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STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 2000
NATIONWIDE ASSET ALLOCATION TRUST
THE AGGRESSIVE PORTFOLIO
THE MODERATELY AGGRESSIVE PORTFOLIO
THE MODERATE PORTFOLIO
THE MODERATELY CONSERVATIVE PORTFOLIO
THE CONSERVATIVE PORTFOLIO
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This Statement of Additional Information is not a prospectus but the Statement
of Additional Information is incorporated by reference into the Prospectus. It
contains information in addition to and more detailed than that set forth in the
Prospectus for each of The Aggressive, The Moderately Aggressive, The Moderate,
The Moderately Conservative, and The Conservative Portfolios (collectively, the
"Portfolios") dated May 1, 2000, and should be read in conjunction with that
Prospectus. The Prospectus may be obtained from Nationwide Life Insurance
Company, One Nationwide Plaza, Columbus, Ohio 43215, or by calling (614)
249-5134.
Terms not defined in this Statement of Additional Information have the meanings
assigned to them in the Prospectus.
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TABLE OF CONTENTS
General Information and History 2
Investment Objectives and Policies 2
Investment Restrictions 37
Major Shareholders 40
Trustees and Officers of the Trust 40
Calculating Total Return 43
Investment Advisory and Other Services 43
Brokerage Allocations 45
Purchases, Redemptions and Pricing of Shares 45
Additional Information 46
Tax Status 47
Financial Statements 49
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GENERAL INFORMATION AND HISTORY
Nationwide Asset Allocation Trust (the "Trust") is an open-end investment
company organized under the laws of Ohio, by a Declaration of Trust, dated
September 9, 1997. The Trust offers shares in five separate mutual funds, each
with its own investment objective(s).
INVESTMENT OBJECTIVES AND POLICIES
UNDERLYING MUTUAL FUNDS
The Prospectus discusses the investment objectives and strategies of the
Portfolios and explains the types of underlying mutual funds the ("Underlying
Funds") that each Portfolio may invest in. The following is a list of the mutual
funds that are part of the Nationwide group of funds (the "Nationwide funds")
that the Portfolios may currently invest in. This list may be updated from time
to time. Villanova Mutual Fund Capital Trust ("VMF"), an affiliate of the
Portfolios' investment adviser, is the investment adviser for all of the
Nationwide funds. As described below, VMF has employed subadvisers to serve as
investment advisers to some of the Nationwide funds.
NATIONWIDE SMALL COMPANY FUND. The Nationwide Small Company Fund is an
aggressive growth fund that seeks long-term growth of capital by investing
primarily in equity securities of small capitalization companies. Under normal
market conditions, the Fund will invest at least 65% of its total assets in
equity securities of companies whose equity market capitalizations at the time
of investment are similar to the market capitalizations of companies in the
Russell 2000(R) Small Stock Index.1 Market capitalization is a common way to
measure the size of a company based on the price of its common stock. The
company's size is the number of outstanding shares of common stock multiplied by
the price of the stock. The balance of the Fund's assets may be invested in
equity securities of companies whose market capitalizations exceed that of small
companies. The Fund may also invest in foreign securities.
VMF manages a portion of and has chosen The Dreyfus Corporation, Lazard Asset
Management, Neuberger Berman, LLC, and Strong Capital Management, Inc.to each
manage a portion of the Fund's investment portfolio. VMF selected these
subadvisers because each approaches investing in small cap securities in
different ways, and VMF believes that diversification among securities and
styles will increase the potential for investment return and potentially reduce
risk and volatility.
NATIONWIDE GROWTH FUND. The Nationwide Growth Fund is a growth fund that seeks
long-term capital appreciation. To achieve its objective, the Fund invests in
common stocks of large capitalization companies. Under normal market conditions,
the Fund invests at least 65% of its total assets in common stock and
convertible securities.
NATIONWIDE FUND. The Nationwide Fund is a growth and income fund that seeks
total return through a flexible combination of current income and capital
appreciation. To achieve its objective, the Fund invests primarily in the common
stock and convertible securities of companies with consistent earnings
performance. The Fund generally intends to be fully invested in these
securities.
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1 The Russell 2000 Small Stock Index is a registered service mark of the Frank
Russell Company, which does not sponsor and is not affiliated with the Fund or
the Trust.
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It will typically hold the securities of no more than 70 companies at any time.
NATIONWIDE SEPARATE ACCOUNT TRUST TOTAL RETURN FUND. The Nationwide Separate
Account Trust Total Return Fund is a growth and income fund. The investment
objective of this Fund is to obtain reasonable, long-term total return on
invested capital. The Fund seeks total return through a flexible combination of
current income and capital appreciation. To achieve its objective, the Fund
invests primarily in the common stock and convertible securities of companies
with consistent earnings performance and generally intends to be fully invested
in these securities. The Fund generally looks for companies whose earnings are
expected to consistently grow faster than other companies in the market. It will
typically hold the securities of no more than 70 companies at any time.
NATIONWIDE SEPARATE ACCOUNT TRUST CAPITAL APPRECIATION FUND. This is a growth
fund. To achieve its objective, the Fund primarily invests in the common stock
of large capitalization companies. Under normal market conditions, the Fund
invests at least 65% of its total assets in common stock and convertible
securities of companies and generally intends to be fully invested in these
securities. The Fund looks for companies whose earnings are expected to
consistently grow faster than other companies in the market.
NATIONWIDE INCOME FUND. The Nationwide Income Fund is a bond fund that seeks to
provide as high a level of income as is consistent with reasonable concern for
safety of principal. The Fund invests at least 65% of its assets, under normal
market conditions, in investment grade corporate bonds (rated in the four
highest categories by a nationally recognized statistical rating organization
("NRSRO")) and U.S. Government securities. The Fund also invests in
mortgage-backed securities and repurchase agreements. VMF has chosen NCM Capital
Management Group, Inc. and Smith Graham & Co. Asset Managers, L.P., each to
manage a portion of the Fund. These subadvisers have been chosen because they
approach investing in debt obligations in different ways, and VMF believes that
diversification among securities and styles will increase the potential for
investment return and reduce risk and volatility.
NATIONWIDE BOND FUND. The Nationwide Bond Fund is a bond fund that seeks to
generate as high a level of income as is consistent with capital preservation.
To achieve its goal, the Fund seeks attractive risk-adjusted total return, with
an emphasis on current income. It invests primarily in investment grade debt
securities, focusing largely on corporate bonds and U.S. Government securities.
NATIONWIDE BALANCED FUND. The Nationwide Balanced Fund is a growth and income
fund whose primary investment objective is to seek high total return from a
diversified portfolio of equity and fixed income securities. VMF has selected
J.P. Morgan Investment Management Inc. as a subadviser to manage the Fund's
portfolio on a day-to-day basis. To achieve its objective, the Fund, under
normal circumstances, invests approximately 60% of its assets in equity
securities and 40% of its assets in fixed income securities (including U.S.
Government, corporate, mortgage-backed and asset-backed securities). The equity
securities held by the Fund generally are common stocks of large and medium
sized companies included in the Standard & Poor's 500 Composite Stock Price
Index (the "S&P 500 Index").
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The fixed income securities held by the Fund will generally be investment grade
securities, or unrated securities of comparable quality, although a portion of
the Fund's fixed income securities will be invested in securities rated below
investment grade (commonly known as junk bonds).
NATIONWIDE EQUITY INCOME FUND. The Nationwide Equity Income Fund is a growth and
income fund whose investment objective is above average income and capital
appreciation. VMF has selected Federated Investment Counseling as a subadviser
to manage the Fund's portfolio on a day-to-day basis. The Fund pursues its
investment objective by investing primarily in income producing U.S. and foreign
equity securities and securities that are convertible into common stock.
Companies with similar characteristics may be grouped together in broad
categories called sectors. In determining the amount to invest in a security,
the subadviser limits the Fund's exposure to each sector that comprises the S&P
500 Index. In seeking to manage sector risk, the Fund's allocation to a sector
will be no more than 120% and no less than 80% of the S&P 500 Index's allocation
to that sector.
NATIONWIDE GLOBAL 50 FUND. The Nationwide Global 50 Fund is an aggressive growth
fund that seeks to provide a high total return from a concentrated portfolio of
global equity securities. VMF has selected J.P. Morgan Investment Management
Inc. as a subadviser to manage the Fund's portfolio on a day-to-day basis. The
Fund invests in approximately fifty stocks of primarily large and mid cap
companies located throughout the world. Using its global perspective, the
subadviser uses its investment process to identify those stocks which in its
view have an exceptional return potential. Under normal conditions, the Fund
invests in stocks of at least three countries, including the United States, and
in a variety of industries; the Fund is not constrained by geographic limits and
will not concentrate in any one industry. The Fund may invest in both developed
and emerging markets. The Fund may invest substantially in securities
denominated in foreign currencies and actively seeks to enhance returns through
managing currency exposure. To the extent that the Fund hedges its currency
exposure to the U.S. dollar, it may reduce the effects of currency fluctuations.
The fund may also hedge from one foreign currency to another, although emerging
markets investments are typically unhedged.
NATIONWIDE S&P 500 INDEX FUND. This Fund, which is subadvised by Fund Asset
Management, L.P., is a growth fund. Its investment objective is to provide
investment results that correspond to the price and yield performance of
publicly traded common stocks as represented by the Standard and Poor's 500
Composite Stock Price Index. The Fund employs a "passive" management approach,
attempting to invest in a portfolio of assets whose performance is expected to
match approximately the performance of the S&P 500. The Fund will be
substantially invested in securities of the S&P 500, and will invest at least
80% of its assets in securities or other financial instruments in, or correlated
with, the S&P 500.
The Fund invests in a statistically selected sample of stocks included in the
S&P 500 and in derivative instruments linked to the S&P 500. The Fund may not
invest in all of the common stocks in the S&P 500, or in the same weightings as
in the S&P 500.
NATIONWIDE MID CAP INDEX FUND. The Nationwide Mid Cap Index Fund is a growth
fund that seeks capital appreciation. The Fund seeks to match the performance
of the Standard & Poor's MidCap 400 Index(3). To pursue this goal, the Fund
generally is fully invested in stocks included in
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2 The S&P 500 is a market-weighted index composed of approximately 500 common
stocks chosen by Standard and Poor's based on a number of factors including
industry group representation, market value, economic sector and
operating/financial condition.
3 "Standard & Poor's MidCap 400 Index" and "S&P" are the trademarks of the
McGraw-Hill Companies, Inc., which do not sponsor and are in no way affiliated
with the Fund.
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this index, and in futures whose performance is tied to the index. The Fund
generally invests in all 400 stocks in the S&P MidCap 400 in proportion to their
weighting in the index. The S&P MidCap 400 is composed of 400 stocks of
medium-size domestic and some Canadian companies with market capitalizations
ranging primarily between $50 million and $10 billion. Each stock is weighted by
its market capitalization, which means larger companies have greater
representation in the index than smaller ones. The Fund may also use stock index
futures as a substitute for the sale or purchase of securities. VMF has chosen
the Dreyfus Corporation to manage the Fund.
NATIONWIDE SMALL CAP VALUE FUND. The Nationwide Small Cap Value Fund is an
aggressive growth fund that seeks capital appreciation through a diversified
portfolio of equity securities of companies with a median market capitalization
of approximately $1 billion. VMF has selected The Dreyfus Corporation as a
subadviser to manage the Fund's portfolio on a day-to-day basis. The Fund
intends to pursue its investment objective by investing, under normal market
conditions, at least 75% of the Fund's total assets in equity securities of
companies whose equity market capitalizations at the time of investment are
similar to the market capitalizations of companies in the Russell 2000(R), known
as small cap companies. The Russell 2000, published by the Frank Russell
Company, is an index consisting of approximately 2000 companies with small
market capitalizations relative to the market capitalizations of other U.S.
companies. Currently the market capitalizations of companies in the Russell 2000
range from approximately $100 million to $13 billion. The Fund may invest up to
20% of its total assets in equity securities of foreign companies. The Fund will
invest in stocks of U.S. and foreign companies which the subadviser considers to
be "value" companies. The subadviser generally believes that such companies have
relatively low price to book ratios, low price to earnings ratios or higher than
average dividend payments in relation to price.
NATIONWIDE SMALL CAP GROWTH FUND. The Nationwide Small Cap Growth Fund is an
aggressive growth fund that seeks capital growth. The Fund seeks to achieve its
investment objective from a broadly diversified portfolio of equity securities
issued by U.S. and foreign companies with market capitalizations in the range of
companies represented by the Russell 2000, known as small cap companies. Under
normal market conditions, the Fund will invest at least 65% of its total assets
in the equity securities of small cap companies. The balance of the Fund's
assets may be invested in equity securities of larger cap companies. Equity
securities include preferred stocks, securities convertible into common stock
and warrants for the purchase of common stock. VMF has selected Franklin
Advisers, Inc., Miller Anderson & Sherrerd, LLP and Neuberger Berman, LLC each
to manage a portion of the Fund's investment portfolio. VMF chose these
subadvisers because each approaches investing in small cap growth securities in
different ways, and VMF believes that diversification among securities and
styles will increase the potential for investment return and potentially reduce
risk and volatility.
NATIONWIDE STRATEGIC GROWTH FUND. The Nationwide Strategic Growth Fund is a
growth fund that seeks capital growth. VMF has selected Strong Capital
Management, Inc. as a subadviser to manage the Fund's portfolio on a day-to-day
basis. The Fund focuses on common stocks of U.S. and foreign companies that the
subadviser believes are reasonably priced and have above-average growth
potential. The Fund's portfolio can include stocks of companies of any size. The
subadviser's buy/sell strategy is not limited by the turnover rate of the Fund's
portfolio. The subadviser may participate in frequent portfolio transactions,
which will lead to higher transaction costs.
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NATIONWIDE STRATEGIC VALUE FUND. The Nationwide Strategic Value Fund is a growth
and income fund that primarily seeks long-term capital appreciation. VMF has
selected Schafer Capital Management, Inc. as subadviser to manage the Fund's
portfolio on a day-to-day basis through a subcontract with Strong Capital
Management, Inc. The Fund invests primarily in common stocks of medium and
large-size companies. The subadviser selects stocks of companies that have
above-average growth potential, but also are inexpensive relative to market
averages. The Fund invests approximately equal amounts of its assets in each
stock in the portfolio at the time of purchase, and generally invests all of its
assets in U.S. and foreign common stock and convertible securities.
PRESTIGE LARGE CAP VALUE FUND. This Fund, which is a growth and income fund, is
subadvised by Brinson Partners, Inc. The Fund seeks to maximize total return,
consisting of both capital appreciation and current income. It seeks to achieve
its investment objective by investing in U.S. equity securities that are
currently undervalued as determined by its subadviser. Under normal market
conditions, substantially all, but in no event less than 65% of the Fund's total
assets will be invested in equity securities of large capitalization U.S.
companies, including foreign companies whose securities are traded in the United
States and who comply with U.S. accounting standards. A large capitalization
company is a company with a market capitalization and industry characteristics
that are similar to companies in the Russell 1000 Value Index.4 The Russell 1000
Value Index contains companies which are among the 1000 largest U.S. companies
and which have greater than average value orientation.
PRESTIGE LARGE CAP GROWTH FUND. This Fund, which is a growth fund, is subadvised
by Goldman Sachs Asset Management. The Fund's investment objective is long-term
capital appreciation. It seeks to achieve its investment objective by investing
in equity securities of large capitalization U.S. companies that are expected to
have better prospects for earnings growth than the growth rate of the general
domestic economy. Dividend income is a secondary objective. The Fund usually is
fully invested with 90% of its total assets invested in equity securities of
large capitalization U.S. companies, including foreign companies whose
securities are traded in the United States (including American Depository
Receipts and Global Depository Receipts). A large capitalization company is a
company with a market capitalization and industry characteristics that are
similar to companies in the Russell 1000 Growth Index. The Russell 1000 Growth
Index contains companies which are among the 1000 largest U.S. companies and
which have greater than average growth orientation.
PRESTIGE BALANCED FUND. This Fund, which is a growth and income fund, is
subadvised by J.P. Morgan Investment Management Inc. The Fund's investment
objective is to provide a high total return form a diversified portfolio of
equity and fixed income securities. It seeks to provide a total return that
approaches the total return of the universe of equity securities of large and
medium sized companies and that exceeds the return of typical of a portfolio of
fixed income securities.
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4 The Russell 1000 Value Index, Russell 1000 Growth Index are registered service
marks of The Frank Russell Company which does not sponsor and is in no way
affiliated with the Large Cap Value Fund or Large Cap Growth Fund
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PRESTIGE INTERNATIONAL FUND. This Fund, which is an aggressive growth fund, is
subadvised by Lazard Asset Management. The Fund's investment objective is
capital appreciation. It seeks to achieve its investment objective by investing
in equity securities of non-U.S. companies that, in the opinion of its
subadviser, are inexpensively priced relative to the return on total capital or
equity. The subadviser currently intends to invest the Fund's assets in
companies based in Continental Europe, the United Kingdom, the Pacific Basin and
in such other areas that the subadviser may determine. Under normal market
conditions, the Fund will invest at least 80% of its total assets in the equity
securities of companies within at least three different companies (not including
the U.S.).
PRESTIGE SMALL CAP FUND. This Fund, which is an aggressive growth fund, is
subadvised by INVESCO Management & Research, Inc. The Fund's investment
objective is long-term capital appreciation. It seeks to achieve its investment
objective from a broadly diversified portfolio of equity securities issued by
U.S. companies that have small market capitalizations. Under normal market
conditions, not less than 65% of the Fund's total assets will be invested in
equity securities of companies whose equity market capitalizations at the time
of investment do not exceed 110% of the largest company in the Russell 2000
Small Stock Index. The Russell 2000 Small Stock Index contains approximately
2000 companies with small market capitalizations relative to the market
capitalizations of other U.S. companies.
INVESTMENT POLICIES AND STRATEGIES OF THE UNDERLYING FUNDS
The following discusses the types of securities and other instruments in which
the Underlying Funds may invest (and certain short-term investments in which the
Portfolios may invest directly), the investment policies and strategies that the
Underlying Funds may utilize and certain risks associated with these
investments, policies and strategies. In addition, the Underlying Funds may
invest in other investments and use other policies and strategies not described
here.
SMALL COMPANY AND EMERGING GROWTH STOCKS - Investing in securities of
small-sized and emerging growth companies may involve greater risks than
investing in larger, more established issuers since these securities may have
limited marketability and thus may be more volatile than securities of larger,
more established companies or the market averages in general. Because
small-sized companies normally have fewer shares outstanding than larger
companies, it may be more difficult for an Underlying Fund to buy or sell
significant numbers of such shares without an unfavorable impact on prevailing
prices. Small-sized companies may have limited product lines, markets or
financial resources and may lack management depth. In addition, small-sized
companies are typically subject to wider variations in earnings and business
prospects than are larger, more established companies. There is typically less
publicly available information concerning small-sized companies than for larger,
more established ones.
SPECIAL SITUATION COMPANIES. Some of the Underlying Funds may invest in the
securities of "special situation companies," which include companies involved in
an actual or prospective acquisition or consolidation; reorganization;
recapitalization; merger, liquidation or distribution of cash, securities or
other assets; a tender or exchange offer; a breakup or workout of a holding
company; or litigation which, if resolved favorably, would improve the value of
the company's stock. If the actual or prospective situation does not materialize
as anticipated, the market price of the securities of a "special situation
company" may decline significantly. Therefore, an investment in
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an underlying Fund that invests a significant portion of its assets in these
securities may involve a greater degree of risk than an investment in other
mutual funds that seeks long-term growth of capital by investing in better
known, larger companies. If the investment adviser of an Underlying Fund
analyzes "special situation companies" carefully and invests in the securities
of these companies at the appropriate time, the Underlying Fund may achieve
capital growth. There can be no assurance however, that a special situation that
exists at the time the Underlying Fund makes its investment will be consummated
under the terms and within the time period contemplated.
FOREIGN SECURITIES. Investors in the Portfolios should recognize that an
investment by the Underlying Funds in foreign securities involves certain
special considerations which are not typically associated with investing in
United States securities. Because investments in foreign companies will
frequently involve currencies of foreign countries, and because the Underlying
Funds may hold securities and funds in foreign currencies, the Portfolios may be
affected favorably or unfavorably by changes in currency rates and in exchange
control regulations, if any, and may incur costs in connection with conversions
between various currencies. Most foreign stock markets, while growing in volume
of trading activity, have less volume than the New York Stock Exchange, and the
securities of some foreign companies are less liquid and more volatile than the
securities of comparable domestic companies. Similarly, volume and liquidity in
most foreign bond markets are less than in the United States and at times the
volatility of price can be greater than in the United States. Fixed commissions
on foreign securities exchanges are generally higher than negotiated commissions
on United States exchanges, although the Underlying Funds endeavor to achieve
the most favorable net results on their portfolio transactions. There is
generally less government supervision and regulation of securities exchanges,
brokers and listed companies in foreign countries than in the United States. In
addition, with respect to certain foreign countries, there is the possibility of
exchange control restrictions, expropriation or confiscatory taxation, and
political, economic or social instability, which could affect investments in
those countries. Foreign securities such as those purchased by the Underlying
Funds may be subject to foreign government taxes, higher custodian fees and
dividend collection fees which could reduce the yield on such securities.
Foreign economies may differ favorably or unfavorably from the U.S. economy in
various respects, including growth of gross domestic product, rates of
inflation, currency depreciation, capital reinvestment, resource
self-sufficiency, and balance of payments positions. Many foreign securities are
less liquid and their prices more volatile than comparable U.S. securities. From
time to time, foreign securities may be difficult to liquidate rapidly without
adverse price effects.
From time to time the Underlying Funds may invest in companies that are in
developing countries as well as in developed countries. Although there is no
universally accepted definition, a developing country is generally considered to
be a country that is in the initial stages of industrialization. Shareholders
should be aware that investing in the equity and fixed income markets of
developing countries involves exposure to unstable governments, economies based
on only a few industries, and securities markets which trade a small number of
securities. Securities markets of developing countries tend to be more volatile
than the markets of developed countries; however, such markets have in the past
provided the opportunity for higher rates of return to investors.
The value and liquidity of investments in developing countries may be affected
favorably or unfavorably by political, economic, fiscal, regulatory or other
developments in the particular
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countries or neighboring regions. The extent of economic development, political
stability and market depth of different countries varies widely. Certain
countries in the Asia region, including Cambodia, China, Laos, Indonesia,
Malaysia, the Philippines, Thailand, and Vietnam are either comparatively
underdeveloped or are in the process of becoming developed. Such investments
typically involve greater potential for gain or loss than investments in
securities of issuers in developed countries.
The securities markets in developing countries are substantially smaller, less
liquid and more volatile than the major securities markets in the United States.
A high proportion of the shares of many issuers may be held by a limited number
of persons and financial institutions, which may limit the number of shares
available for investment by the Underlying Funds. Similarly, volume and
liquidity in the bond markets in developing countries are less than in the
United States and, at times, price volatility can be greater than in the United
States. A limited number of issuers in developing countries' securities markets
may represent a disproportionately large percentage of market capitalization and
trading volume. The limited liquidity of securities markets in developing
countries may also affect an Underlying Fund's ability to acquire or dispose of
securities at the price and time it wishes to do so. Accordingly, during periods
of rising securities prices in the more illiquid securities markets, an
Underlying Fund's ability to participate fully in such price increases may be
limited by its investment policy of investing not more than 15% of its total net
assets in illiquid securities. Conversely, an Underlying Fund's inability to
dispose fully and promptly of positions in declining markets will cause an
Underlying Fund's net asset value to decline as the value of the unsold
positions is marked to lower prices. In addition, securities markets in
developing countries are susceptible to being influenced by large investors
trading significant blocks of securities.
Political and economic structures in many of such countries may be undergoing
significant evolution and rapid development, and such countries may lack the
social, political and economic stability characteristic of the United States.
Certain of such countries have in the past failed to recognize private property
rights and have at times nationalized or expropriated the assets of private
companies. As a result, the risks described above, including the risks of
nationalization or expropriation of assets, may be heightened. In addition,
unanticipated political or social developments may affect the value of an
Underlying Fund's investments in those countries and the availability to the
Underlying Fund of additional investments in those countries.
Economies of developing countries may differ favorably or unfavorably from the
United States economy in such respects as rate of growth of gross national
product, rate of inflation, capital reinvestment, resource self-sufficiency and
balance of payments position. As export-driven economies, the economies of
countries in the Asia Region are affected by developments in the economies of
their principal trading partners. Hong Kong, Japan and Taiwan have limited
natural resources, resulting in dependence on foreign sources for certain raw
materials and economic vulnerability to global fluctuations of price and supply.
Certain developing countries do not have comprehensive systems of laws, although
substantial changes have occurred in many such countries in this regard in
recent years. Laws regarding fiduciary duties of officers and directors and the
protection of shareholders may not be well developed. Even where adequate law
exists in such developing countries, it may be impossible to
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obtain swift and equitable enforcement of such law, or to obtain enforcement of
the judgment by a court of another jurisdiction.
Trading in futures contracts traded on foreign commodity exchanges may be
subject to the same or similar risks as trading in foreign securities.
DEPOSITARY RECEIPTS. Some of the Underlying Funds may invest in foreign
securities by purchasing depositary receipts, including American Depositary
Receipts ("GDRs") and European Depositary Receipts ("EDRs") and Global
Depository Receipts ("GDRS") or other securities convertible into securities of
issuers based in foreign countries. These securities may not necessarily be
denominated in the same currency as the securities into which they may be
converted. Generally, ADRs, in registered form, are denominated in U.S. dollars
and are designed for use in the U.S. securities markets, GDRs, in bearer form,
are issued and designed for use outside the United States and EDRs (also
referred to as Continental Depositary Receipts ("CDRs")), in bearer form, may be
denominated in other currencies and are designed for use in European securities
markets. ADRs are receipts typically issued by a U.S. Bank or trust company
evidencing ownership of the underlying securities. EDRs are European receipts
evidencing a similar arrangement. GDRs are receipts typically issued by
non-United States banks and trust companies that evidence ownership of either
foreign or domestic securities. For purposes of a Fund's investment policies,
ADRs, GDRs and EDRs are deemed to have the same classification as the underlying
securities they represent. Thus, an ADR, GDR or EDR representing ownership of
common stock will be treated as common stock.
An Underlying Fund may invest in depositary receipts through "sponsored" or
"unsponsored" facilities. A sponsored facility is established jointly by the
issuer of the underlying security and a depositary, whereas a depositary may
establish an unsponsored facility without participation by the issuer of the
deposited security. Holders of unsponsored depositary receipts generally bear
all the costs of such facilities and the depositary of an unsponsored facility
frequently is under no obligation to distribute shareholder communications
received from the issuer of the deposited security or to pass through voting
rights to the holders of such receipts in respect of the deposited securities.
PREFERRED STOCK. A number of the Underlying Funds may invest in preferred
stocks. Preferred stocks, like debt obligations, are generally fixed-income
securities. Shareholders of preferred stocks normally have the right to receive
dividends at a fixed rate when and as declared by the company's board of
directors, but do not participate in other amounts available for distribution by
the company issuing the preferred stock. Dividends on the preferred stock may be
cumulative, and all cumulative dividends usually must be paid prior to common
shareholders receiving any dividends. Because preferred stock dividends must be
paid before common stock dividends, preferred stocks generally entail less risk
than common stocks. Upon liquidation, preferred stocks are entitled to a
specified liquidation preference, which is generally the same as the par or
stated value, and are senior in right of payment to common stock. Preferred
stocks are, however, equity securities in the sense that they do not represent a
liability of the issuer and, therefore, do not offer as great a degree or
protection of capital or assurance of continued income as investments in
corporate debt securities. In addition, preferred stocks are subordinated in
right of payment to all debt obligations and creditors of the issuer, and
convertible preferred stocks may be subordinated to other preferred stock of the
same issuer.
CONVERTIBLE SECURITIES. Convertible securities are bonds, debentures, notes,
preferred stocks, or other securities that may be converted into or exchanged
for a specified amount of common stock of the same or a different issuer within
a particular period of time at a specified price or formula. Convertible
securities have general characteristics similar to both debt obligations and
equity securities. A convertible security entitles the holder to receive
interest normally paid or accrued on debt or the dividend paid on preferred
stock until the convertible security matures or is redeemed, converted, or
exchanged. Convertible securities have unique investment characteristics in that
they generally (i) have higher yields than common stocks, but lower yields than
comparable non-convertible securities, (ii) are less subject to fluctuation in
value than the underlying stock since they have fixed income characteristics,
and (iii) provide the potential for capital appreciation if the market price of
the underlying common stock increases. Most convertible securities currently are
issued by U.S. companies, although a substantial Eurodollar convertible
securities market has developed, and the markets for convertible securities
denominated in local currencies are increasing.
The value of a convertible security is a function of its "investment value"
(determined by its yield in comparison with the yields of other securities of
comparable maturity and quality that do not have a conversion privilege) and its
"conversion value" (the security's worth, at market value, if converted into the
underlying common stock). The investment value of a convertible security is
influenced by changes in interest rates, with investment value declining as
interest rates increase and increasing as interest rates decline. The credit
standing of the issuer and other factors also may have an effect on the
convertible security's investment value. The conversion value of a convertible
security is determined by the market price of the underlying common stock. If
the conversion value is low relative to the investment value, the price of the
convertible security is governed principally by its investment value. Generally,
the conversion value decreases as the convertible security approaches maturity.
To the extent the market price of the underlying common stock approaches or
exceeds the conversion price, the price of the convertible security will be
increasingly influenced by its conversion value. A convertible security
generally will sell at a premium over its conversion value by the extent to
which investors place value on the right to acquire the underlying common stock
while holding a fixed income security.
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While no securities investments are without risk, investments in convertible
securities generally entail less risk than investments in common stock of the
same issuer.
A convertible security may be subject to redemption at the option of the issuer
at a price established in the convertible security's governing instrument. If a
convertible security held by an Underlying Fund is called for redemption, the
Underlying Fund will be required to permit the issuer to redeem the security,
convert it into the underlying common stock, or sell it to a third party.
Convertible securities generally are subordinated to other similar but
non-convertible securities of the same issuer, although convertible bonds, as
corporate debt obligations, enjoy seniority in right of payment to all equity
securities, and convertible preferred stock is senior to common stock of the
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same issuer. Because of the subordination feature, however, convertible
securities typically are rated below investment grade or are not rated.
Certain Underlying Funds may invest in convertible preferred stocks that offer
enhanced yield features, such as Preferred Equity Redemption Cumulative Stocks
("PERCS"), which provide an investor, such as a Fund, with the opportunity to
earn higher dividend income than is available on a company's common stock. PERCS
are preferred stocks that generally feature a mandatory conversion date, as well
as a capital appreciation limit, which is usually expressed in terms of a stated
price. Most PERCS expire three years from the date of issue, at which time they
are convertible into common stock of the issuer. PERCS are generally not
convertible into cash at maturity. Under a typical arrangement, after three
years PERCS convert into one share of the issuer's common stock if the issuer's
common stock is trading at a price below that set by the capital appreciation
limit, and into less than one full share if the issuer's common stock is trading
at a price above that set by the capital appreciation limit. The amount of that
fractional share of common stock is determined by dividing the price set by the
capital appreciation limit by the market price of the issuer's common stock.
PERCS can be called at any time prior to maturity, and hence do not provide call
protection. If called early, however, the issuer must pay a call premium over
the market price to the investor. This call premium declines at a preset rate
daily, up to the maturity date.
An Underlying Fund may also invest in other classes of enhanced convertible
securities. These include but are not limited to ACES (Automatically Convertible
Equity Securities), PEPS (Participating Equity Preferred Stock), PRIDES
(Preferred Redeemable Increased Dividend Equity Securities), SAILS (Stock
Appreciation Income Linked Securities), TECONS (Term Convertible Notes), QICS
(Quarterly Income Cumulative Securities), and DECS (Dividend Enhanced
Convertible Securities). ACES, PEPS, PRIDES, SAILS, TECONS, QICS, and DECS all
have the following features: they are issued by the company, the common stock of
which will be received in the event the convertible preferred stock is
converted; unlike PERCS they do not have a capital appreciation limit; they seek
to provide the investor with high current income with some prospect of future
capital appreciation; they are typically issued with three or four-year
maturities; they typically have some built-in call protection for the first two
or three years; and, upon maturity, they will necessarily convert into either
cash or a specified number of shares of common stock.
Similarly, there may be enhanced convertible debt obligations issued by the
operating company, whose common stock is to be acquired in the event the
security is converted, or by a differing issuer, such as an investment bank.
These securities may be identified by names such as ELKS (Equity Linked
Securities) or similar names. Typically they share most of the salient
characteristics of an enhanced convertible preferred stock but will be ranked as
senior or subordinated debt in the issuer's corporate structure according to the
terms of the debt indenture. There may be additional types of convertible
securities not specifically referred to herein, which may be similar to those
described above in which a Fund may invest consistent with its goals and
policies.
An investment in an enhanced convertible security or any other security may
involve additional risks to the fund. An Underlying Fund may have difficulty
disposing of such securities because there may be a thin trading market for a
particular security at any given time. Reduced liquidity may have an adverse
impact on market price and an Underlying Fund's ability to dispose of particular
securities, when necessary, to meet the Fund's liquidity needs or in response to
a specific economic event, such as the deterioration in the credit worthiness of
an issuer. Reduced liquidity in the secondary market for certain securities may
also make it more difficult for the Fund to obtain market quotations based on
actual trades for purposes of valuing the fund's portfolio. An Underlying Fund,
however, intends to acquire liquid securities, though there can be no assurances
that it will always be able to do so.
Certain Underlying Funds may also invest in zero coupon convertible securities.
Zero coupon convertible securities are debt securities which are issued at a
discount to their face amount and do not entitle the holder to any periodic
payments of interest prior to maturity. Rather, interest earned on zero coupon
convertible securities accretes at a stated yield until the security reaches its
face amount at maturity. Zero coupon convertible securities are convertible into
a specific number of shares of the issuer's common stock. In addition, zero
coupon convertible securities usually have put features that provide the holder
with the opportunity to sell the securities back to the issuer at a stated price
before maturity. Generally, the prices of zero coupon convertible securities may
be more sensitive to market interest rate fluctuations then conventional
convertible securities. Federal income tax law requires the holder of a zero
coupon convertible security to recognize income from the security prior to the
receipt of cash payments. To maintain its qualification as a regulated
investment company and avoid liability of federal income taxes, an Underlying
Fund will be required to distribute income accrued from zero coupon convertible
securities which it owns, and may have to sell portfolio securities (perhaps at
disadvantageous times) in order to generate cash to satisfy these distribution
requirements.
REAL ESTATE SECURITIES. Although the Underlying Funds will not invest in real
estate directly, an Underlying Fund may invest in equity securities of real
estate investment trusts ("REITs") and other real estate industry companies or
companies with substantial real estate investments and, as a result, an
Underlying Fund may be subject to certain risks associated with direct ownership
of real estate and with the real estate industry in general. These risks
include, among others: possible declines in the value of real estate; possible
lack of availability of mortgage funds; extended vacancies of properties; risks
related to general and local economic conditions; overbuilding; increases in
competition, property taxes and operating expenses; changes in zoning laws;
costs resulting from the clean-up of, and liability to third parties for damages
resulting from, environmental problems; casualty or condemnation losses;
uninsured damages from floods, earthquakes or other natural disasters;
limitations on and variations in rents; and changes in interest rates.
REITs are pooled investment vehicles which invest primarily in income producing
real estate or real estate related loans or interests. REITs are generally
classified as equity REITs, mortgage REITs or hybrid REITs. Equity REITs invest
the majority of their assets directly in real property and derive income
primarily from the collection of rents. Equity REITs can also realize capital
gains by selling properties that have appreciated in value. Mortgage REITs
invest the majority of their assets in real estate mortgages and derive income
from the collection of interest payments. Hybrid REITs combine the investment
strategies of Equity REITs and Mortgage REITs. REITs are not taxed on income
distributed to shareholders provided they comply with several requirements of
the Internal Revenue Code, as amended (the "Code").
EURODOLLAR AND YANKEE OBLIGATIONS. Eurodollar bank obligations are
dollar-denominated certificates of deposit and time deposits issued outside the
U.S. capital markets by foreign branches of U.S. banks and by foreign banks.
Yankee bank obligations are dollar-denominated obligations issued in the U.S.
capital markets by foreign banks.
Eurodollar and Yankee bank obligations are subject to the same risks that
pertain to domestic issues, notably credit risk, market risk and liquidity risk.
Additionally, Eurodollar (and to a limited extent, Yankee) bank obligations are
subject to certain sovereign risks. One such risk is the possibility that a
sovereign country might prevent capital, in the form of dollars, from flowing
across their borders. Other risks include: adverse political and economic
developments; the extent and quality of government regulation of financial
markets and institutions; the imposition of foreign withholding taxes, and the
expropriation or nationalization of foreign issuers. However Eurodollar and
Yankee bank Obligations held in an Underlying Fund will undergo the same credit
analyses as domestic issues in which an Underlying Fund invests, and will have
at least the same financial strength as the domestic issuers approved for an
Underlying Fund.
DEBT OBLIGATIONS. In addition to equity securities, the Underlying Funds may be
permitted to invest in debt obligations. These include money market instruments,
U.S. Government or Agency securities, and corporate bonds and debentures which
generally have received one of the four highest ratings from a NRSRO, or if not
rated by any NRSRO, are deemed comparable by a fund's investment adviser to such
rated securities ("Comparable Unrated Securities"). The ratings of an NRSRO
represent the opinions of these agencies as to the quality of securities that
they rate. Ratings are not absolute standards of quality; consequently,
securities with the same maturity, coupon, and rating
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may have different yields. The ratings assigned by the NRSROs are described in
Appendix A to this Statement of Additional Information.
Fixed income securities are subject to the risk of an issuer's inability to meet
principal and interest payments on its obligations ("credit risk") and are
subject to price volatility due to such factors as interest rate sensitivity,
market perception of the creditworthiness of the issuer, and general market
liquidity ("market risk"). Lower-rated securities are more likely to react to
developments affecting market and credit risk than are more highly rated
securities, which react primarily to movements in the general level of interest
rates. Subsequent to its purchase by an Underlying Fund, an issue of securities
may cease to be rated or its rating may be reduced, so that the securities may
no longer be eligible for purchase by the Underlying Fund. In such a case, the
Underlying Fund's investment adviser will evaluate whether the downgraded
security should be disposed of.
RATINGS AS INVESTMENT CRITERIA. High-quality and investment grade debt
obligations are characterized as such based on their ratings by NRSROs. In
general, the ratings of NRSROs represent the opinions of these agencies as to
the quality of securities that they rate. Such ratings, however, are relative
and subjective, and are not absolute standards of quality and do not evaluate
the market value risk of the securities. These ratings are used by Underlying
Funds as initial criteria for the selection of portfolio securities, but the
Underlying Funds will also rely upon the independent advice of their respective
advisers to evaluate potential investments. Among the factors that will be
considered are the long-term ability of the issuer to pay principal and interest
and general economic trends. The Appendix to this Statement of Additional
Information contains further information about the rating categories of NRSROs
and their significance.
Subsequent to its purchase by a Fund or Underlying Fund, an issue of securities
may cease to be rated or its rating may be reduced below the minimum required
for purchase by an Underlying Fund. In addition, it is possible that an NRSRO
might not change its rating of a particular issue to reflect subsequent events.
None of these events generally will require sale of such securities, but the
Underlying Fund's investment adviser will consider such events in its
determination of whether the Underlying Fund should continue to hold the
securities. In addition, to the extent that the ratings change as a result of
changes in such organizations or their rating systems, or due to a corporate
reorganization, an Underlying Fund will attempt to use comparable rations as
standards for its investments in accordance with its investment objective and
policies.
U.S. GOVERNMENT SECURITIES. The Underlying Funds may be permitted to purchase
U.S. government securities. U.S. government securities are issued or guaranteed
by the U.S. government or its agencies or instrumentalities. Securities issued
by the government include U.S. Treasury obligations, such as Treasury bills,
notes, and bonds. Securities issued by government agencies or instrumentalities
include, but are not limited to, obligations of the following:
- - the Federal Housing Administration, Farmers Home Administration, and the
Government National Mortgage Association ("GNMA"), including GNMA
pass-through certificates, whose securities are supported by the full faith
and credit of the United States;
- - the Federal Home Loan Banks and the Tennessee Valley Authority, whose
securities are supported by the right of the agency to borrow from the U.S.
Treasury;
- - the Federal National Mortgage Association ("FNMA"), whose securities are
supported by the
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discretionary authority of the U.S. government to purchase certain
obligations of the agency or instrumentality; and
- - the Federal Home Loan Mortgage Corporation ("Freddie Mac"), and the Student
Loan Marketing Association, whose securities are supported only by the
credit of such agencies.
Although the U.S. government or its agencies provide financial support to such
entities, no assurance can be given that they will always do so. The U.S.
government and its agencies and instrumentalities do not guarantee the market
value of their securities; consequently, the value of such securities will
fluctuate.
MONEY MARKET INSTRUMENTS. The Portfolios and Underlying Funds may invest in
certain types of money market instruments, including the following types of
instruments:
- - obligations issued or guaranteed as to interest and principal by the U.S.
government, its agencies, or instrumentalities, or any federally chartered
corporation with remaining maturities of 397 days or less;
- - obligations of sovereign foreign governments, their agencies,
instrumentalities and political subdivisions, with remaining maturities of
397 days or less;
- - repurchase agreements;
- - certificates of deposit, time deposits and bankers acceptances issued by
domestic banks (including their branches located outside the United States
and subsidiaries located in Canada), domestic branches of foreign banks,
savings and loan associations and similar institutions;
- - commercial paper (including asset-backed commercial paper), which are
short-term unsecured promissory notes issued by corporations in order to
finance their current operations. Generally the commercial paper will be
rated within the top two rating categories by an NRSRO, or if not rated, is
issued and guaranteed as to payment of principal and interest by companies
which at the date of investment have a high quality outstanding debt issue;
- - high quality short-term (maturity in 397 days or less) corporate
obligations; These obligations will be rated within the top 2 rating
categories by an NRSRO or if not rated, of comparable quality;
- - bank loan participation agreements representing corporations and banks
having a high quality short-term rating, at the date of investment, and
under which the Portfolio or Underlying Fund will look to the
creditworthiness of the lender bank, which is obligated to make payments of
principal and interest on the loan, as well as to creditworthiness of the
borrower.
Some of the Underlying Funds may invest in the securities of foreign corporate
issuers and in the securities of foreign branches of U.S. banks, such as
negotiable certificates of deposit (Eurodollars) in U.S. dollar denominations.
Because of this, investment in such a Portfolio or Underlying Fund involves
risks that are different in some respects from an investment in a fund which
invests only in debt obligations of U.S. domestic issuers. Such risks may
include future political and economic developments, the possible imposition of
foreign withholding taxes on interest income payable on
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the securities held in the portfolio, 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 securities in the portfolio.
REPURCHASE AGREEMENTS. In connection with entering into a repurchase agreement
the Portfolio or Underlying Fund's custodian will have custody of, and will hold
in a segregated account, securities acquired by the Underlying Fund under a
repurchase agreement. Repurchase agreements are contracts under which the buyer
of a security simultaneously commits to resell the security to the seller at an
agreed-upon price and date. Repurchase agreements are considered by the staff of
the Securities and Exchange Commission (the "SEC") to be loans by the fund.
Repurchase agreements may be entered into with respect to securities of the type
in which it may invest or government securities regardless of their remaining
maturities. A Portfolio or Underlying Fund will require that additional
securities be deposited with it if the value of the securities purchased should
decrease below resale price. Repurchase agreements involve certain risks in the
event of default or insolvency by the other party, including possible delays or
restrictions upon the Portfolio or Underlying Fund's ability to dispose of the
underlying securities, the risk of a possible decline in the value of the
underlying securities during the period in which the Portfolio or Underlying
Fund seek to assert its rights to them, the risk of incurring expenses
associated with asserting those right and the risk of losing all or part of the
income from the repurchase agreement.
MORTGAGE DOLLAR ROLLS AND REVERSE REPURCHASE AGREEMENTS. An Underlying Fund may
engage in reverse repurchase agreements to facilitate portfolio liquidity, a
practice common in the mutual fund industry, or for arbitrage transactions
discussed below. In a reverse repurchase agreement, an Underlying Fund would
sell a security and enter into an agreement to repurchase the security at a
specified future date and price. An Underlying Fund generally retains the right
to interest and principal payments on the security. Because an Underlying Fund
receives cash upon entering into a reverse repurchase agreement, it may be
considered a borrowing. When required by guidelines of the SEC, an Underlying
Fund will set aside permissible liquid assets in a segregated account to secure
its obligations to repurchase the security. At the time an Underlying Fund
enters into a reverse repurchase agreement, it will establish and maintain a
segregated account with an approved custodian containing liquid securities
having a value not less than the repurchase price (including accrued interest).
The assets contained in the segregated account will be marked-to-market daily
and additional assets will be placed in such account on any day in which the
assets fall below the repurchase price (plus accrued interest). An Underlying
Fund's liquidity and ability to manage its assets might be affected when it sets
aside cash or portfolio securities to cover such commitments. Reverse repurchase
agreements involve the risk that the market value of the securities retained in
lieu of sale may decline below the price of the securities the Underlying Fund
has sold but is obligated to repurchase. In the event the buyer of securities
under a reverse repurchase agreement files for bankruptcy or becomes insolvent,
such buyer or its trustee or receiver may receive an extension of time to
determine whether to enforce the Underlying Fund's obligation to repurchase the
securities, and the Underlying Fund's use of the proceeds of the reverse
repurchase agreement may effectively be restricted pending such determination.
Reverse repurchase agreements are considered to be borrowings under the
Investment Company Act of 1940 (the "1940 Act").
An Underlying Fund may also enter into mortgage dollar rolls, in which an
Underlying Fund would
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sell mortgage-backed securities for delivery in the current month and
simultaneously contract to purchase substantially similar securities on a
specified future date. While an Underlying Fund would forego principal and
interest paid on the mortgage-backed securities during the roll period, the Fund
would be compensated by the difference between the current sales price and the
lower price for the future purchase as well as by any interest earned on the
proceeds of the initial sale. An Underlying Fund also could be compensated
through the receipt of fee income equivalent to a lower forward price. When an
Underlying Fund enters into a mortgage dollar roll, it will set aside
permissible liquid assets in a segregated account to secure its obligation for
the forward commitment to buy mortgage-backed securities. Mortgage dollar roll
transactions may be considered a borrowing by an Underlying Fund.
The mortgage dollar rolls and reverse repurchase agreements entered into by the
Underlying Funds may be used as arbitrage transactions in which an Underlying
Fund will maintain an offsetting position in investment grade debt obligations
or repurchase agreements that mature on or before the settlement date on the
related mortgage dollar roll or reverse repurchase agreements. Since an
Underlying Fund will receive interest on the securities or repurchase agreements
in which it invests the transaction proceeds, such transactions may involve
leverage. However, since such securities or repurchase agreements will be high
quality and will mature on or before the settlement date of the mortgage dollar
roll or reverse repurchase agreement, the Adviser or a subadviser believes that
such arbitrage transactions do not present the risks to the Underlying Funds
that are associated with other types of leverage.
MORTGAGE AND ASSET-BACKED SECURITIES. Some of the Underlying Funds may purchase
mortgage-backed securities and asset-backed securities. Mortgage-backed
securities represent direct or indirect participation in, or are secured by and
payable from, mortgage loans secured by real property, and include single- and
multi-class pass-through securities and collateralized mortgage obligations.
Such securities may be issued or guaranteed by U.S. Government agencies or
instrumentalities or by private issuers, generally originators in mortgage
loans, including savings and loan associations, mortgage bankers, commercial
banks, investment bankers, and special purpose entities (collectively, "private
lenders"). Mortgage-backed securities issued by private lenders may be supported
by pools of mortgage loans or other mortgage-backed securities that are
guaranteed, directly or indirectly, by the U.S. Government or one of its
agencies or instrumentalities, or they may be issued without any governmental
guarantee of the underlying mortgage assets but with some form of
non-governmental credit enhancement. These credit enhancements may include
letters of credit, reserve funds, overcollateralization, or guarantees by third
parties.
Since privately-issued mortgage certificates are not guaranteed by an entity
having the credit status of GNMA or FHLMC, such securities generally are
structured with one or more types of credit enhancement. Such credit enhancement
falls into two categories: (i) liquidity protection; and (ii) protection against
losses resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provisions of advances, generally by the
entity administering the pool of asses, to ensure that the pass-through of
payments due on the underlying pool occurs in a timely fashion. Protection
against losses resulting from ultimate default enhances the likelihood of
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or
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sponsor from third parties, through various means of structuring the transaction
or through a combination of such approaches.
The ratings of mortgage-backed securities for which third-party credit
enhancement provides liquidity protection or protection against losses from
default are generally dependent upon the continued creditworthiness of the
provider of the credit enhancement. The ratings of such securities could be
subject to reduction in the event of deterioration in the creditworthiness of
the credit enhancement provider even in cases where the delinquency loss
experience on the underlying pool of assets is better than expected. There can
be no assurance that the private issuers or credit enhancers of mortgage-backed
securities can meet their obligations under the relevant policies or other forms
of credit enhancement.
Examples of credit support arising out of the structure of the transaction
include "senior-subordinated securities" (multiple class securities with one or
more classes subordinate to other classes as to the payment of principal thereof
and interest thereon, with the result that defaults on the underlying asses are
borne first by the holders of the subordinated class), creation of "reserve
funds" (where cash or investments sometimes funded from a portion of the
payments on the underlying assets are held in reserve against future losses) and
"over-collateralization" (where the scheduled payments on, or the principal
amount of, the underlying assets exceed those required to make payment of the
securities and pay any servicing or other fees). The degree of credit support
provided for each issue is generally based on historical information with
respect to the level of credit risk associated with the underlying assets.
Delinquency or loss in excess of that which is anticipated could adversely
affect the return on an investment in such security.
Private lenders or government-related entities may also create mortgage loan
pools offering mortgage-backed securities where the mortgages underlying these
securities may be alternative mortgage instruments, that is, mortgage
instruments whose principal or interest payments may vary or whose terms to
maturity may be shorter than was previously customary. As new types of
mortgage-backed securities are developed and offered to investors, an Underlying
Fund, consistent with its investment objective and policies, may consider making
investments in such new types of securities. The market for privately issued
mortgage and asset-backed securities is smaller and less liquid than the market
for government sponsored mortgaged-backed securities.
Asset-backed securities have structural characteristics similar to
mortgage-backed securities. However, the underlying assets are not first-lien
mortgage loans or interests therein, rather they include assets such as motor
vehicle installment sales contracts, other installment loan contracts, home
equity loans, leases of various types of property and receivables from credit
card and other revolving credit arrangements. Payments or distributions of
principal and interest on asset-backed securities may be supported by
non-governmental credit enhancements similar to those utilized in connection
with mortgage-backed securities.
The yield characteristics of mortgage and asset-backed securities differ from
those of traditional debt obligations. Among the principal differences are that
interest and principal payments are made more frequently on mortgage and
asset-backed securities, usually monthly, and that principal may be prepaid at
any time because the underlying mortgage loans or other assets generally may be
prepaid at any time. As a result, if an Underlying Fund purchases these
securities at a premium, a
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prepayment rate that is faster than expected will reduce yield to maturity,
while a prepayment rate that is lower than expected will have the opposite
effect of increasing the yield to maturity. Conversely, if an Underlying Fund
purchases these securities at a discount, a prepayment rate that is faster than
expected will increase yield to maturity, while a prepayment rate that is slower
than expected will reduce yield to maturity. Accelerated prepayments on
securities purchased by the Underlying Fund at a premium also pose a risk of
loss of principal because the premium may not have been fully amortized at the
time the principal is prepaid in full.
Unlike fixed rate mortgage-backed securities, adjustable rate mortgage-backed
securities are collateralized by or represent interest in mortgage loans with
variable rates of interest. These variable rates of interest reset periodically
to align themselves with market rates. A Fund will not benefit from increases in
interest rates to the extent that interest rates rise to the point where they
cause the current coupon of the underlying adjustable rate mortgages to exceed
any maximum allowable annual or lifetime reset limits (or "cap rates") for a
particular mortgage. In this event, the value of the adjustable rate
mortgage-backed securities in a Fund would likely decrease. Also, a Fund's net
asset value could vary to the extent that current yields on adjustable rate
mortgage-backed securities are different than market yields during interim
periods between coupon reset dates or if the timing of changes to the index upon
which the rate for the underlying mortgage is based lags behind changes in
market rates. During periods of declining interest rates, income to a Fund
derived from adjustable rate mortgage securities which remain in a mortgage pool
will decrease in contrast to the income on fixed rate mortgage securities, which
will remain constant. Adjustable rate mortgages also have less potential for
appreciation in value as interest rates decline than do fixed rate investments.
There are a number of important differences among the agencies and
instrumentalities of the U.S. Government that issue mortgage-related securities
and among the securities that they issue. Mortgage-related securities issued by
GNMA include GNMA Mortgage Pass-Through Certificates (also known as Ginnie Maes)
which are guaranteed as to the timely payment of principal and interest by GNMA
and such guarantee is backed by the full faith and credit of the United States.
GNMA certificates also are supported by the authority of GNMA to borrow funds
from the U.S. Treasury to make payments under its guarantee. Mortgage-related
securities issued by FNMA include FNMA Guaranteed Mortgage Pass-Through
Certificates (also known as Fannie Maes) which are solely the obligations of the
FNMA and are not backed by or entitled to the full faith and credit of the
United States. Fannie Maes are guaranteed as to timely payment of the principal
and interest by FNMA. Mortgage-related securities issued by the Federal Home
Loan Mortgage Corporation (FHLMC) include FHLMC Mortgage Participation
Certificates (also known as Freddie Macs or PCS). The FHLMC is a corporate
instrumentality of the United States, created pursuant to an Act of Congress,
which is owned entirely by Federal Home Loan Banks. Freddie Macs are not
guaranteed by the United States or by any Federal Home Loan Banks and do not
constitute a debt or obligation of the United States or of any Federal Home Loan
Bank. Freddie Macs entitle the holder to timely payment of interest, which is
guaranteed by the FHLMC. The FHLMC guarantees either ultimate collection or
timely payment of all principal payments on the underlying mortgage loans. When
the FHLMC does not guarantee timely payment of principal, FHLMC may remit the
amount due on account of its guarantee of ultimate payment of principal at any
time after default on an underlying mortgage, but in no event later than one
year after it becomes payable.
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COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTICLASS PASS-THROUGH SECURITIES CMO's
are debt obligations collateralized by mortgage loans or mortgage pass-through
securities. Typically, CMOs are collateralized by GNMA, Fannie Mae or Freddie
Mae Certificates, but also may be collateralized by whole loans or private
pass-throughs (such collateral collectively hereinafter referred to as "Mortgage
Assets"). Multiclass pass-through securities are interests in a trust composed
of Mortgage Assets. Unless the Context indicates otherwise, all references
herein to CMOs include multiclass pass-through securities. Payments of principal
and of interest on the Mortgage Assets, and any reinvestment income thereon,
provide the funds to pay debt service on the CMOs or make scheduled
distributions on the multiclass pass-through securities. CMOs may be issued by
agencies or instrumentalities of the U.S. government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special purpose
subsidiaries of the foregoing.
In a CMO, a series of bonds or certificates is issued in multiple classes. Each
class of CMOs, often referred to as a "tranche," is issued at a specified fixed
or floating coupon rate and has a stated maturity or final distribution date.
Principal prepayments on the Mortgage Assets may cause the CMOs to be retired
substantially earlier than their stated maturities or final distribution dates.
Interest is paid or accrues on all classes of the CMOs on a monthly, quarterly
or semi-annual basis. The principal of and interest on the Mortgage Assets may
be allocated among the several classes of a series of a CMO in innumerable ways.
In one structure, payments of principal, including any principal prepayments, on
the Mortgage Assets are applied to the classes of a CMO in the order of their
respective stated maturities or final distribution dates, so that no payment of
principal will be made on any class of CMOs until all other classes having an
earlier stated maturity or final distribution date have been paid in full. As
market conditions change, and particularly during periods of rapid or
unanticipated changes in market interest rates, the attractiveness of the CMO
classes and the ability of the structure to provide the anticipated investment
characteristics may be significantly reduced. Such changes can result in
volatility in the market value, and in some instances reduced liquidity, of the
CMO class.
An Underlying Fund may also invest in, among others, parallel pay CMOs and
Planned Amortization Class CMOs ("PAC Bonds"). Parallel pay CMOs are structured
to provide payments of principal on each payment date to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class, which, was with other
CMO structures, must be retired by its stated maturity date or a final
distribution date but may be retired earlier. PAC Bonds are a type of CMO
tranche or series designed to provide relatively predictable payments of
principal provided that, among other things, the actual prepayment experience on
the underlying mortgage loans falls within a predefined range. If the actual
prepayment experience on the underlying mortgage loans is at a rate faster or
slower than the predefined range or if deviations from other assumptions occur,
principal payments on the PAC Bond may be earlier or later than predicted. The
magnitude of the predefined range varies from one PAC Bond to another; a
narrower range increases the risk that prepayments on the PAC Bond will be
greater or smaller than predicted. Because of these features, PAC Bonds
generally are less subject to the risks of prepayment than are other types of
mortgage-backed securities.
STRIPPED MORTGAGE-BACKED SECURITIES. Some of the Underlying Funds may invest in
stripped mortgage-backed securities. Stripped mortgage-backed securities (SMBS)
are derivative multiclass
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mortgage securities. SMBS may be issued by agencies or instrumentalities of the
U.S. Government or by private originators of, or investors in, mortgage loans,
including savings and loan associations, mortgage banks, commercial banks,
investment banks and special purpose entities of the foregoing. SMBS are usually
structured with two classes that receive different proportions of the interest
and principal distributions on an underlying pool of mortgage assets. A common
type of SMBS will have one class receiving some of the interest and most of the
principal from the mortgage assets, while the other class will receive most of
the interest and the remainder of the principal. In the most extreme case, one
class will receive all of the interest (the interest-only or IO class), while
the other class will receive all of the principal (the principal-only or PO
class). The yield to maturity on an IO class is extremely sensitive to the rate
of principal payments (including prepayments) on the related underlying mortgage
assets, and a rapid rate of principal payments may have a material adverse
effect on an Underlying Funds yield to maturity from these securities. If the
underlying mortgage assets experience greater than anticipated prepayments of
principal, an Underlying Fund may fail to fully recoup its initial investment in
these securities even if the security is in one of the highest rating
categories by a NRSRO.
Although SMBS are purchased and sold by institutional investors through several
investment banking firms acting as brokers or dealers, these securities were
only recently developed. As a result, established trading markets have not yet
developed and, accordingly, certain of these securities may be deemed illiquid
and subject to an Underlying Funds limitations on investment in illiquid
securities.
The market value of such securities generally is more sensitive to changes in
prepayment and interest rates than is the case with traditional mortgage- and
asset-backed securities, and in some cases the market value may be extremely
volatile.
LOWER QUALITY (HIGH-RISK) SECURITIES. Some of the Underlying Funds have the
authority to invest a limited portion of their assets in non-investment grade
debt securities. Non-investment grade debt securities (hereinafter referred to
as "lower-quality securities") include (i) bonds rated as low as C by Moody's,
Standard & Poor's, or Fitch, or CCC by D&P; (ii) commercial paper rated as low
as C by Standard & Poor's, Not Prime by Moody's or Fitch 4 by Fitch; and (iii)
unrated debt securities of comparable quality. Lower-quality securities, while
generally offering higher yields than investment grade securities with similar
maturities, involve greater risks, including the possibility of default or
bankruptcy. There is more risk associated with these investments because of
reduced creditworthiness and increased risk of default. Under NRSRO guidelines,
lower quality securities and comparable unrated securities will likely have some
quality and protective characteristics that are outweighed by large
uncertainties or major risk exposures to adverse conditions. Lower quality
securities are considered to have extremely poor prospects of ever attaining any
real investment standing, to have a current identifiable vulnerability to
default or to be in default, to be unlikely to have the capacity to make
required interest payments and repay principal when due in the event of adverse
business, financial or economic conditions, or to be in default or not current
in the payment of interest or principal. They are regarded as predominantly
speculative with respect to the issuer's capacity to pay interest and repay
principal. The special risk considerations in connection with investments in
these securities are discussed below.
EFFECT OF INTEREST RATES AND ECONOMIC CHANGES. All interest-bearing securities
typically experience appreciation when interest rates decline and depreciation
when interest rates rise. The market values of lower-quality and comparable
unrated securities tend to reflect individual corporate developments to a
greater extent than do higher rated securities, which react primarily to
fluctuations in the general level of interest rates. Lower-quality and
comparable unrated securities also tend to be more sensitive to economic
conditions than are higher-rated securities. As a result, they generally involve
more credit risks than securities in the higher-rated categories. During an
economic downturn or a sustained period of rising interest rates, highly
leveraged issuers of lower-quality and comparable unrated securities may
experience financial stress and may not have sufficient revenues to meet their
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payment obligations. The issuer's ability to service its debt obligations may
also be adversely affected by specific corporate developments, the issuer's
inability to meet specific projected business forecasts or the unavailability of
additional financing. The risk of loss due to default by an issuer of these
securities is significantly greater than issuers of higher-rated securities
because such securities are generally unsecured and are often subordinated to
other creditors. Further, if the issuer of a lower-quality or comparable unrated
security defaulted, an Underlying Fund might incur additional expenses to seek
recovery. Periods of economic uncertainty and changes would also generally
result in increased volatility in the market prices of these securities and thus
in the Underlying Fund's net asset value.
As previously stated, the value of a lower-quality or comparable unrated
security will decrease in a rising interest rate market and, accordingly, so
will the Underlying Fund's net asset value. If the Underlying Fund experiences
unexpected net redemptions in such a market, it may be forced to liquidate a
portion of its portfolio securities without regard to their investment merits.
Due to the limited liquidity of lower-quality and comparable unrated securities
(discussed below), the Underlying Fund may be forced to liquidate these
securities at a substantial discount. Any such liquidation would reduce the
Underlying Fund's asset base over which expenses could be allocated and could
result in a reduced rate of return for the Underlying Fund.
PAYMENT EXPECTATIONS. Lower-quality and comparable unrated securities typically
contain redemption, call or prepayment provisions which permit the issuer of
such securities containing such provisions to, at its discretion, redeem the
securities. During periods of falling interest rates, issuers of these
securities are likely to redeem or prepay the securities and refinance them with
debt securities at a lower interest rate. To the extent an issuer is able to
refinance the securities, or otherwise redeem them, the Underlying Fund may have
to replace the securities with a lower yielding security, which would result in
a lower return for the Underlying Fund.
CREDIT RATINGS. Credit ratings issued by credit-rating agencies evaluate the
safety of principal and interest payments of rated securities. They do not,
however, evaluate the market value risk of lower-quality securities and,
therefore, may not fully reflect the true risks of an investment. In addition,
credit rating agencies may or may not make timely changes in a rating to reflect
changes in the economy or in the condition of the issuer that affect the market
value of the security. Consequently, credit ratings are used only as a
preliminary indicator of investment quality. Investments in lower-quality and
comparable unrated securities will be more dependent on an investment advisers
credit analysis than would be the case with investments in investment-grade debt
securities. An Underlying Funds investment adviser will employ its own credit
research and analysis, which includes a study of existing debt, capital
structure, ability to service debt and to pay dividends, the issuer's
sensitivity to economic conditions, its operating history and the current trend
of earnings. When investing in lower-quality securities, an investment adviser
will continually monitor the investments in an Underlying Fund's portfolio and
carefully evaluate whether to dispose of or to retain lower-quality and
comparable unrated securities whose credit ratings or credit quality may have
changed.
LIQUIDITY AND VALUATION. An Underlying Fund may have difficulty disposing of
certain lower-quality and comparable unrated securities because there may be a
thin trading market for such securities. Because not all dealers maintain
markets in all lower-quality and comparable unrated securities, there is no
established retail secondary market for many of these securities and therefore
such
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securities may be sold only to a limited number of dealers or institutional
investors. To the extent a secondary trading market does exist, it is generally
not as liquid as the secondary market for higher-rated securities. The lack of a
liquid secondary market may have an adverse impact on the market price of the
security. As a result, an Underlying Fund's asset value and ability to dispose
of particular securities, when necessary to meet an Underlying Fund's liquidity
needs or in response to a specific economic event, may be impacted. The lack of
a liquid secondary market for certain securities may also make it more difficult
for the Underlying Fund to obtain accurate market quotations for purposes of
valuing the Underlying Fund's portfolio. Market quotations are generally
available on many lower-quality and comparable unrated issues only from a
limited number of dealers and may not necessarily represent firm bids of such
dealers or prices for actual sales. During periods of thin trading, the spread
between bid and asked prices is likely to increase significantly. In addition,
adverse publicity and investor perceptions, whether or not based on fundamental
analysis, may decrease the values and liquidity of lower-quality and comparable
unrated securities, especially in a thinly traded market.
WARRANTS. Some of the Underlying Funds may acquire warrants. Warrants are
securities giving the holder the right, but not the obligation, to buy the stock
of an issuer at a given price (generally higher than the value of the stock at
the time of issuance), on a specified date, during a specified period, or
perpetually. Warrants may be acquired separately or in connection with the
acquisition of securities. Warrants do not carry with them the right to
dividends or voting rights with respect to the securities that they entitle
their holder to purchase, and they do not represent any rights in the assets of
the issuer. As a result, warrants may be considered more speculative than
certain other types of investments. In addition, the value of a warrant does not
necessarily change with the value of the underlying securities, and a warrant
ceases to have value if it is not exercised prior to its expiration date.
SHORT SALES. Some of the Underlying Funds may from time to time sell securities
short. A short sale is a transaction in which the Underlying Fund sells
securities that it does not own (but has borrowed) in anticipation of a decline
in the market price of the securities.
When an Underlying Fund makes a short sale, the proceeds it receives from the
sale are retained by a broker and the Underlying Fund replaces the borrowed
securities. To deliver the securities to the buyer, the Underlying Fund must
arrange through a broker to borrow the securities and, in so doing, the
Underlying Fund becomes obligated to replace the securities borrowed at their
market price at the time of replacement, whatever the price may be. The
Underlying Fund may have to pay a premium to borrow the securities and must pay
any dividends or interest payable on the securities until they are replaced.
An Underlying Fund's obligation to replace the securities borrowed in connection
with a short sale will be secured by collateral deposited with the broker that
consists of cash or U.S. government securities. In addition, the Underlying Fund
will place in a segregated account with its custodian an amount of cash or U.S.
government securities equal to the difference, if any, between (a) the market
value of the securities sold at the time they were sold short and (b) any cash
or U.S. government securities deposited as collateral with the broker in
connection with the short sale (not including the proceeds of the short sale).
Until it replaces the borrowed securities, the Underlying Fund will maintain the
segregated account daily at a level so that the amount deposited in the account
plus the
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amount deposited with the broker (not including the proceeds from the short
sale) (a) will equal the current market value of the securities sold short and
(b) will not be less than the market value of the securities at the time they
were sold short.
Some of the Underlying Funds may engage in short sales only if at the time of
the short sale the fund owns or has the right to obtain without additional cost
an equal amount of the security being sold short. This investment technique is
known as a short sale "against the box."
RESTRICTED, NON-PUBLICLY TRADED AND ILLIQUID SECURITIES. Each Portfolio or
Underlying Fund may not invest more than 15% of its net assets, in the
aggregate, in illiquid securities, including repurchase agreements which have a
maturity of longer than seven days, time deposits maturing in more than seven
days and securities that are illiquid because of the absence of a readily
available market or legal or contractual restrictions on resale. Each Portfolio
does not currently intend to invest in illiquid securities. Repurchase
agreements subject to demand are deemed to have a maturity equal to the notice
period.
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, as amended (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 placements or
restricted securities and are purchased directly from the issuer or in the
secondary market. Investment companies 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 an
investment company might be unable to dispose of restricted or other illiquid
securities promptly or at reasonable prices and might thereby experience
difficulty satisfying redemptions within seven days. An investment company 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.
The SEC has adopted Rule 144A which allows for a broader institutional trading
market for securities otherwise subject to restriction on resale to the general
public. Rule 144A establishes a "safe harbor" from the registration requirements
of the Securities Act for resales of certain securities to qualified
institutional buyers.
The Underlying Funds may also sell over-the-counter ("OTC") options and, in
connection therewith, segregate assets or cover its obligations with respect to
OTC options written by the fund. The assets used as cover for OTC options
written by an Underlying Fund will be considered illiquid unless the
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OTC options are sold to qualified dealers who agree that the fund may repurchase
any OTC option it writes at a maximum price to be calculated by a formula set
forth in the option agreement. The cover for an OTC option written subject to
this procedure would be considered illiquid only to the extent that the maximum
repurchase price under the formula exceeds the intrinsic value of the option.
WHEN-ISSUED SECURITIES AND DELAYED-DELIVERY TRANSACTIONS. Some of the Underlying
Funds may invest without limitation in securities purchased on a "when-issued"
basis or purchase or sell securities for delayed delivery (i.e., payment or
delivery occurs beyond the normal settlement date at a stated price and yield).
When-issued transactions normally settle within 45 days. The payment obligation
and the interest rate that will be received on when-issued securities are fixed
at the time the buyer enters into the commitment. Due to fluctuations in the
value of securities purchased or sold on a when-issued or delayed-delivery
basis, the yields obtained on such securities may be higher or lower than the
yields available in the market on the dates when the investments are actually
delivered to the buyers.
When an Underlying Fund agrees to purchase when-issued or delayed-delivery
securities, to the extent required by the SEC, its custodian will set aside
cash, U.S. government securities or other liquid high-grade debt obligations
equal to the amount of the commitment in a segregated account. Normally, the
custodian will set aside portfolio securities to satisfy a purchase commitment,
and in such a case the Underlying Fund may be required subsequently to place
additional assets in the segregated account in order to ensure that the value of
the account remains equal to the amount of such fund's commitment. It may be
expected that the Underlying 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. When the Underlying Fund engages in
when-issued or delayed-delivery transactions, it relies on the other party to
consummate the trade. Failure of the seller to do so may result in a fund
incurring a loss or missing an opportunity to obtain a price considered to be
advantageous.
LENDING PORTFOLIO SECURITIES. Some of the Underlying Funds may lend portfolio
securities to brokers, dealers and other financial institutions, provided the
Fund receives cash collateral which at all times is maintained in an amount
equal to at least 100% of the current market value of the securities loaned. By
lending its portfolio securities, an Underlying Fund can increase its income
through the investment of the cash collateral. For the purposes of this policy,
the Underlying Fund considers collateral consisting of cash, U.S. Government
securities or letters of credit issued by banks whose securities meet the
standards for investment by the Underlying Fund to be the equivalent of cash.
From time to time, the Underlying Fund may return to the borrower or a third
party which is unaffiliated with it, and which is acting as a "placing broker,"
a part of the interest earned from the investment of collateral received for
securities loaned.
The SEC currently requires that the following conditions must be met whenever
portfolio securities are loaned: (1) the fund must receive at least 100% cash
collateral of the type discussed in the preceding paragraph from the borrower;
(2) the borrower must increase such collateral whenever the market value of the
securities loaned rises above the level of such collateral; (3) the fund must be
able to terminate the loan at any time; (4) the fund must receive reasonable
interest on the loan, as well as any dividends, interest or other distributions
payable on the loaned securities, and any
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increase in market value; (5) the fund may pay only reasonable custodian fees in
connection with the loan; and (6) while any voting rights on the loaned
securities may pass to the borrower, the funds board of directors or trustees
must be able to terminate the loan and regain the right to vote the securities
if a material event adversely affecting the investment occurs. These conditions
may be subject to future modification. Loan agreements involve certain risks in
the event of default or insolvency of the other party including possible delays
or restrictions upon the Underlying Fund's ability to recover the loaned
securities or dispose of the collateral for the loan.
BORROWING. Some of the Underlying Funds may borrow money from banks, limited by
any investment restrictions of such fund, and may engage in reverse repurchase
agreements which may be considered a form of borrowing. Some of the borrowings
by an Underlying Fund may be on a secured basis. In such situations, either the
custodian will segregate the pledged assets for the benefit of the lender or
arrangements will be made with a suitable subcustodian, which may include the
lender.
SECURITIES OF INVESTMENT COMPANIES. Up to 100% of a Portfolio's assets will be
invested in the securities of other investment companies. As permitted by the
1940 Act, an Underlying Fund may be permitted to invest up to 10% of its total
assets, calculated at the time of investment, in the securities of other
open-end or closed-end investment companies. No more than 5% of an Underlying
Fund's total assets may be invested in the securities of any one investment
company nor may it acquire more than 3% of the voting securities of any other
investment company. Such Underlying Fund will indirectly bear its proportionate
share of any management fees paid by an investment company in which it invests
in addition to the advisory fee paid by the Underlying Fund. Some of the
countries in which an Underlying Fund may invest may not permit direct
investment by outside investors. Investments in such countries may only be
permitted through foreign government-approved or government-authorized
investment vehicles, which may include other investment companies.
BANK OBLIGATIONS. Bank obligations that may be purchased by an Underlying Fund
include certificates of deposit, banker's acceptances and fixed time deposits. A
certificate of deposit is a short-term negotiable certificate issued by a
commercial bank against funds deposited in the bank and is either
interest-bearing or purchased on a discount basis. A bankers' acceptance is a
short-term draft drawn on a commercial bank by a borrower, usually in connection
with an international commercial transaction. The borrower is liable for payment
as is the bank, which unconditionally guarantees to pay the draft at its face
amount on the maturity date. Fixed time deposits are obligations of branches of
U.S. banks or foreign banks which are payable at a stated maturity date and bear
a fixed rate of interest. Although fixed time deposits do not have a market,
there are no contractual restrictions on the right to transfer a beneficial
interest in the deposit to a third party.
Bank obligations may be general obligations of the parent bank or may be limited
to the issuing branch by the terms of the specific obligations or by government
regulation. Bank obligations may be issued by domestic banks (including their
Branches located outside the United States), domestic and foreign branches of
foreign banks and savings and loan associations.
FLOATING AND VARIABLE RATE INSTRUMENTS. Floating or variable rate obligations
bear interest at rates that are not fixed, but vary with changes in specified
market rates or indices, such as the prime rate, or at specified intervals.
Certain of the floating or variable rate obligations that may be purchased by
the Underlying Funds may carry a demand feature that would permit the holder to
tender them
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back to the issuer of the instrument or to a third party at par value prior to
maturity.
Some of the demand instruments purchased by an Underlying Fund are not traded in
a secondary market and derive their liquidity solely from the ability of the
holder to demand repayment from the issuer or third party providing credit
support. If a demand instrument is not traded in a secondary market, the
Underlying Fund will nonetheless treat the instrument as "readily marketable"
for the purposes of its investment restriction limiting investments in illiquid
securities unless the demand feature has a notice period of more than seven days
in which case the instrument will be characterized as "not readily marketable"
and therefore illiquid.
Such obligations include variable rate master demand notes, which are unsecured
instruments issued pursuant to an agreement between the issuer and the holder
that permit the indebtedness thereunder to vary and to provide for periodic
adjustments in the interest rate. An Underlying Fund will limit its purchases of
floating and variable rate obligations to those of the same quality as it is
otherwise allowed to purchase. An Underlying Fund's investment adviser will
monitor on an ongoing basis the ability of an issuer of a demand instrument to
pay principal and interest on demand.
An Underlying Fund's right to obtain payment at par on a demand instrument could
be affected by events occurring between the date the Underlying Fund elects to
demand payment and the date payment is due that may affect the ability of the
issuer of the instrument or third party providing credit support to make payment
when due, except when such demand instruments permit same day settlement. To
facilitate settlement, these same day demand instruments may be held in book
entry form at a bank other than an Underlying Fund's custodian subject to a
subcustodian agreement approved by the Underlying Fund between that bank and the
Underlying Fund's custodian.
DERIVATIVE INSTRUMENTS. As discussed in its Prospectus, a number of the
Underlying Funds may use a variety of derivative instruments, including options,
futures contracts (sometimes referred to as "futures"), options on futures
contracts, stock index options, forward currency contracts and swap agreements
to hedge the Underlying Fund's portfolio or for risk management.
The use of these instruments is subject to applicable regulations of the SEC,
the several options and futures exchanges upon which they may be traded, the
Commodity Futures Trading Commission ("CFTC") and various state regulatory
authorities. In addition, an Underlying Fund's ability to use these instruments
will be limited by tax considerations.
SPECIAL RISKS OF DERIVATIVE INSTRUMENTS. The use of derivative instruments
involves special considerations and risks as described below. Risks pertaining
to particular instruments are described in the sections that follow.
(1) Successful use of most of these instruments depends upon an investment
adviser's ability to predict movements of the overall securities and currency
markets, which requires different skills than predicting changes in the prices
of individual securities. While an investment adviser is experienced in the use
of these instruments, there can be no assurance that any particular strategy
adopted will succeed.
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(2) There might be imperfect correlation, or even no correlation, between
price movements of an instrument and price movements of investments being
hedged. For example, if the value of an instrument used in a short hedge (such
as writing a call option, buying a put option, or selling a futures contract)
increased by less than the decline in value of the hedged investment, the hedge
would not be fully successful. Such a lack of correlation might occur due to
factors unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which these instruments are
traded. The effectiveness of hedges using instruments on indices will depend on
the degree of correlation between price movements in the index and price
movements in the investments being hedged.
(3) Hedging strategies, if successful, can reduce the risk of loss by
wholly or partially offsetting the negative effect of unfavorable price
movements in the investments being hedged. However, hedging strategies can also
reduce opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. For example, if an Underlying Fund entered
into a short hedge because its investment adviser projected a decline in the
price of a security in the Underlying Fund's portfolio, and the price of that
security increased instead, the gain from that increase might be wholly or
partially offset by a decline in the price of the instrument. Moreover, if the
price of the instrument declined by more than the increase in the price of the
security, the Underlying Fund could suffer a loss.
(4) As described below, an Underlying Fund might be required to maintain
assets as "cover," maintain segregated accounts, or make margin payments when it
takes positions in these instruments involving obligations to third parties
(i.e., instruments other than purchased options). If an Underlying Fund were
unable to close out its positions in such instruments, it might be required to
continue to maintain such assets or accounts or make such payments until the
position expired or matured. The requirements might impair an Underlying Fund's
ability to sell a portfolio security or make an investment at a time when it
would otherwise be favorable to do so, or require that the Underlying Fund sell
a portfolio security at a disadvantageous time. An Underlying Fund's ability to
close out a position in an instrument prior to expiration or maturity depends on
the existence of a liquid secondary market or, in the absence of such a market,
the ability and willingness of the other party to the transaction ("counter
party") to enter into a transaction closing out the position. Therefore, there
is no assurance that any hedging position can be closed out at a time and price
that is favorable to the Underlying Fund.
OPTIONS. An Underlying Fund may purchase or write put and call options on
securities, indices, and foreign currency, and enter into closing transactions
with respect to such options to terminate an existing position.
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The purchase of call options serves as a long hedge, and the purchase of put
options serves as a short hedge. Writing put or call options can enable an
Underlying Fund to enhance income by reason of the premiums paid by the
purchaser of such options. Writing call options serves as a limited short hedge
because declines in the value of the hedged investment would be offset to the
extent of the premium received for writing the option. However, if the security
appreciates to a price higher than the exercise price of the call option, it can
be expected that the option will be exercised, and the Underlying Fund will be
obligated to sell the security at less than its market value or will be
obligated to purchase the security at a price greater than that at which the
security must be sold under the option. All or a portion of any assets used as
cover for OTC options written by an Underlying Fund would be considered illiquid
to the extent described under "Restricted and Illiquid Securities" above.
Writing put options serves as a limited long hedge because increases in the
value of the hedged investment would be offset to the extent of the premium
received for writing the option. However, if the security depreciates to a price
lower than the exercise price of the put option, it can be expected that the put
option will be exercised, and the Underlying Fund will be obligated to purchase
the security at more than its market value.
The value of an option position will reflect, among other things, the historical
price volatility of the underlying investment, the current market value of the
underlying investment, the time remaining until expiration, the relationship of
the exercise price to the market price of the underlying investment, and general
market conditions. Options that expire unexercised have no value. Options used
by an Underlying Fund may include European-style options, which are only
exercisable at expiration. This is in contrast to American-style options which
are exercisable at any time prior to the expiration date of the option.
An Underlying Fund may effectively terminate its right or obligation under an
option by entering into a closing transaction. For example, an Underlying Fund
may terminate its obligation under a call or put option that it had written by
purchasing an identical call or put option; this is known as a closing purchase
transaction. Conversely, an Underlying Fund may terminate a position in a put or
call option it had purchased by writing an identical put or call option; this is
known as a closing sale transaction. Closing transactions permit the Underlying
Fund to realize the profit or limit the loss on an option position prior to its
exercise or expiration.
An Underlying Fund may purchase or write both OTC options and options traded on
foreign and U.S. exchanges. Exchange-traded options are issued by a clearing
organization affiliated with the exchange on which the option is listed that, in
effect, guarantees completion of every exchange-traded option transaction. OTC
options are contracts between the Underlying Fund and the counter party (usually
a securities dealer or a bank) with no clearing organization guarantee. Thus,
when an Underlying Fund purchases or writes an OTC option, it relies on the
counter party to make or take delivery of the underlying investment upon
exercise of the option. Failure by the counter party to do so would result in
the loss of any premium paid by the Underlying Fund as well as the loss of any
expected benefit of the transaction.
An Underlying Fund's ability to establish and close out positions in
exchange-listed options depends on the existence of a liquid market. Closing
transactions can be made for OTC options only by negotiating directly with the
counter party, or by a transaction in the secondary market if any such market
exists. Although an Underlying Fund will generally enter into OTC options only
with
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<PAGE> 29
counter parties that are expected to be capable of entering into closing
transactions with the Underlying Fund, there is no assurance that the Underlying
Fund will in fact be able to close out an OTC option at a favorable price prior
to expiration. In the event of insolvency of the counter party, an Underlying
Fund might be unable to close out an OTC option position at any time prior to
its expiration.
If an Underlying Fund were unable to effect a closing transaction for an option
it had purchased, it would have to exercise the option to realize any profit.
The inability to enter into a closing purchase transaction for a covered call
option written by the Underlying Fund could cause material losses because the
Underlying Fund would be unable to sell the investment used as a cover for the
written option until the option expires or is exercised.
An Underlying Fund may engage in options transactions on indices in much the
same manner as the options on securities discussed above, except that index
options may serve as a hedge against overall fluctuations in the securities
markets in general.
The writing and purchasing of options is a highly specialized activity that
involves investment techniques and risks different from those associated with
ordinary portfolio securities transactions. Imperfect correlation between the
options and securities markets may detract from the effectiveness of attempted
hedging.
Transactions using options (other than purchased options) expose an Underlying
Fund to counter party risk. To the extent required by SEC guidelines, an
Underlying Fund will not enter into any such transactions unless it owns either
(1) an offsetting ("covered") position in securities, other options, or futures
or (2) cash and liquid obligations with a value sufficient at all times to cover
its potential obligations to the extent not covered as provided in (1) above.
Such Underlying Fund will set aside cash and/or appropriate liquid assets in a
segregated custodial account if required to do so by the SEC and CFTC
regulations. Assets used as cover or held in a segregated account cannot be sold
while the position in the corresponding option or futures contract is open,
unless they are replaced with similar assets. As a result, the commitment of a
large portion of an Underlying Fund's assets to segregated accounts as a cover
could impede portfolio management or the Underlying Fund's ability to meet
redemption requests or other current obligations.
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<PAGE> 30
SPREAD TRANSACTIONS. A Fund may purchase covered spread options from securities
dealers. Such covered spread options are not presently exchange-listed or
exchange-traded. The purchase of a spread option gives a Fund the right to put,
or sell, a security that it owns at a fixed dollar spread or fixed yield spread
in relationship to another security that the Fund does not own, but which is
used as a benchmark. The risk to a Fund in purchasing covered spread options is
the cost of the premium paid for the spread option and any transaction costs. In
addition, there is no assurance that closing transactions will be available. 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. Such protection is only provided
during the life of the spread option.
FUTURES CONTRACTS. Some of the Underlying Funds may enter into futures
contracts, including interest rate, index, and currency futures and purchase and
write (sell) related options. The purchase of futures or call options thereon
can serve as a long hedge, and the sale of futures or the purchase of put
options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge, using a strategy
similar to that used for writing covered options in securities. An Underlying
Fund's hedging may include purchases of futures as an offset against the effect
of expected increases in securities prices or currency exchange rates and sales
of futures as an offset against the effect of expected declines in securities
prices or currency exchange rates. An Underlying Fund may write put options on
futures contracts while at the same time purchasing call options on the same
futures contracts in order to create synthetically a long futures contract
position. Such options would have the same strike prices and expiration dates.
An Underlying Fund will engage in this strategy only when its investment adviser
believes it is more advantageous to the Underlying Fund than is purchasing the
futures contract.
To the extent required by regulatory authorities, an Underlying Fund will
generally only enter into futures contracts that are traded on U.S. or foreign
exchanges or boards of trade approved by the CFTC and are standardized as to
maturity date and underlying financial instrument. These transactions may be
entered into for "bona fide hedging" purposes as defined in CFTC regulations and
other permissible purposes including increasing return and hedging against
changes in the value of portfolio securities due to anticipated changes in
interest rates, currency values and/or market conditions. The ability of an
Underlying Fund to trade in futures contracts may be limited by the requirements
of the Code applicable to a regulated investment company.
A futures contract provides for the future sale by one party and purchase by
another party of a specified amount of a specific financial instrument (e.g.,
debt security) or currency for a specified price at a designated date, time, and
place. An index futures contract is an agreement pursuant to which the parties
agree to take or make delivery of an amount of cash equal to a specified
multiplier times the difference between the value of the index at the close of
the last trading day of the contract and the price at which the index futures
contract was originally written. Transactions costs are incurred when a futures
contract is bought or sold and margin deposits must be maintained. A futures
contract may be satisfied by delivery or purchase, as the case may be, of the
instrument, the currency, or by payment of the change in the cash value of the
index. More commonly, futures contracts are closed out prior to delivery by
entering into an offsetting transaction in a matching futures contract. Although
the value of an index might be a function of the value of certain specified
securities, no physical delivery of those securities is made. If the offsetting
purchase price is less than the original sale price, an Underlying Fund realizes
a gain; if it is more, the Underlying Fund realizes a loss. Conversely, if the
offsetting sale price is more than the original purchase price, the Underlying
Fund realizes a gain; if it is less, the Underlying Fund realizes a loss. The
transaction costs must also be included in these calculations. There can be no
assurance, however, that the Underlying Fund will be able to enter into an
offsetting transaction with respect to a particular futures contract at a
particular time. If an Underlying Fund is not able to enter into an offsetting
transaction, the fund will continue to be required to maintain the margin
deposits on the futures contract.
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<PAGE> 31
No price is paid by an Underlying Fund upon entering into a futures contract.
Instead, at the inception of a futures contract, the Underlying Fund is required
to deposit in a segregated account with its custodian, in the name of the
futures broker through whom the transaction was effected, "initial margin"
consisting of cash, U.S. government securities or other liquid obligations, in
an amount generally equal to 10% or less of the contract value. Margin must also
be deposited when writing a call or put option on a futures contract, in
accordance with applicable exchange rules. Unlike margin in securities
transactions, initial margin on futures contracts does not represent a
borrowing, but rather is in the nature of a performance bond or good-faith
deposit that is returned to the Underlying Fund at the termination of the
transaction if all contractual obligations have been satisfied. Under certain
circumstances, such as periods of high volatility, the Underlying Fund may be
required by an exchange to increase the level of its initial margin payment, and
initial margin requirements might be increased generally in the future by
regulatory action.
Subsequent "variation margin" payments are made to and from the futures broker
daily as the value of the futures position varies, a process known as "marking
to market." Variation margin does not involve borrowing, but rather represents a
daily settlement of an Underlying Fund's obligations to or from a futures
broker. When an Underlying Fund purchases an option on a future, the premium
paid plus transaction costs is all that is at risk. In contrast, when an
Underlying Fund purchases or sells a futures contract or writes a call or put
option thereon, it is subject to daily variation margin calls that could be
substantial in the event of adverse price movements. If the Underlying Fund has
insufficient cash to meet daily variation margin requirements, it might need to
sell securities at a time when such sales are disadvantageous. Purchasers and
sellers of futures positions and options on futures can enter into offsetting
closing transactions by selling or purchasing, respectively, an instrument
identical to the instrument held or written. Positions in futures and options on
futures may be closed only on an exchange or board of trade on which they were
entered into (or through a linked exchange). Although an Underlying Fund will
only enter into futures transactions only on exchanges or boards of trade where
there appears to be an active market, there can be no assurance that such a
market will exist for a particular contract at a particular time.
Under certain circumstances, futures exchanges may establish daily limits on the
amount that the price of a future or option on a futures contract can vary from
the previous day's settlement price; once that limit is reached, no trades may
be made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If the Underlying Fund were unable to liquidate a futures or option on a futures
contract position due to the absence of a liquid secondary market or the
imposition of price limits, it could incur substantial losses. An Underlying
Fund will continue to be subject to market risk with respect to the position. In
addition, except in the case of purchased options, the Underlying Fund would
continue to be required to make daily variation margin payments and might be
required to maintain the position being hedged by the future or option or to
maintain cash or securities in a segregated account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or options on futures contracts
might not correlate perfectly with movements in the prices of the investments
being hedged. For example, all participants in the futures and options on
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<PAGE> 32
futures contracts markets are subject to daily variation margin calls and might
be compelled to liquidate futures or options on futures contracts positions
whose prices are moving unfavorably to avoid being subject to further calls.
These liquidations could increase price volatility of the instruments and
distort the normal price relationship between the futures or options and the
investments being hedged. Also, because initial margin deposit requirements in
the futures markets are less onerous than margin requirements in the securities
markets, there might be increased participation by speculators in the future
markets. This participation also might cause temporary price distortions. In
addition, activities of large traders in both the futures and securities markets
involving arbitrage, "program trading" and other investment strategies might
result in temporary price distortions.
FOREIGN CURRENCY-RELATED DERIVATIVE STRATEGIES - SPECIAL CONSIDERATIONS. An
Underlying Fund may use options and futures on foreign currencies and forward
currency contracts to hedge against movements in the values of the foreign
currencies in which the Underlying Fund's securities are denominated. The
Underlying Fund may engage in currency exchange transactions to protect against
uncertainty in the level of future exchange rates and may also engage in
currency transactions to increase income and total return. Such currency hedges
can protect against price movements in a security the Underlying Fund owns or
intends to acquire that are attributable to changes in the value of the currency
in which it is denominated. Such hedges do not, however, protect against price
movements in the securities that are attributable to other causes.
An Underlying Fund might seek to hedge against changes in the value of a
particular currency when no hedging instruments on that currency are available
or such hedging instruments are more expensive than certain other hedging
instruments. In such cases, the Underlying Fund may hedge against price
movements in that currency by entering into transactions using hedging
instruments on another foreign currency or a basket of currencies, the values of
which an Underlying Fund's investment adviser believes will have a high degree
of positive correlation to the value of the currency being hedged. The risk that
movements in the price of the hedging instrument will not correlate perfectly
with movements in the price of the currency being hedged is magnified when this
strategy is used.
The value of derivative instruments on foreign currencies depends on the value
of the underlying currency relative to the U.S. dollar. Because foreign currency
transactions occurring in the interbank market might involve substantially
larger amounts than those involved in the use of such hedging instruments, an
Underlying Fund could be disadvantaged by having to deal in the odd lot market
(generally consisting of transactions of less than $1 million) for the
underlying foreign currencies at prices that are less favorable than for round
lots.
There is no systematic reporting of last sale information for foreign currencies
or any regulatory requirement that quotations available through dealers or other
market sources be firm or revised on a timely basis. Quotation information
generally is representative of very large transactions in the interbank market
and thus might not reflect odd-lot transactions where rates might be less
favorable. The interbank market in foreign currencies is a global,
round-the-clock market. To the extent the U.S. options or futures markets are
closed while the markets for the underlying currencies remain open, significant
price and rate movements might take place in the underlying markets that cannot
be reflected in the markets for the derivative instruments until they reopen.
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<PAGE> 33
Settlement of derivative transactions involving foreign currencies might be
required to take place within the country issuing the underlying currency. Thus,
an Underlying Fund might be required to accept or make delivery of the
underlying foreign currency in accordance with any U.S. or foreign regulations
regarding the maintenance of foreign banking arrangements by U.S. residents and
might be required to pay any fees, taxes and charges associated with such
delivery assessed in the issuing country.
Permissible foreign currency options will include options traded primarily in
the OTC market. Although options on foreign currencies are traded primarily in
the OTC market, the Underlying Fund will normally purchase OTC options on
foreign currency only when its investment adviser believes a liquid secondary
market will exist for a particular option at any specific time.
FORWARD CURRENCY CONTRACTS. A forward currency contract involves 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. These contracts are entered into in the
interbank market conducted directly between currency traders (usually large
commercial banks) and their customers.
At or before the maturity of a forward contract, an Underlying Fund may either
sell a portfolio security and make delivery of the currency, or retain the
security and fully or partially offset its contractual obligation to deliver the
currency by purchasing a second contract. If an Underlying Fund retains the
portfolio security and engages in an offsetting transaction, such fund, at the
time of execution of the offsetting transaction, will incur a gain or a loss to
the extent that movement has occurred in forward contract prices.
The precise matching of forward currency contract amounts and the value of the
securities involved generally will not be possible because the value of such
securities, measured in the foreign currency, will change after the foreign
currency contract has been established. Thus, an Underlying Fund might need to
purchase or sell foreign currencies in the spot (cash) market to the extent such
foreign currencies are not covered by forward contracts. The projection of
short-term currency market movements is extremely difficult, and the successful
execution of a short-term hedging strategy is highly uncertain.
CURRENCY HEDGING. While the values of forward currency contracts, currency
options, currency futures and options on futures may be expected to correlate
with exchange rates, they will not reflect other factors that may affect the
value of an Underlying Fund's investments. A currency hedge, for example, should
protect a Yen-denominated bond against a decline in the Yen, but will not
protect the fund against price decline if the issuer's creditworthiness
deteriorates. Because the value of the Underlying Fund's investments denominated
in foreign currency will change in response to many factors other than exchange
rates, a currency hedge may not be entirely successful in mitigating changes in
the value of such fund's investments denominated in that currency over time.
A decline in the dollar value of a foreign currency in which an Underlying
Fund's securities are denominated will reduce the dollar value of the
securities, even if their value in the foreign currency remains constant. The
use of currency hedges does not eliminate fluctuations in the underlying prices
of the securities, but it does establish a rate of exchange that can be achieved
in the future. In
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order to protect against such diminutions in the value of securities it holds,
an Underlying Fund may purchase put options on the foreign currency. If the
value of the currency does decline, the Underlying Fund will have the right to
sell the currency for a fixed amount in dollars and will thereby offset, in
whole or in part, the adverse effect on its securities that otherwise would have
resulted. Conversely, if a rise in the dollar value of a currency in which
securities to be acquired are denominated is projected, thereby potentially
increasing the cost of the securities, an Underlying Fund may purchase call
options on the particular currency. The purchase of these options could offset,
at least partially, the effects of the adverse movements in exchange rates.
Although currency hedges limit the risk of loss due to a decline in the value of
a hedged currency, at the same time, they also limit any potential gain that
might result should the value of the currency increase.
An Underlying Fund's currency hedging will be limited to hedging involving
either specific transactions or portfolio positions. Transaction hedging is the
purchase or sale of forward currency with respect to specific receivables or
payables of the Underlying Fund generally accruing in connection with the
purchase or sale of its portfolio securities. Position hedging is the sale of
forward currency with respect to portfolio security positions. Underlying Funds
may not generally position hedge to an extent greater than the aggregate market
value (at the time of making such sale) of the hedged securities.
FOREIGN COMMERCIAL PAPER. Some of the Underlying Funds may invest in commercial
paper which is indexed to certain specific foreign currency exchange rates. The
terms of such commercial paper provide that its principal amount is adjusted
upwards or downwards (but not below zero) at maturity to reflect changes in the
exchange rate between two currencies while the obligation is outstanding. An
Underlying Fund will purchase such commercial paper with the currency in which
it is denominated and, at maturity, will receive interest and principal payments
thereon in that currency, but the amount or principal payable by the issuer at
maturity will change in proportion to the change (if any) in the exchange rate
between two specified currencies between the date the instrument is issued and
the date the instrument matures. While such commercial paper entails the risk of
loss of principal, the potential for realizing gains as a result of changes in
foreign currency exchange rate enables the Underlying Fund to hedge or
cross-hedge against a decline in the U.S. Dollar value of investments
denominated in foreign currencies while providing an attractive money market
rate of return. Generally an Underlying Fund will purchase such commercial paper
for hedging purposes only, not for speculation. The staff of the SEC is
currently considering whether the purchase of this type of commercial paper
would result in the issuance of a "senior security" within the meaning of the
1940 Act. The Underlying Fund believes that such investments do not involve the
creation of such a senior security, but nevertheless will establish a segregated
account with respect to its investments in this type of commercial paper and to
maintain in such account cash not available for investment or U.S. Government
securities or other liquid high quality debt securities having a value equal to
the aggregate principal amount of outstanding commercial paper of this type.
ZERO COUPON SECURITIES, STEP-COUPON SECURITIES, PAY-IN-KIND BONDS ("PIK BOND")
AND DEFERRED PAYMENT SECURITIES. Zero coupon securities are debt securities that
pay no cash income but are sold at substantial discounts from their value at
maturity. Step-coupon securities are debt securities that do not make regular
cash interest payments and are sold at a deep discount to their face value. When
a zero coupon security is held to maturity, its entire return, which consists of
the amortization of discount, comes from the difference between its purchase
price and its maturity
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value. This difference is known at the time of purchase, so that investors
holding zero coupon securities until maturity know at the time of their
investment what the expected return on their investment will be. Zero coupon
securities may have conversion features. An Underlying Fund also may purchase
PIK bonds. PIK bonds pay all or a portion of their interest in the form of debt
or equity securities. Deferred payment securities are securities that remain
zero coupon securities until a predetermined ate, at which time the stated
coupon rate becomes effective and interest becomes payable at regular intervals.
Deferred payment securities are often sold at substantial discounts from their
maturity value.
Zero coupon securities, PIK bonds and deferred payment securities tend to be
subject to greater price fluctuations in response to changes in interest rates
than are ordinary interest-paying debt securities with similar maturities. The
value of zero coupon securities appreciates more during periods of declining
interest rates and depreciates more during periods of rising interest rates than
ordinary interest-paying debt securities with similar maturities. Zero coupon
securities, PIK bonds and deferred payment securities may be issued by a wide
variety of corporate and governmental issuers. Although these instruments are
generally not traded on a national securities exchange, they are widely traded
by brokers and dealers and, to such extent, will not be considered illiquid for
the purposes of the Underlying Fund's limitation on investments in illiquid
securities.
Current federal income tax law requires the holder of a zero coupon securities,
certain PIK bonds, deferred payment securities and certain other securities
acquired at a discount (such as Brady Bonds) to accrue income with respect to
these securities prior to the receipt of cash payments. Accordingly, to avoid
liability for federal income and excise taxes, the fund may be required to
distribute income accrued with respect to these securities and may have to
dispose of portfolio securities under disadvantageous circumstances in order to
generate cash to satisfy these distribution requirements.
LOAN PARTICIPATIONS AND ASSIGNMENTS - Loan Participations typically will result
in an Underlying Fund having a contractual relationship only with the lender,
not with the borrower. An Underlying Fund will have the right to receive
payments of principal, interest and any fees to which it is entitled only from
the lender selling the Participation and only upon receipt by the lender of the
payments from the borrower. In connection with purchasing Loan Participations,
an Underlying Fund generally will have no right to enforce compliance by the
borrower with the terms of the loan agreement relating to the loan, nor any
rights of set-off against the borrower, and an Underlying Fund may not benefit
directly from any collateral supporting the loan in which it has purchased the
Participation. As a result, an Underlying Fund will assume the credit risk of
both the borrower and the lender that is selling the Participation. In the event
of the insolvency of the lender selling a Participation, an Underlying Fund may
be treated as a general creditor of the lender and may not benefit from any
set-off between the lender and the borrower. An Underlying Fund will acquire
Loan Participations only if the lender interpositioned between the Underlying
Fund and the borrower is determined by the Subadviser to be creditworthy. When
an Underlying Fund purchases assignments from lenders, the Underlying Fund will
acquire direct rights against the borrower on the loan, except that under
certain circumstances such rights may be more limited than those held by the
assigning lender.
An Underlying Fund may have difficulty disposing of Assignments and Loan
Participations. Because the market for such instruments is not highly liquid,
the Underlying Fund anticipates that
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such instruments could be sold only to a limited number of institutional
investors. The lack of a highly liquid secondary market may have an adverse
impact on the value of such instruments and will have an adverse impact on the
Underlying Fund's ability to dispose of particular Assignments or Loan
Participations in response to a specific economic event, such as deterioration
in the creditworthiness of the borrower.
In valuing a Loan Participation or Assignment held by an Underlying Fund for
which a secondary trading market exists, the Underlying Fund will rely upon
prices or quotations provided by banks, dealers or pricing services. To the
extent a secondary trading market does not exist, the Underlying Fund's Loan
Participations and Assignments will be valued in accordance with procedures
adopted by the Board of Trustees, taking into consideration, among other
factors: (i) the creditworthiness of the borrower under the loan and the lender;
(ii) the current interest rate; period until next rate reset and maturity of the
loan; (iii) recent prices in the market for similar loans; and (iv) recent
prices in the market for instruments of similar quality, rate, period until next
interest rate reset and maturity.
TEMPORARY DEFENSIVE POSITION. In response to economic, political or unusual
market conditions, a Portfolio may invest up to 100% of its assets in cash or
money market obligations. Should this occur, a Portfolio may not meet its
investment objectives and may miss potential market upswings.
NON-DIVERSIFIED STATUS. Each Portfolio is classified as non-diversified under
the 1940 Act, which means that the Portfolio is not limited by the 1940 Act in
the proportion of its assets that it may invest in securities of a single
issuer. Each Portfolio's investments will be limited, however, in order to
qualify as a "regulated investment company" for purposes of the Internal Revenue
Code of 1986, as amended (the "Code"). To qualify, a Portfolio will comply with
certain requirements, including limiting its investments so that at the close of
each quarter of its taxable year (a) not more than 25% of the market value of
its total assets will be invested in the securities of a single issuer (other
than U.S. government securities or securities of other regulated investment
companies), and (b) with respect to 50% of the market value of its total assets,
not more than 5% of the market value of its total assets will be invested in the
securities of a single issuer (other than U.S. government securities or
securities of other regulated investment companies) and the Portfolio will not
own more than 10% of the outstanding voting securities of a single issuer. Being
non-diversified means that a Portfolio may invest a greater proportion of its
assets in the obligations of a small number of issuers and, as a result, may be
subject to greater risk with respect to Portfolio securities. To the extent that
a Portfolio assumes large positions in the securities of a small number of
issuers, its return may fluctuate to a greater extent than that of a diversified
company as a result of changes in the financial condition or in the market's
assessment of the issuers.
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PORTFOLIO TURNOVER.
The portfolio turnover rate for each Fund is calculated by dividing the lesser
of purchases or sales of portfolio securities for the year by the monthly
average value of the portfolio securities, excluding securities whose maturities
at the time of purchase were one year or less. The portfolio turnover rate for
the years ended December 31, 1999 and the fiscal period ended December 31, 1998
are as follows:
- --------------------------------------------------------------------------------
FUND 1999 1998
- --------------------------------------------------------------------------------
The Aggressive Portfolio* 29.81% 38.42%
- --------------------------------------------------------------------------------
The Moderately Aggressive Portfolio* 25.88% 52.63%
- --------------------------------------------------------------------------------
The Moderate Portfolio* 25.63% 55.92%
- --------------------------------------------------------------------------------
The Moderately Conservative Portfolio* 50.16% 104.85%
- --------------------------------------------------------------------------------
The Conservative Portfolio* 84.11% 165.15%
- --------------------------------------------------------------------------------
- ------------
* Commenced operations on January 20, 1998.
High portfolio turnover rates will generally result in higher brokerage
expenses.
INVESTMENT RESTRICTIONS
The following are the fundamental investment limitations for each of the
Portfolios. These fundamental investment limitations cannot be changed without
the authorization of the majority of the outstanding shares of the Portfolio for
which a change is proposed. The vote of the majority of the outstanding
securities means the vote of (A) 67% or more of the voting securities present at
such meeting, if the holders of more than 50% of the outstanding voting
securities are present or represented by proxy or (B) a majority of the
outstanding securities, whichever is less.
Each Portfolio:
1. May not borrow money or issue senior securities except that each Portfolio
may enter into reverse repurchase agreements and may otherwise borrow money
and issue Senior Securities as and to the extent permitted by the
Investment Company Act of 1940 (the 1940 Act) or any rule, order of
interpretation thereunder.
2. May not act as an underwriter of another issuers securities, except to the
extent that the Portfolio may be deemed an underwriter within the meaning
of the Securities Act in connection with the purchase and sale of portfolio
securities.
3. May not purchase or sell commodities or commodities contracts unless
acquired as a result of ownership of securities or other instruments, but
this shall not prevent the Portfolio from
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purchasing or selling options, futures contracts, or other derivative
instruments, or from investing in securities or other instruments backed by
physical commodities.
4. May not lend any security or make any other loan except that each Portfolio
may purchase or hold debt securities and lend portfolio securities in
accordance with its investment objective and policies make time deposits
with financial institutions and enter into repurchase agreements.
5. May not purchase or sell real estate except that each Portfolio may acquire
real estate through ownership of securities or instruments, and may
purchase or sell securities issued by entities or investment vehicles that
own or deal in real estate (including interests therein) or instruments
secured by real estate (including interests therein).
6. Each Portfolio may not purchase securities of one issuer, other than
obligations issued or guaranteed by the U.S. Government, its agencies or
instrumentalities, if at the end of each fiscal quarter, (a) more than 5%
of the Portfolios total assets (taken at current value) would be invested
in such issuer (except that up to 50% of the Portfolios total assets may be
invested without regard to such 5% limitation), and (b) more than 25% of
its total assets (taken at current value) would be invested in securities
of a single issuer. There is no limit to the percentage of assets that may
be invested in U.S. Treasury bills, notes, or other obligations issued or
guaranteed by the U.S. Government, its agencies or instrumentalities.
The following are non-fundamental operating policies for the Portfolios which
may be changed by the Board of Trustees of the Trust without shareholder
approval:
Each Portfolio may not:
1. Sell securities short, unless the Portfolio owns or has the right to obtain
securities equivalent in kind and amount to the securities sold short or
unless it covers such short sales as required by the current roles and
positions of the SEC or its staff, and provided that short positions in
forward currency contracts, options, futures contracts, options on futures
contracts, or other derivative instruments are not deemed to constitute
selling security short.
2. Purchase securities on margin, except that the Portfolio may obtain such
short-term credits as are necessary for the clearance of transactions.
3. Invest in illiquid securities if, as a result of such investment, more than
15% of its net assets would be invested in illiquid securities. Illiquid
securities include securities that cannot be sold within seven days in the
ordinary course of business for approximately the amount at which the
Portfolio has valued the securities, such as repurchase agreements maturing
in more than seven days. If any percentage restriction or requirement
described above is satisfied at the time of investment, a later increase or
decrease in such percentage resulting from a change in net asset value will
not constitute such restriction or requirement. However, should a change in
net asset value or other external events cause a Fund's investments in
illiquid securities, including repurchase agreements with maturities in
excess of seven days, to exceed the limit set forth above for such Fund's
investment in illiquid
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securities, a Fund will act to cause the aggregate amount of such
securities to come within such limit as soon as reasonably practicable. In
such event, however, such Fund would not be required to liquidate any
portfolio securities where a fund would suffer a loss on the sale of such
securities.
4. Pledge, mortgage or hypothecate any assets owned by the Portfolio in excess
of 331/3% of the Portfolio's total assets at the time of such pledging,
mortgaging or hypothecating.
Notwithstanding the foregoing investment restrictions, the Underlying Funds in
which the Portfolios invest have adopted investment restrictions which may be
more or less restrictive than those listed above, thereby permitting an
Underlying Fund to engage in investment strategies indirectly that it would be
prohibited to engage in directly. The investment restrictions of an Underlying
Fund are located in its Statement of Additional Information.
Pursuant to an exemptive order issued by the SEC (Investment Company Act Release
No. 22981, Dec. 30, 1997), each Portfolio may (i) purchase more than 3% of the
outstanding voting securities of a Nationwide fund, (ii) invest more than 5% of
its asset in any one Nationwide fund and (iii) invest substantially all of its
assets in the Nationwide funds.
Because of their investment objectives and policies, the Portfolios will each
concentrate more than 25% of its assets in the mutual fund industry. In
accordance with the Portfolios investment policies as set forth in the
Prospectus, each of the Portfolios may invest more than 25% of its assets in
certain Nationwide funds. However, each of the Nationwide funds in which a
Portfolio may invest will not concentrate more than 25% of its total assets in
any one industry.
The investment objective of each Portfolio is to maximize total investment
return (i.e., capital growth and income) subject to the investment restrictions
and asset allocation policies described in the Portfolio's Prospectus. This
investment objective is fundamental and cannot be changed without shareholder
approval.
INSURANCE LAW RESTRICTIONS - In connection with the Trust's agreement to sell
shares to the Accounts, the Adviser and the insurance companies may enter into
agreements, required by certain state insurance departments, under which the
Adviser may agree to use its best efforts to assure and to permit insurance
companies to monitor that each Portfolio of the Trust complies with the
investment restrictions and limitations prescribed by state insurance laws and
regulations applicable to the investment of separate account assets in shares of
mutual funds. If an Underlying Fund failed to comply with such restrictions or
limitations, the Accounts would take appropriate action which might include
ceasing to make investments in the Portfolio or withdrawing from the state
imposing the limitation. Such restrictions and limitations are not expected to
have a significant impact on the Trust's operations.
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MAJOR SHAREHOLDERS
As of April 28, 2000, separate accounts of Nationwide Life Insurance Company had
shared voting and investment power over 100% of the Aggressive Portfolio's
shares, 100% of the Moderately Aggressive Portfolio's shares, 100% of the
Moderate Portfolio's shares, 100% of the Moderately Conservative Portfolio's
shares, and 100% of the Conservative Portfolio's shares.
Nationwide Life Insurance Company, One Nationwide Plaza, Columbus, Ohio 43215 is
wholly-owned by Nationwide Financial Services, Inc. ("NFS"). NFS, a holding
company has two classes of common stock outstanding with different voting rights
enabling Nationwide Corporation (the holder of all outstanding Class B Common
Stock) to control NFS. Nationwide Corporation is also a holding company in the
Nationwide Insurance Enterprise. All of the Common Stock of Nationwide
Corporation is held by Nationwide Mutual Insurance Company (95.24%) and
Nationwide Mutual Fire Insurance Company (4.76%), each of which is a mutual
company owned by its policyholders.
As of April 28, 2000, the Trustees and Officers of the Trust as a group owned
beneficially less than 1% of the shares of the Trust.
TRUSTEES AND OFFICERS OF THE TRUST
Trustees and Officers
The business and affairs of the Trust are managed under the direction of its
Board of Trustees. The Board of Trustees sets and reviews policies regarding the
operation of the Trust, and directs the officers to perform the daily functions
of the Trust.
The principal occupation of the Trustees and Officers during the last five
years, their ages and their affiliations are:
DR. JOHN C. BRYANT, TRUSTEE, Age 63
411 Oak Street - Suite 306
Cincinnati, Ohio 45219
Dr. Bryant is Executive Director of the Cincinnati Youth Collaborative, a
partnership of business, government, schools and social service agencies to
address the educational needs of students. He was formerly Professor of
Education, Wilmington College.
C. BRENT DEVORE, Trustee, Age 58
111 N. West Street, Westerville, Ohio 43081
Dr. DeVore is President of Otterbein College.
SUE DOODY, TRUSTEE, Age 64
169 East Beck Street Columbus, Ohio 43206
Ms. Doody is President of Lindey's Restaurant, Columbus, Ohio. She is an active
member of the Greater Columbus Area Chamber of Commerce Board of Trustees.
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ROBERT M. DUNCAN, TRUSTEE, Age 71
1397 Haddon Road Columbus, Ohio 43209
Mr. Duncan is a member of the Ohio Elections Commission. He was formerly
Secretary to the Board of Trustees of the Ohio State University. Prior to that,
he was Vice President and General Counsel of The Ohio State University.
JOSEPH J. GASPER, TRUSTEE*, CHAIRMAN, Age 54
One Nationwide Plaza Columbus, Ohio 43215
Mr. Gasper is Director, President and Chief Operating Officer for Nationwide
Life and Annuity Insurance Company and Nationwide Life Insurance Company. Prior
to that, he was Executive Vice President and Senior Vice President for the
Nationwide Insurance Enterprise.
DR. THOMAS J. KERR, IV, TRUSTEE, Age 65
4890 Smoketalk Lane Westerville, Ohio 43081
Dr. Kerr is President Emeritus of Kendall College. He was formerly President of
Grant Hospital Development Foundation.
DOUGLAS F. KRIDLER, TRUSTEE, Age 43
55 East State Street, Columbus, Ohio 43215
Mr. Kridler is President of Columbus Association for the Performing Arts.
ARDEN L. SHISLER*, TRUSTEE, Age 58
P.O. Box 267, Dalton, Ohio 44618
Mr. Shisler is President and Chief Executive Officer of K&B Transport, Inc., a
trucking firm.
ROBERT J. WOODWARD, JR., TRUSTEE*, Vice-Chairman, Age 56
One Nationwide Plaza Columbus, Ohio 43215
Mr. Woodward is Executive Vice President - Chief Investment Officer for
Nationwide Life and Annuity Insurance Company and Nationwide Life Insurance
Company.
DAVID C. WETMORE, TRUSTEE, Age 50
11495 Sunset Hills Rd - Suite #210, Reston, Virginia 20190
Mr. Wetmore is the Managing Director of The Updata Capital, a venture capital
firm.
JAMES F. LAIRD, JR., TREASURER, Age 42
Three Nationwide Plaza Columbus, Ohio 43215
Mr. Laird is Senior Vice President - Product Development for Villanova Capital,
Inc. and Vice President and General Manager of Nationwide Advisory Services,
Inc., an affiliate of VMF. He was formerly Treasurer of Nationwide Advisory
Services, Inc.
ELIZABETH A. DAVIN, SECRETARY, Age 35
One Nationwide Plaza Columbus, Ohio 43215
Ms. Davin is a member of the Office of General Counsel and Assistant General
Counsel of Villanova Capital, Inc.
- ------------
* A Trustee who is an "interested person" of the Trust as defined in the 1940
Act.
** Bryant, DeVore, Doody, Duncan, Kerr, Kridler, Wetmore and Shisler are also
Trustees of Nationwide Mutual Funds and Nationwide Separate Account Trust, which
are registered investment companies in the Nationwide fund
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complex. Gasper and Wetmore are also Trustees of Nationwide Separate Account
Trust. Laird and Davin are also officers of Nationwide Mutual Funds and
Nationwide Separate Account Trust.
AFFILIATED PERSONS OF THE TRUST AND THE ADVISER
Mr. Joseph J. Gasper, Trustee and Chairman of the Trust, is also Vice
Chairman of the Board of Directors of VMF and NFS. Mr. Arden L. Shisler, Trustee
of the Trust is also a member of the Board of Directors of NFS and other
Nationwide Insurance entities. Mr. Robert J. Woodward, Jr., Trustee and
Vice-Chairman of the Trust, is also Executive Vice President - Chief Investment
Officer of Villanova SA Capital Trust.
The Trust does not pay any fees to Officers or to Trustees who are
considered "interested persons" of the Trust. The table below lists the
aggregate compensation paid by the Trust to each disinterested Trustee during
the fiscal year ended December 31, 1999, and the aggregate compensation paid to
each disinterested Trustee during the fiscal year ended December 31, 1999 by all
38 registered investment series to which VMF or its affiliates provide
investment advisory services (the "Nationwide Fund Complex") or Villanova SA
Capital Trust serves as fund administrator.
The Trust does not maintain any pension or retirement plans for the
Officers or Trustees of the Trust.
COMPENSATION TABLE
FISCAL YEAR ENDED DECEMBER 31, 1999
- --------------------------------------------------------------------------------
TOTAL
COMPENSATION FROM
AGGREGATE THE NATIONWIDE
COMPENSATION FUND COMPLEX**
DISINTERESTED TRUSTEES FROM THE TRUST INCLUDING THE TRUST
- --------------------------------------------------------------------------------
Dr. John C. Bryant $8,000 $24,000
- --------------------------------------------------------------------------------
C. Brent DeVore $4,500 $16,000
- --------------------------------------------------------------------------------
Sue Doody $8,000 $21,000
- --------------------------------------------------------------------------------
Robert M. Duncan $8,000 $24,000
- --------------------------------------------------------------------------------
Dr. Thomas J. Kerr, IV $8,000 $24,000
- --------------------------------------------------------------------------------
Douglas F. Kridler $8,000 $21,000
- --------------------------------------------------------------------------------
Arden L. Shisler* N/A N/A
- --------------------------------------------------------------------------------
David C. Wetmore $4,500 $16,000
- ------------
* Mr. Shisler was elected as a Trustee on February 9, 2000.
**The Fund Complex includes Trusts comprised of 38 investment company
portfolios.
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CALCULATING TOTAL RETURN
The Portfolios may from time to time advertise historical performance, subject
to Rule 482 under the Securities Act. An investor should keep in mind that any
return quoted represents past performance and is not a guarantee of future
results. The investment return and principal value of investments will fluctuate
so that an investor's shares, when redeemed, may be worth more or less than
their original cost.
All performance advertisements include average annual total return quotations
for the most recent one, five, and ten year periods (or life, if a Portfolio has
been in operation less than one of the prescribed periods). Average annual total
return represents the rate required each year for an initial investment to equal
the redeemable value at the end of the quoted period. It is calculated in a
uniform manner by dividing the ending redeemable value of a hypothetical initial
payment of $1,000 for a specified period of time, by the amount of the initial
payment, assuming reinvestment of all dividends and distributions. The one,
five, and ten year periods are calculated based on periods that end on the last
day of the calendar quarter preceding the date on which an advertisement is
submitted for publication.
The uniformly calculated average annual total returns for the one year period
ended December 31, 1999, and the period from inception (January 20, 1998) to
December 31, 1999, are shown below.
FUND 1 YEAR LIFE*
----- ------ -------
The Aggressive Portfolio 24.19% 21.63%
The Moderately Aggressive Portfolio 19.34% 18.51%
The Moderate Portfolio 14.89% 16.29%
The Moderately Conservative Portfolio 9.80% 12.72%
The Conservative Portfolio 3.77% 8.20%
- ------------
* Commenced operations on January 20, 1998.
CODE OF ETHICS
Federal law requires the Trust and its investment adviser to adopt codes
of ethics which govern the personal securities transactions of their respective
personnel. Accordingly, each such entity has adopted a code of ethics pursuant
to which their respective personnel may invest securities for their personal
accounts (including securities that may be purchased or held by the Trust).
INVESTMENT ADVISORY AND OTHER SERVICES
Under the terms of the Investment Advisory and Administration Agreement dated
January 19, 1998 as amended September 1, 1999, and subject to the supervision of
the Trustees, Villanova SA Capital Trust ("VSA"), Three Nationwide Plaza,
Columbus, Ohio 43215, oversees the investment of the assets of each of the
Portfolios. VSA, a Delaware business trust, is a wholly owned subsidiary of
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Villanova Capital Inc., 97% of the common stock of which is held by Nationwide
Financial Services, Inc. (NFS). NFS, a holding company, has two classes of
common stock outstanding with different voting rights enabling Nationwide
Corporation (the holder of all of the outstanding Class B common stock) to
control NFS. Nationwide Corporation is a holding company in the Nationwide
Insurance Enterprise. All of the common stock of Nationwide Corporation is held
by Nationwide Mutual Insurance Company (95.26%) and Nationwide Mutual Fire
Insurance Company (4.76%), each of which is a mutual company owned by its
policyholders.
Subject to the supervision and direction of the Trust's Board of Trustees, VSA
will determine how each Portfolio's assets will be invested in the Underlying
Funds and the other permissible investments. VSA also provides various
bookkeeping, accounting and administrative services, office space and equipment
and the services of the officers of the Portfolios. Under the Investment
Advisory and Administration Agreement, VSA has agreed to bear all expenses of
the Portfolios other than the management fee and extraordinary expenses. Each
Portfolio pays VSA a monthly fee at the annual rate of 0.50% of the Portfolio's
average daily net assets.
Prior to September 1, 1999, Nationwide Advisory Services, Inc. ("NAS") served as
the investment adviser and fund administrator to the Portfolios. Effective
September 1, 1999, the investment advisory and fund administration services
previously performed for the Portfolios by NAS were transferred to VSA, an
affiliate of NAS. In addition, BISYS Fund Services Ohio, Inc. began performing
certain fund administration services pursuant to a Sub-Administration Agreement
also effective September 1, 1999. After the transfer, there was no change in the
fees charged for investment advisory and fund administration services to each of
the Portfolios.
For the year ended December 31, 1999 and for the period from January 20, 1998
(commencement of operations) through December 31, 1998, NAS/VSA received fees in
the following amounts: Aggressive Portfolio, $41,473 and $18,470, respectively;
Moderately Aggressive Portfolio, $35,081 and $11,805, respectively; Moderate
Portfolio, $35,943 and $8,325, respectively; Moderately Conservative Portfolio,
$14,978 and $4,191; respectively; and Conservative Portfolio, $16,045 and
$3,353, respectively.
The Investment Advisory and Administration Agreement also specifically provides
that VSA, including its directors, officers, and employees, shall not be liable
for any error of judgment, or mistake of law, or for any loss arising out of any
investment, or for any act or omission in the execution and management of the
Trust, except for willful misfeasance, bad faith, or gross negligence in the
performance of its duties, or by reason of reckless disregard of its obligations
and duties under the Agreement. The Investment Advisory and Administration
Agreement will continue in effect only if its continuance is specifically
approved at least annually by the Trustees, or by vote of a majority of the
outstanding voting securities of the Trust, and in either case, by a majority of
the Trustees who are not parties to the Investment Advisory and Administration
Agreement or interested persons of any such party. The Investment Advisory and
Administration Agreement terminates automatically if it is assigned. It may be
terminated without penalty by vote of a majority of the out standing voting
securities, or by either party, on not more than 60 days nor less than 30 days
written notice. The Investment Advisory and Administration Agreement further
provides that VSA may render services to others.
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Villanova Mutual Fund Capital Trust, an affiliate of VSA, serves as investment
adviser to each of the Nationwide funds and is responsible for the selection and
management of the Nationwide funds' assets (VMF is assisted in this task by
subadvisers for a number of Nationwide funds). Each Portfolio, as a shareholder
in the Nationwide funds, will indirectly bear its proportionate share of any
investment management fees and other expenses paid by the Nationwide funds.
BROKERAGE ALLOCATIONS
VSA is responsible for decisions to buy and sell securities and other
investments for the Portfolios and no Portfolio will pay a sales load to buy the
Underlying Funds; instead the Portfolio will purchase classes of Underlying
Funds with no sales load or will use quantity discounts or waivers to avoid
paying a sales load. Because the Portfolios may purchase short-term obligations
as well as Underlying Funds and the Nationwide Contract, it will normally
purchase these short term obligations on a "principal" rather than agency basis.
This may be done through a dealer (e.g. securities firm or bank) who buys or
sells for its own account rather than as an agent for another client, or
directly with the issuer. A dealer's profit, if any, is the difference, or
spread, between the dealer's purchase and sale price for the obligation.
The primary consideration in portfolio security transactions is "best
execution," i.e., execution at the most favorable prices and in the most
effective manner possible. VSA always attempts to achieve best execution, and it
has complete freedom as to the markets in and the broker-dealers through which
it seeks this result. Subject to the requirement of seeking best execution,
securities may be bought from or sold to broker-dealers who have furnished
statistical, research, and other information or services to VSA. In placing
orders with such broker-dealers, VSA will, where possible, take into account the
comparative usefulness of such information. Such information is useful to VSA
even though its dollar value may be indeterminable, and its receipt or
availability generally does not reduce VSA's normal research activities or
expenses.
PURCHASES, REDEMPTIONS AND PRICING OF SHARES
An insurance company purchases shares of the Portfolios at their net asset value
using purchase payments received on variable annuity contracts and variable life
insurance polices issued by life insurance company separate accounts. These life
insurance company separate accounts are funded by shares of the Trust.
All investments in the Trust are credited to the shareholder's account in the
form of full and fractional shares of the designated Portfolio (rounded to the
nearest 1/1000 of a share). The Trust does not issue share certificates.
The net asset value per share of the Portfolios is determined once daily, as of
the close of the New York Stock Exchange (usually 4 P.M. eastern time) on each
business day the New York Stock Exchange is open and on such days as the Board
determines and on any other day in which there is sufficient trading in a
Portfolio's portfolio securities to materially affect the net asset value of the
Portfolio. The Portfolios will not compute net asset value on customary national
business holidays, including the following: Christmas, New Year's Day, Martin
Luther King, Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence
Day, Labor Day and Thanksgiving.
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The offering price of a Portfolio for orders placed before the close of the New
York Stock Exchange, on each business day the Exchange is open for trading, will
be based upon calculation of the net asset value at the close of the Exchange.
For orders placed after the close of the Exchange, or on a day on which the
Exchange is not open for trading, the offering price is based upon net asset
value at the close of the Exchange on the next day thereafter on which the
Exchange is open for trading. The net asset value per share is calculated by
adding the value of all securities and other assets of a Portfolio, deducting
its liabilities, and dividing by the number of shares outstanding. Shares of the
Underlying Funds purchased by a Portfolio are valued as of the last net asset
value calculated for such Portfolios. Securities and other assets, for which
such market prices are unavailable, are valued at fair value as determined by
the Trustees.
A life insurance company separate account redeems shares to make benefit or
surrender payments under the terms of its variable annuity contract or variable
life insurance policy. Redemptions are processed on any day on which the Trust
is open for business and are effected at net asset value next determined after
the redemption order, in proper form, is received by VSA.
The Trust may suspend the right of redemption for such periods as are permitted
under the 1940 Act and under the following unusual circumstances: (a) when the
New York Stock Exchange is closed (other than weekends and holidays) or trading
is restricted; (b) when an emergency exists, making disposal of portfolio
securities or the valuation of net assets not reasonably practicable; or (c)
during any period when the SEC has by order permitted a suspension of redemption
for the protection of shareholders.
ADDITIONAL INFORMATION
DESCRIPTION OF SHARES - The Declaration of Trust permits the Trustees to issue
an unlimited number of full and fractional shares of beneficial interest of each
Portfolio and to divide or combine such shares into a greater or lesser number
of shares without thereby exchanging the proportionate beneficial interests in
the Trust. Each share of a Portfolio represents an equal proportionate interest
in that Portfolio with each other share. The Trust reserves the right to create
and issue a number of series or classes of shares. In that case, the shares of
each series or class would participate equally in the earnings, dividends, and
assets of the particular series or class, but shares of all series would vote
together in the election of Trustees. Upon liquidation of a Portfolio,
shareholders are entitled to share pro rata in the net assets of such Portfolio
available for distribution to shareholders.
VOTING RIGHTS - Shareholders of each class of shares have one vote for each
share held and a proportionate fractional vote for any fractional share held. An
annual or special meeting of shareholders to conduct necessary business is not
required by the Declaration of Trust, the 1940 Act or other authority except,
under certain circumstances, to amend the Declaration of Trust, the investment
advisory and administration agreement, fundamental investment objectives,
investment policies, investment restrictions, to elect and remove Trustees, to
reorganize the Trust or any series or class thereof and to act upon certain
other business matters. In regard to termination, sale of assets, the change of
investment objectives, policies and restrictions or the approval of an
investment advisory agreement, the right to vote is limited to the holders of
shares of the particular class fund affected by the proposal.
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<PAGE> 47
To the extent that such a meeting is not required, the Trust does not intend to
have an annual or special meeting of shareholders. The Trust has represented to
the SEC that the Trustees will call a special meeting of shareholders for
purposes of considering the removal of one or more Trustees upon written request
therefor from shareholders holding not less than 10% of the outstanding votes of
the Trust and the Trust will assist in communicating with other shareholders as
required by Section 16(c) of the 1940 Act. At such meeting, a quorum of
shareholders (constituting a majority of votes attributable to all outstanding
shares of the Trust), by majority vote, has the power to remove one or more
Trustees.
SHAREHOLDER INQUIRIES - All inquiries regarding the Trust should be directed to
the Trust at the telephone number or address shown on the cover page of this
Statement of Additional Information.
TAX STATUS
Nationwide Life Insurance Company and Nationwide Life and Annuity Insurance are
the sole shareholders of record of the Trust. Each Portfolio of the Trust is
treated as a separate entity for purpose of the regulated investment company
provisions of the Code, and, therefore, the assets, income, and distributions of
each Portfolio are considered separately for purposes of determining whether or
not the Portfolio qualifies as a regulated investment company.
Each Portfolio of the Trust intends to qualify as a "regulated investment
company" under Subchapter M of the Code. If it qualifies as a regulated
investment company, a Portfolio will pay no federal income taxes on its taxable
net investment income (that is, taxable income other than net realized capital
gains) and its net realized capital gains that are distributed to shareholders.
To qualify under Subchapter M, a Portfolio must, among other things: (i)
diversify its investments within certain prescribed limits; (ii) distribute to
its shareholders at least 90% of its taxable net investment income (for this
purpose consisting of taxable net investment income and net realized short-term
capital gains); and (iii) derive at least 90% of its gross income from
dividends, interest, payments with respect to loans of securities, gains from
the sale or other disposition of securities, or other income (including, but not
limited to, gains from options, futures, and forward contracts) derived with
respect to its business of investing in securities. As a regulated investment
company, a Portfolio will be subject to a 4% non-deductible excise tax measured
with respect to certain undistributed amounts of ordinary income and capital
gain required to be but not distributed under a prescribed formula. The formula
requires payment to shareholders during a calendar year of distributions
representing at least 98% of the Portfolio's taxable ordinary income for the
calendar year and at least 98% of the excess of its capital gains over capital
losses realized during the one-year period ending October 31 during such year,
together with any undistributed, untaxed amounts of ordinary income and capital
gains from the previous calendar year. The Portfolios expect to pay the
dividends and make the distributions necessary to avoid the application of this
excise tax.
Distributions of an Underlying Fund's investment company taxable income are
taxable as ordinary income to a Portfolio which invests in the Portfolio.
Distributions of the excess of an Underlying Fund's net long-term capital gain
over its net short-term capital loss, which are properly designated as "capital
gain dividends", are taxable as long-term capital gain to a Portfolio which
invests in the
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Underlying Fund, regardless of how long the Portfolio held the Underlying Fund's
shares, and are not eligible for the corporate dividends-received deduction.
Upon the sale or other disposition by a Portfolio of shares of any Underlying
Fund, the Portfolio generally will realize a capital gain or loss which will be
long-term or short-term, generally depending upon the Portfolio's holding period
for the shares.
In addition, each Portfolio intends to comply with the diversification
requirements of Section 817(h) of the Code related to the tax-deferred status of
insurance company separate accounts. To comply with regulations under Section
817(h) of the Code, each Portfolio will be required to diversify its investments
so that on the last day of each calendar quarter no more than 55% of the value
of its assets is represented by any one investment, no more than 70% is
represented by any two investments, no more than 80% is represented by any three
investments and no more than 90% is represented by any four investments.
Generally, all securities of the same issuer are treated as a single investment.
For the purposes of Section 817(h), obligations of the United States Treasury
and each U.S. government instrumentality are treated as securities of separate
issuers. The Treasury Department has indicated that it may issue future
pronouncements addressing the circumstances in which a variable annuity contract
or variable life insurance policy owner's control of the investments of a
separate account may cause the variable annuity contract or variable life
insurance policy owner, rather than the participating insurance company, to be
treated as the owner of the assets held by the separate account. If the variable
annuity contract or variable life insurance policy owner is considered the owner
of the securities underlying the separate account, income and gains produced by
those securities would be included currently in the variable annuity contract or
variable life insurance policy owner's gross income. It is not known what
standards will be set forth in such pronouncements or when, if at all, these
pronouncements may be issued. In the event that rules or regulations are
adopted, there can be no assurance that the Portfolios will be able to operate
as currently described, or that the Trust will not have to change the investment
goal or investment policies of a Portfolio. The Board reserves the right to
modify the investment policies of a Portfolio as necessary to prevent any such
prospective rules and regulations from causing a variable annuity contract or
variable life insurance policy owner to be considered the owner of the shares of
the Portfolio underlying the separate account.
TAX CONSEQUENCES TO SHAREHOLDERS. Since shareholders of the Portfolios will be
the Accounts, no discussion is included herein as to the Federal income tax
consequences at the level of the holders of the Policies. For information
concerning the Federal income tax consequences to such holders, see the
Prospectuses for such Policies.
CUSTODIAN
The Fifth Third Bank ("Fifth Third"), 38 Fountain Square Plaza, Cincinnati,
OH 45263, is the Custodian for the Trust and makes all receipts and
disbursements under a Custodian Agreement. The Custodian has no managerial or
policy making functions for the Funds.
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TRANSFER AGENT AND DIVIDEND DISBURSING AGENT
Nationwide Investors Services, Inc. ("NIS"), Three Nationwide Plaza,
Columbus, Ohio 43215, is the Transfer Agent and Dividend Disbursing Agent for
the Trust. NIS is a wholly-owned subsidiary of VSA.
LEGAL COUNSEL
Stradley Ronon Stevens & Young, LLP, 2600 Commerce Square, Philadelphia, PA
19103, serves as the Trust's legal counsel.
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 100 East Broad Street, Columbus, Ohio 43215,
serves as independent accountants for the Trust.
FINANCIAL STATEMENTS
The Report of Independent Accountants and Financial Statements of the
Portfolios for the year ended December 31, 1999 are incorporated by reference to
the Trust's Annual Report. Copies of the Annual Report and Semi-Annual Report
are available without charge upon request by writing the Trust or by calling
toll free 1 (800) 848-6331.
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APPENDIX A
BOND RATINGS
STANDARD & POOR'S DEBT RATINGS
A Standard & Poor's corporate or municipal debt rating is a current assessment
of the creditworthiness of an obligor with respect to a specific obligation.
This assessment may take into consideration obligors such as guarantors,
insurers, or lessees.
The ratings are based on current information furnished by the issuer or
obtained by Standard & Poor's from other sources it considers reliable. Standard
& Poor's does not perform an audit in connection with any rating and may, on
occasion, rely on unaudited financial information. The ratings may be changed,
suspended, or withdrawn as a result of changes in, or unavailability of, such
information, or for other circumstances.
The ratings are based, in varying degrees, on the following considerations:
1. Likelihood of default - capacity and willingness of the obligor as to
the timely payment of interest and repayment of principal in
accordance with the terms of the obligation.
2. Nature of and provisions of the obligation.
3. Protection afforded by, and relative position of, the obligation in
the event of bankruptcy, reorganization, or other arrangement under
the laws of bankruptcy and other laws affecting creditors' rights.
INVESTMENT GRADE
AAA - Debt rated 'AAA' has the highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.
AA - Debt rated 'AA' has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A - Debt rated 'A' has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB - Debt rated 'BBB' is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
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SPECULATIVE GRADE
Debt rated 'BB', 'B', 'CCC', 'CC' and 'C' is regarded as having predominantly
speculative characteristics with respect to capacity to pay interest and repay
principal. 'BB' indicates the least degree of speculation and 'C' the highest.
While such debt will likely have some quality and protective characteristics,
these are outweighed by large uncertainties or major risk exposures to adverse
conditions.
BB - Debt rated 'BB' has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The 'BB'
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied 'BBB-' rating.
B - Debt rated 'B' has a greater vulnerability to default but currently has
the capacity to meet interest payments and principal repayments. Adverse
business, financial, or economic conditions will likely impair capacity or
willingness to pay interest and repay principal. The 'B' rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
'BB' or 'BB-' rating.
CCC - Debt rated 'CCC' has a currently identifiable vulnerability to default,
and is dependent upon favorable business, financial, and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial, or economic conditions, it is not likely to have
the capacity to pay interest and repay principal. The 'CCC' rating category is
also used for debt subordinated to senior debt that is assigned an actual or
implied 'B' or 'B-' rating.
CC - Debt rated 'CC' typically is applied to debt subordinated to senior debt
that is assigned an actual or implied 'CCC' rating.
C - Debt rated 'C' typically is applied to debt subordinated to senior debt
which is assigned an actual or implied 'CCC-' debt rating. The 'C' rating may be
used to cover a situation where a bankruptcy petition has been filed, but debt
service payments are continued.
CI - The rating 'CI' is reserved for income bonds on which no interest is
being paid.
D - Debt rated 'D' is in payment default. The 'D' rating category is used when
interest payments or principal payments are not made on the date due even if the
applicable grace period has not expired, unless Standard & Poor's believes that
such payments will be made during such grade period. The 'D' rating also will be
used upon the filing of a bankruptcy petition if debt service payments are
jeopardized.
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MOODY'S LONG-TERM DEBT RATINGS
Aaa - Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." 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 risk appear somewhat larger than in Aaa securities.
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 some time 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
length of time. Such Bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba - Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered well-assured. Often the protection of interest and
principal payments may be very moderate, and thereby not well safeguarded during
both good and bad times over the future. Uncertainty of position characterizes
bonds in this class.
B - Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
Caa - Bonds which are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
Ca - Bonds which are rated Ca represent obligations which are speculative in a
high degree. Such issues are often in default or have other marked shortcomings.
C - Bonds which are rated C are the lowest rated class of bonds, and issues so
rated can be regarded as having extremely poor prospects of ever attaining any
real investment standing.
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FITCH'S BOND RATINGS
Fitch investment grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
represent Fitch's assessment of the issuer's ability to meet the obligations of
a specific debt issue or class of debt in a timely manner.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength and credit quality.
Fitch ratings do not reflect any credit enhancement that may be provided by
insurance policies or financial guaranties unless otherwise indicated.
Bonds that have the same rating are of similar but not necessarily identical
credit quality since the rating categories do not fully reflect small
differences in the degrees of credit risk.
Fitch ratings are not recommendations to buy, sell, or hold any security.
Ratings do not comment on the adequacy of market price, the suitability of any
security for a particular investor, or the tax-exempt nature or taxability of
payments made in respect of any security.
Fitch ratings are based on information obtained from issuers, other obligors,
underwriters, their experts, and other sources Fitch believes to be reliable.
Fitch does not audit or verify the truth or accuracy of such information.
Ratings may be changed, suspended, or withdrawn as a result of changes in, or
the unavailability of, information or for other reasons.
AAA Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay
interest and repay principal, which is unlikely to be affected by
reasonably foreseeable events.
AA Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is
very strong, although not quite as strong as bonds rated 'AAA'.
Because bonds rated in the 'AAA' and 'AA' categories are not
significantly vulnerable to foreseeable future developments,
short-term debt of the issuers is generally rated 'F-1+'.
A Bonds considered to be investment grade and of high credit quality.
The obligor's ability to pay interest and repay principal is
considered to be strong, but may be more vulnerable to adverse changes
in economic conditions and circumstances than bonds with higher
ratings.
BBB Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have adverse
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impact on these bonds, and therefore, impair timely payment. The
likelihood that the ratings of these bonds will fall below
investment grade is higher than for bonds with higher ratings.
Fitch speculative grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
('BB' to 'C') represent Fitch's assessment of the likelihood of timely payment
of principal and interest in accordance with the terms of obligation for bond
issues not in default. For defaulted bonds, the rating ('DDD' to 'D') is an
assessment of the ultimate recovery value through reorganization or liquidation.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength.
Bonds that have the same rating are of similar but not necessarily identical
credit quality since the rating categories cannot fully reflect the differences
in the degrees of credit risk. Moreover, the character of the risk factor varies
from industry to industry and between corporate, health care and municipal
obligations.
BB Bonds are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse
economic changes. However, business and financial alternatives can be
identified which could assist the obligor in satisfying its debt
service requirements.
B Bonds are considered highly speculative. While bonds in this class are
currently meeting debt service requirements, the probability of
continued timely payment of principal and interest reflects the
obligor's limited margin of safety and the need for reasonable
business and economic activity throughout the life of the issue.
CCC Bonds have certain identifiable characteristics which, if not
remedied, may lead to default. The ability to meet obligations
requires an advantageous business and economic environment.
CC Bonds are minimally protected. Default in payment of interest and/or
principal seems probable over time.
C Bonds are in imminent default in payment of interest or principal.
DDD, DD Bonds are in default on interest and/or principal
and D
payments. Such bonds are extremely speculative and should be valued on
the basis of their ultimate recovery value in liquidation or
reorganization of the obligor. 'DDD' represents the highest
potential for recovery of these bonds, and 'D' represents the
lowest potential for recovery.
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DUFF & PHELPS' LONG-TERM DEBT RATINGS
These ratings represent a summary opinion of the issuer's long-term
fundamental quality. Rating determination is based on qualitative and
quantitative factors which may vary according to the basic economic and
financial characteristics of each industry and each issuer. Important
considerations are vulnerability to economic cycles as well as risks related to
such factors as competition, government action, regulation, technological
obsolescence, demand shifts, cost structure, and management depth and expertise.
The projected viability of the obligor at the trough of the cycle is a critical
determination.
Each rating also takes into account the legal form of the security, (e.g.,
first mortgage bonds, subordinated debt, preferred stock, etc.). The extent of
rating dispersion among the various classes of securities is determined by
several factors including relative weightings of the different security classes
in the capital structure, the overall credit strength of the issuer, and the
nature of covenant protection. Review of indenture restrictions is important to
the analysis of a company's operating and financial constraints.
The Credit Rating Committee formally reviews all ratings once per quarter
(more frequently, if necessary). Ratings of 'BBB-' and higher fall within the
definition of investment grade securities, as defined by bank and insurance
supervisory authorities.
RATING
SCALE DEFINITION
- -----------------------------------------------------------------
AAA Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
- -----------------------------------------------------------------
AA+ High credit quality. Protection factors are strong. Risk is modest, but
AA may vary slightly from time to time because of economic conditions.
AA-
- -----------------------------------------------------------------
A+ Protection factors are average but adequate. However, risk factors are
A more variable and greater in periods of economic stress.
A-
- -----------------------------------------------------------------
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BBB+ Below average protection factors but still considered sufficient for
BBB prudent investment. Considerable variability in risk during economic
BBB- cycles.
- -----------------------------------------------------------------
BB+ Below investment grade but deemed likely to meet obligations when due.
BB Present or prospective financial protection factors fluctuate according
BB- to industry conditions or company fortunes. Overall quality may move up or
down frequently within this category.
- -----------------------------------------------------------------
B+ Below investment grade and possessing risk that obligations will not be
B met when due. Financial protection factors will fluctuate widely
B- according to economic cycles, industry conditions and/or company fortunes.
Potential exists for frequent changes in the rating within this category or
into a higher or lower rating grade.
- -----------------------------------------------------------------
CCC Well below investment grade securities. Considerable uncertainty exists as
to timely payment of principal, interest or preferred dividends. Protection
factors are narrow and risk can be substantial with unfavorable
economic/industry conditions, and/or with unfavorable company developments.
- -----------------------------------------------------------------
DD Defaulted debt obligations. Issuer failed to meet scheduled principal
and/or interest payments.
DP Preferred stock with dividend arrearages.
- -----------------------------------------------------------------
SHORT-TERM RATINGS
STANDARD & POOR'S COMMERCIAL PAPER RATINGS
A Standard & Poor's commercial paper rating is a current assessment of the
likelihood of timely payment of debt considered short-term in the relevant
market. Factors such as liquidity of the issuer, long-term debt ratings,
reliability and quality of management, and earning and cost flows are considered
by Standard & Poor's when assigning these ratings.
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Ratings are graded into several categories, ranging from 'A-1' for the highest
quality obligations to 'D' for the lowest. These categories are as follows:
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+) designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated 'A-1'.
A-3 Issues carrying this designation have adequate capacity for timely
payment. They are, however, more vulnerable to the adverse effects of changes in
circumstances than obligations carrying the higher designations.
B Issues rated 'B' are regarded as having only speculative capacity for
timely payment.
C This rating is assigned to short-term debt obligations with doubtful
capacity for payment.
D Debt rated 'D' is in payment default. The 'D' rating category is used
when interest payments or principal payments are not made on the date due, even
if the applicable grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such grade period.
MOODY'S COMMERCIAL PAPER RATINGS
The term "commercial paper" as used by Moody's means promissory obligations
not having an original maturity in excess of nine months. Moody's makes no
representation as to whether such commercial paper is by any other definition
"commercial paper" or is exempt from registration under the 1933 Act.
Moody's commercial paper ratings are opinions on the ability of issuers to
repay punctually promissory obligations not having an original maturity in
excess of nine months. Moody's does not represent that any specific note is a
valid obligation of a rated issuer or issued in conformity with any applicable
law. Moody's employs the following three designations, all judged to be
investment grade, to indicate the relative repayment capacity of rated issuers:
Issuers rated PRIME-1 (or related supporting institutions) have a superior
capacity for repayment of short-term promissory obligations. Prime-1 repayment
capacity will normally be evidenced by the following characteristics: (i)
leading market positions in well established industries, (ii) high rates of
return on funds employed, (iii) conservative capitalization structures with
moderate reliance on debt and ample asset protection, (iv) broad margins in
earnings coverage of fixed financial charges and high internal cash generation,
and (v) well established access to a range of financial markets and assured
sources of alternative liquidity.
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Issuers rated PRIME-2 (or related supporting institutions) have a strong
capacity for repayment of short-term promissory obligations. This will normally
be evidenced by many of the characteristics cited above, but to a lesser degree.
Earnings trends and coverage ratios, while sound, will be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.
Issuers rated PRIME-3 (or relates supporting institutions) have an
acceptable capacity for repayment of short-term promissory obligations. The
effect of industry characteristics and market composition may be more
pronounced. Variability in earnings and profitability may result in changes in
the level of debt protection measurements and the requirement for relatively
high financial leverage. Adequate alternate liquidity is maintained.
Issuers rated NOT PRIME do not fall within any of the Prime rating
categories.
FITCH'S SHORT-TERM RATINGS
Fitch's short-term ratings apply to debt obligations that are payable on
demand or have original maturities of generally up to three years, including
commercial paper, certificates of deposit, medium-term notes, and municipal and
investment notes.
The short-term rating places greater emphasis than a long-term rating on the
existence of liquidity necessary to meet the issuer's obligations in a timely
manner.
F-1+ (Exceptionally Strong Credit Quality) Issues assigned this rating are
regarded as having the strongest degree of assurance for timely
payment.
F-1 (Very Strong Credit Quality) Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues
rated 'F-1+'.
F-2 (Good Credit Quality) Issues assigned this rating have a satisfactory
degree of assurance for timely payment but the margin of safety is not
as great as for issues assigned 'F-1+' and 'F-1' ratings.
F-3 (Fair Credit Quality) Issues assigned this rating have characteristics
suggesting that the degree of assurance for timely payment is
adequate, however, near-term adverse changes could cause these
securities to be rated below investment grade.
F-S (Weak Credit Quality) Issues assigned this rating have characteristics
suggesting a minimal degree of assurance for timely payment and are
vulnerable to near-term adverse changes in financial and economic
conditions.
D (Default) Issues assigned this rating are in actual or imminent
payment default.
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LOC The symbol LOC indicates that the rating is based on a letter of
credit issued by a commercial bank.
DUFF & PHELPS SHORT-TERM DEBT RATINGS
Duff & Phelps' short-term ratings are consistent with the rating criteria
utilized by money market participants. The ratings apply to all obligations with
maturities under one year, including commercial paper, the uninsured portion of
certificates of deposit, unsecured bank loans, master notes, bankers
acceptances, irrevocable letters of credit, and current maturities of long-term
debt. Asset-backed commercial paper is also rated according to this scale.
Emphasis is placed on liquidity which as defined is not only cash from
operations, but also access to alternative sources of funds including trade
credit, bank lines, and the capital markets. An important consideration is the
level of an obligor's reliance on short-term funds on an ongoing basis.
RATING SCALE DEFINITION
Duff 1+ Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to
alternative sources of funds, is outstanding, and safety
is just below risk-free U.S. Treasury short-term
obligations.
Duff 1 Very high certainty of timely payment. Liquidity factors
are excellent and supported by good fundamental protection
factors. Risk factors are minor.
Duff 1- High certainty of timely payment. Liquidity factors are
strong and supported by good fundamental protection
factors. Risk factors are very small.
GOOD GRADE
Duff 2 Good certainty of timely payment. Liquidity factors and
company fundamentals are sound. Although ongoing funding
needs may enlarge total financing requirements, access to
capital markets is good. Risk factors are small.
SATISFACTORY GRADE
Duff 3 Satisfactory liquidity and other protection factors
qualify issue as to investment grade. Risk factors are
larger and subject to more variation. Nevertheless, timely
payment is expected.
NON-INVESTMENT GRADE
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Duff 4 Speculative investment characteristics. Liquidity is not
sufficient to insure against disruption in debt service.
Operating factors and market access may be subject to a
high degree of variation.
DEFAULT
Duff 5 Issuer failed to meet scheduled principal and/or interest
payments.
THOMSON'S SHORT-TERM RATINGS
The Thomson Short-Term Ratings apply, unless otherwise noted, to
unsubordinated instruments of the rated entities with a maturity of one year or
less, including deposits, bank notes, bankers' acceptances, federal funds,
letters of credit, commercial paper and other obligations comparable in priority
and security to those specifically listed herein. These ratings do not consider
any collateral or security as the basis for the rating, although some of the
securities may in fact have collateral. Further, these ratings do not
incorporate consideration of the possible sovereign risk associated with a
foreign deposit (defined as a deposit taken in a branch outside the country in
which the rated entity is headquartered) of the rated entity. Thomson Short-Term
Ratings are intended to assess the likelihood of an untimely or incomplete
payments of principal or interest.
TBW-1 The highest category, indicates a very high likelihood that principal
and interest will be paid on a timely basis.
TBW-2 The second highest category, while the degree of safety regarding
timely repayment of principal and interest is strong, the relative degree of
safety is not as high as for issues rated "TBW-1".
TBW-3 The lowest investment-grade category; indicates that while the
obligation is more susceptible to adverse developments (both internal and
external) than those with higher ratings, the capacity to service principal and
interest in a timely fashion is considered adequate.
TBW-4 The lowest rating category; this rating is regarded as non-investment
grade and therefore speculative.
IBCA SHORT-TERM RATINGS
IBCA Short-Term Ratings assess the borrowing characteristics of banks and
corporations, and the capacity for timely repayment of debt obligations. The
Short-Term Ratings relate to debt which has a maturity of less than one year.
IBCA issues ratings and reports on the largest U.S. and international bank
holding companies, as well as major investment banks. IBCA's short-term rating
system utilizes a dual system--Individual Ratings and Legal Ratings. The
Individual Rating addresses 1) the current strength of consolidated banking
companies and their principal bank subsidiaries. A consolidated bank holding
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company/bank with an "A" rating has a strong balance sheet, and a favorable
credit profile without significant problems. A "B" rating indicates sound credit
profile without significant problems. Performance is generally in line with or
better than that of its peers. The Legal Rating addresses the question of
whether an institution would receive support if it ran into difficulties. Issues
rated "A-1" are obligations supported by a very strong capacity for timely
repayment. Issues rated "A-2" have a very strong capacity for timely repayment
although such capacity may be susceptible to adverse changes in business,
economic or financial conditions.
A1+ Obligations supported by the highest capacity for timely repayment and
possess a particularly strong credit feature.
A1 Obligations supported by the highest capacity for timely repayment.
A2 Obligations supported by a good capacity for timely repayment.
A3 Obligations supported by a satisfactory capacity for timely repayment.
B Obligations for which there is an uncertainty as to the capacity to
ensure timely repayment.
C Obligations for which there is a high risk of default or which are
currently in default.
D Obligations which are currently in default.
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