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ACTIVE SHORT-TERM FUND
STATEMENT OF ADDITIONAL INFORMATION
May 26, 1997
This Statement of Additional Information is not a prospectus. This
Statement of Additional Information relates to the Prospectus dated May 26, 1997
of the Active Short-Term Fund, a series of Cash Accumulation Trust, as
supplemented from time to time, and should be read in conjunction therewith. A
copy of the Prospectus may be obtained from PIMCO Funds Distribution Company,
2187 Atlantic Street, Stamford, Connecticut 06902.
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TABLE OF CONTENTS
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INVESTMENT OBJECTIVES, POLICIES AND RESTRICTIONS.. 3
CREDIT AND MARKET RISK............................ 30
PORTFOLIO TRANSACTIONS AND BROKERAGE.............. 31
MANAGEMENT OF THE FUND............................ 33
INVESTMENT ADVISORY AND OTHER SERVICES............ 39
ORGANIZATION AND CAPITALIZATION OF THE TRUST...... 42
NET INCOME, YIELD AND VALUATION................... 44
TAXES............................................. 45
REDEMPTIONS....................................... 46
DESCRIPTION OF INVESTMENTS........................ 48
APPENDIX A........................................ A-1
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INVESTMENT OBJECTIVES, POLICIES AND RESTRICTIONS
The investment objectives and policies of the Active Short-Term Fund
(the "Fund") of Cash Accumulation Trust (the "Trust") are summarized on the
front page of the Prospectus and in the text of the Prospectus following the
captions "Investment Objective and Policies" and "General Policies." For a
description of the investments which the Fund may make, see "Description of
Investments." For a description of the relevant rating categories established
by five major rating agencies, see Appendix A.
Columbus Circle Investors, the manager of the Fund ("CCI" or the
"Manager"), will monitor the Fund's investments in light of general economic and
market conditions and the creditworthiness of the issuers of the Fund's
portfolio securities, including the creditworthiness of issuers of master demand
notes insofar as it relates to the ability of the issuer to make payments on
demand. The Fund does not expect to invest more than 5% of its total assets in
master demand notes in the foreseeable future. As described in the Prospectus,
after purchase by the Fund, a security may cease to be rated, its rating may be
reduced below the minimum required for purchase by the Fund, or the security may
otherwise cease to be eligible for purchase by the Fund. No such event will
require the sale of such security by the Fund. However, the Manager or the
Trust's Trustees will consider any such event in determining whether the Fund
should continue to hold the security.
The Fund, consistent with its investment objective, attempts to
maximize yields by engaging in portfolio trading and by buying and selling
portfolio investments in anticipation of or in response to changing economic and
money market conditions and trends. The Fund also invests to take advantage of
what are believed to be temporary disparities in the yields of the different
segments of the high-grade money market or among particular instruments within
the same segment of the market. These policies may result in frequent changes
in the Fund's portfolio. See "Portfolio Transactions and Brokerage."
Repurchase Agreements
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As is disclosed in the text of the Prospectus following the caption
"General Policies -Repurchase Agreements," there is a risk that in a repurchase
agreement the seller may fail to repurchase the underlying security. In such
event, the Fund would attempt to dispose of the underlying security in the
market or would hold the underlying security until maturity. However, the Fund
may be subject to various delays and risks of loss in attempting to dispose of
the underlying security, including (a) possible declines in the value of the
underlying security during the period while the Fund seeks to enforce its rights
thereto, (b) possible reduced levels of income and lack of access to income
during this period and (c) expenses involved in the enforcement of the Fund's
rights.
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Firm Commitments
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As described in the text of the Prospectus following the caption
"Investment Objective and Policies," the Fund may enter into firm commitment
agreements with banks or broker-dealers for the purchase of securities at an
agreed-upon price on a specified future date. Such agreements might be entered
into, for example, when the Fund anticipates a decline in the yield of
securities of a given issuer and is able to obtain a more advantageous yield by
committing currently to purchase securities to be issued later.
U.S. Government Securities
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U.S. Government securities are obligations of, or guaranteed by, the
U.S. Government, its agencies or instrumentalities. The U.S. Government does
not guarantee the net asset value of the Fund's shares. Some U.S. Government
securities, such as Treasury bills, notes and bonds, and securities guaranteed
by the Government National Mortgage Association ("GNMA"), are supported by the
full faith and credit of the United States; others, such as those of the Federal
Home Loan Bank, those of the Federal National Mortgage Association ("FNMA"), and
those of the Student Loan Marketing Association are not supported by the full
faith and credit of the U.S. Government, but are supported only by the credit of
the instrumentality. U.S. Government securities include securities that have no
coupons, or have been stripped of their unmatured interest coupons, individual
interest coupons from such securities that trade separately, and evidences of
receipt of such securities. Such securities may pay no cash income, and are
purchased at a deep discount from their value at maturity. Because interest on
zero coupon securities is not distributed on a current basis but is, in effect,
compounded, zero coupon securities tend to be subject to greater market risk
than interest-paying securities of similar maturities. Custodial receipts
issued in connection with so-called trademark zero coupon securities, such as
CATs and TIGRs, are not issued by the U.S. Treasury, and are therefore not U.S.
Government securities, although the underlying bond represented by such receipt
is a debt obligation of the U.S. Treasury. Other zero coupon Treasury
securities (e.g., STRIPs and CUBEs) are direct obligations of the U.S.
Government.
Inflation-Indexed Bonds
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The Fund may invest in inflation-indexed bonds, which are fixed income
securities whose principal value is periodically adjusted according to the rate
of inflation. The interest rate on these bonds is generally fixed at issuance at
a rate lower than typical bonds. Over the life of an inflation-indexed bond,
however, interest will be paid based on a principal value which is adjusted for
inflation.
Inflation-indexed securities issued by the U.S. Treasury will
initially have maturities of ten years, although it is anticipated that
securities with other maturities will be issued in the future. The securities
will pay interest on a semi-annual basis, equal to a fixed percentage of
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the inflation-adjusted principal amount. For example, if an investor purchased
an inflation-indexed bond with a par value of $1,000 and a 3% real rate of
return coupon (payable 1.5% semi-annually), and inflation over the first six
months were 1%, the mid-year par value of the bond would be $1,010 and the first
semi-annual interest payment would be $15.15 ($1,010 times 1.5%). If inflation
during the second half of the year reached 3%, the end-of-year par value of the
bond would be $1,030 and the second semi-annual interest payment would be $15.45
($1,030 times 1.5%).
If the periodic adjustment rate measuring inflation falls, the
principal value of inflation-indexed bonds will be adjusted downward, and
consequently the interest payable on these securities (calculated with respect
to a smaller principal amount) will be reduced. Repayment of the original bond
principal upon maturity (as adjusted for inflation) is guaranteed in the case of
U.S. Treasury inflation-indexed bonds, even during a period of deflation.
However, the current market value of the bonds is not guaranteed, and will
fluctuate. The Fund may also invest in other inflation-related bonds which may
or may not provide a similar guarantee. If such a guarantee of principal is not
provided, the adjusted principal value of the bond repaid at maturity may be
less than the original principal. The value of inflation-indexed bonds is
expected to change in response to changes in real interest rates. Real interest
rates in turn are tied to the relationship between nominal interest rates and
the rate of inflation. Therefore, if inflation were to rise at a faster rate
than nominal interest rates, real interest rates might decline, leading to an
increase in value of inflation-indexed bonds. In contrast, if nominal interest
rates increased at a faster rate than inflation, real interest rates might rise,
leading to a decrease in value of inflation-indexed bonds.
While these securities are expected to be protected from long-term
inflationary trends, short-term increases in inflation may lead to a decline in
value. If interest rates rise due to reasons other than inflation (for example,
due to changes in currency exchange rates), investors in these securities may
not be protected to the extent that the increase is not reflected in the bond's
inflation measure.
The U.S. Treasury has only recently begun issuing inflation-indexed
bonds. As such, there is no trading history of these securities, and there can
be no assurance that a liquid market in these instruments will develop. Lack of
a liquid market may impose the risk of higher transaction costs and the
possibility the Fund may be forced to liquidate positions when it would not be
advantageous to do so. There also can be no assurance that the U.S. Treasury
will issue any particular amount of inflation-indexed bonds. Certain foreign
governments, such as the United Kingdom, Canada and Australia, have a longer
history of issuing inflation-indexed bonds, and there may be a more liquid
market in certain of these countries for these securities.
The periodic adjustment of U.S. inflation-indexed bonds is tied to the
Consumer Price Index for Urban Consumers ("CPI-U"), which is calculated monthly
by the U.S. Bureau of Labor Statistics. The CPI-U is a measurement of changes in
the cost of living, made up of
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components such as housing, food, transportation and energy. Inflation-indexed
bonds issued by a foreign government are generally adjusted to reflect a
comparable inflation index, calculated by that government. There can be no
assurance that the CPI-U or any foreign inflation index will accurately measure
the real rate of inflation in the prices of goods and services. Moreover, there
can be no assurance that the rate of inflation in a foreign country will be
correlated to the rate of inflation in the United States.
Any increase in the principal amount of an inflation-indexed bond will
be considered taxable ordinary income, even though investors do not receive
their principal until maturity.
Borrowing
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Subject to the limitations described under "Investment Restrictions"
below, the Fund may be permitted to borrow for temporary purposes and/or for
investment purposes. Such a practice will result in leveraging of the Fund's
assets and may cause the Fund to liquidate portfolio positions when it would not
be advantageous to do so. This borrowing may be unsecured. Provisions of the
Investment Company Act of 1940 (the "1940 Act") require the Fund to maintain
continuous asset coverage (that is, total assets including borrowings, less
liabilities exclusive of borrowings) of 300% of the amount borrowed, with an
exception for borrowings not in excess of 5% of the Fund's total assets made for
temporary administrative purposes. Any borrowings for temporary administrative
purposes in excess of 5% of the Fund's total assets must maintain continuous
asset coverage. If the 300% asset coverage should decline as a result of market
fluctuations or other reasons, the Fund may be required to sell some of its
portfolio holdings within three days to reduce the debt and restore the 300%
asset coverage, even though it may be disadvantageous from an investment
standpoint to sell securities at that time. Borrowing will tend to exaggerate
the effect on net asset value of any increase or decrease in the market value of
the Fund's portfolio. Money borrowed will be subject to interest costs which
may or may not be recovered by appreciation of the securities purchased. The
Fund also may be required to maintain minimum average balances in connection
with such borrowing or to pay a commitment or other fee to maintain a line of
credit; either of these requirements would increase the cost of borrowing over
the stated interest rate.
In addition to borrowing for temporary purposes, the Fund may enter
into reverse repurchase agreements if permitted to do so under its specific
limitations on borrowings. A reverse repurchase agreement involves the sale of
a portfolio-eligible security by the Fund, coupled with its agreement to
repurchase the instrument at a specified time and price. Reverse repurchase
agreements involve the risk that the market value of securities retained by the
Fund may decline below the repurchase price of the securities sold by the Fund
which it is obligated to repurchase. Reverse repurchase agreements will be
subject to the Fund's limitations on borrowings as specified under "Investment
Restrictions" below.
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Preferred Stock
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The Fund may invest in preferred stock. Preferred stock is a form of
equity ownership in a corporation. The dividend on a preferred stock is a fixed
payment which the corporation is not legally bound to pay. Certain classes of
preferred stock are convertible, meaning the preferred stock is convertible into
shares of common stock of the issuer. By holding convertible preferred stock,
the Fund can receive a steady stream of dividends and still have the option to
convert it to common stock.
Corporate Debt Securities
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The Fund may invest in corporate debt securities. The investment
return of corporate debt securities reflects interest earnings and changes in
the market value of the security. The market value of a corporate debt
obligation may be expected to rise and fall inversely with interest rates
generally. There also exists the risk that the issuers of the securities may not
be able to meet their obligations on interest or principal payments at the time
called for by an instrument.
Debt securities are purchased and sold principally in response to
current assessments of future changes in business conditions and the levels of
interest rates on debt/fixed income securities of varying maturities, the
availability of new investment opportunities at higher relative yields, and
current evaluations of an issuer's continuing ability to meet its obligations in
the future. The average maturity or duration of the debt/fixed income
securities in the Fund's portfolio may be varied in response to anticipated
changes in interest rates and to other economic factors. Securities may be
bought and sold in anticipation of a decline or a rise in market interest rates.
In addition, a security may be sold and another of comparable quality and
maturity (usually, but not always, of a different issuer) purchased at
approximately the same time to take advantage of what are believed to be short-
term differentials in values or yields.
The Fund's investments in U.S. dollar or foreign currency-denominated
corporate debt securities of domestic or foreign issuers are limited to
corporate debt securities (corporate bonds, debentures, notes and other similar
corporate debt instruments, including convertible securities) which meet the
minimum ratings criteria set forth for the Fund, or, if unrated, are deemed to
be comparable in quality to corporate debt securities in which the Fund may
invest. The rate of return or return of principal on some debt obligations may
be linked or indexed to the level of exchange rates between the U.S. dollar and
a foreign currency or currencies.
Among the corporate debt securities in which the Fund may invest are
convertible securities. A convertible debt security is a bond, debenture, note,
or other security that entitles the holder to acquire common stock or other
equity securities of the same or a different issuer. A convertible security
generally entitles the holder to receive interest paid or accrued
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until the convertible security matures or is redeemed, converted or exchanged.
Before conversion, convertible securities have characteristics similar to non-
convertible debt securities. Convertible securities rank senior to common stock
in a corporation's capital structure and, therefore, generally entail less risk
than the corporation's common stock.
A convertible security may be subject to redemption at the option of
the issuer at a predetermined price. If a convertible security held by the Fund
is called for redemption, the Fund would be required to permit the issuer to
redeem the security and convert it to underlying common stock, or would sell the
convertible security to a third party. The Fund generally would invest in
convertible securities for their favorable price characteristics and total
return potential and would normally not exercise an option to convert.
High Yield Securities ("Junk Bonds")
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The Fund may invest in debt/fixed income securities of domestic or
foreign issuers that meet minimum ratings criteria set forth for the Fund, or if
unrated, are of comparable quality in the opinion of the Fund's Manager. A
description of the ratings categories used is set forth in Appendix A to this
Statement of Additional Information.
A security is considered to be below "investment grade" quality if it
is either (1) not rated in one of the four highest rating categories by one of
the Nationally Recognized Statistical Rating Organizations ("NRSROs") (i.e.,
rated Ba or below by Moody's Investors Services, Inc. ("Moody's") or BB or below
by Standard & Poor's Corporation ("S&P")) or (2) if unrated, determined by the
Manager to be of comparable quality to obligations so rated.
The Fund may purchase high yield securities (as defined in the
Prospectus). Investment in high yield securities generally provides greater
income and increased opportunity for capital appreciation than investments in
higher quality securities, but it also typically entails greater price
volatility and principal and income risk. High yield securities are regarded as
predominantly speculative with respect to the issuer's continuing ability to
meet principal and interest payments. The market for these securities is
relatively new, and many of the outstanding high yield securities have not
endured a major business recession. A long-term track record on default rates,
such as that for investment grade corporate bonds, does not exist for this
market. Analysis of the creditworthiness of issuers of high yield securities
may be more complex than for issuers of higher quality debt/fixed income
securities. The Fund may continue to hold such securities following a decline
in their rating if in the opinion of the Manager it would be advantageous to do
so. Investments in high yield securities that are eligible for purchase by the
Fund are described as "speculative" by both Moody's and S&P.
Investing in high yield securities involves special risks in addition
to the risks associated with investments in higher rated fixed income
securities. While offering a greater potential opportunity for capital
appreciation and higher yields than investments in higher rated debt securities,
high yield securities typically entail greater potential price volatility and
may
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be less liquid than investment grade debt. High yield securities may be regarded
as predominately speculative with respect to the issuer's continuing ability to
meet principal and interest payments. Analysis of the creditworthiness of
issuers of high yield securities may be more complex than for issuers of higher
quality debt securities, and achievement of the Fund's investment objective may,
to the extent of its investments in high yield securities, depend more heavily
on the Manager's creditworthiness analysis than would be the case if the Fund
were investing in higher quality securities.
High yield securities may be more susceptible to real or perceived
adverse economic and competitive industry conditions than investment grade
securities. The prices of high yield securities are likely to be sensitive to
adverse economic downturns or individual corporate developments. A projection
of an economic downturn or of a period of rising interest rates, for example,
could cause a decline in high yield security prices because the advent of a
recession could lessen the ability of a highly leveraged company to make
principal and interest payments on its debt/fixed income securities. If an
issuer of high yield securities defaults, in addition to risking payment of all
or a portion of interest and principal, the Fund may incur additional expenses
to seek recovery. In the case of high yield securities structured as zero-
coupon or pay-in-kind securities, their market prices are affected to a greater
extent by interest rate changes, and therefore tend to be more volatile than
securities which pay interest periodically and in cash.
Prices of high yield/high risk securities have been found to be less
sensitive to interest rate changes than more highly rated investments, but more
sensitive to economic downturns or individual corporate developments. The
secondary market on which high yield securities are traded may be less liquid
than the market for higher grade securities. Less liquidity in the secondary
trading market could adversely affect the price at which the Fund could sell a
high yield security, and could adversely affect the daily net asset value of the
shares. Lower liquidity in secondary markets could adversely affect the value
of high yield/high risk securities held by the Fund. The market prices of high
yield/high risk securities structured as "zero coupon" or "pay-in-kind"
securities may be affected to a greater extent by interest rate changes. For
instance, adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the values and liquidity of high yield
securities, especially in a thinly traded market. When secondary markets for
high yield securities are less liquid than the market for higher grade
securities, it may be more difficult to value the securities because such
valuation may require more research, and elements of judgment may play a greater
role in the valuation because there is less reliable, objective data available.
See Appendix A to this Statement of Additional Information for further
information regarding high yield/high risk securities.
Participation on Creditors Committees
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The Fund may from time to time participate on committees formed by
creditors to negotiate with the management of financially troubled issuers of
securities held by the Fund.
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Such participation may subject the Fund to expenses such as legal fees and may
make the Fund an "insider" of the issuer for purposes of the federal securities
laws, and therefore may restrict the Fund's ability to trade in or acquire
additional positions in a particular security when it might otherwise desire to
do so. Participation by the Fund on such committees also may expose the Fund to
potential liabilities under the federal bankruptcy laws or other laws governing
the rights of creditors and debtors. The Fund would participate on such
committees only when the Manager believes that such participation is necessary
or desirable to enforce the Fund's rights as a creditor or to protect the value
of securities held by the Fund.
Variable and Floating Rate Securities
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Variable and floating rate securities provide for a periodic
adjustment in the interest rate paid on the obligations. The terms of such
obligations must provide that interest rates are adjusted periodically based
upon an interest rate adjustment index as provided in the respective
obligations. The adjustment intervals may be regular, and range from daily up
to annually, or may be event based, such as based on a change in the prime rate.
The Fund may invest in floating rate debt instruments ("floaters").
The interest rate on a floater is a variable rate which is tied to another
interest rate, such as a money-market index or U.S. Treasury bill rate. The
interest rate on a floater resets periodically, typically every six months.
Because of the interest rate reset feature, floaters provide the Fund with a
certain degree of protection against rises in interest rates. However, the Fund
would generally participate less in appreciation resulting from any general
decline in interest rates.
The Fund may also invest in inverse floating rate debt instruments
("inverse floaters"). The interest rate on an inverse floater resets in the
opposite direction from the market rate of interest to which the inverse floater
is indexed. An inverse floating rate security will generally exhibit greater
price volatility than a fixed rate obligation of similar credit quality.
The values of inverse floating obligations are generally more
volatile, and the market for inverse floating obligations is generally more
illiquid, than those of many other securities. In addition, because coupon rates
of interest on inverse floating obligations vary inversely with changes in
market rates of interest, interest income earned by the Fund and dividends paid
by the Fund may be more volatile than if the Fund invested solely in fixed-rate
securities. Because inverse floating obligations represent a relatively recent
innovation in the securities market, there is a lack of historical data
concerning the attributes of such securities under all market conditions.
Often, inverse floating obligations are created by selling two complementary
interests in a single, previously issued fixed-rate security: a floating rate
obligation and the inverse floating obligation. In other cases, the issuer will
itself issue directly the two complementary obligations. To seek to limit the
interest rate risk of these securities, the Fund may purchase inverse floating
obligations with shorter-term maturities or which contain limitations on the
extent to which the interest rate may vary.
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Inverse floating obligations have the effect of providing a degree of
investment leverage since they will generally increase or decrease in value in
response to changes in market interest rates at a rate which is a multiple of
the rate at which fixed-rate securities of comparable maturity and credit
quality increase or decrease in response to such changes. The Manager believes
that inverse floating obligations represent flexible portfolio management
instruments for the Fund which allows the Manager to vary the degree of
investment leverage relatively efficiently under different market conditions.
Mortgage-Related and Asset-Backed Securities
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Mortgage-related securities are interests in pools of residential or
commercial mortgage loans, including mortgage loans made by savings and loan
institutions, mortgage bankers, commercial banks and others. Pools of mortgage
loans are assembled as securities for sale to investors by various governmental,
government-related and private organizations (see "Mortgage Pass-Through
Securities" below). Certain debt securities are also secured with collateral
consisting of mortgage-related securities (see "Collateralized Mortgage
Obligations" below).
Mortgage Pass-Through Securities. Interests in pools of mortgage-
related securities differ from other forms of debt securities, which normally
provide for periodic payment of interest in fixed amounts with principal
payments at maturity or specified call dates. Instead, these securities provide
a monthly payment which consists of both interest and principal payments. In
effect, these payments are a "pass-through" of the monthly payments made by the
individual borrowers on their residential or commercial mortgage loans, net of
any fees paid to the issuer or guarantor of such securities. Additional payments
are caused by repayments of principal resulting from the sale of the underlying
property, refinancing or foreclosure, net of fees or costs which may be
incurred. Some mortgage-related securities (such as securities issued by GNMA)
are described as "modified pass-through." These securities entitle the holder
to receive all interest and principal payments owed on the mortgage pool, net of
certain fees, at the scheduled payment dates regardless of whether the mortgagor
actually makes the payment.
The principal governmental guarantor of mortgage-related securities is
GNMA. GNMA, a wholly owned U.S. Government corporation within the Department of
Housing and Urban Development, is authorized to guarantee, with the full faith
and credit of the U.S. Government, the timely payment of principal and interest
on securities issued by institutions approved by GNMA (such as savings and loan
institutions, commercial banks and mortgage bankers) and backed by pools of
mortgages insured by the Federal Housing Administration (the "FHA"), or
guaranteed by the Department of Veterans Affairs (the "VA").
Government-related guarantors (i.e., not backed by the full faith and
credit of the United States Government) include the FNMA and the Federal Home
Loan Mortgage Corporation ("FHLMC"). FNMA is a government-sponsored corporation
owned entirely by
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private stockholders. It is subject to general regulation by the Secretary of
Housing and Urban Development. FNMA purchases conventional (i.e., not insured
or guaranteed by any government agency) residential mortgages from a list of
approved seller/services which include state and federally chartered savings and
loan associations, mutual savings banks, commercial banks, and credit unions and
mortgage bankers. Pass-through securities issued by FNMA are guaranteed as to
timely payment of principal and interest by FNMA but are not backed by the full
faith and credit of the United States Government.
FHLMC was created by Congress in 1970 for the purpose of increasing
the availability of mortgage credit for residential housing. It is a
government-sponsored corporation formerly owned by the twelve Federal Home Loan
Banks and now owned entirely by private stockholders. FHLMC issues
Participation Certificates ("PCs") which represent interests in conventional
mortgages from FHLMC's national portfolio. FHLMC guarantees the timely payment
of interest and ultimate collection of principal, but PCs are not backed by the
full faith and credit of the United States Government.
Commercial banks, savings and loan institutions, private mortgage
insurance companies, mortgage bankers and other secondary market issuers also
create pass-through pools of conventional residential mortgage loans. Such
issuers may, in addition, be the originators and/or servicers of the underlying
mortgage loans as well as the guarantors of the mortgage-related securities.
Pools created by such non-governmental issuers generally offer a higher rate of
interest than government and government-related pools because there are no
direct or indirect government or agency guarantees of payments in the former
pools. However, timely payment of interest and principal of these pools may be
supported by various forms of insurance or guarantees, including individual
loan, title, pool and hazard insurance and letters of credit. The insurance and
guarantees are issued by governmental entities, private insurers and the
mortgage poolers. Such insurance and guarantees, and the creditworthiness of
the issuers thereof, will be considered in determining whether a mortgage-
related security meets the Fund's investment quality standards. There can be no
assurance that the private insurers or guarantors can meet their obligations
under the insurance policies or guarantee arrangements. The Fund may buy
mortgage-related securities without insurance or guarantees if, through an
examination of the loan experience and practices of the originator/servicers and
poolers, the Manager determines that the securities meet the Fund's quality
standards. Although the market for such securities is becoming increasingly
liquid, securities issued by certain private organizations may not be readily
marketable. The Fund will not purchase mortgage-related securities or any other
assets which in the Manager's opinion are illiquid if, as a result, more than
15% of the value of the Fund's total assets will be illiquid.
Mortgage-related securities that are issued or guaranteed by the U.S.
Government, its agencies or instrumentalities, are not subject to the Fund's
industry concentration restrictions, see "Investment Restrictions," by virtue of
the exclusion from that test available to all U.S. Government securities. In
the case of privately issued mortgage-related securities, the Fund takes the
position that mortgage-related securities do not represent interests in any
particular
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"industry" or group of industries. The assets underlying such securities may be
represented by a portfolio of first lien residential mortgages (including both
whole mortgage loans and mortgage participation interests) or portfolios of
mortgage pass-through securities issued or guaranteed by GNMA, FNMA or FHLMC.
Mortgage loans underlying a mortgage-related security may in turn be insured or
guaranteed by the FHA or the VA. In the case of private issue mortgage-related
securities whose underlying assets are neither U.S. Government securities nor
U.S. Government-insured mortgages, to the extent that real properties securing
such assets may be located in the same geographical region, the security may be
subject to a greater risk of default than other comparable securities in the
event of adverse economic, political or business developments that may affect
such region and, ultimately, the ability of residential homeowners to make
payments of principal and interest on the underlying mortgages.
Collateralized Mortgage Obligations ("CMOs"). A CMO is a hybrid
between a mortgage-backed bond and a mortgage pass-through security. Similar to
a bond, interest and prepaid principal is paid, in most cases, semi-annually.
CMOs may be collateralized by whole mortgage loans, but are more typically
collateralized by portfolios of mortgage pass-through securities guaranteed by
GNMA, FHLMC, or FNMA, and their income streams.
CMOs are structured into multiple classes, each bearing a different
stated maturity. Actual maturity and average life will depend upon the
prepayment experience of the collateral. Monthly payment of principal received
from the pool of underlying mortgages, including prepayments, is first returned
to investors holding the shortest maturity class. Investors holding the longer
maturity classes receive principal only after the first class has been retired.
An investor is therefore partially guarded (but only partially) against a sooner
than desired return of principal because of the sequential payments.
In a typical CMO transaction, a corporation ("issuer") issues multiple
series (e.g., A, B, C, Z) of CMO bonds ("Bonds"). Proceeds of the Bond offering
are used to purchase mortgages or mortgage pass-through certificates
("Collateral"). The Collateral is pledged to a third party trustee as security
for the Bonds. Principal and interest payments from the Collateral are used to
pay principal on the Bonds in the order A, B, C, Z. The Series A, B, and C
Bonds all bear current interest. Interest on the Series Z Bond is accrued and
added to principal and a like amount is paid as principal on the Series A, B, or
C Bond currently being paid off. When the Series A, B, and C Bonds are paid in
full, interest and principal on the Series Z Bond begins to be paid currently.
With some CMOs, the issuer serves as a conduit to allow loan originators
(primarily builders or savings and loan associations) to borrow against their
loan portfolios.
FHLMC Collateralized Mortgage Obligations. FHLMC CMOs are debt
obligations of FHLMC issued in multiple classes having different maturity dates
which are secured by the pledge of a pool of conventional mortgage loans
purchased by FHLMC. Unlike FHLMC PCs, payments of principal and interest on the
CMOs are made semi-annually, as opposed to
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monthly. The amount of principal payable on each semi-annual payment date is
determined in accordance with FHLMC's mandatory sinking fund schedule, which in
turn, is equal to approximately 100% of FHA prepayment experience applied to the
mortgage collateral pool. All sinking fund payments in the CMOs are allocated to
the retirement of the individual classes of bonds in the order of their stated
maturities. Payment of principal on the mortgage loans in the collateral pool
in excess of the amount of FHLMC's minimum sinking fund obligation for any
payment date are paid to the holders of the CMOs as additional sinking fund
payments. Because of the "pass-through" nature of all principal payments
received on the collateral pool in excess of FHLMC's minimum sinking fund
requirement, the rate at which principal of the CMOs is actually repaid is
likely to be such that each class of bonds will be retired in advance of its
scheduled maturity date.
If collection of principal (including prepayments) on the mortgage
loans during any semi-annual payment period is not sufficient to meet FHLMC's
minimum sinking fund obligation on the next sinking fund payment date, FHLMC
agrees to make up the deficiency from its general funds.
Criteria for the mortgage loans in the pool backing the FHLMC CMOs are
identical to those of FHLMC PCs. FHLMC has the right to substitute collateral
in the event of delinquencies and/or defaults.
Commercial Mortgage-Related Securities. The Fund may invest in
commercial mortgage-related securities. Commercial mortgage-related securities
are securities that represent an interest in, or are secured by, mortgage loans
secured by commercial property, such as industrial and warehouse properties,
office buildings, retail space and shopping malls, multifamily properties and
cooperative apartments, hotels and motels, nursing homes, hospitals, and senior
living centers. The commercial mortgage-related securities market is newer and
in terms of total outstanding principal amount of issues is relatively small
compared to the total size of the market for residential mortgage-related
securities.
Commercial mortgage-related securities are generally structured
similarly to pass-through securities or to CMOs, although other structures are
possible. They may pay fixed or adjustable rates of interest. Commercial
mortgage-related securities have been issued in public or private transactions
by a variety of public and private issuers.
The commercial mortgage loans that underlie commercial mortgage-
related securities have certain distinct risk characteristics. Commercial
mortgage loans generally lack standardized terms, which may complicate their
structure. Commercial properties themselves tend to be unique and are more
difficult to value than single family residential properties. Commercial
mortgage loans also tend to have shorter maturities than residential mortgage
loans, and may not be fully amortizing, meaning that they may have a significant
principal balance, or "balloon" payments, due on maturity. Assets underlying
commercial mortgage-related securities may relate only to a few properties or a
single property. The risk involved
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in single property financings is highly concentrated. In addition, commercial
properties, particularly industrial and warehouse properties, are subject to
environmental risks and the burdens and costs of compliance with environmental
laws and regulations. At the same time, commercial mortgage-related securities
may have a lower prepayment risk than residential mortgage-related securities,
because commercial mortgage loans generally prohibit or impose penalties on
prepayments of principal. In addition, commercial mortgage-related securities
often are structured with some form of credit enhancement to protect against
potential losses on the underlying mortgage loans. See "Credit Enhancement"
below.
Credit Enhancement. Mortgage-related securities are often backed by a
pool of assets representing the obligations of a number of different parties.
To lessen the effect of failures by obligors on underlying mortgages to make
payments, such securities may contain elements of credit support. Such credit
support falls into two categories: (i) liquidity protection and (ii) protection
against losses resulting from ultimate default by an obligor on the underlying
assets. Liquidity protection refers to the provision of advances, generally by
the entity administering the pool of assets, designed to ensure that the receipt
of payments on the underlying pool occurs in a timely fashion. Protection
against losses resulting from ultimate default is designed to ensure ultimate
payment of the obligations on at least a portion of the assets in the pool.
Such protection may be provided through subordination of other debt, guarantees,
insurance policies, or letters of credit obtained by the issuer or sponsor from
third parties, through various means of structuring the transaction or through a
combination of such approaches. The degree of credit support provided for each
issue is generally based on historical information with respect to the level of
credit risk associated with the underlying assets. There can be no assurance
that credit support will be sufficient to ensure the timely payment of principal
and/or interest. Delinquencies or losses in excess of those anticipated could
adversely affect the return on investment in such security.
Other Mortgage-Related Securities. Other mortgage-related securities
include securities other than those described above that directly or indirectly
represent a participation in, or are secured by and payable from, mortgage loans
on real property, including CMO residuals or stripped mortgage-backed
securities. Other mortgage-related securities may be equity or debt securities
issued by agencies or instrumentalities of the U.S. Government or by private
originators of, or investors in, mortgage loans, including savings and loan
associations, homebuilders, mortgage banks, commercial banks, investment banks,
partnerships, trusts and special purpose entities of the foregoing.
CMO Residuals. CMO residuals are mortgage securities issued by
agencies or instrumentalities of the U.S. Government or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
homebuilders, mortgage banks, commercial banks, investment banks and special
purpose entities of the foregoing.
The cash flow generated by the mortgage assets underlying a series of
CMOs is applied first to make required payments of principal and interest on the
CMOs and second to pay the
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<PAGE>
related administrative expenses of the issuer. The residual in a CMO structure
generally represents the interest in any excess cash flow remaining after making
the foregoing payments. Each payment of such excess cash flow to a holder of the
related CMO residual represents income and/or a return of capital. The amount
of residual cash flow resulting from a CMO will depend on, among other things,
the characteristics of the mortgage assets, the coupon rate of each class of
CMO, prevailing interest rates, the amount of administrative expenses and the
prepayment experience on the mortgage assets. In particular, the yield to
maturity on CMO residuals is extremely sensitive to prepayments on the related
underlying mortgage assets, in the same manner as an interest only class of
stripped mortgage-backed securities. See "Other Mortgage-Related Securities--
Stripped Mortgage-Backed Securities." In addition, if a series of a CMO
includes a class that bears interest at an adjustable rate, the yield to
maturity on the related CMO residual will also be extremely sensitive to changes
in the level of the index upon which interest rate adjustments are based. As
described below with respect to stripped mortgage-backed securities, in certain
circumstances the Fund may fail to recoup some or all of its initial investment
in a CMO residual.
CMO residuals are generally purchased and sold by institutional
investors through several investment banking firms acting as brokers or dealers.
The CMO residual market has only very recently developed and CMO residuals
currently may not have the liquidity of other more established securities
trading in other markets. Transactions in CMO residuals are generally completed
only after careful review of the characteristics of the securities in question.
In addition, CMO residuals may, or pursuant to an exemption therefrom, may not
have been registered under the Securities Act of 1933, as amended (the "1933
Act"). CMO residuals, whether or not registered under the 1933 Act, may be
subject to certain restrictions on transferability, and may be deemed "illiquid"
and subject to the Fund's limitations on investment in illiquid securities.
Stripped Mortgage-Backed Securities. Stripped mortgage-backed
securities ("SMBS") are derivative multi-class mortgage securities. SMBS may be
issued by agencies or instrumentalities of the U.S. Government, or by private
originators of, or investors in, mortgage loans, including savings and loan
associations, mortgage banks, commercial banks, investment banks and special
purpose entities of the foregoing.
SMBS are usually structured with two classes that receive different
proportions of the interest and principal distributions on a pool of mortgage
assets. A common type of SMBS will have one class receiving some of the
interest and most of the principal from the mortgage assets, while the other
class will receive most of the interest and the remainder of the principal. In
the most extreme case, one class will receive all of the interest (the "IO"
class), while the other class will receive all of the principal (the "PO"
class). The yield to maturity on an IO class is extremely sensitive to the rate
of principal payments (including prepayments) on the related underlying mortgage
assets, and a rapid rate of principal payments may have a material adverse
effect on the Fund's yield to maturity from these securities. If the underlying
mortgage assets experience greater than anticipated prepayments of principal,
the Fund may
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<PAGE>
fail to recoup some or all of its initial investment in these securities even if
the security is in one of the highest rating categories.
Although SMBS are purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers, these
securities were only recently developed. As a result, established trading
markets have not yet developed and, accordingly, these securities may be deemed
"illiquid" and subject to the Fund's limitations on investment in illiquid
securities.
Other Asset-Backed Securities. Similarly, the Manager expects that
other asset-backed securities (unrelated to mortgage loans) will be offered to
investors in the future. Several types of asset-backed securities have already
been offered to investors, including Certificates for Automobile Receivables(SM)
("CARS(SM)"). CARS(SM) represent undivided fractional interests in a trust
whose assets consist of a pool of motor vehicle retail installment sales
contracts and security interests in the vehicles securing the contracts.
Payments of principal and interest on CARS(SM) are passed through monthly to
certificate holders, and are generally guaranteed up to certain amounts and for
a certain time period by a letter of credit issued by a financial institution
unaffiliated with the trustee or originator of the trust. An investor's return
on CARS(SM) may be affected by early prepayment of principal on the underlying
vehicle sales contracts. If the letter of credit is exhausted, the trust may be
prevented from realizing the full amount due on a sales contract because of
state law requirements and restrictions relating to foreclosure sales of
vehicles and the obtaining of deficiency judgments following such sales or
because of depreciation, damage or loss of a vehicle, the application of federal
and state bankruptcy and insolvency laws, or other factors. As a result,
certificate holders may experience delays in payments or losses if the letter of
credit is exhausted.
Consistent with the Fund's investment objectives and policies, the
Manager also may invest in other types of asset-backed securities.
Foreign Securities
- ------------------
The Fund may invest in U.S. dollar or foreign currency-denominated
corporate debt securities of foreign issuers; preferred securities of foreign
issuers; certain foreign bank obligations; and U.S. dollar- or foreign currency-
denominated obligations of foreign governments or their subdivisions, agencies
and instrumentalities, international agencies and supranational entities.
Investing in the securities of foreign issuers involves special risks
and considerations not typically associated with investing in U.S. companies.
These include: differences in accounting, auditing and financial reporting
standards, generally higher commission rates on foreign portfolio transactions,
the possibility of expropriation or confiscatory taxation, adverse changes in
investment or exchange control regulations (which may include suspension of the
ability to transfer currency from a country), political instability which can
affect U.S.
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<PAGE>
investments in foreign countries and potential restrictions on the flow of
international capital. In addition, foreign securities and dividends and
interest payable on those securities may be subject to foreign taxes, including
taxes withheld from payments on those securities. Foreign securities often
trade with less frequency and volume than domestic securities and therefore may
exhibit greater price volatility. Changes in foreign exchange rates will affect
the value of those securities which are denominated or quoted in currencies
other than the U.S. dollar.
The risks of investing in foreign securities are particularly high
when securities of issuers based in developing (or "emerging market")
countries are involved. Investing in emerging market countries involves certain
risks not typically associated with investing in U.S. securities, and imposes
risks greater than, or in addition to, risks of investing in foreign, developed
countries. These risks include: greater risks of nationalization or
expropriation of assets or confiscatory taxation; currency devaluations and
other currency exchange rate fluctuations; greater social, economic and
political uncertainty and instability (including the risk of war); more
substantial government involvement in the economy; higher rates of inflation;
less government supervision and regulation of the securities markets and
participants in those markets; controls on foreign investment and limitations on
repatriation of invested capital and on the Fund's ability to exchange local
currencies for U.S. dollars; unavailability of currency hedging techniques in
certain emerging market countries; the fact that companies in emerging market
countries may be smaller, less seasoned and newly organized companies; the
difference in, or lack of, auditing and financial reporting standards, which may
result in unavailability of material information about issuers; the risk that it
may be more difficult to obtain and/or enforce a judgment in a court outside the
United States; and greater price volatility, substantially less liquidity and
significantly smaller market capitalization of securities markets.
The Fund may enter into forward foreign currency exchange contracts to
reduce the risks of adverse changes in foreign exchange rates. A forward
foreign currency exchange contract involves an obligation to purchase or sell a
specific currency at a future date, which may be any fixed number of days from
the date of the contract agreed upon by the parties, at a price set at the time
of the contract. By entering into a forward foreign currency exchange contract,
the fund "locks in" the exchange rate between the currency it will deliver and
the currency it will receive for the duration of the contract. As a result, the
Fund reduces its exposure to changes in the value of the currency it will
deliver and increases its exposure to changes in the value of the currency it
will exchange into. Contracts to sell foreign currencies would limit any
potential gain which might be realized by the Fund if the value of the hedged
currency increases. The Fund may enter into these contracts for the purpose of
hedging against foreign exchange risks arising from the Fund's investment or
anticipated investment in securities denominated in foreign currencies. Such
hedging transactions may not be successful and may eliminate any chance for the
Fund to benefit from favorable fluctuations in relevant foreign currencies. In
addition, the Fund may buy and sell foreign currency futures contracts and
options on foreign currencies and foreign currency futures.
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<PAGE>
The Fund may also enter into forward foreign currency exchange
contracts for purposes of increasing exposure to a foreign currency or to shift
exposure to foreign currency fluctuations from one currency to another. To the
extent that it does so, the Fund will be subject to the additional risk that the
relative value of currencies will be different than anticipated by the Fund's
Manager. The Fund may use one currency (or a basket of currencies) to hedge
against adverse changes in the value of another currency (or a basket of
currencies) when exchange rates between the two currencies are positively
correlated. The Fund may be required to segregate assets to cover forward
currency contracts entered into for non-hedging purposes. The Fund may also use
foreign currency futures contracts and related options on currencies for the
same reasons for which forward foreign currency exchange contracts are used.
High Yield/High Risk Foreign Sovereign Debt Securities
- -------------------------------------------------------
The Fund may invest in the sovereign debt of foreign countries which
have issued or have announced plans to issue Brady Bonds, and expect that a
substantial portion of their investments in sovereign debt securities may
consist of Brady Bonds. Brady Bonds are debt securities issued under the
framework of the Brady Plan, an initiative announced by then U.S. Treasury
Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations to
restructure their outstanding external commercial bank indebtedness. In
restructuring its external debt under the Brady Plan framework, a debtor nation
negotiates with its existing bank lenders as well as multilateral institutions
such as the World Bank and the International Monetary Fund (the "IMF"). The
Brady Plan framework, as it has developed, contemplates the exchange of
commercial bank debt for newly issued bonds (Brady Bonds). Brady Bonds may also
be issued in respect of new money being advanced by existing lenders in
connection with the debt restructuring. The World Bank and/or the IMF support
the restructuring by providing funds pursuant to loan agreements or other
arrangements which enable the debtor nation to collateralize the new Brady Bonds
or to repurchase outstanding bank debt at a discount. Under these arrangements
with the World Bank or the IMF, debtor nations have been required to agree to
the implementation of certain domestic monetary and fiscal reforms. Such
reforms have included the liberalization of trade and foreign investment, the
privatization of state-owned enterprises and the setting of targets for public
spending and borrowing. These policies and programs seek to promote the debtor
country's economic growth and development. Investors should recognize that the
Brady Plan only sets forth general guiding principles for economic reform and
debt reduction, emphasizing that solutions must be negotiated on a case-by-case
basis between debtor nations and their creditors. Investors should recognize
that Brady Bonds have been issued only recently, and accordingly do not have a
long payment history.
Agreements implemented under the Brady Plan to date are designed to
achieve debt and debt-service reduction through specific options negotiated by a
debtor nation with its creditors. As a result, the financial packages offered by
each country differ. The types of options have included the exchange of
outstanding commercial bank debt for bonds issued at 100% of face
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value of such debt, which carry a below-market stated rate of interest
(generally known as par bonds), bonds issued at a discount from face value of
such debt (generally known as discount bonds), bonds bearing an interest rate
which increases over time and bonds issued in exchange for the advancement of
new money by existing lenders. Regardless of the stated face amount and stated
interest rate of the various types of Brady Bonds, the Fund may purchase Brady
Bonds in secondary markets, as described below, in which the price and yield to
the investor reflect market conditions at the time of purchase. Brady Bonds
issued to date have traded at a deep discounts from their face value. Certain
Brady Bonds have been collateralized as to principal due at maturity (typically
30 years from the date of issuance) by U.S. Treasury zero coupon bonds with a
maturity equal to the final maturity of such Brady Bonds, although the
collateral is not available to investors until the final maturity of such Brady
Bonds, although the collateral is not available to investors until the final
maturity of the Brady Bonds. Collateral purchases are financed by the IMF, the
World Bank and the debtor nations' reserves. In addition, interest payments on
certain types of Brady Bonds may be collateralized by cash or high-grade
securities in amounts that typically represent between 12 and 18 months of
interest accruals on these instruments with the balance of the interest accruals
being uncollateralized. The Fund may purchase Brady Bonds with no or limited
collaterization, and will be relying for payment of interest and (except in the
case of principal collateralized Brady Bonds) principal primarily on the
willingness and ability of the Brady Bonds issued to date are purchased and sold
in secondary markets through U.S. securities dealers and other financial
institutions and are generally maintained through European transnational
securities depositories.
Commercial Paper
- ----------------
The Fund may invest in commercial paper. Commercial paper represents
short-term unsecured promissory notes issued in bearer form by banks or bank
holding companies, corporations and finance companies. The commercial paper
purchased by the Funds consists of U.S. dollar-denominated obligations of
domestic issuers, or, foreign currency-denominated obligations of domestic or
foreign issuers which, at the time of investment, are (i) rated "P-1" or "P-2"
by Moody's or "A-1" or "A-2" or better by S&P, (ii) issued or guaranteed as to
principal and interest by issuers or guarantors having an existing debt security
rating of "A" or better by Moody's or "A" or better by S&P, or (iii) securities
which, if not rated, are, in the opinion of the Manager, of an investment
quality comparable to rated commercial paper in which the Fund may invest. The
rate of return on commercial paper may be linked or indexed to the level of
exchange rates between the U.S. dollar and a foreign currency or currencies.
Derivative Instruments
- ----------------------
The following describes certain derivative instruments and products in
which the Fund may invest (to the extent described in the Prospectus) and the
risks associated therewith.
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Options on Securities and Securities or Commodities Indexes. The Fund
may, to the extent specified in the Prospectus, purchase and sell both put and
call options on fixed income or other securities or indexes in standardized
contracts traded on foreign or domestic securities exchanges, boards of trade,
or similar entities, or quoted on National Association of Securities Dealers
Automated Quotations ("NASDAQ") or on a regulated foreign over-the-counter
market, and agreements, sometimes called cash puts, which may accompany the
purchase of a new issue of bonds from a dealer.
An option on a security (or index) is a contract that gives the holder
of the option, in return for a premium, the right to buy from (in the case of a
call) or sell to (in the case of a put) the writer of the option the security
underlying the option (or the cash value of the index) at a specified exercise
price at any time during the term of the option. The writer of an option on a
security has the obligation upon exercise of the option to deliver the
underlying security upon payment of the exercise price or to pay the exercise
price upon delivery of the underlying security. Upon exercise, the writer of an
option on an index is obligated to pay the difference between the cash value of
the index and the exercise price multiplied by the specified multiplier for the
index option. (An index is designed to reflect features of a particular
financial or securities market, a specific group of financial instruments or
securities, or certain economic indicators.)
The Fund will write call options and put options only if they are
"covered." In the case of a call option on a security, the option is "covered"
if the Fund owns the security underlying the call or has an absolute and
immediate right to acquire that security without additional cash consideration
(or, if additional cash consideration is required, cash or other liquid assets
are placed in a segregated account by its custodian) upon conversion or exchange
of other securities held by the Fund. For a call option on an index, the option
is covered if the Fund maintains with its custodian liquid assets in an amount
equal to the contract value of the index. A call option is also covered if the
Fund holds a call on the same security or index as the call written where the
exercise price of the call held is (i) equal to or less than the exercise price
of the call written, or (ii) greater than the exercise price of the call
written, provided the difference is maintained by the Fund in liquid assets in a
segregated account with its custodian. A put option on a security or an index is
"covered" if the Fund maintains liquid assets in a segregated account with its
custodian. A put option is also covered if the Fund holds a put on the same
security or index as the put written where the exercise price of the put held is
(i) equal to or greater than the exercise price of the put written, or (ii) less
than the exercise price of the put written, provided the difference is
maintained by the Fund in liquid assets in a segregated account with its
custodian.
If an option written by the Fund expires unexercised, the Fund
realizes a capital gain equal to the premium received at the time the option was
written. If an option purchased by the Fund expires unexercised, the Fund
realizes a capital loss equal to the premium paid. Prior to the earlier of
exercise or expiration, an exchange traded option may be closed out by an
offsetting purchase or sale of an option of the same series (type, exchange,
underlying
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<PAGE>
security or index, exercise price, and expiration). There can be no assurance,
however, that a closing purchase or sale transaction can be effected when the
Fund desires.
The Fund will realize a capital gain from a closing purchase
transaction if the cost of the closing option is less than the premium received
from writing the option, or, if it is more, the Fund will realize a capital
loss. If the premium received from a closing sale transaction is more than the
premium paid to purchase the option, the Fund will realize a capital gain or, if
it is less, the Fund will realize a capital loss. The principal factors
affecting the market value of a put or a call option include supply and demand,
interest rates, the current market price of the underlying security or index in
relation to the exercise price of the option, the volatility of the underlying
security or index, and the time remaining until the expiration date.
The premium paid for a put or call option purchased by the Fund is an
asset of the Fund. The premium received for an option written by the Fund is
recorded as a deferred credit. The value of an option purchased or written is
marked to market daily and is valued at the closing price on the exchange on
which it is traded or, if not traded on an exchange or no closing price is
available, at the mean between the last bid and asked prices.
OTC Options. The Fund will enter into over-the-counter ("OTC")
options transactions only with primary dealers in U.S. Government securities and
only pursuant to agreements that will assure that the Fund will at all times
have the right to repurchase the option written by it from the dealer at a
specified formula price. The Fund will treat the amount by which such formula
price exceeds the intrinsic value of the option (i.e., the amount, if any, by
which the market price of the underlying security exceeds the exercise price of
the option) as an illiquid investment.
It is the present policy of the Fund not to enter into any OTC option
transaction if, as a result, more than 15% of the Fund's net assets would be
invested in (i) OTC options purchased by the Fund, (ii) the illiquid portion
(determined under the foregoing formula) of OTC options written by the Fund, and
(iii) other illiquid investments as set forth below under the heading
"Investment Restrictions."
Risks Associated with Options on Securities and Indexes. There are
several risks associated with transactions in options on securities and on
indexes. For example, there are significant differences between the securities
and options markets that could result in an imperfect correlation between these
markets, causing a given transaction not to achieve its objectives. A decision
as to whether, when and how to use options involves the exercise of skill and
judgment, and even a well-conceived transaction may be unsuccessful to some
degree because of market behavior or unexpected events.
There can be no assurance that a liquid market will exist when the
Fund seeks to close out an option position. If the Fund were unable to close
out an option that it had purchased on a security, it would have to exercise the
option in order to realize any profit or the option may
22
<PAGE>
expire worthless. If the Fund were unable to close out a covered call option
that it had written on a security, it would not be able to sell the underlying
security or other cover unless the option expired without exercise. As the
writer of a covered call option, the Fund forgoes, during the option's life, the
opportunity to profit from increases in the market value of the security
covering the call option above the sum of the premium and the exercise price of
the call.
If trading were suspended in an option purchased by the Fund, the Fund
would not be able to close out the option. If restrictions on exercise were
imposed, the Fund might be unable to exercise an option it has purchased.
Except to the extent that a call option on an index written by the Fund is
covered by an option on the same index purchased by the Fund, movements in the
index may result in a loss to the Fund; however, such losses may be mitigated by
changes in the value of the Fund's securities during the period the option was
outstanding.
Foreign Currency Options. The Fund may buy or sell put and call
options on foreign currencies either on exchanges or in the over-the-counter
market. A put option on a foreign currency gives the purchaser of the option
the right to sell a foreign currency at the exercise price until the option
expires. A call option on a foreign currency gives the purchaser of the option
the right to purchase the currency at the exercise price until the option
expires. Currency options traded on U.S. or other exchanges may be subject to
position limits which may limit the ability of the Fund to reduce foreign
currency risk using such options. Over-the-counter options differ from traded
options in that they are two-party contracts with price and other terms
negotiated between buyer and seller, and generally do not have as much market
liquidity as exchange-traded options.
Futures Contracts and Options on Futures Contracts. The Fund may use
interest rate, foreign currency or index futures contracts, as specified for
that Fund in the Prospectuses. An interest rate, foreign currency or index
futures contract provides for the future sale by one party and purchase by
another party of a specified quantity of a financial instrument, foreign
currency or the cash value of an index at a specified price and time. A futures
contract on an index is an agreement pursuant to which two parties agree to take
or make delivery of an amount of cash equal to the difference between the value
of the index at the close of the last trading day of the contract and the price
at which the index contract was originally written. Although the value of an
index might be a function of the value of certain specified securities, no
physical delivery of these securities is made. A public market exists in
futures contracts covering a number of indexes as well as financial instruments
and foreign currencies, including: the S&P 500; the S&P Midcap 400; the Nikkei
225; the NYSE composite; U.S. Treasury bonds; U.S. Treasury notes; GNMA
Certificates; three-month U.S. Treasury bills; 90-day commercial paper; bank
certificates of deposit; Eurodollar certificates of deposit; the Australian
dollar; the Canadian dollar; the British pound; the German mark; the Japanese
yen; the French franc; the Swiss franc; the Mexican peso; and certain
multinational currencies,
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<PAGE>
such as the European Currency Unit ("ECU"). It is expected that other futures
contracts will be developed and traded in the future.
Although some futures contracts call for making or taking delivery of
the underlying securities, generally these obligations are closed out prior to
delivery by offsetting purchases or sales of matching futures contracts (same
exchange, underlying security or index, and delivery month). If an offsetting
purchase price is less than the original sale price, the Fund realizes a capital
gain, or if it is more, the Fund realizes a capital loss. Conversely, if an
offsetting sale price is more than the original purchase price, the Fund
realizes a capital gain, or if it is less, the Fund realizes a capital loss.
The transaction costs must also be included in these calculations.
The Fund may purchase and write call and put futures options. Futures
options possess many of the same characteristics as options on securities and
indexes (discussed above). A futures option gives the holder the right, in
return for the premium paid, to assume a long position (call) or short position
(put) in a futures contract at a specified exercise price at any time during the
period of the option. Upon exercise of a call option, the holder acquires a
long position in the futures contract and the writer is assigned the opposite
short position. In the case of a put option, the opposite is true.
The Fund will only enter into futures contracts and futures options
which are standardized and traded on a U.S. or foreign exchange, board of trade,
or similar entity, or in the case of futures options, for which an established
over-the-counter market exists.
When a purchase or sale of a futures contract is made by the Fund, the
Fund is required to deposit with its custodian (or broker, if legally permitted)
a specified amount of assets ("initial margin"). The margin required for a
futures contract is set by the exchange on which the contract is traded and may
be modified during the term of the contract. Margin requirements on foreign
exchanges may be different than U.S. exchanges. The initial margin is in the
nature of a performance bond or good faith deposit on the futures contract which
is returned to the Fund upon termination of the contract, assuming all
contractual obligations have been satisfied. The Fund expects to earn interest
income on its initial margin deposits. A futures contract held by the Fund is
valued daily at the official settlement price of the exchange on which it is
traded. Each day the Fund pays or receives cash, called "variation margin,"
equal to the daily change in value of the futures contract. This process is
known as "marking to market." Variation margin does not represent a borrowing
or loan by the Fund but is instead a settlement between the Fund and the broker
of the amount one would owe the other if the futures contract expired. In
computing daily net asset value, the Fund will mark to market its open futures
positions.
The Fund is also required to deposit and maintain margin with respect
to put and call options on futures contracts written by it. Such margin
deposits will vary depending on the
24
<PAGE>
nature of the underlying futures contract (and the related initial margin
requirements), the current market value of the option, and other futures
positions held by the Fund.
Limitations on Use of Futures and Futures Options. In general, the
Fund intends to enter into positions in futures contracts and related options
only for "bona fide hedging" purposes. With respect to positions in futures and
related options that do not constitute bona fide hedging positions, the Fund
will not enter into a futures contract or futures option contract if,
immediately thereafter, the aggregate initial margin deposits relating to such
positions plus premiums paid by it for open futures option positions, less the
amount by which any such options are "in-the-money," would exceed 5% of the
Fund's net assets. A call option is "in-the-money" if the value of the futures
contract that is the subject of the option exceeds the exercise price. A put
option is "in-the-money" if the exercise price exceeds the value of the futures
contract that is the subject of the option.
When purchasing a futures contract, the Fund will maintain with its
custodian (and mark-to-market on a daily basis) liquid assets that, when added
to the amounts deposited with a futures commission merchant as margin, are equal
to the market value of the futures contract. Alternatively, the Fund may
"cover" its position by purchasing a put option on the same futures contract
with a strike price as high or higher than the price of the contract held by the
Fund.
When selling a futures contract, the Fund will maintain with its
custodian (and mark-to-market on a daily basis) liquid assets that are equal to
the market value of the instruments underlying the contract. Alternatively, the
Fund may "cover" its position by owning the instruments underlying the contract
(or, in the case of an index futures contract, a portfolio with a volatility
substantially similar to that of the index on which the futures contract is
based), or by holding a call option permitting the Fund to purchase the same
futures contract at a price no higher than the price of the contract written by
the Fund (or at a higher price if the difference is maintained in liquid assets
with the Trust's custodian).
When selling a call option on a futures contract, the Fund will
maintain with its custodian (and mark-to-market on a daily basis) liquid assets
that, when added to the amounts deposited with a futures commission merchant as
margin, equal the total market value of the futures contract underlying the call
option. Alternatively, the Fund may cover its position by entering into a long
position in the same futures contract at a price no higher than the strike price
of the call option, by owning the instruments underlying the futures contract,
or, in the case of an index futures contract, by holding a separate call option
permitting the Fund to purchase the same futures contract at a price not higher
than the strike price of the call option sold by the Fund.
When selling a put option on a futures contract, the Fund will
maintain with its custodian (and mark-to-market on a daily basis) liquid assets
that equal the purchase price of the futures contract, less any margin on
deposit. Alternatively, the Fund may cover the
25
<PAGE>
position either by entering into a short position in the same futures contract,
or by owning a separate put option permitting it to sell the same futures
contract so long as the strike price of the purchased put option is the same or
higher than the strike price of the put option sold by the Fund.
The requirements for qualification as a regulated investment company
also may limit the extent to which the Fund may enter into futures, futures
options or forward contracts. See "Taxation."
Risks Associated with Futures and Futures Options. There are several
risks associated with the use of futures contracts and futures options as
hedging techniques. A purchase or sale of a futures contract may result in
losses in excess of the amount invested in the futures contract. Some of the
risk may be caused by an imperfect correlation between movements in the price of
the futures contract and the price of the security or other investment being
hedged. The hedge will not be fully effective where there is such imperfect
correlation. For example, if the price of the futures contract moves more than
the price of the hedged security, the Fund would experience either a loss or
gain on the future which is not completely offset by movements in the price of
the hedged securities. To compensate for imperfect correlations, the Fund may
purchase or sell futures contracts in a greater dollar amount than the hedged
securities if the volatility of the hedged securities is historically greater
than the volatility of the futures contracts. Conversely, the Fund may
purchase or sell fewer contracts if the volatility of the price of the hedged
securities is historically less than that of the futures contracts. The risk of
imperfect correlation generally tends to diminish as the maturity date of the
futures contract approaches.
Futures exchanges may limit the amount of fluctuation permitted in
certain futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of the
current trading session. Once the daily limit has been reached in a futures
contract subject to the limit, no more trades may be made on that day at a price
beyond that limit. The daily limit governs only price movements during a
particular trading day and therefore does not limit potential losses because the
limit may work to prevent the liquidation of unfavorable positions. For
example, futures prices have occasionally moved to the daily limit for several
consecutive trading days with little or no trading, thereby preventing prompt
liquidation of positions and subjecting some holders of futures contracts to
substantial losses.
There can be no assurance that a liquid market will exist at a time
when the Fund seeks to close out a futures or a futures option position, and the
Fund would remain obligated to meet margin requirements until the position is
closed. In addition, many of the contracts discussed above are relatively new
instruments without a significant trading history. As a result, there can be no
assurance that an active secondary market will develop or continue to exist.
26
<PAGE>
Additional Risks of Options on Securities, Futures Contracts, Options
on Futures Contracts, and Forward Currency Exchange Contracts and Options
thereon. Options on securities, futures contracts, options on futures
contracts, and options on currencies may be traded on foreign exchanges. Such
transactions may not be regulated as effectively as similar transactions in the
United States, may not involve a clearing mechanism and related guarantees; and
are subject to the risk of governmental actions affecting trading in, or the
prices of, foreign securities. The value of such positions also could be
adversely affected by (i) other complex foreign political, legal and economic
factors, (ii) lesser availability than in the United States of data on which to
make trading decisions, (iii) delays in the Trust's ability to act upon economic
events occurring in foreign markets during non-business hours in the United
States, (iv) the imposition of different exercise and settlement terms and
procedures and margin requirements than in the United States, and (v) lesser
trading volume.
Swap Agreements. The Fund may enter into swap agreements to hedge
against changes in interest rates, foreign currency exchange rates or securities
prices. Swap agreements are two party contracts entered into primarily by
institutional investors for periods ranging from a few weeks to more than one
year. In a standard "swap" transaction, two parties agree to exchange the
returns (or differentials in rates of return) earned or realized on particular
predetermined investments or instruments. The gross returns to be exchanged or
"swapped" between the parties are calculated with respect to a "notional
amount," i.e., the return on or increase in value of a particular dollar amount
invested in the relevant investments or instruments.
Most swap agreements entered into by the Fund calculate the
obligations of the parties to the agreement on a "net basis." Consequently, the
Fund's current obligations (or rights) under a swap agreement will generally be
equal only to the net amount to be paid (or received) under the agreement based
on the relative values of the positions held by each party to the agreement (the
"net amount"). The Fund's current obligations under a swap agreement will be
accrued daily (offset against any amounts owing to the Fund) and any accrued but
unpaid net amounts owed to a swap counterparty will be covered by the
maintenance of a segregated account. Obligations under swap agreements so
covered will not be construed to be "senior securities" for purposes of the
Fund's investment restriction concerning senior securities. The Fund will not
enter into a swap agreement with any single party if the net amount owed or to
be received under existing contracts with that party would exceed 5% of the
Fund's assets.
Whether the Fund's use of swap agreements will be successful in
furthering its investment objective will depend on the Manager's ability to
predict correctly whether certain types of investments are likely to produce
greater returns than other investments. Because they are two party contracts
and because they may have terms of greater than seven days, swap agreements may
be considered to be illiquid. Moreover, the Fund bears the risk of loss of the
amount expected to be received under a swap agreement in the event of the
default or bankruptcy of a swap agreement counterparty. The Fund will enter
into swap agreements only with counterparties that meet certain standards of
creditworthiness (generally, such
27
<PAGE>
counterparties would have to be eligible counterparties under the terms of the
Fund's repurchase agreement guidelines). Certain restrictions imposed on the
Funds by the Internal Revenue Code may limit the Fund's ability to use swap
agreements. The swaps market is a relatively new market and is largely
unregulated. It is possible that developments in the swaps market, including
potential government regulation, could adversely affect the Fund's ability to
terminate existing swap agreements or to realize amounts to be received under
such agreements.
Forward Commitments, When-Issued and Delayed Delivery Transactions
- ------------------------------------------------------------------
The Fund may purchase or sell securities on a when-issued or delayed
delivery basis. These transactions involve a commitment by the Fund to purchase
or sell securities for a predetermined price or yield, with payment and delivery
taking place more than seven days in the future, or after a period longer than
the customary settlement period for that type of security. When delayed
delivery purchases are outstanding, the Fund will set aside and maintain assets
until the settlement date in a segregated account, sufficient to meet the
purchase price. Typically, no income accrues on securities purchased on a
delayed delivery basis prior to the time delivery of the securities is made,
although the Fund may earn income on securities it has deposited in a segregated
account. When purchasing a security on a delayed delivery basis, the Fund
assumes the rights and risks of ownership of the security, including the risk of
price and yield fluctuations, and takes such fluctuations into account when
determining its net asset value. Because the Fund is not required to pay for
the security until the delivery date, these risks are in addition to the risks
associated with the Fund's other investments. If the Fund remains substantially
fully invested at a time when delayed delivery purchases are outstanding, the
delayed delivery purchases may result in a form of leverage. When the Fund has
sold a security on a delayed delivery basis, the Fund does not participate in
future gains or losses with respect to the security. If the other party to a
delayed delivery transaction fails to deliver or pay for the securities, the
Fund could miss a favorable price or yield opportunity or could suffer a loss.
The Fund may dispose of or renegotiate a delayed delivery transaction after it
is entered into, and may sell when-issued securities before they are delivered,
which may result in a capital gain or loss. There is no percentage limitation
on the extent to which the Funds may purchase or sell securities on a delayed
delivery basis.
The Fund may make contracts to purchase securities for a fixed price
at a future date beyond customary settlement time ("forward commitments") if the
Fund either (i) holds, and maintains until the settlement date in a segregated
account, assets sufficient to meet the purchase price or (ii) enters into an
offsetting contract for the forward sale of securities of equal value that it
owns. The Fund may also enter into forward commitments for the purchase or sale
of foreign currencies. Forward commitments may be considered securities in
themselves. They involve a risk of loss if the value of the security to be
purchased declines prior to the settlement date, which risk is in addition to
the risk of decline in value of the Fund's other assets. The Fund may dispose
of a commitment prior to settlement and may realize short-term profits or losses
upon such disposition.
28
<PAGE>
Note on Shareholder Approval
- ----------------------------
The Prospectus describes the investment objective of the Fund. The
Prospectus also identifies some of the policies of the Fund which are
fundamental and may be changed only with the approval of the shareholders.
Unless otherwise indicated, the objective and investment policies of the Fund
are not fundamental and may be changed without shareholder approval. Approval
by the shareholders of the Fund requires approval by the holders of a majority
of the outstanding shares of the Fund. As used in this Statement of Additional
Information, the term "majority of the outstanding shares" of the Fund means the
lesser of (i) 67% of the shares of the Fund represented at a meeting at which
more than 50% of the outstanding shares of the Fund are represented or (ii) more
than 50% of the outstanding shares of the Fund.
Investment Restrictions
- -----------------------
The investment restrictions set forth below are fundamental policies
of the Fund and, accordingly, without the approval of the holders of a majority
of the outstanding shares of the Fund, the Fund will not:
(1) With respect to 75% of its total assets, purchase any security if,
as a result, more than 5% of its total assets (based on current value) would
then be invested in the securities of a single issuer. This limitation does not
apply to Government securities (as defined in the 1940 Act).
(2) With respect to 75% of its total assets, acquire more than 10% of
the outstanding voting securities of any issuer.
(3) Invest more than 25% of its total assets in any one industry.
This restriction does not apply to U.S. Government Securities. For purposes of
this restriction, telephone, gas and electric public utilities are each regarded
as separate industries and finance companies whose financing activities are
related primarily to the activities of their parent companies are classified in
the industry of their parents. For purposes of this restriction with regard to
bank obligations, bank obligations are considered to be one industry, and asset-
backed securities are not considered to be bank obligations.
(4) Make short sales of securities, maintain a short position or
purchase securities on margin, except that the Fund may obtain short-term
credits as necessary for the clearance of security transactions, and the Fund
may make any short sales or maintain any short positions where the short sales
or short positions would not constitute "senior securities" under the 1940 Act.
29
<PAGE>
(5) Borrow money except for temporary or emergency purposes;
provided, however, that the Fund may loan its securities, engage in reverse
repurchase agreements and dollar rolls, in an amount not exceeding 33 1/3% of
its total assets taken at cost.
(6) Make loans, except that the Fund may purchase or hold debt
instruments in accordance with its investment objective and policies. This
restriction does not apply to repurchase agreements or loans of portfolio
securities.
(7) Act as an underwriter of securities of other issuers except
that, in the disposition of portfolio securities, it may be deemed to be an
underwriter under the federal securities laws.
(8) Purchase or sell real estate, although it may purchase
securities of issuers which deal in real estate, securities which are secured by
interests in real estate, and securities which represent interests in real
estate, and it may acquire and dispose of real estate or interests in real
estate acquired through the exercise of its rights as a holder of debt
obligations secured by real estate or interests therein.
(9) Purchase or sell commodities or commodity contracts, except that
the fund may purchase and sell financial futures contracts and options and may
enter into foreign exchange contracts and other financial transactions not
involving physical commodities.
(10) Issue senior securities, except for permitted borrowings or as
otherwise permitted under the 1940 Act.
The percentages and percentage limitations set forth above or in the
Prospectus, other than with respect to restriction (5) pertaining to borrowing,
will apply at the time of the purchase of a security and shall not be considered
violated unless an excess or deficiency occurs or exists immediately after and
as a result of a purchase of such security. Restrictions (4) and (10) shall be
interpreted based upon no-action letters and other pronouncements of the staff
of the Securities and Exchange Commission. Under current pronouncements,
certain Fund positions are excluded from the definition of "senior security" so
long as the Fund maintains adequate cover, segregation of assets or otherwise.
In addition, it is contrary to the Fund's present policy, which may be
changed without shareholder vote, to purchase any illiquid security, including
any securities whose disposition is restricted under federal securities laws and
securities that are not readily marketable, if, as a result, more than 15% of
the Fund's total assets (based on current value) would then be invested in such
securities. The staff of the Securities and Exchange Commission is presently of
the view that repurchase agreements maturing in more than seven days are subject
to this restriction. Until that position is revised, modified or rescinded, the
Fund will conduct its operations in a manner consistent with this view. This
limitation on investment in illiquid securities does not apply to certain
restricted securities, including securities issued pursuant to
30
<PAGE>
Rule 144A under the Securities Act of 1933 and certain commercial paper, that
the Manager has determined to be liquid under procedures approved by the Board
of Trustees.
CREDIT AND MARKET RISK
The portfolio securities of the Fund are subject to credit risk and
market risk. Credit risk relates to the ability of the issuer of an obligation
to make timely payments of principal and interest. In a repurchase agreement
transaction, credit risk relates to the performance by the other party of its
obligation to repurchase the underlying security from the Fund. Obligations of
issuers are subject to the provisions of bankruptcy, insolvency and other laws,
such as the Federal Bankruptcy Reform Act of 1978, affecting the rights and
remedies of creditors.
Market risk relates to changes in the market value of a security as a
result of variations in the level of prevailing interest rates and yield
relationships among particular segments of the fixed income market or the U.S.
Government Securities market. Generally, prices tend to fluctuate less for
higher quality issues than for lower quality issues, and, for any given change
in the level of interest rates, prices for shorter maturity issues tend to
fluctuate less than for longer maturity issues. By restricting the maturity of
its investments and purchasing only high-quality instruments, the Fund seeks
relatively smaller changes in the value of its portfolio securities resulting
from market factors than would be the case for a longer term or lower grade bond
fund.
The value of the securities (other than inverse floaters) in the
Fund's portfolio can be expected to vary inversely to the changes in prevailing
interest rates. Thus, if interest rates increase after a security is purchased,
that security, if sold, might be sold at less than cost. Conversely, if interest
rates decline after purchase, the security, if sold, might be sold at a profit.
In either instance, if the security were held to maturity, no gain or loss would
normally be realized as a result of these fluctuations. Substantial redemptions
of shares of the Fund could require the sale of portfolio investments in the
Fund at a time when a sale might not be desirable.
PORTFOLIO TRANSACTIONS AND BROKERAGE
In general, the Fund will purchase securities with the expectation of
holding them to maturity. However, the Fund may engage in short-term trading to
attempt to take advantage of short-term market variations. The Fund may also
sell securities prior to maturity to meet redemptions or as a result of a
revised management evaluation of the issuer. The Fund will have a high
portfolio turnover due to the short maturities of the securities held in its
portfolio.
31
<PAGE>
In placing orders for the purchase and sale of portfolio securities
for the Fund, the Manager will always seek the best price and execution. It is
expected that portfolio transactions will generally be with issuers or dealers
in money market instruments acting as principal. Purchases from underwriters
will include a commission or concession paid by the issuer to the underwriter,
and purchases from dealers will include the spread between the bid and asked
price. Accordingly, the Fund is not expected to pay significant brokerage
commissions.
Some of the Fund's portfolio transactions are placed with dealers who
provide the Manager with supplementary investment and statistical information or
furnish market quotations to the Fund or other advisory accounts or investment
companies advised by the Manager. The business would not be so placed if the
Fund would not thereby obtain the best price and execution. Although it is not
possible to assign an exact dollar value to these services, they may, to the
extent used, tend to reduce the expenses of the Manager. The services may also
be used by the Manager in connection with its other advisory accounts and in
some cases may not be used with respect to the Fund.
Certain officers of the Manager have responsibility for portfolio
management of certain other investment companies and investment accounts which
may invest in securities in which the Fund also invests. When one or more of
these other investment companies or accounts and the Fund desire to purchase or
sell the same security at or about the same time, purchase and sale orders will
ordinarily be placed and confirmed separately but may be combined to the extent
practicable on a pro rata basis in proportion to the amounts desired to be
purchased or sold for each. It is believed that the ability of the Fund to
participate in larger volume transactions will in some cases produce better
executions for the Fund. However, in some cases, these procedures could have a
detrimental effect on the price and amount of a security available to the Fund
or the price at which a security may be sold.
32
<PAGE>
MANAGEMENT OF THE FUND
Trustees
The Trustees of the Trust, their ages, and a description of their
principal occupations during the past five years are listed below. Except as
shown, each Trustee's principal occupation and business experience for the last
five years have been with the employer(s) indicated, although in some cases the
Trustee may have held different positions with such employer(s).
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Name, Address and Age Principal Occupation(s) During the Past Five Years
- --------------------------------------------------------------------------------
<S> <C>
E. Philip Cannon Trustee of the Trust and PIMCO Funds:
2401 Claremont Lane Multi-Manager Series ("PFMMS"); Headmaster, St.
Houston, TX 77019 John's School, Houston, Texas. Formerly, Trustee,
Age 56 PIMCO Advisors Funds ("PAF"), General Partner,
J.B. Poindexter & Co., Houston, Texas (private
partnership), and Partner, Iberia Petroleum
Company (oil and gas production). Mr. Cannon was
a director of WNS Inc., a retailing company which
filed a petition in bankruptcy within the last
five years.
- --------------------------------------------------------------------------------
Donald P. Carter Trustee of the Trust and PFMMS. Formerly,
434 Stable Lane Trustee, PAF, Chairman, Executive Vice President
Lake Forest, IL 60045 and Director, Cunningham & Walsh, Inc., Chicago
Age 69 (advertising agency).
- --------------------------------------------------------------------------------
Gary A. Childress Trustee of the Trust and PFMMS; Chairman and
11 Longview Terrace Director, Bellefonte Lime Company, Inc.; Chief
Madison, CT 06443 Executive Officer, Woodings & Verona Toolworks
Age 62 Inc. Mr. Childress is a partner in GenLime, L.P.,
a private limited partnership, which has filed a
petition in bankruptcy within the last five years.
Formerly, Trustee, PAF.
- --------------------------------------------------------------------------------
(*) William D. Cvengros Trustee of the Trust and PFMMS; Chairman of the
800 Newport Center Drive Board of PFMMS; Chief Executive Officer,
Newport Beach, CA 92660 President, and member of the Operating Board,
Age 48 Operating Committee, and Equity Board, PIMCO
Advisors L.P.; Director, PIMCO Funds Distribution
Company ("PFDCO"). Formerly, Trustee, PAF,
President, PFMMS, and Director, Vice Chairman, and
Chief Investment Officer, Pacific Mutual Life
Insurance Company ("Pacific Mutual").
- --------------------------------------------------------------------------------
</TABLE>
33
<PAGE>
<TABLE>
- --------------------------------------------------------------------------------
<S> <C>
Gary L. Light Trustee of the Trust and PFMMS; Partner, E.V.A.
12220 N. Meridian Street, Investors Inc. (private investments); Consultant
#145 to and, prior to March, 1987, Executive Vice
Carmel, IN 46032 President, Mayflower Corporation (trucking and
Age 59 transportation); Vice Chairman and Chief Executive
Officer, Sofamor Danek (medical devices).
Formerly, Trustee, PAF.
- --------------------------------------------------------------------------------
Richard L. Nelson President, Nelson Financial Consultants; Director,
8 Cherry Hills Lane Wynn's International, Inc.; Trustee, Pacific
Newport Beach, CA 92660 Select Fund. Formerly, Partner, Ernst & Young.
Age 66
- --------------------------------------------------------------------------------
Lyman W. Porter Professor of Management at the University of
2639 Bamboo Street California, Irvine, Trustee, Pacific Select Fund.
Newport Beach, CA 92660
Age 66
- --------------------------------------------------------------------------------
(*) Robert A. Prindiville Trustee of the Trust and PFMMS. Formerly,
2187 Atlantic Street Trustee, PAF, President and Director, Thomson
Stamford, CT 06903 Advisory Group Inc., Director and Chairman, PFDCO,
Age 61 Executive Vice President, PIMCO Advisors L.P.
- --------------------------------------------------------------------------------
Alan Richards President, Alan Richards Consulting, Inc.;
P.O. Box 675760 Trustee, Pacific Select Fund; Director, Western
18132 Camino de Estrellas National Corporation. Formerly, President, Chief
Rancho Santa Fe, CA 92067 Executive Officer and Director, E.F. Hutton
Age 66 Insurance Group, Inc., Chairman of the Board,
Chief Executive Officer and President, E.F. Hutton
Life Insurance Company, Director, E.F. Hutton &
Company, Inc.
- --------------------------------------------------------------------------------
Joel Segall Trustee of the Trust and PFMMS. Formerly,
11 Linden Shores Trustee, PAF, President and University Professor,
Branford, CT 06405 Bernard M. Baruch College, The City University of
Age 73 New York, Deputy Under Secretary for International
Affairs, United States Department of Labor,
Professor of Finance, University of Chicago, Board
of Managers, Coffee, Sugar and Cocoa Exchange.
- --------------------------------------------------------------------------------
W. Bryant Stooks Trustee of the Trust and PFMMS; President, Bryant
1530 E. Montebello Investments, Ltd. Formerly, Trustee, PAF,
Phoenix, AZ 85014 President, Senior Vice President, Director and
Age 56 Chief Executive Officer, Archirodon Group Inc.,
Partner, Arthur Andersen & Co.
- --------------------------------------------------------------------------------
Gerald M. Thorne Trustee of the Trust and PFMMS. Formerly,
5 Leatherwood Lane Trustee, PAF, President and Director, Firstar
Savannah, GA 31414 National Bank of Milwaukee, Chairman, President
Age 58 and Director, Firstar National Bank of Sheboygan,
Director, Bando-McGlocklin.
- --------------------------------------------------------------------------------
</TABLE>
34
<PAGE>
<TABLE>
- --------------------------------------------------------------------------------
<S> <C>
(*) Stephen J. Treadway Trustee of the Trust and PFMMS; President of
2187 Atlantic Street PFMMS; Executive Vice President, PIMCO Advisors
Stamford, CT 06902 L.P.; Director, Chairman and President, PFDCO.
Age 49 Formerly, Executive Vice President, Smith Barney
Inc.
- --------------------------------------------------------------------------------
</TABLE>
* Trustee is an "interested person" of the Trust (as defined in Section
2(a)(19) of the Investment Company Act).
Officers
- --------
The chart below sets forth the name, address, age, position(s) with
the Trust, and principal occupation(s) during the past five years of each
officer of the Trust. Except as shown, each officer's principal occupation and
business experience for the last five years have been with the employer(s)
indicated, although in some cases the officer may have held different positions
with such employer(s). Unless otherwise indicated, the business address of all
persons listed below is 840 Newport Center Drive, Suite 360, Newport Beach,
California 92660:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Name, Address and Age Position(s) with Principal Occupation(s)
the Trust During the Past Five Years
- --------------------------------------------------------------------------------
<S> <C> <C>
Stephen J. Treadway President Trustee and President,
2187 Atlantic Street PFMMS; Executive Vice
Stamford, CT 06902 President, PIMCO Advisors
Age 49 L.P.; Director, Chairman and
President, PFDCO. Trustee of
the Trust. Formerly,
Executive Vice President,
Smith Barney Inc.
- --------------------------------------------------------------------------------
R. Wesley Burns Vice President Executive Vice President,
Age 37 PFMMS; President, PIMCO
Funds: Pacific Investment
Management Series ("PIMS");
Executive Vice President,
Pacific Investment
Management Company ("Pacific
Investment Management").
Formerly, Vice President,
PAF.
- --------------------------------------------------------------------------------
</TABLE>
35
<PAGE>
<TABLE>
- --------------------------------------------------------------------------------
<S> <C> <C>
Newton B. Schott, Jr. Vice President and Vice President and
2187 Atlantic Street Clerk Secretary, PFMMS; Director,
Stamford, CT 06902 Executive Vice President,
Age 54 Chief Administrative Officer
and Secretary, PFDCO.
Formerly, Senior Vice
President-Legal and
Secretary, PIMCO Advisors
L.P.; Vice President and
Clerk, PAF, Executive Vice
President, Secretary and
General Counsel, Thomson
Advisory Group Inc. and
PIMCO Advisors L.P.,
Executive Vice President,
Secretary, General Counsel
and Director, Thomson
McKinnon Inc.
- --------------------------------------------------------------------------------
Teresa A. Wagner Vice President Vice President of PFMMS;
Age 34 Vice President, PIMS; Vice
President and Manager of
Fund Administration, Pacific
Investment Management.
Formerly, Vice President and
Assistant Clerk, PAF, Vice
President, PIMCO Advisors
Institutional Services,
Finance Director, Pacific
Financial Asset Management
Company.
- --------------------------------------------------------------------------------
John P. Hardaway Treasurer Treasurer of PFMMS and PIMS;
Age 39 Vice President and Manager
of Fund Operations, Pacific
Investment Management.
Formerly, Treasurer, PAF.
- --------------------------------------------------------------------------------
</TABLE>
PFDCO also serves as principal underwriter for PFMMS and PIMS.
Trustees' Compensation
- ----------------------
The Trust's Agreement and Declaration of Trust provides that the Trust
will indemnify its Trustees and officers against liabilities and expenses
incurred in connection with litigation in which they may be involved because of
their offices with the Trust, except if it is determined in the manner specified
in the Agreement and Declaration of Trust that they have not acted in good faith
in the reasonable belief that their actions were in the best interests of the
Trust or that such indemnification would relieve any officer or Trustee of any
liability to
36
<PAGE>
the Trust or its shareholders by reason of willful misfeasance, bad faith, gross
negligence or reckless disregard of his or her duties. The Trust, at its
expense, will provide liability insurance for the benefit of its Trustees and
officers.
The Trust does not pay any remuneration to Trustees who are interested
persons of the Trust or the Manager. Each of the Trust's Trustees, other than
Messrs. Nelson, Porter and Richards, previously served on the Board of PAF, a
mutual fund family advised by PIMCO Advisors L.P., an affiliate of the Manager,
and its affiliates. PAF ceased operations in connection with the reorganization
of its series with series of PFMMS or PIMS in transactions which took place on
January 17, 1997.
Fees paid to the disinterested Trustees for their services on behalf
of the Trust during the fiscal year ended September 30, 1996 aggregated
$124,833. The following table sets forth information concerning fees paid during
the fiscal year ended September 30, 1996 to persons who served as disinterested
Trustees of the Trust during such fiscal year.
<TABLE>
<CAPTION>
--------------------------------------------------
(1) (2) (3)
Total
Aggregate Compensation
Name of Trustee Compensation from Trust
from Trust and Fund
Complex/1/
--------------------------------------------------
<S> <C> <C>
E. Philip Cannon $16,667 $50,000
--------------------------------------------------
Donald P. Carter $17,833 $53,500
--------------------------------------------------
Gary A. Childress $17,667 $53,000
--------------------------------------------------
Gary L. Light $18,333 $55,000
--------------------------------------------------
Richard L. Nelson N/A $14,333
--------------------------------------------------
Lyman W. Porter N/A $12,167
--------------------------------------------------
Alan Richards N/A $14,333
--------------------------------------------------
Joel Segall $19,833 $59,500
--------------------------------------------------
W. Bryant Stooks $17,833 $53,500
--------------------------------------------------
Gerald M. Thorne $16,667 $50,000
--------------------------------------------------
</TABLE>
/1/ The amounts listed in column (3) for Messrs. Cannon, Carter,
Childress, Light, Segall, Stooks and Thorne include total compensation paid for
their services as Trustees of PAF for PAF's fiscal year ended September 30,
1996. The amounts listed in
37
<PAGE>
column (3) do not include pension/retirement benefits earned by these Trustees
for their services on behalf of PAF through its fiscal year ended September 30,
1995 pursuant to a Trustees' Pension Plan for PAF (the "Pension Plan"). The
Trustees of PAF voted to terminate the Pension Plan as of September 28, 1995 and
received lump-sum payments in January of 1996 in respect of services rendered
during periods prior to the fiscal year ended September 30, 1996. Of the
amounts listed in column (3), E. Philip Cannon, Donald P. Carter, Joel Segall
and Gerald M. Thorne elected to have the payment of $50,000, $38,500, $43,000,
and $50,000, respectively, deferred under a deferred compensation plan for PAF
and CAT. The compensation listed in column (3) for Messrs. Light and Segall
does not include amounts which accrued pursuant to 1987 Deferred Fee Agreements
with the Trust and PAF which terminated effective December 14, 1995. These
benefits were distributed to Messrs. Light and Segall during 1996 in respect of
services rendered during periods prior to the fiscal year ended September 30,
1996. The amounts listed on column (3) for Messrs. Nelson, Porter and Richards
are amounts paid for services as Trustees of PFMMS.
38
<PAGE>
INVESTMENT ADVISORY AND OTHER SERVICES
Investment Advisory Agreement
- -----------------------------
Columbus Circle Investors ("CCI") serves as Manager of the Fund. CCI
is a general partnership with PIMCO Advisors L.P. ("PALP") and Columbus Circle
Investors Management Inc., a wholly owned subsidiary of PALP, as its only
partners. PALP is a Delaware limited partnership. The sole general partner of
PALP, PIMCO Partners, G.P., has two partners: (i) an indirect wholly owned of
Pacific Mutual Life Insurance Company; and (ii) PIMCO Partners, L.L.C. ("LLC"),
a limited liability company, all of the interests of which are held directly by
the Managing Directors of Pacific Investment Management Company who are: William
H. Gross, Dean S. Meiling, James F. Muzzy, William F. Podlich III, Frank B.
Rabinovitch, Brent R. Harris, John L. Hague, William S. Thompson, Jr., William
C. Powers, David H. Edington, Benjamin L. Trosky, William R. Benz, II and Lee R.
Thomas, III (collectively, the "Managing Directors"). PIMCO Partners, G.P. has
substantially delegated its management and control of PALP to an Equity Board
and an Operating Board of PALP. The activities of PALP are controlled by its
Operating Board except that certain non-routine or extraordinary actions may not
be effected by the Operating Board without the approval of PALP's Equity Board.
The Operating Board has in turn delegated the authority to manage day-to-day
operations and policies to an Operating Committee. Because of the ability to
designate a majority of the members of the Operating Board, Pacific Investment
Management Company and the Managing Directors could be said to control PALP, and
through PALP, CCI, although Pacific Investment Management Company and the
Managing Directors disclaim such authority.
Pursuant to the Investment Advisory Agreement, the Manager is
responsible for making investment decisions and placing orders for the purchase
and sale of the Trust's investments directly with the issuers or with brokers or
dealers selected by it in its discretion. See "Portfolio Transactions." The
Manager also furnishes to the Board of Trustees, which has overall
responsibility for the business and affairs of the Trust, periodic reports on
the investment performance of each Fund.
Under the terms of the Investment Advisory Agreement, the Manager is
obligated to manage the Funds in accordance with applicable laws and
regulations. The investment advisory services of CCI to the Trust are not
exclusive under the terms of the Investment Advisory Contract. CCI is free to,
and does, render investment advisory services to others. The current Investment
Advisory Agreement was approved most recently by the Board of Trustees,
including a majority of the Trustees who are not parties to the Investment
Advisory Agreement or interested persons of such parties ("Independent
Trustees"), at a meeting held on February 9, 1997.
The Manager's compensation with respect to the Fund under the
Investment Advisory Agreement described in the Prospectus under the heading
"Manager of the Fund" is subject
39
<PAGE>
to reduction to the extent that in any year the expenses of the Fund exceed the
limits on investment company expenses imposed by any statute or regulatory
authority of any jurisdiction in which shares of the Fund are qualified for
offer and sale.
The Fund pays the Manager a monthly fee at the annual percentage rate
of 0.20% based on the level of the Fund's average daily net asset value.
The Investment Advisory Agreement provides that it will continue in
force for two years from its date of execution, and from year to year
thereafter, but only so long as its continuance is approved at least annually by
(i) the vote, cast in person at a meeting called for that purpose, of a majority
of the Independent Trustees, and by (ii) the majority vote of either the full
Board of Trustees or the vote of a majority of the outstanding shares of the
Fund. The Investment Advisory Agreement automatically terminates on assignment,
and is terminable by either the Fund or the Manager on not more than 60 days'
written notice to the other party. If, at any time that the Investment Advisory
Agreement is submitted for approval by the shareholders of the Fund, the
shareholders of the Fund should fail to approve the Investment Advisory
Agreement, the Manager would continue to serve as manager and adviser with
respect to the Fund pending consideration by the Trustees of such further action
as they may deem to be in the best interests of the shareholders of the Fund.
The Investment Advisory Agreement provides that the Manager shall not
be subject to any liability in connection with the performance of its services
thereunder in the absence of willful misfeasance, bad faith, gross negligence or
reckless disregard of its obligations and duties.
Fund Administrator
- ------------------
PALP serves as administrator (and is referred to in this capacity as
the "Administrator") to the Fund pursuant to an administration agreement (the
"Administration Agreement") with the Trust. The Administrator provides or
procures administrative services to the Fund, which include clerical help and
accounting, bookkeeping, internal audit services and certain other services
required by the Fund, and preparation of reports to the Fund's shareholders and
regulatory filings. PALP has retained Pacific Investment Management, as sub-
administrator, to provide such services pursuant to a sub-administration
agreement (the "Sub-Administration Agreement"). PALP may also retain other
affiliates to provide such services. In addition, the Administrator arranges at
its own expense for the provision of legal, audit, custody, transfer agency and
other services necessary for the ordinary operation of the Fund, and is
responsible for the costs of registration of the Trust's shares and the printing
of prospectuses and shareholder reports for current shareholders. Under the
Administration Agreement, the Administrator has agreed to provide or procure
these services, and to bear these expenses. The Administrator will be
compensated at an annual rate of 0.20% of the Fund's average daily net assets.
40
<PAGE>
Except for the expenses paid by the Administrator, the Trust bears all
costs of its operations. The Trust is responsible for the following expenses:
(i) salaries and other compensation of any of the Trust's executive officers and
employees who are not officers, directors, stockholders, or employees of the
Manager, the Administrator or their subsidiaries or affiliates; (ii) taxes and
governmental fees; (iii) brokerage fees and commissions and other portfolio
transaction expenses; (iv) costs of borrowing money, including interest
expenses; (v) fees and expenses of the Trustees who are not "interested persons"
of the Manager or the Trust, and any counsel retained exclusively for their
benefit; (vi) extraordinary expenses, including costs of litigation and
indemnification expenses; and (vii) expenses which are capitalized in accordance
with generally accepted accounting principles; and (viii) any expenses allocated
or allocable to a specific class of shares ("Class-specific expenses").
The Administration Agreement and Sub-Administration Agreement may be
terminated by the Trustees, PALP or Pacific Investment Management (as the case
may be) at any time on 60 days' written notice. Following their initial term of
two years, the Administration and Sub-Administration Agreements would continue
from year to year if approved by the Trustees.
The Administration Agreement is subject to annual approval by the
Board of Trustees, including a majority of the disinterested Trustees defined
above. The current Administration Agreement was last approved by the Board of
Trustees, including all of the disinterested Trustees who are not "interested
persons" of the Trust or Administrator, at a meeting held on February 9, 1997.
In approving the Administration Agreement, the Trustees determined that: (1) the
Administration Agreement is in the best interests of the Fund and its
shareholders; (2) the services to be performed under the Administration
Agreement are services required for the operation of the Fund; (3) the
Administrator is able to provide, or to procure, services for the Fund which are
at least equal in nature and quality to services that could be provided by
others; and (4) the fees to be charged pursuant to the Administration Agreement
are fair and reasonable in light of the usual and customary charges made by
others for services of the same nature and quality.
Distribution Agreement.
- ----------------------
PIMCO Funds Distribution Company (the "Distributor") serves as the
distributor of the Fund's shares pursuant to a distribution contract
("Distribution Contract") with the Trust. The Distributor is a wholly owned
subsidiary of PALP. The Distribution Contract is terminable without penalty, at
any time, by the Fund by not more than 60 days' nor less than 30 days' written
notice to the Distributor, or by the Distributor upon not more than 60 days' nor
less than 30 days' written notice to the Trust. The Distributor is not
obligated to sell any specific amount of Trust shares.
The Distribution Contract will continue in effect for successive one-
year periods, provided that each such continuance is specifically approved (i)
by the vote of a majority of
41
<PAGE>
the Trustees who are not interested persons of the Trust (as defined in the 1940
Act) and who have no direct or indirect financial interest in the Distribution
Contract and (ii) by the vote of a majority of the entire Board of Trustees cast
in person at a meeting called for that purpose.
Although the Trust has no present intention to do so, it reserves the
right at any time to suspend the offering of the shares of the Fund.
Custodial Arrangements.
- ----------------------
Investors Fiduciary Trust Company, 127 West 10th Street, Kansas City,
MO 64105 ("IFTC") is the Fund's custodian. As such, IFTC holds in safekeeping
certificated securities and cash belonging to the Fund and, in such capacity, is
the registered owner of securities in book-entry form belonging to the Fund.
Upon instruction, IFTC receives and delivers cash and securities of the Fund in
connection with the transactions of the Fund and collects all dividends and
other distributions made with respect to the portfolio securities of the Fund.
IFTC also maintains certain accounts and records of the Fund.
Accounting Services.
- -------------------
Pursuant to an agreement between PALP and IFTC, IFTC calculates the
total net asset value, total net income and net asset value per share of the
Fund on a daily basis (and as otherwise may be required by the Investment
Company Act, that is, when there is a sufficient degree of trading in the Fund's
portfolio securities to affect its net asset value) and performs certain
accounting services for the Fund.
Independent Auditors.
- --------------------
Price Waterhouse LLP, 1055 Broadway, Kansas City, Missouri 64105, has
been selected to serve as the independent public accountants for the Fund.
Price Waterhouse LLP provides audit services, accounting assistance, and
consultation in connection with Securities and Exchange Commission filings.
ORGANIZATION AND CAPITALIZATION OF THE TRUST
The organization of the Trust and the voting rights of shareholders
are summarized in the text of the Prospectus following the caption "Description
of the Trust."
The Declaration of Trust permits the Trustees to issue an unlimited
number of full and fractional shares of beneficial interest, which may be
divided into an unlimited number of series of such shares, and which presently
consist of the series of shares constituting the Fund as well as a second series
constituting the National Money Market Fund. The Fund was organized as a series
of the Trust on December 17, 1996. Each share of a series represents
42
<PAGE>
an equal proportionate interest in that series with each other share of that
series and is entitled to a proportionate interest in the dividends and
distributions from that series. Upon termination of a series, whether pursuant
to liquidation of the series or otherwise, shareholders of that series are
entitled to share pro rata in the net assets of the series then available for
distribution to such shareholders. Shareholders have no preemptive rights.
A copy of the Agreement and Declaration of Trust (the "Declaration of
Trust") establishing the Trust is on file with the Secretary of State of The
Commonwealth of Massachusetts. The Declaration of Trust provides for the
perpetual existence of the Trust. The Trust or a series, however, may be
terminated at any time by vote of at least two-thirds of the outstanding shares
of an affected series or by the Trustees upon written notice to the
shareholders. Upon termination of the Trust or of a series, after paying or
otherwise providing for all charges, taxes, expenses and liabilities, whether
due or accrued or anticipated, of the Trust or of the series as may be
determined by the Trustees, the series shall, in accordance with such procedures
as the Trustees consider appropriate, reduce the remaining assets to
distributable form in cash or shares or other securities, or any combination
thereof, and distribute the proceeds to the shareholders of the series involved,
ratably according to the number of shares of such series held by the several
shareholders of the series on the date of termination.
The assets received by the Trust for the issue or sale of shares of a
series and all income, earnings, profits, losses and proceeds therefrom, subject
only to the rights of creditors, are allocated to that series, and constitute
the underlying assets of that series. The underlying assets of a series are
segregated and are charged with the expenses, including the organizational
expenses, in respect of that series and with a share of the general expenses of
the Trust as described above under "Investment Advisory and Other Services."
While the expenses of the Trust are allocated to the separate books of account
of the series, if more than one series has shares outstanding, certain expenses
may be legally chargeable against the assets of all series.
Under Massachusetts law, shareholders could, under certain
circumstances, be held liable for the obligations of the Trust. However, the
Declaration of Trust disclaims shareholder liability for acts or obligations of
the Trust and requires that notice of such disclaimer be given in each
agreement, obligation or instrument entered into or executed by the Trust or the
Trustees. The Declaration of Trust provides for indemnification out of the
property of a series for all loss and expense of any shareholder of that series
held liable on account of being or having been a shareholder. Thus, the risk of
a shareholder incurring financial loss on account of shareholder liability is
limited to circumstances in which the series of which he was a shareholder would
be unable to meet its obligations.
The Declaration of Trust further provides that the Trustees will not
be liable for errors of judgment or mistakes of fact or law. However, nothing
in the Declaration of Trust protects a Trustee against any liability to which
the Trustee would otherwise be subject by
43
<PAGE>
reason of willful misfeasance, bad faith, gross negligence, or reckless
disregard of the duties involved in the conduct of his office. The Declaration
of Trust provides for indemnification by the Trust of the Trustees and the
officers of the Trust except with respect to any matter as to which any such
person did not act in good faith in the reasonable belief that his action was in
or not opposed to the best interests of the Trust. Such person may not be
indemnified against any liability to the Trust or the Trust shareholders 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.
As described in the Prospectus, the Trust will not normally hold
annual shareholders' meetings. At such time as less than a majority of the
Trustees have been elected by the shareholders, the Trustees then in office will
call a shareholders' meeting for the election of Trustees. In addition,
Trustees may be removed from office by a written consent signed by the holders
of two-thirds of the outstanding shares and filed with the Trust's custodian or
by a vote of the holders of two-thirds of the outstanding shares at a meeting
duly called for the purpose, which meeting shall be held upon written request of
the holders of not less than 10% of the outstanding shares. Upon written
request by ten or more shareholders, who have been such for at least six months
and who hold shares constituting 1% of the outstanding shares, stating that such
shareholders wish to communicate with the other shareholders for the purpose of
obtaining the signatures necessary to demand a meeting to consider removal of a
Trustee, the Trust has undertaken to provide a list of shareholders or to
disseminate appropriate materials (at the expense of the requesting
shareholders).
Except as otherwise disclosed in the Prospectus and in this Statement
of Additional Information, the Trustees shall continue to hold office and may
appoint their successors.
NET INCOME, YIELD AND VALUATION
Determination of Net Income
- ---------------------------
The net income of the Fund is determined as of the close of regular
trading (ordinarily 4:00 p.m. (Eastern Time)) on the New York Stock Exchange
(the "Exchange") on each day that the Exchange is open for trading. Net income
includes (i) all interest accrued and discount earned on the portfolio
investments of the Fund, minus (ii) amortized premium on such investments, plus
or minus (iii) all realized gains and losses on such investments, and minus (iv)
all expenses of the Fund.
Calculation of Yield
- --------------------
Quotations of yield for the Fund will be based on all investment
income per share (as defined by the SEC) during a particular 30-day (or one
month) period (including dividends and interest), less expenses accrued during
the period ("net investment income"), and are computed by dividing net
investment income by the maximum offering price per share on the last day of the
period, according to the following formula:
YIELD = 2[(a-b + 1)/6/ -1]
--------------------------
cd
where a = dividends and interest earned during the period,
b = expenses accrued for the period (net of reimbursements),
c = the average daily number of shares outstanding during the
period that were entitled to receive dividends, and
d = the maximum offering price per share on the last day of the
period.
The Fund, in its advertisements, may refer to pending legislation from
time to time and the possible impact of such legislation on investors,
investment strategy and related matters. At any time in the future, yields may
be higher or lower than past yields and there can be no assurance that any
historical results will continue.
Valuing the Fund's Portfolio Investments
- ----------------------------------------
The total net asset value of the Fund (the excess of its assets over
its liabilities) is determined by SSI as of the close of regular trading on the
Exchange on each day the Exchange is open for trading. The Trust expects that
the days, other than weekend days, that
44
<PAGE>
the Exchange will not be open will be New Year's Day, Washington's Birthday,
Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and
Christmas Day.
The Fund's securities which mature in 60 days or less are generally valued
using the amortized cost method of valuation. This involves valuing a security
at cost on the date of acquisition and thereafter assuming a constant accretion
of a discount or amortization of a premium to maturity, regardless of the impact
of fluctuating interest rates on the market value of the instrument. While this
method provides certainty in valuation, it may result in periods during which
value, as determined by amortized cost, is higher or lower than the price the
Fund would receive if it sold the instrument. During such periods the yield to
investors in the Fund may differ somewhat from that obtained in a similar
investment company which uses available market quotations to value all of its
portfolio securities. This method will be used only when the amortized cost
value approximates the fair value of the securities.
TAXES
The tax status of the Fund and the distributions which it may make are
summarized in the text of the Prospectus immediately following the caption
"Taxes."
The Fund intends to qualify each year as a "regulated investment company"
under the Internal Revenue Code of 1986, as amended (the "Code").
If the Fund qualifies for taxation as a regulated investment company, the
Fund will not be subject to federal income tax on income paid to its
shareholders in the form of dividends or capital gain distributions. Except
where specifically noted, the remainder of this section assumes that the Fund
will so qualify.
If the Fund distributes amounts in excess of its current earnings and
profits, such distributions to shareholders would be treated as a return of
capital to the extent of a shareholder's basis in his or her shares, and
thereafter as capital gain. A return of capital is not taxable to a shareholder
and has the effect of reducing the shareholder's basis in the relevant shares.
Current federal tax law requires the holder of a Treasury or other fixed-
income zero-coupon security to accrue as income each year a portion of the
discount at which the security was purchased, even though the holder receives no
interest payment in cash on the security during the year. Accordingly, if the
Fund holds such securities, it may be required to pay out as an income
distribution each year an amount which is greater than the total amount of cash
interest actually received. Such distributions may be made from the cash assets
of the Fund or by liquidation of portfolio securities, if necessary. The Fund
may realize gains or losses from such liquidations. In the event the Fund
realized net capital gains from such
45
<PAGE>
transactions, its shareholders may receive a larger capital gain distribution,
if any, than they would in the absence of such transactions.
The Trust under which the Fund is created is organized as a Massachusetts
business trust. Under current law, so long as the Fund qualifies for federal
income tax treatment as described above, it is believed that neither the Trust
nor the Fund should be liable for any income or franchise tax in The
Commonwealth of Massachusetts.
The Fund is generally required to withhold and remit to the U.S. Treasury
31% of redemption proceeds and dividends from net investment income and capital
gains distributions credited to any shareholder account for which an incorrect
or no taxpayer identification number has been provided or where the Fund is
notified that the shareholder has under-reported income in the past (or the
shareholder fails to certify that he is not subject to such withholding).
Shareholders are advised to consult their own tax advisers for more
detailed information concerning the federal taxation of the Fund and the income
tax consequences of an investment in the Fund to its shareholders.
REDEMPTIONS
The procedures for redemptions and withdrawals are summarized in the
Prospectus following the caption "How to Redeem."
The Fund may suspend the right of redemption for the Fund and may postpone
payment when the Exchange is closed for other than weekends or holidays, or if
permitted by the rules of the Securities and Exchange Commission during periods
when trading on the Exchange is restricted or during an emergency which makes it
impracticable for the Fund to dispose of its securities or fairly to determine
the value of the net assets of the Fund, or during any other period permitted by
the Securities and Exchange Commission for the protection of investors.
The Fund will normally redeem a shareholder's shares for cash. However, if
in any 90-day period a shareholder seeks to redeem shares totaling the lesser of
$250,000 or 1% of the Fund's total assets, the Fund may, in unusual
circumstances, redeem any additional shares by payment in kind of securities
held in the portfolio of the Fund.
46
<PAGE>
DESCRIPTION OF INVESTMENTS
1. U.S. Government Securities.
--------------------------
Obligations Backed by Full Faith and Credit of the U.S. Government -- are
------------------------------------------------------------------
bills, certificates of indebtedness, notes and bonds issued by (i) the U.S.
Treasury or (ii) agencies, authorities and instrumentalities of the U.S.
Government or other entities and backed by the full faith and credit of the U.S.
Government. Such obligations include, but are not limited to, obligations
issued by the Government National Mortgage Association, Farmers' Home
Administration and the Small Business Administration.
Other U.S. Government Securities -- are bills, certificates of
--------------------------------
indebtedness, notes, and bonds issued by agencies, authorities and
instrumentalities of the U.S. Government which are supported by the right of the
issuer to borrow from the U.S. Treasury or by the credit of the agency,
authority or instrumentality itself. Such obligations include, but are not
limited to, obligations issued by the Tennessee Valley Authority, the Bank for
Cooperatives, Federal Home Loan Banks, Federal Intermediate Credit Banks,
Federal Land Banks, and the Federal National Mortgage Association.
U.S. Government Securities do not include securities issued or guaranteed
by state governments or instrumentalities.
2. Money Market Instruments.
------------------------
Certificates of Deposit - certificates issued against funds deposited in a
-----------------------
bank, are for a definite period of time, earn a specified rate of return, and
are normally negotiable.
Bankers' Acceptances - short-term credit instruments used to finance the
--------------------
import, export, transfer or storage of goods. They are termed "accepted" when a
bank guarantees their payment at maturity.
Eurodollar Obligations - obligations of foreign branches of U.S. banks.
----------------------
Yankeedollar Obligations - obligations of domestic branches or subsidiaries
------------------------
of foreign banks.
Commercial Paper - promissory notes issued by corporations (including banks
----------------
and bank holding companies), in order to finance their short-term credit needs.
Master Demand Notes - notes issued by corporations that are payable on
-------------------
demand by either the holder or the issuer.
47
<PAGE>
Corporate Obligations - bonds and notes issued by corporations in order to
---------------------
finance longer term credit needs.
Repurchase Agreements - are agreements by which the Fund acquires a
---------------------
security (usually a U.S. Government Security) and a simultaneous commitment from
the seller (a member bank of the Federal Reserve System or, to the extent
permitted by the Investment Company Act, a recognized securities dealer) to
repurchase the security at an agreed upon price and date. The resale price is
in excess of the purchase price and reflects an agreed upon market rate
unrelated to the coupon rate on the purchased security. Such transactions
afford an opportunity for the Fund to earn a return on temporarily available
cash at no market risk, although the Fund may be subject to various delays and
risks of loss if the seller is unable to meet its obligation to repurchase.
48
<PAGE>
APPENDIX A
-----------
The nationally recognized statistical rating organizations (individually, an
"NRSRO") that may be utilized with regard to portfolio investments for the Fund
include Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's
Corporation ("S&P"), Duff & Phelps, Inc. ("Duff"), Fitch Investors Service, Inc.
("Fitch"), IBCA Limited and its affiliate, IBCA Inc. (collectively, "IBCA"), and
Thomson BankWatch, Inc. ("Thomson"). Set forth below is a description of the
relevant ratings of each such NRSRO. The NRSROs that may be utilized by MERUS
and the description of each NRSRO's ratings is as of the date of this Statement
of Additional Information, and may subsequently change.
Long-Term Debt Ratings (may be assigned, for example, to corporate and municipal
- ----------------------
bonds) Description of the two highest long-term debt ratings by Moody's (Moody's
applies numerical modifiers (1, 2 and 3) in each rating category to indicate the
security's ranking within the category):
Aaa Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are
generally referred to as "gilt edged." Interest payments are
protected by a large or by an exceptionally stable margin and
principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most
unlikely to impair the fundamentally strong position of such
issues.
Aa Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are
generally known as high grade bonds. They are rated lower than the
best bonds because margins of protection may not be as large as in
Aaa securities or fluctuation of protective elements may be of
greater amplitude or there may be other elements present which
make the long-term risk appear somewhat larger than in Aaa
securities.
Description of the two highest long-term debt ratings by S&P (S&P may apply a
plus (+) or minus (-) to a particular rating classification to show relative
standing within that classification):
AAA Debt rated AAA has the highest rating assigned by S&P. Capacity to
pay interest and repay principal is extremely strong.
AA Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the higher rated issues only in small
degree.
A-1
<PAGE>
Description of the two highest long-term debt ratings by Duff:
AAA Highest credit quality. The risk factors are negligible being only
slightly more than for risk-free U.S. Treasury debt.
AA+ High credit quality Protection factors are strong.
AA Risk is modest but may vary slightly from time to time
AA- because of economic conditions.
Description of the two highest long-term debt ratings by Fitch (plus or minus
signs are used with a rating symbol to indicate the relative position of the
credit within the rating category):
AAA Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay
interest and repay principal, which is unlikely to be affected by
reasonably foreseeable events.
AA Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is
very strong, although not quite as strong as bonds rated "AAA."
Because bonds rated in the "AAA" and "AA" categories are not
significantly vulnerable to foreseeable future developments, short-
term debt of these issues is generally rated "[-]+."
IBCA's description of its two highest long-term debt ratings:
AAA Obligations for which there is the lowest expectation of investment
risk. Capacity for timely repayment of principal and interest is
substantial such that adverse changes in business, economic or
financial conditions are unlikely to increase investment risk
significantly.
AA Obligations for which there is a very low expectation of investment
risk. Capacity for timely repayment of principal and interest is
substantial. Adverse changes in business, economic, or financial
conditions may increase investment risk albeit not very significantly.
Thomson's description of its two highest long-term debt ratings:
A Company possesses an exceptionally strong balance sheet and earnings
record, translating into an excellent reputation and unquestioned
access to its natural money markets. If weakness or vulnerability
exists in any aspect of the company's business, it is entirely
mitigated by the strengths of the organization.
A-2
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A/B Company is financially very solid with a favorable track record and no
readily apparent weakness. Its overall risk profile, while low, is not
quite as favorable as for companies in the highest rating category.
Short-Term Debt Ratings (may be assigned, for example, to commercial paper,
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master demand notes, bank instruments, and letters of credit) Moody's
description of its two highest short-term debt ratings:
Prime-1 Issuers rated Prime-1 (or supporting institutions) have a
superior capacity for repayment of senior short-term promissory
obligations. Prime-1 repayment capacity will normally be
evidenced by many of the following characteristics:
-Leading market positions in well-established industries.
-High rates of return on funds employed.
-Conservative capitalization structures with moderate
reliance on debt and ample asset protection.
-Broad margins in earnings coverage of fixed financial
charges and high internal cash generation.
-Well-established access to a range of financial markets and
assured sources of alternate liquidity.
Prime-2 Issuers rated Prime-2 (or supporting institutions) have a strong
capacity for repayment of senior short-term debt obligations.
This will normally be evidenced by many of the characteristics
cited above but to a lesser degree. Earnings trends and coverage
ratios, while sound, may be more subject to variation.
Capitalization characteristics, while still appropriate, may be
more affected by external conditions. Ample alternate liquidity
is maintained.
S&P's description of its two highest short-term debt ratings:
A-1 This designation indicates that the degree of safety regarding timely
payment is strong. Those issues determined to have extremely strong
safety characteristics are denoted with a plus sign (+).
A-3
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A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as
for issues designated "A-1."
Duff's description of its two highest short-term debt ratings (Duff incorporates
gradations of "1+" (one plus) and "1-" (one minus) to assist investors in
recognizing quality differences within the highest rating category):
Duff 1+ Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or access to
alternative sources of funds, is outstanding, and safety is
just below risk-free U.S. Treasury short-term obligations.
Duff 1 Very high certainty of timely payment. Liquidity factors are
excellent and supported by good fundamental protection factors.
Risk factors are minor.
Duff 1- High certainty of timely payment. Liquidity factors are strong
and supported by good fundamental protection factors. Risk
factors are very small.
Duff 2 Good certainty of timely payment. Liquidity factors and company
fundamentals are sound. Although ongoing funding needs may
enlarge total financing requirements, access to capital markets
is good. Risk factors are small.
Fitch's description of its two highest short-term debt ratings:
F-1+ Exceptionally Strong Credit Quality. Issues assigned this
rating are regarded as having the strongest degree of assurance
for timely payment.
F-1 Very Strong Credit Quality. Issues assigned this rating reflect
an assurance of timely payment only slightly less in degree
than issues rated F-1+.
F-2 Good Credit Quality. Issues assigned this rating have a
satisfactory degree of assurance for timely payment, but the
margin of safety is not as great as for issues assigned F-1+ or
F-1 ratings.
IBCA's description of its two highest short-term debt ratings:
A+ Obligations supported by the highest capacity for timely
repayment.
A1 Obligations supported by a very strong capacity for timely
repayment.
A-4
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Short-Term Loan/Municipal Note Ratings
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Moody's description of its two highest short-term loan/municipal note ratings:
MIG-1/VMIG-1 This designation denotes best quality. There is present strong
protection by established cash flows, superior liquidity support
or demonstrated broad-based access to the market for
refinancing.
MIG-2/VMIG-2 This designation denotes high quality. Margins of protection are
ample although not so large as in the preceding group.
S&P's description of its two highest municipal note ratings:
SP-1 Very strong or strong capacity to pay principal and interest.
Those issues determined to possess overwhelming safety
characteristics will be given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest.
Thomson's description of its two highest short-term ratings:
TBW-1 The highest category; indicates the degree of safety regarding
timely repayment of principal and interest is very strong.
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated "TBW-1".
A-5
