The Masters' Select Equity Fund
Semiannual Report
June 30,1997
Litman/Gregory Fund Advisors, LLC
"It's hard to fault the design of this fund. The premise is sound, and you would
have a tough time assembling a more talented lot of money managers for a lower
minimum purchase." --From "Wall Street's Newest Hitmakers,"
Morningstar.net, June 13,1997Ticker symbol: MSEFX
Dear Fellow Shareholder:
Since this is our first formal report to shareholders, it's my first opportunity
to formally thank you for your confidence. We are enthusiastic about the
potential for The Masters' Select Equity Fund. The fund's "favorite stocks"
concept, implemented by a blue chip group of stock pickers and backed by our
combined commitment to its success, is the basis for our optimism.There were
several noteworthy devel-opments during the first six months of operations:
The Fund experienced significant asset growth. As of June 30, assets were $203
million. Expenses declined significantly from the start-up level of 1.75%. For
the first six months, expenses were 1.47% (annualized). With moderate asset
growth over the rest of the year, we expect expenses to average about 1.43% for
the full year. Asset growth was the primary driver in reducing expenses on a
per-share basis. We expect expenses to decline gradually, assuming the Fund's
asset base continues to grow. In addition, we are working hard to reduce
expenses in other ways. We have been able to renegotiate contracts with several
of the Fund's vendors, which should help reduce expenses in the future.
Your Fund benefited from a huge amount of media coverage during the first half
of the year, including coverage in Barron's, Money magazine, Kiplingers'
Personal Finance, Smart Money, the Wall Street Journal, New York Times, Los
Angeles Times, CNBC, CNNfN and Morningstar Investor, among others. Morningstar's
Web site, Morningstar.net, also wrote about Masters' Select Equity. Their
concluding remarks:"It's hard to fault the design of this fund. The premise is
sound, and you would have a tough time assembling a more talented lot of money
managers for a lower minimum purchase. Some potential shareholders will no doubt
want to see a complete portfolio before investing, but this supergroup appears
to have a promising future."
We will continue to do everything we can to maintain and reward your trust. As
overall manager, Litman/Gregory Fund Advisors plays the role of overseeing the
"Masters" and we have the ultimate responsibility for the performance of the
Fund. Working hard to further reduce expenses is part of our focus, as is
ensuring that our "Master" stock pickers are given every opportunity to succeed.
In that regard, we believe that it is critically important to the future success
of this fund to limit assets to a level that allows the managers maximum
flexibility in picking stocks. Based on feedback from the managers, we expect
Masters' Select Equity to close somewhere between $500 million and $750 million
in assets. Keeping the small-cap stock pickers' assets at $50 million to $75
million should give them a great deal of flexibility to execute the Fund's
focused strategy. When the Fund closes, it will remain open to existing
shareholders. It is possible, however, that the Fund may temporarily close even
to existing shareholders if cash inflows continue to be unusually strong. As of
this writing, assets are at $240 million.
As part of our commitment to shareholders, we intend to publish detailed and
informative semiannual and annual reports. In this report we address
performance, provide information on the portfolio and offer insight into the
qualitative side of assessing a stock picker's skill. We also profile Shelby
Davis, one of the Masters' Select Equity Fund managers.
Ken Gregory, President
We are now listed in the Wall Street Journal, Los Angeles Times, USA Today, New
York Times, Chicago Tribune, San Francisco Chronicle and others.
Our listing reads MstrSeltEq. Shareholder information phone number:
1-800-960-0188
To access account information
24 hours a day via touch-tone telephone,
<PAGE>
please note the following:
Masters' Select Equity Fund number: 305
Account number: Second set of digits on your account statement
Your personal identification number:
Last four digits of Social Security or Taxpayer ID number
Address:
Regular Delivery
Masters' Select Equity Fund
P.O. Box 419922
Kansas City, MO 64141-6922
Overnight Delivery
Masters' Select Equity Fund
1004 Baltimore
Kansas City, MO 64105
Contents
Fund Objective 3
Portfolio Fit 3
Performance 4
Portfolio Summary 5
What Makes a Great Stock Picker? 12
Master Profile: Shelby Davis 16
Statement of Assets and Liabilities 18
Statement of Operations 19
Financial Highlights 20
Statement of Changes in Net Assets 20
Notes to Financial Statements 21
Fund Objective
Superior long-term performance relative to the overall U.S. stock market is the
objective of the Masters' Select Equity Fund. Naturally, there is no guarantee
that the Fund will achieve this objective. However, we believe we have a
uniquely structured fund that makes sense on a number of different levels.
1 First, your Fund benefits from the talents of six of the industry's most
experienced and successful investors.
2 Second, and of equal importance, each stock picker runs a very focused
portfolio of not more than 15 of his favorite stocks. We believe that most stock
pickers have an unusually high conviction level in only a small number of
stocks, and that a portfolio limited to these stocks will, on average,
outperform over a market cycle.
3 Third, even though each manager's portfolio is focused, the overall fund is
well diversified by style, industry and number of stocks. Given the
diversification across styles, we don't expect this fund to top the charts in
any single period. We are shooting for superior performance over a full market
cycle, counting on the Fund's structure and the managers' talent to get us
there.
Portfolio Fit
As with all equity funds, Masters' Select Equity is appropriate for investors
with a long-term time horizon who are willing to ride out occasional periods
when the Fund's net asset value declines. Within that context, we created this
fund to be used as a core equity fund holding. Although performance in each
specific down market will vary, we purposely set the allocations to each manager
with the objective of keeping risk about equal to that of the overall stock
market. At the same time, we wanted enough exposure to small caps and growth
stocks to attempt to deliver good performance in a bull market. In the end, the
focus on the highest conviction stocks of six very distinguished managers with
superior track records is what we believe makes the Fund an ideal core equity
fund holding.
Performance
The primary objective of each of your Fund's stock pickers is to deliver
superior long-term performance. Short-term performance is of less concern. We
believe that a disciplined, patient approach to investing is a critical element
to achieving long-term success. It's what allows our stock pickers to act on
their convictions even in periods when market psychology may temporarily lead to
a disconnect between underlying company fundamentals and stock performance. This
long-term approach is particularly important
<PAGE>
given each manager's mandate to run a concentrated portfolio of his
highest-conviction stocks. Though the overall fund is diversified, each stock
picker's portfolio is not. For each individual manager, we believe that this
concentration will result in superior long-term performance made up of shorter,
out-of-sync periods of performance on both the upside and downside. Patience
drawn from a high level of conviction should allow each stock picker to tough
out temporary periods of underperformance. We believe that the Fund as a whole
will deliver smoother performance because of its overall diversification.
Though six months of operations is not a long enough period to draw any
conclusions, we are generally pleased with the Fund's performance. This is
especially true given the huge early cash flows into Masters' Select. Your
Fund's managers had a difficult time keeping up with this early cash surge, and
this resulted in a very heavy cash weighting in the portfolio during the first
few weeks of the year. Because the stock market was strong during this period,
the Fund's high cash holdings hurt performance. (Cash reserves have declined
since January and have remained between 6% and 8% in recent months. We expect
cash to stabilize at less than 5% of assets.) In addition, the first half of
1997 was characterized by very strong performance by large stocks and lagging
performance by the rest of the market. This is indicated in the following chart.
Performance of Market Capitalization Segments (price change only,
1/1/97-6/30/97)
S&P 500 Index (weighted toward the largest companies) 19.5%
S&P 400 MidCap Index 12.2%
Russell 2000 Index (small-cap stocks) 9.3%
Masters' Select by virtue of its diversity had exposure in areas that lagged the
large-cap-driven indexes. Over the long term, we expect performance to be
primarily a function of individual company fundamentals, not market size.
Performance of Masters' Select and Selected Benchmarks (1/1/97-6/30/97)
Masters' Select Equity Fund 15.3%
Lipper Growth Fund Index 15.4%
Lipper Small Cap Fund Index 6.0%
Wilshire 5000 17.6%
Because Masters' Select Equity owns small-, mid- and large-caps, as well as
growth and value stocks, there is no perfect performance benchmark. Over the
long term, our goal is to outperform the U.S. stock market broadly represented
by the Wilshire 5000 Index. The Wilshire 5000 is weighted to big-cap stocks and
closely tracks the S&P 500. It also has some small company exposure that is not
included in the S&P. In our assessment, the Lipper Growth Index is probably the
best overall mutual fund benchmark for the Fund. We show the Lipper Small Cap
Fund Index for a small-cap benchmark, since we have some small-cap exposure.
Portfolio Summary
As reflected below, your Fund is well diversified in terms of industry exposure
and market capitalization exposure. Masters' Select holds 75 securities,
exclusive of cash equivalents.
Schedule of lnvestments as of June 30, 1997
Industry Shares Held Market Value Portfolio %
- -------- ----------- ------------ -----------
Common Stocks (90.48%)
Basic Materials
Carter Holt Harvey
Limited Forest Products 1,000,000 2,587,942 1.26%
Mead Corporation Forest
Products & Paper 36,500 2,272,125 1.11%
Reynolds Metal Co.
Metals & Mining 26,500 1,888,125 0.92%
$6,748,192 3.29%
Business Services
Manpower Inc. Personnel
Services 61,500 2,736,750 1.34%
Consumer Products &
Distribution
St. John Knits Apparel
& Accessories 12,500 675,000 0.33%
TJX Companies, Inc.
Apparel Retailer 49,600 1,308,200 0.64%
Linens 'N Things, Inc.
Bed & Bath Prods., Housewares 52,500 1,555,313 0.76%*
Masco Corporation Building
Products 41,500 1,732,625 0.85%
Triangle Pacific Corporation
Building Products 30,000 952,500 0.46%*
Knoll, Inc. Business
Furnishings 75,000 1,781,250 0.87%*
Fuji Photo Film Co., Ltd.
(ADR + Ord) Film & Photo
Supplies 60,000 2,430,000 1.19%
Dole Food Company, Inc. Food 63,500 2,714,625 1.32%
Quaker Oats Company Food 78,400 3,518,200 1.72%
Archer Daniels Midland Co.
Food Processing 54,700 1,285,450 0.63%
Stage Stores, Inc.
Specialty Retail 127,500 3,326,952 1.62%*
Westpoint Stevens, Inc.
Textiles, Bed & Bath Products 43,900 1,714,844 0.84%*
Phillip Morris Companies, Inc.
Tobacco, Food & Beverages 68,700 3,048,562 1.49%
Quaker Fabric Upholstery
Fabric Mfg. 53,700 879,338 0.43%
$26,922,859 13.15%
*Non-income-producing securities.
continued
<PAGE>
Schedule of lnvestments as of June 30, 1997
Industry Shares Held Market Value Portfolio %
- -------- ----------- ------------ -----------
Durable Goods
Coltec Industries, Inc.
Aerospace Components 45,000 877,500 0.43%*
Buderus AG Boilers &
Heating Systems 4,850 2,669,572 1.30%
Kuhlman Corporation
Electrical & Electronics 54,000 1,741,500 0.85%
Zero Corporation Electrical
& Electronics 107,500 2,821,875 1.38%
$8,110,447 3.96%
Energy
Cabot Oil & Gas (Class A Shares)
North American Oil Exploration 83,000 1,462,875 0.71%
Harken Energy Corporation North
American Oil Exploration 225,000 1,575,000 0.77%*
Halliburton Co. Oil Equipment
& Service 26,400 2,092,200 1.02%
Oceaneering International Inc.
Oil Equipment & Service 40,000 740,000 0.36%*
San Juan Basin Royalty Trust
Oil & Gas 335,000 2,721,875 1.33%
$8,591,950 4.19%
Financial
Chase Manhattan Corporation
Banking 36,300 3,523,369 1.72%
Citicorp Banking 26,400 3,182,850 1.56%
Wells Fargo & Co. Banking 11,200 3,018,400 1.47%
American Express Financial
Services 53,900 4,015,550 1.96%
Morgan Stanley Dean Witter
Discover & Co. Financial
Services/Brokerage 56,600 2,437,337 1.19%*
Washington Mutual Inc.
Savings & Loan Association 53,500 3,198,297 1.56%
$19,375,803 9.46%
Health Care
Gilead Sciences Inc.
Biomedic & Genetic 44,000 1,218,250 0.60%*
Pfizer, Inc. Pharmaceuticals 33,700 4,027,150 1.97%
$5,245,400 2.57%
Hotels & Restaurants
Hilton Hotels Corporation
Hotels 92,100 2,446,406 1.20%
McDonalds Corporation
Restaurants 59,300 2,864,931 1.40%*
$5,311,337 2.60%
Insurance
General Reinsurance Corp.
Property & Casualty
Reinsurance 16,500 3,003,000 1.47%*
Media & Publishing
Edipresse S.A. Media 9,250 2,185,788 1.07%
Independent Press
Communications Ltd. Media 415,000 2,353,771 1.15%
GC Companies, lnc. Motion
Picture Theaters 49,500 2,264,625 1.11%*
Knight Ridder, Inc. Publishing 145,000 7,114,063 3.48%
McClatchy Newspapers
(Class A Shares) Publishing 28,000 822,500 0.40%
$14,740,747 7.21%
*Non-income-producing securities.
<PAGE>
Schedule of lnvestments as of June 30, 1997
Industry Shares Held Market Value Portfolio %
- -------- ----------- ------------ -----------
Mulitple Industries
Boeing Co. Aircraft,
Defense & Electronics 61,400 3,258,038 1.59%
Philips Electronics, NV
(New York Shares) Recording,
Electronics & Electrical 105,000 7,546,875 3.69%
$10,804,913 5.28%
Real Estate
Catellus Development Corporation
Development & Property Mgmt. 375,000 6,796,875 3.32%*
CDL Hotels International
Limited Real Estate &
Hotels 6,150,000 2,500,549 1.22%
$9,297,424 4.54%
Technology
Compaq Computer Corporation
Computer Systems/Peripherals 28,700 2,848,475 1.39%*
Dell Computer Corporation
Computer Systems/Peripherals 20,300 2,383,347 1.16%*
Hewlett-Packard Co. Computer
Systems/Peripherals 120,500 6,748,000 3.30%
IBM Computer
Systems/Peripherals 54,200 4,888,162 2.39%
Stratasys Inc. Computer
Systems/Peripherals 40,000 642,500 0.31%*
Data General Corporation
Computers/Personal
Workstations 60,000 1,560,000 0.76%*
Genrad Inc. Electronic
Instrumentation 52,500 1,187,813 0.58%*
Electro Scientific Industries,
Inc. Electronic Products 30,000 1,255,313 0.61%*
Technitrol Electronics 50,000 1,368,750 0.67%
3Com Corporation Networking 21,200 953,338 0.47%*
Cisco Systems Inc. Networking 44,500 2,988,453 1.46%*
Texas Instruments Inc.
Semiconductor
Devices/Equipment 35,900 3,017,844 1.47%
Generale Cable Corporation
Semiconductors 46,900 1,201,812 0.59%*
Intel Corporation
Semiconductors 22,500 3,185,859 1.56%
Platinum Technology Inc.
Software 131,500 1,758,813 0.86%*
Telxon Corporation Software 89,000 1,596,438 0.78%
JDA Software Group, Inc.
Software & Programming 33,000 1,128,188 0.55%*
Symix Systems, Inc. Software
& Programming 145,000 1,631,250 0.80%*
$40,344,355 19.71%
Telecommunications
Dycom Industries, Inc.
Service & Supplies 40,000 550,000 0.27%*
ICG Communications Inc.
Telecommunications Service 85,000 1,630,937 0.80%*
Omnipoint Corp.
Telecommunications Service 80,000 1,327,500 0.65%*
Western Wireless (Class A Shares)
Telecommunications Service 40,000 636,250 0.31%*
360 Degree Communications
Company Wireless
Communications 375,000 6,421,875 3.14%*
Airtouch Communications Inc.
Wireless Communications 38,300 1,048,462 0.51%*
$11,615,024 5.68%
Transportation
Kansas City Southern Industries,
Inc. Distribution &
Transportation 116,000 7,482,000 3.66%
Burlington Northern Santa Fe
Railroad 29,700 2,669,287 1.30%
Caliber Systems Trucking &
Transportation 30,000 1,117,500 0.55%
$11,268,787 5.51%
Utilities
Questar Corporation Natural-Gas
Distribution 26,500 1,069,937 0.52%
Total Common Stocks $185,186,925 90.48%
*Non-income-producing securities.
continued
<PAGE>
Schedule of lnvestments as of June 30, 1997
Industry Shares Held Market Value Portfolio %
- -------- ----------- ------------ -----------
Convertible Bonds (1.10%)
Scandinavian Broadcasting
System S.A. (7.25% due
8/1/05) Media 2,250,000 2,261,250 1.10%
Short-term Investments (7.66%)
Federal Home Loan Bank @
5.37%, 7/3/97 179,946 0.09%
Federal Home Loan Bank @
5.47%, 7/3/97 334,898 0.16%
State Street Repo @ 5.25%,
7/1/97 15,169,000 7.41%
Total Short-term Investments $15,683,844 7.66%
Cash and Other Assets
(net of liabilities) $1,544,631 0.76%
Total Net Assets $204,676,650 100.00%
*Non-income-producing securities.
<PAGE>
Following, each of the Masters' investment managers profiles one of their
portfolio holdings in your Fund.
CDL Hotels, Jean-Marie Eveillard
CDL Hotels is a chain of hotels in Asia, Australia, Europe and the United
States. It used to be a small division of City Developments Ltd., a major real
estate group in Singapore, until it was listed on the Hong Kong Stock Exchange
in 1989. City Developments Ltd. still has majority control of CDL Hotels.
Five years ago, at a time when prices for hotels were depressed, CDL began
making acquisitions in Asia, New Zealand and London. Additional purchases
followed in 1994, and CDL acquired control of the Plaza Hotel in New York City
in 1995. Today, with more than 60 hotels (mostly of the four-star variety), CDL
is one of the largest worldwide chains. With the Millennium brand, it is
beginning to develop a global identity. As the Pacific Rim continues to prosper,
more Asians (both businessmen and tourists) will travel throughout Asia, as well
as to cosmopolitan cities such as New York and London.
The company is profitable, with a net margin close to 10%. Last year about 47%
of profits came from Asia, 45% from Europe and North America and 8% from
Australia.
At present the stock is selling at about a 40% discount to the current value of
the hotels. While hotel values are high in Hong Kong (the company has only
modest exposure there) and have moved off the bottom in London and New York,
they are still depressed in some Asian countries, as well as in New Zealand and
Australia. So why is the stock apparently so cheap? First, hotels are in
temporary oversupply in some Asian countries. Second, the chain has not fully
developed a global identity. Third, the market capitalization is not large, at
less than $800 million. Fourth, the stock is listed in Hong Kong, where CDL has
only two hotels.
In short, opportunistic management has shrewdly acquired well-located hotels at
the bottom of the cycle. The chain is well run, and its new Millennium brand
will help. Most important, at least to value investors, the stock sells at a
large discount to current value, which seems to have room to grow in the next
few years. It looks like a genuine one dollar for sixty cents.
IBM, Shelby M. C. Davis
IBM is attractive to us because it is in the midst of a massive turnaround and
has a chance to become a growth company again. Finances are rock solid,
management is actively repurchasing stock and the focus for the future is to
grow in most segments of the computer industry by providing solutions to the
customer. Valuation is attractive at around 12 times 1998 earnings estimates.
This is a huge discount from the market (which is selling at around 18 times
earnings) and reflects the long memories investors have of IBM's dismal record
over the past 10 years. In this case, we do not believe the past is prologue.
Rather, IBM has made a new beginning, which, when combined with the fact that
the digital and information age is accelerating, should provide the backdrop for
favorable earnings progress in the new millennium. If our reasoning is correct,
and the company executes as forecast, investors should be treated to both a
rising earnings base and a rising valuation of the earnings--a potent mixture
for wealth building.
Linens `N Things, Foster Friess
Linens `N Things (LIN), a recent spin-off from CVS Corporation, is a NYSE
company that is a super place to buy your sheets, towels, plates, picture
frames, etc. Linens operates 132 specialty superstores and 33 smaller
traditional stores. The superstores average 33,000 square feet, and the smaller
stores average 10,000 square feet.
From 1991 to 1997, the company's gross square footage has more than tripled from
1.2 million to 4.7 million. LIN expects to open approximately 25 stores in 1997
and 30 in 1998. It also could do opportunistic acquisitions of competitors or
sites. The superstores carry 25,000 SKUs (each SKU represents a separate
product). The merchandise is composed of high-quality brand-name bedding,
towels, pillows and the like ("Linens") and housewares and home accessories
("Things"). Some of the brands carried include Laura Ashley, Cannon, Martex,
Royal Velvet, Braun, Krups and Henckels. The company's own private labels are
growing nicely, accounting for approximately 10% of company sales in 1996, and
continue to be an ever larger source of revenues.
<PAGE>
LIN has a very strong balance sheet and is almost debt-free. The company has
surprised the street with positive earnings surprises in each of the two
quarters reported since being spun out of CVS back in late 1996. The surprise
has been driven by a mix shift, more "things" with higher margins and also
higher same-store sales than expected. The "things" mix has grown from 10% of
sales in 1991 to 35% in 1996, and we expect it will continue to grow going
forward. This is the key fundamental development in the company's prospects that
Wall Street has underestimated and is also what served as a catalyst for our
recognition of the opportunity in the stock.
Sales for Linens `N Things are expected to exceed $1 billion in 1998, which
compares with just shy of $700 million in 1996. That is an increase of
approximately 45% in just two years. Over that same two-year period, Wall Street
estimates that earnings per share will grow 82%. In its most recent quarter,
LIN's sales soared 30%.
We are excited about the fact that we can participate in this company's 25%
growth pace, which we were able to purchase for less than 14 times 1998
estimates, and which still possesses a P/E of less than 20. This participation
in the appreciation of the stock as Wall Street comes to fully grasp the dynamic
success of the company is exactly what we strive for!
Telxon, Dick Weiss
Telxon manufactures and integrates wireless and mobile transaction systems for
retail, distribution, transportation and manufacturing customers. Telxon's
subsidiary Aeronet is the largest manufacturer of spread spectrum transmitters
and receivers for wireless local area networks. These networks are becoming more
prevalent in many industries as corporations place more emphasis on inventory
management and customer tracking.
Under the leadership of new CEO Frank Brick, Telxon has undergone a
restructuring to cut costs and standardize its products. These moves are paying
off, as the number of products has been reduced from over 350 to less than 100
and overhead has been cut by $30 million. Additional consolidation will save
another $10 million going forward. More important, revenues should accelerate in
the second half of this year as new "thin client" products utilizing Java come
to market. Backlog continues to increase, and new products could grow to 30% of
sales in the year ending March 1999.
Our target price is $25, based on a conservative discount to the company's
estimated private market value. The Aeronet subsidiary alone is worth more than
$8 per share, and Telxon's earning power should exceed $1.25 by March 1999.
(initial purchase in Masters' Fund at 135/8)
3COM Corporation, Spiros Segalas
3Com is one of the top two suppliers of data communications products, which
include both wide and local area network systems. With its recent acquisition of
US Robotics, 3Com has extended and solidified its reach into the network, from
the edge to the network's core. Worldwide sales, on a combined basis, were
roughly $5.6 billion for FY 97 (ended in May) and are estimated to reach around
$7.5 billion in FY 1997 (combined historical results with detailed revenue
breakdowns will be released in late July). Earnings per share (EPS) were roughly
$1.85 and are estimated at $2.50 for FY 1997 and FY 1998, respectively. Calendar
1998 EPS are estimated at $3.00. There is potential for upside surprises, given
that margins are at the lower end of the company's targeted range and several
new product cycles have begun. Several of the underlying markets in which the
company operates are growing in the 30% to 50% range, with the remainder tied
somewhat to PC unit growth. The total company is likely to grow in a range of
25% to 45% over the next three years.
3Com's traditional approach of "plug and play" when addressing its markets with
easy-to-use products extends into its current end-to-end systems solution
approach to the evolving integrated data/voice/video communications market. The
company's philosophy of putting intelligence in the end points of the network is
unique to 3Com and differentiates it from competitors. This is likely to be
beneficial when penetrating the fast-growing SOHO (small office/home office)
market and can lead to opportunities in the carrier/network service provider
market. The company's strong presence in the distribution and retail channels,
combined with its growing strength in the direct channel, positions it to be a
formidable competitor going forward. 3Com should do well in this industry, where
it has moved into a consolidation mode and where size, breadth of product and
relationships with key telephone equipment vendors will be paramount.
<PAGE>
360 Degrees, Mason Hawkins
360 Degrees (XO) is a cellular phone company, the old Centel Cellular which was
bought and subsequently spun off by Sprint. By objective industry measures, XO
has one of the best management teams in the industry. Our $36-per-share
appraised value of XO is based on 10 times operating cash flow, a multiple below
several recent industry transactions and justified by our own assumptions about
industry growth. The main market fear about XO concerns the entry of Personal
Communication Services (PCS) into the wireless market. We believe this fear to
be overblown. Half of XO's markets are too rural to be built out, and in the
other half we believe the entire wireless market will be stimulated enough for
both types of competitors to prosper. The U.K. and Washington, D.C., are good
examples of markets where PCS results have been excellent; at the same time, the
existing cellular providers are not only surviving but have performed better
than in many markets where PCS hasn't yet arrived. There is not a "better mouse
trap" risk, i.e., digital vs. analog. Although cellular today is analog, within
a few years both cellular and PCS will be digital, and there will be no
difference apparent to the consumer.
The real risk is in having a third competitor in an industry that until now has
been a legislated duopoly. But recent reported numbers and the economics of
running a network suggest that PCS will require higher revenues per customer and
will compete for the high end, rather than wreck overall industry pricing. The
entire wireless industry should expand rapidly enough to provide plenty of room
for cellular and PCS.
What Makes a Great Stock Picker?
First and foremost, the Masters' Select Equity Fund is about pure stock picking:
six world-class stock pickers, running portfolios focused on a small group of
their favorite ideas. As the advisor to Masters' Select, Litman/Gregory Fund
Advisors draws on the expertise of our sister companies, Litman/Gregory &
Company, LLC, an investment management firm, and L/G Research, the publisher of
the No-Load Fund Analyst, a research-intensive investment newsletter. In both
companies we expend a great deal of energy on the study of stock pickers. For
more than 10 years, we've been intensively studying stock pickers from a
quantitative and qualitative perspective. Over that time we've formed some
strong opinions about what makes a good stock picker. Because these opinions
played a big role in the selection of the "Masters," we thought you might be
interested in an article that was published in the No-Load Fund Analyst, long
before we had the idea for Masters' Select. The following is a condensed and
edited version.
What It Takes to Be a Guru
Excerpted from the No-Load Fund Analyst, June 1995
For mutual fund investors, the search for the next Peter Lynch is eternal; and
what seems like a never-ending stream of articles in the personal finance
magazines fuels this obsession with superstar fund managers. Despite all the
coverage, not much attention is paid to what's behind the greatness or what it
takes for a stock picker to perpetuate top performance over the long term.
Because this is something we think about a lot, we'd like to share some of our
insights.
Our approach to evaluating fund managers melds the quantitative with the
qualitative. The numbers fascinate us. We want to know how a manager has done
relative to his or her peers in different market environments, and how
consistent the performance has been. We also want to know what's behind the
numbers. Did the manager make big sector bets or choose a few great stocks? But
while we closely examine the record of each fund we recommend, we are obsessed
with more than the numbers. We apply a qualitative overlay that we believe is
also critically important. Over the years our many conversations with fund
managers have given us insights into the common traits of great stock pickers.
This article outlines these traits.
Common Traits Among Gurus
What do great stock pickers have in common? We apply three general criteria:
1 We look for great long-term record relative to style peers. The proof is in
the pudding, so the numbers have to be there. A long record raises our
conviction level that these managers really are superstars.
2 Exhibiting traits that our experience has taught us make great investors is
also critical. The traits we've keyed in on are based on years of insights
gleaned from talking to many top managers.
3 Finally, we are focusing only on managers, we believe can maintain their guru
status. That means we must have a high level of confidence that they will remain
focused.
<PAGE>
What Makes a Great Stock Picker?
Stock pickers we have identified as "gurus" are extremely bright and work very
hard. But there's more. Despite huge differences among the great stock pickers,
including different investment disciplines, there are common elements that keep
popping up. These can be split into personal characteristics, which many
standouts in other fields including business and the arts also share, and
learned investment principles that govern their investment decisions.
Personal Characteristics
Passion: All the greats love what they do. When discussing their life's work,
they say things like "It's been a journey" and "Investing is in my blood." They
clearly find the work fascinating. Most are observers of the world, who glean
investment insights from their fascination with life. We believe that this
passion is critically important, because the investment business is incredibly
demanding. Such a highly competitive and information-intensive endeavor can
easily lead to burnout. And the huge wealth accumulated by successful investment
managers means great managers have to love their work to maintain the high level
of motivation after their financial independence is assured (as it no doubt is
for all our gurus).
Energy Level: Hand-in-hand with passion, is a high energy level. This goes
beyond just work ethic (although that's important too) to effectiveness. In this
very dynamic business, a high energy level is critical to figuring out what's
important, dealing with the unexpected, handling a multitude of issues and
ultimately maintaining productivity.
Obsessiveness: Casual knowledge is never enough for the great stock pickers.
This seems to be a universal trait. There is an obsessiveness about getting all
the information that might lead to better decisions. Foster Friess talks about
being an investment detective: His team scours every item on the income
statement in a quest to understand exactly what determines the earnings for each
company. Mason Hawkins is relentless in his quest to know management. Chris
Davis (Shelby Davis's son and now Selected American Shares manager) talks about
his dad sneaking in company visits when he was supposed to be dropping him off
atboarding school. In a business where lots of smart people are analyzing the
same information, a relentless effort to get the best information possible can
make a big difference.
Inner Strength: There are no wimps in this crowd. All the great stock pickers
have great confidence in themselves. This allows them to stand apart from the
crowd when their analysis says they should. They don't second-guess themselves
when there is no fundamental reason to. Confidence allows them to act without
being unduly influenced by a fear of being wrong, and it helps them maintain
perspective in bear markets. Exceptional inner strength is a precondition for
success in this business.
Independent Thinking: All the greats are also fiercely independent. They make up
their own minds, and it's difficult to shake them. There is no group-think or
index mentality in the bunch. It is interesting that most in this group
developed their investment approaches early in their careers and pretty much on
their own. Thus their independence has driven both their specific investment
decisions as well as the development of their investment processes. The ability
to think differently, along with the inner strength to have convictions and act
on them, is what allows the greats to channel their obsession, passion and
energy.
Skepticism: The great stock pickers tend to be skeptics. Shelby Davis talks
about separating the bluffers from the doers. These guys take nothing at face
value. Their obsessive nature drives them to get the information they need to
get past their skepticism and base decisions on conviction.
Self-Knowledge: These managers all know themselves. They manage their own
careers to enable themselves to focus on what they like to do and avoid what
they don't. This is probably one reason they aren't burned out. It may not be a
coincidence that most have almost total control over their work environments.
Dick Weiss's group has total autonomy within Strong. This gives them the control
they need to do what they want. Shelby Davis knows he's a loner and "probably
not a great team player." So although he has incorporated analysts' research
into his approach, he's pretty much worked on his own over the years. In recent
years, his sons have become very involved after working elsewhere.
Ability to Learn from Mistakes: Although the gurus are generally a stubborn
bunch, they do learn from their mistakes. While they hate mistakes, they are
secure enough to put success, which demands continuous learning, above their own
egos. They don't wallow in failure. If they make mistakes, they accept them,
learn from them and move on.
<PAGE>
Gut-Level Optimism: With all the great stock pickers, there is an underlying
optimism that the world is not going to end and that their approach will
continue to work. Although this is not rare in the investment business, it is
worth noting that few successful stock pickers got that way by heeding doomsday
scenarios of serious bear markets. It's worth noting, however, the gurus'
attention to downside risk, which we discuss later in this article.
Drive to Win: All the greats are very competitive and have an incredibly strong
drive to win--to be the best. When asked about their goals, performance almost
always comes up first.
Rules to Invest By
Focus on the Knowable: The greats don't speculate on what might happen. They
don't waste time trying to figure out investor behavior. None uses technical
analysis in his approach. These investors have learned to focus intensively on
analyzing what is knowable. Part of this analysis is getting to know company
management extremely well. They tend to view the managers of the companies they
invest in as partners, and, naturally, it is essential to know a partner well.
Because their analysis is not built on hope, it is easier for them to have the
conviction to take sizable positions and stick with them even when they may not
be doing well.
Think Long-term: None of the greats gets caught up in short-term thinking. They
refuse to evaluate their performance over the short term. Even Foster Friess,
who invests in a much faster-moving arena than the other managers we've
identified, emphasizes businesses with strong enough internal dynamics to
overwhelm macroeconomic factors. At the extreme, Shelby Davis talks about
generational investing, which includes an assessment of the long-term viability
of a franchise.
Be Very Cognizant of Downside Risk: All the gurus are keenly aware of risk.
Mason Hawkins, Dick Weiss and Jean-Marie Eveillard have their own valuation
methodologies and will buy only stocks that are selling at huge discounts to
their assessment of value. Shelby Davis focuses on the people and the balance
sheet--he wants to know that his boat can survive a hurricane. Though Sig
Segalas seeks good long- and short-term performance, he only invests in
companies he's comfortable holding for the long term. Even Foster Friess, who
invests in a much more volatile universe, is very cognizant of risk and stays
away from fad stocks. His team invests only when they think they understand the
company better than the market does. These guys don't guess.
Stick to Their Knitting: All the great managers know their strengths and
weaknesses. Each has complete faith in his process and doesn't deviate from it,
though the process itself is generally flexible enough to adjust on the margin
to changing opportunities. Still, one reason these guys haven't made too many
mistakes is that they stick to what they know.
Final Thoughts
Picking great funds requires more than looking for the best records. The numbers
tell us about the past. And, sometimes but not always, tearing the record apart
helps us answer the question Was it luck or talent? But in the end, the numbers
alone can't tell us for sure how much luck was involved in building the record.
To really raise our conviction level about future performance, we've got to get
a sense for whether the manager has what it takes to be great. In our opinion,
the most important characteristics are passion for the business, intellectual
independence and obsessiveness. All the greats have these traits, and we look
for them in managers. Of course, just because we are looking for them doesn't
mean they are easy to identify. It usually takes a number of interviews with a
manager to start to build our conviction level in our qualitative assessment.
It is also critically important to future success for managers to stay focused.
A number of great stock pickers' records have deteriorated as they became
distracted by the operating demands of a growing business. In order to
perpetuate greatness, managers have to keep their eye on the ball.
Master Profile:
Shelby Davis
<PAGE>
Following is a profile of one of the "Master" managers that run your Fund. We
will profile a manager in each future report to shareholders, until all the
"Masters" have been profiled. Going through the group alphabetically, we'll
start with Shelby Davis. The following was also excerpted from the June 1995
No-Load Fund Analyst.
SHELBY DAVIS has investing in his blood. He got an early start, working summers
for his father, who had started his own investment firm after being the
insurance commissioner for the State of New York. He went on field trips with
his dad and had visited almost all the big insurance companies before he ever
graduated from college. When he graduated from Princeton in 1958, he went to
work for the Bank of New York as a research analyst. There he got "good basic
blocking and tackling training." At the time, the bank was writing full-scale
reports on industries and selling them to trust departments all over the United
States. In five years Davis was head of research after rotating around a number
of industries.
Early on, Davis began to disdain short-term thinking and the focus on quarterly
earnings estimates. Davis's investment philosophy, like that of many others, was
influenced by Ben Graham. But his father also taught him to have a three- to
five-year outlook, to avoid trading and to talk to CEOs about earning power,
strategic plans, and hopes and dreams three years down the road. His dad had
told him the most important thing was to be able to "separate the bluffers from
the doers." Between 1958 and 1969, everything was roses: "We all thought we were
geniuses." In 1969 his fund, New York Venture (a load fund he still is involved
with, though his son Chris was recently named portfolio manager), was the
top-performing fund.
But that changed in 1970, when the fund was much closer to the bottom. For the
next four years, the fund bounced around and essentially made no money. The
1973-74 bear market proved that stocks could go down--way down--and stay down
for a long time. During this bear market, Davis went to see Ben Graham, who told
him that there were a lot of bargains and that cycles come and go. This period
turned out to be the greatest buying opportunity in a lifetime. Davis said he
did not do as well as he should have, however, because at the time he was just
looking for cheap stocks and he didn't understand franchise value, pricing
control, balance sheets, use of cash flow and the importance of
shareholder-oriented management. But during these rough years, he began to learn
that all earnings were not the same and all "cheap" stocks weren't really so
cheap. Davis eventually became what he calls a "counter puncher"--playing off
short-term earnings trends and looking for temporarily depressed or out-of-favor
companies and industries.
Over the years Davis has learned two critical lessons: Pay attention to the
balance sheet as well as the income statement, and know the management. If
something starts to go wrong, he says, "You want to know the people." He views
himself as a part owner not an investor. It's the people who make up a company,
and bad people can ruin a good company.
Davis's emphasis on value-priced growth, high-quality franchises, common
senseand a disdain for fads makes his portfolio like a boat built to travel the
entire breadth of the ocean through all kinds of weather. Strong balance sheets
and good management are the weatherproofing that let Davis sleep at night. He
also refuses to buy obsolescence. He is not interested in "coffee stores,
discount chains, jewelry stores or one-product technology companies." On the
other hand, he likes financial stocks because money never gets old.
Though he is an investment maniac, obsessive about his work, Davis has not tried
to master the universe, but has concentrated on what he knows well, stubbornly
sticking to his discipline. He likens investing to painting and says he is not a
Picasso, turning out lots of paintings very fast, but a long-term investor who
sticks with slower yet sustainable growth companies that are easier to
understand.
Davis's love for what he does has been passed on to the next generation of
Davises. When his three kids were in college, he would pay them $100 for each
company report they would write up after going to a company meeting. His two
sons, Chris and Andrew, now work with him. Both worked at other places before
joining their dad, but are now full-blown portfolio managers and critical to the
family business.
Very few managers have consistently and significantly outperformed the S&P 500,
but Davis has. Behind his record is a continued love for the business and an
inner drive to succeed without conforming to the crowd. He also has an uncanny
ability to spot long-term trends and generational changes that he combines with
his keen sense of history to build a very successful thematic portfolio. His
conviction to stay the course has also been critical to his success. Finally, he
also believes what his dad told him: "Work hard and good things will happen."
With his passion for the business intact, and over 35 years of experience,
Shelby Davis is a rare combination of energy and wisdom.
<PAGE>
Statement of Assets and Liabilities--June 30, 1997 (Unaudited)
Assets
Investments in securities at market value
(cost of $181,038,204) $203,132,019
Cash 5,179
Receivables:
Fund shares sold 313,752
Income receivable 293,140
Investment securities sold 1,699,839
Deferred organizational costs 102,953
Prepaid registration expense 33,207
Total assets $205,580,089
Liabilities
Payables:
Fund shares repurchased 5,691
Investment securities purchased 723,500
Miscellaneous 8,503
Accrued expenses 165,745
Total liabilities $903,439
Net Assets $204,676,650
Composition of Net Assets
Paid-in capital 181,416,382
Undistributed net investment income 546,444
Accumulated net realized gains 552,913
Net unrealized appreciation 22,160,911
Net Assets $204,676,650
Number of shares, $0.01 par value,
issued and outstanding (unlimited
shares authorized) 17,751,672
Net Asset Value per Share $11.53
<PAGE>
Statement of Operations--For the period from December 31,
1996, to June 30, 1997 (Unaudited)
Investment Income
Income:
Dividend income $996,549
Interest income 649,042
Total income $1,645,591
Expenses:
Advisory fees 818,335
Transfer agent fees 86,471
Custodian fees 70,168
Administration fees 61,323
Miscellaneous expenses 50,555
Registration fees 12,056
Amortization of deferred organizational costs 11,336
Legal fees 8,301
Trustees' fees 7,440
Insurance fees 7,159
Shareholder reporting fees 6,943
Audit fees 5,952
Total expenses 1,146,039
Less: expenses paid indirectly (45,028)
Less: expenses reimbursed (1,864)
Net expenses 1,099,147
Net investment income $546,444
Realized and Unrealized Gains (Losses)
Net realized gain (loss):
Investments $554,483
Foreign currency transactions ($2,570)
Net unrealized appreciation on:
Investments 22,093,815
Foreign currency transactions 67,096
Net realized and unrealized gains 22,713,824
Net increase in net assets
resulting from operations $23,260,268
<PAGE>
Financial Highlights - For a share outstanding throughout
the period (12/31/96 to 6/30/97)1 (Unaudited)
Net asset value, beginning of period $10.00
Income from investment operations
Net investment income 0.03
Net realized and unrealized gain 1.50
Total from investment operations $1.53
Less distributions
From net investment income --
From net realized gains --
Total distributions --
Net asset value, end of period $11.53
Total return2 15.30%
Net assets at end of period (in 000s) $204.677
Ratio of expenses to average net assets
(net of expense reimbursements and expenses
paid indirectly) 1.47%*
Ratio of net investment income to average net
assets 0.73%*
Portfolio turnover rate 62.73%
*Annualized.
1. The Masters' Select Equity Fund commenced operations on December 31, 1996.
2. Not annualized for periods of less than one year.
<PAGE>
Statement of Changes in Net Assets 12/31/96 to 6/30/97 (Unaudited)
Increase (Decrease) in Net Assets
Operations:
Net investment income $546,444
Net realized gain 552,913
Change in net unrealized appreciation 22,160,911
Net increase in net assets from operations $23,260,268
Distributions to shareholders:
From net investment income --
From net realized gains --
Total distributions --
Fund share transactions:
Proceeds from shares sold 189,634,630
Net asset value of shares issued on
reinvestment of distributions --
Cost of shares redeemed (8,318,248)
Net increase from Fund share transactions 181,316,382
Net increase in net assets $204,576,650
Net Assets
Beginning of period 100,000
End of period $204,676,650
Change in Shares
Shares sold 18,549,293
Shares issued on reinvestment of distributions --
Shares redeemed (807,621)
Net increase 17,741,672
<PAGE>
Notes to Financial Statements
1. Organization
The Masters' Select Equity Fund (the "Fund") is a series of Masters' Select
Investment Trust (the "Trust"), organized as a Delaware business trust on August
1, 1996, and registered under the Investment Company Act of 1940 (the "1940
Act") as an open-end management investment company.
The Masters' Select Equity Fund is a fund that seeks to increase the value of
your investment over the long term by using the combined talents and favorite
stock-picking ideas of six highly regarded portfolio managers.
2. Significant Accounting Policies
The following is a summary of the significant accounting policies followed by
the Fund.
Security Valuation--Portfolio securities that are listed or admitted to trading
on a U.S. exchange are valued at the last sales price on the principal exchange
of which the security is traded or, if there has been no sale that day, at the
mean between the closing bid and asked prices. Securities admitted to trading on
the NASDAQ National Market System and securities traded only in the U.S.
over-the-counter market are valued at the last sale price or, if there has been
no sale that day, at the mean between the closing bid and asked prices.
Securities and other assets for which market prices are not readily available
are valued at fair value determined in good faith by the Board of Trustees. Debt
securities with remaining maturities of 60 days or less are valued at amortized
cost, unless the Board of Trustees determines that amortized cost does not
represent fair value. Cash and receivables are valued at their face amounts.
Foreign Currency Translation--The books and records of the Fund are maintained
in U.S. dollars. The value of securities, currencies and other assets and
liabilities denominated in currencies other than U.S. dollars are translated
into U.S. dollars based upon foreign exchange rates prevailing at the end of the
period. Purchases and sales of investment securities, income and expenses are
translated on the respective dates of such transactions.
<PAGE>
The Fund does not isolate that portion of the results of operations resulting
from changes in foreign exchange rates on investments from the fluctuations
arising from changes in market prices of securities held. Such fluctuations are
included with the net realized and unrealized gain or loss from investments.
Reported net realized foreign exchange gains or losses arise from sales of
foreign currencies, currency gains or losses realized between the trade and
settlement dates on securities transactions, the difference between the amounts
of dividends, interest and foreign withholding taxes recorded on the Fund's
books and the U.S.-dollar equivalent of the amounts actually received or paid.
Net unrealized foreign exchange gains and losses arise from changes in the value
of assets and liabilities other than investments in securities resulting from
changes in the exchange rates.
Federal Income Taxes--The Fund intends to qualify as a regulated investment
company by complying with the appropriate provisions of the Internal Revenue
Code of 1986, as amended. Accordingly, no provisions for federal income taxes
are required.
Security Transactions and Related Income--Security transactions are accounted
for on the date the security is purchased or sold (trade date). Divided income
is recognized on the ex-dividend date, and interest income is recognized on the
accrual basis. Purchase discounts and premiums on securities held by the Fund
are accreted and amortized to maturity using the effective interest method.
Realized gains and losses on securities sold are determined under the identified
cost method.
It is the Trust's policy to take possession of securities as collateral under
repurchase agreement and to determine on a daily basis that the value of such
securities is sufficient to cover the value of the repurchase agreements.
Deferred Organization Costs--Organization costs are amortized on a straight-line
basis over a period of 60 months commencing with the first full month after the
Fund's commencement of operations.
Distributions--Distributions to shareholders are recorded on the ex-dividend
date.
Accounting Estimates--The preparation of financial statements in accordance with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities on
the date of financial statements and the amounts of income and expense during
the reporting period. Actual results could differ from those estimates.
3. Management Fees and Transactions with Affiliates
The Fund pays a management fee to its advisor, Litman/Gregory Fund Advisors, LLC
(the "Advisor"), at the annual rate of 1.10% of the Fund's average daily net
assets. The Advisor pays investment management fees to the six investment
managers. Total management fees incurred by the Fund as of June 30,1997, were
$818,335, of which $523,911 was paid to the investment managers, and $294,724
was retained by the Advisor. Management fees paid to the investment managers
represent 0.704% of the Fund's average daily net assets. Management fees
retained by the Advisor represent 0.396% of the Fund's average daily net assets.
The Advisor has agreed to reimburse the Fund for any ordinary operating expenses
above 1.75% of the Fund's average net assets. The Advisor reserves the right to
be repaid by the Fund if the expenses subsequently fall below the specified
limit in future years. This expense limitation arrangement is guaranteed by the
Advisor for at least the first year of the Fund's operations. After that, it may
be terminated at any time, subject to approval by the Board of Trustees and
prior notice to shareholders. Fee waivers and expense reimbursements are
voluntary and may be terminated at any time.
The Trust, on behalf of the Fund, entered into an Administration Agreement (the
"Agreement") with Investment Company Administration Corporation (the
"Administrator"). Under the terms of the Agreement, the Trust will pay an annual
fee, payable monthly and computed based on the value of the total average net
assets of the Trust at an annual rate of 0.10% of the first $100 million of such
net assets, 0.05% of next $150 million, 0.025% of next 250 million and 0.0125%
thereafter, subject to a minimum fee of $40,000.
<PAGE>
Each unaffiliated Trustee is compensated by the Trust at the rate of $7,500 per
year.
4. Purchases and Sales of Securities
The cost of security purchases and the proceeds from security sales, other than
short-term investments, for the six-month period ended June 30, 1997, were
$258,780,291 and $91,924,280, respectively.
At June 30, 1997, the aggregate unrealized appreciation and depreciation of
portfolio security based on cost for federal income tax purposes was as follows:
Unrealized appreciation $26,044,202
Unrealized depreciation ($3,883,291)
Net unrealized appreciation $22,160,911
This report is authorized for use when preceded or accompanied by a prospectus
for the Masters' Select Equity Fund. Read it carefully before investing. Past
performance is not a guarantee of future results. Share price and returns will
fluctuate and investors may have a gain or loss when they redeem shares.
Statement and other information in this report are dated and are subject to
change. Litman/Gregory Fund Advisors has ultimate responsibility for the Fund's
performance due to its responsibility to oversee its investment managers and
recommend their hiring, termination and replacement. First Fund Distributors,
Inc., Phoenix, AZ 85018.
<PAGE>
THE MASTERS' SELECT EQUITY FUND
Statement of Additional Information
Dated November 15, 1997
This Statement of Additional Information is not a prospectus, and it should be
read in conjunction with the prospectus dated November 15, 1997, as may be
amended from time to time, of The Masters' Select Equity Fund (the "Masters'
Select Equity" or "Equity Fund") and The Masters' Select International Fund (the
"Masters' Select International" or "International Fund"), a series of Masters'
Select Funds (the "Trust"). Litman/Gregory Fund Advisors, LLC (the "Advisor") is
the Advisor of the Funds. The Advisor has retained investment managers as
sub-advisers ("Managers"), each responsible for portfolio management of a
segment of each Fund's total assets. A copy of the combined prospectus may be
obtained from the Trust at 4 Orinda Way, Suite 230-D, Orinda, California 94563,
Telephone (510) 254-8999.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Cross-reference to sections
Page in the prospectus
---- -----------------
<S> <C> <C>
Investment Objective and Policies.................... B-4 The Fund at a Glance; The Fund in
Detail
Management........................................... B-21 The Fund in Detail: Management,
Investment Managers, Breakdown of
Expenses, Organization
Portfolio Transactions and Brokerage................. B-24 The Fund in Detail: Investment
Managers
Net Asset Value...................................... B-25 Your Account: How to Buy Shares
Taxation ........................................... B-26 Taxes
Dividends and Distributions.......................... B-28 Dividends, Capital Gains, and Taxes
Performance Information.............................. B-29 Performance
General Information.................................. B-30 General Information
Appendix............................................. B-30 Not applicable
Statement of Assets and Liabilities.................. B-31 Not applicable
Notes to Statement of Assets and Liabilities......... B-31 Not applicable
</TABLE>
B-1
<PAGE>
INVESTMENT OBJECTIVES AND POLICIES
The investment objective of each Fund is to provide long-term growth of
capital. There is no assurance that each Fund will achieve its objective. The
discussion below supplements information contained in the prospectus as to
investment policies of each Fund.
Convertible Securities and Warrants
Each Fund may invest in convertible securities and warrants. A
convertible security is a fixed income security (a debt instrument or a
preferred stock) which may be converted at a stated price within a specified
period of time into a certain quantity of the common stock of the same or a
different issuer. Convertible securities are senior to common stocks in an
issuer's capital structure, but are usually subordinated to similar
non-convertible securities. While providing a fixed income stream (generally
higher in yield than the income derivable from common stock but lower than that
afforded by a similar nonconvertible security), a convertible security also
affords an investor the opportunity, through its conversion feature, to
participate in the capital appreciation attendant upon a market price advance in
the convertible security's underlying common stock.
A warrant gives the holder a right to purchase at any time during a
specified period a predetermined number of shares of common stock at a fixed
price. Unlike convertible debt securities or preferred stock, warrants do not
pay a fixed dividend. Investments in warrants involve certain risks, including
the possible lack of a liquid market for resale of the warrants, potential price
fluctuations as a result of speculation or other factors, and failure of the
price of the underlying security to reach or have reasonable prospects of
reaching a level at which the warrant can be prudently exercised (in which event
the warrant may expire without being exercised, resulting in a loss of a Fund's
entire investment therein).
Other Corporate Debt Securities
Each Fund may invest in non-convertible debt securities of foreign and
domestic companies over a cross-section of industries. The debt securities in
which each Fund may invest will be of varying maturities and may include
corporate bonds, debentures, notes and other similar corporate debt instruments.
The value of a longer-term debt security fluctuates more widely in response to
changes in interest rates than do shorter-term debt securities.
Risks of Investing in Debt Securities
There are a number of risks generally associated with an investment in
debt securities (including convertible securities). Yields on short,
intermediate, and long-term securities depend on a variety of factors, including
the general condition of the money and bond markets, the size of a particular
offering, the maturity of the obligation, and the rating of the issue.
Debt securities with longer maturities tend to produce higher yields
and are generally subject to potentially greater capital appreciation and
depreciation than obligations with short maturities and lower yields. The market
prices of debt securities usually vary, depending upon available yields. An
increase in interest rates will generally reduce the value of such portfolio
investments, and a decline in interest rates will generally increase the value
of such portfolio investments. The ability of each Fund to achieve its
investment objective also depends on the continuing ability of the issuers of
the debt securities in which each Fund invests to meet their obligations for the
payment of interest and principal when due.
Risks of Investing in Lower-Rated Debt Securities
As set forth in the prospectus, each Fund may invest a portion of its
net assets in debt securities rated below "Baa" by Moody's or "BBB" by S&P or
below investment grade by other recognized rating agencies, or in unrated
securities of comparable quality under certain circumstances. Securities with
ratings below "Baa" and/or "BBB" are commonly referred to as "junk bonds." Such
bonds are subject to greater market fluctuations and risk of loss of income and
principal than higher rated bonds for a variety of reasons, including the
following:
Sensitivity to Interest Rate and Economic Changes. The economy and
interest rates affect high yield securities differently from other securities.
For example, the prices of high yield bonds have been found to be less
B-2
<PAGE>
sensitive to interest rate changes than higher-rated investments, but more
sensitive to adverse economic changes or individual corporate developments.
Also, during an economic downturn or substantial period of rising interest
rates, highly leveraged issuers may experience financial stress which would
adversely affect their ability to service their principal and interest
obligations, to meet projected business goals, and to obtain additional
financing. If the issuer of a bond defaults, each Fund may incur additional
expenses to seek recovery. In addition, periods of economic uncertainty and
changes can be expected to result in increased volatility of market prices of
high yield bonds and a Fund's asset values.
Payment Expectations. High yield bonds present certain risks based on
payment expectations. For example, high yield bonds may contain redemption and
call provisions. If an issuer exercises these provisions in a declining interest
rate market, a Fund would have to replace the security with a lower yielding
security, resulting in a decreased return for investors. Conversely, a high
yield bond's value will decrease in a rising interest rate market, as will the
value of a Fund's assets. If a Fund experiences unexpected net redemptions, it
may be forced to sell its high yield bonds without regard to their investment
merits, thereby decreasing the asset base upon which a Fund's expenses can be
spread and possibly reducing a Fund's rate of return.
Liquidity and Valuation. To the extent that there is no established
retail secondary market, there may be thin trading of high yield bonds, and this
may impact a Manager's ability to accurately value high yield bonds and a Fund's
assets and hinder a Fund's ability to dispose of the bonds. Adverse publicity
and investor perceptions, whether or not based on fundamental analysis, may
decrease the values and liquidity of high yield bonds, especially in a thinly
traded market.
Credit Ratings. Credit ratings evaluate the safety of principal and
interest payments, not the market value risk of high yield bonds. Also, since
credit rating agencies may fail to timely change the credit ratings to reflect
subsequent events, a Manager must monitor the issuers of high yield bonds in a
Fund's portfolio to determine if the issuers will have sufficient cash flow and
profits to meet required principal and interest payments, and to assure the
bonds' liquidity so a Fund can meet redemption requests. A Fund will not
necessarily dispose of a portfolio security when its rating has been changed.
Short-Term Investments
Each Fund may invest in any of the following securities and
instruments:
Bank Certificates or Deposit, Bankers' Acceptances and Time Deposits.
Each Fund may acquire certificates of deposit, bankers' acceptances and time
deposits. Certificates of deposit are negotiable certificates issued against
funds deposited in a commercial bank for a definite period of time and earning a
specified return. Bankers' acceptances are negotiable drafts or bills of
exchange, normally drawn by an importer or exporter to pay for specific
merchandise, which are "accepted" by a bank, meaning in effect that the bank
unconditionally agrees to pay the face value of the instrument on maturity.
Certificates of deposit and bankers' acceptances acquired by a Fund will be
dollar-denominated obligations of domestic or foreign banks or financial
institutions which at the time of purchase have capital, surplus and undivided
profits in excess of $100 million (including assets of both domestic and foreign
branches), based on latest published reports, or less than $100 million if the
principal amount of such bank obligations are fully insured by the U.S.
Government. If a Fund holds instruments of foreign banks or financial
institutions, it may be subject to additional investment risks that are
different in some respects from those incurred by a fund which invests only in
debt obligations of U.S. domestic issuers. See "Foreign Investments" below. Such
risks include future political and economic developments, the possible
imposition of withholding taxes by the particular country in which the issuer is
located on interest income payable on the securities, the possible seizure or
nationalization of foreign deposits, the possible establishment of exchange
controls or the adoption of other foreign governmental restrictions which might
adversely affect the payment of principal and interest on these securities.
Domestic banks and foreign banks are subject to different governmental
regulations with respect to the amount and types of loans which may be made and
interest rates which may be charged. In addition, the profitability of the
banking industry depends largely upon the availability and cost of funds for the
purpose of financing lending operations under prevailing money market
conditions. General economic conditions as well as exposure to credit losses
arising from possible financial difficulties of borrowers play an important part
in the operations of the banking
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industry.
As a result of federal and state laws and regulations, domestic banks
are, among other things, required to maintain specified levels of reserves,
limited in the amount which they can loan to a single borrower, and subject to
other regulations designed to promote financial soundness. However, such laws
and regulations do not necessarily apply to foreign bank obligations that a Fund
may acquire.
In addition to purchasing certificates of deposit and bankers'
acceptances, to the extent permitted under its investment objectives and
policies stated above and in its prospectus, a Fund may make interest-bearing
time or other interest-bearing deposits in commercial or savings banks. Time
deposits are non-negotiable deposits maintained at a banking institution for a
specified period of time at a specified interest rate.
Savings Association Obligations. Each Fund may invest in certificates
of deposit (interest-bearing time deposits) issued by savings banks or savings
and loan associations that have capital, surplus and undivided profits in excess
of $100 million, based on latest published reports, or less than $100 million if
the principal amount of such obligations is fully insured by the U.S.
Government.
Commercial Paper, Short-Term Notes and Other Corporate Obligations.
Each Fund may invest a portion of its assets in commercial paper and short-term
notes. Commercial paper consists of unsecured promissory notes issued by
corporations. Issues of commercial paper and short-term notes will normally have
maturities of less than nine months and fixed rates of return, although such
instruments may have maturities of up to one year.
Commercial paper and short-term notes will consist of issues rated at
the time of purchase "A-2" or higher by S&P, "Prime-1" or "Prime-2" by Moody's,
or similarly rated by another nationally recognized statistical rating
organization or, if unrated, will be determined by a Manager to be of comparable
quality. These rating symbols are described in Appendix A.
Corporate obligations include bonds and notes issued by corporations to
finance longer-term credit needs than supported by commercial paper. While such
obligations generally have maturities of ten years or more, a Fund may purchase
corporate obligations which have remaining maturities of one year or less from
the date of purchase and which are rated "AA" or higher by S&P or "Aa" or higher
by Moody's.
Money Market Funds
Each Fund may under certain circumstances invest a portion of its
assets in money market funds. The Investment Company Act of 1940 (the "1940
Act") prohibits a Fund from investing more than 5% of the value of its total
assets in any one investment company. or more than 10% of the value of its total
assets in investment companies as a group, and also restricts its investment in
any investment company to 3% of the voting securities of such investment
company. The Advisor and the Managers will not impose advisory fees on assets of
a Fund invested in a money market mutual fund. However, an investment in a money
market mutual fund will involve payment by a Fund of its pro rata share of
advisory and administrative fees charged by such fund.
Government Obligations
Each Fund may make short-term investments in U.S. Government
obligations. Such obligations include Treasury bills, certificates of
indebtedness, notes and bonds, and issues of such entities as the Government
National Mortgage Association ("GNMA"), Export-Import Bank of the United States,
Tennessee Valley Authority, Resolution Funding Corporation, Farmers Home
Administration, Federal Home Loan Banks, Federal Intermediate Credit Banks,
Federal Farm Credit Banks, Federal Land Banks, Federal Housing Administration,
Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage
Corporation, and the Student Loan Marketing Association.
Some of these obligations, such as those of the GNMA, are supported by
the full faith and credit of the U.S. Treasury; others, such as those of the
Export-Import Bank of United States, are supported by the right of the issuer to
borrow from the Treasury; others, such as those of the FNMA, are supported by
the discretionary authority of the U.S. Government to purchase the agency's
obligations; still others, such as those of the Student Loan Marketing
Association, are supported only by the credit of the instrumentality. No
assurance can be given that the U.S. Government would provide financial support
to U.S. Government-sponsored instrumentalities if it is not obligated
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to do so by law.
Each Fund may invest in sovereign debt obligations of foreign
countries. A sovereign debtor's willingness or ability to repay principal and
interest in a timely manner may be affected by a number of factors, including
its cash flow situation, the extent of its foreign reserves, the availability of
sufficient foreign exchange on the date a payment is due, the relative size of
the debt service burden to the economy as a whole, the sovereign debtor's policy
toward principal international lenders and the political constraints to which it
may be subject. Emerging market governments could default on their sovereign
debt. Such sovereign debtors also may be dependent on expected disbursements
from foreign governments, multilateral agencies and other entities abroad to
reduce principal and interest arrearages on their debt. The commitments on the
part of these governments, agencies and others to make such disbursements may be
conditioned on a sovereign debtor's implementation of economic reforms and/or
economic performance and the timely service of such debtor's obligations.
Failure to meet such conditions could result in the cancellation of such third
parties' commitments to lend funds to the sovereign debtor, which may further
impair such debtor's ability or willingness to service its debt in a timely
manner.
Zero Coupon Securities
Each Fund may invest up to 35% of its net assets in zero coupon
securities issued by the U.S. Treasury. Zero coupon Treasury securities are U.S.
Treasury notes and bonds which have been stripped of their unmatured interest
coupons and receipts, or certificates representing interests in such stripped
debt obligations or coupons. Because a zero coupon security pays no interest to
its holder during its life or for a substantial period of time, it usually
trades at a deep discount from its face or par value and will be subject to
greater fluctuations of market value in response to changing interest rates than
debt obligations of comparable maturities which make current distributions of
interest.
Variable and Floating Rate Instruments
Each Fund may acquire variable and floating rate instruments. Such
instruments are frequently not rated by credit rating agencies; however, unrated
variable and floating rate instruments purchased by a Fund will be determined by
a Manager under guidelines established by the Trust's Board of Trustees to be of
comparable quality at the time of the purchase to rated instruments eligible for
purchase by a Fund. In making such determinations, a Manager will consider the
earning power, cash flow and other liquidity ratios of the issuers of such
instruments (such issuers include financial, merchandising, bank holding and
other companies) and will monitor their financial condition. An active secondary
market may not exist with respect to particular variable or floating rate
instruments purchased by a Fund. The absence of such an active secondary market
could make it difficult for a Fund to dispose of the variable or floating rate
instrument involved in the event of the issuer of the instrument defaulting on
its payment obligation or during periods in which a Fund is not entitled to
exercise its demand rights, and a Fund could, for these or other reasons, suffer
a loss to the extent of the default. Variable and floating rate instruments may
be secured by bank letters of credit.
Mortgage-Related Securities
Each Fund may invest in mortgage-related securities. Mortgage-related
securities are derivative interests in pools of mortgage loans made to U.S.
residential home buyers, including mortgage loans made by savings and loan
institutions, mortgage bankers, commercial banks and others. Pools of mortgage
loans are assembled as securities for sale to investors by various governmental,
government-related and private organizations. Each Fund may also invest in debt
securities which are secured with collateral consisting of U.S. mortgage-related
securities, and in other types of U.S. mortgage-related securities.
U.S. Mortgage Pass-Through Securities. Interests in pools of
mortgage-related securities differ from other forms of debt securities, which
normally provide for periodic payment of interest in fixed amounts with
principal payments at maturity or specified call dates. Instead, these
securities provide a monthly payment which consists of both interest and
principal payments. In effect, these payments are a "pass-through" of the
monthly payments made by the individual borrowers on their residential mortgage
loans, net of any fees paid to the issuer or guarantor of such securities.
Additional payments are caused by repayments of principal resulting from the
sale of the underlying residential property, refinancing or foreclosure, net of
fees or costs which may be incurred. Some mortgage-related
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securities (such as securities issued by GNMA) are described as "modified
pass-throughs." These securities entitle the holder to receive all interest and
principal payments owed on the mortgage pool, net of certain fees, at the
scheduled payment dates regardless of whether or not the mortgagor actually
makes the payment.
The principal governmental guarantor of U.S. mortgage-related
securities is GNMA, a wholly owned United States Government corporation within
the Department of Housing and Urban Development. GNMA is authorized to
guarantee, with the full faith and credit of the United States Government, the
timely payment of principal and interest on securities issued by institutions
approved by GNMA (such as savings and loan institutions, commercial banks and
mortgage bankers) and backed by pools of mortgages insured by the Federal
Housing Agency or guaranteed by the Veterans Administration.
Government-related guarantors include the Federal National Mortgage
Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
FNMA is a government-sponsored corporation owned entirely by private
stockholders and subject to general regulation by the Secretary of Housing and
Urban Development. FNMA purchases conventional residential mortgages not insured
or guaranteed by any government agency from a list of approved seller/services
which include state and federally chartered savings and loan associations,
mutual savings banks, commercial banks and credit unions and mortgage bankers.
FHLMC is a government-sponsored corporation created to increase availability of
mortgage credit for residential housing and owned entirely by private
stockholders. FHLMC issues participation certificates which represent interests
in conventional mortgages from FHLMC's national portfolio. Pass-through
securities issued by FNMA and participation certificates issued by FHLMC are
guaranteed as to timely payment of principal and interest by FNMA and FHLMC,
respectively, but are not backed by the full faith and credit of the United
States Government.
Although the underlying mortgage loans in a pool may have maturities of
up to 30 years, the actual average life of the pool certificates typically will
be substantially less because the mortgages will be subject to normal principal
amortization and may be prepaid prior to maturity. Prepayment rates vary widely
and may be affected by changes in market interest rates. In periods of falling
interest rates, the rate of prepayment tends to increase, thereby shortening the
actual average life of the pool certificates. Conversely, when interest rates
are rising, the rate of prepayments tends to decrease, thereby lengthening the
actual average life of the certificates. Accordingly, it is not possible to
predict accurately the average life of a particular pool.
Collateralized Mortgage Obligations ("CMOs"). A domestic or foreign CMO
in which a Fund may invest is a hybrid between a mortgage-backed bond and a
mortgage pass-through security. Like a bond, interest is paid, in most cases,
semiannually. CMOs may be collateralized by whole mortgage loans, but are more
typically collateralized by portfolios of mortgage pass-through securities
guaranteed by GNMA, FHLMC, FNMA or equivalent foreign entities.
CMOs are structured into multiple classes, each bearing a different
stated maturity. Actual maturity and average life depend upon the prepayment
experience of the collateral. CMOs provide for a modified form of call
protection through a de facto breakdown of the underlying pool of mortgages
according to how quickly the loans are repaid. Monthly payment of principal and
interest received from the pool of underlying mortgages, including prepayments,
is first returned to the class having the earliest maturity date or highest
maturity. Classes that have longer maturity dates and lower seniority will
receive principal only after the higher class has been retired.
Foreign Investments and Currencies
Each Fund may invest in securities of foreign issuers that are not
publicly traded in the United States (the International Fund will invest
substantially all of its assets in securities of foreign issuers). Each Fund may
also invest in depositary receipts and in foreign currency futures contracts and
may purchase and sell foreign currency on a spot basis.
Depositary Receipts. Depositary Receipts ("DRs") include American
Depositary Receipts ("ADRs"), European Depositary Receipts ("EDRs"), Global
Depositary Receipts ("GDRs") or other forms of depositary receipts. DRs are
receipts typically issued in connection with a U.S. or foreign bank or trust
company which evidence ownership of underlying securities issued by a foreign
corporation.
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Risks of Investing in Foreign Securities. Investments in foreign
securities involve certain inherent risks, including the following:
Political and Economic Factors. Individual foreign economies of certain
countries may differ favorably or unfavorably from the United States' economy in
such respects as growth of gross national product, rate of inflation, capital
reinvestment, resource self-sufficiency, diversification and balance of payments
position. The internal politics of certain foreign countries may not be as
stable as those of the United States. Governments in certain foreign countries
also continue to participate to a significant degree, through ownership interest
or regulation, in their respective economies. Action by these governments could
include restrictions on foreign investment, nationalization, expropriation of
goods or imposition of taxes, and could have a significant effect on market
prices of securities and payment of interest. The economies of many foreign
countries are heavily dependent upon international trade and are accordingly
affected by the trade policies and economic conditions of their trading
partners. Enactment by these trading partners of protectionist trade legislation
could have a significant adverse effect upon the securities markets of such
countries.
Currency Fluctuations. Each Fund may invest in securities denominated
in foreign currencies. Accordingly, a change in the value of any such currency
against the U.S. dollar will result in a corresponding change in the U.S. dollar
value of a Fund's assets denominated in that currency. Such changes will also
affect a Fund's income. The value of a Fund's assets may also be affected
significantly by currency restrictions and exchange control regulations enacted
from time to time.
Market Characteristics. The Managers expect that many foreign
securities in which a Fund invests will be purchased in over-the-counter markets
or on exchanges located in the countries in which the principal offices of the
issuers of the various securities are located, if that is the best available
market. Foreign exchanges and markets may be more volatile than those in the
United States. While growing in volume, they usually have substantially less
volume than U.S. markets, and a Fund's portfolio securities may be less liquid
and more volatile than U.S. Government securities. Moreover, settlement
practices for transactions in foreign markets may differ from those in United
States markets, and may include delays beyond periods customary in the United
States. Foreign security trading practices, including those involving securities
settlement where Fund assets may be released prior to receipt of payment or
securities, may expose a Fund to increased risk in the event of a failed trade
or the insolvency of a foreign broker-dealer.
Transactions in options on securities, futures contracts, futures
options and currency contracts may not be regulated as effectively on foreign
exchanges as similar transactions in the United States, and may not involve
clearing mechanisms and related guarantees. The value of such positions also
could be adversely affected by the imposition of different exercise terms and
procedures and margin requirements than in the United States. The value of a
Fund's positions may also be adversely impacted by delays in its ability to act
upon economic events occurring in foreign markets during non-business hours in
the United States.
Legal and Regulatory Matters. Certain foreign countries may have less
supervision of securities markets, brokers and issuers of securities, and less
financial information available to issuers, than is available in the United
States.
Taxes. The interest payable on certain of a Fund's foreign portfolio
securities may be subject to foreign withholding taxes, thus reducing the net
amount of income available for distribution to a Fund's shareholders.
Costs. To the extent that each Fund invests in foreign securities, its
expense ratio is likely to be higher than those of investment companies
investing only in domestic securities, since the cost of maintaining the custody
of foreign securities is higher.
Emerging markets. Some of the securities in which each Fund may invest
may be located in developing or emerging markets, which entail additional risks,
including less social, political and economic stability; smaller securities
markets and lower trading volume, which may result in a less liquidity and
greater price volatility; national policies that may restrict a Fund's
investment opportunities, including restrictions on investment in issuers or
industries, or expropriation or confiscation of assets or property; and less
developed legal structures governing private or foreign investment.
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In considering whether to invest in the securities of a foreign
company, a Manager considers such factors as the characteristics of the
particular company, differences between economic trends and the performance of
securities markets within the U.S. and those within other countries, and also
factors relating to the general economic, governmental and social conditions of
the country or countries where the company is located. The extent to which a
Fund will be invested in foreign companies and countries and depository receipts
will fluctuate from time to time within the limitations described in the
prospectus, depending on a Manager's assessment of prevailing market, economic
and other conditions.
Options on Securities and Securities Indices
Purchasing Put and Call Options. Each Fund may purchase covered "put"
and "call" options with respect to securities which are otherwise eligible for
purchase by a Fund and with respect to various stock indices subject to certain
restrictions. Each Fund will engage in trading of such derivative securities
primarily for hedging purposes.
If a Fund purchases a put option, a Fund acquires the right to sell the
underlying security at a specified price at any time during the term of the
option (for "American-style" options) or on the option expiration date (for
"European-style" options). Purchasing put options may be used as a portfolio
investment strategy when a Manager perceives significant short-term risk but
substantial long-term appreciation for the underlying security. The put option
acts as an insurance policy, as it protects against significant downward price
movement while it allows full participation in any upward movement. If a Fund is
holding a stock which it feels has strong fundamentals, but for some reason may
be weak in the near term, a Fund may purchase a put option on such security,
thereby giving itself the right to sell such security at a certain strike price
throughout the term of the option. Consequently, a Fund will exercise the put
only if the price of such security falls below the strike price of the put. The
difference between the put's strike price and the market price of the underlying
security on the date a Fund exercises the put, less transaction costs, will be
the amount by which a Fund will be able to hedge against a decline in the
underlying security. If during the period of the option the market price for the
underlying security remains at or above the put's strike price, the put will
expire worthless, representing a loss of the price a Fund paid for the put, plus
transaction costs. If the price of the underlying security increases, the profit
a Fund realizes on the sale of the security will be reduced by the premium paid
for the put option less any amount for which the put may be sold.
If a Fund purchases a call option, it acquires the right to purchase
the underlying security at a specified price at any time during the term of the
option. The purchase of a call option is a type of insurance policy to hedge
against losses that could occur if a Fund has a short position in the underlying
security and the security thereafter increases in price. Each Fund will exercise
a call option only if the price of the underlying security is above the strike
price at the time of exercise. If during the option period the market price for
the underlying security remains at or below the strike price of the call option,
the option will expire worthless, representing a loss of the price paid for the
option, plus transaction costs. If the call option has been purchased to hedge a
short position of a Fund in the underlying security and the price of the
underlying security thereafter falls, the profit a Fund realizes on the cover of
the short position in the security will be reduced by the premium paid for the
call option less any amount for which such option may be sold.
Prior to exercise or expiration, an option may be sold when it has
remaining value by a purchaser through a "closing sale transaction," which is
accomplished by selling an option of the same series as the option previously
purchased. Each Fund generally will purchase only those options for which a
Manager believes there is an active secondary market to facilitate closing
transactions.
Writing Call Options. Each Fund may write covered call options. A call
option is "covered" if a Fund owns the security underlying the call or has an
absolute right to acquire the security without additional cash consideration
(or, if additional cash consideration is required, cash or cash equivalents in
such amount as are held in a segregated account by the Custodian). The writer of
a call option receives a premium and gives the purchaser the right to buy the
security underlying the option at the exercise price. The writer has the
obligation upon exercise of the option to deliver the underlying security
against payment of the exercise price during the option period. If the writer of
an exchange-traded option wishes to terminate his obligation, he may effect a
"closing purchase transaction." This is accomplished by buying an option of the
same series as the option previously written. A writer may not effect a closing
purchase transaction after it has been notified of the exercise of an option.
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Effecting a closing transaction in the case of a written call option
will permit a Fund to write another call option on the underlying security with
either a different exercise price, expiration date or both. Also, effecting a
closing transaction will permit the cash or proceeds from the concurrent sale of
any securities subject to the option to be used for other investments of a Fund.
If a Fund desires to sell a particular security from its portfolio on which it
has written a call option, it will effect a closing transaction prior to or
concurrent with the sale of the security.
Each Fund will realize a gain from a closing transaction if the cost of
the closing transaction is less than the premium received from writing the
option or if the proceeds from the closing transaction are more than the premium
paid to purchase the option. Each Fund will realize a loss from a closing
transaction if the cost of the closing transaction is more than the premium
received from writing the option or if the proceeds from the closing transaction
are less than the premium paid to purchase the option. However, because
increases in the market price of a call option will generally reflect increases
in the market price of the underlying security, any loss to a Fund resulting
from the repurchase of a call option is likely to be offset in whole or in part
by appreciation of the underlying security owned by a Fund.
Stock Index Options. Each Fund may also purchase put and call options
with respect to the S&P 500 and other stock indices. Such options may be
purchased as a hedge against changes resulting from market conditions in the
values of securities which are held in a Fund's portfolio or which it intends to
purchase or sell, or when they are economically appropriate for the reduction of
risks inherent in the ongoing management of a Fund.
The distinctive characteristics of options on stock indices create
certain risks that are not present with stock options generally. Because the
value of an index option depends upon movements in the level of the index rather
than the price of a particular stock, whether a Fund will realize a gain or loss
on the purchase or sale of an option on an index depends upon movements in the
level of stock prices in the stock market generally rather than movements in the
price of a particular stock. Accordingly, successful use by a Fund of options on
a stock index would be subject to a Manager's ability to predict correctly
movements in the direction of the stock market generally. This requires
different skills and techniques than predicting changes in the price of
individual stocks.
Index prices may be distorted if trading of certain stocks included in
the index is interrupted. Trading of index options also may be interrupted in
certain circumstances, such as if trading were halted in a substantial number of
stocks included in the index. If this were to occur, a Fund would not be able to
close out options which it had purchased, and if restrictions on exercise were
imposed, a Fund might be unable to exercise an option it holds, which could
result in substantial losses to a Fund. It is the policy of each Fund to
purchase put or call options only with respect to an index which a Manager
believes includes a sufficient number of stocks to minimize the likelihood of a
trading halt in the index.
Risks Of Investing in Options. There are several risks associated with
transactions in options on securities and indices. Options may be more volatile
than the underlying instruments and, therefore, on a percentage basis, an
investment in options may be subject to greater fluctuation than an investment
in the underlying instruments themselves. There are also significant differences
between the securities and options markets that could result in an imperfect
correlation between these markets, causing a given transaction not to achieve
its objective. In addition, a liquid secondary market for particular options may
be absent for reasons which include the following: there may be insufficient
trading interest in certain options; restrictions may be imposed by an exchange
on opening transactions or closing transactions or both; trading halts,
suspensions or other restrictions may be imposed with respect to particular
classes or series of option of underlying securities; unusual or unforeseen
circumstances may interrupt normal operations on an exchange; the facilities of
an exchange or clearing corporation may not at all times be adequate to handle
current trading volume; or one or more exchanges could, for economic or other
reasons, decide or be compelled at some future date to discontinue the trading
of options (or a particular class or series of options), in which event the
secondary market on that exchange (or in that class or series of options) would
cease to exist, although outstanding options that had been issued by a clearing
corporation as a result of trades on that exchange would continue to be
exercisable in accordance with their terms.
A decision as to whether, when and how to use options involves the
exercise of skill and judgment, and even a well-conceived transaction may be
unsuccessful to some degree because of market behavior or unexpected events. The
extent to which a Fund may enter into options transactions may be limited by the
Internal Revenue Code (the
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"Code") requirements for qualification of a Fund as a regulated investment
company. See "Dividends and Distributions" and "Taxation."
In addition, when trading options on foreign exchanges, many of the
protections afforded to participants in United States option exchanges will not
be available. For example, there may be no daily price fluctuation limits in
such exchanges or markets, and adverse market movements could therefore continue
to an unlimited extent over a period of time. Although the purchaser of an
option cannot lose more than the amount of the premium plus related transaction
costs, this entire amount could be lost. Moreover, a Fund as an option writer
could lose amounts substantially in excess of its initial investment, due to the
margin and collateral requirements typically associated with such option
writing. See "Dealer Options" below.
Dealer Options. Each Fund will engage in transactions involving dealer
options as well as exchange-traded options. Certain risks are specific to dealer
options. While a Fund might look to a clearing corporation to exercise
exchange-traded options, if a Fund were to purchase a dealer option it would
need to rely on the dealer from which it purchased the option to perform if the
option were exercised. Failure by the dealer to do so would result in the loss
of the premium paid by a Fund as well as loss of the expected benefit of the
transaction.
Exchange-traded options generally have a continuous liquid market while
dealer options may not. Consequently, a Fund may generally be able to realize
the value of a dealer option it has purchased only by exercising or reselling
the option to the dealer who issued it. Similarly, when a Fund writes a dealer
option, a Fund may generally be able to close out the option prior to its
expiration only by entering into a closing purchase transaction with the dealer
to whom a Fund originally wrote the option. While a Fund will seek to enter into
dealer options only with dealers who will agree to and which are expected to be
capable of entering into closing transactions with a Fund, there can be no
assurance that a Fund will at any time be able to liquidate a dealer option at a
favorable price at any time prior to expiration. Unless a Fund, as a covered
dealer call option writer, is able to effect a closing purchase transaction, it
will not be able to liquidate securities (or other assets) used as cover until
the option expires or is exercised. In the event of insolvency of the other
party, a Fund may be unable to liquidate a dealer option. With respect to
options written by a Fund, the inability to enter into a closing transaction may
result in material losses to a Fund. For example, because a Fund must maintain a
secured position with respect to any call option on a security it writes, a Fund
may not sell the assets which it has segregated to secure the position while it
is obligated under the option. This requirement may impair a Fund's ability to
sell portfolio securities at a time when such sale might be advantageous.
The Staff of the Securities and Exchange Commission (the "Commission")
has taken the position that purchased dealer options are illiquid securities. A
Fund may treat the cover used for written dealer options as liquid if the dealer
agrees that a Fund may repurchase the dealer option it has written for a maximum
price to be calculated by a predetermined formula. In such cases, the dealer
option would be considered illiquid only to the extent the maximum purchase
price under the formula exceeds the intrinsic value of the option. Accordingly,
each Fund will treat dealer options as subject to a Fund's limitation on
illiquid securities. If the Commission changes its position on the liquidity of
dealer options, each Fund will change its treatment of such instruments
accordingly.
Foreign Currency Options. Each Fund may buy or sell put and call
options on foreign currencies. A put or call option on a foreign currency gives
the purchaser of the option the right to sell or purchase a foreign currency at
the exercise price until the option expires. Each Fund will use foreign currency
options separately or in combination to control currency volatility. Among the
strategies employed to control currency volatility is an option collar. An
option collar involves the purchase of a put option and the simultaneous sale of
call option on the same currency with the same expiration date but with
different exercise (or "strike") prices. Generally, the put option will have an
out-of-the-money strike price, while the call option will have either an
at-the-money strike price or an in-the-money strike price. Foreign currency
options are derivative securities. Currency options traded on U.S. or other
exchanges may be subject to position limits which may limit the ability of a
Fund to reduce foreign currency risk using such options.
As with other kinds of option transactions, the writing of an option on
foreign currency will constitute only a partial hedge, up to the amount of the
premium received. Each Fund could be required to purchase or sell foreign
currencies at disadvantageous exchange rates, thereby incurring losses. The
purchase of an option on foreign currency may constitute an effective hedge
against exchange rate fluctuations: however, in the event of exchange rate
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movements adverse to a Fund's position, a Fund may forfeit the entire amount of
the premium plus related transaction costs.
Spread Transactions. Each Fund may purchase covered spread options from
securities dealers. These covered spread options are not presently
exchange-listed or exchange-traded. The purchase of a spread option gives a Fund
the right to put a securities that it owns at a fixed dollar spread or fixed
yield spread in relationship to another security that a Fund does not own, but
which is used as a benchmark. The risk to a Fund, in addition to the risks of
dealer options described above, is the cost of the premium paid as well as any
transaction costs. The purchase of spread options will be used to protect a Fund
against adverse changes in prevailing credit quality spreads, i.e., the yield
spread between high quality and lower quality securities. This protection is
provided only during the life of the spread options.
Forward Currency Contracts
Each Fund may enter into forward currency contracts in anticipation of
changes in currency exchange rates. A forward currency contract is an obligation
to purchase or sell a specific currency at a future date, which may be any fixed
number of days from the date of the contract agreed upon by the parties, at a
price set at the time of the contract. For example, a Fund might purchase a
particular currency or enter into a forward currency contract to preserve the
U.S. dollar price of securities it intends to or has contracted to purchase.
Alternatively, it might sell a particular currency on either a spot or forward
basis to hedge against an anticipated decline in the dollar value of securities
it intends to or has contracted to sell. Although this strategy could minimize
the risk of loss due to a decline in the value of the hedged currency, it could
also limit any potential gain from an increase in the value of the currency.
Futures Contracts and Related Options
Each Fund may invest in futures contracts and options on futures
contracts as a hedge against changes in market conditions or interest rates. A
Fund will trade in such derivative securities for bona fide hedging purposes and
otherwise in accordance with the rules of the Commodity Futures Trading
Commission ("CFTC"). A Fund will segregate liquid assets in a separate account
with its Custodian when required to do so by CFTC guidelines in order to cover
its obligation in connection with futures and options transactions.
No price is paid or received by a Fund upon the purchase or sale of a
futures contract. When it enters into a domestic futures contract, a Fund will
be required to deposit in a segregated account with its Custodian an amount of
cash or U.S. Treasury bills equal to approximately 5% of the contract amount.
This amount is known as initial margin. The margin requirements for foreign
futures contracts may be different.
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The nature of initial margin in futures transactions is different from
that of margin in securities transactions. Futures contract margin does not
involve the borrowing of funds by the customer to finance the transactions.
Rather, the initial margin is in the nature of a performance bond or good faith
deposit on the contract which is returned to a Fund upon termination of the
futures contract, assuming all contractual obligations have been satisfied.
Subsequent payments (called variation margin) to and from the broker will be
made on a daily basis as the price of the underlying stock index fluctuates, to
reflect movements in the price of the contract making the long and short
positions in the futures contract more or less valuable. For example, when a
Fund has purchased a stock index futures contract and the price of the
underlying stock index has risen, that position will have increased in value and
a Fund will receive from the broker a variation margin payment equal to that
increase in value. Conversely, when a Fund has purchased a stock index futures
contract and the price of the underlying stock index has declined, the position
will be less valuable and a Fund will be required to make a variation margin
payment to the broker.
At any time prior to expiration of a futures contract, a Fund may elect
to close the position by taking an opposite position, which will operate to
terminate a Fund's position in the futures contract A final determination of
variation margin is made on closing the position. Additional cash is paid by or
released to a Fund, which realizes a loss or a gain.
In addition to amounts segregated or paid as initial and variation
margin, a Fund must segregate liquid assets with its custodian equal to the
market value of the futures contracts, in order to comply with Commission
requirements intended to ensure that a Fund's use of futures is unleveraged. The
requirements for margin payments and segregated accounts apply to both domestic
and foreign futures contracts.
Stock Index Futures Contracts. Each Fund may invest in futures
contracts on stock indices. Currently, stock index futures contracts can be
purchased or sold with respect to the S&P 500 Stock Price Index on the Chicago
Mercantile Exchange, the Major Market Index on the Chicago Board of Trade, the
New York Stock Exchange Composite Index on the New York Futures Exchange and the
Value Line Stock Index on the Kansas City Board of Trade. Foreign financial and
stock index futures are traded on foreign exchanges including the London
International Financial Futures Exchange, the Singapore International Monetary
Exchange, the Sydney Futures Exchange Limited and the Tokyo Stock Exchange.
Interest Rate or Financial Futures Contracts. Each Fund may invest in
interest rate or financial futures contracts. Bond prices are established in
both the cash market and the futures market. In the cash market, bonds are
purchased and sold with payment for the full purchase price of the bond being
made in cash, generally within five business days after the trade. In the
futures market, a contract is made to purchase or sell a bond in the future for
a set price on a certain date. Historically, the prices for bonds established in
the futures markets have generally tended to move in the aggregate in concert
with cash market prices, and the prices have maintained fairly predictable
relationships.
The sale of an interest rate or financial futures contract by a Fund
would create an obligation by a Fund, as seller, to deliver the specific type of
financial instrument called for in the contract at a specific future time for a
specified price. A futures contract purchased by a Fund would create an
obligation by a Fund, as purchaser, to take delivery of the specific type of
financial instrument at a specific future time at a specific price. The specific
securities delivered or taken, respectively, at settlement date, would not be
determined until at or near that date. The determination would be in accordance
with the rules of the exchange on which the futures contract sale or purchase
was made.
Although interest rate or financial futures contracts by their terms
call for actual delivery or acceptance of securities, in most cases the
contracts are closed out before the settlement date without delivery of
securities. Closing out of a futures contract sale is effected by a Fund's
entering into a futures contract purchase for the same aggregate amount of the
specific type of financial instrument and the same delivery date. If the price
in the sale exceeds the price in the offsetting purchase, a Fund is paid the
difference and thus realizes a gain. If the offsetting purchase price exceeds
the sale price, a Fund pays the difference and realizes a loss. Similarly, the
closing out of a futures contract purchase is effected by a Fund's entering into
a futures contract sale. If the offsetting sale price exceeds the purchase
price, a Fund realizes a gain, and if the purchase price exceeds the offsetting
sale price, a Fund realizes a loss.
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Each Fund will deal only in standardized contracts on recognized
exchanges. Each exchange guarantees performance under contract provisions
through a clearing corporation, a nonprofit organization managed by the exchange
membership. Domestic interest rate futures contracts are traded in an auction
environment on the floors of several exchanges - principally, the Chicago Board
of Trade and the Chicago Mercantile Exchange. A public market now exists in
domestic futures contracts covering various financial instruments including
long-term United States Treasury bonds and notes; GNMA modified pass-through
mortgage-backed securities; three-month United States Treasury bills; and 90-day
commercial paper. Each Fund may trade in any futures contract for which there
exists a public market, including, without limitation, the foregoing
instruments. International interest rate futures contracts are traded on the
London International Financial Futures Exchange, the Singapore International
Monetary Exchange, the Sydney Futures Exchange Limited and the Tokyo Stock
Exchange.
Foreign Currency Futures Contracts. Each Fund may use foreign currency
future contracts for hedging purposes. A foreign currency futures contract
provides for the future sale by one party and purchase by another party of a
specified quantity of a foreign currency at a specified price and time. A public
market exists in futures contracts covering several foreign currencies,
including the Australian dollar, the Canadian dollar, the British pound, the
German mark, the Japanese yen, the Swiss franc, and certain multinational
currencies such as the European Currency Unit ("ECU"). Other foreign currency
futures contracts are likely to be developed and traded in the future. Each Fund
will only enter into futures contracts and futures options which are
standardized and traded on a U.S. or foreign exchange, board of trade, or
similar entity, or quoted on an automated quotation system.
Risks of Transactions in Futures Contracts. There are several risks
related to the use of futures as a hedging device. One risk arises because of
the imperfect correlation between movements in the price of the futures contract
and movements in the price of the securities which are the subject of the hedge.
The price of the future may move more or less than the price of the securities
being hedged. If the price of the future moves less than the price of the
securities which are the subject of the hedge, the hedge will not be fully
effective, but if the price of the securities being hedged has moved in an
unfavorable direction, a Fund would be in a better position than if it had not
hedged at all. If the price of the securities being hedged has moved in a
favorable direction, this advantage will be partially offset by the loss on the
future. If the price of the future moves more than the price of the hedged
securities, a Fund will experience either a loss or a gain on the future which
will not be completely offset by movements in the price of the securities which
are subject to the hedge.
To compensate for the imperfect correlation of movements in the price
of securities being hedged and movements in the price of the futures contract, a
Fund may buy or sell futures contracts in a greater dollar amount than the
dollar amount of securities being hedged if the historical volatility of the
prices of such securities has been greater than the historical volatility over
such time period of the future. Conversely, a Fund may buy or sell fewer futures
contracts if the historical volatility of the price of the securities being
hedged is less than the historical volatility of the futures contract being
used. It is possible that, when a Fund has sold futures to hedge its portfolio
against a decline in the market, the market may advance while the value of
securities held in a Fund's portfolio may decline. If this occurs, a Fund will
lose money on the future and also experience a decline in value in its portfolio
securities. However, the Advisor believes that over time the value of a
diversified portfolio will tend to move in the same direction as the market
indices upon which the futures are based.
Where futures are purchased to hedge against a possible increase in the
price of securities before a Fund is able to invest its cash (or cash
equivalents) in securities (or options) in an orderly fashion, it is possible
that the market may decline instead. If a Fund then decides not to invest in
securities or options at that time because of concern as to possible further
market decline or for other reasons, it will realize a loss on the futures
contract that is not offset by a reduction in the price of securities purchased.
In addition to the possibility that there may be an imperfect
correlation, or no correlation at all, between movements in the futures and the
securities being hedged, the price of futures may not correlate perfectly with
movement in the stock index or cash market due to certain market distortions.
All participants in the futures market are subject to margin deposit and
maintenance requirements. Rather than meeting additional margin deposit
requirements, investors may close futures contracts through offsetting
transactions, which could distort the normal relationship between the index or
cash market and futures markets. In addition, the deposit requirements in the
futures market are less onerous than margin requirements in the securities
market. Therefore, increased participation by speculators in the futures market
may also cause temporary price distortions. As a result of price distortions in
the
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futures market and the imperfect correlation between movements in the cash
market and the price of securities and movements in the price of futures, a
correct forecast of general trends by a Manager may still not result in a
successful hedging transaction over a very short time frame.
Positions in futures may be closed out only on an exchange or board of
trade which provides a secondary market for such futures. Although a Fund may
intend to purchase or sell futures only on exchanges or boards of trade where
there appears to be an active secondary market, there is no assurance that a
liquid secondary market on an exchange or board of trade will exist for any
particular contract or at any particular time. In such event, it may not be
possible to close a futures position, and in the event of adverse price
movements, a Fund would continue to be required to make daily cash payments of
variation margin. When futures contracts have been used to hedge portfolio
securities, such securities will not be sold until the futures contract can be
terminated. In such circumstances, an increase in the price of the securities,
if any, may partially or completely offset losses on the futures contract.
However, as described above, there is no guarantee that the price of the
securities will in fact correlate with the price movements in the futures
contract and thus provide an offset to losses on a futures contract.
Most United States futures exchanges limit the amount of fluctuation
permitted in futures contract prices during a single trading day. The daily
limit establishes the maximum amount that the price of a futures contract may
vary either up or down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
futures contract, no trades may be made on that day at a price beyond that
limit. The daily limit governs only price movement during a particular trading
day and therefore does not limit potential losses, because the limit may prevent
the liquidation of unfavorable positions. Futures contract prices have
occasionally moved to the daily limit for several consecutive trading days with
little or no trading, thereby preventing prompt liquidation of futures positions
and subjecting some futures traders to substantial losses.
Successful use of futures by a Fund is also subject to a Manager's
ability to predict correctly movements in the direction of the market. For
example, if a Fund has hedged against the possibility of a decline in the market
adversely affecting stocks held in its portfolio and stock prices increase
instead, a Fund will lose part or all of the benefit of the increased value of
the stocks which it has hedged because it will have offsetting losses in its
futures positions. In addition, in such situations, if a Fund has insufficient
cash, it may have to sell securities to meet daily variation margin
requirements. Such sales of securities may be, but will not necessarily be, at
increased prices which reflect the rising market. Each Fund may have to sell
securities at a time when it may be disadvantageous to do so.
In the event of the bankruptcy of a broker through which a Fund engages
in transactions in futures contracts or options, a Fund could experience delays
and losses in liquidating open positions purchased or sold through the broker,
and incur a loss of all or part of its margin deposits with the broker.
Options on Futures Contracts. As described above, each Fund may
purchase options on the futures contracts they can purchase or sell. A futures
option gives the holder, in return for the premium paid, the right to buy (call)
from or sell (put) to the writer of the option a futures contract at a specified
price at any time during the period of the option. Upon exercise, the writer of
the option is obligated to pay the difference between the cash value of the
futures contract and the exercise price. Like the buyer or seller of a futures
contract, the holder or writer of an option has the right to terminate its
position prior to the scheduled expiration of the option by selling, or
purchasing an option of the same series, at which time the person entering into
the closing transaction will realize a gain or loss. There is no guarantee that
such closing transactions can be effected.
Investments in futures options involve some of the same considerations
as investments in futures contracts (for example, the existence of a liquid
secondary market). In addition, the purchase of an option also entails the risk
that changes in the value of the underlying futures contract will not be fully
reflected in the value of the option. Depending on the pricing of the option
compared to either the futures contract upon which it is based, or upon the
price of the securities being hedged, an option may or may not be less risky
than ownership of the futures contract or such securities. In general, the
market prices of options can be expected to be more volatile than the market
prices on the underlying futures contracts. Compared to the purchase or sale of
futures contracts, however, the purchase of call or put options on futures
contracts may frequently involve less potential risk to a Fund because the
maximum amount at risk is limited to the premium paid for the options (plus
transaction costs).
Restrictions on the Use or Futures Contracts and Related Options. Each
Fund will engage in transactions in futures contracts or related options
primarily as a hedge against changes resulting from market conditions in the
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values of securities held in a Fund's portfolio or which it intends to purchase
and where the transactions are economically appropriate to the reduction of
risks inherent in the ongoing management of each Fund. A Fund may not purchase
or sell futures or purchase related options if, immediately thereafter, more
than 25% of its net assets would be hedged. A Fund also may not purchase or sell
futures or purchase related options if, immediately thereafter, the sum of the
amount of margin deposits on a Fund's existing futures positions and premiums
paid for such options would exceed 5% of the market value of a Fund's net
assets.
These restrictions, which are derived from current federal regulations
regarding the use of options and futures by mutual funds, are not "fundamental
restrictions" and may be changed by the Trustees of the Trust if applicable law
permits such a change and the change is consistent with the overall investment
objective and policies of each Fund.
The extent to which a Fund may enter into futures and options
transactions may be limited by the Code requirements for qualification of a Fund
as a regulated investment company. See "Taxation."
Repurchase Agreements
Each Fund may enter into repurchase agreements with respect to its
portfolio securities. Pursuant to such agreements, a Fund acquires securities
from financial institutions such as banks and broker-dealers as are deemed to be
creditworthy by the Advisor or a Manager, subject to the seller's agreement to
repurchase and a Fund's agreement to resell such securities at a mutually agreed
upon date and price. The repurchase price generally equals the price paid by a
Fund plus interest negotiated on the basis of current short-term rates (which
may be more or less than the rate on the underlying portfolio security).
Securities subject to repurchase agreements will be held by the Custodian or in
the Federal Reserve/Treasury Book-Entry System or an equivalent foreign system.
The seller under a repurchase agreement will be required to maintain the value
of the underlying securities at not less than 102% of the repurchase price under
the agreement. If the seller defaults on its repurchase obligation, a Fund
holding the repurchase agreement will suffer a loss to the extent that the
proceeds from a sale of the underlying securities are less than the repurchase
price under the agreement. Bankruptcy or insolvency of such a defaulting seller
may cause a Fund's rights with respect to such securities to be delayed or
limited. Repurchase agreements are considered to be loans under the 1940 Act.
Reverse Repurchase Agreements.
Each Fund may enter into reverse repurchase agreements. A Fund
typically will invest the proceeds of a reverse repurchase agreement in money
market instruments or repurchase agreements maturing not later than the
expiration of the reverse repurchase agreement. A Fund may use the proceeds of
reverse repurchase agreements to provide liquidity to meet redemption requests
when sale of a Fund's securities is disadvantageous.
Each Fund causes the custodian to segregate liquid assets, such as
cash, U.S. Government securities or other high grade liquid debt securities
equal in value to its obligations (including accrued interest) with respect to
reverse repurchase agreements. In segregating such assets, the custodian either
places such securities in a segregated account or separately identifies such
assets and renders them unavailable for investment. Such assets are marked to
market daily to ensure full collateralization is maintained.
Dollar Roll Transactions
Each Fund may enter into dollar roll transactions. A dollar roll
transaction involves a sale by a Fund of a security to a financial institution
concurrently with an agreement by a Fund to purchase a similar security from the
institution at a later date at an agreed-upon price. The securities that are
repurchased will bear the same interest rate as those sold, but generally will
be collateralized by different pools of mortgages with different prepayment
histories than those sold. During the period between the sale and repurchase, a
Fund will not be entitled to receive interest and principal payments on the
securities sold. Proceeds of the sale will be invested in additional portfolio
securities of a Fund, and the income from these investments, together with any
additional fee income received on the sale, may or may not generate income for a
Fund exceeding the yield on the securities sold.
At the time a Fund enters into a dollar roll transaction, it causes its
custodian to segregate liquid assets such as cash, U.S. Government securities or
other high-grade liquid debt securities having a value equal to the purchase
price for the similar security (including accrued interest) and subsequently
marks the assets to market daily to ensure
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that full collateralization is maintained.
When-Issued Securities, Forward Commitments and Delayed Settlements
Each Fund may purchase securities on a "when-issued," forward
commitment or delayed settlement basis. In this event, the Custodian will set
aside cash or liquid portfolio securities equal to the amount of the commitment
in a separate account. Normally, the Custodian will set aside portfolio
securities to satisfy a purchase commitment. In such a case, a Fund may be
required subsequently to place additional assets in the separate account in
order to assure that the value of the account remains equal to the amount of a
Fund's commitment. It may be expected that a Fund's net assets will fluctuate to
a greater degree when it sets aside portfolio securities to cover such purchase
commitments than when it sets aside cash.
Each Fund does not intend to engage in these transactions for
speculative purposes but only in furtherance of its investment objectives.
Because a Fund will set aside cash or liquid portfolio securities to satisfy its
purchase commitments in the manner described, a Fund's liquidity and the ability
of a Manager to manage it may be affected in the event a Fund's forward
commitments, commitments to purchase when-issued securities and delayed
settlements ever exceeded 15% of the value of its net assets.
Each Fund will purchase securities on a when-issued, forward commitment
or delayed settlement basis only with the intention of completing the
transaction. If deemed advisable as a matter of investment strategy, however, a
Fund may dispose of or renegotiate a commitment after it is entered into, and
may sell securities it has committed to purchase before those securities are
delivered to a Fund on the settlement date. In these cases a Fund may realize a
taxable capital gain or loss. When a Fund engages in when-issued, forward
commitment and delayed settlement transactions, it relies on the other party to
consummate the trade. Failure of such party to do so may result in a Fund's
incurring a loss or missing an opportunity to obtain a price credited to be
advantageous.
The market value of the securities underlying a when-issued purchase,
forward commitment to purchase securities, or a delayed settlement and any
subsequent fluctuations in their market value is taken into account when
determining the market value of a Fund starting on the day a Fund agrees to
purchase the securities. A Fund does not earn interest on the securities it has
committed to purchase until they are paid for and delivered on the settlement
date.
Zero-Coupon, Step-Coupon and Pay-in-Kind Securities
Each Fund may invest in zero-coupon, step-coupon and pay-in-kind
securities. These securities are debt securities that do not make regular cash
interest payments. Zero-coupon and step-coupon securities are sold at a deep
discount to their face value. Pay-in-kind securities pay interest through the
issuance of additional securities. Because these securities do not pay current
cash income, the price of these securities can be volatile when interest rates
fluctuate. While these securities do not pay current cash income, the Code
requires the holders of these securities to include in income each year the
portion of the original issue discount (or deemed discount) and other non-cash
income on the securities accruing that year. A Fund may be required to
distribute a portion of that discount and income and may be required to dispose
of other portfolio securities, which may occur in periods of adverse market
prices, in order to generate cash to meet these distribution requirements.
Borrowing
Each Fund is authorized to borrow money from time to time for
temporary, extraordinary or emergency purposes or for clearance of transactions
in amounts up to 20% of the value of its total assets at the time of such
borrowings. The use of borrowing by the Fund involves special risk
considerations that may not be associated with other funds having similar
objectives and policies. Since substantially all of the Fund's assets fluctuate
in value, whereas the interest obligation resulting from a borrowing will be
fixed by the terms of the Fund's agreement with its lender, the asset value per
share of the Fund will tend to increase more when its portfolio securities
increase in value and to decrease more when its portfolio assets decrease in
value than would otherwise be the case if the Fund did not borrow funds. In
addition, interest costs on borrowings may fluctuate with changing market rates
of interest and may partially offset or exceed the return earned on borrowed
funds. Under adverse market conditions, the Fund might have to sell portfolio
securities to meet interest or principal payments at a time when fundamental
investment considerations would not favor such sales.
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Lending Portfolio Securities
Each Fund may lend its portfolio securities in an amount not exceeding
30% of its total assets to financial institutions such as banks and brokers if
the loan is collateralized in accordance with applicable regulations. Under the
present regulatory requirements which govern loans of portfolio securities, the
loan collateral must, on each business day, at least equal the value of the
loaned securities and must consist of cash, letters of credit of domestic banks
or domestic branches of foreign banks, or securities of the U.S. Government or
its agencies. To be acceptable as collateral, letters of credit must obligate a
bank to pay amounts demanded by a Fund if the demand meets the terms of the
letter. Such terms and the issuing bank would have to be satisfactory to a Fund.
Any loan might be secured by any one or more of the three types of collateral.
The terms of a Fund's loans must permit a Fund to reacquire loaned securities on
five days' notice or in time to vote on any serious matter and must meet certain
tests under the Code.
Short Sales
Each Fund is authorized to make short sales of securities which it does
not own or have the right to acquire. In a short sale, a Fund sells a security
which it does not own, in anticipation of a decline in the market value of the
security. To complete the sale, a Fund must borrow the security (generally from
the broker through which the short sale is made) in order to make delivery to
the buyer. Each Fund is then obligated to replace the security borrowed by
purchasing it at the market price at the time of replacement. Each Fund is said
to have a "short position" in the securities sold until it delivers them to the
broker. The period during which a Fund has a short position can range from one
day to more than a year. Until the security is replaced, the proceeds of the
short sale are retained by the broker, and a Fund is required to pay to the
broker a negotiated portion of any dividends or interest which accrue during the
period of the loan. To meet current margin requirements, a Fund is also required
to deposit with the broker additional cash or securities so that the total
deposit with the broker is maintained daily at 150% of the current market value
of the securities sold short (100% of the current market value if a security is
held in the account that is convertible or exchangeable into the security sold
short within 90 days without restriction other than the payment of money).
Short sales by a Fund create opportunities to increase a Fund's return
but, at the same time, involve specific risk considerations and may be
considered a speculative technique. Since each Fund in effect profits from a
decline in the price of the securities sold short without the need to invest the
full purchase price of the securities on the date of the short sale, a Fund's
net asset value per share will tend to increase more when the securities it has
sold short decrease in value, and to decrease more when the securities it has
sold short increase in value, than would otherwise be the case if it had not
engaged in such short sales. The amount of any gain will be decreased, and the
amount of any loss increased, by the amount of any premium, dividends or
interest a Fund may be required to pay in connection with the short sale.
Furthermore, under adverse market conditions a Fund might have difficulty
purchasing securities to meet its short sale delivery obligations, and might
have to sell portfolio securities to raise the capital necessary to meet its
short sale obligations at a time when fundamental investment considerations
would not favor such sales.
Illiquid Securities
Each Fund may not invest more than 15% of the value of its net assets
in illiquid securities, including restricted securities, that are not deemed to
liquid by the sub-advisor. The Advisor and the Managers will monitor the amount
of illiquid securities in a Fund's portfolio, under the supervision of the
Trust's Board of Trustees, to ensure compliance with a Fund's investment
restrictions.
Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act of 1933 (the "Securities Act"), securities
which are otherwise not readily marketable and repurchase agreements having a
maturity of longer than seven days. Securities which have not been registered
under the Securities Act are referred to as private placement or restricted
securities and are purchased directly from the issuer or in the secondary
market. Mutual funds do not typically hold a significant amount of these
restricted or other illiquid securities because of the potential for delays on
resale and uncertainty in valuation. Limitations on resale may have an adverse
effect on the marketability of portfolio securities and a Fund might be unable
to dispose of restricted or other illiquid securities promptly or at reasonable
prices and might thereby experience difficulty satisfying redemption within
seven days. A Fund might also have to register such restricted securities in
order to dispose of them, resulting in additional expense and delay. Adverse
market conditions could impede such a public offering of securities.
In recent years, however, a large institutional market has developed
for certain securities that are not registered under the Securities Act,
including repurchase agreements, commercial paper, foreign securities, municipal
securities and corporate bonds and notes. Institutional investors depend on an
efficient institutional market in which the unregistered security can be readily
resold or on an issuer's ability to honor a demand for repayment. The fact that
there are contractual or legal restrictions on resale to the general public or
to certain institutions may not be indicative of the liquidity of such
investments. If such securities are subject to purchase by institutional buyers
in accordance with Rule 144A promulgated by the Commission under the Securities
Act, the sub-advisor, pursuant to
B-17
<PAGE>
procedures adopted by the Trust's Board of Trustees, may determine that such
securities are not illiquid securities notwithstanding their legal or
contractual restrictions on resale. In all other cases, however, securities
subject to restrictions on resale will be deemed illiquid.
Risks of Investing in Small Companies
As stated in the prospectus, a Fund may invest in securities of small
companies. Additional risks of such investments include the markets on which
such securities are frequently traded. In many instances the securities of
smaller companies are traded only over-the-counter or on a regional securities
exchange, and the frequency and volume of their trading is substantially less
than is typical of larger companies. Therefore, the securities of smaller
companies may be subject to greater and more abrupt price fluctuations. When
making large sales, a Fund may have to sell portfolio holdings at discounts from
quoted prices or may have to make a series of small sales over an extended
period of time due to the trading volume of smaller company securities.
Investors should be aware that, based on the foregoing factors, an investment in
a Fund may be subject to greater price fluctuations than an investment in a fund
that invests exclusively in larger, more established companies. A Manager's
research efforts may also play a greater role in selecting securities for a Fund
than in a fund that invests in larger, more established companies.
Investment Restrictions
The Trust (on behalf of a Fund) has adopted the following restrictions
as fundamental policies, which may not be changed without the favorable vote of
the holders of a "majority," as defined in the 1940 Act, of the outstanding
voting securities of a Fund. Under the 1940 Act, the "vote of the holders of a
majority of the outstanding voting securities" means the vote of the holders of
the lesser of (I) 67% of the shares of a Fund represented at a meeting at which
the holders of more than 50% of its outstanding shares are represented or (ii)
more than 50% of the outstanding shares of a Fund.
As a matter of fundamental policy, a Fund is diversified; i.e., as to
75% of the value of a its total assets: (I) no more than 5% of the value of its
total assets may be invested in the securities of any one issuer (other than
U.S. Government securities); and (ii) a Fund may not purchase more than 10% of
the outstanding voting securities of an issuer. Each Fund's investment objective
is also fundamental.
In addition, a Fund may not:
1. Issue senior securities, borrow money or pledge its assets, except
that (I) a Fund may borrow on an unsecured basis from banks for temporary or
emergency purposes or for the clearance of transactions in amounts not exceeding
10% of its total assets (not including the amount borrowed), provided that it
will not make investments while borrowings in excess of 5% of the value of its
total assets are outstanding; and (ii) this restriction shall not prohibit a
Fund from engaging in options, futures and foreign currency transactions or
short sales;
2. Purchase securities on margin, except such short-term credits as may
be necessary for the clearance of transactions;
3. Act as underwriter (except to the extent a Fund may be deemed to be
an underwriter in connection with the sale of securities in its investment
portfolio);
4. Invest 25% or more of its total assets, calculated at the time of
purchase and taken at market value, in any one industry (other than U.S.
Government securities);
5. Purchase or sell real estate or interests in real estate or real
estate limited partnerships (although a Fund may purchase and sell securities
which are secured by real estate and securities of companies which invest or
deal in real estate);
6. Purchase or sell commodities or commodity futures contracts, except
that a Fund may purchase and sell stock index futures contracts and currency and
financial futures contracts and related options in accordance with any rules of
the Commodity Futures Trading Commission;
7. Invest in oil and gas limited partnerships or oil, gas or mineral
leases;
8. Make loans of money (except for purchases of debt securities
consistent with the investment policies of
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<PAGE>
a Fund and except for repurchase agreements); or
9. Make investments for the purpose of exercising control or
management.
Each Fund observes the following restrictions as a matter of operating
but not fundamental policy, pursuant to positions taken by federal regulatory
authorities:
Each Fund may not:
1. Invest in the securities of other investment companies or purchase
any other investment company's voting securities or make any other investment in
other investment companies except to the extent permitted by federal law.
2. Invest more than 15% of its assets in securities which are
restricted as to disposition or otherwise are illiquid or have no readily
available market (except for securities which are determined by the the
sub-advisor, pursuant to procedures adopted by the Board of Trustees, to be
liquid).
MANAGEMENT
The overall management of the business and affairs of the Trust is
vested with its Board of Trustees. The Board approves all significant agreements
between the Trust and persons or companies furnishing services to it, including
the agreements with the Advisor, Managers, Administrator, Custodian and Transfer
Agent. The day to day operations of the Trust are delegated to its officers,
subject to a Fund's investment objectives and policies and to general
supervision by the Board of Trustees.
The Trustees and officers of the Trust, their ages and positions with
the Trust, their business addresses and principal occupations during the past
five years are:
<TABLE>
<CAPTION>
Name, address and age Position Principal Occupation During Past Five Years
- --------------------- -------- -------------------------------------------
<S> <C> <C>
A. George Battle (53) Trustee Senior Fellow, The Aspen Institute since June, 1995. Director of
1065 Sterling Avenue Peoplesoft, Inc.; Barra, Inc.; and Fair, Isaac. Formerly (until 1995)
Berkeley, CA 94708 Managing Partner, Market Development of Andersen Consulting.
Frederick August
Eigenbrod, Jr. PhD (56) Trustee Senior Vice President, Right Associates (industrial psychologists)
19925 Stevens Creek Blvd.
Cupertino, CA 95014
Kenneth E. Gregory* (40) President and President of the Advisor; President of L/G Research Inc. (publishers)
4 Orinda Way Trustee and Litman/Gregory & Co., LLC (investment advisors)
Suite 230D
Orinda, CA 94556
Craig A. Litman* (50) Secretary and Treasurer and Secretary of the Advisor; Vice President and Secretary
100 Larkspur Landing Circle Trustee of L/G Research Inc.; Chairman of Litman/Gregory & Co., LLC
Suite 204
Larkspur, CA 94939
Taylor M. Welz (38) Trustee Partner, Bowman & Company, LLP (certified public accountants)
2431 W. March Lane
Suite 100
Stockton, CA 95207
John Coughlan (41) Treasurer Chief Operating Officer, Litman/Gregory & Co., LLC since 1996;
4 Orinda Way Controller, Centex Homes of Northern CA, 1995 - 1996;
Suite 230D Senior Vice President, Countrywide Capital Markets, Inc., 1994;
Orinda, CA 94556, Executive Vice President, TMAC, 1992 - 1994 ; Vice President and
Treasurer, Barnett Range Corporation, prior to 1992
</TABLE>
B-19
<PAGE>
* denotes Trustees who are "interested persons" of the Trust under the 1940 Act.
It is estimated that each Trustee who is not an interested person of
the Trust will receive a fee at the annual rate of $5,000.
The Advisor and the Managers
Subject to the supervision of the Board of Trustees, investment
management and related services are provided by the Advisor, pursuant to an
Investment Advisory Agreement (the "Advisory Agreement"). In addition, the
assets of each Fund are divided into segments by the Advisor, and individual
selection of securities in each segment is provided by a Manager selected by the
Board of Trustees pursuant, in each case, to a form of sub-advisory agreement
("Management Agreement"). Under the Advisory Agreement, the Advisor has agreed
to (I) furnish each Fund with advice and recommendations with respect to the
selection and continued employment of Managers to manage the actual investment
of each Fund's assets; (ii) direct the allocation of each Fund's assets among
such Managers; (iii) oversee the investments made by such Managers on behalf of
each Fund, subject to the ultimate supervision and direction of the Trust's
Board of Trustees; (iv) oversee the actions of the Managers with respect to
voting proxies for each Fund, filing Section 13 ownership reports for each Fund,
and taking other actions on behalf of each Fund; (v) maintain the books and
records required to be maintained by each Fund except to the extent arrangements
have been made for such books and records to be maintained by the administrator,
another agent of each Fund or a Manager; (vi) furnish reports, statements and
other data on securities, economic conditions and other matters related to the
investment of each Fund's assets which each Fund's administrator or distributor
or the officers of the Trust may reasonably request; and (vii) render to the
Trust's Board of Trustees such periodic and special reports with respect to each
Fund's investment activities as the Board may reasonably request, including at
least one in-person appearance annually before the Board of Trustees. The
Advisor has agreed, at its own expense, to maintain such staff and employ or
retain such personnel and consult with such other persons as it shall from time
to time determine to be necessary to the performance of its obligations under
this Agreement. Personnel of the Advisor may serve as officers of the Trust
provided they do so without compensation from the Trust. Without limiting the
generality of the foregoing, the staff and personnel of the Advisor shall be
deemed to include persons employed or retained by the Advisor to furnish
statistical information, research, and other factual information, advice
regarding economic factors and trends, information with respect to technical and
scientific developments, and such other information, advice and assistance as
the Advisor or the Trust's Board of Trustees may desire and reasonably request.
With respect to the operation of each Fund, the Advisor has agreed to be
responsible for (I) providing the personnel, office space and equipment
reasonably necessary for the operation of the Trust and each Fund including the
provision of persons qualified to serve as officers of the Trust; (ii)
compensating the Managers selected to invest the assets of each Fund; (iii) the
expenses of printing and distributing extra copies of each Fund's prospectus,
statement of additional information, and sales and advertising materials (but
not the legal, auditing or accounting fees attendant thereto) to prospective
investors (but not to existing shareholders); and (iv) the costs of any special
Board of Trustees meetings or shareholder meetings convened for the primary
benefit of the Advisor or any Manager.
Under each Management Agreement, each Manager agrees to invest its
Allocated Portion of the assets of each Fund in accordance with the investment
objectives, policies and restrictions of each Fund as set forth in each Fund's
and Trust's governing documents, including, without limitation, the Trust's
Agreement and Declaration of Trust and By-Laws; each Fund's prospectus,
statement of additional information, and undertakings; and such other
limitations, policies and procedures as the Advisor or the Trustees of the Trust
may impose from time to time in writing to Manager. In providing such services,
Manager shall at all times adhere to the provisions and restrictions contained
in the federal securities laws, applicable state securities laws, the Internal
Revenue Code, and other applicable law.
Without limiting the generality of the foregoing, each Manager has
agreed to (I) furnish each Fund with advice and recommendations with respect to
the investment of the Manager's Allocated Portion of each Fund's assets, (ii)
effect the purchase and sale of portfolio securities for Manager's Allocated
Portion or determine that a portion of such Allocated Portion will remain
uninvested; (iii) manage and oversee the investments of the Manager's Allocated
Portion, subject to the ultimate supervision and direction of the Trust's Board
of Trustees; (iv) vote proxies and take other actions with respect to the
securities in Manager's Allocated Portion; (v) maintain the books and
B-20
<PAGE>
records required to be maintained with respect to the securities in Manager's
Allocated Portion; (vi) furnish reports, statements and other data on
securities, economic conditions and other matters related to the investment of
each Fund's assets which the Advisor, Trustees or the officers of the Trust may
reasonably request; and (vii) render to the Trust's Board of Trustees such
periodic and special reports with respect to Manager's Allocated Portion as the
Board may reasonably request.
As compensation for the Advisor's services (including payment of the
Managers' fees), each Fund pays it an advisory fee at the rate specified in the
prospectus. In addition to the fees payable to the Advisor and the
Administrator, the Trust is responsible for its operating expenses, including:
fees and expenses incurred in connection with the issuance, registration and
transfer of its shares; brokerage and commission expenses; all expenses of
transfer, receipt, safekeeping, servicing and accounting for the cash,
securities and other property of the Trust for the benefit of each Fund
including all fees and expenses of its custodian, shareholder services agent and
accounting services agent; interest charges on any borrowings; costs and
expenses of pricing and calculating its daily net asset value and of maintaining
its books of account required under the Investment Company Act; taxes, if any; a
pro rata portion of expenditures in connection with meetings of each Fund's
shareholders and the Trust's Board of Trustees that are properly payable by each
Fund; salaries and expenses of officers and fees and expenses of members of the
Trust's Board of Trustees or members of any advisory board or committee who are
not members of, affiliated with or interested persons of the Advisor; insurance
premiums on property or personnel of each Fund which inure to its benefit,
including liability and fidelity bond insurance; the cost of preparing and
printing reports, proxy statements, prospectuses and statements of additional
information of each Fund or other communications for distribution to existing
shareholders; legal, auditing and accounting fees; trade association dues; fees
and expenses (including legal fees) of registering and maintaining registration
of its shares for sale under federal and applicable state and foreign securities
laws; all expenses of maintaining and servicing shareholder accounts, including
all charges for transfer, shareholder recordkeeping, dividend disbursing,
redemption, and other agents for the benefit of each Fund, if any; and all other
charges and costs of its operation plus any extraordinary and non-recurring
expenses, except as otherwise prescribed in the Advisory Agreement.
The Advisor may agree to waive certain of its fees or reimburse each
Fund for certain expenses, in order to limit the expense ratio of each Fund. In
that event, subject to approval by the Trust's Board of Trustees, each Fund may
reimburse the Advisor in subsequent years for fees waived and expenses
reimbursed, provided the expense ratio before reimbursement is less than the
expense limitation in effect at that time.
The Advisor is controlled by Craig A. Litman and Kenneth E. Gregory.
Under the Advisory Agreement and each Management Agreement, the Advisor
and the Managers will not be liable to the Trust for any error of judgment by
the Advisor or Managers or any loss sustained by the Trust except in the case of
a breach of fiduciary duty with respect to the receipt of compensation for
services (in which case any award of damages will be limited as provided in the
1940 Act) or of willful misfeasance, bad faith or gross negligence by reason of
reckless disregard of its obligations and duties under the applicable agreement.
The Advisory Agreement and the Management Agreements will remain in
effect for a period not to exceed two years. Thereafter, if not terminated, each
Advisory and Management Agreement will continue automatically for successive
annual periods, provided that such continuance is specifically approved at least
annually (I) by a majority vote of the
B-21
<PAGE>
Independent Trustees cast in person at a meeting called for the purpose of
voting on such approval, and (ii) by the Board of Trustees or by vote of a
majority of the outstanding voting securities of the Portfolio.
The Advisory and Management Agreements are terminable by vote of the
Board of Trustees or by the holders of a majority of the outstanding voting
securities of the Trust at any time without penalty, on 60 days written notice
to the Advisor or a Manager. The Advisory and Management Agreements also may be
terminated by the Advisor or a Manager on 60 days written notice to the Trust.
The Advisory and Management Agreements terminate automatically upon their
assignment (as defined in the 1940 Act).
The Administrator. The Administrator has agreed to be responsible for
providing such services as the Trustees may reasonably request, including but
not limited to (I) maintaining the Trust's books and records (other than
financial or accounting books and records maintained by any custodian, transfer
agent or accounting services agent); (ii) overseeing the Trust's insurance
relationships; (iii) preparing for the Trust (or assisting counsel and/or
auditors in the preparation of) all required tax returns, proxy statements and
reports to the Trust's shareholders and Trustees and reports to and other
filings with the Securities and Exchange Commission and any other governmental
agency (the Trust agreeing to supply or cause to be supplied to the
Administrator all necessary financial and other information in connection with
the foregoing); (iv) preparing such applications and reports as may be necessary
to register or maintain the Trust's registration and/or the registration of the
shares of the Trust under the securities or "blue sky" laws of the various
states selected by the Trust (the Trust agreeing to pay all filing fees or other
similar fees in connection therewith); (v) responding to all inquiries or other
communications of shareholders, if any, which are directed to the Administrator,
or if any such inquiry or communication is more properly to be responded to by
the Trust's custodian, transfer agent or accounting services agent, overseeing
their response thereto; (vi) overseeing all relationships between the Trust and
any custodian(s), transfer agent(s) and accounting services agent(s), including
the negotiation of agreements and the supervision of the performance of such
agreements; (vii) together with the Advisor, monitoring compliance by the
Managers with tax, securities and other applicable requirements; and (viii)
authorizing and directing any of the Administrator's directors, officers and
employees who may be elected as Trustees or officers of the Trust to serve in
the capacities in which they are elected. All services to be furnished by the
Administrator under this Agreement may be furnished through the medium of any
such directors, officers or employees of the Administrator.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Each Management Agreement states that, with respect to the segment of
each Fund's portfolio allocated to the Manager, the Manager shall be responsible
for broker-dealer selection and for negotiation of brokerage commission rates,
provided that the Manager shall not direct orders to an affiliated person of the
Manager without general prior authorization to use such affiliated broker or
dealer by the Trust's Board of Trustees. In general, a Manager's primary
consideration in effecting a securities transaction will be execution at the
most favorable cost or proceeds under the circumstances. In selecting a
broker-dealer to execute each particular transaction, a Manager may take the
following into consideration: the best net price available; the reliability,
integrity and financial condition of the broker-dealer; the size of and
difficulty in executing the order; and the value of the expected contribution of
the broker-dealer to the investment performance of each Fund on a continuing
basis. The price to each Fund in any transaction may be less favorable than that
available from another broker-dealer if the difference is reasonably justified
by other aspects of the portfolio execution services offered.
Subject to such policies as the Advisor and the Board of Trustees of
the Trust may determine, a Manager shall not be deemed to have acted unlawfully
or to have breached any duty created by this Agreement or otherwise solely by
reason of its having caused each Fund to pay a broker or dealer that provides
(directly or indirectly) brokerage or research services to the Manager an amount
of commission for effecting a portfolio transaction in excess of the amount of
commission another broker or dealer would have charged for effecting that
transaction, if the Manager determines in good faith that such amount of
commission was reasonable in relation to the value of the brokerage and research
services provided by such broker or dealer, viewed in terms of either that
particular transaction or the Manager's or Advisor's overall responsibilities
with respect to each Fund or other advisory clients. Each Manager is further
authorized to allocate the orders placed by it on behalf of each Fund to such
brokers or dealers who also provide research or statistical material, or other
services, to the Trust, the Advisor, or any affiliate of either. Such allocation
shall be in such amounts and proportions as the Manager shall determine, and
each Manager shall
B-22
<PAGE>
report on such allocations regularly to the Advisor and the Trust, indicating
the broker-dealers to whom such allocations have been made and the basis
therefor. Each Manager is also authorized to consider sales of shares of each
Fund as a factor in the selection of brokers or dealers to execute portfolio
transactions, subject to the requirements of best execution.
On occasions when a Manager deems the purchase or sale of a security to
be in the best interest of each Fund as well as other clients of the Manager,
the Manager, to the extent permitted by applicable laws and regulations, may
aggregate the securities to be so purchased or sold in order to obtain the most
favorable price or lower brokerage commissions and the most efficient execution.
In such event, allocation of the securities so purchased or sold, as well as the
expenses incurred in the transaction, will be made by the Manager in the manner
it considers to be the most equitable and consistent with its fiduciary
obligations to each Fund and to such other clients.
NET ASSET VALUE
The net asset value of a Fund's shares will fluctuate and is determined
as of the close of trading on the New York Stock Exchange (currently 4:00 p.m.
Eastern time) each business day. The Exchange annually announces the days on
which it will not be open for trading. The most recent announcement indicates
that it will not be open on the following days: New Year's Day, Presidents' Day,
Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and
Christmas Day. However, the Exchange may close on days not included in that
announcement.
The net asset value per share is computed by dividing the value of the
securities held by a Fund plus any cash or other assets (including interest and
dividends accrued but not yet received) minus all liabilities (including accrued
expenses) by the total number of shares in a Fund outstanding at such time.
Generally, trading in and valuation of foreign securities is
substantially completed each day at various times prior to the close of the
NYSE. In addition, trading in and valuation of foreign securities may not take
place on every day in which the NYSE is open for trading. In that case, the
price used to determine a Fund's net asset value on the last day on which such
exchange was open will be used, unless the Trust's Board of Trustees determines
that a different price should be used. Furthermore, trading takes place in
various foreign markets on days in which the NYSE is not open for trading and on
which a Fund's net asset value is not calculated. Occasionally, events affecting
the values of such securities in U.S. dollars on a day on which a Fund
calculates its net asset value may occur between the times when such securities
are valued and the close of the NYSE that will not be reflected in the
computation of a Fund's net asset value unless the Board or its delegates deem
that such events would materially affect the net asset value, in which case an
adjustment would be made.
Generally, a Fund's investments are valued at market value or, in the
absence of a market value, at fair value as determined in good faith by the
Managers and the Trust's Pricing Committee pursuant to procedures approved by or
under the direction of the Board.
Each Fund's securities, including ADRs, EDRs and GDRs, which are traded
on securities exchanges are valued at the last sale price on the exchange on
which such securities are traded, as of the close of business on the day the
securities are being valued or, lacking any reported sales, at the mean between
the last available bid and asked price. Securities that are traded on more than
one exchange are valued on the exchange determined by the Managers to be the
primary market. Securities traded in the over-the-counter market are valued at
the mean between the last available bid and asked price prior to the time of
valuation. Securities and assets for which market quotations are not readily
available (including restricted securities which are subject to limitations as
to their sale) are valued at fair value as determined in good faith by or under
the direction of the Board.
Short-term debt obligations with remaining maturities in excess of 60
days are valued at current market prices, as discussed above. Short-term
securities with 60 days or less remaining to maturity are, unless conditions
indicate otherwise, amortized to maturity based on their cost to a Fund if
acquired within 60 days of maturity or, if already held by a Fund on the 60th
day, based on the value determined on the 61st day.
Corporate debt securities, mortgage-related securities and asset-backed
securities held by a Fund are valued on the basis of valuations provided by
dealers in those instruments, by an independent pricing service, approved by the
Board, or at fair value as determined in good faith by procedures approved by
the Board. Any such pricing service, in determining value, will use information
with respect to transactions in the securities being valued,
B-23
<PAGE>
quotations from dealers, market transactions in comparable securities, analyses
and evaluations of various relationships between securities and yield to
maturity information.
An option that is written by a Fund is generally valued at the last
sale price or, in the absence of the last sale price, the last offer price. An
option that is purchased by a Fund is generally valued at the last sale price
or, in the absence of the last sale price, the last bid price. The value of a
futures contract is the last sale or settlement price on the exchange or board
of trade on which the future is traded or, if no sales are reported, at the mean
between the last bid and asked price. When a settlement price cannot be used,
futures contracts will be valued at their fair market value as determined by or
under the direction of the Board. If an options or futures exchange closes after
the time at which a Fund's net asset value is calculated, the last sale or last
bid and asked prices as of that time will be used to calculate the net asset
value.
Any assets or liabilities initially expressed in terms of foreign
currencies are translated into U.S. dollars at the official exchange rate or,
alternatively, at the mean of the current bid and asked prices of such
currencies against the U.S. dollar last quoted by a major bank that is a regular
participant in the foreign exchange market or on the basis of a pricing service
that takes into account the quotes provided by a number of such major banks. If
neither of these alternatives is available or both are deemed not to provide a
suitable methodology for converting a foreign currency into U.S. dollars, the
Board in good faith will establish a conversion rate for such currency.
All other assets of a Fund are valued in such manner as the Board in
good faith deems appropriate to reflect their fair value.
TAXATION
Each Fund will be taxed, under the Internal Revenue Code (the "Code"),
as a separate entity from any other series of the Trust, and it intends to elect
to qualify for treatment as a regulated investment company ("RIC") under
Subchapter M of the Code. In each taxable year that a Fund qualifies, a Fund
(but not its shareholders) will be relieved of federal income tax on that part
of its investment company taxable income (consisting generally of interest and
dividend income, net short term capital gain and net realized gains from
currency transactions) and net capital gain that is distributed to shareholders.
In order to qualify for treatment as a RIC, a Fund must distribute
annually to shareholders at least 90% of its investment company taxable income
and must meet several additional requirements. Among these requirements are the
following:
(1) at least 90% of a Fund's gross income each taxable year must be derived
from dividends, interest, payments with respect to securities loans and gains
from the sale or other disposition of securities or foreign currencies, or other
income derived with respect to its business of investing in securities or
currencies;
(2) at the close of each quarter of a Fund's taxable year, at least 50% of
the value of its total assets must be represented by cash and cash items, U.S.
Government securities, securities of other RICs and other securities, limited in
respect of any one issuer, to an amount that does not exceed 5% of the value of
a Fund and that does not represent more than 10% of the outstanding voting
securities of such issuer; and
(3) at the close of each quarter of a Fund's taxable year, not more than
25% of the value of its assets may be invested in securities (other than U.S.
Government securities or the securities of other RICs) of any one issuer.
Distributions of net investment income and net realized capital gains
by a Fund will be taxable to shareholders whether made in cash or reinvested in
shares. In determining amounts of net realized capital gains to be distributed,
any capital loss carryovers from prior years will be applied against capital
gains. Shareholders receiving distributions in the form of additional shares
will have a cost basis for federal income tax purposes in each share so received
equal to the net asset value of a share of a Fund on the reinvestment date. Fund
distributions also will be included in individual and corporate shareholders'
income on which the alternative minimum tax may be imposed.
Each Fund or any securities dealer effecting a redemption of a Fund's
shares by a shareholder will be required to file information reports with the
IRS with respect to distributions and payments made to the shareholder. In
addition, a Fund will be required to withhold federal income tax at the rate of
31% on taxable dividends, redemptions and other payments made to accounts of
individual or other non-exempt shareholders who have not furnished their correct
taxpayer identification numbers and made certain required certifications on the
Account
B-24
<PAGE>
Application Form or with respect to which a Fund or the securities dealer has
been notified by the IRS that the number furnished is incorrect or that the
account is otherwise subject to withholding.
Each Fund intends to declare and pay dividends and other distributions,
as stated in the Prospectus. In order to avoid the payment of any federal excise
tax based on net income, a Fund must declare on or before December 31 of each
year, and pay on or before January 31 of the following year, distributions at
least equal to 98% of its ordinary income for that calendar year and at least
98% of the excess of any capital gains over any capital losses realized in the
one-year period ending October 31 of that year, together with any undistributed
amounts of ordinary income and capital gains (in excess of capital losses) from
the previous calendar year.
Each Fund may receive dividend distributions from U.S. corporations. To
the extent that a Fund receives such dividends and distributes them to its
shareholders, and meets certain other requirements of the Code, corporate
shareholders of a Fund may be entitled to the "dividends received" deduction.
Availability of the deduction is subject to certain holding period and
debt-financing limitations.
The use of hedging strategies, such as entering into futures contracts
and forward contracts and purchasing options, involves complex rules that will
determine the character and timing of recognition of the income received in
connection therewith by a Fund. Income from foreign currencies (except certain
gains therefrom that may be excluded by future regulations) and income from
transactions in options, futures contracts and forward contracts derived by a
Fund with respect to its business of investing in securities or foreign
currencies will qualify as permissible income under Subchapter M of the Code.
For accounting purposes, when the paid by the Fund is recorded as an
asset and is subsequently adjusted to the current market value of the option.
Any gain or loss realized by the Fund upon the expiration or sale of such
options held by the Fund generally will be capital gain or loss.
Any security, option, or other position entered into or held by the
Fund that substantially diminishes the Fund's risk of loss from any other
position held by that Fund may constitute a "straddle" for federal income tax
purposes. In general, straddles are subject to certain rules that may affect the
amount, character and timing of the Fund's gains and losses with respect to
straddle positions by requiring, among other things, that the loss realized on
disposition of one position of a straddle be deferred until gain is realized on
disposition of the offsetting position; that the Fund's holding period in
certain straddle positions not begin until the straddle is terminated (possibly
resulting in the gain being treated as short-term capital gain rather than
long-term capital gain); and that losses recognized with respect to certain
straddle positions, which would otherwise constitute short-term capital losses,
be treated as long-term capital losses. Different elections are available to the
Fund that may mitigate the effects of the straddle rules.
Certain options, futures contracts and forward contracts that are
subject to Section 1256 of the Code ("Section 1256 Contracts") and that are held
by the Fund at the end of its taxable year generally will be required to be
"marked to market" for federal income tax purposes, that is, deemed to have been
sold at market value. Sixty percent of any net gain or loss recognized on these
deemed sales and 60% of any net gain or loss realized from any actual sales of
Section 1256 Contracts will be treated as long-term capital gain or loss, and
the balance will be treated as short-term capital gain or loss.
Section 988 of the Code contains special tax rules applicable to
certain foreign currency transactions that may affect the amount, timing and
character of income, gain or loss recognized by the Fund. Under these rules,
foreign exchange gain or loss realized with respect to foreign
currency-denominated debt instruments, foreign currency forward contracts,
foreign currency-denominated payables and receivables and foreign currency
options and futures contracts (other than options and futures contracts that are
governed by the mark-to-market and 60/40 rules of Section 1256 of the Code and
for which no election is made) is treated as ordinary income or loss. Some part
of the Fund's gain or loss on the sale or other disposition of shares of a
foreign corporation may, because of changes in foreign currency exchange rates,
be treated as ordinary income or loss under Section 988 of the Code, rather than
as capital gain or loss.
Redemptions and exchanges of shares of the Fund will result in gains or
losses for tax purposes to the extent of the difference between the proceeds and
the shareholder's adjusted tax basis for the shares. Any loss realized upon the
redemption or exchange of shares within six months from their date of purchase
will be treated as a long-term capital loss to the extent of distributions of
long-term capital gain dividends with respect to such shares during such
six-month period. All or a portion of a loss realized upon the redemption of
shares of the Fund may be disallowed to the extent shares of the same Fund are
purchased (including shares acquired by means of reinvested dividends)
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<PAGE>
within 30 days before or after such redemption.
Distributions and redemptions may be subject to state and local income
taxes, and the treatment thereof may differ from the federal income tax
treatment. Foreign taxes may apply to non-U.S. investors.
The above discussion and the related discussion in the Prospectus are
not intended to be complete discussions of all Paul Hastings Janofsky & Walker
has expressed no opinion in respect thereof. Nonresident aliens and foreign
persons are subject to different tax rules, and may be subject to withholding of
up to 30% on certain payments received from the Fund. Shareholders are advised
to consult with their own tax advisers concerning the application of foreign,
federal, state and local taxes to an investment in the Fund.
DIVIDENDS AND DISTRIBUTIONS
Dividends from the Fund's investment company taxable income (whether
paid in cash or invested in additional shares) will be taxable to shareholders
as ordinary income to the extent of the Fund's earnings and profits.
Distributions of the Fund's net capital gain (whether paid in cash or invested
in additional shares) will be taxable to shareholders as long-term capital gain,
regardless of how long they have held their Fund shares.
Dividends declared by the Fund in October, November or December of any
year and payable to shareholders of record on a date in one of such months will
be deemed to have been paid by the Fund and received by the shareholders on the
record date if the dividends are paid by the Fund during the following January.
Accordingly, such dividends will be taxed to shareholders for the year in which
the record date falls.
The Fund is required to withhold 31% of all dividends, capital gain
distributions and redemption proceeds payable to any individuals and certain
other noncorporate shareholders who do not provide the Fund with a correct
taxpayer identification number. The Fund also is required to withhold 31% of all
dividends and capital gain distributions paid to such shareholders who otherwise
are subject to backup withholding.
PERFORMANCE INFORMATION
Total Return
Average annual total return quotations used in the Fund's advertising
and promotional materials are calculated according to the following formula:
n
P(1 + T) = ERV
where "P" equals a hypothetical initial payment of $1000; "T" equals average
annual total return; "n" equals the number of years; and "ERV" equals the ending
redeemable value at the end of the period of a hypothetical $1000 payment made
at the beginning of the period.
Under the foregoing formula, the time periods used in advertising will
be based on rolling calendar quarters, updated to the last day of the most
recent quarter prior to submission of the advertising for publication. Average
annual total return, or "T" in the above formula, is computed by finding the
average annual compounded rates of return over the period that would equate the
initial amount invested to the ending redeemable value. Average annual total
return assumes the reinvestment of all dividends and distributions.
Yield
Annualized yield quotations used in the Fund's advertising and
promotional materials are calculated by dividing the Fund's investment income
for a specified thirty-day period, net of expenses, by the average number of
shares outstanding during the period, and expressing the result as an annualized
percentage (assuming semi-annual compounding) of the net asset value per share
at the end of the period. Yield quotations are calculated according to the
following formula:
YIELD = 2 [(a-b + 1)6 - 1]
----
cd
where "a" equals dividends and interest earned during the period; "b" equals
expenses accrued for the period, net
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<PAGE>
of reimbursements; "c" equals the average daily number of shares outstanding
during the period that are entitled to receive dividends and "d" equals the
maximum offering price per share on the last day of the period. Except as noted
below, in determining net investment income earned during the period ("a" in the
above formula), the Fund calculates interest earned on each debt obligation held
by it during the period by (1) computing the obligation's yield to maturity,
based on the market value of the obligation (including actual accrued interest)
on the last business day of the period or, if the obligation was purchased
during the period, the purchase price plus accrued interest; (2) dividing the
yield to maturity by 360 and multiplying the resulting quotient by the market
value of the obligation (including actual accrued interest). Once interest
earned is calculated in this fashion for each debt obligation held by the Fund,
net investment income is then determined by totaling all such interest earned.
For purposes of these calculations, the maturity of an obligation with
one or more call provisions is assumed to be the next date on which the
obligation reasonably can be expected to be called or, if none, the maturity
date.
Other information
Performance data of the Fund quoted in advertising and other
promotional materials represents past performance and is not intended to predict
or indicate future results. The return and principal value of an investment in
the Fund will fluctuate, and an investor's redemption proceeds may be more or
less than the original investment amount. In advertising and promotional
materials the Fund may compare its performance with data published by Lipper
Analytical Services, Inc. ("Lipper") or CDA Investment Technologies, Inc.
("CDA"). The Fund also may refer in such materials to mutual fund performance
rankings and other data, such as comparative asset, expense and fee levels,
published by Lipper or CDA. Advertising and promotional materials also may refer
to discussions of a Fund and comparative mutual fund data and ratings reported
in independent periodicals including, but not limited to, The Wall Street
Journal, Money Magazine, Forbes, Business Week, Financial World and Barron's.
GENERAL INFORMATION
The Trust is a Delaware Business Trust organized on August 1, 1996. The
Masters' Select Equity Fund series of shares commenced operations on January 2,
1997. The Masters' Select International Fund has not commenced operations as of
the date of this Statement of Additional Information. The Declaration of Trust
permits the Trustees to issue an unlimited number of full and fractional shares
of beneficial interest and to divide or combine the shares into a greater or
lesser number of shares without thereby changing the proportionate beneficial
interest in the Fund. Each share represents an interest in the Fund
proportionately equal to the interest of each other share. Upon the Trust's
liquidation, all shareholders would share pro rata in the net assets of the Fund
available for distribution to shareholders. If they deem it advisable and in the
best interest of shareholders, the Board of Trustees may create additional
series of shares which differ from each other only as to dividends. The Board of
Trustees has created two series of shares, and may create additional series in
the future, which have separate assets and liabilities. Income and operating
expenses not specifically attributable to a particular Fund will be allocated
fairly among the Funds by the Trustees, generally on the basis of the relative
net assets of each Fund.
Rule 18f-2 under the 1940 Act provides that as to any investment
company which has two or more series outstanding and as to any matter required
to be submitted to shareholder vote, such matter is not deemed to have been
effectively acted upon unless approved by the holders of a "majority" (as
defined in the Rule) of the voting securities of each series affected by the
matter. Such separate voting requirements do not apply to the election of
Trustees or the ratification of the selection of accountants. The Rule contains
special provisions for cases in which an advisory contract is approved by one or
more, but not all, series. A change in investment policy may go into effect as
to one or more series whose holders so approve the change even though the
required vote is not obtained as to the holders of other affected series.
The Trust's custodian, State Street Bank and Trust Company, 225
Franklin Street, Boston, MA 02110 is responsible for holding the Funds' assets
and acts as the Trust's accounting services agent. The Trust's independent
accountants, McGladrey & Pullen, LLP, 555 Fifth Avenue, New York, NY 10017,
assist in the preparation of certain reports to the Securities and Exchange
Commission and the Fund's tax returns.
The Masters' Select Funds reserve the right, if conditions exist which
make cash payments undesirable, to honor any request for redemption or
repurchase order by making payment in whole or in part in readily marketable
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<PAGE>
securities chosen by the Fund and valued as they are for purposes of computing
the Fund's net asset value (a redemption in kind). If payment is made in
securities, a shareholder may incur transaction expenses in converting these
securities into cash.
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<PAGE>
APPENDIX
Description of Ratings
Moody's Investors Service, Inc.: Corporate Bond Ratings
Aaa--Bonds which are rated Aaa are judged to be of the best quality and
carry the smallest degree of investment risk. Interest payments are protected by
a large or by an exceptionally stable margin, and principal is secure. While the
various protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position of such
issues.
Aa---Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long term risks appear somewhat larger than in Aaa securities.
Moody's applies numerical modifiers "1", "2" and "3" to both the Aaa
and Aa rating classifications. The modifier "1" indicates that the security
ranks in the higher end of its generic rating category; the modifier "2"
indicates a mid-range ranking; and the modifier "3" indicates that the issue
ranks in the lower end of its generic rating category.
A--Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium grade obligations. Factors giving
security to principal and interest are considered adequate but elements may be
present which suggest a susceptibility to impairment sometime in the future.
Baa--Bonds which are rated Baa are considered as medium grade
obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great period of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Standard & Poor's Corporation: Corporate Bond Ratings
AAA--This is the highest rating assigned by Standard & Poor's to a debt
obligation and indicates an extremely strong capacity to pay principal and
interest.
AA--Bonds rated AA also qualify as high-quality debt obligations.
Capacity to pay principal and interest is very strong, and in the majority of
instances they differ from AAA issues only in small degree.
A--Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB--Bonds rated BBB are regarded as having an adequate capacity to pay
principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay principal and interest for bonds in
this category than for bonds in the A category.
Commercial Paper Ratings
Moody's commercial paper ratings are assessments of the issuer's
ability to repay punctually promissory obligations. Moody's employs the
following three designations, all judged to be investment grade, to indicate the
relative repayment capacity of rated issuers: Prime 1--highest quality; Prime
2--higher quality; Prime 3--high quality.
A Standard & Poor's commercial paper rating is a current assessment of
the likelihood of timely payment. Ratings are graded into four categories,
ranging from "A" for the highest quality obligations to "D" for the lowest.
Issues assigned the highest rating, A, are regarded as having the
greatest capacity for timely payment. Issues in this category are delineated
with the numbers "1", "2" and "3" to indicate the relative degree of safety. The
designation A-1 indicates that the degree of safety regarding timely payment is
either overwhelming or very strong. A "+" designation is applied to those issues
rated "A-1" which possess extremely strong safety characteristics.
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<PAGE>
Capacity for timely payment on issues with the designation "A-2" is strong.
However, the relative degree of safety is not as high as for issues designated
A-1. Issues carrying the designation "A-3" have a satisfactory capacity for
timely payment. They are, however, somewhat more vulnerable to the adverse
effect of changes in circumstances than obligations carrying the higher
designations.
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<PAGE>
MASTERS' SELECT EQUITY FUND
STATEMENT OF ASSETS AND LIABILITIES
DECEMBER 12, 1996
<TABLE>
<S> <C>
Assets
Cash in bank....................................................................... $100,000
Prepaid registration fees (Note 3)................................................. 21,091
Deferred organization costs (Note 4)............................................... 94,491
--------
Total assets................................................................... $215,582
Liabilities
Payable for registration expenses and organization costs........................... 115,582
-------
Net Assets
Applicable to 10,000 shares of beneficial interest issued and outstanding; an unlimited
number of shares (par value $.01 authorized)................................... $100,000
=======
Net Asset Value (Offering and Redemption Price) per share............................... $10.00
=====
</TABLE>
NOTES TO STATEMENT OF ASSETS AND LIABILITIES
1. Masters' Select Equity Fund (the "Fund") is a diversified series of
Masters' Select Funds (the "Trust"), a Delaware business trust organized on
August 1, 1996 and registered under the Investment Company Act of 1940 as
an open-end management investment company.
2. The Trust, on behalf of the Fund, has entered into an Investment Advisory
Agreement with Litman/Gregory Fund Advisors LLC (the "Advisor"), a
Distribution Agreement with First Fund Distributors, Inc. (the
"Distributor") and an Administration Agreement with Investment Company
Administration Corporation (the "Administrator"). The Trust, on behalf of
the Fund, has also entered into sub-advisory agreements with six investment
managers pursuant to which each investment manager provides portfolio
management and related services with respect to a segment of the Fund's
portfolio. (See "Management" in the Statement of Additional Information.)
Certain officers and Trustees of the Trust are officers and/or directors of
the Advisor, the Distributor and the Administrator.
The Advisor has agreed to waive its fees, and/or reimburse the Fund for
other operating expenses, to the extent necessary to limit the Fund's total
annual operating expenses to 1.75% of the Fund's average net assets. Any
such waivers or reimbursements are subject to repayment by the Fund in
subsequent years to the extent that the Fund's operating expenses are then
less than that 1.75% limit.
3. Prepaid registration fees are charged to income as the related shares are
issued.
4. Deferred organization costs will be amortized over a period of sixty months
from the date on which the Fund commences operations. In the event that the
original shares invested in the Fund are redeemed prior to the end of the
amortization period, the proceeds of the redemption payable in respect of
those shares will be reduced by the pro rata share (based on the
proportionate share of the original shares redeemed to the total number of
original shares outstanding at the time of redemption) of the unamortized
deferred organization costs as of the date of that redemption. In the event
the Fund is liquidated prior to the end of the amortization period the
holders of the original shares will bear the unamortized deferred
organization costs.
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<PAGE>
INDEPENDENT AUDITOR'S REPORT
To the Trustees and Shareholders
Masters' Select Funds
We have audited the accompanying statement of assets and liabilities of the
Masters' Select Equity Fund, a series of Masters' Select Funds, as of December
12, 1996. This financial statement is the responsibility of the Fund's
management. Our responsibility is to express an opinion on this financial
statement based on our audit.
We conducted our audit 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 are free of material
misstatements. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures related to the schedule. 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statement referred to above presents fairly,
in all material respects, the financial position of Masters' Select Equity Fund
series of Masters' Select Funds as of December 12, 1996, in conformity with
generally accepted accounting principles.
McGladrey & Pullen, LLP
New York, New York
December 13, 1996
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