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[THE MERGER FUND LOGO]
100 Summit Lake Drive
Valhalla, New York 10595
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PROSPECTUS
JANUARY 27, 1999
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THE SECURITIES AND EXCHANGE COMMISSION HAS NOT APPROVED OR DISAPPROVED OF
THESE SECURITIES OR PASSED UPON THE ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
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TABLE OF CONTENTS
<TABLE>
<S> <C>
RISK/RETURN SUMMARY......................................... 1
Bar Chart and Performance Table........................... 2
Fees and Expenses of the Fund............................. 3
INVESTMENT OBJECTIVES AND POLICIES.......................... 4
Risk Factors.............................................. 5
Leverage Through Borrowing................................ 5
Short Sales and Put and Call Options...................... 6
Investment Restrictions................................... 6
INVESTMENT ADVISER.......................................... 7
DISTRIBUTION ARRANGEMENTS................................... 7
PLANS OFFERED BY THE FUND................................... 7
The Merger Fund IRA Plan.................................. 7
Fund Investors Keogh Plans................................ 8
HOW TO PURCHASE SHARES...................................... 8
Automatic Investment Plan................................. 9
NET ASSET VALUE............................................. 9
REDEMPTIONS................................................. 9
Systematic Withdrawal Plan................................ 10
TAX STATUS, DIVIDENDS AND DISTRIBUTIONS..................... 10
FINANCIAL HIGHLIGHTS........................................ 12
</TABLE>
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RISK/RETURN SUMMARY
Investment Goal: The Fund seeks to achieve capital growth by
engaging in merger arbitrage.
Principal Investment
Strategy: Under normal market conditions, the Fund invests
at least 65% of its assets in the equity
securities of companies which are involved in
publicly announced mergers, takeovers, tender
offers, leveraged buyouts, spin-offs, liquidations
and other corporate reorganizations. Merger
arbitrage is a highly specialized investment
approach generally designed to profit from the
successful completion of such transactions. As
compared with conventional investing, the Adviser
considers the Fund's merger arbitrage investment
results to be less volatile than overall stock
prices.
Principal Investment Risks: The principal risk associated with the Fund's
merger arbitrage investment strategy is that
certain of the proposed reorganizations in which
the Fund invests may be renegotiated or
terminated, in which case losses may be realized.
The Fund's investment strategy may result in
short-term capital appreciation. This can be
expected to increase the portfolio turnover rate
and cause increased brokerage commission costs.
More rapid portfolio turnover also exposes taxable
shareholders to a higher current realization of
capital gains and a potentially larger current tax
liability. The Fund is not a "diversified" fund
within the meaning of the Investment Company Act
of 1940. Accordingly, the Fund may invest its
assets in a relatively small number of issuers,
thus making an investment in the Fund potentially
more risky than an investment in a diversified
fund which is otherwise similar to the Fund. Loss
of money is a risk of investing in the Fund.
Who Should Invest in the
Fund: The Fund is not intended to provide a balanced
investment program. The Fund is intended to be an
investment vehicle only for that portion of an
investor's capital which can appropriately be
exposed to risk. Each investor should evaluate an
investment in the Fund in terms of the investor's
own investment goals.
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BAR CHART AND PERFORMANCE TABLE
The bar chart and table shown below indicate the risks of investing in the
Fund. The bar chart shows changes in the performance of the Fund's shares from
year to year over a nine-year period. The Adviser began managing the Fund on
January 31, 1989. Prior to that time, the Fund was managed in part by other
advisers with different investment objectives. The table following the bar chart
shows how the Fund's average annual returns for the listed periods compare to
those of the S&P 500, a widely used composite index of 500 publicly traded
stocks.
The Fund's past performance does not necessarily indicate how the Fund will
perform in the future.
<TABLE>
<CAPTION>
'1990' '1991' '1992' '1993' '1994' '1995' '1996' '1997'
- ------ ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C>
1.1 16.84 5.34 17.69 7.13 14.15 9.95 11.65
<CAPTION>
'1990' '1998'
- ------ ------
<S> <C>
1.1 5.35
</TABLE>
During the nine-year period shown in the above chart, the highest quarterly
return was 9.38% (for the quarter ended December 31, 1990) and the lowest
quarterly return was (10.04)% (for the quarter ended September 30, 1990).
AVERAGE ANNUAL TOTAL RETURNS
FOR THE PERIODS ENDED DECEMBER 31, 1998
<TABLE>
<CAPTION>
PAST 1 YEAR PAST 5 YEARS SINCE JANUARY 31, 1989
<S> <C> <C> <C>
The Merger
Fund......... 5.35% 9.60% 9.56%
S&P 500........ 28.58% 24.06% 18.54%
</TABLE>
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FEES AND EXPENSES OF THE FUND
THIS TABLE DESCRIBES THE FEES AND EXPENSES THAT YOU MAY PAY IF YOU BUY AND
HOLD SHARES OF THE FUND.
<TABLE>
<S> <C>
SHAREHOLDER FEES
(fees paid directly from your account)
Maximum Sales Charge (Load) Imposed on Purchases (as a
percentage of offering price).......................... None
Maximum Deferred Sales Charge (Load) (as a percentage
of offering price)..................................... None
Maximum Sale Charge (Load) Imposed on Reinvested
Dividends and Other Distributions...................... None
Redemption Fee (as a percentage of amount redeemed).... None(1)
Exchange Fee........................................... None
ANNUAL FUND OPERATING EXPENSES
(expenses that are deducted from Fund assets)
Management Fees........................................ 1.00%
Distribution and/or Service (12b-1) Fees............... 0.15%
Other Expenses......................................... 0.18%(2)
Total Annual Fund Operating Expenses................... 1.33%
</TABLE>
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(1) Shareholders will be assessed fees for outgoing wire transfers, returned
checks and stop payment orders at prevailing rates charged by Firstar Mutual
Fund Services, LLC, the Fund's transfer agent.
(2) Each IRA and Keogh account will be charged a $12.50 annual maintenance fee
as well as fees for certain transactions.
EXAMPLE
THIS EXAMPLE IS INTENDED TO HELP YOU COMPARE THE COST OF INVESTING IN THE
FUND WITH THE COST OF INVESTING IN OTHER MUTUAL FUNDS.
The example assumes that you invest $10,000 in the Fund for the time
periods indicated and then redeem all of your shares at the end of those
periods. The example also assumes that your investment has a 5% return each year
and that the Fund's operating expenses remain the same. Although your actual
costs may be higher or lower, based on these assumptions, your costs would be:
<TABLE>
<CAPTION>
1 YEAR 3 YEARS 5 YEARS 10 YEARS
<S> <C> <C> <C>
$135.. $421 $729 $1601
</TABLE>
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INVESTMENT OBJECTIVES AND POLICIES
The Fund seeks to achieve capital growth by engaging in merger arbitrage.
The Fund's investment adviser is Westchester Capital Management, Inc. (the
"Adviser").
Under normal market conditions, the Fund invests at least 65% of its total
assets in the equity securities of companies which are involved in publicly
announced mergers, takeovers and other corporate reorganizations ("merger
arbitrage investments"). Depending upon the level of merger activity and other
economic and market conditions, the Fund may temporarily invest a substantial
portion of its assets in cash or cash equivalents, including money market
instruments such as Treasury bills and other short-term obligations of the
United States Government, its agencies or instrumentalities; negotiable bank
certificates of deposit; prime commercial paper; and repurchase agreements with
respect to the above securities.
Merger arbitrage is a highly specialized investment approach generally
designed to profit from the successful completion of proposed mergers,
takeovers, tender offers, leveraged buyouts, spin-offs, liquidations and other
types of corporate reorganizations. Although a variety of strategies may be
employed depending upon the nature of the reorganizations selected for
investment, the most common merger arbitrage activity involves purchasing the
shares of an announced acquisition target at a discount to their expected value
upon completion of the acquisition.
As compared to conventional investing, the Adviser considers the Fund's
merger arbitrage investment results to be less volatile than overall stock
prices. Over the last three-year period, the Fund's "beta" (a statistical
measure of market-related risk, whereby a fund's sensitivity to movements in the
Standard & Poor's 500 Stock Index is expressed relative to the Index's beta of
1.0) has averaged less than 0.2. The Adviser believes that this number is
significantly lower than comparable figures for other equity mutual funds
seeking capital growth. While some periods will be more conducive to a merger
arbitrage strategy than others, a systematic, disciplined arbitrage program may
produce attractive rates of return, even in flat or down markets.
The Fund's investment objective of achieving capital growth by engaging in
merger arbitrage is a fundamental policy which may not be changed without
shareholder approval. Except as otherwise stated, the Fund's other investment
objectives and policies are not fundamental and may be changed without obtaining
approval by the Fund's shareholders.
In making investments for the Fund, the Adviser is guided by the following
general principles: (1) Securities are purchased only after a reorganization is
announced or when one or more publicly disclosed events point toward the
likelihood of some type of reorganization within a reasonable period of time;
(2) Before an initial position is established, a preliminary analysis is made of
the proposed transaction to determine the probability and timing of a successful
completion. A more detailed review then takes place before the position is
enlarged; (3) In deciding whether or to what extent to invest in any given
reorganization, the Adviser places particular emphasis on the credibility,
strategic motivation and financial resources of the participants, and the
liquidity of the securities involved in the transaction; (4) The risk-reward
characteristics of each arbitrage position are assessed on an ongoing basis, and
the Fund's holdings may be adjusted accordingly; (5) The Adviser attempts to
invest in as many attractive reorganizations as can be effectively monitored in
order to minimize the impact on the Fund of losses resulting from the
termination of any given proposed transaction; and (6) The Adviser may invest
the Fund's assets in both negotiated, or "friendly," reorganizations and
non-negotiated, or "hostile," takeover attempts, but in either case the
Adviser's primary consideration is the likelihood that the transaction will be
successfully completed.
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RISK FACTORS
The Fund's investment program involves investment techniques and securities
holdings which entail risks, in some cases different from the risks ordinarily
associated with investments in equity securities. The principal risk associated
with the Fund's merger arbitrage investments is that certain of the proposed
reorganizations in which the Fund invests may be renegotiated or terminated, in
which case losses may be realized. Also, because the Fund's assets are invested
in a smaller number of issues, there is a somewhat greater risk associated with
investment in the Fund than in a diversified investment company, as defined in
the Investment Company Act of 1940.
The Fund invests a portion of its assets to seek short-term capital
appreciation, which increases the portfolio turnover rate and causes increased
brokerage commission costs. A high turnover rate exposes taxable shareholders to
a higher current realization of capital gains, and thus a higher current tax
liability, than may be associated with investments in other investment companies
which emphasize long-term investment strategies and thus have a lower turnover
rate. The Fund's portfolio turnover rate for its fiscal year ended September 30,
1998 was 355%.
Like other mutual funds, financial and business organizations and
individuals around the world, the Fund could be adversely affected if the
computer systems used by the Adviser and the Fund's service providers do not
properly process and calculate date-related information and data from and after
January 1, 2000. This is commonly known as the "Y2K Problem." The Adviser is
taking steps to address the Y2K Problem with respect to the computer systems
that it uses and understands that comparable steps are being taken by the Fund's
other major service providers.
The Y2K Problem may also be experienced by the companies in which the Fund
invests, and there can be no assurance that the Fund may not be adversely
affected in this regard.
LEVERAGE THROUGH BORROWING
The Fund may borrow from banks to increase its portfolio holdings of
securities. Such borrowings may be on a secured or unsecured basis at fixed or
variable rates of interest. The Investment Company Act of 1940 requires the Fund
to maintain continuous asset coverage of not less than 300% with respect to all
borrowings. This allows the Fund to borrow for such purposes an amount (when
taken together with any borrowings for temporary or emergency purposes as
described below) equal to as much as 50% of the value of its net assets (not
including such borrowings). If such asset coverage should decline to less than
300% due to market fluctuations or other reasons, the Fund may be required to
dispose of some of its portfolio holdings within three days in order to reduce
the Fund's debt and restore the 300% asset coverage, even though it may be
disadvantageous from an investment standpoint to dispose of assets at that time.
Leveraging will exaggerate any increase or decrease in the net asset value of
the Fund's portfolio, and in that respect may be considered a speculative
practice. The interest which the Fund must pay on borrowed money, together with
any additional fees to maintain a line of credit or any minimum average balances
required to be maintained, are additional costs which will reduce or eliminate
any net investment income and may also offset any potential capital gains.
Unless the appreciation and income, if any, on assets acquired with borrowed
funds exceed the costs of borrowing, the use of leverage will diminish the
investment performance of the Fund compared with what it would have been without
leverage.
The Fund, like many other investment companies, may also borrow money for
temporary or emergency purposes, but such borrowings, together with all other
borrowings, may not exceed 33% of the value of the Fund's gross assets when the
loan is made.
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SHORT SALES AND PUT AND CALL OPTIONS
The Fund may employ various hedging techniques, such as short selling and
the selective use of put and call options, in an effort to reduce the risks
associated with certain of its investments. For example, when the terms of a
proposed acquisition call for the exchange of common stock and/or other
securities, the common stock of the company to be acquired may be purchased and,
at approximately the same time, an equivalent amount of the acquiring company's
common stock and/or other securities may be sold short. Any such short sale will
be made with the intention of later closing out ("covering") the short position
with the securities of the acquiring company received upon consummation of the
acquisition. The purpose of the short sale is to protect against a decline in
the market value of the acquiring company's securities prior to the
acquisition's completion. However, should the acquisition be called off or
otherwise not completed, the Fund may realize losses on both its long position
in the target company's shares and its short position in the acquirer's
securities.
At all times when the Fund does not own, or have an unconditional right to
receive, securities which are sold short, the Fund will maintain a segregated
account consisting of cash, cash equivalents and liquid securities equal in
value on a daily marked-to-market basis to the securities sold short.
The purchase of put options may be similarly used for hedging purposes. A
put option is a short-term contract which gives the purchaser of the option, in
return for a premium paid, the right to sell the underlying security at a
specified price upon exercise of the option at any time prior to the expiration
of the option. The market price of a put option will normally vary inversely
with the market price of the underlying security. Consequently, by purchasing
put options on merger arbitrage stocks, it may be possible for the Fund to
partially offset any decline in the market value of certain of the equity
positions held by the Fund. Also, as part of a merger arbitrage strategy
involving a pending corporate reorganization, the Fund may also write (sell)
uncovered put options. As a matter of fundamental policy, which may not be
changed without shareholder approval, the value of all put options purchased or
sold by the Fund, as measured by the premiums paid or received, may not exceed
25% of the Fund's net assets.
The sale of covered call options may also be used by the Fund to reduce the
risks associated with individual investments and to increase total investment
return. The sale of call options will not be used for speculative purposes, and,
accordingly, call options will be written solely as covered call options; that
is, options on securities which the Fund owns at the time the call is sold. As a
matter of fundamental policy, the value of securities underlying call options
written by the Fund may not exceed 50% of the Fund's net assets. In addition,
the Fund may purchase call options only for the purpose of closing out
previously written covered call options.
The Adviser believes that, when used for hedging purposes, short sales and
options transactions should be viewed less as speculative strategies than as
techniques to help protect the assets of the Fund against unfavorable market
conditions that might otherwise adversely affect certain of its investments.
Nonetheless, a substantial percentage of the investments made by the Fund will
not lend themselves to hedging strategies and, even when available, such
strategies may not be successful. Also, options transactions involve special
risks including (i) possible imperfect correlation between the price movements
of the option and the underlying security and (ii) lack of assurance of a liquid
secondary market at any particular time and possible price fluctuation limits,
either of which may make it difficult or impossible to close a position when so
desired.
INVESTMENT RESTRICTIONS
The investment restrictions set forth below have been adopted by the Fund
as fundamental policies which may be changed only by a vote of the Fund's
shareholders. The Fund may not invest more than 5% of its total assets in
enterprises with less than three years of continuous operation; may not invest
more than 10% of its assets in the securities of any one issuer; may not
purchase more than 10% of an issuer's voting securities; may not invest more
than 10% of its assets in restricted securities or securities without readily
available market quotations,
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<PAGE> 9
including repurchase agreements having a maturity of more than seven days; may
not borrow money in an amount exceeding 33% of its total assets; and may not
invest more than 25% of its total assets in securities of companies in the same
industry. The Fund may not invest more than 5% of its net assets in warrants or
more than 2% of its net assets in warrants not listed on specified national
stock exchanges. The Fund may make short sales but only under certain conditions
to the extent of 50% of its net assets. The value of securities of any one
company in which the Fund is short may not exceed the lesser of 10% of its net
assets or 10% of any class of such company's securities.
INVESTMENT ADVISER
Westchester Capital Management, Inc., 100 Summit Lake Drive, Valhalla, New
York 10595, a registered investment adviser since 1980, is the Fund's investment
adviser. Westchester Capital Management, Inc. and affiliates also manage merger
arbitrage programs for other institutional investors, including offshore funds
and private limited partnerships. Subject to the authority of the Fund's Board
of Trustees, the Adviser is responsible for the overall management of the Fund's
business affairs. The fee charged the Fund is higher than those typically paid
by other mutual funds. This higher fee is attributable in part to the higher
expense incurred by the Adviser and the specialized skills required to manage a
portfolio of merger arbitrage investments. The Fund paid the Adviser an advisory
fee of 1.0% of the Fund's average daily net assets for the most recent fiscal
year.
Mr. Frederick W. Green has served as President of the Adviser since 1980
and also serves as the President and a Trustee of the Fund. Ms. Bonnie L. Smith
has served as Vice President of the Adviser since 1986 and also serves as Vice
President, Treasurer and Secretary of the Fund. Mr. Green and Ms. Smith have
been primarily responsible for the day-to-day management of the Fund's portfolio
since January 1989.
DISTRIBUTION ARRANGEMENTS
The Fund has adopted a plan of distribution (the "Plan") pursuant to Rule
12b-1 under the Investment Company Act of 1940. Under the Plan, the Fund may pay
to any broker-dealer with whom the Fund has entered into a contract to
distribute the Fund's shares, or any other qualified financial services firm,
compensation for distribution and/or shareholder-related services with respect
to shares held or purchased by their respective customers or in connection with
the purchase of shares attributable to their efforts. 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. In addition, the Adviser may pay amounts from its own
resources for the provision of such services and the Fund may pay for its
expenses of distribution of its shares to prospective shareholders.
PLANS OFFERED BY THE FUND
Additional information about any of the plans described below may be
obtained by contacting the Adviser at 100 Summit Lake Drive, Valhalla, New York
10595 (telephone (914) 741-5600).
THE MERGER FUND IRA PLAN
The Fund makes available The Merger Fund IRA Plan for individuals to
establish an Individual Retirement Account ("IRA") under which shares of the
Fund may be purchased. The Merger Fund IRA Plan can be used to make regular IRA
contributions, and can also be used for a rollover or transfer from an existing
IRA, or for a rollover from a qualified retirement plan from which the
individual receives a lump-sum distribution.
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<PAGE> 10
An annual maintenance fee of $12.50 will be charged for each IRA account.
In addition, a $15.00 fee will be assessed to any IRA account which is
transferred to a successor trustee, distributed to a participant or for which a
refund of excess contribution is paid. These fees are subject to change upon
notification by Firstar Mutual Fund Services, LLC to the Fund.
The Fund also makes available to qualifying shareholders a "Roth IRA,"
which is a form of IRA created in 1997. Shareholders should consult with their
own financial advisers to determine eligibility.
FUND INVESTORS KEOGH PLANS
The Fund makes available the Fund Investors Defined Contribution Prototype
Plan and the Fund Investors Defined Benefit Prototype Plan (referred to
collectively in this prospectus as the "Fund Investors Keogh Plans"), for
corporations, self-employed individuals or partnerships, to establish a
qualified retirement plan under which shares of the Fund may be purchased. The
Fund Investors Keogh Plans can accept a transfer or qualified rollover from an
existing qualified retirement plan from which an individual receives a lump-sum
distribution, as well as regular annual contributions.
An annual maintenance fee of $12.50 will be charged for each Keogh account.
In addition, a $15.00 fee will be assessed to any Keogh account which is
transferred to a successor trustee or distributed to a participant, or for which
a refund of excess contribution is paid. These fees are subject to change upon
notification by Firstar Mutual Fund Services, LLC to the Fund.
HOW TO PURCHASE SHARES
Shares of the Fund may be purchased at net asset value without any sales or
other charge by sending a completed application form to:
The Merger Fund
c/o Firstar Mutual Fund Services, LLC
P.O. Box 701
Milwaukee, Wisconsin 53201-0701
However, applicants should not send any correspondence by overnight courier
to this post office box address. Correspondence sent by overnight courier should
be addressed to the Fund at:
Firstar Mutual Fund Services, LLC
Mutual Fund Services, Third Floor
615 East Michigan Street
Milwaukee, Wisconsin 53202
The minimum initial investment for individuals, IRAs, corporations,
partnerships or trusts is $2,000. There is no minimum for subsequent
investments. There is no minimum investment requirement for Fund Investors Keogh
Plans. Shares of the Fund are offered on a continuous basis. The Fund, however,
reserves the right, in its sole discretion, to reject any application to
purchase shares. Applications will not be accepted unless they are accompanied
by a check drawn on a U.S. bank, savings and loan, or credit union in U.S. funds
for the full amount of the shares to be purchased.
After an account is opened, additional shares may be purchased by sending a
check payable to "The Merger Fund," together with a note stating the name(s) on
the account and the account number, to Firstar Mutual Fund Services, LLC, P.O.
Box 701, Milwaukee, Wisconsin 53201-0701. All shares will be purchased at the
net asset value per share next determined after receipt of the shareholder's
application in proper order and acceptance of
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such application by the Fund. No share certificates will be issued unless
requested in writing. Shares of the Fund may also be purchased through
authorized broker-dealers who may charge for their services.
The custodian, Firstar Bank Milwaukee, N.A., will charge a $25.00 fee
against a shareholder's account, in addition to any loss sustained by the Fund,
for any payment check returned to the custodian for insufficient funds.
Shareholders should contact the Administrator at (800) 343-8959 to obtain
the latest wire instructions for wiring funds to Firstar Mutual Fund Services,
LLC for the purchase of Fund shares and to notify Firstar Mutual Fund Services,
LLC that a wire transfer is coming.
AUTOMATIC INVESTMENT PLAN
A shareholder may also participate in the Fund's Automatic Investment Plan,
an investment plan that automatically debits money from the shareholder's bank
account and invests it in the Fund through the use of electronic funds transfers
or automatic bank drafts. After making an initial investment of at least $2,000,
shareholders may elect to make subsequent investments by transfers of a minimum
of $100 on specified days of each month into their established Fund account.
Shareholders should contact the Administrator at (800) 343-8959 for more
information about the Fund's Automatic Investment Plan.
NET ASSET VALUE
The net asset value per share of the Fund will be determined on each day
when the New York Stock Exchange is open for business at the close of the
Exchange and will be computed by determining the aggregate market value of all
assets of the Fund less its liabilities, and then dividing by the total number
of shares outstanding. The determination of net asset value for a particular day
is applicable to all applications for the purchase of shares as well as all
requests for the redemption of shares received at or before the close of trading
on the Exchange on that day.
REDEMPTIONS
Fund shareholders will be entitled to redeem all or any portion of the
shares credited to their accounts by submitting a written request for redemption
to:
The Merger Fund
c/o Firstar Mutual Fund Services, LLC
P.O. Box 701
Milwaukee, Wisconsin 53201-0701
Upon the receipt of such a request in "proper order," as described below,
the shareholder will receive a check based on the net asset value next
determined after the redemption request has been received, which may be more or
less than the amount originally invested. If the shares to be redeemed represent
an investment made by check, the Fund reserves the right to withhold the
proceeds until the check clears. It will normally take seven days to clear
checks.
A redemption request will be considered to have been received in "proper
order" if the following conditions are satisfied:
(i) the request is in writing, indicates the number of shares to be redeemed
and identifies the shareholder's account number;
(ii) the request is signed by the shareholder(s) exactly as the shares are
registered;
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<PAGE> 12
(iii) the request is accompanied by certificates, if any, issued representing
the shares, which have been endorsed for transfer (or are themselves
accompanied by an endorsed stock power) exactly as the shares are
registered; and
(iv) if the redemption proceeds are requested to be sent other than to the
address of record or if the proceeds of a requested redemption exceed
$25,000, the signature(s) on the request is/are guaranteed by an eligible
signature guarantor.
Questions concerning a redemption request may be addressed to the Fund at
its principal office. No redemption request will become effective until all
documents have been received in "proper order" by Firstar Mutual Fund Services,
LLC. The Fund does not accept telephone redemptions.
Shareholders who have an IRA or other retirement plan must indicate on
their redemption request whether or not to withhold federal income tax.
Redemption requests failing to indicate an election not to have federal tax
withheld will be subject to withholding.
Shareholders may also redeem Fund shares through broker-dealers holding
such shares who have made arrangements with the Fund permitting redemptions by
telephone or facsimile transmission. These broker-dealers may charge a fee for
this service.
If a shareholder's transactions at any time reduce the shareholder's
account in the Fund to below $1,000 in value, the Fund may notify the
shareholder that, unless the account is brought up to at least such minimum
amount, the Fund may, within 30 days, redeem all shares in the account and close
it by making payment to the shareholder.
Shareholders who effect redemptions by wire transfer will pay a $12.00 wire
transfer fee to the Transfer Agent to cover costs associated with the transfer.
In addition, a shareholder's bank may impose a charge for receiving wires.
SYSTEMATIC WITHDRAWAL PLAN
Individuals in whose accounts shares of the Fund are held or accounts in
which shares are allocated to The Merger Fund IRA Plan, the Fund Investors Keogh
Plans or other qualified retirement plan, which accounts in each case have a
current account value of at least $10,000, may adopt a Systematic Withdrawal
Plan to provide for periodic distributions for an annual fee of $15.00 per plan,
which fee is subject to change upon notification by Firstar Mutual Fund
Services, LLC to the Fund. By using the Systematic Withdrawal Plan, a
shareholder can request monthly, quarterly or other periodic checks for any
designated amount of $500 or more. A Systematic Withdrawal Plan may be opened by
making an application to Firstar Mutual Fund Services, LLC.
TAX STATUS, DIVIDENDS AND DISTRIBUTIONS
The Fund intends to distribute substantially all of its net investment
income and net capital gain in December. Both distributions will be in shares of
the Fund unless a shareholder elects to receive cash. Dividends from net
investment income (including any excess of net short-term capital gain over net
long-term capital loss) are taxable to investors as ordinary income, while
distributions of net capital gain (the excess of net long-term capital gain over
net short-term capital loss) are taxable as long-term capital gain regardless of
the shareholder's holding period for the shares. The Fund expects that, as a
result of its investment objectives and strategies, its distributions will
consist primarily of short-term capital gains, which are taxable as ordinary
income. Certain dividends or distributions declared in October, November or
December will be taxed to shareholders as if received in December if they are
paid during the following January.
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<PAGE> 13
Each year the Fund informs its shareholders of the amount and type of its
distributions. The Fund is required by federal tax law to withhold 31% of
dividends (including capital gain dividends) and redemption proceeds for
accounts (other than those of corporations and certain other exempt entities)
without a certified taxpayer identification number ("TIN") and certain other
certified information or with respect to which the IRS or a broker has notified
the Fund that withholding is required due to an incorrect TIN or a failure to
report taxable interest or dividends. The shareholder also must certify that the
number is correct and that he/she is not subject to backup withholding. The
certification is included as part of the share purchase application form. If the
shareholder does not have a social security number, he/she should indicate on
the purchase form that an application to obtain a number is pending. The Fund is
required to withhold taxes if a number is not delivered to the Fund within seven
days.
IRA's, Keogh plans and other qualified retirement plans are exempt from
federal income taxation under the Code.
This summary is not intended to be, nor should it be, construed as legal or
tax advice to any current holder of the Fund's shares. The Fund's shareholders
are urged to consult their own tax advisors to determine the tax consequences to
them of their ownership of the Fund's shares.
11
<PAGE> 14
FINANCIAL HIGHLIGHTS
The financial highlights table is intended to help you understand the
Fund's financial performance for the past 5 years. Certain information reflects
financial results for a single Fund share. The total returns in the table
represent the rate that an investor would have earned on an investment in the
Fund (assuming reinvestment of all dividends and distributions). Information for
1995 through 1998 has been audited by PricewaterhouseCoopers LLP, whose report,
along with the Fund's financial statements, is included in the Fund's Annual
Report, which is available upon request. Information for 1994 was audited by the
Fund's prior independent accountants whose report dated December 21, 1994
expressed an unqualified opinion on those statements. Effective December 1,
1996, the Fund changed its fiscal year to end on September 30 in each year,
commencing with the fiscal year which ran from December 1, 1996 through
September 30, 1997.
<TABLE>
<CAPTION>
THE MERGER FUND CONDENSED FINANCIAL INFORMATION
(FOR THE FISCAL YEARS 1994 -- 1998) (AUDITED)
YEAR ENDED TEN MONTHS ENDED
SEPTEMBER-30,-------SEPTEMBER-30,--------------YEAR-ENDED-NOVEMBER-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/(Loss).............. 0.20(2)(3) 0.02(2)(3) 0.20(2)(3) 0.08(2)(3) --(2)(3)
Net Gain/(Loss) on securities (realized
and unrealized)....................... (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 capital 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 year (000's)........... $426,392 $445,987 $489,084 $243,082 $170,344
Ratio of 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 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 fiscal years ended September 30, 1998 and 1997 and for the fiscal
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 fiscal
years ended September 30, 1998 and 1997 and for the fiscal 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 fiscal years ended September 30, 1998 and 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 fiscal 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.
Further information regarding the Fund's performance is contained in the
Fund's Annual Report, a copy of which may be obtained without charge.
12
<PAGE> 15
For investors who want more information about the Fund, the following
documents are available upon request:
ANNUAL/SEMI-ANNUAL REPORTS: Additional information about the Fund's
investments is available in the Fund's annual and semi-annual reports to
shareholders. In the annual report, you will find a discussion of the market
conditions and investment strategies that significantly affected the Fund's
performance during its last fiscal year.
STATEMENT OF ADDITIONAL INFORMATION: The Fund's SAI provides more detailed
information about the Fund and is incorporated into this Prospectus by
reference.
The Fund's Annual Report, Semi-Annual Report and SAI are available, without
charge, upon request by contacting the Fund's Transfer Agent, Firstar Mutual
Fund Services, LLC, at 800-343-8959. Shareholder inquiries should be directed to
Firstar Mutual Fund Services, LLC, Mutual Fund Services, P.O. Box 701,
Milwaukee, WI 53201-0701. Correspondence sent by overnight courier should be
sent to Firstar Mutual Fund Services, LLC, Third Floor, 615 East Michigan
Street, Milwaukee, WI 53202.
You also can review the Fund's reports and SAI at the Securities and
Exchange Commission's Public Reference Room. Text-only copies can be obtained
from the SEC for a fee by writing to or calling the Public Reference Room of the
SEC, Washington, D.C. 20549-6009. 800-SEC-0330. Copies also can be obtained free
from the SEC's website at www.sec.gov.
Investment Company Act
File No. 811-3445
[THE MERGER FUND LOGO]
PROSPECTUS
JANUARY 27, 1999
<PAGE> 16
[THE MERGER FUND LOGO]
100 Summit Lake Drive
Valhalla, New York 10595
- --------------------------------------------------------------------------------
A no-load, open-end, nondiversified investment company which seeks capital
growth by engaging in merger arbitrage.
- --------------------------------------------------------------------------------
STATEMENT OF ADDITIONAL INFORMATION
JANUARY 27, 1999
- --------------------------------------------------------------------------------
THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A PROSPECTUS AND SHOULD BE
READ IN CONJUNCTION WITH THE PROSPECTUS OF THE MERGER FUND DATED JANUARY 27,
1999, A COPY OF WHICH MAY BE OBTAINED WITHOUT CHARGE BY CONTACTING THE FUND'S
TRANSFER AGENT, FIRSTAR MUTUAL FUND SERVICES, LLC, P.O. BOX 701, MILWAUKEE,
WISCONSIN 53201-0701 OR (800) 343-8959.
- --------------------------------------------------------------------------------
The Fund's financial statements are incorporated by reference in this
Statement of Additional Information from the Fund's Annual Report.
<PAGE> 17
TABLE OF CONTENTS
<TABLE>
<S> <C>
INVESTMENT OBJECTIVES AND POLICIES.......................... 1
Merger Arbitrage.......................................... 1
Special Risks of Over-the-Counter Options Transactions.... 1
Investment Restrictions................................... 2
INVESTMENT ADVISER.......................................... 4
Investment Adviser and Advisory Contract.................. 4
Other Service Providers................................... 4
MANAGEMENT.................................................. 6
Trustees and Officers..................................... 6
Remuneration.............................................. 6
SERVICES AND PLANS OFFERED BY THE FUND...................... 8
The Merger Fund IRA Plan.................................. 8
Fund Investors Keogh Plans................................ 8
Systematic Withdrawal Plan................................ 8
NET ASSET VALUE............................................. 9
ADDITIONAL INFORMATION ABOUT REDEMPTIONS.................... 9
PERFORMANCE INFORMATION..................................... 10
Total Return.............................................. 10
Other Information......................................... 10
Comparison of Fund Performance............................ 10
TAX STATUS.................................................. 11
ORGANIZATION AND CAPITALIZATION............................. 15
General................................................... 15
Shareholder and Trustee Liability......................... 15
ALLOCATION OF PORTFOLIO BROKERAGE........................... 16
PORTFOLIO TURNOVER.......................................... 16
INDEPENDENT ACCOUNTANTS..................................... 17
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT, ACCOUNTING
SERVICES AGENT AND ADMINISTRATOR.......................... 17
COUNSEL..................................................... 18
EXPERTS..................................................... 18
FINANCIAL STATEMENTS........................................ 18
APPENDIX.................................................... A-1
Covered Option Writing.................................... A-1
Money Market Instruments.................................. A-1
Repurchase Agreements..................................... A-1
Short Selling............................................. A-1
</TABLE>
i
<PAGE> 18
INVESTMENT OBJECTIVES AND POLICIES
(SEE "INVESTMENT OBJECTIVES AND
POLICIES" IN THE FUND'S PROSPECTUS.)
The Merger Fund (the "Fund") is a no-load, open-end, nondiversified,
registered management investment company which seeks to achieve capital growth
by engaging in merger arbitrage. The Fund's adviser is Westchester Capital
Management, Inc., 100 Summit Lake Drive, Valhalla, New York 10595 (the
"Adviser").
Trading to seek short-term capital appreciation can be expected to cause
the Fund's portfolio turnover rate to be substantially higher than that of the
average equity-oriented investment company and, as a result, may involve
increased brokerage commission costs which will be borne directly by the Fund
and ultimately by its investors. See "Allocation of Portfolio Brokerage" and
"Portfolio Turnover." Certain investments of the Fund may, under certain
circumstances, be subject to rapid and sizable losses, and there are additional
risks associated with the Fund's overall investment strategy, which may be
considered speculative.
MERGER ARBITRAGE.
Although a variety of strategies may be employed depending upon the nature
of the reorganizations selected for investment, the most common merger arbitrage
activity involves purchasing the shares of an announced acquisition target at a
discount from the expected value of such shares upon completion of the
acquisition. The size of the discount, or spread, and whether the potential
reward justifies the potential risk, are functions of numerous factors affecting
the riskiness and timing of the acquisition. Such factors include the status of
the negotiations between the two companies (for example, spreads typically
narrow as the parties advance from an agreement in principle to a definitive
agreement), the complexity of the transaction, the number of regulatory
approvals required, the likelihood of government intervention on antitrust or
other grounds, the type of consideration to be received and the possibility of
competing offers for the target company.
Because the expected gain on an individual arbitrage investment is normally
considerably smaller than the possible loss should the transaction be
unexpectedly terminated, Fund assets will not be committed unless the proposed
acquisition or other reorganization plan appears to the Adviser to have a
substantial probability of success. The expected timing of each transaction is
also extremely important since the length of time that the Fund's capital must
be committed to any given reorganization will affect the rate of return realized
by the Fund, and delays can substantially reduce such returns. See "Portfolio
Turnover."
SPECIAL RISKS OF OVER-THE-COUNTER OPTIONS TRANSACTIONS.
As part of its merger arbitrage strategy, the Fund may engage in
transactions in options and futures contracts which are traded over-the-counter
("OTC transactions"). OTC transactions differ from exchange-traded transactions
in several respects. OTC transactions are transacted directly with dealers and
not with a clearing corporation. Without the availability of a clearing
corporation, OTC transaction pricing is normally done by reference to
information from market makers, which information is carefully monitored by the
Adviser and verified in appropriate cases.
As the OTC transactions are transacted directly with dealers, there is a
risk of nonperformance by the dealer as a result of the insolvency of such
dealer or otherwise, in which event the Fund may experience a loss. An OTC
transaction may only be terminated voluntarily by entering into a closing
transaction with the dealer with whom the Fund originally dealt. Any such
cancellation, if agreed to, may require the Fund to pay a premium to that
dealer. In those cases in which the Fund has entered into a covered transaction
and cannot voluntarily terminate the transaction, the Fund will not be able to
sell the underlying security until the investment instrument expires or is
exercised or different cover is substituted. In such cases, the Fund may not be
able to sell an underlying security even though it might otherwise be
advantageous to do so.
It is the Fund's intention to enter into OTC transactions only with dealers
which agree to, and which are expected to be capable of, entering into closing
transactions with the Fund, although there is no assurance that
1
<PAGE> 19
a dealer will voluntarily agree to terminate the transaction. There is also no
assurance that the Fund will be able to liquidate an OTC transaction at any time
prior to expiration. OTC transactions for which there is no adequate secondary
market will be considered illiquid.
INVESTMENT RESTRICTIONS.
The following investment restrictions have been adopted by the Fund as
fundamental policies and may be changed only by the affirmative vote of a
majority of the outstanding shares of the Fund. As used in this Statement of
Additional Information and in the Fund's prospectus, the term "majority of the
outstanding shares of the Fund" means the vote of (i) 67% or more of the Fund's
shares present at a meeting, if the holders of more than 50% of the outstanding
shares of the Fund are present or represented by proxy, or (ii) more than 50% of
the Fund's outstanding shares, whichever is less.
These investment restrictions provide that:
(1) The Fund may not issue senior securities other than to evidence
borrowings as permitted in paragraph (5) below.
(2) The Fund may not make short sales of securities (unless by virtue
of its ownership of other securities at the time of such sale, it owns or
has a prospective right to receive, without the payment of additional
compensation, securities equivalent in kind and amount to the securities
sold). The total market value of all securities sold short may not exceed
50% of the value of the net assets of the Fund, and the value of securities
of any one issuer in which the Fund is short may not exceed the lesser of
10% of the value of the Fund's net assets or 10% of the securities of any
class of any issuer.
(3) The Fund may not purchase securities on margin, except that the
Fund may obtain such short-term credits as may be necessary for the
clearance of purchases and sales of securities.
(4) The Fund may not (a) purchase call options except to terminate,
through a closing purchase transaction, its obligation with respect to a
previously written covered call option; (b) sell uncovered (naked) call
options; (c) sell covered call options the underlying securities of which
have an aggregate value (determined as of the date the calls are sold)
exceeding 50% of the value of the net assets of the Fund; or (d) invest in
put options to the extent that the premiums on protective put options
exceed 25% of the value of its net assets; provided that the provisions of
this paragraph (4) shall not prevent the purchase, ownership, holding or
sale of forward contracts with respect to foreign securities or currencies.
(5) The Fund may not borrow money except that it may borrow (i) from
banks to purchase or carry securities or other investments, (ii) from banks
for temporary or emergency purposes, or (iii) by entering into reverse
repurchase agreements, if, immediately after any such borrowing, the value
of the Fund's assets, including all borrowings then outstanding less its
liabilities, is equal to at least 300% of the aggregate amount of
borrowings then outstanding (for the purpose of determining the 300% asset
coverage, the Fund's liabilities will not include amounts borrowed). Any
such borrowings may be secured or unsecured. The Fund may issue securities
(including senior securities) appropriate to evidence the indebtedness,
including reverse repurchase agreements, which the Fund is permitted to
incur.
(6) The Fund may not pledge, mortgage or hypothecate its assets,
except that to secure borrowings as permitted in paragraph (5) above, the
Fund may pledge securities having a market value at the time of pledge not
exceeding 33% of the value of its total assets. The Fund may, in addition,
pledge securities having a market value at the time of pledge not exceeding
50% of the value of its net assets to secure short sales as permitted in
paragraph (2) above or covered option writing as permitted in paragraph (4)
above.
(7) The Fund may not underwrite or participate in the marketing of
securities issued by other persons except to the extent that the Fund may
be deemed to be an underwriter under federal securities laws in connection
with the disposition of portfolio securities.
(8) The Fund may not knowingly purchase or otherwise acquire
securities which are subject to legal or contractual restrictions on resale
or invest more than 10% of its total assets in securities without readily
available market quotations, including repurchase agreements having a
maturity of more than seven days.
2
<PAGE> 20
(9) The Fund may not concentrate its investments in any industry. No
more than 25% of the value of the total assets of the Fund may be invested
in the securities of issuers having their principal business activities in
the same industry.
(10) The Fund may not purchase or sell real estate or real estate
mortgage loans as such, but this restriction shall not prevent the Fund
from investing in readily marketable interests in real estate investment
trusts, readily marketable securities of companies which invest in real
estate, or obligations secured by real estate or interests therein.
(11) The Fund may not purchase or sell commodities or commodity
contracts.
(12) The Fund may not make loans, except that subject to paragraph
(8), the Fund may enter into repurchase agreements maturing in seven days
or less.
(13) The Fund may not purchase warrants, valued at the lower of cost
or market, in excess of 5% of the net assets of the Fund (taken at current
value); provided that this shall not prevent the purchase, ownership,
holding or sale of warrants of which the grantor is the issuer of the
underlying securities. Included within that amount, but not to exceed 2% of
the value of the Fund's net assets, may be warrants which are not listed on
the New York or American Stock Exchange. Warrants acquired by the Fund at
any time in units or attached to securities are not subject to this
restriction.
(14) The Fund may not invest in interests (other than equity stock
interests or debentures) in oil, gas or other mineral exploration or
development programs.
(15) The Fund may not invest in companies for the purpose of
exercising control or management.
(16) The Fund may not purchase or retain the securities of any issuer,
other than its own securities, if, to the knowledge of the Fund's
management, the Trustees and officers, or the directors and employees of
the Fund's investment adviser, who individually own beneficially more than
1/2% of the outstanding securities of such issuer, together own
beneficially more than 5% of such outstanding securities.
(17) The Fund may not invest more than 5% of the value of its total
assets in the securities of issuers which, together with any predecessors,
have been in continuous operation for less than three years.
(18) The Fund may not participate on a joint or a joint and several
basis in any trading account in securities.
(19) The Fund may not purchase securities of other investment
companies, except by purchases in the open market where no underwriter or
dealer's commission or profit is involved, other than customary brokers'
commissions, and except as they may be acquired as part of a merger,
consolidation or acquisition of assets.
(20) The Fund may not invest more than 10% of its total assets (taken
at market value) in the securities of any one issuer, except those issued
or guaranteed by the United States Government, its agencies or
instrumentalities.
(21) The Fund may not purchase securities of any one issuer if as a
result more than 10% of the voting securities of such issuer would be held
by the Fund.
If a particular percentage restriction as set forth above is adhered to at
the time of investment, a later increase or decrease in percentage resulting
from a change in values or assets will not constitute a violation of that
restriction.
3
<PAGE> 21
INVESTMENT ADVISER
(SEE "INVESTMENT ADVISER" AND "PRINCIPAL
UNDERWRITER" IN THE FUND'S PROSPECTUS.)
INVESTMENT ADVISER AND ADVISORY CONTRACT.
The Fund's investment advisory contract with the Adviser (the "Advisory
Contract") provides that the Fund pay all of the Fund's expenses, including,
without limitation, (i) the costs incurred in connection with registration and
maintenance of its registration under the Securities Act of 1933, as amended,
the Investment Company Act of 1940, as amended, and state securities laws and
regulations, (ii) preparation of and printing and mailing reports, notices and
prospectuses to current shareholders, (iii) transfer taxes on the sales of the
Fund's shares and on the sales of portfolio securities, (iv) brokerage
commissions, (v) custodial and shareholder transfer charges, (vi) legal,
auditing and accounting expenses, (vii) expenses of servicing shareholder
accounts, (viii) insurance expenses for fidelity and other coverage, (ix) fees
and expenses of Trustees who are not "interested persons" within the meaning of
the Investment Company Act of 1940, (x) expenses of Trustee and shareholder
meetings and (xi) any expenses of distributing the Fund's shares which may be
payable pursuant to a Plan of Distribution adopted pursuant to Rule 12b-1 under
the Investment Company Act of 1940. The Fund is also liable for such
nonrecurring expenses as may arise, including litigation to which the Fund may
be a party. The Fund has an obligation to indemnify each of its officers and
Trustees with respect to such litigation but not against any liability to which
he would otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the conduct of his
office.
The Adviser receives an advisory fee, payable monthly, for the performance
of its services at an annual rate of 1.0% (1/12 of 1% monthly) of the average
daily net assets of the Fund. The fee will be accrued daily for the purpose of
determining the offering and redemption price of the Fund's shares.
The Advisory Contract will continue in effect from year to year provided
such continuance is approved at least annually by (i) a vote of the majority of
the Fund's Trustees who are not parties thereto or "interested persons" (as
defined in the Investment Company Act of 1940) of the Fund or the Adviser, cast
in person at a meeting specifically called for the purpose of voting on such
approval and by (ii) the majority vote of either all of the Fund's Trustees or
the vote of a majority of the outstanding shares of the Fund. The Advisory
Contract may be terminated without penalty on 60 days' written notice by a vote
of a majority of the Fund's Trustees or by the Adviser, or by holders of a
majority of the Fund's outstanding shares. The Advisory Contract shall terminate
automatically in the event of its assignment.
For the fiscal years ended November 30, 1996, September 30, 1997 and
September 30, 1998, the Fund incurred advisory fees of $4,114,105, $3,864,592
and $4,722,291, respectively, to the Adviser.
OTHER SERVICE PROVIDERS.
The Fund's principal underwriter is Mercer Allied Company, L.P. ("Mercer"),
One Wall Street, Albany, New York 12205. Mercer is a Delaware limited
partnership organized in 1994, and is currently majority-owned by The Ayco
Company, L.P., a registered investment adviser principally engaged in personal
financial counseling. Mercer is a broker-dealer registered under the Securities
Exchange Act of 1934 and a member of the National Association of Securities
Dealers, Inc.
The Fund has adopted a plan of distribution dated July 14, 1998 (the
"Plan") pursuant to Rule 12b-1 under the Investment Company Act of 1940. Under
the Plan, the Fund may pay to Mercer, to any broker-dealer with whom Mercer or
the Fund has entered into a contract to distribute Fund shares, or to any other
qualified financial services firm, compensation for distribution and/or
shareholder-related services with respect to shares held or purchased by their
respective customers or in connection with the purchase of shares attributable
to their efforts. 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.
4
<PAGE> 22
The Plan provides that the Trustees will review, at least quarterly, a
report of distribution expenses incurred under the Plan and the purposes for
which such expenses were incurred. The Plan will remain in effect from year to
year provided such continuance is approved at least annually by the vote of a
majority of the Fund's Trustees who are not "interested persons" (as defined in
the Investment Company Act of 1940) of the Fund, the Adviser or Mercer and who
have no direct or indirect interest in the operation of the Plan or any related
agreement (the "Rule 12b-1 Trustees"), cast in person at a meeting called for
the purpose of voting on such approval, and additionally by a vote of either a
majority of the Fund's Trustees or a majority of the outstanding shares of the
Fund.
The Plan may be terminated at any time by vote of a majority of the Rule
12b-1 Trustees or by vote of a majority of the Fund's outstanding shares. The
Plan may not be amended to increase materially the amount of distribution
expenses payable under the Plan without approval of the Fund's shareholders. In
addition, all material amendments to the Plan must be approved by the Trustees
in the manner described above.
The Fund has entered into service agreements with, among others, Charles
Schwab & Company, Inc. ("Schwab") and National Financial Services Corporation
("NFSC"). Though the terms of the Fund's agreements vary, service providers
generally are required to provide various shareholder services to the Fund,
including records maintenance, shareholder communications, transactional
services, tax information and reports, and facilitation of purchase and
redemption orders. Payments generally are made under the Plan at the annual rate
of 0.25% of the value of the Fund's shares held in accounts maintained by each
such service provider. In the case of the Fund's agreements with Schwab and
NFSC, the Adviser is required to pay an additional 0.10% of the value of all
Fund shares held in their respective accounts. The Fund is required to make
these payments to its service providers regardless of any actual expenses
incurred by them.
The Fund incurred total expenses of $708,635, $618,416 and $580,487 during
fiscal years 1998, 1997 and 1996, respectively, under its agreements with its
principal underwriter and other service providers. During fiscal 1998, the Fund
paid or accrued $83,625 to Mercer, $361,109 to Schwab and $125,684 to NFSC.
During fiscal 1997, the Fund paid or accrued $57,379 to Mercer, $329,465 to
Schwab and $99,841 to NFSC. During fiscal 1996, the Fund paid or accrued $26,269
to Mercer, $221,322 to Schwab and $63,802 to NFSC.
During the last fiscal year, the Fund paid or incurred the following
amounts for the following services under the Plan:
<TABLE>
<S> <C>
Advertising............................................. $ --
Printing and mailing prospectuses to other than current
shareholders.......................................... 2,705
Compensation to broker-dealers.......................... 768,489
Compensation to sales personnel......................... --
Interest, carrying or other financing charges........... --
Other................................................... --
</TABLE>
5
<PAGE> 23
MANAGEMENT
TRUSTEES AND OFFICERS.
The Fund's Trustees and officers are listed below. Except as indicated,
each Trustee has held the office shown or other offices in the same company for
the last five years.
The "interested" Trustees as defined in the Investment Company Act of 1940
are indicated by an asterisk(*).
<TABLE>
<CAPTION>
POSITION(S) HELD PRINCIPAL OCCUPATION(S)
NAME AND ADDRESS AGE WITH THE FUND DURING THE PAST 5 YEARS
- ---------------- --- ----------------------- -------------------------------
<S> <C> <C> <C>
Frederick W. Green*............ 52 President and Trustee President of Westchester
Westchester Capital Management, Capital Management, Inc., the
Inc. Fund's Adviser.
100 Summit Lake Drive
Valhalla, NY 10595
Bonnie L. Smith................ 50 Vice President, Vice President of Westchester
Westchester Capital Management, Treasurer and Secretary Capital Management, Inc., the
Inc. Fund's Adviser.
100 Summit Lake Drive
Valhalla, NY 10595
William H. Bohnett*............ 50 Assistant Secretary and Partner in the law firm of
Fulbright & Jaworski L.L.P. Trustee Fulbright & Jaworski L.L.P.
666 Fifth Avenue
New York, NY 10103
James P. Logan, III............ 62 Trustee President of Logan, Chace &
Logan, Chace & Company, Inc. Company, Inc., an executive
420 Lexington Avenue search firm.
New York, NY 10170
Michael J. Downey.............. 55 Trustee Consultant and independent
2 Parsons Lane financial adviser since July
Rochester, NY 14610 1993. President and Director of
Asia Pacific Fund, Inc.
Joseph Neuberger............... 36 Assistant Secretary Vice President of Firstar
Firstar Mutual Fund Services, Mutual Fund Services, LLC, and
LLC Manager of Fund Administration
615 East Michigan Street and Compliance since August
Milwaukee, WI 53202 1994. Previously, manager with
Arthur Andersen LLP.
Michael Peck................... 31 Assistant Secretary Compliance Administrator and
Firstar Mutual Fund Services, other positions, Firstar Mutual
LLC Fund Services, LLC.
615 East Michigan Street
Milwaukee, WI 53202
</TABLE>
As of January 27, 1999, the Trustees and officers of the Fund and the
Adviser's retirement funds, as a group, owned less than 1% of the Fund's
outstanding shares.
REMUNERATION.
Management considers that Messrs. Logan and Downey are not "interested
persons" (as defined in the Investment Company Act of 1940) of the Fund or the
Adviser. The fees of the non-interested Trustees (which are $6,000 per year and
$1,000 per meeting attended effective January 1, 1999), in addition to their
out-of-
6
<PAGE> 24
pocket expenses in connection with attendance at Trustees meetings, are paid by
the Fund. For the fiscal year ended September 30, 1998, the Fund paid the
following in Trustees' fees:
COMPENSATION TABLE
(FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998)
<TABLE>
<CAPTION>
PENSION OR ESTIMATED
AGGREGATE RETIREMENT BENEFITS ANNUAL TOTAL
COMPENSATION ACCRUED AS PART OF BENEFITS UPON COMPENSATION
NAME OF TRUSTEE FROM REGISTRANT FUND EXPENSES RETIREMENT FROM REGISTRANT
- --------------- --------------- -------------------- ------------- ---------------
<S> <C> <C> <C> <C>
Frederick W. Green............... 0 0 0 0
William H. Bohnett............... 0 0 0 0
Michael J. Downey................ $8,000 0 0 $8,000
James P. Logan................... 8,000 0 0 8,000
Frank McDermott (resigned October
13, 1998)...................... 8,000 0 0 8,000
</TABLE>
7
<PAGE> 25
SERVICES AND PLANS OFFERED BY THE FUND
(SEE "PLANS OFFERED BY THE FUND" IN THE FUND'S PROSPECTUS.)
The costs of services rendered to the Fund's investors by its transfer
agent, Firstar Mutual Fund Services, LLC ("Firstar") are paid for by the Fund;
however, in order to cover abnormal administrative costs, investors requesting
an historical transcript of their account will be charged a fee based upon the
number of years researched. The Fund reserves the right, on 60 days' written
notice, to charge investors to cover other administrative costs of services
provided to shareholders.
THE MERGER FUND IRA PLAN.
The Fund makes available an Individual Retirement Account ("IRA"), known as
"The Merger Fund IRA Plan." The Merger Fund IRA Plan provides individuals with
the opportunity to establish an IRA in order to purchase shares of the Fund. The
Merger Fund IRA Plan can also be used for a transfer from an existing IRA, or
for a rollover from a qualified retirement plan from which the individual
receives a lump-sum distribution. The form of The Merger Fund IRA Plan meets the
requirements of Section 408 of the Internal Revenue Code. Firstar Bank
Milwaukee, N.A. acts as custodian for The Merger Fund IRA Plan, and the adoption
of The Merger Fund IRA Plan by each individual is subject to acceptance or
rejection by Firstar Bank Milwaukee, N.A. in its capacity as custodian.
The Fund also makes available to qualifying shareholders a "Roth IRA,"
which is a form of IRA created in 1997. Shareholders should consult with their
own financial advisers to determine eligibility.
FUND INVESTORS KEOGH PLANS.
The Fund makes available the Fund Investors Defined Contribution Prototype
Plan (the "Fund Investors Defined Contribution Keogh Plan") and the Fund
Investors Defined Benefit Prototype Plan (the "Fund Investors Defined Benefit
Keogh Plan"). The Fund Investors Defined Contribution Keogh Plan and the Fund
Investors Defined Benefit Keogh Plan (collectively hereinafter referred to as
the "Fund Investors Keogh Plans") provide opportunities to corporations,
self-employed individuals and partnerships to establish qualified retirement
plans under which shares of the Fund may be purchased. The Fund Investors Keogh
Plans can, in most cases, also accept a transfer or a rollover from an existing
qualified retirement plan from which an individual receives a lump-sum
distribution of the individual's entire account balance in such plan. A defined
benefit qualified retirement plan specifies what a participant's pension benefit
will be, and the employer (including a self-employed individual) adopting the
plan must then fund the plan on an actuarial basis so it can pay the promised
benefit. A defined contribution qualified retirement plan does not promise any
definite benefit but instead provides for certain contributions to be made to
the plan, and a participant's ultimate benefit depends on the amount that has
accumulated in his account. The Fund Investors Keogh Plans have received an
opinion from the Internal Revenue Service approving the plans as prototype plans
which meet the requirements of Sections 401 and 501 of the Internal Revenue Code
of 1986, as amended. The Fund Investors Keogh Plans are in the process of being
submitted to the Internal Revenue Service for additional approval of certain
amendments required by recent changes in tax law. Firstar acts as custodian of
the Fund Investors Keogh Plans. The Fund Investors Keogh Plans as adopted by
each employer (including a self-employed individual) or partnership are subject
to acceptance or rejection by Firstar in its capacity as trustee of the Fund
Investors Keogh Plans.
SYSTEMATIC WITHDRAWAL PLAN.
Shareholders participating in the Fund's Systematic Withdrawal Plan should
note that disbursements may be based on the redemption of a fixed dollar amount,
fixed number of shares, percent of account or declining balance. Any income,
dividends and capital gain distributions on shares held in Systematic Withdrawal
Plan accounts will be reinvested in additional Fund shares. Systematic
Withdrawal Plan payments will be made out of the proceeds realized from the
redemption of Fund shares held in the account. These redemptions made to effect
withdrawal payments may reduce or exhaust entirely the original investment held
under the Plan. A Systematic Withdrawal Plan may be terminated at any time by
the shareholder or the Fund
8
<PAGE> 26
upon written notice and will be automatically terminated when all Fund shares in
the shareholder's account under the Plan have been liquidated.
NET ASSET VALUE
(SEE "NET ASSET VALUE" IN THE FUND'S PROSPECTUS.)
The net asset value per share of the Fund will be determined on each day
when the New York Stock Exchange is open for business and will be computed by
taking the aggregate market value of all assets of the Fund less its
liabilities, and dividing by the total number of shares outstanding. Each
determination will be made (i) by valuing portfolio securities, including open
short positions, which are traded on the New York Stock Exchange, American Stock
Exchange and on the Nasdaq National Market System at the last reported sales
price on that exchange; (ii) by valuing put and call options which are traded on
the Chicago Board Options Exchange or any other domestic exchange at the last
sale price on such exchange; (iii) by valuing listed securities and put and call
options for which no sale was reported on a particular day and securities traded
on the over-the-counter market at the mean between the last bid and asked
prices; and (iv) by valuing any securities or other assets for which market
quotations are not readily available at fair value in good faith and under the
supervision of the Trustees, although the actual calculation may be done by
others. The Adviser reserves the right to value securities, including options,
at prices other than last-sale prices when such last-sale prices are believed
unrepresentative of fair market value as determined in good faith by the
Adviser.
The assets of the Fund received for the issue or sale of its shares, and
all income, earnings, profits and proceeds thereof, subject only to the rights
of creditors, shall constitute the underlying assets of the Fund. In the event
of the dissolution or liquidation of the Fund, the holders of shares of the Fund
are entitled to share pro rata in the net assets of the Fund available for
distribution to shareholders.
ADDITIONAL INFORMATION ABOUT REDEMPTIONS
(SEE "REDEMPTIONS" IN THE FUND'S PROSPECTUS.)
Supporting documents in addition to those listed under "Redemptions" in the
Fund's prospectus will be required from executors, administrators, trustees, or
if redemption is requested by one other than the shareholder of record. Such
documents include, but are not restricted to, stock powers, trust instruments,
certificates of death, appointments as executor, certificates of corporate
authority and waiver of tax required in some states when settling estates.
Under the Investment Company Act of 1940, a shareholder's right to redeem
shares and to receive payment therefor may be suspended at times: (a) when the
New York Stock Exchange is closed, other than customary weekend and holiday
closings; (b) when trading on that exchange is restricted for any reason; (c)
when an emergency exists as a result of which disposal by the Fund of securities
owned by it is not reasonably practicable or it is not reasonably practicable
for the Fund fairly to determine the value of its net assets, provided that
applicable rules and regulations of the Securities and Exchange Commission (or
any succeeding governmental authority) will govern as to whether the conditions
prescribed in (b) or (c) exist; or (d) when the Securities and Exchange
Commission by order permits a suspension of the right to redemption or a
postponement of the date of payment on redemption. In case of suspension of the
right of redemption, payment of a redemption request will be made based on the
net asset value next determined after the termination of the suspension.
9
<PAGE> 27
PERFORMANCE INFORMATION
TOTAL RETURN.
Average annual total return quotations which may used in the Fund's
advertising and promotional materials are calculated according to the following
formula:
P(1+T)(n) = ERV
<TABLE>
<S> <C> <C> <C>
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment
made at the beginning of the period.
</TABLE>
Under the foregoing formula, the time periods used in any advertising will
be based on rolling calendar quarters, updated to the last day of the most
recent quarter prior to submission of the advertising for publication. Average
annual total return, or "T" in the above formula, is computed by finding the
average annual compounded rates of return over the period that would equate the
initial amount invested to the ending redeemable value. Average annual total
return assumes the reinvestment of all dividends and distributions.
The calculation assumes an initial $1,000 payment and assumes all dividends
and distributions by the Fund are reinvested at the price stated in the
Prospectus on the reinvestment dates during the period, and includes all
recurring fees that are charged to all shareholder accounts.
A Fund may also calculate total return on a cumulative basis which reflects
the cumulative percentage change in value over the measuring period. The formula
for calculating cumulative total return can be expressed as follows:
Cumulative Total Return = [(ERV) -- 1]
P
OTHER INFORMATION.
The Fund's performance data quoted in any advertising and other promotional
materials represents past performance and is not intended to predict or indicate
future results. The return and principal value of an investment in the Fund will
fluctuate, and an investor's redemption proceeds may be more or less than the
original investment amount.
COMPARISON OF FUND PERFORMANCE.
The performance of the Fund may be compared to data prepared by Lipper
Analytical Services, Inc., Morningstar, Inc. or other independent services which
monitor the performance of investment companies, and may be quoted in
advertising in terms of its ranking in each applicable universe. In addition,
the Fund may use performance data reported in financial and industry
publications, including Barron's, Business Week, Forbes, Fortune, Investor's
Daily, IBC/Donoghue's Money Fund Report, Money Magazine, The Wall Street Journal
and USA Today.
The Fund may from time to time use the following unmanaged index for
performance comparison purposes:
S&P 500 Index -- the S&P 500 is an index of 500 stocks designed to mirror
the overall equity market's industry weighting. Most, but not all, large
capitalization stocks are in the Index. There are also some small capitalization
names in the Index. The Index is maintained by Standard & Poor's Corporation. It
is market capitalization weighted. There are always 500 issuers in the S&P 500.
Changes are made by Standard & Poor's as needed.
10
<PAGE> 28
TAX STATUS
(SEE "TAX STATUS, DIVIDENDS AND DISTRIBUTIONS" IN THE FUND'S PROSPECTUS.)
The Fund has qualified and elected to be treated as a regulated investment
company under the Internal Revenue Code of 1986, as amended (the "Code"), and
intends to continue to so qualify, which requires compliance with certain
requirements concerning the sources of its income, diversification of its
assets, and the amount and timing of its distributions to shareholders. Such
qualification does not involve supervision of management or investment practices
or policies by any government agency or bureau. By so qualifying, the Fund will
not be subject to federal income or excise tax on its net investment income or
net capital gain which are distributed to shareholders in accordance with the
applicable timing requirements. Net investment income and net capital gain of
the Fund will be computed in accordance with Section 852 of the Code.
The Fund intends to distribute all of its net investment income, any excess
of net short-term capital gains over net long-term capital losses, and any
excess of net long-term capital gains over net short-term capital losses in
accordance with the timing requirements imposed by the Code and therefore will
not be required to pay any federal income or excise taxes. Distributions of net
investment income and net capital gain will be made after September 30, the end
of each fiscal year, and no later than December 31 of each year. Both types of
distributions will be in shares of the Fund unless a shareholder elects to
receive cash.
The Fund is subject to a 4% nondeductible excise tax on certain
undistributed amounts of ordinary income and capital gain under a prescribed
formula contained in Section 4982 of the Code. The formula requires payment to
shareholders during a calendar year of distributions representing at least 98%
of the Fund's ordinary income for the calendar year and at least 98% of its
capital gain net income (i.e., the excess of its capital gains over capital
losses) realized during the one-year period ending October 31 during such year
plus 100% of any income that was neither distributed nor taxed to the Fund
during the preceding calendar year. Under ordinary circumstances, the Fund
expects to time its distributions so as to avoid liability for this tax.
Net investment income is made up of dividends and interest less expenses.
Net capital gain for a fiscal year is computed by taking into account any
capital loss carryforward of the Fund.
The following discussion of tax consequences is for the general information
of shareholders who are subject to tax. Shareholders that are IRAs, Keogh plans
or other qualified retirement plans are exempt from income taxation under the
Code.
To the extent that the Fund retains any of its net long-term capital gain
for the year for reinvestment, requiring federal corporate income taxes to be
paid thereon by the Fund, the Fund will elect to treat the undistributed net
long-term capital gain as having been distributed to shareholders. As a result,
each shareholder will report for federal income tax purposes its proportionate
share of the undistributed net long-term capital gain, will be able to claim his
proportionate share of federal income taxes paid by the Fund on that amount as a
credit against his own federal income tax liability and will be able to claim a
refund to the extent that the credit exceeds such tax liability. In addition,
each shareholder of the Fund will be entitled to increase the adjusted tax basis
of his Fund shares by the difference between his pro rata share of such
undistributed gain and his deemed tax credit.
Distributions of taxable net investment income and the excess of net
short-term capital gain over net long-term capital loss are taxable to
shareholders as ordinary income.
Dividends from domestic corporations may comprise some portion of the
Fund's gross income. To the extent that such dividends constitute a portion of
the Fund's gross income, a portion of the income distributions received by
corporations from the Fund may be eligible for the 70% deduction for dividends
received. Taxable corporate shareholders will be informed of the portion of
dividends which so qualify. Receipt of qualifying dividends may result in the
reduction of a corporate shareholder's tax basis in its shares by the untaxed
portion of such dividends if they are treated as "extraordinary dividends" under
Section 1059 of the Code. The dividends-received deduction is reduced to the
extent the shares of the Fund with respect to which the dividends are received
are treated as debt-financed under federal income tax law and is eliminated if
the
11
<PAGE> 29
shares are deemed to have been held for less than 46 days (91 days for preferred
stock) during the 90-day (180 days for preferred stock) period beginning on the
date which is 45 days (90 days for preferred stock) before the ex-dividend date
(for this purpose, holding periods are reduced for periods where the risk of
loss with respect to shares is diminished). The same restrictions apply to the
Fund with respect to its ownership of the dividend-paying stock. In addition,
the deducted amount is included in the calculation of the federal alternative
minimum tax, if any, applicable to such corporate shareholders.
Distributions of net capital gain ("capital gain dividends") are taxable to
shareholders as long-term capital gain, regardless of the length of time the
shares of the Fund have been held by such shareholders. Capital gain dividends
are not eligible for the dividends-received deduction. A noncorporate
shareholder's net capital gains will be taxed at a maximum rate of 20% for
property held more than 12 months.
A redemption of Fund shares by a shareholder will result in the recognition
of taxable gain or loss depending upon the difference between the amount
realized and his tax basis in his Fund shares. Such gain or loss is treated as a
capital gain or loss if the shares are held as capital assets. In the case of a
noncorporate shareholder, if such shares were held for more than 12 months at
the time of disposition such gain will be long-term capital gain and will be
taxed at a maximum effective rate of 20%; and if such shares were held for one
year or less at the time of disposition, such gain will be short-term capital
gain and will be taxed at a maximum effective rate of 39.6%. Capital gains of
corporate shareholders will be long-term or short-term depending upon whether
the shareholder's holding period exceeds one year, and are not subject to
varying effective tax rates. However, any loss realized upon the redemption of
shares within six months from the date of their purchase will be treated as a
long-term capital loss to the extent of any amounts treated as capital gain
dividends during such six-month period. All or a portion of any loss realized
upon the redemption of shares may be disallowed to the extent shares are
purchased (including shares acquired by means of reinvested dividends) within 30
days before or after such redemption.
All distributions will be included in the individual shareholder's
alternative minimum taxable income and in the income which may be subject to tax
under the alternative minimum tax for corporations.
Distributions of taxable net investment income and net capital gain will be
taxable as described above, whether received in shares or in cash. Shareholders
electing to receive distributions in the form of additional shares will have a
cost basis for federal income tax purposes in each share so received equal to
the net asset value of a share on the reinvestment date.
All distributions of taxable net investment income and net capital gain,
whether received in shares or in cash, must be reported by each taxable
shareholder on his or her federal income tax return. Dividends or distributions
declared in October, November or December as of a record date in such a month,
if any, will be deemed to have been received by shareholders on December 31, if
paid during January of the following year. Redemptions of shares may result in
tax consequences (gain or loss) to the shareholder and are also subject to these
reporting requirements.
Assuming sufficient earned income, an individual may generally contribute
up to $2,000 per year to a regular IRA. A regular IRA contribution may be
deductible if (i) neither the individual nor his or her spouse is an active
participant in an employer's retirement plan ("Plan Participant"), or (ii) the
individual (and his or her spouse, if applicable) has an adjusted gross income
("AGI") below a certain level ("Threshold Level"). For 1999, the Threshold Level
is $51,000 for married individuals filing a joint return (with a phase-out of
the deduction for AGI between $51,000 and $61,000) and $31,000 for a single
individual (with a phase-out of the deduction for AGI between $31,000 and
$41,000). The Threshold Levels are scheduled to continue to gradually increase
through the year 2007. There is a separate Threshold Level and phase-out limit
that applies to certain individuals who are not Plan Participants but whose
spouses are Plan Participants. These "non-working spouses" can make deductible
IRA contributions for a taxable year if their AGI does not exceed $150,000 (with
a phase-out of the deduction for AGI between $150,000 and $160,000).
There are a number of additional forms of IRA that may be available,
including a Roth IRA and an Educational IRA. Shareholders should contact their
tax advisers for more information regarding their eligibility to make IRA
contributions and the advisability of same.
12
<PAGE> 30
Distributions by the Fund result in a reduction in the net asset value of
the Fund's shares. Should a distribution reduce the net asset value below a
shareholder's cost basis, such distribution would nevertheless be taxable to the
shareholder as ordinary income or capital gain as described above, even though,
from an investment standpoint, it may constitute a partial return of capital. In
particular, investors should consider the tax implications of buying shares just
prior to a distribution. The price of shares purchased at that time includes the
amount of the forthcoming distribution. Those purchasing just prior to a
distribution will then receive a partial return of capital upon the
distribution, which will nevertheless be taxable to them.
If the Fund makes a "constructive sale" of an "appreciated financial
position," the Fund will recognize gain as if the position were sold at fair
market value on the date of such constructive sale. Constructive sales include
short sales of substantially identical property, offsetting notional principal
contracts with respect to substantially identical property and futures and
forward contracts to deliver substantially identical property. However,
transactions that otherwise would be treated as constructive sales are
disregarded if closed within 30 days after the close of the taxable year and the
Fund holds the position and does not hedge such position for 60 days thereafter.
In addition, to the extent provided in regulations (which have not yet been
promulgated), a constructive sale also occurs if a taxpayer enters into one or
more other transactions (or acquires one or more positions) that have
"substantially the same effect" as the transactions described above. Appreciated
financial positions include positions with respect to stock, debt, instruments
or partnership interests if gain would be recognized on a disposition at fair
market value. If the constructive sale rules apply, adjustments are made to the
basis and holding period of the affected financial position.
Equity options (including call and put options on stock) and
over-the-counter options on debt securities written or purchased by the Fund
will be subject to tax under Section 1234 of the Code. The character of any gain
or loss recognized (i.e., long-term or short-term) generally will depend, in the
case of a lapse or sale of the option, on the Fund's holding period for the
option, and in the case of an exercise of the option, on the Fund's holding
period for the underlying security. The purchase of a put option may constitute
a short sale for federal income tax purposes, causing an adjustment in the
holding period of the underlying security or a substantially identical security
in the Fund's portfolio. If the Fund writes a put or call option, no gain is
recognized upon its receipt of a premium. If the option lapses or is closed out,
any gain or loss is treated as short-term capital gain or loss. If a call option
is exercised, the character of the gain or loss depends on the holding period of
the underlying security. The exercise of a put option written by the Fund is not
a taxable transaction for the Fund.
Any listed nonequity options written or purchased by the Fund (including
options on debt securities) will be governed by Section 1256 of the Code. Absent
a tax election to the contrary, gain or loss attributable to the lapse, exercise
or closing out of any such position will be treated as 60% long-term and 40%
short-term capital gain or loss, and on the last trading day of the Fund's
fiscal year, all outstanding Section 1256 positions will be marked to market
(i.e., treated as if such positions were closed out at their closing price on
such day), with any resulting gain or loss recognized as 60% long-term and 40%
short-term capital gain or loss.
Ordinarily, gains and losses realized from portfolio transactions will be
treated as capital gain or loss. However, all or a portion of the gain or loss
from the disposition of non-U.S. dollar denominated securities (including debt
instruments, certain financial forward, futures and option contracts, and
certain preferred stock) may be treated as ordinary income or loss under Section
988 of the Internal Revenue Code. In addition, all or a portion of the gain
realized from the disposition of market discount bonds will be treated as
ordinary income under Section 1276 of the Internal Revenue Code. Generally, a
market discount bond is defined as any bond bought by the Fund after its
original issuance at a price below its face or accreted value. Finally, all or a
portion of the gain realized from engaging in "conversion transactions" may be
treated as ordinary income under Section 1258 of the Internal Revenue Code.
"Conversion transactions" are defined to include certain forward, futures,
option and straddle transactions, transactions marketed or sold to produce
capital gains, or transactions described in Treasury regulations to be issued in
the future.
Offsetting positions held by the Fund involving certain financial forward,
futures or options contracts (including certain foreign currency forward
contracts or options) may constitute "straddles." "Straddles" are defined to
include "offsetting positions" in actively traded personal property. The tax
treatment of "straddles"
13
<PAGE> 31
is governed by Sections 1092 and 1258 of the Internal Revenue Code, which, in
certain circumstances, override or modify the provisions of Sections 1256 and
988. If the Fund were treated as entering into "straddles" by reason of its
engaging in certain forward contracts or options transactions, such "straddles"
would be characterized as "mixed straddles" if the forward contracts or options
transactions comprising a part of such "straddles" were governed by Section
1256. The Fund may make one or more elections with respect to "mixed straddles."
Depending on which election is made, if any, the results to the Fund may differ.
If no election is made to the extent the "straddle" rules apply to positions
established by the Fund, losses realized by the Fund will be deferred to the
extent of unrealized gain in the offsetting position. Moreover, as a result of
the "straddle" rules, short-term capital loss on "straddle" positions may be
recharacterized as long-term capital loss, and long-term capital gains may be
treated as short-term capital gains.
Under the Code, the Fund will be required to report to the Internal Revenue
Service all distributions of taxable income and capital gains as well as gross
proceeds from the redemption or exchange of Fund shares, except in the case of
certain exempt shareholders. Under the backup withholding provisions of Section
3406 of the Code, distributions of taxable net investment income and net capital
gain and proceeds from the redemption or exchange of the shares of a regulated
investment company may be subject to withholding of federal income tax at the
rate of 31% in the case of non-exempt shareholders who fail to furnish the
investment company with their taxpayer identification numbers and with required
certifications regarding their status under the federal income tax law, or if
the Fund is notified by the IRS or a broker that withholding is required due to
an incorrect TIN or a previous failure to report taxable interest or dividends.
If the withholding provisions are applicable, any such distributions and
proceeds, whether taken in cash or reinvested in additional shares, will be
reduced by the amounts required to be withheld.
Shareholders of the Fund may be subject to state and local taxes on
distributions received from the Fund and on redemptions of the Fund's shares.
Each distribution is accompanied by a brief explanation of the form and
character of the distribution. In January of each year the Fund issues to each
shareholder a statement of the federal income tax status of all distributions.
The Fund is organized as a Massachusetts business trust and generally will
not be liable for any income or franchise tax in the Commonwealth of
Massachusetts. If the Fund qualifies as a regulated investment company for
federal income tax purposes and pays no federal income tax, it generally will
also not be liable for New York State income taxes, other than a nominal
corporation franchise tax (as adjusted by the applicable New York State
surtaxes).
The foregoing discussion is a general summary of certain of the material
U.S. federal income tax consequences to U.S. persons (as defined below) of
owning and disposing of shares in the Fund. This summary is based on the
provisions of the Code, final, temporary and proposed U.S. Treasury Regulations
promulgated thereunder, and administrative and judicial interpretations thereof,
all as in effect on the date hereof, and all of which are subject to change,
possibly with retroactive effect.
The foregoing discussion of U.S. federal income tax law relates solely to
the application of that law to U.S. persons; i.e., U.S. citizens and residents
and U.S. domestic corporations, partnerships, estates the income of which is
includible in its gross income for U.S. federal income tax purposes without
regard to its source, or trusts if either: (i) a U.S. court is able to exercise
primary supervision over the administration of the trust and one or more U.S.
persons have the authority to control all the substantial decisions of the trust
or (ii) the trust was in existence on August 20, 1996 and, in general, would
have been treated as a U.S. person under rules applicable prior to such time,
provided the trust elects to continue such treatment thereafter. Each
shareholder who is not a U.S. person should consider the U.S. and foreign tax
consequences of ownership of shares of the Fund, including the possibility that
such a shareholder may be subject to a U.S. withholding tax at a rate of 30% (or
at a lower rate under an applicable income tax treaty) on amounts constituting
ordinary income received by him or her.
This summary does not deal with all aspects of U.S. federal income taxation
that may be relevant to particular shareholders in light of their particular
circumstances. Accordingly, shareholders should consult
14
<PAGE> 32
their tax advisers about the application of the provisions of tax law described
in this statement of additional information in light of their particular tax
situations.
ORGANIZATION AND CAPITALIZATION
GENERAL.
The Fund is an open-end investment company established under the laws of
the Commonwealth of Massachusetts by Declaration of Trust dated April 12, 1982,
as amended and restated on August 22, 1989 (the "Declaration of Trust").
Previously known as the Risk Portfolio of The Ayco Fund, the Fund commenced
doing business as The Merger Fund on January 31, 1989. The Fund's name was
formally changed to The Merger Fund on August 22, 1989.
The Fund's activities are supervised by its Trustees, who are elected by
the Fund's shareholders. The Declaration of Trust permits the Trustees to issue
an unlimited number of full and fractional shares. The Trustees are also
empowered by the Declaration of Trust and the By-Laws to create additional
series of shares, or portfolios.
As permitted by Massachusetts law, there will normally be no meetings of
shareholders for the purpose of electing Trustees unless and until such time as
less than a majority of the Trustees holding office have been elected by
shareholders. In such an event, the Trustees then in office will call a
shareholders' meeting for the election of Trustees. Except for the foregoing and
unless removed by action of the shareholders in accordance with the Fund's
By-Laws, the Trustee shall continue to hold office and may appoint successor
Trustees. The Trustees shall only be liable in cases of their willful
misfeasance, bad faith, gross negligence or reckless disregard of their duties.
Shares of the Fund's common stock entitle their holders to one vote per
share. Shares have noncumulative voting rights, which means that holders of more
than 50% of the shares voting for the election of Trustees can elect all
Trustees and, in such event, the holders of the remaining shares voting for the
election of Trustees will not be able to elect any person or persons as
Trustees. Shares have no preemptive or subscription rights, and are
transferable. Each share represents an equal proportionate interest in the Fund.
The following broker-dealers each hold of record 5% or more of the Fund's
outstanding common stock:
<TABLE>
<CAPTION>
NAME AND ADDRESS PERCENT HELD
- ---------------- ------------
<S> <C>
Charles Schwab & Co. Inc.
101 Montgomery Street
San Francisco, CA 94104-4122 37.19%
National Financial Services Corp.
Church Street Station
P.O. Box 3908
New York, NY 10008-3908 13.26%
Donaldson Lufkin Jenrette Securities
P.O. Box 2052
Jersey City, NJ 07303-2052 9.39%
Millenco Limited Partnership
111 Broadway
New York, NY 10006-1901 7.76%
</TABLE>
SHAREHOLDER AND TRUSTEE LIABILITY.
The Fund is an entity of the type commonly known as a "Massachusetts
business trust." Under Massachusetts law, shareholders of such a trust may,
under certain circumstances, be held personally liable as partners for the
obligations of the trust. The Declaration of Trust contains an express
disclaimer of shareholder liability for acts or obligations of the Fund and
provides for indemnification out of Fund property of any shareholder held
personally liable for the obligations of the Fund. Thus, the risk of a
shareholder incurring
15
<PAGE> 33
financial loss on account of shareholder liability is limited to circumstances
in which the Fund itself would be unable to meet its obligations. Management
believes that, in view of the above, the risk of personal liability of
shareholders is remote. The Declaration of Trust does not require the Fund to
hold annual meetings of shareholders. However, the Fund will hold special
meetings when required by federal or state securities laws. The holders of at
least 10% of the Fund's outstanding shares have the right to call a meeting of
shareholders for the purpose of voting upon the removal of one or more Trustees,
and in connection with any such meeting, the Fund will comply with the
provisions of Section 16(c) of the Investment Company Act of 1940 relating to
shareholder communications.
The Declaration of Trust further provides that the Trustees will not be
liable for errors of judgment or mistakes of fact or law, but nothing in the
Declaration of Trust protects a Trustee against any liability to which he would
otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the conduct of his
office.
ALLOCATION OF PORTFOLIO BROKERAGE
Subject to the supervision of the Trustees, decisions to buy and sell
securities for the Fund are made by the Adviser. The Adviser is authorized by
the Trustees to allocate the orders placed by it on behalf of the Fund to
brokers or dealers who may, but need not, provide research or statistical
material or other services to the Fund or the Adviser for the Fund's use. Such
allocation is to be in such amounts and proportions as the Adviser may
determine.
In selecting a broker or dealer to execute each particular transaction, the
Adviser will take the following into consideration: the best net price
available; the reliability, integrity and financial condition of the broker or
dealer; the size of and difficulty in executing the order; and the value of the
expected contribution of the broker or dealer to the investment performance of
the Fund on a continuing basis. Brokers or dealers executing a portfolio
transaction on behalf of the Fund may receive a commission in excess of the
amount of commission another broker or dealer would have charged for executing
the transaction if the Adviser determines in good faith that such commission is
reasonable in relation to the value of brokerage, research and other services
provided to the Fund.
In allocating portfolio brokerage, the Adviser may select brokers or
dealers who also provide brokerage, research and other services to other
accounts over which the Adviser exercises investment discretion. Some of the
services received as the result of Fund transactions may primarily benefit
accounts other than the Fund, while services received as the result of portfolio
transactions effected on behalf of those other accounts may primarily benefit
the Fund. The Adviser is unable to quantify the amount of commissions set forth
below which were paid as a result of such services because a substantial number
of transactions were effected through brokers which provide such services but
which were selected principally because of their execution capabilities.
For the fiscal years ended November 30, 1996, September 30, 1997 and
September 30 1998, the Fund paid brokerage commissions of approximately
$2,467,162, $2,298,674 and $3,159,845, respectively.
PORTFOLIO TURNOVER
The portfolio turnover rate may be defined as the ratio of the lesser of
annual sales or purchases to the monthly average value of the portfolio,
excluding from both the numerator and the denominator (1) securities with
maturities at the time of acquisition of one year or less and (2) short
positions. For the fiscal year ended September 30, 1998, the Fund's portfolio
annual turnover rate was 355%. The Fund will invest portions of its assets to
seek short-term capital appreciation. The Fund's investment objective and
corresponding investment policies can be expected to cause the portfolio
turnover rate to be substantially higher than that of the average
equity-oriented investment company.
Merger arbitrage investments are characterized by a high turnover rate
because, in general, a relatively short period of time elapses between the
announcement of a reorganization and its completion or termination.
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The majority of mergers and acquisitions are consummated in less than six
months, while tender offers are normally completed in less than two months.
Liquidations and certain other types of corporate reorganizations usually
require more than six months to complete. The Fund will generally benefit from
the timely completion of the proposed reorganizations in which it has invested,
and a correspondingly high portfolio turnover rate would be consistent with,
although it would not necessarily ensure, the achievement of the Fund's
investment objective. Short-term trading involves increased brokerage
commissions, which expense is ultimately borne by the shareholders.
Fund management believes that the fiscal 1998 portfolio turnover rate of
355% is within the range to be expected for a merger arbitrage fund, and
anticipates that the 1999 rate will be within the same range or somewhat lower.
INDEPENDENT ACCOUNTANTS
The Fund has selected PricewaterhouseCoopers LLP, 100 East Wisconsin
Avenue, Milwaukee, Wisconsin 53202, as its independent accountants.
CUSTODIAN, TRANSFER AGENT, DIVIDEND PAYING AGENT,
ACCOUNTING SERVICES AGENT AND ADMINISTRATOR
Firstar Mutual Fund Services, LLC ("Firstar"), P.O. Box 701, Milwaukee,
Wisconsin 53201-0701 is the Fund's transfer agent and dividend paying agent.
Firstar Bank Milwaukee, N.A. ("Firstar Bank") acts as the Fund's custodian.
The custody services performed by Firstar Bank include maintaining custody
of the Fund's assets, record keeping, processing of portfolio securities
transactions, collection of income, special services relating to put and call
options and making cash disbursements. Firstar Bank is also custodian for The
Merger Fund IRA Plan and trustee for the Fund Investors Keogh Plans. Firstar
Bank takes no part in determining the investment policies of the Fund or in
deciding which securities are purchased or sold by the Fund. The Fund pays to
Firstar Bank a custodian fee, payable monthly, at the annual rate of .020% of
the total value of the Fund's assets, plus a fee for each transaction with
respect to the Fund's portfolio securities, which varies depending on the nature
of the transaction.
Firstar is the Fund's transfer agent and dividend paying agent. The
transfer agent services provided by Firstar include: performing customary
transfer agent functions; making dividend and distribution payments;
administering shareholder accounts in connection with the issuance, transfer and
redemption of the Fund's shares; performing related record keeping services;
answering shareholders correspondence; mailing reports, proxy statements,
confirmations and other communications to shareholders; and filing tax
information returns. Firstar's transfer agent fee is equal to a maximum of
$14.00 per shareholder account.
Firstar also serves as the Fund's accounting services agent and Fund
Administrator. As such, Firstar provides a variety of administrative and
accounting services to the Fund, such as accounting relating to the Fund's
portfolio and portfolio transactions, the determination of net asset value and
pricing of the Fund's shares of beneficial interest, and maintaining the books
of account of the Fund. Accounting services for the Fund are provided pursuant
to a separate agreement with Firstar. The Fund pays Firstar a minimum annual fee
of $22,000 plus an additional .010% of the value of the Fund's net assets in
excess of $40 million up to $200 million and .005% of the value of the Fund's
net assets in excess of $200 million.
Under the Fund Administration Servicing Agreement, Firstar maintains the
books, accounts and other documents required by the Investment Company Act of
1940; prepares the Fund's financial statements and tax returns; prepares certain
reports and filings with the Securities and Exchange Commission; furnishes
statistical and research data, clerical, accounting and bookkeeping services and
office supplies; and generally assists in all aspects of the Fund's operations.
Firstar, as Administrator, furnishes office space and all necessary office
facilities, equipment and executive personnel for performing the services
required pursuant to the agreement. For the foregoing, the Fund pays Firstar a
fee, payable monthly, at the annual rate of .050% of the
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Fund's first $100 million of average aggregate daily net assets, .040% of the
next $400 million and .030% of the Fund's average daily net assets in excess of
$500 million. The Fund also reimburses the Administrator for all out-of-pocket
expenses.
The fees charged to the Fund by Firstar for custody, transfer agent, fund
accounting and administration services are competitive with fees charged by
other providers of such services within the investment company industry.
COUNSEL
The firm of Fulbright & Jaworski L.L.P. is counsel to the Fund.
EXPERTS
The financial statements incorporated in this Statement of Additional
Information have been so incorporated in reliance upon the report of
PricewaterhouseCoopers LLP, independent accountants given on authority of said
firm, as experts in accounting and auditing.
FINANCIAL STATEMENTS
The statement of assets and liabilities, including the schedules of
investments, of options written and of securities sold short, as of September
30, 1998, the related statements of operations and of cash flows for the fiscal
year ended September 30, 1998, statements of changes in net assets for the
fiscal years ended September 30, 1998 and September 30, 1997, financial
highlights, and notes to the financial statements and the independent
accountants' report to the Trustees and shareholders of the Fund dated November
13, 1998 are incorporated herein by reference to the Fund's Annual Report. A
copy of the Fund's Annual Report may be obtained without charge from Firstar by
calling (800) 343-8959.
Effective December 1, 1996, the Fund changed its fiscal year to end on
September 30 in each year, commencing with the fiscal year which ran from
December 1, 1996 through September 30, 1997.
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APPENDIX
Some of the terms used in this Statement of Additional Information and the
Fund's prospectus are described below.
COVERED OPTION WRITING.
A call option is a short-term contract which gives the purchaser of the
option, in return for a premium paid, the right to buy, and the writer the
obligation to sell, the underlying security at the exercise price at any time
upon the assignment of an exercise notice prior to the expiration of the option,
regardless of the market price of the security during the option period. A
covered call option is an option written on a security which is owned by the
writer throughout the option period.
The Fund will write covered call options both to reduce the risks
associated with certain of its investments and to increase total investment
return. In return for the premium income, the Fund will give up the opportunity
to profit from an increase in the market price of the underlying security above
the exercise price so long as its obligations under the contract continue,
except insofar as the premium represents a profit. Moreover, in writing the
option, the Fund will retain the risk of loss should the price of the security
decline, which loss the premium is intended to offset. Unlike the situation in
which the Fund owns securities not subject to a call option, the Fund, in
writing call options, must assume that the call may be exercised at any time
prior to the expiration of its obligations as a writer, and that in such
circumstances the net proceeds realized from the sale of the underlying
securities pursuant to the call may be substantially below the prevailing market
price. The Adviser may deem it desirable to close out a particular position
prior to the expiration of the option through the purchase of an equivalent
option, in which case the underlying security may either be sold or retained in
the Fund's portfolio.
MONEY MARKET INSTRUMENTS.
Money market instruments are liquid, short-term, high-grade debt
instruments, including United States Government obligations, commercial paper,
certificates of deposit and bankers' acceptances.
REPURCHASE AGREEMENTS.
Repurchase agreements are agreements by which a person purchases a security
and simultaneously commits to resell that security to the seller (a member bank
of the Federal Reserve System or recognized securities dealer) at an agreed upon
price on an agreed upon date within a number of days (usually not more than
seven) from the date of purchase. The resale price reflects the purchase price
plus an agreed upon market rate of interest which is unrelated to the coupon
rate or maturity of the purchased security. A repurchase agreement involves the
obligation of the seller to repurchase the securities at the agreed upon price,
which obligation is in effect secured by the value of the underlying security.
The Fund may enter into repurchase agreements with respect to obligations in
which the Fund is authorized to invest.
SHORT SELLING.
A short sale is a transaction involving the sale of a security that is not
owned by the seller, the security having been borrowed from a third party by the
seller in order to make delivery to the buyer. In a transaction of this type,
the seller has a continuing obligation to replace the borrowed security; and
until such replacement, the broker retains the proceeds from the sale and the
seller is required to pay to the lender any dividends or interest due to holders
of the security. Although the seller's obligation to the lender can be met by
purchasing the security in the open market and delivering it against the short
position, the Fund will effect short sales only in anticipation of replacing the
borrowed security with an identical security received upon the successful
completion of a merger, acquisition or exchange offer. (This strategy is
illustrated by the following example: Company A proposes to acquire Company B
through a merger in which each outstanding common share of Company B is
exchanged for two shares of Company A. Assume that following the announcement of
the merger terms, Company A's stock is trading at $20 while Company B's shares
are trading at $35, or $5 below the market value of Company A's offer (2 x $20
per A Share). Believing that the proposed merger represents
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an attractive arbitrage opportunity, but wanting to protect against a decline in
the market price of Company A's stock prior to the completion of the
acquisition, the Fund purchases 1,000 shares of Company B at a total cost of
$35,000 plus commissions, and, at approximately the same time, borrows and sells
short 2,000 shares of Company A, yielding proceeds of $40,000 less commissions.
The Fund is now hedged; that is, a decline in the market price of Company A's
stock will not reduce the Fund's potential profit should the deal go through.
Upon completion of the merger, the 1,000 shares of Company B held by the Fund
are exchanged for 2,000 shares of Company A. These shares are then delivered to
the lender, thereby satisfying the Fund's obligation to replace the borrowed
shares, and the proceeds from the short sale become available to the Fund. In
this example a profit of $5,000 less commissions and any other expenses is
realized.) However, should the merger, acquisition or exchange offer be
terminated or otherwise not completed, the Fund will be required to satisfy its
obligation to the lender by making an open-market purchase, and to the extent
the price paid exceeds the proceeds from the short sale, the Fund will incur a
loss on the transaction. The amount of any such loss will be increased by the
amount of any dividends or interest the Fund may be required to pay in
connection with the short sale.
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