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ZERO GRAVITY INTERNET FUND,
A SERIES OF ZERO GRAVITY FUNDS
PROSPECTUS SUPPLEMENT DATED AUGUST 25, 2000
TO PROSPECTUS DATED APRIL 24, 2000
NAME CHANGES
e-harmon Funds changed its name to "Zero Gravity Funds." e-harmon
Internet Fund, a series of Zero Gravity Funds, changed its name to "Zero Gravity
Internet Fund."
The investment adviser to the Fund changed its name to "Zero Gravity
Capital Management LLC."
References in the Prospectus to the "e-harmon Internet Fund" and the "Fund"
refer to the Zero Gravity Internet Fund, and references to "e-harmon Capital
Management LLC" and the "Adviser" refer to Zero Gravity Capital Management LLC.
INVESTMENT TEAM
THE FOLLOWING REPLACES THE INFORMATION CONTAINED IN THE PROSPECTUS ON
PAGES 5-7 OF THE PROSPECTUS UNDER "HOW THE FUND IS MANAGED," BEGINNING WITH THE
THIRD PARAGRAPH OF THAT SECTION.
The Fund is managed by an investment team comprised of Steve Harmon, Lisa
Cavallari, Randy Chin and Patrick Wong. The Fund's annual management fee is
1.25% of average daily net assets.
STEVE HARMON
Steve Harmon is a founder of Zero Gravity Internet Group, Inc., the holding
company, which is the parent company of the Adviser. Mr. Harmon has been
involved in the Internet investing field since 1994. Mr. Harmon authored "Zero
Gravity" (Bloomberg Press, November, 1999), an Internet venture capital book and
a guide for entrepreneurs and investors wanting to get inside the how-to of
going from garage to the Web.
Mr. Harmon was Vice President of Business Development & Senior Investment
Analyst for Internet.com (a news and information source) and Mecklermedia
(Internet.com's former parent company) from 1996 to 1999. Mr. Harmon's role at
Internet.com and Mecklermedia included responsibility for business and content
alliances, strategic acquisitions, new products and revenue streams.
Mr. Harmon was Senior Investment Analyst for Jupiter Communications in 1995-96
where he covered Internet and media industries. In December 1995, he authored
"Internet Investment Outlook 1996" published by Jupiter Communications, which
forecast five years of Internet growth in several areas including e-commerce,
e-music, broadband cable Internet, content, software and hardware.
LISA A. CAVALLARI
Ms. Cavallari was a Principal at Barclays Global Investors ("BGI") from 1997 to
February 2000 when she joined Zero Gravity Capital Management LLC. As part of
the Advanced Active Group there, she served as Portfolio Manager for the retail
asset allocation funds, including the actively managed Barclays Global Investors
LifePath(R) mutual funds. As a Portfolio Manager for the U.S. Tactical Asset
Allocation products ($20 billion assets under management), she co-managed the
team that conducted $1 billion asset class mix
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shifts. At BGI she was also responsible for the construction and trading of
equity and fixed income derivative strategies for institutional clients. From
1991 to 1995, Ms. Cavallari was an analyst in the Russell Index Group at Frank
Russell Company where she was responsible for the annual index reconstitution
efforts. Ms. Cavallari holds a B.A. in Economics from Northwestern University
and graduated from the University of Chicago's Graduate School of Business with
an MBA in finance and statistics.
RANDY CHIN,
Mr. Chin joined Zero Gravity Capital Management LLC in March, 2000 from Deutsche
Banc Alex. Brown where he spent over three years as an equity research analyst
covering the e-Business/e-Process sectors (B2B e-commerce, digital marketplaces,
e-hubs, Internet infrastructure, enterprise applications, business intelligence,
ERP, etc.). From 1993 to 1996, Mr. Chin was an Assistant Vice President,
securities analyst and Portfolio Manager at Beacon Fiduciary Advisors. From 1988
to 1993, Mr. Chin worked at Hellman, Jordan Management Co. as an Assistant Vice
President and equity analyst. Mr. Chin received his A.B. magna cum laude from
Harvard College. Mr. Chin is a Chartered Financial Analyst and is currently a
member of the Los Angeles Society of Financial Analysts, the Security Analysts
of San Francisco, and the Association for Investment Management and Research.
PATRICK WONG
Prior to joining Zero Gravity Capital Management LLC in April, 2000, Mr. Wong
was an Associate in the International Offshore Banking Group at Merrill Lynch in
New York from 1998 to 1999. From 1997 to 1998, Mr. Wong was an analyst in the
Fixed Income Derivatives Group at Morgan Stanley in Tokyo. Mr. Wong graduated
from Boston College with a B.S. degree from the Carroll Wallace School of
Management, and a M.S. and MBA from Northeastern University Graduate School of
Professional Accounting. Mr. Wong is a Certified Public Accountant and a member
of the AICPA.
OVERNIGHT DELIVERY ADDRESS CHANGE
The Fund's overnight delivery address for use when sending applications,
additional investments, redemption requests and other correspondence via an
overnight courier will change beginning October 1, 2000. The Fund's P.O. Box and
its phone number will not change.
Effective October 1, 2000, the Fund's overnight delivery address will be:
Zero Gravity Internet Fund
Suite A
803 West Michigan
Milwaukee, Wisconsin
53233-2301
The above replaces the overnight delivery address appearing on pages 18 and 20
and the back cover of the Prospectus.
PLEASE RETAIN THIS SUPPLEMENT WITH YOUR RECORDS FOR FUTURE REFERENCE.
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STATEMENT OF ADDITIONAL INFORMATION
April 24, 2000
(as amended and restated August 25, 2000)
Zero Gravity Internet Fund is a portfolio or "Fund" of Zero Gravity Funds (the
"Trust"), an open-end management investment company.
The Fund is managed by Zero Gravity Capital Management LLC (the "Adviser").
This Statement of Additional Information is not a prospectus but should be read
in conjunction with the Prospectus dated April 24, 2000, and supplemented August
25, 2000 which may be obtained upon request. The Fund's address is 400
Montgomery Street, 3rd floor, San Francisco, California 94104, and the telephone
number is 1-800-392-6563.
HISTORY OF THE TRUST B-2
INVESTMENT POLICIES AND STRATEGIES B-2
INVESTMENT RESTRICTIONS B-15
MANAGEMENT OF THE FUND B-16
PRINCIPAL HOLDERS OF SECURITIES B-18
INVESTMENT MANAGEMENT SERVICES B-18
PORTFOLIO TRANSACTIONS B-22
PRICING OF SECURITIES B-25
NET ASSET VALUE PER SHARE B-26
TAX STATUS B-26
INVESTMENT PERFORMANCE B-29
SHARES B-30
LEGAL COUNSEL B-31
INDEPENDENT ACCOUNTANTS B-31
FINANCIAL STATEMENTS B-32
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HISTORY OF THE TRUST
The Trust was organized under the name "e-harmon Funds" as an unincorporated
business trust in December 1999 under the laws of the State of Delaware. In
August 2000, the Trust changed its name to "Zero Gravity Funds."
CLASSIFICATION
The Trust is an open-end management investment company.
INVESTMENT POLICIES AND STRATEGIES
The Prospectus describes the fundamental investment objectives and certain
investment policies and restrictions applicable to the Fund. The following is
additional information for your consideration.
EQUITY SECURITIES
WARRANTS. The Fund may invest in warrants. A warrant is a security that gives
the holder the right, but not the obligation, to purchase a given number of
shares of a particular company at a fixed price within a certain period of time.
Warrants generally trade in the open market and may be sold rather than
exercised. The purchaser of a warrant expects the market price of the security
underlying the warrant to exceed the purchase price of the warrant plus the
exercise price of the warrant, thus yielding a profit. Of course, it is possible
that the market price of the security underlying a warrant won't exceed the
exercise price of the warrant before the expiration date of the warrant.
Consequently, the purchaser of a warrant risks the loss of the entire purchase
price of the warrant. Additionally, price movements in the security underlying a
warrant are generally magnified in the price movements of the warrant.
Therefore, the price of a warrant tends to be more volatile than, and may not
correlate exactly to, the price of its underlying security.
CONVERTIBLE SECURITIES. The Fund may invest in convertible securities, that is,
securities which convert into common stock. These convertible securities are
typically not rated in one of the four highest rating categories by a Nationally
Recognized Statistical Ratings Organization ("NRSRO"). The yields on such lower
rated securities, which include securities also known as junk bonds, generally
are higher than the yields available on higher-rated securities. However,
investments in lower rated securities and comparable unrated securities
generally involve greater volatility of price and risk of loss of income and
principal, including the probability of default by or bankruptcy of the issuers
of such securities. Lower rated securities and comparable unrelated securities
(1) will likely have some quality and protective characteristics that, in the
judgment of the rating organization, are outweighed by large uncertainties or
major risk exposures to adverse conditions and (2) are predominantly speculative
with respect to the issuer's capacity to pay interest and repay principal in
accordance with the terms of the obligations. Accordingly, it is possible that
these types of factors could, in certain instances, reduce the value of
securities held in the Fund's portfolio, with a commensurate effect on the value
of the Fund's shares.
While the market values of lower rated securities and comparable unrated
securities tend to react
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less to fluctuations in interest rate levels than the market values of
higher-rated securities, the market values of certain lower rated securities and
comparable unrated securities also tend to be more sensitive to individual
corporate developments and changes in economic conditions than higher-rated
securities. In addition, lower rated securities and comparable unrated
securities generally present a higher degree of credit risk. Issuers of lower
rated securities and comparable unrated securities often are highly leveraged
and may not have more traditional methods of financing available to them so that
their ability to service their debt obligations during an economic downturn or
during sustained periods of rising interest rates may be impaired. This risk of
loss due to default by such issuers is significantly greater because lower rated
securities and comparable unrated securities generally are unsecured and
frequently are subordinated to the prior payment of senior indebtedness. The
Fund may incur additional expenses to the extent that it is required to seek
recovery upon a default in the payment of principal or interest on its portfolio
holdings. The existence of limited markets for lower rated securities and
comparable unrated securities may diminish the Fund's ability to (1) obtain
accurate market quotations for purposes of valuing such securities and
calculating its net assets value and (2) sell the securities at fair value
either to meet redemption requests or to respond to changes in the economy or in
financial markets.
Certain lower rated debt securities and comparable unrated securities frequently
have call or buy-back features that permit their issuers to call or repurchase
the securities from their holders, such as the Fund. If an issuer exercises
these rights during periods of declining interest rates, the Fund may have to
replace the security with a lower yielding security, thus resulting in a
decreased return to the Fund.
The market for certain lower rated securities and comparable unrated securities
is relatively new and has not weathered a major economic recession. The effect
that such a recession might have on such securities is not known. Any such
recession, however, could disrupt severely the market for such securities and
adversely affect the value of such securities. Any such economic downturn also
could adversely affect the ability of the issuers of such securities to repay
principal and pay interest thereon.
The Fund may invest in convertible securities that provide current income and
are issued by companies with the characteristics described above and that have a
strong earnings and credit record. The Fund may purchase convertible securities
that are fixed-income debt securities or preferred stock, and which may be
converted at a stated price within a specified period of time into a certain
quantity of the common stock of the same issuer. Convertible securities, while
usually subordinate to similar nonconvertible securities, are senior to common
stocks in an issuer's capital structure. Convertible securities offer
flexibility by provided the investor with a steady income stream (which
generally yield a lower amount than similar nonconvertible securities and a
higher amount than common stocks) as well as the opportunity to take advantage
of increased in the price of the issuer's common stock through the conversion
feature. Fluctuations in the convertible security's price can reflect changes in
the market value of the common stock or changes in market interest rates. At
most, 5% of the Fund's net assets will be invested, at the time of purchase, in
convertible securities that are not rated in the four highest rating categories
by one or more NRSROs,s such as Moody's Investors Services, Inc. ("Moody's") or
Standard &
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Poor's Ratings Group ("S&P"), or unrated but determined by the Advisor to be of
comparable quality.
FUTURES, OPTIONS AND OTHER DERIVATIVE INSTRUMENTS
FUTURES CONTRACTS. The Fund may enter into contracts for the purchase or sale
for future delivery of equity securities, financial indices and foreign
currencies. U.S. futures contracts are traded on exchanges which have been
designated "contract markets" by the CFTC and must be executed through a futures
commission merchant ("FCM"), or brokerage firm, which is a member of the
relevant contract market. Through their clearing corporations, the exchanges
guarantee performance of the contracts as between the clearing members of the
exchange.
The buyer or seller of a futures contract is not required to deliver or pay for
the underlying instrument unless the contract is held until the delivery date.
However, both the buyer and seller are required to deposit "initial margin" for
the benefit of the FCM when the contract is entered into. Initial margin
deposits are equal to a percentage of the contract's value, as set by the
exchange on which the contract is traded, and may be maintained in cash or
certain other liquid assets by the Fund's custodian for the benefit of the FCM.
Initial margin payments are similar to good faith deposits or performance bonds.
Unlike margin extended by a securities broker, initial margin payments do not
constitute purchasing securities on margin for purposes of the Fund's investment
limitations. If the value of either party's position declines, that party will
be required to make additional "variation margin" payments for the benefit of
the FCM to settle the change in value on a daily basis. The party that has a
gain may be entitled to receive all or a portion of this amount. In the event of
the bankruptcy of the FCM that holds margin on behalf of the Fund, the Fund may
be entitled to a return of margin owed to the Fund only in proportion to the
amount received by the FCM's other customers. The Adviser will attempt to
minimize the risk by careful monitoring of the creditworthiness of the FCMs with
which the Fund does business and by depositing margin payments in a segregated
account with the Fund's custodian.
The Fund intends to comply with guidelines of eligibility for exclusion from the
definition of the term "commodity pool operator" adopted by the CFTC and the
National Futures Association, which regulate trading in the futures markets. The
Fund will use futures contracts and related options primarily for bona fide
hedging purposes within the meaning of CFTC regulations. To the extent that the
Fund holds positions in futures contracts and related options that do not fall
within the definition of bona fide hedging transactions, the aggregate initial
margin and premiums required to establish such positions will not exceed 5% of
the fair market value of the Fund's net assets, after taking into account
unrealized profits and unrealized losses on any such contracts it has entered
into.
The Fund's primary purpose in entering into futures contracts is to protect the
Fund from fluctuations in the value of securities or interest rates without
actually buying or selling the underlying security. For example, if the Fund
anticipates an increase in the price of stocks, and it intends to purchase
stocks at a later time, the Fund could enter into a futures contract to purchase
a stock index as a temporary substitute for stock purchases. If an increase in
the market occurs that influences the stock index as anticipated, the value of
the futures contracts will increase,
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thereby serving as a hedge against the Fund not participating in a market
advance. This technique is sometimes known as an anticipatory hedge. To the
extent the Fund enters into futures contracts for this purpose, the segregated
assets maintained to cover the Fund's obligations with respect to the futures
contracts will consist of other liquid assets from its portfolio in an amount
equal to the difference between the contract price and the aggregate value of
the initial and variation margin payments made by the Fund with respect to the
futures contracts. Conversely, if the Fund holds stocks and seeks to protect
itself from a decrease in stock prices, the Fund might sell stock index futures
contracts, thereby hoping to offset the potential decline in the value of its
portfolio securities by a corresponding increase in the value of the futures
contract position. The Fund could protect against a decline in stock prices by
selling portfolio securities and investing in money market instruments, but the
use of futures contracts enables it to maintain a defensive position without
having to sell portfolio securities.
The ordinary spreads between prices in the cash and futures markets, due to
differences in the nature of those markets, are subject to distortions. First,
all participants in the futures market are subject to initial margin and
variation margin requirements. Rather than meeting additional variation margin
requirements, investors may close out futures contracts through offsetting
transactions which could distort the normal price relationship between the cash
and futures markets. Second, the liquidity of the futures market depends on
participants entering into offsetting transactions rather than making or taking
delivery of the instrument underlying a futures contract. To the extent
participants decide to make or take delivery, liquidity in the futures market
could be reduced and prices in the futures market distorted. Third, from the
point of view of speculators, the margin deposit requirements in the futures
market are less onerous than margin requirements in the securities market.
Therefore, increased participation by speculators in the futures market may
cause temporary price distortions. Due to the possibility of the foregoing
distortions, a correct forecast of general price trends by the Adviser still may
not result in a successful use of futures.
RISK CONSIDERATIONS REGARDING FUTURES CONTRACTS. Although the Adviser believes
that use of such contracts will benefit the Fund, the Fund's overall performance
could be worse than if the Fund had not entered into futures contracts if the
Adviser's investment judgement proves incorrect. For example, if the Fund has
hedged against the effects of a possible decrease in prices of securities held
in its portfolio and prices increase instead, the Fund will lose part or all of
the benefit of the increased value of these securities because of offsetting
losses in its futures positions. In addition, if the Fund has insufficient cash,
it may have to sell securities from its portfolio to meet daily variation margin
requirements. Those sales may be, but will not necessarily be, at increased
prices which reflect the rising market and may occur at a time when the sales
are disadvantageous to the Fund.
Although the Fund will segregate cash and liquid assets in an amount sufficient
to cover its open futures obligations, the segregated assets would be available
to the Fund immediately upon closing out the futures position, while settlement
of securities transactions could take several days. However, because the Fund's
cash that may otherwise be invested would be held uninvested or invested in
other liquid assets so long as the futures position remains open, the Fund's
return could be diminished due to the opportunity losses of foregoing other
potential investments.
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The prices of futures contracts depend primarily on the value of their
underlying instruments. Because there are a limited number of types of futures
contracts, it is possible that the standardized futures contracts available to
the Fund will not match exactly the Fund's current or potential investments. The
Fund may buy and sell futures contracts based on underlying instruments with
different characteristics from the securities in which it typically invests -
for example, by hedging investments in portfolio securities with a futures
contract based on a broad index of securities - which involves a risk that the
futures position will not correlate precisely with the performance of the Fund's
investments.
Futures prices can also diverge from the prices of their underlying instruments,
even if the underlying instruments closely correlate with the Fund's
investments. Futures prices are affected by factors such as current and
anticipated short-term interest rates, changes in volatility of the underlying
instruments and the time remaining until expiration of the contract. Those
factors may affect securities prices differently from futures prices. Imperfect
correlations between the Fund's investments and its futures positions also may
result from differing levels of demand in the futures markets and the securities
markets, from structural differences in how futures and securities are traded,
and from imposition of daily price fluctuation limits for futures contracts. The
Fund may buy or sell futures contracts with a greater or lesser value than the
securities it wishes to hedge or is considering purchasing in order to attempt
to compensate for differences in historical volatility between the futures
contract and the securities, although this may not be successful in all cases.
If price changes in the Fund's futures positions are poorly correlated with its
other investments, its futures positions may fail to produce desired gains or
result in losses that are not offset by the gains in the Fund's other
investments.
Because futures contracts are generally settled within a day from the date they
are closed out, compared with a settlement period of three days for some types
of securities, the futures markets can provide superior liquidity to the
securities markets. Nevertheless, there is no assurance that a liquid secondary
market will exist for any particular futures contract at any particular time. In
addition, futures exchanges may establish daily price fluctuation limits for
futures contracts and may halt trading if a contract's price moves upward or
downward more than the limit in a given day. On volatile trading days when the
price fluctuation limit is reached, it may be impossible for the Fund to enter
into new positions or close out existing positions. If the secondary market for
a futures contract is not liquid because of price fluctuation limits or
otherwise, the Fund may not be able to promptly liquidate unfavorable futures
positions and potentially could be required to continue to hold a futures
position until the delivery date, regardless of changes in its value. As a
result, the Fund's access to other assets held to cover its futures positions
also could be impaired.
OPTIONS ON FUTURES CONTRACTS. The Fund may buy and write put and call options on
futures contracts. An option on a future gives the Fund the right (but not the
obligation) to buy or sell a futures contract at a specified price on or before
a specified date. The purchase of a call option on a futures contract is similar
in some respects to the purchase of a call option on an individual security.
Depending on the pricing of the option compared to either the price of the
futures contract upon which it is based or the price of the underlying
instrument, ownership of the option
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may or may not be less risky than ownership of the futures contract or the
underlying instrument. As with the purchase of futures contracts, when the Fund
is not fully invested it may buy a call option on a futures contract to hedge
against a market advance.
The writing of a call option on a futures contract constitutes a partial hedge
against declining prices of the security or foreign currency which is
deliverable under, or of the index comprising, the futures contract. If the
future's price at the expiration of the option is below the exercise price, the
Fund will retain the full amount of the option premium which provides a partial
hedge against any decline that may have occurred in the Fund's portfolio
holdings. The writing of a put option on a futures contract constitutes a
partial hedge against increasing prices of the security or foreign currency
which is deliverable under, or of the index comprising, the futures contract. If
the futures' price at expiration of the option is higher than the exercise
price, the Fund will retain the full amount of the option premium which provides
a partial hedge against any increase in the price of securities which the Fund
is considering buying.
The purchase of a put option on a futures contract is similar in some respects
to the purchase of protective put options on portfolio securities. For example,
the Fund may buy a put option on a futures contract to hedge its portfolio
against the risk of falling prices or rising interest rates.
RISK CONSIDERATIONS REGARDING OPTIONS ON FUTURES. If a call or put option the
Fund has written is exercised, the Fund will incur a loss which will be reduced
by the amount of the premium it received. Depending on the degree of correlation
between the change in the value of its portfolio securities and changes in the
value of the futures positions, the Fund's losses from existing options on
futures may to some extent be reduced or increased by changes in the value of
portfolio securities.
The amount of risk the Fund assumes when it buys an option on a futures contract
is the premium paid for the option plus related transaction costs. In addition
to the correlation risks discussed above, the purchase of an option also entails
the risk that changes in the value of the underlying futures contract will not
be fully reflected in the value of the options bought.
FOREIGN CURRENCY FORWARD CONTRACTS. A forward contract is an agreement between
two parties in which one party is obligated to deliver a stated amount of a
stated asset at a specified time in the future and the other party is obligated
to pay a specified amount for the assets at the time of delivery. The Fund may
enter into forward contracts to purchase and sell equity securities, foreign
currencies or other financial instruments. Forward contracts generally are
traded in an interbank market conducted directly between traders (usually large
commercial banks) and their customers. Unlike futures contracts, which are
standardized contracts, forward contracts can be specifically drawn to meet the
needs of the parties that enter into them. The parties to a forward contract may
agree to offset or terminate the contract before its maturity, or may hold the
contract to maturity and complete the contemplated exchange. The following
discussion summarizes the Fund's principal uses of foreign currency forward
exchange contracts ("forward currency contracts").
The Fund may enter into forward currency contracts with stated contract values
of up to the value of the Fund's assets. A forward currency contract is an
obligation to buy or sell an amount of a
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specified currency for an agreed price (which may be in U.S. dollars or a
foreign currency). The Fund will exchange foreign currencies for U.S. dollars
and for other foreign currencies in the normal course of business and may buy
and sell currencies through forward currency contracts in order to fix a price
for securities it has agreed to buy or sell ("transaction hedge"). The Fund also
may hedge some or all of its investments denominated in a foreign currency or
exposed to foreign currency fluctuations against a decline in the value of that
currency relative to the U.S. dollar by entering into forward currency contracts
to sell an amount of that currency (or a proxy currency whose performance is
expected to replicate or exceed the performance of that currency relative to the
U.S. dollar) approximating the value of some or all of its portfolio securities
denominated in that currency ("position hedge") or by participating in options
or futures contracts with respect to the currency. The Fund also may enter into
a forward currency contract with respect to a currency where the Fund is
considering the purchase or sale of investments denominated in that currency but
has not yet selected the specific investments ("anticipatory hedge"). In any of
these circumstances the Fund may, alternatively, enter into a forward currency
contract to purchase or sell one foreign currency for a second currency that is
expected to perform more favorably relative to the U.S. dollar if the Adviser
believes there is a reasonable degree of correlation between movements in the
two currencies ("cross-hedge").
These types of hedging minimize the effect of currency appreciation as well as
depreciation, but do not eliminate fluctuations in the underlying U.S. dollar
equivalent value of the proceeds of or rates of return on the Fund's foreign
currency denominated portfolio securities. The matching of the increase in value
of a forward contract and the decline in the U.S. dollar equivalent value of the
foreign currency denominated asset that is the subject of the hedge generally
will not be precise.
The Fund will cover outstanding forward currency contracts by maintaining liquid
portfolio securities denominated in or whose value its tied to, the currency
underlying the forward contract or the currency being hedged. To the extent that
the Fund is not able to cover its forward currency positions with underlying
portfolio securities, the Fund's custodian will segregate cash or other liquid
assets having a value equal to the aggregate amount of the Fund's commitments
under forward contracts entered into with respect to position hedges,
cross-hedges and anticipatory hedges. If the value of the securities used to
cover a position or the value of segregated assets declines, the Fund will find
alternative cover or segregate additional cash or liquid assets on a daily basis
so that the value of the covered and segregated assets will be equal to the
amount of the Fund's commitments with respect to such contracts. As an
alternative to segregating assets, the Fund may buy call options permitting the
Fund to buy the amount of foreign currency being hedged by a forward sale
contract or the Fund may buy put options permitting it to sell the amount of
foreign currency subject to a forward buy contract.
RISK CONSIDERATIONS REGARDING FORWARD CURRENCY CONTRACTS. Shifting the Fund's
currency exposure from one foreign currency to another removes the Fund's
opportunity to profit from increases in the value of the original currency and
involves a risk of increased losses to the Fund if its Adviser's projection of
future exchange rates is inaccurate. Proxy hedges and cross-hedges may result in
losses if the currency used to hedge does not perform similarly to the currency
in which hedged securities are denominated. Unforeseen changes in currency
prices may result in
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poorer overall performance for the Fund than if it had not entered into such
contracts.
While forward contracts are not currently regulated by the CFTC, the CFTC may in
the future assert authority to regulate forward contacts. In such event, the
Fund's ability to utilize forward contracts may be restricted. In addition, the
Fund may not always be able to enter into forward contracts at attractive prices
and may be limited in its ability to use these contracts to hedge Fund assets.
OPTIONS ON SECURITIES. In an effort to increase current income and to reduce
fluctuations in net asset value, the Fund may write covered put and call options
and buy put and call options on securities that are traded on United States and
foreign securities exchanges and over-the-counter. The Fund may write and buy
options on the same types of securities that the Fund may purchase directly.
A put option written by the Fund is "covered" if the Fund (i) segregates cash
not available for investment or other liquid assets with a value equal to the
exercise price of the put with the Fund's custodian or (ii) holds a put on the
same security and in the same principal amount as the put written and the
exercise price of the put held is equal to or greater than the exercise price of
the put written. The premium paid by the buyer of an option will reflect, among
other things, the relationship of the exercise price to the market price and the
volatility of the underlying security, the remaining term of the option, supply
and demand and interest rates.
A call option written by the Fund is "covered" if the Fund owns the underlying
security covered by the call or has an absolute and immediate right to acquire
that security without additional cash consideration (or for additional cash
consideration held in a segregated account by the Fund's custodian) upon
conversion or exchange of other securities held in its portfolio. A call option
is also deemed to be covered if the Fund holds a call on the same security and
in the same principal amount as the call written and the exercise price of the
call held (i) is equal to or less than the exercise price of the call written or
(ii) is greater than the exercise price of the call written if the difference is
maintained by the Fund in cash and other liquid assets in a segregated account
with its custodian.
The Fund also may write call options that are not covered for cross-hedging
purposes. The Fund collateralizes its obligation under a written call option for
cross-hedging purposes by segregating cash or other liquid assets in an amount
not less than the market value of the underlying security, marked-to-market
daily. The Fund would write a call option for cross-hedging purposes, instead of
writing a covered call option, when the premium to be received from the
cross-hedge transaction would exceed that which would be received from writing a
covered call option and its Adviser believes that writing the option would
achieve the desired hedge.
The writer of an option that wishes to terminate its obligation may effect a
"closing purchase transaction." This is accomplished by buying an option of the
same series as the option previously written. The effect of the purchase is that
the writer's position will be canceled by the clearing corporation. However, a
writer may not effect a closing purchase transaction after being notified of the
exercise of an option. Likewise, an investor who is the holder of an option may
liquidate its
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<PAGE> 12
position by effecting a "closing sale transaction." This is accomplished by
selling an option of the same series as the option previously bought.
In the case of a written call option, effecting a closing transaction will
permit the Fund to write another call option on the underlying security with
either a different exercise price or expiration date or both. In the case of a
written put option, such transaction will permit the Fund to write another put
option to the extent that the exercise price is secured by other liquid assets.
Effecting a closing transaction also will permit the Fund to use the cash or
proceeds from the concurrent sale of any securities subject to the option for
other investments. If the Fund desires to sell a particular security from its
portfolio on which it has written a call option, the Fund will effect a closing
transaction prior to or concurrent with the sale of the security.
The Fund will realize a profit from a closing transaction if the price of the
purchase transaction is less than the premium received from writing the option
or the price received from a sale transaction is more than the premium paid to
buy the option. The Fund will realize a loss from a closing transaction if the
price of the purchase transaction is more than the premium received from writing
the option or the price received from a sale transaction is less than the
premium paid to buy the option. Because increases in the market of a call option
generally will reflect increases in the market price of the underlying security,
any loss resulting from the repurchase of a call option is likely to be offset
in whole or in part by appreciation of the underlying security owned by the
Fund.
The Fund may write options in connection with buy-and-write transactions. In
other words, the Fund may buy a security and then write a call option against
that security. The exercise price of such call will depend upon the expected
price movement of the underlying security. The exercise price of a call option
may be below ("in-the-money"), equal to ("at-the-money") or above
("out-of-the-money") the current value of the underlying security at the time
the option is written. Buy-and-write transactions using in-the-money call
options may be used when it is expected that the price of the underlying
security will remain flat or decline moderately during the option period.
Buy-and-write transactions using at-the-money call options may be used when it
is expected that the price of the underlying security will remain fixed or
advance moderately during the option period. Buy-and-write transactions using
out-of-the-money call options may be used when it is expected that the premiums
received from writing the call option plus the appreciation in the market price
of the underlying security up to the exercise price will be greater than the
appreciation in the price of the underlying security alone. If the call options
are exercised in such transactions, the Fund's maximum gain will be the premium
received by it for writing the option, adjusted upwards or downwards by the
difference between the Fund's purchase price of the security and the exercise
price. If the options are not exercised and the price of the underlying security
declines, the amount of such decline will be offset by the amount of premium
received.
RISK CONSIDERATIONS REGARDING OPTIONS. The writer of an option may have no
control over when the underlying securities must be sold, in the case of a call
option, or bought, in the case of a put option, since with regard to certain
options, the writer may be assigned an exercise notice at any time prior to the
termination of the obligation. Whether or not an option expires unexercised, the
writer retains the amount of the premium. This amount, of course, may, in the
case of a
B-10
<PAGE> 13
covered call option, be offset by a decline in the market value of the
underlying security during the option period. If a call option is exercised, the
writer experiences a profit or loss from the sale of the underlying security. If
a put option is exercised, the writer must fulfill the obligation to buy the
underlying security at the exercise price, which will usually exceed the then
market value of the underlying security.
There is no guarantee that either a closing purchase or a closing sale
transaction can be effected. An option position may be closed out only where a
secondary market for an option of the same series exists. If a secondary market
does not exist, the Fund may not be able to effect closing transactions in
particular options and the Fund would have to exercise the options in order to
realize any profit. If the Fund is unable to effect a closing purchase
transaction in a secondary market, it will not be able to sell the underlying
security until the option expires or it delivers the underlying security upon
exercise. The absence of a liquid secondary market may be due to the following:
(i) insufficient trading interest in certain options, (ii) restrictions imposed
by a national securities exchange ("Exchange") on which the option is traded on
opening or closing transactions or both, (iii) trading halts, suspensions or
other restrictions imposed with respect to particular classes or series of
options or underlying securities, (iv) unusual or unforeseen circumstances that
interrupt normal operations on an Exchange, (v) the facilities of an Exchange or
of the Options Clearing Corporation ("OCC") 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 options (or a particular class or series of options), in which event
the secondary market on that Exchange (or in that class or series of options)
would cease to exist, although outstanding options on that Exchange that had
been issued by the OCC as a result of trades on that Exchange would continue to
be exercisable in accordance with their terms.
The writing of covered put options is similar in terms of risk and return
characteristics to buy-and-write transactions. If the market price of the
underlying security rises or otherwise is above the exercise price, the put
option will expire worthless and the Fund's gain will be limited to the premium
received. If the market price of the underlying security declines or otherwise
is below the exercise price, the Fund may elect to close the position or take
delivery of the security at the exercise price and the Fund's return will be the
premium received from the put options minus the amount by which the market price
of the security is below the exercise price.
The Fund may buy put options to hedge against a decline in the value of its
portfolio. By using put options in this way, the Fund will reduce any profit it
might otherwise have realized in the underlying security by the amount of the
premium paid for the put option and by transaction costs.
The Fund may buy call options to hedge against an increase in the price of
securities that it may buy in the future. The premium paid for the call option
plus any transaction costs will reduce the benefit, if any, realized by the Fund
upon exercise of the option, and, unless the price of the underlying security
rises sufficiently, the option may expire worthless to the Fund.
WRITING COVERED OVER-THE-COUNTER ("OTC") OPTIONS. A Fund may write (sell)
covered call
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<PAGE> 14
options that trade in the OTC market in the same manner that it will engage in
exchange traded options. Just as with exchange traded options, OTC call options
give the holder the right to buy an underlying security from an option writer at
a stated exercise price. However, OTC options differ from exchange traded
options in certain material respects. Because there is no exchange, pricing is
typically done by reference to information from market makers. OTC options are
available for a greater variety of securities, and in a wider range of
expiration dates and exercise prices, than exchange traded options, and the
writer of an OTC option is paid the premium in advance by the dealer.
RISK CONSIDERATIONS REGARDING OTC OPTIONS. OTC options are arranged directly
with dealers and not, as is the case with exchange traded options, with a
clearing corporation. Thus, there is a risk of non-performance by the dealer.
There can be no assurance that a continuous liquid secondary market will exist
for any particular OTC option at any specific time. When a Fund writes an OTC
option, it generally can close out that option prior to its expiration only by
entering into a closing purchase transaction with the dealer to which the Fund
originally wrote the option.
RISK CONSIDERATIONS REGARDING OPTIONS ON SECURITIES INDICES. The risks of
investment in index options may be greater than options on securities. Because
index options are settled in cash, when the Fund writes a call option on an
index it cannot provide in advance for its potential settlement obligations by
acquiring and holding the underlying securities. The Fund can offset some of the
risk of writing a call index option position by holding a diversified portfolio
of securities similar to those on which the underlying index is based. However,
the Fund cannot, as a practical matter, acquire and hold a portfolio containing
exactly the same securities as underlie the index and, as a result, bears a risk
that the value of the securities held will vary from the value of the index.
Even if the Fund could assemble a securities portfolio that exactly reproduced
the composition of the underlying index, it still would not be fully covered
from a risk standpoint because of the "timing risk" inherent in writing index
options. When an index option is exercised, the amount of cash that the holder
is entitled to receive is determined by the difference between the exercise
price and the closing index level on the date when the option is exercised. As
with other kinds of options, the Fund as the call writer will not know that it
has been assigned until the next business day at the earliest. The time lag
between exercise and notice of assignment poses no risk for the writer of a
covered call on a specific underlying security, such as a common stock, because
there the writer's obligation is to deliver the underlying security, not to pay
its value as of a fixed time in the past. So long as the writer already owns the
underlying security, it can satisfy its settlement obligations by simply
delivering it, and the risk that its value may have declined since the exercise
date is borne by the exercising holder. In contrast, even if the writer of an
index call holds securities that exactly match the composition of the underlying
index, it will not be able to satisfy its assignment obligations by delivering
those securities against payment of the exercise price. Instead, it will be
required to pay cash in an amount based on the closing index value on the
exercise date; and by the time it learns that it has been assigned, the index
may have declined, with a corresponding decline in the value of its securities
portfolio. This "timing risk" is an inherent limitation on the ability of index
call writers to cover their risk exposure by holding securities positions.
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<PAGE> 15
If the Fund has purchased an index option and exercises it before the closing
index value for that day is available, it runs the risk that the level of the
underlying index may subsequently change. If such a change causes the exercised
option to fall out-of-the-money, the Fund will be required to pay the difference
between the closing index value and the exercise price of the option (times the
applicable multiplier) to the assigned writer.
ILLIQUID AND RESTRICTED SECURITIES
The Fund may invest up to 15% of its net assets in illiquid securities,
including repurchase agreements with maturities in excess of seven days.
RESTRICTED/RULE 144A SECURITIES. Subject to the 15% limitation, the Board of
Trustees has authorized the Fund to invest in restricted securities where such
investment is consistent with that Fund's investment objective, and has
authorized such securities to be considered liquid to the extent Zero Gravity
Capital Management LLC (the "Adviser") determines that there is a liquid
institutional or other market for such securities -- for example, restricted
securities that may be freely transferred among qualified institutional buyers
under Rule 144A of the Securities Act of 1933 ("1933 Act"), and for which a
liquid institutional market has developed. The Board of Trustees will review any
determination by the Adviser to treat a restricted security as a liquid security
on an ongoing basis, including the Adviser's assessment of current trading
activity and the availability of reliable price information. In determining
whether a restricted security is properly considered a liquid security, the
Adviser will take into account the following factors:
. the frequency of trades and quotes for the security;
. the number of dealers willing to buy or sell the security and the
number of other potential buyers;
. dealer undertakings to make a market in the security;
. the nature of the security and marketplace trades, including the time
needed to dispose of the security, the method of soliciting offers,
and the mechanics of transfer; and
. such other factors as the Adviser may determine to be relevant to such
determination.
VENTURE CAPITAL COMPANIES. The Fund expects to invest in venture capital
companies that it determines to be in the "late-stage" or "pre-IPO" stage of
development. The Adviser considers a company to be in the late stage if it has a
developed infrastructure and has commenced earning revenues. The Fund expects
that late-stage companies will undertake an initial public offering within a
period of one to three years. A pre-IPO company is somewhat more developed than
a late-stage company. The Adviser expects to be able to acquire equity
securities for the Fund of pre-IPO companies in private placements within a year
prior to their planned initial public offerings. Of the Fund's venture capital
investments, up to 5% of the Fund's total assets may be invested in securities
of investment funds that invest primarily in venture capital companies.
RISKS. Late-stage and pre-IPO companies will typically have small market
capitalizations and limited or no liquidity; even after an initial public
offering, liquidity may be limited and the Fund
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<PAGE> 16
may be subject to contractual limitations on its ability to sell shares.
BORROWING
The Fund may (1) borrow money from banks and (2) make other investments or
engage in other transactions permissible under the Investment Company Act of
1940 ("1940 Act") which may involve a borrowing, provided that the combination
of (1) and (2) shall not exceed 33-1/3% of the value of the Fund's total assets
(including the amount borrowed), less the Fund's liabilities (other than
borrowings), except that the Fund may borrow up to an additional 5% of its total
assets (not including the amount borrowed) from a bank for temporary or
emergency purposes (but not for leverage or the purchase of investments). The
Fund may also borrow money from other persons to the extent permitted by
applicable law. The Fund will not purchase securities when bank borrowings
exceed 5% of the Fund's total net assets.
REPURCHASE AGREEMENTS
The Fund may enter into repurchase agreements. A repurchase agreement is an
instrument under which the Fund acquires ownership of a debt security and the
seller agrees, at the time of the sale, to repurchase the obligation at a
mutually agreed upon time and price, thereby determining the yield during the
Fund's holding period. Although the Fund will enter into repurchase agreements
only with institutions that the Adviser believes present minimal credit risk, it
is conceivable that a repurchase agreement issuer could seek relief under
bankruptcy laws or otherwise default on its obligations under its repurchase
agreement. In that event, the Fund could experience both delays in liquidating
the underlying securities and losses, including: (1) a possible decline in the
value of the underlying security during the period while the Fund seeks to
enforce its rights thereto; (2) possible subnormal levels of income and lack of
access to income during this period; (3) a possible loss on the sale of the
underlying collateral; and (4) expenses of enforcing its rights.
LENDING OF PORTFOLIO SECURITIES
Securities loans are made to broker-dealers or institutional investors or other
persons, pursuant to agreements requiring that the loans be continuously secured
by collateral at least equal at all times to the value of the securities lent,
marked to market on a daily basis. The collateral received will consist of cash,
U.S. Government securities, letters of credit or such other collateral as may be
permitted under the Fund's investment program. While the securities are being
lent, the Fund will continue to receive the equivalent of the interest or
dividends paid by the issuer on the securities, as well as interest on the
investment of the collateral or a fee from the borrower. The Fund has a right to
call each loan and obtain the securities, within such period of time which
coincides with the normal settlement period for purchases and sales of such
securities in the respective markets. The Fund will not have the right to vote
on securities while they are being lent, but it will call a loan in anticipation
of any important vote.
RISKS. The risks in lending portfolio securities, as with other extensions of
secured credit, consist of possible delay in receiving additional collateral or
in the recovery of the securities or possible loss of rights in the collateral
should the borrower fail financially. Loans will only be made to firms deemed by
the Adviser to be of good standing and will not be made unless, in the judgment
B-14
<PAGE> 17
of the Adviser, the consideration to be earned from such loans would justify the
risk.
PORTFOLIO TURNOVER
The Fund may sell a portfolio security, and will reinvest the proceeds, whenever
the Adviser deems such action prudent. The Fund's annual portfolio turnover rate
may vary significantly from year to year. A higher rate of portfolio turnover
may result in higher transaction costs, including brokerage commissions. Also,
to the extent that higher portfolio turnover results in a higher rate of net
realized capital gains to the Fund, the portion of the Fund's distributions
constituting taxable capital gains may increase. The Adviser does not expect the
annual portfolio turnover rates for the Fund to exceed 100%.
INVESTMENT RESTRICTIONS
The Trust has adopted the following restrictions as fundamental policies for the
Fund as stated. These restrictions are fundamental policies of the Fund and may
not be changed for any given Fund without the approval of the lesser of (i) more
than 50% of the outstanding voting securities of the Fund or (ii) 67% or more of
the voting securities present at a shareholder meeting of the Fund if more than
50% of the outstanding voting securities of the Fund are represented at the
meeting in person or by proxy. The investment restrictions of one Fund thus may
be changed without affecting those of the other Fund. Under the restrictions,
the Fund MAY NOT:
1. Issue senior securities, except to the extent permitted by the 1940 Act,
including permitted borrowings.
2. Make loans, except for collateralized loans of portfolio securities in an
amount not exceeding 331/3% of the Fund's total assets (at the time of the
most recent loan). This limitation does not apply to purchases of debt
securities or to repurchase agreements.
3. (1) Borrow money from banks and (2) make other investments or engage in
other transactions permissible under the Investment Company Act of 1940
("1940 Act") which may involve a borrowing, provided that the combination
of (1) and (2) shall not exceed 33-1/3% of the value of the Fund's total
assets (including the amount borrowed), less the Fund's liabilities (other
than borrowings), except that the Fund may borrow up to an additional 5% of
its total assets (not including the amount borrowed) from a bank for
temporary or emergency purposes (but not for leverage or the purchase of
investments). The Fund may also borrow money from other persons to the
extent permitted by applicable law.
4. Invest 25% or more of the Fund's total assets (at the time of the most
recent investment) in any single industry. The Internet is not considered
an industry for purposes of this limitation. This limitation does not apply
to investments in obligations of the US. Government or any of its agencies
or instrumentalities.
5. Act as an underwriter, except to the extent that, in connection with the
disposition of portfolio securities, the Fund may be deemed to be an
underwriter for purposes of the 1933 Act.
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<PAGE> 18
6. Purchase securities of other investment companies, except to the extent
permitted by the 1940 Act, regulations thereunder, or exemptions therefrom.
7. Purchase or sell commodity contracts, except that the Fund may, as
appropriate and consistent with its investment objectives and policies,
enter into financial futures contracts, options on such futures contracts,
foreign currency forward contracts, forward commitments, and repurchase
agreements.
8. Make short sales of securities or maintain a short position if, when added
together, more than 25% of the value of the Fund's net assets would be (i)
deposited as collateral for the obligation to replace securities borrowed
to effect short sales and (ii) allocated to segregated accounts in
connection with short sales. Short sales "against-the-box" are not subject
to this limitation.
9. Purchase or sell real estate or any interest therein, except that the Fund
may, as appropriate and consistent with its investment objectives and
policies, invest in securities of corporate and governmental entities
secured by real estate or marketable interests therein, or securities of
issuers that engage in real estate operations or interests therein, and may
hold and sell real estate acquired as a result of ownership of such
securities.
The 1940 Act generally prohibits investment companies from issuing any class of
senior securities. Senior securities include preferred stock, bonds, debentures,
notes and other securities evidencing indebtedness. Funds may, however, borrow
from banks if they maintain 300% asset coverage.
MANAGEMENT OF THE FUND
The officers and Trustees of the Fund are listed below. Unless otherwise noted,
the address of each is 400 Montgomery Street, 3rd Floor, San Francisco,
California 94104. In the list below, the Fund's Trustees who are considered
"interested persons" of Zero Gravity Capital Management LLC, as defined under
Section 2(a)(19) of the 1940 Act are noted with an asterisk (*).
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<PAGE> 19
NAME AND AGE POSITION WITH PRINCIPAL OCCUPATIONS
------------ THE TRUST DURING PAST FIVE YEARS
--------- ----------------------
*Joseph N. Van Remortel President and Senior Vice President,
(35) Trustee Business Development,
Zero Gravity Internet Group,
Inc. (since December 1999);
Senior Vice President, Zero
Gravity Capital Management
LLC (since February 2000);
Vice President and
Secretary, E*TRADE Funds,
January 1999 - November
1999; Vice President of
Operations, E*TRADE Asset
Management, December 1998 -
November 1999; Senior
Manager, E*TRADE Securities,
Inc., September 1996 -
November 1999; Senior
Consultant, KPMG Peat
Marwick Strategic
Consulting, March 1994 -
September 1996; Associate,
Analysis Group, Inc, May
1992 - March 1994.
*James A. Hartmann Secretary, President, Chief Operating
(34) Treasurer and Officer and Chief Compliance
Trustee Officer (since August 1999)
of Zero Gravity Internet
Group, Inc. and Zero Gravity
Management LLC (since
January 2000); President of
Zero Gravity Capital
Management LLC (since
February 2000); Director of
Institutional Services,
Capstone Investments
(January 1999 - July 1999);
Consultant, MCG LLC (June
1998 - January 1999); Vice
President of Institutional
Marketing and Product
Development, Summit Capital
Management LLC and Summit
Capital Partners LP (June
1997 - May 1998); Chief
Compliance Officer,
Prudential Insurance Co. of
America (April 1994 - June
1997); Investment Company
Examiner, U.S. Securities &
Exchange Commission (January
1990 - April 1994). Lisa A.
Cavallari (30) Vice
President Senior Vice
President, Zero Gravity
Internet Group, Inc. and
Senior Vice President, Zero
Gravity Capital Management
LLC (since February 2000);
Principal, Barclays Global
Investors (August 1997 -
February 2000); Analyst,
Frank Russel Company
(1991-1995).
Cheryl A. Burgermeister (48) Trustee Retired in 1999; formerly
Chief Financial Officer and
Treasurer of Crabbe Huson
Group and Treasurer of
Crabbe Huson Mutual Fund
Family (January 1995 -
August 1999); also a Trustee
of Select Sector SPDR Funds.
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<PAGE> 20
Ming Huang (36) Trustee Assistant Professor or
Finance, Stanford Graduate
School of Business (since
July 1998); Assistant
Professor of Finance,
University of Chicago
Graduate School of Business
(April 1996 - June 1998);
PhD candidate in finance,
Stanford Graduate School of
Business; also a partner in
The U Group, engaged in
short-term business strategy
consulting.
Ashley T. Rabun (47) Trustee Owner, Chief Executive
Officer and Trustee of
InvestorReach (since 1996);
Partner, Nicholas-Applegate
Capital Management,
President Nicholas-Applegate
Mutual Funds and President
of Nicholas-Applegate
Securities (January 1995-May
1996); also a Trustee of
E*TRADE Mutual Funds and
Trust Investment Management.
The Fund does not pay pension or retirement benefits to its officers. Also, any
trustee of the Fund who is an officer or employee of Zero Gravity Internet
Group, Inc. or Zero Gravity Capital Management LLC does not receive any
compensation from the Fund. We will pay our trustees who are not interested
persons a $2,000 quarterly retainer and $2,000 for each board meeting attended.
PRINCIPAL HOLDERS OF SECURITIES
As of April 24, 2000, the officers and trustees of the Trust, as a group, owned
less than 1% of the outstanding shares of the Fund and Zero Gravity Capital
Management LLC owned all of the Fund's shares. Upon the public offering of the
Fund's shares, that control position is expected to diminish.
INVESTMENT MANAGEMENT SERVICES
SERVICES
Under an Advisory Agreement, Zero Gravity Capital Management LLC, formerly
e-harmon Capital Management LLC, (which we call the Adviser) provides the Fund
with discretionary investment services. Specifically, it is responsible for
supervising and directing the investments of the Fund in accordance with the
Fund's investment objectives, program, and restrictions as provided in the
Prospectus and this Statement of Additional Information. The Adviser is also
responsible for effecting all security transactions on behalf of the Fund,
including the negotiation of commissions and the allocation of portfolio
brokerage. In addition to these services, the Adviser provides the Fund with
certain corporate administrative services, including: maintaining the Fund's
corporate records; registering and qualifying Fund shares under federal laws;
monitoring the financial, accounting, and administrative functions of the Fund;
maintaining relationships with the agents employed by the Fund such as the
Fund's custodian and transfer agent; assisting the Fund in the coordination of
such agents' activities; and permitting the
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<PAGE> 21
Adviser's employees to serve as officers, trustees, and committee members of the
Trust without cost to the Fund.
The Advisory Agreement also provides that the Adviser, its members, officers,
employees, and certain other persons performing specific functions for the Fund
will only be liable to the Fund for losses resulting from willful misfeasance,
bad faith, gross negligence, or reckless disregard of duty.
MANAGEMENT FEE
The Fund pays the Adviser a management fee of 1.25% of the average daily net
assets of the Fund. The Advisory Agreement between the Fund and the Adviser
provides that the Fund bears all expenses of its operations not specifically
assumed by the Adviser.
The Advisory Agreement permits the Adviser to seek reimbursement of any
reductions made to its management fee and payments made to limit expenses which
are the responsibility of the Fund within the three-year period after such
reduction, subject to the Fund's ability to effect such reimbursement and remain
in compliance with applicable expense limitations. Any such management fee or
expense reimbursement will be accounted for on the financial statements of the
Fund as a contingent liability of the Fund until such time as it appears that
the Fund will be able to effect reimbursement. When it appears that the Fund is
able to effect reimbursement, the amount of reimbursement that the Fund is able
to effect as an expense of the Fund will be accrued as an expense of the Fund
for that current period.
FUND EXPENSES
In addition to the management fee, the Fund pays for the following: shareholder
service expenses; custodial, accounting, legal and audit fees; costs of
preparing and printing prospectuses and reports sent to shareholders;
registration fees and expenses; proxy and annual meeting expenses (if any) and
Trustee fees and expenses.
ADMINISTRATION AND FUND ACCOUNTING
Sunstone Financial Group, Inc., 207 East Buffalo Street, Suite 400, Milwaukee,
Wisconsin 53202 (after October 1, 2000, 803 West Michigan, Milwaukee, Wisconsin
53233)("Sunstone") provides various administrative and fund accounting services
to the Fund under an Administration and Fund Accounting Agreement dated April
23, 2000 (the "Administration Agreement"). Sunstone's services include, but are
not limited to, the following: calculating the daily net asset value for the
Fund; overseeing the Fund's Custodian; assistance in preparing and filing all
federal income and excise tax filings (other than those to be made by the Fund's
Custodian); overseeing the Fund's fidelity insurance relationships; preparing
notice and renewal securities filings pursuant to state securities laws;
compiling data for and preparing notices to the SEC; preparing financial
statements for the annual and semi-annual reports to the SEC and current
investors; monitoring the Fund's expenses; monitoring the Fund's status as a
regulated investment company under Subchapter M of the Code; monitoring
compliance with the Fund's investment policies and restrictions and generally
assisting the Fund's administrative operations.
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<PAGE> 22
Sunstone, at its own expense, and without reimbursement from the Fund, furnishes
office space and all necessary office facilities, equipment, supplies and
clerical and executive personnel for performing the services required to be
performed by it under the Administration Agreement. The Administration Agreement
will remain in effect until April 23, 2002 (the "Initial Term") and thereafter
for successive annual periods. After the Initial Term, the Administration
Agreement may be terminated on not less than 90 days' notice, without the
payment of any penalty, by the Board of Trustees of the Trust or by Sunstone.
Sunstone may provide similar services to others, including other investment
companies.
For the foregoing, Sunstone receives a fee on the value of the Fund computed
daily and payable monthly, at the annual rate of 0.15 percent of the first $50
million of its average daily net assets, and decreasing as assets reach certain
levels, subject to an annual minimum fee of $70,000, plus out-of-pocket
expenses.
TRANSFER AGENT AND DIVIDEND-PAYING AGENT
Sunstone also acts as the Fund's transfer agent and dividend-paying agent. As
such, Sunstone processes purchase and redemption requests for the securities of
the Fund, keeps records of shareholder accounts and transactions, pays dividends
as declared by the Board of Trustees and issues confirmations of transactions to
shareholders. For these services, the Fund pays Sunstone a fee based on the
number of shareholder accounts, transactions and other activities, subject to a
minimum annual fee. Sunstone does not exercise any supervisory functions over
the management of the Fund or the purchase and sale of Fund securities. Under
the Transfer Agency Agreement, the Fund has agreed to indemnify Sunstone against
all claims except those resulting from the willful misfeasance, bad faith or
gross negligence of Sunstone.
FUND DISTRIBUTION
Sunstone Distribution Services, LLC ("Sunstone Distribution") serves as
distributor to the Fund pursuant to a Distribution Agreement ("Distribution
Agreement"). The offering of the Fund's shares is continuous. The Distribution
Agreement provides that Sunstone Distribution may incur expenses for appropriate
distribution activities that it deems reasonable and which are primarily
intended to result in the sale of shares of the Fund, including, but not limited
to, advertising, the printing and mailing of prospectuses to other than current
shareholders, and the printing and mailing of sales literature. Under the
Distribution Agreement, the Fund has agreed to indemnify Sunstone against all
claims except those resulting from the willful misfeasance, bad faith or gross
negligence of Sunstone. At the direction of the Trust, Sunstone Distribution may
enter into servicing and/or selling agreements with qualified broker-dealers and
other persons with respect to the offering of Shares to the public. Sunstone
Distribution's address is 207 East Buffalo Street, Milwaukee, WI 53202 (after
October 1, 2000, 803 West Michigan, Milwaukee, Wisconsin 53233).
DISTRIBUTION AND SERVICE PLAN
The Fund has adopted a Distribution and Service Plan (the "Plan") for its Class
A shares. Only Class A shares are currently offered. The Plan authorizes
payments by the Fund in connection
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<PAGE> 23
with the distribution of its shares at an annual rate based on average daily net
assets of .25% for Class A shares.
Payments may be made by the Fund under the Plan for the purpose of financing any
activity primarily intended to result in the sales of shares of the Fund as
determined by the Board of Trustees. Such activities typically include
advertising compensation for sales and sales marketing activities, such as
dealers or distributors; shareholder account servicing; and production and
dissemination of prospectuses and sales and marketing materials to prospective
investors. To the extent any activity is one which the Fund may finance without
a Plan, the Fund may also make payments to finance such activity outside of the
Plan and not subject to its limitations. Payments under the Plan are not tied
exclusively to actual distribution and service expenses, and the payments may
exceed distribution and service expenses actually incurred.
Administration of the Class A Plan is regulated by Rule 12b-1 under the 1940
Act, under which the Board of Trustees is required to receive and review at
least quarterly reports concerning the nature and qualification of expenses
incurred and approve all agreements implementing the Plan. The Plan may be
continued from year-to-year only if the Board of Trustees concludes at least
annually that continuation of the Plan is likely to benefit shareholders.
SHAREHOLDER SERVICES
The Fund from time to time may enter into agreements with outside parties
through which shareholders hold Fund shares. The shares would be held by such
parties in omnibus accounts. The agreements would provide for payments by the
Fund to the outside party for shareholder services provided to shareholders in
the omnibus accounts.
CUSTODIAN
UMB Bank, n.a., is the custodian for the Fund's U.S. securities and cash, but it
does not participate in the Fund's investment decisions. Portfolio securities
purchased in the U.S. are maintained in the custody of the Bank. UMB Bank's main
office is at Kansas City, Missouri.
CODE OF ETHICS
The Board of Trustees of the Trust has adopted a Code of Ethics. The Adviser has
the same Code of Ethics. The Code permits persons subject to the Code to invest
in securities, including securities that may be purchased or held by the Fund.
However, the Code prohibits certain investments and limits these persons from
making investments during periods when the Fund is making such investments. The
Code is on file with the Securities and Exchange Commission and copies are
publicly available.
PORTFOLIO TRANSACTIONS
INVESTMENT OR BROKERAGE DISCRETION
Decisions with respect to the purchase and sale of portfolio securities on
behalf of the Fund are
B-21
<PAGE> 24
made by the Adviser. The Adviser is also responsible for implementing these
decisions, including the negotiation of commissions and the allocation of
portfolio brokerage and principal business.
HOW BROKERS AND DEALERS ARE SELECTED
EQUITY SECURITIES
In purchasing and selling equity securities, it is the Adviser's policy to
obtain quality execution at the most favorable prices through responsible
brokers and dealers and, in the case of agency transactions, at competitive
commission rates. However, under certain conditions, the Fund may pay higher
brokerage commissions in return for brokerage and research services. As a
general practice, over-the-counter orders are executed with market-makers. In
selecting among market-makers, the Adviser generally seeks to select those it
believes to be actively and effectively trading the security being purchased or
sold. In selecting broker-dealers to execute the Fund's portfolio transactions,
consideration is given to such factors as the price of the security, the rate of
the commission, the size and difficulty of the order, the reliability,
integrity, financial condition, general execution and operational capabilities
of competing brokers and dealers, their expertise in particular markets and
brokerage and research services provided by them. It is not the policy of the
Adviser to seek the lowest available commission rate where it is believed that a
broker or dealer charging a higher commission rate would offer greater
reliability or provide better price or execution services.
FIXED INCOME SECURITIES
Fixed income securities are generally purchased from the issuer or a primary
market-maker acting as principal for the securities on a net basis, with no
brokerage commission being paid by the client although the price usually
includes an undisclosed compensation. Transactions placed through dealers
serving as primary market-makers reflect the spread between the bid and asked
prices. Securities may also be purchased from underwriters at prices which
include underwriting fees.
With respect to equity and fixed income securities, the Adviser may effect
principal transactions on behalf of the Fund with a broker or dealer who
furnishes brokerage and/or research services, designate any such broker or
dealer to receive selling concessions, discounts or other allowances, or
otherwise deal with any such broker or dealer in connection with the acquisition
of securities in underwritings. The Adviser may receive research services in
connection with brokerage transactions, including designations in a fixed price
offerings.
HOW EVALUATIONS ARE MADE OF THE OVERALL
REASONABLENESS OF BROKERAGE COMMISSIONS PAID
On a continuing basis, the Adviser seeks to determine what levels of commission
rates are reasonable in the marketplace for transactions executed on behalf of
the Fund. In evaluating the reasonableness of commission rates, the Adviser
considers: (1) historical commission rates, (2) rates which other institutional
investors are paying, based on available public information, (3) rates quoted by
brokers and dealers, (4) the size of a particular transaction, in terms of the
B-22
<PAGE> 25
number of shares, dollar amount, and number of clients involved, (5) the
complexity of a particular transaction in terms of both execution and
settlement, (6) the level and type of business done with a particular firm over
a period of time, and (7) the extent to which the broker or dealer has capital
at risk in the transaction.
RESEARCH SERVICES RECEIVED FROM BROKERS AND DEALERS
The Adviser receives a wide range of research services from brokers and dealers.
These services include information on the economy, industries, groups of
securities, individual companies, statistical information, accounting and tax
law interpretations, political developments, legal developments affecting
portfolio securities, technical market action, pricing and appraisal services,
credit analysis, risk measurement analysis, performance analysis and analysis of
corporate responsibility issues. These services provide both domestic and
international perspective. Research services are received primarily in the form
of written reports, computer generated services, telephone contacts and personal
meetings with security analysts. In addition, such services may be provided in
the form of meetings arranged with corporate and industry spokespersons,
economists, and government representatives. In some cases, research services are
generated by third parties but are provided to the adviser by or through
broker-dealers.
Research services received from brokers and dealers are supplemental to the
Adviser's own research efforts and, when utilized, are subject to internal
analysis before being incorporated by the Adviser into its investment process.
As a practical matter, it would not be possible for the Adviser to generate all
of the information presently provided by brokers and dealers. The Adviser pays
cash for certain research services received from external sources. The Adviser
also allocates brokerage for research services which are available for cash.
While receipt of research services from brokerage firms has not reduced the
Adviser's normal research activities, the expenses of the Adviser could be
materially increased if it attempted to generate such additional information
through its own staff. To the extent that research services of value are
provided by brokers or dealers, the Adviser may be relieved of expenses which it
might otherwise bear.
The Adviser has a policy of not allocating brokerage business in return for
products or services other than brokerage or research services. In accordance
with the provisions of Section 28(e) of the Securities Exchange Act of 1934, the
Adviser may from time to time receive services and products which serve both
research and non-research functions. In such event, the Adviser makes a good
faith determination of the anticipated research and non-research use of the
product or service and allocates brokerage only with respect to the research
component.
COMMISSIONS TO BROKERS WHO FURNISH RESEARCH SERVICES
Certain brokers and dealers who provide quality brokerage and execution services
also furnish research services to the Adviser. With regard to the payment of
brokerage commissions, the Adviser has adopted a brokerage allocation policy
embodying the concepts of Section 28(e) of the Securities Exchange Act of 1934,
which permits an investment adviser to cause an account to pay commission rates
in excess of those another broker or dealer would have charged for effecting the
same transaction, if the Adviser determines in good faith that the commission
paid is reasonable in relation to the value of the brokerage and research
services provided. The determination may be
B-23
<PAGE> 26
viewed in terms of either the particular transaction involved or the overall
responsibilities of the Adviser with respect to the accounts over which it
exercises investment discretion. Accordingly, while the Adviser cannot readily
determine the extent to which commission rates or net prices charged by
broker-dealers reflect the value of their research services, the Adviser would
expect to assess the reasonableness of commissions in light of the total
brokerage and research services provided by each particular broker. The Adviser
may receive research, as defined in Section 28(e), in connection with selling
concessions and designations in fixed price offerings in which the Fund
participates.
INTERNAL ALLOCATION PROCEDURES
The Adviser has a policy of not precommitting a specific amount of business to
any broker or dealer over any specific time period. Brokerage placement is
determined by the needs of a specific transaction such as market-making,
availability of a buyer or seller of a particular security, or specialized
execution skills. However, the Adviser does have an internal brokerage
allocation procedure for that portion of its discretionary client brokerage
business where special needs do not exist, or where the business may be
allocated among several brokers or dealers which are able to meet the needs of
the transaction.
Each year, the Adviser assesses the contribution of the brokerage and research
services provided by brokers or dealers, and attempts to allocate a portion of
its brokerage business in response to these assessments. The investment team
seeks to evaluate the brokerage and research services they receive from brokers
or dealers and make judgments as to the level of business which would recognize
such services. In addition, brokers or dealers sometimes suggest a level of
business they would like to receive in return for the various brokerage and
research services they provide. Actual brokerage received by any firm may be
less than the suggested allocations but can, and often does, exceed the
suggestions, because the total business is allocated on the basis of all the
considerations described above. In no case is a broker or dealer excluded from
receiving business from the Adviser because it has not been identified as
providing research services.
MISCELLANEOUS
The Adviser's brokerage allocation policy is consistently applied to all its
fully discretionary accounts, which represent a substantial majority of all
assets under management. Research services furnished by brokers or dealers
through which the Adviser effects securities transactions may be used in
servicing all accounts (including non-Fund accounts) managed by the Adviser.
Conversely, research services received from brokers or dealers which execute
transactions for the Fund are not necessarily used by the Adviser exclusively in
connection with the management of the Fund. From time to time, orders for
clients may be placed through a computerized transaction network.
The Fund does not allocate business to any broker-dealer on the basis of sales
of the Fund's shares. However, this does not mean that broker-dealers who
purchase Fund shares for their clients will not receive business from the Fund.
Some of the Adviser's other clients have investment objectives and programs
similar to those of
B-24
<PAGE> 27
the Fund. The Adviser may occasionally make recommendations to other clients
which result in their purchasing or selling securities simultaneously with the
Fund. As a result, the demand for securities being purchased or the supply of
securities being sold may increase, and this could have an adverse effect on the
price of those securities. It is the Adviser's policy not to favor one client
over another in making recommendations or in placing orders. The Adviser
frequently follows the practice of grouping orders of various clients for
execution which generally results in lower commission rates being attained. In
certain cases, where the aggregate order is executed in a series of transactions
at various prices on a given day, each participating client's proportionate
share of such order reflects the average price paid or received with respect to
the total order.
At the present time, the Adviser does not recapture commissions or underwriting
discounts or selling group concessions in connection with taxable securities
acquired in underwritten offerings.
TRADE ALLOCATION POLICIES
The Adviser has developed written trade allocation guidelines for its accounts.
Generally, when the amount of securities available in a public offering or the
secondary market is insufficient to satisfy the volume or price requirements for
the participating client portfolios, the guidelines require a pro-rata
allocation based upon the amounts initially requested by each portfolio manager.
In allocating trades made on combined basis, the Adviser seeks to achieve the
same net unit price of the securities for each participating client. Because a
pro-rata allocation may not always adequately accommodate all facts and
circumstances, the guidelines provide for exceptions to allocate trades on an
adjusted, pro-rata basis. Examples of where adjustments may be made include: (1)
reallocations to recognize the efforts of a portfolio manager in negotiating a
transaction or a private placement, (2) reallocations to eliminate de minimis
positions, (3) priority for accounts with specialized investment policies and
objectives and (4) reallocations in light of a participating portfolio's
characteristics (e.g., industry or issuer concentration, duration, and credit
exposure).
PRICING OF SECURITIES
Equity securities listed or regularly traded on a securities exchange are valued
at the last quoted sales price at the time the valuations are made. A security
that is listed or traded on more than one exchange is valued at the quotation on
the exchange determined to be the primary market for such security. Listed
securities not traded on a particular day and securities regularly traded in the
over-the-counter market are valued at the mean of the latest bid and asked
prices. Other equity securities are valued at a price pursuant to procedures
approved by the Board of Trustees, or by persons delegated by the Board, best to
reflect fair value.
Debt securities are generally traded in the over-the-counter market and are
valued at the bid price obtained from an independent pricing service.
Investments in mutual funds are valued at the closing net asset value per share
of the mutual fund on the day of valuation. In the absence of a last sale price,
purchased and written options are valued at the mean of the latest bid and asked
prices, respectively.
For the purposes of determining the Fund's net asset value per share, the U.S.
dollar value of all
B-25
<PAGE> 28
assets and liabilities initially expressed in foreign currencies is determined
by using the prevailing rates provided by an independent pricing source. Assets
and liabilities for which the above valuation procedures are inappropriate or
are deemed not to reflect fair value, are stated at fair value as determined in
good faith by or under the supervision of the officers of the Adviser, as
authorized by the Board of Trustees.
NET ASSET VALUE PER SHARE
The Fund's net asset value per share is determined by subtracting its
liabilities (including accrued expenses and dividends payable) from its total
assets (the market value of the securities the Fund holds plus cash and other
assets, including income accrued but not yet received) and dividing the result
by the total number of shares outstanding. The net asset value per share of the
Fund is normally calculated as of the close of trading (generally 3 p.m. Central
time) on the New York Stock Exchange ("NYSE") every day the NYSE is open for
trading. The NYSE is closed on the following days: New Year's Day, Dr. Martin
Luther King, Jr. Holiday, Presidents' Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, and Christmas Day.
Determination of net asset value (and the offering, redemption and repurchase of
shares) for the Fund may be suspended at times (1) during which the NYSE is
closed, other than customary weekend and holiday closings, (2) during which
trading on the NYSE is restricted, (3) during which an emergency exists as a
result of which disposal by the Fund of securities owned by it is not reasonably
practicable or it is not reasonably practicable for the Fund fairly to determine
the value of its net assets, or (4) during which a governmental body having
jurisdiction over the Fund may by order permit such a suspension for the
protection of the Fund's shareholders; provided that applicable rules and
regulations of the SEC shall govern as to whether the conditions prescribed in
(2), (3), or (4) exist.
TAX STATUS
The Fund intends to qualify as a "regulated investment company" under Subchapter
M of the Internal Revenue Code of 1986, as amended (the "Code"). Qualification
as a regulated investment company essentially allows the Fund (but not its
shareholders) to avoid paying federal income tax on ordinary income and capital
gains which are distributed to shareholders. In addition, it permits net capital
gains (the excess of net long-term capital gains over net short-term capital
losses) of the Fund to be treated as long-term capital gains of the Fund's
shareholders, regardless of how long the shareholders have held their shares.
If the Fund fails to qualify for treatment as a regulated investment company
under the Code, that Fund will not be afforded this special treatment. Rather,
the Fund will be subject to federal income tax on its net income and capital
gains at the applicable corporate income tax rate, regardless of whether
distributions are made to shareholders. In addition, any dividend distributions
to the shareholders will constitute ordinary income which will be subject to
federal income tax at the shareholder level.
As a regulated investment company, the Fund will be required to distribute 98%
of its ordinary income in the same calendar year in which such income is earned.
During the calendar year, the
B-26
<PAGE> 29
Fund is also required to distribute 98% of the capital gain net income they
earned during the twelve-month period ending on October 31 of such calendar
year. In addition, during the calendar year, the Fund must distribute all
undistributed ordinary income from the prior year and all undistributed capital
gain net income from the twelve-month period ending on October 31 of the prior
calendar year. To the extent they do not meet these distribution requirements,
the Fund will be subject to a non-deductible 4% excise tax on the undistributed
amount. For purposes of this excise tax, income on which the Fund pays income
tax is treated as distributed.
At the time of an investor's purchase, the Fund's net asset values may reflect
undistributed income, capital gains, and/or net unrealized appreciation of
securities held by the Fund. A subsequent distribution to an investor of such
amounts, although constituting a return of his or her investment, would be
taxable as a dividend or capital gain distribution. For federal income tax
purposes, dividends and capital gain distributions paid to shareholders in
additional shares are treated the same as if such payments were made in cash. A
portion of the dividends paid by the Fund to corporate shareholders may be
eligible for the 70% dividends-received deduction.
Gains or losses on sales of securities by the Fund will be treated as long-term
capital gains or losses if the securities have been held by it for more than one
year, except in certain cases where the Fund acquires a put or writes a call
thereon or otherwise holds an offsetting position with respect to the
securities. Other gains or losses on the sale of securities will be short-term
capital gains or losses. Gains and losses on the sale, lapse or other
termination of options on securities will be treated as gains and losses from
the sale of securities. If an option written by the Fund on securities lapses or
is terminated through a closing transaction, such as a repurchase by the Fund of
the option from its holder, the Fund will generally realize short-term capital
gain or loss. If securities are sold by the Fund pursuant to the exercise of a
call option written by it, the Fund will include the premium received in the
sale proceeds of the securities delivered in determining the amount of gain or
loss on the sale. Certain of the Fund's transactions may be subject to wash
sale, short sale, constructive sale, anti-conversion and straddle provisions of
the Code which may, among other things, require the Fund to defer recognition of
losses. In addition, debt securities acquired by the Fund may be subject to
original issue discount and market discount rules which, respectively, may cause
the Fund to accrue income in advance of the receipt of cash with respect to
interest or cause gains to be treated as ordinary income.
Special rules apply to most options on stock indices, future contracts and
options thereon, and foreign currency forward contracts in which the Fund may
invest. These investments will generally constitute Section 1256 contracts under
the Code, and will be required to be "marked to market" for federal income tax
purposes at the end of the Fund's taxable year; that is, treated as having been
sold at market value. Except with respect to certain foreign currency forward
contracts, sixty percent of any gain or loss recognized on such deemed sales and
on actual dispositions will be treated as long-term capital gain or loss, and
the remainder will be treated as short-term capital gain or loss.
For federal income tax purposes, the Fund is permitted to carry forward their
net realized capital losses, if any, for eight years and thus may realize net
capital gains up to the amount of such losses without being required to pay
taxes on, or distribute, such gains. However, the Fund
B-27
<PAGE> 30
currently does not have any net realized capital losses, and thus will not be
able to offset any net realized capital gains.
Dividends and capital gain distributions may also be subject to state and/or
local taxes.
FOREIGN CURRENCY GAINS AND LOSSES
Gains or losses attributable to fluctuations in exchange rates which occur
between the time the Fund accrues interest or other receivables or accrues
expenses or other liabilities denominated in a foreign currency and the time the
Fund actually collects such receivables or pays such liabilities are treated as
ordinary income or ordinary loss. Similarly, gains or losses on foreign currency
forward contracts or dispositions of debt securities denominated in a foreign
currency attributable to fluctuations in the value of the foreign currency
between the date of acquisition of the security and the date of disposition also
are treated as ordinary gain or loss. These gains or losses, referred to under
the Code as "Section 988" gains or losses, increase or decrease the amount of
the Fund's investment company taxable income available to be distributed to its
shareholders as ordinary income, rather than increasing or decreasing the amount
of the Fund's net capital gain. If Section 988 losses exceed other investment
company taxable income during a taxable year, (1) the Fund would not be able to
make any ordinary dividend distributions, or (2) distributions made before the
losses were realized would be recharacterized as a return of capital to
shareholders (as opposed to being treated as an ordinary dividend) thereby
reducing each shareholder's basis in his or her Fund shares.
Investors should consult their own tax advisers with respect to the particular
tax consequences to them of an investment in the Fund.
PASSIVE FOREIGN INVESTMENT COMPANIES
The Fund may purchase the securities of certain foreign investment funds or
trusts called passive foreign investment companies ("PFICs"). In addition to
bearing their proportionate share of the Fund's expenses (management fees and
operating expenses), the Fund's shareholders will also indirectly bear similar
expenses of any PFICs in which the Fund invests. Capital gains on the sale of
such holdings are considered ordinary income regardless of how long the Fund
holds the investment. In addition, the Fund may be subject to corporate income
tax and an interest charge on certain dividends and capital gains earned from
these investments, regardless of whether such income and gains are distributed
to the Fund's shareholders.
To avoid such tax and interest, the Fund intends to treat these securities as
sold on the last day of its fiscal year and recognize any gains for federal
income tax purposes at that time. Deductions for losses are allowable only to
the extent of any gains resulting from these deemed sales for prior taxable
years. Such gains and losses will be treated as ordinary income. The Fund will
be required to distribute any resulting income even though it has not actually
sold the security and received cash to pay such distributions.
Income received by the Fund from sources within foreign countries may be subject
to withholding and other taxes imposed by such countries. Income tax treaties
between certain countries and the
B-28
<PAGE> 31
United States may reduce or eliminate such taxes. However, it is impossible to
determine in advance the effective rate of foreign tax to which the Fund will be
subject, since the amount of the Fund's assets to be invested in various
countries will vary.
INVESTMENT PERFORMANCE
ZERO GRAVITY
Steve Harmon, a member of the investment team of the Adviser, uses the term
"Zero Gravity" to describe the Internet. According to Mr. Harmon, "heavy gravity
businesses" are held to earth with buildings, delivery vehicles and paperwork.
He defines "Zero Gravity" as "the ability to operate in a purely digital
environment...[where] information, entertainment, communications all flow...as
easily in one direction as another, similar to the way in which an astronaut can
move in all directions in a weightless environment."
TOTAL RETURN PERFORMANCE
The Fund's calculation of total return performance includes the reinvestment of
all capital gain distributions and income dividends for the period or periods
indicated, without regard to tax consequences to a shareholder in the Fund.
Total return is calculated as the percentage change between the beginning value
of a static account in the Fund and the ending value of that account measured by
the then current net asset value, including all shares acquired through
reinvestment of income and capital gain dividends.
OUTSIDE SOURCES OF INFORMATION
From time to time, in reports and promotional literature: (1) the Fund's total
return performance, ranking, or any other measure of the Fund's performance may
be compared to any one or combination of the following: (a) a broad-based index;
(b) other groups of mutual funds, tracked by independent research firms ranking
entities, or financial publications; (c) indices of securities comparable to
those in which the Fund invests; (2) the Consumer Price Index (or any other
measure for inflation, government statistics, such as GNP may be used to
illustrate investment attributes of the Fund or the general economic, business,
investment, or financial environment in which the Fund operates; (3) various
financial, economic and market statistics developed by brokers, dealers and
other persons may be used to illustrate aspects of the Fund's performance; (4)
the effect of tax-deferred compounding on the Fund's investment returns, or on
returns in general in both qualified and nonqualified retirement plans or any
other tax advantage product, may be illustrated by graphs, charts, etc.; and (5)
the sectors or industries in which the Fund invests may be compared to relevant
indices or surveys in order to evaluate the Fund's historical performance or
current or potential value with respect to the particular industry or sector.
OTHER PUBLICATIONS
From time to time, in newsletters and other publications issued by Zero Gravity
Internet Group, Inc. our mutual fund investment team or analysts may discuss
economic, financial and political developments in the U.S. and abroad and how
these conditions have affected or may affect
B-29
<PAGE> 32
securities prices or the Fund; individual securities within the Fund's
portfolio; and their philosophy regarding the selection of individual stocks,
including why specific stocks have been added, removed or excluded from the
Fund's portfolio.
SHARES
The Trust was organized as an unincorporated business trust in 1999 under the
laws of Delaware. The Trust is authorized to issue an unlimited number of shares
of beneficial interest, $.01 par value per share, divided into two series (the
Funds).
Zero Gravity Internet Fund is divided into three classes, designated Class A,
Class B and Class C shares. Only Class A shares are currently offered. Each
class of shares represents an interest in the same assets of the Fund and is
identical in all respects except that (1) each class is subject to different
sales charges and distribution and/or service fees which will affect
performance, (2) each class has exclusive voting rights on any matter submitted
to shareholders that relates solely to its arrangement and has separate voting
rights on any matter submitted to shareholders in which the interests of one
class differ from the interests of any other class, (3) and only Class B shares
have a conversion feature.
In accordance with the Trust's Declaration of Trust, the Trustees may authorize
the creation of additional series and classes within such series, with such
preferences, privileges, limitations and voting and dividend rights as the
Trustees may determine. The voting rights of the shareholders of a series or
class can be modified only by the vote of shareholders of that series or class.
Shares of the Trust, when issued, are fully paid, nonassessable, fully
transferable and redeemable at the option of the holder. Shares are also
redeemable at the option of the Trust under certain circumstances. Each share of
each class is equal as to earnings, assets and voting privileges, except as
noted above, and each class of shares bears the expenses related to the
distribution of its shares. Except for the conversion feature applicable to the
Class B shares, there are no conversion, preemptive or other subscription
rights. In the event of liquidation, each share of the Fund is entitled to its
portion of all of the Fund's assets after all debt and expenses of the Fund have
been paid.
The Trust does not intend to hold annual meetings of shareholders unless
otherwise required by law. The Trust will not be required to hold meetings of
shareholders unless, for example, the election of Trustees is required to be
acted on by shareholders under the 1940 Act. Shareholders have certain rights,
including the right to call a meeting upon the vote of 10% of the Trust's
outstanding shares for the purpose of voting on the removal of one or more
Trustees or to transact any other business. Under the Declaration of Trust, the
Trustees may authorize the creation of additional series of shares (the proceeds
of which would be invested in separate, independently managed portfolios with
distinct investment objectives and policies and share purchase, redemption and
net asset value procedures) with such preferences, privileges, limitations and
voting and dividend rights as the Trustees may determine. All consideration
received by the Trust for shares of any additional series, and all assets in
which such consideration is invested, would belong to that series (subject only
to the rights of creditors of that series) and would be subject to the
liabilities related thereto. Under the 1940 Act, shareholders of any additional
series of shares would normally have to approve the adoption of any advisory
contract
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<PAGE> 33
relating to such series and of certain changes in the investment policies
related thereto. The Trustees have the power to alter the number and the terms
of office of the Trustees, provided that always at least a majority of the
Trustees have been elected by the shareholders of the Trust. The voting rights
of shareholders are not cumulative, so that holders of more than 50 percent of
the shares voting can, if they choose, elect all Trustees being selected, while
the holders of the remaining shares would be unable to elect any Trustees.
LEGAL COUNSEL
Gardner, Carton & Douglas, whose address is 321 North Clark Street, Suite 3300,
Chicago, Illinois 60610 is legal counsel to the Trust.
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP, 333 Market Street, San Francisco, California 94105
are the independent accountants to the Trust.
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<PAGE> 34
FINANCIAL STATEMENTS
E-HARMON INTERNET FUND
Statement of Assets and Liabilities
APRIL 18, 2000
Assets
<TABLE>
<CAPTION>
INTERNET FUND
-------------
<S> <C>
Cash $100,000
Receivable from Adviser 84,042
Prepaid initial registration expenses (Note 2) 22,310
------
TOTAL ASSETS 206,352
-------
LIABILITIES AND NET ASSETS
Payable to Adviser 106,352
-------
TOTAL LIABILITIES 106,352
-------
Net Assets
Applicable to 10,000 shares of beneficial interest (par value $0.01) $100,000
=======
CALCULATION OF OFFERING PRICE:
Class A: Net asset value and redemption price per Class A share
($100,000/10,000 shares of beneficial interest
issued and outstanding)1 $10.00
=====
Maximum sales charge (% of offering price) 5.75%
=====
Offering price to public $10.61
=====
</TABLE>
(1) A redemption fee of 1.00% is imposed for shares held less than six months.
The accompanying Notes to the Financial Statements are an integral part of this
statement.
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<PAGE> 35
E-HARMON INTERNET FUND
Statement of Operations
FOR THE PERIOD FROM DECEMBER 22, 1999 (INCEPTION) TO APRIL 18, 2000
<TABLE>
<CAPTION>
INTERNET FUND
-------------
<S> <C>
Organization expenses $ 84,042
Less: Expenses paid by Adviser (84,042)
-------
NET INVESTMENT INCOME $ -
=======
</TABLE>
The accompanying Notes to the Financial Statements are an integral part of this
statement.
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E-HARMON INTERNET FUND
NOTES TO THE FINANCIAL STATEMENTS
FOR THE PERIOD FROM DECEMBER 22, 1999 (INCEPTION) TO APRIL 18, 2000
Note 1 - Organization and Registration
e-harmon Funds (the "Trust") was established on December 22, 1999 as a Delaware
business trust and is registered under the Investment Company Act of 1940, as
amended (the "1940 Act"), as an open-end management investment company. The
Trust currently consists of two series: e-harmon Internet Fund and e-harmon
Net30 Index Fund. The e-harmon Internet Fund (the "Fund"), included in this
report, is a separate, non-diversified investment portfolio of the Trust. The
Fund has had no operations other than those relating to organizational matters,
including the sale of 10,000 Class A shares of beneficial interest of the Fund
to capitalize the Trust ("Original Shares"), which were sold to e-harmon Capital
Management LLC on April 18, 2000, for cash in the amount of $100,000. As of
April 18, 2000, e-harmon Net30 Index Fund had no assets.
Note 2 - Significant Accounting Policies
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. These
policies are in conformity with accounting principles generally accepted in the
United States ("GAAP").
A. USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported changes in net assets during
the reporting period. Actual results could differ from those estimates.
B. ORGANIZATION AND PREPAID INITIAL REGISTRATION EXPENSES
Expenses incurred by the Trust in connection with the organization and
the initial public offering of shares are expensed as incurred. These expenses
were advanced by the Adviser, and the Adviser has agreed to voluntarily
reimburse the Fund for these expenses, subject to potential recovery (see Note
3). Prepaid initial registration expenses are deferred and amortized over the
period of benefit (not to exceed twelve months).
C. FEDERAL INCOME TAXES
The Fund intends to qualify annually for treatment as a "regulated
investment company" under Subchapter M of the Internal Revenue Code of 1986, as
amended, and, if so qualified, will not be liable for federal income taxes to
the extent earnings are distributed to shareholders on a timely basis.
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Note 3 - Agreements and Transactions with Affiliates
e-harmon Capital Management LLC (the "Adviser") serves as the Fund's investment
adviser. As compensation for its services to the Fund, the Adviser will receive,
upon commencement of operations an investment advisory fee at an annual rate of
1.25% of the average daily net assets of the Fund, which is accrued daily and
paid monthly. The Adviser has also agreed to voluntarily pay Fund expenses
(exclusive of brokerage, interest, taxes and extraordinary expenses) that exceed
2.00% of average daily net assets of the Fund's Class A shares and 2.75% of the
Fund's Class B and C shares until May 16, 2001. The Adviser is entitled to
recoup amounts waived or reimbursed for a period of up to three years after the
date such amounts were reimbursed or waived, to the extent that actual fees and
expenses for a period are less than the expense limitation.
The officers and the "interested" trustees of the Trust are also officers and
directors of the Adviser.
The Trust has entered into an administration and fund accounting agreement and
transfer agent agreement with Sunstone Financial Group, Inc. The administrative
services agreement provides for an annual fee of 0.15%, which decreases as the
assets of the Fund reach certain levels, subject to a minimum annual fee of
$70,000, plus out-of-pocket expenses. The transfer agent agreement provides for
an annual base fee per shareholder account, with a minimum annual fee of
$18,000. The transfer agent is also paid certain fees related to set-up costs,
processing and out-of-pocket expenses.
The Trust has entered into a distribution agreement with Sunstone Distribution
Services, LLC (the "Distributor"). Under the Distribution Agreement, the
Distributor shall offer shares of the Fund on a continuous basis and may engage
in advertising and solicitation activities in connection therewith.
Note 4 - Service and Distribution Plan
The Fund has adopted a Service and Distribution Plan for Class A shares (the
"Plan") pursuant to Rule 12b-1 under the 1940 Act. The Plan authorizes payments
by the Fund in connection with the distribution of its shares at an annual rate,
as determined from time to time by the Board of Trustees, of up to 0.25% of
average daily net assets for Class A shares.
Note 5 - Beneficial Interests
The Trust is authorized to issue an unlimited number of shares of beneficial
interest in the Trust with a par value of $0.01 per share. The Fund has three
separate classes: Class A, Class B, and Class C. Each class of shares has a
different combination of sales charges, fees and eligibility requirements. As of
April 18, 2000, Class A shares are the only class of shares outstanding.
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REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Trustees
of e-harmon Funds
In our opinion, the accompanying statements of assets and liabilities and of
operations present fairly, in all material respects, the financial position of
the e-harmon Internet Fund (a portfolio of e-harmon Funds, hereinafter referred
to as the "Fund") at April 18, 2000 and the results of its operations for the
period from December 22, 1999 (inception) through April 18, 2000, in conformity
with accounting principles generally accepted in the United States. These
financial statements are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audit. We conducted our audit of these financial statements in accordance
with auditing standards generally accepted in the United States which require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for the opinion expressed above.
PricewaterhouseCoopers LLP
April 18, 2000
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