Somerset Exchange Fund
Annual Report
December 31, 1999
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, 1999
DEAR SHAREHOLDER
The Fund's total return for the year ended December 31, 1999 was
+0.36%. Since inception (July 11, 1996) through December 31, 1999,
the Fund had a total return of +52.11%. During these same two
periods, the unmanaged Standard & Poor's (S&P) 500 Index had total
returns of +21.04% and +140.55%, respectively. The total return for
the unmanaged S&P MidCap Index for 1999 was +14.70%, and the total
return for the unmanaged Standard & Poor's Small Cap Index for 1999
was +21.35%.
Strong returns from Somerset Exchange Fund's holdings of technology
and telecommunications stocks were nearly equally offset by weakness
in the Fund's consumer, financial, and pharmaceutical stocks. This
led to a fiscal year for the Fund that largely mirrored that of the
US equity market. While most stocks were down significantly for the
year, large-cap growth stocks (particularly in the technology
sector) produced strong gains that powered the unmanaged S&P 500
Composite Index to another year with total returns in excess of 20%.
Seven of the Fund's holdings more than doubled in price during 1999,
including Telephone and Data Systems, Inc., RCN Corporation,
Motorola, Inc., Pinnacle Systems, Inc., Solectron Corporation,
Commonwealth Telephone Enterprises, Inc. and Apria Healthcare Group
Inc. However, general broad-based weakness in all but the technology
sector kept the Fund's overall returns in check. A 43% drop in the
price of Watson Pharmaceuticals, Inc. reduced the Fund's equity
portfolio value by $5.4 million during the fiscal year. HEALTHSOUTH
Corporation, one of the Fund's best-performing stocks in 1998 with a
return of 47%, was the Fund's second worst-performing stock in 1999,
declining by 65% during the fiscal year.
The Fund's five largest holdings at the end of 1998 (Watson
Pharmaceuticals, Inc., Abbott Laboratories, MAXXAM Inc., UST Inc.
and Washington Mutual, Inc.) declined by 43%, 26%, 25%, 28% and 33%,
respectively, for the fiscal year ended December 31, 1999.
Collectively, these five holdings were valued at $26.66 million at
December 31, 1998, and represented 22.7% of the Fund's common stock
portfolio. However, as of December 31, 1999, these five positions
were cumulatively valued at $17.36 million, and represented 14.9% of
the Fund's common stock holdings. As of December 31, 1999, the
Fund's five largest holdings were Watson Pharmaceuticals, Inc.,
Pinnacle Systems, Inc., Motorola, Inc., General Electric Company and
Solectron Corporation. Collectively, these five companies accounted
for nearly $24.7 million of the Fund's equity portfolio at December
31, 1999, and represented a combined weight of 21.3%.
Overall, the Fund's equity portfolio declined by approximately $1.4
million during 1999. The equity portfolio was valued at $117.64
million at December 31, 1998, but was worth $116.26 million at
December 31, 1999. An additional drag on the Fund's performance was
the decline in value of the qualifying assets; specifically, the two
privately placed preferred stocks purchased at the Fund's inception.
These two holdings suffered a decline of more than $2 million during
1999, dropping from $24.6 million at the end of 1998 to $22.6
million at December 31, 1999.
Portfolio Matters
At the Fund's inception, we initiated two loans in order to purchase
$24 million in preferred stock as well as 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
annual loan on July 11, 1997, its one-year anniversary. On its third
annual rollover, the rate on the remaining one-year loan of $500,000
($2 million had been retired after the Fund's first year of
existence and $500,000 in the second quarter of 1999) was reset at
6.38125% (5.78125% plus 0.60% margin) with the interest rate left
unchanged. At the most recent reset date of October 14, 1999, the
$25 million quarterly loan was rolled over with the interest rate at
6.7875%, an increase of 0.875%.
The fixed-for-floating-rate swap agreements entered into with
Goldman Sachs Financial Products (GSFP), on a notional amount of $14
million whereby the Fund pays a fixed rate of 6.89% (annualized) and
receives payments based on the prevailing three-month LIBOR rate,
are still in place. Both the $25 million loan facility and the
interest-rate swap agreements are reset on a quarterly basis, and
both have shown similar rate adjustments at each reset period. At
the October 15, 1999 reset of the swap, the rate the Fund received
from GSFP increased to 6.1775%, an increase of 0.8675%. Thus, the
interest rate swaps are accomplishing their intended objective of
insulating the Fund from changes in the interest rate being charged
on its borrowed funds.
In Conclusion
We thank you for your investment in Somerset Exchange Fund, and we
look forward to updating 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 17, 2000
Somerset Exchange Fund, December 31, 1999
<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 Materials Aluminum ++MAXXAM Inc. 64,000 $ 2,744,000 2.4%
Chemicals E.I. du Pont de Nemours and Company 40,000 2,635,000 2.3
Chemicals--Diverse ++Airgas, Inc. 24,000 228,000 0.2
Paper & Forest Products Longview Fibre Company 29,140 415,245 0.4
Capital Goods Electrical Equipment General Electric Company 27,942 4,324,024 3.8
Honeywell International Inc. 10,715 618,122 0.5
Engineering & ++Jacobs Engineering Group Inc. 77,250 2,510,625 2.2
Construction
Manufacturing Dover Corporation 13,800 626,175 0.6
Tyco International Ltd. 25,000 971,875 0.9
Pollution Control World Fuel Services Corporation 69,000 517,500 0.5
Consumer Auto Parts Bandag, Incorporated (Class A) 6,200 131,750 0.1
Cyclicals
Entertainment ++Pinnacle Systems, Inc. 120,000 4,882,500 4.3
The Walt Disney Company 87,000 2,544,750 2.2
Hotel/Motel ++Harrah's Entertainment, Inc. 40,000 1,057,500 0.9
++Park Place Entertainment Corporation 61,300 766,250 0.7
Household Furniture Bassett Furniture Industries,
& Appliances Incorporated 12,000 186,750 0.2
Leggett & Platt, Incorporated 86,000 1,843,625 1.6
Leisure Time ++Lakes Gaming Inc. 15,325 121,642 0.1
Office Equipment IKON Office Solutions, Inc. 10,000 68,125 0.1
& Supplies
Publishing--Newspaper The Times Mirror Company (Class A) 11,330 759,110 0.7
Restaurants Bob Evans Farms, Inc. 50,000 771,875 0.7
Darden Restaurants, Inc. 18,605 337,216 0.3
McDonald's Corporation 8,510 343,059 0.3
++Rainforest Cafe, Inc. 22,500 89,297 0.1
Retail--General Casey's General Stores, Inc. 30,000 313,125 0.3
Merchandise
Retail--Specialty Amplicon, Inc. 125,000 1,359,375 1.2
++Office Depot, Inc. 72,000 787,500 0.7
Regis Corporation 30,000 566,250 0.5
++Sunglass Hut International, Inc. 12,000 135,000 0.1
Specialized Services ++Catalina Marketing Corporation 23,000 2,662,250 2.3
++Modis Professional Services, Inc. 30,600 436,050 0.4
Service Corporation International 12,000 83,250 0.1
The ServiceMaster Company 82,518 1,016,003 0.9
Textiles--Apparel Russell Corporation 19,900 333,325 0.3
Manufacturing
Consumer Beverages--Soft Drink The Coca-Cola Company 13,800 803,850 0.7
Staples Panamerican Beverages, Inc. 'A'
(US Registered Shares) 28,000 575,750 0.5
Foods ++Agribrands International, Inc. 600 27,600 0.0
Archer-Daniels-Midland Company 12,598 153,538 0.1
General Mills, Inc. 8,000 286,000 0.3
H.J. Heinz Company 16,200 644,962 0.6
Ralston-Ralston Purina Group 18,000 501,750 0.4
Household Products The Procter & Gamble Company 22,162 2,428,124 2.1
Retail--Food Chains Albertson's, Inc. 7,500 241,875 0.2
++Safeway Inc. 24,000 853,500 0.8
Smart & Final Inc. 60,000 435,000 0.4
Tobacco Phillip Morris Companies Inc. 41,013 950,989 0.8
UST Inc. 100,000 2,518,750 2.2
Energy Oil--International Exxon Mobil Corporation 33,000 2,658,562 2.3
</TABLE>
Somerset Exchange Fund, December 31, 1999
<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 $ 2,736,873 2.4%
Johnson & Johnson 19,600 1,825,250 1.6
Warner-Lambert Company 16,500 1,351,969 1.2
Healthcare--Drugs Pfizer Inc. 61,200 1,985,175 1.7
++Watson Pharmaceuticals, Inc. 200,000 7,162,500 6.3
Healthcare--HMOs ++Caremark Rx, Inc. 175,000 885,937 0.8
++Mid Atlantic Medical Services, Inc. 21,240 176,558 0.2
Healthcare-- ++Apria Healthcare Group Inc. 39,060 700,639 0.6
Miscellaneous ++HEALTHSOUTH Corporation 113,730 611,299 0.5
++HEARx, Ltd. 6,000 27,750 0.0
Hospital Management ++Tenet Healthcare Corporation 25,000 587,500 0.5
Medical Products ++St. Jude Medical, Inc. 50,000 1,534,375 1.4
Interest Rate Banks--Money Center The Chase Manhattan Corporation 10,000 776,875 0.7
Sensitive
Banks--Regional First Union Corporation 8,400 275,625 0.2
Northern Trust Corporation 37,800 2,003,400 1.8
PNC Bank Corp. 18,860 839,270 0.7
Wells Fargo Company 21,000 849,188 0.7
Financial-- Bank One Corporation 38,451 1,232,835 1.1
Miscellaneous Forest City Enterprises, Inc.
(Class A) 66,000 1,848,000 1.6
++MFN Financial Corporation 108 702 0.0
MFN Financial Corporation (Series A)
(Warrants) (a) 126 55 0.0
MFN Financial Corporation (Series B)
(Warrants) (a) 126 32 0.0
MFN Financial Corporation (Series C)
(Warrants) (a) 126 24 0.0
SLM Holding Corporation 14,385 607,766 0.5
Insurance--Brokers Marsh & McLennan Companies, Inc. 13,200 1,263,075 1.1
Insurance--Multiline American International Group, Inc. 14,103 1,524,887 1.3
Insurance--Property The Commerce Group, Inc. 50,000 1,306,250 1.2
Savings & Loan CCB Financial Corporation 13,286 578,771 0.5
Washington Mutual, Inc. 84,672 2,201,472 1.9
Miscellaneous Miscellaneous ++Imation Corp. 286 9,599 0.0
Minnesota Mining and Manufacturing
Company (3M) 2,860 279,923 0.2
Technology Computer Software ++Informix Corporation 13,273 150,980 0.1
++Parametric Technology Corporation 14,000 378,875 0.3
++Sungard Data Systems Inc. 16,200 384,750 0.3
Computer Systems ++3Com Corporation 6,000 282,000 0.2
++The Cerplex Group, Inc. 5,350 6,019 0.0
Compaq Computer Corporation 31,500 852,469 0.8
Hewlett-Packard Company 16,000 1,823,000 1.6
International Business Machines
Corporation 26,000 2,808,000 2.5
Electronics-- ++GenRad, Inc. 25,000 403,125 0.4
Instruments
Electronics-- Intel Corporation 16,000 1,317,000 1.2
Semiconductors Motorola, Inc. 31,500 4,638,375 4.1
++Solectron Corporation 39,000 3,709,875 3.3
Telecommunications AT&T Corp. 12,300 624,225 0.6
Lucent Technologies Inc. 23,003 1,720,912 1.5
++MCI WorldCom Inc. 28,904 1,531,886 1.3
++NCR Corporation 512 19,392 0.0
Telecommuni- Utilities-- ALLTEL Corporation 35,000 2,894,062 2.5
cations Telecommunications ++Commonwealth Telephone
Enterprises, Inc. (Class B) 23,333 1,335,814 1.2
++RCN Corporation 70,000 3,390,625 3.0
Telephone and Data Systems, Inc. 11,300 1,423,800 1.3
Transportation Truckers ++FDX Corporation 13,760 563,300 0.5
++TransFinancial Holdings, Inc. 34,221 175,383 0.2
</TABLE>
Somerset Exchange Fund, December 31, 1999
<TABLE>
SCHEDULE OF INVESTMENTS (concluded) (in US dollars)
<CAPTION>
Common Stock Shares Held/ Percent of
Sectors Industries Investments Face Amount Value Net Assets
<S> <S> <S> <C> <C> <C>
Utilities Utilities--Electric ++Citizens Utilities Company (Class B) 26,637 $ 377,912 0.3%
Total Investments in Common Stock 116,261,746 102.2
Preferred Stock Banks--Foreign Banesto Holdings (10.50%, Series A)* 476,786 12,992,418 11.4
Indosuez Holdings (10.375%,
Series A)* 379,000 9,569,750 8.4
Total Investments in Preferred Stock 22,562,168 19.8
Short-Term Commercial Paper** General Motors Acceptance Corp.,
Investments 5% due 1/03/2000 $522,000 521,783 0.5
Total Investments in
Short-Term Securities 521,783 0.5
Total Investments, at Value 139,345,697 122.5
Unrealized Depreciation on
Interest Rate Swaps (132,240) (0.1)
Liabilities in Excess of Other Assets (25,483,779) (22.4)
------------ ------
Net Assets $113,729,678 100.0%
============ ======
(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, December 31, 1999
<TABLE>
STATEMENT OF ASSETS AND LIABILITIES
<CAPTION>
As of December 31, 1999
<S> <S> <C> <C>
Assets: Investments, at value (cost--$97,902,480) $139,345,697
Cash 468
Dividends receivable 663,712
Prepaid expenses and other assets 23,968
------------
Total assets 140,033,845
------------
Liabilities: Loans 25,500,000
Unrealized depreciation on interest rate swaps 132,240
Payables:
Interest on loans $ 387,614
Investment adviser 165,648
Administrator 55,216
Interest rate swap contracts 29,507 637,985
------------
Accrued expenses and other liabilities 33,942
------------
Total liabilities 26,304,167
------------
Net Assets: Net assets $113,729,678
============
Net Assets Capital stock $ 73,622,171
Consist of: Undistributed investment income--net 1,213,139
Accumulated realized capital losses on investments--net (2,409,352)
Accumulated distributions in excess of realized capital
gains on investments--net (7,257)
Unrealized appreciation on investments--net 41,310,977
------------
Net assets--Equivalent to $761.82 per share based on 149,287
shares of beneficial interest outstanding $113,729,678
============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1999
<TABLE>
STATEMENT OF OPERATIONS
<CAPTION>
For the Year Ended December 31, 1999
<S> <S> <C> <C>
Investment Dividends $ 3,504,580
Income: Discount earned 34,571
------------
Total income 3,539,151
------------
Expenses: Loan interest expense $ 1,559,070
Investment advisory fees 679,299
Interest rate swap expense 351,881
Administrative fees 226,433
Organization expenses 154,506
Professional fees 138,166
Trustees' fees and expenses 15,373
Borrowing costs 9,364
Printing and shareholder reports 5,315
Other 2,663
------------
Total expenses 3,142,070
------------
Investment income--net 397,081
------------
Realized & Realized loss on investments--net (1,675,150)
Unrealized Change in unrealized appreciation on investments--net 1,675,409
Gain (Loss) on ------------
Investments--Net: Net Increase in Net Assets Resulting from Operations $ 397,340
============
See Notes to Financial Statements.
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
For the Year Ended
December 31,
Increase (Decrease) in Net Assets: 1999 1998
<S> <S> <C> <C>
Operations: Investment income--net $ 397,081 $ 497,766
Realized loss on investments--net (1,675,150) (600,802)
Change in unrealized appreciation on investments--net 1,675,409 10,716,120
------------ ------------
Net increase in net assets resulting from operations 397,340 10,613,084
------------ ------------
Distributions to Investment income--net (248,253) (232,671)
Shareholders: In excess of realized gain on investments--net (7,257) --
------------ ------------
Net decrease in net assets resulting from
distributions to shareholders (255,510) (232,671)
------------ ------------
Beneficial In-kind redemption of beneficial interest (2,507,802) (580,451)
Interest ------------ ------------
Transactions:
Net Assets: Total increase (decrease) in net assets (2,365,972) 9,799,962
Beginning of year 116,095,650 106,295,688
------------ ------------
End of year* $113,729,678 $116,095,650
============ ============
*Undistributed investment income--net $ 1,213,139 $ 1,064,311
============ ============
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1999
<TABLE>
STATEMENT OF CASH FLOWS
<CAPTION>
For the Year Ended December 31, 1999
<S> <S> <C> <C>
Cash Provided by Net increase in net assets resulting from operations $ 397,340
Operating Adjustments to reconcile net increase in net assets
Activities: resulting from operations to net cash provided
by operating activities:
Increase in receivables (6,376)
Decrease in other assets 132,362
Decrease in payables (3,472)
Realized and unrealized loss on investments--net (259)
Amortization of discount (31,684)
------------
Net cash provided by operating activities 487,911
------------
Cash Provided by Proceeds from sales and maturities of short-term investments (155,656,490)
Investing Purchases of short-term investments 155,924,000
Activities: ------------
Net cash provided by investing activities 267,510
------------
Cash Used for Repayments of borrowings (500,000)
Financing Distributions paid to shareholders (255,510)
Activities: ------------
Net cash used for financing activities (755,510)
------------
Cash: Net decrease in cash (89)
Cash at beginning of year 557
------------
Cash at end of year $ 468
============
Cash Flow Cash paid for interest $ 1,528,025
Information: ============
Non-Cash In-kind redemption of beneficial interest $ 2,507,802
Financing ============
Activities:
See Notes to Financial Statements.
</TABLE>
Somerset Exchange Fund, December 31, 1999
<TABLE>
FINANCIAL HIGHLIGHTS
<CAPTION>
For the
Period
The following per share data and ratios have been derived July 11,
from information provided in the financial statements. For the Year Ended 1996++ to
December 31, Dec. 31,
Increase (Decrease) in Net Asset Value: 1999 1998 1997 1996
<S> <S> <C> <C> <C> <C>
Per Share Net asset value, beginning of period $ 760.86 $ 692.47 $ 516.04 $ 503.02
Operating -------- -------- -------- --------
Performance: Capital charge resulting from
issuance of shares -- -- -- (3.02)
-------- -------- -------- --------
Net asset value, beginning of period,
net of capital charges 760.86 692.47 516.04 500.00
-------- -------- -------- --------
Investment income--net 2.78 3.29 3.18 2.01
Realized and unrealized gain (loss) on
investments--net
(including discount for restricted securities) (.14) 66.62 173.25 14.03
-------- -------- -------- --------
Total from investments operations 2.64 69.91 176.43 16.04
-------- -------- -------- --------
Less distributions:
Investment income--net (1.63) (1.52) -- --
In excess of realized gain on
investments--net (.05) -- -- --
-------- -------- -------- --------
Total distributions (1.68) (1.52) -- --
-------- -------- -------- --------
Net asset value, end of period $ 761.82 $ 760.86 $ 692.47 $ 516.04
======== ======== ======== ========
Total Investment Based on net asset value per share .36% 10.10% 34.19% 2.59%+++
Return: ======== ======== ======== ========
Based on net asset value, net of
capital charge .36% 10.10% 34.19% 3.21%+++
======== ======== ======== ========
Ratios to Average Expenses, excluding interest expense 1.09% .94% .94% 1.05%*
Net Assets: ======== ======== ======== ========
Expenses 2.78% 2.71% 3.13% 3.78%*
======== ======== ======== ========
Investment income--net .35% .46% .53% .87%*
======== ======== ======== ========
Supplemental Data: Net assets, end of period (in thousands) $113,730 $116,096 $106,296 $ 79,315
======== ======== ======== ========
Portfolio turnover .00% .00% .00% .00%
======== ======== ======== ========
Leverage: Amount of borrowings outstanding,
end of period (in thousands) $ 25,500 $ 26,000 $ 26,000 $ 28,000
======== ======== ======== ========
Average amount of borrowings outstanding
during the period (in thousands) $ 25,766 $ 26,000 $ 27,047 $ 28,000
======== ======== ======== ========
Average amount of borrowings per share
during the period $ 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, December 31, 1999
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 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 Asset Management, L.P. ("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 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).
(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, December 31, 1999
NOTES TO FINANCIAL STATEMENTS (concluded)
(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) Organization expenses--In accordance with Statement of Position
98-5, unamortized organization expenses of $154,506 were expensed on
January 1, 1999. This is considered to be a change in accounting
principle and had no 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. Distributions of
cash from 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
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 .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 .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
agrees to provide information and advice relating to securities
valuation and portfolio activities. For such services, MLAM 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 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 .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 losses for the year ended December 31, 1999 and net
unrealized gains (losses) as of December 31, 1999 were as follows:
Realized Unrealized
Losses Gains (Losses)
Long-term investments $(1,675,150) $41,443,217
Interest rate swaps -- (132,240)
----------- -----------
Total $(1,675,150) $41,310,977
=========== ===========
The Fund has entered into the following interest rate swaps as of
December 31, 1999:
Interest Received Interest Paid
Notional Current Current Expiration
Amount Rate Type Rate Type Date
$24,000,000 6.7875% Variable* 6.89% Fixed 7/15/2001
*3-month LIBOR at reset date.
As of December 31, 1999, net unrealized appreciation for Federal
income tax purposes aggregated $107,957,261, all of which related to
appreciated securities. The aggregate cost of investments at
December 31, 1999 for Federal income tax purposes was $31,388,436.
4. Beneficial Interest Transactions:
Shares issued and outstanding decreased by approximately 3,297 and
919 for the years ended December 31, 1999 and December 31, 1998,
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, 1999, the average amount borrowed was approximately
$25,766,000 and the daily weighted average interest rate was 6.05%.
For the year ended December 31, 1999, facility and commitment fees
aggregated approximately $9,400.
Somerset Exchange Fund, December 31, 1999
<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, 1999, the related statements of
operations and cash flows for the year then ended, and changes in
net assets for each of the years in the two-year period then ended,
and the financial highlights for each of the years in the three-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, 1999 by correspondence with the custodian and brokers. 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, 1999, 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 22, 2000
</AUDIT-REPORT>
Somerset Exchange Fund, December 31, 1999
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, December 31, 1999
OFFICERS AND TRUSTEES
Individual Trustees
Terry K. Glenn
Jack B. Sunderland
Stephen B. Swensrud
J. Thomas Touchton
David Fann
Officers
Terry K. Glenn, President
Robert C. Doll, 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 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
