PROSPECTUS
October 1, 1997
LOGO: POTOMAC FUNDS
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
<PAGE>
PROSPECTUS
LOGO: POTOMAC FUNDS
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
The Potomac Funds (the "Trust") is a no-load management investment company, or
mutual fund, which consists of seven separate investment portfolios (the
"Funds"). The Funds are designed principally for experienced investors who
intend to follow a global asset allocation strategy. The Funds are not designed
for inexperienced or less sophisticated investors. An important feature of the
Trust is that it primarily consists of pairs of Funds, one of which attempts to
provide results correlating to a specific index, while the other attempts to
provide inverse performance that is similar to a short position in the specific
index. In particular, the following Funds seek investment results that
correspond over time to the following benchmarks:
FUND BENCHMARK
Potomac Japan/Long Fund Nikkei 225 Stock Average
Potomac Japan/Short Fund Inverse (opposite) of the Nikkei 225
Stock Average
Potomac U.S. Plus Fund 150% of the performance of the
Standard & Poor's 500 Composite
Stock Price Index(TM)
Potomac U.S./Short Fund Inverse (opposite) of the Standard & Poor's
500 Composite Stock
Price Index(TM)
Potomac OTC Plus Fund 125% of the performance of the Nasdaq 100
Index(TM)
Potomac OTC/Short Fund Inverse (opposite) of the Nasdaq 100
Index(TM)
October 1, 1997
<PAGE>
The Trust also offers the Potomac U.S. Government Money Market Fund,
which seeks security of principal, current income and liquidity by investing
primarily in money market instruments issued or guaranteed, as to principal and
interest, by the U.S. Government, its agencies or instrumentalities. THIS FUND
SEEKS TO MAINTAIN A CONSTANT $1.00 NET ASSET VALUE PER SHARE, ALTHOUGH THIS
CANNOT BE ASSURED.
The Funds (other than the Potomac U.S. Government Money Market Fund) may
engage in certain aggressive investment techniques, which include engaging in
short sales and transactions in options and futures contracts. The Potomac U.S.
Plus Fund and the Potomac OTC Plus Fund may use the speculative technique known
as leverage to increase funds available for investment. See "Special Risk
Considerations." Investors in the Potomac Japan/Long Fund, Potomac U.S. Plus
Fund and Potomac OTC Plus Fund may experience substantial losses during
sustained periods of falling equity prices. Investors in the Potomac Japan/Short
Fund, Potomac U.S./Short Fund and Potomac OTC/Short Fund may experience
substantial losses during periods of sustained periods of rising equity prices.
None of the Funds alone constitutes a balanced investment plan, and investments
in certain of the Funds involve special risks not traditionally associated with
investment companies, including significant portfolio turnover. SHARES OF THE
POTOMAC U.S. GOVERNMENT MONEY MARKET FUND ARE NOT DEPOSITS OR OBLIGATIONS, OR
GUARANTEED OR ENDORSED BY, THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE
FEDERAL RESERVE BOARD OR ANY OTHER AGENCY. AN INVESTMENT IN THIS FUND IS NEITHER
INSURED NOR GUARANTEED BY THE UNITED STATES GOVERNMENT. See "Special Risk
Considerations." There can be no assurance that a Fund will achieve its
investment objective.
Investors should read this Prospectus and retain it for future
reference. This Prospectus is designed to set forth concisely the information an
investor should know about the Trust before investing. A Statement of Additional
Information ("SAI"), dated October 1, 1997, containing additional information
about the Trust, has been filed with the Securities and Exchange Commission
("SEC") and is incorporated herein by reference. A copy of the SAI is available,
without charge, upon request to the Trust at the address or telephone number
above.
The SEC maintains a Web site (http://www.sec.gov) that contains the SAI,
material incorporated by reference and other information regarding the Funds.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
<PAGE>
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TABLE OF CONTENTS
Page
PROSPECTUS SUMMARY 3
FEES AND EXPENSES OF THE FUNDS 6
INVESTMENT OBJECTIVES
AND POLICIES 7
SPECIAL RISK CONSIDERATIONS 12
INVESTMENT TECHNIQUES AND
OTHER INVESTMENT POLICIES 15
PORTFOLIO TRANSACTIONS
AND BROKERAGE 21
HOW TO INVEST IN THE FUNDS 21
TAX-SHELTERED RETIREMENT PLANS 22
REDEEMING SHARES (WITHDRAWALS) 22
EXCHANGES 23
PROCEDURES FOR REDEMPTIONS
AND EXCHANGES 24
DETERMINATION OF NET ASSET VALUE 25
PERFORMANCE INFORMATION 26
DIVIDENDS AND OTHER DISTRIBUTIONS 27
TAXES 27
MANAGEMENT AND ADMINISTRATION
OF THE TRUST 28
GENERAL INFORMATION ABOUT
THE TRUST 29
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PROSPECTUS SUMMARY
THE POTOMAC FUNDS
Each Fund has its own distinct investment objective. There is no
guarantee that any Fund will achieve its investment objective. The investment
objectives of the Funds are as follows.
The POTOMAC JAPAN/LONG FUND ("Japan/Long Fund") seeks to provide
investment returns that correspond to the Nikkei 225 Stock Average ("Nikkei
Index"). The Nikkei Index is a price-weighted index of the 225 largest Japanese
companies listed on the Tokyo Stock Exchange. In attempting to achieve its
objective, the Fund may invest in securities included in that index and may
enter into long positions in Nikkei Index futures contracts, options on such
futures contracts and options on securities and on the Nikkei Index traded on
foreign and domestic exchanges. In addition, the Fund will use forward contracts
on Japanese Yen, futures contracts on Japanese Yen, options on such futures
contracts, and options on Japanese Yen to attempt to eliminate the effect that
fluctuations in the U.S. Dollar/Japanese Yen exchange rate may have on the
Fund's net asset value per share. The Fund also will invest in short-term
debt securities.
The POTOMAC JAPAN/SHORT FUND ("Japan/Short Fund") seeks to provide
investment returns that inversely correlate to the performance of the Nikkei
Index. If the Fund is successful in achieving its objective, the net asset value
of the Fund will increase in direct proportion to any decrease in the level of
the Nikkei Index and, conversely, the net asset value of the Fund will decrease
in direct proportion to any increase in the Nikkei Index. In attempting to
achieve its objective, the Fund may enter into short positions in Nikkei Index
futures contracts, options on such futures contracts and options on securities
and on the Nikkei Index traded on foreign and domestic exchanges. In addition,
the Fund will use forward contracts on Japanese Yen, futures contracts on
Japanese Yen, options on such futures contracts, and options on Japanese Yen to
attempt to eliminate the effect that fluctuations in the U.S. Dollar/Japanese
Yen exchange rate may have on the Fund's net asset value per share. The Fund
involves special risks not traditionally associated with investment companies.
Investors in this Fund may experience substantial losses during sustained
periods of rising Japanese equity prices. The Fund also will invest in
short-term debt securities.
<PAGE>
The POTOMAC U.S. PLUS FUND ("U.S. Plus Fund") seeks to provide
investment returns that correspond to 150% of the performance of the Standard &
Poor's 500 Composite Stock Price IndexTM (the "S&P 500 Index"). In attempting to
achieve its objective, the Fund may invest in securities included in that index
and may enter into long positions in stock index futures contracts, options on
stock index futures contracts and options on securities and on stock indices. In
contrast to the returns of a mutual fund that seeks to approximate the return of
the S&P 500 Index, the Fund may produce gains greater than that return during
periods when the prices of securities included in the S&P 500 Index are rising
and below that return during periods when such prices are declining. Investors
in the Fund may experience substantial losses during sustained periods of
falling U.S. equity prices. The Fund also will invest in short-term debt
securities.
The POTOMAC U.S./SHORT FUND ("U.S./Short Fund") seeks to provide
investment returns that inversely correlate to the performance of the S&P 500
Index. If the Fund is successful in meeting its objective, the Fund's net asset
value per share will increase in direct proportion to any decrease in the level
of the S&P 500 Index and, conversely, the net asset value of the Fund will
decrease in direct proportion to any increase in the level of the S&P 500 Index.
In seeking to achieve its objective, the Fund may enter into positions in stock
index futures contracts, options on stock index futures contracts and options on
securities and on stock indices. The Fund involves special risks not
traditionally associated with investment companies. Investors in the Fund may
experience substantial losses during sustained periods of rising U.S. equity
prices. The Fund also will invest in short-term debt securities.
The POTOMAC OTC PLUS FUND ("OTC Plus Fund") seeks to provide investment
returns that correspond to 125% of the performance of the Nasdaq 100 IndexTM
("Nasdaq Index"). The Fund will invest in the securities included in that index,
as well as enter into long positions in stock index futures contracts, options
on such index futures contracts and options on securities and on stock indices.
In contrast to the returns of a mutual fund that seeks to approximate the return
of the Nasdaq Index, the Fund may produce gains greater than that return during
periods when prices of securities in the Nasdaq Index are rising and below that
return during periods when such prices are declining. Investors in the Fund may
experience substantial losses during sustained periods of falling U.S. equity
prices. The Fund also will invest in short-term debt securities.
The POTOMAC OTC/SHORT FUND ("OTC/Short Fund") seeks to provide
investment results that will inversely correlate to the performance of the
Nasdaq Index. If the Fund is successful in meeting its objective, the Fund's net
asset value per share will increase in direct proportion to any decrease in the
level of the Nasdaq Index and, conversely, the net asset value of the Fund will
decrease in direct proportion to any increase in the level of the Nasdaq Index.
In seeking to achieve its objective, the Fund may enter into short positions in
stock index futures contracts, options on stock index futures contracts, and
options on securities and on stock indices. The Fund involves risks not
traditionally associated with investment companies. Investors in the Fund may
experience substantial losses during sustained periods of rising U.S. equity
prices. The Fund also will invest in short-term debt securities.
<PAGE>
The POTOMAC U.S. GOVERNMENT MONEY MARKET FUND ("Money Market Fund")
seeks to provide security of principal, current income and liquidity. To achieve
its objective, the Money Market Fund invests primarily in money market
instruments that are issued or guaranteed as to principal and interest by the
U.S. Government, its agencies or instrumentalities, as well as in repurchase
agreements collateralized fully by U.S. Government securities.
Further discussion of each Fund's investment objective and policies and
the risks associated with investing in the Funds may be found under "Investment
Objectives and Policies," "Special Risk Considerations" and "Investment
Techniques and Other Investment Policies" below.
SPECIAL RISK CONSIDERATIONS
Each Fund (except the Money Market Fund) may engage in certain
aggressive investment techniques, which may include engaging in short sales and
transactions in futures contracts and options on securities, stock indices and
futures contracts. As discussed more fully under "Investment Objectives and
Policies," "Special Risk Considerations" and "Investment Techniques and Other
Investment Policies," these techniques are specialized and involve risks not
traditionally associated with investment companies.
The Trust expects that a substantial number of the Funds' investors will
be experienced and will invest in the Funds as part of an asset allocation
investment strategy. These shareholders likely will redeem or exchange their
Fund shares frequently to take advantage of anticipated changes in market
conditions. The strategies employed by investors in the Funds may result in
considerable assets moving in and out of the Funds and, consequently, a high
portfolio turnover rate. A high portfolio turnover rate generally causes a Fund
to incur higher expenses and additional costs and may adversely affect the
ability of a Fund to meet its investment objective.
Investors in the Japan/Long Fund and the Japan/Short Fund should be able
to assume the special risks of investing in foreign securities, which include
possible adverse political and economic developments abroad, fluctuations in
foreign currency values and differing character istics of foreign economies and
markets.
The U.S. Plus Fund and the OTC Plus Fund may borrow money from banks for
investment purposes, which is a form of leveraging. This leverage may exaggerate
the gains and losses on a Fund's investments and the changes in a Fund's net
asset value per share. Each Fund may borrow money for temporary or emergency
purposes and to meet redemption requests without immediately selling portfolio
securities.
While the Funds do not expect their returns over a twelve-month period
to deviate adversely from their respective current benchmarks by more than 10%,
certain factors may affect each Fund's ability to achieve this correlation.
Under certain circumstances, trading on an exchange may be halted or
closed early, resulting in a Fund being unable to execute buy or sell orders
that day. If that occurs and a Fund needs to execute a high volume of trades on
that trading day, a Fund may incur substantial trading losses.
<PAGE>
PURCHASES, REDEMPTIONS, AND EXCHANGES OF TRUST SHARES
The minimum initial investment is $10,000, which can be allocated in any
amounts among the Funds. The shares of each Fund may be purchased and redeemed
without any sales or redemption charges at the net asset value of the Fund next
determined. Exchanges must be for at least the lesser of $1,000 or the entire
account balance for the Fund from which the exchange is made. Shares of any Fund
may be exchanged at any time for shares of any other Fund, on the basis of the
relative net asset values next computed, without charge. Because of the
administrative expense of handling small accounts, the Trust reserves the right
to redeem involuntarily an investor's account, including a retirement account,
that falls below the minimum investment of $10,000 in total value in the Trust
due to redemptions. The Trust reserves the right to modify its minimum
investment requirements and the corresponding amounts below which an involuntary
redemption may be effected. See "How to Invest in the Funds," "Redeeming Shares
(Withdrawals)" and "Procedures for Redemptions and Exchanges."
INVESTMENT ADVISER
Rafferty Asset Management, LLC ("Adviser") serves as the investment
adviser to each Fund. The Adviser is a newly created investment adviser and has
had no previous experience advising investment companies. Lawrence C. Rafferty
controls the Adviser.
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FEES AND EXPENSES OF THE FUNDS
Shown below are all expenses expected to be incurred by each Fund during
its initial fiscal year. Because each Fund's shares were not offered for sale
prior to the date of this Prospectus, Other Expenses are based on estimated
expenses.
<TABLE>
ANNUAL FUND OPERATING EXPENSES
<CAPTION>
Total Fund
Management Other Operating
Fees 12b-1 Fees* Expenses Expenses+
------------ ---------- -------- ---------
<S> <C> <C> <C> <C>
Japan/Long Fund 0.75% None 0.75% 1.50%
Japan/Short Fund 0.90 None 0.75 1.65
U.S. Plus Fund 0.75 None 0.75 1.50
U.S./Short Fund 0.90 None 0.75 1.65
OTC Plus Fund 0.75 None 0.75 1.50
OTC/Short Fund 0.90 None 0.75 1.65
Money Market Fund 0.50 None 0.50 1.00
<FN>
- ---------------
* The Funds have adopted a Rule 12b-1 Distribution Plan; however, the Board of
Trustees has not authorized payment of any fees pursuant to such Plan. See
"General Information about the Trust - Distribution of Fund Shares" below.
+ You will be charged $12.00 per wire redemption to cover transaction costs.
</FN>
</TABLE>
<PAGE>
EXAMPLE
Assuming a hypothetical investment of $1,000 in each Fund, a 5% annual
return, and redemption at the end of each time period, an investor in each
Fund would pay transaction and operating expenses at the end of each period
as follows:
1 Year 3 Years
-------- --------
Japan/Long Fund $15 $47
Japan/Short Fund $17 $52
U.S. Plus Fund $15 $47
U.S./Short Fund $17 $52
OTC Plus Fund $15 $47
OTC/Short Fund $17 $52
Money Market Fund $10 $32
The preceding table of fees and expenses is provided to assist investors
in understanding the various costs and expenses that may be borne directly or
indirectly by an investor in each of the Funds. The assets of the Japan/Short
Fund, the U.S./Short Fund and the OTC/Short Fund may decline in a rising stock
market. During such periods, it is possible that the expense ratio of those
funds may increase. The 5% assumed annual return is for comparison purposes
only. THE FOREGOING EXAMPLES SHOULD NOT BE CONSIDERED A REPRESENTATION OF FUTURE
EXPENSES OR PERFORMANCE. ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN
AND PERFORMANCE MAY BE BETTER OR WORSE THAN THE 5% ANNUAL RETURN ASSUMED IN THE
EXAMPLES. For additional information about the Funds' fees, see "Management and
Administration of the Trust" in this Prospectus and in the SAI.
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INVESTMENT OBJECTIVES AND POLICIES
GENERAL
The Funds are designed principally for experienced investors who intend
to follow an asset allocation investment strategy. The Funds are not designed
for inexperienced or less sophisticated investors. Except for the Money Market
Fund, each Fund is intended to provide investment exposure to a particular
segment of the domestic or international securities markets. These Funds seek
investment results that correspond over time to a specified benchmark. The terms
"long" and "short" in the Funds' names are not intended to refer to the duration
of the Funds' investment portfolios. The Funds may be used independently or in
combination with each other as part of an overall investment strategy.
Additional funds may be offered by the Trust from time to time.
The Adviser uses a number of investment techniques in an effort to
correlate a Fund's return with the return of its respective benchmark. The
Adviser generally does not use fundamental securities analysis to accomplish
such correlation. Rather, the Adviser primarily uses statistical and
quantitative analysis to determine the investments a Fund makes and techniques
it employs. While the Adviser attempts to minimize any "tracking error" (the
statistical measure of the difference between the investment results of a Fund
and the performance of its benchmark), certain factors will tend to cause a
Fund's investment results to vary from a perfect correlation to its benchmark.
The Funds, however, do not expect that their total returns will vary from their
respective current benchmarks by more than 10% over a twelve-month period. See
"Special Risk Considerations - Tracking Error." It is the Funds' policy to
pursue their respective investment objectives regardless of market conditions,
to remain fully invested and not to take defensive positions.
<PAGE>
Each Fund's investment objective and certain investment restrictions are
fundamental policies and may not be changed without the affirmative vote of at
least the majority of the outstanding shares of that Fund, as defined in the
Investment Company Act of 1940, as amended (the "1940 Act"). All other
investment policies of the Funds not specified as fundamental may be changed by
the Board of Trustees of the Trust ("Trustees" or the "Board") without
shareholder approval. There can be no assurance that a Fund will achieve its
objective. For a discussion of the instruments a Fund may use, see "Investment
Techniques and Other Investment Policies."
THE POTOMAC JAPAN/LONG FUND
The investment objective of the Japan/Long Fund is to provide investment
returns that correspond to the performance of the Nikkei Index. In attempting to
achieve its objective, the Fund may enter into long positions in Nikkei Index
futures contracts, options on such futures contracts and options on securities
and on the Nikkei Index traded on domestic and foreign exchanges. Under the
investment techniques that the Fund employs, the Fund generally will incur a
loss if the price of the underlying security or index decreases between the date
of the employment of the technique and the date on which it terminates the
position. The amount of any gain or loss on these transactions may be affected
by any premium or interest income the Fund pays or receives as a result of the
transaction. The Fund may invest in the shares of individual securities that are
included in its benchmark. The Fund will use forward contracts on Japanese Yen,
futures contracts on Japanese Yen, options on such futures contracts and options
on Japanese Yen to attempt to eliminate the effect that fluctuations in the U.S.
Dollar/Japanese Yen exchange rate may have on the Fund's net asset value per
share. The Fund also may invest in U.S. Government securities in order to
deposit such securities as initial or variation margin, as "cover" for the
investment techniques it employs, as part of a cash reserve and for liquidity
purposes.
THE POTOMAC JAPAN/SHORT FUND
The Japan/Short Fund is intended to allow investors to benefit from
anticipated decreases in the Nikkei Index or to hedge an existing portfolio of
Japanese stocks. The Fund's investment objective is to provide investment
results that will inversely correlate to the performance of the Nikkei Index.
If the Fund achieves a perfect inverse correlation for any single
trading day, the Fund's net asset value per share would increase for that day in
direct proportion to any decrease in the level of the Nikkei Index and,
conversely, the Fund's net asset value per share would decrease for that day in
direct proportion to any increase in the level of the Nikkei Index. For example,
if the Nikkei Index were to decrease by 1% by the close of business on a
particular trading day, investors in the Fund should experience a gain in net
asset value of approximately 1% for that day. Conversely, if the Nikkei Index
were to increase by 1% by the close of business on a particular trading day,
investors in the Fund should experience a loss in net asset value of
approximately 1% for that day.
The Fund intends to pursue its investment objective regardless of market
conditions and does not intend to take defensive positions in anticipation of
rising Japanese equity prices. Consequently, investors in the Fund may
experience substantial losses during sustained periods of rising Japanese equity
prices.
<PAGE>
In pursuing its investment objective, the Fund generally does not invest
in traditional equity securities, such as common stock. Rather, the Fund employs
certain investment techniques, including engaging in short sales and entering
into short positions in Nikkei Index futures contracts, options on such futures
contracts, and options on securities and on the Nikkei Index. See "Investment
Techniques and Other Investment Policies." Under these techniques, the Fund
generally will incur a loss if the price of the underlying security or index
increases between the date the Fund initially entered into the transaction and
the date on which the Fund terminates its position. The Fund generally will
realize a gain if the underlying security or index declines in price between
those dates. This result is the opposite of what one would expect from a cash
purchase of a long position in a security. In addition, the Fund will use
forward contracts on Japanese Yen, futures contracts on Japanese Yen, options on
such futures contracts and options on Japanese Yen to attempt to eliminate the
effect that fluctuations in the U.S. Dollar/Japanese Yen exchange rate may have
on the Fund's net asset value per share. The Fund also may invest in U.S.
Government securities in order to deposit such securities as initial or
variation margin, as "cover" for the investment techniques it employs, as part
of a cash reserve and for liquidity purposes.
THE POTOMAC U.S. PLUS FUND
The investment objective of the U.S. Plus Fund is to provide investment
returns that correspond to 150% of the performance of the S&P 500 Index. In
attempting to achieve its objective, the Fund may enter into long positions in
stock index futures contracts, options on stock index futures contracts, and
options on securities and on stock indices. Under these techniques, the Fund
generally will incur a loss if the price of the underlying security or index
decreases between the date the Fund initially entered into the transaction and
the date on which the Fund terminates its position. The Fund also may invest in
shares of individual stocks that are included in its benchmark. The Fund also
may invest in U.S. Government securities in order to deposit such securities as
initial or variation margin, as "cover" for the investment techniques it
employs, as part of a cash reserve and for liquidity purposes.
In contrast to a mutual fund that seeks to approximate the return of the
S&P 500 Index, the Fund may produce greater returns than such a fund during
periods when the prices of the securities in the S&P 500 Index are rising and
lower returns than such a fund during periods when the price of securities are
declining. Investors in the Fund may experience substantial losses during
sustained periods of falling U.S. equity prices.
THE POTOMAC U.S./SHORT FUND
The U.S./Short Fund is intended to allow investors to benefit from
anticipated decreases in the S&P 500 Index or hedge an existing portfolio of
U.S. securities or mutual fund shares. The Fund's investment objective is to
provide investment results that will inversely correlate to the performance of
the S&P 500 Index.
If the Fund achieves a perfect inverse correlation for any single
trading day, the net asset value of the Fund would increase for that day in
direct proportion to any decrease in the level of the S&P 500 Index and,
conversely, the net asset value of the Fund would decrease for that day in
direct proportion to any increase in the level of the S&P 500 Index. For
example, if the S&P 500 Index were to decrease by 1% by the close of business on
a particular trading day, investors in the Fund should experience a gain in net
asset value of approximately 1% for that day. Conversely, if the S&P 500 Index
were to increase by 1% by the close of business on a particular trading day,
investors in the Fund should experience a loss in net asset value of
approximately 1% for that day.
<PAGE>
The Fund intends to pursue its investment objective regardless of market
conditions and does not intend to take defensive positions in anticipation of
rising U.S. equity prices. Consequently, investors in the Fund may experience
substantial losses during sustained periods of rising U.S. equity prices.
In pursuing its investment objective, the Fund generally does not invest
in traditional equity securities, such as common stock. Rather, the Fund employs
certain investment techniques, including engaging in short sales and entering
into short positions in stock index futures contracts, options on stock index
futures contracts, and options on securities and on indices. See "Investment
Techniques and Other Investment Policies." Under these techniques, the Fund
generally will incur a loss if the price of the underlying security or index
increases between the date the Fund initially entered into the transaction and
the date on which the Fund terminates its position. The Fund generally will
realize a gain if the underlying security or index declines in price between
those dates. This result is the opposite of what one would expect from a cash
purchase of a long position in a security. The Fund also may invest in U.S.
Government securities in order to deposit such securities as initial or
variation margin, as "cover" for the investment techniques it employs, as part
of a cash reserve and for liquidity purposes.
THE POTOMAC OTC PLUS FUND
The investment objective of the OTC Plus Fund is to provide investment
results that correspond to 125% of the performance of the Nasdaq Index. The Fund
may not necessarily hold all 100 stocks included in the Nasdaq Index. Instead,
the Fund may hold representative stocks included in that index or other
securities that the Adviser believes will provide returns that correspond to
those of the Nasdaq Index. The Fund may enter into long positions in stock index
futures contracts, options on stock index futures, and options on securities and
on stock indices. Under these techniques, the Fund generally will incur a loss
if the price of the underlying security or index decreases between the date the
Fund initially entered into the transaction and the date on which the Fund
terminates its position. The Fund also may invest in U.S. Government securities
in order to deposit such securities as initial or variation margin, as "cover"
for the investment techniques it employs, as part of a cash reserve and for
liquidity purposes.
Companies whose securities are traded on the over-the-counter ("OTC")
markets, which include the Nasdaq Stock Market ("Nasdaq"), generally are newer
companies or have smaller market-capitalization than those listed on the New
York Stock Exchange ("NYSE") or the American Stock Exchange ("AMEX"). OTC
companies often have limited product lines or relatively new products or
services, and may lack established markets, experienced management, financial
resources or the ability to raise capital. In addition, the securities of these
companies may have limited marketability and may be more volatile in price than
securities of larger capitalized and widely recognized companies. Among the
reasons for the greater price volatility of securities of certain small OTC
companies are less certain growth prospects of comparably smaller firms, the
lower degree of liquidity in the OTC markets for such securities and the greater
sensitivity of smaller capitalized companies to changing economic conditions
than larger capitalized, exchange-traded stocks. Conversely, the Adviser
believes that, because many of these OTC securities may be overlooked by
investors and undervalued in the marketplace, there is potential for significant
capital appreciation.
<PAGE>
In contrast to a mutual fund that seeks to approximate the return of the
Nasdaq Index, the Fund may produce greater returns than such a fund during
periods when the prices of the securities in the Nasdaq Index are rising and
lower returns than such a fund during periods when the prices of securities are
declining. Investors in the Fund may experience substantial losses during
sustained periods of falling U.S. equity prices.
THE POTOMAC OTC/SHORT FUND
The OTC/Short Fund is intended to allow investors to benefit from
anticipated decreases in the Nasdaq Index or hedge an existing portfolio of U.S.
securities or mutual fund shares. The Fund's investment objective is to provide
investment results that will inversely correlate to the performance of the
Nasdaq Index.
If the Fund achieves a perfect inverse correlation for any single
trading day, the net asset value of the Fund would increase for that day in
direct proportion to any decrease in the level of the Nasdaq Index and,
conversely, the net asset value of the shares of the Fund would decrease for
that day in direct proportion to any increase in the level of the Nasdaq Index.
For example, if the Nasdaq Index were to decrease by 1% by the close of business
on a particular trading day, investors in the Fund should experience a gain in
net asset value of approximately 1% for that day. Conversely, if the Nasdaq
Index were to increase by 1% by the close of business on a particular trading
day, investors in the Fund should experience a loss in net asset value of
approximately 1% for that day.
The Fund intends to pursue its investment objective regardless of market
conditions and does not intend to take defensive positions in anticipation of
rising U.S. equity prices. Consequently, investors in the Fund may experience
substantial losses during sustained periods of rising equity prices.
In pursuing its investment objective, the Fund generally does not invest
in traditional equity securities, such as common stock. Rather, the Fund employs
certain investment techniques, including engaging in short sales and entering
into short positions in stock index futures contracts, options on stock index
futures contracts, and options on securities and on indices. See "Investment
Techniques and Other Investment Policies." Under these transactions, the Fund
generally will incur a loss if the price of the underlying security or index
increases between the date the Fund initially entered into the transaction and
the date on which the Fund terminates its position. The Fund generally will
realize a gain if the underlying security or index declines in price between
those dates. This result is the opposite of what one would expect from a cash
purchase of a long position in a security. The Fund also may invest in U.S.
Government securities in order to deposit such securities as initial or
variation margin, as "cover" for the investment techniques it employs, as part
of a cash reserve and for liquidity purposes.
THE POTOMAC U.S. GOVERNMENT MONEY MARKET FUND
The investment objectives of the Money Market Fund are to provide
security of principal, current income, and liquidity. The Fund seeks to achieve
these objectives by investing in high quality, U.S. dollar-denominated
short-term obligations that have been determined by the Trustees or by the
Adviser, subject to supervision by the Trustees, to present minimal credit risk.
The Fund will invest exclusively in obligations issued or guaranteed by the U.S.
Government, its agencies or instrumentalities ("U.S. Government Securities") and
repurchase agreements that are fully collateralized by such obligations.
<PAGE>
THE BENCHMARKS
THE NIKKEI 225 STOCK AVERAGE. The Nikkei Index is a price-weighted index
of 225 top-rated Japanese companies listed in the First Section of the Tokyo
Stock Exchange. The Nikkei Index was first published in 1949.
STANDARD & POOR'S 500 COMPOSITE STOCK PRICE INDEX.TM Standard & Poor's,
a division of The McGraw-Hill Companies, Inc. ("Standard & Poor's"), selects the
500 stocks comprising the S&P 500 Index on the basis of market values and
industry diversification. Most of the stocks in the S&P 500 Index are issued by
the 500 largest companies, in terms of the aggregate market value of their
outstanding stock, and generally are listed on the NYSE. Standard & Poor's is
not a sponsor of, or in any way affiliated with, the Funds.
NASDAQ 100 INDEX.(TM) The Nasdaq Index is a capitalization-weighted
index composed of 100 of the largest non-financial domestic companies
listed on the Nasdaq National Market tier of the Nasdaq. All listed on the index
have a minimum market capitalization of $500 million and an average daily
trading volume of at least 100,000 shares. The Nasdaq Index was created in 1985.
================================================================================
SPECIAL RISK CONSIDERATIONS
Investors should consider the following special notes in determining the
appropriateness of investing in the Funds.
AGGRESSIVE INVESTMENT TECHNIQUES. Each Fund (other than the Money Market
Fund) may engage in certain aggressive investment techniques that may include
engaging in short sales and transactions in futures contracts and options on
securities, securities indices, and futures contracts. The Japan/Long Fund, the
Japan/Short Fund, the U.S. Plus Fund, the U.S./Short Fund and the OTC/Short Fund
will use these techniques primarily in seeking to achieve their investment
objectives. The OTC Plus Fund also will use these techniques in seeking to
achieve its investment objective. In doing so, a significant portion of these
Funds' assets will be held in an account consisting of cash or liquid assets as
"cover" for these investment techniques.
The use of options, futures contracts, options on futures contracts,
forward contracts, swaps, caps, floors and collars, and the investment in
indexed securities, involves special risks, including (1) imperfect or no
correlation between the price of options and futures contracts and the movements
in the price of the underlying securities, indices, or futures contracts, (2)
possible lack of a liquid secondary market for any particular instrument at a
particular time, (3) the fact that the skills needed to use these strategies are
different from those needed to select portfolio securities, (4) losses due to
unanticipated market price movements, (5) incorrect forecasts by the Adviser
concerning interest or currency exchange rates or direction of price
fluctuations of the investment involved in the transaction, which may result in
the strategy being ineffective, (6) loss of premiums paid by a Fund on options
it purchases, and (7) the possible inability of a Fund to purchase or sell a
portfolio security at a time when it would otherwise be favorable for it to do
so, or the possible need for a Fund to sell a portfolio security at a
disadvantageous time, due to the need for the Fund to maintain "cover" or to
segregate assets in connection with such transactions and the possible inability
of a Fund to close out or liquidate its position.
<PAGE>
These instruments may increase the volatility of a Fund and may involve
a small investment of cash relative to the magnitude of the risk assumed. In
addition, these instruments could result in a loss if the counterparty to the
transaction does not perform as promised or if there is not a liquid secondary
market to close out a position that a Fund has entered into.
The ordinary spreads between prices in the cash and futures markets, due
to the differences in the natures of those markets, are subject to distortion.
Due to the possibility of distortion, a correct forecast of general interest
rates, currency exchange rates or stock market trends by the Adviser may still
not result in a successful transaction. The Adviser may be incorrect in its
expectations as to the extent of various interest or currency exchange rates or
stock market movements or the time span within which the movements take place.
Options and futures transactions may increase portfolio turnover rates,
which results in correspondingly greater commission expenses and transaction
costs and may result in certain tax consequences.
New financial products and risk management techniques continue to be
developed. Each Fund may use these instruments and techniques to the extent
consistent with its investment objective and regulatory requirements applicable
to investment companies. For further information regarding these techniques, see
"Investment Techniques and Other Investment Policies" below.
PORTFOLIO TURNOVER. The Trust anticipates that investors in the Funds
frequently will redeem Fund shares, as well as exchange their Fund shares for
shares of another Fund. A Fund may have to dispose of certain investments in
order to maintain sufficient liquid assets to meet such redemption and exchange
requests, thereby causing a high portfolio turnover rate. Because each Fund's
portfolio turnover rate will depend largely on the purchase, redemption, and
exchange activity of its investors, it is difficult to estimate what each Fund's
actual turnover rate will be. Based on the formula prescribed by the SEC, the
portfolio turnover rate of each Fund is calculated without regard to securities,
including options and futures contracts, having a maturity of less than one
year. The Japan/Long Fund, the Japan/Short Fund, the U.S. Plus Fund, the
U.S./Short Fund, and the OTC/Short Fund typically will hold most of their
investments in options and futures contracts, which are excluded from the
portfolio turnover rate calculations. If, however, options and futures contracts
were included in such calculation, it is expected that the portfolio turnover
rate of each Fund would be approximately 500%. The OTC Plus Fund, which will
invest primarily in common stocks, is expected to have a similar rate.
A higher portfolio turnover ratio would likely involve correspondingly
higher brokerage commissions and other expenses borne by a Fund. Such higher
expenses can adversely affect the ability of a Fund to achieve its investment
objective.
FOREIGN SECURITIES. Investing in foreign companies may involve risks not
typically associated with investing in U.S. companies. The value of securities
denominated in foreign currencies, and of dividends from such securities, can
change significantly when foreign currencies strengthen or weaken relative to
the U.S. Dollar. Foreign securities markets generally have less trading volume
and less liquidity than U.S. markets, and prices in some foreign markets can be
extremely volatile. Many foreign countries lack uniform accounting and
disclosure standards comparable to those that apply to U.S. companies, and it
may be more difficult to obtain reliable information regarding a foreign
issuer's financial condition and operations. In addition, the costs of foreign
investing, including withholding taxes, brokerage commissions and custodial
fees, generally are higher than for U.S. investments.
<PAGE>
BORROWING. The U.S. Plus Fund and the OTC Plus Fund may borrow money
from banks for investment purposes, which is a form of leveraging. This leverage
may exaggerate the gains and losses on a Fund's investments and on changes in a
Fund's net asset value. Leverage also creates interest expenses -- if those
expenses exceed the return on the transactions that the borrowings facilitate,
the Fund will be in a worse position than if it had not borrowed. The use of the
derivatives in connection with leverage may create the potential for significant
losses.
TRACKING ERROR. While the Funds do not expect that their returns over a
twelve-month period will deviate adversely from their respective benchmarks by
more than 10%, several factors may affect the Funds' ability to achieve this
correlation. Among these factors are: (1) Fund expenses, including brokerage
expenses and commissions (which may be increased by high portfolio turnover);
(2) less than all of the securities in the benchmark being held by a Fund and
securities not included in the benchmark being held by a Fund; (3) an imperfect
correlation between the performance of instruments held by a Fund, such as
futures contracts and options, and the performance of the underlying securities
in the cash market comprising an index; (4) bid-ask spreads (the effect of which
may be increased by portfolio turnover); (5) a Fund holding instruments that are
illiquid or the market for which becomes disrupted; (6) the need to conform a
Fund's portfolio holdings to comply with that Fund's investment restrictions or
policies, or regulatory or tax law requirements and (7) market movements that
run counter to a leveraged Fund's investments (which will cause divergence
between the Fund and its benchmark over time due to the mathematical effects of
leveraging).
Investors should be aware that while index futures and options contracts
closely correlate with the applicable indices over long periods, shorter-term
deviation, such as on a daily basis, does occur with these instruments. As a
result, a Fund's short-term performance will reflect such deviation from its
benchmark.
In the case of the Funds whose net asset values move inversely from
their benchmarks -- the Japan/Short Fund, the U.S./Short Fund and the OTC/Short
Fund -- the factor of compounding also may lead to tracking error. Even if there
is a perfect inverse correlation between a Fund and the return of its applicable
benchmark on a daily basis, the symmetry between the changes in the benchmark
and the changes in the Fund's net asset value can be altered significantly over
time by a compounding effect. For example, if the Japan/Short Fund achieved a
perfect inverse correlation with the Nikkei Index on every trading day over an
extended period and the level of returns of the Nikkei Index significantly
decreased during that period, a compounding effect for that period would result,
causing an increase on the Japan/Short Fund's net asset value by a percentage
that is somewhat greater than the percentage the Nikkei Index returns decreased.
Conversely, if the Japan/Short Fund maintained a perfect inverse correlation
with the Nikkei Index over an extended period and if the level of returns of the
Nikkei Index significantly increased over that period, a compounding effect
would result, causing a decrease of the Japan/Short Fund's net asset value by a
percentage that would be somewhat less than the percentage the Nikkei Index
returns increased.
<PAGE>
TRADING HALTS. All of the Funds, with the exception of the OTC Plus Fund
and the Money Market Fund, typically will hold most of their investments in
short-term options and futures contracts. The major exchanges on which these
contracts are traded, such as the Chicago Mercantile Exchange ("CME"), the
Chicago Board of Options Exchange ("CBOE"), the Singapore International Monetary
Exchange ("SIMEX") and the Osaka Securities Exchange, have established limits on
how much an option or futures contract may decline over various time periods
within a day. If an option or futures contract's price declines more than the
established limits, trading is halted on that instrument. If such trading halts
are instituted by an options or futures exchange at the close of a trading day,
a Fund will not be able to execute purchase or sales transactions in the
specific options or futures contracts affected. In such an event, a Fund also
would be unable to accurately price its outstanding contracts. A trading halt at
the end of a business day would constitute an emergency situation under SEC
regulations. A Fund affected by such an emergency would not be able to accept
investors' orders for purchases, redemptions, or exchanges received earlier
during the business day.
EARLY NASDAQ CLOSINGS. The normal close of trading of securities listed
on the Nasdaq is 4:00 p.m. While an infrequent occurrence, trading on the Nasdaq
has closed as much as 15 minutes prior to the normal close because of computer
systems failures. Early closing of the Nasdaq may result in a Fund, particularly
the OTC Plus Fund and the OTC/Short Fund, being unable to execute buy or sell
orders on the Nasdaq that day. If that occurs and a Fund needs to execute a high
volume of trades late in a trading day, a Fund may incur substantial trading
losses.
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INVESTMENT TECHNIQUES AND OTHER
INVESTMENT POLICIES
FUTURES CONTRACTS AND OPTIONS ON
FUTURES CONTRACTS
Each Fund, other than the Money Market Fund, may purchase and sell stock
index futures contracts and options on such futures contracts. The Japan/Long
Fund and the Japan/Short Fund may also purchase and sell futures contracts on
Japanese Yen and options on such futures contracts. Each Fund, other than the
Money Market Fund, may purchase and sell futures and options thereon as a
substitute for a comparable market position in the underlying securities or
currency, to attempt to hedge or limit the exposure of its position, to create a
synthetic money market position, for certain tax-related purposes and to effect
closing transactions.
A futures contract obligates the seller to deliver (and the purchaser to
take delivery of) the specified security or currency on the expiration date of
the contract. An index futures contract obligates the seller to deliver (and the
purchaser to take) an amount of cash equal to a specific dollar amount times the
difference between the value of a specific index at the close of the last
trading day of the contract and the price at which the agreement is made. No
physical delivery of the underlying securities in the index is made.
When a Fund writes an option on a futures contract, it becomes
obligated, in return for the premium paid, to assume a position in the futures
contract at a specified exercise price at any time during the term of the
option. If a Fund writes a call, it assumes a short futures position. If it
writes a put, it assumes a long futures position. When the Fund purchases an
option on a futures contract, it acquires the right in return for the premium it
pays to assume a position in a futures contract (a long position if the option
is a call and a short position if the option is a put).
<PAGE>
Whether a Fund realizes a gain or loss from futures activities depends
upon movements in the underlying security, currency or index. The extent of the
Fund's loss from an unhedged short position in futures contracts or from writing
unhedged call options on futures contracts is potentially unlimited. The Funds
will only purchase and sell futures contracts and options on futures contracts
that are traded on a U.S. exchange or board of trade or, in the case of the
Japan/Long and Japan/Short Funds, also on the Osaka Securities Exchange or
SIMEX.
To the extent that a Fund enters into futures contracts, options on
futures contracts or options on foreign currencies traded on an exchange
regulated by the Commodity Futures Trading Commission ("CFTC"), in each case
other than for bona fide hedging purposes (as defined by the CFTC), the
aggregate initial margin and the premiums required to establish those positions
(excluding the amount by which options are "in-the-money" at the time of
purchase) will not exceed 5% of the liquidation value of the Fund's portfolio,
after taking into account unrealized profits and unrealized losses on any
contracts the Fund has entered into. (In general, a call option on a futures
contract is "in-the-money" if the value of the underlying futures contract
exceeds the strike, i.e., exercise, price of the call. A put option on a futures
contract is "in-the-money" if the value of the underlying futures contract is
exceeded by the strike price of the put.) This policy does not limit to 5% the
percentage of a Fund's assets that are at risk in futures contracts, options on
futures contracts and currency options.
OPTIONS ON INDICES, SECURITIES AND CURRENCIES
Each Fund, other than the Money Market Fund, may purchase and sell put
and call options on stock indices and on individual securities. The Japan/Long
Fund and the Japan/Short Fund may also purchase and sell put and call options on
Japanese Yen. Each Fund, other than the Money Market Fund, may purchase and sell
put and call options as a substitute for a comparable market position in the
underlying securities or currency, to attempt to hedge or limit the exposure of
its position, to create a synthetic money market position, for certain
tax-related purposes and to effect closing transactions.
An index fluctuates with changes in the market values of the securities
included in the index. Options on indices give the holder the right to receive
an amount of cash upon exercise of the option. Receipt of this cash amount will
depend upon the closing level of the index upon which the option is based being
greater than (in the case of a call) or less than (in the case of a put) the
exercise price of the option. The amount of cash received, if any, will be the
difference between the closing price of the index and the exercise price of the
option, multiplied by a specified dollar multiple. The writer (seller) of the
option is obligated, in return, for the premium received from the purchaser of
the option, to make delivery of this amount to the purchaser. Unlike the option
on securities discussed below, all settlements of index options transactions are
in cash.
Some stock index options are based on a broad market index such as the
S&P 500 Index, the NYSE Composite Index or the AMEX Major Market Index, or on a
narrower index such the Philadelphia Stock Exchange Over-the-Counter Index.
Options currently are traded on the CBOE, the AMEX and other exchanges. Options
also are traded in the OTC markets and each Fund may buy and sell both
exchange-traded and OTC options.
<PAGE>
Each of the exchanges has established limitations governing the maximum
number of call or put options on the same index that may be bought or written by
a single investor, whether acting alone or in concert with others (regardless of
whether such options are written on the same or different exchanges or are held
or written on one or more accounts or through one or more brokers). Under these
limitations, option positions of all investment companies advised by the same
investment adviser are combined for purposes of these limits. Pursuant to these
limitations, an exchange may order the liquidation of positions and may impose
other sanctions or restrictions. These positions limits may restrict the number
of listed options that a Fund may buy or sell.
By buying a call option on a security or currency, a Fund has the right,
in return for the premium paid, to buy the security or currency underlying the
option at the exercise price. By writing (selling) a call option and receiving a
premium, a Fund becomes obligated during the term of the option to deliver
securities or currency underlying the option at the exercise price if the option
is exercised. By buying a put option, a Fund has the right, in return for the
premium, to sell the security or currency underlying the option at the exercise
price. By writing a put option, a Fund becomes obligated during the term of the
option to purchase the securities or currency underlying the option at the
exercise price.
Because options premiums paid or received by a Fund are small in
relation to the market value of the investments underlying the options, buying
and selling put and call options can be more speculative than investing directly
in securities.
FORWARD CONTRACTS AND FOREIGN CURRENCY
Both the Japan/Long Fund and the Japan/Short Fund may enter into forward
currency contracts for the purchase or sale of Japanese Yen at a specified
future date to attempt to eliminate the effect that fluctuations in the U.S.
Dollar/Japanese Yen exchange rate may have on the Fund's net asset value per
share. Forward currency contracts are traded directly between currency traders
(usually large commercial banks) and their customers.
These Funds also may purchase and sell foreign currency and invest in
foreign currency deposits. Currency conversion involves dealer spreads and other
costs, although commissions usually are not charged.
INDEXED SECURITIES
Each Fund (other than the Money Market Fund) may purchase indexed
securities, which are securities the value of which varies positively or
negatively in relation to the value of other securities, securities indices,
currencies or other financial indicators, consistent with its investment
objective. Indexed securities typically, but not always, are debt securities or
deposits whose value at maturity or coupon rate is determined by reference to a
specific instrument or statistic. The performance of indexed securities depends
to a great extent on the performance of the security, currency or other
instrument to which they are indexed and also may be influenced by interest rate
changes in the United States and abroad. At the same time, indexed securities
are subject to the credit risks associated with the issuer of the security, and
their values may decline substantially if the issuer's creditworthiness
deteriorates. Indexed securities may be more volatile than the underlying
instruments.
SWAPS, CAPS, FLOORS AND COLLARS
A Fund (other than the Money Market Fund) may enter into equity swaps,
caps, floors and collars. For example, the Japan/Long Fund, the U.S. Plus Fund
and the OTC Plus Fund may enter into equity swaps where the Fund receives a
return based on the increase in value of a specified index, and pays the
counterparty an amount based on a floating rate of interest, on the notional
amount of the swap. The Japan/Short Fund, the U.S./Short Fund and the OTC/Short
Fund may enter into reverse equity swaps where the Fund receives a floating rate
of interest, and pays an amount equal to the increase in value of a specified
index, on the notional amount of the swap. The Japan/Long Fund and the
Japan/Short Fund also may use swaps, caps, floors and collars where a payment
stream is payable in Japanese Yen or is based on the U.S. Dollar/Japanese Yen
exchange rate. Each Fund (other than the Money Market Fund) may use equity
swaps, caps, floors and collars consistent with its investment objective and
also may enter into offsetting positions.
<PAGE>
Swaps involve the exchange by a Fund with another party of their
respective commitments to pay or receive cash flows, e.g., an exchange of
payments based on the increase in value of an equity index for floating interest
rate payments. The purchase of a cap entitles the purchaser, to the extent that
a specified index exceeds a predetermined value, to receive payments on a
notional principal amount from the party selling such cap. The purchase of a
floor entitles the purchaser, to the extent that a specified index falls below a
predetermined value, to receive payments on a notional principal amount from the
party selling such floor. A collar combines elements of buying a cap and selling
a floor.
A Fund usually will enter into swaps on a net basis, i.e., the two
payment streams are netted out, with the Fund receiving or paying, as the case
may be, only the net amount of the two payments. If, however, an agreement calls
for payments by a Fund, the Fund must be prepared to make such payments when
due. The creditworthiness of firms with which a Fund enters into swaps, caps,
floors or collars will be monitored by the Adviser in accordance with procedures
adopted by the Trustees. If a firm's creditworthiness declines, the value of an
agreement would be likely to decline, potentially resulting in losses. If a
default occurs by the other party to such transaction, a Fund will have
contractual remedies pursuant to the agreements related to the transaction.
SHORT SALES
The Japan/Short Fund, the U.S./Short Fund and the OTC/Short Fund may
engage in short sales transactions under which the Fund sells a security it does
not own. To complete such a transaction, the Fund must borrow the security to
make delivery to the buyer. The Fund then is obligated to replace the security
borrowed by purchasing the security at the market price at the time of
replacement. The price at such time may be more or less than the price at which
the security was sold by the Fund. Until the security is replaced, the Fund is
required to pay to the lender amounts equal to any dividends that accrue during
the period of the loan. The proceeds of the short sale will be retained by the
broker, to the extent necessary to meet the margin requirements, until the short
position is closed out.
Until a Fund closes its short position or replaces the borrowed stock,
the Fund will: (1) maintain an account containing cash or liquid assets at such
a level that (a) the amount deposited in the account plus that amount deposited
with the broker as collateral will equal the current value of the stock sold
short and (b) the amount deposited in the account plus the amount deposited with
the broker as collateral will not be less than the market value of the stock at
the time the stock was sold short; or (2) otherwise cover the Fund's short
position.
<PAGE>
The Japan/Long Fund, the U.S. Plus Fund and the OTC Plus Fund each may
engage in short sales if, at the time of the short sale, the Fund owns or has
the right to acquire an equal amount of the stock being sold at no additional
cost ("selling short against the box").
FOREIGN SECURITIES
The Japan/Long Fund and the Japan/Short Fund may invest in issuers
located outside the United States. These investments may be made by purchasing
American Depository Receipts ("ADRs"), "ordinary shares" or "New York" shares in
the United States. The Japan/Short Fund also may sell these securities short.
ADRs are dollar denominated receipts representing interests in the
securities of a foreign issuer, which securities may not necessarily be
denominated in the same currency as the securities into which they may be
converted. ADRs are receipts typically issued by United States banks and trust
companies that evidence ownership of underlying securities issued by a foreign
corporation. Generally, ADRs in registered form are designed for use in domestic
securities markets and are traded on exchanges or OTC in the United States.
Ordinary shares are shares of foreign issuers that are traded abroad and on a
U.S. exchange. New York shares are shares that a foreign issuer has allocated
for trading in the United States. ADRs, ordinary shares and New York shares all
may be purchased with and sold for U.S. Dollars.
Investing in companies located abroad carries political and economic
risks distinct from those associated with investing in the United States.
Foreign investments may be affected by actions of foreign governments adverse to
the interests of U.S. investors, including the possibility of expropriation or
nationalization of assets, confiscatory taxation, restrictions on U.S.
investment, or on the ability to repatriate assets or to convert currency into
U.S. dollars. There may be a greater possibility of default by foreign
governments or foreign-government sponsored enterprises. Investments in foreign
countries also involve a risk of local political, economic, or social
instability, military action or unrest, or adverse diplomatic developments.
U.S. GOVERNMENT SECURITIES
The Money Market Fund will invest in U.S. Government Securities in
pursuit of its investment objectives. The other Funds may invest in U.S.
Government Securities in order to deposit such securities as initial or
variation margin, as "cover" for the investment techniques they employ, as part
of a cash reserve and for liquidity purposes. U.S. Government Securities include
direct obligations of the U.S. Treasury (such as Treasury bills, Treasury notes
and Treasury bonds).
U.S. Government Securities are high-quality instruments issued or
guaranteed as to principal or interest by the U.S. Treasury or by an agency or
instrumentality of the U.S. Government. Not all U.S. Government Securities are
backed by the full faith and credit of the United States. Some are backed by the
right of the issuer to borrow from the U.S. Treasury; others are backed by
discretionary authority of the U.S. Government to purchase the agencies'
obligations; while others are supported only by the credit of the
instrumentality. In the case of securities not backed by the full faith and
credit of the United States, the investor must look principally to the agency
issuing or guaranteeing the obligation for ultimate repayment.
Yields on short-, intermediate- and long-term U.S. Government Securities
are dependent on a variety of factors, including the general conditions of the
money and bond markets, the size of a particular offering and the maturity of
the obligation. Debt securities with longer maturities tend to produce higher
capital appreciation and depreciation than obligations with shorter maturities
and lower yields. The market value of U.S. Government Securities generally
varies inversely with changes in the market interest rates. An increase in
interest rates, therefore, generally would reduce the market value of a Fund's
portfolio investments in U.S. Government Securities; while a decline in interest
rates generally would increase the market value of a Fund's portfolio
investments in these securities.
<PAGE>
REPURCHASE AGREEMENTS
Under a repurchase agreement, a Fund purchases a U.S. Government
Security and simultaneously agrees to sell the security back to the seller at a
mutually agreed-upon future price and date, normally one day or a few days
later. The resale price is greater than the purchase price, reflecting an
agreed-upon market interest rate during the Fund's holding period. While the
maturities of the underlying securities in repurchase agreement transactions may
be more than one year, the term of each repurchase agreement always will be less
than one year. Each Fund may enter into repurchase agreements with banks that
are members of the Federal Reserve System or securities dealers who are members
of a national securities exchange or are primary dealers in U.S. Government
Securities. The Adviser will monitor the creditworthiness of each firm that is a
party to a repurchase agreement with any Fund. In the event of default or
bankruptcy by the seller, the Fund will liquidate those securities (whose market
value, including accrued interest, must be at least 100% of the amount invested
by the Fund) held under the applicable repurchase agreement, which securities
constitute collateral for the seller's obligation to repurchase the security.
ILLIQUID INVESTMENTS
Each Fund may purchase and hold illiquid investments, including
securities that are not readily marketable and securities that are not
registered ("restricted securities") under the Securities Act of 1933, as
amended ("1933 Act"), but which can be offered and sold to "qualified
institutional buyers" pursuant to Rule 144A under the 1933 Act. A Fund will not
invest more than 15% (10% with respect to the Money Market Fund) of its net
assets in illiquid investments. The term "illiquid investments" for this purpose
means investments that cannot be disposed of within seven days in the ordinary
course of business at approximately the amount at which a Fund has valued the
investments. Under the current SEC staff guidelines, illiquid investments also
include purchased OTC options, certain cover for OTC options, securities
involved in swap, cap, floor and collar transactions, repurchase agreements not
terminable in seven days and restricted securities not determined to be liquid
pursuant to guidelines established by the Trustees.
OTHER INVESTMENT PRACTICES
The U.S. Plus Fund and the OTC Plus Fund may borrow for investment
purposes. Each Fund may borrow money as a temporary measure for extraordinary or
emergency purposes and to meet redemption requests without immediately selling
portfolio securities. In addition, each Fund may lend securities to
broker-dealers and financial institutions, provided that the borrower at all
times maintains collateral in an amount equal to at least 100% of the market
value of the securities loaned. Such loans will not be made if, as a result, the
aggregate amount of all outstanding loans by any Fund would exceed 33 1/3% (10%
in the case of the Money Market Fund) of its total assets. For a more detailed
discussion of these practices, see the SAI.
<PAGE>
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PORTFOLIO TRANSACTIONS AND BROKERAGE
The Adviser will place orders to execute securities transactions that
are designed to implement each Fund's investment objective and policies. In
placing such orders, the Adviser will seek the most favorable price and
efficient execution available. In order to obtain brokerage and research
services, however, a higher commission sometimes may be paid. Brokerage
commissions normally are paid on exchange-traded securities transactions and on
options and futures transactions.
When selecting a broker or dealer to execute portfolio transactions, the
Adviser considers many factors, including the rate of commission or the size of
the broker-dealer's "spread," the size and difficulty of the order, the nature
of the market for the security, operational capabilities of the broker-dealer
and the research, statistical and economic data furnished by the broker-dealer
to the Adviser. The Adviser may select one broker-dealer over another based on
whether the broker-dealer provides research services to the Adviser.
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HOW TO INVEST IN THE FUNDS
GENERAL
The minimum initial investment is $10,000, which can be allocated in any
amounts among the Funds. The shares of each Fund are offered at the daily public
offering price, which is the net asset value per share next computed after
receipt of the investor's order. See "Determination of Net Asset Value." No
sales charges are imposed on initial or subsequent investments in a Fund. The
Trust reserves the right to reject or refuse, at the Trust's discretion, any
order for the purchase of a Fund's shares in part or whole.
The minimum amount for subsequent investments in a Fund is $1,000.
Investments in the Funds may be made
(1) through securities dealers who have the responsibility to transmit orders
promptly and who may charge a processing fee or (2) directly with the Trust
either by mail or bank wire transfer to the Trust's transfer agent, Firstar
Trust Company ("Transfer Agent") as described below.
BY MAIL
You may purchase shares of a Fund directly by completing and signing the
Account Application included with the Prospectus and making out a check payable
to "Potomac Funds." Your investment will be allocated among the Funds as you
specify on the Account Application. Mail the check, along with the completed
Account Application, to Potomac Funds, c/o Firstar Trust Company, P.O. Box 1993,
Milwaukee, Wisconsin 53201-1993.
Completed Account Applications and checks also may be sent by overnight
or express mail. To ensure proper delivery, please use the following address:
Potomac Funds, c/o Firstar Trust Company, Mutual Fund Services, 3rd Floor, 615
East Michigan Street, Milwaukee, Wisconsin 53202.
Third-party checks will not be accepted by the Funds. All purchases
must be in U.S. Dollars. A $20.00 fee will be imposed by the Transfer Agent if
any check used for investment in an account does not clear due to
insufficient funds.
<PAGE>
BY BANK WIRE TRANSFER
To establish a new account by wire transfer, please call the Transfer
Agent at (800) 851-0511 to obtain a Potomac Funds account number. You must send
a completed Account Application to
the Trust at the above address immediately following the investment. Payment for
Fund shares should be wired through the Federal Reserve System as follows:
Firstar Bank Milwaukee, N.A.
777 East Wisconsin Avenue
Milwaukee, Wisconsin 53202
ABA number 0750-00022
For credit to Firstar Trust Company
Account Number 112-952-137
For further credit to the Potomac Funds
Shareholder name: ___________________
Shareholder account number: ___________
Your bank may charge a fee for such services. If the purchase is
canceled because your wire transfer is not received, you may be liable
for any loss the Trust may incur. Physical certificates representing a
Fund's shares are not issued. Shares of each Fund are recorded on a
register by the Transfer Agent.
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TAX-SHELTERED RETIREMENT PLANS
The Trust offers individual retirement accounts ("IRAs") that may be
funded with purchases of Fund shares and may allow investors to shelter or defer
some of their income from taxes. A description of applicable service fees and
certain limitations on contributions and withdrawals, as well as Application
Forms, are available from the Trust upon request.
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REDEEMING SHARES (WITHDRAWALS)
GENERAL
You may withdraw all or any part of your investment by redeeming Fund
shares at the next determined net asset value per share after receipt of the
order. The amount received will depend on the market value of the investments in
a Fund's portfolio at the time of determination of net asset value. Shares of
the Funds may be redeemed by written request or by telephone to the Transfer
Agent subject to the procedures described below. When you redeem shares over the
telephone, those redemption proceeds will be sent only to your address of record
or to a bank account specified in your Account Application. In addition,
redemption proceeds may be sent by wire transfer to a bank account specified in
your Account Application. The minimum amount of a wire transfer redemption is
$5,000. You will be charged $12.00 for wire redemptions to cover transaction
costs.
If you request payment of redemption proceeds to a third party or to a
location other than your address of record or a bank account specified in the
Account Application, your request must be in writing and your signature
guaranteed. In addition, if you request in writing redemption of $100,000 or
more, your signature must be guaranteed. A signature guarantee will be accepted
from a commercial bank, savings association, securities broker or dealer, or
credit union. A notary public cannot provide a signature guarantee.
Payment of redemption proceeds will be made within seven days following
a Fund's receipt of your request for redemption. For investments that have been
made by check, payment on redemption requests may be delayed until the Transfer
Agent is reasonably satisfied that the purchase payment has been collected by
the Trust (which may require up to 10 business days). To avoid redemption
delays, purchases may be made by cashiers or certified check or by direct wire
transfers.
<PAGE>
With respect to the U.S. Plus Fund, the U.S./Short Fund, the OTC Plus
Fund, the OTC/Short Fund and the Money Market Fund, the right of redemption may
be suspended or the date of payment postponed for any period during which the
NYSE, the Nasdaq, the CME, or the CBOE, or the Federal Reserve Bank of New York,
as appropriate, is closed (other than customary weekend or holiday closings) or
trading on the NYSE, the Nasdaq, the CME, or the CBOE, as appropriate, is
restricted. With respect to the Japan/Long Fund and the Japan/Short Fund, the
right of redemption may be suspended or the date of payment postponed for any
period during which the SIMEX or the Osaka Securities Exchange is closed (other
than customary weekend or holiday closings) or trading on that exchange is
restricted. In addition, the rights of redemption may be suspended or the date
of payment postponed for any Fund for a period during which an emergency exists
so that disposal of the Fund's investments or the determination of its net asset
value is not reasonably practicable or for such periods as the SEC, by order,
may permit for protection of a Fund's investors.
DRAFT CHECKS
Checkwriting privileges are available to investors in the Money Market
Fund. With a Money Market Fund checking account, shares may be redeemed simply
by writing a check for $500 or more. The redemption will be made at the net
asset value next determined after the Transfer Agent presents the check to the
Money Market Fund. A check should not be written to close an account. There is a
$20 charge for each stop payment request on Money Market Fund checks. You are
subject to the same rules and regulations that banks apply to checking accounts.
LOW BALANCE ACCOUNTS
Because of the high cost of maintaining accounts with low balances, it
is the Trust's policy to redeem involuntarily Fund shares in any account,
including a retirement account, if the account balance falls below $10,000 in
total value in the Trust. This policy does not apply to accounts that fall below
the minimum balance due to market fluctuations. The Trust will provide 30 days'
written notice to all such shareholders to bring the account balance up to the
minimum investment required or the Trust may redeem shares in the account and
pay the proceeds to the shareholder. A redemption from a tax-qualified
retirement plan may have adverse tax consequences and a shareholder
contemplating such a redemption should consult his or her tax adviser.
================================================================================
EXCHANGES
Shares of a Fund may be exchanged, without any charge, for shares of any
other Fund on the basis of the respective net asset values of the shares
involved. Exchanges may be effected by written request or by telephone to the
Transfer Agent subject to the procedures described below. Exchanges must be for
at least the lesser of $1,000 or the entire account balance for the Fund from
which the exchange is made.
When you exchange shares from one Fund to another, your investment may
be uninvested in shares of a Fund until that Fund's next determined net asset
value. For example, if you exchange shares from the Japan/Short Fund to the U.S.
Plus Fund, your investment will be uninvested from 1:15 a.m., the time the
Japan/Short Fund determines net asset value, until 4:15 p.m., the time the U.S.
Plus Fund next determines its net asset value. See "Determination of Net Asset
Value" below.
<PAGE>
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PROCEDURES FOR REDEMPTIONS AND EXCHANGES
GENERAL
In requesting a redemption or exchange, you should provide your account
name, account number, the number of or percentage of shares or the dollar value
of shares to be exchanged or redeemed, as applicable, and the names of the Funds
involved. Exchanges may only be made between identically registered accounts. In
addition, any written request must be signed by a shareholder and all co-owners
of the account with exactly the same name or names used in establishing the
account.
BY MAIL
Requests for redemptions and exchanges may be made in writing and
directed to the Potomac Funds, c/o Firstar Trust Company, P.O. Box 1993
Milwaukee, Wisconsin 53201-1993. Any such requests sent overnight or express
mail should be directed to the Potomac Funds, c/o Firstar Trust Company, Mutual
Fund Services, 3rd Floor, 615 East Michigan Street, Milwaukee, Wisconsin 53202.
BY TELEPHONE
You may redeem or exchange Fund shares by calling the Transfer Agent at
(800) 851-0511. Shares may be redeemed by telephone only if your Account
Application reflects that option. Telephone requests may be made only between
9:00 a.m., Eastern time, and the times listed below. For telephone exchanges,
the closing time is the earlier closing time below of the two Funds involved in
the exchange:
Japan/Long Fund 4:00 p.m.
Japan/Short Fund 4:00 p.m.
U.S. Plus Fund 3:40 p.m.
U.S./Short Fund 3:40 p.m.
OTC Plus Fund 3:40 p.m.
OTC/Short Fund 3:40 p.m.
Money Market Fund 4:00 p.m.
TELEPHONE REDEMPTION AND EXCHANGE ORDERS WILL BE ACCEPTED ONLY DURING THE
PERIODS INDICATED ABOVE.
By establishing such telephone services, you authorize the Funds or
their agents to act upon verbal instructions to redeem or exchange Fund shares
for any account for which such service has been authorized. In an effort to
prevent unauthorized or fraudulent telephone transaction requests, the transfer
agent will employ reasonable procedures specified by the Funds to confirm that
such instructions are genuine. For instance, the Transfer Agent will require
some form of personal identification prior to acting upon telephone
instructions, provide written confirmation after such transactions, and record
telephone instructions. When acting on instructions believed to be genuine, the
Trust, Adviser, Transfer Agent and their trustees, directors, officers and
employees are not liable for any loss resulting from a fraudulent telephone
transaction request and the investor will bear the risk of loss. To the extent
that the Trust, Adviser, Transfer Agent and their trustees, directors, officers
and employees do not employ such procedures, some or all of them may be liable
for losses due to unauthorized or fraudulent transactions. You also should be
aware that telephone redemption or exchanges may be difficult to implement in a
timely manner during periods of drastic economic or market changes. If such
conditions occur, redemption or exchange orders can be made by mail.
<PAGE>
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DETERMINATION OF NET ASSET VALUE
The net asset value per share of the U.S. Plus Fund, the U.S./Short
Fund, the OTC Plus Fund and the OTC/Short Fund is determined as of 4:15 p.m.
Eastern time, 15 minutes after the close of normal trading on the NYSE
(currently 4:00 p.m., Eastern time) each day the NYSE is open for business. The
net asset value per share of the Japan/Long Fund and the Japan/Short Fund is
determined as of 1:15 a.m., Eastern time, 15 minutes after the close of normal
trading on the SIMEX (currently 1:00 a.m., Eastern time) each day that exchange
is open for business. The Money Market Fund's net asset value per share is
determined as of 1:00 p.m., Eastern time, each day that both the NYSE and the
Federal Bank of New York are open for business.
Purchase, redemption and exchange requests for the Japan/Long Fund and
the Japan/Short Fund properly received by the Transfer Agent by 4:00 p.m.,
Eastern time, on Monday through Thursday are priced based on the net asset value
determined at 1:15 a.m., Eastern time, 15 minutes after the close of regular
trading on the SIMEX on the following day. Requests received by the Transfer
Agent prior to 4:00 p.m., Eastern time, on a Friday will be effected at the net
asset value determined as of the close of regular trading on the SIMEX on the
following Monday.
A Fund's net asset value serves as the basis for the purchase and
redemption price of its shares. The net asset value per share of a Fund is
calculated by dividing the market value of the Fund's securities plus the value
of its other assets, less all liabilities, by the number of outstanding shares
of the Fund. If market quotations are not readily available, a security will be
valued at fair value by the Trustees or by the Adviser using methods established
or ratified by the Trustees.
The Money Market Fund will utilize the amortized cost method in valuing
its portfolio securities. This method involves valuing a security at its cost
adjusted by a constant amortization to maturity of any discount or premium,
regardless of the impact of fluctuating interest rates on the market value of
the instrument. The purpose of this method of calculation is to facilitate the
maintenance of a constant net asset value per share for the Money Market Fund of
$1.00. However, there is no assurance that the $1.00 net asset value per share
will be maintained. For further information on valuing the Money Market Fund's
portfolio securities, see "Determination of Net Asset Value" in the SAI.
For purposes of determining net asset value per share of a Fund, options
and futures contracts are valued at the closing prices of the exchanges on which
they trade. The value of a futures contract equals the unrealized gain or loss
on the contract that is determined by marking the contract to the current
settlement price for a like contract acquired on the day on which the futures
contract is being valued. The value of options on futures contracts is
determined based upon the current settlement price for a like option acquired on
the day on which the option is being valued. A settlement price may not be used
for the foregoing purposes if the market makes a limited move with respect to a
particular commodity.
<PAGE>
OTC securities held by a Fund shall be valued at the last sales price
or, if no sales price is reported, the mean of the last bid and asked price is
used. The portfolio securities of a Fund that are listed on national exchanges
or foreign stock exchanges are valued at the last sales price of such
securities; if no sales price is reported, the mean of the last bid and asked
price is used. For valuation purposes, all assets and liabilities initially
expressed in foreign currency values will be converted into U.S. Dollars at the
mean between the bid and offered quotations of such currencies against U.S.
Dollars as last quoted by a recognized dealer. Dividend income and other
distributions are recorded on the ex-distribution date, except for certain
dividends from foreign securities that are recorded as soon as the Trust is
informed after the ex-distribution date.
Illiquid securities, securities for which reliable quotations or pricing
services are not readily available, and all other assets not valued in
accordance with the foregoing principles will be valued at their respective fair
value as determined in good faith by, or under procedures established by, the
Trustees, which procedures may include the delegation of certain
responsibilities regarding valuation to the Adviser or the officers of the
Trust. The officers of the Trust report, as necessary, to the Trustees regarding
portfolio valuation determinations. The Trustees, from time to time, will review
these methods of valuation and will recommend changes that may be necessary to
assure that the investments of the Funds are valued at fair value.
================================================================================
PERFORMANCE INFORMATION
TOTAL RETURN
From time to time each Fund may advertise its average annual total
return and compare its performance to that of other mutual funds with similar
investment objectives and to relevant indices. Performance information is
computed separately for those Funds in accordance with the methods discussed
below.
Each Fund may include the total return of its shares in advertisements
or other written material. When a Fund advertises the total return of its
shares, it will be calculated for the one-, five-, and ten-year periods or, if
such periods have not yet elapsed, the period since the establishment of that
Fund. Total return is measured by comparing the value of an investment in a Fund
at the beginning of the relevant period to the redemption value of the
investment in that Fund at the end of the period (assuming reinvestment of any
dividends capital gain distributions at net asset value). For more information
on Fund performance, see "Performance Information" in the SAI.
YIELD
From time to time the Money Market Fund may advertise "yield" and
"effective yield." The Money Market Fund's yield figure is based on historical
earnings and is not intended to indicate future performance. The yield of the
Money Market Fund refers to the income generated by an investment in the Fund
over a seven-day period. This income is then "annualized." The effective yield
is calculated similarly but, when annualized, the income earned by an investment
in the Fund is assumed to be reinvested. The effective yield will be slightly
higher than the average yield because of the compounding effect of this assumed
reinvestment. See "Performance Information - Yield Computations" in the SAI.
<PAGE>
================================================================================
DIVIDENDS AND OTHER DISTRIBUTIONS
Each Fund, except the Money Market Fund, intends to distribute to its
shareholders annually any net investment income, net realized capital gains, and
net realized gains from foreign currency transactions. The Money Market Fund
ordinarily will declare dividends from net investment income on a daily basis
and distribute those dividends monthly. All income dividends and distributions
of net capital gains and net gains from foreign currency transactions, if any,
of each Fund will be automatically reinvested in additional shares of the Fund
at the net asset value calculated on the ex-distribution date, unless you
request otherwise in writing. Dividends and other distributions of a Fund are
taxable to its shareholders, as discussed below under "Taxes," whether the
dividends or other distributions are reinvested in additional shares or are
received in cash. You will receive a statement of your account at least
quarterly.
================================================================================
TAXES
Each Fund is treated as a separate corporation for Federal income tax
purposes and will seek to qualify as a regulated investment company ("RIC")
under Subchapter M of the Internal Revenue Code of 1986, as amended ("Code").
Because of the investment strategies of each Fund other than the Money Market
Fund, there can be no assurance that any such Fund will qualify as a RIC. If a
Fund so qualifies and satisfies the distribution requirement under the Code for
a taxable year, the Fund will not be subject to Federal income tax on the part
of its investment company taxable income (generally consisting of net investment
income, net short-term capital gains, and net gains from certain foreign
currency transactions) and net capital gain (the excess of net long-term capital
gain over net short-term capital loss) it distributes to its shareholders for
that year. If a Fund fails to qualify as a RIC for any taxable year, its taxable
income, including net capital gain, will be taxed at corporate income tax rates
(up to 35%) and it will not receive a deduction for distributions to its
shareholders.
To qualify as a RIC, a Fund must satisfy certain requirements, including
certain diversification requirements. The investment by a Fund, other than the
Money Market Fund, primarily in options and futures positions entails some risk
that such a Fund might fail to satisfy those diversification requirements
because of some uncertainty regarding the valuation of such positions. For
additional information concerning these requirements, see "Dividends, Other
Distributions and Taxes" in the SAI.
If the Trust determines that a Fund will not qualify as a RIC and that
Federal income tax likely will be payable by the Fund for its current taxable
year, the Trust will make a good-faith estimate of the Fund's anticipated tax
liability, which will be accrued as tax expenses, and will establish procedures
for the Fund to reflect that liability in its net asset value per share.
Thereafter, the Trust will determine daily whether it is appropriate to continue
to accrue that tax expense and, if so, will make a good-faith estimate of the
amount thereof. Any amount by which any such accrual is reduced, or the entire
amount of the accrual if the Trust determines that accrual is no longer
appropriate, will be reclassified as a reduction of tax expenses.
<PAGE>
Dividends from a Fund's investment company taxable income, if any, are
taxable to its shareholders as ordinary income (at rates up to 39.6% for
individuals), regardless of whether the dividends are reinvested in Fund shares
or received in cash. Distributions of a Fund's net capital gain, if any, when
designated as such, are taxable to its shareholders as long-term capital gains
(at rates of up to 28% for individuals), regardless of how long they have held
their Fund shares and whether the distributions are reinvested in Fund shares or
received in cash. The Taxpayer Relief Act of 1997 ("Act"), enacted in August
1997, dramatically changes the taxation of net capital gain, by applying
different rates (including reduced maximum rates of 20%, 18%, 10%, and 8%)
thereto depending on the taxpayer's holding period and marginal rate of Federal
income tax. The Act, however, does not address the application of these rules to
distributions by RICs and instead authorizes the issuance of regulations to do
so. Accordingly, shareholders should consult their tax advisers as to the effect
of the Act on distributions by a Fund to them of net capital gain. Shareholders
that are not subject to tax on their income generally will not be required to
pay tax on distributions. Statements as to the Federal tax status of each Fund's
distributions will be mailed to its shareholders annually. Shareholders should
consult their tax advisers concerning the tax status of a Fund's distributions
in their own states and localities.
Shareholders are required by law to certify that their taxpayer
identification number ("TIN") is correct and that they are not subject to
back-up withholding. Each Fund is required to withhold 31% of all dividends,
capital gain distributions, and redemption proceeds payable to individuals and
certain other non-corporate shareholders who do not provide the Fund with a
correct TIN. Withholding at that rate also is required from dividends and
capital gain distributions payable to such shareholders who otherwise are
subject to back-up withholding.
Because the foregoing only summarizes some of the important tax
considerations affecting the Funds and their shareholders, please see the
further discussion in the SAI. Prospective investors are urged to consult their
tax advisers.
===============================================================================
MANAGEMENT AND ADMINISTRATION OF THE TRUST
BOARD OF TRUSTEES
The business and affairs of each Fund are managed under the direction of
the Trustees. The Trustees are responsible for the general supervision of the
Funds' business affairs and for exercising all the Funds' powers except those
reserved to the shareholders. The day-to-day operations of the Funds are the
responsibility of the Trust's officers.
INVESTMENT ADVISER
Rafferty Asset Management, LLC, 550 Mamaroneck Avenue, Harrison, New
York 10528, provides investment advice to the Funds. The Adviser is a newly
created investment adviser and has had no previous experience advising
investment companies. The Adviser was organized as a New York limited liability
corporation in May 1997. Lawrence C. Rafferty owns a controlling interest in the
Adviser.
The Adviser manages the investment of the assets of each Fund, in
accordance with its investment objective, policies and limitations, subject to
the general supervision and control of the Trustees and the officers of the
Trust. The Adviser bears all costs associated with providing these advisory
services and the expenses of the Trustees who are affiliated persons of the
Adviser. The Adviser, from its own resources, also may make payments to
broker-dealers and other financial institutions for their expenses in connection
with the distribution of Fund shares, and otherwise currently pays all
distribution costs for Fund shares.
<PAGE>
Under an investment agreement between the Trust and the Adviser, each
Fund pays the Adviser a fee at an annualized rate, based on a percentage of its
daily net assets: 0.75% for the Japan/Long Fund, the U.S. Plus Fund, and the OTC
Plus Fund; 0.90% for the Japan/Short Fund, the U.S./Short Fund, and the
OTC/Short Fund; and 0.50% for the Money Market Fund.
PORTFOLIO MANAGEMENT
Each Fund, except for the OTC Plus Fund and the OTC/Short Fund, is
managed by an investment committee, which is responsible for the investment
activities of the Funds.
James T. Apple is the portfolio manager for the OTC Plus Fund and the
OTC/Short Fund. From 1992 to December 1993, he was Director of Investments
for The Rushmore Funds, Inc. From February 1994 to May 1997, Mr. Apple was
portfolio manager for the Rydex OTC, which seeks to match the performance of the
Nasdaq Index, and the U.S. Government Bond Funds.
ADMINISTRATOR
The Trust has entered into an Administrative Services Agreement with
Firstar Trust Company ("Administrator") that obligates the Administrator to
provide the Funds with administrative and management services, other than
investment advisory services. As compensation for these services, the Trust pays
the Administrator a fee of .06% of the first $200,000,000 of the Trust's average
daily net assets, .05% of the next $300,000,000 of the Trust's average daily net
assets, and .03% of the Trust's average daily net assets in excess of
$500,000,000. Notwithstanding the foregoing, the Administrator's minimum annual
fee is $170,000.
DISTRIBUTOR
First Data Distributors, Inc. ("Distributor"), 4400 Computer Drive,
Westboro, Massachusetts 01581, serves as the distributor of the Funds' shares.
The Distributor has entered into dealer agreements with participating dealers
who will distribute shares of the Funds.
TRANSFER AGENT AND CUSTODIAN
Firstar Trust Company, 615 East Michigan Street, Milwaukee, Wisconsin
53202, serves as the transfer agent and custodian of the portfolio securities of
the Trust.
INDEPENDENT AUDITORS
Price Waterhouse LLP, 100 East Wisconsin Avenue, Suite 1500, Milwaukee,
Wisconsin 53202, are the auditors of and the independent accountants for the
Trust.
================================================================================
GENERAL INFORMATION ABOUT THE TRUST
ORGANIZATION OF THE TRUST AND VOTING RIGHTS
The Trust was organized as a Massachusetts business trust on June 6,
1997 and registered with the SEC as an open-end management investment company
under the 1940 Act. The Trust may issue unlimited shares of beneficial interest,
no par value, in such separate and distinct series and classes of shares as the
Trustees shall from time to time establish. The shares of beneficial interest of
the Trust presently are divided into seven separate series.
<PAGE>
Fund shares have equal voting rights. Only shares of a particular Fund
may vote on matters affecting that Fund. All shares of the Trust vote on matters
affecting the Trust as a whole and to elect Trustees. Share voting rights are
not cumulative, and shares have no preemptive or conversion rights. Shares of
the Trust are nontransferable.
As a Massachusetts business trust, the Trust is not obligated to conduct
annual shareholder meetings. However, the Trust will hold special shareholder
meetings whenever required to do so under the Federal securities laws or the
Trust's Declaration of Trust or its By-Laws. Shareholders may remove Trustees
from office by votes cast at a special meeting of shareholders. If requested by
the shareholders of at least 10% of the outstanding shares of the Trust, the
Trustees will call a special meeting of shareholders to vote on the removal of a
Trustee and will assist in communications with other shareholders.
FUND EXPENSES
Expenses of the Trust that are not directly attributable to a Fund are
typically allocated among the Funds in proportion to their respective net
assets, number of shareholder accounts, or net sales, where applicable. Each
Fund pays all of its own expenses. These expenses include organizational costs,
expenses for legal accounting and auditing services, preparing (including
typesetting and printing) reports, prospectuses, supplements thereto and notices
to its existing shareholders, advisory and management fees, fees and expenses of
the custodian and transfer and dividend disbursing agents, the distribution fee,
the expense of issuing and redeeming shares, the cost of registering shares
under the Federal and state laws, shareholder meeting and related proxy
solicitation expenses, the fees and out-of-pocket expenses of Trustees who are
not affiliated with the Adviser, insurance, brokerage costs, litigation, and
other expenses properly payable by the Funds.
CLASSIFICATION OF THE FUNDS
Each Fund (other than the Money Market Fund) is a "non-diversified"
series of the Trust pursuant to the 1940 Act. A Fund is considered
"non-diversified" because a relatively high percentage of its assets may be
invested in the securities of a limited number of issuers, primarily within the
same industry or economic sector. A non-diversified Fund's portfolio securities,
therefore, may be more susceptible to any single economic, political, or
regulatory occurrence than the portfolio securities of a diversified investment
company.
A Fund's classification as a "non-diversified" investment company means
that the proportion of its assets that may be invested in the securities of a
single issuer is not limited by the 1940 Act. Each Fund, however, intends to
qualify as a RIC. This requires, among other things, that each Fund, at the end
of each quarter of its tax year, meet certain diversification standards.
CONCENTRATION OF INVESTMENTS
The OTC Plus Fund and the OTC/Short Fund generally do not intend to
concentrate more than 25% of their respective investments in a particular
industry. However, because these Funds seek investment results that correspond
to 125% and the inverse, respectively, of the performance of the Nasdaq Index,
the Funds may invest more than 25% of their assets in securities of issuers in
one industry. When a Fund concentrates its investments in an industry,
financial, economic, business and other developments affecting issuers in that
industry will have a greater effect on the Fund than if the Fund had not
concentrated its assets in that industry. Accordingly, the performance of these
Funds may be subject to a greater risk of market fluctuation than that of a fund
invested in a wider spectrum of industries.
<PAGE>
DISTRIBUTION OF FUND SHARES
The Funds have adopted a distribution plan (the "Plan") pursuant to Rule
12b-1 under the 1940 Act. The Plan provides that each Fund will compensate the
Distributor for certain expenses incurred in the distribution of that Fund's
shares and the servicing and maintenance of existing Fund shareholder accounts.
However, the Trustees have not authorized payment of any fees pursuant to
the Plan.
MASTER/FEEDER OPTION
The Trust may in the future seek to achieve a Fund's investment
objective by investing all net assets of that Fund ("Feeder Fund") in another
investment company ("Master Fund") having the same investment objective and
substantially the same investment policies and restrictions as those applicable
to the Feeder Fund. It is expected that any such investment company would be
managed by the Adviser in substantially the same manner as the Feeder Fund. If
permitted by applicable laws and policies then in effect, any such investment
may be made in the sole discretion of the Trustees without further approval of
shareholders of the Funds. However, the Funds' shareholders will be given 30
days' prior notice of any such investment. Such investment would be made only if
the Trustees determine it to be in the best interests of the Funds and their
shareholders. In making that determination, the Trustees will consider, among
other things, the benefits to shareholders and/or the opportunity to reduce
costs and achieve operational efficiencies. No assurance can be given that costs
will be materially reduced if this option is implemented.
SHAREHOLDER INQUIRIES
Shareholder inquiries can be made by telephone to the Trust at (800)
851-0511.
<PAGE>
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATION NOT CONTAINED IN THIS PROSPECTUS, OR IN THE SAI INCORPORATED
HEREIN BY REFERENCE, IN CONNECTION WITH THE OFFERING MADE BY THIS PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR PRESENTATIONS MUST NOT BE RELIED UPON
AS HAVING BEEN AUTHORIZED BY THE TRUST. THIS PROSPECTUS DOES NOT CONSTITUTE AN
OFFERING BY THE TRUST IN ANY JURISDICTION IN WHICH SUCH AN OFFERING MAY NOT
LAWFULLY BE MADE.
================================================================================
INVESTMENT ADVISOR
Rafferty Asset Management, LLC
550 Mamaroneck Avenue
Harrison, NY10528
ADMINISTRATOR, TRANSFER AGENT, DIVIDEND
PAYING AGENT, SHAREHOLDER SERVICING AGENT & CUSTODIAN
Firstar Trust Company
P.O. Box 1993
Milwaukee, WI 53201-1993
COUNSEL
Kirkpatrick & Lockhart, LLP
1800 Massachusetts Avenue, N.W.
Washington, D.C. 20036-1800
INDEPENDENT AUDITORS
Price Waterhouse, LLP
100 East Wisconsin Avenue
Milwaukee, WI53202
<PAGE>
POTOMAC FUNDS
STATEMENT OF ADDITIONAL INFORMATION
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
The Potomac Funds (the "Trust") is a no-load management investment company, or
mutual fund, which consists of seven separate investment portfolios (the
"Funds"). The Funds are designed principally for experienced investors who
intend to follow a global asset allocation strategy. The Funds are not designed
for inexperienced or less sophisticated investors. An important feature of the
Trust is that it primarily consists of pairs of Funds, one of which attempts to
provide results correlating to a specific index, while the other attempts to
provide inverse performance, that is, similar to a short position in the
specific index. In particular, the following Funds seek investment results that
correspond over time to the following benchmarks:
FUND BENCHMARK
Potomac Japan/Long Fund Nikkei 225 Stock Average
Potomac Japan/Short Fund Inverse (opposite) of the Nikkei 225 Stock Average
Potomac U.S. Plus Fund 150% of the performance of the Standard & Poor's
500 Composite Stock Price Index[TRADEMARK]
Potomac U.S./Short Fund Inverse (opposite) of the
Standard & Poor's 500 Composite Stock Price
Index[TRADEMARK]
Potomac OTC Plus Fund 125% of the performance of the Nasdaq 100 Stock
Index[TRADEMARK]
Potomac OTC/Short Fund Inverse (opposite) of the Nasdaq 100 Stock
Index[TRADEMARK]
The Trust also offers the Potomac U.S. Government Money Market Fund, which seeks
security of principal, current income and liquidity by investing primarily in
money market instruments issued or guaranteed, as to principal and interest, by
the U.S. Government, its agencies or instrumentalities. THE FUND SEEKS TO
MAINTAIN A CONSTANT $1.00 NET ASSET VALUE PER SHARE, ALTHOUGH THIS CANNOT BE
ASSURED. SHARES OF THIS FUND ARE NOT DEPOSITS OR OBLIGATIONS, OR GUARANTEED OR
ENDORSED BY, THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE
BOARD OR ANY OTHER AGENCY. AN INVESTMENT IN THIS FUND IS NEITHER INSURED NOR
GUARANTEED BY THE UNITED STATES GOVERNMENT.
This Statement of Additional Information is not a prospectus. It should be read
in conjunction with the Trust's Prospectus dated October 1, 1997. A copy of the
Prospectus is available, without charge, upon request to the Trust at the
address or telephone number above.
STATEMENT OF ADDITIONAL INFORMATION DATED OCTOBER 1, 1997
<PAGE>
TABLE OF CONTENTS
PAGE
THE POTOMAC FUNDS........................................................ 3
INVESTMENT POLICIES AND TECHNIQUES....................................... 3
General............................................................... 3
Options, Futures and Other Strategies................................. 3
U.S. Government Securities............................................. 10
Indexed Securities..................................................... 10
American Depository Receipts........................................... 11
Repurchase Agreements.................................................. 11
Borrowing.............................................................. 11
Lending Portfolio Securities........................................... 12
Investments in Other Investment Companies.............................. 12
Illiquid Investments and Restricted Securities......................... 13
Portfolio Turnover..................................................... 13
INVESTMENT RESTRICTIONS................................................... 14
PORTFOLIO TRANSACTIONS AND BROKERAGE...................................... 17
MANAGEMENT OF THE TRUST................................................... 18
Trustees and Officers.................................................. 18
Investment Adviser..................................................... 20
Fund Administrator, Fund Accountant, Transfer Agent and Custodian...... 21
Distributor............................................................ 21
Distribution Plan...................................................... 22
Independent Accountants................................................ 22
DETERMINATION OF NET ASSET VALUE.......................................... 22
PERFORMANCE INFORMATION................................................... 23
Comparative Information................................................ 23
Total Return Computations.............................................. 24
Yield Computations..................................................... 25
DIVIDENDS, OTHER DISTRIBUTIONS AND TAXES.................................. 26
Dividends and Other Distributions........................................26
Taxes....................................................................26
FINANCIAL STATEMENTS...................................................... 29
2
<PAGE>
THE POTOMAC FUNDS
The Trust is a Massachusetts business trust organized on June 6, 1997 and is
registered with the Securities and Exchange Commission ("SEC") as an open-end
management investment company under the Investment Company Act of 1940, as
amended ("1940 Act"). The Trust currently consists of seven separate series: the
Potomac Japan/Long Fund ("Japan/Long Fund"), the Potomac Japan/Short Fund
("Japan/Short Fund"), the Potomac U.S. Plus Fund ("U.S. Plus Fund"), the Potomac
U.S./Short Fund ("U.S. Short Fund"), the Potomac OTC Plus Fund ("OTC Plus
Fund"), the Potomac OTC/Short Fund ("OTC/Short Fund") and the Potomac U.S.
Government Money Market Fund ("Money Market Fund") (collectively, the "Funds").
The Trust may offer additional series in the future.
The Funds are designed principally for experienced investors seeking a global
asset allocation vehicle. Except for the Money Market Fund, the Funds provide
investment exposure to various securities markets. Each Fund seeks investment
results that correspond over time to a specific benchmark. The terms "long" and
"short" in the Funds' names are not intended to refer to the duration of the
Funds' investment portfolios. The Funds may be used independently or in
combination with each other as part of an overall strategy.
INVESTMENT POLICIES AND TECHNIQUES
GENERAL
- -------
The following information supplements the discussion in the Prospectus of the
investment objective, policies and limitations of each Fund. Please refer to the
sections entitled "Investment Objectives and Policies" and "Investment
Techniques and Other Investment Policies" in the Prospectus for a discussion of
the investment objectives and policies of the Funds. Rafferty Asset Management,
LLC (the "Adviser") serves as each Fund's investment adviser. Capitalized terms
not otherwise defined herein shall have the same meaning as assigned in the
Prospectus.
The Funds may engage in the investment strategies discussed below. There is no
assurance that any of these strategies or any other strategies and methods of
investment available to a Fund will result in the achievement of the Fund's
objectives.
OPTIONS, FUTURES AND OTHER STRATEGIES
- -------------------------------------
GENERAL. As discussed in the Prospectus, each Fund (other than the Money Market
Fund) may use certain options, futures contracts (sometimes referred to as
"futures"), options on futures contracts, forward currency contracts, swaps,
caps, floors and collars (collectively, "Financial Instruments") as a substitute
for a comparable market position in the underlying security or currency, to
attempt to hedge or limit the exposure of a Fund's position, to create a
synthetic money market position, for certain tax-related purposes and to effect
closing transactions. Each of the Japan/Long Fund and the Japan/Short Fund also
may purchase and sell Financial Instruments on Japanese Yen to attempt to
eliminate the effect that fluctuations in the U.S. Dollar/Japanese Yen exchange
rate may have on each Fund's net asset value per share.
The use of Financial Instruments is subject to applicable regulations of the
SEC, the several exchanges upon which they are traded and the Commodity Futures
3
<PAGE>
Trading Commission (the "CFTC"). In addition, a Fund's ability to use Financial
Instruments will be limited by tax considerations. See "Dividends, Other
Distributions and Taxes."
In addition to the instruments, strategies and risks described below and in the
Prospectus, the Adviser may discover additional opportunities in connection with
Financial Instruments and other similar or related techniques. These new
opportunities may become available as the Adviser develops new techniques, as
regulatory authorities broaden the range of permitted transactions and as new
Financial Instruments or other techniques are developed. The Adviser may utilize
these opportunities to the extent that they are consistent with a Fund's
investment objective and permitted by a Fund's investment limitations and
applicable regulatory authorities. The Funds' Prospectus or SAI will be
supplemented to the extent that new products or techniques involve materially
different risks than those described below or in the Prospectus.
SPECIAL RISKS. The use of Financial Instruments involves special considerations
and risks, certain of which are described below. Risks pertaining to particular
Financial Instruments are described in the sections that follow.
(1) Successful use of most Financial Instruments depends upon the 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. There can be no assurance that any particular strategy
will succeed.
(2) Options and futures prices can diverge from the prices of their underlying
instruments. Options and futures prices are affected by such factors as current
and anticipated short-term interest rates, changes in volatility of the
underlying instrument and the time remaining until expiration of the contract,
which may not affect security prices the same way. Imperfect correlation also
may result from differing levels of demand in the options and futures markets
and the securities markets, from structural differences in how options and
futures and securities are traded, and from imposition of daily price
fluctuation limits or trading halts.
(3) As described below, a Fund might be required to maintain assets as
"cover," maintain segregated accounts or make margin payments when it takes
positions in Financial Instruments involving obligations to third parties (E.G.,
Financial Instruments other than purchased options). If a Fund were unable to
close out its positions in such Financial Instruments, it might be required to
continue to maintain such assets or accounts or make such payments until the
position expired or matured. These requirements might impair a 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 a Fund sell a portfolio
security at a disadvantageous time. A Fund's ability to close out a position in
a Financial 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 (the "counterparty") to
enter into a transaction closing out the position. Therefore, there is no
assurance that any position can be closed out at a time and price that is
favorable to a Fund.
COVER. Transactions using Financial Instruments, other than purchased options,
expose a Fund to an obligation to another party. A Fund will not enter into any
such transactions unless it owns either (1) an offsetting ("covered") position
in securities, currencies or other options, futures contracts or forward
4
<PAGE>
currency contracts, or (2) cash and liquid assets with a value, marked-to-market
daily, sufficient to cover its potential obligations to the extent not covered
as provided in (1) above. Each Fund will comply with SEC guidelines regarding
cover for these instruments and will, if the guidelines so require, set aside
cash or liquid assets in an account with its custodian, Firstar Trust Company
("Custodian"), in the prescribed amount as determined daily.
Assets used as cover or held in an account cannot be sold while the position in
the corresponding Financial Instrument is open, unless they are replaced with
other appropriate assets. As a result, the commitment of a large portion of a
Fund's assets to cover or accounts could impede portfolio management or the
Fund's ability to meet redemption requests or other current obligations.
OPTIONS. The value of an option position will reflect, among other things, 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.
A Fund may effectively terminate its right or obligation under an option by
entering into a closing transaction. For example, a 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, a 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 a Fund to realize profits or limit
losses on an option position prior to its exercise or expiration.
RISKS OF OPTIONS ON SECURITIES. Exchange-traded options in the United States 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. In contrast, over-the-counter ("OTC") options are contracts
between a Fund and its counterparty (usually a securities dealer or a bank) with
no clearing organization guarantee. Thus, when a Fund purchases an OTC option,
it relies on the counterparty from whom it purchased the option to make or take
delivery of the underlying investment upon exercise of the option. Failure by
the counterparty to do so would result in the loss of any premium paid by the
Fund as well as the loss of any expected benefit of the transaction.
A Fund's ability to establish and close out positions in exchange-traded options
depends on the existence of a liquid market. However, there can be no assurance
that such a market will exist at any particular time. Closing transactions can
be made for OTC options only by negotiating directly with the counterparty, or
by a transaction in the secondary market if any such market exists. There can be
no assurance that a Fund will in fact be liable to close out an OTC option
position at a favorable price prior to expiration. In the event of insolvency of
the counterparty, a Fund might be unable to close out an OTC option position at
any time prior to its expiration.
If a 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 a Fund could cause material losses because the Fund would be unable
to sell the investment used as cover for the written option until the option
expires or is exercised.
5
<PAGE>
OPTIONS ON INDICES. Puts and calls on indices are similar to puts and calls on
securities or futures contracts except that all settlements are in cash and gain
or loss depends on changes in the index in question rather than on price
movements in individual securities or futures contracts. When a Fund writes a
call on an index, it receives a premium and agrees that, prior to the expiration
date, the purchaser of the call, upon exercise of the call, will receive from
the Fund an amount of cash if the closing level of the index upon which the call
is based is greater than the exercise price of the call. The amount of cash is
equal to the difference between the closing price of the index and the exercise
price of the call times a specified multiple ("multiplier"), which determines
the total value for each point of such difference. When a Fund buys a call on an
index, it pays a premium and has the same rights to such call as are indicated
above. When a Fund buys a put on an index, it pays a premium and has the right,
prior to the expiration date, to require the seller of the put, upon the Fund's
exercise of the put, to deliver to the Fund an amount of cash if the closing
level of the index upon which the put is based is less than the exercise price
of the put, which amount of cash is determined by the multiplier, as described
above for calls. When a Fund writes a put on an index, it receives a premium and
the purchaser of the put has the right, prior to the expiration date, to require
the Fund to deliver to it an amount of cash equal to the difference between the
closing level of the index and the exercise price times the multiplier if the
closing level is less than the exercise price.
RISKS OF OPTIONS ON INDICES. If a Fund has purchased an index option and
exercises it before the closing index value for that day is available, it runs
the risk that the level of the underlying index may subsequently change. If such
a change causes the exercised option to fall out-of-the-money, the Fund will be
required to pay the difference between the closing index value and the exercise
price of the option (times the applicable multiplier) to the assigned writer.
OTC OPTIONS. Unlike exchange-traded options, which are standardized with respect
to the underlying instrument, expiration date, contract size and strike price,
the terms of OTC options (options not traded on exchanges) generally are
established through negotiation with the other party to the option contract.
While this type of arrangement allows a Fund great flexibility to tailor the
option to its needs, OTC options generally involve greater risk than
exchange-traded options, which are guaranteed by the clearing organization of
the exchanges where they are traded.
Generally, OTC foreign currency options used by the Japan/Long Fund and the
Japan/Short Fund are European-style options. This means that the option is
exercisable only immediately prior to its expiration. This is in contrast to
American-style options, which are exercisable at any time prior to the
expiration date of the option.
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS. No price is paid upon
entering into a futures contract. Instead, at the inception of a futures
contract a Fund is required to deposit "initial margin" in an amount generally
equal to 10% or less of the contract value. Margin also must 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 does not represent a borrowing, but rather is in the nature of a
performance bond or good-faith deposit that is returned to the Fund at the
termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility, the
6
<PAGE>
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
commission merchant 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 the Fund's obligations to or from a
futures commission merchant. When a Fund purchases an option on a futures
contract, the premium paid plus transaction costs is all that is at risk. In
contrast, when a 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 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 contracts and options on futures can enter
into offsetting closing transactions, similar to closing transactions in
options, by selling or purchasing, respectively, an instrument identical to the
instrument purchased or sold. Positions in futures and options on futures
contracts may be closed only on an exchange or board of trade that provides a
secondary market. However, there can be no assurance that a liquid secondary
market will exist for a particular contract at a particular time. In such event,
it may not be possible to close a futures contract or options position.
Under certain circumstances, futures exchanges may establish daily limits on the
amount that the price of a futures contract or an 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 a Fund were unable to liquidate a futures contract or an option on a futures
position due to the absence of a liquid secondary market or the imposition of
price limits, it could incur substantial losses. The Fund would continue to be
subject to market risk with respect to the position. In addition, except in the
case of purchased options, the Fund would continue to be required to make daily
variation margin payments and might be required to maintain cash or liquid
assets in an account.
RISKS OF FUTURES CONTRACTS AND OPTIONS THEREON. The ordinary spreads between
prices in the cash and futures markets (including the options on futures
markets), due to differences in the natures of those markets, are subject to the
following factors, which may create distortions. First, all participants in the
futures market are subject to margin deposit and maintenance requirements.
Rather than meeting additional margin deposit requirements, investors may close
futures contracts through offsetting transactions, which could distort the
normal relationships between the cash and futures markets. Second, the liquidity
of the futures market depends on participants entering into offsetting
transactions rather than making or taking delivery. To the extent participants
decide to make or take delivery, liquidity in the futures market could be
reduced, thus producing distortion. Third, from the point of view of
speculators, the deposit requirements in the futures market are less onerous
than margin requirements in the securities market. Therefore, increased
participation by speculators in the futures market may cause temporary price
distortions.
7
<PAGE>
FOREIGN CURRENCY STRATEGIES - SPECIAL CONSIDERATIONS. The Japan/Long Fund and
the Japan/Short Fund may use options and futures contracts on Japanese Yen, as
described above, and forward contracts, swaps, caps, floors and collars on
Japanese Yen, as described below.
The value of Financial 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 Financial Instruments, a
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 Financial Instruments until they reopen.
Settlement of transactions involving foreign currencies might be required to
take place within the country issuing the underlying currency. Thus, a 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.
FORWARD CURRENCY CONTRACTS. The Japan/Long Fund and the Japan/Short Fund may
enter into forward currency contracts to purchase or sell Japanese Yen for a
fixed amount of U.S. Dollars. 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 (term) from the date of the forward currency contract agreed upon
by the parties, at a price set at the time of the forward currency contract.
These forward currency contracts are traded directly between currency traders
(usually large commercial banks) and their customers.
The cost to a Fund of engaging in forward currency contracts varies with factors
such as the currency involved, the length of the contract period and the market
conditions then prevailing. Because forward currency contracts are usually
entered into on a principal basis, no fees or commissions are involved. When a
Fund enters into a forward currency contract, it relies on the counterparty to
make or take delivery of the underlying currency at the maturity of the
contract. Failure by the counterparty to do so would result in the loss of any
expected benefit of the transaction.
As is the case with futures contracts, purchasers and sellers of forward
currency contracts can enter into offsetting closing transactions, similar to
closing transactions on futures contracts, by selling or purchasing,
respectively, an instrument identical to the instrument purchased or sold.
Secondary markets generally do not exist for forward currency contracts, with
the result that closing transactions generally can be made for forward currency
8
<PAGE>
contracts only by negotiating directly with the counterparty. Thus, there can be
no assurance that a Fund will in fact be able to close out a forward currency
contract at a favorable price prior to maturity. In addition, in the event of
insolvency of the counterparty, a Fund might be unable to close out a forward
currency contract at any time prior to maturity. In either event, the Fund would
continue to be subject to market risk with respect to the position, and would
continue to be required to maintain a position in securities denominated in the
foreign currency or to maintain cash or liquid assets in a segregated account.
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 forward
currency contract has been established. Thus, a 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 currency contracts.
COMBINED POSITIONS. A Fund may purchase and write options in combination with
each other, or in combination with futures or forward currency contracts. For
example, a Fund may purchase a put option and write a call option on the same
underlying instrument, in order to construct a combined position whose risk and
return characteristics are similar to selling a futures contract. Another
possible combined position would involve writing a call option at one strike
price and buying a call option at a lower price, in order to reduce the risk of
the written call option in the event of a substantial price increase. Because
combined options positions involve multiple trades, they result in higher
transaction costs and may be more difficult to open and close out.
SWAPS, CAPS, FLOORS AND COLLARS. Swap agreements, including caps, floors and
collars, can be individually negotiated and structured. Swap agreements will
tend to shift a Fund's investment exposure from one type of investment to
another. For example, if a Fund agrees to exchange payments based on a floating
rate of interest for payments based on a specified stock index, the swap
agreement would tend to decrease the Fund's exposure to U.S. interest rates and
increase its exposure to changes in the value of the index. Caps and floors have
an effect similar to buying or writing options.
The creditworthiness of firms with which a Fund enters into swaps, caps, floors
or collars will be monitored by the Adviser in accordance with procedures
adopted by the Trust's Board of Trustees ("Trustees" or the "Board"). If a
default occurs by the other party to such transaction, a Fund will have
contractual remedies pursuant to the agreements related to the transaction.
The net amount of the excess, if any, of a Fund's obligations over its
entitlements with respect to each swap entered into on a net basis will be
accrued on a daily basis and an amount of cash or liquid assets having an
aggregate net asset value at least equal to the accrued excess will be
maintained in an account with the Custodian that satisfies the requirements of
the 1940 Act. Each Fund also will establish and maintain such account with
respect to its total obligations under any swaps that are not entered into on a
net basis and with respect to any caps or floors that are written by the Fund.
The Adviser and the Funds believe that such obligations do not constitute senior
securities under the 1940 Act and, accordingly, will not treat them as being
subject to a Fund's borrowing restrictions.
9
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U.S. GOVERNMENT SECURITIES
- --------------------------
Securities issued or guaranteed by the U.S. Government or its agencies or
instrumentalities ("U.S. Government Securities") include Treasury Bills (which
mature within one year of the date they are issued), Treasury Notes (which have
maturities of one to ten years) and Treasury Bonds (which generally have
maturities of more than 10 years). All such Treasury securities are backed by
the full faith and credit of the United States.
U.S. Government agencies and instrumentalities that issue or guarantee
securities include, but are not limited to, the Federal Housing Administration,
Fannie Mae (formerly, the Federal National Mortgage Association), the Farmers
Home Administration, the Export-Import Bank of the United States, the Small
Business Administration, the Government National Mortgage Association ("Ginnie
Mae"), the General Services Administration, the Central Bank for Cooperatives,
the Federal Home Loan Banks, the Federal Home Loan Mortgage Corporation
("Freddie Mac"), the Farm Credit Banks, the Maritime Administration, the
Tennessee Valley Authority, the Resolution Funding Corporation and the Student
Loan Marketing Association.
Securities issued or guaranteed by U.S. Government agencies and
instrumentalities are not always supported by the full faith and credit of the
United States. Some, such as securities issued by the Federal Home Loan Banks,
are backed by the right of the agency or instrumentality to borrow from the
Treasury. Others, such as securities issued by Fannie Mae, are supported only by
the credit of the instrumentality and by a pool of mortgage assets. If the
securities are not backed by the full faith and credit of the United States, the
owner of the securities must look principally to the agency issuing the
obligation for repayment and may not be able to assert a claim against the
United States in the event that the agency or instrumentality does not meet its
commitment. The Money Market Fund will invest in securities of agencies and
instrumentalities only if the Adviser is satisfied that the credit risk involved
is acceptable.
INDEXED SECURITIES
- ------------------
Each Fund (other than the Money Market Fund) may purchase securities the value
of which varies in relation to the value of other securities, securities
indices, currencies or other financial indicators, consistent with its
investment objective. Indexed securities typically, but not always, are debt
securities or deposits whose value at maturity or coupon rate is determined by
reference to a specific instrument or statistic. Currency-indexed securities
typically are short-term to intermediate-term debt securities whose maturity
values or interest rates are determined by reference to the values of one more
specified foreign currencies, and may offer higher yields than U.S.
Dollar-denominated securities of equivalent issuers. Currency-indexed securities
may be positively or negatively indexed; that is, their maturity value may
increase when the value of a specified foreign currency increases, resulting in
a security that performs similarly to a foreign-denominated instrument, or their
maturity value may decline when the value of a specified foreign currency
increases, resulting in a security whose price characteristics are similar to a
put on the underlying currency.
Recent issuers of indexed securities have included banks, corporations and
certain U.S. Government agencies. Certain indexed securities that are not traded
on an established market may be deemed illiquid. See "Illiquid Investments and
Restricted Securities" below.
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AMERICAN DEPOSITORY RECEIPTS ("ADRS")
- ------------------------------------
ADRs include ordinary shares and New York shares. ADRs may be purchased through
"sponsored" or "unsponsored" facilities. A sponsored facility is established
jointly by the issuer of the underlying security and a depository, whereas a
depository may establish an unsponsored facility without participation by the
issuer of the depository security. Holders of unsponsored depository receipts
generally bear all the costs of such facilities and the depository 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 of the deposited
securities. ADRs are not necessarily denominated in the same currency as the
underlying securities to which they may be connected. Generally, ADRs in
registered form are designed for use in the U.S. securities market and ADRs in
bearer form are designed for used outside the United States.
REPURCHASE AGREEMENTS
- ---------------------
Each Fund may enter into repurchase agreements with banks that are members of
the Federal Reserve System or securities dealers who are members of a national
securities exchange or are primary dealers in U.S. Government Securities.
Repurchase agreements generally are for a short period of time, usually less
than a week. Repurchase agreements with a maturity of more than seven days are
considered to be illiquid investments. No Fund may enter into such a repurchase
agreement if, as a result, more than 15% (10% in the case of the Money Market
Fund) of the value of its net assets would then be invested in such repurchase
agreements and other illiquid investments. See "Illiquid Investments and
Restricted Securities" below.
Each Fund follows certain procedures and guidelines adopted by the Trustees
designed to minimize the risks inherent in such transactions. These procedures
include effecting repurchase transactions only with large, well-capitalized and
well-established institutions whose financial condition will be monitored by the
Adviser. In addition, each Fund will always receive, as collateral, securities
whose market value, including accrued interest, at all times will be at least
equal to 100% of the dollar amount invested by the Fund in each repurchase
agreement. If the seller defaults, a Fund might incur a loss if the value of the
collateral securing the repurchase agreement declines and might incur
disposition costs in connection with liquidating the collateral. In addition, if
bankruptcy or similar proceedings are commenced with respect to the seller of
the security, realization upon the collateral by a Fund may be delayed or
limited.
BORROWING
- ---------
The U.S. Plus Fund and the OTC Plus Fund may borrow money for investment
purposes. Each Fund may borrow money as a temporary measure for extraordinary or
emergency purposes and to meet redemption requests without immediately selling
portfolio securities.
U.S. PLUS FUND AND OTC PLUS FUND. Borrowing for investment is known as
leveraging. Leveraging investments, by purchasing securities with borrowed
money, is a speculative technique that increases investment risk while
increasing investment opportunity. Leverage may exaggerate changes in a Fund's
net asset value. Although the principal of such borrowings will be fixed, a
Fund's assets may change in value during the time the borrowing is outstanding.
Leverage also creates interest expenses for a Fund. To the extent the income
derived from securities purchased with borrowed funds exceeds the interest a
Fund will have to pay, that Fund's net income will be greater than it would be
if leverage were not used. Conversely, if the income from the assets obtained
11
<PAGE>
with borrowed funds is not sufficient to cover the cost of leveraging, the net
income of a Fund will be less than it would be if leverage were not used, and
therefore the amount available for distribution to shareholders as dividends
will be reduced.
ALL FUNDS. Each Fund may borrow money to facilitate management of the Fund's
portfolio by enabling the Fund to meet redemption requests when the liquidation
of portfolio instruments would be inconvenient or disadvantageous. Such
borrowing is not for investment purposes and will be repaid by the borrowing
Fund promptly.
As required by the 1940 Act, a Fund must maintain continuous asset coverage
(total assets, including assets acquired with borrowed funds, less liabilities
exclusive of borrowings) of 300% of all amounts borrowed. If at any time the
value of the required asset coverage declines as a result of market fluctuations
or other reasons, a Fund may be required to sell some of its portfolio
investments within three days to reduce the amount of its borrowings and restore
the 300% asset coverage, even though it may be disadvantageous from an
investment standpoint to sell portfolio instruments at that time.
In addition to the foregoing, each Fund may borrow money from a bank as a
temporary measure for extraordinary or emergency purposes in amounts not in
excess of 5% of the value of its total assets. This borrowing is not subject to
the foregoing 300% asset coverage requirement. Each Fund may pledge portfolio
securities as the Adviser deems appropriate in connection with any borrowings.
LENDING PORTFOLIO SECURITIES
- ----------------------------
Each Fund may lend portfolio securities with a value not exceeding 33 1/3% (10%
in the case of the Money Market Fund) of its total assets to brokers, dealers,
and financial institutions. Borrowers are required continuously to secure their
obligations to return securities on loan from a Fund by depositing any
combination of short-term government securities and cash as collateral with the
Fund. The collateral must be equal to at least 100% of the market value of the
loaned securities, which will be marked to market daily. While a Fund's
portfolio securities are on loan, the Fund continues to receive interest on the
securities loaned and simultaneously earns either interest on the investment of
the collateral or fee income if the loan is otherwise collateralized. The Fund
may invest the interest received and the collateral, thereby earning additional
income. Loans would be subject to termination by the lending Fund on four
business days' notice or by the borrower on one day's notice. Borrowed
securities must be returned when the loan is terminated. Any gain or loss in the
market price of the borrowed securities that occurs during the term of the loan
inures to the lending Fund and that Fund's shareholders. A lending Fund may pay
reasonable finders, borrowers, administrative and custodial fees in connection
with a loan. Each Fund currently has no intention of lending its portfolio
securities.
INVESTMENTS IN OTHER INVESTMENT COMPANIES
- -----------------------------------------
Each Fund may invest in the securities of other investment companies to the
extent that such an investment would be consistent with the requirements of the
1940 Act. The Money Market Fund will invest only in those investment companies
that invest in the same quality of investments as the Money Market Fund.
Investments in the securities of other investment companies may involve
duplication of advisory fees and certain other expenses. By investing in another
investment company, a Fund becomes a shareholder of that investment company. As
a result, Fund shareholders indirectly will bear a Fund's proportionate share of
12
<PAGE>
the fees and expenses paid by shareholders of the other investment company, in
addition to the fees and expenses Fund shareholders directly bear in connection
with the Fund's own operations.
ILLIQUID INVESTMENTS AND RESTRICTED SECURITIES
- ----------------------------------------------
Each Fund will not purchase or otherwise acquire any security if, as a result,
more than 15% (10% for the Money Market Fund) of its net assets (taken at
current value) would be invested in investments that are illiquid by virtue of
the absence of a readily available market or legal or contractual restrictions
on resale. This policy does not include restricted securities eligible for
resale pursuant to Rule 144A under the Securities Act of 1933, as amended ("1933
Act"), which the Board or the Adviser has determined under Board-approved
guidelines are liquid. None of the Funds, however, currently anticipates
investing in such restricted securities.
The term "illiquid investments" for this purpose means investments that cannot
be disposed of within seven days in the ordinary course of business at
approximately the amount at which a Fund has valued the investments. Investments
currently considered to be illiquid include: (1) repurchase agreements not
terminable within seven days, (2) securities for which market quotations are not
readily available, (3) OTC options and their underlying collateral, (4) bank
deposits, unless they are payable at principal amount plus accrued interest on
demand or within seven days after demand, (5) restricted securities not
determined to be liquid pursuant to guidelines established by the Board, and (6)
securities involved in swap, cap, floor and collar transactions. The assets used
as cover for OTC options written by a Fund will be considered illiquid unless
the 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.
A Fund may not be able to sell illiquid investments when the Adviser considers
it desirable to do so or may have to sell such investments at a price that is
lower than the price that could be obtained if the investments were liquid. In
addition, the sale of illiquid investments may require more time and result in
higher dealer discounts and other selling expenses than does the sale of
investments that are not illiquid. Illiquid investments also may be more
difficult to value due to the unavailability of reliable market quotations for
such investments, and investment in illiquid investments may have an adverse
impact on net asset value.
Rule 144A under the 1933 Act establishes a "safe harbor" from the registration
requirements of the 1933 Act for resales of certain securities to qualified
institutional buyers. Institutional markets for restricted securities that have
developed as a result of Rule 144A provide both readily ascertainable values for
certain restricted securities and the ability to liquidate an investment to
satisfy share redemption orders. An insufficient number of qualified
institutional buyers interested in purchasing Rule 144-eligible securities held
by a Fund, however, could affect adversely the marketability of such portfolio
securities and a Fund may be unable to dispose of such securities promptly or at
reasonable prices.
PORTFOLIO TURNOVER
- ------------------
As discussed in the Prospectus, the Trust anticipates that investors in the
Funds, as part of an asset allocation investment strategy, frequently will
redeem Fund shares, as well as exchange their Fund shares for shares of other
Funds. A Fund may have to dispose of certain portfolio investments to maintain
13
<PAGE>
sufficient liquid assets to meet such redemption and exchange requests, thereby
causing a high portfolio turnover.
A Fund's portfolio turnover rate is calculated by the value of the securities
purchased or securities sold, excluding all securities whose maturities at the
time of acquisition were one year or less, divided by the average monthly value
of such securities owned during the year. Based on this calculation, instruments
with remaining maturities of less than one year are excluded from the portfolio
turnover rate. Such instruments generally would include futures contracts and
options, since such contracts generally have a remaining maturity of less than
one year. In any given period, all of a Fund's investments may have a remaining
maturity of less than one year; in which case, the portfolio turnover rate for
that period would be equal to zero. However, each Fund's portfolio turnover
rate, except for the Money Market Fund, calculated with all securities whose
maturities were one year or less is anticipated to be unusually high.
INVESTMENT RESTRICTIONS
In addition to the investment policies and limitations described above and
described in the Prospectus, each Fund has adopted the following investment
limitations, which are fundamental policies and may not be changed without the
vote of a majority of the outstanding voting securities of that Fund. Under the
1940 Act, a "vote of the majority of the outstanding voting securities" of a
Fund means the affirmative vote of the lesser of: (1) more than 50% of the
outstanding shares of a Fund or (2) 67% or more of the shares of a Fund present
at a shareholders meeting if more than 50% of the outstanding shares are
represented at the meeting in person or by proxy.
For purposes of the following limitations, all percentage limitations apply
immediately after a purchase or initial investment. Except with respect to
borrowing money, if a percentage limitation is adhered to at the time of the
investment, a later increase or decrease in the percentage resulting from any
change in value or net assets will not result in a violation of such
restrictions. If at any time a Fund's borrowings exceed its limitations due to a
decline in net assets, such borrowings will be reduced promptly to the extent
necessary to comply with the limitation.
EACH FUND HAS ADOPTED THE FOLLOWING FUNDAMENTAL INVESTMENT POLICY that enables
it to invest in another investment company or series thereof that has
substantially similar investment objectives and policies:
Notwithstanding any other limitation, the Fund may invest all of its
investable assets in an open-end management investment company with
substantially the same investment objectives, policies and limitations as
the Fund. For this purpose, "all of the Fund's investable assets" means
that the only investment securities that will be held by the Fund will be
the Fund's interest in the investment company.
EACH FUND, EXCEPT THE MONEY MARKET FUND, HAS ADOPTED THE FOLLOWING INVESTMENT
LIMITATIONS:
A Fund shall not:
14
<PAGE>
1. Lend any security or make any other loan if, as a result, more than 33 1/3%
of the value of the Fund's total assets would be lent to other parties,
except (1) through the purchase of a portion of an issue of debt securities
in accordance with the Fund's investment objective, policies and
limitations, or (2) by engaging in repurchase agreements with respect to
portfolio securities.
2. Underwrite securities of any other issuer.
3. Purchase, hold, or deal in real estate or oil and gas interests.
4. Issue any senior security (as such term is defined in Section 18(f) of the
1940 Act) (including the amount of senior securities issued by excluding
liabilities and indebtedness not constituting senior securities), except
(1) that the Fund may issue senior securities in connection with
transactions in options, futures, options on futures, forward contracts,
swaps, caps, floors, collars and other similar investments, (2) as
otherwise permitted herein and in Investment Limitations Nos. 5, 7, and 8,
and (3) the Japan/Short Fund, the U.S./Short Fund and the OTC/Short Fund
may make short sales of securities.
5. Pledge, mortgage, or hypothecate the Fund's assets, except (1) to the
extent necessary to secure permitted borrowings, (2) in connection with the
purchase of securities on a forward-commitment or delayed-delivery basis or
the sale of securities on a delayed-delivery basis, and (3) in connection
with options, futures contracts, options on futures contracts, forward
contracts, swaps, caps, floors, collars and other financial instruments.
6. Invest in physical commodities, except that the Fund may purchase and sell
foreign currency, options, futures contracts, options on futures contracts,
forward contracts, swaps, caps, floors, collars, securities on a
forward-commitment or delayed-delivery basis, and other financial
instruments.
EACH FUND, EXCEPT THE U.S. PLUS FUND AND THE OTC PLUS FUND, HAS ADOPTED THE
FOLLOWING INVESTMENT LIMITATION:
A Fund shall not:
7. Borrow money, except (1) as a temporary measure for extraordinary or
emergency purposes and then only in amounts not to exceed 5% of the value
of the Fund's total assets, (2) in an amount up to 33 1/3% of the value of
the Fund's total assets, including the amount borrowed, in order to meet
redemption requests without immediately selling portfolio securities, (3)
to enter into reverse repurchase agreements, and (4) to lend portfolio
securities. For purposes of this investment limitation, the purchase or
sale of options, futures contracts, options on futures contracts, forward
contracts, swaps, caps, floors, collars and other financial instruments
shall not constitute borrowing.
THE JAPAN/LONG FUND, THE U.S. PLUS FUND AND THE OTC PLUS FUND HAVE ADOPTED THE
FOLLOWING INVESTMENT LIMITATION:
A Fund shall not:
15
<PAGE>
8. Make short sales of portfolio securities or purchase any portfolio
securities on margin but may make short sales "against the box," obtain
such short-term credits as are necessary for the clearance of transactions,
and make margin payments in connection with options, futures contracts,
options on futures contracts, forward contracts, swaps, caps, floors,
collars and other financial instruments.
THE U.S. PLUS FUND AND THE OTC PLUS FUND HAVE ADOPTED THE FOLLOWING INVESTMENT
LIMITATION:
A Fund shall not:
9. Borrow money, except (1) to the extent permitted under the 1940 Act (which
currently limits borrowing to no more than 33 1/3% of the value of the
Fund's total assets), (2) as a temporary measure and then only in amounts
not to exceed 5% of the value of the Fund's total assets, (3) to enter into
reverse repurchase agreements, and (4) to lend portfolio securities. For
purposes of this investment limitation, the purchase or sale of options,
futures contracts, options on futures contracts, forward contracts, swaps,
caps, floors, collars and other financial instruments shall not constitute
borrowing.
EACH FUND, EXCEPT THE OTC PLUS FUND AND THE OTC/SHORT FUND, HAS ADOPTED THE
FOLLOWING INVESTMENT LIMITATION:
A Fund shall not:
10. Invest more than 25% of the value of its total assets in the securities of
issuers in any single industry, provided that there shall be no limitation
on the purchase of obligations issued or guaranteed by the U.S. Government,
its agencies or instrumentalities.
THE OTC PLUS FUND AND THE OTC/SHORT FUND HAVE ADOPTED THE FOLLOWING
INVESTMENT LIMITATION:
A Fund shall not:
11. Invest more than 25% of the value of its total assets in the securities of
issuers in any single industry, except for the software and hardware
industries when the percentage of the securities of either industry
constitutes more than 25% of the Nasdaq Index. There shall be no limitation
on the purchase of obligations issued or guaranteed by the U.S. Government,
its agencies or instrumentalities.
THE MONEY MARKET FUND HAS ADOPTED THE FOLLOWING INVESTMENT LIMITATIONS:
The Money Market Fund shall not:
1. Make loans, except through the purchase of qualified debt obligations,
loans of portfolio securities and entry into repurchase agreements.
2. Lend the Fund's portfolio securities in excess of 15% of its total assets.
Any loans of the Fund's portfolio securities will be made according to
16
<PAGE>
guidelines established by the Trustees, including the maintenance of cash
collateral of the borrower equal at all times to the current market value
of the securities loaned.
3. Underwrite securities of any other issuer.
4. Purchase, hold, or deal in real estate or oil and gas interests.
5. Issue senior securities, except as permitted by the Fund's investment
objective and policies.
6. Purchase or sell physical commodities; PROVIDED, HOWEVER, that this
investment limitation does not prevent the Fund from purchasing and selling
options, futures contracts, options on futures contracts, forward
contracts, swaps, caps, floors, collars and other financial instruments.
7. Invest in securities of other investment companies, except to the extent
permitted under the 1940 Act.
8. Mortgage, pledge, or hypothecate the Money Market Fund's assets except to
secure permitted borrowings or in connection with options, futures
contracts, options on futures contracts, forward contracts, swaps, caps,
floors, collars and other financial instruments. In those cases, the Money
Market Fund may mortgage, pledge, or hypothecate assets having a market
value not exceeding the lesser of the dollar amount borrowed or 15% of the
value of total assets of the Money Market Fund at the time of the
borrowing.
9. Make short sales of portfolio securities or purchase any portfolio
securities on margin, except to obtain such short-term credits as are
necessary for the clearance of purchases and sales of securities; provided,
HOWEVER, that this investment limitation does not prevent the Fund from
purchasing and selling options, futures contracts, options on futures
contracts, forward contracts, swaps, caps, floors, collars and other
financial instruments.
In addition, the Money Market Fund does not presently intend to purchase and
sell foreign currency, options, futures contracts, options on futures contracts,
forward contracts, swaps, caps, floors and collars.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to the general supervision by the Trustees, the Adviser is responsible
for decisions to buy and sell securities for each Fund, the selection of
broker-dealers to effect the transactions, and the negotiation of brokerage
commissions, if any. The Adviser expects that the Funds may execute brokerage or
other agency transactions through registered broker-dealers, for a commission,
in conformity with the 1940 Act, the Securities Exchange Act of 1934, as
amended, and the rules and regulations thereunder.
In effecting portfolio transactions for the Funds, the Adviser seeks best
execution of trades either (1) at the most favorable price and efficient
execution of transactions, or (2) with respect to agency transactions, at a
higher rate of commission if reasonable in relation to brokerage and research
services provided to the Funds or the Adviser. Such services may include the
following: information as to the availability of securities for purchase or
sale; statistical or factual information or opinions pertaining to investment;
17
<PAGE>
wire services; and appraisals or evaluations of portfolio securities. Each Fund
believes that the requirement always to seek the lowest possible commission cost
could impede effective portfolio management and preclude the Fund and the
Adviser from obtaining a high quality of brokerage and research services. In
seeking to determine the reasonableness of brokerage commissions paid in any
transaction, the Adviser relies upon its experience and knowledge regarding
commissions generally charged by various brokers and on its judgment in
evaluating the brokerage and research services received from the broker
effecting the transaction.
The Adviser may use research and services provided to it by brokers in servicing
all the Funds; however, not all such services may be used by the Adviser in
connection with a Fund. While the receipt of such information and services is
useful in varying degrees and generally would reduce the amount of research or
services otherwise performed by the Adviser, this information and these services
are of indeterminable value and would not reduce the Adviser's investment
advisory fee to be paid by the Funds.
Purchases and sales of U.S. Government Securities normally are transacted
through issuers, underwriters or major dealers in U.S. Government Securities
acting as principals. Such transactions are made on a net basis and do not
involve payment of brokerage commissions. The cost of securities purchased from
an underwriter usually includes a commission paid by the issuer to the
underwriters; transactions with dealers normally reflect the spread between bid
and asked prices.
MANAGEMENT OF THE TRUST
TRUSTEES AND OFFICERS
The following table lists the Trustees and officers of the Trust, their age,
business address and principal occupation during the past five years. Unless
otherwise noted, an individual's business address is 550 Mamaroneck Avenue,
Harrison, New York 10528.
<TABLE>
<CAPTION>
Position with Principal Occupation
Name The Trust During Past Five Years
---- ------------- ----------------------
<S> <C> <C>
Lawrence C. Rafferty* (55) Chief Executive Officer, Chairman and Chief Executive Officer of
(55) President, Chairman of the Adviser, 1997-present; Chief
the Board of Trustees Executive Officer of Rafferty Companies,
LLC, 1996-present; Chief Executive
Officer of Cohane Rafferty Securities,
Inc., 1987-present (investment banking);
Chief Executive Officer of Rafferty
Capital Markets, Inc., 1995-present;
Trustee of Fairfield University.
Jay F. Higgins* (52) Trustee Managing Partner of CloverLeaf Partners,
411 West Putnam Street Inc., 1992-1997 (investment banking).
Greenwich, CT 06830
18
<PAGE>
Position with Principal Occupation
Name The Trust During Past Five Years
---- ------------- ----------------------
Daniel J. Byrne (53) Trustee President and Chief Executive Officer of
1325 Franklin Avenue Byrne Securities Inc., 1992-present;
Suite 285 Partner of Byrne Capital Management llp,
Garden City, NY 11530 1996-present.
George T. Glisker (50) Trustee President of GTG Securities Corp., April
1010 Franklin Avenue 1997-present (hedge fund); President of
Garden City, NY 11530 New York Capital Mkts. Inc.
Gerald E. Shanley III (53) Trustee Business Consultant, 1985-present;
12 First Street Trustee of Estate of Charles S. Payson,
Pelham, NY 10803 1987-present.
James Terry Apple (58) Chief Investment Officer Vice President of the Adviser, 1997-
100 S. Royal Street present; Portfolio Manager of PADCO
Alexandria, VA 22314 Advisors, 1994-1997; Portfolio Manager
of Money Management Associates,
1992-1993.
Timothy P. Hagan (55) Chief Financial Officer Vice President of the Adviser, 1997-
100 S. Royal Street present; Vice President of PADCO
Alexandria, VA 22314 Advisers, 1993-1997, Vice President of
Money Management Associates, 1981- 1993.
Philip A. Harding (54) Senior Vice President Vice President of the Adviser, 1997-
100 S. Royal Street present; Vice President of Commerzbank
Alexandria, VA 22314 (USA), 1995-1997; Senior Vice President
of Sanwa Bank (USA), 1992-1995.
Thomas A. Mulrooney (50) Chief Operating Officer Chief Operating Officer of the Adviser,
1997-present; President of Rafferty
Capital Markets, 1995-1997; Managing
Partner of Cantor Fitzgerald, Inc.,
1993- 1995; Executive Vice President and
Director of Trading for J.J. Kenny
Drake, Inc., 1985-1993.
Stephen P. Sprague (48) Treasurer, Controller and Vice President and Chief Financial
Assistant Secretary Officer of the Adviser, 1997-present;
Chief Financial Officer of Rafferty
Companies, LLC, 1994-present; Chief
Accountant--International Sub., Goldman
Sachs & Co., 1983-1993.
19
<PAGE>
Position with Principal Occupation
Name The Trust During Past Five Years
---- ------------- ----------------------
Robert J. Zutz (44) Secretary Partner, Kirkpatrick & Lockhart LLP
1800 Massachusetts Ave. (law firm).
Washington, DC 20036
Paul W. Rock (38) Assistant Secretary Vice President, Firstar Trust Company,
9 Greenridge Avenue 1996-present; Senior Vice President,
White Plains, NY 10605 UNB Bank, 1994-1996; Vice President,
Chemical Bank, 1993-1994; Vice
President, US Trust Company, 1990-1993.
Mary S. Kraft (28) Assistant Secretary Compliance Officer, Firstar Trust
615 East Michigan Street Company, 1994-present; Audit Senior with
Milwaukee, WI 53202 Arthur Andersen LLP, 1991-1994.
</TABLE>
- -----------------
* Messrs. Rafferty and Higgins are deemed to be "interested persons" of the
Trust, as defined by the 1940 Act.
The Trustees and officers of the Trust, as a group, own less than 1% of each
Fund's shares outstanding. The Trust's Declaration of Trust provides that the
Trustees will not be liable for errors of judgment or mistakes of fact or law.
However, they are not protected against any liability to which they would
otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence or reckless disregard of the duties involved in the conduct of their
office.
The Trust will pay the Trustees who are not "interested persons" of the Trust as
defined by the 1940 Act ("Independent Trustees") $500 per meeting of the Board.
The Adviser will pay Mr. Higgins similar compensation per meeting of the Board.
Trustees also are reimbursed for any expenses incurred in attending Board
meetings. None of the Trustees have previously or currently serve as a Trustee
or in a comparable capacity for any other registered investment company and,
thus, have not received any prior compensation for such service.
INVESTMENT ADVISER
- ------------------
The Funds' investment adviser, Rafferty Asset Management, LLC, was organized as
a New York limited liability corporation in 1997. The Adviser is a newly
registered investment adviser and has no prior experience advising investment
companies. The Adviser is controlled by Lawrence C. Rafferty.
Under an Investment Advisory Agreement between the Trust, on behalf of the
Funds, and the Adviser ("Advisory Agreement"), the Adviser provides a continuous
investment program for each Fund's assets in accordance with its investment
objectives, policies and limitations, and oversees the day-to-day operations of
the Funds, subject to the supervision of the Trustees. The Adviser bears all
costs associated with providing these advisory services and the expenses of the
Trustees who are affiliated with or interested persons of the Adviser. The Trust
bears all other expenses that are not assumed by the Adviser as described in the
Prospectus. The Trust also is liable for nonrecurring expenses as may arise,
20
<PAGE>
including litigation to which a Fund may be a party. The Trust also may have an
obligation to indemnify its Trustees and officers with respect to any such
litigation.
Pursuant to the Advisory Agreement, each Fund pays the Adviser the following fee
at an annual rate based on its average daily net assets of: 0.75% of the
Japan/Long Fund, U.S. Plus Fund and OTC Plus Fund; 0.90% of the Japan/Short
Fund, U.S./Short Fund and OTC/Short Fund; and 0.50% of the Money Market Fund.
The Advisory Agreement was approved by the Trustees (including all Independent
Trustees) and the Adviser, as sole shareholder of each Fund, in compliance with
the 1940 Act. The Advisory Agreement will continue in force for a period of two
years after the date of its approval. The Agreement is renewable thereafter from
year to year with respect to each Fund, so long as its continuance is approved
at least annually (1) by the vote, cast in person at a meeting called for that
purpose, of a majority of those Trustees who are not "interested persons" of the
Adviser or the Trust, or (2) by the majority vote of either the full Board or
the vote of a majority of the outstanding shares of a Fund. The Advisory
Agreement automatically terminates on assignment and is terminable on 60 days'
written notice either by the Trust or the Adviser.
FUND ADMINISTRATOR, FUND ACCOUNTANT, TRANSFER AGENT AND CUSTODIAN
- ------------------------------------------------------------------
Firstar Trust Company, 615 East Michigan Street, Milwaukee, Wisconsin 53202,
provides administrative, fund accounting, transfer agent and custodian services
to the Funds.
Pursuant to an Administration Servicing Agreement ("Service Agreement") between
the Trust and Firstar Trust Company ("Administrator"), the Administrator
provides the Trust with administrative and management services (other than
investment advisory services). As compensation for these services, the Trust
pays the Administrator a fee of .06% of the first $200,000,000 of the Trust's
average daily net assets, .05% of the next $300,000,000 of the Trust's average
daily net assets, and .03% of the Trust's average daily net assets in excess of
$500,000,000. Notwithstanding the foregoing, the Administrator's minimum annual
fee is $170,000.
Pursuant to a Fund Accounting Servicing Agreement between the Trust and Firstar
Trust Company ("Fund Accountant"), the Fund Accountant provides the Trust with
accounting services, including portfolio accounting services, tax accounting
services and furnishing financial reports. For these services, the Trust pays
the Fund Accountant a flat fee of $25,000 for the first $40 million of average
daily net assets for each the Japan/Long, Japan/Short, OTC/Short and Money
Market Funds; and $22,000 for the first $40 million of average daily net assets
for each the U.S. Plus, U.S./Short and OTC Plus Funds. The Fund Accountant also
is entitled to certain out-of-pocket expenses, including pricing expenses.
Pursuant to a Custodian Agreement, Firstar Trust Company ("Custodian") also
serves as the Custodian of the Funds' assets. Under the terms of the Custodian
Agreement, the Custodian holds and administers the assets in the Funds'
portfolios.
DISTRIBUTOR
- -----------
First Data Distributors, Inc., 4400 Computer Drive, Westborough,
Massachusetts 01581, serves as the distributor ("Distributor") in connection
with the offering of each Fund's shares on a no-load basis. The Distributor
currently receives from the Adviser a fee of $10,000.
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<PAGE>
DISTRIBUTION PLAN
- -----------------
Rule 12b-1 under the 1940 Act provides that an investment company may bear
expenses of distributing its shares only pursuant to a plan adopted in
accordance with the Rule. The Trustees have adopted such a plan (the "Plan") for
each Fund pursuant to which the Funds would compensate the Distributor for
certain expenses incurred in the distribution of that Fund's shares and the
servicing and maintenance of existing Fund shareholder accounts. Pursuant to the
Plan, a Fund may pay the Distributor a service fee of up to 0.25% and a
distribution fee of up to 0.75% of the Fund's average daily net assets. However,
the Trustees have not authorized payment of any fees pursuant to the Plan. The
Trustees will authorize such payments only when they believe that there is a
reasonable likelihood that the Plan will benefit each Fund and its shareholders.
If the Trustees do authorize payment of fees pursuant to the Plan, the Trustees
will review quarterly and annually a written report provided by the Treasurer of
the amounts expended under the Plan and the purposes for which such expenditures
were made.
The Plan will continue in effect, with respect to a Fund, from year to year as
long as its continuance is approved annually by either the Trustees or by a vote
of a majority of the outstanding voting securities of that Fund. In either case,
to continue, the Plan must be approved by the vote of a majority of Independent
Trustees. The Plan can be terminated, with respect to a Fund, at any time by a
vote of a majority of the Independent Trustees or by a vote of a majority of the
outstanding voting securities of that Fund.
INDEPENDENT ACCOUNTANTS
- -----------------------
Price Waterhouse LLP, 100 East Wisconsin Avenue, Suite 1500, Milwaukee,
Wisconsin 53202, are the auditors and the independent accountants for the Trust.
DETERMINATION OF NET ASSET VALUE
As described in the Prospectus, the net asset value per share of the U.S. Plus
Fund, the U.S./Short Fund, the OTC Plus Fund and the OTC/Short Fund is
determined daily, Monday through Friday, each day the New York Stock Exchange
("NYSE") is open for business, which excludes New Year's Day, Presidents' Day,
Martin Luther King's Birthday, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving Day, and Christmas Day. The net asset value per share of
the Japan Plus Fund and the Japan/Short Fund is determined each day the
Singapore International Monetary Exchange ("SIMEX") is open for business.
Trading on the SIMEX may not take place on all days on which the NYSE is open.
The SIMEX is closed on the following Japanese holidays: New Year's Day, New
Year's Holiday, Bank Holiday, Coming-of-Age Day, National Foundation Day, Vernal
Equinox Day, Greenery Day, Constitution Memorial Day, Children's Day, Marine
Day, Respect-for-the-Aged Day, Autumnal Equinox Day, Health-Sports Day, Culture
Day, Labor Thanksgiving Day and the Emperor's Birthday. The net asset value per
share of the Money Market Fund is determined each day that both the NYSE and the
Federal Reserve Bank of New York are open for business.
It is the policy of the Money Market Fund to attempt to maintain a constant
price per share of $1.00. There can be no assurance that a $1.00 net asset value
per share will be maintained. The portfolio instruments held by the Money Market
Fund are valued based on the amortized cost valuation method pursuant to Rule
2a-7 under the 1940 Act. This involves valuing an instrument at its cost and
22
<PAGE>
thereafter assuming a constant amortization to maturity of any discount or
premium, even though the portfolio security may increase or decrease in market
value. Such fluctuations generally are in response to changes in interest rates.
Use of the amortized cost valuation method requires the Money Market Fund to
purchase instruments having remaining maturities of 397 days or less, to
maintain a dollar-weighted average portfolio maturity of 90 days or less, and to
invest only in securities determined by the Trustees to be of high quality with
minimal credit risks. The Money Market Fund may invest in issuers or instruments
that at the time of purchase have received the highest short-term rating by any
two nationally recognized statistical rating organizations ("NRSROs").
Rule 2a-7 requires the Trustees to establish procedures reasonably designed to
stabilize the net asset value per share as computed for purposes of distribution
and redemption. The Board's procedures include monitoring the relationship
between the amortized cost value per share and a net asset value per share based
upon available indications of market value. The Board will decide what, if any,
steps should be taken if there is a difference of more than .5% between the two
methods. The Board will take any steps they consider appropriate (such as
redemption in kind or shortening the average portfolio maturity) to minimize any
material dilution or other unfair results arising from differences between the
two methods of determining net asset value.
A security listed or traded on an exchange, domestic or foreign, is valued at
its last sales price on the principal exchange on which it is traded prior to
the time when assets are valued. If no sale is reported at that time, the most
recent bid price is used. When market quotations for options and futures
positions held by a Fund are readily available, those positions will be valued
based upon such quotations. Securities and other assets for which market
quotations are not readily available, or for which the Adviser has reason to
question the validity of quotations received, are valued at fair value as
determined in good faith by the Board. For valuation purposes, quotations of
foreign securities or other assets denominated in foreign currencies are
translated to U.S. Dollar equivalents using the net foreign exchange rate in
effect at the close of the stock exchange in the country where the security is
issued. Short-term investments having a maturity of 60 days or less are valued
at amortized cost, which approximates market value.
PERFORMANCE INFORMATION
Each Fund's performance data quoted in reports, advertising and other
promotional materials represents past performance and is not intended to
indicate future performance. The investment return and principal value for each
Fund, except for the Money Market Fund, will fluctuate so that an investor's
shares, when redeemed, may be worth more or less than their original costs.
COMPARATIVE INFORMATION
- -----------------------
From time to time, each Fund's performance may be compared with recognized stock
and other indices, such as the Standard & Poor's Composite Stock Price Index
("S&P 500 Index"), the Dow Jones Industrial Average ("DJIA"), the Nasdaq 100
Stock IndexTM ("Nasdaq Index"), and the Nasdaq Composite IndexTM ("Nasdaq
Composite"), the Nikkei 225 Stock Average ("Nikkei Index") and various other
domestic, international and global indices. The S&P 500 Index is a broad index
of common stock prices, while the DJIA represents a narrower segment of
23
<PAGE>
industrial companies. Each assumes reinvestment of distributions and is
calculated without regard to tax consequences or operating expenses. The Nasdaq
Composite comparison may be provided to show how the OTC/Long and the OTC/Short
Funds' total returns compare to the record of a broad average of OTC stock
prices over the same period. The OTC/Long and the OTC/Short Funds have the
ability to invest in securities not included in the Nasdaq Index or the Nasdaq
Composite, and the OTC/Long and the OTC/Short Funds' investment portfolio may or
may not be similar in composition to the Nasdaq Index or the Nasdaq Composite.
In addition, a Fund's total return may be compared to the performance of broad
groups of comparable mutual funds with similar investment objectives, as such
performance is tracked and published by such independent organizations as Lipper
Analytical Services, Inc. ("Lipper"), and CDA Investment Technologies, Inc. When
Lipper's tracking results are used, the Fund will be compared to Lipper's
appropriate fund category, that is, by fund objective and portfolio holdings.
Accordingly, the Lipper ranking and comparison, which may be used by the Trust
in performance reports, will be drawn from the "Capital Appreciation Funds"
grouping for the U.S. Plus Fund and the U.S./Short Fund, from the "Small Company
Growth Funds" grouping for the OTC/Long and the OTC/Short Funds, and from the
"International Funds" grouping for the Japan/Long and the Japan/Short Funds.
Since the assets in all mutual funds are always changing, a Fund may be ranked
within one Lipper asset-size class at one time and in another Lipper asset-size
class at some other time. Footnotes in advertisements and other marketing
literature will include the time period and Lipper asset-size class, as
applicable, for the ranking in question. Performance figures are based on
historical results and are not intended to indicate future performance.
TOTAL RETURN COMPUTATIONS
- -------------------------
For purposes of quoting and comparing the performance of a Fund to that of other
mutual funds and to other relevant market indices in advertisements or in
reports to shareholders, performance for the Fund may be stated in terms of
total return. Such average annual total return quotes for the Funds are
calculated according to the following formula:
P(1+T)[SUPERSCRIPT]n=ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years (either 1, 5 or 10)
ERV = ending redeemable value of a hypothetical $1,000 payment
made at the beginning of the 1, 5 or 10 year periods, as
applicable, at the end of that period
Under the foregoing formula, the time periods used in advertising will be based
on rolling calendar quarters, updated to the last day of the most recent quarter
prior to submission of the advertising for publication, and will cover 1, 5 and
10 year periods or a shorter period dating from the commencement of a Fund's
operations. In calculating the ending redeemable value, all dividends and
distributions by a Fund are assumed to have been reinvested at net asset value
on the reinvestment dates during the period. Total return, or "T" in the formula
above, is computed by finding the average annual compounded rates of return over
the 1, 5 and 10 year periods (or fractional portion thereof) that would equate
the initial amount invested to the ending redeemable value.
24
<PAGE>
From time to time, each Fund also may include in such advertising a total return
figure that is not calculated according to the formula set forth above in order
to compare more accurately the performance of a Fund with other measures of
investment return. For example, in comparing the total return of a Fund with
data published by Lipper or with such market indices as the performance of (1)
the S&P 500 Index or the DJIA for the U.S. Plus and the U.S./Short Funds, (2)
the Nasdaq Index for the OTC/Long and the OTC/Short Funds; and (3) the Nikkei
Index for the Japan/Long and the Japan/Short Funds, each respective Fund
calculates its aggregate total return for the specified periods of time by
assuming an investment of $10,000 in Fund shares and assuming the reinvestment
of each dividend or other distribution at net asset value on the reinvestment
date. Percentage increases are determined by subtracting the initial value of
the investment from the ending value and by dividing the remainder by the
beginning value.
YIELD COMPUTATIONS
- ------------------
The Money Market Fund's annualized current yield, as may be quoted from time to
time in advertisements and other communications to shareholders and potential
investors, is computed for a seven-day period by determining the net change,
exclusive of capital changes and including the value of additional shares
purchased with dividends and any dividends declared therefrom (which reflect
deductions of all expenses of the Fund such as advisory fees), in the value of a
hypothetical preexisting account having a balance of one share at the beginning
of the period, subtracting a hypothetical charge reflecting deductions from
shareholder accounts, and dividing the difference by the value of the account at
the beginning of the base period to obtain the base period return, and then
multiplying the base period return by (365/7).
The Money Market Fund's annualized effective yield, as may be quoted from time
to time in advertisements and other communications to shareholders and potential
investors, is computed by determining (for the same stated seven-day period as
the current yield) the net change, exclusive of capital changes and including
the value of additional shares purchased with dividends and any dividends
declared therefrom (which reflect deductions of all expenses of the Fund such as
advisory fees), in the value of a hypothetical preexisting account having a
balance of one share at the beginning of the period, and dividing the difference
by the value of the account at the beginning of the base period to obtain the
base period return, and then compounding the base period return by adding 1,
raising the sum to a power equal to 365 divided by 7, and subtracting 1 from the
result, according to the following formula:
Effective Yield = [(Base Period Return + 1) 365/7] - 1
The yields quoted in any advertisement or other communication should not be
considered a representation of the yields of the Money Market Fund in the future
since the yield is not fixed. Actual yields will depend not only on the type,
quality, and maturities of the investments held by the Money Market Fund and
changes in interest rates on such investments, but also on changes in the Money
Market Fund's expenses during the period.
Yield information may be useful in reviewing the performance of the Money Market
Fund and for providing a basis for comparison with other investment
alternatives. However, unlike bank deposits or other investments, which
typically pay a fixed yield for a stated period of time, the Money Market Fund's
yield will fluctuate.
25
<PAGE>
DIVIDENDS, OTHER DISTRIBUTIONS AND TAXES
DIVIDENDS AND OTHER DISTRIBUTIONS
- ---------------------------------
Dividends from net investment income and any distributions of realized net
capital gains and net gains from foreign currency transactions will be
distributed as described in the Prospectus under "Dividends and Other
Distributions." All distributions from a Fund normally will be automatically
reinvested without charge in additional shares of that Fund.
As discussed in the Prospectus, the Money Market Fund ordinarily will declare
dividends daily from net investment income and distribute such dividends
monthly. Net income, for these purposes, includes accrued interest and accretion
of original issue and market discounts, less amortization of market premium and
estimated expenses, and will be calculated immediately prior to the
determination of the Fund's net asset value per share. The Fund distributes its
net short-term capital gain, if any, annually but may make more frequent
distributions thereof if necessary to maintain its net asset value per share at
$1.00 or to avoid income or excise taxes. The Fund does not expect to realize
net long-term capital gain and thus does not anticipate payment of any
distributions of net capital gain (the excess of net long-term capital gain over
net short-term capital loss). The Trustees may revise this dividend policy, or
postpone the payment of dividends, if the Fund has or anticipates any large
unexpected expense, loss, or fluctuation in net assets that, in the Trustees'
opinion, might have a significant adverse effect on its shareholders.
TAXES
- -----
REGULATED INVESTMENT COMPANY STATUS. To qualify for treatment as a regulated
investment company ("RIC") under the Internal Revenue Code of 1986, as amended
("Code"), each Fund -- which is treated as a separate corporation for these
purposes -- must distribute to its shareholders for each taxable year at least
90% of its investment company taxable income (consisting generally of net
investment income, net short-term capital gain, and net gains from certain
foreign currency transactions) ("Distribution Requirement") and must meet
several additional requirements. For each Fund, these requirements include the
following: (1) the Fund must derive at least 90% of its gross income each
taxable year from dividends, interest, payments with respect to securities
loans, and gains from the sale or other disposition of securities or foreign
currencies, or other income (including gains from options, futures, or forward
contracts) derived with respect to its business of investing in securities or
those currencies ("Income Requirement"); and (2) at the close of each quarter of
the Fund's taxable year, (i) at least 50% of the value of its total assets must
be represented by cash and cash items, U.S. Government Securities, securities of
other RICs, and other securities, with those other securities limited, in
respect of any one issuer, to an amount that does not exceed 5% of the value of
the Fund's total assets and that does not represent more than 10% of the
issuer's outstanding voting securities, and (ii) not more than 25% of the value
of its total assets may be invested in securities (other than U.S. Government
Securities or the securities of other RICs) of any one issuer (collectively,
"Diversification Requirements").
Although the Funds intend to satisfy all the foregoing requirements, there is no
assurance that each Fund will be able to do so. The investment by a Fund other
than the Money Market Fund primarily in options and futures positions entails
some risk that such a Fund might fail to satisfy the Diversification
Requirements. There is some uncertainty regarding the valuation of such
positions for purposes of those requirements; accordingly, it is possible that
the method of valuation used by the Funds, pursuant to which each of them would
be treated as satisfying the Diversification Requirements, would not be accepted
26
<PAGE>
in an audit by the Internal Revenue Service, which would apply a different
method resulting in disqualification of one or more of those Funds.
GENERAL. If Fund shares are sold at a loss after being held for six months or
less, the loss will be treated as long-term, instead of short-term, capital loss
to the extent of any capital gain distributions received on those shares.
Investors also should be aware that if shares are purchased shortly before the
record date for any dividend or capital gain distribution, the shareholder will
pay full price for the shares and receive some portion of the purchase price
back as a taxable distribution.
Each Fund will be subject to a nondeductible 4% excise tax ("Excise Tax") to the
extent it fails to distribute by the end of any calendar year substantially all
of its ordinary income for that year and capital gain net income for the
one-year period ending on October 31 of that year, plus certain other amounts.
INCOME FROM FOREIGN SECURITIES. Dividends and interest received by the
Japan/Long Fund and dividends received by the Japan/Short Fund, and gains
realized by each such Fund, may be subject to income, withholding, or other
taxes imposed by foreign countries and U.S. possessions that would reduce the
yield and/or total return on their securities. Tax conventions between certain
countries and the United States may reduce or eliminate these foreign taxes,
however, and many foreign countries do not impose taxes on capital gains in
respect of investments by foreign investors.
The Japan/Long Fund may invest in the stock of "passive foreign investment
companies" ("PFICs"). A PFIC is a foreign corporation -- other than a
"controlled foreign corporation" (I.E., a foreign corporation in which, on any
day during its taxable year, more than 50% of the total voting power of all
voting stock therein or the total value of all stock therein is owned, directly,
indirectly, or constructively, by "U.S. shareholders," defined in the singular
as a U.S. person that owns, directly, indirectly, or constructively, at least
10% of that voting power) as to which the Fund is a U.S. shareholder (effective
for the Fund's taxable years beginning after 1997) -- that, in general, meets
either of the following tests: (1) at least 75% of its gross income is passive
or (2) an average of at least 50% of its assets produce, or are held for the
production of, passive income. Under certain circumstances, the Fund will be
subject to Federal income tax on a portion of any "excess distribution" received
on the stock of a PFIC or of any gain on disposition of the stock (collectively,
"PFIC income"), plus interest thereon, even if the Fund distributes the PFIC
income as a taxable dividend to its shareholders. The balance of the PFIC income
will be included in the Fund's investment company taxable income and,
accordingly, will not be taxable to it to the extent that income is distributed
to its shareholders. If the Fund invests in a PFIC and elects to treat the PFIC
as a "qualified electing fund" ("QEF"), then, in lieu of the foregoing tax and
interest obligation, the Fund would be required to include in income each year
its PRO RATA share of the QEF's annual ordinary earnings and net capital gain --
which probably would have to be distributed by the Fund to satisfy the
Distribution Requirement and avoid imposition of the Excise Tax -- even if those
earnings and gain were not received by the Fund from the QEF. In most instances
it will be very difficult, if not impossible, to make this election because of
certain requirements thereof.
Effective for its taxable years beginning after 1997, the Japan/Long Fund may
elect to "mark to market" its stock in any PFIC. "Marking-to-market," in this
context, means including in ordinary income each taxable year the excess, if
any, of the fair market value of the PFIC's stock over the Fund's adjusted basis
therein as of the end of that year. Pursuant to the election, the Fund also
would be allowed to deduct (as an ordinary, not capital, loss) the excess, if
any, of its adjusted basis in PFIC stock over the fair market value thereof as
27
<PAGE>
of the taxable year-end, but only to the extent of any net mark-to-market gains
with respect to that stock included by the Fund for prior taxable years. The
Fund's adjusted basis in each PFIC's stock with respect to which it makes this
election would be adjusted to reflect the amounts of income included and
deductions taken under the election. Regulations proposed in 1992 would provide
a similar election with respect to the stock of certain PFICs.
Gains or losses (1) from the disposition of foreign currencies, (2) from the
disposition of debt securities denominated in foreign currency that, in each
instance, are attributable to fluctuations in the value of the foreign currency
between the date of acquisition of the security and the date of disposition
thereof, and (3) that are attributable to fluctuations in exchange rates that
occur between the time a Fund accrues dividends, interest, or other receivables
or expenses or other liabilities denominated in a foreign currency and the time
the Fund actually collects the receivables or pays the liabilities, generally
will be treated as ordinary income or loss. These gains or losses, referred to
under the Code as "section 988" gains or losses, may increase or decrease the
amount of a Fund's investment company taxable income to be distributed to its
shareholders.
DISTRIBUTIONS TO FOREIGN SHAREHOLDERS. Dividends paid by a Fund to a shareholder
who, as to the United States, is a nonresident alien individual or nonresident
alien fiduciary of a trust or estate, foreign corporation, or foreign
partnership ("foreign shareholder") generally will be subject to U.S.
withholding tax (at a rate of 30% or, if the United States has an income tax
treaty with the foreign country where the foreign shareholder resides, any lower
treaty rate). An investor claiming to be a foreign shareholder will be required
to provide a Fund with supporting documentation in order for the Fund to apply a
reduced withholding rate or exemption from withholding. Withholding will not
apply if a dividend paid by a Fund to a foreign shareholder is "effectively
connected with the conduct of a U.S. trade or business," in which case the
reporting and withholding requirements applicable to domestic shareholders will
apply.
DERIVATIVES STRATEGIES. The use of derivatives strategies, such as writing
(selling) and purchasing options and futures contracts and entering into forward
contracts, involves complex rules that will determine for income tax purposes
the amount, character, and timing of recognition of the gains and losses a Fund
realizes in connection therewith. Gains from the disposition of foreign
currencies (except certain gains that may be excluded by future regulations),
and gains from options, futures, and forward contracts derived by a Fund with
respect to its business of investing in securities or foreign currencies, will
qualify as permissible income under the Income Requirement.
Certain options (including options on "broad-based" stock indices) and futures
in which the Funds may invest will be "section 1256 contracts." Section 1256
contracts held by a Fund at the end of each taxable year, other than section
1256 contracts that are part of a "mixed straddle" with respect to which the
Fund has made an election not to have the following rules apply, must be
"marked-to-market" (that is, treated as sold for their fair market value) for
Federal income tax purposes, with the result that unrealized gains or losses
will be treated as though they were realized. Sixty percent of any net gain or
loss recognized on these deemed sales, and 60% of any net realized gain or loss
from any actual sales of section 1256 contracts, will be treated as long-term
capital gain or loss, and the balance will be treated as short-term capital gain
or loss. Section 1256 contracts also may be marked-to-market for purposes of the
Excise Tax.
Code section 1092 (dealing with straddles) may also affect the taxation of
options and futures contracts in which the Funds may invest. Section 1092
28
<PAGE>
defines a "straddle" as offsetting positions with respect to personal property;
for these purposes, options and futures contracts are personal property. Section
1092 generally provides that any loss from the disposition of a position in a
straddle may be deducted only to the extent the loss exceeds the unrealized gain
on the offsetting position(s) of the straddle. Section 1092 also provides
certain "wash sale" rules, which apply to transactions where a position is sold
at a loss and a new offsetting position is acquired within a prescribed period,
and "short sale" rules applicable to straddles. If a Fund makes certain
elections, the amount, character, and timing of recognition of gains and losses
from the affected straddle positions would be determined under rules that vary
according to the elections made. Because only a few of the regulations
implementing the straddle rules have been promulgated, the tax consequences to
the Funds of straddle transactions are not entirely clear.
If a call option written by a Fund lapses (I.E., terminates without being
exercised), the amount of the premium it received for the option will be
short-term capital gain. If a Fund enters into a closing purchase transaction
with respect to a written call option, it will have a short-term capital gain or
loss based on the difference between the premium it received for the option it
wrote and the premium it pays for the option it buys. If such an option is
exercised and a Fund thus sells the securities or futures contract subject to
the option, the premium the Fund received will be added to the exercise price to
determine the gain or loss on the sale. If a call option purchased by a Fund
lapses, it will realize short-term or long-term capital loss, depending on its
holding period for the security or futures contract subject thereto. If a Fund
exercises a purchased call option, the premium it paid for the option will be
added to the basis of the subject securities or futures contract.
The foregoing is only a general summary of some of the important Federal income
tax considerations generally affecting the Funds. No attempt is made to present
a complete explanation of the Federal tax treatment of their activities, and
this discussion is not intended as a substitute for careful tax planning.
Accordingly, potential investors are urged to consult their own tax advisers for
more detailed information and for information regarding any state, local or
foreign taxes applicable to the Funds and to dividends and other distributions
therefrom.
FINANCIAL STATEMENTS
The Trust's audited financial statements as of September 2, 1997, which
have been audited by Price Waterhouse LLP, are included herein this Statement of
Additional Information.
<PAGE>
Potomac Funds
Statement of Assets and Liabilities
September 2, 1997
<TABLE>
<CAPTION>
Government
Japan/ Japan/ U.S. U.S./ OTC OTC/ Money
Long Short Plus Short Plus Short Market
Fund Fund Fund Fund Fund Fund Fund
----- ----- ----- ----- ---- ----- ---------
<S> <C> <C> <C> <C> <C> <C>
ASSETS
Cash $ 10 $ 10 $ 10 $ 10 $ 10 $ 10 $ 99,940
Unamortized organization costs 14,860 14,860 14,859 14,859 14,859 14,859 14,859
Prepaid initial registration expenses 15,575 15,575 15,576 15,576 15,576 15,576 15,576
------- ------- ------- ------- -------- ------ ----------
Total Assets 30,445 30,445 30,445 30,445 30,445 30,445 130,375
------- ------- ------- ------- -------- ------ ----------
LIABILITIES
Payable to adviser 30,435 30,435 30,435 30,435 30,435 30,435 30,435
------- ------- ------- ------- -------- ------ ---------
Total Liabilities 30,435 30,435 30,435 30,435 30,435 30,435 30,435
------- ------- ------- ------- -------- ------ ---------
NET ASSETS $ 10 $ 10 $ 10 $ 10 $ 10 $ 10 $ 99,940
======= ======= ======= ======= ======== ======= =========
Capital shares, no par value;
unlimited shares of beneficial
interest authorized 1 1 1 1 1 1 99,940
======= ======= ======= ======= ======== ======= =========
Net asset value, offering and
redemption price per share
(net assets/shares of beneficial
interest outstanding) $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 1.00
======= ======= ======= ======= ======== ======= =========
The accompanying notes to the financial statement are an integral part of this statement.
</TABLE>
<PAGE>
Potomac Funds
Notes to the Financial Statement
September 2, 1997
1. Organization
------------
Potomac Funds (the "Trust") was organized as a Massachusetts Business
Trust on June 6, 1997 and is registered under the Investment Company
Act of 1940, as amended (the "1940 Act"), as an open-end management
investment company issuing its shares in series, each series
representing a distinct portfolio with its own investment objectives
and policies. The series presently authorized are the Japan/Long Fund,
Japan/Short Fund, U.S. Plus Fund, U.S./Short Fund, OTC Plus Fund,
OTC/Short Fund and the U.S. Government Money Market Fund (collectively,
the "Funds"). Each Fund (other than the U.S. Government Money Market
Fund) is a "non-diversified" series of the Trust pursuant to the 1940
Act. The Funds have had no operations other than those relating to
organizational matters, including the sale of one share for cash in the
amount of $10 of each of the Japan/Long Fund, Japan/Short Fund, U.S.
Plus Fund, U.S./Short Fund, OTC Plus Fund, OTC/Short Fund and 99,940
shares for cash in the amount of $99,940 of the U.S. Government Money
Market Fund to capitalize the Funds, which were sold to Rafferty Asset
Management LLC (the "Adviser") on September 2, 1997.
2. Significant Accounting Policies
-------------------------------
(a) Organization Costs
------------------
Costs incurred by the Trust in connection with the organization,
registration and the initial public offering of shares, are being
deferred and amortized over the period of benefit, but not to
exceed sixty months from the Trust's commencement of operations.
These costs were advanced by the Adviser and will be reimbursed
by the Trust. The proceeds of any redemption of the initial
shares by the original shareholder will be reduced by a pro-rata
portion of any then unamortized organizational expenses in the
same proportion as the number of initial shares being redeemed
bears to the number of initial shares outstanding at the time of
such redemption.
(b) Federal Income Taxes
--------------------
Each Fund intends to comply with the requirements of the Internal
Revenue Code necessary to qualify as a regulated investment
company and to make the requisite distributions of income and
capital gains to their shareholders sufficient to relieve it from
all or substantially all Federal income taxes.
3. Investment Adviser
------------------
The Trust has an agreement with the Adviser, with whom certain officers
and Trustees of the Trust are affiliated, to furnish investment
<PAGE>
advisory services to the Funds. Under the terms of this agreement, the
Adviser will receive the following percentage of average daily net
assets for each Fund: 0.75% for the Japan/Long Fund, 0.90% for the
Japan/Short Fund, 0.75% for the U.S. Plus Fund, 0.90% for the
U.S./Short Fund, 0.75% for the OTC Plus Fund, 0.90% for the OTC/Short
Fund and 0.50% for the U.S. Government Money Market Fund.
4. Service and Distribution Plan
-----------------------------
Pursuant to Rule 12b-1 under the 1940 Act, the Funds have adopted a
Service and Distribution Plan (the "Plan"). The Plan provides that each
Fund will compensate the distributor for certain expenses incurred in
the distribution of that Fund's shares and the servicing and
maintenance of existing Fund shareholder accounts. Pursuant to the
Plan, a Fund may pay the distributor a service fee of up to 0.25% and a
distribution fee of up to 0.75% of the Fund's average daily net assets.
However, the Plan will not be activated until such time as the Trust
obtains Trustee approval.
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Trustees of
Potomac Funds
In our opinion, the accompanying statement of assets and liabilities presents
fairly, in all material respects, the financial position of each of the
portfolios of Potomac funds (the "Fund") at September 2, 1997, in conformity
with generally accepted accounting principles. This financial statement is the
responsibility of the Fund's management; our responsibility is to express an
opinion on this financial statement based on our audits. We conducted our audits
of this financial statement in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statement is free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statement, assessing the accounting
principles used and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ Price Waterhouse LLP
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Price Waterhouse LLP
Milwaukee Wisconsin
September 2, 1997
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CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the use in the Statement of Additional Information
constituting part of this Pre-Effective Amendment No. 1 to the registration
statement on Form n-1A (the "Registration statement") of our report dated
September 2, 1997, relating to the statement of assets and liabilities of the
Potomac Funds, which appears in such Statement of Additional Information, and to
the incorporation by reference of our report into the Prospectus which
constitutes part of this Registration Statement. We also consent to the
references to us under the heading "Independent Accountants" in such Statement
of Additional Information and to the reference under the hearing "Independent
Auditors" in such Prospectus.
Price Waterhouse LLP
Milwaukee, Wisconsin
September 15, 1997
