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PROSPECTUS
[LOGO]
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
The Potomac Small Cap Plus Fund (the "Fund") is a separate investment
portfolio of the Potomac Funds (the "Trust"), a no-load management investment
company or mutual fund. The Fund is designed principally for experienced
investors many of whom employ an asset allocation strategy. The Fund is not
designed for inexperienced or less sophisticated investors.
The Fund seeks to provide investment returns that correspond to 125% of
the performance of the Russell 2000 Index.-TM- The Fund may engage in certain
aggressive investment techniques including transactions in options and futures
contracts. It also may use the speculative technique known as leverage to
increase funds available for investment. See "Special Risk Considerations."
Investors in the Fund may experience substantial losses during sustained periods
of falling equity prices. The Fund alone does not constitute a balanced
investment plan, and investments in the Fund involve special risks not
traditionally associated with investment companies, including significant
portfolio turnover. There can be no assurance that the 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 Fund before investing. A Statement of Additional
Information ("SAI"), dated February 16, 1999, containing additional information
about the Fund,
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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 Fund 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 Fund.
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.
Prospectus dated February 16, 1999
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TABLE OF CONTENTS
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Page
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PROSPECTUS SUMMARY........................................................ 3
FEES AND EXPENSES OF THE FUND............................................. 5
INVESTMENT OBJECTIVE AND POLICIES......................................... 6
SPECIAL RISK CONSIDERATIONS............................................... 7
INVESTMENT TECHNIQUES AND OTHER INVESTMENT POLICIES....................... 9
PORTFOLIO TRANSACTIONS AND BROKERAGE...................................... 13
HOW TO INVEST IN THE FUND................................................. 13
TAX-DEFERRED RETIREMENT PLANS............................................. 14
REDEEMING SHARES (WITHDRAWALS)............................................ 14
EXCHANGES................................................................. 15
PROCEDURES FOR REDEMPTIONS AND EXCHANGES.................................. 16
DETERMINATION OF NET ASSET VALUE.......................................... 17
PERFORMANCE INFORMATION................................................... 17
DIVIDENDS AND OTHER DISTRIBUTIONS......................................... 18
TAXES..................................................................... 18
MANAGEMENT AND ADMINISTRATION OF THE FUND................................. 19
GENERAL INFORMATION ABOUT THE TRUST AND FUND.............................. 20
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PROSPECTUS SUMMARY
The Potomac Small Cap Plus Fund seeks to provide investment returns that
correspond to 125% of the performance of the Russell 2000 Index-TM- ("Russell
2000"). 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 Russell 2000, the Fund may produce
gains greater than that return during periods when the prices of securities
included in the Russell 2000 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. There is no guarantee that the Fund
will achieve its investment objective.
SPECIAL RISK CONSIDERATIONS
The Fund may engage in certain aggressive investment techniques, including
investing in futures contracts and options on securities, stock indices and
futures contracts. As discussed more fully under "Investment Objective 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 Fund expects that a substantial number of its investors will be
experienced and will invest as part of an asset allocation investment strategy.
These shareholders likely will
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redeem or exchange their Fund shares frequently to take advantage of anticipated
changes in market conditions. The strategies employed by Fund investors may
result in considerable assets moving in and out of the Fund and, consequently, a
high portfolio turnover rate. A high portfolio turnover rate generally causes
the Fund to incur higher expenses and additional costs and may adversely affect
the ability of the Fund to meet its investment objective.
The Fund may borrow money from banks for investment purposes, which is a
form of leveraging. This leverage will magnify the gains and losses on the
Fund's investments and the changes in the Fund's net asset value per share. The
Fund may borrow money for temporary or emergency purposes and to meet redemption
requests without immediately selling portfolio securities.
While the Fund does not expect its returns over a twelve-month period to
deviate from its current benchmark by more than 10%, certain factors may affect
its ability to achieve this correlation.
Under certain circumstances, trading on an exchange may be halted or
closed early, resulting in the Fund being unable to execute buy or sell orders
that day. If that occurs and the Fund needs to execute a high volume of trades
on that trading day, it may incur substantial trading losses.
PURCHASES, REDEMPTIONS, AND EXCHANGES OF FUND SHARES
The minimum initial investment is $10,000, which can be allocated in any
amounts among any of the six portfolios of the Trust, including the Fund. Please
call (800) 851-0511 to obtain a prospectus for the Trust's other portfolios.
Fund shares may be purchased and redeemed without any sales or redemption
charges at the Fund's next determined net asset value. Fund shares may be
exchanged at any time for shares of any other portfolio of the Trust, on the
basis of the relative net asset values next computed, without charge. 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. 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 Fund," "Redeeming Shares (Withdrawals)" and "Procedures
for Redemptions and Exchanges."
INVESTMENT ADVISER
Rafferty Asset Management, LLC ("Adviser") serves as the Fund's investment
adviser. The Adviser has been registered as an investment adviser since June
1997. Lawrence C. Rafferty controls the Adviser.
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FEES AND EXPENSES OF THE FUND
The following table illustrates the various expenses and fees that a
shareholder of the Fund may incur either directly or indirectly. The Fund's
total operating expenses, including Other Expenses, are based on estimated
amounts for the fiscal year ending August 31, 1999.
ANNUAL FUND OPERATING EXPENSES
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Total Fund
Management Rule 12b-1 Other Operating
Fees# Fees+ Expenses# Expenses#*
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<S> <C> <C> <C> <C>
Small Cap Plus
Fund: 0.75% None 0.73% 1.48%
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# The Adviser voluntarily will waive its fees and, if necessary, reimburse
the Fund to the extent that annual operating expenses exceed 1.50% of the
Fund's average daily net assets.
+ The Fund has 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 and Fund -- Distribution of Fund
Shares" below.
* You will be charged $12.00 per wire redemption to cover transaction costs.
EXAMPLE
Assuming a hypothetical investment of $1,000 in the Fund, a 5% annual
return, and redemption at the end of each time period, an investor in the Fund
would pay transaction and operating expenses at the end of each period as
follows:
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<CAPTION>
1 3
Year Years
----- -----
<S> <C> <C>
Small Cap Plus Fund $ 15 $ 47
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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 the Fund. The 5% assumed annual return is for
comparison purposes only. THE FOREGOING EXAMPLES SHOULD NOT BE CONSIDERED A
REPRESENTATION OF PAST OR 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
Fund's fees, see "Management and Administration of the Fund" in this Prospectus
and in the SAI.
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INVESTMENT OBJECTIVE
AND POLICIES
The investment objective of the Fund is to provide investment returns that
correspond to 125% of the performance of the Russell 2000. 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 the Russell 2000. 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
Russell 2000, the Fund may produce greater returns than such a fund during
periods when the prices of the securities in the Russell 2000 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 Fund is designed principally for experienced investors who intend to
follow an asset allocation investment strategy. The Fund is not designed for
inexperienced or less sophisticated investors. The Fund seeks investment results
that correspond over time to the Russell 2000.
The Adviser uses a number of investment techniques in an effort to
correlate the 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 the 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 the Fund
and the performance of its benchmark), certain factors will tend to cause the
Fund's investment results to vary from a perfect correlation to its benchmark.
The Adviser, however, does not expect that the Fund's total returns will vary
from its current benchmark by more than 10% over a twelve-month period. See
"Special Risk Considerations -- Tracking Error." It is the Fund's policy to
pursue its investment objective regardless of market conditions, to remain
substantially fully invested and not to take defensive positions. However,
because of the difficulty in tracking the Fund's benchmark with a small amount
of net assets, the Advisor will invest the Fund's assets in short-term U.S.
Government securities until the Fund's net assets reach $10 million. As a
result, the Fund may not achieve its investment objective during this period.
The Fund's investment objective is not a fundamental policy and may be
changed by the Board of Trustees ("Trustees" or the "Board") without shareholder
approval. Certain investment restrictions of the Fund are fundamental policies
and may not be changed without the affirmative vote of at least the majority of
the outstanding shares of the Fund, as defined in the Investment
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Company Act of 1940, as amended (the "1940 Act"). All other investment policies
of the Fund not specified as fundamental may be changed by the Board of Trustees
of the Trust without shareholder approval. There can be no assurance that the
Fund will achieve its objective. For a discussion of the instruments the Fund
may use, see "Investment Techniques and Other Investment Policies."
THE BENCHMARK
RUSSELL 2000 INDEX.-TM- The Russell 2000 is comprised of the smallest 2000
companies in the Russell 3000 Index. The smallest 2000 companies represent
approximately 11% of the Russell 3000 in total market capitalization. Currently,
the average market capitalization of the companies included in the Russell 2000
is between $500 million and $750 million.
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SPECIAL RISK CONSIDERATIONS
The following factors may be important in determining the appropriateness
of investing in the Fund.
AGGRESSIVE INVESTMENT TECHNIQUES. The Fund may engage in certain
aggressive investment techniques that may include investing in futures contracts
and options on securities, securities indices, and futures contracts. In doing
so, a significant portion of the Fund's 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 and the investment in indexed securities, involve 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 the 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 the Fund
on options it purchases, and (7) the possible inability of the 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 the 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 the Fund to close out or liquidate its position.
These instruments may increase the Fund's volatility 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 the 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 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
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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. The 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 Fund anticipates that its investors frequently
will redeem Fund shares, as well as exchange their Fund shares for shares of
another portfolio of the Trust. The 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 the Fund's portfolio turnover rate will depend largely on the
purchase, redemption, and exchange activity of its investors, it is difficult to
estimate what the Fund's actual turnover rate will be. Based on the formula
prescribed by the SEC, the Fund's portfolio turnover rate is calculated without
regard to securities, including options and futures contracts, having a maturity
of less than one year. The Fund will hold most of its 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 Fund's portfolio turnover rate would be
approximately 500%.
A higher portfolio turnover ratio would likely involve correspondingly
higher brokerage commissions and other expenses borne by the Fund. Such higher
expenses can adversely affect the ability of the Fund to achieve its investment
objective.
BORROWING. The Fund may borrow money from banks for investment purposes,
which is a form of leveraging. This leverage will magnify the gains and losses
on the Fund's investments and on changes in its 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 creates the potential for significant losses.
TRACKING ERROR. While the Fund does not expect that its returns over a
twelve-month period will deviate from its benchmark by more than 10%, several
factors may affect the Fund's 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 the Fund and securities not included
in the benchmark being held by the Fund; (3) an imperfect correlation between
the performance of instruments held by the 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) the Fund holding instruments that are illiquid or
the market for which becomes disrupted; (6) the need to conform the Fund's
portfolio holdings to comply with the Fund's investment restrictions or
policies, or regulatory or tax law requirements; and (7) market
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movements that run counter to the 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, the Fund's short-term performance will reflect such deviation from its
benchmark.
TRADING HALTS. The Fund typically will hold most of its investments in
short-term options and futures contracts. The major exchanges on which these
contracts are traded, such as the Chicago Mercantile Exchange ("CME") and the
Chicago Board of Options Exchange ("CBOE") 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, the
Fund will not be able to execute purchase or sales transactions in the specific
option or futures contracts affected. In such an event, the Fund also would be
unable to accurately price its outstanding contracts. A trading halt by the CME
or the CBOE at the end of a business day would constitute an emergency situation
under SEC regulations. If affected by such an emergency, the Fund would not be
able to accept investors' orders for purchases, redemptions, or exchanges
received earlier during the business day.
CLASSIFICATION OF THE FUND. The Fund is a "non-diversified" series of the
Trust pursuant to the 1940 Act. The 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. 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. The Fund, however, intends to
qualify as a RIC. This requires, among other things, that the Fund, at the end
of each quarter of its tax year, meet certain diversification standards.
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INVESTMENT TECHNIQUES
AND OTHER
INVESTMENT POLICIES
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS
The Fund may purchase and sell stock index futures contracts and options
on such futures contracts. The Fund may purchase and sell futures and options
thereon as a substitute for a comparable market position in the underlying
securities 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 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
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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 the 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 the 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).
Whether the Fund realizes a gain or loss from futures activities depends
upon movements in the underlying 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 Fund will only
purchase and sell futures contracts and options on futures contracts that are
traded on a U.S. exchange or board of trade.
To the extent that the Fund enters into futures or options on futures
contracts 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 its 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 the Fund's assets that are at risk in futures contracts
and options on futures contracts.
OPTIONS ON INDICES AND SECURITIES
The Fund may purchase and sell put and call options on stock indices and
on individual securities. The Fund may purchase and sell put and call options as
a substitute for a comparable market position in the underlying securities 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 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
Russell 2000, S&P 500 Index, the New York Stock Exchange Composite Index or the
American Stock Exchange
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Major Market Index, or on a narrower index such as the Philadelphia Stock
Exchange Over-the-Counter Index. Options currently are traded on the CBOE, the
American Stock Exchange and other exchanges. Options also are traded in the OTC
markets and the Fund may buy and sell both exchange-traded and OTC options.
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 the Fund may buy or sell.
By buying a call option on a security the Fund has the right, in return
for the premium paid, to buy the security underlying the option at the exercise
price. By writing (selling) a call option and receiving a premium, the Fund
becomes obligated during the term of the option to deliver securities underlying
the option at the exercise price if the option is exercised. By buying a put
option, the Fund has the right, in return for the premium, to sell the security
underlying the option at the exercise price. By writing a put option, the Fund
becomes obligated during the term of the option to purchase the securities
underlying the option at the exercise price.
Because options premiums paid or received by the 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.
INDEXED SECURITIES
The 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 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 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.
U.S. GOVERNMENT SECURITIES
The Fund 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.
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.
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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 the Fund's
portfolio investments in U.S. Government Securities; while a decline in interest
rates generally would increase the market value of the Fund's portfolio
investments in these securities.
REPURCHASE AGREEMENTS
Under a repurchase agreement, the 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. The 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 the 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
The 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. The Fund will not invest more than 15%
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 the Fund
has valued the investments. Under the current SEC staff guidelines, illiquid
investments also include purchased OTC options, certain cover for OTC options,
repurchase agreements not terminable within seven days and restricted securities
not determined to be liquid pursuant to guidelines established by the Trustees.
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OTHER INVESTMENT PRACTICES
The Fund may borrow for investment purposes. The Fund may also borrow
money as a temporary measure for extraordinary or emergency purposes and to meet
redemption requests without immediately selling portfolio securities. In
addition, the Fund may lend securities to broker-dealers and financial
institutions, provided that the borrower at all times maintains cash 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 the Fund would exceed 33 1/3% of its total assets. For a
more detailed discussion of these practices, see the SAI.
----------------------------------------
PORTFOLIO
TRANSACTIONS AND
BROKERAGE
The Adviser will place orders to execute securities transactions that are
designed to implement the 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.
----------------------------------------
HOW TO INVEST IN
THE FUND
GENERAL
The minimum initial investment is $10,000, which can be allocated in any
amounts among the six portfolios of the Potomac Funds. Fund shares 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 the
Fund. The Fund reserves the right to reject or refuse, at its discretion, any
order for the purchase of Fund shares in part or whole. The minimum amount for
subsequent investments in the Fund is $1,000.
Investments in the Fund may be made (1) through securities broker-dealers
or agents who have the responsibility to transmit orders promptly and who may
charge a processing fee, (2) directly with the Fund by mail or bank wire
transfer to the Fund's transfer agent, Firstar Mutual Fund Services, LLC
("Transfer Agent") as described below.
BY MAIL
You may purchase shares of the 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 six
- --------------------------------------------------------------------------------
13
<PAGE>
portfolios of the Trust as you specify on the Account Application. Please call
(800) 851-0511 to obtain a prospectus for the Trust's other portfolios. Mail the
check, along with the completed Account Application, to Potomac Funds, c/o
Firstar Mutual Fund Services, LLC, P.O. Box 1993, Milwaukee, Wisconsin
53201-1993.
Your completed Account Application and check also may be sent by overnight
or express mail. To ensure proper delivery, please use the following address:
Potomac Funds, c/o Firstar Mutual Fund Services, LLC, 3rd Floor, 615 East
Michigan Street, Milwaukee, Wisconsin 53202.
Third party checks will not by accepted by the Fund. All purchases must be
in U.S. Dollars. A $25.00 fee will be imposed by the Transfer Agent if any check
used for investment in an account does not clear due to insufficient funds.
BY BANK WIRE TRANSFER
To establish a new account by wire transfer, please call the Transfer
Agent at (800) 851-0511 to obtain a Fund account number. You must send a
completed Account Application to the Fund 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 Mutual Fund
Services, LLC
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 the loss
the Fund may incur.
Physical certificates representing the Fund's shares are not issued.
Shares of the Fund are recorded on a register by the Transfer Agent.
----------------------------------------
TAX-DEFERRED RETIREMENT PLANS
The Fund offers individual retirement accounts ("IRAs"), including Roth
IRAs, that may be funded with purchases of Fund shares and may allow investors
to defer tax on their income from amounts contributed to the IRAs. A description
of applicable service fees and certain limitations on contributions and
withdrawals, as well as Application Forms, are available from the Fund upon
request.
----------------------------------------
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
the Fund's portfolio at the time of determination of net asset value. Shares of
the Fund 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
- ---------------------------------------------------------------
14
<PAGE>
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
the 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 Fund (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.
The right of redemption may be suspended or the date of payment postponed
for any period during which the New York Stock Exchange ("NYSE"), the Nasdaq
Stock Market ("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. In addition, the rights of redemption may be
suspended or the date of payment postponed for the 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 a such
periods as the SEC, by order, may permit for protection of the Fund's investors.
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-deferred retirement plan
may have adverse tax consequences and a shareholder contemplating such a
redemption should consult his or her tax adviser.
----------------------------------------
EXCHANGES
Fund shares may be exchanged, without any charge, for shares of any
portfolios of the Trust 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.
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15
<PAGE>
----------------------------------------
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 Mutual Fund Services, LLC, 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 Mutual Fund Services,
LLC 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. AND 3:40 P.M, EASTERN TIME.
TELEPHONE REDEMPTION AND EXCHANGE ORDERS WILL BE ACCEPTED ONLY DURING THE
PERIODS INDICATED ABOVE.
By establishing such telephone services, you authorize the Fund or its
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 Fund 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 markets changes. If such conditions
occur, redemption or exchange orders can be made by mail.
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16
<PAGE>
----------------------------------------
DETERMINATION OF NET ASSET VALUE
The net asset value per Fund share is computed at 4:15 p.m. Eastern time,
fifteen 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 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 the 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.
For purposes of determining net asset value per share of the 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.
OTC securities held by the Fund will be valued at the last sales price or,
if no sales price is reported, the mean of the last bid and ask price is used.
The portfolio securities of the Fund that are listed on national exchanges are
valued at the last sales price of such securities; if no sales price is
reported, the mean of the last bid and ask price is used. Dividend income and
other distributions are recorded on 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 Fund are valued at fair value.
----------------------------------------
PERFORMANCE INFORMATION
From time to time the 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 for the Fund in accordance with the methods discussed below.
The Fund may include the total return of its shares in advertisements or
other written material. When the Fund advertises the total return of its shares,
it will be calculated for the one-, five-, and ten-year periods or, if such
- --------------------------------------------------------------------------------
17
<PAGE>
periods have not yet elapsed, the period since the establishment of the Fund.
Total return is measured by comparing the value of an investment in the Fund at
the beginning of the relevant period to the redemption value of that investment
at the end of the period (assuming reinvestment of any dividends and capital
gain distributions at net asset value). For more information on Fund
performance, SEE "Performance Information" in the SAI.
----------------------------------------
DIVIDENDS AND OTHER DISTRIBUTIONS
The Fund intends to distribute to its shareholders annually all of its net
investment income and net realized capital gains. All income dividends and
distributions of net capital gains 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 the Fund are taxable to its shareholders, as discussed
below under "Taxes," whether the distributions are reinvested in additional
shares or are received in cash. You will receive a statement of your account at
least quarterly.
----------------------------------------
TAXES
The 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").
Dividends distributed by the Fund (including distributions of net short-term
capital gain), if any, are taxable to its shareholders as ordinary income,
regardless of whether the dividends are reinvested in Fund shares or received in
cash. Distributions of the Fund's net capital gain (I.E., the excess of net
long-term gain over net short-term capital loss), if any, are taxable to you as
long-term capital gains, regardless of how long you have held your Fund shares
and whether the distributions were reinvested in Fund shares or received in
cash. A shareholders sale (redemption) of Fund shares may result in a taxable
gain, depending on whether the redemption proceeds are more or less than the
adjusted basis for the shares. An exchange of Fund shares for shares of another
portfolio of the Trust generally will have similar consequences.
You are required by law to certify that your taxpayer identification
number ("TIN") is correct and that you are not subject to back-up withholding.
The Fund is required to withhold 31% of all dividends, capital gain
distributions, and redemption proceeds payable to individuals and 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 shareholders who, otherwise are subject to back-up
withholding.
Because the foregoing only summarizes some of the important federal income
tax considerations affecting the Fund and its shareholders, please see the
discussion in the SAI. Prospective investors are urged to consult their tax
advisers.
- ---------------------------------------------------------------
18
<PAGE>
----------------------------------------
MANAGEMENT AND ADMINISTRATION OF
THE FUND
BOARD OF TRUSTEES
The business and affairs of the Fund are managed under the direction of
the Trustees. The Trustees are responsible for the general supervision of the
Fund's business affairs and for exercising all the Fund's powers except those
reserved to the shareholders. The day-to-day operations of the Fund are the
responsibility of the its officers.
INVESTMENT ADVISER
Rafferty Asset Management, LLC, 550 Mamaroneck Avenue, Harrison, New York
10528, provides investment advice to the Fund. The Adviser has been registered
as an investment adviser since June 1997 and 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 the 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.
Under an investment agreement between the Trust and the Adviser, the Fund
pays the Adviser a fee 0.75% at an annualized rate, based on a percentage of its
daily net assets.
PORTFOLIO MANAGEMENT
The Fund is managed by an investment committee, which is responsible for
the investment activities of the Fund.
ADMINISTRATOR
The Trust, on behalf of the Fund, has entered into an Administrative
Services Agreement with Firstar Mutual Fund Services, LLC ("Administrator") that
obligates the Administrator to provide the Fund 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 net assets, and .03% of the Trust's average
net assets in excess of $500,000,000. Notwithstanding the foregoing, the
Administrator's minimum annual fee from the Trust is $150,000.
DISTRIBUTOR
Rafferty Capital Markets, Inc., 550 Mamaroneck Avenue, Harrison, NY 10528,
serves as the distributor of the Fund's shares. The Distributor has entered into
dealer agreements with participating dealers who will distribute shares of the
Fund.
TRANSFER AGENT AND CUSTODIAN
Firstar Mutual Fund Services, LLC, 615 East Michigan Street, Milwaukee,
Wisconsin 53202, serves as transfer agent to the Fund. Firstar Bank Milwaukee,
N.A., 615 East
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19
<PAGE>
Michigan Street, Milwaukee, Wisconsin 53202, serves as custodian of the
portfolio securities of the Fund.
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 100 East Wisconsin Avenue, Suite 1500,
Milwaukee, Wisconsin 53202, are the auditors of and the independent accountants
for the Fund.
----------------------------------------
GENERAL INFORMATION ABOUT THE TRUST
AND FUND
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.
Fund shares have equal voting rights. Only shares of the Fund may vote on
matters affecting it. 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. Fund shares are
nontransferable.
As a Massachusetts business trust, the Fund is not obligated to conduct
annual shareholder meetings. However, the Fund 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
The Fund pays all of its own expenses. These expenses include 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 Fund.
DISTRIBUTION OF FUND SHARES
The Fund has adopted a distribution plan (the "Plan") pursuant to Rule
12b-1 under the 1940 Act. The Plan provides that the Fund will compensate the
Distributor for certain expenses incurred in the distribution of its 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 Fund may in the future seek to achieve its investment objective by
investing all its net assets in another investment company
- ---------------------------------------------------------------
20
<PAGE>
("Master Fund") having the same investment objective and substantially the same
investment policies and restrictions as those applicable to the Fund. It is
expected than any such investment company would be managed by the Adviser in
substantially the same manner as the 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 Fund. However,
the Fund's 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 Fund and its 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 Fund at (800)
851-0511.
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21
<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 REPRESENTATIONS 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, NY 10528
ADMINISTRATOR, TRANSFER AGENT, DIVIDEND
PAYING AGENT, SHAREHOLDER SERVICING
AGENT & CUSTODIAN
Firstar Mutual Fund Services LLC
P.O. Box 1993
Milwaukee, WI 53201-1993
COUNSEL
Kirkpatrick & Lockhart, LLP
1800 Massachusetts Avenue, N.W.
Washington, D.C. 20036-1800
INDEPENDENT AUDITORS
PricewaterhouseCoopers LLP
100 East Wisconsin Avenue
Milwaukee, WI 53202
PROSPECTUS
February 16, 1999
[LOGO]
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
POTOMAC SMALL CAP PLUS FUND
STATEMENT OF ADDITIONAL INFORMATION
100 South Royal Street
Alexandria, Virginia 22314
550 Mamaroneck Avenue
Harrison, New York 10528
(800) 851-0511
The Potomac Small Cap Plus Fund (the "Fund") is an investment portfolio of the
Potomac Funds (the "Trust"), a no-load management investment company, or mutual
fund. The Fund seeks to provide investment returns that correspond to 125% of
the performance of the Russell 2000 Index. The Fund is designed principally for
experienced investors many of whom employ an asset allocation strategy. The Fund
is not designed for inexperienced or less sophisticated investors. This
Statement of Additional Information dated February 16, 1999, is not a
prospectus. It should be read in conjunction with the Trust's Prospectus dated
February 16, 1999. A copy of the Prospectus is available, without charge, upon
request to the Trust at the address or telephone number above.
TABLE OF CONTENTS
Page
GENERAL INFORMATION............................................................2
INVESTMENT POLICIES AND TECHNIQUES.............................................2
General....................................................................2
Options, Futures and Other Strategies......................................2
U.S. Government Securities.................................................6
Indexed Securities.........................................................7
American Depository Receipts ("ADRs")......................................7
Repurchase Agreements......................................................7
Borrowing..................................................................8
Lending Portfolio Securities...............................................9
Investments in Other Investment Companies..................................9
Illiquid Investments and Restricted Securities.............................9
Portfolio Turnover........................................................10
INVESTMENT RESTRICTIONS.......................................................10
PORTFOLIO TRANSACTIONS AND BROKERAGE..........................................12
MANAGEMENT OF THE TRUST AND FUND..............................................13
Trustees and Officers.....................................................13
Investment Adviser........................................................15
Fund Administrator, Fund Accountant, Transfer Agent and Custodian.........16
Distributor...............................................................17
Distribution Plan.........................................................17
Independent Accountants...................................................17
DETERMINATION OF NET ASSET VALUE..............................................17
PERFORMANCE INFORMATION.......................................................18
Comparative Information...................................................18
Total Return Computations.................................................18
DIVIDENDS, OTHER DISTRIBUTIONS AND TAXES......................................19
<PAGE>
GENERAL INFORMATION
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 offers six separate investment
portfolios, including the Fund. The Fund is designed principally for experienced
investors seeking an asset allocation vehicle. The Fund seeks investment results
that correspond over time to a specific benchmark. The Fund may be used
independently or in combination with the other investment portfolios of the
Trust 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 the Fund. Please refer to the
sections entitled "Investment Objective and Policies" and "Investment Techniques
and Other Investment Policies" in the Prospectus for a discussion of the
investment objective and policies of the Fund. Rafferty Asset Management, LLC
(the "Adviser") serves as the Fund's investment adviser. Capitalized terms not
otherwise defined herein shall have the same meaning as assigned in the
Prospectus.
The Fund 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 the Fund will result in the achievement of the Fund's
objectives.
Options, Futures and Other Strategies
- -------------------------------------
GENERAL. As discussed in the Prospectus, the Fund may use certain options,
futures contracts (sometimes referred to as "futures"), and options on futures
contracts (collectively, "Financial Instruments") as a substitute for a
comparable market position in the underlying security, to attempt to hedge or
limit the exposure of the Fund's position, to create a synthetic money market
position, for certain tax-related purposes and to effect closing transactions.
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
Trading Commission (the "CFTC"). In addition, the 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 the Fund's
investment objective and permitted by the Fund's investment limitations and
applicable regulatory authorities. The Fund's 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.
2
<PAGE>
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 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, the 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 the 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 the Fund's ability
to sell a portfolio security or make an investment at a time when it would
otherwise be favorable to do so, or require that the Fund sell a portfolio
security at a disadvantageous time. The 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 the Fund.
COVER. Transactions using Financial Instruments, other than purchased options,
expose the Fund to an obligation to another party. The Fund will not enter into
any such transactions unless it owns either (1) an offsetting ("covered")
position in securities or other options or futures 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. The
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 Bank Milwaukee, N.A. ("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 the
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
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<PAGE>
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.
The Fund may effectively terminate its right or obligation under an option by
entering into a closing transaction. For example, the 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, the Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a closing
sale transaction. Closing transactions permit the 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 the Fund and its counterparty (usually a securities dealer or a bank)
with no clearing organization guarantee. Thus, when the 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.
The 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 the Fund will in fact be able to close
out an OTC option position at a favorable price prior to expiration. In the
event of insolvency of the counterparty, the Fund might be unable to close out
an OTC option position at any time prior to its expiration.
If the Fund were unable to effect a closing transaction for an option it had
purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call option
written by the 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.
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 the 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 the Fund buys a call on
an index, it pays a premium and has the same rights to such call as are
indicated above. When the 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
4
<PAGE>
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 the 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 the 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 the 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.
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 the 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
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 the Fund purchases an option on a futures
contract, the premium paid plus transaction costs is all that is at risk. In
contrast, when the 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
5
<PAGE>
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 the 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.
COMBINED POSITIONS. The Fund may purchase and write options in combination with
each other. For example, the 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.
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,
6
<PAGE>
the Federal National Mortgage Association ("Fannie Mae"), 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.
INDEXED SECURITIES
The Fund may purchase securities the value of which varies in relation to the
value of other securities, securities indices 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. 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.
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 use outside the United States.
REPURCHASE AGREEMENTS
The 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. The Fund may not enter into such a
repurchase agreement if, as a result, more than 15% 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.
7
<PAGE>
The Fund follows certain procedures and guidelines adopted by the Board of
Trustees ("Trustees" or the "Board") 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, the 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, the
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 the Fund may be delayed or limited.
BORROWING
The Fund may borrow money for investment purposes, as a temporary measure for
extraordinary or emergency purposes and to meet redemption requests without
immediately selling portfolio securities.
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 will
magnify changes in the Fund's net asset value. Although the principal of such
borrowings will be fixed, the Fund's assets may change in value during the time
the borrowing is outstanding. Leverage also creates interest expenses for the
Fund. To the extent the income derived from securities purchased with borrowed
funds exceeds the interest the Fund will have to pay, the Fund's net income will
be greater than it would be if leverage were not used. Conversely, if the income
from the assets obtained with borrowed funds is not sufficient to cover the cost
of leveraging, the net income of the 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.
The Fund may borrow money to facilitate management of its portfolio by enabling
it 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 Fund promptly.
As required by the 1940 Act, the 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, the 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, the 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. The Fund may pledge portfolio
securities as the Adviser deems appropriate in connection with any borrowings.
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<PAGE>
LENDING PORTFOLIO SECURITIES
The Fund may lend portfolio securities with a value not exceeding 33 1/3% of its
total assets to brokers, dealers, and financial institutions. Borrowers are
required continuously to secure their obligations to return securities on loan
from the 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 the 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 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 Fund and its shareholders. The Fund
may pay reasonable finders, borrowers, administrative and custodial fees in
connection with a loan. The Fund currently has no intention of lending its
portfolio securities.
INVESTMENTS IN OTHER INVESTMENT COMPANIES
The 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. Investments in the securities of other investment companies may
involve duplication of advisory fees and certain other expenses. By investing in
another investment company, the Fund becomes a shareholder of that investment
company. As a result, Fund shareholders indirectly will bear the Fund's
proportionate share of 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
The Fund will not purchase or otherwise acquire any security if, as a result,
more than 15% 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. The Fund,
however, currently does not anticipate 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 the 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 and (5) restricted
securities not determined to be liquid pursuant to guidelines established by the
Board. The assets used as cover for OTC options written by the 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.
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<PAGE>
The 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 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 144A-eligible securities held by the Fund,
however, could affect adversely the marketability of such portfolio securities
and the Fund may be unable to dispose of such securities promptly or at
reasonable prices.
PORTFOLIO TURNOVER
As discussed in the Prospectus, the Fund anticipates that its investors, as part
of an asset allocation investment strategy, frequently will redeem Fund shares,
as well as exchange their Fund shares for shares of other portfolios of the
Trust. The Fund may have to dispose of certain portfolio investments to maintain
sufficient liquid assets to meet such redemption and exchange requests, thereby
causing a high portfolio turnover.
The 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 the 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, the Fund's portfolio
turnover rate calculated with all securities whose maturities were one year or
less is anticipated to be unusually high.
INVESTMENT RESTRICTIONS
The 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 the 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
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<PAGE>
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 the 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.
THE 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.
THE FUND HAS ADOPTED THE FOLLOWING INVESTMENT LIMITATIONS:
The Fund shall not:
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 and (2) as otherwise permitted
herein and in Investment Limitations Nos. 5, 7, and 8.
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
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.
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<PAGE>
7. 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.
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.
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.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to the general supervision by the Trustees, the Adviser is responsible
for decisions to buy and sell securities for the Fund, the selection of
broker-dealers to effect the transactions, and the negotiation of brokerage
commissions, if any. The Adviser expects that the Fund 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 Fund, 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 Fund 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;
wire services; and appraisals or evaluations of portfolio securities. The 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
the Fund; 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 Fund.
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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 AND FUND
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* Chief Executive Officer, Chairman and Chief Executive Officer
(56) President, Chairman of 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* (53) Trustee Managing Partner of CloverLeaf
411 West Putnam Street Partners, Inc., 1992-1997 (investment
Greenwich, CT 06830 banking).
Daniel J. Byrne (54) Trustee President and Chief Executive Officer
1325 Franklin Avenue of Byrne Securities Inc.,
Suite 285 1992-present; Partner of Byrne Capital
Garden City, NY 11530 Management LLP, 1996-present.
George T. Glisker (51)* Trustee President of GTG Securities Corp.,
1010 Franklin Avenue April 1997-present (hedge fund);
Garden City, NY 11530 President of New York Capital Mkts.
Inc.
Gerald E. Shanley III (55) Trustee Business Consultant, 1985-present;
12 First Street Trustee of Estate of Charles S.
Pelham, NY 10803 Payson, 1987-present.
James Terry Apple (59) Chief Investment Officer Vice President of the Adviser,
100 S. Royal Street 1997-present; Portfolio Manager of
Alexandria, VA 22314 PADCO Advisors, 1994-1997; Portfolio
Manager of Money Management
Associates, 1992-1993.
13
<PAGE>
Timothy P. Hagan (56) Chief Financial Officer Vice President of the Adviser,
100 S. Royal Street 1997-present; Vice President of PADCO
Alexandria, VA 22314 Advisers, 1993-1997, Vice President of
Money Management Associates, 1981-1993.
Philip A. Harding (55) Senior Vice President Vice President of the Adviser,
1997-present; Vice President of
Commerzbank (USA), 1995-1997; Senior
Vice President of Sanwa Bank (USA),
1992-1995.
Thomas A. Mulrooney Chief Operating Officer Chief Operating Officer of the
(51) 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.
Mark D. Edwards (40) Vice President Vice President of the Adviser, 1997 to
100 S. Royal Street present; President & Co-Founder of
Alexandria, VA 22314 Systems Management Group, 1990-1997.
Stephen P. Sprague (49) Treasurer, Vice President and Chief Financial
Controller and Officer of the Adviser, 1997-present;
Assistant Secretary Chief Financial Officer of Rafferty
Companies, LLC, 1994-present; Chief
Accountant--International Sub.,
Goldman Sachs & Co., 1983-1993.
Robert J. Zutz (46) Secretary Partner, Kirkpatrick & Lockhart LLP
1800 Massachusetts Ave. (law firm).
Washington, DC 20036
Eric W. Falkeis (25) Assistant Secretary Compliance Officer, Firstar Mutual
615 East Michigan Street Fund Services LLC, 1997-present; Audit
Milwaukee, WI 53202 Senior with Pricewaterhouse-Coopers
LLP, 1995-1997
</TABLE>
- -----------------
* Messrs. Rafferty, Higgins and Glisker are deemed to be "interested persons"
of the Trust, as defined by the 1940 Act.
14
<PAGE>
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 Messrs. Higgins and Glisker similar compensation per
meeting of the Board. Trustees also are reimbursed for any expenses incurred in
attending Board meetings. No officer, director or employee of the Adviser
receives any compensation from the Fund for acting as a director or officer. The
following table shows the compensation earned by each Trustee for the Trust's
prior fiscal year ended August 31, 1998. For that prior fiscal year, Mr. Glisker
served as an Independent Trustee to the Board.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------
Pension or Aggregate
Retirement Estimated Compensation
Aggregate Benefits Accrued Annual From the Trust
Name of Person, Compensation As Part of the Benefits Upon Paid to the
Position From the Trust Trust's Expenses Retirement Trustees
-------- -------------- ---------------- ---------- --------
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Lawrence C. Rafferty, $0 $0 $0 $0
Trustee
Jay F. Higgins, Trustee $0 $0 $0 $0
Daniel J. Byrne, Trustee $2,000 $0 $0 $2,000
George T. Glisker, $2,000 $0 $0 $2,000
Trustee
Gerald E. Shanley III, $2,000 $0 $0 $2,000
Trustee
- -----------------------------------------------------------------------------------------------------
</TABLE>
INVESTMENT ADVISER
The Fund's investment adviser, Rafferty Asset Management, LLC, was organized as
a New York limited liability corporation in 1997. The Adviser has been
registered as an investment adviser since June 1997. The Adviser is controlled
by Lawrence C. Rafferty.
15
<PAGE>
Under an Investment Advisory Agreement between the Trust, on behalf of the Fund,
and the Adviser ("Advisory Agreement"), the Adviser provides a continuous
investment program for the Fund's assets in accordance with its investment
objective, policies and limitations, and oversees the day-to-day operations of
the Fund, 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 Fund
bears all other expenses that are not assumed by the Adviser as described in the
Prospectus. The Fund also is liable for nonrecurring expenses as may arise,
including litigation to which the Fund may be a party. The Fund also may have an
obligation to indemnify its Trustees and officers with respect to any such
litigation.
Pursuant to the Advisory Agreement the Fund pays the Adviser a fee at an annual
rate of 0.75% based on its average daily net assets. The Adviser voluntarily
will waive its fees and, if necessary, reimburse the Fund to the extent that
annual operating expenses exceed 1.50% of the Fund's average daily net assets.
The Advisory Agreement was approved by the Trustees (including all Independent
Trustees) and the Adviser, 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 the 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 Fund, and
(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 Fund or the Adviser.
FUND ADMINISTRATOR, FUND ACCOUNTANT, TRANSFER AGENT AND CUSTODIAN
Firstar Mutual Fund Services, LLC 615, East Michigan Street, Milwaukee,
Wisconsin 53202, provides administrative, fund accounting and transfer agent
services to the Fund. Firstar Bank Milwaukee, N.A., 615 East Michigan Street,
Milwaukee, Wisconsin 53202 provides custodian services to the Fund.
Pursuant to an Administration Servicing Agreement ("Service Agreement") between
the Trust and Firstar Mutual Fund Services, LLC ("Administrator"), the
Administrator provides the Fund 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 $150,000.
Pursuant to a Fund Accounting Servicing Agreement between the Trust and Firstar
Mutual Fund Services, LLC ("Fund Accountant"), the Fund Accountant provides the
Fund 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 annual fee of $22,000 for the first $40
million of average daily net assets of the Fund. The Fund Accountant also is
entitled to certain out-of-pocket expenses, including pricing expenses.
16
<PAGE>
Pursuant to a Custodian Agreement, Firstar Bank Milwaukee, N.A. serves as the
Custodian of the Fund's assets. Under the terms of the Custodian Agreement, the
Custodian holds and administers the assets in the Fund's portfolio.
DISTRIBUTOR
Rafferty Capital Markets, Inc., 550 Mamaroneck Avenue, Harrison, New York 10528,
serves as the distributor ("Distributor") in connection with the offering of the
Fund's shares on a no-load basis. The Distributor and participating dealers with
whom it has entered into dealer agreements offer shares of the Fund as agents on
a best efforts basis and are not obligated to sell any specific amount of
shares.
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
the Fund pursuant to which the Fund would compensate the Distributor for certain
expenses incurred in the distribution of its shares and the servicing and
maintenance of existing Fund shareholder accounts. Pursuant to the Plan, the
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 the 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 the 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 the 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 the 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 the Fund.
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 100 East Wisconsin Avenue, Suite 1500, Milwaukee,
Wisconsin 53202, are the auditors and the independent accountants for the Fund.
DETERMINATION OF NET ASSET VALUE
As described in the Prospectus, the net asset value per share of the 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.
A security listed or traded on an exchange or the Nasdaq Stock Market is valued
at its last sales price on the principal exchange or market on which it is
traded prior to the time when assets are valued. If no sale is reported at that
time, the mean of the last bid and ask price is used. When market quotations for
options and futures positions held by the Fund are readily available, those
17
<PAGE>
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 in accordance with procedures established by
the Board. Short-term investments having a maturity of 60 days or less are
valued at amortized cost, which approximates market value.
PERFORMANCE INFORMATION
The 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 the 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, the Fund's performance may be compared with recognized stock
and other indices, such as the Russell 2000 Index ("Russell 2000"), the Standard
& Poor's Composite Stock Price Index ("S&P 500"), the Dow Jones Industrial
Average ("DJIA"), the Nasdaq 100 Stock IndexTM ("Nasdaq Index"), and the Nasdaq
Composite IndexTM ("Nasdaq Composite") and various other domestic indices. The
S&P 500 is a broad index of common stock prices, while the DJIA represents a
narrower segment of industrial companies. Each assumes reinvestment of
distributions and is calculated without regard to tax consequences or operating
expenses.
In addition, the 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.
Since the assets in all mutual funds are always changing, the 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 the 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 Fund are
calculated according to the following formula:
P(1+T)n(SUPERSCRIPT)=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
18
<PAGE>
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 the Fund's
operations. In calculating the ending redeemable value, all dividends and
distributions by the 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.
From time to time, the 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 the Fund with other measures of
investment return. For example, in comparing the total return of the Fund with
data published by Lipper or with such market indices as the performance of the
Russell 2000 the 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.
DIVIDENDS, OTHER DISTRIBUTIONS AND TAXES
DIVIDENDS AND OTHER DISTRIBUTIONS
Dividends from net investment income and any distributions of realized net
capital gains will be distributed as described in the Prospectus under
"Dividends and Other Distributions." All distributions from the Fund normally
will be automatically reinvested without charge in additional shares of the
Fund.
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"), the 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 and net short-term capital gain) ("Distribution Requirement")
and must meet several additional requirements. 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 other
income (including gains from options or futures) derived with respect to its
business of investing in securities ("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").
19
<PAGE>
Although the Funds intend to satisfy all the foregoing requirements, there is no
assurance that the Fund will be able to do so. An investment primarily in
options and futures positions entails some risk such that the 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 Fund, pursuant to which
it would be treated as satisfying the Diversification Requirements, would not be
accepted in an audit by the Internal Revenue Service, which might apply a
different method resulting in disqualification of the Fund.
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.
The 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.
DISTRIBUTIONS TO FOREIGN SHAREHOLDERS. Dividends paid by the 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 the 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 the 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, involves complex rules
that will determine for income tax purposes the amount, character, and timing of
recognition of the gains and losses the Fund realizes in connection therewith.
Gains from options or futures derived by the Fund with respect to its business
of investing in securities will qualify as permissible income under the Income
Requirement.
Certain options (including options on "broad-based" stock indices) and futures
in which the Fund may invest may be "section 1256 contracts." Section 1256
contracts held by the 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.
20
<PAGE>
Code section 1092 (dealing with straddles) may also affect the taxation of
options and futures contracts in which the Fund may invest. Section 1092 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 the 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 Fund of straddle transactions are not entirely clear.
If a call option written by the 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 the 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 the 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 the 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 the 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 Fund. 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 Fund and to dividends and other distributions
therefrom.
