MERGER FUND, N-30D, 1998-12-04

MERGER FUND
N-30D, 1998-12-04

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<PAGE> 1

November 16, 1998

Dear Fellow Shareholder:

The Merger Fund(R) failed to meet its investment objectives in the fiscal
year ended September 30, but we did manage to eke out a small gain that
preserved an unbroken string of profitable years extending back to the Fund's
inception in 1989. As previously reported, the Fund returned 0.8% in fiscal
1998. In addition to being adversely affected by the termination of several
proposed mergers in which we had invested, the Fund's performance was hurt by a
dramatic widening of arbitrage spreads in our fiscal fourth quarter as investors
became extremely sensitive to perceived risk and many hedge funds were forced to
dump takeover stocks. The good news is that the arbitrage business has taken a
decided turn for the better in recent weeks -- as reflected in the Fund's
NAV -- and we begin the new fiscal year with our capital fully committed to a
diversified portfolio of what we regard as highly attractive investment
opportunities.

The drubbing taken by many investors in the September quarter has put the
spotlight on the riskiness of individual mutual funds. It will probably come as
no surprise to our long-time shareholders to learn that The Merger Fund(R)
remains one of the least risky equity funds in the Morningstar universe. In
fact, for the three years ended September 30, 1998, the Fund showed the most
consistent monthly returns, the least sensitivity to market fluctuations and the
lowest Morningstar risk out of more than 1,900 equity funds. We are proud of the
effectiveness of our risk-management strategies and the Fund's unique risk
profile.

After a surge in both the number and dollar value of newly announced deals
in this year's first half, the pace of M&A activity has slowed as buyers and
sellers struggle to find appropriate transaction prices at a time when economic
forecasts are unusually divergent. Nonetheless, the fact that numerous major
business combinations have been announced in the wake of the market's turbulence
suggests that deal activity is not about to fall off a cliff. Qualitative
factors, of course, are equally important to arbitrageurs, and the news here is
also positive. As has become customary in these annual reports, we have included
a series of charts which reflect the nature of the corporate reorganizations in
which the Fund has invested. Chart 1 shows that negotiated, or "friendly,"
transactions represented 99% of the Fund's investments by dollar value as of
September 30. Waging a hostile takeover attempt against a company protected by a
poison pill, staggered board, restrictive by-laws and, in some cases, target-
friendly state laws can be a quixotic endeavor, and most such efforts don't
work. Arbs sometimes experience "windfalls" when the target is driven into the
hands of a white knight, but it takes an extraordinary degree of planning and
attention to detail for a hostile bidder to capture its prey.

Chart 2 shows that virtually all of the acquisitions in which the Fund has
recently invested are strategic in nature, meaning deals that involve a
corporate buyer -- generally operating in the same industry as the
target -- whose management sees the transaction as a means to achieve an
important long-term business objective. Highly leveraged, financially driven
takeovers of public companies remain relatively infrequent. As we noted last
year, the bull market has narrowed the gap between private market values and
public market values, meaning that fewer companies are attractive candidates for
LBOs. Moreover, LBO firms often still find themselves "outgunned" by corporate
buyers, whose richly valued shares represent high-powered currency with which to
make acquisitions. Adding to the obstacles faced by buyout companies is the fact
that the recent flight to quality in the debt markets has practically closed the
junk-bond market to new issuers, making highly leveraged transactions much
harder to finance on acceptable terms. Should recession fears abate and yield
<PAGE> 2

spreads return to more typical levels, LBO activity is likely to pick up, but
until then these transactions will be few and far between. Although, as
arbitrageurs, we would like to see as many potential acquirers of publicly
traded companies as possible, we would rather invest in strategic deals than
LBOs since the latter tend to be more "accident prone" and subject to
renegotiation or termination.

Chart 3 shows the type of consideration to be received by the selling
company's shareholders in transactions in which The Merger Fund(R) has invested.
Because stock-for-stock deals offer tax benefits to sellers and allow many
buyers to avoid the hit to earnings associated with the amortization of
goodwill, shares -- as opposed to cash -- remain the currency of choice for
making acquisitions. However, had the market's sell-off this summer deepened
instead of having reversed itself, the percentage of all-cash transactions
probably would be running at higher levels. Corporate managers are naturally
reluctant to issue shares at what they view as bargain-basement prices. It is
worth noting that many of the stock-for-stock mergers announced so far in the
fourth quarter involve some form of "collar," in which the target's shareholders
are promised a fixed value for their stock as long as the acquirer's shares
trade within a specified range immediately prior to the close. Such flexible
exchange ratios offer meaningful price protection and are often preferred by
sellers following periods of unusual market volatility.

Chart 4 shows our investments classified by economic sector. As has been
the case each year since the Fund's inception, financial services, a category
that includes banks, S&Ls and insurers, represents the largest segment of our
portfolio (32%). Not only has consolidation in this sector continued to run at a
rapid pace, but arbitrage spreads, which for many low-risk bank deals had
offered annualized returns of under 10%, have recently widened to more
attractive levels. Reflecting a spate of transactions involving manufacturers of
medical devices and equipment, healthcare investments represent 14% of our
holdings, up from 8% a year ago. Many of these deals are happening because the
acquirers are seeking to broaden their product lines and leverage their existing
sales and marketing infrastructure, a rationale that underlies much of the M&A
activity in other industries as well. The energy sector, which last year
accounted for 17% of our portfolio, now represents just 4%, in part because most
of the obvious combinations in the oil patch, especially among the larger
oil-field services companies, have already occurred.

Finally, last month's decision to reopen The Merger Fund(R) to new
investors reflects our optimism regarding the outlook for the merger arbitrage
business and our unique investment vehicle. We have been through a difficult
period, but we have been through difficult periods before, and each time the
Fund's performance has returned to its historical trendline. We look forward to
writing next year's letter!

Sincerely,

/s/ FREDERICK W. GREEN

Frederick W. Green
President

2
<PAGE> 3
THE MERGER FUND(R)

CHART 1
PORTFOLIO COMPOSITION
BY TYPE OF DEAL*

Friendly 98.7%
Hostile 1.3%

CHART 2
PORTFOLIO COMPOSITION
BY TYPE OF BUYER*

Strategic 96.2%
Financial 3.8%

* Data as of 9/30/98

3
<PAGE> 4
THE MERGER FUND(R)

CHART 3
PORTFOLIO COMPOSITION
BY DEAL TERMS*

Cash 43.1%
Stock with Fixed
Exchange Ratio 33.8%
Cash & Stock 11.2%
Stock with
Flexible Exchange
Ratio 8.3%
Undetermined 3.6%

CHART 4
PORTFOLIO COMPOSITION
BY SECTOR*

Financial Services 31.9%
Healthcare 13.5%
Technology 8.6%
Telecommunications 7.1%
Consumer Non-Durables 6.7%
Consumer Durables 6.5%
Utilities 6.1%
Consumer Services 6.0%
Basic Industries 4.4%
Energy 4.0%
Transportation 3.8%
Business Services 1.4%

* Data as of 9/30/98

4
<PAGE> 5

A $10,000 INVESTMENT SINCE INCEPTION

Note: Westchester Capital Management, Inc. became sole adviser to the Fund in
January of 1989. Results for earlier periods are not shown. All figures
represent past performance and may not be indicative of future results. The
Fund's share price and return will vary, and Investors may have a gain or loss
when they redeem their shares.

<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURN
-------------------------------
1 YR. 5 YR. SINCE INCEPTION
----- ----- ---------------
<S> <C> <C> <C>
The Merger Fund..................................... 0.8% 9.2% 9.0%
</TABLE>

5
<PAGE> 6

THE MERGER FUND
SCHEDULE OF INVESTMENTS
SEPTEMBER 30, 1998

<TABLE>
<CAPTION>
SHARES VALUE
------ ------------
<C> <S> <C>
COMMON STOCKS -- 109.92%*
AGRICULTURAL BIOTECHNOLOGY -- 5.67%*
130,000 DEKALB Genetics Corporation -- Class B(1)................... $ 11,960,000
217,000 Monsanto Company(2)......................................... 12,233,375
------------
24,193,375
------------
AUTOS -- 7.07%*
629,300 Chrysler Corporation(1)..................................... 30,127,738
------------
BANKS -- 5.20%*
208,500 Citicorp(2)................................................. 19,377,469
49,100 Crestar Financial Corporation(3)............................ 2,786,425
------------
22,163,894
------------
BROADCASTING -- 3.24%*
353,000 Tele-Communications, Inc. -- Class A**(2)................... 13,811,125
------------
COMPUTER SERVICES -- 4.08%*
300,000 Icon CMT Corp.**............................................ 3,337,500
417,400 Stratus Computer, Inc.**(2)................................. 14,061,163
------------
17,398,663
------------
CONSUMER FINANCE -- 1.38%*
562,203 Advanta Corp. -- Class B(3)................................. 5,903,131
------------
ELECTRIC UTILITIES -- 6.62%*
1,067,800 MidAmerican Energy Holdings Company(2)...................... 28,229,963
------------
ELECTRONIC PRODUCTS & DISTRIBUTION -- 3.83%*
207,800 AMP Incorporated(1)......................................... 7,428,850
257,500 Berg Electronics Corp.**(2)................................. 8,915,937
------------
16,344,787
------------
ENVIRONMENTAL & INDUSTRIAL SERVICES -- 0.74%*
275,000 Waste Management International plc -- ADR**(1).............. 3,162,500
------------
FIBER OPTICS -- 1.14%*
338,250 CIENA Corporation**......................................... 4,841,203
------------
FOOD RETAILERS -- 5.83%*
105,000 American Stores Company(3).................................. 3,379,687
497,400 Giant Food Inc. -- Class A(2)............................... 21,481,463
------------
24,861,150
------------
GIFTWARE -- 0.34%*
73,554 Syratech Corporation(1)(5).................................. 1,471,080
------------
HOTELS & GAMING -- 0.21%*
38,000 Harveys Casino Resorts(1)................................... 909,625
------------
</TABLE>

See notes to the financial statements.
6
<PAGE> 7
THE MERGER FUND
SCHEDULE OF INVESTMENTS (CONTINUED)
SEPTEMBER 30, 1998

<TABLE>
<CAPTION>
SHARES VALUE
------ ------------
<C> <S> <C>
INSURANCE -- 23.09%*
762,000 ALLIED Group, Inc.(1)....................................... $ 36,623,625
74,000 ALLIED Life Financial Corporation........................... 2,192,250
472,300 American Bankers Insurance Group, Inc.(3)................... 20,072,750
20,000 General Re Corporation(3)................................... 4,060,000
134,700 Life Re Corporation(1)...................................... 12,383,981
300,000 Summit Holding Southeast, Inc.**............................ 9,862,500
217,200 SunAmerica Inc.(2).......................................... 13,249,200
------------
98,444,306
------------
INTEGRATED OIL COMPANIES -- 3.34%*
264,400 Amoco Corporation(2)........................................ 14,244,550
------------
LEISURE & RECREATIONAL PRODUCTS -- 6.94%*
87,200 The Coleman Company, Inc.**(1).............................. 806,600
507,100 PolyGram NV -- NYS(1)....................................... 28,777,925
------------
29,584,525
------------
MEDICAL INFORMATION SYSTEMS -- 2.14%*
380,200 IMNET Systems, Inc.**(2).................................... 9,124,800
------------
MEDICAL SUPPLIES & DEVICES -- 12.42%*
520,000 DePuy, Inc.(1).............................................. 18,200,000
278,000 Marquette Medical Systems, Inc.**(1)........................ 12,075,625
457,100 Physio-Control International Corporation**.................. 12,570,250
243,100 United States Surgical Corporation(1)....................... 10,134,231
------------
52,980,106
------------
OIL & GAS EXPLORATION -- 0.95%*
175,000 Northstar Energy Corporation**(2)(4)........................ 1,221,170
284,400 Triton Energy Limited(2).................................... 2,826,225
------------
4,047,395
------------
OILFIELD EQUIPMENT & SERVICES -- 0.72%*
107,000 Halliburton Company......................................... 3,056,187
------------
REAL ESTATE INVESTMENT TRUSTS -- 1.54%*
383,858 Meditrust Companies(1)...................................... 6,549,577
------------
SAVINGS & LOANS -- 4.08%*
243,300 H.F. Ahmanson & Company(2).................................. 13,503,150
442,700 Coast Federal Litigation Contingent Payment Rights
Trust**(6)................................................ 3,901,294
------------
17,404,444
------------
SPECIALTY CHEMICALS -- 4.75%*
293,300 BetzDearborn Inc.(2)........................................ 20,274,363
------------
</TABLE>

See notes to the financial statements.
7
<PAGE> 8
THE MERGER FUND
SCHEDULE OF INVESTMENTS (CONTINUED)
SEPTEMBER 30, 1998

<TABLE>
<CAPTION>
SHARES VALUE
------ ------------
<C> <S> <C>
TRANSPORTATION -- 4.16%*
380,600 XTRA Corporation(1)......................................... $ 17,721,688
------------
TRAVEL-RELATED SERVICES -- 0.44%*
159,800 Cendant Corporation**(3).................................... 1,857,675
------------
TOTAL COMMON STOCKS (Cost $524,232,925)..................... 468,707,850
------------

CONTRACTS (100 SHARES PER CONTRACT)
- -----------------------------------
PUT OPTIONS PURCHASED -- 0.75%*
2,730 AT&T Corp.
Expiration October 1998, Exercise Price $70.00 (Cost
$3,558,570)............................................... 3,173,625
------------
TOTAL INVESTMENTS
(Cost $527,791,495)....................................... $471,881,475
============
</TABLE>

- ------------------------------

* Calculated as a percentage of net assets.
** Non-income producing security.
NYS -- New York Shares
(1) All or a portion of the shares have been committed as collateral for open
short positions.
(2) All or a portion of the shares have been committed as collateral for the
credit facility.
(3) All or a portion of the shares have been committed as collateral for
foreign currency contracts.
(4) Foreign security.
(5) Fair-valued security.
(6) Litigation settlement rights.

See notes to the financial statements.
8
<PAGE> 9

THE MERGER FUND
SCHEDULE OF SECURITIES SOLD SHORT
SEPTEMBER 30,1998

<TABLE>
<CAPTION>
SHARES VALUE
- ------ ------------
<C> <S> <C>
820 AT&T Corp. ................................................. $ 47,919
66,200 Albertson's, Inc. .......................................... 3,583,075
249,550 American Home Products Corporation.......................... 13,070,181
185,825 American International Group, Inc. ......................... 14,308,525
312,950 Ascend Communications, Inc. ................................ 14,239,225
70 Berkshire Hathaway Inc. -- Class A.......................... 4,172,000
174,800 British Petroleum Company plc -- ADR........................ 15,251,300
58,100 Daimler-Benz AG(1).......................................... 4,859,627
332,066 Daimler-Benz AG -- ADR...................................... 27,208,658
39,750 Devon Energy Corporation.................................... 1,309,266
319,328 HBO & Company............................................... 9,220,596
107,000 Halliburton Company......................................... 3,056,187
220,550 Medtronic, Inc. ............................................ 12,764,331
96,000 Qwest Communications International Inc. .................... 3,006,000
49,500 Sunbeam Corporation......................................... 346,500
47,100 SunTrust Banks, Inc. ....................................... 2,920,200
521,250 Travelers Group Inc. ....................................... 19,546,875
184,900 Tyco International Ltd. .................................... 10,215,725
408,450 Washington Mutual, Inc. .................................... 13,785,187
------------
TOTAL SECURITIES SOLD SHORT
(Proceeds $197,651,762) $172,911,377
============
</TABLE>

- ------------------------------
(1) Foreign security.

See notes to the financial statements.
9
<PAGE> 10

THE MERGER FUND
SCHEDULE OF OPTIONS WRITTEN
SEPTEMBER 30,1998

<TABLE>
<CAPTION>
CONTRACTS (100 SHARES PER CONTRACT) VALUE
- ----------------------------------- ----------
<C> <S> <C>
CALL OPTIONS
AMP Incorporated(1)
300 Expiration October 1998, Exercise Price $35.00............. $ 84,375
CIENA Corporation
961 Expiration October 1998, Exercise Price $15.00............. 108,113
2,296 Expiration October 1998, Exercise Price $12.50(1).......... 545,300

STRUCTURED OPTION PACKAGES
HBO & Company(1)(2)
3,802 Expiration November 1998, Exercise Price $30.00, $22.50.... 490,458
Qwest Communications International Inc.(1)(3)
3,000 Expiration December 1998, Exercise Price $37.50, $27.00.... 426,000
----------
TOTAL OPTIONS WRITTEN
(Premiums received $1,632,021).............................. $1,654,246
==========
</TABLE>

- ------------------------------

(1) Fair-valued security.
(2) Multiplier for exposure to underlying security is .84, or an equivalent of
319,328 shares.
(3) Multiplier for exposure to underlying security is .32, or an equivalent of
96,000 shares.

See notes to the financial statements.
10
<PAGE> 11

THE MERGER FUND
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 30, 1998

<TABLE>
<S> <C> <C>
ASSETS:
Investments, at value (Cost $527,791,495)................. $471,881,475
Deposit at brokers for short sales........................ 17,483,969
Receivable from brokers for proceeds on securities sold
short.................................................. 196,346,160
Receivable for investments sold........................... 30,979,470
Dividends receivable...................................... 286,931
Other receivables......................................... 86,334
------------
Total Assets...................................... 717,064,339
------------
LIABILITIES:
Loan payable (Note 10).................................... $ 97,480,000
Securities sold short, at value (Proceeds of $197,651,762)
See accompanying schedule.............................. 172,911,377
Payable for investment securities purchased............... 2,975,500
Payable to custodian...................................... 13,187,593
Payable for forward currency exchange contracts........... 1,059,548
Options written, at value (Premiums received $1,632,021)
See accompanying schedule.............................. 1,654,246
Accrued interest payable.................................. 726,337
Investment advisory fee payable........................... 376,167
Distribution fees payable................................. 36,917
Dividends payable on short positions...................... 62,149
Accrued expenses and other payables....................... 202,141
------------
Total Liabilities................................. 290,671,975
------------
NET ASSETS.................................................. $426,392,364
============
NET ASSETS Consist Of:
Accumulated undistributed net investment income........... $ 5,458,760
Accumulated undistributed net realized gain on investments
sold, securities sold short and option contracts
expired or closed...................................... 21,084,792
Net unrealized appreciation (depreciation) on:
Investments and foreign currency related items......... (55,909,715)
Short positions........................................ 24,740,385
Written options........................................ (22,225)
Forward currency exchange contracts.................... (1,059,548)
Paid-in capital........................................... 432,099,915
------------
Total Net Assets.................................. $426,392,364
============
NET ASSET VALUE, offering price and redemption price per
share ($426,392,364/30,667,591 shares of beneficial
interest outstanding)..................................... $13.90
======
</TABLE>

See notes to the financial statements.
11
<PAGE> 12

THE MERGER FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 1998

<TABLE>
<S> <C> <C>
INVESTMENT INCOME:
Interest.................................................. $ 9,940,077
Dividend income on long positions
(net of foreign withholding taxes of $85,948).......... 11,892,956
------------
Total investment income................................ 21,833,033
------------
EXPENSES:
Investment advisory fee................................... $ 4,722,291
Distribution fees......................................... 708,635
Transfer agent and shareholder servicing agent fees....... 177,915
Federal and state registration fees....................... 59,008
Professional fees......................................... 149,215
Trustees' fees and expenses............................... 21,567
Custody fees.............................................. 139,001
Administration fee........................................ 195,701
Reports to shareholders................................... 84,295
Other..................................................... 33,618
------------
Total operating expenses before interest expense and
dividends on short positions......................... 6,291,246
Interest expense.......................................... 4,770,330
Dividends on short positions (net of foreign withholding
taxes of $3,526)....................................... 4,338,295
------------
Total expenses......................................... 15,399,871
------------
NET INVESTMENT INCOME....................................... 6,433,162
------------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Realized gain (loss) on:
Long transactions and foreign currency related items... 42,793,561
Short transactions..................................... 447,521
Option contracts expired or closed..................... (11,075,238)
Forward currency exchange contracts.................... 584,322
------------
Net realized gain...................................... 32,750,166
Change in unrealized (depreciation) appreciation on:
Investments and foreign currency related items......... (71,774,414)
Short positions........................................ 37,164,087
Written options........................................ (345,063)
Forward currency exchange contracts.................... (1,030,668)
------------
NET REALIZED AND UNREALIZED LOSS ON INVESTMENTS............. (3,235,892)
------------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $ 3,197,270
============
</TABLE>

See notes to the financial statements.
12
<PAGE> 13

THE MERGER FUND
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED SEPTEMBER 30, 1998

<TABLE>
<S> <C> <C>
CASH PROVIDED (USED) BY FINANCING ACTIVITIES:
Sales of Capital Shares..................................... $ 208,258,666
Repurchases of Capital Shares............................... (229,499,670)
---------------
Cash Provided by Capital Share Transactions................. (21,241,004)
Cash Provided by Borrowings................................. 106,308,739
Distributions Paid in Cash*................................. (1,550,787)
---------------
$ 83,516,948
------------

CASH (USED) PROVIDED BY OPERATIONS:
Purchases of Investments.................................... (3,121,016,773)
Net Proceeds from Short-Term Investments.................... 0
Proceeds from Sales of Investments.......................... 3,004,598,979
---------------
(116,417,794)
---------------
Increase in Deposit at Brokers and Custodian for Short
Sales..................................................... 26,188,685
Net Investment Income....................................... 6,433,162
Net Change in Receivables/Payables Related to Operations.... 278,999
---------------
32,900,846 (83,516,948)
--------------- ------------
Net Increase in Cash........................................ 0
Cash, Beginning of Year..................................... 0
------------
Cash, End of Year........................................... $ 0
============
</TABLE>

- ------------------------------

*Non-cash financing activities include reinvestment of dividends of $43,453,261.

See notes to the financial statements.
13
<PAGE> 14

THE MERGER FUND
STATEMENT OF CHANGES IN NET ASSETS

<TABLE>
<CAPTION>
FISCAL YEAR ENDED TEN MONTHS ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1997
------------------ ------------------
<S> <C> <C>
Net investment income.................................... $ 6,433,162 $ 507,738
Net realized gain on investments sold, forward currency
exchange contracts, securities sold short and option
contracts expired or closed............................ 32,750,166 41,019,184
Change in unrealized (depreciation) appreciation of
investments, forward currency exchange contracts, short
positions and written options.......................... (35,986,058) 667,095
------------ ------------
Net increase in net assets resulting from operations..... 3,197,270 42,194,017
------------ ------------
Distributions to shareholders from:
Net investment income.................................. (813,613) (5,757,534)
Net realized gains..................................... (44,190,435) (38,089,672)
------------ ------------
Total dividends and distributions...................... (45,004,048) (43,847,206)
------------ ------------
Net increase (decrease) in net assets from capital share
transactions (Note 6).................................. 22,212,257 (41,443,872)
------------ ------------
Net decrease in net assets............................... (19,594,521) (43,097,061)

NET ASSETS:
Beginning of period...................................... 445,986,885 489,083,946
------------ ------------
End of period (including accumulated undistributed net
investment income of $5,458,760 and $589,493,
respectively).......................................... $426,392,364 $445,986,885
============ ============
</TABLE>

See notes to the financial statements.
14
<PAGE> 15

THE MERGER FUND
FINANCIAL HIGHLIGHTS

Selected per share data is based on a share of beneficial interest outstanding
throughout each period.

<TABLE>
<CAPTION>
YEAR TEN MONTHS
ENDED ENDED YEAR ENDED NOVEMBER 30,
SEPTEMBER 30, SEPTEMBER 30, ------------------------------------
1998 1997 1996 1995 1994
------------- ------------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Net Asset Value, beginning of period..... $15.35 $15.41 $14.87 $13.72 $13.70
Income from investment operations:
Net investment income.................. 0.20(2)(3) 0.02(2)(3) 0.20(2)(3) 0.08(2)(3) --(2)(3)
Net realized and unrealized gain on
investments.......................... (0.05) 1.35 1.24 1.78 1.08
-------- -------- -------- -------- --------
Total from investment operations....... 0.15 1.37 1.44 1.86 1.08
Less distributions:
Dividends from net investment income... (0.03) (0.19) (0.08) -- --
Distributions from net realized
gains................................ (1.57) (1.24) (0.82) (0.71) (1.06)
-------- -------- -------- -------- --------
Total distributions.................... (1.60) (1.43) (0.90) (0.71) (1.06)
-------- -------- -------- -------- --------
Net Asset Value, end of period........... $13.90 $15.35 $15.41 $14.87 $13.72
======== ======== ======== ======== ========
Total Return............................. 0.82% 9.68%(5) 10.26% 14.26% 8.41%
Supplemental Data and Ratios:
Net assets, end of period (000's)...... $426,392 $445,987 $489,084 $243,082 $170,344
Ratio of operating expenses to average
net assets........................... 1.33%(1) 1.36%(1)(6) 1.36%(1) 1.41%(1) 1.58%(1)
Ratio of interest expense and dividends
on short positions to average net
assets............................... 1.93% 2.93%(6) 0.95% 2.42% 1.72%
Ratio of net investment income (loss)
to average net assets................ 1.36% 0.13%(6) 1.36% 0.57% (0.03)%
Portfolio turnover rate................ 355.38% 271.24% 276.99% 290.48% 390.34%(4)
</TABLE>

- ------------------------------
(1) For the year ended September 30, 1998, the ten months ended September 30,
1997, and for the years ended November 30, 1996, 1995, and 1994, the
operating expense ratio excludes interest expense and dividends on short
positions. The ratios including interest expense and dividends on short
positions for the year ended September 30, 1998, the ten months ended
September 30, 1997, and for the years ended November 30, 1996, 1995, and
1994, were 3.26%, 4.29%, 2.31%, 3.83% and 3.30%, respectively.
(2) Net investment income before interest expense and dividends on short
positions for the year ended September 30, 1998, the ten months ended
September 30, 1997, and for the years ended November 30, 1996, 1995, and
1994 was $0.49, $0.38, $0.35, $0.42, and $0.21, respectively.
(3) Net investment income (loss) per share represents net investment income for
the respective year divided by the monthly average shares of beneficial
interest outstanding throughout each year.
(4) The numerator for the portfolio turnover rate includes the lesser of
purchases or sales (including both long and short positions). The
denominator includes the average long position throughout the year.
(5) Not annualized.
(6) Annualized.

See notes to the financial statements.
15
<PAGE> 16

THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS
SEPTEMBER 30, 1998

NOTE 1 -- ORGANIZATION

The Merger Fund (the "Fund") is a no-load, open-end, non-diversified
investment company organized as a trust under the laws of the Commonwealth of
Massachusetts on April 12, 1982, and registered under the Investment Company Act
of 1940 (the "1940 Act"), as amended. The Fund was formerly known as the Risk
Portfolio of The Ayco Fund. In January of 1989, the Fund's fundamental policies
were amended to permit the Fund to engage exclusively in merger arbitrage. At
the same time, Westchester Capital Management, Inc. became the Fund's investment
adviser, and the Fund began to do business as The Merger Fund. Merger arbitrage
is a highly specialized investment approach generally designed to profit from
the successful completion of proposed mergers, takeovers, tender offers,
leveraged buyouts, liquidations and other types of corporate reorganizations.
Effective December 1, 1996 the Fund's fiscal year end was changed to September
30 from November 30.

NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES

The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. These
policies are in conformity with generally accepted accounting principles.

A. Investment Valuation

Investments in securities and commodities (including options) are valued at
the last sales price on the securities or commodities exchange on which such
financial instruments are primarily traded. Securities not listed on an exchange
or securities for which there were no transactions are valued at the average of
the current bid and asked prices. Securities for which there are no such
valuations are valued at fair value as determined in good faith by management
under the supervision of the Board of Trustees. At September 30, 1998 such long
securities represent 0.3% of investments, at value, while such written options
represent 93.5% of options written, at value. The investment adviser reserves
the right to value securities, including options, at prices other than last-sale
prices or the average of current bid and asked prices when such prices are
believed unrepresentative of fair market value as determined in good faith by
the adviser. Investments in United States government securities (other than
short-term securities) are valued at the average of the quoted bid and asked
prices in the over-the-counter market. Short-term investments are carried at
amortized cost, which approximates market value.

B. Transactions with Brokers for Short Sales

Cash and liquid securities in the amount of $192,781,232 have been
committed as collateral for open short investment positions and specifically
identfied in the Fund's records. The Fund's receivable from brokers for proceeds
on securities sold short and deposit at brokers for short sales are with three
major securities dealers. The Fund does not require the brokers to maintain
collateral in support of the receivable from the broker for proceeds on
securities sold short.

16
<PAGE> 17
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

C. Federal Income Taxes

No provision for federal income taxes has been made since the Fund has
complied to date with the provisions of the Internal Revenue Code applicable to
regulated investment companies and intends to continue to so comply in future
years and to distribute investment company net taxable income and net capital
gains to shareholders. Additionally, the Fund intends to make all required
distributions to avoid federal excise tax.

D. Written Option Accounting

The Fund writes (sells) covered call options to hedge portfolio
investments. Uncovered put options can also be written by the Fund as part of a
merger arbitrage strategy involving a pending corporate reorganization. When the
Fund writes (sells) an option, an amount equal to the premium received by the
Fund is included in the Statement of Assets and Liabilities as an asset and an
equivalent liability. The amount of the liability is subsequently
marked-to-market to reflect the current value of the option written. By writing
an option, the Fund may become obligated during the term of the option to
deliver or purchase the securities underlying the option at the exercise price
if the option is exercised. Option contracts are valued at the last sales price
reported on the date of valuation. If no sale is reported, the option contract
written is valued at the average of the current bid and asked price reported on
the day of valuation. When an option expires on its stipulated expiration date
or the Fund enters into a closing purchase transaction, the Fund realizes a gain
or loss if the cost of the closing purchase transaction differs from the premium
received when the option was sold without regard to any unrealized gain or loss
on the underlying security, and the liability related to such option is
eliminated. When an option is exercised, the premium originally received
decreases the cost basis of the security (or increases the proceeds on a sale of
the security), and the Fund realizes a gain or loss from the sale of the
underlying security.

E. Purchased Option Accounting

The Fund purchases put options to hedge portfolio investments. Call options
may be purchased only for the purpose of closing out previously written covered
call options. Premiums paid for option contracts purchased are included in the
Statement of Assets and Liabilities as an asset. Option contracts are valued at
the last sales price reported on the date of valuation. If no sale is reported,
the option contract purchased is valued at the average of the current bid and
asked price reported on the day of valuation. When option contracts expire or
are closed, realized gains or losses are recognized without regard to any
unrealized gains or losses on the underlying securities.

F. Distributions to Shareholders

Dividends from net investment income and net realized capital gains, if
any, are declared and paid annually. Income and capital gain distributions are
determined in accordance with income tax regulations which may differ from
generally accepted accounting principles. These differences are due primarily to
wash loss and straddle loss deferrals and unrealized gains or losses on Section
1256 contracts, which are realized, for tax purposes, at September 30, 1998. The
Fund also utilized earnings

17
<PAGE> 18
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

and profits distributed to shareholders on redemption of shares as part of the
dividends paid deduction.

G. Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

H. Foreign Securities

Investing in securities of foreign companies and foreign governments
involves special risks and considerations not typically associated with
investing in U.S. companies and the U.S. government. These risks include
revaluation of currencies and future adverse political and economic
developments. Moreover, securities of many foreign companies and foreign
governments and their markets may be less liquid and their prices more volatile
than those of securities of comparable U.S. companies and the U.S. government.

I. Foreign Currency Translations

The books and records of the Fund are maintained in U.S. dollars. Foreign
currency transactions are translated into U.S. dollars on the following basis:
(i) market value of investment securities, assets and liabilities at the daily
rates of exchange, and (ii) purchases and sales of investment securities,
dividend and interest income and certain expenses at the rates of exchange
prevailing on the respective dates of such transactions. For financial reporting
purposes, the Fund does not isolate changes in the exchange rate of investment
securities from the fluctuations arising from changes in the market prices of
securities. However, for federal income tax purposes the Fund does isolate and
treat as ordinary income the effect of changes in foreign exchange rates on
realized gain or loss from the sale of investment securities and payables and
receivables arising from trade date and settlement date differences.

J. When-Issued Securities

The Fund may sell securities on a when-issued or delayed delivery basis.
Although the payment and interest terms of these securities are established at
the time the Fund enters into the agreement, these securities may be delivered
for cash proceeds at a future date. The Fund records sales of when-issued
securities and reflects the values of such securities in determining net asset
value in the same manner as other open short sale positions. The Fund segregates
and maintains at all times cash, cash equivalents, or other liquid securities in
an amount at least equal to the market value for when-issued securities.

18
<PAGE> 19
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

K. Other

Investment and shareholder transactions are recorded on the trade date.
Realized gains and losses from security transactions are recorded on the
identified cost basis. Dividend income and distributions to shareholders are
recorded on the ex-dividend date. Interest is accounted for on the accrual
basis. Investment income includes $9,731,401 of interest earned on receivables
from brokers for proceeds on securities sold short and deposits. Generally
accepted accounting principles require that permanent financial reporting and
tax differences be reclassified in the capital accounts.

NOTE 3 -- AGREEMENTS

The Fund's investment adviser is Westchester Capital Management, Inc. (the
"Adviser") pursuant to an investment advisory agreement dated January 31, 1989.
Under the terms of this agreement, the Adviser is entitled to receive a fee,
calculated daily and payable monthly, at the annual rate of 1.00% of the Fund's
average daily net assets.

Firstar Mutual Fund Services, LLC, a subsidiary of Firstar Corporation, a
publicly held bank holding company, serves as transfer agent, administrator and
accounting services agent for the Fund. Firstar Bank Milwaukee, N.A. serves as
custodian for the Fund.

Distribution services are performed pursuant to distribution contracts with
Mercer Allied Company, L.P. ("Mercer"), the Fund's principal underwriter, and
other broker-dealers.

NOTE 4 -- SHORT POSITIONS

The Fund may sell securities short for hedging purposes. For financial
statement purposes, an amount equal to the settlement amount is included in the
Statement of Assets and Liabilities as an asset and an equivalent liability. The
amount of the liability is subsequently marked-to-market to reflect the current
value of the short position. Subsequent fluctuations in the market prices of
securities sold, but not yet purchased, may require purchasing the securities at
prices which may differ from the market value reflected on the Statement of
Assets and Liabilities. The Fund is liable for any dividends payable on
securities while those securities are in a short position. As collateral for its
short positions, the Fund is required under the 1940 Act to maintain assets
consisting of cash, cash equivalents or liquid securities. These assets are
required to be adjusted daily to reflect changes in the value of the securities
sold short.

NOTE 5 -- RELATED PARTY TRANSACTIONS

William H. Bohnett, Esq., a partner of Fulbright & Jaworski L.L.P., serves
as a Trustee and Assistant Secretary of the Fund. Fulbright & Jaworski L.L.P.
furnishes legal services to the Fund. For the year ended September 30, 1998 the
Fund paid $84,749 for such services.

Certain officers of the Fund are also officers of the Adviser.

19
<PAGE> 20
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 6 -- SHARES OF BENEFICIAL INTEREST

The Trustees have the authority to issue an unlimited amount of shares of
beneficial interest without par value.

Changes in shares of beneficial interest were as follows:

<TABLE>
<CAPTION>
YEAR ENDED TEN MONTHS ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1997
----------------------------- -----------------------------
SHARES AMOUNT SHARES AMOUNT
------------ -------------- ------------ --------------
<S> <C> <C> <C> <C>
Sold........................ 14,330,739 $ 208,258,666 8,129,829 $ 117,907,516
Issued as reinvestment of
dividends................. 3,071,709 43,453,261 2,826,841 39,886,639
Redeemed.................... (15,780,835) (229,499,670) (13,652,842) (199,238,027)
----------- ------------- ----------- -------------
Net increase (decrease)..... 1,621,613 $ 22,212,257 (2,696,172) $ (41,443,872)
=========== ============= =========== =============
</TABLE>

Effective June 1, 1996, through the fiscal year ended September 30, 1998,
The Merger Fund was closed to new investors.

NOTE 7 -- INVESTMENT TRANSACTIONS

Purchases and sales of securities for the year ended September 30, 1998
(excluding short-term investments, options and short positions) aggregated
$1,936,484,658 and $1,862,631,260, respectively.

At September 30, 1998, gross unrealized appreciation and depreciation of
investments for federal income tax purposes were:

<TABLE>
<S> <C>
Appreciation................................................ $ 13,475,622
(Depreciation).............................................. (73,519,812)
------------
Net unrealized depreciation on investments.................. $(60,044,190)
============
</TABLE>

At September 30, 1998, the cost of investments for federal income tax
purposes was $531,925,665. The primary difference between the cost amount for
book purposes and tax purposes is due to deferred wash sale losses.

20
<PAGE> 21
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 8 -- OPTION CONTRACTS WRITTEN

The premium amount and the number of option contracts written during the
year ended September 30, 1998, were as follows:

<TABLE>
<CAPTION>
PREMIUM NUMBER OF
AMOUNT CONTRACTS
------------ ---------
<S> <C> <C>
Options outstanding at September 30, 1997.................. $ 2,294,272 17,002
Options written............................................ 43,883,831 123,339
Options closed............................................. (26,852,558) (87,985)
Options exercised.......................................... (14,961,160) (33,408)
Options expired............................................ (2,732,364) (8,589)
------------ -------
Options outstanding at September 30, 1998.................. $ 1,632,021 10,359
============ =======
</TABLE>

NOTE 9 -- DISTRIBUTION PLAN

The Fund has adopted a Plan of Distribution (the "Plan") dated July 1,
1993, as amended, pursuant to Rule 12b-1 under the 1940 Act. Under the Plan, the
Fund will compensate its principal underwriter, Mercer, and any other
broker-dealers with whom Mercer or the Fund has entered into a contract to
distribute Fund shares ("Dealers"). Under the Plan, the amount of such
compensation paid in any one year shall not exceed 0.25% annually of the average
daily net assets of the Fund, which may be payable as a service fee for
providing record keeping, subaccounting, subtransfer agency and/or shareholder
liaison services. For the year ended September 30, 1998, the Fund incurred
$708,635 pursuant to the Plan.

The Plan will remain in effect from year to year provided such continuance
is approved at least annually by a vote either of a majority of the Trustees,
including a majority of the non-interested Trustees, or a majority of the Fund's
outstanding shares.

NOTE 10 -- CREDIT FACILITY

Custodial Trust Company has made available to the Fund a $230 million
credit facility pursuant to a Loan and Security Agreement ("Agreement") dated
March 18, 1992 (subsequently amended) for the purpose of purchasing portfolio
securities. The Agreement can be terminated by either the Fund or Custodial
Trust Company with three months' prior notice. For the period October 1, 1997 to
December 31, 1997, the interest rate on the outstanding principal amount was the
Federal Funds Rate plus 0.625%. The interest rate changed on January 1, 1998 to
the Federal Funds Rate plus 1.00% (weighted average rate of 6.47% during the
year ended September 30, 1998). Advances are collateralized by securities owned
by the Fund and held separately in a special custody account pursuant to a
Special Custody Agreement dated March 31, 1994. During the year ended September
30, 1998, the Fund had an outstanding average daily balance of $73,741,082. The
maximum amount outstanding during the year ended September 30, 1998, was
$141,700,000. Interest expense amounted to $4,836,371 for the year ended
September 30, 1998. At September 30, 1998, the Fund had a loan payable balance
of $97,480,000 and the securities collateralizing the Agreement amounted to
$196,455,245.

21
<PAGE> 22
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1998

NOTE 11 -- FORWARD CURRENCY EXCHANGE CONTRACTS

At September 30, 1998, the Fund had entered into "position hedge" forward
currency exchange contracts that obligate the Fund to deliver and receive
currencies at specified future dates. The net unrealized depreciation of
$1,059,548 is included in the net unrealized appreciation (depreciation) section
of the accompanying financial statements. The terms of the open contracts are as
follows:

<TABLE>
<CAPTION>
SETTLEMENT CURRENCY TO U.S. $ VALUE AT CURRENCY TO U.S. $ VALUE AT
DATE BE DELIVERED SEPTEMBER 30, 1998 BE RECEIVED SEPTEMBER 30, 1998
---------- ------------ ------------------ ----------- ------------------
<C> <S> <C> <C> <C>
10/15/98 58,316,500 Netherland Guilders $30,964,117 30,027,099 U.S. Dollars $30,027,099
11/16/98 1,897,500 British Pounds 3,215,265 3,092,735 U.S. Dollars 3,092,735
----------- -----------
$34,179,382 $33,119,834
=========== ===========
</TABLE>

NOTE 12 -- INCOME TAX INFORMATION

The Fund hereby designates the following amounts as 20% and 28% rate
capital gain distributions for purposes of the dividends paid deduction.

<TABLE>
<S> <C>
Capital Gains Taxed at 20%.................................. $ 438,645
Capital Gains Taxed at 28%.................................. 968,453
----------
Total Long-term Capital Gains............................... $1,407,098
==========
</TABLE>

NOTE 13 -- SUBSEQUENT EVENTS

On October 14, 1998, The Merger Fund reopened to new investors.

22
<PAGE> 23

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Trustees and Shareholders
of The Merger Fund

In our opinion, the accompanying statement of assets and liabilities,
including the schedules of investments, of options written and of securities
sold short, and the related statements of operations, of cash flows and of
changes in net assets and financial highlights present fairly, in all material
respects, the financial position of The Merger Fund (the "Fund") at September
30, 1998, the results of its operations, the results of its cash flows, the
changes in its net assets and the financial highlights for each of the periods
indicated, except for the year ended November 30, 1994, in conformity with
generally accepted accounting principles. These financial statements and
financial highlights (hereafter referred to as "financial statements") are the
responsibility of the Fund's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these financial statements in accordance with generally accepted
auditing standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits, which included confirmation of securities at September 30, 1998 by
correspondence with the custodian and brokers, provide a reasonable basis for
the opinion expressed above. The financial statements of The Merger Fund for the
year ended November 30, 1994 were audited by other independent accountants whose
report dated December 21, 1994 expressed an unqualified opinion on those
statements.

/s/ PRICEWATERHOUSECOOPERS LLP

Milwaukee, Wisconsin
November 13, 1998

23
<PAGE> 24

INVESTMENT ADVISER
Westchester Capital Management, Inc.
100 Summit Lake Drive
Valhalla, NY 10595
(914) 741-5600

ADMINISTRATOR, TRANSFER AGENT, DIVIDEND
PAYING AGENT, AND SHAREHOLDER
SERVICING AGENT
Firstar Mutual Fund Services, LLC
615 East Michigan Street
P.O. Box 701
Milwaukee, WI 53201-0701
(800) 343-8959

CUSTODIAN
Firstar Bank Milwaukee, N.A.
P.O. Box 701
Milwaukee, WI 53201-0701
(800) 343-8959

TRUSTEES
Frederick W. Green
William H. Bohnett
Michael J. Downey
James P. Logan III
Frank A. McDermott, Jr.

EXECUTIVE OFFICERS
Frederick W. Green, President
Bonnie L. Smith, Vice President, Treasurer
and Secretary

COUNSEL
Fulbright & Jaworski L.L.P.
666 Fifth Avenue
New York, NY 10103

INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP
100 East Wisconsin Avenue
Milwaukee, WI 53202

[THE MERGER FUND(R) LOGO]

ANNUAL REPORT

SEPTEMBER 30, 1998