<PAGE> 1
NATIONWIDE SEPARATE ACCOUNT TRUST
NATIONWIDE INCOME FUND
SUPPLEMENT DATED SEPTEMBER 1, 1999
TO
PROSPECTUS DATED MAY 1, 1999 (REVISED JULY 1, 1999)
Effective September 1, 1999, the investment advisory services previously
performed for the Nationwide Income Fund by Nationwide Advisory Services, Inc.
("NAS") were transferred to Villanova Mutual Fund Capital Trust ("VMF"), an
affiliate of NAS and an indirect subsidiary of Nationwide Financial Services,
Inc. VMF assumed all rights and responsibilities performed by NAS including the
supervision and monitoring of the Fund's subadvisers, and the Fund's subadvisers
continue to manage the Fund after the transfer to VMF. After the transfer, there
was no change in the fees charged for investment advisory services.
VMF was organized in 1999, and beginning September 1, 1999, it provides
investment advisory services to both Nationwide Separate Account Trust and
Nationwide Mutual Funds. Its principal offices are located at Three Nationwide
Plaza, Columbus, Ohio 43215.
All references in the Prospectus to Nationwide Advisory Services, Inc. should be
changed to Villanova Mutual Fund Capital Trust.
INVESTORS SHOULD RETAIN THIS SUPPLEMENT WITH THE
PROSPECTUS FOR FUTURE REFERENCE
<PAGE> 2
NATIONWIDE SEPARATE ACCOUNT TRUST
- TOTAL RETURN FUND
- CAPITAL APPRECIATION FUND
- GOVERNMENT BOND FUND
- MONEY MARKET FUND
SUPPLEMENT DATED SEPTEMBER 1, 1999
TO
PROSPECTUS DATED MAY 1, 1999 (REVISED JULY 1, 1999)
Effective September 1, 1999, the investment advisory services previously
performed for each of the Funds listed above by Nationwide Advisory Services,
Inc. ("NAS") were transferred to Villanova Mutual Fund Capital Trust ("VMF"), an
affiliate of NAS and an indirect subsidiary of Nationwide Financial Services,
Inc. The portfolio managers for each of the Funds continue to manage the Funds
after the transfer to VMF. After the transfer, there was no change in the fees
charged to each of the Funds for investment advisory services.
VMF was organized in 1999, and beginning September 1, 1999, it provides
investment advisory services to both Nationwide Separate Account Trust and
Nationwide Mutual Funds. Its principal offices are at Three Nationwide Plaza,
Columbus, Ohio 43215.
All references in the Prospectus to Nationwide Advisory Services, Inc. should be
changed to Villanova Mutual Fund Capital Trust.
INVESTORS SHOULD RETAIN THIS SUPPLEMENT WITH THE
PROSPECTUS FOR FUTURE REFERENCE
<PAGE> 3
NATIONWIDE SEPARATE ACCOUNT TRUST
- NATIONWIDE STRATEGIC GROWTH FUND
- NATIONWIDE STRATEGIC VALUE FUND
- NATIONWIDE SELECT ADVISERS MID CAP FUND
- NATIONWIDE SMALL CAP VALUE FUND
- NATIONWIDE SELECT ADVISERS SMALL CAP GROWTH FUND
- NATIONWIDE GLOBAL EQUITY FUND
- NATIONWIDE EQUITY INCOME FUND
- NATIONWIDE BALANCED FUND
- NATIONWIDE MULTI SECTOR BOND FUND
- NATIONWIDE HIGH INCOME BOND FUND
SUPPLEMENT DATED SEPTEMBER 1, 1999
TO
PROSPECTUS DATED MAY 1, 1999 (REVISED JULY 1, 1999)
Effective September 1, 1999, the investment advisory services previously
performed for the Nationwide Separate Account Trust Funds listed above (except
the Nationwide Select Advisers Mid Cap Fund) by Nationwide Advisory Services,
Inc. ("NAS") were transferred to Villanova Mutual Fund Capital Trust ("VMF"), an
affiliate of NAS and an indirect subsidiary of Nationwide Financial Services,
Inc. The investment advisory services for the Nationwide Select Advisers Mid Cap
Fund will be transferred from NAS to VMF effective on or about September 27,
1999. VMF assumes all rights and responsibilities performed by NAS, including
the supervision and monitoring of each Funds' subadviser(s), and the Fund's
subadviser(s) continue to manage the Fund after the transfer to VMF. After the
transfer, there was no change in the fees charged for investment advisory
services to each of the Funds.
VMF was organized in 1999, and beginning September 1, 1999, it provides
investment advisory services to both Nationwide Separate Account Trust and
Nationwide Mutual Funds. Its principal offices are located at Three Nationwide
Plaza, Columbus, Ohio 43215.
All references in the Prospectus to Nationwide Advisory Services, Inc. should be
changed to Villanova Mutual Fund Capital Trust.
INVESTORS SHOULD RETAIN THIS SUPPLEMENT WITH THE
PROSPECTUS FOR FUTURE REFERENCE
<PAGE> 4
NATIONWIDE SEPARATE ACCOUNT TRUST
NATIONWIDE SMALL COMPANY FUND
SUPPLEMENT DATED SEPTEMBER 1, 1999
TO
PROSPECTUS DATED MAY 1, 1999 (REVISED JULY 1, 1999)
Effective September 1, 1999, the investment advisory services previously
performed for the Nationwide Small Company Fund by Nationwide Advisory Services,
Inc. ("NAS") were transferred to Villanova Mutual Fund Capital Trust ("VMF"), an
affiliate of NAS and an indirect subsidiary of Nationwide Financial Services,
Inc. VMF assumed all rights and responsibilities performed by NAS, including the
supervision and monitoring of the Fund's subadvisers, and the Fund's subadvisers
continue to manage the Fund after the transfer to VMF. At the time of the
transfer, the management fee that the Fund pays was split between investment
advisory and fund administration agreements, and the revised management fee is
0.93%, based on the Fund's average daily net assets.
VMF was organized in 1999, and beginning September 1, 1999, it provides
investment advisory services to both Nationwide Separate Account Trust and
Nationwide Mutual Funds. Its principal offices are located at Three Nationwide
Plaza, Columbus, Ohio 43215.
On page 4 of the Prospectus under the caption "Fees and expenses," the table is
amended to read as follows:
Shareholder Fees(1)
(paid directly from an investment) None
Annual Fund Operating Expenses
(deducted from Fund assets)
Management Fees 0.93%
Other Expenses 0.32%
----
Total Annual Fund Operating Expenses(2) 1.25%
====
(1)Sales charges may be imposed by variable annuity contracts or variable life
insurance policies if the Fund's shares are purchased by a life insurance
separate account as an investment option for these contracts or policies.
(2)At least through December 31, 1999, VMF has agreed to waive management fees
and, if necessary, to reimburse "Other Expenses" so that Total Annual Fund
Operating Expenses will not exceed 1.25%.
All references in the Prospectus to Nationwide Advisory Services, Inc. should be
changed to Villanova Mutual Fund Capital Trust.
INVESTORS SHOULD RETAIN THIS SUPPLEMENT WITH THE
PROSPECTUS FOR FUTURE REFERENCE
<PAGE> 5
STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 1999 (REVISED SEPTEMBER 1, 1999)
NATIONWIDE SEPARATE ACCOUNT TRUST
--NATIONWIDE STRATEGIC GROWTH FUND
--NATIONWIDE STRATEGIC VALUE FUND
--NATIONWIDE EQUITY INCOME FUND
--NATIONWIDE HIGH INCOME BOND FUND
--NATIONWIDE BALANCED FUND
--NATIONWIDE MULTI SECTOR BOND FUND
--NATIONWIDE SMALL CAP VALUE FUND
--NATIONWIDE SELECT ADVISERS SMALL CAP GROWTH FUND
--NATIONWIDE GLOBAL EQUITY FUND
--NATIONWIDE SELECT ADVISERS MID CAP FUND
--NATIONWIDE SMALL COMPANY FUND
--NATIONWIDE INCOME FUND
--TOTAL RETURN FUND
--CAPITAL APPRECIATION FUND
--GOVERNMENT BOND FUND
--MONEY MARKET FUND
Nationwide Separate Account Trust is a registered open-end investment
company consisting of 16 series. This Statement of Additional Information
relates to all series of the Trust (each, a "Fund" and collectively, the
"Funds").
This Statement of Additional Information is not a prospectus but the
Statement of Additional Information is incorporated by reference into the
Prospectuses. 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, 1999 (as revised July 1, 1999) and
supplemented September 1, 1999, for the Funds. Terms not defined in this
Statement of Additional Information have the meanings assigned to them in the
Prospectuses. 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>
<CAPTION>
TABLE OF CONTENTS PAGE
- ----------------- ----
<S> <C>
General Information and History......................................................2
Additional Information on Portfolio Instruments and Investment Policies..............2
Investment Restrictions.............................................................35
Major Shareholders..................................................................40
Trustees and Officers of the Trust..................................................40
Calculating Yield and Total Return..................................................43
Investment Advisory and Other Services..............................................45
Brokerage Allocations...............................................................56
Purchases, Redemptions and Pricing of Shares........................................61
Additional Information..............................................................62
Tax Status..........................................................................63
Other Tax Consequences..............................................................64
Tax Consequences to Shareholders....................................................65
Financial Statements................................................................65
Appendix A - Bond Ratings...........................................................66
</TABLE>
<PAGE> 6
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 currently offers shares in sixteen
(16) separate series, each with its own investment objective. Each of the Funds
except for the Nationwide Small Company Fund is a diversified fund as defined in
the Investment Company Act of 1940.
ADDITIONAL INFORMATION ON PORTFOLIO INSTRUMENTS AND INVESTMENT POLICIES
The Funds invest in a variety of securities and employ a number of
investment techniques, which involve certain risks. The Prospectuses for the
Funds highlight the principal investment strategies, investment techniques and
risks. The following table sets forth additional information concerning
permissible investments and techniques for each of the Funds. A "Y" in the table
indicates that the Fund may invest in or follow the corresponding instrument or
technique. An empty box indicates that the Fund does not intend to invest in or
follow the corresponding instrument or technique.
2
<PAGE> 7
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Select
Select Advisers
Advisers Small Small
Capital Strategic Strategic Mid Small Cap Cap Global
TYPE OF INVESTMENT OR TECHNIQUE Appreciation Growth Value Cap Company Growth Value Equity
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. common stocks Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Preferred stocks Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Small company stocks Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Special situation companies Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Illiquid securities Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Restricted securities Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
When-issued / delayed-delivery securities Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Limited liability companies
- ------------------------------------------------------------------------------------------------------------------------------------
Investment companies Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Real estate investment trusts (REITS) Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Securities of foreign issuers Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Depository receipts Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------------
Multi High
Equity Total Government Sector Income Money
TYPE OF INVESTMENT OR TECHNIQUE Income Return Balanced Bond Income Bond Bond Market
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. common stocks Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Preferred stocks Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Small company stocks Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Special situation companies Y
- --------------------------------------------------------------------------------------------------------------------------
Illiquid securities Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Restricted securities Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
When-issued / delayed-delivery securities Y Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Limited liability companies Y Y
- --------------------------------------------------------------------------------------------------------------------------
Investment companies Y Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Real estate investment trusts (REITS) Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Securities of foreign issuers Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Depository receipts Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
3
<PAGE> 8
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
Select
Select Advisers
Advisers Small Small
Capital Strategic Strategic Mid Small Cap Cap Global
TYPE OF INVESTMENT OR TECHNIQUE Appreciation Growth Value Cap Company Growth Value Equity
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Securities from developing countries/ Y Y
emerging markets
- -----------------------------------------------------------------------------------------------------------------------------------
Convertible securities Y Y Y Y Y Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Long-term debt Y Y Y Y Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Short-term debt Y Y Y Y Y Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Floating and variable rate securities
- -----------------------------------------------------------------------------------------------------------------------------------
Zero coupon securities Y Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Step-coupon securities
- -----------------------------------------------------------------------------------------------------------------------------------
Pay-in-kind bonds Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Deferred payment securities Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Brady bonds
- -----------------------------------------------------------------------------------------------------------------------------------
Non-investment grade debt Y Y Y Y Y
- -----------------------------------------------------------------------------------------------------------------------------------
Loan participations and assignments
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------------
Multi High
Equity Total Government Sector Income Money
TYPE OF INVESTMENT OR TECHNIQUE Income Return Balanced Bond Income Bond Bond Market
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Securities from developing countries/ Y Y Y Y
emerging markets
- --------------------------------------------------------------------------------------------------------------------------
Convertible securities Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Long-term debt Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Short-term debt Y Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Floating and variable rate securities Y Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Zero coupon securities Y Y Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Step-coupon securities Y Y
- --------------------------------------------------------------------------------------------------------------------------
Pay-in-kind bonds Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Deferred payment securities Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Brady bonds Y Y
- --------------------------------------------------------------------------------------------------------------------------
Non-investment grade debt Y Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
Loan participations and assignments Y Y Y
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
4
<PAGE> 9
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Select
Select Advisers
Advisers Small Small
Capital Strategic Strategic Mid Small Cap Cap Global
TYPE OF INVESTMENT OR TECHNIQUE Appreciation Growth Value Cap Company Growth Value Equity
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Sovereign debt (foreign) Y
- ------------------------------------------------------------------------------------------------------------------------------------
Foreign commercial paper Y
- ------------------------------------------------------------------------------------------------------------------------------------
Duration
- ------------------------------------------------------------------------------------------------------------------------------------
U.S. Government securities Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Money market instruments Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Stripped mortgage-backed securities
- ------------------------------------------------------------------------------------------------------------------------------------
Collateralized mortgage obligations
- ------------------------------------------------------------------------------------------------------------------------------------
Mortgage dollar rolls Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Asset-backed securities Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Bank obligations Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Repurchase agreements Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------
Multi High
Equity Total Government Sector Income Money
TYPE OF INVESTMENT OR TECHNIQUE Income Return Balanced Bond Income Bond Bond Market
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Sovereign debt (foreign) Y
- -------------------------------------------------------------------------------------------------------------------------
Foreign commercial paper Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Duration Y Y
- -------------------------------------------------------------------------------------------------------------------------
U.S. Government securities Y Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Money market instruments Y Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Stripped mortgage-backed securities Y
- -------------------------------------------------------------------------------------------------------------------------
Collateralized mortgage obligations Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Mortgage dollar rolls Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Asset-backed securities Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Bank obligations Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Repurchase agreements Y Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
</TABLE>
5
<PAGE> 10
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Select
Select Advisers
Advisers Small Small
Capital Strategic Strategic Mid Small Cap Cap Global
TYPE OF INVESTMENT OR TECHNIQUE Appreciation Growth Value Cap Company Growth Value Equity
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Reverse repurchase agreements Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Warrants Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Futures Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Options Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Foreign currencies Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Forward currency contracts Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Borrowing money Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Lending of portfolio securities Y Y Y Y Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
Short sales Y Y Y Y
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------
Multi High
Equity Total Government Sector Income Money
TYPE OF INVESTMENT OR TECHNIQUE Income Return Balanced Bond Income Bond Bond Market
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Reverse repurchase agreements Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Warrants Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Futures Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Options Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Foreign currencies
- -------------------------------------------------------------------------------------------------------------------------
Forward currency contracts
- -------------------------------------------------------------------------------------------------------------------------
Borrowing money Y Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Lending of portfolio securities Y Y Y Y Y Y Y Y
- -------------------------------------------------------------------------------------------------------------------------
Short sales
- -------------------------------------------------------------------------------------------------------------------------
</TABLE>
6
<PAGE> 11
DESCRIPTION OF PORTFOLIO INSTRUMENTS AND INVESTMENT POLICIES
INFORMATION CONCERNING DURATION. Duration is a measure of the average life of a
fixed-income security that was developed as a more precise alternative to the
concepts of "term to maturity" or "average dollar weighted maturity" as measures
of "volatility" or "risk" associated with changes in interest rates. Duration
incorporates a security's yield, coupon interest payments, final maturity and
call features into one measure.
Most debt obligations provide interest ("coupon") payments in addition
to final ("par") payment at maturity. Some obligations also have call
provisions. Depending on the relative magnitude of these payments and the nature
of the call provisions, the market values of debt obligations may respond
differently to changes in interest rates.
Traditionally, a debt security's "term-to-maturity" has been used as a
measure of the sensitivity of the security's price to changes in interest rates
(which is the "interest rate risk" or "volatility" of the security). However,
"term-to-maturity" measures only the time until a debt security provides its
final payment, taking no account of the pattern of the security's payments prior
to maturity. Average dollar weighted maturity is calculated by averaging the
terms of maturity of each debt security held with each maturity "weighted"
according to the percentage of assets that it represents. Duration is a measure
of the expected life of a debt security on a present value basis and reflects
both principal and interest payments. Duration takes the length of the time
intervals between the present time and the time that the interest and principal
payments are scheduled or, in the case of a callable security, expected to be
received, and weights them by the present values of the cash to be received at
each future point in time. For any debt security with interest payments
occurring prior to the payment of principal, duration is ordinarily less than
maturity. In general, all other factors being the same, the lower the stated or
coupon rate of interest of a debt security, the longer the duration of the
security; conversely, the higher the stated or coupon rate of interest of a debt
security, the shorter the duration of the security.
There are some situations where the standard duration calculation does
not properly reflect the interest rate exposure of a security. For example,
floating and variable rate securities often have final maturities of ten or more
years; however, their interest rate exposure corresponds the frequency of the
coupon reset. Another example where the interest rate exposure is not properly
captured by duration is the case of mortgage pass-through securities. The stated
final maturity of such securities is generally 30 years, but current prepayment
rates are more critical in determining the securities' interest rate exposure.
In these and other similar situations, a Fund's investment adviser or subadviser
will use more sophisticated analytical techniques to project the economic life
of a security and estimate its interest rate exposure. Since the computation of
duration is based on predictions of future events rather than known factors,
there can be no assurance that a Fund will at all times achieve its targeted
portfolio duration.
The change in market value of U.S. Government fixed-income securities
is largely a function of changes in the prevailing level of interest rates. When
interest rates are falling, a portfolio with a shorter duration generally will
not generate as high a level of total return as a portfolio with a longer
duration. When interest rates are stable, shorter duration portfolios generally
will not generate as high a level of total return as longer duration portfolios
(assuming that long-term interest rates are higher than short-term rates, which
is commonly the case.) When interest rates are rising, a portfolio with a
shorter duration will generally outperform longer duration portfolios. With
respect to the composition of a fixed-income portfolio, the longer the duration
of the portfolio, generally, the greater the anticipated potential for total
return, with, however, greater attendant interest rate risk and price volatility
than for a portfolio with a shorter duration.
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.
7
<PAGE> 12
Lower-rated securities are more likely to react to developments affecting these
risks than are more highly rated securities, which react primarily to movements
in the general level of interest rates. Although the fluctuation in the price of
debt securities is normally less than that of common stocks, in the past there
have been extended periods of cyclical increases in interest rates that have
caused significant declines in the price of debt securities in general and have
caused the effective maturity of securities with prepayment features to be
extended, thus effectively converting short or intermediate securities (which
tend to be less volatile in price) into long term securities (which tend to be
more volatile in price).
RATINGS AS INVESTMENT CRITERIA. High-quality, medium-quality and
non-investment grade debt obligations are characterized as such based on their
ratings by nationally recognized statistical rating organizations ("NRSROs"),
such as Standard & Poor's Rating Group ("Standard & Poor's") or Moody's Investor
Services ("Moody's"). 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 a Fund as initial criteria for the selection of portfolio securities,
but the Fund also relies upon the independent advice of a Fund's adviser or
subadviser(s) to evaluate potential investments. This is particularly important
for lower-quality securities. Among the factors that will be considered are the
long-term ability of the issuer to pay principal and interest and general
economic trends, as well as an issuer's capital structure, existing debt and
earnings history. 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 a Fund, an issue of securities may cease
to be rated or its rating may be reduced below the minimum required for purchase
by such 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 a Fund's adviser or
subadviser will consider such events in its determination of whether the 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 reorganization, the Fund will attempt to use
comparable ratings as standards for its investments in accordance with its
investment objective and policies.
MEDIUM-QUALITY SECURITIES. Certain Funds anticipate investing in
medium-quality obligations, which are obligations rated in the fourth highest
rating category by any NRSRO. Medium-quality securities, although considered
investment-grade, may have some speculative characteristics and may be subject
to greater fluctuations in value than higher-rated securities. In addition, the
issuers of medium-quality securities may be more vulnerable to adverse economic
conditions or changing circumstances than issues of higher-rated securities.
LOWER QUALITY (HIGH-RISK) SECURITIES. Non-investment grade debt or
lower quality/rated securities (hereinafter referred to as "lower-quality
securities") include (i) bonds rated as low as C by Moody's, Standard & Poor's,
or Fitch/IBCA Investors Service, Inc. ("Fitch"), or CCC by D&P; (ii) commercial
paper rated as low as C by Standard & Poor's, Not Prime by Moody's or Fitch 4 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 greater risks, including the
possibility of default or bankruptcy. There is more risk associated with these
investments because of reduced creditworthiness and increased risk of default.
Under NRSRO guidelines, lower quality securities and comparable unrated
securities will likely have some quality and protective characteristics that are
outweighted by large uncertainties or major risk exposures to adverse
conditions. Lower quality securities are considered to have extremely poor
prospects of ever attaining any real investment standing, to have a current
identifiable vulnerability to default or to be in default, to be unlikely to
have the capacity to make required interest payments and repay principal when
due in the event of adverse business, financial or economic conditions, or to be
in default or not current in the payment of interest or principal. 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.
8
<PAGE> 13
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 generally decrease in a rising interest rate market, and
accordingly so will a Fund's net asset value. If a 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), a Fund may be forced to liquidate these securities at a substantial
discount which would result in a lower rate of return to 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, a Fund may have to
replace the securities with a lower yielding security, which would result in a
lower return for that Fund.
Liquidity And Valuation. A 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 may be no
established retail secondary market for many of these securities. The Funds
anticipate 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, a Fund's asset
value and ability to dispose of particular securities, when necessary to meet
such 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 a Fund to obtain accurate market quotations for
purposes of valuing that 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.
U.S. GOVERNMENT SECURITIES. U.S. government securities are issued or
guaranteed by the U.S. government or its agencies or instrumentalities.
Securities issued by the U.S. government include U.S. Treasury obligations, such
as Treasury bills, notes, and bonds. Securities issued by government agencies or
instrumentalities include obligations of the following:
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- - the Federal Housing Administration, Farmers Home Administration, and
the Government National Mortgage Association ("GNMA"), including GNMA
pass-through certificates, whose securities are supported by the full
faith and credit of the United States;
- - the Federal Home Loan Banks whose securities are supported by the right
of the agency to borrow from the U.S. Treasury;
- - the Federal National Mortgage Association, whose securities are
supported by the discretionary authority of the U.S. government to
purchase certain obligations of the agency or instrumentality; and
- - the Student Loan Marketing Association and the Federal Home Loan
Mortgage Corporation ("FHLMC"), whose securities are supported only by
the credit of such agencies.
Although the U.S. government provides financial support to such U.S.
government-sponsored agencies or instrumentalities, no assurance can be given
that it will always do so. The U.S. government and its agencies and
instrumentalities do not guarantee the market value of their securities;
consequently, the value of such securities will fluctuate.
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 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"). The purchase of mortgage-backed securities from private lenders may
entail greater risk than mortgage-backed securities that are issued or
guaranteed by the U.S. government, its agencies or instrumentalities.
Mortgage-backed securities issued by private lenders maybe 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.
Since privately-issued mortgage certificates are not guaranteed by an
entity having the credit status of GNMA or FHLMC, such securities generally are
structured with one or more types of credit enhancement. Such credit enhancement
falls into two categories: (i) liquidity protection; and (ii) protection against
losses resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provisions of advances, generally by the
entity administering the pool of assets, to ensure that the pass-through of
payments due on the underlying pool occurs in a timely fashion. Protection
against losses resulting from ultimate default enhances the likelihood of
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or sponsor from third parties, through
various means of structuring the transaction or through a combination of such
approaches.
The ratings of mortgage-backed securities for which third-party credit
enhancement provides liquidity protection or protection against losses from
default are generally dependent upon the continued creditworthiness of the
provider of the credit enhancement. The ratings of such securities could be
subject to reduction in the event of deterioration in the creditworthiness of
the credit enhancement provider even in cases where the delinquency loss
experience on the underlying pool of assets is better than expected. There can
be no assurance that the private issuers or credit enhancers of mortgage-backed
securities can meet their obligations under the relevant policies or other forms
of credit enhancement.
Examples of credit support arising out of the structure of the
transaction include "senior-subordinated securities" (multiple class securities
with one or more classes subordinate to other classes as to the payment of
principal thereof and interest thereon, with the result that defaults on the
underlying assets are borne first by the holders of the subordinated class),
creation of "reserve funds" (where cash or investments sometimes
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funded from a portion of the payments on the underlying assets are held in
reserve against future losses) and "over-collateralization" (where the scheduled
payments on, or the principal amount of, the underlying assets exceed those
required to make payment of the securities and pay any servicing or other fees).
The degree of credit support provided for each issue is generally based on
historical information with respect to the level of credit risk associated with
the underlying assets. Delinquency or loss in excess of that which is
anticipated could adversely affect the return on an investment in such security.
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 was previously customary. As new types of
mortgage-related securities are developed and offered to investors, a 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 or other assets generally may be prepaid
at any time. As a result, if a 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 a 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.
Unlike fixed rate mortgage-backed securities, adjustable rate
mortgage-backed securities are collateralized by or represent interest in
mortgage loans with variable rates of interest. These variable rates of interest
reset periodically to align themselves with market rates. A Fund will not
benefit from increases in interest rates to the extent that interest rates rise
to the point where they cause the current coupon of the underlying adjustable
rate mortgages to exceed any maximum allowable annual or lifetime reset limits
(or "cap rates") for a particular mortgage. In this event, the value of the
adjustable rate mortgage-backed securities in a Fund would likely decrease.
Also, a Fund's net asset value could vary to the extent that current yields on
adjustable rate mortgage-backed securities are different than market yields
during interim periods between coupon reset dates or if the timing of changes to
the index upon which the rate for the underlying mortgage is based lags behind
changes in market rates. During periods of declining interest rates, income to a
Fund derived from adjustable rate mortgage securities which remain in a mortgage
pool will decrease in contrast to the income on fixed rate mortgage securities,
which will remain constant. Adjustable rate mortgages also have less potential
for appreciation in value as interest rates decline than do fixed rate
investments.
There are a number of important differences among the agencies and
instrumentalities of the U.S. Government that issue mortgage-backed securities
and among the securities that they issue. Mortgage-backed securities issued by
GNMA include GNMA Mortgage Pass-Through Certificates (also known as "Ginnie
Maes") which are guaranteed as to the timely payment of principal and interest
by GNMA and such guarantee is backed by the full faith and credit of the United
States. GNMA certificates also are supported by the authority of GNMA to borrow
funds from the U.S. Treasury to make payments under its guarantee.
Mortgage-backed securities issued by FNMA include FNMA Guaranteed Mortgage
Pass-Through Certificates (also known as "Fannie Maes") which are solely the
obligations of the FNMA and are not backed by or entitled to the full faith and
credit of the United States. Fannie Maes are guaranteed as to timely payment of
the principal and interest by FNMA. Mortgage-backed securities issued by the
Federal Home Loan Mortgage Corporation ("FHLMC") include FHLMC Mortgage
Participation Certificates (also known as "Freddie Macs" or "PCs"). The FHLMC is
a corporate instrumentality of the United States,
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created pursuant to an Act of Congress, which is owned entirely by Federal Home
Loan Banks and do not constitute a debt or obligation of the United States or by
any Federal Home Loan Bank. Freddie Macs entitle the holder to timely payment of
interest, which is guaranteed by the FHLMC. The FHLMC guarantees either ultimate
collection or timely payment of all principal payments on the underlying
mortgage loans. When the FHLMC does not guarantee timely payment of principal,
FHLMC may remit the amount due on account of its guarantee of ultimate payment
of principal at any time after default on an underlying mortgage, but in no
event later than one year after it becomes payable.
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 or any other affiliated entities, and the amount
and quality of any credit enhancement of the securities.
Collateralized Mortgage Obligations and Multiclass Pass-Through Securities. CMOs
are debt obligations collateralized by mortgage loans or mortgage pass-through
securities. Typically, CMOs are collateralized by GNMA, Fannie Mae or Freddie
Mae Certificates, but also may be collateralized by whole loans or private
pass-throughs (such collateral collectively hereinafter referred to as "Mortgage
Assets"). Multiclass pass-through securities are interests in a trust composed
of Mortgage Assets. Unless the context indicates otherwise, all references
herein to CMOs include multiclass pass-through securities. Payments of principal
and interest on the Mortgage Assets, and any reinvestment income thereon,
provide the funds to pay debt service on the CMOs or make scheduled
distributions on the multiclass pass-through securities. CMOs may be issued by
agencies or instrumentalities of the U.S. government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special purpose
subsidiaries of the foregoing.
In a CMO, a series of bonds or certificates is issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is issued at a
specified fixed or floating coupon rate and has a stated maturity or final
distribution date. Principal prepayments on the Mortgage Assets may cause the
CMOs to be retired substantially earlier than their stated maturities or final
distribution dates. Interest is paid or accrues on all classes of the CMOs on a
monthly, quarterly or semi-annual basis. The principal of and interest on the
Mortgage Assets may be allocated among the several classes of a series of a CMO
in innumerable ways. In one structure, payments of principal, including any
principal prepayments, on the Mortgage Assets are applied to the classes of a
CMO in the order of their respective stated maturities or final distribution
dates, so that no payment of principal will be made on any class of CMOs until
all other classes having an earlier stated maturity or final distribution date
have been paid in full. As market conditions change, and particularly during
periods of rapid or unanticipated changes in market interest rates, the
attractiveness of the CMO classes and the ability of the structure to provide
the anticipated investment characteristics may be significantly reduced. Such
changes can result in volatility in the market value, and in some instances
reduced liquidity, of the CMO class.
A Fund may also invest in, among others, parallel pay CMOs and Planned
Amortization Class CMOs ("PAC Bonds"). Parallel pay CMOs are structured to
provide payments of principal on each payment date to more than one class. These
simultaneous payments are taken into account in calculating the stated maturity
date or final distribution date of each class, which, as with other CMO
structures, must be retired by its stated maturity date or a final distribution
date but may be retired earlier. PAC Bonds are a type of CMO tranche or series
designed to provide relatively predictable payments of principal provided that,
among other things, the actual prepayment experience on the underlying mortgage
loans falls within a predefined
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range. If the actual prepayment experience on the underlying mortgage loans is
at a rate faster or slower than the predefined range or if deviations from other
assumptions occur, principal payments on the PAC Bond may be earlier or later
than predicted. The magnitude of the predefined range varies from one PAC Bond
to another; a narrower range increases the risk that prepayments on the PAC Bond
will be greater or smaller than predicted. Because of these features, PAC Bonds
generally are less subject to the risks of prepayment than are other types of
mortgage-backed securities.
Stripped Mortgage Securities. Stripped mortgage securities are derivative
multiclass mortgage securities. Stripped mortgage securities may be issued by
agencies or instrumentalities of the U.S. government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks and special purpose
subsidiaries of the foregoing. Stripped mortgage securities have greater
volatility than other types of mortgage securities. Although stripped mortgage
securities are purchased and sold by institutional investors through several
investment banking firms acting as brokers or dealers, the market for such
securities has not yet been fully developed. Accordingly, stripped mortgage
securities are generally illiquid.
Stripped mortgage securities are structured with two or more classes of
securities that receive different proportions of the interest and principal
distributions on a pool of mortgage assets. A common type of stripped mortgage
security will have at least one class receiving only a small portion of the
interest and a larger portion of the principal from the mortgage assets, while
the other class will receive primarily interest and only a small portion of the
principal. In the most extreme case, one class will receive all of the interest
("IO" or interest-only), while the other class will receive all of the principal
("PO" or principal-only class). The yield to maturity on IOs, POs and other
mortgage-backed securities that are purchased at a substantial premium or
discount generally are extremely sensitive not only to changes in prevailing
interest rates but also to the rate of principal payments (including
prepayments) on the related underlying mortgage assets, and a rapid rate of
principal payments may have a material adverse effect on such securities' yield
to maturity. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, the Fund may fail to fully recoup its
initial investment in these securities even if the securities have received the
highest rating by a nationally recognized statistical rating organization.
In addition to the stripped mortgage securities described above, the
Fund may invest in similar securities such as Super POs and Levered IOs which
are more volatile than POs, IOs and IOettes. Risks associated with instruments
such as Super POs are similar in nature to those risks related to investments in
POs. IOettes represent the right to receive interest payments on an underlying
pool of mortgages with similar risks as those associated with IOs. Unlike IOs,
the owner also has the right to receive a very small portion of the principal.
Risks connected with Levered IOs and IOettes are similar in nature to those
associated with IOs. The Fund may also invest in other similar instruments
developed in the future that are deemed consistent with its investment
objective, policies and restrictions. POs may generate taxable income from the
current accrual of original issue discount, without a corresponding distribution
of cash to the Fund. See "Tax Status" in the Prospectus and "Additional
Information Concerning Taxes" in the Statement of Additional Information.
A Fund may also purchase stripped mortgage-backed securities for
hedging purposes to protect that Fund against interest rate fluctuations. For
example, since an IO will tend to increase in value as interest rates rise, it
may be utilized to hedge against a decrease in value of other fixed-income
securities in a rising interest rate environment. With respect to IOs, if the
underlying mortgage securities experience greater than anticipated prepayments
of principal, the Fund may fail to recoup fully its initial investment in these
securities even if the securities are rated in the highest rating category by an
NRSRO. Stripped mortgage-backed securities may exhibit greater price volatility
than ordinary debt securities because of the manner in which their principal and
interest are returned to investors. The market value of the class consisting
entirely of principal payments can be extremely volatile in response to changes
in interest rates. The yields on stripped mortgage-backed securities that
receive all or most of the interest are generally higher than prevailing market
yields on other mortgage-backed obligations because their cash flow patterns are
also
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volatile and there is a greater risk that the initial investment will not
be fully recouped. The market for CMOs and other stripped mortgage-backed
securities may be less liquid if these securities lose their value as a result
of changes in interest rates; in that case, a Fund may have difficulty in
selling such securities.
MONEY MARKET INSTRUMENTS. Money market instruments 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, with remaining maturities of 397 days or less;
--obligations of sovereign foreign governments, their agencies,
instrumentalities and political subdivisions, with remaining maturities
of 397 days or less;
--asset-backed commercial paper whose own rating or the rating of any
guarantor is in one of the two highest categories of any NRSRO;
-- 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,
and such obligations issued by foreign branches of foreign banks and
financial institutions;
-- commercial paper (including asset-backed 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, these obligations will be rated within the top two rating
categories by an NRSRO or if not rated, of comparable quality.
REPURCHASE AGREEMENTS. In connection with the purchase of a repurchase agreement
from member banks of the Federal Reserve System or certain non-bank dealers by a
Fund, the Fund's custodian, or a subcustodian, 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 resale price.
Repurchase agreements involve certain risks in the event of default or
insolvency by the other party, including possible delays or restrictions upon a
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 a
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. A Fund's adviser or subadviser, acting
under the supervision of the Board of Trustees, reviews the creditworthiness of
those banks and non-bank dealers with which the Funds enter into repurchase
agreements to evaluate these risks.
WHEN-ISSUED SECURITIES AND DELAYED-DELIVERY TRANSACTIONS. When securities are
purchased on a "when-issued" basis or purchased for delayed delivery, then
payment and delivery occur 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 securities
are fixed at the time
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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. The greater a Fund's outstanding commitments for these
securities, the greater the exposure to potential fluctuations in the net asset
value of a Fund. Purchasing when-issued or delayed-delivery securities may
involve the additional risk that the yield or market price available in the
market when the delivery occurs may be higher or the market price lower than
that obtained at the time of commitment.
When a Fund agrees to purchase when-issued or delayed-delivery
securities, to the extent required by the SEC, its custodian will set aside
permissible liquid assets 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 a 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. A 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) a 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) a
Fund must be able to terminate the loan at any time; (4) a 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) a 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, a Fund's board of 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.
SMALL COMPANY AND EMERGING GROWTH STOCKS. Investing in securities of small-sized
and emerging growth companies may involve greater risks than investing in the
stocks of larger, more established companies since these securities may have
limited marketability and thus may be more volatile than securities of larger,
more established companies or the market averages in general. Because
small-sized and emerging growth companies normally have fewer shares outstanding
than larger companies, it may be more difficult for a Fund to buy or sell
significant numbers of such shares without an unfavorable impact on prevailing
prices. Small-sized and emerging growth companies may have limited product
lines, markets or financial resources and may lack management depth. In
addition, small-sized and emerging growth companies are typically subject to
wider variations in earnings and business prospects than are larger, more
established companies. There is typically less publicly available information
concerning small-sized and emerging growth companies than for larger, more
established ones.
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SPECIAL SITUATION COMPANIES. "Special situation companies" 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. Therefore, an investment in a Fund
that invests a significant portion of its assets in these securities may involve
a greater degree of risk than an investment in other mutual funds that seek
long-term growth of capital by investing in better-known, larger companies. The
subadvisers of such Funds believe, 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, if it is consummated at all.
FOREIGN SECURITIES Investing in foreign securities (including through the use of
depository receipts) 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 a Fund may hold securities and funds in foreign currencies,
a 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 each Fund endeavors to achieve
the most favorable net results on its 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 a Fund, may be subject
to foreign government taxes, higher custodian fees, higher brokerage costs and
dividend collection fees which could reduce the yield on such securities.
Foreign economies may differ favorably or unfavorably from the U.S.
economy in various respects, including growth of gross domestic product, rates
of inflation, currency depreciation, capital reinvestment, resource
self-sufficiency, and balance of payments positions. Many foreign securities are
less liquid and their prices more volatile than comparable U.S. securities. From
time to time, foreign securities may be difficult to liquidate rapidly without
adverse price effects.
INVESTMENT IN COMPANIES IN DEVELOPING COUNTRIES. Investments may be
made from time to time 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,
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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 a 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 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 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 on foreign commodity exchanges may be
subject to the same or similar risks as trading in foreign securities.
DEPOSITORY RECEIPTS. A Fund may invest in foreign securities by
purchasing depository receipts, including American Depository Receipts ("ADRs"),
European Depository Receipts ("EDRs") and Global Depository Receipts ("GDRs") 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, GDRs, in bearer form, are issued and designed for use
outside the United States and EDRs (also referred to as Continental Depository
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
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underlying securities. EDRs are European receipts evidencing a similar
arrangement. GDRs are receipts typically issued by non-United States banks and
trust companies that evidence ownership of either foreign or domestic
securities. For purposes of a Fund's investment policies, ADRs, GDRs and EDRs
are deemed to have the same classification as the underlying securities they
represent. Thus, an ADR, GDR or EDR representing ownership of common stock will
be treated as common stock.
Each Fund may invest in depository receipts through "sponsored" or
"unsponsored" facilities. While ADRs issued under these two types of facilities
are in some respects similar, there are distinctions between them relating to
the rights and obligations of ADR holders and the practices of market
participants.
A depository may establish an unsponsored facility without
participation by (or even necessarily the acquiescence of) the issuer of the
deposited securities, although typically the depository requests a letter of
non-objection from such issuer prior to the establishment of the facility.
Holders of unsponsored ADRs generally bear all the costs of such facilities. The
depository usually charges fees upon the deposit and withdrawal of the deposited
securities, the conversion of dividends into U.S. dollars, the disposition of
non-cash distributions, and the performance of other services. The depository of
an unsponsored facility frequently is under no obligation to pass through voting
rights to ADR holders in respect of the deposited securities. In addition, an
unsponsored facility is generally not obligated to distribute communications
received from the issuer of the deposited securities or to disclose material
information about such issuer in the U.S. and thus there may not be a
correlation between such information and the market value of the depository
receipts. Unsponsored ADRs tend to be less liquid than sponsored ADRs.
Sponsored ADR facilities are created in generally the same manner as
unsponsored facilities, except that the issuer of the deposited securities
enters into a deposit agreement with the depository. The deposit agreement sets
out the rights and responsibilities of the issuer, the depository, and the ADR
holders. With sponsored facilities, the issuer of the deposited securities
generally will bear some of the costs relating to the facility (such as dividend
payment fees of the depository), although ADR holders continue to bear certain
other costs (such as deposit and withdrawal fees). Under the terms of most
sponsored arrangements, depositories agree to distribute notices of shareholder
meetings and voting instructions, and to provide shareholder communications and
other information to the ADR holders at the request of the issuer of the
deposited securities.
EURODOLLAR AND YANKEE OBLIGATIONS. Eurodollar bank obligations are
dollar-denominated certificates of deposit and time deposits issued outside the
U.S. capital markets by foreign branches of U.S. banks and by foreign banks.
Yankee bank obligations are dollar-denominated obligations issued in the U.S.
capital markets by foreign banks.
Eurodollar and Yankee bank obligations are subject to the same risks
that pertain to domestic issues, notably credit risk, market risk and liquidity
risk. Additionally, Eurodollar (and to a limited extent, Yankee) bank
obligations are subject to certain sovereign risks. One such risk is the
possibility that a sovereign country might prevent capital, in the form of
dollars, from flowing across their borders. Other risks include: adverse
political and economic developments; the extent and quality of government
regulation of financial markets and institutions; the imposition of foreign
withholding taxes, and the expropriation or nationalization of foreign issues.
However, Eurodollar and Yankee bank obligations held in a Fund will undergo the
same credit analysis as domestic issues in which the Fund invests, and will have
at least the same financial strength as the domestic issuers approved for the
Fund.
FOREIGN SOVEREIGN DEBT. Certain Funds may invest in sovereign debt
obligations issued by foreign governments. To the extent that a Fund invests in
obligations issued by developing or emerging markets, these investments involve
additional risks. Sovereign obligors in developing and emerging market countries
are among the world's largest debtors to commercial banks, other governments,
international financial organizations and other financial institutions. These
obligors have in the past experienced substantial difficulties in servicing
their external debt obligations, which led to defaults on certain obligations
and the
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restructuring of certain indebtedness. Restructuring arrangements have
included, among other things, reducing and rescheduling interest and principal
payments by negotiation new or amended credit agreements or converting
outstanding principal and unpaid interest to Brady Bonds, and obtaining new
credit fo finance interest payments. Holders of certain foreign sovereign debt
securities may be requested to participate in the restructuring of such
obligations and to extend further loans to their issuers. There can be no
assurance that the foreign sovereign debt securities in which a Fund may invest
will not be subject to similar restructuring arrangements or to requests for new
credit which may adversely affect the Fund's holdings. Furthermore, certain
participants in the secondary market for such debt may be directly involved in
negotiating the terms of these arrangements and may therefore have access to
information not available to other market participants.
BRADY BONDS. Brady Bonds are debt securities, generally denominated in U.S.
dollars, issued under the framework of the Brady Plan. The Brady Plan is an
initiative announced by former U.S. Treasury Secretary Nicholas F. Brady in 1989
as a mechanism for debtor nations to restructure their outstanding external
commercial bank indebtedness. In restructuring its external debt under the Brady
Plan framework, a debtor nation negotiates with its existing bank lenders as
well as multilateral institutions such as the International Bank for
Reconstruction and Development (the "World Bank") and the International Monetary
Fund (the "IMF"). The Brady Plan framework, as it has developed, contemplates
the exchange of external commercial bank debt for newly issued bonds known as
"Brady Bonds". Brady Bonds may also be issued in respect of new money being
advanced by existing lenders in connection with the debt restructuring. The
World Bank and/or the IMF support the restructuring by providing funds pursuant
to loan agreements or other arrangements which enable the debtor nation to
collateralize the new Brady Bonds or to repurchase outstanding bank debt at a
discount. Under these arrangements with the World Bank and/or the IMF, debtor
nations have been required to agree to the implementation of certain domestic
monetary and fiscal reforms. Such reforms have included the liberalization of
trade and foreign investment, the privatization of state-owned enterprises and
the setting of targets for public spending and borrowing. These policies and
programs seek to promote the debtor country's economic growth and development.
Investors should also recognize that the Brady Plan only sets forth general
guiding principles for economic reform and debt reduction, emphasizing that
solutions must be negotiated on a case-by-case basis between debtor nations and
their creditors. A Fund's adviser or subadviser may believe that economic
reforms undertaken by countries in connection with the issuance of Brady Bonds
may make the debt of countries which have issued or have announced plans to
issue Brady Bonds an attractive opportunity for investment. However, there can
be no assurance that the adviser or the subadviser's expectations with respect
to Brady Bonds will be realized.
Investors should recognize that Brady Bonds have been issued only
recently, and accordingly, do not have a long payment history. Brady Bonds which
have been issued to date are rated in the categories "BB" or "B" by Standard &
Poor's or "Ba" or "B" by Moody's or, in cases in which a rating by S&P or
Moody's has not been assigned, are generally considered by the Fund's adviser or
subadviser to be of comparable quality.
Agreements implemented under the Brady Plan to date are designed to
achieve debt and debt-service reduction through specific options negotiated by a
debtor nation with its creditors. As a result, the financial packages offered by
each country differ. The types of options have included the exchange of
outstanding commercial bank debt for bonds issued at 100% of face value of such
debt which carry a below-market stated rate of interest (generally known as par
bonds), bonds issued at a discount from the face value of such debt (generally
known as discount bonds), bonds bearing an interest rate which increases over
time and bonds issued in exchange for the advancement of new money by existing
lenders. Discount bonds issued to date under the framework of the Brady Plan
have generally borne interested computed semi-annually at a rate equal to 13/16
of 1% above the then current six month London Inter-Bank Offered Rate ("LIBOR")
rate. Regardless of the stated face amount and stated interest rate of the
various types of Brady Bonds, the applicable Funds will purchase Brady Bonds in
secondary markets, as described below, in which the price and yield to the
investor reflect market conditions at the time of purchase. Brady Bonds issued
to date have traded at a deep discount from their face value. Certain sovereign
bonds are entitled to "value recovery
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payments" in certain circumstances, which in effect constitute supplemental
interest payments but generally are not collateralized. Certain Brady Bonds have
been collateralized as to principal due date at maturity (typically 30 years
from the date of issuance) by U.S. Treasury zero coupon bonds with a maturity
equal to the final maturity of such Brady Bonds. Collateral purchases are
financed by the IMF, the World Bank and the debtor nations' reserves. In
addition, interest payments on certain types of Brady Bonds may be
collateralized by cash or high-grade securities in amounts that typically
represent between 12 and 18 months of interest accruals on these instruments
with the balance of the interest accruals being uncollateralized. In the event
of a default with respect to collateralized Brady Bonds as a result of which the
payment obligations of the issuer are accelerated, the U.S. Treasury zero coupon
obligations held as collateral for the payment of principal will not be
distributed to investors, nor will such obligations be sold and the proceeds
distributed. The collateral will be held by the collateral agent to the
scheduled maturity of the defaulted Brady Bonds, which will continue to be
outstanding, at which time the fact amount of the collateral will equal the
principal payments which would have then been due on the Brady Bonds in the
normal course. Based upon current market conditions, the Fund would not intend
to purchase Brady Bonds which, at the time of investment, are in default as to
payments. However, in light of the risidual risk of the Brady Bonds and, among
other factors, the history of default with respect to commercial bank loans by
public and private entities of countries issuing Brady Bonds, investments in
Brady Bonds are considered speculative. A Fund may purchase Brady Bonds with no
or limited collateralization, and will be relying for payment of interest and
(except in the case of principal collateralized Brady Bonds) principal primarily
on the willingness and ability of the foreign government to make payment in
accordance with the terms of the Brady Bonds.
Brady Bonds issued to date are purchased and sold in secondary markets
through U.S. securities dealers and other financial institutions and are
generally maintained through European transnational securities depositories. A
substantial portion of the Brady Bonds and other sovereign debt securities in
which a Fund may invest are likely to be acquired at a discount, which involves
certain considerations discussed below under "Additional Information Concerning
Taxes."
REAL ESTATE SECURITIES - Although no Fund will invest in real estate directly, a
Fund may invest in securities of real estate investment trusts ("REITs") and
other real estate industry companies or companies with substantial real estate
investments and, as a result, such Fund may be subject to certain risks
associated with direct ownership of real estate and with the real estate
industry in general. These risks include, among others: possible declines in the
value of real estate; possible lack of availability of mortgage funds; extended
vacancies of properties; risks related to general and local economic conditions;
overbuilding; increases in competition, property taxes and operating expenses;
changes in zoning laws; costs resulting from the clean-up of, and liability to
third parties for damages resulting from, environmental problems; casualty or
condemnation losses; uninsured damages from floods, earthquakes or other natural
disasters; limitations on and variations in rents; and changes in interest
rates.
REITs are pooled investment vehicles which invest primarily in income
producing real estate or real estate related loans or interests. REITs are
generally classified as equity REITs, mortgage REITs or hybrid REITs. Equity
REITs invest the majority of their assets directly in real property and derive
income primarily from the collection of rents. Equity REITs can also realize
capital gains by selling properties that have appreciated in value. Mortgage
REITs invest the majority of their assets in real estate mortgages and derive
income from the collection of interest payments. Hybrid REITs combine the
investment strategies of Equity REITs and Mortgage REITs. REITs are not taxed on
income distributed to shareholders provided they comply with several
requirements of Internal Revenue Code, as amended (the "Code").
CONVERTIBLE SECURITIES. Convertible securities are bonds, debentures, notes,
preferred stocks, or other securities that may be converted into or exchanged
for a specified amount of common stock of the same or a different issuer within
a particular period of time at a specified price or formula. Convertible
securities have general characteristics similar to both debt obligations and
equity securities. The value of a convertible security is a function of its
"investment value" (determined by its yield in comparison with the yields of
other securities of comparable maturity and quality that do not have a
conversion privilege) and its
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"conversion value" (the security's worth, at market value, if converted into the
underlying common stock). The investment value of a convertible security is
influenced by changes in interest rates, the credit standing of the issuer and
other factors. The market value of convertible securities tends to decline as
interest rates increase and, conversely, tends to increase as interest rates
decline. The conversion value of a convertible security is determined by the
market price of the underlying common stock. The market value of convertible
securities tends to vary with fluctuations in the market value of the underlying
common stock and therefore will react to variations in the general market for
equity securities. If the conversion value is low relative to the investment
value, the price of the convertible security is governed principally by its
investment value. Generally, the conversion value decreases as the convertible
security approaches maturity. To the extent the market price of the underlying
common stock approaches or exceeds the conversion price, the price of the
convertible security will be increasingly influenced by its conversion value. A
convertible security generally will sell at a premium over its conversion value
by the extent to which investors place value on the right to acquire the
underlying common stock while holding a fixed income security. While no
securities investments are without risk, investments in convertible securities
generally entail less risk than investments in common stock of the same issuer.
A convertible security entitles the holder to receive interest normally
paid or accrued on debt or the dividend paid on preferred stock until the
convertible security matures or is redeemed, converted, or exchanged.
Convertible securities have unique investment characteristics in that they
generally (i) have higher yields than common stocks, but lower yields than
comparable non-convertible securities, (ii) are less subject to fluctuation in
value than the underlying stock since they have fixed income characteristics,
and (iii) provide the potential for capital appreciation if the market price of
the underlying common stock increases. Most convertible securities currently are
issued by U.S. companies, although a substantial Eurodollar convertible
securities market has developed, and the markets for convertible securities
denominated in local currencies are increasing.
A convertible security may be subject to redemption at the option of
the issuer at a price established in the convertible security's governing
instrument. If a convertible security held by a Fund is called for redemption, a
Fund will be required to permit the issuer to redeem the security, convert it
into the underlying common stock, or sell it to a third party.
Convertible securities generally are subordinated to other similar but
non-convertible securities of the same issuer, although convertible bonds, as
corporate debt obligations, generally enjoy seniority in right of payment to all
equity securities, and convertible preferred stock is senior to common stock of
the same issuer. Because of the subordination feature, however, convertible
securities typically are rated below investment grade or are not rated.
Certain Funds may invest in convertible preferred stocks that offer
enhanced yield features, such as Preferred Equity Redemption Cumulative Stocks
("PERCS"), which provide an investor, such as a Fund, with the opportunity to
earn higher dividend income than is available on a company's common stock. PERCS
are preferred stocks that generally feature a mandatory conversion date, as well
as a capital appreciation limit, which is usually expressed in terms of a stated
price. Most PERCS expire three years from the date of issue, at which time they
are convertible into common stock of the issuer. PERCS are generally not
convertible into cash at maturity. Under a typical arrangement, after three
years PERCS convert into one share of the issuer's common stock if the issuer's
common stock is trading at a price below that set by the capital appreciation
limit, and into less than one full share if the issuer's common stock is trading
at a price above that set by the capital appreciation limit. The amount of that
fractional share of common stock is determined by dividing the price set by the
capital appreciation limit by the market price of the issuer's common stock.
PERCS can be called at any time prior to maturity, and hence do not provide call
protection. If called early, however, the issuer must pay a call premium over
the market price to the investor. This call premium declines at a preset rate
daily, up to the maturity date.
A Fund may also invest in other classes of enhanced convertible
securities. These include but are
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not limited to ACES (Automatically Convertible Equity Securities), PEPS
(Participating Equity Preferred Stock), PRIDES (Preferred Redeemable Increased
Dividend Equity Securities), SAILS (Stock Appreciation Income Linked
Securities), TECONS (Term Convertible Notes), QICS (Quarterly Income Cumulative
Securities), and DECS (Dividend Enhanced Convertible Securities). ACES, PEPS,
PRIDES, SAILS, TECONS, QICS, and DECS all have the following features: they are
issued by the company, the common stock of which will be received in the event
the convertible preferred stock is converted; unlike PERCS they do not have a
capital appreciation limit; they seek to provide the investor with high current
income with some prospect of future capital appreciation; they are typically
issued with three or four-year maturities; they typically have some built-in
call protection for the first two to three years; and, upon maturity, they will
necessarily convert into either cash or a specified number of shares of common
stock.
Similarly, there may be enhanced convertible debt obligations issued by
the operating company, whose common stock is to be acquired in the event the
security is converted, or by a different issuer, such as an investment bank.
These securities may be identified by names such as ELKS (Equity Linked
Securities) or similar names. Typically they share most of the salient
characteristics of an enhanced convertible preferred stock but will be ranked as
senior or subordinated debt in the issuer's corporate structure according to the
terms of the debt indenture. There may be additional types of convertible
securities not specifically referred to herein, which may be similar to those
described above in which a Fund may invest, consistent with its goals and
policies.
An investment in an enhanced convertible security or any other security
may involve additional risks to the fund. A Fund may have difficulty disposing
of such securities because there may be a thin trading market for a particular
security at any given time. Reduced liquidity may have an adverse impact on
market price and a Fund's ability to dispose of particular securities, when
necessary, to meet the Fund's liquidity needs or in response to a specific
economic event, such as the deterioration in the credit worthiness of an issuer.
Reduced liquidity in the secondary market for certain securities may also make
it more difficult for the Fund to obtain market quotations based on actual
trades for purposes of valuing the fund's portfolio. A Fund, however, intends to
acquire liquid securities, though there can be no assurances that it will always
be able to do so.
Certain Funds may also invest in zero coupon convertible securities.
Zero coupon convertible securities are debt securities which are issued at a
discount to their face amount and do not entitle the holder to any periodic
payments of interest prior to maturity. Rather, interest earned on zero coupon
convertible securities acretes at a stated yield until the security reaches its
face amount at maturity. Zero coupon convertible securities are convertible into
a specific number of shares of the issuer's common stock. In addition, zero
coupon convertible securities usually have put features that provide the holder
with the opportunity to sell the securities back to the issuer at a stated price
before maturity. Generally, the prices of zero coupon convertible securities may
be more sensitive to market interest rate fluctuations then conventional
convertible securities. Federal income tax law requires the holder of a zero
coupon convertible security to recognize income from the security prior to the
receipt of cash payments. To maintain its qualification as a regulated
investment company and avoid liability of federal income taxes, a Fund will be
required to distribute income accrued from zero coupon convertible securities
which it owns, and may have to sell portfolio securities (perhaps at
disadvantageous times) in order to generate cash to satisfy these distribution
requirements.
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. Warrants acquired by a 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.
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PREFERRED STOCK. Preferred stocks, like debt obligations, are generally
fixed-income securities. Shareholders of preferred stocks normally have the
right to receive dividends at a fixed rate when and as declared by the issuer's
board of directors, but do not participate in other amounts available for
distribution by the issuing corporation. Dividends on the preferred stock may be
cumulative, and all cumulative dividends usually must be paid prior to common
shareholders receiving any dividends. Because preferred stock dividends must be
paid before common stock dividends, preferred stocks generally entail less risk
than common stocks. Upon liquidation, preferred stocks are entitled to a
specified liquidation preference, which is generally the same as the par or
stated value, and are senior in right of payment to common stock. Preferred
stocks are, however, equity securities in the sense that they do not represent a
liability of the issuer and, therefore, do not offer as great a degree of
protection of capital or assurance of continued income as investments in
corporate debt securities. Preferred stocks are generally subordinated in right
of payment to all debt obligations and creditors of the issuer, and convertible
preferred stocks may be subordinated to other preferred stock of the same
issuer.
SHORT SELLING OF SECURITIES. In a short sale of securities, a Fund sells stock
which it does not own, making delivery with securities "borrowed" from a broker.
The Fund is then obligated to replace the security borrowed by purchasing it at
the market price at the time of replacement. This price may or may not be less
than the price at which the security was sold by the Fund. Until the security is
replaced, the Fund is required to pay the lender any dividends or interest which
accrue during the period of the loan. In order to borrow the security, the Fund
may also have to pay a fee which would increase the cost of the security sold.
The proceeds of the short sale will be retained by the broker, to the extent
necessary to meet margin requirements, until the short position is closed out.
A Fund will incur a loss as a result of the short sale if the price of
the security increases between the date of the short sale and the date on which
the Fund replaces the borrowed security. A Fund will realize a gain if the
security declines in price between those two dates. The amount of any gain will
be decreased and the amount of any loss will be increased by any interest the
Fund may be required to pay in connection with the short sale.
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. A Fund must deposit in a segregated account an amount of cash or liquid
assets equal to the difference between (a) the market value of securities sold
short at the time that they were sold short and (b) the value of the collateral
deposited with the broker in connection with the short sale (not including the
proceeds from the short sale). While the short position is open, the Fund must
maintain on a daily basis the segregated account at such a level that (1) the
amount deposited in it plus the amount deposited with the broker as collateral
equals the current market value of the securities sold short and (2) the amount
deposited in it plus the amount deposited with the broker as collateral is not
less than the market value of the securities at the time they were sold short.
A 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." The Funds do not intend to engage in short sales against
the box for investment purposes. A 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), or when the Fund wants to sell the security
at an attractive current price, but also wishes to defer recognition of gain or
loss for U.S. federal income tax purposes and for purposes of satisfying certain
tests applicable to regulated investment companies under the Code. 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
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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. A Fund may not invest
more than 15% (10% for the Money Market Fund) 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. Unless subsequently registered for sale, these securities can
only be sold in privately negotiated transactions or pursuant to an exemption
from registration. 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
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.
A 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 a 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.
The applicable subadviser or adviser will monitor the liquidity of
restricted securities in the portion of a Fund it manages. In reaching liquidity
decisions, the following factors are considered: (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).
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PRIVATE PLACEMENT COMMERCIAL PAPER. Commercial paper eligible for
resale under Section 4(2) of the Securities Act is offered only to accredited
investors. Rule 506 of Regulation D in the Securities Act of 1933 lists
investment companies as an accredited investor.
Section 4(2) paper not eligible for resale under Rule 144A under the
Securities Act shall be deemed liquid if (1) the Section 4(2) paper is not
traded flat or in default as to principal and interest; (2) the Section 4(2)
paper is rated in one of the two highest rating categories by at least two
NRSROs, or if only NRSRO rates the security, it is rated in one of the two
highest categories by that NRSRO; and (3) the Adviser believes that, based on
the trading markets for such security, such security can be disposed of within
seven days in the ordinary course of business at approximately the amount at
which the Fund has valued the security.
BORROWING. A Fund may borrow money from banks, limited by each Fund's
fundamental investment restriction to 33-1/3% of its total assets (including the
amount borrowed), and may engage in mortgage dollar roll and reverse repurchase
agreements which may be considered a form of borrowing. In addition, a Fund may
borrow up to an additional 5% of its total assets from banks for temporary or
emergency purposes. A Fund will not purchase securities when bank borrowings
exceed 5% of such Fund's total assets. Each Fund expects that its borrowings
will 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. The Funds
have established a line-of-credit ("LOC") with their custodian by which they may
borrow for temporary or emergency purposes. The Funds intend to use the LOC to
meet large or unexpected redemptions that would otherwise force a Fund to
liquidate securities under circumstances which are unfavorable to a Fund's
remaining shareholders.
DERIVATIVE INSTRUMENTS. A Fund's adviser or subadviser 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 a Fund's portfolio or for risk management or for any
other permissible purposes consistent with that Fund's investment objective.
Derivative instruments are securities or agreements whose value is based on the
value of some underlying asset (e.g., a security, currency or index) or the
level of a reference index.
Derivatives generally have investment characteristics that are based
upon either forward contracts (under which one party is obligated to buy and the
other party is obligated to sell an underlying asset at a specific price on a
specified date) or option contracts (under which the holder of the option has
the right but not the obligation to buy or sell an underlying asset at a
specified price on or before a specified date). Consequently, the change in
value of a forward-based derivative generally is roughly proportional to the
change in value of the underlying asset. In contrast, the buyer of an
option-based derivative generally will benefit from favorable movements in the
price of the underlying asset but is not exposed to the corresponding losses
that result from adverse movements in the value of the underlying asset. The
seller (writer) of an option-based derivative generally will receive fees or
premiums but generally is exposed to losses resulting from changes in the value
of the underlying asset. Derivative transactions may include elements of
leverage and, accordingly, the fluctuation of the value of the derivative
transaction in relation to the underlying asset may be magnified.
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, and the Commodity Futures Trading Commission ("CFTC"). In addition, a
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 Fund's
adviser's or 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. 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, as well as, how similar the index is
to the portion of the Fund's assets being hedged in terms of securities
composition.
(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 a Fund entered into a short
hedge because a Fund's adviser or 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, a Fund could
suffer a loss.
(4) As described below, a 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 a Fund's
derivative instruments, see "Tax Status" below.
OPTIONS. A Fund may purchase or write put and call options on
securities and indices, and may purchase options on foreign currencies, 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 a 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
option, it can be expected that
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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 of the
option, 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 a Fund may include European-style
options, which can only be exercised at expiration. This is in contrast to
American-style options which can be exercised at any time prior to the
expiration date of the option.
A Fund may effectively terminate its right or obligation under an
option by entering into a closing transaction. For example, a 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, a 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.
A 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 counterparty (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.
A Fund's ability to establish and close out positions in
exchange-listed options depends on the existence of a liquid market. A 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 counterparty, or by a
transaction in the secondary market if any such market exists. Although a Fund
will enter into OTC options only with counterparties that are expected to be
capable of entering into closing transactions with a Fund, there is no assurance
that such 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, a
Fund might be unable to close out an OTC option position at any time prior to
its expiration.
If a Fund is 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 a 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.
A 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.
Transactions using OTC options (other than purchased options) expose a
Fund to counter party risk. To the extent required by SEC guidelines, a 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
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<PAGE> 32
obligations with a value sufficient at all times to cover its potential
obligations to the extent not covered as provided in (1) above. A 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.
SPREAD TRANSACTIONS. A 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 a 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 a Fund in purchasing covered
spread options is 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 a 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. A 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. A 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. A 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. A Fund will engage in this strategy only when a Fund's adviser
or a subadviser believes it is more advantageous to a Fund than is purchasing
the futures contract.
To the extent required by regulatory authorities, a 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 a Fund to trade in
futures contracts may be limited by the requirements of the Code applicable to a
regulated investment company.
A 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 a Fund's assets that may be at risk with respect to futures activities.
Although techniques other than sales and purchases of futures contracts could be
used to reduce a Fund's exposure to market, currency, or interest rate
fluctuations, such 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
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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, a Fund
realizes a gain; if it is more, a Fund realizes a loss. Conversely, if the
offsetting sale price is more than the original purchase price, a Fund realizes
a gain; if it is less, a Fund realizes a loss. The transaction costs must also
be included in these calculations. There can be no assurance, however, that a
Fund will be able to enter into an offsetting transaction with respect to a
particular futures contract at a particular time. If a Fund is not able to enter
into an offsetting transaction, that Fund will continue to be required to
maintain the margin deposits on the futures contract.
No price is paid by a 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 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 a Fund at
the termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility, a
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 a Fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when a 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 a 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 Funds intend 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 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 a 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, because it 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.
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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. A Fund may enter into interest rate, securities index,
commodity, or security and currency exchange rate swap agreements for any lawful
purpose consistent with such 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. A 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 a Fund, the obligations
of the parties would be exchanged on a "net basis." Consequently, a 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").
A 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 segregated account
consisting of cash or liquid assets.
Whether a Fund's use of swap agreements will be successful in
furthering its investment objective will depend, in part, on a Fund's adviser's
or 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, a 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 a Fund by the Internal Revenue Code may limit a Fund's
ability to use swap agreements. The swaps market is largely unregulated.
A Fund will enter swap agreements only with counterparties that a
Fund's adviser or subadviser reasonably believes are capable of performing under
the swap agreements. If there is a default by the other party to such a
transaction, a 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.
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FOREIGN CURRENCY-RELATED DERIVATIVE STRATEGIES - SPECIAL
CONSIDERATIONS. A Fund may use options and futures and options on futures on
foreign currencies and forward currency contracts to hedge against movements in
the values of the foreign currencies in which a Fund's securities are
denominated. A 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. The Global Equity
Fund may engage in foreign currency exchange transactions to adjust its currency
exposure relative to its benchmark, the MSCI World Equity Index. 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.
A 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, a 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, a 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, a 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.
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, a Fund will normally purchase OTC options on
foreign currency only when a Fund's adviser or subadviser believes a liquid
secondary market will exist for a particular option at any specific time.
FORWARD CURRENCY CONTRACTS. A Fund may enter into 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.
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At or before the maturity of a forward contract, a 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 a 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 a Fund's investments. A currency hedge, for example, should
protect a Yen-denominated bond against a decline in the Yen, but will not
protect a Fund against price decline if the issuer's creditworthiness
deteriorates. Because the value of a 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 a Fund's investments denominated in that currency over time.
A decline in the dollar value of a foreign currency in which a 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, a 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, a 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.
A Fund may enter into foreign currency exchange transactions to hedge
its currency exposure in specific transactions or portfolio positions or, in the
case of the Global Equity Fund, to adjust its currency exposure relative to its
benchmark, the MSCI World Equity Index. Transaction hedging is the purchase or
sale of forward currency with respect to specific receivables or payables of a
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 positions. A 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.
FOREIGN COMMERCIAL PAPER. A 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. A 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
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enables a 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. A 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
Investment Company Act of 1940. The Funds believe 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 other
liquid assets having a value equal to the aggregate principal amount of
outstanding commercial paper of this type.
SECURITIES OF INVESTMENT COMPANIES. As permitted by the Investment Company Act
of 1940, a Fund may invest up to 10% 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 a 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. A Fund will 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 Fund. Some of the
countries in which a 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.
BANK OBLIGATIONS. Bank obligations that may be purchased by a Fund include
certificates of deposit, banker's acceptances and fixed time deposits. A
certificate of deposit is a short-term negotiable certificate issued by a
commercial bank against funds deposited in the bank and is either
interest-bearing or purchased on a discount basis. A bankers' acceptance is a
short-term draft drawn on a commercial bank by a borrower, usually in connection
with an international commercial transaction. The borrower is liable for payment
as is the bank, which unconditionally guarantees to pay the draft at its face
amount on the maturity date. Fixed time deposits are obligations of branches of
U.S. banks or foreign banks which are payable at a stated maturity date and bear
a fixed rate of interest. Although fixed time deposits do not have a market,
there are no contractual restrictions on the right to transfer a beneficial
interest in the deposit to a third party.
Bank obligations may be general obligations of the parent bank or may
be limited to the issuing branch by the terms of the specific obligations or by
government regulation.
FLOATING AND VARIABLE RATE INSTRUMENTS. Floating or variable rate obligations
bear interest at rates that are not fixed, but vary with changes in specified
market rates or indices, such as the prime rate, or at specified intervals.
Certain of the floating or variable rate obligations that may be purchased by
the Funds may carry a demand feature that would permit the holder to tender them
back to the issuer of the instrument or to a third party at par value prior to
maturity.
Some of the demand instruments purchased by a Fund may not be traded in
a secondary market and derive their liquidity solely from the ability of the
holder to demand repayment from the issuer or third party providing credit
support. If a demand instrument is not traded in a secondary market, the Fund
will nonetheless treat the instrument as "readily marketable" for the purposes
of its investment restriction limiting investments in illiquid securities unless
the demand feature has a notice period of more than seven days in which case the
instrument will be characterized as "not readily marketable" and therefore
illiquid.
Such obligations include variable rate master demand notes, which are
unsecured instruments issued pursuant to an agreement between the issuer and the
holder that permit the indebtedness thereunder to vary and to provide for
periodic adjustments in the interest rate. A Fund will limit its purchases of
floating and variable rate obligations to those of the same quality as it is
otherwise allowed to purchase. A Fund's adviser or subadviser will monitor on an
ongoing basis the ability of an issuer of a demand instrument to pay principal
and interest on demand.
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<PAGE> 38
A Fund's right to obtain payment at par on a demand instrument could be
affected by events occurring between the date the Fund elects to demand payment
and the date payment is due that may affect the ability of the issuer of the
instrument or third party providing credit support to make payment when due,
except when such demand instruments permit same day settlement. To facilitate
settlement, these same day demand instruments may be held in book entry form at
a bank other than a Fund's custodian subject to a subcustodian agreement
approved by the Fund between that bank and the Fund's custodian.
ZERO COUPON SECURITIES, STEP-COUPON SECURITIES, PAY-IN-KIND BONDS ("PIK BONDS")
AND DEFERRED PAYMENT SECURITIES. Zero coupon securities are debt securities that
pay no cash income but are sold at substantial discounts from their value at
maturity. Step-coupon securities are debt securities that do not make regular
cash interest payments and are sold at a deep discount to their face value. When
a zero coupon security is held to maturity, its entire return, which consists of
the amortization of discount, comes from the difference between its purchase
price and its maturity value. This difference is known at the time of purchase,
so that investors holding zero coupon securities until maturity know at the time
of their investment what the expected return on their investment will be. Zero
coupon securities may have conversion features. PIK bonds pay all or a portion
of their interest in the form of debt or equity securities. Deferred payment
securities are securities that remain zero coupon securities until a
predetermined date, at which time the stated coupon rate becomes effective and
interest becomes payable at regular intervals. Deferred payment securities are
often sold at substantial discounts from their maturity value.
Zero coupon securities, PIK bonds and deferred payment securities tend
to be subject to greater price fluctuations in response to changes in interest
rates than are ordinary interest-paying debt securities with similar maturities.
The value of zero coupon securities appreciates more during periods of declining
interest rates and depreciates more during periods of rising interest rates than
ordinary interest-paying debt securities with similar maturities. Zero coupon
securities, PIK bonds and deferred payment securities may be issued by a wide
variety of corporate and governmental issuers. Although these instruments are
generally not traded on a national securities exchange, they are widely traded
by brokers and dealers and, to such extent, will not be considered illiquid for
the purposes of a Fund's limitation on investments in illiquid securities.
Current federal income tax law requires the holder of a zero coupon
security, certain PIK bonds, deferred payment securities and certain other
securities acquired at a discount (such as Brady Bonds) to accrue income with
respect to these securities prior to the receipt of cash payments. Accordingly,
to avoid liability for federal income and excise taxes, a Fund may be required
to distribute income accrued with respect to these securities and may have to
dispose of portfolio securities under disadvantageous circumstances in order to
generate cash to satisfy these distribution requirements.
LOAN PARTICIPATIONS AND ASSIGNMENTS. Loan Participations typically will result
in a Fund having a contractual relationship only with the lender, not with the
borrower. A Fund will have the right to receive payments of principal, interest
and any fees to which it is entitled only from the lender selling the
Participation and only upon receipt by the lender of the payments from the
borrower. In connection with purchasing Loan Participations, a Fund generally
will have no right to enforce compliance by the borrower with the terms of the
loan agreement relating to the loan, nor any rights of set-off against the
borrower, and a Fund may not benefit directly from any collateral supporting the
loan in which it has purchased the Participation. As a result, a Fund will
assume the credit risk of both the borrower and the lender that is selling the
Participation. In the event of the insolvency of the lender selling a
Participation, a Fund may be treated as a general creditor of the lender and may
not benefit from any set-off between the lender and the borrower. A Fund will
acquire Loan Participations only if the lender interpositioned between the Fund
and the borrower is determined by the applicable subadviser to be creditworthy.
When a Fund purchases Assignments from lenders, the Fund will acquire direct
rights against the borrower on the loan, except that under certain circumstances
such rights may be more limited than those held by the assigning lender.
A Fund may have difficulty disposing of Assignments and Loan
Participations. Because the market for such instruments is not highly liquid,
the Fund anticipates that such instruments could be sold only to
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<PAGE> 39
a limited number of institutional investors. The lack of a highly liquid
secondary market may have an adverse impact on the value of such instruments and
will have an adverse impact on the Fund's ability to dispose of particular
Assignments or Loan Participations in response to a specific economic event,
such as deterioration in the creditworthiness of the borrower.
In valuing a Loan Participation or Assignment held by a Fund for which
a secondary trading market exists, the Fund will rely upon prices or quotations
provided by banks, dealers or pricing services. To the extent a secondary
trading market does not exist, the Fund's Loan Participations and Assignments
will be valued in accordance with procedures adopted by the Board of Trustees,
taking into consideration, among other factors: (i) the creditworthiness of the
borrower under the loan and the lender; (ii) the current interest rate; period
until next rate reset and maturity of the loan; (iii) recent prices in the
market for similar loans; and (iv) recent prices in the market for instruments
of similar quality, rate, period until next interest rate reset and maturity.
MORTGAGE DOLLAR ROLLS AND REVERSE REPURCHASE AGREEMENTS. A Fund may engage in
reverse repurchase agreements to facilitate portfolio liquidity, a practice
common in the mutual fund industry, or for arbitrage transactions discussed
below. In a reverse repurchase agreement, a Fund would sell a security and enter
into an agreement to repurchase the security at a specified future date and
price. A Fund generally retains the right to interest and principal payments on
the security. Since a Fund receives cash upon entering into a reverse repurchase
agreement, it may be considered a borrowing (see "Borrowing"). When required by
guidelines of the SEC, a Fund will set aside permissible liquid assets in a
segregated account to secure its obligations to repurchase the security. At the
time a Fund enters into a reverse repurchase agreement, it will establish and
maintain a segregated account with an approved custodian containing liquid
securities having a value not less than the repurchase price (including accrued
interest). The assets contained in the segregated account will be
marked-to-market daily and additional assets will be placed in such account on
any day in which the assets fall below the repurchase price (plus accrued
interest). A Fund's liquidity and ability to manage its assets might be affected
when it sets aside cash or portfolio securities to cover such commitments.
Reverse repurchase agreements involve the risk that the market value of the
securities retained in lieu of sale may decline below the price of the
securities the Fund has sold but is obligated to repurchase. In the event the
buyer of securities under a reverse repurchase agreement files for bankruptcy or
becomes insolvent, such buyer or its trustee or receiver may receive an
extension of time to determine whether to enforce the Fund's obligation to
repurchase the securities, and the Fund's use of the proceeds of the reverse
repurchase agreement may effectively be restricted pending such determination.
Reverse repurchase agreements are considered to be borrowings under the
Investment Company Act of 1940.
Mortgage dollar rolls are arrangements in which a Fund would sell
mortgage-backed securities for delivery in the current month and simultaneously
contract to purchase substantially similar securities on a specified future
date. While a Fund would forego principal and interest paid on the
mortgage-backed securities during the roll period, the Fund would be compensated
by the difference between the current sales price and the lower price for the
future purchase as well as by any interest earned on the proceeds of the initial
sale. A Fund also could be compensated through the receipt of fee income
equivalent to a lower forward price. At the time the Fund would enter into a
mortgage dollar roll, it would set aside permissible liquid assets in a
segregated account to secure its obligation for the forward commitment to buy
mortgage-backed securities. Mortgage dollar roll transactions may be considered
a borrowing by the Funds. (See "Borrowing")
Mortgage dollar rolls and reverse repurchase agreements may be used as
arbitrage transactions in which a Fund will maintain an offsetting position in
investment grade debt obligations or repurchase agreements that mature on or
before the settlement date on the related mortgage dollar roll or reverse
repurchase agreements. Since a Fund will receive interest on the securities or
repurchase agreements in which it invests the transaction proceeds, such
transactions may involve leverage. However, since such securities or repurchase
agreements will be high quality and will mature on or before the settlement date
of the mortgage dollar roll or reverse repurchase agreement, the Fund's adviser
or subadviser believes that such
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<PAGE> 40
arbitrage transactions do not present the risks to the Funds that are associated
with other types of leverage.
TEMPORARY DEFENSIVE POSITIONS. In response to economic, political or unusual
market conditions, each Fund may invest up to 100% of its assets in cash or
money market obligations. In addition, a Fund may have, from time to time,
significant cash positions until suitable investment opportunities are
available.
INVESTMENT RESTRICTIONS FOR THE FUNDS
The following are fundamental investment restrictions for each of the Funds
which cannot be changed without the authorization of the majority of the
outstanding shares of the Fund for which a change is proposed. The vote of the
majority of the outstanding securities means the vote of (A) 67% or more of the
voting securities present at such meeting, if the holders of more than 50% of
the outstanding voting securities are present or represented by proxy or (B) a
majority of the outstanding securities, whichever is less.
INVESTMENT RESTRICTIONS FOR: STRATEGIC VALUE FUND, EQUITY INCOME FUND, HIGH
INCOME BOND FUND, BALANCED FUND, MULTI SECTOR BOND FUND, SMALL CAP VALUE FUND,
SELECT ADVISERS SMALL CAP GROWTH FUND, GLOBAL EQUITY FUND, AND SELECT ADVISERS
MID CAP FUND
A Fund:
May not 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% of 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.
May (i) borrow money from banks and (ii) make other investments or
engage in other transactions permissible under the Investment Company
Act of 1940 (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 (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.
May not issue senior securities, except as permitted under the 1940
Act.
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.
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.
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<PAGE> 41
May not purchase or sell commodities or commodities contracts, except
to the extent disclosed in the current Prospectus of such Fund.
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.
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.
INVESTMENT RESTRICTIONS FOR: STRATEGIC GROWTH FUND, SMALL COMPANY FUND AND
INCOME FUND
A Fund:
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
(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). A 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.
May not issue senior securities, except as permitted under the 1940
Act.
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.
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.
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.
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.
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<PAGE> 42
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.
INVESTMENT RESTRICTIONS FOR: TOTAL RETURN FUND, CAPITAL APPRECIATION FUND,
GOVERNMENT BOND FUND, MONEY MARKET FUND
A Fund:
May not 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.
May not 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.
May not 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.
May not 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% of 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 instrumantalities. 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.
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.
May not purchase or sell commodities or commodities contracts, except
to the extent disclosed in the current Prospectus of such Fund.
May not issue securities except as permitted by the Investment Company
Act of 1940.
The following are the NON-FUNDAMENTAL operating policies of the Strategic Growth
Fund, Strategic Value Fund, Equity Income Fund, High Income Bond Fund, Balanced
Fund, Multi Sector Bond Fund, Small Cap Value Fund, Select Advisers Small Cap
Growth Fund, Global Equity Fund, Select Advisers Mid Cap Fund, Small Company
Fund and Income Fund, which MAY BE CHANGED by the Board of Trustees of the Trust
WITHOUT SHAREHOLDER APPROVAL:
Each Fund may not:
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Sell securities short (except for the Mid Cap Fund), 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
sales 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. The Mid Cap Fund may only sell securities short in accordance
with the description contained in its Prospectus.
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.
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.
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.
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.
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:
Make short sales of securities.
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.
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 thereunder, or pursuant to any exemption therefrom.
The investment objectives of each of the Funds is not fundamental and may be
changed by the Board of Trustees without shareholder approval.
PORTFOLIO TURNOVER. The portfolio turnover rate for each Fund is calculated by
dividing the lessor of purchases or sales of portfolio securities for the year
by the monthly average value of the portfolio securities, excluding securities
whose maturities at the time of purchase were one year or less. The portfolio
turnover rate for the year ended December 31, 1998 and the period ended December
31, 1997 were as follows:
- -------------------------------------------------------------------------------
FUND 1998 1997
- -------------------------------------------------------------------------------
Strategic Growth* 369.83% 27.32%
- -------------------------------------------------------------------------------
Strategic Value* 68.65% 5.38%
- -------------------------------------------------------------------------------
Equity Income* 49.12% 14.52%
- -------------------------------------------------------------------------------
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- -------------------------------------------------------------------------------
High Income Bond* 24.25% 7.37%
- -------------------------------------------------------------------------------
Balanced* 137.35% 0.19%
- -------------------------------------------------------------------------------
Multi Sector Bond* 287.69% 48.90%
- -------------------------------------------------------------------------------
Small Cap Value* 283.65% 8.38%
- -------------------------------------------------------------------------------
Small Cap Growth** N/A N/A
- -------------------------------------------------------------------------------
Global Equity* 59.01% 9.32%
- -------------------------------------------------------------------------------
Select Advisers Mid Cap* 119.37% 7.81%
- -------------------------------------------------------------------------------
Small Company 141.27% 134.38%
- -------------------------------------------------------------------------------
Income*** 157.21% N/A
- -------------------------------------------------------------------------------
Total Return 17.13% 13.85%
- -------------------------------------------------------------------------------
Capital Appreciation 10.67% 10.88%
- -------------------------------------------------------------------------------
Government Bond 32.03% 68.61%
- -------------------------------------------------------------------------------
* Commenced operations on October 31,1997.
** Had no operations prior to May 1,1999.
*** Commenced operations on January 20, 1998.
High portfolio turnover rate will generally result in higher brokerage expenses.
INSURANCE LAW RESTRICTIONS - In connection with the Trust's agreement to sell
shares to the Accounts, Villanova Mutual Fund Capital Trust ("VMF") and the
insurance companies may enter into agreements, required by certain state
insurance departments, under which VMF 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 separate 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.
MAJOR SHAREHOLDERS
As of April 19, 1999, separate accounts of Nationwide Life Insurance
Company had shared voting and investment power over 97.9% of the Balanced Fund
shares, 97.6% of the Multi Sector Bond Fund shares, 98.4% of the Small Cap Value
Fund shares, 76.7% of the Global Equity Fund shares, 72.8% of the Select
Advisors Mid Cap Fund shares, 91.2% of the Strategic Growth Fund shares, 93.2%
of the Strategic Value Fund shares, 93.2% of the Equity Income Fund shares,
88.4% of the High Income Bond Fund shares, 99.1% of the Small Company Fund
shares, 100% of the Total Return Fund shares, 100% of the Government Bond Fund
shares, 99.8% of the Capital Appreciation Fund shares, and 100% of the Money
Market Fund shares, respectively. As of April 19, 1999, Nationwide Life
Insurance Company owned beneficially 2.1% of the Balanced Fund shares, 2.4% of
the Multi Sector Bond Fund shares, 1.6% of the Small Cap Value Fund shares,
23.3% of the Global Equity Fund shares, 27.2% of the Select Advisors Mid Cap
Fund shares, 8.8% of the Strategic Growth Fund shares, 6.8% of the Strategic
Value Fund shares, 6.8% of the Equity Income Fund shares, 11.6% of the High
Income Bond Fund shares, and 32.3% of the Income Fund shares. As of April 19,
1999, the following portfolios of Nationwide Asset Allocation Trust had shared
voting and investment power over shares of the Income Fund: Moderately
Aggressive Portfolio, 9.9%, Moderate Portfolio, 19.8%; Moderately Conservative
Portfolio, 12.4%; and Conservative Portfolio, 23.9%. Nationwide Asset Allocation
Trust is a registered investment company advised by Villanova SA Capital Trust,
an affiliate of VMF, and sold to separate accounts of Nationwide Life Insurance
Company.
Nationwide Life Insurance Company, One Nationwide Plaza, Columbus, Ohio
43215 is wholly owned by Nationwide Financial Services, Inc. ("NFS"). NFS, a
holding company, has two classes of common stock outstanding with different
voting rights enabling Nationwide Corporation (the holder of all outstanding
Class B Common Stock) to control NFS. Nationwide Corporation is also a holding
company
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in the Nationwide Insurance Enterprise. All of the common stock of
Nationwide Corporation is held by Nationwide Mutual Insurance Company (95.3%)
and Nationwide Mutual Fire Insurance Company (4.7%), each of which is a mutual
company owned by its policyholders.
As of April 19, 1999, the Trustees and Officers of the Trust as a group
owned beneficially less than 1% of the shares of the Trust.
TRUSTEES AND OFFICERS OF THE TRUST
TRUSTEES AND OFFICERS
The business and affairs of the Trust are managed under the direction of its
board of Trustees. The Board of Trustees sets and reviews policies regarding the
operation of the Trust, and directs the officers to perform the daily functions
of the Trust.
The principal occupations of the Trustees and Officers during the last five
years and their affiliations are:
Dr. John C. Bryant, Trustee, Age 63
411 Oak Street - Suite 306
Cincinnati, Ohio 45219
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.
C. Brent DeVore, Trustee, Age 58
111 N. West Street, Westerville, Ohio 43081
Dr. DeVore is President of Otterbein College.
Sue Doody, Trustee, Age 64
169 East Beck Street
Columbus, Ohio 43206
Ms. Doody is President of Lindey's Restaurant, Columbus, Ohio. She is
an active member of the Greater Columbus Area Chamber of Commerce Board of
Trustees.
Robert M. Duncan, Trustee, Age 71
1397 Haddon Road
Columbus, Ohio 43209
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 43215
Mr. Gasper is Director, President and Chief Operating Officer for
Nationwide Life and Annuity Insurance Company and Nationwide Life
Insurance Company. Prior to that, he was Executive Vice President and
Senior Vice President for the Nationwide Insurance Enterprise.
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<PAGE> 46
Dr. Thomas J. Kerr, IV, Trustee, Age 65
4890 Smoketalk Lane
Westerville, Ohio 43081
Dr. Kerr is President Emeritus of Kendall College. He was formerly
President of Grant Hospital Development Foundation.
Douglas F. Kridler, Trustee, Age 43
55 East State Street
Columbus, Ohio 43215
Mr. Kridler is President of Columbus Association for the Performing
Arts.
Robert J. Woodward, Jr., Trustee*, Vice-Chairman, Age 56
One Nationwide Plaza
Columbus, Ohio 43215
Mr. Woodward is Executive Vice President - Chief Investment Officer for
Nationwide Life and Annuity Insurance Company and Nationwide Life
Insurance Company.
David C. Wetmore, Trustee, Age 50
11495 Sunset Hills Rd - Suite #210, Reston, Virginia 20190
Mr. Wetmore is the Managing Director of The Updata Capital, a venture
capital firm.
James F. Laird, Jr., Treasurer, Age 42
Three Nationwide Plaza
Columbus, Ohio 43215
Mr. Laird is Vice President and General Manager of Nationwide Advisory
Services, Inc., the Distributor. He was formerly Treasurer of
Nationwide Advisory Services, Inc.
Elizabeth A. Davin, Secretary, Age 34
One Nationwide Plaza
Columbus, Ohio 43215
Ms. Davin is a member of the Office of General Counsel of the
Nationwide Insurance Enterprise and a partner in Dietrich, Reynolds &
Koogler.
*A Trustee who is an "interested person" of the Trust as defined in the 1940
Act.
Bryant, DeVore, Doody, Duncan, Kerr, Kridler and Wetmore are also
Trustees of Nationwide Mutual Funds and Nationwide Asset Allocation Trust, which
are registered investment companies in the Nationwide fund complex. Gasper and
Wetmore are also Trustees of Nationwide Asset Allocation Trust. Laird and Davin
are also officers of Nationwide Mutual Funds and Nationwide Asset Allocation
Trust.
42
<PAGE> 47
AFFILIATED PERSONS OF THE TRUST AND THE ADVISER - Mr. Joseph J. Gasper, Trustee
and Chairman of the Trust, is also Vice Chairman of the Board of Directors of
VMF. Mr. Robert J. Woodward, Jr., Trustee and Vice-Chairman of the Trust, is
also Executive Vice President - Chief Investment Officer of VMF. Mr. Christopher
A. Cray, Assistant Treasurer of the Trust, is also Treasurer of VMF.
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, 1998, and the aggregate compensation paid to
each disinterested Trustee during the fiscal year ended December 31, 1998 by all
thirty-six registered investment companies to which VMF or its affiliates
provide 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.
COMPENSATION TABLE
FISCAL YEAR ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------
Total
Compensation from
Aggregate the Nationwide
Compensation Fund Complex
Disinterested Trustees From the Trust Including the Trust
---------------------- -------------- -------------------
------------------------------------------------------------------------------------
<S> <C> <C>
Dr. John C. Bryant $8,000 $24,000
------------------------------------------------------------------------------------
C. Brent DeVore $4,500 $16,000
------------------------------------------------------------------------------------
Sue Doody $8,000 $21,000
------------------------------------------------------------------------------------
Robert M. Duncan $8,000 $24,000
------------------------------------------------------------------------------------
Dr. Thomas J. Kerr, IV $8,000 $24,000
------------------------------------------------------------------------------------
Douglas F. Kridler $8,000 $21,000
------------------------------------------------------------------------------------
David C. Wetmore $4,500 $16,000
------------------------------------------------------------------------------------
</TABLE>
PERFORMANCE ADVERTISING
The Funds may use past performance in advertisements, sales literature,
and their prospectuses, including calculations of average annual total return,
30-day yield, and seven-day yield., as described below.
CALCULATING YIELD AND TOTAL RETURN
CALCULATING YIELD - THE MONEY MARKET FUND
Any current yield quotations for the Money Market Fund, subject to Rule
482 under the Securities Act of 1933, 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
43
<PAGE> 48
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, 1998, the Fund's seven-day current yield
was 4.84%. 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, 1998, was 4.96%.
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 of 1933. 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, five, and ten
year period ended December 31, 1998, and the period from inception to December
31, 1998, are shown below.
<TABLE>
<CAPTION>
10 Years
Fund 1 Year 5 years or Life
---- ------ ------- -------
<S> <C> <C> <C>
Strategic Growth Fund* 14.59% N/A 14.53%
Strategic Value Fund* 0.39% N/A 1.74%
Equity Income Fund* 15.13% N/A 14.64%
High Income Bond Fund* 5.80% N/A 7.04%
Balanced Fund* 8.07% N/A 8.26%
Multi Sector Bond Fund* 2.60% N/A 3.16%
</TABLE>
44
<PAGE> 49
<TABLE>
<S> <C> <C> <C>
Small Cap Value Fund* -3.06% N/A -4.00%
Global Equity Fund* 19.14% N/A 17.47%
Select Advisers Mid Cap Fund*
10.81% N/A 8.91%
Select Advisers Small Cap Growth -- --
Fund****
Small Company Fund** 1.01% N/A 17.34%
Income Fund*** N/A N/A 7.13%
Total Return Fund 18.07% 19.43% 15.44%
Capital Appreciation Fund 29.96% 23.10% 19.32%
Government Bond Fund 8.91% 7.27% 9.35%
</TABLE>
* These Funds commenced operations on October 31, 1997.
** This Fund commenced operations on October 23, 1995.
*** This Fund commenced operations on January 20, 1998.
****Operations for the Select Advisers Small Cap Growth Fund will commence on or
about May 1, 1999.
Certain Funds 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, and annualizing the
results, assuming reinvestment of all dividends and distributions. This yield
formula uses the average number of share 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 uniformly calculated yields for the 30 day period ended
December 31, 1998 were as follows:
<TABLE>
<CAPTION>
Fund 30-day yield
---- ------------
<S> <C>
High Income Bond Fund 8.57%
Balanced Fund 3.71%
Multi Sector Bond Fund 6.58%
Government Bond Fund 5.00%
</TABLE>
INVESTMENT ADVISORY AND OTHER SERVICES
Villanova Mutual Fund Capital Trust ("VMF") oversees the
management of each of the Funds pursuant to Investment Advisory Agreements with
the Trust (the "Investment Advisory Agreements").
45
<PAGE> 50
Pursuant to the Investment Advisory Agreements, VMF either provides portfolio
management for the Funds directly or hires and monitors the subadvisers who are
responsible for daily portfolio management. VMF pays the compensation of the
Trustees affiliated with VMF. The officers of the Trust receive no compensation
from the Trust. VMF also pays all expenses incurred by it in providing service
under the Investment Advisory Agreements, other than the cost of investments
(including brokerage commissions and other transaction costs).
The Investment Advisory Agreements also provide that VMF shall not
be liable for any act or omission in providing advisory services, or for any
loss arising out of any investment, unless VMF has acted with willful
misfeasance, bad faith, or gross negligence in the performance of its duties, or
by reason ofVMF's reckless disregard of its obligations and duties under the
Agreements. After an initial two-year period, the Investment Advisory Agreements
must be approved each year by the Trust's board of trustees or by shareholders
in order to continue. Each Investment Advisory Agreement terminates
automatically if it is assigned. They may be terminated without penalty by vote
of a majority of the outstanding voting securities, or by either party, on not
less than 60 days written notice.
VMF, a Delaware business trust, is a wholly owned subsidiary of
Villanova Capital, Inc., 97% of the common stock of which is owned by Nationwide
Financial Services, Inc. (NFS). NFS, a holding company, has two classes of
common stock outstanding with different voting rights enabling Nationwide
Corporation to control NFS. Nationwide Corporation, is also a holding company in
the Nationwide Insurance Enterprise. All of the common stock of Nationwide
Corporation is held by Nationwide Mutual Insurance Company (95.3%) and
Nationwide Mutual Fire Insurance Company (4.7%), each of which is a mutual
company owned by its policyholders.
Subject to the supervision of VMF and the Trustees, each
subadviser manages a Fund's assets in accordance with such Fund's investment
objective and policies. Each subadviser shall make investment decisions for such
Fund, and in connection with such investment decisions, shall place purchase and
sell orders for securities.
Each subadviser provides investment advisory services to one or
more Funds pursuant to a Subadvisory Agreement. Each of the Subadvisory
Agreements specifically provides that the subadviser 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
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. After an initial two-year period, each
Subadvisory Agreement must be approved each year by the Trust's board of
trustees or by shareholders in order to continue. 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 not less than 60 days written notice.
Prior to September 1, 1999, Nationwide Advisory Services, Inc. ("NAS")
served as the investment adviser to the Funds and paid fees to the subadvisers
pursuant to the Funds' Subadvisory Agreements. Effective September 1, 1999, the
investment advisory services previously performed for the Funds (except the
Nationwide Select Advisers Mid Cap Fund) by NAS were transferred to Villanova
Mutual Fund Capital Trust ("VMF"), an affiliate of NAS and an indirect
subsidiary of Nationwide Financial Services, Inc. The investment advisory
services for the Nationwide Select Advisers Mid Cap Fund will be transferred
from NAS to VMF effective on or about September 27, 1999. VMF assumed all
rights and responsibilities performed by NAS, including the supervision and
monitoring of each Funds' subadviser(s), and the Fund's subadviser(s) continue
to manage the Fund after the transfer to VMF. After the transfer, there will be
no change in the fees charged for investment advisory services to each of
46
<PAGE> 51
the Funds.
The following is a summary of the investment advisory fees paid
and the subadvisory arrangements for each Fund.
TOTAL RETURN FUND, CAPITAL APPRECIATION FUND, GOVERNMENT BOND FUND AND MONEY
MARKET FUND. Prior to November 1, 1997, NAS received a fee computed and paid
monthly at the annual rate equal to .50% of the average daily net assets of each
Fund.
As of November 1, 1997 (paid to VMF effective September 1,
1999), the following are the advisory fees 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 then $2 billion
0.45% on assets of $2 billion and more but less then $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 then $5 billion
0.34% for assets of $5 billion and more
</TABLE>
VMF has agreed to waive advisory fees and, if necessary, to
reimburse expenses in order to limit total annual Fund operating expenses to
0.78% on the Total Return Fund, 0.80% on the Capital Appreciation Fund, 0.66% on
the Government Bond Fund and 0.55% on the Money Market Fund until at least
December 31, 1999.
For the years ended December 31, 1998, 1997 and 1996, NAS received
fees in the following amounts: Total Return Fund $12,401,821, $7,903,818 and
$4,851,676, respectively; Capital Appreciation Fund, $4,402,924, $1,759,412 and
$684,932, respectively; Government Bond Fund, $3,015,171, $2,231,930 and
$2,225,962, respectively; and Money Market Fund $5,043,088, $4,969,345 and
$4,518,925, respectively.
EQUITY INCOME FUND
- ------------------
Under the terms of its Investment Advisory Agreement, the Equity
Income Fund pays to VMF a fee at the annual rate of 0.80% of the Fund's average
daily net assets. VMF has agreed to waive advisory fees and, if necessary,
reimburse expenses in order to limit total annual Fund operating expenses to
0.95% until at least December 31, 1999. For the fiscal year ended December 31,
1998, NAS was paid $46,531 net of waivers in the amount of $16,475.
Federated Investment Counseling ("Federated") is the subadviser of
the Fund. For the investment management services it provides to the Fund,
Federated receives an annual fee from VMF in the amount of 0.40% on assets up to
$50 million, 0.25% on assets of $50 million and more but less than $250
47
<PAGE> 52
million, 0.20% on assets of $250 million and more but less than $500 million,
and 0.15% on assets of $500 million and more. These fees are calculated at an
annual rate based upon the Fund's average daily net assets. For the period
October 31, 1997 (commencement of operations) through December 31, 1997, NAS
paid $842 in fees to Federated. For the fiscal year ended December 31, 1998, NAS
paid Federated $31,503.
Federated, a Delaware business trust organized on April 11, 1989
is a registered investment adviser under the Investment Advisers Act of 1940. It
is a subsidiary of Federated Investors, Inc. Federated and other subsidiaries of
Federated Investors, Inc. serve as investment advisers to an open number of
investment companies and private accounts. Certain other subsidiaries also
provide administrative services to a number of investment companies.
HIGH INCOME BOND FUND
- ---------------------
Under the terms of its Investment Advisory Agreement, the High
Income Bond Fund pays to VMF a fee at the annual rate of .80% of the Fund's
average daily net assets. VMF has agreed to waive advisory fees and, if
necessary, reimburse expenses in order to limit total annual Fund operating
expenses to 0.95% until at least December 31, 1999. For the period October 31,
1997 (commencement of operations) through December 31, 1997, NAS waived all
advisory fees in the amount of $7,374. For the fiscal year ended December 31,
1998, NAS was paid $126,140 net of waivers in the amount of $32,820.
Federated Investment Counseling is the subadviser of the Fund. For
the investment management services it provides to the Fund, Federated receives
an annual fee from VMF in the amount of 0.40% on assets up to $50 million, 0.25%
on assets of $50 million and more but less than $250 million, 0.20% on assets of
$250 million and more but less than $500 million, and 0.15% on assets of $500
million and more. These fees are calculated at an annual rate based upon the
Fund's average daily net assets. Additional information about Federated is
included above. For the period October 31, 1997 (commencement of operations)
through December 31, 1997, NAS paid $3,687 in fees to Federated. For the fiscal
year ended December 31, 1998, NAS paid Federated $79,480.
GLOBAL EQUITY FUND
- ------------------
Under the terms of its Investment Advisory Agreement the Global
Equity Fund pays to VMF a fee at the annual rate of 1.00% of the Fund's average
daily net assets. VMF has agreed to waive advisory fees and, if necessary,
reimburse expenses in order to limit total annual Fund operating expenses to
1.20% until at least December 31, 1999. For the period October 31, 1997
(commencement of operations) through December 31, 1997, NAS waived all advisory
fees in the amount of $8,799. For the fiscal year ended December 31, 1998, NAS
was paid $101,488 net of waivers of $32,240.
J.P. Morgan Investment Management Inc. ("J.P. Morgan") is the
subadviser of the Fund. For the investment management services it provides to
the Fund, J.P. Morgan receives an annual fee from VMF in an amount equal to
0.60% on assets up to $50 million and 0.55% on assets of $50 million and over.
These fees are calculated at an annual rate based on the Fund's average daily
net assets. For the period October 31, 1997 (commencement of operations) through
December 31, 1997, NAS paid $5,279 in fees to, J. P. Morgan. For the fiscal year
ended December 31, 1998, NAS paid J.P. Morgan $80,237.
J.P. Morgan is a wholly owned subsidiary of J.P. Morgan & Co.
Incorporated, a bank holding company organized under the laws of Delaware. J.P.
Morgan offers a wide range of investment management services and acts as
investment adviser to corporate and institutional clients. J.P. Morgan uses a
sophisticated, disciplined, collaborative process for managing all asset
classes. As of December 31, 1998, J.P. Morgan and its affiliates had assets
under management of approximately $308 billion, including approximately $11.6
billion in global equity portfolios.
48
<PAGE> 53
SELECT ADVISERS MID CAP FUND
- ----------------------------
Under the terms of its Investment Advisory Agreement the Fund pays
to NAS a fee at the annual rate of 1.05% of the Fund's average daily net assets.
NAS has agreed to waive advisory fees and, if necessary, reimburse expenses in
order to limit total annual Fund operating expenses to 1.20% until at least
December 31, 1999. For the period October 31, 1997 (commencement of operations)
through December 31, 1997, NAS waived all advisory fees in the amount of $5,371.
For the fiscal year ended December 31, 1998, NAS was paid $50,235 net of waivers
of $24,305.
NAS has selected three subadvisers, each of whom will each manage
part of the Fund's portfolio. Each subadviser receives an annual fee from NAS in
an amount equal to 0.65% on assets up to $50 million managed by such subadviser
and 0.50% on assets of $50 million and more managed by a subadviser. For the
period October 31, 1997 (commencement of operations) through December 31, 1997,
NAS paid $3,325 in fees to the subadvisers. For the fiscal year ended December
31, 1998, NAS paid the subadvisers $46,144.
The Select Advisers Mid Cap Fund's subadvisers are:
- First Pacific Advisors, Inc. ("First Pacific")
- Pilgrim Baxter & Associates, Ltd. ("Pilgrim Baxter")
- Rice, Hall, James & Associates ("Rice Hall")
Subject to the supervision of NAS and the Trustees, the
subadvisers each manage separate portions 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 investment decisions shall
place purchase and sell orders for securities. No subadviser shall have any
investment responsibility for any portion of the Fund's assets not allocated to
it by VMF for investment management.
Each of First Pacific, Pilgrim Baxter and Rice Hall is wholly
owned by United Asset Management Corporation ("UAM"), a NYSE-listed holding
company organized to acquire and own firms that provide investment advisory
services primarily for institutional clients. First Pacific is an indirect
wholly-owned subsidiary of UAM. Pilgrim Baxter and Rice Hall are each direct
wholly-owned subsidiaries of UAM. UAM's corporate headquarters are located at
One International Place, Boston 02110.
Under the terms of its Investment Advisory Agreement the Fund pays
to NAS a fee at the annual rate of 1.05% of the Fund's average daily net assets.
NAS has agreed to waive advisory fees and, if necessary, reimburse expenses in
order to limit total annual Fund operating expenses to 1.20% until at least
December 31, 1999. For the period October 31, 1997 (commencement of operations)
through December 31, 1997, NAS waived all advisory fees in the amount of $5,371.
For the fiscal year ended December 31, 1998, NAS was paid $50,235 net of waivers
of $24,305.
BALANCED FUND
- -------------
Under the terms of its Investment Advisory Agreement, the Balanced
Fund pays to VMF a fee at the annual rate of 0.75% of the Fund's average daily
net assets. VMF has agreed to waive advisory fees and, if necessary, reimburse
expenses in order to limit total annual Fund operating expenses to 0.90% until
at least December 31, 1999. For the period October 31, 1997 (commencement of
operations) through December 31, 1997, NAS waived all advisory fees in the
amount of $1,605. For the fiscal year ended December 31, 1998, NAS was paid
$131,136 net of waivers of $12,162.
Salomon Brothers Asset Management Inc. ("SBAM") is the subadviser
of the Fund. For the investment management services it provides to the Fund,
SBAM receives an annual fee from VMF in an amount equal to 0.35% on assets up to
$150 million, 0.30% on assets of $150 million and more but less than $500
million, and 0.25% on assets of $500 million and more. These fees are calculated
as an annual rate
49
<PAGE> 54
based upon the Fund's average daily net assets. For the period October 31, 1997
(commencement of operations) through December 31, 1997, NAS paid $749 in fees to
SBAM. For the fiscal year ended December 31, 1998, NAS paid SBAM $66,872.
SBAM is a wholly owned subsidiary of Salomon Brothers Holding
Company Inc, which is in turn wholly owned by Salomon Smith Barney Holdings,
Inc. which is, in turn, wholly owned by Citigroup, Inc. SBAM was incorporated in
1987 and together with affiliates in London, Frankfurt, Tokyo and Hong Kong,
provides a broad range of fixed-income and equity investment advisory services
to various individuals and institutional clients located throughout the world,
and serves as investment adviser to various investment companies. As of December
31, 1998, SBAM and its worldwide investment advisory affiliates managed
approximately $29 billion of assets.
MULTI SECTOR BOND FUND
- ----------------------
Under the terms of its Investment Advisory Agreement, the Multi
Sector Bond Fund pays to VMF a fee at the annual rate of 0.75% of the Fund's
average daily net assets. VMF has agreed to waive advisory fees and, if
necessary, reimburse expenses in order to limit total annual Fund operating
expenses to 0.90% until at least December 31, 1999. For the period October 31,
1997 (commencement of operations) through December 31, 1997, NAS waived all
advisory fees in the amount of $1,724. For the fiscal year ended December 31,
1998, NAS was paid $132,978 net of waivers of $11,628.
Salomon Brothers Asset Management is the subadviser of the Fund.
For the investment management services it provides to the Fund, SBAM receives an
annual fee from VMF in the amount of 0.35% on assets up to $50 million, 0.30% on
assets of $50 million and more but less than $200 million, 0.25% on assets of
$200 million and more but less than $500 million, and 0.20% on assets of $500
million and more. These fees are calculated at an annual rate based upon the
Fund's average daily net assets. For the period October 31, 1997 (commencement
of operations) through December 31, 1997, NAS paid $805 in fees to SBAM. For the
fiscal year ended December 31, 1998, NAS paid SBAM $67,483.
In connection with SBAM's service as investment manager to the
Multi Sector Bond Fund, SBAM has entered into a subadvisory agreement with its
London based affiliate Salomon Brothers Asset Management Limited ("SBAM
Limited") pursuant to which SBAM has delegated to SBAM Limited responsibility
for management of the Fund's investments in non dollar-denominated debt
securities and currency transactions. SBAM Limited is compensated by SBAM at no
additional expense to the Fund. Like SBAM, SBAM Limited is an indirect,
wholly-owned subsidiary of Citigroup, Inc.
SMALL CAP VALUE FUND
- --------------------
Under the terms of its Investment Advisory Agreement, the Small
Cap Value Fund pays to VMF a fee at the annual rate of 0.90% of the Fund's
average daily net assets. VMF has agreed to waive advisory fees and, if
necessary, reimburse expenses in order to limit total annual Fund operating
expenses to 1.05% until at least December 31, 1999. For the period October 31,
1997 (commencement of operations) through December 31, 1997, NAS waived all
advisory fees in the amount of $2,029. For the fiscal year ended December 31,
1998, NAS was paid $128,764 net of waivers of $57,626.
The Dreyfus Corporation ("Dreyfus"). For the investment management
services it provides to the Small Cap Value Fund, Dreyfus receives an annual fee
from VMF in an amount equal to 0.50% on assets up to $200 million and 0.45% on
assets of $200 million and more. These fees are calculated at an annual rate
based on each Fund's average daily net assets. For the period October 31, 1997
(commencement of operations) through December 31, 1997, NAS paid $1,127 in fees
to the subadviser. For the fiscal year ended December 31, 1998, NAS paid Dreyfus
$103,550.
50
<PAGE> 55
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 Corporation ("Mellon"). As of January 31,
1999, Dreyfus managed or administered approximately $121 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.
Through its subsidiaries, including Dreyfus, Mellon managed more than $334
billion in assets as of September 30, 1998, including approximately $125 billion
in mutual fund assets. As of September 30, 1998, various subsidiaries of Mellon
provided non-investment services, such as custodial or administration services,
for more than $1.6 trillion in assets, including approximately $52 billion in
mutual fund assets.
SELECT ADVISERS SMALL CAP GROWTH FUND
- -------------------------------------
Under the terms of its Investment Advisory Agreement, the Fund pays VMF
a fee at the annual rate of 1.10% of the Fund's average daily net assets. The
Fund commenced operations on or around May 1, 1999 and has not incurred any
investment advisory fees prior to this date. NAS has agreed to waive advisory
fees and, if necessary, to reimburse expenses in order to limit total annual
Fund operating expenses to 1.30% until at least December 31, 1999.
VMF has selected three subadvisers, each of whom will each manage part
of the Fund's portfolio. Each subadviser receives an annual fee from VMF in an
amount equal to 0.60% on assets managed by such subadviser and has not incurred
any subadvisory fees prior to May 1, 1999.
The Select Advisers Small Cap Growth Fund's subadvisers are:
-Franklin Advisers, Inc. ("Franklin")
-Miller Anderson & Sherrerd, LLP ("MAS")
-Neuberger Berman, LLC ("Neuberger Berman")
Subject to the supervision of VMF and the Trustees, the subadvisers
each manage separate portions 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 investment decisions shall place purchase and
sell orders for securities. No subadviser shall have any investment
responsibility for any portion of the Fund's assets not allocated to it by VMF
for investment management.
Franklin is a wholly owned subsidiary of Franklin Resources, Inc., one
of the oldest mutual fund organizations in the U.S. Franklin and its affiliates
act as investment manager to numerous other investment companies and accounts.
Together with its affiliates, Franklin manages over $220 billion in assets as of
December 31, 1998.
MAS is wholly owned by subsidiaries of Morgan Stanley Dean Witter & Co.
and is a division of Morgan Stanley Dean Witter Investment Management ("MSDW
Investment Management") and provides investment advisory services to employee
benefit plans, endowment funds, foundations and other institutional investors.
As of December 31, 1998, MSDW Investment Management managed in excess of $163
billion in assets.
Neuberger Berman and its predecessor firms and affiliates have
specialized in the management of no-load mutual funds since 1950. Neuberger
Berman and its affiliates manage securities accounts that had approximately $55
billion of assets as of December 31, 1998. Neuberger Berman is a member of the
NYSE and other principal exchanges and acts as the Fund's principal broker in
the purchase and sale
51
<PAGE> 56
of their securities for that portion of the Fund's portfolio managed by
Neuberger Berman.
STRATEGIC VALUE FUND AND STRATEGIC GROWTH FUND
- ----------------------------------------------
Under the terms of the Investment Advisory Agreement, each of the
Strategic Value Fund and Strategic Growth Fund pays to VMF a fee at the annual
rate of 0.90% of that Fund's average daily net assets. VMF has agreed to waive
advisory fees and, if necessary, reimburse expenses in order to limit total
annual Fund operating expenses to 1.00% in each Fund until at least December 31,
1999. For the period October 31, 1997 (commencement of operations) through
December 31, 1997, NAS waived all advisory fees for the Strategic Value and
Strategic Growth Fund in the amount of $1,715 and $1,645, respectively. For the
fiscal year ended December 31, 1998, NAS was paid $57,340 for the Strategic
Value Fund and $19,683 for the Strategic Growth Fund net of waivers of $19,318
and $31,214, respectively.
VMF has selected Strong Capital Management, Inc. ("Strong") to be the
subadviser to the Strategic Value Fund and the Strategic Growth Fund. Strong has
subcontracted with Schafer Capital Management, Inc. ("Schafer Capital") to
subadviser the Strategic Value Fund. For the investment management services
provided to each Fund, Strong receives an annual fee from VMF in an amount equal
to 0.50% on assets of each Fund up to $500 million and 0.45% on assets of each
Fund of $500 million and more. These fees are calculated at an annual rate based
on each Fund's average daily net assets. Pursuant to its subcontract with
Schafer Capital, Strong pays Schafer's subadvisory fees. For the period October
31, 1997 (commencement of operations) through December 31, 1997, NAS paid $953
and $914, respectively for the Strategic Value and Strategic Growth Funds, in
fees to the subadviser. For the fiscal year ended December 31, 1998, Strong was
paid $42,588 and $28,276 for the Strategic Value Fund and the Strategic Growth
Fund, respectively.
Strong began conducting business in 1974. Since then, its principal
business has been providing continuous investment supervision for individuals
and institutional accounts. Strong also acts as investment advisor for each of
the mutual funds within the Strong Family of Funds. As of December 31, 1998,
Strong had over $32 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.
Schafer Capital's controlling person and sole shareholder is David K.
Schafer. Mr. Schafer has been in the investment management business for more
than 25 years and founded Schafer Capital in 1981.
SMALL COMPANY FUND
- ------------------
At the time of the transfer of investment advisory services from NAS to
VMF, the management fee that the Fund pays was split between investment advisory
and fund administration agreements, and the revised management fee for the Fund
is 0.93% on the Fund's first $250 million of average daily net assets, 0.95% on
the next $750 million and 0.96% on assets of more than $1 billion, based on the
Fund's average daily net assets. Prior to September 1, 1999, the Fund paid NAS a
fee at the annual rate of 1.00% of the Fund's average daily net assets. VMF has
agreed to waive advisory fees and , if necessary, to reimburse expenses in order
to limit total annual Fund operating expenses to 1.25% until at least December
31, 1999. During the fiscal years ended December 31, 1998, 1997, and 1996, NAS
received advisory fees in the amount of $3,598,194, $2,520,540 and $851,352
respectively.
NAS has selected five subadvisers, each of whom will each manage part
of the Fund's portfolio. Each subadviser receives an annual fee from VMF in an
amount equal to 0.60% on assets managed by a subadviser. During the fiscal years
ended December 31, 1998, 1997 and 1996, the subadvisers were paid $2,119,688,
$1,402,367 and $483,472 by NAS.
52
<PAGE> 57
The Small Company Fund's subadvisers are:
- The Dreyfus Company
- Neuberger Berman LLC
- Strong Capital Management, Inc.
- Lazard Asset Management
- Credit Suisse Asset Management,LLC.
Subject to the supervision of VMF and the Trustees, the subadvisers
each manage separate portions 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 investment decisions shall place purchase and
sell orders for securities. No subadviser shall have any investment
responsibility for any portion of the Fund's assets not allocated to it by VMF
for investment management.
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 Corporation ("Mellon"). As of March 31,
1999, Dreyfus managed or administered approximately $120 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.
Through its subsidiaries, including Dreyfus, Mellon managed more than $389
billion in assets as of December 31, 1998, including approximately $141 billion
in mutual fund assets. As of December 31, 1998, various subsidiaries of Mellon
provided non-investment services, such as custodial or administration services,
for more than $1.9 trillion in assets, including approximately $52 billion in
mutual fund assets.
Neuberger Berman L.L.C. Neuberger Berman also serves as a subadviser 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 $55 billion of
assets as of December 31, 1998. 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. Strong also acts as investment adviser
for each of the mutual funds within the Strong Family of Funds. As of December
31, 1998, Strong had over $32 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 began
serving as one of the subadvisers to the Fund. Lazard, a division of Lazard
Freres & Co. LLC, a New York limited liability company, manages approximately
$62 billion, as of March 31, 1999, 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 has offices in New
York and San Francisco. In addition, Lazard provides asset management services
worldwide through its affiliates in London, Tokyo, Sydney, Frankfurt and Cairo.
Lazard's address is 30 Rockefeller Center, New York, New York 10112.
53
<PAGE> 58
Credit Suisse Asset Management, LLC ("Credit Suisse"). Effective July
6, 1999, one of the subadvisers for the Fund became Credit Suisse as the result
of merger between the parent company of Warburg Pincus Asset Management, Inc.
and Credit Suisse Group. In connection with the transaction, effective July 6,
1999, Warburg Pincus Asset Management, Inc. and Credit Suisse Asset Management,
the U.S.- based asset management affiliate of Credit Suisse Group, reorganized
as Credit Suisse Asset Management, LLC, a subsidiary of Credit Suisse Group.
Credit Suisse is a professional investment advisory firm which provides
investment services to investment companies, employee benefit plans, endowment
funds, foundations and other institutions and individuals. . Credit Suisse Asset
Management LLC, together with its predecessor firms, has been in the investment
advisory business for over 60 years and have assets under management of
approximately $80 billion. Credit Suisse's address is 466 Lexington Avenue, New
York, New York 10017-3147.
INCOME FUND
- -----------
Under the terms of its Investment Advisory Agreement, the Fund pays VMF
a fee at the annual rate of 0.45% of the Fund's average daily net assets. VMF
has voluntarily agreed to waive advisory fees and, if necessary, to reimburse
expenses in order to limit total annual Fund operating expenses to 0.75% of the
Fund's average daily net assets until at least December 31, 1999. The Fund
commenced operations on January 20, 1998. For the period from commencement of
operations to December 31, 1998, NAS received $5,839 in fees net of waivers and
reimbursements of $8,115.
VMF has selected two subadvisers, each of whom will manage part of the
Fund's portfolio. Each subadviser receives an annual fee from VMF 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> <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.
NCM CAPITAL MANAGEMENT GROUP, INC. NCM Capital was founded in 1986 and
serves as one of the Fund's subadvisers. As of December 31, 1998, NCM Capital
had approximately $4.4 billion in assets under management.
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 53.8% ; Justin F. Beckett, Executive Vice
President and director of NCM Capital, owns 21.1%; and American Express Asset
Management owns 25.1% as of May 1, 1999. On or around July 1, 1999, Sloan
Financial Group, Inc. will repurchase the shares owned by American Express Asset
Management; after this transaction is completed, Maceo K. Sloan will own 72% and
Justin F. Beckett will own 28% of Sloan Financial Group, Inc.
SMITH GRAHAM & CO. ASSET MANAGERS, L.P. Smith Graham also services as a
subadviser to the Fund. Its corporate offices are located at 6900 Chase 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
54
<PAGE> 59
mutual fund clients. The firm provides domestic, global and international money
management. As of December 31, 1998, Smith Graham managed approximately $2.3
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 Robecco Group.
Smith Graham & Co., Inc. is wholly owned by Gerald B. Smith and Jamie G. House.
FUND ADMINISTRATION SERVICES
TOTAL RETURN FUND, CAPITAL APPRECIATION FUND, GOVERNMENT BOND FUND, MONEY MARKET
FUND. Effective November 1, 1997, NAS entered into an agreement to provide
various administration and accounting services for these Funds. For these
services, NAS received 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 years ended
December 31, 1998 and 1997, NAS received fund administration fees in the
following amounts: Total Return Fund $947,890 and $135,272, Capital Appreciation
Fund $366,788 and $37,284, Government Bond Fund $301,517 and $39,441 and Money
Market Fund $608,781 and $89,708, respectively.
Effective September 1, 1999, the fund administration services previously
performed for the Funds by Nationwide Advisory Services, Inc. ("NAS") were
transferred to Villanova SA Capital Trust ("VSA"), an affiliate of NAS and an
indirect subsidiary of Nationwide Financial Services, Inc. In addition, BISYS
Fund Services Ohio, Inc. will perform certain fund administration services
pursuant to a Sub-Administration Agreement also effective September 1, 1999.
After these changes are implemented, there will be no change in the fees charged
for fund administration services for each of the Funds.
ALL OTHER FUNDS. Under the terms of a Fund Administration Agreement, VSA
provides various administration and accounting services, including daily
valuation of each Fund's shares and preparation of financial statements, tax
returns and regulatory reports. For these services, each Fund pays VSA an annual
fee in the amount of 0.07% of the Fund's first $250 million of average daily net
assets, 0.05% on the next $750 million and 0.04% on assets of more than $1
billion.
Effective September 1, 1999, the fund administration services previously
performed for the Funds by Nationwide Advisory Services, Inc. ("NAS") were
transferred to Villanova SA Capital Trust ("VSA"), an affiliate of NAS and an
indirect subsidiary of Nationwide Financial Services, Inc. Effective with this
change, the Small Company Fund was added to the Fund Administration Agreement
and began paying for these services. In addition, BISYS Fund Services Ohio, Inc.
will perform certain fund administration services pursuant to a
Sub-Administration Agreement also effective September 1, 1999. After these
changes are implemented, there will be no change in the fees charged for fund
administration services for each of the Funds.
55
<PAGE> 60
Prior to September 1, 1999, Nationwide Advisory Services, Inc. provided
fund administration services to the Funds. For the period from commencement of
operations to December 31, 1997 and the year ended December 31, 1998, NAS
received and/or waived all fund administration fees as follows:
<TABLE>
<CAPTION>
1997 Fund
Administration 1998 1998
Fund Fees Waived Received Waived
---- ----------- -------- -------
<S> <C> <C> <C>
Strategic Growth Fund $128 $ 3,959 $ ---
Strategic Value Fund $134 $ 5,962 $ ---
Equity Income Fund $147 $ 5,513 $ ---
High Income Bond Fund $645 $13,909 $ ---
Balanced Fund $150 $13,374 $ ---
Multi Sector Bond Fund $161 $13,497 $ ---
Small Cap Value Fund $158 $14,497 $ ---
Global Equity Fund $616 $ 9,361 $ ---
Select Advisers Mid Cap Fund $358 $ 4,969 $---
Income Fund* N/A $ 2,171 $ ---
</TABLE>
*The Income Fund commenced operations on January 20, 1998 and did not incur
administration fees in 1997.
The Select Advisers Small Cap Growth Fund had not commenced operations as of
December 31, 1998 and had not incurred any fund administration fees as of that
date.
56
<PAGE> 61
ADMINISTRATIVE SERVICE PLAN
Under the terms of an Administrative Services Plan, a Fund is permitted
to enter Servicing Agreements with servicing organizations who agree to provide
certain administrative support services for the Funds. Such administrative
support services include but are not limited to the following: establishing and
maintaining shareholder accounts, processing purchase and redemption
transactions, arranging for banks wires, performing shareholder sub-accounting,
answering inquiries regarding the Funds, providing periodic statements showing
the account balance for beneficial owners or for Plan participants or contract
holders of insurance company separate accounts, transmitting proxy statements,
periodic reports, updated prospectuses and other communications to shareholders
and, with respect to meetings of shareholders, collecting, tabulating, and
forwarding to the Trust executed proxies and obtaining such other information
and performing such other services as may reasonably be required.
As authorized by the Administrative Services Plan, the Trust has
entered into a Servicing Agreement effective July 1, 1999 pursuant to which
Nationwide Financial Services, Inc. has agreed to provide certain administrative
support services to the Funds held beneficially by its customers. In
consideration for providing administrative support services, Nationwide
Financial Services, Inc. and other entities with which the Trust may enter into
Servicing Agreements (which may include NAS) will receive a fee, computed at the
annual rate of up to 0.25% of the average daily net assets of the shares of the
Funds held by customers of Nationwide Financial Services, Inc. or such other
entity.
CUSTODIAN
The Fifth Third Bank ("Fifth Third"), 38 Fountain Square Plaza,
Cincinnati, OH 45263, is the Custodian for the Funds and makes all receipts and
disbursements under a Custodian Agreement. Pursuant to the Custodian Agreement,
Fifth Third utilizes the services of the global custody network of Bank of New
York for foreign custody of the Funds' assets. The Custodian performs no
managerial or policy making functions for the Funds.
LEGAL COUNSEL
Dietrich, Reynolds & Koogler, One Nationwide Plaza, Columbus, Ohio
43215, serves as the Trust's legal counsel.
INDEPENDENT ACCOUNTANTS
PriceWaterhouseCoopers, LLP, 100 E. Broad Street, Columbus, Ohio 43215
serves as independent accountants for the Trust.
TRANSFER AGENT AND DIVIDEND DISBURSING AGENT
Nationwide Investors Services, Inc. (NIS), Three Nationwide Plaza,
Columbus, Ohio 43215 is the Transfer Agent and Dividend Disbursing Agent for the
Funds. NIS is an affiliate of VMF. For these services, NIS is paid a fee by each
Fund at the annual rate of 0.01% of that Fund's average daily net assets.
Management believes the charges for the services performed are comparable to
fees charged by other companies performing similar services.
BROKERAGE ALLOCATIONS
VMF (or a subadviser) is responsible for decisions to buy and sell
securities and other investments for the Funds and 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
57
<PAGE> 62
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 and other debt 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 price," "best execution," i.e., prompt and reliable execution at the most
favorable prices and in the most effective manner possible taking into account
all considerations discussed below. VMF or a subadviser 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
VMF or a subadviser. In placing orders with such broker-dealers, VMF or a
subadviser will, where possible, take into account the comparative usefulness of
such information. Such information is useful to VMF or a subadviser even though
its dollar value may be indeterminable, it does not directly benefit a Fund and
its receipt or availability generally does not reduce VMF's or a subadviser's
normal research activities or expenses.
Fund portfolio transactions may be effected with broker-dealers who
have assisted investors in the purchase of the variable life insurance policies
or variable annuity contracts. 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 a Fund are
executed as part of concurrent authorizations to purchase or sell the same
security for trusts or other accounts served by affiliated companies of VMF or a
subadviser and their affiliates. Although such concurrent authorizations
potentially could be either advantageous or disadvantageous to a Fund, they are
effected for a Fund only when VMF or a subadviser believes that to do so is in
the best interest of the Fund. When such concurrent authorizations occur, the
executions will be allocated in an equitable manner.
In purchasing and selling investments for the Funds, it is the policy
of each of the subadvisers to obtain best execution at the most favorable prices
through responsible broker-dealers. The determination of what may constitute
best execution in a securities transaction by a broker involves a number of
considerations, including the overall direct net economic result to the Fund
(involving both price paid or received and any commissions and other costs
paid), the efficiency with which the transaction is effected, the ability to
effect the transaction at all when a large block is involved, the availability
of the broker to stand ready to execute possibly difficult transactions in the
future, and the financial strength and stability of the broker. These
considerations are judgmental and are weighed by VMF or subadviser in
determining the overall reasonableness of securities executions and commissions
paid. 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.
VMF and each subadviser may cause a 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.
58
<PAGE> 63
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 VMF. The fees
to each of the subadvisers pursuant to its subadvisory agreement with VMF 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, subadviser or administrator.
The following tables list the amount of brokerage commissions
(excluding directed brokerage) and the amount of transactions and related
commissions paid to brokers providing research and other services to the
subadvisers for the following periods:
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------
For the year ended December 31, 1998
-------------------------------------------------------------------------------------------------------------------
Transactions Related to
-----------------------
Brokerage Services
------------------
-------------------------------------------------------------------------------------------------------------------
Fund Commission $ Amount Commission
---- ---------- -------- ----------
-------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Strategic Growth Fund $44,342 $ -- $ --
-------------------------------------------------------------------------------------------------------------------
Strategic Value Fund 40,906 -- --
-------------------------------------------------------------------------------------------------------------------
Equity Income Fund 16,519 7,066,374 6,448
-------------------------------------------------------------------------------------------------------------------
High Income Bond Fund 72 -- --
-------------------------------------------------------------------------------------------------------------------
Balanced Fund 20,024 641,284 1,224
-------------------------------------------------------------------------------------------------------------------
Multi Sector Bond Fund -- -- --
-------------------------------------------------------------------------------------------------------------------
Small Cap Value Fund 249,877 -- --
-------------------------------------------------------------------------------------------------------------------
Global Equity Fund 37,313 -- --
-------------------------------------------------------------------------------------------------------------------
Select Advisers Mid Cap Fund 23,405 -- --
-------------------------------------------------------------------------------------------------------------------
Small Cap Growth Fund * -- -- --
-------------------------------------------------------------------------------------------------------------------
Small Company Fund 1,252,284 3,155,796 13,596
-------------------------------------------------------------------------------------------------------------------
Income Fund -- -- --
-------------------------------------------------------------------------------------------------------------------
Total Return Fund 881,930 -- --
-------------------------------------------------------------------------------------------------------------------
Capital Appreciation Fund 699,978 -- --
-------------------------------------------------------------------------------------------------------------------
Government Bond Fund -- -- --
-------------------------------------------------------------------------------------------------------------------
* Operations for the Small Cap Growth Fund commenced on or around May 1, 1999.
</TABLE>
59
<PAGE> 64
<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------
For the year ended December 31, 1997
-----------------------------------------------------------------------------------------------------------
Transactions Related to
-----------------------
Brokerage Services
------------------
-----------------------------------------------------------------------------------------------------------
Fund Commission $ Amount Commission
---- ---------- -------- ----------
-----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Strategic Growth Fund $2,117 $ --0 -- $ - 0 -
-----------------------------------------------------------------------------------------------------------
Strategic Value Fund 2,664 --0 -- -- 0 --
-----------------------------------------------------------------------------------------------------------
Equity Income Fund 1,319 1,018,166 910
-----------------------------------------------------------------------------------------------------------
High Income Bond Fund -- 0 -- -- 0 -- -- 0 --
-----------------------------------------------------------------------------------------------------------
Balanced Fund 1,038 315,101 420
-----------------------------------------------------------------------------------------------------------
Multi Sector Bond Fund -- 0 -- -- 0 -- -- 0 --
-----------------------------------------------------------------------------------------------------------
Small Cap Value Fund 2,317 3,045 30
-----------------------------------------------------------------------------------------------------------
Global Equity Fund 8,058 -- 0 -- -- 0 --
-----------------------------------------------------------------------------------------------------------
Select Advisers Mid Cap Fund 3,479 509,403 828
-----------------------------------------------------------------------------------------------------------
Small Company Fund 887,672 -- --
-----------------------------------------------------------------------------------------------------------
Total Return Fund 924,959 -- --
-----------------------------------------------------------------------------------------------------------
Capital Appreciation Fund 327,691 -- --
-----------------------------------------------------------------------------------------------------------
Government Bond Fund -- 0 -- -- --
-----------------------------------------------------------------------------------------------------------
Money Market Fund -- 0 -- -- --
-----------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------
For the year ended December 31, 1996
-----------------------------------------------------------------------------------------------------------
Transactions Related to
-----------------------
Brokerage Services
------------------
-----------------------------------------------------------------------------------------------------------
Fund Commission $ Amount Commission
---- ---------- -------- ----------
-----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Small Company Fund 424,176 -- --
-----------------------------------------------------------------------------------------------------------
Total Return Fund 519,949 -- --
-----------------------------------------------------------------------------------------------------------
Capital Appreciation Fund 196,526 -- --
-----------------------------------------------------------------------------------------------------------
Government Bond Fund -- -- --
-----------------------------------------------------------------------------------------------------------
</TABLE>
60
<PAGE> 65
Under the 1940 Act, "affiliated persons" of a Fund are prohibited from
dealing with it as a principal in the purchase and sale of securities unless an
exemptive order allowing such transactions is obtained from the SEC. However,
each Fund may purchase securities from underwriting syndicates of which a
subadviser or any of its affiliates as defined in the 1940 Act, is a member
under certain conditions, in accordance with Rule 10f-3 under the 1940 Act.
Certain of the Funds contemplate that, consistent with the policy of
obtaining best results, brokerage transactions may be conducted through
"affiliated broker/dealers," as defined in the 1940 Act. Under the 1940 Act,
commissions paid by a Fund to an "affiliated broker/dealer" 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 Funds'
policy that the commissions to be paid to an affiliated broker-dealer must, in
its judgment, be (1) at least as favorable as those that would be charged by
other brokers having comparable execution capability and (2) at least as
favorable as commissions contemporaneously charged by such broker/dealer on
comparable transactions for its most favored unaffiliated customers, except for
accounts for which the affiliated broker/dealer acts as a clearing broker for
another brokerage firm and customers of an affiliated broker/dealer 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 following table lists the amount of brokerage commissions paid to
affiliated brokers:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------
COMMISSIONS
- ------------------------------------------------------------------------------------------------------------------------------
FUND BROKER 1998 1997 1996
---- ------ ---- ---- ----
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balanced Fund Salomon Smith Barney $2,010 --- ---
- ------------------------------------------------------------------------------------------------------------------------------
Small Company Fund Lazard Freres $542 -- --
- ------------------------------------------------------------------------------------------------------------------------------
Small Company Fund Neuberger & Berman $31,801 $35,069 $24,069
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
During the year ended December 31, 1998, commissions paid by the
Balanced Fund to Saloman Smith Barney represented 10.0% of total commissions
paid by the Fund or 12.1% of the aggregate dollar amount of transactions
involving the payment of commissions.. During the year ended December 31, 1998,
commissions paid by the Small Company Fund to Lazard Freres and Neuberger &
Berman represented __% and 2.5%, respectively, of total commissions paid by the
Funds or 0.1% and 3.1%, respectively, of the aggregate dollar amount of
transactions involving the payment of commissions.
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<PAGE> 66
As of December 31, 1998, the following Funds held investments in their
regular broker/dealers as follows:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------
FUND SECURITY SHARES/PRINCIPAL VALUE
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Capital Appreciation Fund Merrill Lynch 137,500 $9,178,125
- ---------------------------------------------------------------------------------------------------------
Money Market Fund Bear Stearns Co. $40,000,000 $39,702,886
Goldman Sachs Group $40,663,000 $40,487,782
Merrill Lynch & Co. $42,503,000 $42,318,610
Morgan Stanley Group $38,082.000 $37,915,542
Salomon Smith Barney $30,000,000 29,981,956
- ---------------------------------------------------------------------------------------------------------
Income Fund Lehman Brothers Holdings $50,000 $50,525
- ---------------------------------------------------------------------------------------------------------
Equity Income Fund Merrill Lynch STRYPES 1,900 $45,125
Morgan Stanley Dean Witter & 1,900 $134,900
Co.
- ---------------------------------------------------------------------------------------------------------
Balanced Fund Morgan Stanley Dean Witter & 2,000 $82,500
Co. $50,789
Merrill Lynch & Co. $50,000
- ---------------------------------------------------------------------------------------------------------
Multi Sector Bond Fund Merrill Lynch & Co. $30,000 $30,474
Donaldson, Lufkin, Jenrette $5,250,000 $278,649
- ---------------------------------------------------------------------------------------------------------
</TABLE>
PURCHASES, REDEMPTIONS AND PRICING OF SHARES
An insurance company purchases shares of the Funds at their net asset
value using purchase payments received on variable annuity contracts and
variable life insurance policies issued by separate accounts. These separate
accounts are funded by shares of the Funds. For certain of the Funds, shares may
also be sold to affiliated Funds 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 regular trading on the New York Stock Exchange (generally 4 P.M.
Eastern Time) on each business day the New York Stock Exchange is open for
regular trading (and on such other 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 Day, 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 regular trading on
the Exchange. For orders placed after the close of regular trading on 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
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<PAGE> 67
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 prices as provided by an independent pricing organization. Securities
traded in the over-the-counter market are valued at the last quoted sale price,
or if there is no sale on that day, the quoted bid price as provided by an
independent pricing organization. U.S. Government securities are valued at the
quoted bid price as provided from an independent pricing organization. Money
market obligations with remaining maturities of 10 days or less purchase by a
non-money market fund are valued at amortized cost in accordance with provisions
contained in Rule 2a-7 of the 1940 Act. Other portfolio securities are valued at
the quoted prices obtained from an independent pricing organization which
employs a combination of methods, including among others, the obtaining and
comparison of market valuations from dealers who make markets and deal in such
securities and the comparison of valuations with those of other comparable
securities in a matrix of such securities. The pricing service activities and
results are reviewed by an officer of the Trust. 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 value in the judgement of VSA or its designee, are valued at fair
value in accordance with procedures authorized 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 under The Investment Company Act of
1940.
A separate account redeems shares to make benefit or surrender payments
under the terms of its variable annuity contracts or variable life insurance
policies. 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
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 different funds and currently has authorized 16
separate funds. Shares of each fund would participate equally in the earnings,
dividends, and assets of that particular fund. 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 voting securities of the Trust. The Trustees may, however, amend the
Declaration of Trust without the vote or consent of shareholders to:
(1) designate series of the Trust; or
(2) change the name of the Trust; or
(3) apply 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.
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Shares have no pre-emptive or conversion rights. Shares, when issued,
are fully paid and nonassessable. In regard to termination, sale of assets, or
change of 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 vote together, and not by fund, in the election of Trustees. If an
issue must be approved by a majority as defined in 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 is treated as a separate entity for purpose of the regulated
investment company provisions of the Internal Revenue Code (the "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 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, and (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's 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% 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
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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
of Trustees 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.
OTHER TAX CONSEQUENCES
Foreign Transactions. Dividends and interest received by a 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.
A 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 to the Fund, defer Fund losses and
cause the Fund to be subject to hyper inflationary currency rules. These rules
could therefore affect the character, amount and timing of distributions to
shareholders. These provisions also (a) will require a 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. A 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.
Investment in Passive Foreign Investment Companies. If a Fund purchases
shares in certain foreign entities classified under the Code as "passive foreign
investment companies" ("PFICs"), such 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 Contracts. 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
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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.
On April 1, 1992 proposed regulations of the Internal Revenue Service
were published providing a mark-to-market election for shares in certain PFICs
held by regulated investment companies. If the Fund is able to make the
foregoing election in the first year in which it is permitted to do so, 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 a 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 a 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 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 Accountants and Financial Statements of the
Funds for the period ended December 31, 1998 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 by 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:
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.
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.
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
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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 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
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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.
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+'.
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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
DD ultimate recovery value in liquidation or reorganization of the
obligor. `DDD' represents the highest potential for recovery of
&D these bonds, and 'D' represents the lowest potential for recovery.
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,
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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
AA strong. Risk is modest, but may vary slightly
AA- from time to time because of economic conditions.
A+ Protection factors are average but adequate.
A However, risk factors are more variable and
A- greater in periods of economic stress.
BBB+ Below average protection factors but still considered
BBB sufficient for prudent investment.
BBB- Considerable variability in risk during economic cycles.
BB+ Below investment grade but deemed likely to meet
BB obligations when due. Present or prospective
BB- financial protection factors fluctuate 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
B obligations will not be met when due. Financial
B- protection factors will fluctuate widely 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.
DD Defaulted debt obligations. Issuer failed to meet scheduled
principal and/or interest payments.
DP Preferred stock with dividend arrearages.
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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.
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.
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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.
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.
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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.
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.
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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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