<PAGE> 1
FRANK RUSSELL INVESTMENT COMPANY
Supplement Dated August 11, 1995
to Statement of Additional Information
(Dated April 1, 1995 as revised April 28, 1995)
Effective August 11, 1995, Frank Russell Investment Company makes the changes
set forth below to its Statement of Additional Information.
The Trustee Compensation table under the Section captioned "Trustees and
Officers" is amended to read as follows:
TRUSTEE COMPENSATION TABLE
<TABLE>
<CAPTION>
Pension or
Retirement
Aggregate Benefits Accrued Total
Compensation as Part of Compensation
from Investment Estimated Annual From Investment
Investment Company Benefits Upon Company Paid to
Trustee Company Expenses Retirement Trustees
------- ------------ ---------------- ---------------- ---------------
<S> <C> <C> <C> <C>
Lynn L. Anderson $0 $0 $0 $0
Paul E. Anderson $20,000 $0 $0 $20,000
Paul Anton, PhD. $20,000 $0 $0 $20,000
William E. Baxter $20,000 $0 $0 $20,000
Lee C. Gingrich $20,000 $0 $0 $20,000
Eleanor W. Palmer $20,000 $0 $0 $20,000
George F. Russell $0 $0 $0 $0
</TABLE>
The Section captioned "Transfer and Dividend Disbursing" is amended to read
as follows:
Transfer and Dividend Disbursing. Management Company serves as Transfer Agent
for the Investment Company. For this service, Management Company is paid a fee
of $20.00 per shareholder transaction. Management Company is also reimbursed by
the Investment Company for certain out-of-pocket expenses including postage,
taxes, wires, stationery, and telephone.
<PAGE> 2
FRANK RUSSELL INVESTMENT COMPANY
Supplement Dated April 28, 1995
to Statement of Additional Information
Effective April 28, 1995, Frank Russell Investment Company makes the changes
set forth below to its Statement of Additional Information.
The Section Captioned "Investment Restrictions, Policies and Certain
Investments -- Investment Policies -- Liquidity Portfolios" is amended to read
as follows:
Liquidity Portfolios. A Fund at times has to sell portfolio
securities in order to meet redemption requests. The selling of
securities may effect a Fund's performance since the Money Manager
sells the securities for other than investment reasons. A Fund can
avoid selling its portfolio securities by holding adequate levels of
cash to meet anticipated redemption requests.
The holding of significant amounts of cash is contrary to the
investment objectives of the Equity I, Equity II, Equity III, Equity
Q, International, Diversified Equity, Special Growth, Equity Income,
Quantitative Equity and International Securities Funds. The more cash
these Funds hold, the more difficult it is for their returns to meet
or surpass their respective benchmarks.
A Liquidity Portfolio addresses this potential detriment by
having Management Company or a Money Manager selected for this purpose
create an equity exposure for cash reserves through the use of options
and futures contracts. This will enable the Funds to hold cash while
receiving a return on the cash which is similar to holding equity
securities.
The Section captioned "Investment Restrictions, Policies, and Certain
Investments -- Certain Investments -- Future Contracts and Option on Future
Contracts" is amended to read as follows:
Futures Contracts and Options on Futures Contracts. A Fund
may use interest rate, foreign currency or index futures contracts, as
specified for that Fund in its Prospectus. An interest rate, foreign
currency or index futures contract provides for the future sale by one
party and purchase by another party of a specified quantity of a
financial instrument, foreign currency or the cash value of an index
at a specified price and time. A futures contract on an index is an
agreement pursuant to which two parties agree to take or make delivery
of an amount of cash equal to the difference between the value of the
index at the close of the last trading day of the contract and the
price at which the index contract was originally written. Although the
value of an index may be a function of the value of certain specified
securities, no physical delivery of these securities is made. A public
market exists in futures contracts covering several indexes as well as
a number of financial instruments and foreign currencies. For example:
<PAGE> 3
the S&P 500; the Russell 2000(R); Nikkei 225; CAC-40; FT-SE 100; the
NYSE composite; US Treasury bonds; US Treasury notes; GNMA
Certificates; three-month US Treasury bills; Eurodollar certificates
of deposit; the Australian Dollar; the Canadian Dollar; the British
Pound; the German Mark; the Japanese Yen; the French Franc; the Swiss
Franc; the Mexican Peso; and certain multinational currencies, such as
the European Currency Unit ("ECU"). It is expected that other futures
contracts will be developed and traded in the future.
A Fund may purchase and write call and put options on futures
contracts. Options on futures contracts possess many of the same
characteristics as options on securities and indexes (discussed
above). A futures option gives the holder the right, in return for the
premium paid to assume a long position (call) or short position (put)
in a futures contract at a specified exercise price at any time during
the period of the option. Upon exercise of a call option, the holder
acquires a long position in the futures contract and the writer is
assigned the opposite short position. In the case of a put option, the
opposite is true.
As long as required by regulatory authorities, each Fund will
limit its use of futures contracts and options on futures contracts to
hedging transactions. For example, a Fund might use futures contracts
to hedge against anticipated changes in interest rates that might
adversely affect either the value of the Fund's securities or the
price of the securities which the Fund intends to purchase.
Additionally, a Fund may use futures contracts to create equity
exposure for its cash reserves for liquidity purposes.
A Fund will only enter into futures contracts and options on
futures contracts which are standardized and traded on a US or foreign
exchange, board of trade, or similar entity, or quoted on an automated
quotation system.
When a purchase or sale of a futures contract is made by a
Fund, the Fund is required to deposit with its custodian (or broker,
if legally permitted) a specified amount of cash or US Government
securities ("initial margin"). The margin required for a futures
contract is set by the exchange on which the contract is traded
and may be modified during the term of the contract. The initial
margin is in the nature of a performance bond or good faith deposit on
the futures contract which is returned to the Fund upon termination of
the contract, assuming all contractual obligations have been
satisfied. Each Fund expects to earn interest income on its initial
margin deposits. A futures contract held by a Fund is valued daily at
the official settlement price of the exchange on which it is traded.
Each day the Fund pays or receives cash, called "variation margin,"
equal to the daily change in value of the futures contract. This
process is known as "marking to market." Variation margin does not
represent a borrowing or loan by a Fund but is instead a settlement
between the Fund and the broker of the amount one would owe the other
if the futures contract expired. In computing daily net asset value,
each Fund will mark-to-market its open futures positions.
2
<PAGE> 4
A Fund is also required to deposit and maintain margin with
respect to put and call options on futures contracts written by it.
Such margin deposits will vary depending on the nature of the
underlying futures contract (and the related initial margin
requirements), the current market value of the option, and other
futures positions held by the Fund.
Although some futures contracts call for making or taking
delivery of the underlying securities, generally these obligations are
closed out prior to delivery by offsetting purchases or sales of
matching futures contracts (same exchange, underlying security or
index, and delivery month). If an offsetting purchase price is less
than the original sale price, the Fund realizes a capital gain, or if
it is more, the Fund realizes a capital loss. Conversely, if an
offsetting sale price is more than the original purchase price, the
Fund realizes a capital gain, or if it is less, the Fund realizes a
capital loss. The transaction costs must also be included in these
calculations.
The section captioned "Investment Restrictions, Policies, and Certain
Investments -- Certain Investment -- Hedging Strategies" is amended to read as
follows:
Hedging strategies. Stock index futures contracts may be
used by the Equity I, Equity II, Equity III, Equity Q, International,
Emerging Markets, Diversified Equity, Special Growth, Equity Income,
Quantitative Equity and International Securities Funds as a hedge for
cash reserves held by the Funds. For example: equity index futures
contracts are purchased to correspond with the cash reserves in each
of the Funds. As a result, a Fund's cash reserves will realize gains
or losses based on the performance of the equity market corresponding
to the relevant indices for which futures contracts have been
purchased. Thus, each Fund's cash reserves always will be fully
exposed to equity market performance.
Financial futures contracts may be used by the International,
Emerging Markets, Fixed Income I, Fixed Income II, International
Securities, Diversified Bond, Volatility Constrained Bond, and Limited
Volatility Tax Free Funds as a hedge during or in anticipation of
interest rate changes. For example: If interest rates were anticipated
to rise, financial futures contracts would be sold (short hedge) which
would have an effect similar to selling bonds. Once interest rates
increase, fixed income securities held in the Fund's portfolio would
decline, but the futures contract value would decrease, partly
offsetting the loss in value of the fixed income security by enabling
the Fund to repurchase the futures contract at a lower price to close
out the position.
The Funds may purchase a put and/or sell a call option on a
stock index futures contract instead of selling a futures contract in
anticipation of market decline. Purchasing a call and/or selling a put
option on a stock index futures contract is used instead of buying a
futures contract in anticipation of a market advance, or to
temporarily create an equity exposure for cash balances until those
balances are invested in equities. Options on financial futures are
used in a similar
3
<PAGE> 5
manner in order to hedge portfolio securities against anticipated
changes in interest rates.
When purchasing a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) cash, US
government securities, or other highly liquid debt securities that,
when added to the amounts deposited with a futures commission merchant
as margin, are equal to the market value of the futures contract.
Alternatively, the Fund may "cover" its position by purchasing a put
option on the same futures contract with a strike price as high or
higher than the price of the contract held by the Fund.
The section captioned "Investment Restrictions, Policies and Certain
Investments -- Certain Investments -- Foreign Currency Futures Contracts" is
amended to read as follows:
Foreign Currency Futures Contracts. The Funds are also
permitted to enter into foreign currency futures contracts in
accordance with their investment objectives and as limited by the
procedures outlined above.
A foreign currency futures contract is a bilateral agreement
pursuant to which one party agrees to make, and the other party agrees
to accept delivery of a specified type of debt security or currency at
a specified price. Although such futures contracts by their terms call
for actual delivery or acceptance of debt securities or currency, in
most cases the contracts are closed out before the settlement date
without the making or taking of delivery.
The Fund may sell a foreign currency futures contract to hedge
against possible variations in the exchange rate of the foreign
currency in relation to the US dollar. When a manager anticipates a
significant change in a foreign exchange rate while intending to
invest in a foreign security, the Fund may purchase a foreign currency
futures contract to hedge against a rise in foreign exchange rates
pending completion of the anticipated transaction. Such a purchase
would serve as a temporary measure to protect the Fund against any
rise in the foreign exchange rate which may add additional costs to
acquiring the foreign security position. The Fund may also purchase
call or put options on foreign currency futures contracts to obtain a
fixed foreign exchange rate. The Fund may purchase a call option or
write a put option on a foreign exchange futures contract to hedge
against a decline in the foreign exchange rates or the value of its
foreign securities. The Fund may write a call option on a foreign
currency futures contract as a partial hedge against the effects of
declining foreign exchange rates on the value of foreign securities.
4
<PAGE> 6
FRANK RUSSELL INVESTMENT COMPANY
909 A Street
Tacoma, Washington 98402
Telephone (800) 972-0700
In Washington (206) 627-7001
STATEMENT OF ADDITIONAL INFORMATION
April 1, 1995
Frank Russell Investment Company is a single legal entity organized as a
"Massachusetts business trust." Investment Company operates and except for the
Money Market Fund, offers shares of beneficial interest in offered investment
portfolios referred to as "Funds" which are divided into two groupings and are
described in separate Prospectuses dated April 1, 1995:
Ten External Fee Funds which had aggregate net assets of
$3,038,867,438 on March 22, 1995. The Funds except Equity II, Equity
III, Equity Q, International, Emerging Markets and Fixed Income III
began operations in October, 1981. Equity II, Equity III, Equity Q
and International Funds began operation in December 1981, November
1981, January 1983 and May 1987, respectively. Emerging Markets and
Fixed Income III began operations in January, 1993. These ten Funds
are:
<TABLE>
<S> <C>
Equity I Emerging Markets
Equity II Fixed Income I
Equity III Fixed Income II
Equity Q Fixed Income III
International Money Market
</TABLE>
Twelve Internal Fee Funds which had aggregate net assets of
$3,259,529,994 on March 22, 1995. The Funds, except Quantitative
Equity, Tax Free Money Market, Real Estate Securities and
Multistrategy Bond, began operations in September, 1985. Quantitative
Equity and Tax Free Money Market Funds began operations in May, 1987.
Real Estate Securities Fund began operation in July, 1989.
Multistrategy Bond Fund began operation in January, 1993. These
twelve Funds are:
<TABLE>
<S> <C>
Diversified Equity Diversified Bond
Special Growth Volatility Constrained Bond
Equity Income Multistrategy Bond
Quantitative Equity Limited Volatility Tax Free
International Securities U.S. Government Money Market
Real Estate Securities Tax Free Money Market
</TABLE>
1
<PAGE> 7
(cover page continued............)
The principal distinction between the External Fee Funds and the Internal Fee
Funds is: Each Shareholder of External Fee Funds pays a quarterly individual
shareholder investment services fee directly to Management Company based upon
the amount the shareholder has invested in the Funds. Each Shareholder of
Internal Fee Funds pays no such fees. In each case, Management Company may
charge fees to a shareholder for non-investment services provided directly to
that shareholder.
This Statement of Additional Information supplements or describes in greater
detail information concerning Investment Company and the Funds contained in the
Prospectuses of the Funds dated April 1, 1995. This Statement is not a
Prospectus; the Statement should be read in conjunction with the Funds'
Prospectuses. Prospectuses may be obtained without charge by telephoning or
writing the Investment Company at the number or address shown above.
This Statement incorporates by reference the Investment Company's Annual
Reports to Shareholders for the year ended December 31, 1994. Copies of the
Funds' Annual Reports accompany this Statement.
2
<PAGE> 8
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
4 STRUCTURE AND GOVERNANCE
4 Organization and Business History
4 Shareholder Meetings
4 Controlling Shareholders
7 Trustees and Officers
9 OPERATION OF INVESTMENT COMPANY
9 Service Providers
10 Consultant
11 Manager
13 Money Managers
13 Distributor
13 Custodian
13 Transfer and Dividend Disbursing
14 Fund Expenses
14 Valuation of Fund Shares
15 Portfolio Transaction Policies
15 Portfolio Turnover Rate
16 Brokerage Allocations
17 Brokerage Commissions
24 Yield and Total Return Quotations
25 INVESTMENT RESTRICTIONS, POLICIES AND CERTAIN INVESTMENTS
26 Investment Restrictions
29 Investment Policies
30 Certain Investments
51 TAXES
56 RATINGS OF DEBT INSTRUMENTS
65 FINANCIAL STATEMENTS
</TABLE>
3
<PAGE> 9
STRUCTURE AND GOVERNANCE
Organization and Business History. Investment Company commenced business
operations as a Maryland Corporation in October 1981 and on January 2, 1985 was
"reorganized" as a Massachusetts business trust.
Investment Company is currently organized and operates under an amended Master
Trust Agreement dated July 26, 1984 and the provisions of Massachusetts law
governing the operation of "Massachusetts business trusts." The Board of
Trustees may amend the Master Trust Agreement from time to time; provided,
however, that any amendment which would materially and adversely affect
shareholders of the Investment Company as a whole, or shareholders of a
particular Fund, must be approved by the holders of a majority of the shares of
the Investment Company or Fund, respectively.
Investment Company is authorized to issue shares of beneficial interest, but
may divide the shares into two or more series, each of which evidences a pro
rata ownership interest in a different investment portfolio--a "Fund." The
Trustees may, without seeking shareholder approval, create additional Funds at
any time.
Under certain unlikely circumstances, as is the case with any Massachusetts
business trust, a shareholder of a Fund may be held personally liable for the
obligations of the Fund. The Master Trust Agreement provides that shareholders
shall not be subject to any personal liability for the acts or obligations of a
Fund and that every written agreement, obligation or other undertaking of the
Funds shall contain a provision to the effect that the shareholders are not
personally liable thereunder. The amended Master Trust Agreement also provides
that the Fund shall, upon request, assume the defense of any claim made against
any shareholder for any act or obligation of the Fund and satisfy any judgment
thereon. Thus, the risk of any shareholder incurring financial loss beyond his
investment on account of shareholder liability is limited to circumstances in
which the Fund itself would be unable to meet its obligations.
Shareholder Meetings. The Investment Company will not have an annual meeting
of shareholders, but special meetings may be held. Special meetings may be
convened by (i) the Board of Trustees, (ii) upon written request to the Board
by shareholders holding at least 10% of the outstanding shares, or (iii) upon
the Board's failure to honor the shareholders' request described above, by
shareholders holding at least 10% of the outstanding shares by giving notice of
the special meeting to shareholders.
Controlling Shareholders. The Trustees have the authority and responsibility
to manage the business of Investment Company, and hold office for life unless
they resign or are removed by, in substance, a vote of two-thirds of the
Investment Company shares outstanding. Under these circumstances, no one
person, entity or shareholder "controls" Investment Company.
The following shareholders owned 5% or more of the voting shares of Investment
Company or of the Funds at March 22, 1995:
4
<PAGE> 10
Frank Russell Investment Company: U.S. National Bank of Oregon, 111 S.W. Fifth
Avenue, Portland, OR 97208, 10.53%, record; Second National Bank (Saginaw),
101 North Washington Avenue, Saginaw, MI 48607, 10.46%, record; Ronald Blue &
Co., 1100 Johnson Ferry Road N.E., Atlanta, GA 30342, 9.54%, record;
FMB-Financial Group, N.A., One Financial Plaza, Holland, MI 49423 7.05%, record.
Equity I: U.S. National Bank of Oregon, 39.68%, record; First Fidelity, 123
Broad Street, Philadelphia, PA 19109, 10.75%, record; Ronald Blue & Co., 8.43%,
record; Reber/Russell Company, 1225 Seventeenth Street, Denver, CO 80202-5820
6.38%, record.
Equity II: U.S. National Bank of Oregon, 18.89%, record; Ronald Blue & Co.,
14.54%, record; National City Bank of Minneapolis, 75 South Fifth Street,
Minneapolis, MN 55402, 9.97%, record; First Fidelity, 8.70%, record;
Reber/Russell Company, 7.88%, record.
Equity III: U.S. National Bank of Oregon, 24.23%, record; National City Bank
of Minneapolis, 11.54%, record; Firstar Bank Sheboygan, N.A., 605 North Eighth
Street, Sheboygan, WI 53081, 11.25%, record; First Fidelity, 10.20%, record;
Reber/Russell Company, 6.87%, record; Ingram/Russell, 1570 Madruga Avenue, 4th
Floor, Coral Gables, FL 33146, 5.21%, record.
Equity Q: U.S. National Bank of Oregon, 48.67%, record; Ronald Blue & Co.,
10.67%, record; First Fidelity, 10.14%, record; National City Bank of
Minneapolis, 6.02%, record.
International: U.S. National Bank of Oregon, 49.89%, record; Ronald Blue &
Co., 7.86%, record; National City Bank of Minneapolis, 5.39%, record.
Emerging Markets: U.S. National Bank of Oregon, 29.75%, record; Ronald Blue &
Co., 11.08%, record; National City Bank of Minneapolis, 5.45%, record; Sun
Alliance Superannuation Investments Limited, P. O. Box 894, Wellington, New
Zealand 5.11%, record.
Fixed Income I: U.S. National Bank of Oregon, 25.97% record; First Fidelity,
22.41%, record; Ronald Blue & Co., 8.55%, record; Reber/Russell Company, 6.37%,
record; National City Bank of Minneapolis, 5.45%, record.
Fixed Income II: Ronald Blue & Co., 20.42%, record; U.S. National Bank of
Oregon, 19.75%, record; Reber/Russell Company, 13.77%, record; Boys Republic,
3493 Grand Avenue, Chino, CA 91709, 11.41%, record; National City Bank of
Minneapolis, 10.56%, record; First Fidelity, 9.81%, record; Anchor/Russell, One
Post Office Square, 38th Floor, Boston, MA 02109, 8.74%, record.
5
<PAGE> 11
Fixed Income III Fund: U.S. National Bank of Oregon, 46.60%, record; Ronald
Blue & Co., 19.67%, record; Anchor/Russell, 7.34%, record.
Money Market: Reber/Russell Company 31.01%, record; Ingram/Russell, 10.75%,
record; Frank Russell Company, 909 A Street, Tacoma, WA 98402, 10.71%, record;
Lawton/Russell, 135 South LaSalle Street, Chicago, IL 60603, 7.35%, record;
Miller/Russell, 2929 E. Camelback Road, Phoenix, AZ 85016, 6.64%, record;
Ronald Blue & Co., 6.64%, record.
Diversified Equity: FMB-Financial Group, N.A., 6.76%, record; Ronald Blue &
Co., 5.31%, record; Hawaiian Trust Company, 130 Merchant Street, 2nd Floor
Tower, Honolulu, HI 96802-3170, 5.11%; First Trust, N.A., 601 Second Avenue
South, Minneapolis, MN 55402-4302, 5.04%, record.
Special Growth: FMB-Financial Group, N.A., 10.13%, record; Ronald Blue & Co.,
5.48% record; Hawaiian Trust Company, 5.36%, record.
Equity Income: FMB-Financial Group, N.A., 9.94%, record; Second National Bank
(Saginaw), 8.04%, record; Hawaiian Trust Company, 6.47%, record; First Trust,
N.A., 6.26%, record.
Quantitative Equity: FMB-Financial Group, N.A., 11.26%, record; Ronald Blue &
Co., 5.93%, record.
International Securities: FMB-Financial Group, N.A., 6.61%, record; Ronald
Blue & Co., 5.66%, record; First Tennessee, Plaza Tower, 5th Floor, 800 S. Gay
Street, Knoxville, TN 37995-1230, 5.30%, record.
Real Estate Securities: U.S. National Bank of Oregon, 22.61%, record; Ronald
Blue & Co., 15.77%, record; FMB-Financial Group, N.A., 6.30%, record.
Diversified Bond: National City Bank of Minneapolis, 16.52%, record; Second
National Bank (Saginaw), 8.82%, record; FMB-Financial Group, N.A., 7.45%,
record; Hawaiian Trust Company, 6.83%, record; Society Bank, Michigan, 100
South Main Street, Ann Arbor, MI 48104, 5.16%, record.
Volatility Constrained Bond: First Tennessee Bank, 7.04%, record; Ronald Blue &
Co., 7.03%, record; First Trust N.A., 6.30%, record.
Multistrategy Bond: Ronald Blue & Co., 11.20%, record; Halbert,
Hargrove/Russell, 111 West Long Beach, CA 90801, 8.92%, record; National Bank
of Alaska, 301 West Northern Lights Blvd, Anchorage, AK 99503, 8.53%, record;
CP&S/Russell, 1508 Elizabeth Avenue, Charlotte, NC 28204, 6.90%, record; Empire
National Bank, 1227 East Front Street, Traverse City, MI 49684, 6.55%, record;
Anchor/Russell, 5.87%, record; Indiana Trust & Investment Management Company,
3930 Edison Lakes Parkway, Mishawaka, IN 46545, 5.51%, record.
6
<PAGE> 12
Limited Volatility Tax Free: Ronald Blue & Co., 20.60%, record; Halbert,
Hargrove/Russell, Inc., 13.37%, record; U.S. National Bank of Oregon, 9.67%,
record; Branson, Fowlkes/Russell, 2603 Augusta, Houston, TX 77057-5638, 8.53%,
record; First Trust N.A., 7.85%, record; Zions First National Bank, Trust
Dept., 3rd Floor, One South Main Street, Salt Lake City, UT 84111-0880, 7.58%,
record; EFR/Russell, 17 W. 662 Butterfield Road, Suite 200, Oakbrook Terrace,
IL 60181, 6.14%, record.
U.S. Government Money Market: Ronald Blue & Co., 16.98%, record; FMB-Financial
Group, N.A., 13.29%, record; Second National Bank (Saginaw), 8.29%, record;
Tri-AD/Russell, 221 West Crest Street, Escondido, CA 92025, 6.72%, record.
Tax Free Money Market: Second National Bank (Saginaw), 43.54%, record;
FMB-Financial Group, N.A., 15.67%, record; Empire National Bank, 10.71%,
record; Branson, Fowlkes/Russell, 5.87%, record.
Trustees and Officers. The Board of Trustees is responsible for overseeing
generally the operation of the Funds. The officers, all of whom are employed
by and are officers of Frank Russell Investment Management Company or its
affiliates, are responsible for the day-to-day management and administration of
the Funds' operations.
Investment Company paid $79,973 for the year ended December 31, 1994 to the
Trustees as a group who are not officers or employees of Management Company or
its affiliates. Trustees are paid an annual fee plus travel and other expenses
incurred in attending Board meetings. The Funds' officers and employees are
paid by Frank Russell Investment Management Company or its affiliates.
The following lists the Trustees and officers and their positions with the
Investment Company, their present and principal occupations during the past
five years, and the mailing addresses of Trustees who are not affiliated with
Investment Company. The mailing address for all Trustees and officers
affiliated with Investment Company is Frank Russell Investment Company, 909 A
Street, Tacoma, WA 98402.
An asterisk (*) indicates that the Trustee or officer is an "interested person"
of the Investment Company as defined in the Investment Company Act of l940. As
used in the table, "Frank Russell Company" includes its corporate predecessor,
Frank Russell Co., Inc.
*George F. Russell, Jr.--Trustee, Chairman of the Board. Director, and
Chairman of the Board, Frank Russell Company; Director, Chairman of the Board
and Chief Executive Officer Russell Building Management Company; Director,
Chairman of the Board, Frank Russell Securities, Inc., Frank Russell Investment
Management Company, Frank Russell Trust Company; Director of Russell 20-20
Association. March 1988 to April 1992, Director Russell-Zisler, Inc.; January
1957 to March 1993, Chief Executive Officer of Frank Russell Company
7
<PAGE> 13
*Lynn L. Anderson--Trustee, President, and Chief Executive Officer. Director
and President, Russell Fund Distributors, Inc. and Russell Insurance Funds,
Inc.; Trustee, Chairman of the Board and President, The Seven Seas Series Fund;
Director, Chief Executive Officer and President, Frank Russell Investment
Management Company and Frank Russell Trust Co.; Director and Chairman Frank
Russell Investment Company Public Limited Company, March 1989 to June 1993
Director, Frank Russell Company, Director of Frank Russell Investments
(Ireland) Limited. Until September 1994, Director and President, The Laurel
Funds, Inc.
Paul E. Anderson--Trustee. 23 Forest Glen Lane, Tacoma, Washington 98409.
President, Vancouver Door Company, Inc.
Paul Anton, PhD--Trustee. 2218 55th Street, NW., Gig Harbor, Washington 98335.
President, Paul Anton and Associates, (marketing consultant on emerging
international markets for small corporations). From 1986 to 1991, Visiting
Associate Professor International Marketing, School of Business Administration
and International Trade Institute, Portland State University, Portland,
Oregon., 1991-1994 Adjunct Professor, International Marketing, University of
Washington, Tacoma, Washington.
William E. Baxter--Trustee. 800 North C Street, Tacoma, Washington 98403.
Lee C. Gingrich--Trustee. 1730 North Jackson, Tacoma, Washington 98406.
President, Gingrich Enterprises, Inc. (Business and Property Management)
Eleanor W. Palmer--Trustee. 2025 Narrows View Circle, P. O. Box 1057, Gig
Harbor, Washington 98335. Retired. Until August 1981, Director, Vice
President and Treasurer of Frank Russell Company; since October 1980, Director
of Frank Russell Trust Company.
*Margaret L. Barclay--Treasurer and Chief Accounting Officer. Director of
Finance, Fund Administration and Operations, Frank Russell Investment
Management Company; Senior Vice President and Fund Treasurer, The Seven Seas
Series Fund; Director of Finance and Operations, Frank Russell Trust Company;
Director and Director of Finance and Operations, Russell Fund Distributors,
Inc.; Director, Treasurer and Chief Accounting Officer for Russell Insurance
Funds, Inc.; Director, President and Treasurer of Russell-MLC Management
Company; Treasurer of Frank Russell International Services, Co. Until
September 1994, Senior Vice President, Fund Treasurer and Director of
Operations, The Laurel Funds, Inc.
*Randall P. Lert--Director of Investments. Senior Investment Officer and
Director of Investment Services, Frank Russell Trust Company; Director and
Director of Investments, Frank Russell Investment Management Company and
Director, Russell Fund Distributors, Inc.
*Karl J. Ege -- Secretary and Legal Counsel. Director, Secretary and General
Counsel of Frank Russell Company, and Russell Insurance Funds; Secretary and
General Counsel of
8
<PAGE> 14
Frank Russell Investment Management Company, Frank Russell Trust Company and
Russell Fund Distributors; Director and Secretary of Russell Building
Management Company; Director of Frank Russell Company Party Limited and Frank
Russell Japan; Director and Assistant Secretary of Frank Russell Company
Limited and Russell Systems Ltd. Director, Frank Russell Investment Company
LLC, Frank Russell Investments (Cayman) Ltd., Frank Russell Investment Company
Public Limited Company and Frank Russell Investments (Ireland) Limited;
Director and Secretary Russell-MLC Management Company and Frank Russell
International Services, Co., Inc.; Director, Secretary and General Counsel,
Russell Fiduciary Services Company; Director, General Counsel and Secretary,
Frank Russell Capital Inc., Director of Frank Russell Company, S.A., Frank
Russell Company (N.Z.) Limited and Russell 20-20 Association. From July 1992
to June 1994, Director, President and Secretary of Frank Russell Shelf
Corporation. From 1972 to 1991 Partner, Bogle and Gates (law firm)
*Peter Apanovitch--Manager of Short-Term Investment Funds. Manager of
Short-Term Investment Funds, Frank Russell Investment Management Company and
Frank Russell Trust Company. From 1986 to 1989, Assistant Vice President and
Assistant Treasurer of CIGNA Corporation
TRUSTEE COMPENSATION TABLE
<TABLE>
<CAPTION>
Pension or
Retirement Total
Aggregate Benefits Accrued Compensation From
Compensation as Part of Estimated Annual Investment
from Investment Investment Benefits Upon Company Paid to
Trustee Company Company Expenses Retirement Trustees
------- --------------- ---------------- ---------------- -----------------
<S> <C> <C> <C> <C>
Lynn L. Anderson $0 $0 $0 $0
Paul E. Anderson $16,000 $0 $0 $16,000
Paul Anton, PhD. $16,000 $0 $0 $16,000
William E. Baxter $16,000 $0 $0 $16,000
Lee C. Gingrich $16,000 $0 $0 $16,000
Eleanor W. Palmer $16,000 $0 $0 $16,000
George F. Russell $0 $0 $0 $0
</TABLE>
OPERATION OF INVESTMENT COMPANY
Service Providers. Most of Investment Company's necessary day-to-day
operations are performed by separate business organizations under contract to
Investment Company. The principal service providers are:
9
<PAGE> 15
Consultant Frank Russell Company
Manager, Transfer and Frank Russell Investment
Dividend Disbursing Management Company
Agent
Money Managers Multiple professional discretionary
investment management organizations
Custodian and Portfolio State Street Bank and Trust Company
Accountant
Consultant. Frank Russell Company, the corporate parent of Management Company,
was responsible for organizing Investment Company and provides ongoing
consulting services, described in the Prospectus, to Investment Company and
Management Company. Frank Russell Company provides (i) Portfolio Verification
Services ("PVS"), which are based upon a transactional verification of
securities purchases and sales, cash transactions and other investment
portfolio operations of each Money Manager's portfolio except Money Managers
for the Money Market, Limited Volatility Tax Free, U.S. Government Money Market
and Tax Free Money Market Funds, and (ii) Analysis of International Management
Reports ("AIM") by country on each International, Emerging Markets, and
International Securities Funds' Money Manager's portfolio. The reports are
paid for by the Funds and provide certain of the financial and tax accounting
information required by Investment Company.
The Management Company does not pay Frank Russell Company an annual fee for
consulting services.
For the years ended December 31, 1994, 1993 and 1992, respectively, the Funds
paid Frank Russell Company for PVS and AIM Reports the following fees:
<TABLE>
<CAPTION>
Years Ended
-----------------------------------------------
12/31/94 12/31/93 12/31/92
-------- -------- --------
<S> <C> <C> <C>
Equity I $25,182 $25,000 $63,535
Equity II 21,186 17,859 38,116
Equity III 12,000 11,255 46,354
Equity Q 23,631 23,000 81,070
International 62,137 61,334 62,125
Emerging Markets* 47,431 29,062 --
Fixed Income I 41,500 34,725 37,878
Fixed Income II 23,372 20,160 26,431
Fixed Income III* 26,752 18,750 --
Diversified Equity 25,000 25,000 60,923
Special Growth 23,613 20,875 37,862
Equity Income 12,000 11,593 39,741
Quantitative Equity 23,299 23,000 72,449
International Securities 62,137 61,333 60,500
Real Estate Securities 5,000 5,000 17,738
Diversified Bond 39,173 31,274 34,227
</TABLE>
10
<PAGE> 16
<TABLE>
<S> <C> <C> <C>
Volatility Constrained Bond 24,982 20,098 26,332
Multistrategy Bond* 27,022 18,750 --
</TABLE>
____________
* The Emerging Markets, Fixed Income III and Multistrategy Bond Funds
commenced operations on January 29, 1993.
Frank Russell Company provides comprehensive consulting and Money Manager
evaluation services to institutional clients, including Management Company and
Frank Russell Trust Company, and to high net worth individuals and families
($100 million) through its Russell Private Investment Division. Frank Russell
Company also provides: (i) consulting services for international investment to
these and other clients through its International Division and its wholly owned
subsidiaries, Frank Russell Company London (Frank Russell Company Limited),
Frank Russell Canada (Frank Russell Canada Limited/Limitee), Frank Russell
Australia (Frank Russell Company Pty., Limited), Frank Russell Japan, Frank
Russell AG (Zurich), Frank Russell Company S.A. (Paris) and Frank Russell
Company (N.Z.) Limited (Auckland), and (ii) investment account and portfolio
evaluation services to corporate pension plan sponsors and institutional Money
Managers through its Russell Data Services Division. Frank Russell Securities,
Inc., a wholly owned subsidiary of Frank Russell Company, carries on an
institutional brokerage business as a member of the New York Stock Exchange.
Frank Russell Capital Inc., a wholly owned subsidiary of Frank Russell Company
carries on an investment banking business as a registered broker-dealer. Frank
Russell Trust Company, a wholly-owned subsidiary of Frank Russell Company,
provides comprehensive trust and investment management services to corporate
pension and profit-sharing plans. Frank Russell Investments (Cayman) Ltd, a
wholly owned subsidiary of Frank Russell Company, provide investment advice and
other services. Frank Russell Investment (Ireland) Ltd., a wholly owned
subsidiary of Frank Russell Company, provides investment advice and other
services. Frank Russell International Services Co., Inc., a wholly owned
subsidiary of Frank Russell Company, provides services to U.S. personnel
secunded to overseas enterprises. Russell Fiduciary Services Company, a wholly
owned subsidiary of Frank Russell Company, provides fiduciary services to
pension and welfare benefit plans and other institutional investors. The
mailing address of Frank Russell Company is 909 A Street, Tacoma, WA 98402.
Manager. Frank Russell Investment Management Company provides or oversees the
provision of all general management and administration, investment advisory and
portfolio management, and distribution services for the Funds. Management
Company provides the Funds with office space, equipment and the personnel
necessary to operate and administer the Funds' business and to supervise the
provision of services by third parties such as the Money Managers and
custodian. Management Company also develops the investment programs for each
of the Funds, selects Money Managers for the Funds (subject to approval by the
Board of Trustees), allocates assets among Money Managers, monitors the Money
Managers' investment programs and results, and may exercise investment
discretion over assets invested in the Funds' Liquidity Portfolios. (See,
"Investment Policies -- Liquidity Portfolios.") Management Company also acts
as
11
<PAGE> 17
the Investment Company's transfer agent and as the Money Manager for the Money
Market and U.S. Government Money Market Funds. Management Company, as agent for
the Investment Company, pays the Money Managers' fees for the Funds, as a
fiduciary for the Funds.
Prior to April 1, 1995, The External Fee Funds paid no management fee to
Management Company. Each shareholder entered into a written Asset Management
Services Agreement with Management Company and agreed to pay annual fees,
billed quarterly on a pro rata basis and calculated as a specified percentage
of the average assets which the shareholder had invested at each month end in
any of the Funds. Beginning April 1, 1995, the Investment Company's Management
Agreement was amended to provide that each External Fee Fund will pay an annual
management fee directly to Management Company, billed monthly on a pro-rata
basis and calculated as a specified percentage of the average daily net assets
of each of the External Fee Funds (see the External Fee Fund Prospectus for
each External Fee Fund's annual percentage rate.) Shareholders of the External
Fee Funds will each continue to enter into a written Asset Management Service
Agreement with Management Company pursuant to which each agrees to pay
additional fees based on a specified percentage of average assets which the
shareholders have invested in each Fund in consideration of Management
Company's provision of individual shareholder investment services with respect
to that shareholder.
Each of the Internal Fee Funds pays an annual management fee directly to
Management Company, billed monthly on a pro rata basis and calculated as a
specified percentage of the average daily net assets of each of the Funds.
(See, the Internal Fee Fund Prospectus for each Internal Fee Fund's annual
percentage rate.)
The following Internal Fee Funds paid Management Company the listed management
fees for the years ended December 31, 1994, 1993 and 1992:
<TABLE>
<CAPTION>
Years Ended
---------------------------------------------
12/31/94 12/31/93 12/31/92
---------- ---------- ----------
<S> <C> <C> <C>
Diversified Equity $3,156,276 $2,859,190 $2,536,276
Special Growth 2,028,150 1,544,101 1,095,991
Equity Income 1,196,187 1,204,256 1,039,834
Quantitative Equity 2,712,324 2,209,895 1,668,809
International Securities 5,096,797 3,376,561 2,549,029
Real Estate Securities 1,541,758 968,541 493,848
Diversified Bond 2,263,561 2,063,142 1,944,320
Volatility Constrained Bond 1,094,128 1,232,493 1,567,309
Multistrategy Bond* 945,756 275,047 --
Limited Volatility Tax Free 290,090 212,524 157,100
U.S. Government Money Market 207,926 256,180 441,913
Tax Free Money Market 228,123 157,066 166,726
</TABLE>
____________
* Multistrategy Bond Fund commenced operations on January 29, 1993.
12
<PAGE> 18
During 1992, Management Company waived a portion of its management fee in the
Diversified Bond Fund amounting to $176,592. Additionally, effective August 7,
1992, Management Company reduced the management fee from 0.60% to 0.45%.
During 1993, Management Company reimbursed the Emerging Markets, Fixed Income
III and Multistrategy Bond Funds for all expenses exceeding 0.80%, 0.20% and
0.85%, respectively, on an annualized basis of average net assets. In 1994,
reimbursements for the Emerging Markets and Multistrategy Bond Funds were
$13,539 and $66,525, respectively. As a result of the reimbursement,
management fees paid by the Multistrategy Bond Fund amounted to $879,231. The
amounts reimbursed for the Emerging Markets, Fixed Income III and Multistrategy
Bond Funds in 1993 were $187,755, $103,620, and $148,504, respectively. As a
result of the reimbursement, management fees paid by the Multistrategy Bond
Fund amounted to $126,543. Prior to April 1, 1995, Fixed Income III and
Emerging Markets Funds did pay a management fee to management company.
Management Company is a wholly owned subsidiary of Frank Russell Company.
Management Company's mailing address is 909 A Street, Tacoma, WA 98402.
Money Managers. Except with respect to the Money Market and U.S. Government
Money Market Funds, Money Managers have no affiliations or relationships with
Investment Company or Management Company other than as discretionary managers
for all or a portion of a Fund's portfolio, except some Money Managers (and
their affiliates) may effect brokerage transactions for the Funds (see,
"Brokerage Allocations" and "Brokerage Commissions"). Money managers may serve
as advisers or discretionary managers for Frank Russell Trust Company, other
consulting clients of Frank Russell Company, other off-shore vehicles and/or
for accounts which have no business relationship with the Frank Russell Company
organization.
Distributor. Russell Fund Distributors, Inc. serves as the distributor of
Investment Company shares. The distributor receives no compensation from
Investment Company for its services. The distributor is a wholly owned
subsidiary of Management Company and its mailing address is: 909 A Street,
Tacoma, WA 98402.
Custodian. State Street Bank and Trust Company serves as the custodian for the
Investment Company. State Street also provides the basic portfolio
recordkeeping required by each of the Funds for regulatory and financial
reporting purposes. State Street is paid an annual fee of $16,800 per
portfolio per fund, except for Emerging Markets which is $18,000, plus
specified transaction costs per portfolio per Fund for these portfolio
recordkeeping services.
Transfer and Dividend Disbursing. Management Company serves as Transfer Agent
for the Investment Company. For this service, Management Company is paid a fee
of $15.00 per shareholder transaction. Management Company is also reimbursed
by the Investment Company for certain out-of-pocket expenses including
postage, taxes, wires, stationery, and telephone.
13
<PAGE> 19
Fund Expenses. The Funds will pay all their expenses other than those
expressly assumed by Management Company. The principal expense of the Funds is
the annual management fee payable to Management Company. The Funds' other
expenses include: fees for independent accountants, legal, transfer agent,
registrar, custodian, dividend disbursement, and portfolio and shareholder
recordkeeping services fees for Portfolio Verification Services and Analysis of
International Management Reports, and maintenance of tax records payable to
Frank Russell Company (except for Money Market, Limited Volatility Tax Free,
U.S. Government Money Market, and Tax Free Money Market Funds); state taxes;
brokerage fees and commissions; insurance premiums; association membership
dues; fees for filing of reports and registering shares with regulatory bodies;
and such extraordinary expenses as may arise such as federal taxes and expenses
incurred in connection with litigation proceedings and claims and the legal
obligations of the Investment Company to indemnify its Trustees, officers,
employees, shareholders, distributors and agents with respect thereto.
Whenever an expense can be attributed to a particular Fund, the expense is
charged to that Fund. Other common expenses are allocated among the Funds
based primarily upon their relative net assets.
As of the date of this Statement of Additional Information, Management Company
has voluntarily agreed to reimburse Fund expenses in excess of certain limits
on an annualized basis. These limits may be changed or rescinded at any time
to certain of the Funds. (See, the Prospectus of the External and Internal Fee
Funds for the expense guarantees.) In addition to these "voluntary limits," if
the expenses of any Fund exceed the expense limitations established by the
State of California, Management Company will pay the excess amount.
California's expense limitation is 2.5% of the Investment Company's first $30
million of average net assets, 2.0% of the next $70 million of average net
assets, and 1.5% of the remaining average net assets for any year.
Valuation of Fund Shares. The net asset value per share is calculated for each
Fund on which shares are offered or orders to redeem are tendered. A business
day is one on which the New York Stock Exchange is open for trading, and for
the Money Market, U.S. Government Money Market, and Tax Free Money Market Funds
any day on which both the New York Stock Exchange and the Boston Federal
Reserve Bank are open for trading. Currently, the New York Stock Exchange is
open for trading every weekday except New Year's Day, Presidents' Day, Good
Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and
Christmas Day. The Boston Federal Reserve Bank is open for business Good
Friday and every day the New York Stock Exchange is open, except Martin Luther
King Day, Columbus Day, and Veterans Day.
The International, Emerging Markets, International Securities, Fixed Income I,
Diversified Bond, Fixed Income III and Multistrategy Bond Funds' portfolio
securities actively trade on foreign exchanges which may trade on Saturdays and
on days that the Funds do not offer or redeem shares. The trading of portfolio
securities on foreign exchanges on such days may significantly increase or
decrease the net asset value of
14
<PAGE> 20
Fund shares when the shareholder is not able to purchase or redeem Fund shares.
Further, because foreign securities markets may close prior to the time the
Funds determine net asset value, events affecting the value of the portfolio
securities occurring between the time prices are determined and the time the
Funds calculate net asset value may not be reflected in the calculation of net
asset value unless FRIMCo determines that a particular event would materially
affect the net asset value.
Portfolio Transaction Policies. Generally, securities are purchased for Equity
I, Equity III, Equity Q, International, Emerging Markets, Fixed Income I,
Diversified Equity, Equity Income, Quantitative Equity, International
Securities, Real Estate Securities and Diversified Bond Funds for investment
income and/or capital appreciation and not for short-term trading profits.
However, these Funds may dispose of securities without regard to the time they
have been held when such action, for defensive or other purposes, appears
advisable to its Money Managers. Equity II, Fixed Income II, Fixed Income III,
Special Growth, Volatility Constrained Bond, Multistrategy Bond and Limited
Volatility Tax Free Funds trade more actively to realize gains and/or to
increase yields on investments by trading to take advantage of short-term
market variations. This policy is expected to result in higher portfolio
turnover for these Funds.
The portfolio turnover rates for certain Funds are likely to be somewhat higher
than the rates for comparable mutual funds with a single Money Manager.
Decisions to buy and sell securities for each Fund are made by a Money Manager
independently from other Money Managers. Thus, one Money Manager could be
selling a security when another Money Manager for the same Fund is purchasing
the same security thereby increasing the Funds' portfolio turnover ratios and
brokerage commissions. The Funds' changes of Money Managers may also result in
a significant number of portfolio sales and purchases as the new Money Manager
restructures the former Money Manager's portfolio.
The Funds, except the Limited Volatility Tax Free Fund, do not give significant
weight to attempting to realize long-term, rather than short-term, capital
gains when making portfolio management decisions.
Portfolio Turnover Rate. The portfolio turnover rate for each Fund is
calculated by dividing the lesser of purchases or sales of portfolio securities
for the particular year, by the monthly average value of the portfolio
securities owned by the Fund during the year. For purposes of determining the
rate, all short-term securities, including options, futures, forward contracts,
and repurchase agreements, are excluded.
15
<PAGE> 21
The portfolio turnover rates for the last two years for each Fund (other than
the Money Market, U.S. Government Money Market, and Tax Free Money Market
Funds) were:
<TABLE>
<CAPTION>
Years Ended
----------------------
12/31/94 12/31/93
-------- --------
<S> <C> <C>
Equity I 75% 92%
Equity II 58 87
Equity III 86 77
Equity Q 46 55
International 71 62
Emerging Markets* 57 90
Fixed Income I 174 173
Fixed Income II 234 229
Fixed Income III* 134 182
Diversified Equity 58 100
Special Growth 55 92
Equity Income 90 79
Quantitative Equity 46 62
International Securities 72 60
Real Estate Securities 46 58
Diversified Bond 153 178
Volatility Constrained Bond 183 221
Multistrategy Bond 136 189
Limited Volatility Tax Free 72 24
</TABLE>
Brokerage Allocations. Transactions on US stock exchanges involve the payment
of negotiated brokerage commissions; on non-US exchanges, commissions are
generally fixed. There is generally no stated commission in the case of
securities traded in the over-the-counter markets, including most debt
securities and money market instruments, but the price includes an undisclosed
"commission" in the form of a mark-up or mark-down. The cost of securities
purchased from underwriters includes an underwriting commission or concession.
Subject to the arrangements and provisions described below, the selection of a
broker or dealer to execute portfolio transactions is usually made by the Money
Manager. The Investment Company's Agreements with Management Company and the
Money Managers provide, in substance and subject to specific directions from
officers of the Funds or Management Company, that in executing portfolio
transactions and selecting brokers or dealers, the principal objective is to
seek the best overall terms available to the Fund. Securities will ordinarily
be purchased from the primary markets, and the Money Manager shall consider all
factors it deems relevant in assessing the best overall terms available for any
transaction, including the breadth of the market in the security, the price of
the security, the financial condition and execution capability of the broker or
dealer, and the reasonableness of the commission, if any (for the specific
transaction and on a continuing basis).
16
<PAGE> 22
In addition, those Agreements authorize the Management Company and Money
Manager, respectively, in selecting brokers or dealers to execute a particular
transaction and in evaluating the best overall terms available, to consider the
"brokerage and research services" (as those terms are defined in Section 28(e)
of the Securities Exchange Act of 1934) provided to the Fund, Management
Company and/or to the Money Manager (or their affiliates). The Management
Company and Money Managers are authorized to cause the Funds to pay a
commission to a broker or dealer who provides such brokerage and research
services for executing a portfolio transaction which is in excess of the amount
of commission another broker or dealer would have charged for effecting that
transaction. The Investment Company, Management Company or the Money Manager,
as appropriate, must determine in good faith that such commission was
reasonable in relation to the value of the brokerage and research services
provided -- viewed in terms of that particular transaction or in terms of all
the accounts over which Management Company or the Money Manager exercises
investment discretion. Any commission, fee or other remuneration paid to an
affiliated broker-dealer is paid in compliance with Investment Company
procedures adopted in accordance with Rule 17e-1 of the Investment Company Act
of 1940, as amended.
Management Company does not expect the Investment Company to ordinarily effect
a significant portion of the Investment Company's total brokerage business with
broker-dealers affiliated with its Money Managers. However, a Money Manager
may effect portfolio transactions for the segment of the Fund's portfolio
assigned to the Money Manager with a broker-dealer affiliated with the manager,
as well as with brokers affiliated with other Money Managers.
The Investment Company effects portfolio transactions with or through Frank
Russell Securities, Inc., only when it has been determined by the applicable
Money Managers that the Investment Company will receive competitive execution,
price and commission. Frank Russell Securities refunds up to 70% of the
commissions paid to the Funds effecting such transactions, after reimbursement
for research services provided to the Management Company. As to brokerage
transactions effected by Money Managers on behalf of the funds through Frank
Russell Securities at the request of the Manager, research services obtained
from third party service providers at market rates are provided to the funds by
Frank Russell Securities. Such research services include performance
measurement statistics, fund analytics systems, and market monitoring systems.
As to other brokerage transactions effected by the Funds through Frank Russell
Securities, research services provided by Frank Russell Company and Russell
Data Services are provided to the Money Managers. Such services include market
performance indices, investment adviser performance information, and market
analysis. This arrangement is used by Equity I, Equity II, Equity III, Equity
Q, International, Emerging Markets, Diversified Equity, Special Growth, Equity
Income, Quantitative Equity, International Securities and Real Estate
Securities Funds.
Brokerage Commissions. The Board of Trustees reviews, at least annually, the
commissions paid by the Funds to evaluate whether the commissions paid over
representative periods of time were reasonable in relation to commissions being
charged
17
<PAGE> 23
by other brokers and the benefits to the Funds. Frank Russell Company
maintains an extensive data base showing commissions paid by institutional
investors, which is the primary basis for making this evaluation. Certain
services received by the Management Company or Money Managers attributable to a
particular transaction may benefit one or more other accounts for which
investment discretion is exercised by the Money Manager, or a Fund other than
that for which the particular portfolio transaction was effected. The fees of
the Money Managers are not reduced by reason of their receipt of such brokerage
and research services.
During the last three years, the brokerage commissions paid by the Funds that
offered their shares throughout this period were:
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------
1994 1993 1992
---------- ---------- ----------
<S> <C> <C> <C>
Equity I $1,102,030 $1,197,566 $ 806,511
Equity II 327,972 301,635 138,697
Equity III 482,877 360,540 373,695
Equity Q 351,400 314,482 277,739
International 2,130,525 1,394,963 1,084,652
Emerging Markets* 635,093 310,566 --
Fixed Income II -- -- 48
Diversified Equity 807,894 943,992 693,463
Special Growth 382,307 382,457 151,035
Equity Income 388,380 318,701 319,177
Quantitative Equity 284,366 294,689 219,109
International
Securities 1,896,734 1,096,271 782,337
Real Estate Securities 627,282 454,990 148,246
========== ========== ==========
Total $9,416,860 $7,370,852 $4,994,709
========== ========== ==========
</TABLE>
---------------
* Emerging Markets Fund commenced operations on January 29, 1993.
The principal reasons for changes in several Funds' brokerage commissions for
the three years were (1) change in Fund asset size, (2) changes in market
conditions, and (3) in 1994, 1993 and 1992, changes in Money Managers of
certain Funds which required substantial portfolio restructuring resulting in
increased securities transactions and brokerage commissions.
Fixed Income I, Fixed Income II, Fixed Income III, Diversified Bond, Volatility
Constrained Bond, Multistrategy Bond, Limited Volatility Tax Free, Money
Market, U.S. Government Money Market, and Tax Free Money Market Funds normally
do not pay a stated brokerage commission on transactions.
During the year ended December 31, 1994, approximately $1,455,000 of the
brokerage commissions of the Funds were directed to brokers who provided
research services to the
18
<PAGE> 24
Management Company. The research services included industry and company
analysis, portfolio strategy reports, economic analysis, and statistical data
pertaining to the capital markets.
Gross brokerage commissions received by affiliated broker/dealers from
affiliated and non-affiliated Money Managers for the years ended December 31,
1994, 1993 and 1992 from portfolio transactions effected for the Funds were as
follows: (Table 1)
During the year ended December 31, 1994, the Funds purchased securities issued
by the following brokers or dealers, each of which is one of the Funds' ten
largest brokers or dealers by dollar amounts of securities executed or
commissions received on behalf of the Funds. The value of broker-dealer
securities held as of December 31, 1994, is as follows: (Table 2)
19
<PAGE> 25
TABLE 1
1992-1994 Affiliated Broker/Dealer Commissions
<TABLE>
<CAPTION>
1994 1994 1993
Affiliated Non Affiliated Affiliated
---------- -------------- ----------
<S> <C> <C> <C> <C>
Alliance Capital Management Corp.
---------------------------------------
Affiliated Broker/Dealers:
Autranet, Inc. Commission Dollars $ 0 $ 11,217 $ 0
Percentage of Commission Dollars -- 0.1% --
Percentage of Net Money -- 0.2% --
Donaldson Lufkin & Jenrette
Securities, Inc. Commission Dollars $ 0 $ 72,745 $ 0
Percentage of Commission Dollars -- 0.8% --
Percentage of Net Money -- 1.0% --
Frank Russell Investment Management Co.
---------------------------------------
Affiliated Broker/Dealer:
Frank Russell Securities, Inc. Commission Dollars $ 0 $ 1,322,679 $ 0
Percentage of Commission Dollars -- 14.1% --
Percentage of Net Money -- 12.1% --
Amount Refunded $ 0 ($481,286) $ 0
Rowe Price-Fleming International, Inc.
---------------------------------------
Affiliated Broker/Dealers:
Jardine-Fleming Securities Commission Dollars $25,352 $ 14,230 $ 55,107
Percentage of Commission Dollars 0.3% 0.1% 0.8%
Percentage of Net Money 0.2% 0.0% 0.4%
Ord Minnett, Inc. Commission Dollars $ 6,106 $ 58,108 $ 14,150
Percentage of Commission Dollars 0.1% 0.6% 0.2%
Percentage of Net Money 0.0% 0.4% 0.1%
</TABLE>
<TABLE>
<CAPTION>
1993 1992 1992
Non Affiliated Affiliated Non Affiliated
-------------- ---------- --------------
<S> <C> <C> <C> <C>
Alliance Capital Management Corp.
---------------------------------------
Affiliated Broker/Dealers:
Autranet, Inc. Commission Dollars $ 8,009 $ 0 $ 4,852
Percentage of Commission Dollars 0.1% -- 0.1%
Percentage of Net Money 0.2% -- 0.1%
Donaldson Lufkin & Jenrette
Securities, Inc. Commission Dollars $ 75,614 $ 0 $ 74,375
Percentage of Commission Dollars 1.0% -- 1.5%
Percentage of Net Money 1.2% -- 1.6%
Frank Russell Investment Management Co.
---------------------------------------
Affiliated Broker/Dealer:
Frank Russell Securities, Inc. Commission Dollars $ 569,885 $ 1,628 $ 560,727
Percentage of Commission Dollars 7.7% 0.0% 11.2%
Percentage of Net Money 6.1% 0.0% 9.0%
Amount Refunded $(398,920) $(1,140) $(392,509)
Rowe Price-Fleming International, Inc.
--------------------------------------
Affiliated Broker/Dealers:
Jardine-Fleming Securities Commission Dollars $ 9,913 $41,405 $ 3,597
Percentage of Commission Dollars 0.1% 0.8% 0.1%
Percentage of Net Money 0.1% 0.3% 0.0%
Ord Minnett, Inc. Commission Dollars $ 0 -- --
Percentage of Commission Dollars -- -- --
Percentage of Net Money -- -- --
</TABLE>
20
<PAGE> 26
TABLE 1
1992-1994 Affiliated Broker/Dealer Commissions (continued)
<TABLE>
<CAPTION>
1994 1994 1993
Affiliated Non Affiliated Affiliated
---------- -------------- ----------
<S> <C> <C> <C> <C>
Montgomery Asset Management, L.P.
---------------------------------------
Affiliated Broker/Dealers:
Montgomery Securities Commission Dollars $ 0 $ 50,193 $ 0
Percentage of Commission Dollars -- 0.5% --
Percentage of Net Money -- 0.7% --
J.P. Morgan Investment Management, Inc.
---------------------------------------
Affiliated Broker/Dealer:
J.P. Morgan Securities, Inc. Commission Dollars $ 0 $ 24,688 $ 0
Percentage of Commission Dollars -- 0.3% --
Percentage of Net Money -- 0.3% --
Wells Fargo Nikko Investment Advisors
---------------------------------------
Affiliated Broker/Dealer:
Nikko Securities Co. Commission Dollars $ 0 $ 9,423 $ 0
Percentage of Commission Dollars -- 0.1% --
Percentage of Net Money -- 0.0% --
BEA Associates
---------------------------------------
Affiliated Broker/Dealers:
First Boston Corp. Commission Dollars $ 0 $ 98,417 $ 0
Percentage of Commission Dollars -- 1.1% --
Percentage of Net Money -- 1.2% --
Credit Swisse First Boston Commission Dollars $ 0 $ 4,594 $ 0
Percentage of Commission Dollars -- 0.1% --
Percentage of Net Money -- 0.0% --
Swiss American Securities Commission Dollars $ 0 $ 19,399 $ 0
Percentage of Commission Dollars -- 0.2% --
Percentage of Net Money -- 0.1% --
</TABLE>
<TABLE>
<CAPTION>
1993 1992 1992
Non Affiliated Affiliated Non Affiliated
-------------- ---------- --------------
<S> <C> <C> <C> <C>
Montgomery Asset Management, L.P.
---------------------------------------
Affiliated Broker/Dealers:
Montgomery Securities Commission Dollars $ 72,212 -- --
Percentage of Commission Dollars 1.0% -- --
Percentage of Net Money 1.1% -- --
J.P. Morgan Investment Management, Inc.
---------------------------------------
Affiliated Broker/Dealer:
J.P. Morgan Securities, Inc. Commission Dollars $ 14,489 -- --
Percentage of Commission Dollars 0.2% -- --
Percentage of Net Money 0.2% -- --
Wells Fargo Nikko Investment Advisors
---------------------------------------
Affiliated Broker/Dealer:
Nikko Securities Co. Commission Dollars $ 1,098 $0 $561
Percentage of Commission Dollars 0.0% -- 0.0%
Percentage of Net Money 0.0% -- 0.0%
BEA Associates
---------------------------------------
Affiliated Broker/Dealers:
First Boston Corp. Commission Dollars $140,313 -- --
Percentage of Commission Dollars 1.9% -- --
Percentage of Net Money 1.8% -- --
Credit Swisse First Boston Commission Dollars $ 65 -- --
Percentage of Commission Dollars 0.0% -- --
Percentage of Net Money 0.0% -- --
Swiss American Securities Commission Dollars $ 13,688 -- --
Percentage of Commission Dollars 0.2% -- --
Percentage of Net Money 0.1% -- --
</TABLE>
21
<PAGE> 27
TABLE 1
1992-1994 Affiliated Broker/Dealer Commissions (continued)
<TABLE>
<CAPTION>
1994 1994 1993
Affiliated Non Affiliated Affiliated
----------- -------------- -----------
<S> <C> <C> <C> <C>
Baring International Investment Limited
---------------------------------------
Affiliated Broker/Dealers:
Baring Securities Commission Dollars $ 14 $ 61,145 $ 105
Percentage of Commission Dollars 0.0% 0.7% 0.0%
Percentage of Net Money 0.0% 0.3% 0.0%
Baring London Commission Dollars $ 0 $ 19,566 $ 0
Percentage of Commission Dollars -- 0.2% --
Percentage of Net Money -- 0.2% --
Dillon Reed Commission Dollars $ 0 $ 3,420 $ 0
Percentage of Commission Dollars -- 0.0% --
Percentage of Net Money -- 0.1% --
Oechsle International Advisors
---------------------------------------
Affiliated Broker/Dealers:
ABD Securities Corp. Commission Dollars $ 0 $ 0 $ 0
Percentage of Commission Dollars -- -- --
Percentage of Net Money -- -- --
Dresdner Bank Commission Dollars $ 25,845 $ 0 $ 2,397
Percentage of Commission Dollars 0.3% -- 0.0%
Percentage of Net Money 0.3% -- --
Mitchell, Hutchins
Institutional Investors, Inc.
---------------------------------------
Affiliated Broker/Dealers:
PaineWebber, Inc. Commission Dollars $ 100 $ 104,526 $ 0
Percentage of Commission Dollars 0.0% 1.1% --
Percentage of Net Money 0.0% 1.4% --
--------------------------------------------------------------------------------------
Total Commission Dollars: $ 57,417 $1,874,350 $ 71,759
Combined Affiliated $1,931,767 $1,059,157
and Non-Affiliated
</TABLE>
<TABLE>
<CAPTION>
1993 1992 1992
Non Affiliated Affiliated Non Affiliated
-------------- ---------- --------------
<S> <C> <C> <C> <C>
Baring International Investment Limited
---------------------------------------
Affiliated Broker/Dealers:
Baring Securities Commission Dollars $ 39,570 -- --
Percentage of Commission Dollars 0.5% -- --
Percentage of Net Money 0.3% -- --
Baring London Commission Dollars $ 21,623 -- --
Percentage of Commission Dollars 0.3% -- --
Percentage of Net Money 0.3% -- --
Dillon Reed Commission Dollars $ 4,932 -- --
Percentage of Commission Dollars 0.1% -- --
Percentage of Net Money 0.1% -- --
Oechsle International Advisors
---------------------------------------
Affiliated Broker/Dealers:
ABD Securities Corp. Commission Dollars $ 0 $ 64 $ 0
Percentage of Commission Dollars -- -- 0.0%
Percentage of Net Money -- -- 0.0%
Dresdner Bank Commission Dollars $ 15,987 $ 2,546 $ 9,050
Percentage of Commission Dollars 0.2% 0.1% 0.2%
Percentage of Net Money 0.1% 0.1% 0.0%
Mitchell, Hutchins
Institutional Investors, Inc.
---------------------------------------
Affiliated Broker/Dealers:
PaineWebber, Inc. Commission Dollars $ 0 $ 0 $ 0
Percentage of Commission Dollars -- -- --
Percentage of Net Money -- -- --
--------------------------------------------------------------------------------------
Total Commission Dollars: $987,398 $ 45,643 $653,162
Combined Affiliated $698,805
and Non-Affiliated
</TABLE>
22
<PAGE> 28
TABLE 2
Holdings of Top 10 Broker-Dealers at 12/31/94
<TABLE>
<CAPTION>
MORGAN MERRILL GOLDMAN SALOMON
FUND STANLEY LYNCH SACHS & CO. BEAR STEARNS BROTHERS
---- -------- ---------- ----------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Equity I $826,000 $3,045,900 -- -- --
Equity Q 532,675 -- $368,431 $ 30,000
Fixed Income I -- -- $ 810,586 -- 6,428,077
Fixed Income II -- 1,829,199 1,214,790 -- 1,034,000
Fixed Income III -- -- 945,662 -- 2,248,994
Money Market Fund -- -- 20,000,000 -- --
Diversified Equity 619,500 2,291,575 -- -- --
Quantitative Equity 17,700 396,825 -- 295,677 116,250
Diversified Bond -- -- 716,425 -- 1,343,396
Volatility Constrained Bond 896,967 3,890,858 1,913,293 -- 1,598,000
Multistrategy Bond -- -- 900,630 -- 3,280,196
</TABLE>
At 12/31/94, the Funds did not have any holdings in the following top 10
broker-dealers:
- UBS Securities
- Investment Technology Group
- Frank Russell Securities
- Instinet Corp.
- Smith New Court, Inc.
23
<PAGE> 29
Yield and Total Return Quotations. The Funds compute their average annual
total return by using a standardized method of calculation required by the
Securities and Exchange Commission. Average annual total return is computed by
finding the average annual compounded rates of return on a hypothetical initial
investment of $1,000 over the one, five and ten year periods (or life of the
funds as appropriate), that would equate the initial amount invested to the
ending redeemable value, according to the following formula:
P(1+T)n = ERV
Where: P = a hypothetical initial payment of $1,000;
T = average annual total return;
N = number of years; and
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the one, five or
ten year period at the end of the one, five, or
ten year period (or fractional portion thereof).
The calculation assumes that all dividends and distributions of each Fund are
reinvested at the price stated in the prospectus on the dividend dates during
the period, and includes all recurring fees that are charged to all shareholder
accounts. The average annual total returns for the External and Internal Fee
Funds are reported in their respective Prospectuses.
Yields are computed by using standardized methods of calculation required by
the Securities and Exchange Commission. Yields for Funds other than the Money
Market Funds are calculated by dividing the net investment income per share
earned during a 30-day (or one month) period by the maximum offering price per
share on the last day of the period, according to the following formula:
YIELD = 2[(a-b+1)6-1]
cd
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of
reimbursements)
c = average daily number of shares outstanding during
the period that were entitled to receive dividends
d = the maximum offering price per share on the last
day of the period
The yields for the Funds investing primarily in fixed income instruments are
reported in the Funds Prospectuses, respectively.
Each Fund investing primarily in money market instruments ("Money Market
Funds") computes its current annualized and compound effective annualized
yields using standardized methods required by the Securities and Exchange
Commission. The annualized yield for each Money Market Fund is computed by (a)
determining the net
24
<PAGE> 30
change in the value of a hypothetical account having a balance of one share at
the beginning of a seven calendar day period; (b) dividing the net change by
the value of the account at the beginning of the period to obtain the base
period return; and (c) annualizing the results (i.e., multiplying the base
period return by 365/7). The net change in the value of the account reflects
the value of additional shares purchased with dividends declared on both the
original share and such additional shares, but does not include realized gains
and losses or unrealized appreciation and depreciation. Compound effective
yields are computed by adding 1 to the base period return (calculated as
described above), raising that sum to a power equal to 365/7 and subtracting 1.
Yield may fluctuate daily and does not provide a basis for determining future
yields. Because each Money Market Fund's yield fluctuates, its yield cannot be
compared with yields on savings accounts or other investment alternatives that
provide an agreed-to or guaranteed fixed yield for a stated period of time.
However, yield information may be useful to an investor considering temporary
investments in money market instruments. In comparing the yield of one money
market fund to another, consideration should be given to each fund's investment
policies, including the types of investments made, length of maturities of
portfolio securities, the methods used by each fund to compute the yield
(methods may differ) and whether there are any special account charges which
may reduce effective yield.
Current and effective yields for the Money Market Funds are reported in the
Funds' Prospectuses.
Each Fund may, from time to time, advertise non-standard performances,
including average annual total return.
Each Fund may compare its performance with various industry standards of
performance, including Lipper Analytical Services, Inc. or other industry
publications, business periodicals, rating services and market indices.
Tax-equivalent yields for the Limited Volatility Tax Free and Tax Free Money
Market Funds are calculated by dividing that portion of the yield of the
appropriate Fund as computed above which is tax exempt by one minus a stated
income tax rate and adding the product to that quotient, if any, of the yield
of the Fund that is not tax exempt. The tax-equivalent yields for the Limited
Volatility Tax Free and Tax Free Money Market Funds' are reported in the
Internal Fee Fund Prospectus.
INVESTMENT RESTRICTIONS, POLICIES AND CERTAIN INVESTMENTS
Each Fund has certain "fundamental" investment objectives, restrictions and
policies which may be changed only with the approval of a majority of the
shareholders of that Fund. Other policies may be changed by the Funds without
shareholder approval. The Funds' investment objectives are set forth in the
Prospectus.
25
<PAGE> 31
Investment Restrictions. Each Fund is subject to the following "fundamental"
investment restrictions. Unless otherwise noted, these restrictions apply on a
Fund-by-Fund basis at the time an investment is being made. No Fund will:
1. Invest in any security if, as a result of such investment, less than 75%
of its assets would be represented by cash; cash items; securities of
the US government, its agencies, or instrumentalities; securities of
other investment companies; and other securities limited in respect of
each issuer to an amount not greater in value than 5% of the total
assets of such Fund. Investments by Funds, other than the Tax Free
Money Market and U.S. Government Money Market Funds, in shares of the
Money Market Fund are not subject to this restriction, or to
restrictions 2, 3, 10 and 14. (See, "Investment Policies -- Cash
Reserves.")
2. Invest 25% or more of the value of the Fund's total assets in the
securities of companies primarily engaged in any one industry (other
than the US government, its agencies and instrumentalities), but such
concentration may occur incidentally as a result of changes in the
market value of portfolio securities. This restriction does not apply
to the Real Estate Securities Fund. The Real Estate Securities Fund may
invest 25% or more of its total assets in the securities of companies
directly or indirectly engaged in the real estate industry. The Money
Market Fund may invest more than 25% of its assets in money market
instruments issued by domestic branches of US banks having net assets in
excess of $100,000,000.
3. Acquire more than 5% of the outstanding voting securities, or 10% of all
of the securities, of any one issuer.
4. Invest in companies for the purpose of exercising control or management.
5. Purchase or sell real estate; provided that a Fund may invest in
securities secured by real estate or interests therein or issued by
companies which invest in real estate or interests therein.
6. Purchase or sell commodities or commodities contracts, or interests in
oil, gas or other mineral exploration or development programs, except
stock index and financial futures contracts.
7. Borrow amounts more than 5% of the Fund's total assets taken at cost or
at market value, whichever is lower, and only from banks as a temporary
measure for extraordinary or emergency purposes, except that a Fund may
engage in reverse repurchase agreements to meet redemption requests
without immediately selling any portfolio instruments. The Fund will
not mortgage, pledge or in any other manner transfer as security for any
indebtedness, any of its assets. Collateral arrangements with respect
to margin for futures contracts are not deemed a pledge of assets.
26
<PAGE> 32
8. Purchase securities on margin or effect short sales (except that a Fund
may obtain such short-term credits as may be necessary for the clearance
of purchases or sales of securities, may trade in futures and related
options, and may make margin payments in connection with transactions in
futures contracts and related options).
9. Engage in the business of underwriting securities issued by others or
purchase securities, except as permitted by the Limited Volatility Tax
Free and Tax Free Money Market Funds' investment objectives.
10. Invest in securities of an issuer which, together with any predecessor,
has been in operation for less than three years if, as a result, more
than 5% of the Fund's total assets would then be invested in such
securities.
11. The Investment Company will not participate on a joint or a joint and
several basis in any trading account in securities except to the extent
permitted by the Investment Company Act of 1940, as amended, and any
applicable rules and regulations and except as permitted by any
applicable exemptive orders from the 1940 Act. The "bunching" of orders
for the sale or purchase of marketable portfolio securities with two or
more Funds, or with a Fund and such other accounts under the management
of Management Company or any Money Manager for the Funds to save
brokerage costs or to average prices among them shall not be considered
a joint securities trading account. The purchase of shares of the Money
Market Fund by any other Fund shall also not be deemed to be a joint
securities trading account.
12. Make loans of money or securities to any person or firm; provided,
however, that the making of a loan shall not be construed to include (i)
the acquisition for investment of bonds, debentures, notes or other
evidences of indebtedness of any corporation or government which are
publicly distributed or of a type customarily purchased by institutional
investors; (ii) the entry into "repurchase agreements"; or (iii) the
lending of portfolio securities in the manner generally described and in
the Funds' prospectus section "Investment Policies -- Lending Portfolio
Securities."
13. Purchase or sell options except to the extent permitted by the policies
set forth in the sections "Certain Investments -- Options on Securities
and Indices", "Certain Investments -- Foreign Currency Options",
"Certain Investments -- Futures Contracts and Options on Future
Contracts" and "Certain Investments -- Forward Foreign Currency
Contracts" below. The Limited Volatility Tax Free and Tax Free Money
Market Funds may purchase municipal obligations from an issuer, broker,
dealer, bank or other persons accompanied by the agreement of such
seller to purchase, at the Fund's option, the municipal obligation prior
to maturity thereof.
14. The Investment Company will not purchase the securities of other
investment companies except to the extent permitted by the Investment
Company Act of 1940, as amended, and any applicable rules and
regulations and except as permitted by any applicable exemptive orders
from the 1940 Act.
27
<PAGE> 33
15. Purchase from or sell portfolio securities to its officers, trustees or
other "interested persons" (as defined in the Act) of the Fund,
including the Fund's Money Managers and their affiliates, except as
permitted by the 1940 Act, SEC rules or exemptive orders.
Additional fundamental policies are: (a) Equity I, Equity II, Equity III,
Equity Q, Emerging Markets, Fixed Income III, Diversified Equity, Special
Growth, Equity Income, Quantitative Equity and Multistrategy Bond Funds will
not invest more than 5% of the current market value of its assets in warrants
nor more than 2% of such value in warrants which are not listed on the New York
or American Stock Exchanges; warrants attached to other securities are not
subject to this limitation. (b) Fixed Income I, Fixed Income II, Diversified
Bond, and Volatility Constrained Bond Funds may acquire convertible bonds which
will be disposed of by these Funds in as timely a manner as is practical after
conversion. (c) No Fund will purchase or retain the securities of an issuer
if, to the Fund's knowledge, one or more of the trustees or officers of the
Fund, or one or more of the officers or directors of the Money Manager
responsible for the investment or its directors or officers, individually own
beneficially more than l/2 of l% of the securities of such issuer and together
own beneficially more than 5% of such securities. Compliance with this policy
by the Fund's trustees and officers is monitored by Fund officers.
For purposes of these Investment Restrictions, the Limited Volatility Tax Free
and Tax Free Money Market Funds will consider as a separate issuer each:
governmental subdivision (i.e., state, territory, possession of the United
States or any political subdivision of any of the foregoing, including
agencies, authorities, instrumentalities, or similar entities, or of the
District of Columbia) if its assets and revenues are separate from those of the
government body creating it and the security is backed by its own assets and
revenues; the non-governmental user of an industrial development bond, if the
security is backed only by the assets and revenues of a non-governmental user.
The guarantee of a governmental or some other entity is considered a separate
security issued by the guarantor as well as the other issuer for Investment
Restrictions Nos. 1 and 3, industrial development bonds and governmental issued
securities. The issuer of all other municipal obligations will be determined
by the Money Manager on the basis of the characteristics of the obligation the
most significant being the source of the funds for the payment of principal and
interest.
Each Fund has adopted the following additional "non-fundamental" investment
restrictions, which may be changed without shareholder approval, in compliance
with applicable law and regulatory policy. No Fund will:
1) Invest in real estate limited partnerships that are not
readily marketable. This restriction shall not apply to the
Real Estate Securities Fund's investment in partnership units
of master limited partnerships;
2) Invest in oil, gas and mineral leases.
28
<PAGE> 34
Investment Policies.
Cash Reserves. Each Fund, except the Money Market, U.S.
Government Money Market, and Tax Free Money Market Funds, and their Money
Managers, may elect to invest the Fund's cash reserves in the Money Market
Fund. The Money Market Fund and the Funds investing in the Money Market Fund
treat such investments as the purchase and redemption of Money Market Fund
shares. Any Fund investing in the Money Market Fund pursuant to this procedure
participates equally on a pro rata basis in all income, capital gains and net
assets of the Money Market Fund, and will have all rights and obligations of a
shareholder as provided in the Trust's Master Trust Agreement, including voting
rights. However, shares of the Money Market Fund issued to other Funds will be
voted by the Trustees of the Investment Company in the same proportion as the
shares of the Money Market Fund which are held by shareholders which are not
Funds. Funds investing in the Money Market Fund currently do not pay a
management fee to the Money Market Fund.
Liquidity Portfolios. A Fund at times has to sell portfolio
securities in order to meet redemption requests. The selling of securities may
effect a Fund's performance since the Money Manager sells the securities for
other than investment reasons. A Fund can avoid selling its portfolio
securities by holding adequate levels of cash to meet anticipated redemption
requests.
The holding of significant amounts of cash is contrary to the
investment objectives of the Equity I, Equity II, Equity III, Equity Q,
International, Diversified Equity, Special Growth, Equity Income, Quantitative
Equity and International Securities Funds. The more cash these Funds hold, the
more difficult it is for their returns to meet or surpass their respective
benchmarks.
A Liquidity Portfolio addresses this potential detriment by
having Management Company or a Money Manager selected for this purpose create
an equity exposure for cash reserves through the use of options and futures
contracts. This will enable the Funds to hold cash while receiving a return on
the cash which is similar to holding equity securities.
Liquidity Portfolios are currently used for Equity I, Equity
II, Equity III, Equity Q, Diversified Equity, Special Growth, Equity Income and
Quantitative Equity Funds. Management Company intends to use a liquidity
portfolio in International and International Securities Funds in the coming
year.
Money Market Instruments. The Money Market, U.S. Government
Money Market, and Tax Free Money Market Funds expect to maintain, but do not
guarantee, a net asset value of $1.00 per share for purposes of purchases and
redemptions by valuing their Fund shares at "amortized cost." The three money
market funds will maintain a dollar-weighted average maturity of 90 days or
less. Each of the Funds will invest in securities with maturities of 397 days
or less at the time from the trade date or
29
<PAGE> 35
such other date upon which the fund's interest in security is subject to market
action. Each Fund will follow procedures reasonably designed to assure that
the prices so determined approximate the current market value of the Funds'
securities. The procedures also address such matters as diversification and
credit quality of the securities the Funds purchase, and were designed to
ensure compliance by the Funds with the requirements of Rule 2a-7 of the
Investment Company Act of 1940, as amended. For additional information
concerning these Funds, refer to the appropriate Prospectus.
Russell 1000(R) Index. The Russell 1000(R) Index consists of
the 1,000 largest US Companies by capitalization. The Index does not include
cross corporate holdings in a company's capitalization. For example, when IBM
owned approximately 20% of Intel, only 80% of the total shares outstanding of
Intel were used to determine Intel's capitalization. Also not included in the
Index are closed-end investment companies, companies that do not file a Form
10-K report with the Securities and Exchange Commission, foreign securities,
and American Depository Receipts (ADRs).
The Index's composition is changed annually to reflect changes
in market capitalization and share balances outstanding. These changes are
expected to represent less than 1% of the total market capitalization of the
Index. Changes for mergers and acquisitions are made when trading ceases in
the acquirer's shares. The 1,001st largest US company by capitalization is
then added to the Index to replace the acquired stock.
Certain Investments.
Repurchase Agreements. Each Fund may enter into repurchase
agreements with the seller -- a bank or securities dealer -- who agrees to
repurchase the securities at the Fund's cost plus interest within a specified
time (normally one day). The securities purchased by the Fund have a total
value in excess of the value of the repurchase agreement and are held by the
Fund's custodian bank until repurchased. Repurchase agreements assist a Fund
in being invested fully while retaining "overnight" flexibility in pursuit of
investments of a longer-term nature. The Fund will limit repurchase
transactions to those member banks of the Federal Reserve System and primary
dealers in US government securities whose credit worthiness is continually
monitored and found satisfactory by the Fund's Money Manager.
Reverse Repurchase Agreements. Each Fund may enter into
reverse repurchase agreements to meet redemption requests where the liquidation
of portfolio securities is deemed by the Fund's Money Manager to be
inconvenient or disadvantageous. A reverse repurchase agreement is a
transaction whereby a Fund transfers possession of a portfolio security to a
bank or broker-dealer in return for a percentage of the portfolios' securities
market value. The Fund retains record ownership of the security involved
including the right to receive interest and principal payments. At an agreed
upon future date, the Fund repurchases the security by paying an agreed upon
purchase price plus interest. Cash or liquid high-grade debt obligations of
the Fund equal in value to the repurchase price including any accrued interest
will be segregated on the Fund's records while a reverse repurchase agreement
is in effect.
30
<PAGE> 36
High Risk Bonds. The Funds, other than the Emerging Markets,
Fixed Income III and Multistrategy Bond Funds, do not invest assets in
securities rated less than BBB by Standard & Poor's Corporation ("S&P") or Baa
by Moody's Investors Service, Inc. ("Moody's"), or in unrated securities judged
by the Money Manager to be of a lesser credit quality than those designations.
Securities rated BBB by S&P or Baa by Moody's are the lowest ratings which are
considered "investment grade." The Funds, other than Emerging Markets, Fixed
Income III and Multistrategy Bond Funds, will dispose of securities which they
have purchased which drop below these minimum ratings.
Securities rated BBB by S&P or Baa by Moody's may involve
greater risks than securities in higher rating categories. Securities
receiving S&P's BBB rating are regarded as having adequate capacity to pay
interest and repay principal. Such securities typically exhibit adequate
investor protections but adverse economic conditions or changing circumstances
are more likely to lead to a weakened capacity to pay interest and repay
principal for debt in this category than in higher rating categories.
Securities possessing Moody's Baa rating are considered medium
grade obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security is judged adequate for the present,
but certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such securities lack outstanding
investment characteristics and in fact may have speculative characteristics as
well.
Risk Factors. The market for lower rated debt securities is
relatively new, its operating history is not extensive, and its growth has
paralleled a long period of economic expansion. Although the market has
experienced a period of recession, it has not weathered a major business
recession. Lower rated debt securities may be more susceptible to real or
perceived adverse economic and competitive industry conditions than investment
grade securities. The prices of low rated debt securities have been found to
be less sensitive to interest rate changes than investment grade securities,
but more sensitive to economic downturns, individual corporate developments,
and price fluctuations in response to changing interest rates. A projection of
an economic downturn or of a period of rising interest rates, for example,
could cause a sharper decline in the prices of low rated debt securities
because the advent of a recession could lessen the ability of a highly
leveraged company to make principal and interest payments on its debt
securities. If the issuer of low rated debt securities defaults, the Fund may
incur additional expenses to seek financial recovery.
In addition, the markets in which low rated debt securities
are traded are more limited than those for higher rated securities. The
existence of limited markets for particular securities may diminish the Fund's
ability to sell the securities at fair value either to meet redemption requests
or to respond to changes in the economy or in the financial markets and could
adversely affect and cause fluctuations in the daily net asset value of the
Fund's shares.
31
<PAGE> 37
Adverse publicity and investor perceptions, whether or not
based on fundamental analysis, may decrease the values and liquidity of low
rated debt securities, especially in a thinly traded market. Analysis of the
creditworthiness of issuers of low rated securities may be more complex than
for issuers of other investment grade securities, and the ability of the Fund
to achieve its investment objectives may be more dependent on credit analysis
than would be the case if the Fund was investing only in investment grade
securities.
The managers of the Fund may use ratings to assist in
investment decisions. Ratings of debt securities represent the rating agency's
opinion regarding their quality and are not a guarantee of quality. Rating
agencies attempt to evaluate the safety of principal and interest payments and
do not evaluate the risks of fluctuations in market value. Also, rating
agencies may fail to make timely changes in credit ratings in response to
subsequent events, so that an issuer's current financial condition may be
better or worse than a rating indicates.
Illiquid Securities. The expenses of registration of
restricted securities that are illiquid (excluding securities that may be
resold by the Fund pursuant to Rule 144A, as explained in the Prospectus) may
be negotiated at the time such securities are purchased by a Fund. When
registration is required, a considerable period may elapse between a decision
to sell the securities and the time the sale would be permitted. Thus, the
Fund may not be able to obtain as favorable a price as that prevailing at the
time of the decision to sell. The Fund also may acquire, through private
placements, securities having contractual resale restrictions, which might
lower the amount realizable upon the sale of such securities.
Delayed Delivery Transactions. A Fund may make contracts to
purchase securities for a fixed price at a future date beyond customary
settlement time ("forward commitments" or "when-issued" transactions)
consistent with the Fund's ability to manage its investment portfolio and meet
redemption requests. The Fund may dispose of a commitment or when issued
transaction prior to settlement if it is appropriate to do so and realize
short-term profits or losses upon such sale. When effecting such transactions,
cash or liquid high-grade debt obligations of the Fund in a dollar amount
sufficient to make payment for the portfolio securities to be purchased will be
segregated on the Fund's records at the trade date and maintained until the
transaction is settled. Forward commitments and when-issued transactions
involve a risk of loss if the value of the security to be purchased declines
prior to the settlement date or the other party to the transaction fails to
complete the transaction.
Additionally, under certain circumstances, International, International
Securities and Emerging Markets Funds may occasionally engage in "free trade"
transactions in which delivery of securities sold by the Fund is made prior to
the Fund's receipt of cash payment therefor or the Fund's payment of cash for
portfolio securities occurs prior to the Fund's receipt of those securities.
"Free trade" transactions involve the risk of loss to
32
<PAGE> 38
a Fund if the other party to the "free trade" transaction fails to complete the
transaction after the Fund has tendered cash payment or securities, as the case
may be.
Options and Futures. The Funds, other than the Money Market,
US Government Money Market, and Tax Free Money Market Funds, may purchase and
sell (write) both call and put options on securities, securities indexes, and
foreign currencies, and enter into interest rate, foreign currency and index
futures contracts and purchase and sell options on such futures contracts for
hedging purposes. If other types of options, futures contracts, or options on
futures contracts are traded in the future, the Funds may also use those
instruments, provided that the Funds' Board determines that their use is
consistent with the Funds' investment objectives, and provided that their use
is consistent with restrictions applicable to options and futures contracts
currently eligible for use by the Funds (i.e., that written call or put options
will be "covered" or "secured" and that futures and options on futures
contracts will be used only for hedging purposes).
Options on Securities and Indexes. Each Fund, except as noted
above, may purchase and write both call and put options on securities and
securities indexes in standardized contracts traded on foreign or national
securities exchanges, boards of trade, or similar entities, or quoted on NASDAQ
or on a regulated foreign over-the-counter market, and agreements, sometimes
called cash puts, which may accompany the purchase of a new issue of bonds from
a dealer.
An option on a security (or index) is a contract that gives
the holder of the option, in return for a premium, the right to buy from (in
the case of a call) or sell to (in the case of a put) the writer of the option
the security underlying the option (or the cash value of the index) at a
specified exercise price at any time during the term of the option. The writer
of an option on a security has the obligation upon exercise of the option to
deliver the underlying security upon payment of the exercise price or to pay
the exercise price upon delivery of the underlying security. Upon exercise,
the writer of an option on an index is obligated to pay the difference between
the cash value or the index and the exercise price multiplied by the specified
multiplier for the index option. (An index is designed to reflect specified
facets of a particular financial or securities market, a specified group of
financial instruments or securities, or certain economic indicators.)
A Fund will write call options and put options only if they
are "covered." In the case of a call option on a security, the option is
"covered" if the Fund owns the security underlying the call or has an absolute
and immediate right to acquire that security without additional cash
consideration (or, if additional cash consideration is required, cash or cash
equivalents in such amount are placed in a segregated account by its custodian)
upon conversion or exchange of other securities held by the Fund. For a call
option on an index, the option is covered if the Fund maintains with its
custodian cash or cash equivalents equal to the contract value. A call option
is also covered if the Fund holds a call on the same security or index as the
call written where the exercise price of the call held is (1) equal to or less
than the exercise price of the call written, or (2) greater than the exercise
price of the call written, provided the difference is maintained by the Fund in
cash or cash equivalents in a segregated account with its
33
<PAGE> 39
custodian. A put option on a security or an index is "covered" if the Fund
maintains cash or cash equivalents equal to the exercise price in a segregated
account with its custodian. A put option is also covered if the Fund holds a
put on the same security or index as the put written where the exercise price
of the put held is (1) equal to or greater than the exercise price of the put
written, or (2) less than the exercise price of the put written, provided the
difference is maintained by the Fund in cash or cash equivalents in a
segregated account with its custodian.
If an option written by a Fund expires, the Fund realizes a
short term capital gain equal to the premium received at the time the option
was written. If an option purchased by a Fund expires unexercised, the Fund
realizes a capital loss (long or short term depending on whether the Fund's
holding period for the option is greater than one year) equal to the premium
paid.
Prior to the earlier of exercise or expiration, an option may
be closed out by an offsetting purchase or sale of an option of the same series
(type, exchange, underlying security or index, exercise price, and expiration).
There can be no assurance, however, that a closing purchase or sale transaction
can be effected when the Fund desires.
A Fund will realize a short term capital gain from a closing
transaction on an option it has written if the cost of the closing option is
less than the premium received from writing the option, or, if it is more, the
Fund will realize a capital loss. If the premium received from a closing sale
transaction is more than the premium paid to purchase the option, the Fund will
realize a capital gain or, if it is less, the Fund will realize a capital loss.
With respect to closing transactions on purchased options, the capital gain or
loss realized will be short or long term depending on the holding period of the
option closed out. The principal factors affecting the market value of a put
or a call option include supply and demand, interest rates, the current market
price of the underlying security or index in relation to the exercise price of
the option, the volatility of the underlying security or index, and the time
remaining until the expiration date.
The premium paid for a put or call option purchased by a Fund
is an asset of the Fund. The premium received for an option written by a Fund
is recorded as a deferred credit. The value of an option purchased or written
is marked-to-market daily and is valued at the closing price on the exchange on
which it is traded or, if not traded on an exchange or no closing price is
available, at the mean between the last bid and asked prices.
Risks Associated with Options on Securities and Indexes.
There are several risks associated with transactions in options on securities
and on indexes. For example, there are significant differences between the
securities and options markets that could result in an imperfect correlation
between these markets, causing a given transaction not to achieve its
objectives. A decision as to whether, when and how to use options involves the
exercise of skill and judgment, and even a well-conceived
34
<PAGE> 40
transaction may be unsuccessful to some degree because of market behavior or
unexpected events.
There can be no assurance that a liquid market will exist when
a Fund seeks to close out an option position. If a Fund were unable to close
out an option that it had purchased on a security, it would have to exercise
the option in order to realize any profit or the option may expire worthless.
If a Fund were unable to close out a covered call option that it had written on
a security, it would not be able to sell the underlying security unless the
option expired without exercise. As the writer of a covered call option, a
Fund forgoes, during the option's life, the opportunity to profit from
increases in the market value of the security covering the call option above
the sum of the premium and the exercise price of the call.
If trading were suspended in an option purchased by a Fund,
the Fund would not be able to close out the option. If restrictions on
exercise were imposed, the Fund might be unable to exercise an option it has
purchased. Except to the extent that a call option on an index written by the
Fund is covered by an option on the same index purchased by the Fund, movements
in the index may result in a loss to the Fund; however, such losses may be
mitigated by changes in the value of the Fund's securities during the period
the option was outstanding.
Foreign Currency Options. A Fund may buy or sell put and call
options on foreign currencies either on exchanges or in the over-the-counter
market. A put option on a foreign currency gives the purchaser of the option
the right to sell a foreign currency at the exercise price until the option
expires. Currency options traded on US or other exchanges may be subject to
position limits which may limit the ability of a Fund to reduce foreign
currency risk using such options. Over-the-counter options differ from traded
options in that they are two-party contracts with price and other terms
negotiated between buyer and seller, and generally do not have as much market
liquidity as exchange-traded options.
Futures Contracts and Options on Futures Contracts. A Fund
may use interest rate, foreign currency or index futures contracts, as
specified for that Fund in its Prospectus. An interest rate, foreign currency
or index futures contract provides for the future sale by one party and
purchase by another party of a specified quantity of a financial instrument,
foreign currency or the cash value of an index at a specified price and time.
A futures contract on an index is an agreement pursuant to which two parties
agree to take or make delivery of an amount of cash equal to the difference
between the value of the index at the close of the last trading day of the
contract and the price at which the index contract was originally written.
Although the value of an index might be a function of the value of certain
specified securities, no physical delivery of these securities is made. A
public market exists in futures contracts covering several indexes as well as a
number of financial instruments and foreign currencies, including: the S&P
500; the S&P 100; the NYSE composite; US Treasury bonds; US Treasury notes;
GNMA Certificates; three-month US Treasury bills; 90-day commercial paper; bank
certificates of deposit; bills; Eurodollar certificates of deposit; the
Australian Dollar; the
35
<PAGE> 41
Canadian Dollar; the British Pound; the German Mark; the Japanese Yen; the
French Franc; the Swiss Franc; the Mexican Peso; and certain multinational
currencies, such as the European Currency Unit ("ECU"). It is expected that
other futures contracts will be developed and traded in the future.
A Fund may purchase and write call and put options on futures
contracts. Options on futures contracts possess many of the same
characteristics as options on securities and indexes (discussed above). A
futures option gives the holder the right, in return for the premium paid, to
assume a long position (call) or short position (put) in a futures contract at
a specified exercise price at any time during the period of the option. Upon
exercise of a call option, the holder acquires a long position in the futures
contract and the writer is assigned the opposite short position. In the case
of a put option, the opposite is true.
As long as required by regulatory authorities, each Fund will
limit its use of futures contracts and options on futures contracts to hedging
transactions. For example, a Fund might use futures contracts to hedge against
anticipated changes in interest rates that might adversely affect either the
value of the Fund's securities or the price of the securities which the Fund
intends to purchase. A Fund's hedging activities may include sales of futures
contracts as an offset against the effect of expected increases in interest
rates, and purchases of futures contracts as an offset against the effect of
expected declines in interest rates. Although other techniques could be used
to reduce that Fund's exposure to interest rate fluctuation, the Fund may be
able to hedge its exposure more effectively and perhaps at a lower cost by
using futures contracts and options on futures contracts.
A Fund will only enter into futures contracts and options on
futures contracts which are standardized and traded on a US or foreign
exchange, board of trade, or similar entity, or quoted on an automated
quotation system.
When a purchase or sale of a futures contract is made by a
Fund, the Fund is required to deposit with its custodian (or broker, if legally
permitted) a specified amount of cash or US Government securities ("initial
margin"). The margin required for a futures contract is set by the exchange on
which the contract is traded and may be modified during the term of the
contract. The initial margin is in the nature of a performance bond or good
faith deposit on the futures contract which is returned to the Fund upon
termination of the contract, assuming all contractual obligations have been
satisfied. Each Fund expects to earn interest income on its initial margin
deposits. A futures contract held by a Fund is valued daily at the official
settlement price of the exchange on which it is traded. Each day the Fund pays
or receives cash, called "variation margin," equal to the daily change in value
of the futures contract. This process is known as "marking to market."
Variation margin does not represent a borrowing or loan by a Fund but is
instead a settlement between the Fund and the broker of the amount one would
owe the other if the futures contract expired. In computing daily net asset
value, each Fund will mark-to-market its open futures positions.
36
<PAGE> 42
A Fund is also required to deposit and maintain margin with
respect to put and call options on futures contracts written by it. Such
margin deposits will vary depending on the nature of the underlying futures
contract (and the related initial margin requirements), the current market
value of the option, and other futures positions held by the Fund.
Although some futures contracts call for making or taking
delivery of the underlying securities, generally these obligations are closed
out prior to delivery by offsetting purchases or sales of matching futures
contracts (same exchange, underlying security or index, and delivery month).
If an offsetting purchase price is less than the original sale price, the Fund
realizes a capital gain, or if it is more, the Fund realizes a capital loss.
Conversely, if an offsetting sale price is more than the original purchase
price, the Fund realizes a capital gain, or if it is less, the Fund realizes a
capital loss. The transaction costs must also be included in these
calculations.
Limitations on Use of Futures and Options on Futures
Contracts. A Fund will not enter into a futures contract or futures option
contract if, immediately thereafter, the aggregate initial margin deposits
relating to such positions plus premiums paid by it for open futures option
positions, less the amount by which any such options are "in-the-money," would
exceed 5% of the Fund's total assets. A call option is "in-the-money" if the
value of the futures contract that is the subject of the option exceeds the
exercise price. A put option is "in-the-money" if the exercise price exceeds
the value of the futures contract that is the subject of the option.
When purchasing a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) cash, US Government
securities, or other highly liquid debt securities that, when added to the
amounts deposited with a futures commission merchant as margin, are equal to
the market value of the futures contract. Alternatively, the Fund may "cover"
its position by purchasing a put option on the same futures contract with a
strike price as high or higher than the price of the contract held by the Fund.
When selling a futures contract, a Fund will maintain with its
custodian (and mark-to-market on a daily basis) liquid assets that, when added
to the amount deposited with a futures commission merchant as margin, are equal
to the market value of the instruments underlying the contract. Alternatively,
the Fund may "cover" its position by owning the instruments underlying the
contract (or, in the case of an index futures contract, a portfolio with a
volatility substantially similar to that of the index on which the futures
contract is based), or by holding a call option permitting the Fund to purchase
the same futures contract at a price no higher than the price of the contract
written by the Fund (or at a higher price if the difference is maintained in
liquid assets with the Fund's custodian).
When selling a call option on a futures contract, a Fund will
maintain with its custodian (and mark-to-market on a daily basis) cash, US
Government securities, or other highly liquid debt securities that, when added
to the amounts deposited with a
37
<PAGE> 43
futures commission merchant as margin, equal the total market value of the
futures contract underlying the call option. Alternatively, the Fund may cover
its position by entering into a long position in the same futures contract at a
price no higher than the strike price of the call option, by owning the
instruments underlying the futures contract, or by holding a separate call
option permitting the Fund to purchase the same futures contract at a price not
higher than the strike price of the call option sold by the Fund.
When selling a put option on a futures contract, a Fund will
maintain with its custodian (and mark-to-market on a daily basis) cash, US
Government securities, or other highly liquid debt securities that equal the
purchase price of the futures contract, less any margin on deposit.
Alternatively, the Fund may cover the position either by entering into a short
position in the same futures contract, or by owning a separate put option
permitting it to sell the same futures contract so long as the strike price of
the purchased put option is the same or higher than the strike price of the put
option sold by the Fund.
In order to comply with applicable regulations of the
Commodity Futures Trading Commission ("CFTC") pursuant to which the Fund avoids
being deemed a "commodity pool," the Funds are limited in their futures
activities to positions which constitute "bona fide hedging" positions within
the meaning and intent of applicable CFTC rules, and with respect to positions
which do not qualify under that hedging test, to positions for which the
aggregate initial margins and premiums will not exceed 5% of the net assets of
the Fund as determined under the CFTC Rules.
The requirements for qualification as a regulated investment
company also may limit the extent to which a Fund may enter into futures,
options on futures contracts or forward contracts. See "Taxation."
Risks Associated with Futures and Options on Futures
Contracts. There are several risks associated with the use of futures
contracts and options on futures contracts as hedging techniques. A purchase
or sale of a futures contract may result in losses in excess of the amount
invested in the futures contract. There can be no guarantee that there will be
a correlation between price movements in the hedging vehicle and in the Fund
securities being hedged. In addition, there are significant differences
between the securities and futures markets that could result in an imperfect
correlation between the markets, causing a given hedge not to achieve its
objectives. The degree of imperfection of correlation depends on circumstances
such as variations in speculative market demand for futures and options on
futures contracts on securities, including technical influences in futures
trading and options on futures contracts, and differences between the financial
instruments being hedged and the instruments underlying the standard contracts
available for trading in such respects as interest rate levels, maturities, and
creditworthiness of issuers. A decision as to whether, when and how to hedge
involves the exercise of skill and judgment, and even a well-conceived hedge
may be unsuccessful to some degree because of market behavior or unexpected
interest rate trends.
38
<PAGE> 44
Futures exchanges may limit the amount of fluctuation
permitted in certain futures contract prices during a single trading day. The
daily limit establishes the maximum amount that the price of a futures contract
may vary either up or down from the previous day's settlement price at the end
of the current trading session. Once the daily limit has been reached in a
futures contract subject to the limit, no more trades may be made on that day
at a price beyond that limit. The daily limit governs only price movements
during a particular trading day and therefore does not limit potential losses
because the limit may work to prevent the liquidation of unfavorable positions.
For example, futures prices have occasionally moved to the daily limit for
several consecutive trading days with little or no trading, thereby preventing
prompt liquidation of positions and subjecting some holders of futures
contracts to substantial losses.
There can be no assurance that a liquid market will exist at a
time when a Fund seeks to close out a futures or a futures option position, and
that Fund would remain obligated to meet margin requirements until the position
is closed. In addition, many of the contracts discussed above are relatively
new instruments without a significant trading history. As a result, there can
be no assurance that an active secondary market will develop or continue to
exist.
Additional Risks of Options on Securities, Futures Contracts,
Options on Futures Contracts, and Forward Currency Exchange Contract and
Options Thereon. Options on securities, futures contracts, options on futures
contracts, currencies and options on currencies may be traded on foreign
exchanges. Such transactions may not be regulated as effectively as similar
transactions in the United States; may not involve a clearing mechanism and
related guarantees, and are subject to the risk of governmental actions
affecting trading in, or the prices of, foreign securities. The value of such
positions also could be adversely affected by (1) other complex foreign
political, legal and economic factors, (2) lesser availability than in the
United States of data on which to make trading decisions, (3) delays in the
Fund's ability to act upon economic events occurring in foreign markets during
non-business hours in the United States, (4) the imposition of different
exercise and settlement terms and procedures and margin requirements than in
the United States, and (5) lesser trading volume.
Hedging strategies. Stock index futures contracts may be used
by the Equity I, Equity II, Equity III, Equity Q, International, Emerging
Markets, Diversified Equity, Special Growth, Equity Income, Quantitative Equity
and International Securities Funds as a hedge during or in anticipation of
market decline. For example: If the market was anticipated to decline, stock
index futures contracts in a stock index with a value that correlates with the
declining stock value would be sold (short hedge) which would have an effect
similar to selling the stock. As the market value declines, the stock index
futures contracts value decreases partly offsetting the loss in value on the
stock by enabling the Fund to repurchase the futures contract at a lower price
to close out the position.
39
<PAGE> 45
Financial futures contracts may be used by the International,
Emerging Markets, Fixed Income I, Fixed Income II, International Securities,
Diversified Bond, Volatility Constrained Bond, and Limited Volatility Tax Free
Funds as a hedge during or in anticipation of interest rate changes. Fixed
Income III and Multistrategy Bond may use financial futures contracts as a
hedge and intend to do so within the coming year. For example: If interest
rates were anticipated to rise, financial futures contracts would be sold
(short hedge) which have an effect similar to selling bonds. Once interest
rates increase, fixed income securities held in the Fund's portfolio would
decline, but the futures contract value decreases partly offsetting the loss in
value of the fixed income security by enabling the Fund to repurchase the
futures contract at a lower price to close out the position.
The Funds may purchase a put option on a stock index futures
contract instead of selling a futures contract in anticipation of market
decline. Purchasing a call option on a stock index futures contract is used
instead of buying a futures contract in anticipation of a market advance, or to
temporarily create an equity exposure for cash balances until those balances
are invested in equities. Options on financial futures are used in a similar
manner in order to hedge portfolio securities against anticipated changes in
interest rates.
When purchasing a futures contract, a Fund will maintain with
its custodian (and mark-to-market on a daily basis) cash, US government
securities, or other highly liquid debt securities that, when added to the
amounts deposited with a futures commission merchant as margin, are equal to
the market value of the futures contract. Alternatively, the Fund may "cover"
its position by purchasing a put option on the same futures contract with a
strike price as high or higher than the price of the contract held by the Fund.
Foreign Currency Futures Contracts. The Funds are also
permitted to enter into foreign currency futures contracts in accordance with
their investment objectives and as limited by the procedures outlined above.
Only the Fixed Income III and Multistrategy Bond Funds intend to enter into
foreign currency futures contracts.
A foreign currency futures contract is a bilateral agreement
pursuant to which one party agrees to make, and the other party agrees to
accept delivery of a specified type of debt security or currency at a specified
price. Although such futures contacts by their terms call for actual delivery
or acceptance of debt securities or currency, in most cases the contracts are
closed out before the settlement date without the making or taking of delivery.
The Fund may sell a foreign currency futures contract to hedge
against possible variations in the exchange rate of the foreign currency in
relation to the US dollar. When a manager anticipates a significant change in
a foreign exchange rate while intending to invest in a foreign security, the
Fund may purchase a foreign currency futures contract to hedge against a rise
in foreign exchange rates pending completion of the anticipated transaction.
Such a purchase would serve as a temporary measure to
40
<PAGE> 46
protect the Fund against any rise in the foreign exchange rate which may add
additional costs to acquiring the foreign security position. The Fund may also
purchase call or put options on foreign currency futures contracts to obtain a
fixed foreign exchange rate. The Fund may purchase a call option or write a
put option on a foreign exchange futures contract to hedge against a decline in
the foreign exchange rates or the value of its foreign securities. The Fund
may write a call option on a foreign currency futures contract as a partial
hedge against the effects of declining foreign exchange rates on the value of
foreign securities.
Risk Factors. There are certain investment risks in using
futures contracts and/or options as a hedging technique. One risk is the
imperfect correlation between price movement of the futures contracts or
options and the price movement of the portfolio securities, stock index or
currency subject of the hedge. The risk increases for the Limited Volatility
Tax Free Fund since financial futures contracts that may be engaged in are on
taxable securities rather than tax exempt securities. There is no assurance
that the price of taxable securities move in a similar manner to the price of
tax exempt securities. Another risk is that a liquid secondary market may not
exist for a futures contract causing a Fund to be unable to close out the
futures contract thereby affecting a Fund's hedging strategy.
In addition, foreign currency options and foreign currency
futures involve additional risks. Such transaction may not be regulated as
effectively as similar transactions in the United States; may not involve a
clearing mechanism and related guarantees, and are subject to the risk of
governmental actions affecting trading in, or the prices of, foreign
securities. The value of such positions could also be adversely affected by
(i) other complex foreign, political, legal and economic factors, (ii) lesser
availability than in the United States of data on which to make trading
decisions, (iii) delays in the Fund's ability to act upon economic events
occurring in foreign markets during non-business hours in the United States,
(iv) the imposition of different exercise and settlement terms and procedures
and margin requirements than in the United States, and (v) lesser trading
volume.
Forward Foreign Currency Exchange Transactions. The Funds may
engage in forward foreign currency exchange transactions to hedge against
uncertainty in the level of future exchange rates. The Funds will conduct
their forward foreign currency exchange transactions either on a spot (i.e.
cash) basis at the rate prevailing in the currency exchange market, or through
entering into forward currency exchange contracts ("forward contract") to
purchase or sell currency at a future date. A forward contract involves an
obligation to purchase or sell a specific currency at a future date, which may
be any fixed number of days from the date of the contract agreed upon by the
parties, at a price set at the time of the contract. The Funds may engage in a
forward contract that involves transacting in a currency whose changes in value
are considered to be linked (a proxy) to a currency or currencies in which some
or all of the Fund's portfolio securities are or are expected to be
denominated. The Fund's dealings in forward contracts will be limited to
hedging involving either specific transactions or portfolio positions.
Transaction hedging is the purchase or sale of foreign currency with
41
<PAGE> 47
respect to specific receivables or payables of the Funds generally accruing in
connection with the purchase or sale of its portfolio securities. Position
hedging is the sale of foreign currency with respect to portfolio security
positions denominated or quoted in the currency. The Funds may not position
hedge with respect to a particular currency to an extent greater than the
aggregate market value (at the time of making such sale) of the securities held
in its portfolio denominated or quoted in or currency convertible into that
particular currency (or another currency or aggregate of currencies which act
as a proxy for that currency). The Funds may, however, enter into a position
hedging transaction with respect to a currency other than that held in the
Fund's portfolio, if such a transaction is deemed a hedge. If a Fund enters
into this type of hedging transaction, cash or liquid high-grade debt
securities will be placed in a segregated account in an amount equal to the
value of the Fund's total assets committed to the consummation of the forward
contract. If the value of the securities placed in the segregated account
declines, additional cash or securities will be placed in the account so that
the value of the account will equal the amount of the Fund's commitment with
respect to the contract. Hedging transactions may be made from any foreign
currency into US dollars or into other appropriate currencies.
At or before the maturity of a forward foreign currency
contract, the Fund may either sell a portfolio security and make delivery of
the currency, or retain the security and offset its contractual obligation to
deliver the currency by purchasing a second contract pursuant to which the Fund
will obtain, on the same maturity date, the same amount of the currency which
it is obligated to deliver. If the Fund retains the portfolio security and
engages in an offsetting transaction, the Fund, at the time of execution of the
offsetting transaction, will incur a gain or a loss to the extent that
movement has occurred in forward currency contract prices. Should forward
prices decline during the period between the Fund's entering into a forward
contract for the sale of a currency and the date that it enters into an
offsetting contract for the purchase of the currency, the Fund will realize a
gain to the extent that the price of the currency that it has agreed to sell
exceeds the price of the currency that it has agreed to purchase. Should
forward prices increase, the Fund will suffer a loss to the extent that the
price of the currency it has agreed to purchase exceeds the price of the
currency that it has agreed to sell.
The cost to the Fund of engaging in currency transactions
varies with factors such as the currency involved, the length of the contract
period and the market conditions then prevailing. Because transactions in
currency exchange are usually conducted on a principal basis, no fees or
commissions are involved. The use of forward foreign currency contracts does
not eliminate fluctuations in the underlying prices of the securities, but it
does establish a rate of exchange that can be achieved in the future. In
addition, although forward foreign currency contracts limit the risk of loss
due to a decline in the value of the hedged currency, at the same time, they
limit any potential gain that might result should the value of the currency
increase.
If a devaluation is generally anticipated, the Fund may be
able to contract to sell the currency at a price above the devaluation level
that it anticipates. The Fund
42
<PAGE> 48
will not enter into a currency transaction if, as a result, it will fail to
qualify as a regulated investment company under the Internal Revenue Code of
1986, as amended (the "Code"), for a given year.
Forward foreign currency contracts are not regulated by the
SEC. They are traded through financial institutions acting as market-makers.
In the forward foreign currency market, there are no daily price fluctuation
limits, and adverse market movements could therefore continue to an unlimited
extent over a period of time. Moreover, a trader of forward contracts could
lose amounts substantially in excess of its initial investments, due to the
collateral requirements associated with such positions.
Forward foreign currency transactions are subject to the risk of governmental
actions affecting trading in or the prices of foreign currencies or securities.
The value of such positions also could be adversely affected by (a) other
complex foreign political and economic factors, (b) lesser availability than in
the United States of data on which to make trading decisions, (c) delays in the
Fund's ability to act upon economic events occurring in foreign markets during
non-business hours in the United States and the United Kingdom, (d) the
imposition of different exercise and settlement terms and procedures and margin
requirements than in the United States, (e) lesser trading volume and (f) that
a perceived linkage between various currencies may not persist throughout the
duration of the contracts.
Indexed Commercial Paper. Indexed commercial paper is
US-dollar denominated commercial paper the yield of which is linked to certain
foreign exchange rate movements. The yield to the investor on commercial
indexed paper is established at maturity as a function of spot exchange rates
between the US dollar and a designated currency as of or about that time. The
yield to the investor will be within a range stipulated at the time of purchase
of the obligation, generally with a guaranteed minimum rate of return that is
below, and a potential maximum rate of return that is above, market yields on
US-dollar denominated commercial paper, with both the minimum and maximum rates
of return on the investment corresponding to the minimum and maximum values of
the spot exchange rate two business days prior to maturity. While such
commercial paper entails risk of loss of principal, the potential risk for
realizing gains as a result of changes in foreign currency exchange rates
enables the Fund to hedge (or cross-hedge) against a decline in the US-dollar
value of investments denominated in foreign currencies while providing an
attractive money market rate of return. Currently only the Fixed Income III
and Multistrategy Bond Funds intend to invest in indexed commercial paper, and
then only for hedging purposes. The staff of the Securities and Exchange
Commission ("SEC") is currently considering whether the purchase of this type
of commercial paper would result in the issuance of a "senior security." If
required by the appropriate authorities to assure that investments in indexed
commercial paper are not used to achieve investment leverage, a Fund will
segregate cash or readily marketable high-quality securities in an amount at
all times equal or exceeding the Fund's commitment with respect to these
contracts.
43
<PAGE> 49
US Government Obligations. The types of US government
obligations the Funds may at times invest in include: (1) A variety of US
Treasury obligations which differ only in their interest rates, maturities and
times of issuance: (a) US Treasury bills at time of issuance have maturities
of one year or less, (b) US Treasury notes at time of issuance have maturities
of one to ten years and (c) US Treasury bonds at time of issuance generally
have maturities of greater than ten years; (2) obligations issued or guaranteed
by US government agencies and instrumentalities are supported by any of the
following: (a) the full faith and credit of the US Treasury (such as
Government National Mortgage Association participation certificates), (b) the
right of the issuer to borrow an amount limited to a specific line of credit
from the US Treasury, (c) discretionary authority of the US government agency
or instrumentality, or (d) the credit of the instrumentality (examples of
agencies and instrumentalities are: Federal Land Banks, Farmers Home
Administration, Central Bank for Cooperatives, Federal Intermediate Credit
Banks, Federal Home Loan Banks, Federal National Mortgage Association). No
assurance can be given that the US government will provide financial support to
such US government agencies or instrumentalities described in (2)(b), (2)(c)
and (2)(d) in the future, other than as set forth above, since it is not
obligated to do so by law. The Funds may purchase US government obligations on
a forward commitment basis.
Variable and Floating Rate Securities. A floating rate
security is one whose terms provide for the automatic adjustment of interest
rate whenever a specified interest rate changes. A variable rate security is
one whose terms provide for the automatic establishment of a new interest rate
on set dates. The interest rate on floating rate securities is ordinarily tied
to and is a percentage of the prime rate of a specified bank or some similar
objective standard, such as 90-day US Treasury Bill rate, and may change as
often as twice daily. Generally, changes in interest rates on floating rate
securities will reduce changes in the security's market value from the original
purchase price resulting in the potential for capital appreciation or capital
depreciation being less than for fixed income obligations with a fixed interest
rate.
The U.S. Government Money Market Fund may purchase variable
rate US government obligations which are instruments issued or guaranteed by
the US government, or an agency or instrumentality thereof, which has a rate of
interest subject to adjustment at regular intervals but no less frequently than
annually. Variable rate US government obligations whose interest rate is
readjusted no less frequently than annually will be deemed to have a maturity
equal to the period remaining until the next readjustment of the interest rate.
Variable Amount Master Demand Notes. The Money Market and
U.S. Government Money Market Funds, consistent with their fundamental
investment objectives, may invest in variable amount master demand notes.
Variable amount master demand notes are unsecured obligations redeemable upon
notice that permit investment of fluctuating amounts at varying rates of
interest pursuant to direct arrangements with the issuer of the instrument. A
variable amount master demand note differs from ordinary commercial paper in
that (1) it is issued pursuant to a written agreement
44
<PAGE> 50
between the issuer and the holders, (2) its amount may, from time to time, be
increased (subject to an agreed maximum) or decreased by the holder of the
issue, (3) it is payable on demand, (4) its rate of interest payable varies
with an agreed upon formula and (5) it is not typically rated by a rating
agency.
Zero Coupon Securities. Zero coupon securities are notes,
bonds and debentures that (i) do not pay current interest and are issued at a
substantial discount from par value, (ii) have been stripped of their unmatured
interest coupons and receipts or (iii) pay no interest until a stated date one
or more years into the future. These securities also include certificates
representing interests in such stripped coupons and receipts. Zero coupon
securities trade at a discount from their par value and are subject to greater
fluctuations of market value in response to changing interest rates.
Mortgage-Related and other Asset-Backed Securities. The forms
of mortgage-related and other asset-backed securities the Funds may invest in
include the securities described below:
Mortgage pass-through securities. Mortgage pass-through
securities are securities representing interests in "pools" of
mortgages in which payments of both interest and principal on
the securities are generally made monthly. The securities are
"pass-through" securities because they provide investors with
monthly payments of principal and interest which in effect are
a "pass through" of the monthly payments made by the
individual borrowers on the underlying mortgages, net of any
fees paid to the issuer or guarantor. The principal
governmental issuer of such securities is the Government
National Mortgage Association ("GNMA"), which is a
wholly-owned US government corporation within the Department
of Housing and Urban Development. Government-related issuers
include the Federal Home Loan Mortgage Corporation ("FHLMC"),
a corporate instrumentality of the United States created
pursuant to an act of Congress which is owned entirely by the
Federal Home Loan Banks, and the Federal National Mortgage
Association ("FNMA"), a government sponsored corporation owned
entirely by private stockholders. Commercial banks, savings
and loans institutions, private mortgage insurance companies,
mortgage bankers and other secondary market issuers also
create pass-through pools of conventional residential mortgage
loans. Such issuers may be the originators of the underlying
mortgage loans as well as the guarantors of the
mortgage-related securities.
Collateralized Mortgage Obligations. Collateralized Mortgage
Obligations ("CMOs") are hybrid instruments with
characteristics of both mortgage-backed bonds and mortgage
pass-through securities. Similar to a bond, interest and
pre-paid principal on a CMO are paid, in most cases, monthly.
CMOs may be collateralized by whole mortgage loans but are
more typically collateralized by portfolios of mortgage
pass-through
45
<PAGE> 51
securities guaranteed by GNMA, FHLMC, or FNMA. CMOs are
structured into multiple classes (or "tranches"), with each
class bearing a different stated maturity.
Asset-Backed Securities. Asset-backed securities represent
undivided fractional interests in pools of instruments, such
as consumer loans, and are similar in structure to
mortgage-related pass-through securities. Payments of
principal and interest are passed through to holders of the
securities and are typically supported by some form of credit
enhancement, such as a letter of credit, surety bond, limited
guarantee by another entity or by priority to certain of the
borrower's other securities. The degree of enhancement
varies, generally applying only until exhausted and covering
only a fraction of the security's par value. If the credit
enhancement held by a Fund has been exhausted, and if any
required payments of principal and interest are not made with
respect to the underlying loans, a Fund may experience loss or
delay in receiving payment and a decrease in the value of the
security.
Risk Factors. Prepayment of principal on mortgage or
asset-backed securities may expose a Fund to a lower rate of
return upon reinvestment of principal. Also, if a security
subject to prepayment has been purchased at a premium, in the
event of prepayment the value of the premium would be lost.
Like other fixed income securities, the value of
mortgage-related securities is affected by fluctuations in
interest rates.
Loan Participations. The Fixed Income III and Multistrategy
Bond Funds may purchase participations in commercial loans. Such indebtedness
may be secured or unsecured. Loan participations typically represent direct
participation in a loan to a corporate borrower, and generally are offered by
banks or other financial institutions or lending syndicates. In purchasing the
loan participations, a Fund assumes the credit risk associated with the
corporate buyer and may assume the credit risk associated with the interposed
bank or other financial intermediary. The participation may not be rated by a
nationally recognized rating service. Further, loan participations may not be
readily marketable and may be subject to restrictions on resale.
Municipal Obligations. "Municipal obligations" are debt
obligations issued by states, territories and possessions of the United States
and the District of Columbia and their political subdivisions, agencies and
instrumentalities, or multi-state agencies or authorities the interest from
which is exempt from federal income tax in the opinion of bond counsel to the
issuer. Municipal obligations include debt obligations issued to obtain funds
for various public purposes and certain industrial development bonds issued by
or on behalf of public authorities. Municipal obligations are classified as
general obligation bonds, revenue bonds and notes.
46
<PAGE> 52
Municipal Bonds. Municipal bonds generally have maturities of
more than one year when issued and have two principal
classifications -- General Obligation Bonds and Revenue Bonds.
General Obligation Bonds - are secured by the issuer's
pledge of its faith, credit and taxing power for the
payment of principal and interest.
Revenue Bonds - are payable only from the revenues
derived from a particular facility or group of
facilities or from the proceeds of special excise or
other specific revenue service.
Industrial Development Bonds - are a type of revenue
bond and do not generally constitute the pledge of
credit of the issuer of such bonds. The payment of
the principal and interest on such bonds is dependent
on the facility's user to meet its financial
obligations and the pledge, if any, of real and
personal property financed as security for such
payment. Industrial development bonds are issued by
or on behalf of public authorities to raise money to
finance public and private facilities for business,
manufacturing, housing, ports, pollution control,
airports, mass transit and other similar type
projects.
Municipal Notes. Municipal notes generally have maturities of
one year or less when issued and are used to satisfy
short-term capital needs. Municipal notes include:
Tax Anticipation Notes - are issued to finance
working capital needs of municipalities and are
generally issued in anticipation of future tax
revenues.
Bond Anticipation Notes - are issued in expectation of
a municipality issuing a longer term bond in the
future. Usually the long-term bonds provide the
money for the repayment of the notes.
Revenue Anticipation Notes - are issued in expectation
of receipt of other types of revenues such as certain
federal revenues.
Construction Loan Notes - are sold to provide
construction financing and may be insured by the
Federal Housing Administration. After completion of
the project the Federal National Mortgage Association
or the Government National Mortgage Association
frequently provides permanent financing.
47
<PAGE> 53
Pre-Refunded Municipal Bonds - are bonds no longer
secured by the credit of the issuing entity, having
been escrowed with US Treasury Securities as a result
of a refinancing by the issuer. The bonds are
escrowed for retirement either at original maturity
or at an earlier call date.
Tax Free Commercial Paper - is a promissory
obligation issued or guaranteed by a municipal issuer
and frequently accompanied by a letter of credit of a
commercial bank. It is used by agencies of state and
local governments to finance seasonal working capital
needs, or as short-term financing in anticipation of
long term financing.
Tax Free Floating and Variable Rate Demand Notes - are
municipal obligations backed by an obligation of a
commercial bank to the issuer thereof which allows
the issuer to issue securities with a demand feature,
which, when exercised, usually becomes effective
within thirty days. The rate of return on the notes
is readjusted periodically according to some
objective standard such as changes in a commercial
bank's prime rate.
Tax Free Participation Certificates - are tax-free
floating or variable rate demand notes which are
issued by a bank, insurance company or other
financial institution or affiliated organization that
sells a participation in the note. They are usually
purchased by the Limited Volatility Tax Free and Tax
Free Money Market Funds to maintain liquidity. The
Funds' Money Managers will continually monitor the
pricing, quality and liquidity of the floating and
variable rate demand instruments held by the Funds,
including the participation certificates.
A participation certificate gives the Fund an
undivided interest in the municipal obligation in the
proportion that the Fund's participation interest
bears to the total principal amount of the municipal
obligation and provides the demand feature described
below. Each participation is backed by: an
irrevocable letter of credit or guaranty of a bank
which may be the bank issuing the participation
certificate, a bank issuing a confirming letter of
credit to that of the issuing bank, or a bank serving
as agent of the issuing bank with respect to the
possible repurchase of the certificate of
participation; or insurance policy of an insurance
company that the Money Manager has determined meets
the prescribed quality standards for the Fund. The
Fund has the right to sell the participation
certificate back to the institution and draw on the
letter of credit or insurance on demand after thirty
days' notice for all or any part of the full
principal amount of the
48
<PAGE> 54
Fund's participation interest in the security plus
accrued interest. The Funds' Money Managers intend
to exercise the demand feature only (1) upon a
default under the terms of the bond documents, (2) as
needed to provide liquidity to the Fund in order to
make redemptions of Fund shares, or (3) to maintain
the required quality of its investment portfolio.
The institutions issuing the participation
certificates will retain a service and letter of
credit fee and a fee for providing the demand
feature, in an amount equal to the excess of the
interest paid on the instruments over the negotiated
yield at which the participations were purchased by
the Fund. The total fees generally range from 5% to
15% of the applicable prime rate or other interest
rate index. The Fund will attempt to have the issuer
of the participation certificate bear the cost of the
insurance. The Fund retains the option to purchase
insurance if necessary, in which case the cost of
insurance will be a capitalized expense of the Fund.
Demand Notes. The Limited Volatility Tax Free and Tax Free
Money Market Funds may purchase municipal obligations with the
right to a "put" or "stand-by commitment." A "put" on a
municipal obligation obligates the seller of the put to buy
within a specified time and at an agreed upon price a
municipal obligation the put is issued with. A stand-by
commitment is similar to a put except the seller of the
commitment is obligated to purchase the municipal obligation
on the same day the Fund exercises the commitment and at a
price equal to the amortized cost of the municipal obligation
plus accrued interest. The seller of the put or stand-by
commitment may be the issuer of the municipal obligation, a
bank or broker-dealer.
The Funds will enter into put and stand-by commitment with
institutions such as banks and broker-dealers that the Funds'
Money Manager continually believes satisfy the Funds' credit
quality requirements. The ability of the Funds to exercise
the put or stand-by commitment may depend on the seller's
ability to purchase the securities at the time the put or
stand-by commitment is exercised or on certain restrictions in
the buy back arrangement. Such restrictions may prohibit the
Funds from exercising the put or stand-by commitment except to
maintain portfolio flexibility and liquidity. In the event
the seller would be unable to honor a put or stand-by
commitment for financial reasons, the Funds may, in the
opinion of Funds' management, be a general creditor of the
seller. There may be certain restrictions in the buy back
arrangement which may not obligate the seller to repurchase
the securities. (See, "Certain Investments -- Municipal Notes
-- Tax-Free Participation Certificates.")
49
<PAGE> 55
The Limited Volatility Tax Free and Tax Free Money Market
Funds may purchase from issuers floating or variable rate
municipal obligations some of which are subject to payment of
principal by the issuer on demand by the Fund (usually not
more than thirty days' notice). The Funds may also purchase
floating or variable rate municipal obligations or
participations therein from banks, insurance companies or
other financial institutions which are owned by such
institutions or affiliated organizations. Each participation
is usually backed by an irrevocable letter of credit, or
guaranty of a bank or insurance policy of an insurance
company.
Interest Rate Transactions. The Fixed Income II, Fixed Income
III, Volatility Constrained Bond and Multistrategy Bond Funds may enter into
interest rate swaps, on either an asset-based or liability-based basis,
depending on whether they are hedging their assets or their liabilities, and
will usually enter into interest rate swaps on a net basis, i.e., the two
payment streams are netted out, with the Funds receiving or paying, as the case
may be, only the net amount of the two payments. Inasmuch as these hedging
transactions are entered into for good faith hedging purposes, the adviser and
the Funds believe such obligations do not constitute senior securities and,
accordingly, will not treat them as being subject to its borrowing
restrictions. The net amount of the excess, if any, of the Funds' obligations
over its entitlements with respect to each interest rate swap will be accrued
on a daily basis and an amount of cash or liquid high-grade debt securities
having an aggregate net asset value at least equal to the accrued excess will
be maintained in a segregated account by the Funds' custodian. To the extent
that the Funds enter into interest rate swaps on other than a net basis, the
amount maintained in a segregated account will be the full amount of the Funds'
obligations, if any, with respect to such interest rate swaps, accrued on a
daily basis. The Funds will not enter into any interest rate swaps unless the
unsecured senior debt or the claims-paying ability of the other party thereto
is rated in the highest rating category of at least one nationally recognized
rating organization at the time of entering into such transaction. If there is
a default by the other party to such a transaction, the Funds will have
contractual remedies pursuant to the agreement related to the transaction. The
swap market has grown substantially in recent years with a large number of
banks and investment banking firms acting both as principals and as agents
utilizing standardized swap documentation. As a result, the swap market has
become relatively liquid.
The use of interest rate swaps is a highly specialized
activity which involves investment techniques and risks different from those
associated with ordinary portfolio securities transactions. If a Money Manager
using this technique is incorrect in its forecast of market values, interest
rates and other applicable factors, the investment performance of the Funds
would diminish compared to what it would have been if this investment technique
was not used.
The Funds may only enter into interest rate swaps to hedge its
portfolio. Interest rate swaps do not involve the delivery of securities or
other underlying assets or principal. Accordingly, the risk of loss with
respect to interest rates swaps is limited to the net amount of interest
payments that the Funds are contractually obligated to make.
50
<PAGE> 56
If the other party to an interest rate swap defaults, the Funds' risk of loss
consists of the net amount of interest payments that the Funds are
contractually entitled to receive. Since interest rate swaps are individually
negotiated, the Funds expect to achieve an acceptable degree of correlation
between its rights to receive interest on its portfolio securities and its
rights and obligations to receive and pay interest pursuant to interest rate
swaps.
Foreign Government Securities. Foreign government securities
which the Fund may invest in generally consist of obligations issued or backed
by the national, state or provincial government or similar political
subdivisions or central banks in foreign countries. Foreign government
securities also include debt obligations of supranational entities, which
include international organizations designated or backed by governmental
entities to promote economic reconstruction or development, international
banking institutions and related government agencies. These securities also
include debt securities of "quasi-government agencies" and debt securities
denominated in multinational currency units of an issuer.
Brady Bonds. The Fixed Income III and Multistrategy Bond
Funds may invest in Brady Bonds, the products of the "Brady Plan," under which
bonds are issued in exchange for cash and certain of the country's outstanding
commercial bank loans. The Brady Plan offers relief to debtor countries that
have effected substantial economic reforms. Specifically, debt reduction and
structural reform are the main criteria countries must satisfy in order to
obtain Brady Plan status. Brady Bonds may be collateralized or
uncollateralized, are issued in various currencies (primarily US-dollar) and
are actively traded on the over-the-counter market. Brady Bonds have been
issued only recently and accordingly they do not have a long payment history.
TAXES
In order to qualify for treatment as a regulated investment company ("RIC")
under Subchapter M of the Internal Revenue Code of 1986, as amended ("Code"),
each Fund must distribute annually to its shareholders at least 90% of its
investment company taxable income (generally, net investment income plus net
short-term capital gain) ("Distribution Requirement") and also must meet
several additional requirements. Among these requirements are the following:
(i) at least 90% of a Fund's gross income each taxable year must be derived
from dividends, interest, payments with respect to securities loans and gains
from the sale or other disposition of stock or securities or foreign currencies
(exclusive of losses), or other income (including gains from options, futures,
or forward contracts) derived with respect to its business of investing in such
stock, securities or currencies ("Income Requirement"); (ii) less than 30% of a
Fund's gross income each taxable year may be derived from gains (exclusive of
losses) from the sale or other disposition of any stock or securities; any
options, futures, or forward contracts; foreign currencies including any
options or futures thereon (which are not directly related to a Fund's business
in investing) held for less than three months (the "Short-Short Limitation");
(iii) at the close of each quarter of a Fund's taxable year, at
51
<PAGE> 57
least 50% of the value of its total assets must be represented by cash and cash
items, US government securities, securities of other RICs and other securities,
with such other securities limited, in respect of any one issuer, to an amount
that does not exceed 5% of the value of the Fund and that does not represent
more than 10% of the outstanding voting securities of such issuer; and (iv) at
the close of each quarter of the Fund's taxable year, not more than 25% of the
value of its assets may be invested in securities (other than US government
securities or the securities of other RICs) of any one issuer.
Notwithstanding the Distribution Requirement described above, which only
requires each Fund to distribute at least 90% of its annual investment company
taxable income and does not require any minimum distribution of net capital
gain (the excess of net long-term capital gain over net short-term capital
loss), each Fund will be subject to a nondeductible 4% excise tax to the extent
it fails to distribute by the end of any calendar year at least 98% of its
ordinary income for that year and 98% of its capital gain net income for the
one-year period ending on October 31 of that year, plus prior-year shortfalls.
For this and other purposes, dividends declared by a RIC in October, November
or December of any calendar year and payable to shareholders of record on a
date in such a month will be deemed to have been paid by the RIC and received
by shareholders on December 31 of such year if the dividends are paid by the
RIC at any time through the end of the following January.
At December 31, 1994, certain of the Funds had net tax basis capital loss
carryforwards which may be applied against any realized net taxable gains of
each succeeding year until their respective expiration dates, whichever occurs
first. Available capital loss carryforwards and expiration dates are as
follows:
<TABLE>
<CAPTION>
12/31/95 12/31/96 12/31/97 12/31/98 12/31/99 12/31/01 12/31/02
-------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Fixed Income
I $ ---- $ ---- $ ---- $ ---- $ ---- $ ---- $(13,727,694)
Fixed Income ---- ---- ---- ---- ----
II (948,478) (3,534,633)
Fixed Income
III ---- ---- ---- ---- ---- ---- (5,734,410)
Diversified
Bond ---- ---- ---- ---- ---- ---- (10,502,697)
Volatility
Constrained
Bond (708,248) (2,298,957) ---- ---- ---- ---- (5,583,410)
Multistrategy
Bond ---- ---- ---- ---- ---- ---- (4,776,029)
Limited
Volatility
Tax Free (162,781) (238,975) (103,283) (26,604) (383,404) ---- (345,504)
</TABLE>
52
<PAGE> 58
Issues Related to Hedging and Option Investments. The use of
hedging instruments, such as options and futures contracts, involves
specialized and complex rules that will determine the character for income tax
purposes of the income received in connection therewith by the Fund and thereby
affect, among other things, the amount and proportion of distributions that
will be taxable to shareholders as ordinary income or capital gain.
As described above and in the Funds' prospectuses, the Funds
may buy and sell foreign currencies and options on foreign currencies, and may
enter into forward currency contracts and currency futures contracts. The
Funds anticipate that these investment activities will not prevent the Funds
from qualifying as a regulated investment company. As a general rule, gains or
losses on the disposition of debt securities denominated in a foreign currency
that are attributable to fluctuations in exchange rates between the date that
the debt securities are acquired and the date of disposition, gains and losses
from the disposition of foreign currencies, and gains and losses attributable
to options on foreign currencies, forward currency contracts and currency
futures contracts will be treated as ordinary income or loss.
Gains or losses attributable to fluctuations in exchange rates
which occur between the time the fund accrues interest or other receivables, or
expenses or other liabilities, denominated in a foreign currency and the time
the Fund actually collects such receivables, or pays such liabilities, are
generally treated as ordinary income or loss. Similarly, gains or losses on
disposition of debt securities denominated in a 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, referred to under the Internal
Revenue Code of 1986, as amended (the "Code") as "Section 988" gains or losses,
may increase or decrease the amount of the fund's investment company taxable
income to be distributed to its shareholders, rather than increasing or
decreasing the amount of the Fund's capital gains or losses.
As noted above and in the Prospectuses, the Funds may acquire
forward currency contracts, currency futures contracts and options on foreign
currencies to hedge its risk of currency fluctuations with regard to property
held or to be held by the Funds, and before the close of the day on which the
Funds enters into the contract or option, the Funds will, as a general rule,
identify on its records that the contract or option was entered into as part of
a hedging transaction. If the Funds were to invest in a forward currency
contract, currency futures contract or option on a foreign currency and
offsetting positions in such contracts or options, and if the two offsetting
positions were characterized as a straddle (as opposed to a hedge) for federal
income tax purposes, then the Funds might not be able to receive the benefit of
certain realized losses from the liquidation of one of those positions for an
indefinite period of time (i.e., until the gain position and any successor
positions are disposed of). The Funds expect that its activities with respect
to forward foreign currency contracts, currency futures contracts and options
on foreign currencies will not require it, as a general rule, to have to treat
such contracts or options as straddle positions for federal income tax
purposes. Under current law, unless certain requirements are satisfied, the
Funds, will be required to calculate
53
<PAGE> 59
separately certain gains and losses attributable to certain of its forward
currency contracts, currency futures contracts and options on foreign
currencies even if the Funds acquired the contract or option to hedge its risk
of currency fluctuations with regard to capital assets held or to be held by
the Funds. The Internal Revenue Service, however, has the authority to issue
additional regulations that would permit or require the Funds either to
integrate some or all if its forward currency contracts, currency futures
contracts, options on foreign currencies and hedged investments as a single
transaction or otherwise to treat the contracts or options in the manner that
is consistent with the hedged investments. It is uncertain if or when these
regulations will be issued.
To the extent that the Fund's forward contracts, currency
futures contracts or options on foreign currencies can be classified as either
regulated futures contracts or foreign currency contracts (as described in
section 1256(b) of the Code) (collectively referred to herein as "section 1256
contracts"), such investments will be taxed pursuant to a special
"mark-to-market" system. Under the mark-to-market system, the Funds may be
treated as realizing a greater or lesser amount of gains or losses than
actually realized. As a general rule, except for certain currency related
activities ( as described above) in which gain or loss is treated as ordinary
income or loss, gain or loss on section 1256 contracts is treated as 60%
long-term capital gain or loss and 40% short-term capital gain or loss, and
accordingly, the mark-to-market system generally will affect the amount of
capital gains or losses taxable to the Funds and the amount of distributions
taxable to a shareholder. Moreover, if the Funds invested in both section 1256
contracts and offsetting positions with respect to such contracts, then the
Funds might not be able to receive the benefit of certain realized losses for
an indeterminate period of time (i.e., until disposition of the "gain leg" of
the straddle and any successor position). The Funds expect that its activities
with respect to section 1256 contracts and offsetting positions in such
contracts (a) will not cause it or its shareholders to be treated as receiving
a materially greater amount of ordinary income, capital gains, dividends, or
distributions than actually realized or received by the Funds and (b) will
permit it to use substantially all of the losses of the Funds for the fiscal
years in which such losses actually occur.
Generally, the hedging transactions and certain other
transactions in options, futures and forward contracts undertaken by a
portfolio may result in "straddles" for U.S. federal income tax purposes. The
straddle rules may affect the character of gains (or losses) realized by a
Portfolio. In addition, losses realized by a Portfolio on positions that are
part of a straddle may be deferred under the straddle rules, rather than being
taken into account in calculating the taxable income for the taxable year in
which such losses are realized. Because only a few regulations implementing
the straddle rules have been promulgated, the tax consequences of transactions
in options, futures and forward contracts to a Portfolio are not entirely
clear. The transactions may increase the amount of short-term capital gain
realized by a Portfolio which is taxed as ordinary income when distributed to
shareholders.
A Portfolio may make one or more of the elections available
under the Code which are applicable to straddles. If a portfolio makes any of
the elections, the amount, character and timing of the recognition of gains or
losses from the affected
54
<PAGE> 60
straddle positions will be determined under rules that vary according to the
election(s) made. The rules applicable under certain of the elections operate
to accelerate the recognition of gains or losses from the affected straddle
positions.
Because application of the straddle rules may affect the
character of gains or losses, defer losses and/or accelerate the recognition of
gains or losses from the affected straddle positions, the amount which must be
distributed to shareholders, and which will be taxed to shareholders as
ordinary income or long-term capital gains, may be increased or decreased
substantially in any given fiscal year as compared to a fund that did not
engage in such hedging transactions.
The 30% limit on gains from the disposition of certain
options, futures and forward contracts held less than three months and the
qualifying income and diversification requirements applicable to a Portfolio's
assets may limit the extent to which a Portfolio will be able to engage in
transactions in options, futures contracts or forward contracts.
Income (excluding certain gains) from transactions in options
and futures contracts derived by the Fund with respect to its business of
investing in securities, will qualify as permissible income under the Income
Requirement. Furthermore, any increase in value on a position that is part of
a "designated hedge" will be offset by any decrease in value (whether realized
or not) of the offsetting hedging position during the period of the hedge for
purposes of determining whether the Fund satisfies the Short-Short Limitation.
Thus, only the net gain (if any) from the designated hedge will be included in
gross income for purposes of that limitation. The Fund anticipates engaging in
hedging transactions that are intended to qualify for this treatment, but at
the present time it is not clear whether this treatment will be available to
all of the Fund's hedging transactions. To the extent this treatment is not
available, the Fund may be forced to defer the closing out of certain options
and futures contracts beyond the time when it otherwise would be advantageous
to do so, in order for the Fund to qualify as a RIC. Income derived from
currencies, options, futures and forward contracts on currencies directly
related to the Fund's principal business of investing in stocks or securities
is excluded from the Short-Short Limitation computation.
If a call option written by the Fund expires, the Fund will
realize a short-term capital gain equal to the amount of the premium it
received for writing the option. If the Fund terminates its obligations under
a call option it has written, or if the Fund writes a put option terminating
its rights as the holder of a put option, the Fund will realize a short-term
capital gain or loss, depending on whether the cost of the closing transaction
is less than or exceeds the premium received when the option was written. If a
call option written by the Fund is exercised, the Fund will be treated as
having sold the underlying security and will realize a long-term or short-term
capital gain and loss, depending on the holding period of the underlying
security and on whether the sum of the option price received upon the exercise
plus the premium received when the option was written exceeds or is less than
the basis of the optioned security.
55
<PAGE> 61
If an option purchased by the Fund expires, the Fund generally
will realize a capital loss equal to the cost of the option, long term if the
option was held for more than one year. If the Fund sells the option, it
generally will realize a capital gain or loss, depending on whether the
proceeds from the sale are greater or less than the cost of the option plus the
transaction costs. If the Fund exercises a call option, the cost of the option
will be added to the basis of the security purchased. If the Fund exercises a
put option, it will realize a capital gain or loss (depending on the Fund's
basis for the underlying security), which will be long-term or short-term
depending on the holding period of the underlying security. Any such capital
gain will be decreased (or loss increased) by the premium paid for the option.
FOREIGN INCOME TAXES. Investment income received from sources
within foreign countries may be subject to foreign income taxes withheld at the
source. The United States has entered into tax treaties with many foreign
countries which would entitle the Fund to a reduced rate on such taxes or
exemption from taxes on such income. It is impossible to determine the
effective rate of foreign tax for a Fund in advance since the amount of the
assets to be invested within various countries is not known.
If a Fund invests in an entity that is classified as a
"passive foreign investment company" ("PFIC") for federal income tax purposes,
the application of certain provisions of the Code applying to PFICs could
result in the imposition of certain federal income taxes on the Fund. Under
U.S. Treasury regulations for PFICs, the International, Emerging Markets and
International Securities Funds can elect to mark- to-market their PFIC holdings
in lieu of paying taxes on gains or distributions therefrom.
STATE AND LOCAL TAXES. Depending upon the extent of a Fund's
activities in states and localities in which its offices are maintained, in
which its agents or independent contractors are located or in which it is
otherwise deemed to be conducting business, a Fund may be subject to the tax
laws of such states or localities.
RATINGS OF DEBT INSTRUMENTS
Corporate and Municipal Bond Ratings.
Moody's Investors Service, Inc. (Moody's:
Aaa -- Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally
referred to as "gilt-edge." Interest payments are protected by a
large or exceptionally stable margin and principal is secure. While
the various protective elements are likely to change, such changes as
can be visualized are most unlikely to impair the fundamentally strong
position of such issues.
Aa -- Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are
generally known as high
56
<PAGE> 62
grade bonds. They are rated lower than the best bonds because margins
of protection may not be as large as in Aaa securities or fluctuation
of protective elements may be of greater amplitude or there may be
other elements present which make the long-term risks appear somewhat
larger than in Aaa securities.
A -- Bonds which are rated A possess many favorable investment
attributes and are to be considered as upper medium grade obligations.
Factors giving security to principal and interest are considered
adequate, but elements may be present which suggest a susceptibility
to impairment sometime in the future.
Baa -- Bonds which are rated Baa are considered as medium-grade
obligations (i.e., they are neither highly protected nor poorly
secured). Interest payments and principal security appear adequate
for the present but certain protective elements may be lacking or may
be characteristically unreliable over any great period of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
Ba -- Bonds which are rated Ba are judged to have speculative
elements; their future cannot be considered as well assured. Often
the protection of interest and principal payments may be very moderate
and thereby not well safeguarded during other good and bad times over
the future. Uncertainty of position characterizes bonds in this
class.
B -- Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or
maintenance of other terms of the contract over any long period of
time may be small.
Caa -- Bonds which are rated Caa are of poor standing. Such issues
may be in default or there may be present elements of danger with
respect to principal and interest.
Ca -- Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or
have other marked shortcomings.
C -- Bonds which are rated C are the lowest rated class of bonds and
issues so rated can be regarded as having extremely poor prospects of
ever attaining any real investment standing.
Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification in its corporate bond rating system. The modifier 1
indicates that the security ranks in the higher end of its generic
category; the modifier 2 indicates a mid-range ranking; and modifier 3
indicates that the issue ranks in the lower end of its generic rating
category.
57
<PAGE> 63
Standard & Poor's Corporation ("S&P"):
AAA -- This is the highest rating assigned by S&P to a debt obligation
and indicates an extremely strong capacity to pay principal and
interest.
AA -- Bonds rated AA also qualify as high-quality debt obligations.
Capacity to pay principal and interest is very strong, and in the
majority of instances they differ from AAA issues only in small
degree.
A -- Bonds rated A have a strong capacity to pay principal and
interest, although they are somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions.
BBB -- Bonds rated BBB are regarded as having an adequate capacity to
pay interest and repay principal. While bonds with this rating
normally exhibit adequate protection parameters, adverse economic
conditions or changing circumstances are more likely to lead to a
weakened capacity to pay interest and repay principal for debt in this
category than debt in higher rated categories.
BB, B, CCC, CC, C -- Bonds rated BB, B, CCC, CC and C are regarded, on
balance, as predominantly speculative with respect to capacity to pay
interest and repay principal in accordance with the terms of the
obligation. BB indicates the lowest degree of speculation and C the
highest degree of speculation. While such debt will likely have some
quality and protective characteristics, these are outweighed by large
uncertainties or major risk exposures to adverse conditions.
BB -- Bonds rated BB have less near-term vulnerability to default than
other speculative issues. However, they face major ongoing
uncertainties or exposure to adverse business, financial, or economic
conditions which could lead to inadequate capacity to meet timely
interest and principal payments. The BB rating category is also used
for debt subordinated to senior debt that is assigned an actual
implied BBB- rating.
B -- Bonds rated B have a greater vulnerability to default but
currently have the capacity to meet interest payments and principal
repayments. Adverse business, financial, or economic conditions will
likely impair capacity or willingness to pay interest and repay
principal. The B rating category is also used for debt subordinated
to senior debt that is assigned an actual implied BB or BB- rating.
CCC -- Bonds rated CCC have a currently identifiable vulnerability to
default, and are dependent upon favorable business, financial, and
economic conditions to meet timely payment of interest and repayment
of principal. In the event of adverse business, financial, or
economic conditions, it is not likely to have the capacity to pay
interest and repay principal. The CCC rating category is also used
for debt subordinated to senior debt that is assigned an actual
implied B or B- rating.
58
<PAGE> 64
CC -- The rating CC is typically applied to debt subordinated to
senior debt that is assigned an actual or implied CCC rating.
C -- The rating C is typically applied to debt subordinated to senior
debt which is assigned an actual or implied CCC debt rating. The C
rating has been used to cover a situation where a bankruptcy petition
has been filed but debt service payments are continued.
C1 -- The rating C1 is reserved for income bonds on which no interest
is being paid.
D -- Bonds rated D are in payment default. The D rating is used when
interest payments or principal payments are not made on the date due
even if the applicable grace period has not expired, unless S&P
believes such payments will be made during such grace period. The D
rating also will be used upon the filing of a bankruptcy petition if
debt service payments are jeopardized.
Plus (+) or Minus (-): The ratings from AA to CCC may be modified by
the addition of a plus or minus sign to show relative standing within
the appropriate category.
Debt obligations of issuers outside the United States and its
territories are rated on the same basis as domestic issues. The ratings
measure the creditworthiness of the obligor but do not take into account
currency exchange and related uncertainties.
State, Municipal Notes and Tax Exempt Demand Notes.
Moody's:
Moody's rating for state, municipal and other short-term obligations
will be designated Moody's Investment Grade ("MIG"). This distinction
is in recognition of the differences between short-term credit risk
and long-term risk. Factors affecting the liquidity of the borrower
are uppermost in importance in short-term borrowing, while various
factors of the first importance in bond risk are of lesser importance
in the short run. Symbols used are as follows:
MIG-1--Notes bearing this designation are of the best quality,
enjoying strong protection from established cash flows of funds for
their servicing or from established and broad-based access to the
market for refinancing or both.
MIG-2--Notes bearing this designation are of high quality, with
margins of protection ample although not so large as in the preceding
group.
59
<PAGE> 65
S&P:
A S&P note rating reflects the liquidity concerns and market access
risks unique to notes. Notes due in 3 years or less will likely
receive a note rating. Notes maturing beyond 3 years will most likely
receive a long-term debt rating. The following criteria will be used
in making that assessment.
-- Amortization schedule (the larger the final maturity relative
to other maturities, the more likely it will be treated as a
note).
-- Source of Payment (the more dependent the issue is on the
market for its refinancing, the more likely it will be treated
as a note).
Note rating symbols are as follows:
SP-1--Very strong or strong capacity to pay principal and interest.
Those issues determined to possess overwhelming safety characteristics
will be given a plus (+) designation.
SP-2--Satisfactory capacity to pay principal and interest.
S&P assigns "dual" ratings to all long-term debt issues that have as
part of their provisions a variable rate demand or double feature.
The first rating addresses the likelihood of repayment of principal
and interest as due, and the second rating addresses only the demand
feature. The long-term debt rating symbols are used to denote the put
option (for example, "AAA/A-1+") or if the nominal maturity is short,
a rating of "SP-1+/AAA" is assigned.
Commercial Paper Ratings.
Moody's:
Commercial paper rated Prime by Moody's is based upon its evaluation
of many factors, including: (1) management of the issuer; (2) the
issuer's industry or industries and the speculative-type risks which
may be inherent in certain areas; (3) the issuer's products in
relation to competition and customer acceptance; (4) liquidity; (5)
amount and quality of long-term debt; (6) trend of earnings over a
period of ten years; (7) financial strength of a parent company and
the relationships which exist with the issue; and (8) recognition by
the management of obligations which may be present or may arise as a
result of public interest questions and preparations to meet such
obligations. Relative differences in these factors determine whether
the issuer's commercial paper is rated Prime-1, Prime-2, or Prime-3.
60
<PAGE> 66
Prime-1 - indicates a superior capacity for repayment of short-term
promissory obligations. Prime-1 repayment capacity will normally be
evidenced by the following characteristics: (1) leading market
positions in well established industries; (2) high rates of return on
funds employed; (3) conservative capitalization structures with
moderate reliance on debt and ample asset protection; (4) broad
margins in earnings coverage of fixed financial charges and high
internal cash generation; and (5) well established access to a range
of financial markets and assured sources of alternative liquidity.
Prime-2 - indicates a strong capacity for repayment of short-term
promissory obligations. This will normally be evidenced by many of
the characteristics cited above but to a lesser degree. Earnings
trends and coverage ratios, while sound, will be more subject to
variation. Capitalization characteristics, while still appropriate,
may be more affected by external conditions. Ample alternative
liquidity is maintained.
S&P:
Commercial paper rated A by S&P has the following characteristics:
liquidity ratios are adequate to meet cash requirements. Long-term
senior debt is rated A or better. The issuer has access to at least
two additional channels of borrowing. Basic earnings and cash flow
have an upward trend with allowance made for unusual circumstances.
Typically, the issuer's industry is well established and the issuer
has a strong position within the industry. The reliability and
quality of management are unquestioned. Relative strength or weakness
of the above factors determine whether the issuer's commercial paper
is rated A-1, A-2, or A-3.
A-1--This designation indicates that the degree of safety regarding
timely payment is either overwhelming or very strong. Those issues
determined to possess overwhelming safety characteristics are denoted
with a plus (+) sign designation.
A-2--Capacity for timely payment on issues with this designation is
strong. However, the relative degree of safety is not as high as for
issues designated A-1.
Duff and Phelps, Inc.:
Duff & Phelps' short-term ratings are consistent with the rating
criteria utilized by money market participants. The ratings apply to
all obligations with maturities of under one year, including
commercial paper, the uninsured portion of certificates of deposit,
unsecured bank loans, master notes, bankers acceptances, irrevocable
letters of credit, and current maturities of long-term debt.
Asset-backed commercial paper is also rated according to this scale.
Emphasis is placed on liquidity which is defined as not only cash from
operations, but also access to alternative sources of funds including
trade credit, bank lines,
61
<PAGE> 67
and the capital markets. An important consideration is the level of
an obligor's reliance on short-term funds on an ongoing basis.
The distinguishing feature of Duff & Phelps' short-term ratings is the
refinement of the traditional '1' category. The majority of
short-term debt issuers carry the highest rating, yet quality
differences exist within that tier. As a consequence, Duff & Phelps
has incorporated gradations of '1+' (one plus) and '1-' (one minus) to
assist investors in recognizing those differences.
Duff 1+--Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to alternative
sources of funds, is outstanding, and safety is just below risk-free
US Treasury short-term obligations.
Duff 1--Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection factors. Risk
factors are minor.
Duff 1- --High certainty of timely payment. Liquidity factors are
strong and supported by good fundamental protection factors. Risk
factors are very small.
Good Grade
Duff 2--Good certainty of timely payment. Liquidity factors and
company fundamentals are sound. Although ongoing funding needs may
enlarge total financing requirements, access to capital markets is
good. Risk factors are small.
Satisfactory Grade
Duff 3--Satisfactory liquidity and other protection factors qualify
issue as to investment grade. Risk factors are larger and subject to
more variation. Nevertheless, timely payment is expected.
Non-Investment Grade
Duff 4--Speculative investment characteristics. Liquidity is not
sufficient to ensure against disruption in debt service. Operating
factors and market access may be subject to a high degree of
variation.
Default
Duff 5--Issuer failed to meet scheduled principal and/or interest
payments.
IBCA, Inc.:
In addition to conducting a careful review of an institution's reports
and published figures, IBCA's analysts regularly visit the companies
for discussions with senior management. These meetings are
fundamental to the preparation of individual
62
<PAGE> 68
reports and ratings. To keep abreast of any changes that may affect
assessments, analysts maintain contact throughout the year with the
management of the companies they cover.
IBCA's analysts speak the languages of the countries they cover, which
is essential to maximize the value of their meetings with management
and to properly analyze a company's written materials. They also have
a thorough knowledge of the laws and accounting practices that govern
the operations and reporting of companies within the various
countries.
Often, in order to ensure a full understanding of their position,
companies entrust IBCA with confidential data. While these data
cannot be disclosed in reports, they are taken into account when
assigning ratings. Before dispatch to subscribers, a draft of the
report is submitted to each company to permit correction of any
factual errors and to enable clarification of issues raised.
IBCA's Rating Committees meet at regular intervals to review all
ratings and to ensure that individual ratings are assigned
consistently for institutions in all the countries covered. Following
the Committee meetings, ratings are issued directly to subscribers.
At the same time, the company is informed of the ratings as a matter
of courtesy, but not for discussion.
A1+--Obligations supported by the highest capacity for timely
repayment.
A1--Obligations supported by a very strong capacity for timely
repayment.
A2--Obligations supported by a strong capacity for timely repayment,
although such capacity may be susceptible to adverse changes in
business, economic or financial conditions.
B1--Obligations supported by an adequate capacity for timely
repayment. Such capacity is more susceptible to adverse changes in
business, economic, or financial conditions than for obligations in
higher categories.
B2--Obligations for which the capacity for timely repayment is
susceptible to adverse changes in business, economic or financial
conditions.
C1--Obligations for which there is an inadequate capacity to ensure
timely repayment.
D1--Obligations which have a high risk of default or which are
currently in default.
63
<PAGE> 69
Fitch Investors Service, Inc:
Fitch's short-term ratings apply to debt obligations that are payable
on demand or have original maturities of generally up to three years,
including commercial paper, certificates of deposit, medium-term
notes, and municipal and investment notes.
The short-term rating places greater emphasis than a long-term rating
on the existence of liquidity necessary to meet the issuer's
obligations in a timely manner.
Fitch short-term ratings are as follows:
F-1+--Exceptionally strong credit quality. Issues assigned this
rating are regarded as having the strongest degree of assurance for
timely payment.
F-1--Very strong credit quality. Issues assigned this rating reflect
an assurance of timely payment only slightly less in degree than
issues rated F-1+.
F-2--Good credit quality. Issues assigned this rating have a
satisfactory degree of assurance for timely payment, but the margin of
safety is not as great as for issues assigned 'F-1+' and 'F-1'
ratings.
F-3--Fair credit quality. Issues assigned this rating have
characteristics suggesting that the degree of assurance for timely
payment is adequate, however, near-term adverse changes could cause
these securities to be rated below investment grade.
F-5--Weak credit quality. Issues assigned this rating have
characteristics suggesting a minimal degree of assurance for timely
payment and are vulnerable to near-term adverse changes in financial
and economic conditions.
D--Default. Issues assigned this rating are in actual or imminent
payment default.
Thomson BankWatch (TBW) Short-Term Ratings:
The TBW Short-Term Ratings apply to commercial paper, other senior short-term
obligations and deposit obligations of the entities to which the rating has
been assigned. These ratings are derived exclusively from a quantitative
analysis of publicly available information. Qualitative judgments have not
been incorporated. The ratings are intended to be applicable to all operating
entities of an organization but there may be in some cases more credit
liquidity and/or risk in one segment of the business than another.
The TBW short-term rating applies only to unsecured instruments that have a
maturity of one year or less, and reflects the likelihood of an untimely
payment of principal or interest.
TBW-1 The highest category; indicates a very high degree of likelihood that
principal and interest will be paid on a timely basis.
64
<PAGE> 70
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated "TBW-1".
TBW-3 The lowest investment grade category; indicates that while more
susceptible to adverse developments (both internal and external) than
obligations with higher ratings, capacity to service principal and
interest in a timely fashion is considered adequate.
TBW-4 The lowest rating category; this rating is regarded as non-investment
grade and therefore speculative.
FINANCIAL STATEMENTS
The 1994 annual financial statements of the Funds, including notes to the
financial statements and financial highlights and the Report of Independent
Accountants are included in either the External Fee or Internal Fee Funds'
Annual Reports to Shareholders. Copies of these Annual Reports accompany this
Statement of Additional Information and are incorporated herein by reference.
65
