert C. Doll, Jr., Senior Vice President
Eric S. Mitofsky, Senior Vice President and Portfolio Manager
Donald C. Burke, Vice President and Treasurer
Robert E. Putney, III, Secretary
Somerset Exchange Fund
800 Scudders Mill Road
Plainsboro, NJ 08536
Investment Adviser, Adviser Trustee and Administrator
Merrill Lynch Investment Managers, 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
