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LM INSTITUTIONAL FUND ADVISORS JUNE 30, 1998
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IMPORTANT INFORMATION!
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This prospectus offers shares in six no-load mutual funds comprising LM
Institutional Fund Advisors II, Inc. (each a "Portfolio"). The Portfolios, which
are intended to serve as investment vehicles for institutional investors such as
pension plans, endowments and foundations, offer two classes of shares: the
Institutional Class and the Financial Intermediary Class.
This prospectus explains concisely what you should know before investing in the
Portfolios. Please read it carefully and keep it for future reference. You can
find more detailed information in the June 30, 1998 statement of additional
information (the "SAI"), as amended from time to time. For a free copy of the
SAI or other information, call Legg Mason Wood Walker, Incorporated ("LMWW") at
1-800-822-5544. The SAI has been filed with the Securities and Exchange
Commission ("SEC") and is incorporated into this prospectus by reference.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
FUND SHARES ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED BY,
ANY FINANCIAL INSTITUTION, ARE NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE
CORPORATION, THE FEDERAL RESERVE BOARD OR ANY OTHER AGENCY, AND INVOLVE RISK,
INCLUDING THE POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED.
PORTFOLIO PAGE
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Legg Mason Fund Adviser Large Cap Value Portfolio 10
Legg Mason Fund Adviser Mid Cap Value Portfolio 11
Brandywine Small Cap Value Portfolio 13
Batterymarch Emerging Markets Portfolio 14
Batterymarch International Equity Portfolio 15
Legg Mason Fund Adviser Total Return Portfolio 17
THE LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO AND THE LEGG MASON FUND
ADVISER MID CAP VALUE PORTFOLIO EACH MAY INVEST UP TO 35% OF THEIR TOTAL ASSETS
IN LOWER-RATED BONDS, COMMONLY KNOWN AS "JUNK BONDS." INVESTMENTS OF THIS TYPE
ARE SUBJECT TO A GREATER RISK OF LOSS OF PRINCIPAL AND NONPAYMENT OF INTEREST.
INVESTORS SHOULD CAREFULLY ASSESS THE RISKS ASSOCIATED WITH AN INVESTMENT IN
THESE PORTFOLIOS. FOR MORE INFORMATION CONCERNING THESE RISKS, SEE "COMMON
INVESTMENT POLICIES AND TECHNIQUES; RISK FACTORS."
[LM INSTITUTIONAL FUND ADVISORS LOGO HERE]
<PAGE>
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TABLE OF CONTENTS
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PROSPECTUS SUMMARY 4
EXPENSE INFORMATION 6
Legg Mason Fund Adviser Large Cap Value Portfolio 6
Legg Mason Fund Adviser Mid Cap Value Portfolio 7
Brandywine Small Cap Value Portfolio 7
Batterymarch Emerging Markets Portfolio 8
Batterymarch International Equity Portfolio 8
Legg Mason Fund Adviser Total Return Portfolio 9
DESCRIPTION OF EACH PORTFOLIO AND ITS
INVESTMENT STRATEGY 10
Legg Mason Fund Adviser Large Cap Value Portfolio 10
Legg Mason Fund Adviser Mid Cap Value Portfolio 11
Brandywine Small Cap Value Portfolio 13
Batterymarch Emerging Markets Portfolio 14
Batterymarch International Equity Portfolio 15
Legg Mason Fund Adviser Total Return Portfolio 17
COMMON INVESTMENT POLICIES AND TECHNIQUES;
RISK FACTORS 18
Foreign Securities 18
Options and Futures 21
Foreign Currency Exchange Transactions 23
Preferred Stocks and Convertible Securities 24
Debt and Fixed Income Securities 25
Commercial Paper and Other Short-term Investments 29
Indexed Securities and Structured Notes 30
Forward Commitments 30
Restricted and Illiquid Securities 31
Securities of Other Investment Companies 32
Repurchase Agreements 32
Reverse Repurchase Agreements and Other Borrowing 32
Loans of Portfolio Securities 33
Portfolio Turnover 34
Alternative Investment Strategies 35
New Investment Products 35
Investment Policies 35
PERFORMANCE DATA 36
MANAGEMENT OF THE PORTFOLIOS 37
Board of Directors 37
Manager, Advisers 37
The Distributor 40
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Portfolio Transactions 40
Expenses 41
ORGANIZATION AND HISTORY 41
PURCHASE OF SHARES 42
Initial Investment 42
Additional Investments 43
Other Purchase Information 44
Retirement Plans 44
Account Registration Changes 45
DISTRIBUTION PLANS 45
REDEMPTION OF SHARES 45
Signature Guarantee 47
EXCHANGE PRIVILEGE 47
NET ASSET VALUE 48
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS 49
TAX INFORMATION 50
APPENDICES
APPENDIX A -- SECURITIES RATINGS A-1
APPENDIX B -- PRIOR PERFORMANCE OF ADVISERS' OTHER ACCOUNTS B-1
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PROSPECTUS SUMMARY
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GENERAL
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LM Institutional Fund Advisors II, Inc. is an open-end management
investment company ("mutual fund") comprised of a variety of separate
investment portfolios. LM Institutional Fund Advisors II, Inc. was organized as
a Maryland corporation on January 13, 1998.
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COMPARISON OF THE PORTFOLIOS
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The following chart provides general information about each Portfolio.
It is qualified in its entirety by the more complete descriptions of the
Portfolios appearing elsewhere in this prospectus.
<TABLE>
<CAPTION>
- ---------------------------------- ------------------------------------ --------------------------------------------
Equity Portfolios Investment Objectives Primary Investments
- ---------------------------------- ------------------------------------ --------------------------------------------
<S><C>
Legg Mason Fund Adviser Large Long-term growth of capital Large cap equity securities that are
Cap Value Portfolio undervalued
- ---------------------------------- ------------------------------------ --------------------------------------------
Legg Mason Fund Adviser Mid Cap Capital appreciation Mid cap equity securities that are
Value Portfolio undervalued
- ---------------------------------- ------------------------------------ --------------------------------------------
Brandywine Small Cap Value Long-term capital appreciation Small cap equity securities that are
Portfolio undervalued
- ---------------------------------- ------------------------------------ --------------------------------------------
Batterymarch Emerging Markets Long-term capital appreciation Emerging market equity securities
Portfolio
- ---------------------------------- ------------------------------------ --------------------------------------------
Batterymarch International Long-term total return Foreign equity securities
Equity Portfolio
- ---------------------------------- ------------------------------------ --------------------------------------------
Legg Mason Fund Adviser Total Capital appreciation and current Dividend-paying common stocks, debt
Return Portfolio income in order to achieve an securities and securities convertible into
attractive total investment return common stocks which, in the opinion of
consistent with reasonable risk Legg Mason Fund Adviser, Inc., offer
potential for attractive total return
- ---------------------------------- ------------------------------------ --------------------------------------------
</TABLE>
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MANAGER AND ADVISERS
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LM Institutional Advisors, Inc. (the "Manager") serves as the
investment manager to each Portfolio. Legg Mason Fund Adviser, Inc. ("LMFA"") is
the investment adviser to each of the Legg Mason Fund Adviser Large Cap Value
Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the Legg
Mason Fund Adviser Total Return Portfolio. Brandywine Asset Management, Inc.
("Brandywine") is the investment adviser to the Brandywine Small Cap Value
Portfolio. Batterymarch Financial Management, Inc. ("Batterymarch") is the
investment adviser to the Batterymarch Emerging Markets Portfolio and the
Batterymarch International Equity Portfolio. Collectively LMFA, Brandywine and
Batterymarch are referred to herein as "Advisers" and individually as the
"Adviser."
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CERTAIN RISK FACTORS
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In addition to the typical risks of investing in securities, and in
equity securities in particular, the Portfolios may be subject to certain
special risks. These risks include the risks associated with investing in:
foreign markets and the securities of foreign issuers (these risks increase to
the extent a Portfolios invests in emerging markets); small cap securities
(which tend to be less liquid, more difficult to value and more volatile); and
fixed income securities (in particular, junk bonds). See "Description of Each
Portfolio and Its Investment Strategy" and "Common Investment Policies and
Techniques; Risk Factors" for more information about which Portfolios are likely
to be subject to the foregoing risks and a description of other risks to which
the Portfolios are subject.
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PURCHASE OF SHARES
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The Portfolios offer two classes of shares: Institutional Class and
Financial Intermediary Class. Shares in the Financial Intermediary Class bear a
12b-1 fee. See "Distribution Plans" below for more information. The minimum
initial investment is $1 million, subject to certain exceptions. See "Purchase
of Shares."
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REDEMPTIONS AND EXCHANGES
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Shares of each Portfolio may be redeemed without cost at the relevant
net asset value per share next determined after receipt of the redemption
request. The redemption price may be more or less than the purchase price. See
"Redemption of Shares." Shares of any Portfolio may be exchanged on the basis of
relative net asset values for shares of the same class of any other Portfolio or
of any portfolio of LM Institutional Fund Advisors I, Inc. See "Exchange
Privilege."
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DIVIDENDS AND DISTRIBUTIONS
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The Legg Mason Fund Adviser Large Cap Value Portfolio and the Legg
Mason Total Return Portfolio declare and pay dividends quarterly out of their
net investment income for that quarter. All other Portfolios declare and pay
dividends annually out of their net investment income for that year.
Distributions of net realized capital gains are made annually. All dividends and
distributions will be reinvested automatically at net asset value in additional
shares of the same class of the same Portfolio, unless cash payment is
requested. See "Dividends and Distributions to Shareholders."
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EXPENSE INFORMATION
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Expenses are one of several factors to consider when investing. The
following tables contain expense information about the Portfolios based on the
amounts expected to be incurred in the current fiscal year. The examples show
the cumulative expenses attributable to a hypothetical $1,000 investment over
specified periods, assuming 5% annual return and redemption at the end of each
period. The paragraph following the tables and examples contains additional
information about the tables, the examples and the Portfolios' expenses.
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LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $ 8
TRANSACTION EXPENSES None None 3 years $24
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .50% .50%
(REFLECTING EXPENSE
LIMITATION)
12b-1 Fees None .25% 1 year $10
Other Expenses .25% .25% 3 years $32
---- ----
Total
Operating Expenses .75% 1.00%
==== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
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LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $ 8
TRANSACTION EXPENSES None None 3 years $24
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .50% .50%
(REFLECTING EXPENSE
LIMITATION)
12b-1 Fees None .25% 1 year $10
Other Expenses .25% .25% 3 years $32
---- ----
Total
Operating Expenses .75% 1.00%
==== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
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BRANDYWINE SMALL CAP VALUE PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $ 9
TRANSACTION EXPENSES None None 3 years $27
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .60% .60%
(REFLECTING EXPENSE
LIMITATION)
12b-1 Fees None .25% 1 year $11
Other Expenses .25% .25% 3 years $35
---- ----
Total
Operating Expenses .85% 1.10%
==== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
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BATTERYMARCH EMERGING MARKETS PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $15
TRANSACTION EXPENSES None None 3 years $46
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .60% .60%
(REFLECTING EXPENSE
LIMITATION) 1 year $17
12b-1 Fees None .25% 3 years $54
Other Expenses .85% .85%
---- ----
Total
Operating Expenses 1.45% 1.70%
===== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
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BATTERYMARCH INTERNATIONAL EQUITY PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $10
TRANSACTION EXPENSES None None 3 years $32
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .60% .60%
(REFLECTING EXPENSE
LIMITATION)
12b-1 Fees None .25% 1 year $13
Other Expenses .40% .40% 3 years $40
---- ----
Total
Operating Expenses 1.00% 1.25%
===== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
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LEGG MASON FUND ADVISER TOTAL RETURN PORTFOLIO
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<TABLE>
<CAPTION>
Institutional Financial Institutional Class Example
Class Intermediary Class ---------------------------
-------------- -------------------
<S><C>
SHAREHOLDER 1 year $ 8
TRANSACTION EXPENSES None None 3 years $24
ANNUAL FUND
OPERATING EXPENSES
(AS A PERCENTAGE OF Financial Intermediary
AVERAGE NET ASSETS) Class Example
----------------------
Management Fees .50% .50%
(REFLECTING EXPENSE
LIMITATION) 1 year $10
12b-1 Fees None .25% 3 years $32
Other Expenses .25% .25%
---- ----
Total
Operating Expenses .75% 1.00%
==== =====
(REFLECTING EXPENSE
LIMITATION)
</TABLE>
The tables are provided to help you understand the expenses of investing
in a Portfolio and your share of the Portfolio's operating expenses. The
management fees shown in the table for each Portfolio reflect voluntary expense
limitations currently in effect which are expected to continue for the current
fiscal year. In the absence of such limitations, management fees and total
operating expenses for each Portfolio would be:
<TABLE>
<CAPTION>
TOTAL OPERATING
MANAGEMENT FEE EXPENSES
PORTFOLIO CLASS WITHOUT LIMITATION WITHOUT LIMITATION
--------- ----- ------------------ ------------------
<S><C>
Legg Mason Fund Adviser Large Cap Value Institutional 0.60% 0.85%
Portfolio Financial Intermediary 0.60% 1.10%
Legg Mason Fund Adviser Mid Cap Value Institutional 0.60% 0.85%
Portfolio Financial Intermediary 0.60% 1.10%
Brandywine Small Cap Value Portfolio Institutional 0.65% 0.90%
Financial Intermediary 0.65% 1.15%
Batterymarch Emerging Markets Portfolio Institutional 0.65% 1.50%
Financial Intermediary 0.65% 1.75%
Batterymarch International Equity Portfolio Institutional 0.65% 1.05%
Financial Intermediary 0.65% 1.30%
Legg Mason Fund Adviser Total Return Portfolio Institutional 0.60% 0.85%
Financial Intermediary 0.60% 1.10%
</TABLE>
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<PAGE>
"Other expenses" are based on estimated amounts for the current fiscal year. The
12b-1 fees shown in the tables reflect the amount to which the Directors have
currently limited payments under the Portfolios' Distribution Plans. Pursuant to
each Portfolio's Distribution Plan, the Directors may increase the 12b-1 fees to
0.40% of average net assets without shareholder approval. The examples do not
represent past or future expense levels. Actual expenses may be greater or less
than those shown. Federal regulations require the examples to assume a 5% annual
return, but actual annual returns will vary. As a result of the 12b-1 fees,
long-term shareholders of the Financial Intermediary Class may pay more than the
economic equivalent of the maximum sales charge permitted by the National
Association of Securities Dealers, Inc.
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DESCRIPTION OF EACH PORTFOLIO AND ITS
INVESTMENT STRATEGY
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The investment objective and policies for each Portfolio are stated
below. The Portfolios are not intended to be a complete investment program, and
there is no assurance that any Portfolio will achieve its investment objective.
Please see "Common Investment Policies and Techniques; Risk Factors" below and
the SAI for additional information concerning the Portfolios' investment
programs and the risks associated with investing in the Portfolios. Each of the
Portfolios may from time to time depart from the policies described below for
temporary "defensive" purposes. See "Common Investment Policies and Techniques;
Risk Factors -- Alternative Investment Strategies" for more information.
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LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO
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Adviser: LMFA
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Objective: long-term growth of capital
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Under normal market conditions, the Portfolio will invest at least 65%
of its total assets in equity securities that LMFA believes are undervalued in
relation to the long-term earning power or asset value of the issuer and
therefore offer above average potential for capital appreciation. The Portfolio
will also invest at least 65% of its total assets in "large cap" equity
securities. Large cap equity securities are securities of companies that, at the
time of purchase, have an equity market capitalization of more than $5 billion.
Equity securities include common stock, preferred stock, securities convertible
into common stock, rights and warrants to acquire such securities and
substantially similar forms of equity with comparable risk characteristics. The
Portfolio may invest in securities that pay no dividends or interest, and
current dividend income is not a prerequisite in the selection of securities.
Securities may be undervalued because of many factors, including not
being closely followed by investors, being out of favor with investors, or
because the issuer is experiencing
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<PAGE>
unusual circumstances suggesting the possibility that the market value of the
securities may increase. Other factors that may contribute to a security being
undervalued include an overall market decline, poor economic conditions,
tax-loss selling and actual or anticipated unfavorable developments affecting
the issuer. LMFA believes that the securities of sound, well-managed companies
that may be undervalued for these reasons are likely to provide a greater
opportunity for long-term growth of capital than securities with prices that
appear to reflect anticipated favorable developments and that are therefore
subject to correction should any unfavorable developments occur.
Equity securities are normally the Portfolio's main investments.
However, the Portfolio may invest up to 35% of its total assets in any type of
debt or fixed income security, including securities that, at the time of
purchase, are not rated investment grade by a nationally recognized statistical
rating organization (an "NRSRO"), if LMFA believes they would help achieve the
Portfolio's investment objective. Lower-rated securities (and unrated securities
determined by LMFA to be of comparable quality) are considered to be primarily
speculative and may be in default. The Portfolio may also invest up to 25% of
its total assets in securities principally traded in foreign markets, engage in
foreign currency exchange transactions and transactions in futures contracts and
options, enter into repurchase agreements, purchase shares of other investment
companies, invest in real estate investment trusts ("REITs"), purchase
restricted and illiquid securities, loan its portfolio securities, borrow money
for temporary or emergency purposes, and purchase or sell securities on a
forward commitment basis. See "Common Investment Policies and Techniques; Risk
Factors" below for more information. The Portfolio may also hold a portion of
its assets in cash or money market instruments.
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LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO
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Adviser: LMFA
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Objective: capital appreciation
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Under normal market conditions, the Portfolio will invest at least 65%
of its total assets in equity securities of companies that have an equity market
capitalization at the time of purchase within the range used from time to time
for inclusion in the S&P Midcap 400 Index (currently, approximately $500 million
to $5 billion). Equity securities include common stock, preferred stock,
securities convertible into common stock, rights and warrants to acquire such
securities and substantially similar forms of equity with comparable risk
characteristics. Issuers in which the Portfolio will invest will typically
exhibit one or more of the following characteristics:
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<PAGE>
1. The companies generally are not closely followed by, or are
out of favor with, investors, and appear to be undervalued in
relation to their long-term earning power or asset values.
2. The companies are experiencing unusual and possibly
non-repetitive developments which, in LMFA's opinion, may
cause the market values of the securities to increase. Such
developments may include: (a) a sale or termination of an
unprofitable part of the company's business; (b) a change in
the company's management or in management's philosophy; (c) a
basic change in the industry in which the company operates;
(d) the introduction of new products or technologies; or (e)
the prospect or effect of acquisition or merger activities.
3. The companies are involved in actual or anticipated
reorganizations or restructurings under the Bankruptcy Code.
No more than 20% of the Portfolio's total assets at the time
of purchase may be invested in such securities.
Investments in securities with such characteristics may involve greater
risks of loss than investments in securities of larger, well-established
companies which typically have a history of consistent operating patterns and
greater financial resources. In addition, the prices of securities of mid-sized
companies generally are more volatile than those of larger companies, the
securities of mid-sized companies generally are less liquid and may, at times,
be more difficult to value, and mid-sized companies generally are more likely to
be adversely affected by poor economic or market conditions. Investments in
securities of companies involved in actual or anticipated reorganizations or
restructurings involve special risks, including difficulty in obtaining
information as to the financial condition of such issuers and the fact that the
market prices of such securities are subject to sudden and erratic market
movements and above-average price volatility.
Subject to the 65% test described above, the Portfolio may also invest
in larger, more highly capitalized companies when circumstances warrant such
investments. The Portfolio may invest in securities that pay no dividends or
interest, and current dividend income is not a prerequisite in the selection of
securities.
Equity securities are normally the Portfolio's main investments.
However, the Portfolio may invest up to 35% of its total assets in any type of
debt or fixed income security, including securities that, at the time of
purchase, are not rated investment grade by an NRSRO, if LMFA believes they
would help achieve the Portfolio's investment objective. Lower-rated securities
(and unrated securities determined by LMFA to be of comparable quality) are
considered to be primarily speculative and may be in default. The Portfolio may
also invest up to 25% of its total assets in securities principally traded in
foreign markets, engage in foreign currency exchange transactions and
transactions in futures contracts and
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<PAGE>
options, purchase restricted and illiquid securities, enter into repurchase
agreements, purchase shares of other investment companies, invest in REITs, loan
its portfolio securities, borrow money for temporary or emergency purposes, and
purchase or sell securities on a forward commitment basis. See "Common
Investment Policies and Techniques; Risk Factors" below for more information.
The Portfolio may also hold a portion of its assets in cash or money market
instruments.
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BRANDYWINE SMALL CAP VALUE PORTFOLIO
- --------------------------------------------------------------------------------
Adviser: Brandywine
- --------------------------------------------------------------------------------
Objective: long-term capital appreciation
- --------------------------------------------------------------------------------
Under normal market conditions, the Portfolio will invest at least 65%
of its total assets in equity securities of "small cap" companies (generally
defined as companies at the time of initial investment with an equity market
capitalization not in excess of the 40th percentile of the capitalization of
issuers traded on the New York Stock Exchange). A company that was a "small cap"
company at the time of the Portfolio's initial investment will continue to be
treated as such for purposes of the 65% test, even if the equity capitalization
exceeds the 40th percentile at the time of subsequent investment. Equity
securities include common stock, preferred stock, securities convertible into
common stock, rights and warrants to acquire such securities and substantially
similar forms of equity with comparable risk characteristics.
Securities of "small cap" companies entail special risks. Such
companies often have limited operating histories and may have more restricted
product lines or more limited financial resources than larger, more established
companies. For these and other reasons, they may be more severely affected by
economic downturns or other adverse developments than are larger, more
established companies. Securities of "small cap" companies may be traded
"over-the-counter" and often trade less frequently and in more limited volume,
may be subject to greater volatility and may be more difficult to value than
securities of larger, more established companies. "Small cap" companies are
often involved in actual or anticipated reorganizations or restructurings, which
involve special risks, including difficulty in obtaining information as to the
financial condition of such companies and the fact that market prices of such
companies' securities are subject to sudden and erratic price volatility.
Although the Portfolio expects to remain substantially fully invested
in equity securities, the Portfolio may invest in cash and money market
instruments, including repurchase agreements. For temporary defensive purposes,
the Portfolio may also invest in investment grade debt and fixed income
investments. The Portfolio may also engage in reverse repurchase agreement
transactions and other borrowings, purchase restricted and illiquid securities,
loan its portfolio securities, and invest in securities of other investment
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<PAGE>
companies. For more information, see "Common Investment Policies and Techniques;
Risk Factors."
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BATTERYMARCH EMERGING MARKETS PORTFOLIO
- --------------------------------------------------------------------------------
Adviser: Batterymarch
- --------------------------------------------------------------------------------
Objective: long-term capital appreciation
- --------------------------------------------------------------------------------
Under normal market conditions, the Portfolio will invest substantially
all of its assets, but in any event at least 65% of its total assets, in
"emerging market" equity securities. Emerging markets include any country: (i)
having an "emerging stock market" or considered a "frontier market" as defined
by the International Finance Corporation; (ii) with low- to middle-income
economies according to the International Bank for Reconstruction and Development
("World Bank"); (iii) listed in World Bank publications as developing; or (iv)
included in the Morgan Stanley Capital International (MSCI) Emerging Markets
published index. Emerging market equity securities include common stock,
preferred stock, securities convertible into common stock, rights and warrants
to acquire such securities and substantially similar forms of equity with
comparable risk characteristics that are: (1) publicly traded on emerging market
stock exchanges, or whose principal trading market is over-the-counter (i.e.,
off-exchange) in an emerging market country; (2) securities denominated in any
currency if issued by companies to finance operations in an emerging market
country; (3) securities of companies that derive a substantial portion (i.e., in
excess of 50%) of their total revenues from goods or services produced in, or
sales made in, emerging market countries; (4) securities of companies organized
under the laws of an emerging market country or region, which are publicly
traded in securities markets elsewhere; or (5) American depositary receipts
("ADRs") (or similar instruments) with respect to the foregoing. Investing in
foreign issuers, and in particular in emerging market equity securities,
involves special risks. See "Common Investment Policies and Techniques; Risk
Factors -- Foreign Securities."
The Portfolio intends to invest in Asia, Latin America, the Indian
Sub-continent, Southern and Eastern Europe, the Middle East, and Africa,
although it may not invest in all these markets at all times and may not invest
in any particular market when it deems such an investment to be inadvisable. The
Portfolio will normally diversify its investments among a number of different
countries, although more than 25% of its total assets may be invested in
securities denominated in a single currency. The concentration of the
Portfolio's assets in this manner will increase the Portfolio's exposure to
adverse developments affecting the value of that currency, subjecting the
Portfolio to greater risk. For more information concerning the risks associated
with investments denominated in foreign currencies, see "Common Investment
Policies and Techniques; Risk Factors -- Foreign Securities." An issuer of
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<PAGE>
securities purchased by the Portfolio may be domiciled in a country other than
the country in whose currency the securities are denominated.
Assets not invested in emerging market equity securities may be
invested in any combination of debt securities or equity securities, including
securities of issuers located in developed countries, cash, money market
instruments and repurchase agreements. In addition, the Portfolio may invest up
to 10% of its total assets in lower-rated fixed income securities (i.e.,
securities rated below investment grade at the time of purchase or unrated
securities of comparable quality at the time of purchase). Lower-rated
securities (and unrated securities determined by Batterymarch to be of
comparable quality) are considered to be primarily speculative and may be in
default. The Portfolio may also invest in securities of other investment
companies, invest in indexed securities and structured notes, purchase
restricted and illiquid securities, borrow money for temporary or emergency
purposes, engage in futures and options transactions, and engage in foreign
currency exchange transactions. For more information, see "Common Investment
Policies and Techniques; Risk Factors." Although the Portfolio has the ability
to hedge its foreign currency risk, appropriate hedging instruments are not
available with respect to most emerging market currencies, and it is therefore
unlikely that the Portfolio will be able to employ such hedging strategies to a
significant extent, if at all.
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BATTERYMARCH INTERNATIONAL EQUITY PORTFOLIO
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Adviser: Batterymarch
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Objective: long-term total return
- --------------------------------------------------------------------------------
Under normal market conditions, the Portfolio will invest substantially
all of its assets, but in any event at least 65% of its total assets, in equity
securities of issuers located in at least three different countries other than
the United States. Equity securities include common stock, preferred stock,
securities convertible into common stock, rights and warrants to acquire such
securities and substantially similar forms of equity with comparable risk
characteristics. When selecting securities for the Portfolio, Batterymarch
examines securities from over 20 international stock markets, with emphasis on
several of the largest -- Japan, the United Kingdom, France, Canada and Germany.
Securities are chosen using Batterymarch's model for identifying securities it
believes to be undervalued. The weighting of the Portfolio's assets among
individual countries will reflect an assessment of the attractiveness of
individual securities. The Portfolio also may invest up to 35% of its total
assets in emerging market equity securities (as defined above under
"Batterymarch Emerging Markets Portfolio"). Investing in foreign issuers, and in
particular in emerging market equity securities, involves special risks. See
"Common Investment Policies and Techniques; Risk Factors -- Foreign Securities."
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The Portfolio's investments will normally be diversified across a broad
range of industries and across a number of countries, consistent with the
objective of long-term total return. However, the Portfolio currently expects
that it may invest more than 25% of its total assets in securities of Japanese
and United Kingdom ("UK") issuers. As a result, the value of its shares will be
especially affected by Japanese and UK political, economic, market and exchange
rate conditions, and may fluctuate more widely than the value of shares of other
equity funds.
The Japanese economy is dependent to a significant extent on foreign
trade, and the relationships between Japan and its trading partners and between
the yen and other currencies are expected to have a significant impact on the
Japanese economy generally and therefore are expected to influence the
Portfolio's performance. Japan has in the past experienced difficult relations
with its trading partners, particularly the United States. It is possible that
trade sanctions or other protectionist measures could impact the Japanese
economy and markets, and have an adverse effect on the value of the Portfolio's
assets, in both the short and long term. Japan is currently experiencing a
recession, including a decline in real estate values, that has adversely
affected the balance sheets of many financial institutions. Certain Japanese
financial institutions have experienced extreme financial difficulties,
including bankruptcy. On the other hand, a strong Japanese currency may
adversely affect industries engaged substantially in export. Japan's economy is
heavily dependent on foreign oil. Japan is located in a seismically active area,
and severe earthquakes may damage important elements of the country's
infrastructure. Japanese economic prospects may be affected by the economic,
political and military situations of its neighbors, notably North and South
Korea, Thailand, China, and Russia.
The UK is the world's sixth largest economy and is home to one of the
oldest, most established, and most active stock markets. Trade remains a very
key component of the UK economy, with over $520 billion in goods passing through
its borders last year. Strong domestic sectors are services, natural energy
resources, and heavy industry, including steel, autos, and machinery. Imports
generally emphasize food and manufacturing components. Their trading partners
are predominately established market economies, such as the US, Japan, and other
member countries of the European Union. The UK, via the North Sea, also has
substantial petroleum resources. Healthy relations with its trading partners is
an important factor in determining the UK's economic outlook. In addition, the
UK's nonparticipation in the European Monetary Union could have a negative
impact on certain UK issuers and on the UK's short term and long term economic
prospects.
Although the Portfolio expects to remain substantially fully invested
in equity securities, the Portfolio may invest in any type of debt or fixed
income security (including securities issued by U.S. issuers), cash and money
market instruments, including repurchase agreements. The Portfolio may invest up
to 5% of its total assets in lower-rated fixed income securities (i.e.,
securities rated below investment grade at the time of purchase or unrated
securities of comparable quality at the time of purchase). Lower-rated
securities (and unrated
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securities determined by Batterymarch to be of comparable quality) are
considered to be primarily speculative and may be in default. The Portfolio may
also purchase restricted and illiquid securities, invest in securities of other
investment companies, invest in indexed securities and structured notes, borrow
money for temporary or emergency purposes, engage in futures and options
transactions, and engage in foreign currency exchange transactions. For more
information, see "Common Investment Policies and Techniques; Risk Factors."
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LEGG MASON FUND ADVISER TOTAL RETURN PORTFOLIO
- --------------------------------------------------------------------------------
Adviser: LMFA
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<TABLE>
<S><C>
Objective: capital appreciation and current income in order to achieve an attractive
total investment return consistent with reasonable risk
</TABLE>
- --------------------------------------------------------------------------------
The Portfolio attempts to meet its objective by investing primarily in
dividend-paying common stocks, debt securities and securities convertible into
common stocks which, in the opinion of LMFA, offer potential for attractive
total return. The Portfolio also invests in common stocks and securities
convertible into common stocks which do not pay current dividends but which, in
LMFA's opinion, offer prospects for capital appreciation or future income.
The Portfolio may invest in debt securities of any maturity of both
foreign and domestic issuers without regard to a percentage limit or any limits
on credit quality. LMFA currently anticipates that under normal market
conditions the Portfolio will invest no more than 50% of its total assets in
intermediate-term and long-term debt securities, and no more than 5% of its
total assets in the aggregate in debt securities not rated investment grade,
i.e., not rated at least BBB by S&P or Baa by Moody's, or in unrated securities
if determined by LMFA to be of comparable quality. Lower-rated securities (and
unrated securities determined by LMFA to be of comparable quality) are
considered to be primarily speculative and may be in default. For more
information, see "Common Investment Policies and Techniques; Risk Factors --
Debt and Fixed Income Securities -- Lower-Rated Securities."
The Portfolio may also invest up to 25% of its total assets in
securities principally traded in foreign markets, purchase preferred stock,
engage in foreign currency exchange transactions and transactions in futures
contracts and options, enter into repurchase agreements, purchase shares of
other investment companies, invest in REITs, purchase restricted and illiquid
securities, loan its portfolio securities, borrow money for temporary or
emergency purposes, and purchase or sell securities on a forward commitment
basis. For more information, see "Common Investment Policies and Techniques;
Risk Factors." The Portfolio may also hold a portion of its assets in cash or
money market instruments.
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COMMON INVESTMENT POLICIES AND TECHNIQUES;
RISK FACTORS
- --------------------------------------------------------------------------------
Some or all of the Portfolios may engage in the following investment
practices and techniques to the extent described in this Prospectus. See the SAI
for a further description of the uses, risks and costs of these practices.
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FOREIGN SECURITIES
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Investing in the securities of issuers in any foreign country, or in
securities denominated in a foreign currency, involves special risks and
considerations not typically associated with investing in U.S. issuers or U.S.
dollar-denominated securities. These include risks resulting from differences in
accounting, auditing and financial reporting standards; lower liquidity than
U.S. securities; the possibility of nationalization, expropriation or
confiscatory taxation; adverse changes in investment or exchange control
regulations (which may include suspension of the ability to transfer currency
out of a country); and political instability. In many cases, there is less
publicly available information concerning foreign issuers than is available
concerning U.S. issuers. Additionally, purchases and sales of foreign securities
and dividends and interest payable on those securities may be subject to foreign
taxes and tax withholding. Foreign securities generally exhibit greater price
volatility and a greater risk of illiquidity.
To the extent a Portfolio purchases securities denominated in a foreign
currency, a change in the value of any such currency against the U.S. dollar
will result in a change in the U.S. dollar value of the Portfolio's assets and
the Portfolio's income available for distribution. In addition, a Portfolio is
required to compute and distribute its income in U.S. dollars. Therefore, if the
exchange rate for a foreign currency declines after a Portfolio's income has
been earned and translated into U.S. dollars (but before payment), the Portfolio
could be required to liquidate portfolio securities to make such distributions.
Similarly, if an exchange rate declines between the time a Portfolio incurs
expenses in U.S. dollars and the time such expenses are paid, the amount of such
currency required to be converted into U.S. dollars in order to pay such
expenses in U.S. dollars will be greater than the equivalent amount in any such
currency of such expenses at the time they were incurred.
The relative performance of various countries' securities markets
historically has reflected wide variations relating to the unique
characteristics of each country's economy. Individual foreign economies may
differ favorably or unfavorably from the U.S. economy in such respects as growth
of gross domestic product, rate of inflation, capital reinvestment, resource
self-sufficiency and balance of payments position. Bank deposit insurance, if
any, may be subject to widely varying regulations and limits in foreign
countries.
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Foreign securities purchased by a Portfolio may be listed on foreign
exchanges, traded over-the-counter or purchased in private transactions.
Transactions on foreign exchanges are usually subject to mark-ups or commissions
higher than negotiated commissions on U.S. transactions. There is less
government supervision and regulation of exchanges and brokers in many foreign
countries than in the United States. Additional costs associated with an
investment in foreign securities may include higher custodial fees than apply to
domestic custodial arrangements and transaction costs of foreign currency
conversions.
Certain of the foregoing risks may also apply to some extent to
securities of U.S. issuers that are denominated in foreign currencies or that
are traded in foreign markets, or to securities of U.S. issuers having
significant foreign operations.
EMERGING MARKET ISSUERS. The risks of foreign investment, described
above, are greater for investments in emerging market issuers, and such
investments should therefore be considered speculative. Debt securities of
governmental and other issuers in emerging market countries will typically be
rated below investment grade or be of comparable quality. For more information
about lower-rated securities, see "Debt and Fixed Income Securities --
Lower-Rated Securities" below.
Investors are strongly advised to consider carefully the special risks
involved in emerging markets, which are in addition to the usual risks of
investing in developed markets around the world. Emerging market countries may
experience substantial rates of inflation or deflation. Inflation, deflation and
rapid fluctuations in such rates have had, and may continue to have, very
negative effects on the economies and securities markets of certain emerging
market countries. While some emerging market countries have sought to develop a
number of corrective mechanisms to reduce inflation or deflation or mitigate
their effects, inflation and deflation may continue to have significant effects
both on emerging market countries and their securities markets. In addition,
many of the currencies of emerging market countries have experienced steady
devaluations relative to the U.S. dollar, and major devaluations have occurred
in certain countries.
Economies in emerging market countries generally are dependent heavily
upon international trade and, accordingly, have been and may continue to be
affected adversely by economic conditions, trade barriers, exchange controls,
managed adjustments in relative currency values and other protectionist measures
imposed or negotiated by the countries with which they trade.
Because of the high levels of foreign-denominated debt owed by many
emerging market countries, fluctuating exchange rates can significantly affect
the debt service obligations of those countries. This could, in turn, affect
local interest rates, profit margins and exports, which are a major source of
foreign exchange earnings. Hedging instruments are not typically available with
respect to investments in emerging market countries and, to the extent they are
available, the ongoing and indeterminate nature of the foregoing risks (and the
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costs associated with hedging transactions) would make it virtually impossible
to hedge effectively against such risks.
To the extent an emerging market country faces a liquidity crisis with
respect to its foreign exchange reserves, it may increase restrictions on the
outflow of any foreign exchange. Repatriation is ultimately dependent on the
ability of a Portfolio to liquidate its investments and convert the local
currency proceeds obtained from such liquidation into U.S. dollars. Where this
conversion must be done through official channels (usually the central bank or
certain authorized commercial banks), the ability to obtain U.S. dollars is
dependent on the supply of such U.S. dollars through those channels and, if
available, upon the willingness of those channels to allocate those U.S. dollars
to the Portfolio. In such a case, a Portfolio's ability to obtain U.S. dollars
may be adversely affected by any increased restrictions imposed on the outflow
of foreign exchange. If the Portfolio is unable to repatriate any amounts due to
exchange controls, it may be required to accept an obligation payable at some
future date by the central bank or other governmental entity of the jurisdiction
involved. If such conversion can legally be done outside official channels,
either directly or indirectly, a Portfolio's ability to obtain U.S. dollars may
not be affected as much by any increased restrictions except to the extent of
the price which may be required to be paid for the U.S. dollars.
Many emerging market countries have little experience with the
corporate form of business organization, and may not have well developed
corporation and business laws or concepts of fiduciary duty in the business
context. The securities markets of emerging market countries are substantially
smaller, less developed, less liquid and more volatile than the securities
markets of the U.S. and other more developed countries. Disclosure and
regulatory standards in many respects are less stringent than in the U.S. and
other major markets. There also may be a lower level of monitoring and
regulation of an emerging market country's securities markets and the activities
of investors in such markets; enforcement of existing regulations has been
extremely limited.
Some emerging markets have different settlement and clearance
procedures, which, for example, may not call for delivery of a security to a
Portfolio until well after the Portfolio has paid for such security. In certain
markets there have been times when settlements have been unable to keep pace
with the volume of securities transactions, making it difficult to conduct such
transactions. The inability of a Portfolio to make intended securities purchases
due to settlement problems could cause that Portfolio to miss attractive
investment opportunities. Inability to dispose of a portfolio security caused by
settlement problems could result either in losses to the Portfolio due to
subsequent declines in value of the portfolio security or, if the Portfolio has
entered into a contract to sell the security, in possible liability to the
purchaser.
The risk also exists that an emergency situation may arise in one or
more emerging market countries as a result of which trading of securities may
cease or may be substantially
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curtailed and prices for a Portfolio's portfolio securities in such markets may
not be readily available.
SOVEREIGN DEBT SECURITIES. Sovereign debt is subject to risks in
addition to those relating to foreign investments generally. As a sovereign
entity, the issuing government may be immune from lawsuits in the event of its
failure or refusal to pay the obligations when due. The debtor's willingness or
ability to repay in a timely manner may be affected by, among other factors, its
cash flow situation, the extent of its foreign reserves, the availability of
sufficient foreign exchange on the date a payment is due, the relative size of
the debt service burden to the economy as a whole, the sovereign debtor's policy
toward principal international lenders and the political constraints to which
the sovereign debtor may be subject. Sovereign debtors also may be dependent on
expected disbursements from foreign governments or multinational agencies, the
country's access to trade and other international credits, and the country's
balance of trade. Some emerging market sovereign debtors have in the past
rescheduled their debt payments or declared moratoria on payments, and similar
occurrences may happen in the future.
DEPOSITARY RECEIPTS. American Depositary Receipts, or "ADRs," are
securities issued by a U.S. depositary (usually a bank) and represent a
specified quantity of underlying non-U.S. securities on deposit with a custodian
bank as collateral. A foreign issuer of the security underlying an ADR is
generally not subject to the same reporting requirements in the United States as
a domestic issuer. Accordingly, the information available to a U.S. investor
will be limited to the information the foreign issuer is required to disclose in
its own country and the market value of an ADR may not reflect undisclosed
material information concerning the issuer or the underlying security. ADRs may
also be subject to exchange rate risks if the underlying securities are
denominated in foreign currency. The Portfolios may also invest in similar
non-U.S. instruments issued by foreign banks or trust companies such as "GDRs"
and "EDRs." For purposes of its investment policies, each Portfolio will treat
ADRs and similar instruments as equivalent to investment in the underlying
securities.
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OPTIONS AND FUTURES
- --------------------------------------------------------------------------------
A futures contract is an agreement between the parties to buy or sell a
specified amount of one or more securities, units of an index or currencies at a
specified price and date; futures contracts are generally closed out by the
parties in advance of that date for a cash settlement. Under an option contract,
one party generally has the right to require the other to buy or sell a
specified amount of securities, units of an index, currencies or futures
contracts, and may exercise that right if the market price of the underlying
instrument moves in a direction advantageous to the holder of the option.
Options with respect to securities indices typically call for cash settlement
instead of delivery of the securities that comprise the index. Options and
futures are generally considered to be "derivatives."
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<PAGE>
The Portfolios may buy and sell (i.e., write) options and futures for
hedging purposes and, to the extent permitted by applicable law, for non-hedging
purposes, such as to earn additional income. Futures contracts and options may
also be used for other non-hedging purposes, such as to simulate full investment
in underlying securities while retaining a cash balance for Portfolio management
purposes, as a substitute for direct investment in a security, to facilitate
trading, to reduce transaction costs, or to seek higher investment returns when
a futures contract or option is priced more attractively than the underlying
security or index.
The use of options and futures involves certain investment risks and
transaction costs. These risks include (1) difficulty in predicting movements in
the prices of individual securities or an index, fluctuations in the general
securities markets or in market sectors and movements in interest rates and
currency markets; (2) imperfect correlation, or no correlation at all, between
movements in the price of options and futures contracts, movements in the price
of the underlying instruments, index or currencies and movements in the
securities or currencies that are the subject of a hedge; (3) the fact that
skills needed to use these instruments are different from those needed to select
a Portfolio's other investments; (4) the possible lack of a liquid secondary
market for any particular instrument at any particular time; (5) the possibility
that the use of cover or segregation involving a large percentage of a
Portfolio's assets could impede portfolio management or the Portfolio's ability
to meet redemption requests or other short-term obligations; and (6) the fact
that, although use of these instruments for hedging purposes can reduce the risk
of loss, they can also reduce the opportunity for gain, or even result in
losses, by offsetting favorable price movements in hedged investments. There can
be no assurance that a Portfolio's use of futures contracts or options will be
successful. Moreover, in the event that an anticipated change in the price of
the instruments, index or currencies that are the subject of the strategy does
not occur, the Portfolio might have been in a better position had it not used
that strategy at all. Options and futures traded on U.S. or other exchanges may
be subject to position and daily fluctuation limits, which may limit the ability
of a Portfolio to reduce risk using such options and futures and may limit their
liquidity.
The use of options and futures contracts for speculative purposes,
e.g., to enhance income or to increase a Portfolio's exposure to a particular
security or type of security or a particular foreign currency, subjects the
Portfolio to additional risk. The use of options and futures to hedge an
anticipated purchase also subjects a Portfolio to additional risk until the
purchase is completed or the position is closed out.
Many options on securities are traded primarily on the over-the-counter
("OTC") market. OTC options are two-party contracts with price and other terms
negotiated between buyer and seller and generally do not have as much, if any,
liquidity. Thus, when a Portfolio purchases an OTC option, it relies on the
dealer from which it has purchased the option to make or take delivery of the
instruments or currencies underlying the option or otherwise fulfill its
obligations under the contract. Failure by the dealer to do so would result in
the loss of the premium paid by that Portfolio as well as the loss of the
expected benefit of the
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transaction. OTC options may be considered "illiquid securities" for purposes of
each Portfolio's investment limitations.
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FOREIGN CURRENCY EXCHANGE TRANSACTIONS
- --------------------------------------------------------------------------------
Each Portfolio that may invest in securities that are denominated in
foreign currencies may engage in a variety of foreign currency exchange
transactions to protect against uncertainty in the level of future exchange
rates. These transactions may be engaged in connection with the purchase and
sale of portfolio securities ("transaction hedging") and to protect the value of
specific portfolio positions ("position hedging").
A Portfolio may engage in transaction hedging to protect against a
change in the foreign currency exchange rates between the date on which the
Portfolio contracts to purchase or sell the security and the settlement date, or
to "lock in" the U.S. dollar equivalent of a dividend or interest payment in a
foreign currency. A Portfolio may purchase or sell a foreign currency on a spot
(or cash) basis at the prevailing spot rate. If conditions warrant, for
transaction hedging purposes, a Portfolio may also enter into contracts to
purchase or sell foreign currencies at a future date ("forward contracts") and
may purchase and sell foreign currency futures contracts. A foreign currency
forward contract is a negotiated agreement to exchange currency at a future time
at a rate or rates that may be higher or lower than the spot rate. Foreign
currency futures contracts are standardized exchange-traded contracts and have
margin requirements. Each Portfolio may also purchase and sell (i.e., write)
exchange-listed and over-the-counter call and put options on foreign currency
futures contracts and on foreign currencies.
A Portfolio may engage in "position hedging" to protect against a
decline in the value relative to the U.S. dollar of the currencies in which its
portfolio securities are denominated or quoted (or an increase in the value of
the currency in which securities the Portfolio intends to buy are denominated).
For position hedging purposes, each Portfolio may purchase and sell (i.e.,
write) foreign currency futures contracts, foreign currency forward contracts,
and options on exchanges or over-the-counter markets. In connection with
position hedging, a Portfolio may also purchase or sell foreign currency on a
spot basis.
A Portfolio's currency hedging transactions may call for the delivery
of one foreign currency in exchange for another foreign currency and may at
times involve currencies other than those in which its portfolio securities are
then denominated. "Cross hedging" activities will be used when a Portfolio's
Adviser believes that such transactions provide significant hedging
opportunities for the Portfolio. Cross hedging transactions by a Portfolio
involve the further risk of imperfect correlation between changes in the values
of the currencies to which such transactions relate and changes in the values of
such currencies and of the currency or other asset or liability which is the
subject of the hedge.
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The decision as to whether and to what extent a Portfolio will engage
in foreign currency exchange transactions will depend on a number of factors,
including prevailing market conditions, the composition of a Portfolio's
investments and the availability of suitable transactions. Accordingly, there
can be no assurance that a Portfolio will engage in foreign currency exchange
transactions at any given time or from time to time.
For a further discussion of the risks associated with purchasing and
selling futures contracts and options, see "Options and Futures" above. A
Portfolio may also use other foreign currency exchange instruments and
techniques when available and deemed appropriate by its Adviser.
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PREFERRED STOCKS AND CONVERTIBLE SECURITIES
- --------------------------------------------------------------------------------
A preferred stock pays dividends at a specified rate and has preference
over common stock in the payment of dividends and the liquidation of an issuer's
assets but is junior to the debt securities of the issuer in those same
respects. The market prices of preferred stocks are subject to changes in
interest rates and are more sensitive to changes in an issuer's creditworthiness
than are the prices of debt securities. Shareholders of preferred stock may
suffer a loss of value if dividends are not paid. Under ordinary circumstances,
preferred stock does not carry voting rights.
A convertible security is a bond, debenture, note, preferred stock or
other security that may be converted into or exchanged for a prescribed amount
of common stock (or another equity security) of the same or a different issuer
within a particular period of time at a specified price or formula. A
convertible security entitles the holder to receive interest paid or accrued on
debt or the dividend paid or accrued on preferred stock until the convertible
security matures or is redeemed, converted or exchanged. Before conversion,
convertible securities have characteristics similar to nonconvertible debt
securities in that they ordinarily provide a stream of income with generally
higher yields than those of common stocks of the same or similar issuers.
Convertible securities are usually subordinated to comparable-tier
nonconvertible securities but rank senior to common stock in a corporation's
capital structure.
The value of a convertible security is a function of (1) its yield in
comparison with the yields of other securities of comparable maturity and
quality that do not have a conversion privilege and (2) its worth, at market
value, if converted into the underlying common stock. A convertible security may
be subject to redemption at the option of the issuer at a price established in
the convertible security's governing instrument. If a convertible security held
by a Portfolio is called for redemption, the Portfolio will be required to (1)
permit the issuer to redeem the security, (2) convert it into the underlying
common stock or (3) sell it to a third party. Any of these actions could have an
adverse effect on a Portfolio's ability to achieve its investment objective.
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DEBT AND FIXED INCOME SECURITIES
- --------------------------------------------------------------------------------
The Portfolios may invest in a variety of debt and fixed income
securities. These securities share one principal risk: their values fluctuate
with changes in interest rates. Thus, a decrease in interest rates will
generally result in an increase in the value of a Portfolio's fixed income
investments. Conversely, during periods of rising interest rates, the value of a
Portfolio's fixed income investments will generally decline. The magnitude of
these fluctuations will generally be greater when a security's duration or
average maturity is longer. Changes in the value of portfolio securities will
not affect interest income from those securities, but will be reflected in a
Portfolio's net asset value. The most common types of these instruments, and the
associated risks, are described below. Subject to its investment policies and
applicable law, each of the Portfolios may invest in these and other
instruments.
U.S. GOVERNMENT OBLIGATIONS. U.S. Government securities include (1)
U.S. Treasury bills (maturity of one year or less), U.S. Treasury notes
(maturity of one to ten years) and U.S. Treasury bonds (maturities generally
greater than ten years) and (2) obligations issued or guaranteed by U.S.
Government agencies or instrumentalities. In the case of obligations not backed
by the full faith and credit of the United States, a Portfolio must look
principally to the agency or instrumentality issuing or guaranteeing the
obligation for ultimate repayment and may not be able to assert a claim against
the United States itself in the event the agency or instrumentality does not
meet its commitments. Neither the U.S. Government nor any of its agencies or
instrumentalities guarantees the market value of the securities they issue.
Therefore, the market value of such securities will fluctuate in response to
changes in interest rates.
MORTGAGE-RELATED SECURITIES. Mortgage-related securities represent an
interest in a pool of mortgages made by lenders such as commercial banks,
savings and loan institutions, mortgage bankers and others. Mortgage-related
securities may be issued by governmental, government-related or non-governmental
entities, and provide regular payments which consist of interest and, in most
cases, principal. In contrast, other forms of debt securities normally provide
for periodic payment of interest in fixed amounts with principal payments at
maturity or specified call dates. In effect, payments on mortgage-related
securities are a "pass-through" of the payments made by the individual borrowers
on their mortgage loans, net of any fees paid to the issuer or guarantor of such
securities. Additional payments to holders of mortgage-related securities are
caused by repayments resulting from the sale of the underlying property,
refinancing or foreclosure, net of fees or costs which may be incurred.
As prepayment rates of individual pools of mortgage loans vary widely,
it is not possible to predict accurately the average life of a particular
security. Although mortgage-related securities are issued with stated maturities
of up to forty years, unscheduled or early payments of principal and interest on
the underlying mortgages may shorten
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considerably the securities' effective maturities. The volume of prepayments of
principal on a pool of mortgages underlying a particular mortgage-related
security will influence the yield of that security, and the principal returned
to a Portfolio may be reinvested in instruments whose yield may be higher or
lower than that which might have been obtained had such prepayments not
occurred. When interest rates are declining, such prepayments usually increase,
and reinvestments of such principal prepayments will be at a lower rate than
that on the original mortgage-related security. An increase in mortgage
prepayments could cause the Portfolio to incur a loss on a mortgage-related
security that was purchased at a premium. On the other hand, a decrease in the
rate of prepayments, resulting from an increase in market interest rates or
other causes, may extend the effective maturities of mortgage-related
securities, increasing their sensitivity to changes in market interest rates and
potentially increasing the volatility of a Portfolio's shares. The rate of
prepayment may also be affected by general economic conditions, the location and
age of the mortgages, and other social and demographic conditions. In
determining the average maturity or duration of a mortgage-related security, a
Portfolio's Adviser must apply certain assumptions and projections about the
maturity and prepayment of such security; actual prepayment rates may differ.
Because of prepayments, mortgage-related securities may have less potential for
capital appreciation during periods of declining interest rates than other
securities of comparable maturities, although they may have a similar risk of
decline in market value during periods of rising interest rates.
ASSET-BACKED SECURITIES. Asset-backed securities refer to securities
that directly or indirectly represent a participation in, or are secured by and
payable from, assets such as motor vehicle installment sales, installment loan
contracts, leases of various types of real and personal property and receivables
from revolving credit (credit card) agreements. Such assets are securitized
through the use of trusts or special purpose corporations. Asset-backed
securities are backed by a pool of assets representing the obligations often of
a number of different parties. Certain of such securities may be illiquid.
The principal on asset-backed securities, like that on mortgage-backed
securities, may be prepaid at any time. As a result, if such securities are
purchased at a premium, a prepayment rate that is faster than expected will
reduce yield to maturity, while a prepayment rate that is slower than expected
will have the opposite effect. Conversely, if the securities are purchased at a
discount, prepayments faster than expected will increase yield to maturity and
prepayments slower than expected will decrease it. Accelerated prepayments also
reduce the certainty of the yield because the Portfolio must reinvest the assets
at the then-current rates. Accelerated prepayments on securities purchased at a
premium also impose a risk of loss of principal. On the other hand, a decrease
in the rate of prepayments may extend the effective maturities of the
securities, increasing their sensitivity to changes in market interest rates and
potentially increasing the volatility of a Portfolio's shares. The rate of
prepayment may also be affected by general economic conditions and other social
and demographic conditions.
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<PAGE>
Each type of asset-backed security also entails unique risks depending
on the type of assets involved and the legal structure used. For example, credit
card receivables are generally unsecured obligations of the credit card holder
and the debtors are entitled to the protection of a number of state and federal
consumer credit laws, many of which give such debtors the right to set off
certain amounts owed on the credit cards, thereby reducing the balance due.
There have also been proposals to cap the interest rate that a credit card
issuer may charge. In some transactions, the value of the asset-backed security
is dependent on the performance of a third party acting as credit enhancer or
servicer. Furthermore, in some transactions (such as those involving the
securitization of vehicle loans or leases) it may be administratively burdensome
to perfect the interest in the underlying collateral, and the underlying
collateral may become damaged or stolen.
CORPORATE DEBT SECURITIES. A Portfolio may invest in debt securities
(i.e., bonds, debentures, notes and other similar debt instruments) of domestic
or foreign non-governmental issuers which meet the minimum credit quality
criteria, if any, set forth for the Portfolio. Corporate debt securities may pay
fixed or variable rates of interest, or interest at a rate contingent upon some
other factor, such as the price of some commodity. These securities may include
warrants, may be convertible into preferred or common equity, or may be bought
as part of a unit containing common stock.
LOWER-RATED SECURITIES. Non-investment grade securities, i.e.,
securities rated below Baa by Moody's or BBB by S&P or unrated securities of
comparable quality, are described as "speculative" by Moody's and S&P and may be
subject to greater market fluctuations and greater risk of loss of income or
principal, including a greater possibility of default or bankruptcy of the
issuer of such securities, than are more highly rated debt securities. Such
securities are commonly referred to as "junk bonds." A Portfolio's Adviser seeks
to minimize the risks of investing in all securities through diversification,
in-depth credit analysis and attention to current developments in interest rates
and market conditions and will monitor the ratings of securities held by the
Portfolios and the creditworthiness of their issuers. See the Appendix to this
Prospectus for a description of the ratings assigned to fixed income securities
by the rating agencies.
A debt security may be callable, i.e., subject to redemption at the
option of the issuer at a price established in the security's governing
instrument. If a debt security held by a Portfolio is called for redemption, the
Portfolio will be required to permit the issuer to redeem the security or sell
it to a third party. Either of these actions could have an adverse effect on a
Portfolio's ability to achieve its investment objective because, for example,
the Portfolio may be able to reinvest the proceeds only in securities with lower
yields or may receive a price upon sale that is lower than it would have
received in the absence of the redemption.
The prices of debt securities fluctuate in response to perceptions of
the issuer's creditworthiness. Generally, lower-rated securities offer a higher
current yield than that provided by higher grade issues, but also involve higher
risks. Debt securities rated C by
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Moody's and S&P are bonds on which no interest is being paid and which can be
regarded as having extremely poor prospects of ever attaining any real
investment standing. Debt securities rated D by an NRSRO are bonds that are in
default or arrears and have questionable value. Lower-rated securities are
especially affected by adverse changes in the industries in which the issuers
are engaged and by changes in the financial condition of the issuers. Highly
leveraged issuers may also experience financial stress during periods of rising
interest rates.
The market for lower-rated securities has expanded rapidly in recent
years. This growth has paralleled a long economic expansion. At certain times in
the past, the prices of many lower-rated securities declined, indicating
concerns that issuers of such securities might experience financial
difficulties. At those times, the yields on lower-rated securities rose
dramatically, reflecting the risk that holders of such securities could lose a
substantial portion of their value as a result of the issuers' financial
restructuring or default. There can be no assurance that such declines will not
recur.
The market for lower-rated securities is generally thinner and less
active than that for higher quality debt securities, which may make it difficult
for a Portfolio to value its securities or may limit a Portfolio's ability to
sell such securities at fair value. As a result, judgment plays a greater role
in pricing such securities than is the case for securities having more active
markets. Adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may also decrease the values and liquidity of lower-rated
securities, especially in a thinly traded market.
The ratings of Moody's and S&P represent the opinions of those agencies
as to the quality of the debt securities which they rate. Such ratings are
relative and subjective, and are not absolute standards of quality. Unrated debt
securities are not necessarily of lower quality than rated securities, but they
may not be attractive to as many buyers. If securities are rated investment
grade by one rating organization and below investment grade by the other, a
Portfolio's Adviser may rely on the rating that it believes is more accurate.
Each Portfolio's Adviser will consider a security's quality and credit rating
when determining whether such security is an appropriate investment. Subject to
its investment objective, policies and applicable law, a Portfolio may purchase
a security with the lowest rating (or an unrated security of comparable
quality).
STRIPPED SECURITIES. Stripped securities are created by separating
bonds into their principal and interest components and selling each piece
separately (commonly referred to as IOs and POs). The yield to maturity on an IO
or PO class of stripped mortgage-backed securities is extremely sensitive not
only to changes in prevailing interest rates but also to the rate of principal
payments (including prepayments) on the underlying assets. A rapid rate of
principal prepayments may have a measurably adverse effect on a Portfolio's
yield to maturity to the extent it invests in IOs. If the assets underlying the
IOs experience greater than anticipated prepayments of principal, the fund may
fail to recoup fully its initial investment in these securities. Conversely, POs
tend to increase in value if prepayments are greater than
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<PAGE>
anticipated and decline if prepayments are slower than anticipated. The
secondary market for stripped mortgage-backed securities may be more volatile
and less liquid than that for other mortgage-backed securities, potentially
limiting a Portfolio's ability to buy or sell those securities at any particular
time. The Board has approved guidelines for determining a security's liquidity
and has delegated to each Portfolio's Adviser the responsibility for determining
whether a particular security eligible for trading is "liquid" pursuant to such
guidelines.
ZERO COUPON AND PAY-IN-KIND SECURITIES. A zero coupon bond is a
security that makes no fixed interest payments but instead is sold at a discount
from its face value. The bond is redeemed at its face value on the specified
maturity date. Zero coupon bonds may be issued as such, or they may be created
by a broker who strips the coupons from a bond and separately sells the rights
to receive principal and interest. The prices of zero coupon bonds tend to
fluctuate more in response to changes in market interest rates than do the
prices of interest-paying debt securities with similar maturities. A Portfolio
investing in zero coupon bonds generally accrues income on such securities prior
to the receipt of cash payments. Since each Portfolio must distribute
substantially all of its income to shareholders to qualify as a regulated
investment company under federal income tax law, a Portfolio investing in zero
coupon bonds may have to dispose of other securities to generate the cash
necessary for the distribution of income attributable to its zero coupon bonds.
Pay-in-kind securities have characteristics similar to those of zero coupon
securities, but interest on such securities may be paid in the form of
obligations of the same type rather than cash.
- --------------------------------------------------------------------------------
COMMERCIAL PAPER AND OTHER SHORT-TERM INVESTMENTS
- --------------------------------------------------------------------------------
Each of the Portfolios may invest and hold cash or other short-term
investments, including commercial paper. Commercial paper represents short-term
unsecured promissory notes issued in bearer form by banks or bank holding
companies, corporations and finance companies. The Portfolios may purchase
commercial paper issued pursuant to the private placement exemption in Section
4(2) of the Securities Act of 1933. Section 4(2) paper is restricted as to
disposition under federal securities laws in that any resale must similarly be
made in an exempt transaction. The Portfolios may or may not regard such
securities as illiquid, depending on the circumstances of each case.
Any Portfolio may also invest in obligations (including certificates of
deposit, demand and time deposits and bankers' acceptances) of U.S. banks and
savings and loan institutions. While domestic bank deposits are insured by an
agency of the U.S. Government, the Portfolios will generally assume positions
considerably in excess of the insurance limits.
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- --------------------------------------------------------------------------------
INDEXED SECURITIES AND STRUCTURED NOTES
- --------------------------------------------------------------------------------
The values of indexed securities and structured notes are linked to
currencies, other securities, interest rates, commodities, indices or other
financial indicators ("reference instruments"). These instruments differ from
other types of debt securities in several respects. The interest rate or
principal amount payable at maturity may vary based on changes in one or more
specified reference instruments, such as a floating interest rate compared with
a fixed interest rate or the currency exchange rates between two currencies
(neither of which need be the currency in which the instrument is denominated).
An indexed security or structured note may be positively or negatively indexed;
that is, its value or interest rate may increase or decrease if the value of the
reference instrument increases. Further, the change in the principal amount
payable with respect to, or the interest rate of, an indexed security or
structured note may be a multiple of the percentage change (positive or
negative) in the value of the underlying reference instrument(s).
Investment in indexed securities and structured notes involves certain
risks, including the credit risk of the issuer and the normal risks of price
changes in response to changes in interest rates. Further, in the case of
certain indexed securities or structured notes, a decline in the reference
instrument may cause the interest rate to be reduced to zero, and any further
declines in the reference instrument may then reduce the principal amount
payable on maturity. Finally, these securities may be less liquid than other
types of securities, and may be more volatile than their underlying reference
instruments.
- --------------------------------------------------------------------------------
FORWARD COMMITMENTS
- --------------------------------------------------------------------------------
Each Portfolio may enter into commitments to purchase securities on a
"forward commitment" basis, including purchases on a "when-issued" basis or a
"to be announced" basis. When such transactions are negotiated, certain terms
may be fixed at the time the commitment is made, but delivery and payment for
the securities takes place at a later date. Such securities are often the most
efficiently priced and have the best liquidity in the bond market. During the
period between a commitment and settlement, no payment is made by the purchaser
for the securities purchased and, thus, no interest accrues to the purchaser
from the transaction. In a "to be announced" transaction, a Portfolio commits to
purchase securities for which all specific information is not yet known at the
time of the trade, particularly the exact face amount in forward commitment
mortgage-backed securities transactions.
A Portfolio may sell the securities subject to a forward commitment
purchase, which may result in a gain or loss. When a Portfolio purchases
securities on a forward commitment basis, it assumes the risks of ownership,
including the risk of price fluctuation, at the time of purchase, not at the
time of receipt. Purchases of forward commitment securities also involve
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<PAGE>
a risk of loss if the seller fails to deliver after the value of the securities
has risen. Depending on market conditions, a Portfolio's forward commitment
purchases could cause its net asset value to be more volatile.
Each Portfolio may also enter into a forward commitment to sell
securities it owns and will generally do so only with the intention of actually
delivering the securities. The use of forward commitments enables a Portfolio to
hedge against anticipated changes in interest rates and prices. In a forward
sale, a Portfolio does not participate in gains or losses on the security
occurring after the commitment date. Forward commitments to sell securities also
involve a risk of loss if the seller fails to take delivery after the value of
the securities has declined.
Forward commitment transactions involve additional risks similar to
those associated with investments in options and futures contracts. See "Options
and Futures Contracts." It is not expected that any Portfolio's purchases of
forward commitments will at any time exceed, in the aggregate, 20% of that
Portfolio's total assets.
- --------------------------------------------------------------------------------
RESTRICTED AND ILLIQUID SECURITIES
- --------------------------------------------------------------------------------
Restricted securities are securities subject to legal or contractual
restrictions on their resale, such as private placements. Such restrictions
might prevent the sale of restricted securities at a time when the sale would
otherwise be desirable. No securities for which there is not a readily available
market ("illiquid securities") will be acquired by any Portfolio if such
acquisition would cause the aggregate value of illiquid securities to exceed 15%
of the Portfolio's net assets.
Under SEC regulations, certain securities acquired through private
placements can be traded freely among qualified purchasers. The SEC has stated
that an investment company's board of directors, or its investment adviser
acting under authority delegated by the board, may determine that a security
eligible for trading under this rule is "liquid." The Portfolios intend to rely
on this rule, to the extent appropriate, to deem specific securities acquired
through private placements as "liquid." The Board has approved guidelines for
determining such securities' liquidity and has delegated to each Portfolio's
Adviser the responsibility for determining whether a particular security
eligible for trading under this rule is "liquid" pursuant to such guidelines.
Investing in these restricted securities could have the effect of increasing a
Portfolio's illiquidity if qualified purchasers become, for a time, uninterested
in buying these securities.
Illiquid securities may be difficult to value, and a Portfolio may have
difficulty disposing of such securities promptly. The Portfolios do not consider
foreign securities to be restricted if they can be freely sold in the principal
markets in which they are traded, even if they are not registered for sale in
the U.S.
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<PAGE>
- --------------------------------------------------------------------------------
SECURITIES OF OTHER INVESTMENT COMPANIES
- --------------------------------------------------------------------------------
Investments in other investment companies may involve the payment of
substantial premiums above the net asset value of such issuers' portfolio
securities, and the total return on such investments will be reduced by the
operating expenses and fees of such investment companies, including advisory
fees. The Portfolios may invest in both closed-end and open-end investment
companies.
- --------------------------------------------------------------------------------
REPURCHASE AGREEMENTS
- --------------------------------------------------------------------------------
A repurchase agreement is an agreement under which securities are
acquired from a securities dealer or bank subject to resale at an agreed upon
price and date. The securities are held by a Portfolio as collateral until
retransferred and will be supplemented by additional collateral if necessary to
maintain a total market value equal to or in excess of the value of the
repurchase agreement. The Portfolio bears a risk of loss in the event that the
other party to a repurchase agreement defaults on its obligations and the
Portfolio is delayed or prevented from exercising its rights to dispose of the
collateral securities. A Portfolio also bears the risk that the proceeds from
any sale of collateral will be less than the repurchase price.
- --------------------------------------------------------------------------------
REVERSE REPURCHASE AGREEMENTS AND OTHER BORROWING
- --------------------------------------------------------------------------------
A reverse repurchase agreement is a portfolio management technique in
which a Portfolio temporarily transfers possession of a portfolio instrument to
another person, such as a financial institution or broker-dealer, in return for
cash. At the same time, the Portfolio agrees to repurchase the instrument at an
agreed upon time (normally within seven days) and price, including interest
payment. While engaging in reverse repurchase agreements, each Portfolio will
maintain cash or securities in a segregated account with a value at least equal
to the Portfolio's obligation under the agreements, adjusted daily. Reverse
repurchase agreements may expose a Portfolio to greater fluctuations in the
value of its assets and renders the segregated assets unavailable for sale or
other disposition.
The Portfolios may also enter into dollar roll transactions in which a
Portfolio sells a fixed income security for delivery in the current month and
simultaneously contracts to purchase substantially similar (same type, coupon
and maturity) securities at an agreed upon future time. By engaging in the
dollar roll transaction the Portfolio foregoes principal and interest paid on
the security that is sold, but receives the difference between the current sales
price and the forward price for the future purchase. The Portfolio would also be
able to earn interest on the income that is received from the initial sale.
The obligation to purchase securities on a specified future date
involves the risk that the market value of the securities that a Portfolio is
obligated to purchase may decline below the
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purchase price. In addition, in the event the other party to the transaction
files for bankruptcy, becomes insolvent or defaults on its obligation, a
Portfolio may be adversely affected.
Each Portfolio will limit its investments in reverse repurchase
agreements and other borrowing (including dollar roll transactions) to no more
than one-third of its total assets. To avoid potential leveraging effects of
such borrowing (including reverse repurchase agreements and dollar rolls), a
Portfolio will not make investments while its borrowing is in excess of 5% of
its total assets.
- --------------------------------------------------------------------------------
LOANS OF PORTFOLIO SECURITIES
- --------------------------------------------------------------------------------
A Portfolio may lend its portfolio securities, provided that cash or
equivalent collateral, equal to at least 100% of the market value of the
securities loaned, is continuously maintained by the borrower with the
Portfolio. During the time securities are on loan, the borrower will pay the
Portfolio an amount equivalent to any dividends or interest paid on such
securities, and the Portfolio may invest the cash collateral and earn additional
income, or it may receive an agreed upon amount of interest income from the
borrower who has delivered equivalent collateral. These loans are subject to
termination at the option of the Portfolio or the borrower. A Portfolio may pay
administrative and custodial fees in connection with a loan and may pay a
negotiated portion of the interest earned on the cash or equivalent collateral
to the borrower or placing broker. No Portfolio presently expects to have on
loan at any given time securities totaling more than one-third of its net
assets. A Portfolio runs the risk that the counterparty to a loan transaction
will default on its obligation and that the value of the collateral received may
decline before the Portfolio can dispose of it.
- --------------------------------------------------------------------------------
REITs
- --------------------------------------------------------------------------------
REITs pool investors' funds for investment primarily in income
producing real estate or real estate related loans or interests. Under the
Internal Revenue Code of 1986 (the "Code"), a REIT is not taxed on income it
distributes to its shareholders if it complies with several requirements
relating to its organization, ownership, assets, and income and a requirement
that it generally distribute to its shareholders at least 95% of its taxable
income (other than net capital gains) for each taxable year. REITs can generally
be classified as Equity REITs, Mortgage REITs, and Hybrid REITs. Equity REITs,
which invest the majority of their assets directly in real property, derive
their income primarily from rents. Equity REITs can also realize capital gains
by selling properties that have appreciated in value. Mortgage REITs, which
invest the majority of their assets in real estate mortgages, derive their
income primarily from interest payments. Hybrid REITS combine the
characteristics of both Equity REITs and Mortgage REITs.
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<PAGE>
While a Portfolio will not generally invest in real estate directly, it
may be subject to risks similar to those associated with the direct ownership of
real estate. These risks include declines in the value of real estate, risks
related to general and local economic conditions, dependency on management
skill, heavy cash flow dependency, possible lack of availability of mortgage
funds, overbuilding, extended vacancies of properties, increased competition,
increases in property taxes and operating expenses, changes in zoning laws,
losses due to costs resulting from the clean-up of environmental problems,
liability to third parties for damages resulting from environmental problems,
casualty or condemnation losses, limitations on rents, changes in neighborhood
values and in the appeal of properties to tenants and changes in interest rates.
In addition to these risks, REITs may be affected by changes in the
value of the underlying property owned by the trusts, or by the quality of any
credit they extend. Further, REITs are dependent upon management skills and
generally may not be diversified. REITs are also subject to heavy cash flow
dependency, defaults by borrowers and self-liquidation. In addition, REITs could
possibly fail to qualify for tax-free pass-through of income under the Code or
to maintain their exemptions from registration under the 1940 Act. The above
factors may also adversely affect a borrower's or a lessee's ability to meet its
obligations to the REIT. In the event of a default by a borrower or lessee, the
REIT may experience delays in enforcing its rights as a mortgagee or lessor and
may incur substantial costs associated with protecting its investments. In
addition to the foregoing risks, certain "special purpose" REITs in which a
Portfolio invests may invest their assets in specific real estate sectors, such
as hotel REITs, nursing home REITs or warehouse REITs, and are therefore subject
to the risks associated with adverse developments in any such sectors.
- --------------------------------------------------------------------------------
PORTFOLIO TURNOVER
- --------------------------------------------------------------------------------
While it is impossible to predict portfolio turnover rates, the Legg
Mason Fund Adviser Large Cap Value Portfolio, the Legg Mason Fund Adviser Mid
Cap Value Portfolio, the Brandywine Small Cap Value Portfolio, the Batterymarch
Emerging Markets Portfolio, the Batterymarch International Equity Portfolio and
the Legg Mason Fund Adviser Total Return Portfolio currently expect that their
average turnover rate will not exceed 100%, 100%, 175%, 50%, 75% and 100%
respectively.
The length of time a Portfolio has held a particular security is not
generally a consideration in investment decisions. A change in the securities
held by a Portfolio is known as "portfolio turnover." As a result of a
Portfolio's investment policies, under certain market conditions a Portfolio's
portfolio turnover rate may be higher than that of other mutual funds. Portfolio
turnover generally involves some expense to a Portfolio, including brokerage
commissions or dealer mark-ups and other transaction costs on the sale of
securities and reinvestment in other securities. These transactions may result
in realization of taxable capital gains. Higher portfolio turnover rates, such
as those above 100%, are likely to result in
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<PAGE>
higher brokerage commissions or other transactions costs and could give rise to
a greater amount of taxable capital gains.
- --------------------------------------------------------------------------------
ALTERNATIVE INVESTMENT STRATEGIES
- --------------------------------------------------------------------------------
At times a Portfolio's Adviser may judge that conditions in the
securities markets make pursuing the Portfolio's typical investment strategy
inconsistent with the best interests of its shareholders. At such times, the
Adviser may temporarily use alternative strategies, primarily designed to reduce
fluctuations in the value of the Portfolio's assets. In implementing these
defensive strategies, a Portfolio may invest without limit in securities that
the Adviser believes present less risk to a Portfolio, including equity
securities, debt and fixed income securities, preferred stocks, U.S. Government
and agency obligations, cash or money market instruments, or in other securities
the Adviser considers consistent with such defensive strategies. As a result of
these strategies, the Batterymarch Emerging Markets Portfolio and the
Batterymarch International Equity Portfolio may invest up to 100% of their
assets in securities of U.S. issuers. It is impossible to predict when, or for
how long, a Portfolio will use these alternative strategies.
- --------------------------------------------------------------------------------
NEW INVESTMENT PRODUCTS
- --------------------------------------------------------------------------------
New types of mortgage-backed and asset-backed securities, derivative
instruments and hedging instruments are developed and marketed from time to
time. Consistent with its investment limitations, each Portfolio expects to
invest in those new types of securities and instruments that its Adviser
believes may assist the Portfolio in achieving its investment objective.
- --------------------------------------------------------------------------------
INVESTMENT POLICIES
- --------------------------------------------------------------------------------
Except for investment policies designated as fundamental in this
prospectus or the SAI, the investment policies described in this prospectus and
in the SAI are not fundamental policies. Changes to fundamental investment
policies require shareholder approval; the Directors may change any
non-fundamental investment policy without shareholder approval.
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<PAGE>
- --------------------------------------------------------------------------------
PERFORMANCE DATA
- --------------------------------------------------------------------------------
Advertisements and other communications to shareholders or prospective
investors may include performance information about a Portfolio. "Yield" for
each class of shares of a Portfolio is calculated by dividing the annualized net
investment income per share during a recent 30-day period by the maximum public
offering price per share of the class on the last day of that period.
"Total return" is a measurement of the overall change in value,
including changes in share price and assuming reinvestment of distributions, of
an investment in a Portfolio. "Cumulative total return" shows a Portfolio's
performance over a specific period of time. "Average annual total return" for
the one-, five- and ten-year periods (or for the life of a class, if shorter)
through the most recent calendar quarter represents the average annual
compounded rate of return on an investment of $1,000 in a Portfolio invested at
the maximum public offering price.
Investment performance, which will vary, is based on many factors,
including market conditions, portfolio composition, Portfolio operating expenses
and the class of shares the investor purchases. Investment performance also
often reflects the risks associated with a Portfolio's investment objective and
policies. These factors should be considered when comparing a Portfolio's
investment results with those of other mutual funds and other investment
vehicles. Performance information is based on historical performance and should
not be viewed as representative of a Portfolio's future performance. The
investment return and principal value of an investment in a Portfolio will
fluctuate so that an investor's shares, when redeemed, may be worth more or less
than their original cost.
Quotations of investment performance for any period when an expense
limitation was in effect will be greater than if the limitation had not been in
effect. Portfolio performance may be compared to that of various indexes. See
the SAI.
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<PAGE>
- --------------------------------------------------------------------------------
MANAGEMENT OF THE PORTFOLIOS
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
BOARD OF DIRECTORS
- --------------------------------------------------------------------------------
The business affairs of LM Institutional Fund Advisors II, Inc.
("Corporation") are managed under the direction of a Board of Directors, and the
Directors of the Corporation are responsible for generally overseeing the
conduct of each Portfolio's business. Information about the Directors and
executive officers of the Corporation may be found in the SAI.
The Board of Directors has retained the Manager and the Advisers to
manage the Portfolios' affairs, furnish a continuing investment program for the
Portfolios and make investment decisions on their behalf, subject to such
policies as the Directors may determine.
- --------------------------------------------------------------------------------
MANAGER, ADVISERS AND PORTFOLIO MANAGERS
- --------------------------------------------------------------------------------
The Portfolios are managed by the Manager. Each Portfolio pays the
Manager a monthly fee based on the average net assets of the Portfolio at the
following rates:
ANNUAL PERCENTAGE OF
PORTFOLIO AVERAGE NET ASSETS
--------- --------------------
Legg Mason Fund Adviser Large Cap Value Portfolio 0.60%
Legg Mason Fund Adviser Mid Cap Value Portfolio 0.60%
Brandywine Small Cap Value Portfolio 0.65%
Batterymarch Emerging Markets Portfolio 0.65%
Batterymarch International Equity Portfolio 0.65%
Legg Mason Fund Adviser Total Return Portfolio 0.60%
The Manager is a Maryland corporation formed on February 20, 1998 and
is a wholly owned subsidiary of Legg Mason, Inc., a financial services holding
company.
In order to assist in carrying out its investment advisory
responsibilities, the Manager has retained the Advisers to render advisory
services to the Portfolios. The Manager pays the fees of the Advisers.
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<PAGE>
The Manager pays a Portfolio's Adviser a monthly fee based on the
average net assets of the Portfolio at the following rates:
<TABLE>
<CAPTION>
- ------------------------------------------------------ ------------------------- --------------------------
Portfolio Adviser Adviser Fee
- ------------------------------------------------------ ------------------------- --------------------------
<S><C>
Legg Mason Fund Adviser Large Cap Value LMFA .55%
- ------------------------------------------------------ ------------------------- --------------------------
Legg Mason Fund Adviser Mid Cap Value LMFA .55%
- ------------------------------------------------------ ------------------------- --------------------------
Brandywine Small Cap Value Brandywine .60%
- ------------------------------------------------------ ------------------------- --------------------------
Batterymarch Emerging Markets Batterymarch .60%
- ------------------------------------------------------ ------------------------- --------------------------
Batterymarch International Equity Batterymarch .60%
- ------------------------------------------------------ ------------------------- --------------------------
Legg Mason Fund Adviser Total Return LMFA .55%
- ------------------------------------------------------ ------------------------- --------------------------
</TABLE>
LMFA. LMFA acts as adviser or manager to eighteen investment company
portfolios which had aggregate assets under management of approximately $12
billion as of April 30, 1998. LMFA s address is 100 Light Street, Baltimore,
Maryland 21202. LMFA is a subsidiary of Legg Mason, Inc.
BRANDYWINE. Brandywine, a wholly owned subsidiary of Legg Mason, Inc.,
acts as investment adviser to institutional accounts, such as corporate pension
plans, mutual funds and endowment funds, as well as to individual investors.
Total assets under management by Brandywine were approximately $8.2 billion as
of April 30, 1998. The address of Brandywine is Three Christina Centre, Suite
1200, 201 N. Walnut Street, Wilmington, Delaware 19801.
BATTERYMARCH. Batterymarch, a wholly owned subsidiary of Legg Mason,
Inc., acts as investment adviser to institutional accounts, such as corporate
pension plans, mutual funds and endowment funds, as well as to individual
investors. Total assets under management by Batterymarch were approximately $4.4
billion as of April 30, 1998. The address of Batterymarch is 200 Clarendon
Street, Boston, Massachusetts 02116.
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<PAGE>
EXPENSE LIMITATIONS. The Manager and the Advisers have until July 31,
1999 voluntarily agreed to waive their fees and/or reimburse each Portfolio in
any month to the extent a Portfolio's expenses (exclusive of taxes, interest,
deferred organizational expenses, 12b-1 fees, brokerage and extraordinary
expenses) exceed during that month the annual rate of that Portfolio's average
net assets set forth below:
Legg Mason Fund Adviser Large Cap Value Portfolio,
Legg Mason Fund Adviser Mid Cap Value Portfolio
and Legg Mason Fund Adviser Total Return Portfolio 0.75%
Brandywine Small Cap Value Portfolio 0.85%
Batterymarch International Equity Portfolio 1.00%
Batterymarch Emerging Markets Portfolio 1.45%
Any amounts waived or reimbursed in a particular fiscal year will be
subject to repayment by a Portfolio to the Manager and the Advisers to the
extent that from time to time during the next three fiscal years the repayment
will not cause a Portfolio's expenses to exceed the limit, if any, imposed by
the Manager and the Advisers at that time.
These agreements are voluntary and may be terminated by the Manager and
the Advisers at any time.
PORTFOLIO MANAGERS. The names and business experience for the past
five years for each portfolio manager are set forth in the following chart.
-39-
<PAGE>
<TABLE>
<CAPTION>
- ------------------------------------------------ ------------------------------------------------------
Portfolio Portfolio Manager and Business Experience
(past five years)
- ------------------------------------------------ ------------------------------------------------------
<S><C>
Legg Mason Fund Adviser Large Cap Value William H. Miller, III is a portfolio manager
Value Portfolio and President of LMFA. Mr. Miller has been
employed by LMFA since 1982.
- ------------------------------------------------ ------------------------------------------------------
Legg Mason Fund Adviser Mid Cap Value William H. Miller, III (see above)
Portfolio
- ------------------------------------------------ ------------------------------------------------------
Brandywine Small Cap Value Portfolio Henry F. Otto is a senior portfolio manager at
Brandywine. Mr. Otto has been employed by
Brandywine since 1987. Steven M. Tonkovich
is a portfolio manager and analyst at
Brandywine. Mr. Tonkovich has been
employed by Brandywine since 1989.
- ------------------------------------------------ ------------------------------------------------------
Batterymarch Emerging Markets Portfolio Batterymarch emerging markets team
- ------------------------------------------------ ------------------------------------------------------
Batterymarch International Equity Portfolio Batterymarch developed markets (EAFE) team
- ------------------------------------------------ ------------------------------------------------------
Legg Mason Fund Adviser Total Return Nancy T. Dennin is a portfolio manager and
Portfolio Senior Vice President of LMFA. Ms. Dennin
has been employed by LMFA since 1985.
- ------------------------------------------------ ------------------------------------------------------
</TABLE>
- --------------------------------------------------------------------------------
THE DISTRIBUTOR
- --------------------------------------------------------------------------------
LMWW is the distributor of each Portfolio's shares. LMWW pays certain
expenses in connection with the offering of shares of each Portfolio, including
any compensation to its financial advisors, the printing and distribution of
prospectuses, SAIs and periodic reports used in connection with the offering to
prospective investors, and expenses relating to any supplementary sales
literature or advertising. The Portfolios bear the expenses of preparing,
setting in type and mailing the prospectuses, SAIs and periodic reports to
existing shareholders.
- --------------------------------------------------------------------------------
PORTFOLIO TRANSACTIONS
- --------------------------------------------------------------------------------
Each Portfolio's Adviser places all orders for the purchase and sale of
portfolio investments with brokers or dealers selected by it in its discretion.
It will seek the best price and execution of each Portfolio's orders. However,
the Adviser may pay higher commission rates than the lowest available when it
believes it is reasonable to do so in light of the value of
-40-
<PAGE>
brokerage and research services provided by the broker effecting the
transaction. The Adviser may also consider sales of shares of the Portfolio (or
other Portfolios or other funds managed by it or its affiliates, to the extent
permitted by applicable law) in selecting broker-dealers to execute Portfolio
transactions. The Portfolios may use LMWW, among others, as broker for agency
transactions in listed and over-the-counter securities at commission rates and
under circumstances consistent with the policy of best execution.
Some securities considered by an Adviser for purchase by a Portfolio
may also be appropriate for other clients served by the Adviser. Transactions in
such securities will be allocated among the Portfolios and such other clients in
a manner considered fair and reasonable by the Adviser.
- --------------------------------------------------------------------------------
EXPENSES
- --------------------------------------------------------------------------------
Each Portfolio pays its share of all expenses of the Corporation that
are not assumed by the Manager, the Adviser or other parties, including
Directors', auditing, legal, custodial, transfer agency and distribution fees
(which are in turn allocated to the Financial Intermediary Class of shares).
- --------------------------------------------------------------------------------
ORGANIZATION AND HISTORY
- --------------------------------------------------------------------------------
The Corporation was incorporated in Maryland on January 13, 1998. Each
Portfolio is an open-end, diversified management company. The Directors of the
Corporation may, without shareholder approval, create, in addition to the
Portfolios, other series of shares representing separate investment portfolios.
Any such series may be divided without shareholder approval into two or more
classes of shares having such terms as the Directors may determine.
The Corporation has a total of seven billion shares of common stock at
par value $0.001. Each share has one vote, with fractional shares voting
proportionally. Voting on matters pertinent only to a particular Portfolio, such
as the adoption of an investment advisory contract for that Portfolio, is
limited to that Portfolio's shareholders. Shares of all classes of a Portfolio
will vote together as a single class except when otherwise required by law or as
determined by the Directors. Shares are freely transferable, are entitled to
dividends as declared by the Directors, and, if a Portfolio were liquidated,
would receive the net assets of that Portfolio. Voting rights are not
cumulative, and all shares of the Portfolios are fully paid and nonassessable
and have no preemptive or conversion rights.
Although no Portfolio intends to hold annual shareholder meetings, it
will hold a special meeting of shareholders when the Investment Company Act of
1940 (the "1940 Act")
-41-
<PAGE>
requires a shareholder vote on certain matters (including the election of
Directors in certain cases or approval of an advisory contract).
- --------------------------------------------------------------------------------
PURCHASE OF SHARES
- --------------------------------------------------------------------------------
The Portfolios offer two classes of shares: Institutional Class and
Financial Intermediary Class. Shares in the Financial Intermediary Class bear a
12b-1 fee. See "Distribution Plans" below for more information.
- --------------------------------------------------------------------------------
INITIAL INVESTMENT
- --------------------------------------------------------------------------------
Prior to or concurrent with the initial purchase of shares in any
Portfolio, each investor must open an account for that Portfolio by completing
and signing an Application and mailing it to Boston Financial Data Services (the
"Transfer Agent" or "BFDS") at the following address: P.O. Box 953, Boston,
Massachusetts 02103. The Portfolios have established minimum investment criteria
that vary depending upon which class of shares you wish to purchase. For
Institutional Class shares, investors must have at least $50 million in assets
and invest in the aggregate at least $1 million in the Portfolios and the
portfolios of LM Institutional Fund Advisors I, Inc. For Financial Intermediary
Class shares, investors must have at least $30 million in assets and invest in
the aggregate at least $1 million in the Portfolios and the portfolios of LM
Institutional Fund Advisors I, Inc. The Portfolios reserve the right to revise
the minimum investment requirement and may waive it in their sole discretion.
A purchase order, together with payment in proper form, received by the
Transfer Agent prior to the close of regular trading on the Exchange (ordinarily
4:00 p.m., Eastern time) ("close of the Exchange") will be effected at that
day's net asset value. An order received after the close of the Exchange will
generally be effected at the net asset value determined on the next business
day. However, orders received by certain retirement plans and other financial
intermediaries by the close of the Exchange and communicated to the Transfer
Agent by 9:00 a.m., Eastern time, on the following business day will be effected
at the net asset value determined on the prior business day.
Purchases of shares can be made by wiring federal funds to State Street
Bank and Trust Company. Before wiring federal funds, the investor must first
telephone the Portfolio at 888-42LMIFA to receive instructions for wire
transfer. On the telephone, the following information will be required:
shareholder name; name of the person authorizing the transaction; shareholder
account number; name of the Portfolio and class of shares to be purchased;
amount being wired; and name of the wiring bank.
-42-
<PAGE>
Funds should be wired through the Federal Reserve System to:
State Street Bank and Trust Company
ABA # 011-000-028
LM Institutional Fund Advisors [insert name of Portfolio]
[Insert your account name and number]
The wire should state that the funds are for the purchase of shares of
a specific Portfolio and include the account name and number.
Shares may also be purchased and paid for by the contribution of
eligible portfolio securities, subject in each case to approval by the Manager.
Approval will depend on, among other things, the nature and quality of the
securities offered and the current needs of the Portfolio in question.
Securities offered in payment for shares will be valued in the same way and at
the same time the Portfolio values it portfolio securities for purposes of
determining net asset value. See "How Each Portfolio Values Its Shares," below.
Investors who wish to purchase Portfolio shares through the contribution of
securities should contact the Portfolio at 888-42LMIFA for instructions.
Investors should also realize that at the time of contribution they may be
required to recognize a gain or loss for tax purposes on securities contributed.
The Portfolio has full discretion to reject any securities offered as payment
for shares. As described below, each Portfolio may offer Financial Intermediary
Class shares that are offered primarily through financial intermediaries. Each
Portfolio may pay financial intermediaries for their services out of that
class's assets pursuant to the class' distribution plan or otherwise. Legg Mason
and its affiliates (including the Manager and the Advisers) may also from time
to time, at their own expense, make payments to financial intermediaries that
sell shares of the Portfolios or to other parties in connection with the sale of
shares. If investors effect transactions through a broker or agent, investors
may be charged a fee by that broker or agent.
Any shares purchased or received as a distribution will be credited
directly to the investor's account.
- --------------------------------------------------------------------------------
ADDITIONAL INVESTMENTS
- --------------------------------------------------------------------------------
Additional investments may be made at any time at the relevant net
asset value for that class by following the procedures outlined above. Investors
should always furnish a shareholder account number when making additional
purchases.
-43-
<PAGE>
- --------------------------------------------------------------------------------
OTHER PURCHASE INFORMATION
- --------------------------------------------------------------------------------
Purchases will be made in full and fractional shares. In the interest
of economy and convenience, certificates for shares will not be issued.
Each Portfolio and LMWW reserves the right, in its sole discretion, to
suspend the offering of shares or to reject any purchase order, in whole or in
part, when, in the judgment of management, such suspension or rejection is in
the best interests of the Portfolio; to waive the minimum initial investment for
certain investors; and to redeem shares if information provided in the
Application should prove to be incorrect in any manner judged by a Portfolio to
be material (e.g., in a manner such as to render the shareholder ineligible to
purchase shares of a Portfolio). A Portfolio may suspend the offering of shares
at any time and resume it at any time thereafter.
Shares of the Portfolios may not be qualified or registered for sale in
all States. Prospective investors should inquire as to whether shares of a
particular Portfolio are available for offer and sale in their State of
residence. Shares of the Portfolio may not be offered or sold in any State
unless registered or qualified in that jurisdiction or unless an exemption from
registration or qualification is available.
Purchases and sales of Portfolio shares should be made for long-term
investment purposes only. Each Portfolio reserves the right to restrict
purchases of shares (including exchanges) when a pattern of frequent purchases
and sales made in response to short-term fluctuations in share price appears
evident.
- --------------------------------------------------------------------------------
RETIREMENT PLANS
- --------------------------------------------------------------------------------
Shares of the Portfolios are available for purchase by retirement
plans, including 401(k) plans, 403(b) plans and Individual Retirement Accounts
("IRAs"). The administrator of a plan or employee benefits office can provide
participants or employees with detailed information on how to participate in the
plan and how to elect a Portfolio as an investment option. Participants in a
retirement or savings plan may be permitted to elect different investment
options, alter the amounts contributed to the plan, or change how contributions
are allocated among investment options in accordance with the plan's specific
provisions. The plan administrator or employee benefits office should be
consulted for details. For questions about participant accounts, participants
should contact their employee benefits office, the plan administrator, or the
organization that provides recordkeeping services for the plan. Investors who
purchase shares through retirement plans should be aware that the plan
administrator may aggregate purchase and redemption orders of participants in
the plan. Therefore, there may be a delay between the time the investor places
an order with the plan administrator and the time the order is forwarded to the
Transfer Agent for execution.
-44-
<PAGE>
- --------------------------------------------------------------------------------
ACCOUNT REGISTRATION CHANGES
- --------------------------------------------------------------------------------
Changes in registration or account privileges may be made in writing to
the Transfer Agent. Signature guarantees may be required. See "Signature
Guarantee" below. All correspondence must include the account number and must
be sent to:
Boston Financial Data Services
P.O. Box 953
Boston, Massachusetts, 02103
- --------------------------------------------------------------------------------
DISTRIBUTION PLANS
- --------------------------------------------------------------------------------
The Board of Directors has adopted Distribution Plans pursuant to Rule
12b-1 under the 1940 Act with respect to shares of the Financial Intermediary
Class of each Portfolio. Under the terms of each Plan, a Portfolio is permitted
to pay, out of the assets of the Financial Intermediary Class of the Portfolio,
in an amount up to 0.40% on an annual basis of the average daily net assets of
that class, LMWW, financial intermediaries and other parties that provide
services in connection with or are otherwise involved in the distribution of
shares or administration of plans or programs that use Portfolio shares as their
funding medium, and to reimburse certain other expenses and payments. Payments
under the Plans are currently limited to 0.25% of average daily net assets. For
more information regarding the Plans and their terms, see the SAI.
- --------------------------------------------------------------------------------
REDEMPTION OF SHARES
- --------------------------------------------------------------------------------
Portfolio shares may be redeemed through three methods: (1) by sending
a written request for redemption to the Transfer Agent at P.O. Box 953, Boston,
Massachusetts 02103; (2) by calling the Portfolio at 888-42LMIFA; or (3) by wire
communication with the Transfer Agent. In each case, the investor should first
notify the Portfolio at 888-42LMIFA of the intention to redeem. No charge is
made for redemptions. Shareholders who wish to be able to redeem by telephone or
wire communication must complete an authorization form in advance. Redemptions
over $10,000,000 may be initiated by telephone, but must be confirmed in writing
prior to processing. With respect to telephone redemptions or transfers, the
Transfer Agent will process orders based on instructions from a shareholder, or
any person claiming to act as his or her representative, who can provide it with
his or her account registration and address as it appears on its records. The
Transfer Agent will employ these and other reasonable procedures to confirm that
instructions communicated by telephone are genuine; if it fails to employ
reasonable procedures, the Transfer Agent may be liable for any losses due to
unauthorized or fraudulent instructions.
-45-
<PAGE>
Upon receipt of a request for redemption as described below (a request
"in good order") before the close of the Exchange on any day when the Exchange
is open, the Transfer Agent will redeem Portfolio shares at that day's net asset
value per share. Requests for redemption received by the Transfer Agent after
the close of the Exchange will be executed at the net asset value next
determined. However, orders received by certain retirement plans and other
financial intermediaries by the close of the Exchange and communicated to the
Transfer Agent by 9:00 a.m., Eastern time, on the following business day will be
effected at the net asset value determined on the prior business day. The
Portfolios may refuse to effect redemption requests during periods permitted by
federal securities laws.
Requests for redemption should indicate:
1) The number of shares or dollar amount to be redeemed and
the investor's shareholder account number;
2) The investor's name and the names of any co-owner of the
account, using exactly the same name or names used in
establishing the account;
3) Proof of authorization to request redemption on behalf of
any co-owner of the account (please contact the Portfolio
for further details); and
4) The name, address, and account number to which the
redemption payment should be sent.
Payment of the redemption price normally will be made by wire three
business days after receipt of a redemption request in good order. However, each
Portfolio reserves the right to postpone the payment date when the Exchange is
closed, when trading is restricted, or during other periods as permitted by
federal securities laws, or to take up to seven days to make payment upon
redemption if the Portfolio involved could be adversely affected by immediate
payment. Redemption proceeds may also be paid in kind at the discretion of the
Portfolio. Shareholders who receive a redemption in kind may incur costs to
dispose of such securities.
Shareholders of some investment companies have experienced difficulty
contacting their funds by telephone during periods of intense market activity.
Shareholders who are unable to contact a Portfolio by telephone and wish to make
a redemption should follow the instructions for redeeming by mail or by wire.
Other supporting legal documents, such as copies of the trust
instrument or power of attorney, may be required from corporations or other
organizations, fiduciaries or persons other than the shareholder of record
making the request for redemption or repurchase. If you have a question
concerning the sale or redemption of shares, please contact the Portfolio or the
Transfer Agent.
-46-
<PAGE>
Any Portfolio may elect to close any shareholder account when the
current value of the account is less than $1 million due to redemptions or
exchanges by the shareholder by redeeming all of the shares in the account and
mailing the proceeds to the investor. If a Portfolio elects to redeem the shares
in an account, the shareholder will be notified that the account is below $1
million and will be allowed 30 days in which to make an additional investment in
order to avoid having the account closed. Shares will be redeemed at the net
asset value calculated on the day of redemption. Any Portfolio may change the $1
million minimum account balance from time to time without notice to
shareholders.
- --------------------------------------------------------------------------------
SIGNATURE GUARANTEE
- --------------------------------------------------------------------------------
When a signature guarantee is called for, the shareholder should have
"Signature Guaranteed" stamped under his signature and guaranteed by any of the
following entities: U.S. banks, foreign banks having a U.S. correspondent bank,
credit unions, savings associations, U.S. registered dealers and brokers,
municipal securities dealers and brokers, government securities dealers and
brokers, national securities exchanges, registered securities associations and
clearing agencies (each an "Eligible Guarantor Institution"). Each Portfolio and
its agents reserve the right to reject any signature guarantee pursuant to
written signature guarantee standards or procedures, which may be revised in the
future to permit them to reject signature guarantees from Eligible Guarantor
Institutions that do not, based on credit guidelines, satisfy such written
standards or procedures. Any Portfolio may change the signature guarantee
requirements from time to time without prior notice to shareholders.
- --------------------------------------------------------------------------------
EXCHANGE PRIVILEGE
- --------------------------------------------------------------------------------
Shareholders in any Portfolio may exchange their shares for shares of
the same class of any of the other Portfolios or of any of the portfolios
offered by LM Institutional Fund Advisors I, Inc., provided that the shares of
that class are being offered at the time of the proposed exchange. Investments
by exchange among any of the Portfolios are made at the per share net asset
values next determined after the order for exchange is received in good order.
The exchange privilege is not intended as a vehicle for short-term
trading. Excessive exchange activity may interfere with portfolio management and
have an adverse effect on all shareholders. In order to limit excessive exchange
activity and in other circumstances where a Portfolio believes doing so would be
in its best interest, the Portfolio reserves the right to revise or terminate
the exchange privilege, limit the amount or number of exchanges or reject any
exchange. For further information concerning the exchange privilege, or to make
an exchange, please contact the Portfolio at 888-42LMIFA.
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<PAGE>
- --------------------------------------------------------------------------------
NET ASSET VALUE
- --------------------------------------------------------------------------------
Net asset value per share of each class of shares is determined daily
for each Portfolio as of the close of regular trading on the Exchange (normally
4:00 p.m., Eastern time), on every day that the Exchange is open, by subtracting
the Portfolio's liabilities attributable to a given class of shares from its
total assets attributable to the class and dividing the result by the number of
shares of that class outstanding. Net asset value will not be determined on days
on which the Exchange is closed.
Portfolio securities and other assets for which market quotations are
readily available are valued at current market value. Current market value means
the last sale price of the day for a comparable position, or, in the absence of
any such sales, the mean between representative bid and asked prices obtained
from a quotation reporting system. Securities with remaining maturities of 60
days or less are generally valued at amortized cost. Fixed income securities,
including those to be purchased under firm commitment agreements, are normally
valued on the basis of quotations obtained from brokers and dealers or pricing
services which take into account appropriate factors such as institutional-size
trading in similar groups of securities, yield, quality, coupon rate, maturity,
type of issue, trading characteristics and other market data. Certain fixed
income securities for which daily market quotations are not readily available
may be valued with reference to fixed income securities whose prices are more
readily available and whose durations are comparable to those of the securities
being valued.
Other assets and securities for which no quotations are readily
available are valued at fair value as determined in good faith by the Directors
or persons acting at their direction. The values of foreign securities quoted in
foreign currencies are translated into U.S. dollars at current exchange rates or
at such other rates as the Directors or persons acting at their direction may
determine in computing net asset value.
Because of time zone differences, foreign exchanges and securities
markets will usually be closed prior to the time of the closing of the Exchange
and values of foreign investments will be determined as of the earlier closing
of such exchanges and securities markets. However, events affecting the values
of such foreign securities may occasionally occur between the earlier closings
of such exchanges and securities markets and the closing of the Exchange which
will not be reflected in the computation of the net asset value. If an event
materially affecting the value of such foreign securities occurs during such
period, then such securities will be valued at fair value as determined in good
faith by the Directors or persons acting at their direction.
-48-
<PAGE>
- --------------------------------------------------------------------------------
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS
- --------------------------------------------------------------------------------
The Legg Mason Fund Adviser Large Cap Value Portfolio and the Legg
Mason Fund Adviser Total Return Portfolio declare and pay dividends quarterly
out of their net investment income for that quarter. All other Portfolios
declare and pay dividends annually out of their net investment income for that
year. Distributions of net realized capital gains are made annually.
Shareholders may elect to receive dividends and distributions in one of
four ways:
1) Receive both dividends and other distributions in shares
of the same class of the distributing Portfolio;
2) Receive dividends in cash and other distributions in
shares of the same class of the distributing Portfolio;
3) Receive dividends in shares of the same class of the
distributing Portfolio and other distributions in cash; or
4) Receive both dividends and other distributions in cash.
If no election is made, both dividends and other distributions are
credited to a shareholder's Portfolio account in shares (of the same class as
the shares already held) at the net asset value of the shares determined as of
the close of the Exchange on the reinvestment date.
Reinvestment of dividends and other distributions occurs on the
ex-dividend date. An election to receive dividends or other distributions in
cash rather than additional shares may be made by notifying the Transfer Agent
in writing.
If a shareholder has elected to receive dividends and/or other
distributions in cash and the postal or other delivery service is unable to
deliver checks to the shareholder's address of record, such shareholder's
distribution option will automatically be converted to having all dividends and
other distributions reinvested in additional shares. No interest will accrue on
amounts represented by uncashed distribution or redemption checks.
The Directors reserve the right to revise the dividend policy or
postpone the payment of dividends if warranted in their judgment due to unusual
circumstances, such as an unexpected large expense, loss or fluctuation in net
asset value.
-49-
<PAGE>
- --------------------------------------------------------------------------------
TAX INFORMATION
- --------------------------------------------------------------------------------
Each Portfolio intends to qualify as a "regulated investment company"
for federal income tax purposes and to meet all other requirements necessary for
it to be relieved of federal taxes on income and gains it distributes to
shareholders. Each Portfolio will distribute substantially all its net
investment income and net realized capital gains to its shareholders on a
current basis.
Distributions from a Portfolio (whether paid in cash or reinvested in
shares of the Portfolio) will be taxable to shareholders (other than IRAs, other
qualified retirement plans and other tax-exempt investors) as ordinary income to
the extent derived from the Portfolio's investment income and net short-term
gains. Portfolio distributions of net capital gains (that is, the excess of net
gains from capital assets held for more than one year over net losses from
capital assets held for not more than one year) will be taxable as long-term
capital gain.
Special tax rules apply to investments through defined contributions
plans and other tax-qualified plans. Shareholders should consult their tax
adviser to determine the suitability of shares of a Portfolio as an investment
through such plans and the precise effect of an investment on their particular
tax situation.
A Portfolio's investments in foreign securities may be subject to
withholding taxes at the source on dividend or interest payments. In that case,
a Portfolio's yield on those securities would be decreased.
If at the end of a Portfolio's fiscal year more than 50% of the value
of its total assets represents securities of foreign corporations, the Portfolio
may make an election to treat any foreign taxes paid by it as paid by its
shareholders. In this case, shareholders who are U.S. citizens, U.S.
corporations and, in some cases, U.S. residents generally will be required to
include in U.S. taxable income their pro rata share of such taxes, but may then
generally be entitled to claim a foreign tax credit or deduction (but not both)
for their share of such taxes. A shareholder's ability to claim a foreign tax
credit or deduction in respect of foreign taxes paid by a Portfolio may be
subject to certain limitations (including a holding period requirement,
applicable to both a Portfolio and its shareholders, imposed by the Taxpayer
Relief Act of 1997).
A Portfolio's transactions in foreign currencies and hedging activities
may give rise to ordinary income or loss to the extent such income or loss
results from fluctuations in value of the foreign currency concerned. In
addition, such activities will likely produce a difference between book income
and taxable income. This difference may cause a portion of a Portfolio's income
distributions to constitute a return of capital for tax purposes or require a
Portfolio to make distributions exceeding book income to qualify as a regulated
investment company for tax purposes.
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<PAGE>
Investment in an entity that qualifies as a "passive foreign investment
company" under the Internal Revenue Code of 1986 could subject a Portfolio to a
U.S. federal income tax or other charge on certain "excess distributions" with
respect to the investment, and on the proceeds from disposition of the
investment. A Portfolio may make an election to mark the gains (and to a limited
extent losses) in such investments "to the market" as though it had sold and
repurchased its holdings in those passive foreign investment companies on the
last day of the Portfolio's taxable year.
Early each year each Portfolio will notify its shareholders of the
amount and tax status of distributions paid during that year.
The foregoing is a summary of certain federal income tax consequences
of investing in a Portfolio. Shareholders are urged to consult their tax
advisers with respect to the effects of this investment on their particular tax
situation (including possible liability for state and local taxes).
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<PAGE>
- --------------------------------------------------------------------------------
APPENDIX A -- SECURITIES RATINGS
- --------------------------------------------------------------------------------
The following rating services describe rated securities as follows:
MOODY'S INVESTORS SERVICE, INC.
BONDS
Aaa -- Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
Aa -- Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they compromise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risk appear somewhat larger than the Aaa securities.
A -- Bonds which are rated A possess many favorable investment attributes and
are to be considered as upper-medium grade obligations. Factors giving security
to principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
Baa -- Bonds which are rated Baa are considered as medium grade obligations
(i.e., they are neither highly protected nor poorly secured). Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba -- Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well-assured. Often the protection of interest
and principal payments may be very moderate, and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B -- Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
A-1
<PAGE>
Caa -- Bonds which are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
Ca -- Bonds which are rated Ca represent obligations which are speculative in a
high degree. Such issues are often in default or have other marked shortcomings.
C -- Bonds which are rated C are the lowest rated class of bonds, and issues so
rated can be regarded as having extremely poor prospects of ever attaining any
real investment standing.
NOTES
MIG 1/VMIG 1 -- This designation denotes best quality. There is present strong
protection by established cash flows, superior liquidity support or demonstrated
broad-based access to the market for refinancing.
MIG 2/VMIG 2 -- This designation denotes high quality. Margins of protection are
ample although not so large as in the preceding group.
COMMERCIAL PAPER
Issuers rated Prime-1 (or supporting institutions) have a superior ability for
repayment of senior short-term debt obligations. Prime-1 repayment ability will
often be evidenced by the following characteristics:
- -- Leading market positions in well established industries.
- -- High rates of return on funds employed.
- -- Conservative capitalization structure with moderate
reliance on debt and ample asset protection.
- -- Broad margins in earnings coverage of fixed financial
charges and high internal cash generation.
- -- Well established access to a range of financial markets
and assured sources of alternate liquidity.
Issuers rated Prime-2 (or supporting institutions) have a strong ability for
repayment of senior short-term debt obligations. This will normally be evidenced
by many of the characteristics cited above to a lesser degree. Earnings trends
and coverage ratios, while sound, may be more subject to variation.
Capitalization characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
A-2
<PAGE>
STANDARD & POOR'S
BONDS
AAA -- Debt rated "AAA" has the highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.
AA -- Debt rated "AA" has a very strong capacity to pay interest and repay
principal and differs from the higher rated issues only in small degree.
A -- Debt rated "A" has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher rated categories.
BBB -- Debt rated "BBB" is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
BB-B-CCC-CC-C -- Debt rated "BB", "B", "CCC", "CC" and "C" is regarded, on
balance, as predominantly speculative with respect to capacity to pay interest
and repay principal in accordance with the terms of the obligation. "BB"
indicates the lowest degree of speculation and "C" the highest. While such debt
will likely have some quality and protective characteristics, these are
outweighed by large uncertainties or major exposures to adverse conditions.
BB -- Debt rated "BB" has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The "BB"
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied "BBB" rating.
B -- Debt rated "B" has a greater vulnerability to default but currently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial, or economic conditions will likely impair capacity or willingness to
pay interest and repay principal. The "B" rating category is also used for debt
subordinated to senior debt that is assigned as actual or implied "BB" or "BB-"
rating.
CCC -- Debt rated "CCC" has a currently identifiable vulnerability to default,
and is dependent upon favorable business, financial, and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial, or economic conditions, it is not likely to have
the capacity to pay interest and repay principal.
A-3
<PAGE>
The "CCC" rating category is also used for debt subordinated to senior debt that
is assigned an actual or implied "B" or "B-" rating.
CC -- The rating "CC" typically is applied to debt subordinated to senior debt
that is assigned an actual or implied "CCC" rating.
C -- The rating "C" typically is applied to debt subordinated to senior debt
which is assigned an actual or implied "CCC-" debt rating. The "C" rating may be
used to cover a situation where a bankruptcy petition has been filed, but debt
service payments are continued.
D -- Bonds rated "D" are in payment default. The "D" rating category is used
when interest payments or principal payments are not made on the date due even
if the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grace period. The "D" rating also will be used
on the filing of a bankruptcy petition if debt service payments are jeopardized.
NOTES
SP-1 -- Strong capacity to pay principal and interest. Those issues determined
to possess overwhelming safety characteristics are given a plus sign (+)
designation.
SP-2 -- Satisfactory capacity to pay principal and interest.
SP-3 -- Speculative capacity to pay principal and interest.
COMMERCIAL PAPER
A-1 -- This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+) designation.
A-2 -- Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated "A-1."
A-3 -- Issues carrying this designation have adequate capacity for timely
payment. They are, however, more vulnerable to the adverse effects of changes in
circumstances than obligations carrying the higher designations.
FITCH INVESTORS SERVICE, INC.
AAA -- Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest and
repay principal, which is unlikely to be affected by reasonably foreseeable
events.
A-4
<PAGE>
AA -- Bonds considered to be investment grade and of very high credit quality.
The obligor's ability to pay interest and repay principal is very strong,
although not quite as strong as bonds rated AAA.
A -- Bonds considered to be investment grade and of high credit quality. The
obligor's ability to pay interest and repay principal is considered to be
strong, but may be more vulnerable to adverse changes in economic conditions and
circumstances than bonds with higher ratings.
BBB -- Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is considered
to be adequate. Adverse changes in economic conditions and circumstances,
however, are more likely to have adverse impact on these bonds, and therefore
impair timely payment. The likelihood that the ratings of these bonds will fall
below investment grade is higher than for bonds with higher ratings.
BB -- Bonds considered to be speculative. The obligor's ability to pay interest
and repay principal may be affected over time by adverse economic changes.
However, business and financial alternatives can be identified which could
assist the obligor in satisfying its debt service requirements.
B -- Bonds are considered highly speculative. Bonds in this class are lightly
protected as to the obligor's ability to pay interest over the life of the issue
and repay principal when due.
CCC -- Bonds have certain characteristics which, with passing of time, could
lead to the possibility of default on either principal or interest payments.
CC -- Bonds are minimally protected. Default in payment of interest and/or
principal seems probable.
C -- Bonds are in actual or imminent default in payment of interest or
principal.
DDD -- Bonds are in default and in arrears in interest and/or principal
payments. Such bonds are extremely speculative and should be valued only on the
basis of their value in liquidation or reorganization of the obligor.
SHORT TERM RATINGS
Fitch's short-term ratings apply to debt obligations that are payable on demand
or have original maturities of generally up to three years, including commercial
paper, certificates of deposit, medium-term notes, and municipal and investment
notes.
The short-term rating places greater emphasis than a long-term rating on the
existence of liquidity necessary to meet the issuer's obligations in a timely
manner.
A-5
<PAGE>
F-1+ -- Exceptionally Strong Credit Quality. Issues assigned this rating are
regarded as having the strongest degree of assurance for timely payment.
F-1 -- Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated
"F-1+".
F-2 -- Good Credit Quality. Issues assigned this rating have a satisfactory
degree of assurance for timely payment, but the margin of safety is not as great
as for issues assigned "F-1+" and "F-1 " ratings.
F-3 -- Fair Credit Quality. Issues assigned this rating have characteristics
suggesting that the degree of assurance for timely payment is adequate; however,
near-term adverse changes could cause these securities to be rated below
investment grade.
F-S -- Weak Credit Quality. Issues assigned this rating have characteristics
suggesting a minimal degree of assurance for timely payment and are vulnerable
to near-term adverse changes in financial and economic conditions.
D -- Default. Issues assigned this rating are in actual or imminent payment
default.
LOC -- The symbol LOC indicates that the rating is based on a letter of credit
issued by a commercial bank.
A-6
<PAGE>
- --------------------------------------------------------------------------------
APPENDIX B -- PRIOR PERFORMANCE OF ADVISERS' OTHER ACCOUNTS
- --------------------------------------------------------------------------------
The Portfolios are newly organized, have not yet commenced operations
and have no performance record of their own. However, the Advisers have managed
other client accounts that have investment objectives and policies that are
similar, but not necessarily identical to, those of the Portfolios.
Representative investment performance for these accounts is stated below. The
investment performance is shown on an annual total return basis, with returns
for periods of less than one year not annualized, and on an average annual total
return basis. The performance information is provided through June 30, 1998
The prior performance information shown is in two forms: (1) composites
of certain of the Adviser's separately managed accounts and (2) SEC-registered,
open-end investment companies. In each case, the account or accounts have
investment objectives and policies substantially similar (although not
necessarily identical) to those of the relevant Portfolio; were managed
throughout the periods shown using investment styles and strategies
substantially similar (although not necessarily identical) to those of the
relevant Portfolio; and, to the extent a composite of accounts is shown, the
composite includes all of the fully-discretionary, fee-paying accounts managed
by such Adviser during the periods shown using investment objectives, policies
and strategies substantially similar (although not necessarily identical) to
those of the relevant Portfolio.
The performance information for composites has been adjusted to give
effect to the Portfolios' estimated fees and expenses, before waivers and
reimbursements, for the Financial Intermediary Class shares as shown in the
table on page 9. The performance information for composites assumes reinvestment
of all dividends and proceeds from capital transactions and has been prepared in
accordance with the Performance Presentation Standards established by the
Association for Investment Management and Research ("AIMR standards"), except
for the deduction of estimated fees and expenses as noted above. The performance
results would be more favorable if they had been adjusted for estimated fees and
expenses of the Institutional Class shares of the Portfolios. Accounts included
in composites are generally not subject to the diversification requirements,
specific tax restrictions and investment limitations imposed on each of the
Portfolios by the 1940 Act or the Code. The performance results for these
accounts might have been adversely affected had the accounts been subject to
these requirements, restrictions and limitations.
Performance for SEC-registered, open-end investment companies is
calculated using the SEC's standardized total return formula, which is based
upon the change in value of an assumed initial investment of $1,000 from the
beginning through the end of a period and assumes reinvestment of all dividends
and other distributions. For periods of more than one year, the result is then
annualized and expressed as a percentage of the initial investment, and includes
the effect of operating expenses, including advisory fees. Information about the
investment objectives, policies, expenses and net assets of each of the
investment companies follows the performance information.
B-1
<PAGE>
The method for calculating performance for the composites produces a
different result than if the performance were calculated using the SEC's method
for calculating the total return of an open-end investment company.
A Portfolio's expenses, timing of purchases and sales of portfolio
securities, timing and availability of cash flows, cash positions (which are
typically greater for open-end investment companies than for separate accounts),
and brokerage commissions are some of the reasons that might cause performance
results of the Portfolio to vary from that of the accounts and/or investment
companies shown below. In particular, the large infusions of cash that are
typically associated with the commencement of operations of new mutual funds
such as the Portfolios, as well as differences in the amount of assets, which
can affect the ability and the manner in which security positions are
accumulated or liquidated, may also cause a Portfolio's performance to vary from
that of the accounts and/or investment companies shown below.
As noted above, the investment objective, policies, styles and
strategies of each Portfolio are not necessarily identical to those of the
relevant accounts and/or investment companies shown below. Again, for these and
other reasons, the performance of the Portfolios will vary from that of the
accounts and/or investment companies.
PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE LEGG MASON FUND ADVISER
LARGE CAP VALUE PORTFOLIO. The investment performance for the period from July
1, 1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Value
Trust ("Value Trust") is shown below. The benchmark index to which Value Trust
is compared is the S&P 500 Index. The S&P 500 Index is an unmanaged index
representing the performance of 500 companies selected by S&P. Although used as
a benchmark, the Index's performance may not be comparable to Value Trust's
performance because, unlike the performance of Value Trust, the Index's
performance has not been adjusted for any fees or expenses.
B-2
<PAGE>
<TABLE>
<CAPTION>
- ---------------------------------------- ------------------------------------- -------------------------------------
Yearly Total Return
- ---------------------------------------- ------------------------------------- -------------------------------------
Year Ended June 30 Account Performance (%) S&P 500 Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1998 38.48 30.16
- ---------------------------------------- ------------------------------------- -------------------------------------
1997 52.16 34.71
- ---------------------------------------- ------------------------------------- -------------------------------------
1996 28.64 26.00
- ---------------------------------------- ------------------------------------- -------------------------------------
1995 27.59 26.07
- ---------------------------------------- ------------------------------------- -------------------------------------
1994 4.86 1.41
- ---------------------------------------- ------------------------------------- -------------------------------------
1993 13.95 13.63
- ---------------------------------------- ------------------------------------- -------------------------------------
1992 18.48 13.41
- ---------------------------------------- ------------------------------------- -------------------------------------
1991 -5.20 7.39
- ---------------------------------------- ------------------------------------- -------------------------------------
1990 4.80 16.49
- ---------------------------------------- ------------------------------------- -------------------------------------
1989 16.67 20.55
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- ------------------------------------ -------------------------------------------- ----------------------------------
AVERAGE ANNUAL RETURNS
- ------------------------------------ -------------------------------------------- ----------------------------------
Period ended Account S&P 500
June 30 Performance (%) Performance (%)
- ------------------------------------ -------------------------------------------- ----------------------------------
<S><C>
1 Year 38.48 30.16
- ------------------------------------ -------------------------------------------- ----------------------------------
3 Year 39.43 30.24
- ------------------------------------ -------------------------------------------- ----------------------------------
5 Year 29.39 23.08
- ------------------------------------ -------------------------------------------- ----------------------------------
10 Year 18.96 18.54
- ------------------------------------ -------------------------------------------- ----------------------------------
</TABLE>
Value Trust, which commenced operations on April 16, 1982, is a
diversified open-end investment company. Value Trust's investment objective is
long-term growth of capital. Value Trust invests primarily in securities that
appear to be undervalued in relation to the long-term earning power or asset
value of their issuers. Value Trust invests primarily in companies with a record
of earnings and dividends, reasonable return on equity, and sound finances.
Value Trust may from time to time invest in securities that pay no dividends or
interest. Current dividend income is not a prerequisite in the selection of
equity securities. Value Trust normally invests primarily in equity securities.
It may invest in debt securities for temporary defensive purposes and,
consistent with its investment objective, during periods when or under
circumstances where LMFA believes the return on certain debt securities may
equal or exceed the return on equity securities. Value Trust may invest in debt
securities of both foreign and domestic issuers of any maturity without regard
to rating, and may invest its
B-3
<PAGE>
assets in such securities without regard to a percentage limit. LMFA currently
anticipates that, under normal market conditions, Value Trust will invest no
more than 25% of its total assets in long-term debt securities. Up to 10% of
Value Trust's total assets may be invested in debt securities not rated
investment grade, i.e., not rated at least BBB by S&P or Baa by Moody's or, if
unrated by those entities, deemed by LMFA to be of comparable quality. Value
Trust may purchase preferred stock, indexed securities, closed-end investment
companies, foreign securities (25% or less of total assets), illiquid securities
(10% or less of net assets) and when-issued securities; may invest in futures
and options transactions, including puts and calls; and may enter into forward
foreign currency contracts. As of June 30, 1998, Value Trust had approximately
$5,753,938,809 in assets. For its fiscal year ended March 31, 1998, the Primary
shares of Value Trust had a total expense ratio of 1.73%.
Legg Mason Capital Management, Inc. ("LMCM"), an affiliate of LMFA (the
Adviser to the Portfolio) that shares investment personnel with LMFA, manages
separate accounts in a manner substantially similar (although not necessarily
identical to) that of the Portfolio. The total return for the composite of these
accounts for the year ended June 30, 1998 and the period from January 1, 1997
through June 30, 1997 was 35.52% and 22.30%, respectively, and the average
annual total return for the composite for one year (July 1, 1997 to June 30,
1998) was 35.52% and since inception (January 1, 1997 to June 30, 1998) was
38.00%. The number of accounts included in the composite has ranged from 1 to 25
over the relevant period and the aggregate assets of the accounts has ranged
from $4.4 million to $599.3 million over the period. All of the fully
discretionary tax-exempt accounts of LMCM with assets greater than $3 million
are included in the composite after a period of three months and after the
account becomes fully invested. Taxable and non-fully discretionary accounts and
accounts that hold large amounts of cash are not managed by LMCM in a manner
that is substantially similar to the Portfolio. The inclusion of taxable
accounts, non-fully discretionary accounts, or accounts that hold large amounts
of cash might have adversely affected the performance of the composite. Accounts
included in the composite are generally not subject to the diversification
requirements, specific tax restrictions and investment limitations imposed on
the Portfolio by the 1940 Act or the Code. The performance results for these
accounts might have been adversely affected had the accounts been subject to
these requirements, restrictions and limitations. These potential differences do
not adversely affect the determination that the accounts included in this
composite are managed in a substantially similar manner to the Portfolio.
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
PRIOR PERFORMANCE OF AN ACCOUNT SIMILAR TO THE LEGG MASON FUND ADVISER
MID CAP VALUE PORTFOLIO. The investment performance for the period from July 1,
1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Special
Investment Trust ("Special Investment Trust") is shown below. The benchmark
index to which Special Investment Trust is compared is the Russell 2000 Index.
The Russell 2000 Index is an unmanaged index representing the performance of the
2000 smallest of the 3000 largest U.S.-domiciled corporations, ranked by
B-4
<PAGE>
market capitalization. Although used as a benchmark, the Index's performance may
not be comparable to Special Investment Trust's performance since, unlike the
performance of Special Investment Trust, the Index's performance has not been
adjusted for any fees or expenses.
<TABLE>
<CAPTION>
- ---------------------------------------- ------------------------------------- -------------------------------------
Yearly Total Return
- ---------------------------------------- ------------------------------------- -------------------------------------
Year Ended June 30 Account Performance (%) Russell 2000 Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1998 22.29 16.51
- ---------------------------------------- ------------------------------------- -------------------------------------
1997 22.52 16.33
- ---------------------------------------- ------------------------------------- -------------------------------------
1996 25.89 23.89
- ---------------------------------------- ------------------------------------- -------------------------------------
1995 8.85 20.11
- ---------------------------------------- ------------------------------------- -------------------------------------
1994 4.97 4.34
- ---------------------------------------- ------------------------------------- -------------------------------------
1993 25.72 26.01
- ---------------------------------------- ------------------------------------- -------------------------------------
1992 12.34 14.54
- ---------------------------------------- ------------------------------------- -------------------------------------
1991 14.37 1.33
- ---------------------------------------- ------------------------------------- -------------------------------------
1990 10.96 2.96
- ---------------------------------------- ------------------------------------- -------------------------------------
1989 20.57 12.81
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- ---------------------------------------- ------------------------------------- -------------------------------------
AVERAGE ANNUAL RETURNS
- ---------------------------------------- ------------------------------------- -------------------------------------
Period ended Account Russell 2000
June 30 Performance (%) Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1 Year 22.29 16.51
- ---------------------------------------- ------------------------------------- -------------------------------------
3 Year 23.56 18.86
- ---------------------------------------- ------------------------------------- -------------------------------------
5 Year 16.60 16.04
- ---------------------------------------- ------------------------------------- -------------------------------------
10 Year 16.63 13.58
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
Special Investment Trust, which commenced operations on December 30,
1985, is a diversified open-end investment company. Special Investment Trust's
investment objective is capital appreciation. Current income is not a
consideration. Special Investment Trust invests principally in equity
securities, and securities convertible into equity securities, of companies with
market capitalizations of less than $2.5 billion which LMFA believes have one or
more of the following characteristics: they are not closely followed by, or are
out of favor with, investors, and appear to be undervalued in relation to their
long-term earning power or asset values; unusual developments have occurred
which suggest the possibility that the market value of the securities will
increase; or they are involved in actual or anticipated reorganizations or
restructurings under the Bankruptcy Code (no more than 20% of Special Investment
Trust's total
B-5
<PAGE>
assets may be invested in such securities). Special Investment Trust also
invests in debt securities of companies having one or more of these
characteristics. Special Investment Trust may invest in larger, more
highly-capitalized companies when circumstances warrant such investments.
Special Investment Trust may invest up to 20% of its total assets in securities
of companies involved in actual or anticipated reorganizations or
restructurings, and may purchase debt securities. Up to 35% of its net assets
may be invested in debt securities not rated at least BBB by S&P, or Baa by
Moody's, and securities unrated by those entities, deemed by LMFA to be of
comparable quality. Special Investment Trust may purchase preferred stock,
indexed securities, closed-end investment companies, foreign securities (25% or
less of total assets), illiquid securities (10% or less of net assets) and
when-issued securities; may invest in futures and options transactions,
including puts and calls; and may enter into forward foreign currency contracts.
When conditions warrant, for temporary defensive purposes, Special Investment
Trust also may invest without limit in short-term debt instruments. As of June
30, 1998, Special Investment Trust had approximately $1,626,638,158 in assets.
For its fiscal year ended June 30, 1998, the Primary shares of Special
Investment Trust had a total expense ratio of 1.86%.
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BRANDYWINE SMALL CAP VALUE
PORTFOLIO. The investment performance for the period from September 30, 1988 to
June 30, 1998 of all accounts managed by Brandywine that are substantially
similar to the Portfolio is shown below. The benchmark index to which the
accounts are compared is the Russell 2000 Index. The Russell 2000 Index is an
unmanaged index representing the performance of the 2000 smallest of the 3000
largest U.S.-domiciled corporations, ranked by market capitalization. Although
used as a benchmark, the Index's performance may not be comparable to the
accounts' performance since, unlike the performance of the accounts, the Index's
performance has not been adjusted for any fees or expenses.
B-6
<PAGE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- -----------------------------------------------------------------------------------------------------------------------
Composite
Year Ended June 30 Performance (%) Russell 2000 Performance (%)
- ------------------------------------------- -------------------------------- ------------------------------------------
<S><C>
1998 23.16 16.51
- ------------------------------------------- -------------------------------- ------------------------------------------
1997 32.65 16.33
- ------------------------------------------- -------------------------------- ------------------------------------------
1996 19.21 23.89
- ------------------------------------------- -------------------------------- ------------------------------------------
1995 16.87 20.11
- ------------------------------------------- -------------------------------- ------------------------------------------
1994 6.26 4.34
- ------------------------------------------- -------------------------------- ------------------------------------------
1993 22.53 26.01
- ------------------------------------------- -------------------------------- ------------------------------------------
1992 18.01 14.54
- ------------------------------------------- -------------------------------- ------------------------------------------
1991 13.21 1.33
- ------------------------------------------- -------------------------------- ------------------------------------------
1990 -2.82 2.96
- ------------------------------------------- -------------------------------- ------------------------------------------
1989 (beginning September 30, 12.88 12.81
1988)
- ------------------------------------------- -------------------------------- ------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ---------------------------------------- ------------------------------------- ----------------------------------------
Period ended Composite Russell 2000
June 30 Performance (%) Performance (%)
- ---------------------------------------- ------------------------------------- ----------------------------------------
<S><C>
1 Year 23.16 16.51
- ---------------------------------------- ------------------------------------- ----------------------------------------
3 Year 24.88 18.86
- ---------------------------------------- ------------------------------------- ----------------------------------------
5 Year 19.32 16.04
- ---------------------------------------- ------------------------------------- ----------------------------------------
Since Inception 16.26 13.58
September 30, 1988
- ---------------------------------------- ------------------------------------- ----------------------------------------
</TABLE>
The number of accounts included in the composite has ranged from 2 to 9
over the relevant period and the aggregate assets of the accounts has ranged
from $21 million to $1 billion over the period. One of the accounts included in
the composite is a registered open-end investment company. Accounts included in
the composite are generally not subject to the diversification requirements,
specific tax restrictions and investment limitations imposed on the Portfolio by
the 1940 Act or the Code. The performance results for these accounts might have
been adversely affected had the accounts been subject to these requirements,
restrictions and limitations. In addition, the accounts included in the
composite have invested in so-called "micro" cap stocks to a greater extent than
the Portfolio is likely to. These potential differences
B-7
<PAGE>
do not adversely affect the determination that the accounts included in this
composite are managed in a substantially similar manner to the Portfolio.
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BATTERYMARCH EMERGING
MARKETS PORTFOLIO. The investment performance for the period from January 1,
1994 to June 30, 1998 of all accounts managed by Batterymarch that are
substantially similar to the Portfolio is shown below. The benchmark index to
which the accounts are compared is the MSCI Emerging Markets Free Index with
Gross Dividends ("MSCI EMF"). The MSCI EMF is an unmanaged index representing
the performance of a market weighted aggregate of 26 individual emerging country
indices and takes into account local and market restrictions on share ownership
by foreigners. Although used as a benchmark, the Index's performance may not be
comparable to the accounts' performance since, unlike the performance of the
accounts, the Index's performance has not been adjusted for any fees or
expenses.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- ---------------------------------------- ------------------------------------- -------------------------------------
Year Ended June 30 Composite Performance (%) MSCI EMF Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1998 -34.01 -39.08
- ---------------------------------------- ------------------------------------- -------------------------------------
1997 19.99 12.82
- ---------------------------------------- ------------------------------------- -------------------------------------
1996 10.61 8.47
- ---------------------------------------- ------------------------------------- -------------------------------------
1995 -7.51 0.01
- ---------------------------------------- ------------------------------------- -------------------------------------
1994 -10.82 -9.04
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ---------------------------------------- ------------------------------------- ----------------------------------------
Period ended Composite MSCI EMF
June 30 Performance (%) Performance (%)
- ---------------------------------------- ------------------------------------- ----------------------------------------
<S><C>
1 Year -34.01 -39.08
- ---------------------------------------- ------------------------------------- ----------------------------------------
3 Year -1.14 -5.93
- ---------------------------------------- ------------------------------------- ----------------------------------------
Since Inception -2.64 -4.44
(January 1, 1994)
- ---------------------------------------- ------------------------------------- ----------------------------------------
</TABLE>
The number of accounts included in the composite has ranged from 1 to 5
over the relevant period and the aggregate assets of the accounts has ranged
from $65 million to $1 billion over the period. One of the accounts included in
the composite is the mutual fund
B-8
<PAGE>
described below. Accounts included in the composite are generally not subject to
the diversification requirements, specific tax restrictions and investment
limitations imposed on the Portfolio by the 1940 Act or the Code. The
performance results for these accounts might have been adversely affected had
the accounts been subject to these requirements, restrictions and limitations.
These potential differences do not adversely affect the determination that the
accounts included in this composite are managed in a substantially similar
manner to the Portfolio. The performance of the composite is calculated based on
AIMR standards, including the performance of the "mutual fund account" included
in the composite, while the separate performance of the mutual fund shown below
is calculated according to the SEC's method for calculating performance.
The investment performance for the period from May 28, 1996 to June 30,
1998 for the Primary shares of the Legg Mason Emerging Markets Trust ("Emerging
Markets Trust"), which has been advised by Batterymarch since its inception, is
shown below.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- ------------------------------------------------- --------------------------------------- -----------------------------
Year Ended June 30 Account Performance (%) MSCI EMF
Performance (%)
- ------------------------------------------------- --------------------------------------- -----------------------------
<S><C>
1998 -34.42 -39.08
- ------------------------------------------------- --------------------------------------- -----------------------------
1997 27.41 12.82
- ------------------------------------------------- --------------------------------------- -----------------------------
1996 (Inception of May 28, 1996) 0.20 -0.45
- ------------------------------------------------- --------------------------------------- -----------------------------
</TABLE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ------------------------------------------------- --------------------------------------- -----------------------------
Period ended Account Performance (%) MSCI EMF
June 30 Performance (%)
- ------------------------------------------------- --------------------------------------- -----------------------------
<S><C>
1 Year -34.42 -39.08
- ------------------------------------------------- --------------------------------------- -----------------------------
Since Inception -8.13 -8.90
(May 28, 1996)
- ------------------------------------------------- --------------------------------------- -----------------------------
</TABLE>
Emerging Markets Trust, which commenced operations on May 28, 1996, is
a diversified open-end investment company. Emerging Markets Trust's investment
objective is long-term capital appreciation. Emerging Markets Trust normally
invests at least 65% of its total assets in emerging market equity securities.
Assets not invested in emerging market equity securities may be invested in any
combination of debt securities of the U.S. Government, equity securities of
issuers in developed countries, cash and money market instruments, including
repurchase agreements. Batterymarch intends Emerging Markets Trust to be
substantially fully invested in equity securities and convertible securities of
emerging market issuers. Emerging Markets Trust may use options and stock index
futures and may also enter into forward foreign currency exchange contracts in
order to protect against fluctuations in exchange rates. More than 25% of
B-9
<PAGE>
Emerging Markets Trust's total assets may be denominated in a single currency.
When abnormal market or economic situations warrant in the opinion of
Batterymarch, Emerging Markets Trust may invest without limit for temporary
defensive purposes in short-term debt instruments, including government,
corporate and money market securities of domestic issuers, as well as repurchase
agreements. Emerging Markets Trust also may purchase preferred stock,
convertible securities, open- and closed-end investment companies, illiquid
securities (15% or less of net assets) and when-issued securities; may invest in
futures and options transactions, including puts and calls; and may borrow
money, lend securities and enter into repurchase and reverse repurchase
agreements. As of June 30, 1998, Emerging Markets Trust had approximately
$57,604,878 in assets. For its fiscal year ended December 31, 1997, the Primary
shares of Emerging Markets Trust had a total expense ratio of 2.50% (after fee
waivers; 2.86% in the absence of such waivers).
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BATTERYMARCH INTERNATIONAL
EQUITY PORTFOLIO. The investment performance for the period from July 1, 1988 to
June 30, 1998 of all accounts managed by Batterymarch that are substantially
similar to the Portfolio is shown below. The benchmark index to which the
accounts are compared is the MSCI Europe Australia & Far East Index ("MSCI
EAFE"). The MSCI EAFE is an unmanaged index representing the performance of
share prices of approximately 1100 companies listed on stock exchanges around
the world. Twenty countries are included in the Index. Although used as a
benchmark, the Index's performance may not be comparable to the accounts'
performance since, unlike the performance of the accounts, the Index's
performance has not been adjusted for any fees or expenses.
B-10
<PAGE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- ---------------------------------------- ------------------------------------- -------------------------------------
Year Ended June 30 Composite Performance (%) MSCI EAFE Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1998 11.72 6.38
- ---------------------------------------- ------------------------------------- -------------------------------------
1997 18.51 13.16
- ---------------------------------------- ------------------------------------- -------------------------------------
1996 14.24 13.62
- ---------------------------------------- ------------------------------------- -------------------------------------
1995 1.20 1.95
- ---------------------------------------- ------------------------------------- -------------------------------------
1994 17.32 17.30
- ---------------------------------------- ------------------------------------- -------------------------------------
1993 6.60 20.70
- ---------------------------------------- ------------------------------------- -------------------------------------
1992 8.26 -0.31
- ---------------------------------------- ------------------------------------- -------------------------------------
1991 -15.96 -11.23
- ---------------------------------------- ------------------------------------- -------------------------------------
1990 25.04 3.53
- ---------------------------------------- ------------------------------------- -------------------------------------
1989 11.49 9.79
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ---------------------------------------- ------------------------------------- -------------------------------------
Period ended Composite MSCI EAFE
June 30 Performance (%) Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1 Year 11.72 6.38
- ---------------------------------------- ------------------------------------- -------------------------------------
3 Year 14.82 11.06
- ---------------------------------------- ------------------------------------- -------------------------------------
5 Year 12.60 10.48
- ---------------------------------------- ------------------------------------- -------------------------------------
10 Year 9.84 7.49
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
The number of accounts included in the composite has ranged from 4 to
11 over the relevant period and the aggregate assets of the accounts has ranged
from $700 million to $1.8 billion over the period. One of the accounts included
in the composite is the mutual fund described below. Accounts included in the
composite are generally not subject to the diversification requirements,
specific tax restrictions and investment limitations imposed on the Portfolio by
the 1940 Act or the Code. The performance results for these accounts might have
been adversely affected had the accounts been subject to these requirements,
restrictions and limitations. These potential differences do not adversely
affect the determination that the accounts included in this composite are
managed in a substantially similar manner to the Portfolio. The performance of
the composite is calculated based on AIMR standards, including the performance
of the "mutual fund account" included in the composite, while the separate
performance of the mutual fund shown below is calculated according to the SEC's
method for calculating performance.
B-11
<PAGE>
The investment performance for the period from February 17, 1995 to
December 31, 1997 for the Primary shares of the Legg Mason International Equity
Trust ("International Equity Trust"), which has been advised by Batterymarch
since its inception, is shown below.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- ------------------------------------------------- --------------------------------------- -----------------------------
Year Ended June 30 Account Performance (%) MSCI EAFE
Performance (%)
- ------------------------------------------------- --------------------------------------- -----------------------------
<S><C>
1998 5.73 6.38
- ------------------------------------------------- --------------------------------------- -----------------------------
1997 18.74 13.16
- ------------------------------------------------- --------------------------------------- -----------------------------
1996 15.90 13.62
- ------------------------------------------------- --------------------------------------- -----------------------------
1995 (Inception February 17, 1995) 4.00 6.08
- ------------------------------------------------- --------------------------------------- -----------------------------
</TABLE>
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ------------------------------------------------- --------------------------------------- -----------------------------
Period ended Account Performance (%) MSCI EAFE Performance (%)
June 30
- ------------------------------------------------- --------------------------------------- -----------------------------
<S><C>
1 Year 5.73 6.38
- ------------------------------------------------- --------------------------------------- -----------------------------
3 Years 13.32 11.06
- ------------------------------------------------- --------------------------------------- -----------------------------
Since Inception 13.08 9.81
(February 17, 1995)
- ------------------------------------------------- --------------------------------------- -----------------------------
</TABLE>
International Equity Trust, which commenced operations on February 17,
1995, is a diversified open-end investment company. International Equity Trust's
investment objective is maximum long-term total return. International Equity
Trust normally invests at least 65% of its assets in equity securities of
companies located outside the United States, and Batterymarch currently intends
to invest substantially all of International Equity Trust's assets in non-U.S.
equity securities. International Equity Trust may invest up to 35% of its total
assets in emerging market securities. When cash is temporarily available, or for
temporary defensive purposes, when Batterymarch believes such action is
warranted by abnormal market or economic situations, International Equity Trust
may invest without limit in cash and U.S. dollar-denominated money market
instruments, including repurchase agreements of domestic issuers. When
Batterymarch believes such action is warranted by abnormal market or economic
situations, for temporary defensive purposes, International Equity Trust also
may invest without limit in short-term debt instruments, including government,
corporate and money market securities of domestic issuers. International Equity
Trust is authorized to invest in stock index futures and options. International
Equity Trust may also enter into forward foreign currency exchange contracts in
order to protect against fluctuations in exchange rates. International Equity
Trust also may purchase securities other than common stock, such as debentures
or preferred stock that may or may not be convertible into common stock. Some of
these instruments may be rated below investment grade. International Equity
Trust will not purchase
B-12
<PAGE>
securities rated below investment grade (or comparable unrated securities) if,
as a result, more than 5% of its assets would be so invested. International
Equity Trust may also invest in open- and closed-end investment companies,
illiquid securities (15% or less of net assets) and when-issued securities; may
invest in futures and options transactions, including puts and calls; and may
borrow money, lend securities and enter into repurchase and reverse repurchase
agreements. As of June 30, 1998, International Equity Trust had approximately
$286,359,073 in assets. For its fiscal year ended December 31, 1997, the Primary
shares of International Equity Trust had a total expense ratio of 2.17%.
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
PRIOR PERFORMANCE OF AN ACCOUNT SIMILAR TO THE LEGG MASON FUND ADVISER
TOTAL RETURN PORTFOLIO. The investment performance for the period from July 1,
1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Total
Return Trust, Inc. ("Total Return Trust") is shown below. The benchmark index to
which Total Return Trust is compared is the S&P 500 Index. The S&P 500 Index is
an unmanaged index representing the performance of 500 companies selected by
S&P. Although used as a benchmark, the Index's performance may not be comparable
to Total Return Trust's performance since, unlike the performance of Total
Return Trust, the Index's performance has not been adjusted for any fees or
expenses.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Yearly Total Return
- ------------------------------------- ------------------------------------- ----------------------------------------
Year Ended June 30 Account Performance (%) S&P 500 Index Performance (%)
- ------------------------------------- ------------------------------------- ----------------------------------------
<S><C>
1998 23.31 30.16
- ------------------------------------- ------------------------------------- ----------------------------------------
1997 38.14 34.71
- ------------------------------------- ------------------------------------- ----------------------------------------
1996 23.28 26.00
- ------------------------------------- ------------------------------------- ----------------------------------------
1995 11.83 26.07
- ------------------------------------- ------------------------------------- ----------------------------------------
1994 4.69 1.41
- ------------------------------------- ------------------------------------- ----------------------------------------
1993 14.66 13.63
- ------------------------------------- ------------------------------------- ----------------------------------------
1992 25.09 13.41
- ------------------------------------- ------------------------------------- ----------------------------------------
1991 2.45 7.39
- ------------------------------------- ------------------------------------- ----------------------------------------
1990 -0.84 16.49
- ------------------------------------- ------------------------------------- ----------------------------------------
1989 14.16 20.55
- ------------------------------------- ------------------------------------- ----------------------------------------
</TABLE>
B-13
<PAGE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL RETURNS
- ---------------------------------------- ------------------------------------- -------------------------------------
Period ended Account S&P 500 Index
June 30 Performance (%) Performance (%)
- ---------------------------------------- ------------------------------------- -------------------------------------
<S><C>
1 Year 23.31 30.16
- ---------------------------------------- ------------------------------------- -------------------------------------
3 Year 28.06 30.24
- ---------------------------------------- ------------------------------------- -------------------------------------
5 Year 19.71 23.08
- ---------------------------------------- ------------------------------------- -------------------------------------
10 Year 15.13 18.54
- ---------------------------------------- ------------------------------------- -------------------------------------
</TABLE>
Total Return Trust, which commenced operations on November 21, 1985, is
a diversified open-end investment company. Total Return Trust's investment
objective is to obtain capital appreciation and current income in order to
achieve an attractive total investment return consistent with reasonable risk.
Total Return Trust invests in dividend-paying common stocks, debt securities and
securities convertible into common stocks which, in the opinion of LMFA, offer
potential for attractive total return. Total Return Trust also invests in common
stocks and securities convertible into common stocks which do not pay current
dividends but which, in LMFA's opinion, offer prospects for capital appreciation
and future income. Total Return Trust may invest in debt securities, including
government, corporate and money market securities, consistent with its
investment objective, during periods when or under circumstances where LMFA
believes the return on certain debt securities may equal or exceed the return on
equity securities. Total Return Trust may invest in debt securities of any
maturity of both foreign and domestic issuers without regard to rating and may
invest its assets in such securities without regard to a percentage limit. LMFA
currently anticipates that, under normal market conditions, Total Return Trust
will invest no more than 50% of its total assets in intermediate-term and
long-term debt securities, and no more than 5% of its total assets in debt
securities not rated investment grade, i.e., not rated at least BBB by S&P or
Baa by Moody's or, if unrated by those entities, deemed by LMFA to be of
comparable quality. Total Return Trust also may purchase preferred stock,
indexed securities, closed-end investment companies, foreign securities (25% or
less of total assets), illiquid securities (10% or less of net assets) and
when-issued securities; may invest in futures and options transactions,
including puts and calls; and may enter into forward foreign currency contracts.
As of June 30, 1998, Total Return Trust had approximately $728,661,319 in
assets. For its fiscal year ended June 30, 1998, the Primary shares of Total
Return Trust had a total expense ratio of 1.88%.
THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE
PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO
PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE
CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S
PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN.
B-14
<PAGE>
LM INSTITUTIONAL FUND ADVISORS II, INC.
CUSTODIAN: TRANSFER AND SHAREHOLDER
STATE STREET BANK SERVICING AGENT:
AND TRUST CO. BOSTON FINANCIAL DATA
P.O. Box 1713 SERVICES
Boston, Massachusetts 02105 P.O. Box 953
Boston, Massachusetts, 02103
[LM INSTITUTIONAL FUND ADVISORS LOGO HERE]
COUNSEL: INDEPENDENT ACCOUNTANT:
ROPES & GRAY ERNST & YOUNG LLP
One International Place 2001 Market Street
Boston, MA 02110 Philadelphia, PA 19103
(617) 951-7000
DISTRIBUTOR:
Legg Mason Wood Walker, Incorporated
100 Light Street
P.O. Box 1476
Baltimore, MD 21203-1476
410-539-0000
800-822-5544
<PAGE>
- --------------------------------------------------------------------------------
LM INSTITUTIONAL FUND ADVISORS II, INC. June 30, 1998
- --------------------------------------------------------------------------------
STATEMENT OF ADDITIONAL INFORMATION
LM Institutional Fund Advisors II, Inc. (the "Fund") is a no-load,
open-end management investment company. LM Institutional Fund Advisors II, Inc.
currently consists of six separate professionally managed investment portfolios
which are described in this Statement of Additional Information ("SAI"). Each
of these portfolios is referred to herein as a "Portfolio".
This SAI is not a prospectus and should be read in conjunction with the
Prospectus for the Portfolios, dated June 30, 1998, which has been filed with
the Securities and Exchange Commission ("SEC"). Copies of the Portfolios'
Prospectus are available without charge from Legg Mason Wood Walker,
Incorporated at 1-800-822-5544.
<PAGE>
TABLE OF CONTENTS
DEFINITIONS 1
ADDITIONAL INFORMATION ABOUT
INVESTMENT LIMITATIONS AND POLICIES 2
ADDITIONAL INFORMATION ABOUT SECURITIES,
INVESTMENT TECHNIQUES AND RELATED RISKS 4
Ratings of Debt Obligations 4
Mortgage-Related Securities 4
Private Mortgage-Related Securities 6
Asset-Backed Securities 6
Non-Governmental Fixed Income and Other Debt Securities 7
Restricted Securities 8
Borrowings 8
Options on Securities 9
Futures Contracts and Options on Futures Contracts 9
Risks Associated with Futures and Options 13
Additional Risks of Options on Securities, Futures Contracts and
Options on Futures Contracts Traded on Foreign Exchanges 16
Cover for Hedging Strategies 16
VALUATION OF PORTFOLIO SHARES 17
MANAGEMENT OF THE PORTFOLIOS 17
Directors and Officers 17
Manager and Advisers 19
PURCHASES AND REDEMPTIONS 23
EXCHANGE PRIVILEGE 24
PORTFOLIO TRANSACTIONS AND BROKERAGE 24
ADDITIONAL TAX INFORMATION 25
OTHER INFORMATION 27
PERFORMANCE INFORMATION 27
-i-
<PAGE>
DEFINITIONS
"Adviser" means the investment advisory firm that manages a Portfolio's assets.
LMFA, Brandywine and Batterymarch are each Advisers.
"Batterymarch" means Batterymarch Financial Management, Inc., 200 Clarendon
Street, Boston, Massachusetts 02116. Batterymarch is the Adviser to the
Batterymarch Emerging Markets Portfolio and the Batterymarch International
Equity Portfolio.
"Brandywine" means Brandywine Asset Management, Inc., Three Christina Centre,
Suite 1200, 201 N. Walnut Street, Wilmington, Delaware 19801. Brandywine is the
Adviser to the Brandywine Small Cap Value Portfolio.
"Code" means the Internal Revenue Code of 1986, as amended.
"Distributor" means the party that is responsible for the distribution or sale
of the Fund's shares. Legg Mason is the Fund's Distributor.
"Exchange" means the New York Stock Exchange.
"Fundamental Investment Limitation" means an investment limitation of a
Portfolio that may be changed only with the affirmative vote of the lesser of
(a) more than 50% of the outstanding shares of the relevant Portfolio or (b) 67%
or more of the shares of the relevant Portfolio present at a shareholders'
meeting if more than 50% of the outstanding shares of that Portfolio are
represented at the meeting in person or by proxy. Only those policies or
limitations expressly designated as such are fundamental investment limitations.
All other policies and restrictions may be changed without shareholder approval.
"Independent Director" means a Director of the Fund who is not an "interested
person" (as defined in the 1940 Act) of the Fund.
"Legg Mason" means Legg Mason Wood Walker, Incorporated.
"LMFA" means Legg Mason Fund Adviser, Inc., 100 Light Street, Baltimore, MD
21202. LMFA is the Adviser to the Legg Mason Fund Adviser Large Cap Value
Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the Legg
Mason Fund Adviser Total Return Portfolio.
"Manager" means LM Institutional Advisors, Inc., 100 Light Street, Baltimore, MD
21202.
"1940 Act" means the Investment Company Act of 1940, as amended.
<PAGE>
"NRSROs" means nationally recognized (or foreign) statistical rating
organizations, including Moody's Investors Service, Inc. ("Moody's") and
Standard & Poor's ("S&P").
"Plan" means the Fund's Distribution and Shareholder Services Plans.
"SEC" means the Securities and Exchange Commission.
"12b-1 Director" means a Director of the Fund who is an Independent Director
and who has no direct or indirect financial interest in the operation of the
Fund's Plans or the Fund's Underwriting Agreement.
ADDITIONAL INFORMATION ABOUT
INVESTMENT LIMITATIONS AND POLICIES
Each Portfolio has adopted certain fundamental investment limitations
that are set forth below.
Each Portfolio may:
(1) make loans, borrow money or issue senior securities to the fullest
extent permitted by the 1940 Act, the rules or regulations thereunder or
applicable orders of the SEC, as such statute, rules, regulations or orders may
be amended from time to time.
(2) not concentrate investments in a particular industry or group of
industries as concentration is defined under the 1940 Act, the rules or
regulations thereunder or applicable orders of the SEC, as such statute, rules,
regulations or orders may be amended from time to time. Securities issued or
guaranteed by the U.S. Government, its agencies or instrumentalities and
repurchase agreements thereon will not be considered to represent an industry.
(3) underwrite securities to the fullest extent permitted by the 1940
Act, the rules or regulations thereunder or applicable orders of the SEC, as
such statute, rules, regulations or orders may be amended from time to time.
(4) purchase or sell commodities, commodities contracts, futures
contracts, options, forward contracts or real estate to the fullest extent
permitted by the 1940 Act, the rules or regulations thereunder or applicable
orders of the SEC, as such statute, rules, regulations or orders may be amended
from time to time.
-2-
<PAGE>
Additional Information
The fundamental investment limitations set forth above limit a
Portfolio's ability to engage in certain investment practices and purchase
securities to the extent permitted by, or consistent with, the 1940 Act.
Relevant limitations of the 1940 Act are described below, which are based either
on the 1940 Act itself, the rules or regulations thereunder, or interpretations
promulgated by the SEC. As such, these limitations of the 1940 Act are not
"fundamental," that is, the limitations will change as the statute, rules,
regulations or interpretations change, and no shareholder vote will be required
or sought.
Fundamental investment restriction (1). The 1940 Act presently limits a
Portfolio's ability to borrow up to one-third of the value of its total assets.
Borrowing by a Portfolio allows it to leverage its portfolio, which exposes it
to certain risks. Leveraging increases the effect of any increase or decrease in
the value of portfolio securities on a Portfolio's net asset value, and money
borrowed will be subject to interest costs (which may include commitment fees
and/or the cost of maintaining minimum average balances) which may or may not
exceed the return from the securities purchased with borrowed funds.
The 1940 Act also restricts the ability of any mutual fund to lend.
Under the 1940 Act, a Portfolio may only make loans if expressly permitted to do
so by the Portfolio's investment policies, and a Portfolio may not make loans to
persons who control or are under common control with the Portfolio. Thus, the
1940 Act effectively prohibits a Portfolio from making loans to certain persons
when conflicts of interest or undue influence are most likely present. The
Portfolios may, however, make other loans which if made would expose
shareholders to additional risks, such as the failure of the other party to
repay the loan.
The ability of a mutual fund to issue senior securities is severely
circumscribed by complex regulatory constraints under the 1940 Act that
restrict, for instance, the amount, timing, and form of senior securities that
may be issued. Certain portfolio management techniques such as the purchase of
securities on margin, short sales, or the writing of puts on portfolio
securities, may be considered senior securities unless appropriate steps are
taken to segregate a Portfolio's assets or otherwise cover its obligations.
Fundamental investment restriction (2). "Concentration" is interpreted
under the 1940 Act to mean investment of 25% or more of a Portfolio's total
assets in a single industry. If a Portfolio were to "concentrate" its
investments in a particular industry, investors would be exposed to greater
risks because the Portfolio's performance would be largely dependent on that
industry's performance.
Fundamental investment restriction (3). The 1940 Act prohibits a
diversified mutual fund from underwriting securities in excess of 25% of its
total assets.
-3-
<PAGE>
Fundamental investment restriction (4). This restriction would permit
investment in commodities, commodities contracts (e.g., futures contracts or
options), forward contracts or real estate to the extent permitted under the
1940 Act. However, it is unlikely that the Portfolios would make such
investments, other than the use of futures contracts, options, forward contracts
and certain real estate-related securities as explained in the Prospectus and
this Statement of Additional Information. Each Portfolio, however, would like
the ability to consider using these investment techniques in the future.
Commodities, as opposed to commodity futures, represent the actual underlying
bulk goods, such as grains, metals and food stuffs. Real estate-related
securities include real estate investment trusts, commercial and residential
mortgage-backed securities, and real estate financings, and such instruments are
generally sensitive to factors such as changes in real estate values and
property taxes, interest rates, cash flow of underlying real estate assets,
overbuilding, and the management skill and creditworthiness of the issuer.
ADDITIONAL INFORMATION ABOUT SECURITIES,
INVESTMENT TECHNIQUES AND RELATED RISKS
RATINGS OF DEBT OBLIGATIONS
Moody's, S&P and NRSROs are private organizations that provide ratings
of the credit quality of debt obligations. A description of the ratings assigned
to corporate debt obligations by Moody's and S&P is included as Appendix A to
the Prospectus. A Portfolio may consider these ratings in determining whether to
purchase, sell or hold a security. Ratings are not absolute assurances of
quality. Consequently, securities with the same maturity, interest rate and
rating may have different market prices. Credit rating agencies attempt to
evaluate the safety of principal and interest payments and do not evaluate the
risks of fluctuations in market value. Also, rating agencies may fail to make
timely changes in credit ratings in response to subsequent events, so that an
issuer's current financial condition may be better or worse than the rating
indicates.
MORTGAGE-RELATED SECURITIES
Mortgage-related securities represent an ownership interest in a pool
of residential mortgage loans. These securities are designed to provide monthly
payments of interest and, in most instances, principal to the investor. The
mortgagor's monthly payments to his/her lending institution are "passed-through"
to investors such as the Portfolios. Most issuers or poolers provide guarantees
of payments, regardless of whether the mortgagor actually makes the payment. The
guarantees made by issuers or poolers are often backed by various forms of
credit, insurance and collateral, although these may be in amounts less than the
full obligation of the pool to its shareholders.
Pools often consist of whole mortgage loans or participations in loans.
The majority of these loans are made to purchasers of one- to four-family homes.
The terms and
-4-
<PAGE>
characteristics of the mortgage instruments are generally uniform within a pool
but may vary among pools. For example, in addition to fixed-rate, fixed-term
mortgages, the Portfolios may purchase pools of variable-rate mortgages,
growing-equity mortgages, graduated-payment mortgages and other types.
All poolers apply standards for qualification to lending institutions
which originate mortgages for the pools. Poolers also establish credit standards
and underwriting criteria for individual mortgages included in the pools. In
addition, many mortgages included in pools are insured through private mortgage
insurance companies.
The average life of mortgage-related securities varies with the
maturities and the nature of the underlying mortgage instruments. For example,
securities issued by the Government National Mortgage Association ("GNMA") tend
to have a longer average life than participation certificates ("PCs") issued by
the Federal Home Loan Mortgage Corporation ("FHLMC") because there is a tendency
for the conventional and privately-insured mortgages underlying FHLMC PCs to
repay at faster rates than the Federal Housing Administration and Veterans
Administration loans underlying GNMAs. In addition, the term of a security may
be shortened by unscheduled or early payments of principal and interest on the
underlying mortgages. The occurrence of mortgage prepayments is affected by
factors including the level of interest rates, general economic conditions, the
location and age of the mortgage and other social and demographic conditions.
In determining the dollar-weighted average maturity of a Portfolio, the
Portfolio's Adviser will follow industry practice in assigning an average life
to the mortgage-related securities held by each Portfolio unless the interest
rate on the mortgages underlying the securities is such that a different
prepayment rate is likely. For example, if a GNMA has a high interest rate
relative to the market, that GNMA is likely to have a shorter overall maturity
than a GNMA with a market rate coupon. Moreover, LMFA may deem it appropriate to
change the projected average life for a Portfolio's mortgage-related securities
as a result of fluctuations in market interest rates and other factors.
Yields on mortgage-related securities are typically quoted based on the
maturity of the underlying instruments and the associated average life
assumption. Actual prepayment experience may cause the yield to differ from the
yield expected on the basis of average life. Reinvestment of the prepayments may
occur at higher or lower interest rates than the original investment, thus
affecting the yield of the Portfolio. The compounding effect from reinvestments
of monthly payments received by each Portfolio will increase the yield to
shareholders compared to bonds that pay interest semi-annually.
-5-
<PAGE>
PRIVATE MORTGAGE-RELATED SECURITIES
Certain private mortgage pools are organized in such a way that the SEC
staff considers them to be closed-end investment companies. Each Portfolio's
investment in such pools is constrained by federal statute, which restricts
investments in the shares of other investment companies.
The private mortgage-related securities in which the Portfolios may
invest include foreign mortgage pass-through securities ("Foreign
Pass-Throughs"), which are structurally similar to the pass-through instruments
described above. Such securities are issued by originators of and investors in
mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, investment bankers, specialized financial institutions and
special purpose subsidiaries of the foregoing. Foreign Pass-Throughs usually are
backed by a pool of fixed rate or adjustable-rate mortgage loans. Certain
Foreign Pass-Throughs in which the Portfolios invest typically are not
guaranteed by an entity having the credit status of GNMA, but generally utilize
various types of credit enhancement.
ASSET-BACKED SECURITIES
Asset-backed securities are structurally similar to mortgage-backed
securities, but are secured by interests in a different type of receivable.
Asset-backed securities therefore present certain risks that are not presented
by mortgage-related debt securities or other securities in which the Portfolios
may invest. Primarily, these securities do not have the benefit of the same
security interest in the related collateral. Credit card receivables are
generally unsecured and the debtors are entitled to the protection of a number
of state and federal consumer credit laws, many of which give such debtors the
right to set off certain amounts owed on the credit cards, thereby reducing the
balance due. Most issuers of automobile receivables permit the servicers to
retain possession of the underlying obligations. If the servicer were to sell
these obligations to another party, there is a risk that the purchaser would
acquire an interest superior to that of the holders of the related automobile
receivables. In addition, because of the large number of vehicles involved in a
typical issuance and technical requirements under state laws, the trustee for
the holders of the automobile receivables may not have a proper security
interest in all of the obligations backing such receivables. Therefore, there is
the possibility that recoveries on repossessed collateral may not, in some
cases, be available to support payments on these securities. Because
asset-backed securities are relatively new, the market experience in these
securities is limited and the market's ability to sustain liquidity through all
phases of the market cycle is not certain.
-6-
<PAGE>
NON-GOVERNMENTAL FIXED INCOME AND OTHER DEBT SECURITIES
A Portfolio's investments in fixed income and other debt securities of
non-governmental domestic or foreign issuers are limited to fixed income or
other debt obligations (bonds, debentures, notes and other similar instruments)
which meet the minimum ratings criteria set forth for the Portfolio or, if
unrated, are determined by the Portfolio's Adviser to be of comparable quality
to fixed income or other debt obligations in which the Portfolio may invest.
Where one of the NRSROs has assigned an investment grade rating to an
instrument and others have given it a lower rating, the Portfolios may consider
the instrument to be investment grade. The market for lower-rated securities may
be thinner and less active than that for higher-rated securities, which can
adversely affect the prices at which these securities can be sold, and may make
it difficult for a Portfolio to obtain market quotations daily. If market
quotations are not available, these securities will be valued by a method that
the Portfolios' Boards of Directors believe accurately reflects fair market
value. Judgment may play a greater role in valuing lower-rated debt securities
than is the case with respect to securities for which a broader range of dealer
quotations and last-sale information is available.
Although the prices of lower-rated bonds are generally less sensitive
to interest rate changes than are higher-rated bonds, the prices of lower-rated
bonds may be more sensitive to adverse economic changes and developments
regarding the individual issuer. Although the market for lower-rated debt
securities is not new, and the market has previously weathered economic
downturns, there has been in recent years a substantial increase in the use of
such securities to fund corporate acquisitions and restructurings. Accordingly,
the past performance of the market for such securities may not be an accurate
indication of its performance during future economic downturns or periods of
rising interest rates. When economic conditions appear to be deteriorating,
medium- to lower-rated securities may decline in value due to heightened concern
over credit quality, regardless of the prevailing interest rates. Investors
should carefully consider the relative risks of investing in high yield
securities and understand that such securities are not generally meant for
short-term investing.
Adverse economic developments can disrupt the market for lower-rated
securities, and severely affect the ability of issuers, especially highly
leveraged issuers, to service their debt obligations or to repay their
obligations upon maturity which may lead to a higher incidence of default on
such securities. In addition, the secondary market for lower-rated securities,
which is concentrated in relatively few market makers, may not be as liquid as
the secondary market for more highly rated securities. As a result, a Portfolio
could find it more difficult to sell these securities or may be able to sell the
securities only at prices lower than if such securities were widely traded.
Therefore, prices realized upon the sale of such lower rated or unrated
securities, under these circumstances, may be less than the prices used in
calculating a Portfolio's net asset value.
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Lower-rated or unrated debt obligations also present risks based on
payment expectations. If an issuer calls an obligation for redemption, the
Portfolio may have to replace the security with a lower yielding security,
resulting in a decreased return for investors. If a Portfolio experiences
unexpected net redemptions, it may be forced to sell its higher-rated
securities, resulting in a decline in the overall credit quality of the
Portfolio's investment portfolio and increasing the exposure of the Portfolio to
the risks of lower-rated securities.
RESTRICTED SECURITIES
Restricted securities may be sold only (1) pursuant to SEC Rule 144A or
other exemption, (2) in privately negotiated transactions or (3) in public
offerings with respect to which a registration statement is in effect under the
Securities Act of 1933, as amended. Rule 144A securities, although not
registered in the U.S., may be sold to qualified institutional buyers in
accordance with Rule 144A under the Securities Act of 1933, as amended. Each
Portfolio's Adviser, acting pursuant to guidelines established by its Board of
Directors, may determine that some Rule 144A securities are liquid for purposes
of limitations on the amount of illiquid investments a Portfolio may own. Where
registration is required, a Portfolio may be obligated to pay all or part of the
registration expenses and a considerable period may elapse between the time of
the decision to sell and the time the Portfolio may be permitted to sell a
security under an effective registration statement. If, during such a period,
adverse market conditions were to develop, the Portfolio might obtain a less
favorable price than prevailed when it decided to sell.
BORROWINGS
The 1940 Act requires a Portfolio to maintain continuous asset coverage
(that is, total assets including borrowings, less liabilities exclusive of
borrowings) of at least 300% of the amount borrowed. If the asset coverage
should decline below 300% as a result of market fluctuations or for other
reasons, a Portfolio may be required to sell some of its holdings within three
days to reduce the debt and restore the 300% asset coverage, even though it may
be disadvantageous from an investment standpoint to sell securities at that
time. Borrowing may increase the effect on net asset value of any increase or
decrease in the market value of the Portfolio.
Money borrowed will be subject to interest costs which may or may not
be recovered by appreciation of the securities purchased. A Portfolio also may
be required to maintain minimum average balances in connection with such
borrowing or to pay a commitment or other fee to maintain a line of credit;
either of these requirements would increase the cost of borrowing over the
stated interest rate. The Portfolios may enter into reverse repurchase
agreements and dollar roll transactions as a method of borrowing.
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OPTIONS ON SECURITIES
A Portfolio may purchase call options on securities for any purpose.
For example, a call option may be purchased by a Portfolio on a security that
its Adviser intends to include in the Portfolio's investment portfolio in order
to fix the cost of a future purchase. Call options also may be used as a means
of participating in an anticipated price increase of a security on a more
limited risk basis than would be possible if the security itself were purchased.
In the event of a decline in the price of the underlying security, use of this
strategy would serve to limit the Portfolio's potential loss to the option
premium paid; conversely, if the market price of the underlying security
increases above the exercise price and the Portfolio either sells or exercises
the option, any profit realized would be reduced by the premium.
A Portfolio may purchase put options on securities for any purpose. For
example, a put option may be purchased by a Portfolio in order to hedge against
a decline in the market value of securities held in its portfolio. The put
option enables a Portfolio to sell the underlying security at the predetermined
exercise price; thus the potential for loss to the Portfolio below the exercise
price is limited to the option premium paid. If the market price of the
underlying security is higher than the exercise price of the put option, any
profit the Portfolio realizes on the sale of the security would be reduced by
the premium paid for the put option less any amount for which the put option may
be sold.
A Portfolio may also write call and put options.
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS
Each Portfolio will limit its use of futures contracts and futures
options to hedging transactions or other circumstances permitted to registered
investment companies by regulatory authorities. For example, a Portfolio might
use futures contracts to attempt to hedge against anticipated changes in
interest rates or the economy that might adversely affect either the value of
the Portfolio's securities or the price of the securities which the Portfolio
intends to purchase. A Portfolio's hedging may include sales of futures
contracts as an offset against the effect of expected increases in interest
rates, and purchases of futures contracts as an offset against the effect of
expected declines in interest rates. Although other techniques could be used to
reduce exposure to interest rate fluctuations, a Portfolio may be able to hedge
its exposure more effectively and perhaps at a lower cost by using futures
contracts and options on futures contracts.
A futures contract on a security or foreign currency is a bilateral
agreement pursuant to which one party agrees to make, and the other party agrees
to accept, delivery of the specified type of security or foreign currency called
for in the contract at a specified future time and at a specified price. A
Portfolio may, for example, purchase a futures contract on a security or foreign
currency when it intends to purchase securities or foreign currency but has not
yet
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done so. This strategy may minimize the effect of all or part of an increase in
the market price of the security or the relative value of the foreign currency
that a Portfolio intends to purchase in the future. A rise in the price of the
security or foreign currency prior to its purchase may either be offset by an
increase in the value of the futures contract purchased by a Portfolio or
avoided by taking delivery of the security or foreign currency under the futures
contract. Conversely, a fall in the market price of the underlying security or
foreign currency may result in a corresponding decrease in the value of the
futures position. A Portfolio may sell a futures contract on a security or
foreign currency, for example, in order to continue to receive the income from a
security or foreign currency, while endeavoring to avoid part or all of the
decline in the market value of that security that would accompany an increase in
interest rates.
A Portfolio may also purchase a call option on a futures contract to
hedge against a market advance in securities or foreign currency which the
Portfolio plans to acquire at a future date. The purchase of a call option on a
futures contract is analogous to the purchase of a call option on an individual
security or foreign currency which can be used as a temporary substitute for a
position in the security itself. A Portfolio also may write covered call options
on futures contracts as a partial hedge against a decline in the price of
securities or foreign currency held in the Portfolio's investment portfolio, or
purchase put options on futures contracts in order to hedge against a decline in
the value of securities or foreign currency held in the Portfolio's investment
portfolio. A Portfolio may write a covered put option as a partial anticipatory
hedge.
A financial futures contract sale creates an obligation by the seller
to deliver the type of financial instrument called for in the contract in a
specified delivery month for a stated price. A financial futures contract
purchase creates an obligation by the purchaser to take delivery of the type of
financial instrument called for in the contract in a specified delivery month at
a stated price. The specific instruments delivered or taken, respectively, at
settlement date are not determined until on or near that date. The determination
is made in accordance with the rules of the exchange on which the futures
contract sale or purchase was made. Futures contracts are traded in the United
States only on commodity exchanges or boards of trade -- known as "contract
markets" -- approved for such trading by the Commodity Futures Trading
Commission (the "CFTC"), and must be executed through a futures commission
merchant or brokerage firm which is a member of the relevant contract market.
When a purchase or sale of a futures contract is made by a Portfolio,
the Portfolio is required to deposit with its custodian (or a broker, if legally
permitted) a specified amount of cash or U.S. Government securities ("initial
margin"). The margin required for a futures contract is set by the exchange on
which the contract is traded and may be modified during the term of the
contract. The initial margin is in the nature of a performance bond or good
faith deposit on the futures contract which is returned to the Portfolio upon
termination of the contract, assuming all contractual obligations have been
satisfied. Under certain circumstances, such as during periods of high
volatility, a Portfolio may be required by an exchange to increase the level of
its initial margin payment. Additionally, initial margin
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requirements may be increased generally in the future by regulatory action. Each
Portfolio expects to earn interest income on its initial margin deposits. A
futures contract held by a Portfolio is valued daily at the official settlement
price of the exchange on which it is traded. Each day the Portfolio pays or
receives cash, called "variation margin," equal to the daily change in value of
the futures contract. This process is known as "marking to market." Variation
margin does not represent a borrowing or loan by a Portfolio but is instead
settlement between the Portfolio and the broker of the amount one would owe the
other if the futures contract expired. In computing daily net asset value, each
Portfolio will mark to market its open futures positions.
A Portfolio is also required to deposit and maintain margin with
respect to put and call options on futures contracts written by it. Such margin
deposits will vary depending on the nature of the underlying futures contract
(and the related initial margin requirements) and the current market value of
the option and other futures positions held by the Portfolio.
Although some futures contracts call for making or taking delivery of
the underlying securities or currencies, generally those contracts are closed
out prior to delivery by offsetting purchases or sales of matching futures
contracts (involving the same currency or underlying security and delivery
month). If an offsetting purchase price is less than the original sale price,
the Portfolio realizes a gain, or if it is more, the Portfolio realizes a loss.
If an offsetting sale price is more than the original purchase price, the
Portfolio realizes a gain, or if it is less, the Portfolio realizes a loss. If
the Portfolio is unable to enter into a closing transaction, the amount of the
Portfolio's potential loss is unlimited. In general, 40% of the gain or loss
arising from the closing out of a futures contract traded on an exchange
approved by the CFTC is treated as short-term gain or loss, and 60% is treated
as long- term gain or loss. The Portfolio will also bear transaction costs for
each contract which will be included in these calculations.
A Portfolio may purchase and write call and put options on futures
contracts it may buy or sell and enter into closing transactions with respect to
such options to terminate existing positions. In return for the premium paid,
options on futures contracts give the purchaser the right to assume a position
in a futures contract at the specified option exercise price at any time during
the period of the option. The Portfolio may use options on futures contracts in
lieu of writing or buying options directly on the underlying securities or
purchasing and selling the underlying futures contracts. For example, to hedge
against a possible decrease in the value of its portfolio securities, a
Portfolio may purchase put options or write call options on futures contracts
rather than selling futures contracts. Similarly, a Portfolio may purchase call
options or write put options on futures contracts as a substitute for the
purchase of futures contracts to hedge against a possible increase in the price
of securities which the Portfolio expects to purchase. Such options generally
operate in the same manner as options purchased or written directly on the
underlying investments.
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<PAGE>
As with options on securities, the holder or writer of an option may
terminate his position by selling or purchasing an offsetting option. There is
no guarantee that such closing transactions can be effected.
A Portfolio will be required to deposit initial margin and maintenance
margin with respect to put and call options on futures contracts written by it
pursuant to brokers' requirements similar to those described above in connection
with the discussion of futures contracts.
An index futures contract is a contract to buy or sell units of an
index at a specified future date at a price agreed upon when the contract is
made. Entering into a contract to buy units of an index is commonly referred to
as buying or purchasing a contract or holding a long position in the index.
Entering into a contract to sell units of an index is commonly referred to as
selling a contract or holding a short position. A unit is the current value of
the index. A Portfolio may enter into stock index futures contracts, debt index
futures contracts, or other index futures contracts appropriate to its
objective. A Portfolio may also purchase and sell options on index futures
contracts.
For example, the Standard & Poor's 500 Composite Stock Price Index
("S&P 500") is composed of 500 selected common stocks, most of which are listed
on the New York Stock Exchange. The S&P 500 assigns relative weightings to the
common stocks included in the Index, and the value fluctuates with changes in
the market values of those common stocks. In the case of the S&P 500, contracts
are to buy or sell 500 units. Thus, if the value of the S&P 500 were $150, one
contract would be worth $75,000 (500 units x $150). The stock index futures
contract specifies that no delivery of the actual stocks making up the index
will take place. Instead, settlement in cash must occur upon the termination of
the contract, with the settlement being the difference between the contract
price and the actual level of the stock index at the expiration of the contract.
For example, if a Portfolio enters into a futures contract to buy 500 units of
the S&P 500 at a specified future date at a contract price of $150 and the S&P
500 is at $154 on that future date, the Portfolio will gain $2,000 (500 units x
gain of $4). If the Portfolio enters into a futures contract to sell 500 units
of the stock index at a specified future date at a contract price of $150 and
the S&P 500 is at $152 on that future date, the Portfolio will lose $1,000 (500
units x loss of $2).
A Portfolio will not enter into futures contracts or option positions
if, immediately thereafter, the initial margin deposits plus premiums paid by
it, less the amount by which any such options positions are "in-the-money" at
the time of purchase, would exceed 5% of the fair market value of the
Portfolio's total assets. A call option is "in-the-money" if the value of the
futures contract that is the subject of the option exceeds the exercise price. A
put option is "in-the-money" if the exercise price exceeds the value of the
futures contract that is the subject of the option.
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RISKS ASSOCIATED WITH FUTURES AND OPTIONS
In considering the Portfolios' use of futures contracts and options,
particular note should be taken of the following:
(1) Positions in futures contracts and options may be closed out only
on an exchange or board of trade which provides a secondary market for such
futures contracts or options. Futures exchanges may limit the amount of
fluctuation permitted in certain futures contract and option prices during a
single trading day. The daily limit establishes the maximum amount that the
price of a futures contract or option may vary either up or down from the
previous day's settlement price at the end of the current trading session. Once
the daily limit has been reached in a futures contract or option subject to the
limit, no more trades may be made on that day at a price beyond that limit. The
daily limit governs only price movements during a particular trading day and
therefore does not limit potential losses because the limit may work to prevent
the liquidation of unfavorable positions. For example, futures prices have
occasionally moved to the daily limit for several consecutive trading days with
little or no trading, thereby preventing prompt liquidation of positions and
subjecting some holders of futures contracts to substantial losses.
(2) The ability to establish and close out positions in either futures
contracts or exchange-listed options is also subject to the maintenance of a
liquid secondary market. Consequently, it may not be possible for a Portfolio to
close a position and, in the event of adverse price movements, the Portfolio
would have to make daily cash payments of variation margin (except in the case
of purchased options). However, in the event futures contracts or options have
been used to hedge portfolio securities, such securities generally will not be
sold until the contracts can be terminated. In such circumstances, an increase
in the price of the securities, if any, may partially or completely offset
losses on the futures contract. However, there is no guarantee that the price of
the securities will, in fact, correlate with the price movements in the
contracts and thus provide an offset to losses on the contracts. The inability
to close out a futures or option position may also restrict the Portfolio's
ability to sell the underlying security or currency at a time when the Adviser
might otherwise do so. Reasons for the absence of a liquid secondary market on
an exchange include the following: (i) there may be insufficient trading
interest in certain contracts or options; (ii) restrictions may be imposed by an
exchange on opening transactions or closing transactions or both; (iii) trading
halts, suspensions or other restrictions may be imposed with respect to
particular classes or series of contracts or options, or underlying securities;
(iv) unusual or unforeseen circumstances may interrupt normal operations on an
exchange; (v) the facilities of an exchange or a clearing corporation may not at
all times be adequate to handle current trading volume; or (vi) one or more
exchanges could, for economic or other reasons, decide or be compelled at some
future date to discontinue the trading of contracts or options (or a particular
class or series of contracts or options), in which event the secondary market on
that exchange for such contracts or options (or in the class or series of
contracts or options) would cease to
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exist, although outstanding contracts or options on the exchange that had been
issued by a clearing corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms.
(3) Successful use by a Portfolio of futures contracts and options will
depend upon its Adviser's ability to predict market movements, which may require
different skills and techniques than predicting changes in the prices of
individual securities. Moreover, futures contracts relate not to the current
level of the underlying instrument but to anticipated levels at some point in
the future. There is, in addition, the risk that movements in the price of the
futures contract or option will not correlate with movements in the prices of
the securities or currencies being hedged. If the price of the securities or
currencies being hedged has moved in a favorable direction, this advantage may
be partially offset by losses in the futures or option position. For example, it
is possible that, where a Portfolio has sold futures to hedge its portfolio
against a decline in the market, the index on which the futures are written may
advance and the value of securities held in the Portfolio's portfolio may
decline. If this occurred, the Portfolio would lose money on the futures and
also experience a decline in value in its portfolio securities. It is also
possible that, if a Portfolio has hedged against the possibility of a decline in
the market adversely affecting securities held in its portfolio and securities
prices increase instead, the Portfolio will lose part or all of the benefit of
the increased value of those securities it has hedged because it will have
offsetting losses in its futures positions. In addition, if the Portfolio has
insufficient cash, it may have to sell assets from its investment portfolio to
meet daily variation margin requirements. Any such sale of assets may or may not
be made at prices that reflect the rising market; consequently, a Portfolio may
need to sell assets at a time when such sales are disadvantageous to the
Portfolio. If the price of the futures or option contract moves more than the
price of the underlying securities or currencies, the Portfolio will experience
either a loss or a gain on the futures contract or option that may or may not be
completely offset by movements in the price of the securities or currencies that
are the subject of the hedge.
(4) The value of an option position will reflect, among other things,
the current market price of the underlying security, currency or futures
contract, the time remaining until expiration, the relationship of the exercise
price to the market price, the historical price volatility of the underlying
security, currency or futures contract and general market conditions. For this
reason, the successful use of options as a hedging strategy depends upon the
Adviser's ability to forecast the direction of price fluctuations in the
underlying market.
(5) In addition to the possibility that there may be an imperfect
correlation, or no correlation at all, between price movements in the futures
and options position and the securities or currencies being hedged, movements in
the prices of futures and options contracts may not correlate perfectly with
movements in the prices of the hedged securities or currencies due to price
distortions in the futures and options markets. There may be several reasons
unrelated to the value of the underlying securities or currencies which cause
this situation to occur. First, as noted above, all participants in the futures
market are subject to initial and
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variation margin requirements. If, to avoid meeting additional margin deposit
requirements or for other reasons, investors choose to close a significant
number of futures contracts through offsetting transactions, distortions in the
normal price relationship between the securities or currencies and the futures
markets may occur. Second, because the margin deposit requirements in the
futures market are less onerous than margin requirements in the securities
market, there may be increased participation by speculators in the futures
market; such speculative activity in the futures market also may cause temporary
price distortions. Third, participants could make or take delivery of the
underlying securities or currencies instead of closing out their contracts. As a
result, a correct forecast of general market trends may not result in successful
hedging through the use of futures or options contracts over the short term. In
addition, activities of large traders involving arbitrage and other investment
strategies may result in temporary price distortions.
(6) Options normally have expiration dates of up to nine months. The
exercise price of the options may be below, equal to or above the current market
value of the underlying security, currency or futures contract. Options that
expire unexercised have no value, and the Portfolio will realize a loss in the
amount paid and any transaction costs.
(7) Like options on securities, options on futures contracts have a
limited life. The ability to establish and close out options on futures will be
subject to the development and maintenance of liquid secondary markets on the
relevant exchanges or boards of trade. There can be no certainty that liquid
secondary markets for all options on futures contracts will develop.
(8) Purchasers of options on futures contracts pay a premium in cash at
the time of purchase. This amount and the transaction costs are all that is at
risk. Sellers of options on futures contracts, however, must post an initial
margin and are subject to additional margin calls which could be substantial in
the event of adverse price movements. In addition, although the maximum amount
at risk when the Portfolio purchases an option is the premium paid for the
option and the transaction costs, there may be circumstances when the purchase
of an option on a futures contract would result in a loss to the Portfolio when
the use of a futures contract would not, such as when there is no movement in
the value of the securities or currencies being hedged.
(9) A Portfolio's activities in the futures and options markets may
result in a higher portfolio turnover rate and additional transaction costs in
the form of added brokerage commissions; however, a Portfolio also may save on
commissions by using such contracts as a hedge rather than buying or selling
individual securities in anticipation or as a result of market movements.
(10) A Portfolio may purchase and write both exchange-traded options
and options traded on the OTC market. Exchange markets for options on debt
securities exist but are relatively new, and the ability to establish and close
out positions on the exchanges is subject to
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<PAGE>
the maintenance of a liquid secondary market. Although the Portfolios intend to
purchase or write only those exchange-traded options for which there appears to
be an active secondary market, there is no assurance that a liquid secondary
market will exist for any particular option at any specific time. Closing
transactions may be effected with respect to options traded in the OTC markets
only by negotiating directly with the other party to the option contract, or in
a secondary market for the option if such market exists. Although the Portfolios
will enter into OTC options only with dealers which agree to enter into, and
which are expected to be capable of entering into, closing transactions with the
Portfolios, there can be no assurance that a Portfolio will be able to liquidate
an OTC option at a favorable price at any time prior to expiration. In the event
of insolvency of the contra-party, a Portfolio may be unable to liquidate an OTC
option. Accordingly, it may not be possible to effect closing transactions with
respect to certain options, with the result that the Portfolio would have to
exercise those options which it has purchased in order to realize any profit.
With respect to options written by a Portfolio, the inability to enter into a
closing transaction may result in material losses to the Portfolio. For example,
because a Portfolio must maintain a covered position with respect to any call
option it writes on a security or futures contract the Portfolio may not sell
the underlying security or futures contract or invest any cash, U.S. Government
securities or short-term debt securities used as cover during the period it is
obligated under such option. This requirement may impair a Portfolio's ability
to sell a portfolio security or make an investment at a time when such a sale or
investment might be advantageous.
ADDITIONAL RISKS OF OPTIONS ON SECURITIES, FUTURES CONTRACTS AND OPTIONS ON
FUTURES CONTRACTS TRADED ON FOREIGN EXCHANGES
Options on securities, options on currencies, futures contracts and
options on futures contracts may be traded on foreign exchanges. Such
transactions may not be regulated as effectively as similar transactions in the
United States, may not involve a clearing mechanism and related guarantees and
are subject to the risk of governmental actions affecting trading in, or the
price of, foreign securities. The value of such positions also could be
adversely affected by (1) other complex foreign political, legal and economic
factors, (2) lesser availability than in the United States of data on which to
make trading decisions, (3) delays in the Portfolios' ability to act upon
economic events occurring in foreign markets during non-business hours in the
United States, (4) the imposition of different exercise and settlement terms and
procedures and margin requirements than in the United States and (5) lesser
trading volume.
COVER FOR HEDGING STRATEGIES
Each Portfolio will comply with guidelines established by the SEC with
respect to coverage of hedging strategies by mutual funds, and, if the
guidelines so require, will set aside cash or liquid securities in a segregated
account with its custodian in the amount prescribed, as marked to market daily.
Securities, options or futures positions used for cover and securities held in a
segregated account cannot be sold or closed out while the hedging strategy is
outstanding, unless they are replaced with similar assets. As a result, there is
a possibility that
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the use of cover or segregation involving a large percentage of a Portfolio's
assets could impede portfolio management or a Portfolio's ability to meet
redemption requests or other current obligations.
VALUATION OF PORTFOLIO SHARES
As described in the Prospectus, securities owned by any of the
Portfolios for which market quotations are readily available are valued at
current market value. Securities are valued at the last sale price for a
comparable position on the day the securities are being valued or, lacking any
sales on such day, at the last available bid price. In cases where securities
are traded on more than one market, the securities are generally valued on the
market considered by the Adviser as the primary market.
Occasionally, events affecting the value of foreign investments occur
between the time at which they are determined and the close of trading on the
Exchange, which events will not be reflected in a computation of a Portfolio's
net asset value on that day. If events materially affecting the value of such
investments occur during such time period, the investments will be valued at
their fair value as determined in good faith by, or under the direction of, the
Board of Directors.
MANAGEMENT OF THE PORTFOLIOS
DIRECTORS AND OFFICERS
The Fund's officers are responsible for the operation of the Fund under
the direction of its Board of Directors. The officers and Directors of the Fund
and their principal occupations during the past five years are set forth below.
An asterisk (*) indicates Interested Directors.
The business address of Mr. Livingston is 117 Colorado Boulevard,
Pasadena, California 91105. The business address of each officer and Director
is 100 Light Street, Baltimore, Maryland 21202, unless otherwise indicated.
Catherine H. Bray, 41, Director; Portfolio Manager, T. Rowe Price, June
1989-May 1996.
*Edmund J. Cashman, 61, Director; Senior Executive Vice President and
Director of Legg Mason, Inc.; Officer and/or Director of various other
affiliates of Legg Mason, Inc.; President or Vice Chairman of the Board and
Director/Trustee of four Legg Mason funds.
*W. Curtis Livingston, III, 53, Director and Vice Chairman; President,
Director and Chief Executive Officer of Western Asset Management Company
(investment management firm) ("Western Asset"), December 1980-present;
President, Pacific American Income Shares,
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Inc.; Director, Legg Mason, Inc.; Director and President, LM Institutional Fund
Advisors I, Inc.; Director and Vice Chairman of LM Institutional Advisors, Inc.
Emmett J. Rice, 78, Director; Governor, Federal Reserve Central Bank,
June 1979-February 1987; Director, Jardine-Fleming China Region Fund, July
1992-present; Director, Albermarle Corporation and Tredegar Industries, Inc.
*Edward A. Taber, 54, Chairman, Director and President; Senior
Executive Vice President of Legg Mason, Inc.; Director of the Legg Mason Value
Trust, Inc., the Legg Mason Total Return Trust, Inc. and the Legg Mason Special
Investment Trust, Inc.; Trustee of the Legg Mason Tax-Free Income Fund and the
Legg Mason Cash Reserve Trust; President of the Legg Mason Income Trust, Inc.,
the Legg Mason Global Trust, Inc., LM Institutional Fund Advisors II, Inc. and
the Legg Mason Investors Trust, Inc.; Director of Western Asset, Western Asset
Global Management, Limited, Bartlett & Co., Batterymarch Financial Management,
Inc., Gray, Seifert & Co., Inc. (investment adviser), GSH & Co. Inc. (investment
adviser holding company), Fairfield Group, Inc. (investment adviser), LM
Institutional Advisors, Inc., and Legg Mason Fund Adviser, Inc.; formerly
director of Taxable Fixed Income Division of T. Rowe Price Associates, Inc.
Robert M. Tarola, 48, Director; Senior Vice President and Chief
Financial Officer, Helix Health, Inc., July 1996-present; Partner, Price
Waterhouse LLP, May 1974-June 1996.
Linda R. Taylor, 52, Director.
Marie K. Karpinski, 49, Vice President and Treasurer; Vice President
and Treasurer of twenty-one Legg Mason/Bartlett funds (open-end investment
companies), 1986-present; Vice President and Treasurer of LM Institutional Fund
Advisors I, Inc.; Assistant Treasurer of Pacific American Income Shares, Inc.
(closed-end investment company), 1988-present; Treasurer of Legg Mason Fund
Adviser, Inc., March 1986-present; Vice-President of Legg Mason Wood Walker,
Incorporated., 1992-present; Assistant Vice-President of Legg Mason Wood Walker,
Incorporated, 1989-1992.
Kathi Bair, 33, Secretary; Secretary of nine Legg Mason Funds;
Assistant Treasurer of three Legg Mason Funds.
Officers and Directors of the Fund who are affiliated persons of the
Manager, the Advisers, LMFA or Legg Mason receive no salary or fees from the
Fund. Each Independent Director receives an annual retainer of $500 per
Portfolio and a per meeting fee of $500 per Portfolio.
The following table provides certain information relating to the
compensation of the Fund's Directors and senior executive officers.
-18-
<PAGE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------
Name of Person and Position Total Compensation From Aggregate Compensation
the Fund* From the Fund and Complex
Paid to Directors**
- --------------------------------------------------------------------------------------------------------
<S><C>
Catherine H. Bray $17,500 -0-
Director
- --------------------------------------------------------------------------------------------------------
Edmund J. Cashman -0- -0-
Director
- --------------------------------------------------------------------------------------------------------
W. Curtis Livingston, III
Director -0- -0-
- --------------------------------------------------------------------------------------------------------
Emmett J. Rice $17,500 -0-
Director
- --------------------------------------------------------------------------------------------------------
Edward A. Taber III -0- -0-
Director and President
- --------------------------------------------------------------------------------------------------------
Robert M. Tarola $17,500 -0-
Director
- --------------------------------------------------------------------------------------------------------
Linda R. Taylor $17,500 -0-
Director
- --------------------------------------------------------------------------------------------------------
<FN>
*Represents fees expected to be paid to each person during the fiscal year ended
March 31, 1999.
**Represents aggregate compensation paid to each person during the calendar year
ended December 31, 1997.
</FN>
- --------------------------------------------------------------------------------------------------------
</TABLE>
MANAGER AND ADVISERS
THE MANAGER. The Manager serves as investment manager to the Portfolios
of the Fund under separate Investment Management Agreements dated June 3, 1998
between the Manager and the Fund (the "Management Agreements"). The Management
Agreements were most recently approved by the Board of Directors, including a
majority of Independent Directors, on March 27, 1998, other than the Legg Mason
Fund Adviser Total Return Portfolio, which was most recently approved by the
Board of Directors, including a majority of Independent Directors, on May 29,
1998.
Under the Management Agreement, the Manager is responsible, subject to
the general supervision of the Fund's Board of Directors, for the actual
management of the Fund's assets, including the responsibility for making
decisions and placing orders to buy, sell or hold a particular security,
consistent with the investment objectives and policies described in the
Prospectus and this Statement of Additional Information. The Manager also is
responsible for
-19-
<PAGE>
the compensation of Directors and officers of the Fund who are employees of the
Manager or its affiliates. The Manager receives for its services a fee as
described in the Prospectus. As noted below, the Manager has delegated
responsibility for the selection of the Fund's investments to the Advisers.
Each Portfolio pays all of its other expenses which are not assumed by
the Manager. These expenses include, among others, expenses of preparing and
printing prospectuses, statements of additional information, proxy statements
and reports and of distributing them to existing shareholders, custodian
charges, transfer agency fees, organizational expenses, compensation of the
Directors who are not "interested persons" of the Manager, or its affiliates, as
that term is defined in the 1940 Act, legal and audit expenses, insurance
expenses, expenses of registering and qualifying shares of the Portfolios for
sale under federal and state law, Rule 12b-1 fees, governmental fees, expenses
incurred in connection with membership in investment company organizations,
interest expense, taxes and brokerage fees and commissions. The Portfolios also
are liable for such nonrecurring expenses as may arise, including litigation to
which a Portfolio or the Fund may be a party. The Fund may also have an
obligation to indemnify its Directors and officers with respect to litigation.
Under the Management Agreement, the Manager will not be liable for any
error of judgment or mistake of law or for any loss suffered by the Portfolios
in connection with the performance of the Management Agreement, except a loss
resulting from a breach of fiduciary duty with respect to the receipt of
compensation for services or a loss resulting from willful misfeasance, bad
faith or gross negligence on its part in the performance of its duties or from
reckless disregard by it of its obligations or duties thereunder.
The Management Agreement terminates automatically upon assignment and
is terminable with respect to any Portfolio at any time without penalty by vote
of the Fund's Board of Directors, by vote of a majority of that Portfolio's
outstanding voting securities, or by the Manager, on not less than 60 days'
notice to the Fund, and may be terminated immediately upon the mutual written
consent of the Manager and the Fund.
ADVISERS
LMFA. LMFA serves as Adviser to the Legg Mason Fund Adviser Large Cap
Value Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the
Legg Mason Fund Adviser Total Return Portfolio under separate Investment
Advisory Agreements dated June 3, 1998 between LMFA and the Manager (the "LMFA
Advisory Agreements"). The LMFA Advisory Agreements were most recently approved
by the Board of Directors, including a majority of the Independent Directors, on
March 27, 1998, other than for the Legg Mason Fund Adviser Total Return
Portfolio, which was most recently approved by the Board of Directors, including
a majority of Independent Directors, on May 29, 1998.
-20-
<PAGE>
Under the LMFA Advisory Agreement, LMFA is responsible, subject to the
general supervision of the Fund's Board of Directors and the Manager, for the
actual management of the Portfolios' assets, including the responsibility for
making decisions and placing orders to buy, sell or hold a particular security,
consistent with the investment objectives and policies described in the
Prospectus and this Statement of Additional Information. LMFA receives from the
Manager for its services an advisory fee as described in the Prospectus.
Under the LMFA Advisory Agreement, LMFA will not be liable for any
error of judgment or mistake of law or for any loss suffered by the Portfolios
in connection with the performance of the LMFA Advisory Agreement, except a loss
resulting from a breach of fiduciary duty with respect to the receipt of
compensation for services or a loss resulting from willful misfeasance, bad
faith or gross negligence on its part in the performance of its duties or from
reckless disregard by it of its obligations or duties thereunder.
The LMFA Advisory Agreement terminates automatically upon assignment
and is terminable with respect to any Portfolio at any time without penalty by
vote of the Fund's Board of Directors, by vote of a majority of that Portfolio's
outstanding voting securities, or by LMFA, on not less than 60 days' notice, and
may be terminated immediately upon the mutual written consent of the parties.
BRANDYWINE. Brandywine serves as the Adviser to the Brandywine Small
Cap Value Portfolio under an Investment Advisory Agreement dated June 3, 1998
between Brandywine and the Manager (the "Brandywine Advisory Agreement"). The
Brandywine Advisory Agreement was most recently approved by the Board of
Directors, including a majority of the Independent Directors, on March 27, 1998.
Under the Brandywine Advisory Agreement, Brandywine is responsible,
subject to the general supervision of the Fund's Board of Directors and the
Manager, for the actual management of the Portfolios' assets, including the
responsibility for making decisions and placing orders to buy, sell or hold a
particular security, consistent with the investment objectives and policies
described in the Prospectus and this Statement of Additional Information.
Brandywine also is responsible for the compensation of Directors and officers of
the Fund who are employees of Brandywine or its affiliates. Brandywine receives
from the Manager for its services to the Portfolios' an advisory fee as
described in the Prospectus.
Under the Brandywine Advisory Agreement, Brandywine will not be liable
for any error of judgment or mistake of law or for any loss suffered by the
Portfolios in connection with the performance of the Brandywine Advisory
Agreement, except a loss resulting from a breach of fiduciary duty with respect
to the receipt of compensation for services or a loss resulting from willful
misfeasance, bad faith or gross negligence on its part in the performance of its
duties or from reckless disregard by it of its obligations or duties thereunder.
-21-
<PAGE>
The Brandywine Advisory Agreement terminates automatically upon
assignment and is terminable with respect to the Portfolio at any time without
penalty by vote of the Fund's Board of Directors, by vote of a majority of the
Portfolio's outstanding voting securities, or by Brandywine, on not less than 60
days' notice, and may be terminated immediately upon the mutual written consent
of the parties.
BATTERYMARCH. Batterymarch serves as the Adviser to the Batterymarch
Emerging Markets Portfolio and the Batterymarch International Equity Portfolio
under separate Investment Advisory Agreements dated June 3, 1998 between
Batterymarch and the Manager (the "Batterymarch Advisory Agreements"). The
Batterymarch Advisory Agreements were most recently approved by the Board of
Directors, including a majority of the Independent Directors, on March 27, 1998.
Under the Batterymarch Advisory Agreement, Batterymarch is responsible,
subject to the general supervision of the Fund's Board of Directors and the
Manager, for the actual management of the Portfolios' assets, including the
responsibility for making decisions and placing orders to buy, sell or hold a
particular security, consistent with the investment objectives and policies
described in the Prospectus and this Statement of Additional Information.
Batterymarch also is responsible for the compensation of Directors and officers
of the Fund who are employees of Batterymarch or its affiliates. Batterymarch
receives from the Manager for its services to the Portfolios' an advisory fee as
described in the Prospectus.
Under the Batterymarch Advisory Agreement, Batterymarch will not be
liable for any error of judgment or mistake of law or for any loss suffered by
the Portfolios in connection with the performance of the Batterymarch Advisory
Agreement, except a loss resulting from a breach of fiduciary duty with respect
to the receipt of compensation for services or a loss resulting from willful
misfeasance, bad faith or gross negligence on its part in the performance of its
duties or from reckless disregard by it of its obligations or duties thereunder.
The Batterymarch Advisory Agreement terminates automatically upon
assignment and is terminable with respect to any Portfolio at any time without
penalty by vote of the Fund's Board of Directors, by vote of a majority of that
Portfolio's outstanding voting securities, or by Batterymarch, on not less than
60 days' notice, and may be terminated immediately upon the mutual written
consent of the parties.
DISTRIBUTOR
Legg Mason acts as distributor of the Fund's shares pursuant to an
Underwriting Agreement with the Fund dated June 3, 1998 (the "Underwriting
Agreement").
Legg Mason is not obligated to sell any specific amount of Fund shares
and receives no compensation pursuant to the Underwriting Agreement. The
Underwriting Agreement is terminable with respect to any Portfolio without
penalty, at any time, by vote of a majority of
-22-
<PAGE>
the Fund's Independent Directors, or by vote of the holders of a majority of the
shares of that Portfolio, or by Legg Mason upon 60 days' notice to the Fund.
The Fund has adopted a Plan for each Portfolio which, among other
things, permits the Fund to pay Legg Mason fees for its services related to
sales and distribution of Financial Intermediary Class shares and the provision
of ongoing services to Financial Intermediary Class shareholders. Payments are
made only from assets attributable to Financial Intermediary Class shares. Under
the Plan, the aggregate fees may not exceed an annual rate of 0.40% of each
Portfolio's average daily net assets attributable to Financial Intermediary
Class shares. Payments under the Plan are currently limited to 0.25% of average
daily net assets. The Board of Directors may increase the limit up to 0.40% of
average daily net assets as provided by the Plan without obtaining shareholder
approval. Distribution activities for which such payments may be made include,
but are not limited to, compensation to persons who engage in or support
distribution and redemption of Shares, printing of prospectuses and reports for
persons other than existing shareholders, advertising, preparation and
distribution of sales literature, overhead, travel and telephone expenses, all
with respect to Financial Intermediary Class shares only.
The Plan was approved by the sole shareholder of the Financial
Intermediary Class of each Portfolio on June 3, 1998. Legg Mason may pay all or
a portion of the fee to its investment executives.
The Plan will continue in effect only so long as it is approved at
least annually by the vote of a majority of the Board of Directors, including a
majority of the 12b-1 Directors, cast in person at a meeting called for the
purpose of voting on the Plan. The Plan may be terminated by a vote of a
majority of the 12b-1 Directors or by a vote of a majority of the outstanding
voting securities of the Financial Intermediary Class shares. Any change in the
Plan that would materially increase the distribution cost to a Portfolio
requires shareholder approval; otherwise the Plan may be amended by the
Directors, including a majority of the 12b-1 Directors, as previously described.
In accordance with Rule 12b-1, the Plan provides that Legg Mason will
submit to the Fund's Board of Directors, and the Directors will review, at least
quarterly, a written report of any amounts expended pursuant to the Plan and the
purposes for which expenditures were made. In addition, as long as the Plan is
in effect, the selection and nomination of the Independent Directors will be
committed to the discretion of such Independent Directors.
PURCHASES AND REDEMPTIONS
The Fund reserves the right to modify the mail, telephone or wire
redemption services or to terminate the telephone or wire redemption services
described in the Prospectus at any time without prior notice to shareholders.
The Fund also reserves the right to suspend or postpone redemptions (1) for any
period during which the Exchange is closed (other than for
-23-
<PAGE>
customary weekend and holiday closings), (2) when trading in markets the Fund
normally utilizes is restricted or an emergency, as defined by rules and
regulations of the SEC, exists, making disposal of the Fund's investments or
determination of its net asset value not reasonably practicable, or (3) for such
other periods as the SEC by regulation or order may permit for the protection of
the Fund's shareholders.
The Fund agrees to redeem shares of each Portfolio solely in cash up to
the lesser of $250,000 or 1% of the relevant Portfolio's net assets during any
90-day period for any one shareholder. In consideration of the best interests of
the remaining shareholders, the Fund reserves the right to pay any redemption
price exceeding this amount in whole or in part by a distribution in kind of
readily marketable securities held by a Portfolio in lieu of cash. It is highly
unlikely that shares would ever be redeemed in kind. If shares are redeemed in
kind, however, the redeeming shareholder should expect to incur transaction
costs upon the disposition of the securities received in the distribution.
EXCHANGE PRIVILEGE
Shareholders in any of the Portfolios are entitled to exchange their
shares for shares of the other Portfolios or of the portfolios of LM
Institutional Fund Advisors I, Inc., provided that such shares are eligible for
sale in the shareholder's state of residence, and are being offered at the time.
When a shareholder decides to exchange shares of a Portfolio, the
Fund's transfer agent will redeem shares of the Portfolio and invest the
proceeds in shares of the Portfolio selected. Redemptions of shares of the
Portfolio will be made at their net asset value determined on the same day that
the request is received in proper order, if received before the close of regular
trading on the Exchange. If the request is received by the transfer agent after
such close of regular trading, shares will be redeemed at their net asset value
determined as of the close of the Exchange on the next day the Exchange is open.
There is no charge for the exchange privilege and no sales charge
imposed on an exchange, but the Portfolios reserve the right to modify or
terminate the exchange privilege at any time. For more information concerning
the exchange privilege, or to make an exchange, please contact the Portfolios.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Under the various Management Agreements and Advisory Agreements, the
Manager and the Advisers are responsible for the execution of the Portfolios'
transactions. In selecting brokers or dealers, the Advisers must seek the most
favorable price (including the applicable dealer spread) and execution for such
transactions, subject to the possible payment as described below of higher
brokerage commissions or spreads to brokers or dealers who provide research and
analysis. The Portfolios may not always pay the lowest commission or spread
available.
-24-
<PAGE>
Rather, in placing orders on behalf of the Portfolios, the Advisers will also
take into account such factors as size of the order, difficulty of execution,
efficiency of the executing broker's or dealer's facilities (including the
services described below) and any risk assumed by the executing broker or
dealer.
Consistent with the policy of obtaining most favorable price
and execution, an Adviser may give consideration to research, statistical and
other services furnished by brokers or dealers to the Adviser for its use, may
place orders with brokers or dealers who provide supplemental investment and
market research and securities and economic analysis, and may pay to those
brokers or dealers a higher brokerage commission or spread than may be charged
by other brokers or dealers. Such research, analysis and other services may be
useful to an Adviser in connection with services to clients other than the
Portfolios. An Adviser's fee is not reduced by reason of its receiving such
brokerage and research services.
The Portfolios may not buy securities from, or sell securities to, an
Adviser or its affiliated persons as principal, except as permitted by the rules
and regulations of the SEC. Subject to certain conditions, the Portfolios may
purchase securities that are offered in underwritings in which an affiliate of
an Adviser is a participant, although the Portfolios may not make such purchases
directly from such affiliate.
The Advisers will select brokers to execute portfolio transactions. In
the over-the-counter market, the Portfolios generally will deal with responsible
primary market-makers unless a more favorable execution can otherwise be
obtained.
Investment decisions for the Portfolios are made independently from
those of other funds and accounts advised by the Advisers. However, the same
security may be held in the portfolios of more than one fund or account. When
two or more accounts simultaneously engage in the purchase or sale of the same
security, the prices and amounts will be equitably allocated to each account. In
some cases, this procedure may adversely affect the price or quantity of the
security available to a particular account. In other cases, however, an
account's ability to participate in larger volume transactions may produce
better executions and prices.
ADDITIONAL TAX INFORMATION
GENERAL REQUIREMENTS FOR "PASS-THROUGH" TREATMENT
In order to continue to qualify for treatment as a regulated investment
company ("RIC") under the Code, each Portfolio must distribute annually to its
shareholders at least 90% of its investment company taxable income (consisting
generally of net investment income and net short-term capital gain, if any) and
must meet several additional requirements. With respect to each Portfolio, these
requirements include the following: (1) the Portfolio 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
-25-
<PAGE>
(including but not limited to gains from options or futures ) derived with
respect to its business of investing in securities ("Income Requirement"); (2)
at the close of each quarter of the Portfolio's taxable year, at least 50% of
the value of its total assets must be represented by cash and cash items, U.S.
Government securities, securities of other regulated investment companies 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 Portfolio's
total assets and not 10% of the outstanding voting securities of such issuer;
and (3) at the close of each quarter of the Portfolio's taxable year, not more
than 25% of its total assets may be invested in securities (other than U.S.
Government securities and securities of other regulated investment companies) of
any one issuer and two or more issuers which the Portfolio controls and which
are engaged in the same, similar, or related trades or businesses.
If a Portfolio fails to distribute in a calendar year substantially all
of its ordinary income for such year and substantially all of its capital gain
net income for the one-year period ending October 31 (or later if the Portfolio
is permitted and so elects), plus any retained amount from the prior year, the
Portfolio will be subject to a 4% excise tax on the undistributed amounts. A
distribution declared by a Portfolio in October, November or December of any
year and payable to shareholders of record on a date in such months will be
deemed to have been paid by the Portfolio and received by the shareholders on
December 31 if the distribution is paid by the Portfolio during the following
January. Such a distribution, therefore, will be taxable to shareholders for the
year in which that December 31 falls. Each Portfolio intends generally to make
distributions sufficient to avoid imposition of the 4% excise tax.
ORIGINAL ISSUE DISCOUNT
A Portfolio may purchase debt securities issued with original issue
discount. Original issue discount that accrues in a taxable year will be treated
as income earned by the Portfolio and therefore an equivalent amount must be
distributed to satisfy the distribution requirement and avoid imposition of the
4% excise tax. Because the original issue discount earned by a Portfolio in a
taxable year may not be represented by cash income, the Portfolio may have to
dispose of other securities and use the proceeds thereof to make distributions
in amounts necessary to satisfy those distribution requirements. A Portfolio may
realize capital gains or losses from such dispositions, which would increase or
decrease the Portfolio's investment company taxable income and/or net capital
gain.
MISCELLANEOUS
If a Portfolio invests in shares of preferred stock or otherwise holds
dividend-paying securities as a result of exercising a conversion privilege, a
portion of the dividends from the Portfolio's investment company taxable income
(whether paid in cash or reinvested in additional shares) may be eligible for
the dividends-received deduction allowed to corporations that meet certain
holding period requirements. The eligible portion may not exceed the aggregate
dividends received by the Portfolio from U.S. corporations. However, dividends
-26-
<PAGE>
received by a corporate shareholder and deducted by it pursuant to the
dividends-received deduction are subject indirectly to the alternative minimum
tax.
Dividends and interest received by a Portfolio, and gains realized by a
Portfolio on foreign securities, may be subject to income, withholding or other
taxes imposed by foreign countries and U.S. possessions that would reduce the
yield on the Portfolio's securities. Tax conventions between certain countries
and the United States may reduce or eliminate these foreign taxes, however, and
foreign countries generally do not impose taxes on capital gains in respect of
investments by foreign investors.
OTHER INFORMATION
LM Institutional Fund Advisors II, Inc. is a Maryland corporation,
incorporated on January 13, 1998, and its capitalization consists of five
billion shares of common stock with a par value of $0.001 each. The Board of
Directors of the Fund may establish additional portfolios (with different
investment objectives and fundamental policies) or classes of shares within a
portfolio at any time in the future. Establishment and offering of additional
portfolios or classes of shares of a portfolio will not alter the rights of the
Fund's shareholders. When issued, shares are fully paid, non-assessable,
redeemable and freely transferable. Shares do not have preemptive rights or
subscription rights. In liquidation of a Portfolio, each shareholder is entitled
to receive his or her pro rata share of the net assets of that Portfolio.
PERFORMANCE INFORMATION
Each Portfolio may, from time to time, include its total return in
marketing materials or reports to shareholders or prospective investors.
Quotations of average annual total return for a class of shares of a Portfolio
will be expressed in terms of the average annual compounded rate of return of a
hypothetical investment in that class of shares over periods of one, five and
ten years (up to the life of the class), calculated pursuant to the following
formula: P (1 + T)(exponent n) = ERV (where P = a hypothetical initial payment
of $1,000, T = the average annual total return, n = number of years, and ERV =
the ending redeemable value of a hypothetical $1,000 payment made at the
beginning of the period). All total return figures reflect the deduction of a
proportional share of Portfolio expenses on an annual basis and assume that all
dividends and other distributions are reinvested when paid. The performance of
each class of a Portfolio will differ because each class is subject to different
expenses.
Each Portfolio's performance may fluctuate daily depending upon such
factors as the average maturity of its securities, changes in investments,
changes in interest rates and variations in operating expenses. Therefore,
current performance does not provide a basis for determining future performance.
The fact that a Portfolio's performance will fluctuate and that shareholders'
principal is not guaranteed or insured should be considered in comparing the
Portfolio's performance with the performance of other investments.
-27-
<PAGE>
From time to time each Portfolio may compare the performance of a class
of shares in advertising and sales literature to the performance of other
investment companies, groups of investment companies or various market indices.
One such market index is the S&P 500, a widely recognized, unmanaged index
composed of the capitalization-weighted average of the prices of 500 of the
largest publicly traded stocks in the U.S. The S&P 500 includes reinvestment of
all dividends. It takes no account of the costs of investing or the tax
consequences of distributions. The Portfolios invest in many securities that are
not included in the S&P 500.
Each Portfolio may also cite rankings and ratings, and compare the
return of a class of shares with data published by Lipper Analytical Services,
Inc., CDA Investment Technologies, Inc., Wiesenberger Investment Company
Services, Value Line, Morningstar, and other services or publications that
monitor, compare and/or rank the performance of investment companies. Each
Portfolio may also refer in such materials to mutual fund performance rankings,
ratings, comparisons with funds having similar investment objectives, and other
mutual funds reported in independent periodicals, including, but not limited to,
Financial World, Money Magazine, Forbes, Business Week, Barron's, Fortune, the
Kiplinger Letters, the Wall Street Journal, and the New York Times.
Each Portfolio may compare the investment return of a class of shares
to the return on certificates of deposit and other forms of bank deposits, and
may quote from organizations that track the rates offered on such deposits. Bank
deposits are insured by an agency of the federal government up to specified
limits. In contrast, Portfolio shares are not insured, the value of Portfolio
shares may fluctuate, and an investor's shares, when redeemed, may be worth more
or less than the investor originally paid for them. Unlike the interest paid on
many certificates of deposit, which remains at a specified rate for a specified
period of time, the return of each class of shares will vary.
Portfolio advertisements may reference the history of Legg Mason and
its affiliates, the education and experience of the portfolio manager, and the
fact that the portfolio manager engages in a particular style of investing
(e.g., growth or value).
In advertising, each Portfolio may illustrate hypothetical investment
plans designed to help investors meet long-term financial goals, such as saving
for a child's college education or for retirement. Sources such as the Internal
Revenue Service, the Social Security Administration, the Consumer Price Index
and Chase Global Data and Research may supply data concerning interest rates,
college tuitions, the rate of inflation, Social Security benefits, mortality
statistics and other relevant information. Each Portfolio may use other
recognized sources as they become available.
Each Portfolio may use data prepared by Ibbotson Associates of Chicago,
Illinois ("Ibbotson") to compare the returns of various capital markets and to
show the value of a hypothetical investment in a capital market. Ibbotson relies
on different indices to calculate the performance of common stocks, corporate
and government bonds and Treasury bills.
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<PAGE>
Each Portfolio may illustrate and compare the historical volatility of
different portfolio compositions where the performance of stocks is represented
by the performance of an appropriate market index, such as the S&P 500, and the
performance of bonds is represented by a nationally recognized bond index, such
as the Lehman Brothers Long-Term Government Bond Index.
Each Portfolio may also include in advertising biographical information
on key investment and managerial personnel.
Each Portfolio may advertise examples of the potential benefits of
periodic investment plans, such as dollar cost averaging, a long-term investment
technique designed to lower average cost per share. Under such a plan, an
investor invests in a mutual fund at regular intervals a fixed dollar amount
thereby purchasing more shares when prices are low and fewer shares when prices
are high. Although such a plan does not guarantee profit or guard against loss
in declining markets, the average cost per share could be lower than if a fixed
number of shares were purchased at the same intervals. Investors should consider
their ability to purchase shares through low price levels.
Each Portfolio may discuss Legg Mason's tradition of service. Since
1899, Legg Mason and its affiliated companies have helped investors meet their
specific investment goals and have provided a full spectrum of financial
services. Legg Mason affiliates serve as investment advisers for private
accounts and mutual funds with assets of more than $71 billion as of March 31,
1998.
In advertising, each Portfolio may discuss the advantages of saving
through tax-deferred retirement plans or accounts, including the advantages and
disadvantages of "rolling over" a distribution from a retirement plan into an
IRA, factors to consider in determining whether you qualify for such a rollover,
and the other options available. These discussions may include graphs or other
illustrations that compare the growth of a hypothetical tax-deferred investment
to the after-tax growth of a taxable investment.
CUSTODIAN, TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT
State Street Bank and Trust Company, P.O. Box 1790, Boston,
Massachusetts 02105, serves as custodian of the Fund's assets. Boston Financial
Data Services, Inc., P.O. Box 953, Boston, Massachusetts 02103, serves as
transfer and dividend-disbursing agent and administrator of various shareholder
services. Shareholders who request an historical transcript of their account
will be charged a fee based upon the number of years researched. The Fund
reserves the right, upon 60 days' written notice, to make other charges to
investors to cover administrative costs.
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<PAGE>
INDEPENDENT ACCOUNTANTS
Ernst & Young, LLP have been selected to serve as the Fund's
independent accountants. The statements of assets and liabilities of the
Portfolios and related notes thereto included in this Statement of Additional
Information have been so included in reliance upon the report of Ernst & Young,
LLP, given on their authority as experts in auditing and accounting.
LEGAL COUNSEL
Ropes & Gray, Boston, MA, serves as legal counsel to the Fund.
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<PAGE>
LM INSTITUTIONAL FUND ADVISORS II, INC.
STATEMENT OF ASSETS AND LIABILITIES
MAY 20, 1998
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
LMFA LMFA MID LMFA BRANDYWINE BATTERYMARCH BATTERYMARCH LMFA/WA
LARGE CAP TOTAL SMALL CAP INTERNATIONAL EMERGING BALANCED
CAP VALUE RETURN VALUE EQUITY MARKETS
VALUE
<S><C>
ASSETS
- ----------------------------------------------------------------------------------------------------------------------------------
Cash $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000
- ----------------------------------------------------------------------------------------------------------------------------------
Deferred organization $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000
and initial offering
costs
- ----------------------------------------------------------------------------------------------------------------------------------
Total Assets $57,000 $57,000 $57,000 $57,000 $57,000 $57,000 $57,000
- ----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES
- ----------------------------------------------------------------------------------------------------------------------------------
Accrued organization $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000
expenses and initial
offering costs
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Total liabilities $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000
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Net Assets - Offering
and redemption price
of $10.00 per share
with 1,500 shares
outstanding for each
portfolio (6,000,
000,000) shares par
value $.001 per share
authorized $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000
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</TABLE>
NOTES TO STATEMENT OF ASSETS AND LIABILITIES
A. LM Institutional Fund Advisors II, Inc. ("Corporation") was organized on
January 13, 1998. The Portfolios have had no operations other than those matters
related to their organization and registration as an investment company under
the Investment Company Act of 1940 and the sale of their shares. LM
Institutional Advisors, Inc. ("LMIA"), a wholly owned subsidiary of Legg Mason,
Inc. (a financial services holding company), has provided the initial capital
for the Portfolios by purchasing 1,500 shares each at $10.00 per share. Such
shares were acquired for investment and can be disposed of only by redemption.
Legg Mason Wood Walker, Incorporated ("Legg Mason"), a wholly owned subsidiary
of Legg Mason, Inc. and a member of the New York Stock Exchange, acts as the
distributor of the Portfolios' shares.
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<PAGE>
B. Deferred organization represent expenses incurred in connection with the
Portfolios' organization and will be amortized on a straight line basis over
five years commencing on the effective date of each Portfolio's initial sale of
shares to the public. The Portfolios have agreed to reimburse LMIA for the
organization expenses advanced by LMIA. The advanced are repayable on demand but
must be fully repaid within five years from the commencement of operations. The
proceeds realized by LMIA or any holder thereof upon redemption during the
amortization period of any of the shares constituting initial capital will be
reduced by a proportionate amount of unamortized deferred organization expenses
which the number of initial shares redeemed bears to the number of initial
shares then outstanding.
Initial offering costs represent costs associated with the sale of shares of the
Portfolios and will be amortized over a one year period.
REPORT OF INDEPENDENT AUDITORS
To the Shareholders and Board of Directors
LM Institutional Fund Advisors II, Inc.
We have audited the accompanying statements of assets and liabilities
of LM Institutional Fund Advisors II, Inc., (the "Fund") (comprised of,
respectively, the Legg Mason Fund Adviser Large Cap Value Portfolio, Legg Mason
Fund Adviser Mid Cap Value Portfolio, Brandywine Small Cap Value Portfolio,
Batterymarch Emerging Markets Portfolio, Batterymarch International Equity
Portfolio, Legg Mason Fund Adviser/Western Asset Balanced Portfolio and Legg
Mason Fund Adviser Total Return Portfolio (the "Portfolios")) as of May 27,
1998. These statements of assets and liabilities are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
statements of assets and liabilities based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the statements of assets and liabilities are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the statements of assets and
liabilities. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
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<PAGE>
In our opinion, the statements of assets and liabilities referred to
above present fairly, in all material respects, the financial position of each
of the respective portfolios of LM Institutional Fund Advisors II, Inc. at May
27, 1998, in conformity with generally accepted accounting principles.
Ernst & Young LLP
Philadelphia, Pennsylvania
May 27, 1998
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