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STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 1998
SUPPLEMENTED AS OF OCTOBER 1, 1998
NATIONWIDE SEPARATE ACCOUNT TRUST
--TOTAL RETURN FUND
--CAPITAL APPRECIATION FUND
--GOVERNMENT BOND FUND
--MONEY MARKET FUND
--SMALL COMPANY FUND
--INCOME FUND
This Statement of Additional Information is not a prospectus. It contains
information in addition to and more detailed than that set forth in the
Prospectuses for the Funds and should be read in conjunction with the
Prospectuses, dated May 1, 1998 as supplemented, for all of such Funds. The
Prospectuses may be obtained from Nationwide Life Insurance Company, One
Nationwide Plaza, Columbus, Ohio 43215, or by calling toll free 1 (800)
848-6331.
TABLE OF CONTENTS PAGE
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General Information and History 1
Investment Objectives and Policies 2
Investment Restrictions 25
Major Shareholders 29
Trustees and Officers of the Trust 29
Calculating Yield - The Money Market Fund 31
Calculating Yield and Total Return-Non-Money Market Funds 31
Investment Adviser and Other Services 32
Brokerage Allocations 38
Purchases, Redemptions and Pricing of Shares 40
Additional Information 41
Tax Status 42
Tax Consequences for the Small Company Fund 43
Tax Consequences to Shareholders 45
Financial Statements 45
Appendix A - Bond Ratings 46
GENERAL INFORMATION AND HISTORY
Nationwide Separate Account Trust is an open-end investment company
organized under the laws of Massachusetts, by a Declaration of Trust, dated June
30, 1981, as subsequently amended. The Trust offers shares in fifteen separate
mutual funds, each with its own investment objective. This Statement of
Additional Information describes further six of those funds -- the Total Return
Fund, the Capital Appreciation Fund, the Government Bond Fund, the Money Market
Fund, the Small Company Fund and the Income Fund (collectively, the "Funds" and
individually, a "Fund").
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INVESTMENT OBJECTIVES AND POLICIES
The following information supplements the discussion of the Funds'
investment objectives and policies discussed in the Prospectuses. Defined terms
used in this Statement of Additional Information, unless otherwise defined
herein, have the meaning assigned to them in the relevant Prospectus.
The investment policies and types of permitted investments described here
may be changed without prior approval by, or notice to, the shareholders. There
is no guarantee that the objectives will be realized.
- --Total Return Fund
This Fund's investment objective is to obtain a reasonable, long term
total return on invested capital from a flexible combination of dividend return
and capital gains. The Fund seeks to achieve its objective through investments
in common stocks, convertible issues, money market instruments, and bonds, with
a primary emphasis on common stocks.
While it is the intention of the Fund to invest in common stocks or in
issues convertible to common stock, there are no restrictive provisions covering
the proportion of one or another class of securities that may be held, or other
restriction, other than those stated in the investment restrictions.
- --Capital Appreciation Fund
The Fund is designed for investors who are interested in long-term growth.
The Fund seeks to meet its objectives primarily through a diversified portfolio
of the common stock of companies which the investment manager determines have a
better-than-average potential for sustained capital growth over the long term.
While it is the intention of the Fund to invest in common stocks or in
issues convertible to common stock, there are no restrictive provisions covering
the proportion of one or another class of securities that may be held, or other
restriction, other than those stated in the investment restrictions.
The investment manager will focus mainly on a company's or industry's
potential for long term growth, with dividend and interest income being
secondary in importance. The manager's evaluation of a company or industry will
be based more on probable future earnings, relative financial strength and
competitive position. The manager believes this approach will provide a greater
return potential over the long run than simply seeking current dividend or
interest income. The Fund's portfolio will not be limited to any particular type
of company or industry.
- --Government Bond Fund
The investment objective of the Government Bond Fund is to provide as high
a level of income as is consistent with the preservation of capital. It seeks to
achieve its objective by investing in a diversified portfolio of securities
issued or backed by the U.S. Government, and its agencies or instrumentalities.
These securities are of varying types which include but are not limited
to:
Treasury Notes And Bonds - These are direct obligations of the U.S.
Government. New issues of notes mature in one to ten years while bonds generally
have a maturity of ten years or more.
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Treasury Bills - These are direct obligations of the U.S. Government
backed by the full faith and credit of the United States and mature in one year
or less.
Securities Issued By Instrumentalities of the U.S. Government - These
securities are issued by federally-chartered instrumentalities. Some of these
securities are guaranteed by the United States Treasury or are supported by the
issuer's right to borrow from the Treasury and are backed by the credit of the
federal instrumentality itself.
Some of these instrumentalities (listed for example purposes only) are:
Bank for Cooperatives (COOP)
Federal Home Loan Banks (FHLB)
Federal National Mortgage Association (FNMA)
Government National Mortgage Association (GNMA)
Tennessee Valley Authority (TVA)
Farmers Home Administration (FHA)
Federal Home Loan Mortgage Corporation (FHLMC)
The Government Bond Fund will normally invest at least 65% of its assets in
bonds issued by the U.S. Government, and its agencies and instrumentalities.
These bonds pay interest at regular intervals, usually semi-annually, and pay
principal at maturity.
The Government Bond Fund may invest up to 35% of its assets in zero coupon
securities and up to 20% of its assets in securities purchased on a
"when-issued" or on a "delayed-delivery" basis, provided those securities are
issued or backed by the U.S. Government, its agencies or instrumentalities (for
a further description of when-issued or delayed-delivery transactions, see
Income Fund--When-Issued Securities and Delayed-Delivery Transactions below).
The Government Bond Fund may also enter into repurchase agreements in any of the
securities described above (for a description of repurchase agreements, see
Income Fund -Repurchase Agreements below).
The Government Bond Fund may invest up to 35% of its assets in mortgage-backed
securities. Mortgage-backed securities represent direct or indirect
participation in, or are secured by and payable from, mortgage loans secured by
real property, and include single- and multi-class pass-through securities and
collateralized mortgage obligations. The securities purchased by the Government
Bond Fund are issued or guaranteed by U.S. government agencies or
instrumentalities.
Government-related entities may also create mortgage loan pools offering
pass-through investments where the mortgages underlying these securities may be
alternative mortgage instruments, that is, mortgage instruments whose principal
or interest payments may vary or whose terms to maturity may be shorter than
previously customary. As new types of mortgage-related securities are developed
and offered to investors, the Fund, consistent with its investment objective and
policies, may consider making investments in such new types of securities.
The yield characteristics of mortgage-backed securities differ from those of
traditional debt obligations. Among the principal differences are that interest
and principal payments are made more frequently on mortgage-backed securities,
usually monthly, and that principal may be prepaid at any time because the
underlying mortgage loans generally may be prepaid at any time. As a result, if
the Fund purchases these
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securities at a premium, a prepayment rate that is faster than expected will
reduce yield to maturity, while a prepayment rate that is lower than expected
will have the opposite effect of increasing the yield to maturity. Conversely,
if the Fund purchases these securities at a discount, a prepayment rate that is
faster than expected will increase yield to maturity, while a prepayment rate
that is slower than expected will reduce yield to maturity. Accelerated
prepayments on securities purchased by the Fund at a premium also impose a risk
of loss of principal because the premium may not have been fully amortized at
the time the principal is prepaid in full.
The Government Bond Fund will normally invest no more than 20% of its assets in
repurchase agreements or in U.S. Government securities maturing in less than one
year. For temporary defensive purposes, however the Fund may invest up to 100%
of its assets in these securities.
There is a minimal credit risk involved in the purchase of U.S. Government or
U.S. Government guaranteed securities. Securities issued by U.S. Government
agencies or instrumentalities, while perhaps having the implicit backing of the
U.S. Government, may not have an explicit guarantee of the payment of principal
and interest.
The value of shares of the Government Bond Fund will vary inversely with changes
in interest rates. As with any fixed income investment, interest rate risk does
exist; i.e., when interest rates decline, the market value of a portfolio can be
expected to rise; conversely, when interest rates rise, the market value of the
portfolio can be expected to fall. While the Government Bond Fund will engage in
portfolio trading to manage this risk (i.e., shortening the average maturity of
the portfolio in anticipation of a rise in interest rates so as to minimize
depreciation of principal, or lengthening the portfolio in anticipation of a
decline in interest rates so as to maximize appreciation of capital) there is no
assurance that capital will be preserved. Thus, the Government Bond Fund is
designed for those willing to accept market fluctuations to obtain income.
- --Money Market Fund
The investment objective of this Fund is to seek as high a level of current
income as it considered consistent with the preservation of capital and
liquidity through investments in a portfolio of money market instruments with
remaining maturities of 397 days or less. The Fund seeks to achieve its
objective by investing primarily in instruments receiving a rating in one of the
two highest categories by the following six nationally recognized statistical
rating organizations ("NRSROs"): Duff and Phelps, Inc. ("D&P"), Fitch/IBCA
Information Services, Inc. ("Fitch"), Moody's Investors Service Inc.
("Moody's"), Standard & Poor's Ratings Group ("Standard & Poor's"), and Thomson
Bank Watch ("Thomson"). See Appendix A for a further description of the NRSRO
ratings.
The Fund may invest in the following instruments:
-- obligations issued or guaranteed as to interest and principal by
the U.S. government, its agencies, or instrumentalities, or any
federally chartered corporation.
-- repurchase agreements, subject to the restrictions set forth
under "Investment Restrictions." Potential risks associated with
investment in repurchase agreements are twofold: (a) in the event of
default of an issuer and a decrease in the value of the underlying
securities below the repurchase price, the Fund could suffer a loss,
and (b) in the event of an issuer's bankruptcy, the Fund's ability
to dispose of underlying securities could be delayed. (For a further
description, see iIncome Fund--Repurchase Agreementsi below.)
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-- obligations of banks which at the date of investment are rated
TBW1 by Thomson. Obligations of savings and loan associations
(including certificates of deposit and bankers' acceptances) which
at the date of investment have capital, surplus, and undivided
profits (as of the date of their most recently published financial
statements) in excess of $100 million; and obligations of other
banks or savings and loan associations if such obligations are
insured by the Federal Deposit Insurance Corporation, provided that
not more than 10% of the Fund's total assets shall be invested in
such insured obligations.
-- commercial paper which at the date of investment is rated Duff 1
or Duff 2, by D&F, F-1 or F-2 by Fitch, P-1 or P-2 by Moody's, or
A-1 or A-2 by Standard & Poor's, or if not rated, is issued and
guaranteed as to payment of principal and interest by companies
which at the date of investment have an outstanding debt issue rated
AA or better by D&F, AA or better by Fitch, Aa or better by Moody's,
or AA or better by Standard & Poor's.
-- up to 5% of its total assets in commercial paper which at the
date of investment is rated F-2 by Fitch, Duff 2 by D&P, P-2 by
Moody's, or A-2 by Standard and Poor's. However, the Fund is limited
as to the amount it may invest in the commercial paper of a single
issuer to the greater of 1% of the Fund's total assets or $1
million.
-- short-term (maturity in 397 days or less) corporate obligations
which at the date of investment are rated AA or better by D&F, AA or
better by Fitch, Aa or better by Moody's, or AA or better by
Standard & Poor's.
-- bank loan participation agreements representing corporations and
banks having a short-term rating, at the date of investment, of F-1
or F-2 by Fitch, Duff 1 or Duff 2 by D&P, P-1 or P-2 by Moody's or
A-1 or A-2 by Standard & Poor's, under which the Fund will look to
the creditworthiness of the lender bank, which is obligated to make
payments of principal and interest on the loan, as well as to
creditworthiness of the borrower.
All the assets of the Fund will be invested in obligations with remaining
maturities of 397 days or less and which generally will be held to maturity. The
Fund will, to the extent feasible, make portfolio investments primarily in
anticipation of, or in response to, changing economic and financial conditions.
The Fund will attempt to maximize the return on its investments through careful
analysis of a wide range of investments available and different yield
relationships existing among various sectors of the market. The average dollar
weighted maturity of the Fund's investments may not exceed 90 days. There can be
no assurance that the Fund's investment objective will be achieved.
The Fund may invest in the securities of foreign corporate and governmental
issuers and in the securities of foreign branches of U.S. banks, such as
negotiable certificates of deposit (Eurodollars) in U.S. dollar denominations
which at the date of investment are rated TBW1 by Thomson. Because of this,
investment in the Fund involves risks that are different in some respects from
an investment in a fund which invests only in debt obligations of U.S. domestic
issuers. Such risks may include future political and economic developments, the
possible imposition of foreign withholding taxes on interest income payable on
the securities held in the portfolio, possible seizure or nationalization of
foreign deposits, the possible establishment of exchange controls, or the
adoption of other foreign governmental restrictions which might adversely affect
the payment of principal and interest on securities in the portfolio.
- -- Income Fund
The Income Fund seeks to provide as high a level of income as is
consistent with reasonable concern for safety of principal. The Fund intends to
pursue its investment objective by investing at least 65% of its assets, under
normal market conditions, in investment grade corporate and U.S. Government
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debt obligations. The Fund may invest the remainder of its portfolio in high
quality short-term money market obligations.
Debt Obligations. Debt obligations are subject to the risk of an issuer's
inability to meet principal and interest payments on its obligations ("credit
risk") and are subject to price volatility due to such factors as interest rate
sensitivity, market perception of the creditworthiness of the issuer, and
general market liquidity ("market risk"). Lower-rated securities are more likely
to react to developments affecting market and credit risk than are more highly
rated securities, which react primarily to movements in the general level of
interest rates.
Ratings as Investment Criteria. The Income Fund may invest in high-quality
and medium-quality debt obligations which are characterized as such based on
their ratings by NRSROs. In general, the ratings of NRSROs represent the
opinions of these agencies as to the quality of securities that they rate. Such
ratings, however, are relative and subjective, and are not absolute standards of
quality and do not evaluate the market value risk of the securities. These
ratings are used by the Fund as initial criteria for the selection of portfolio
securities, but the Fund will also rely upon the independent advice of the
Subadvisers to evaluate potential investments. Among the factors that will be
considered are the long-term ability of the issuer to pay principal and interest
and general economic trends. The Appendix to this Statement of Additional
Information contains further information about the rating categories of NRSROs
and their significance.
Subsequent to its purchase by the Income Fund, an issue of securities may cease
to be rated or its rating may be reduced below the minimum required for purchase
by the Income Fund. In addition, it is possible that an NRSRO might not change
its rating of a particular issue to reflect subsequent events. None of these
events generally will require sale of such securities, but the Income Fund's
Subadviser will consider such events in its determination of whether the Income
Fund should continue to hold the securities. In addition, to the extent that the
ratings change as a result of changes in such organizations or their rating
systems, or due to a corporate reorganizations, the Income Fund will attempt to
use comparable ratings as standards for its investments in accordance with its
investment objective and policies.
Money Market Instruments. The Income Fund may invest in certain types of money
market instruments which may include the following types of instruments:
-- obligations issued or guaranteed as to interest and
principal by the U.S. government, its agencies, or
instrumentalities, or any federally chartered corporation;
-- repurchase agreements;
-- certificates of deposit, time deposits and bankers'
acceptances issued by domestic banks (including their branches
located outside the United States and subsidiaries located in
Canada), domestic branches of foreign banks, savings and loan
associations and similar institutions
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-- commercial paper, which are short-term unsecured promissory
notes issued by corporations in order to finance their current
operations. Generally the commercial paper will be rated within the
top two rating categories by an NRSRO, or if not rated, is issued
and guaranteed as to payment of principal and interest by companies
which at the date of investment have a high quality outstanding debt
issue;
-- high quality short-term (maturity in 397 days or less)
corporate obligations;
-- bank loan participation agreements representing
corporations and banks having a high quality short-term rating, at
the date of investment, and under which the Fund will look to the
creditworthiness of the lender bank, which is obligated to make
payments of principal and interest on the loan, as well as to
creditworthiness of the borrower.
Mortgage- and Asset-Backed Securities - The Income Fund may purchase both
mortgage- and asset-backed securities. Mortgage-backed securities represent
direct or indirect participation in, or are secured by and payable from,
mortgage loans secured by real property, and include single- and multi-class
pass-through securities and collateralized mortgage obligations. Such securities
may be issued or guaranteed by U.S. government agencies or instrumentalities or
by private issuers, generally originators in mortgage loans, including savings
and loan associations, mortgage bankers, commercial banks, investment bankers,
and special purpose entities (collectively, "private lenders"). Mortgage-backed
securities issues by private lenders may be supported by pools of mortgage loans
or other mortgage-backed securities that are guaranteed, directly or indirectly,
by the U.S. government or one of its agencies or instrumentalities, or they may
be issued without any governmental guarantee of the underlying mortgage assets
but with some form of non-governmental credit enhancement. These credit
enhancements may include letters of credit, reserve funds,
overcollateralization, or guarantees by third parties..
Private lenders or government-related entities may also create mortgage loan
pools offering pass-through investments where the mortgages underlying these
securities may be alternative mortgage instruments, that is, mortgage
instruments whose principal or interest payments may vary or whose terms to
maturity may be shorter than previously customary. As new types of
mortgage-related securities are developed and offered to investors, the Fund,
consistent with its investment objective and policies, may consider making
investments in such new types of securities.
Asset-backed securities have structural characteristics similar to
mortgage-backed securities. However, the underlying assets are not first-lien
mortgage loans or interests therein; rather they include assets such as motor
vehicle installment sales contracts, other installment loan contracts, home
equity loans, leases of various types of property and receivables from credit
card and other revolving credit arrangements. Payments or distributions of
principal and interest on asset-backed securities may be supported by
non-governmental credit enhancements similar to those utilized in connection
with mortgage-backed securities. The credit quality of most asset-backed
securities depends primarily on the credit quality of the assets underlying such
securities, how well the entity issuing the security is insulated from the
credit risk of the originator any other affiliated entities, and the amount and
quality of any credit enhancement of the securities.
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The yield characteristics of mortgage- and asset-backed securities differ from
those of traditional debt obligations. Among the principal differences are that
interest and principal payments are made more frequently on mortgage- and
asset-backed securities, usually monthly, and that principal may be prepaid at
any time because the underlying mortgage loans or other assets generally may be
prepaid at any time. As a result, if the Fund purchases these securities at a
premium, a prepayment rate that is faster than expected will reduce yield to
maturity, while a prepayment rate that is lower than expected will have the
opposite effect of increasing the yield to maturity. Conversely, if the Fund
purchases these securities at a discount, a prepayment rate that is faster than
expected will increase yield to maturity, while a prepayment rate that is slower
than expected will reduce yield to maturity. Accelerated prepayments on
securities purchased by the Fund at a premium also impose a risk of loss of
principal because the premium may not have been fully amortized at the time the
principal is prepaid in full. The market for privately issued mortgage- and
asset-backed securities is smaller and less liquid than the market for
government sponsored mortgage-backed securities.
The Fund may invest in stripped mortgage- or asset-backed securities, which
receive differing proportions of the interest and principal payments from the
underlying assets. The market value of such securities generally is more
sensitive to changes in prepayment and interest rates than is the case with
traditional mortgage- and asset-backed securities, and in some cases the market
value may be extremely volatile. With respect to certain stripped securities,
such as interest-only ("IO") and principal-only ("PO") classes, a rate of
prepayment that is faster or slower than anticipated may result in the Fund
failing to recover all or a portion of its investment, even though the
securities are rated investment grade.
Repurchase Agreements. In connection with the purchase of a repurchase agreement
by the Income Fund, the Fund's custodian will have custody of, and will hold in
a segregated account, securities acquired by the Fund under a repurchase
agreement. Repurchase agreements are contracts under which the buyer of a
security simultaneously commits to resell the security to the seller at an
agreed-upon price and date. Repurchase agreements are considered by the staff of
the Securities and Exchange Commission (the "SEC") to be loans by the Fund.
Repurchase agreements may be entered into with respect to securities of the type
in which it may invest or government securities regardless of their remaining
maturities, and will require that additional securities be deposited with it if
the value of the securities purchased should decrease below the resale price.
Repurchase agreements involve certain risks in the event of default or
insolvency by the other party, including possible delays or restrictions upon
the Fund's ability to dispose of the underlying securities, the risk of a
possible decline in the value of the underlying securities during the period in
which the Fund seeks to assert its rights to them, the risk of incurring
expenses associated with asserting those rights and the risk of losing all or
part of the income from the repurchase agreement.
Investment Companies. The Income Fund reserves the right to invest up to 5% of
its total assets, calculated at the time of investment, in the securities of
other open-end or closed end investment companies. No more than 5% of the Income
Fund's total assets may be invested in the securities of any one investment
company nor may it acquire more than 3% of the voting securities of any other
investment company. Investing through such vehicles may involve frequent or
layered fees or expenses and may be subject to limitation under the Investment
Company Act of 1940 (the "1940 Act"). The Income Fund will
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indirectly bear its proportionate share of any management fees paid by an
investment company in which it invests in addition to the advisory fee paid by
the Income Fund.
When-Issued Securities and Delayed-Delivery Transactions. The Income Fund may
invest without limitation in securities purchased on a "when-issued" basis or
purchase or sell securities for delayed delivery (i.e., payment or delivery
occurs beyond the normal settlement date at a stated price and yield).
When-issued transactions normally settle within 45 days. The payment obligation
and the interest rate that will be received on when-issued or delayed-delivery
securities are fixed at the time the buyer enters into the commitment. Due to
fluctuations in the value of securities purchased or sold on a when-issued or
delayed-delivery basis, the yields obtained on such securities may be higher or
lower than the yields available in the market on the dates when the investments
are actually delivered to the buyers.
When the Fund agrees to purchase when-issued or delayed-delivery securities, its
custodian will set aside cash or liquid securities equal to the amount of the
commitment in a segregated account. Normally, the custodian will set aside
portfolio securities to satisfy a purchase commitment, and in such a case the
Fund may be required subsequently to place additional assets in the segregated
account in order to ensure that the value of the account remains equal to the
amount of such fund's commitment. It may be expected that the Fund's net assets
will fluctuate to a greater degree when it sets aside portfolio securities to
cover such purchase commitments than when it sets aside cash. When the Fund
engages in when-issued or delayed-delivery transactions, it relies on the other
party to consummate the trade. Failure of the seller to do so may result in a
fund incurring a loss or missing an opportunity to obtain a price considered to
be advantageous.
Lending Portfolio Securities. The Income Fund may lend its portfolio securities
to brokers, dealers and other financial institutions, provided it receives cash
collateral which at all times is maintained in an amount equal to at least 100%
of the current market value of the securities loaned. By lending its portfolio
securities, the Fund can increase its income through the investment of the cash
collateral. For the purposes of this policy, the Fund considers collateral
consisting of cash, U.S. Government securities or letters of credit issued by
banks whose securities meet the standards for investment by the Fund to be the
equivalent of cash. From time to time, the Fund may return to the borrower or a
third party which is unaffiliated with it, and which is acting as a "placing
broker," a part of the interest earned from the investment of collateral
received for securities loaned.
The SEC currently requires that the following conditions must be met whenever
portfolio securities are loaned: (1) the fund must receive at least 100% cash
collateral of the type discussed in the preceding paragraph from the borrower;
(2) the borrower must increase such collateral whenever the market value of the
securities loaned rises above the level of such collateral; (3) the fund must be
able to terminate the loan at any time; (4) the fund must receive reasonable
interest on the loan, as well as any dividends, interest or other distributions
payable on the loaned securities, and any increase in market value; (5) the fund
may pay only reasonable custodian fees in connection with the loan; and (6)
while any voting rights on the loaned securities may pass to the borrower, the
fund's board of directors or trustees must be able to terminate the loan and
regain the right to vote the securities if a material event adversely affecting
the investment occurs. These conditions may be subject to future modification.
Loan agreements involve certain risks in the
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event of default or insolvency of the other party including possible delays or
restrictions upon the Fund's ability to recover the loaned securities or dispose
of the collateral for the loan.
Borrowing. The Income Fund may borrow money from banks, limited by any
investment restrictions to 33 1/3% of its total assets. However, the Fund
currently intends to borrow money only for temporary or emergency purposes in an
amount of up to 5% of the value of the Fund's total asset (including the amount
borrowed) valued at the time the borrowing is made. In such situations, either
the custodian will segregate the pledged assets for the benefit of the lender or
arrangements will be made with a suitable subcustodian, which may include the
lender.
Small Company Fund
The Small Company Fund seeks long-term growth of capital. It seeks to
achieve this objective by investing primarily in equity securities of both
domestic and foreign small market capitalization companies ("small company
stocks"). To attempt to achieve this objective, the Adviser has hired a number
of subadvisers to direct the day-to-day management of the Small Company Fund.
The following information supplements the discussion of the Fund's objectives,
policies and techniques that are described in the Fund's prospectus under
"INVESTMENT OBJECTIVES AND POLICIES" and "INVESTMENT TECHNIQUES, CONSIDERATIONS
AND RISK FACTORS."
Special Situation Companies. The Small Company Fund may invest in the
securities of "special situation companies," which include those involved in an
actual or prospective acquisition or consolidation; reorganization;
recapitalization; merger, liquidation or distribution of cash, securities or
other assets; a tender or exchange offer; a breakup or workout of a holding
company; or litigation which, if resolved favorably, would improve the value of
the company's stock. If the actual or prospective situation does not materialize
as anticipated, the market price of the securities of a "special situation
company" may decline significantly. The Fund believes, however, that if a
Subadviser analyzes "special situation companies" carefully and invests in the
securities of these companies at the appropriate time, the Fund may achieve
capital growth. There can be no assurance however, that a special situation that
exists at the time the Fund makes its investment will be consummated under the
terms and within the time period contemplated.
Foreign Securities. Investors in the Small Company Fund should recognize
that investing in foreign securities involves certain special considerations
which are not typically associated with investing in United States securities.
Since investments in foreign companies will frequently involve currencies of
foreign countries, and since the Fund may hold securities and funds in foreign
currencies, the Fund may be affected favorably or unfavorably by changes in
currency rates and in exchange control regulations, if any, and may incur costs
in connection with conversions between various currencies. Most foreign stock
markets, while growing in volume of trading activity, have less volume than the
New York Stock Exchange, and securities of some foreign companies are less
liquid and more volatile than securities of comparable domestic companies.
Similarly, volume and liquidity in most foreign bond markets are less than in
the United States and at times, volatility of price can be greater than in the
United States. Fixed commissions on foreign securities exchanges are generally
higher than negotiated commissions on United States exchanges, although the Fund
endeavors to achieve the most favorable net results on their portfolio
transactions. There is generally less government supervision and regulation of
securities exchanges, brokers and listed companies in foreign countries than in
the United States. In addition, with respect to certain foreign countries, there
is the possibility of exchange control restrictions, expropriation or
confiscatory taxation, and political, economic or social instability, which
could affect investments in those countries. Foreign securities such as those
purchased by the Fund may be subject to foreign government taxes, higher
custodian fees and dividend collection fees which could reduce the yield on such
securities.
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Investments may be made from time to time by the Small Company Fund in
companies in developing countries as well as in developed countries. Although
there is no universally accepted definition, a developing country is generally
considered to be a country which is in the initial stages of industrialization.
Shareholders should be aware that investing in the equity and fixed income
markets of developing countries involves exposure to unstable governments,
economies based on only a few industries, and securities markets which trade a
small number of securities. Securities markets of developing countries tend to
be more volatile than the markets of developed countries; however, such markets
have in the past provided the opportunity for higher rates of return to
investors.
The value and liquidity of investments in developing countries may be
affected favorably or unfavorably by political, economic, fiscal, regulatory or
other developments in the particular countries or neighboring regions. The
extent of economic development, political stability and market depth of
different countries varies widely. Certain countries in the Asia region,
including Cambodia, China, Laos, Indonesia, Malaysia, the Philippines, Thailand,
and Vietnam are either comparatively underdeveloped or are in the process of
becoming developed. Such investments typically involve greater potential for
gain or loss than investments in securities of issuers in developed countries.
The securities markets in developing countries are substantially smaller,
less liquid and more volatile than the major securities markets in the United
States. A high proportion of the shares of many issuers may be held by a limited
number of persons and financial institutions, which may limit the number of
shares available for investment by the fund. Similarly, volume and liquidity in
the bond markets in developing countries are less than in the United States and,
at times, price volatility can be greater than in the United States. A limited
number of issuers in developing countries' securities markets may represent a
disproportionately large percentage of market capitalization and trading volume.
The limited liquidity of securities markets in developing countries may also
affect the Fund's ability to acquire or dispose of securities at the price and
time it wishes to do so. Accordingly, during periods of rising securities prices
in the more illiquid securities markets, the Fund's ability to participate fully
in such price increases may be limited by its investment policy of investing not
more than 15% of its total net assets in illiquid securities. Conversely, the
Fund's inability to dispose fully and promptly of positions in declining markets
will cause the Fund's net asset value to decline as the value of the unsold
positions is marked to lower prices. In addition, securities markets in
developing countries are susceptible to being influenced by large investors
trading significant blocks of securities.
Political and economic structures in many of such countries may be
undergoing significant evolution and rapid development, and such countries may
lack the social, political and economic stability characteristic of the United
States. Certain of such countries have in the past failed to recognize private
property rights and have at times nationalized or expropriated the assets of
private companies. As a result, the risks described above, including the risks
of nationalization or expropriation of assets, may be heightened. In addition,
unanticipated political or social developments may affect the value of the
Fund's investments in those countries and the availability to the fund of
additional investments in those countries.
Economies of developing countries may differ favorably or unfavorably from
the United States economy in such respects as rate of growth of gross national
product, rate of inflation, capital reinvestment, resource self-sufficiency and
balance of payments position. As export-driven economies, the economies of
countries in the Asia Region are affected by developments in the economies of
their principal trading partners. Hong Kong, Japan and Taiwan have limited
natural resources, resulting in dependence on foreign sources for certain raw
materials and economic vulnerability to global fluctuations of price and supply.
Certain developing countries do not have comprehensive systems of laws,
although substantial changes have occurred in many such countries in this regard
in recent years. Laws regarding fiduciary duties of officers and directors and
the protection of shareholders may not be well developed. Even where
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adequate law exists in such developing countries, it may be impossible to obtain
swift and equitable enforcement of such law, or to obtain enforcement of the
judgment by a court of another jurisdiction.
Trading in futures contracts traded on foreign commodity exchanges may be
subject to the same or similar risks as trading in foreign securities.
Depositary Receipts. As indicated in the Fund's prospectus, the Small
Company Fund may invest in foreign securities by purchasing depositary receipts,
including American Depositary Receipts ("ADRs") and European Depositary Receipts
("EDRs") or other securities convertible into securities of issuers based in
foreign countries. These securities may not necessarily be denominated in the
same currency as the securities into which they may be converted. Generally,
ADRs, in registered form, are denominated in U.S. dollars and are designed for
use in the U.S. securities markets, while EDRs (also referred to as Continental
Depositary Receipts ("CDRs"), in bearer form, may be denominated in other
currencies and are designed for use in European securities markets. ADRs are
receipts typically issued by a U.S. Bank or trust company evidencing ownership
of the underlying securities. EDRs are European receipts evidencing a similar
arrangement. For purposes of the Fund's investment policies, ADRs and EDRs are
deemed to have the same classification as the underlying securities they
represent. Thus, an ADR or EDR representing ownership of common stock will be
treated as common stock. (For further information on these instruments, see the
descriptions above for the Government Bond Fund and the Money Market Fund.)
The Small Company Fund may invest in depositary receipts through
"sponsored" or "unsponsored" facilities. A sponsored facility is established
jointly by the issuer of the underlying security and a depositary, whereas a
depositary may establish an unsponsored facility without participation by the
issuer of the deposited security. Holders of unsponsored depositary receipts
generally bear all the costs of such facilities and the depositary of an
unsponsored facility frequently is under no obligation to distribute shareholder
communications received from the issuer of the deposited security or to pass
through voting rights to the holders of such receipts in respect of the
deposited securities.
Debt Obligations. While the emphasis of the Small Company Fund's
investment is on common stocks and other equity securities (including preferred
stocks and securities convertible into or exchangeable for common stocks), it
may also invest in money market instruments, U.S. Government or Agency
securities, (for further information concerning these securities, see the
descriptions above for the Government Bond and the Money Market Funds) and
corporate bonds and debentures receiving one of the four highest ratings from an
NRSRO, or if not rated by any NRSRO, deemed comparable by a Subadviser to such
rated securities ("Comparable Unrated Securities"). The ratings of an NRSRO
represent its opinion as to the quality of securities it undertakes to rate.
Ratings are not absolute standards of quality; consequently, securities with the
same maturity, coupon, and rating may have different yields. The ratings
assigned by the NRSROS are described in Appendix A to this Statement of
Additional Information.
Fixed income securities are subject to the credit risk and market risk as
described above. Lower-rated securities are more likely to react to developments
affecting market and credit risk than are more highly rated securities, which
react primarily to movements in the general level of interest rates. Subsequent
to its purchase by the Fund, an issue of securities may cease to be rated or its
rating may be reduced, so that the securities would not be eligible for purchase
by the Fund. In such a case, the Subadviser will evaluate whether the downgraded
security should be disposed of.
High-Yield (High-Risk) Securities -- In General. The Fund has the
authority to invest up to 5% of its net assets in non-investment grade debt
securities. Non-investment grade debt securities (hereinafter referred to as
"lower-quality securities") include (i) bonds rated as low as C by Moody's,
Standard & Poor's, or Fitch, or CCC by D&P; (ii) commercial paper rated as low
as C by Standard & Poor's, Not Prime by Moody's or B by Fitch; and (iii) unrated
debt securities of comparable quality. Lower-quality securities, while generally
offering higher yields than investment grade securities with similar maturities,
involve
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<PAGE> 13
greater risks, including the possibility of default or bankruptcy. They are
regarded as predominantly speculative with respect to the issuer's capacity to
pay interest and repay principal. The special risk considerations in connection
with investments in these securities are discussed below. Refer to Appendix A of
this Statement of Additional Information for a discussion of securities ratings.
Effect of Interest Rates And Economic Changes. All interest-bearing
securities typically experience appreciation when interest rates decline and
depreciation when interest rates rise. The market values of lower-quality and
comparable unrated securities tend to reflect individual corporate developments
to a greater extent than do higher rated securities, which react primarily to
fluctuations in the general level of interest rates. Lower-quality and
comparable unrated securities also tend to be more sensitive to economic
conditions than are higher-rated securities. As a result, they generally involve
more credit risks than securities in the higher-rated categories. During an
economic downturn or a sustained period of rising interest rates, highly
leveraged issuers of lower-quality and comparable unrated securities may
experience financial stress and may not have sufficient revenues to meet their
payment obligations. The issuer's ability to service its debt obligations may
also be adversely affected by specific corporate developments, the issuer's
inability to meet specific projected business forecasts or the unavailability of
additional financing. The risk of loss due to default by an issuer of these
securities is significantly greater than issuers of higher-rated securities
because such securities are generally unsecured and are often subordinated to
other creditors. Further, if the issuer of a lower-quality or comparable unrated
security defaulted, the Fund might incur additional expenses to seek recovery.
Periods of economic uncertainty and changes would also generally result in
increased volatility in the market prices of these securities and thus in the
Fund's net asset value.
As previously stated, the value of a lower-quality or comparable unrated
security will decrease in a rising interest rate market, and accordingly so will
the Fund's net asset value. If the Fund experiences unexpected net redemptions
in such a market, it may be forced to liquidate a portion of its portfolio
securities without regard to their investment merits. Due to the limited
liquidity of lower-quality and comparable unrated securities (discussed below),
the Fund may be forced to liquidate these securities at a substantial discount.
Any such liquidation would reduce the Fund's asset base over which expenses
could be allocated and could result in a reduced rate of return for the Fund.
Payment Expectations. Lower-quality and comparable unrated securities
typically contain redemption, call or prepayment provisions which permit the
issuer of such securities containing such provisions to, at its discretion,
redeem the securities. During periods of falling interest rates, issuers of
these securities are likely to redeem or prepay the securities and refinance
them with debt securities at a lower interest rate. To the extent an issuer is
able to refinance the securities, or otherwise redeem them, the Fund may have to
replace the securities with a lower yielding security, which would result in a
lower return for the Fund.
Credit Ratings. Credit ratings issued by credit-rating agencies evaluate
the safety of principal and interest payments of rated securities. They do not,
however, evaluate the market value risk of lower-quality securities and,
therefore, may not fully reflect the true risks of an investment. In addition,
credit rating agencies may or may not make timely changes in a rating to reflect
changes in the economy or in the condition of the issuer that affect the market
value of the security. Consequently, credit ratings are used only as a
preliminary indicator of investment quality. Investments in lower-quality and
comparable unrated securities will be more dependent on a Subadviser's credit
analysis than would be the case with investments in investment-grade debt
securities. Each Subadviser will employ its own credit research and analysis,
which includes a study of existing debt, capital structure, ability to service
debt and to pay dividends, the issuer's sensitivity to economic conditions, its
operating history and the current trend of earnings. When investing in
lower-quality securities, each Subadviser will continually monitor the
investments in the Fund's portfolio and carefully evaluate whether to dispose of
or to retain lower-quality and comparable unrated securities whose credit
ratings or credit quality may have changed.
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Liquidity And Valuation. The Fund may have difficulty disposing of certain
lower-quality and comparable unrated securities because there may be a thin
trading market for such securities. Because not all dealers maintain markets in
all lower-quality and comparable unrated securities, there is no established
retail secondary market for many of these securities. The Fund anticipates that
such securities could be sold only to a limited number of dealers or
institutional investors. To the extent a secondary trading market does exist, it
is generally not as liquid as the secondary market for higher-rated securities.
The lack of a liquid secondary market may have an adverse impact on the market
price of the security. As a result, the Fund's asset value and ability to
dispose of particular securities, when necessary to meet the Fund's liquidity
needs or in response to a specific economic event, may be impacted. The lack of
a liquid secondary market for certain securities may also make it more difficult
for the Fund to obtain accurate market quotations for purposes of valuing the
Fund's portfolio. Market quotations are generally available on many
lower-quality and comparable unrated issues only from a limited number of
dealers and may not necessarily represent firm bids of such dealers or prices
for actual sales. During periods of thin trading, the spread between bid and
asked prices is likely to increase significantly. In addition, adverse publicity
and investor perceptions, whether or not based on fundamental analysis, may
decrease the values and liquidity of lower-quality and comparable unrated
securities, especially in a thinly traded market.
Proposed Legislation. From time to time proposals have been discussed,
regarding new legislation designed to limit the use of certain lower-quality and
comparable unrated securities by certain issuers. However, it is possible that
if legislation is enacted or proposed, it could have a material affect on the
value of these securities and the existence of a secondary trading market for
the securities.
Convertible Securities. Convertible securities in which the Fund may
invest, including both convertible debt and convertible preferred stock, may be
converted at either a stated price or stated rate into underlying shares of
common stock. Because of this feature, convertible securities enable an investor
to benefit from increases in the market price of the underlying common stock.
Convertible securities provide higher yields than the underlying equity
securities, but generally offer lower yields than non-convertible securities of
similar quality. Like bonds, the value of convertible securities fluctuates in
relation to changes in interest rates and, in addition, also fluctuates in
relation to the underlying common stock.
Warrants. The Small Company Fund may acquire warrants. Warrants are
securities giving the holder the right, but not the obligation, to buy the stock
of an issuer at a given price (generally higher than the value of the stock at
the time of issuance), on a specified date, during a specified period, or
perpetually. Warrants may be acquired separately or in connection with the
acquisition of securities. The Fund may purchase warrants, valued at the lower
of cost or market value, of up to 5% of the Fund's net assets. Included in that
amount, but not to exceed 2% of the Fund's net assets, may be warrants that are
not listed on any recognized U.S. or foreign stock exchange. Warrants acquired
by the Fund in units or attached to securities are not subject to these
restrictions. Warrants do not carry with them the right to dividends or voting
rights with respect to the securities that they entitle their holder to
purchase, and they do not represent any rights in the assets of the issuer. As a
result, warrants may be considered more speculative than certain other types of
investments. In addition, the value of a warrant does not necessarily change
with the value of the underlying securities, and a warrant ceases to have value
if it is not exercised prior to its expiration date.
Repurchase Agreements. The Small Company Fund's custodian or a
sub-custodian will have custody of, and will hold in a segregated account,
securities acquired by the Fund under a repurchase agreement. Repurchase
agreements are contracts under which the buyer of a security simultaneously
commits to resell the security to the seller at an agreed-upon price and date.
Repurchase agreements are considered by the staff of the Securities and Exchange
Commission to be loans by the Fund. In an attempt to reduce the risk of
incurring a loss on the repurchase agreement, the Fund will enter into
repurchase
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agreements with certain banks and non-bank dealers, all of whose use has been
approved by the Board of Trustees. Repurchase agreements may be entered into
with respect to securities of the type in which it may invest or government
securities regardless of their remaining maturities, and will require that
additional securities be deposited with it if the value of the securities
purchased should decrease below resale price. Each Subadviser will monitor on an
ongoing basis the value of the collateral to assure that it always equals or
exceeds the repurchase price. The Fund will consider on an ongoing basis the
creditworthiness of the institutions with which the Fund enters into repurchase
agreements. Repurchase agreements involve certain risks in the event of default
or insolvency by the other party, including possible delays or restrictions upon
the Fund's ability to dispose of the underlying securities.
Short Sales "Against The Box". In a short sale, the Small Company Fund
sells a borrowed security and has a corresponding obligation to the lender to
replace with such security. The Fund may engage in short sales if at the time of
the short sale the Fund owns or has the right to obtain without additional cost
an equal amount of the security being sold short. This investment technique is
known as a short sale "against the box."
In a short sale, the seller does not immediately deliver the securities
sold and is said to have a short position in those securities until delivery
occurs. If the Fund engages in a short sale, the collateral for the short
position will be maintained by the Fund's custodian or qualified sub-custodian.
While the short sale against the box is open, the Fund will maintain in a
segregated account an amount of securities equal in kind and amount to the
securities sold short or securities convertible into or exchangeable for such
equivalent securities. These securities constitute the Fund's long position. Not
more than 15% of the Fund's net assets (taken at current value) may be held as
collateral for such short sales at any one time.
The Fund does not intend to engage in short sales against the box for
investment purposes. The Fund may, however, make a short sale as a hedge, when
it believes that the price of a security may decline, causing a decline in the
value of a security owned by the Fund (or a security convertible or exchangeable
for such security). In such case, any future losses in the Fund's long position
should be offset by a gain in the short position and, conversely, any gain in
the long position should be reduced by a loss in the short position. The extent
to which such gains or losses are reduced will depend upon the amount of the
security sold short relative to the amount the Fund owns. There will be certain
additional transaction costs associated with short sales against the box, but
the Fund will endeavor to offset these costs with the income from the investment
of the cash proceeds of short sales.
Restricted, Non-Publicly Traded and Illiquid Securities. The Small Company
Fund may not invest more than 15% of its net assets, in the aggregate, in
illiquid securities, including repurchase agreements which have a maturity of
longer than seven days, time deposits maturing in more than seven days and
securities that are illiquid because of the absence of a readily available
market or legal or contractual restrictions on resale. Repurchase agreements
subject to demand are deemed to have a maturity equal to the notice period.
Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act of 1933, as amended (the "Securities Act"),
securities which are otherwise not readily marketable and repurchase agreements
having a maturity of longer than seven days. Securities which have not been
registered under the Securities Act are referred to as private placements or
restricted securities and are purchased directly from the issuer or in the
secondary market. Investment companies do not typically hold a significant
amount of these restricted or other illiquid securities because of the potential
for delays on resale and uncertainty in valuation. Limitations on resale may
have an adverse effect on the marketability of portfolio securities, and an
investment company might be unable to dispose of restricted or other illiquid
securities promptly or at reasonable prices and might thereby experience
difficulty satisfying redemptions within seven days. An investment company might
also have to register such restricted securities in order to dispose of them
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resulting in additional expense and delay. Adverse market conditions could
impede such a public offering of securities.
In recent years, however, a large institutional market has developed for
certain securities that are not registered under the Securities Act including
repurchase agreements, commercial paper, foreign securities, municipal
securities and corporate bonds and notes. Institutional investors depend on an
efficient institutional market in which the unregistered security can be readily
resold or on an issuer's ability to honor a demand for repayment. The fact that
there are contractual or legal restrictions on resale to the general public or
to certain institutions may not be indicative of the liquidity of such
investments.
The SEC has adopted Rule 144A which allows for a broader institutional
trading market for securities otherwise subject to restriction on resale to the
general public. Rule 144A establishes a "safe harbor" from the registration
requirements of the securities act for resales of certain securities to
qualified institutional buyers. It is anticipated that the market for certain
restricted securities such as institutional commercial paper will expand further
as a result of this regulation and use of automated systems for the trading,
clearance and settlement of unregistered securities of domestic and foreign
issuers, such as the PORTAL System sponsored by the National Association of
Securities Dealers, Inc.
The Fund may sell over-the-counter ("OTC") options and, in connection
therewith, segregate assets or cover its obligations with respect to OTC options
written by the Fund. The assets used as cover for OTC options written by the
Fund will be considered illiquid unless the OTC options are sold to qualified
dealers who agree that the Fund may repurchase any OTC option it writes at a
maximum price to be calculated by a formula set forth in the option agreement.
The cover for an OTC option written subject to this procedure would be
considered illiquid only to the extent that the maximum repurchase price under
the formula exceeds the intrinsic value of the option.
Each Subadviser will monitor the liquidity of restricted securities in the
portion of the Fund it manages under the supervision of the Board of Trustees
and the Adviser. In reaching liquidity decisions, each Subadviser may consider
the following factors: (A) the unregistered nature of the security; (B) the
frequency of trades and quotes for the security; (C) the number of dealers
wishing to purchase or sell the security and the number of other potential
purchasers; (D) dealer undertakings to make a market in the security and (E) the
nature of the security and the nature of the marketplace trades (e.g., the time
needed to dispose of the security, the method of soliciting offers and the
mechanics of the transfer).
When-Issued Securities And Delayed-Delivery Transactions. The Small
Company Fund may invest without limitation in securities purchased on a
"when-issued" basis or purchase or sell securities for delayed delivery (i.e.,
payment or delivery occurs beyond the normal settlement date at a stated price
and yield). When-issued transactions normally settle within 45 days. The Fund
will enter into a when-issued or delayed-delivery transaction for the purpose of
acquiring portfolio securities and not for the purpose of leverage, but may sell
the securities before the settlement date if a Subadviser which purchased such
security deems it advantageous to do so. The payment obligation and the interest
rate that will be received on when-issued or delayed delivery securities are
fixed at the time the buyer enters into the commitment. Due to fluctuations in
the value of securities purchased or sold on such a basis, the yields obtained
on such securities may be higher or lower than the yields available in the
market on the dates when the investments are actually delivered to the buyers.
When the Fund agrees to purchase when-issued or delayed-delivery
securities, its custodian will set aside cash, U.S. government securities or
other liquid high-grade debt obligations equal to the amount of the commitment
in a segregated account. Normally, the custodian will set aside portfolio
securities to satisfy a purchase commitment, and in such a case the Fund may be
required subsequently to place additional assets in the segregated account in
order to ensure that the value of the account remains equal to the amount of the
Fund's commitment. It may be expected that the Fund's net assets will fluctuate
to a
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greater degree when it sets aside portfolio securities to cover such purchase
commitments than when it sets aside cash. When the Fund engages in when-issued
or delayed-delivery transactions, it relies on the other party to consummate the
trade. Failure of the seller to do so may result in the Fund incurring a loss or
missing an opportunity to obtain a price considered to be advantageous.
Lending Portfolio Securities. The Small Company Fund may lend its
portfolio securities to brokers, dealers and other financial institutions,
provided it receives cash collateral which at all times is maintained in an
amount equal to at least 100% of the current market value of the securities
loaned. By lending its portfolio securities, the Fund can increase its income
through the investment of the cash collateral. For the purposes of this policy,
the Fund considers collateral consisting of cash, U.S. Government securities or
letters of credit issued by banks whose securities meet the standards for
investment by the Fund to be the equivalent of cash. From time to time, the Fund
may return to the borrower or a third party which is unaffiliated with the Fund,
and which is acting as a "placing broker," a part of the interest earned from
the investment of collateral received for securities loaned. The SEC currently
requires that the following conditions must be met whenever portfolio securities
are loaned: (1) the Fund must receive at least 100% cash collateral of the type
discussed in the preceding paragraph from the borrower; (2) the borrower must
increase such collateral whenever the market value of the securities loaned
rises above the level of such collateral; (3) the Fund must be able to terminate
the loan at any time; (4) the Fund must receive reasonable interest on the loan,
as well as any dividends, interest or other distributions payable on the loaned
securities, and any increase in market value; (5) the Fund may pay only
reasonable custodian fees in connection with the loan; and (6) while any voting
rights on the loaned securities may pass to the borrower, the Trust's Trustees
must be able to terminate the loan and regain the right to vote the securities
if a material event adversely affecting the investment occurs. These conditions
may be subject to future modification. Loan agreements involve certain risks in
the event of default or insolvency of the other party including possible delays
or restrictions upon the Fund's ability to recover the loaned securities or
dispose of the collateral for the loan.
Borrowing. The Small Company Fund may borrow money from banks, limited by
the Fund's fundamental investment restriction to 33-1/3% of its total assets,
and may engage in reverse repurchase agreements which may be considered a form
of borrowing. (See "INVESTMENT TECHNIQUES, CONSIDERATIONS AND RISK FACTORS -
Reverse Repurchase Agreements" in the Small Company Fund's Prospectus.) In
addition, the Fund may borrow up to an additional 5% of its total assets from
banks for temporary or emergency purposes. The Fund will not purchase securities
when bank borrowings exceed 5% of the Fund's total assets. The Fund expects that
some of its borrowings may be on a secured basis. In such situations, either the
custodian will segregate the pledged assets for the benefit of the lender or
arrangements will be made with a suitable subcustodian, which may include the
lender.
Derivative Instruments. As discussed in its Prospectus, each of the Small
Company Fund's Subadvisers may use a variety of derivative instruments,
including options, futures contracts (sometimes referred to as "futures"),
options on futures contracts, stock index options and forward currency contracts
to hedge the Fund's portfolio or for risk management.
The use of these instruments is subject to applicable regulations of the
SEC, the several options and futures exchanges upon which they may be traded,
the Commodity Futures Trading Commission ("CFTC") and various state regulatory
authorities. In addition, the Fund's ability to use these instruments will be
limited by tax considerations.
Special Risks Of Derivative Instruments. The use of derivative instruments
involves special considerations and risks as described below. Risks pertaining
to particular instruments are described in the sections that follow.
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(1) Successful use of most of these instruments depends upon a
Subadviser's ability to predict movements of the overall securities and currency
markets, which requires different skills than predicting changes in the prices
of individual securities. While each Subadviser is experienced in the use of
these instruments, there can be no assurance that any particular strategy
adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of an instrument and price movements of investments being
hedged. For example, if the value of an instrument used in a short hedge (such
as writing a call option, buying a put option, or selling a futures contract)
increased by less than the decline in value of the hedged investment, the hedge
would not be fully successful. Such a lack of correlation might occur due to
factors unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which these instruments are
traded. The effectiveness of hedges using instruments on indices will depend on
the degree of correlation between price movements in the index and price
movements in the investments being hedged.
(3) Hedging strategies, if successful, can reduce the risk of loss by
wholly or partially offsetting the negative effect of unfavorable price
movements in the investments being hedged. However, hedging strategies can also
reduce opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. For example, if the Fund entered into a
short hedge because a Subadviser projected a decline in the price of a security
in the Fund's portfolio, and the price of that security increased instead, the
gain from that increase might be wholly or partially offset by a decline in the
price of the instrument. Moreover, if the price of the instrument declined by
more than the increase in the price of the security, the Fund could suffer a
loss.
(4) As described below, the Fund might be required to maintain assets as
"cover," maintain segregated accounts, or make margin payments when it takes
positions in these instruments involving obligations to third parties (i.e.,
instruments other than purchased options). If the Fund were unable to close out
its positions in such instruments, it might be required to continue to maintain
such assets or accounts or make such payments until the position expired or
matured. The requirements might impair the Fund's ability to sell a portfolio
security or make an investment at a time when it would otherwise be favorable to
do so, or require that the Fund sell a portfolio security at a disadvantageous
time. The Fund's ability to close out a position in an instrument prior to
expiration or maturity depends on the existence of a liquid secondary market or,
in the absence of such a market, the ability and willingness of the other party
to the transaction ("counter party") to enter into a transaction closing out the
position. Therefore, there is no assurance that any hedging position can be
closed out at a time and price that is favorable to the Fund.
For a discussion of the federal income tax treatment of the Fund's
derivative instruments, see "Tax Status" below.
Options. The Small Company Fund may purchase or write put and call options
on securities and indices, and may purchase options on foreign currency, and
enter into closing transactions with respect to such options to terminate an
existing position. The purchase of call options serves as a long hedge, and the
purchase of put options serves as a short hedge. Writing put or call options can
enable the Fund to enhance income by reason of the premiums paid by the
purchaser of such options. Writing call options serves as a limited short hedge
because declines in the value of the hedged investment would be offset to the
extent of the premium received for writing the option. However, if the security
appreciates to a price higher than the exercise price of the call option, it can
be expected that the option will be exercised, and the Fund will be obligated to
sell the security at less than its market value or will be obligated to purchase
the security at a price greater than that at which the security must be sold
under the option. All or a portion of any assets used as cover for OTC options
written by a Fund would be considered illiquid to the extent described under
"Restricted and Illiquid Securities" above. Writing put options serves as a
limited long hedge because increases in the value of the hedged investment would
be offset to the extent of the premium received for writing the option. However,
if the security depreciates to a price lower than the exercise price of the put
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option, it can be expected that the put option will be exercised, and the Fund
will be obligated to purchase the security at more than its market value.
The value of an option position will reflect, among other things, the
historical price volatility of the underlying investment, the current market
value of the underlying investment, the time remaining until expiration, the
relationship of the exercise price to the market price of the underlying
investment, and general market conditions. Options that expire unexercised have
no value. Options used by the Fund may include European-style options, which are
only exercisable at expiration. This is in contrast to American-style options
which are exercisable at any time prior to the expiration date of the option.
The Fund may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, the Fund may terminate its
obligation under a call or put option that it had written by purchasing an
identical call or put option; this is known as a closing purchase transaction.
Conversely, the Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a closing
sale transaction. Closing transactions permit the fund to realize the profit or
limit the loss on an option position prior to its exercise or expiration.
The Fund may purchase or write both OTC options and options traded on
foreign and U.S. exchanges. Exchange-traded options are issued by a clearing
organization affiliated with the exchange on which the option is listed that, in
effect, guarantees completion of every exchange-traded option transaction. OTC
options are contracts between the fund and the counter party (usually a
securities dealer or a bank) with no clearing organization guarantee. Thus, when
the Fund purchases or writes an OTC option, it relies on the counter party to
make or take delivery of the underlying investment upon exercise of the option.
Failure by the counter party to do so would result in the loss of any premium
paid by the fund as well as the loss of any expected benefit of the transaction.
The Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. The Fund intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions can be made for
OTC options only by negotiating directly with the counter party, or by a
transaction in the secondary market if any such market exists. Although the Fund
will enter into OTC options only with counter parties that are expected to be
capable of entering into closing transactions with the fund, there is no
assurance that the Fund will in fact be able to close out an OTC option at a
favorable price prior to expiration. In the event of insolvency of the counter
party, the Fund might be unable to close out an OTC option position at any time
prior to its expiration.
If the Fund were unable to effect a closing transaction for an option it
had purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call option
written by the Fund could cause material losses because the Fund would be unable
to sell the investment used as a cover for the written option until the option
expires or is exercised.
The Fund may engage in options transactions on indices in much the same
manner as the options on securities discussed above, except that index options
may serve as a hedge against overall fluctuations in the securities markets in
general.
The writing and purchasing of options is a highly specialized activity
that involves investment techniques and risks different from those associated
with ordinary portfolio securities transactions. Imperfect correlation between
the options and securities markets may detract from the effectiveness of
attempted hedging.
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To the extent required by SEC guidelines, the Fund will not enter into any
such transactions unless it owns either (1) an offsetting ("covered") position
in securities, other options, or futures or (2) cash and liquid securities with
a value sufficient at all times to cover its potential obligations to the extent
not covered as provided in (1) above. The Fund will also set aside cash and/or
appropriate liquid assets in a segregated custodial account if required to do so
by the SEC and CFTC regulations. Assets used as cover or held in a segregated
account cannot be sold while the position in the corresponding option or futures
contract is open, unless they are replaced with similar assets. As a result, the
commitment of a large portion of the Fund's assets to segregated accounts as a
cover could impede portfolio management or the Fund's ability to meet redemption
requests or other current obligations.
Transactions using options (other than purchased options) also expose the Fund
to market risk. Market risk is that the price of the option will fluctuate with
the price of the underlying security. Due to the leverage effect of the option
this price fluctuation of the option will be greater than that of the underlying
security.
Spread Transactions. The Small Company Fund may purchase covered spread
options from securities dealers. Such covered spread options are not presently
exchange-listed or exchange-traded. The purchase of a spread option gives the
Fund the right to put, or sell, a security that it owns at a fixed dollar spread
or fixed yield spread in relationship to another security that the Fund does not
own, but which is used as a benchmark. The risk to the Fund in purchasing
covered spread options it the cost of the premium paid for the spread option and
any transaction costs. In addition, there is no assurance that closing
transactions will be available. The purchase of spread options will be used to
protect the Fund against adverse changes in prevailing credit quality spreads,
i.e., the yield spread between high quality and lower quality securities. Such
protection is only provided during the life of the spread option.
Futures Contracts. The Small Company Fund may enter into futures
contracts, including interest rate, index, and currency futures and purchase and
write (sell) related options. The purchase of futures or call options thereon
can serve as a long hedge, and the sale of futures or the purchase of put
options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge, using a strategy
similar to that used for writing covered options in securities. The Fund's
hedging may include purchases of futures as an offset against the effect of
expected increases in securities prices or currency exchange rates and sales of
futures as an offset against the effect of expected declines in securities
prices or currency exchange rates. The Fund may write put options on futures
contracts while at the same time purchasing call options on the same futures
contracts in order to create synthetically a long futures contract position.
Such options would have the same strike prices and expiration dates. The Fund
will engage in this strategy only when a Subadviser believes it is more
advantageous to the Fund than is purchasing the futures contract.
The Fund will only enter into futures contracts that are traded on U.S. or
foreign exchanges or boards of trade approved by the CFTC and are standardized
as to maturity date and underlying financial instrument. These transactions may
be entered into for "bona fide hedging" purposes as defined in CFTC regulations
and other permissible purposes including increasing return and hedging against
changes in the value of portfolio securities due to anticipated changes in
interest rates, currency values and/or market conditions. The ability of the
Fund to trade in futures contracts may be limited by the requirements of the
code applicable to a regulated investment company.
The Fund will not enter into futures contracts and related options for
other than "bona fide hedging" purposes for which the aggregate initial margin
and premiums required to establish positions exceed 5% of the Fund's net asset
value after taking into account unrealized profits and unrealized losses on any
such contracts it has entered into. There is no overall limit on the percentage
of the Fund's assets that may be at risk with respect to futures activities.
Although techniques other than sales and purchases of futures
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<PAGE> 21
contracts could be used to reduce the Fund's exposure to market, currency, or
interest rate fluctuations, the Fund may be able to hedge its exposure more
effectively and perhaps at a lower cost through using futures contracts.
A futures contract provides for the future sale by one party and purchase
by another party of a specified amount of a specific financial instrument (e.g.,
debt security) or currency for a specified price at a designated date, time, and
place. An index futures contract is an agreement pursuant to which the parties
agree to take or make delivery of an amount of cash equal to a specified
multiplier times 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 futures
contract was originally written. Transactions costs are incurred when a futures
contract is bought or sold and margin deposits must be maintained. A futures
contract may be satisfied by delivery or purchase, as the case may be, of the
instrument, the currency, or by payment of the change in the cash value of the
index. More commonly, futures contracts are closed out prior to delivery by
entering into an offsetting transaction in a matching futures contract. Although
the value of an index might be a function of the value of certain specified
securities, no physical delivery of those securities is made. If the offsetting
purchase price is less than the original sale price, the Fund realizes a gain;
if it is more, the Fund realizes a loss. Conversely, if the offsetting sale
price is more than the original purchase price, the Fund realizes a gain; if it
is less, the Fund realizes a loss. The transaction costs must also be included
in these calculations. There can be no assurance, however, that the Fund will be
able to enter into an offsetting transaction with respect to a particular
futures contract at a particular time. If the Fund is not able to enter into an
offsetting transaction, the Fund will continue to be required to maintain the
margin deposits on the futures contract.
No price is paid by the Fund upon entering into a futures contract.
Instead, at the inception of a futures contract, the fund is required to deposit
in a segregated account with its custodian, in the name of the futures broker
through whom the transaction was effected, "initial margin" consisting of cash,
U.S. government securities or other liquid, high grade debt obligations, in an
amount generally equal to 10% or less of the contract value. Margin must also be
deposited when writing a call or put option on a futures contract, in accordance
with applicable exchange rules. Unlike margin in securities transactions,
initial margin on futures contracts does not represent a borrowing, but rather
is in the nature of a performance bond or good-faith deposit that is returned to
the Fund at the termination of the transaction if all contractual obligations
have been satisfied. Under certain circumstances, such as periods of high
volatility, the Fund may be required by an exchange to increase the level of its
initial margin payment, and initial margin requirements might be increased
generally in the future by regulatory action.
Subsequent "variation margin" payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
"marking to market." Variation margin does not involve borrowing, but rather
represents a daily settlement of a Fund's obligations to or from a futures
broker. When the fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when the Fund purchases
or sells a futures contract or writes a call or put option thereon, it is
subject to daily variation margin calls that could be substantial in the event
of adverse price movements. If the Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities at a time when
such sales are disadvantageous. Purchasers and sellers of futures positions and
options on futures can enter into offsetting closing transactions by selling or
purchasing, respectively, an instrument identical to the instrument held or
written. Positions in futures and options on futures may be closed only on an
exchange or board of trade on which they were entered into (or through a linked
exchange). Although the Fund intends to enter into futures transactions only on
exchanges or boards of trade where there appears to be an active market, there
can be no assurance that such a market will exist for a particular contract at a
particular time.
Under certain circumstances, futures exchanges may establish daily limits
on the amount that the price of a future or option on a futures contract can
vary from the previous day's settlement price; once that limit is reached, no
trades may be made that day at a price beyond the limit. Daily price limits do
not limit
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<PAGE> 22
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If the Fund were unable to liquidate a futures or option on a futures
contract position due to the absence of a liquid secondary market or the
imposition of price limits, it could incur substantial losses. The Fund would
continue to be subject to market risk with respect to the position. In addition,
except in the case of purchased options, the Fund would continue to be required
to make daily variation margin payments and might be required to maintain the
position being hedged by the future or option or to maintain cash or securities
in a segregated account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or options on futures contracts
might not correlate perfectly with movements in the prices of the investments
being hedged. For example, all participants in the futures and options on
futures contracts markets are subject to daily variation margin calls and might
be compelled to liquidate futures or options on futures contracts positions
whose prices are moving unfavorably to avoid being subject to further calls.
These liquidations could increase price volatility of the instruments and
distort the normal price relationship between the futures or options and the
investments being hedged. Also, because initial margin deposit requirements in
the futures markets are less onerous than margin requirements in the securities
markets, there might be increased participation by speculators in the future
markets. This participation also might cause temporary price distortions. In
addition, activities of large traders in both the futures and securities markets
involving arbitrage, "program trading" and other investment strategies might
result in temporary price distortions.
Swap Agreements. The Small Company Fund may enter into interest rate,
securities index, commodity, or security and currency exchange rate swap
agreements for any lawful purpose consistent with the Fund's investment
objective, such as for the purpose of attempting to obtain or preserve a
particular desired return or spread at a lower cost to the Fund than if the Fund
had invested directly in an instrument that yielded that desired return or
spread. The Fund also may enter into swaps in order to protect against an
increase in the price of, or the currency exchange rate applicable to,
securities that the Fund anticipates purchasing at a later date. Swap agreements
are two-party contracts entered into primarily by institutional investors for
periods ranging from a few weeks to several years. In a standard swap
transaction, two parties agree to exchange the returns (or differentials in
rates of return) earned or realized on particular predetermined investments or
instruments. The gross returns to be exchanged or swapped between the parties
are calculated with respect to a notional amount, i.e., the return on or
increase in value of a particular dollar amount invested at a particular
interest rate, in a particular foreign currency, or in a basket of securities
representing a particular index. Swap agreements may include interest rate caps,
under which, in return for a premium, one party agrees to make payments to the
other to the extent that interest rates exceed a specified rate, or cap;
interest rate floors under which, in return for a premium, one party agrees to
make payments to the other to the extent that interest rates fall below a
specified level, or "floor"; and interest rate collars, under which a party
sells a cap and purchases a floor, or vice versa, in an attempt to protect
itself against interest rate movements exceeding given minimum or maximum
levels.
The notional amount of the swap agreement is the agreed upon basis for
calculating the obligations that the parties to a swap agreement have agreed to
exchange. Under most swap agreements entered into by the Fund, the obligations
of the parties would be exchanged on a net basis. Consequently, the Fund's
obligation (or rights) under a swap agreement will generally be equal only to
the net amount to be paid or received under the agreement based on the relative
values of the positions held by each party to the agreement (the "net amount").
The Fund's obligation under a swap agreement will be accrued daily (offset
against amounts owed to the Fund) and any accrued but unpaid net amounts owed to
a swap counterparty will be covered by the maintenance of a segregate account
consisting of cash, or liquid high grade debt obligations.
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<PAGE> 23
Whether the Fund's use of swap agreements will be successful in furthering
its investment objective will depend, in part, on a Subadviser's ability to
predict correctly whether certain types of investments are likely to produce
greater returns than other investments. Swap agreements may be considered to be
illiquid. Moreover, the Fund bears the risk of loss of the amount expected to be
received under a swap agreement in the event of the default or bankruptcy of a
swap agreement counterparty. Certain restrictions imposed on the Fund by the
Internal Revenue Code may limit the Fund's ability to use swap agreements. The
swaps market is largely unregulated.
The Fund will enter swap agreements only with counterparties that a
Subadviser reasonably believes are capable of performing under the swap
agreements. If there is a default by the other party to such a transaction, the
Fund will have to rely on its contractual remedies (which may be limited by
bankruptcy, insolvency or similar laws) pursuant to the agreements related to
the transaction.
Foreign Currency-Related Derivative Strategies - Special Considerations.
The Small Company Fund may use options and futures on foreign currencies and
forward currency contracts to hedge against movements in the values of the
foreign currencies in which the Fund's securities are denominated. The Fund may
engage in currency exchange transactions to protect against uncertainty in the
level of future exchange rates and may also engage in currency transactions to
increase income and total return. Such currency hedges can protect against price
movements in a security the Fund owns or intends to acquire that are
attributable to changes in the value of the currency in which it is denominated.
Such hedges do not, however, protect against price movements in the securities
that are attributable to other causes.
The Fund might seek to hedge against changes in the value of a particular
currency when no hedging instruments on that currency are available or such
hedging instruments are more expensive than certain other hedging instruments.
In such cases, the Fund may hedge against price movements in that currency by
entering into transactions using hedging instruments on another foreign currency
or a basket of currencies, the values of which a subadviser believes will have a
high degree of positive correlation to the value of the currency being hedged.
The risk that movements in the price of the hedging instrument will not
correlate perfectly with movements in the price of the currency being hedged is
magnified when this strategy is used.
The value of derivative instruments on foreign currencies depends on the
value of the underlying currency relative to the U.S. dollar. Because foreign
currency transactions occurring in the interbank market might involve
substantially larger amounts than those involved in the use of such hedging
instruments, the Fund could be disadvantaged by having to deal in the odd lot
market (generally consisting of transactions of less than $1 million) for the
underlying foreign currencies at prices that are less favorable than for round
lots.
There is no systematic reporting of last sale information for foreign
currencies or any regulatory requirement that quotations available through
dealers or other market sources be firm or revised on a timely basis. Quotation
information generally is representative of very large transactions in the
interbank market and thus might not reflect odd-lot transactions where rates
might be less favorable. The interbank market in foreign currencies is a global,
round-the-clock market. To the extent the U.S. options or futures markets are
closed while the markets for the underlying currencies remain open, significant
price and rate movements might take place in the underlying markets that cannot
be reflected in the markets for the derivative instruments until they reopen.
Settlement of derivative transactions involving foreign currencies might
be required to take place within the country issuing the underlying currency.
Thus, the Fund might be required to accept or make delivery of the underlying
foreign currency in accordance with any U.S. or foreign regulations regarding
the maintenance of foreign banking arrangements by U.S. residents and might be
required to pay any fees, taxes and charges associated with such delivery
assessed in the issuing country.
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Permissible foreign currency options will include options traded primarily
in the OTC market. Although options on foreign currencies are traded primarily
in the OTC market, the Fund will normally purchase OTC options on foreign
currency only when a Subadviser believes a liquid secondary market will exist
for a particular option at any specific time.
Forward Currency Contracts. A forward currency contract involves an
obligation to purchase or sell a specific currency at a future date, which may
be any fixed number of days from the date of the contract agreed upon by the
parties, at a price set at the time of the contract. These contracts are entered
into in the interbank market conducted directly between currency traders
(usually large commercial banks) and their customers.
At or before the maturity of a forward contract, the Small Company Fund
may either sell a portfolio security and make delivery of the currency, or
retain the security and fully or partially offset its contractual obligation to
deliver the currency by purchasing a second contract. 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 contract prices.
The precise matching of forward currency contract amounts and the value of
the securities involved generally will not be possible because the value of such
securities, measured in the foreign currency, will change after the foreign
currency contract has been established. Thus, the Fund might need to purchase or
sell foreign currencies in the spot (cash) market to the extent such foreign
currencies are not covered by forward contracts. The projection of short-term
currency market movements is extremely difficult, and the successful execution
of a short-term hedging strategy is highly uncertain.
Currency Hedging. While the values of forward currency contracts, currency
options, currency futures and options on futures may be expected to correlate
with exchange rates, they will not reflect other factors that may affect the
value of the Small Company Fund's investments. A currency hedge, for example,
should protect a Yen-denominated bond against a decline in the Yen, but will not
protect the Fund against price decline if the issuer's creditworthiness
deteriorates. Because the value of the Fund's investments denominated in foreign
currency will change in response to many factors other than exchange rates, a
currency hedge may not be entirely successful in mitigating changes in the value
of the Fund's investments denominated in that currency over time.
A decline in the dollar value of a foreign currency in which the Fund's
securities are denominated will reduce the dollar value of the securities, even
if their value in the foreign currency remains constant. The use of currency
hedges 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 order to protect against such diminutions in the value of securities
it holds, the Fund may purchase put options on the foreign currency. If the
value of the currency does decline, the Fund will have the right to sell the
currency for a fixed amount in dollars and will thereby offset, in whole or in
part, the adverse effect on its securities that otherwise would have resulted.
Conversely, if a rise in the dollar value of a currency in which securities to
be acquired are denominated is projected, thereby potentially increasing the
cost of the securities, the Fund may purchase call options on the particular
currency. The purchase of these options could offset, at least partially, the
effects of the adverse movements in exchange rates. Although currency hedges
limit the risk of loss due to a decline in the value of a hedged currency, at
the same time, they also limit any potential gain that might result should the
value of the currency increase.
The Fund's currency hedging will be limited to hedging involving either
specific transactions or portfolio positions. Transaction hedging is the
purchase or sale of forward currency with respect to specific receivables or
payables of the Fund generally accruing in connection with the purchase or sale
of its portfolio securities. Position hedging is the sale of forward currency
with respect to portfolio security
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<PAGE> 25
positions. The Fund may not position hedge to an extent greater than the
aggregate market value (at the time of making such sale) of the hedged
securities.
Securities Of Other Non-Affiliated Investment Companies. Some of the
countries in which the Small Company Fund may invest may not permit direct
investment by outside investors. Investments in such countries may only be
permitted through foreign government-approved or government-authorized
investment vehicles, which may include other investment companies. Investing
through such vehicles may involve frequent or layered fees or expenses and may
also be subject to limitation under the 1940 Act. Under the 1940 Act, a Fund may
invest up to 10% of its assets in shares of investment companies and up to 5% of
its assets in any one investment company as long as the investment does not
represent more than 3% of the voting stock of the acquired investment company.
Commercial Paper. The Small Company Fund may invest in commercial paper
which is indexed to certain specific foreign currency exchange rates. The terms
of such commercial paper provide that its principal amount is adjusted upwards
or downwards (but not below zero) at maturity to reflect changes in the exchange
rate between two currencies while the obligation is outstanding. The Fund will
purchase such commercial paper with the currency in which it is denominated and,
at maturity, will receive interest and principal payments thereon in that
currency, but the amount or principal payable by the issuer at maturity will
change in proportion to the change (if any) in the exchange rate between two
specified currencies between the date the instrument is issued and the date the
instrument matures. While such commercial paper entails the risk of loss of
principal, the potential for realizing gains as a result of changes in foreign
currency exchange rate enables the Fund to hedge or cross-hedge against a
decline in the U.S. Dollar value of investments denominated in foreign
currencies while providing an attractive money market rate of return. The Fund
will purchase such commercial paper for hedging purposes only, not for
speculation. The staff of the SEC is currently considering whether the purchase
of this type of commercial paper would result in the issuance of a "senior
security" within the meaning of the 1940 Act. The Fund believes that such
investments do not involve the creation of such a senior security, but
nevertheless will establish a segregated account with respect to its investments
in this type of commercial paper and to maintain in such account cash not
available for investment or U.S. Government securities or other liquid high
quality debt securities having a value equal to the aggregate principal amount
of outstanding commercial paper of this type.
Investment Restrictions
The following are fundamental investment limitations, which cannot be
changed without the approval of the holders of a majority of the shares of the
Fund for which the change is proposed, and apply to all of the Funds of the
Trust (except the Small Company and Income Funds, whose restrictions are listed
separately below), unless otherwise stated.
The Trust may not:
1. Borrow money, except an amount equal to no more than 5% of the value
of each of the Fund's total assets (calculated when the loan is
made) for temporary, emergency purposes or for the clearance of
transactions. This limited borrowing authority will not be used to
leverage the Funds or to borrow for extended periods of time. This
authority is intended to provide the investment manager additional
flexibility in the execution of routine daily transactions, and
allow for more efficient cash management.
2. Purchase securities on margin, but the Trust may obtain such credits
as may be necessary for the clearance of purchases and sales of
securities and except as may be necessary to make margin payments in
connection with derivative securities transactions.
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<PAGE> 26
3. Make loans to other persons, except by the purchase of obligations
in which the Trust is authorized to invest. The Trust may, however,
enter into repurchase agreements, but a Fund will not enter into
repurchase agreements if, as a result thereof, more than 10% of the
Fund's total assets (taken at current value) would be subject to
repurchase agreements maturing in more than 7 days.
4. Purchase securities of any one issuer, other than obligations issued
or guaranteed by the U. S. Government, its agencies or
instrumentalities, if, immediately after such purchase, more than 5%
of the Fund's total assets would be invested in such issuer or the
Fund would hold more than 10% the outstanding voting securities of
the issuer, except that 25% or less of the Fund's total assets may
be invested without regard to such limitations. There is no limit to
the percentage of assets that may be invested in U. S. Treasury
bills, notes, or other obligations issued or guaranteed by the U.S.
Government, its agencies or instrumentalities. The Money Market Fund
will be deemed to be in compliance with this restriction as long as
it is in compliance with Rule 2a-7 under the 1940 Act, as such Rule
may be amended from time to time.
5. Purchase or sell real estate unless acquired as a result of
ownership of securities or instruments, but this restriction shall
not prohibit the Fund from purchasing or selling securities issued
by entities or investment vehicles that own or deal in real estate
or interests therein or instruments secured by real estate or
interests therein.
6. Purchase or sell commodities or commodities contracts, except to the
extent disclosed in the current Prospectus of such Fund.
7. Issue securities except as permitted by the Investment Company Act
of 1940.
The following are the non-fundamental operating policies of the Capital
Appreciation Fund, Total Return Fund, Government Bond Fund and Money Market Fund
which may be changed by the Board of Trustees of the Trust without shareholder
approval:
No Fund may:
1. Make short sales of securities.
2. Purchase or otherwise acquire any other securities if, as a result,
more than 15% (10% with respect to the Money Market Fund of its net
assets would be invested in securities that are illiquid.
3. Purchase securities of other investment companies, except (a) in
connection with a merger, consolidation, acquisition or
reorganization and (b) to the extent permitted by the 1940 Act, or
any rules or regulations theunder, or pursuant to any exemption
therefrom.
Investment Restrictions for the Small Company Fund and the Income Fund -- The
following are fundamental investment limitations for the Small Company and the
Income Fund which cannot be changed without shareholder approval:
The Small Company Fund and the Income Fund:
1. May (i) borrow money from banks and (ii) make other investments or
engage in other transactions permissible under the 1940 Act which
may involve a borrowing, provided that the combination of (i) and
(ii) shall not exceed 33-1/3% of the value of the Fund's total
assets
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<PAGE> 27
(including the amount borrowed), less the Fund's liabilities (other
than borrowings), except that the Fund may borrow up to an
additional 5% of its total assets (not including the amount
borrowed) from a bank for temporary or emergency purposes (but not
for leverage or the purchase of investments). The Fund may also
borrow money from other persons to the extent permitted by
applicable law. For purposes of this restriction, short sales, the
entry into currency transactions, options, futures contracts,
options on futures contracts, forward commitment transactions and
dollar roll transactions that are not accounted for as financings
(and the segregation of assets in connection with any of the
foregoing) shall not constitute borrowing.
2. May not issue senior securities, except as permitted under the 1940
Act.
3. May not act as an underwriter of another issuer's securities, except
to the extent that the Fund may be deemed an underwriter within the
meaning of the Securities Act in connection with the purchase and
sale of portfolio securities.
4. May not purchase or sell physical commodities unless acquired as a
result of ownership of securities or other instruments, but this
shall not prevent the Fund from purchasing or selling options,
futures contracts, or other derivative instruments, or from
investing in securities or other instruments backed by physical
commodities.
5. May not lend any security or make any other loan if, as a result,
more than 33 1/3% of its total assets (taken at current value) would
be lent to other parties, except in accordance with its investment
objective, policies and limitations through (i) purchase of debt
securities or other debt instruments, including loan participations,
assignments and structured securities, or (ii) by engaging in
repurchase agreements.
6. May not purchase the securities of any issuer if, as a result, more
than 25% (taken at current value) of the Fund's total assets would
be invested in the securities of issuers, the principal activities
of which are in the same industry. This limitation does not apply to
securities issued by the U.S. government or its agencies or
instrumentalities.
7. May not purchase or sell real estate unless acquired as a result of
ownership of securities or instruments, but this restriction shall
not prohibit the Fund from purchasing or selling securities issued
by entities or investment vehicles that own or deal in real estate
or interests therein or instruments secured by real estate or
interests therein.
The following are the non-fundamental operating policies of the Small Company
Fund and the Income Fund which may be changed by the Board of Trustees of the
Trust without shareholder approval:
The Small Company and the Income Fund each may not:
1. Sell securities short, unless the Fund owns or has the right to
obtain securities equivalent in kind and amount to the securities
sold short or unless it covers such short sale as required by the
current rules and positions of the SEC or its staff, and provided
that short positions in forward currency contracts, options, futures
contracts, options on futures contracts, or other derivative
instruments are not deemed to constitute selling securities short.
2. Purchase securities on margin, except that the Fund may obtain such
short-term credits as are necessary for the clearance of
transactions; and provided that margin deposits in connection with
options, futures contracts, options on futures contracts,
transactions in currencies or other derivative instruments shall not
constitute purchasing securities on margin.
27
<PAGE> 28
3. Purchase or otherwise acquire any security if, as a result, more
than 15% of its net assets would be invested in securities that are
illiquid.
4. Purchase securities of other investment companies except in
connection with a merger, consolidation, acquisition, reorganization
or offer of exchange, or as otherwise permitted under the 1940 Act.
5. Pledge, mortgage or hypothecate any assets owned by the Fund except
as may be necessary in connection with permissible borrowings or
investments and then such pledging, mortgaging, or hypothecating may
not exceed 33 1/3% of the Fund's total assets at the time of the
borrowing or investment.
Insurance Law Restrictions - In connection with the Trust's agreement to
sell shares to the Accounts, the Adviser and the insurance companies may enter
into agreements, required by certain state insurance departments, under which
the Adviser may agree to use its best efforts to assure and to permit insurance
companies to monitor that each Fund of the Trust complies with the investment
restrictions and limitations prescribed by state insurance laws and regulations
applicable to the investment of separate account assets in shares of mutual
funds. If a Fund failed to comply with such restrictions or limitations, the
Accounts would take appropriate action which might include ceasing to make
investments in the Fund or withdrawing from the state imposing the limitation.
Such restrictions and limitations are not expected to have a significant impact
on the Trust's operations.
28
<PAGE> 29
Major Shareholders
As of March 31, 1998, separate accounts of Nationwide Life Insurance
Company and Nationwide Life and Annuity Insurance Company had shared voting and
investment power of 92.8% and 7.2% of the shares of the Total Return Fund, 93.7%
and 6.3% of the shares of Government Bond Fund, 97.7% and 2.3% of the shares of
Money Market Fund, and 97.2% and 2.5% of the shares of Capital Appreciation
Fund, respectively. As of March 31, 1998, Nationwide Life Insurance Company
owned beneficially 2.3% and had shared voting and investment power for 97.5% of
the shares of the Small Company Fund.
As of March 31, 1998, the Trustees and Officers of the Trust as a group
owned less than 1% of the shares of the Funds.
Trustees And Executive Officers Of The Trust
Trustees and Executive Officers
The principal occupations of the Trustees and Officers during the last
five years and their affiliations are:
Dr. John C. Bryant, Trustee, Age 62
411 Oak Street, Suite 306, Cincinnati, Ohio.
Dr. Bryant is Executive Director of the Cincinnati Youth Collaborative a
partnership of business, government, schools and social service agencies
to address the educational needs of students. He was formerly Professor of
Education, Wilmington College.
Sue A. Doody, Trustee, Age 63
169 East Beck Street, Columbus, Ohio.
Ms. Doody is owner of Lindey's Restaurant, Columbus, Ohio.
Robert M. Duncan, Trustee, Age 70.
1397 Haddon Road, Columbus, Ohio.
Mr. Duncan is a member of the Ohio Elections Commission. He was formerly
Secretary to the Board of Trustees of The Ohio State University. Prior to
that, he was Vice President and General Counsel of The Ohio State
University.
Joseph J. Gasper*, Trustee, Chairman, Age 54
One Nationwide Plaza, Columbus, Ohio
Mr. Gasper is President and Chief Operating Officer of Nationwide Life
Insurance Company and Nationwide Life and Annuity Insurance Company. Prior
to that, he was Executive Vice President and Senior Vice President for
Nationwide Insurance Enterprise.
Dr. Thomas J. Kerr, IV, Trustee, Age 64
4890 Smoketalk Lane, Westerville, Ohio.
Dr. Kerr is President Emeritus of Kendall College. He was formerly
President of Kendall College.
29
<PAGE> 30
Douglas F. Kridler, Trustee, Age 42
55 E. State Street, Columbus, Ohio.
Mr. Kridler is President and Executive Director of the Columbus
Association for the Performing Arts.
Robert J. Woodward, Jr.*, Trustee, Age 56
One Nationwide Plaza, Columbus, Ohio.
Mr. Woodward is Executive Vice President - Chief Investment Officer of
Nationwide Insurance Enterprise and of Nationwide Advisory Services, Inc.
James F. Laird, Jr., Treasurer, Age 41.
Three Nationwide Plaza, Columbus, Ohio.
Mr. Laird is Vice President and General Manager of Nationwide Advisory
Services, Inc., the Distributor and Investment Adviser. He was formerly
Treasurer of Nationwide Advisory Services, Inc.
Elizabeth A. Davin, Secretary, Age 34
One Nationwide Plaza, Columbus, Ohio.
Ms. Davin is a member of the Office of General Counsel of the Nationwide
Insurance Enterprise and partner in Druen, Dietrich, Reynolds & Koogler.
*A Trustee who is an "interested person" of the Trust as defined in the 1940
Act.
The Funds do not pay any fees to Officers or to Trustees who are
considered "interested persons" of the Trust. The table below lists the
aggregate compensation paid by the Trust to each disinterested Trustee during
the fiscal year ended December 31, 1997, and the aggregate compensation paid to
each disinterested Trustee during the year by all registered investment
companies to which the Adviser provides investment advisory services (the
"Nationwide Fund Complex").
The Trust does not maintain any pension or retirement plans for the
Officers or Trustees of the Trust.
Fiscal Year Ended December 31, 1997
<TABLE>
<CAPTION>
Total
Compensation
from the
Nationwide
Fund
Aggregate Complex
Compensation including
from the Trust the Trust
-------------- ---------
<S> <C> <C>
Dr. John C. Bryant $2,500 $18,500
Sue A. Doody $ 750 $10,750
Robert M. Duncan $2,500 $18,500
Dr. Thomas J. Kerr IV $2,500 $18,500
Douglas F. Kridler $ 750 $10,750
</TABLE>
30
<PAGE> 31
Calculating Yield - The Money Market Fund
Any current Fund yield quotations, subject to Rule 482 under the
Securities Act, shall consist of a seven calendar day historical yield, carried
at least to the nearest hundredth of a percent. The yield shall be calculated by
determining the net change, excluding realized and unrealized gains and losses,
in the value of a hypothetical pre-existing account having a balance of one
share at the beginning of the period, dividing the net change in account value
by the value of the account at the beginning of the base period to obtain the
base period return, and multiplying the base period return by 365/7 (or 366/7
during a leap year). For purposes of this calculation, the net change in account
value reflects the value of additional shares purchased with dividends from the
original share, and dividends declared on both the original share and any such
additional shares. As of December 31, 1997, the Fund's seven-day current yield
was 5.36%. The Fund's effective yield represents an annualization of the current
seven day return with all dividends reinvested, and for the period ended
December 31, 1997, was 5.51%.
The Fund's yield will fluctuate daily. Actual yields will depend on
factors such as the type of instruments in the Fund's portfolio, portfolio
quality and average maturity, changes in interest rates, and the Fund's
expenses. There is no assurance that the yield quoted on any given occasion will
remain in effect for any period of time and there is no guarantee that the net
asset value will remain constant. It should be noted that a shareholder's
investment in the Fund is not guaranteed or insured. Yields of other money
market funds may not be comparable if a different base period or another method
of calculation is used.
Calculating Yield And Total Return - Non-Money Market Funds
The Funds may from time to time advertise historical performance, subject
to Rule 482 under the Securities Act. An investor should keep in mind that any
return or yield quoted represents past performance and is not a guarantee of
future results. The investment return and principal value of investments will
fluctuate so that an investor's shares, when redeemed, may be worth more or less
than their original cost.
All performance advertisements shall include average annual total return
quotations for the most recent one, five, and ten year periods (or life, if a
fund has been in operation less than one of the prescribed periods). Average
annual total return represents the rate required each year for an initial
investment to equal the redeemable value at the end of the quoted period. It is
calculated in a uniform manner by dividing the ending redeemable value of a
hypothetical initial payment of $1,000 for a specified period of time, by the
amount of the initial payment, assuming reinvestment of all dividends and
distributions. The one, five, and ten year periods are calculated based on
periods that end on the last day of the calendar quarter preceding the date on
which an advertisement is submitted for publication.
The uniformly calculated average annual total returns for the one year,
five year, and ten year periods for the Total Return and Government Bond Funds,
ended December 31, 1997 are shown below.
<TABLE>
<CAPTION>
Total Government
Return Bond
------ ----
<S> <C> <C>
1 Year 29.4% 9.7%
5 Years 17.9% 7.4%
10 Years 15.6% 9.3%
</TABLE>
31
<PAGE> 32
The Capital Appreciation Fund began operations on May 1, 1992. Its average
annual total return for one year ended December 31, 1997, the five years ended
December 31, 1997 and for the period from May 1, 1992 through December 31, 1997
was 34.5%, 19.0% and 17.6%, respectively. The Small Company Fund began
operations on October 23, 1995. Its average total return for the year ended
December 31, 1997 and period from October 23, 1995 through December 31, 1997 was
17.4% and 25.6%, respectively.
The Government Bond Fund may also from time to time advertise a uniformly
calculated yield quotation. This yield is calculated by dividing the net
investment income per share earned during a 30-day base period by the maximum
offering price per share on the last day of the period, assuming reinvestment of
all dividends and distributions. This yield formula uses the average number of
shares entitled to receive dividends, provides for semi-annual compounding of
interest, and includes a modified market value method for determining
amortization. The yield will fluctuate, and there is no assurance that the yield
quoted on any given occasion will remain in effect for any period of time. The
Government Bond Fund yield for the 30-day period ended December 31, 1997 was
5.94%.
Investment Adviser And Other Services
The Adviser provides the Trust with overall investment advisory services
and, subject to such policies as the Trustees may determine, makes investment
decisions for the Trust.
The Trust pays the compensation of the five Trustees who are not
affiliated with the Adviser and all expenses (other than those assumed by the
Adviser), including governmental fees, interest charges, taxes, membership dues
in the Investment Company Institute allocable to the Trust; fees and expenses of
independent certified public accountants, legal counsel, and any transfer agent,
registrar, and dividend disbursing agent of the Trust; expenses of preparing,
printing, and mailing shareholders' reports, notices, proxy statements, and
reports to governmental offices and commissions; expenses connected with the
execution, recording, and settlement of portfolio security transactions,
insurance premiums, fees and expenses of the custodian for all services to the
Trust; and expenses of calculating the net asset value of shares of the Trust,
expenses of shareholders' meetings, and expenses relating to the issuance,
registration, and qualification of shares of the Trust.
NAS pays the compensation of the Trustees affiliated with the Adviser. The
officers of the Trust receive no compensation from the Trust. NAS also furnishes
all necessary administrative services, office space, equipment, and clerical
personnel for servicing the investments of the Trust and maintaining its
organization, investment advisory facilities, and executive and supervisory
personnel for managing the investments and effecting the portfolio transactions
of the Trust.
The Investment Advisory Agreement also specifically provides that the
Adviser, including its directors, officers, and employees, shall not be liable
for any error of judgment, or mistake of law, or for any loss arising out of any
investment, or for any act or omission in the execution and management of the
Trust, except for willful misfeasance, bad faith, or gross negligence in the
performance of its duties, or by reason of reckless disregard of its obligations
and duties under the Agreement. The Agreement will continue in effect only if
its continuance is specifically approved at least annually by the Trustees, or
by vote of a majority of the outstanding voting securities of the Trust, and in
either case, by a majority of the Trustees who are not parties to the Agreement
or interested persons of any such party. The Agreement terminates automatically
if it is assigned. It may be terminated without penalty by vote of a majority of
the out standing voting securities, or by either party, on not less than 60 days
written notice. The Agreement further provides that the Adviser may render
services to others.
32
<PAGE> 33
The Adviser, Nationwide Advisory Services, Inc. ("NAS"), manages the Funds
(except the Small Company Fund and the Income Fund) pursuant to an Investment
Advisory Agreement (the "Agreement") dated as of November 1, 1997. Prior to
November 1, 1997, the Adviser received a fee computed and paid monthly at the
annual rate equal to .5% of the average daily net assets of each Fund of the
Trust (except for the Small Company and Income Funds).
The following are the advisory fees (except for Small Company and Income
Fund), expressed as an annual percentage of average daily net assets:
<TABLE>
<CAPTION>
Fund Advisory Fees
---- -------------
<S> <C>
Total Return Fund and 0.60% on assets up to $1 billion
Capital Appreciation Fund 0.575% on assets of $1 billion and more but
less than $2 billion
0.55% on assets of $2 billion and more but less
than $5 billion
0.50% for assets of $5 billion and more
Government Bond Fund 0.50% on assets up to $1 billion
0.475% on assets of $1 billion and more but less
than $2 billion
0.45% on assets of $2 billion and more but less
than $5 billion
0.40% for assets of $5 billion and more
Money Market Fund 0.40% on assets up to $1 billion
0.38% on assets of $1 billion and more but less
than $2 billion
0.36% on assets of $2 billion and more but less
than $5 billion
0.34% for assets of $5 billion and more
</TABLE>
For the years ended December 31, 1997, 1996, and 1995, the Adviser
received fees in the following amounts: Total Return Fund $7,903,818,
$4,851,676, and $3,406,571, respectively; Government Bond Fund $2,231,930,
$2,225,962, and $2,088,523, respectively; Money Market Fund $4,969,345,
$4,518,925, and $3,574,486, respectively; and Capital Appreciation Fund
$1,759,412, $684,932, and $326,158,
respectively.
Effective November 1, 1997, NAS also provides fund accounting and
administrative services to the Trust (except Small Company and Income Fund)
pursuant to a separate Fund Administration Agreement dated November 1, 1997. For
these services, NAS receives a fee, calculated daily and paid monthly at an
annual rate of 0.05% for each Fund's average net assets on the first $1 billion
of assets and 0.04% on the assets of $1 billion and more. During the year ended
December 31, 1997, NAS received administration fees in the following amounts:
Total Return Fund $135,272, Capital Appreciation Fund $37,284, Government Bond
Fund $39,441 and Money Market Fund $89,708.
Advisory Services for the Small Company Fund
The Adviser oversees the management of the Small Company Fund pursuant to
an Investment Advisory Agreement dated October 20, 1995. Subject to the
supervision and direction of the Trustees, the Adviser determines the allocation
of assets among the Subadvisers and evaluates and monitors the
33
<PAGE> 34
performance of the Subadvisers. The Adviser is also authorized to select and
place portfolio investments on behalf of the Fund; however, the Adviser
generally intends to limit its direct portfolio management to the investment of
a portion of the Fund's assets in cash or money market instruments. The Adviser
has responsibility for communicating performance expectations and evaluations to
the Subadvisers and ultimately recommending to the Trust's Board of Trustees
whether a Subadviser's contract should be renewed, modified or terminated;
however, the Adviser does not expect to recommend frequent changes of
subadvisers. The Adviser will regularly provide written reports to the Board of
Trustees regarding the results of its evaluation and monitoring functions. The
Advisory Agreement of the Small Company Fund contains termination and
indemnification provisions similar to those in the Agreement as described above.
The Fund pays to the Adviser a fee at the annual rate of 1.00% of the
Fund's average daily net assets. The Adviser has voluntarily agreed to waive all
or part of its fees in order to limit the Fund's total operating expenses to not
more than 1.25% of the Fund's average daily net assets on an annual basis. These
fee waivers are voluntary and may be terminated at any time. During the year
ended December 31, 1997, December 31, 1996 and the period from October 23, 1995
(date of commencement of operations) through December 31, 1995, the Adviser
received advisory fees in the amount of $2,520,540, $851,352, and $11,003,
respectively, and waived fees and reimbursed expenses in the amount of $0, $0,
and $10,495, respectively.
The Subadvisers - Pursuant to Subadvisory Agreements between each of the
Subadvisers and the Adviser, each of which are dated October 20, 1995, the
Subadvisers each manage a portion of the Fund's assets in accordance with the
Fund's investment objective and policies. With regard to the portion of the
Fund's assets allocated to it, each Subadviser shall make investment decisions
for the Fund and in connection with such decisions place purchase and sell
orders for the securities in the Fund. For the investment management services
they provide to the Fund, each Subadviser, or PIML and VEAC together, receives a
fee from the Adviser at the annual rate of .60% of the average daily net assets
of the portion of the Fund managed by that Subadviser or group of Subadvisers.
During the year ended December 31, 1997, December 31, 1996 and the period
from October 23 (date of commencement of operations) through December 31, 1995,
the Adviser paid $1,402,367, $483,572 and $11,394 in fees to the Subadvisers.
Each of the Subadvisory Agreements specifically provides that the
Subadviser, including its directors, officers, partners and employees, shall not
be liable for any error of judgment, or mistake of law, or for any loss arising
out of any investment, or for any act or omission in the execution and
management of the Small Company Fund, except for willful misfeasance, bad faith,
or gross negligence in the performance of its duties, or by reason of reckless
disregard of its obligations and duties under such Agreement. Each Subadvisory
Agreement will continue in effect for an initial period of two years and
thereafter shall continue automatically for successive annual periods provided
such continuance is specifically approved at least annually by the Trustees, or
by vote of a majority of the outstanding voting securities of the Fund, and in
either case, by a majority of the Trustees who are not parties to the Agreement
or interested persons of any such party. Each Subadvisory Agreement terminates
automatically if it is assigned. It may also be terminated without penalty by
vote of a majority of the out standing voting securities, or by either party, on
not more than 60 days nor less than 30 days written notice.
Below is a brief description of each of the Subadvisers.
The Dreyfus Corporation. Dreyfus, located at 200 Park Avenue, New York,
New York 10166, was formed in 1947 and serves as one of the Small Company Fund's
Subadvisers. Dreyfus is a wholly-owned subsidiary of Mellon Bank, N.A., which is
a wholly-owned subsidiary of Mellon Bank
34
<PAGE> 35
Corporation ("Mellon"). As of March 31, 1998, Dreyfus managed or administered
approximately $100 billion in assets for approximately 1.7 million investor
accounts nationwide.
Mellon is a publicly owned multibank holding company incorporated under
Pennsylvania law in 1971 and registered under the Federal Bank Holding Company
Act of 1956, as amended. Mellon provides a comprehensive range of financial
products and services in domestic and selected international markets. Mellon is
among the twenty-five largest bank holding companies in the United States based
on total assets. Mellon's principal wholly-owned subsidiaries are Mellon Bank,
N.A., Mellon Bank (DE) National Association, Mellon Bank (MD), The Boston
Company, Inc. AFCO Credit Corporation and a number of companies known as Mellon
Financial Services Corporations. Through its subsidiaries, including Dreyfus,
Mellon managed approximately $305 billion in assets as of December 31, 1997,
including approximately $104 billion in mutual fund assets. As of December 31,
1997, various subsidiaries of Mellon provided non-investment services, such as
custodial or administration services, for approximately $1.5 billion in assets
including approximately $60 billion in mutual fund assets.
Neuberger & Berman L.L.C. Neuberger & Berman, also serves as a sub-adviser
to the Fund. Neuberger & Berman and its predecessor firms have specialized in
the management of no-load mutual funds since 1950. Neuberger & Berman and its
affiliates manage securities accounts that had approximately $52 billion of
assets as of December 31, 1997. Neuberger & Berman is a member firm of the NYSE
and other principal exchanges and acts as the Fund's principal broker in the
purchase and sale of their securities for that portion of the Fund's portfolio
managed by Neuberger & Berman.
Strong Capital Management, Inc. Strong, which also serves as one of the
Subadvisers for the Fund, began conducting business in 1974. Since then, its
principal business has been providing continuous investment supervision for
individuals and institutional accounts, such as pension funds and profit-sharing
plans. Strong also acts as investment advisor for each of the mutual funds
within the Strong Family of Funds. As of February 28, 1998, Strong had over $29
billion under management. Strong's principal mailing address is P.O. Box 2936,
Milwaukee, Wisconsin 53201. Mr. Richard S. Strong is the controlling shareholder
of Strong.
Lazard Asset Management. Effective October 1, 1998, Lazard will begin
serving as one of the Subadvisers to the Fund, replacing PIML and VEAC. Lazard,
a New York-based division of Lazard Freres & Co. LLC ("Lazard Freres"), a
New York limited liability company, manages over $67 billion in investments for
corporations, endowments, public and private pension plans and wealthy
individuals and is recognized as one of the premier global investment advisory
firms. Lazard Freres, one of the world's first global investment banks, has
advised sophisticated investors for more than 150 years. Lazard Freres has
offices in New York, San Francisco, and Washington DC and affiliates in London,
Paris, Tokyo, Sydney, Frankfurt and Cairo that extend its research worldwide.
Lazard Freres address is 30 Rockefeller Center, New York, New York 10112.
Warburg, Pincus Asset Management, Inc. The Fund also employs Warburg as a
Subadviser to the Fund. Warburg is a professional investment counselling firm
which provides investment services to
35
<PAGE> 36
investment companies, employee benefit plans, endowment funds, foundations and
other institutions and individuals. As of March 31, 1998, Warburg managed
approximately $22 billion in assets including approximately $10.9 billion of
investment company assets. Incorporated in 1970, Warburg is a wholly owned
subsidiary of Warburg, Pincus Counsellors G.P. (Warburg G.P."), a New York
general partnership which itself is controlled by Warburg, Pincus & Co. ("W P &
Co."), also a New York general partnership. Lionel I. Pincus, the managing
partner of W P & Co., may be deemed to control, both W P & Co. and Warburg.
Warburg G.P. has no business other than being a holding company of Warburg and
its subsidiaries. Warburg's address is 466 Lexington Avenue, New York, New York
10017-3147.
Advisory Services for the Income Fund
The Adviser oversees the management of the Income Fund pursuant to an
Investment Advisory Agreement. Subject to the supervision and direction of the
Trustees, the Adviser will determine the allocation of assets among the
Subadvisers and evaluate and monitor the performance of Subadvisers. The Adviser
also is authorized to select and place portfolio investments on behalf of the
Fund; however, the Adviser currently does not intend to do so. The Adviser is
responsible for communicating performance expectations and evaluations to the
Subadvisers and ultimately recommending to the Trust's Board of Trustees whether
a Subadviser's contract should be renewed, modified or terminated; however, the
Adviser does not expect to recommend frequent changes of subadvisers. The
Adviser will regularly provide written reports to the Board of Trustees
regarding the results of its evaluation and monitoring functions. The Advisory
Agreement of the Income Fund contains termination and indemnification provisions
similar to those in the Agreement as described above for the Small Company Fund.
The Fund pays to the Adviser a fee at the annual rate of 0.45% of the
Fund's average daily net assets. The Adviser has voluntarily agreed to waive all
or part of its fees in order to limit the Fund's total operating expenses to not
more than 0.75% of the Fund's average daily net assets on an annual basis. These
fee waivers are voluntary and may be terminated at any time. The Fund commenced
operations on January 20, 1998.
The Subadvisers - Pursuant to Subadvisory Agreements between each of the
Subadvisers and the Adviser, the Subadvisers each manage a portion of the Fund's
assets in accordance with the Fund's investment objective and policies. With
regard to the portion of the Fund's assets allocated to it, each Subadviser
makes investment decisions for the Fund and in connection with such decisions
place purchase and sell orders for the securities in the Fund. For the
investment management services they provide to the Fund, each Subadviser
receives an annual fee from the Adviser based on the average daily net assets of
the portion of the Fund managed by that Subadviser as specified below:
<TABLE>
<CAPTION>
Subadvisory Fees Average Daily Net Assets
---------------- ------------------------
<S> <C>
0.25% on the first $100 million
0.15% on assets in excess of $100
million
</TABLE>
The fees for each of the Subadvisers are subject to the following annual
minimum fees: $15,000 for NCM Capital and $25,000 for Smith Graham.
Below is a brief description of each of the Subadvisers.
36
<PAGE> 37
NCM Capital Management Group, Inc. NCM Capital was founded in 1986 and serves as
one of the Fund's Subadvisers. As of December 31, 1997, NCM Capital had
approximately $4.2 billion in assets under management.
NCM Capital's Chairman of the Board, President and Chief Executive Officer is
Maceo K. Sloan. Other directors are Justin F. Beckett, Executive Vice President;
Peter J. Anderson, Chairman and Chief Investment Officer of American Express
Asset Management Group, Inc.; and Morris Goodwin, Jr., Vice President, Corporate
Treasurer, American Express Financial Advisers Inc.
NCM Capital is a wholly-owned subsidiary of Sloan Financial Group, Inc. Both NCM
Capital and Sloan Financial Group, Inc. are located at 103 West Main Street, 4th
Floor, Durham, North Carolina 27701. Sloan Financial Group, Inc. is a
corporation of which Maceo K. Sloan, CFA, Chairman, President and Chief
Executive Officer of NCM Capital, owns 43%; Justin F. Beckett, Executive Vice
President and director of NCM Capital, owns 17%; and IDS Financial Services
Inc., a wholly-owned subsidiary of American Express Company owns 40% as of
December 31, 1997.
Smith Graham & Co. Asset Managers, L.P. Smith Graham also serves as a
sub-adviser to the Fund. Its corporate offices are located at 6900 Texas
Commerce Tower, 600 Travis Street, Houston, Texas 77002-3007. Smith Graham
serves as an investment adviser to a variety of corporate, foundation, public,
Taft Hartley and mutual fund clients. The firm provides global and international
money management through its affiliate Smith Graham Robeco Global Advisers. As
of December 31, 1997, Smith Graham managed approximately $2 billion of assets.
Smith Graham is 60% owned by its Managing General Partner, Smith Graham & Co.,
Inc., while 40% of the firm is owned by the Dutch based Robeco Group. Smith
Graham & Co., Inc. is wholly owned by Gerald B. Smith, Ladell Graham and Jamie
G. House.
Each of the Subadvisory Agreements specifically provides that the
Subadviser, including its directors, officers, partners and employees, shall not
be liable for any error of judgment, or mistake of law or for any loss arising
out of any investment, or for any act or omission in the execution and
management of the Income Fund, except for willful misfeasance, bad faith, or
gross negligence in the performance of its duties, or by reason of reckless
disregard of its obligations and duties under such Agreement. Each Subadvisory
Agreement will continue in effect for an initial period of two years and
thereafter shall continue automatically for successive annual periods provided
such continuance is specifically approved at least annually by the Trustees, or
by vote of a majority of the outstanding voting securities of the Fund, and in
either case, by a majority of the Trustees who are not parties to the Agreement
or interested persons of any such party. Each Subadvisory Agreement terminates
automatically if it is assigned. It may also be terminated without penalty by
vote of a majority of the outstanding voting securities, or by either party, on
60 days written notice.
Other Services Provided By The Adviser for the Income Fund
Under the terms of an Administrative Services Agreement, the Adviser
provides various administrative and accounting services, including daily
valuation of the Income Fund's shares, preparation of financial statements,
taxes, and regulatory reports. For these services the Fund pays to the Adviser a
fee at the annual rate of 0.07% of the Fund's average net assets up to $250
million in assets, 0.05% on the next $750 million and 0.04% on assets of $1
billion and more.
Custodian
37
<PAGE> 38
The Fifth Third Bank, 38 Fountain Square Plaza, Cincinnati, OH 45263, is
the Custodian for the Funds and makes all receipts and disbursements under a
Custodian Agreement. The Custodian performs no managerial or policymaking
functions for the Fund.
Transfer Agent and Dividend Disbursing Agent
Nationwide Investors Services, Inc. (NIS) is the Transfer Agent and
Dividend Disbursing Agent for the Funds. NIS is a wholly-owned subsidiary of
Nationwide Advisory Services, Inc. NISI receives a fee, calculated daily and
paid monthly at a rate of 0.01% of average daily net assets of each Fund.
Management believes the charges for the services performed are comparable to
fees charged by other companies performing similar services.
Brokerage Allocations
In General. During the fiscal years ended December 31, 1997, 1996, and
1995,, the Total Return Fund, paid brokerage commissions of $924,959, $519,949,
and $377,463, respectively, and the Capital Appreciation Fund paid brokerage
commissions of $327,691, $196,526, and $36,471, all to firms rendering
statistical services. The Money Market Fund and Government Bond Fund paid no
brokerage commissions during the periods covered by the financial statements.
The Adviser (or a Subadviser) is responsible for decisions to buy and sell
securities and other investments for the Funds, the selection of brokers and
dealers to effect the transactions and the negotiation of brokerage commissions,
if any. In transactions on stock and commodity exchanges in the United States,
these commissions are negotiated, whereas on foreign stock and commodity
exchanges these commissions are generally fixed and are generally higher than
brokerage commissions in the United States. In the case of securities traded on
the OTC markets, there is generally no commission, but the price includes a
spread between the dealer's purchase and sale price which makes up the dealer's
profit. In underwritten offerings, the price includes a disclosed, fixed
commission or discount. Most short term obligations are normally traded on a
"principal" rather than agency basis. This may be done through a dealer (e.g.
securities firm or bank) who buys or sells for its own account rather than as an
agent for another client, or directly with the issuer. A dealer's profit, if
any, is the difference, or spread, between the dealer's purchase and sale price
for the obligation.
The primary consideration in portfolio security transactions is "best
execution," i.e., execution at the most favorable prices and in the most
effective manner possible. The Adviser or Subadvisers always attempts to achieve
best execution, and it has complete freedom as to the markets in and the
broker-dealers through which it seeks this result. Subject to the requirement of
seeking best execution, securities may be bought from or sold to broker-dealers
who have furnished statistical, research, and other information or services to
the Adviser or a Subadviser. In placing orders with such broker-dealers, the
Adviser will, where possible, take into account the comparative usefulness of
such information. Such information is useful to the Adviser or a Subadviser even
though its dollar value may be indeterminable, and its receipt or availability
generally does not reduce the Adviser's or a Subadviser's normal research
activities or expenses.
Trust portfolio transactions may be effected with broker-dealers who have
assisted investors in the purchase of Policies. However, neither such assistance
nor sale of other investment company shares is a qualifying or disqualifying
factor in a broker-dealer's selection, nor is the selection of any broker-dealer
based on the volume of shares sold.
There may be occasions when portfolio transactions for the Trust are
executed as part of concurrent authorizations to purchase or sell the same
security for trusts or other accounts served by affiliated companies of the
Adviser or a Subadviser. Although such concurrent authorizations potentially
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could be either advantageous or disadvantageous to the Trust, they are effected
only when the Adviser or a Subadviser believes that to do so is in the interest
of the Trust. When such concurrent authorizations occur, the executions will be
allocated in an equitable manner.
The Trustees periodically review the Adviser's and each Subadviser's
performance of its responsibilities in connection with the placement of
portfolio transactions on behalf of the Fund and review the commissions paid by
the Fund over representative periods of time to determine if they are reasonable
in relation to the benefits to the Fund.
Special Brokerage Allocation Considerations Relating to the Small Company
Fund and the Income Fund. In purchasing and selling investments for these Funds,
it is the policy of each of the Subadvisers to obtain best execution at the most
favorable prices through responsible broker-dealers. In selecting
broker-dealers, each Subadviser will consider various relevant factors,
including, but not limited to, the size and type of the transaction; the nature
and character of the markets for the security or asset to be purchased or sold;
the execution efficiency, settlement capability, and financial condition of the
broker-dealer's firm; the broker-dealer's execution services, rendered on a
continuing basis; and the reasonableness of any commissions. During the year
ended December 31, 1997, December 31, 1996 and the period ended December 31,
1995, the Small Company Fund paid brokerage commissions of $887,672, $ 424,176
and $27,100, respectively.
Each Subadviser may cause the Small Company or the Income Fund to pay a
broker-dealer who furnishes brokerage and/or research services a commission that
is in excess of the commission another broker-dealer would have received for
executing the transaction if it is determined that such commission is reasonable
in relation to the value of the brokerage and/or research services as defined in
Section 28(e) of the Securities Exchange Act of 1934 which have been provided.
Such research services may include, among other things, analyses and reports
concerning issuers, industries, securities, economic factors and trends, and
portfolio strategy. Any such research and other information provided by brokers
to a Subadviser is considered to be in addition to and not in lieu of services
required to be performed by the Subadviser under its subadvisory agreement with
the Adviser. The fees to each of the Subadvisers pursuant to its subadvisory
agreement with the Adviser is not reduced by reason of its receiving any
brokerage and research services. The research services provided by
broker-dealers can be useful to a Subadviser in serving its other clients or
clients of the Subadviser's affiliates. Subject to the policy of the Subadvisers
to obtain best execution at the most favorable prices through responsible
broker-dealers, a Subadviser also may consider the broker-dealer's sale of
shares of any fund for which the Subadviser serves as investment adviser,
sub-adviser or administrator.
Considerations Relating to the Small Company Fund. Neuberger & Berman will act
as the principal broker in the purchase and sale of portfolio securities for the
portion of the Fund advised by Neuberger & Berman and in connection with the
writing of covered call options on their securities. Transactions in portfolio
securities for which Neuberger & Berman serves as broker will be affected in
accordance with Rule 17e-1 under the 1940 Act.
The Fund will continue to use Neuberger & Berman as its principal broker
for the portion of the Fund advised by Neuberger & Berman where, in the judgment
of Neuberger & Berman, the firm is able to obtain a price and execution at least
as favorable as that provided by other qualified brokers. To the Fund's
knowledge, however, no affiliate of Neuberger & Berman receives give-ups or
reciprocal business in connection with their securities transactions.
Under the 1940 Act, commissions paid by the Fund to Neuberger & Berman in
connection with a purchase or sale of securities offered on a securities
exchange may not exceed the usual and customary broker's commission.
Accordingly, it is the Fund's policy that the commissions to be paid to
Neuberger & Berman must, in its judgment, be (1) at least as favorable as those
that would be charged by other
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brokers having comparable execution capability and (2) at least as favorable as
commissions contemporaneously charged by Neuberger & Berman on comparable
transactions for its most favored unaffiliated customers, except for accounts
for which Neuberger & Berman acts as a clearing broker for another brokerage
firm and customers of Neuberger & Berman considered by a majority of the
independent trustees not to be comparable to the Fund. The Fund does not deem it
practicable and in its best interests to solicit competitive bids for
commissions on each transaction. However, consideration regularly is given to
information concerning the prevailing level of commissions charged on comparable
transactions by other brokers during comparable periods of time. The 1940 Act
generally prohibits Neuberger & Berman from acting as principal in the purchase
or sale of securities for the Fund's account, unless an appropriate exemption is
available.
During the year ended December 31, 1997, December 31, 1996 and the period
ended December 31, 1995, the Small Company Fund paid brokerage commissions to
Neuberger & Berman in the amount of $35,069, $24,069 and $4,434, respectively,
representing 4.0%, 5.7% and 16.4%, respectively, of the total commissions paid
by the Fund. The aggregate dollar amount of transactions involving the payment
of commissions to Neuberger & Berman represented 6.1%, 5.5% and 20.2%,
respectively, of total transactions on which commissions were paid by the Fund
during the periods ended December 31, 1997, 1996 and 1995.
Purchases, Redemptions And Pricing Of Shares
An insurance company purchases shares of the Funds at their net asset
value using purchase payments received on Contracts issued by Accounts. These
Accounts are funded by shares of the Trust. For certain of the Funds, shares may
also be sold to affiliated Fund of Funds.
All investments in the Trust are credited to the shareholder's account in
the form of full and fractional shares of the designated Fund (rounded to the
nearest 1/1000 of a share). The Trust does not issue share certificates.
The net asset value per share of the Funds is determined once daily, as of
the close of the New York Stock Exchange (currently 4 P.M. eastern time) on each
business day the New York Stock Exchange is open and on such days as the Board
determines and on any other day during which there is a sufficient degree of
trading in each Fund's portfolio securities that the net asset value of the Fund
is materially affected by changes in the value of portfolio securities. The
Trust will not compute net asset value for the Funds on customary national
business holidays, including the following: Christmas, New Year's Day, Martin
Luther King, Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence
Day, Labor Day and Thanksgiving Day. The net asset value per share is calculated
by adding the value of all securities and other assets of a Fund, deducting its
liabilities, and dividing by the number of shares outstanding.
The offering price for orders placed before the close of the New York
Stock Exchange, on each business day the Exchange is open for trading, will be
based upon calculation of the net asset value at the close of the Exchange. For
orders placed after the close of the Exchange, or on a day on which the Exchange
is not open for trading, the offering price is based upon net asset value at the
close of the Exchange on the next day thereafter on which the Exchange is open
for trading. The net asset value of a share of each Fund on which offering and
redemption prices are based is the net asset value of that Fund, divided by the
number of shares outstanding, the result being adjusted to the nearer cent. The
net asset value of each Fund is determined by subtracting the liabilities of the
Fund from the value of its assets (chiefly composed of investment securities).
Securities of the Funds listed on national exchanges are valued at the last
quoted sales price on the principal exchange, or if there is no sale on that
day, the securities are valued at the prior day's closing price as provided by
an independent pricing organization. Securities traded in the over-the-counter
market are valued at the quoted sales price or if there is no sale
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that day, the last quoted bid price as provided by an independent pricing
organization. Securities and other assets, for which such market prices are
unavailable, or for which an independent pricing organization does not provide a
value or provides a value that does not represent fair market value in the
judgement of the Adviser, are valued at fair value as determined by the
Trustees. For the Money Market Fund, all securities are valued at amortized
cost, which approximates market value, in accordance with Rule 2a-7 of the 1940
Act.
The net income of the Money Market Fund is determined once daily, as of
the close of the New York Stock Exchange (currently 4:00 P.M., New York time) on
each business day on which such Exchange is open. All the net income of the
Fund, so determined, is declared in shares as a dividend to shareholders of
record at the time of such determination. (Shares purchased become entitled to
dividends declared as of the first day following the date of investment.)
Dividends are distributed in the form of additional shares of the Fund on the
last business day of each month at the rate of one share (and fraction thereof)
of the Fund for each one dollar (and fraction thereof) of dividend income.
For this purpose, the net income of the Money Market Fund (from the time
of the immediately preceding determination thereof) shall consist of: (a) all
interest income accrued on the portfolio assets of the Fund, (b) less all actual
and accrued expenses and (c) plus or minus net realized gains and losses on the
assets of the Fund determined in accordance with generally accepted accounting
principles. Interest income shall include discount earned (including both
original issue and market discount) on discount paper accrued ratably to the
date of maturity. Securities are valued at market or amortized cost which
approximates market, which the Trustees have determined in good faith
constitutes fair value for the purposes of complying with the Investment Company
Act of 1940.
Because the net income of the Money Market Fund is declared as a dividend
each time the net income is determined, the net asset value per share (i.e., the
value of the net assets of the Fund divided by the number of shares outstanding)
remains at one dollar per share immediately after each such determination and
dividend declaration. Any increase in the value of a shareholder's investment in
the Fund, representing the reinvestment of dividend income, is reflected by an
increase in the number of shares of the Fund in its account.
Pursuant to its objective of maintaining a fixed one dollar share price,
the Fund will not purchase securities with a remaining maturity of more than 397
days and will maintain a dollar weighted average portfolio maturity of 90 days
or less.
The Accounts redeem shares to make benefit or surrender payments under the
terms of its Contracts. Redemptions are processed on any day on which the Trust
is open for business and are effected at net asset value next determined after
the redemption order, in proper form, is received by the Trust's transfer agent,
NIS.
The Trust may suspend the right of redemption for such periods as are
permitted under the 1940 Act and under the following unusual circumstances: (a)
when the New York Stock Exchange is closed (other than weekends and holidays) or
trading is restricted; (b) when an emergency exists, making disposal of
portfolio securities or the valuation of net assets not reasonably practicable;
or (c) during any period when the SEC has by order permitted a suspension of
redemption for the protection of shareholders.
Additional Information
Description of Shares - The Declaration of Trust permits the Trustees to
issue an unlimited number of full and fractional shares of beneficial interest
of each Fund and to divide or combine such shares into a greater or lesser
number of shares without thereby exchanging the proportionate beneficial
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interests in the Trust. Each share of a Fund represents an equal proportionate
interest in that Fund with each other share. The Trust reserves the right to
create and issue a number of series of shares and currently has authorized 15
separate funds. Shares of each series would participate equally in the earnings,
dividends, and assets of that fund. Upon liquidation of a Fund, shareholders are
entitled to share pro rata in the election of Trustees. Upon liquidation of a
Fund, shareholders are entitled to share pro rata in the net assets of such Fund
available for distribution to shareholders.
Voting Rights - Shareholders are entitled to one vote for each share held.
Shareholders may vote in the election of Trustees and on other matters submitted
to meetings of shareholders. Generally, amendment may be made to the Declaration
of Trust without the affirmative vote of a majority of the outstanding shares of
the Trust. The Trustees may, however, amend the Declaration of Trust without the
vote or consent of shareholders to:
o designate series of the Trust; or
o change the name of the Trust; or
o supply any omission, cure, correct, or supplement any
ambiguous, defective, or inconsistent provision to conform the
Declaration of Trust to the requirements of applicable federal
laws or regulations if they deem it necessary.
Shares have no pre-emptive or conversion rights. Shares, when issued, are
fully paid and nonassessable, except as set forth below. In regard to
termination, sale of assets, or change of fundamental investment restrictions,
the right to vote is limited to the holders of shares of the particular Fund
affected by the proposal. However, shares of all funds would vote together, and
not by fund, in the election of Trustees. If an issue must be approved by a
majority as defined by the 1940 Act, a "majority of the outstanding voting
securities" means the lesser of (i) 67% or more of the shares present at a
meeting when the holders of more than 50% of the outstanding shares are present
or represented by proxy, or (ii) more than 50% of the outstanding shares. For
the election of Trustees only a plurality is required.
Shareholder Inquiries - All inquiries regarding the Trust should be
directed to the Trust at the telephone number or address shown on the cover page
of this Prospectus.
Tax Status
Each Fund of the Trust is treated as a separate entity for purpose of the
regulated investment company provisions of the Internal Revenue Code, and,
therefore, the assets, income, and distributions of each Fund are considered
separately for purposes of determining whether or not the Fund qualifies as a
regulated investment company.
Each Fund of the Trust intends to qualify as a "regulated investment
company" under Subchapter M of the Code. If it qualifies as a regulated
investment company, a Fund will pay no federal income taxes on its taxable net
investment income (that is, taxable income other than net realized capital
gains) and its net realized capital gains that are distributed to shareholders.
To qualify under Subchapter M, a Fund must, among other things: (i) distribute
to its shareholders at least 90% of its taxable net investment income (for this
purpose consisting of taxable net investment income and net realized short-term
capital gains); (ii) derive at least 90% of its gross income from dividends,
interest, payments with respect to loans of securities, gains from the sale or
other disposition of securities, or other income (including, but not limited to,
gains from options, futures, and forward contracts) derived with respect to its
business of investing in securities; (iii) diversify its holdings so that, at
the end of each fiscal quarter of the Fund (a) at least 50% of the market value
of the Fund assets is represented by cash, U.S. government securities and other
securities, with those other securities limited, with respect to any one issuer,
to an amount no greater in value than 5%
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of the Fund's total assets and to not more than 10% of the outstanding voting
securities of the issuer, and (b) not more than 25% of the market value of the
Fund's assets is invested in the securities of any one issuer (other than U.S.
government securities or securities of other regulated investment companies) or
of two or more issuers that the Fund controls and that are determined to be in
the same or similar trades or businesses or related trades or businesses. In
meeting these requirements, a Fund may be restricted in the selling of
securities held by the Fund for less than three months and in the utilization of
certain of the investment techniques described above and in the respective
Fund's Prospectus. As a regulated investment company, a Fund will be subject to
a 4% non-deductible excise tax measured with respect to certain undistributed
amounts of ordinary income and capital gain required to be but not distributed
under a prescribed formula. The formula requires payment to shareholders during
a calendar year of distributions representing at least 98% of the Fund's taxable
ordinary income for the calendar year and at least 98% of the excess of its
capital gains over capital losses realized during the one-year period ending
October 31 during such year, together with any undistributed, untaxed amounts of
ordinary income and capital gains from the previous calendar year. The Funds
expect to pay the dividends and make the distributions necessary to avoid the
application of this excise tax.
In addition, each Fund intends to comply with the diversification
requirements of Section 817(h) of the Code related to the tax-deferred status of
insurance company separate accounts. To comply with regulations under Section
817(h) of the code, each Fund will be required to diversify its investments so
that on the last day of each calendar quarter no more than 55% of the value of
its assets is represented by any one investment, no more than 70% is represented
by any two investments, no more than 80% is represented by any three investments
and no more than 90% is represented by any four investments. Generally, all
securities of the same issuer are treated as a single investment. For the
purposes of Section 817(h), obligations of the United States Treasury and each
U.S. government instrumentality are treated as securities of separate issuers.
The Treasury Department has indicated that it may issue future pronouncements
addressing the circumstances in which a Policy owner's control of the
investments of a separate account may cause the Policy owner, rather than the
participating insurance company, to be treated as the owner of the assets held
by the separate account. If the Policy owner is considered the owner of the
securities underlying the separate account, income and gains produced by those
securities would be included currently in the Policy owner's gross income. It is
not known what standards will be set forth in such pronouncements or when, if at
all, these pronouncements may be issued. In the event that rules or regulations
are adopted, there can be no assurance that the Funds will be able to operate as
currently described, or that the Trust will not have to change the investment
goal or investment policies of a Fund. The board reserves the right to modify
the investment policies of a Fund as necessary to prevent any such prospective
rules and regulations from causing a Policy owner to be considered the owner of
the shares of the Fund underlying the separate account.
Tax Consequences for the Small Company Fund
Foreign Transactions. Dividends and interest received by the Small Company
Fund may be subject to income, withholding, or other taxes imposed by foreign
countries and U.S. possessions that would reduce the yield on its securities.
Tax conventions between certain countries and the United States may reduce or
eliminate these foreign taxes, however, and many foreign countries do not impose
taxes on capital gains in respect of investments by foreign investors. Policy
holders will bear the cost of foreign tax withholding in the form of increased
expenses to the Fund but generally will not be able to claim a foreign tax
credit or deduction for foreign taxes paid by the Fund by reason of the
tax-deferred status of the policies.
The Fund's transactions, if any, in foreign currencies, forward contracts,
options and futures contracts (including options and forward contracts on
foreign currencies) will be subject to special provisions of the Code that,
among other things, may affect the character of gains and losses recognized by
the Fund (i.e., may affect whether gains or losses are ordinary or capital),
accelerate recognition of income
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to the Fund, defer Fund losses and cause the fund to be subject to
hyperinflationary currency rules. These rules could therefore affect the
character, amount and timing of distributions to shareholders. These provisions
also (a) will require the Fund to mark-to-market certain types of its positions
(i.e., treat them as if they were closed out) and (b) may cause the fund to
recognize income without receiving cash with which to pay dividends or make
distributions in amounts necessary to satisfy the distribution requirements for
avoiding income and excise taxes. The Fund will monitor its transactions, will
make the appropriate tax elections and will make the appropriate entries in its
books and records when it acquires any foreign currency, forward contract,
option, futures contract or hedged investment so that (i) neither the Fund nor
its shareholders will be treated as receiving a materially greater amount of
capital gains or distributions than actually realized or received, (ii) the Fund
will be able to use substantially all of its losses for the fiscal years in
which the losses actually occur, and (iii) the Fund will continue to qualify as
a regulated investment company.
As described in the Prospectus, because shares of the Fund may only be
purchased through Policies, it is anticipated that dividends and distributions
will be exempt from current taxation if left to accumulate within the Policies.
Investment in Passive Foreign Investment Companies. If the Fund purchases
shares in certain foreign entities classified under the Code as "passive foreign
investment companies" ("PFICs"), the Fund may be subject to federal income tax
on a portion of an "excess distribution" or gain from the disposition of the
shares, even though the income may have to be distributed by the Fund to its
shareholders, the Policies. In addition, gain on the disposition of shares in a
PFIC generally is treated as ordinary income even though the shares are capital
assets in the hands of the Fund. Certain interest charges may be imposed on the
Fund with respect to any taxes arising from excess distributions or gains on the
disposition of shares in a PFIC.
The Fund may be eligible to elect to include in its gross income its share
of earnings of a PFIC on a current basis. Generally, the election would
eliminate the interest charge and the ordinary income treatment on the
disposition of stock, but such an election may have the effect of accelerating
the recognition of income and gains by the Fund compared to a fund that did not
make the election. In addition, information required to make such an election
may not be available to the Fund.
Regulations of the Internal Revenue Service (the "IRS") provide a
mark-to-market election for shares in certain PFICs held by regulated investment
companies. If the Fund makes the election, it may be able to avoid the interest
charge (but not the ordinary income treatment) on disposition of the PFIC stock
by each year marking-to-market the stock (that is, by treating it as if it were
sold for fair market value on the last day of the year). Such an election could
also result in acceleration of income to the Fund.
Derivative Instruments. The use of derivatives strategies, such as
purchasing and selling (writing) options and futures and entering into forward
currency contracts, involves complex rules that will determine for income tax
purposes the character and timing of recognition of the gains and losses the
Small Company Fund realizes in connection therewith. Gains from the disposition
of foreign currencies (except certain gains therefrom that may be excluded by
future regulations), and income from transactions in options, futures, and
forward currency contracts derived by the Fund with respect to its business of
investing in securities or foreign currencies, will qualify as permissible
income. However, income from the disposition of options and futures (other than
those on foreign currencies) will be subject to a 30% limitation if they are
held for less than three months. Income from the disposition of foreign
currencies, and options, futures, and forward contracts on foreign currencies,
that are not directly related to the Fund's principal business of investing in
securities (or options and futures with respect to securities) also will be
subject to a 30% limitation if they are held for less than three months.
If the Fund satisfies certain requirements, any increase in value of a
position that is part of a "designated hedge" will be offset by any decrease in
value (whether realized or not) for the offsetting
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hedging position during the period of the hedge for purposes of determining
whether the Fund satisfies the 30% limitation on the gross income that can be
derived from the sale or other disposition of securities or derivative
instruments that were held for less than three months. Thus, only the net gain
(if any) from the designated hedge will be included in gross income for purposes
of that limitation. The Fund intends that, when it engages in hedging
strategies, the hedging transactions will qualify for this treatment, but at the
present time it is not clear whether this treatment will be available for all of
the Fund's hedging transactions. To the extent this treatment is not available
or is not elected by the Fund, it may be forced to defer the closing out of
certain options, futures, or forward currency contracts beyond the time when it
otherwise would be advantageous to do so, in order for the Fund to continue to
qualify as a regulated investment company.
Tax Consequences to Shareholders
Since shareholders of the Funds will be the Accounts, no discussion is
included herein as to the Federal income tax consequences at the level of the
holders of the Contracts. For information concerning the Federal income tax
consequences to such holders, see the Prospectuses for such Contracts.
Financial Statements
The Report of Independent Auditors and Financial Statements of the Funds for the
period ended December 31, 1997 are incorporated by reference to the Trust's
Annual Report. Copies of the Annual Report are available without charge upon
request by writing the Trust or calling toll free 1 (800) 848-6331.
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APPENDIX A
BOND RATINGS
STANDARD & POOR'S DEBT RATINGS
A Standard & Poor's corporate or municipal debt rating is a current
assessment of the creditworthiness of an obligor with respect to a specific
obligation. This assessment may take into consideration obligors such as
guarantors, insurers, or lessees.
The debt rating is not a recommendation to purchase, sell, or hold a
security, inasmuch as it does not comment as to market price or suitability for
a particular investor. The ratings are based on current information furnished by
the issuer or obtained by Standard & Poor's from other sources it considers
reliable. Standard & Poor's does not perform an audit in connection with any
rating and may, on occasion, rely on unaudited financial information. The
ratings may be changed, suspended, or withdrawn as a result of changes in, or
unavailability of, such information, or for other circumstances.
The ratings are based, in varying degrees, on the following
considerations:
o 1. Likelihood of default - capacity and willingness of the obligor as to the
timely payment of interest and repayment of principal in accordance with the
terms of the obligation.
o 2. Nature of and provisions of the obligation.
Protection afforded by, and relative position of, the obligation in the
event of bankruptcy, reorganization, or other arrangement under the laws
of bankruptcy and other laws affecting creditors' rights.
Investment Grade
AAA - Debt rated 'AAA' has the highest rating assigned by Standard &
Poor's. Capacity to pay interest and repay principal is extremely strong.
AA - Debt rated 'AA' has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.
A - Debt rated 'A' has a strong capacity to pay interest and repay
principal although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher rated
categories.
BBB - Debt rated 'BBB' is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
Speculative Grade
Debt rated 'BB', 'B', 'CCC', 'CC' and 'C' is regarded as having
predominantly speculative characteristics with respect to capacity to pay
interest and repay principal. 'BB' indicates the least degree of speculation and
'C' the highest. While such debt will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
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BB - Debt rated 'BB' has less near-term vulnerability to default than
other speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions which could lead
to inadequate capacity to meet timely interest and principal payments. The 'BB'
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied 'BBB-' rating.
B - Debt rated 'B' has a greater vulnerability to default but currently
has the capacity to meet interest payments and principal repayments. Adverse
business, financial, or economic conditions will likely impair capacity or
willingness to pay interest and repay principal. The 'B' rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
'BB' or 'BB-' rating.
CCC - Debt rated 'CCC' has a currently identifiable vulnerability to
default, and is dependent upon favorable business, financial, and economic
conditions to meet timely payment of interest and repayment of principal. In the
event of adverse business, financial, or economic conditions, it is not likely
to have the capacity to pay interest and repay principal. The 'CCC' rating
category is also used for debt subordinated to senior debt that is assigned an
actual or implied 'B' or 'B-' rating.
CC - Debt rated 'CC' typically is applied to debt subordinated to senior
debt that is assigned an actual or implied 'CCC' rating.
C - Debt rated 'C' typically is applied to debt subordinated to senior
debt which is assigned an actual or implied 'CCC-' debt rating. The 'C' rating
may be used to cover a situation where a bankruptcy petition has been filed, but
debt service payments are continued.
CI - The rating 'CI' is reserved for income bonds on which no interest is
being paid.
D - Debt rated 'D' is in payment default. The 'D' rating category is used
when interest payments or principal payments are not made on the date due even
if the applicable grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such grade period. The 'D'
rating also will be used upon the filing of a bankruptcy petition if debt
service payments are jeopardized.
MOODY'S LONG-TERM DEBT RATINGS
Aaa - Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
Aa - Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risk appear somewhat larger than 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 some time 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
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present but certain protective elements may be lacking or may be
characteristically unreliable over any great length of time. Such bonds lack
outstanding investment characteristics and in fact have speculative
characteristics as well.
Ba - Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered well-assured. Often the protection of interest
and principal payments may be very moderate, and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B - Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
Caa - Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect to principal
or interest.
Ca - Bonds which are rated Ca represent obligations which are speculative
in a high degree. Such issues are often in default or have other marked
shortcomings.
C - Bonds which are rated C are the lowest rated class of bonds, and
issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
FITCH/IBCA INVESTORS SERVICE, INC. BOND RATINGS
Fitch/IBCA investment grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
represent Fitch's assessment of the issuer's ability to meet the obligations of
a specific debt issue or class of debt in a timely manner.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength and credit quality.
Fitch ratings do not reflect any credit enhancement that may be provided
by insurance policies or financial guaranties unless otherwise indicated.
Bonds that have the same rating are of similar but not necessarily
identical credit quality since the rating categories do not fully reflect small
differences in the degrees of credit risk.
Fitch ratings are not recommendations to buy, sell, or hold any security.
ratings do not comment on the adequacy of market price, the suitability of any
security for a particular investor, or the tax-exempt nature or taxability of
payments made in respect of any security.
Fitch ratings are based on information obtained from issuers, other
obligors, underwriters, their experts, and other sources Fitch believes to be
reliable. Fitch does not audit or verify the truth or accuracy of such
information. Ratings may be changed, suspended, or withdrawn as a result of
changes in, or the unavailability of, information or for other reasons.
AAA Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest
and repay principal, which is unlikely to be affected by reasonably
foreseeable events.
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AA Bonds considered to be investment grade and of very high credit quality.
The obligor's ability to pay interest and repay principal is very strong,
although not quite as strong as bonds rated 'AAA'. Because bonds rated in
the 'AAA' and 'AA' categories are not significantly vulnerable to
foreseeable future developments, short-term debt of the issuers is
generally rated 'F-1+'.
A Bonds considered to be investment grade and of high credit quality. The
obligor's ability to pay interest and repay principal is considered to be
strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
BBB Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have adverse impact on these
bonds, and therefore, impair timely payment. The likelihood that the
ratings of these bonds will fall below investment grade is higher than for
bonds with higher ratings.
Fitch speculative grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
('BB' to 'C') represent Fitch's assessment of the likelihood of timely payment
of principal and interest in accordance with the terms of obligation for bond
issues not in default. For defaulted bonds, the rating ('DDD' to 'D') is an
assessment of the ultimate recovery value through reorganization or liquidation.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength.
Bonds that have the same rating are of similar but not necessarily
identical credit quality since the rating categories cannot fully reflect the
differences in the degrees of credit risk.
BB Bonds are considered speculative. The obligor's ability to pay interest
and repay principal may be affected over time by adverse economic changes.
However, business and financial alternatives can be identified which could
assist the obligor in satisfying its debt service requirements.
B Bonds are considered highly speculative. While bonds in this class are
currently meeting debt service requirements, the capacity for continued
payment is contingent upon a sustained, favorable business and economic
environment.
CCC Bonds have certain identifiable characteristics which, if not remedied,
may lead to default. The ability to meet obligations requires an
advantageous business and economic environment.
CC Bonds are minimally protected. Default in payment of interest and/or
principal seems probable over time.
C Bonds are in imminent default in payment of interest or principal.
DDD, Bonds are in default on interest and/or principal payments. Such bonds are
extremely speculative, and should be valued on the basis of their ultimate
DD recovery value in liquidation or reorganization of the obligor. `DDD'
&D represents the highest potential for recovery of these bonds, and 'D'
represents the lowest potential for recovery.
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DUFF & PHELPS, INC. LONG-TERM DEBT RATINGS
These ratings represent a summary opinion of the issuer's long-term
fundamental quality. Rating determination is based on qualitative and
quantitative factors which may vary according to the basic economic and
financial characteristics of each industry and each issuer. Important
considerations are vulnerability to economic cycles as well as risks related to
such factors as competition, government action, regulation, technological
obsolescence, demand shifts, cost structure, and management depth and expertise.
The projected viability of the obligor at the trough of the cycle is a critical
determination.
Each rating also takes into account the legal form of the security, (e.g.,
first mortgage bonds, subordinated debt, preferred stock, etc.). The extent of
rating dispersion among the various classes of securities is determined by
several factors including relative weightings of the different security classes
in the capital structure, the overall credit strength of the issuer, and the
nature of covenant protection. Review of indenture restrictions is important to
the analysis of a company's operating and financial constraints.
The Credit Rating Committee formally reviews all ratings once per quarter
(more frequently, if necessary). Ratings of 'BBB-' and higher fall within the
definition of investment grade securities, as defined by bank and insurance
supervisory authorities.
Rating
Scale Definition
- ----- ----------
AAA Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
AA+ High credit quality. Protection factors are strong. Risk is modest,
AA but may vary slightly from time to time because of economic
AA- conditions.
A+ Protection factors are average but adequate. However, risk factors
A are more variable and greater in periods of economic stress.
A-
BBB+ Below average protection factors but still considered sufficient for
BBB prudent investment. Considerable variability in risk during economic
BBB- cycles.
BB+ Below investment grade but deemed likely to meet obligations when
BB due. Present or prospective financial protection factors fluctuate
BB- according to industry conditions or company fortunes. Overall
quality may move up or down frequently within this category.
B+ Below investment grade and possessing risk that obligations will not
B be met when due. Financial protection factors will fluctuate widely
B- according to economic cycles, industry conditions and/or company
fortunes. Potential exists for frequent Changes in the rating within
this category or into a higher or lower rating grade.
CCC Well below investment grade securities. Considerable uncertainty
exists as to timely payment of principal, interest or preferred
dividends. Protection factors are narrow and risk can be substantial
with unfavorable economic/industry conditions, and/or with
unfavorable company developments.
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DD Defaulted debt obligations. Issuer failed to meet scheduled
principal and/or interest payments.
DP Preferred stock with dividend arrearages.
SHORT-TERM RATINGS
STANDARD & POOR'S COMMERCIAL PAPER RATINGS
A Standard & Poor's commercial paper rating is a current assessment of the
likelihood of timely payment of debt considered short-term in the relevant
market.
Ratings are graded into several categories, ranging from 'A-1' for the
highest quality obligations to 'D' for the lowest. These categories are as
follows:
A-1 This highest category indicates that the degree of safety regarding timely
payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+) designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated 'A-1'.
A-3 Issues carrying this designation have adequate capacity for timely
payment. They are, however, more vulnerable to the adverse effects of
changes in circumstances than obligations carrying the higher
designations.
B Issues rated 'B' are regarded as having only speculative capacity for
timely payment.
C This rating is assigned to short-term debt obligations with doubtful
capacity for payment.
D Debt rated 'D' is in payment default. the 'D' rating category is used when
interest payments or principal payments are not made on the date due, even
if the applicable grace period has not expired, unless Standard & Poor's
believes that such payments will be made during such grade period.
STANDARD & POOR'S NOTE RATINGS
An S&P note rating reflects the liquidity factors and market-access risks
unique to notes. Notes maturing in three years or less will likely receive a
note rating. Notes maturing beyond three years will most likely receive a
long-term debt rating.
The following criteria will be used in making the assessment:
- Amortization schedule - the larger the final maturity relative to
other maturities, the more likely the issue is to be treated as a
note.
- Source of payment - the more the issue depends on the market for
its refinancing, the more likely it is to be considered a note.
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Note rating symbols and definitions are as follows:
SP-1 Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term of
the notes.
SP-3 Speculative capacity to pay principal and interest.
MOODY'S SHORT-TERM RATINGS
Moody's short-term debt ratings are opinions on the ability of issuers to
repay punctually senior debt obligations. These obligations have an original
maturity not exceeding one year, unless explicitly noted. Moody's employs the
following three designations, all judged to be investment grade, to indicate the
relative repayment capacity of rated issuers:
Issuers rated Prime-1 (or supporting institutions) have a superior
capacity for repayment of senior short-term debt obligations. Prime-1 repayment
capacity will normally be evidenced by the following characteristics: (I)
leading market positions in well established industries, (II) high rates of
return on funds employed, (III) conservative capitalization structures with
moderate reliance on debt and ample asset protection, (IV) broad margins in
earnings coverage of fixed financial charges and high internal cash generation,
and (V) well established access to a range of financial markets and assured
sources of alternative liquidity.
Issuers rated Prime-2 (or supporting institutions) have 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 alternate liquidity is maintained.
Issuers rated Prime-3 (or supporting institutions) have an acceptable
capacity for repayment of short-term promissory obligations. The effect of
industry characteristics and market composition may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt protection measurements and may require relatively high financial leverage.
Adequate alternate liquidity is maintained.
Issuers rated Not Prime do not fall within any of the prime rating
categories.
MOODY'S NOTE RATINGS
MIG 1/VMIG 1 This designation denotes best quality. There is present strong
protection by established cash flows, superior liquidity
support or demonstrated broad based access to the market for
refinancing.
MIG 2/VMIG 2 This designation denotes high quality. Margins of
protection are ample although not so large as in the preceding
group.
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MIG 3/VMIG 3 This designation denotes favorable quality. All security
elements are accounted for but there is lacking the undeniable
strength of the preceding grades. Liquidity and cash flow
protection may be narrow and market access for refinancing is
likely to be less well established.
MIG 4/VMIG 4 This designation denotes adequate quality. Protection commonly
regarded as required of an investment security is present and
although not distinctly or predominantly speculative, there is
specific risk.
SG This designation denotes speculative quality. Debt instruments
in this category lack margins of protection.
FITCH/IBCA SHORT-TERM RATINGS
Fitch/IBCA 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.
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.
B Speculative. 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.
C High default risk. Default is a real possibility, Capacity for meeting
financial commitments is solely reliant upon a sustained, favorable
business and economic environment.
D Default. Issues assigned this rating are in actual or imminent payment
default.
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DUFF & PHELPS SHORT-TERM DEBT RATINGS
Duff & Phelps' short-term ratings are consistent with the rating criteria
utilized by money market participants. The ratings apply to all obligations with
maturities 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, and the capital markets. An important consideration is the
level of an obligor's reliance on short-term funds on an ongoing basis.
Rating Scale Definition
- ------------ ----------
High Grade
D-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 U.S. Treasury short-term obligations.
D-1 Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection
factors. Risk factors are minor.
D-1- High certainty of timely payment. Liquidity factors are strong
and supported by good fundamental protection factors. Risk
factors are very small.
Good Grade
D-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
D-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
D-4 Speculative investment characteristics. Liquidity is not
sufficient to insure against disruption in debt service.
Operating factors and market access may be subject to a high
degree of variation.
Default
D-5 Issuer failed to meet scheduled principal and/or interest
payments.
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THOMSON'S SHORT-TERM RATINGS
The Thomson Short-Term Ratings apply, unless otherwise noted, to specific
debt instruments of the rated entities with a maturity of one year or less.
Thomson short-term ratings are intended to assess the likelihood of an untimely
or incomplete payments of principal or interest.
TBW-1 the highest category, indicates a very high likelihood that
principal and interest will be paid on a timely basis.
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 the
obligation is more susceptible to adverse developments (both internal and
external) than those with higher ratings, the 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.
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