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A Member of The Vanguard Group
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PROSPECTUS -- January 16, 1998
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NEW ACCOUNT INFORMATION: Investor Information Department -- 1-800-662-7447
(SHIP)
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SHAREHOLDER ACCOUNT SERVICES: Client Services Department -- 1-800-662-2739
(CREW)
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INVESTMENT Vanguard Asset Allocation Fund, Inc. (the "Fund") is an
OBJECTIVE & open-end diversified investment company that seeks to
POLICIES maximize total return (i.e., capital change plus income).
The Fund invests in common stocks, bonds and money market
instruments in proportions consistent with their expected
returns and risks as evaluated by the Fund's adviser. The
Fund should not be considered a complete investment program.
There is no assurance that the Fund will achieve its stated
objective. Shares of the Fund are neither insured nor
guaranteed by any agency of the U.S. Government, including
the FDIC.
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OPENING AN To open a regular (non-retirement) account, please complete
ACCOUNT and return the Account Registration Form. If you need
assistance in completing this form, please call our Investor
Information Department. To open an Individual Retirement
Account (IRA), please use a Vanguard IRA Adoption Agreement.
To obtain a copy of this form, call 1-800-662-7447, Monday
through Friday from 8:00 a.m. to 9:00 p.m. and Saturday, from
9:00 a.m. to 4:00 p.m. (Eastern time). The minimum initial
investment is $3,000, or $1,000 for Uniform Gifts/Transfers
to Minors Act accounts. The Fund is offered on a no-load
basis (i.e., there are no sales commissions or 12b-1 fees).
However, the Fund incurs expenses for investment advisory,
management, administrative and distribution services.
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ABOUT THIS This Prospectus is designed to set forth concisely the
PROSPECTUS information you should know about the Fund before you invest.
It should be retained for future reference. A "Statement of
Additional Information" containing additional information
about the Fund has been filed with the Securities and
Exchange Commission. Such Statement is dated January 16, 1998
and has been incorporated by reference into this Prospectus.
A copy may be obtained without charge by writing to the Fund,
by calling our Investor Information Department at
1-800-662-7447 or by visiting the Securities and Exchange
Commission's website (www.sec.gov).
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page Page Page
<S> <C> <C> <C>
Fund Expenses ............... 2 Implementation of Policies ... 6 SHAREHOLDER GUIDE
Financial Highlights ......... 2 Investment Limitations ...... 8 Opening an Account and
Yield and Total Return ...... 3 Management of the Fund ...... 9 Purchasing Shares ......... 15
FUND INFORMATION Investment Adviser ............ 9 When Your Account Will Be
Investment Objective ......... 3 Performance Record ............ 11 Credited .................. 18
Investment Policies ......... 3 Dividends, Capital Gains and Selling Your Shares ......... 19
Investment Risks ............ 4 Taxes ..................... 12 Exchanging Your Shares ...... 21
Who Should Invest ............ 6 The Share Price of the Fund ... 13 Important Information About
General Information ......... 14 Telephone Transactions ... 23
Transferring Registration ... 23
Other Vanguard Services ...... 24
</TABLE>
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION, NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
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<PAGE>
FUND EXPENSES The following table illustrates all expenses and fees that you
would incur as a shareholder of the Fund. The expenses and fees
set forth in the table are for the 1997 fiscal year.
Shareholder Transaction Expenses
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Sales Load Imposed on Purchases .................. None
Sales Load Imposed on Reinvested Dividends ...... None
Redemption Fees ................................. None
Exchange Fees .................................... None
<TABLE>
<CAPTION>
Annual Fund Operating Expenses
--------------------------------------------------------------------
<S> <C> <C>
Management & Administrative Expenses ...... 0.36%
Investment Advisory Fees .................. 0.09
12b-1 Fees ................................. None
Other Expenses
Distribution Costs ........................ 0.02%
Miscellaneous Expenses ..................... 0.02
-----
Total Other Expenses ..................... 0.04
----
Total Operating Expenses ............... 0.49%
====
</TABLE>
The purpose of this table is to assist you in understanding the
various costs and expenses that you would bear directly or
indirectly as an investor in the Fund.
The following example illustrates the expenses that you would
incur on a $1,000 investment over various periods, assuming (1)
a 5% annual rate of return and (2) redemption at the end of
each period. As noted in the table above, the Fund charges no
redemption fees of any kind.
1 Year 3 Years 5 Years 10 Years
------- --------- --------- ---------
$5 $16 $27 $62
This example should not be considered a representation of past
or future expenses or performance. Actual expenses may be
higher or lower than those shown.
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FINANCIAL The following financial highlights information, for a share
HIGHLIGHTS outstanding throughout each period, insofar as it relates to
each of the five years in the period ended September 30, 1997,
has been derived from the financial statements which were
audited by Price Waterhouse LLP, independent accountants, whose
report thereon was unqualified. This information should be read
in conjunction with the financial statements and notes thereto,
which, together with the remaining portions of the Fund's 1997
Annual Report to Shareholders, are incorporated by reference in
the Statement of Additional Information and this Prospectus,
and which appear, along with the report of Price Waterhouse
LLP, in the Fund's 1997 Annual Report to Shareholders. For a
more complete discussion of the Fund's performance, please see
the Fund's 1997 Annual Report to Shareholders, which may be
obtained without charge by writing to the Fund or by calling
our Investor Information Department at 1-800-662-7447.
2
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<TABLE>
<CAPTION>
Year Ended September 30,
-------------------------------------------------
1997 1996 1995 1994
----------- ----------- ----------- ----------
<S> <C> <C> <C> <C>
Net Asset Value, Beginning of
Period ........................ $18.27 $17.03 $13.78 $15.08
------- ------- -------- ---------
Investment Operations
Net Investment Income ......... .74 .69 .64 .52
Net Realized and Unrealized
Gain (Loss) on Investments..... 4.29 1.82 3.18 (.81)
------- ------- -------- ---------
Total from Investment
Operations .................. 5.03 2.51 3.82 (.29)
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Distributions
Dividends from Net Investment
Income ........................ (.72) ( .66) (.57) (.48)
Distributions from Realized
Capital Gains ............... (1.05) ( .61) -- (.53)
-------- -------- -------- ---------
Total Distributions ......... (1.77) ( 1.27) (.57) (1.01)
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Net Asset Value, End of
Period ........................ $21.53 $18.27 $17.03 $13.78
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Total Return .................. 29.42% 15.27% 28.57% (2.05)%
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Ratios/Supplemental Data
Net Assets, End of Period
(Millions) ..................... $3,738 $2,341 $1,593 $1,120
Ratio of Total Expenses to
Average Net Assets ............ 0.49% 0.47% 0.49% 0.50%
Ratio of Net Investment Income
to Average Net Assets ......... 3.96% 4.17% 4.41% 3.68%
Portfolio Turnover Rate ......... 10% 47% 34% 51%
Average Commission Rate Paid ... $.0099 $.0160 N/A N/A
Nov. 3, 1988+ to
1993 1992 1991 1990 Sept. 30, 1989
----------- ----------- ----------- ------------- ------------------
Net Asset Value, Beginning of
Period ........................ $ 13.79 $ 13.06 $ 10.93 $ 12.11 $ 10.00
-------- -------- -------- --------- --------
Investment Operations
Net Investment Income ......... .54 .61 .60 .60 .46
Net Realized and Unrealized
Gain (Loss) on Investments .... 1.51 .90 2.28 (1.12) 1.90
-------- -------- -------- --------- --------
Total from Investment
Operations .................. 2.05 1.51 2.88 (.52) 2.36
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Distributions
Dividends from Net Investment
Income ........................ (.59) (.59) (.62) (.51) (.25)
Distributions from Realized
Capital Gains ............... (.17) (.19) (.13) (.15) --
-------- -------- -------- --------- --------
Total Distributions ......... (.76) (.78) (.75) (.66) (.25)
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Net Asset Value, End of
Period ........................ $ 15.08 $ 13.79 $ 13.06 $ 10.93 $ 12.11
===========================================================================================================
Total Return .................. 15.41% 12.16% 27.32% (4.57)% 23.93%
===========================================================================================================
Ratios/Supplemental Data
Net Assets, End of Period
(Millions) ..................... $ 1,003 $ 502 $ 265 $ 160 $ 107
Ratio of Total Expenses to
Average Net Assets ............ 0.49% 0.52% 0.44% 0.50% 0.49%*
Ratio of Net Investment Income
to Average Net Assets ......... 4.07% 4.95% 5.28% 5.53% 5.53%*
Portfolio Turnover Rate ......... 31% 18% 44% 12% 52%
Average Commission Rate Paid ... N/A N/A N/A N/A N/A
</TABLE>
* Annualized.
+Commencement of operations.
<PAGE>
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YIELD AND TOTAL From time to time the Fund may advertise its yield and total
RETURN return. Both yield and total return figures are based on
historical earnings and are not intended to indicate future
performance. The "total return" of the Fund refers to the
average annual compounded rates of return over one-, five- and
ten-year periods or for the life of the Fund (which periods
will be stated in the advertisement) that would equate an
initial amount invested at the beginning of a stated period to
the ending redeemable value of the investment, assuming the
reinvestment of all dividend and capital gains distributions.
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INVESTMENT The objective of the Fund is to maximize total return (i.e.,
OBJECTIVE capital change plus income) while exhibiting less investment
The Fund seeks risk than a portfolio consisting entirely of common stocks.
to maximize There is no assurance that the Fund will achieve its stated
total return objective.
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INVESTMENT The Fund will allocate its assets among a common stock
POLICIES portfolio, a bond portfolio, and money market instruments. The
Fund's adviser, Mellon Capital Management, allocates the Fund's
The Fund assets among stocks, bonds and money market instruments in
invests in proportions which reflect the anticipated returns and risks of
stocks, bonds each asset class. The estimates of return and risk are
and money developed based upon the adviser's disciplined valuation
market methodology. There are no limitations on the amount of
instruments
in
varying
proportions
3
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the Fund's assets which may be allocated to each of the three
asset classes (stocks, bonds and money market instruments). The
Fund is managed without regard to tax ramifications.
In estimating the relative attractiveness of each asset class,
the adviser takes into account various factors. Common stocks
are evaluated using a "dividend-discount" model. This model
provides an estimate of the expected return of the Standard &
Poor's 500 Composite Stock Price Index (the "S&P 500 Index")
based upon earnings forecasts for companies whose stocks are
included in the S&P 500 Index. The expected bond return is the
current yield-to-maturity of long-term U.S. Treasury bonds,
while the return on money market instruments reflects the
current yield on three-month U.S. Treasury bills and long-term
inflation forecasts.
Once expected return and volatility (risk) estimates are
developed for each asset class, the adviser attempts to
identify apparent imbalances in the relative pricing of common
stocks, bonds and money market instruments, using a computer
model. Implicit in the adviser's approach is the belief that
such short-term imbalances occur periodically but tend to be
corrected fairly quickly. The Fund's allocation among the three
asset classes is then structured to take advantage of these
perceived imbalances.
To implement a particular allocation strategy, the Fund may
invest in the following securities: a diversified portfolio of
common stocks selected by the adviser to parallel the
performance of the S&P 500 Index; long-term U.S. Treasury bonds
with maturities generally in excess of 20 years; and selected
money market instruments, including repurchase agreements. The
Fund may also invest in futures contracts on stock indexes and
bonds. See "Implementation of Policies" for a description of
the securities in which the Fund invests and other investment
practices of the Fund.
The Fund is responsible for voting the shares of all securities
it holds.
The investment objective and policies of the Fund are not
fundamental and so may be changed by the Board of Directors
without shareholder approval. However, shareholders would be
notified prior to a material change in either.
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INVESTMENT RISKS Depending on the adviser's allocation of the Fund's assets
among stocks, bonds and cash reserves, investors in the Fund
The Fund is may be exposed to the market risk of common stocks and bonds.
subject to stock
and bond Stock market risk is the possibility that stock prices in
market risk general will decline over short or even extended periods. The
stock market tends to be cyclical, with periods when stock
prices generally rise and periods when stock prices generally
decline. To illustrate the volatility of domestic stock prices,
the table on page 5 sets forth the extremes for U.S. stock
market returns as well as the average return for the period
from 1926 to 1997, as measured by the Standard & Poor's 500
Composite Stock Price Index:
4
<PAGE>
Average Annual U.S. Stock Market Returns (1926-1997)
Over Various Time Horizons
<TABLE>
<CAPTION>
1 Year 5 Years 10 Years 20 Years
-------------- -------------- --------------- -----------
<S> <C> <C> <C> <C>
Best +53.9% +23.9% +20.1% +16.9%
Worst -43.3 -12.5 -0.9 +3.1
Average +13.0 +10.5 +10.9 +10.9
</TABLE>
As shown, from 1926 to 1997, U.S. common stocks as measured by
the Index provided an average annual total return (capital
appreciation plus dividend income) for 10 years, of +10.9%.
Average return may not be useful for forecasting future returns
in any particular period, as stock returns are quite volatile
from year to year.
Bond market risk is the potential for fluctuations in the
market value of bonds. Bond prices vary inversely with changes
in the level of interest rates. When interest rates rise, the
prices of bonds fall; conversely, when interest rates fall,
bond prices rise. While bonds normally fluctuate less in price
than stocks, there have been extended periods of cyclical
increases in interest rates that have caused significant
declines in bond prices. For example, long-term bond prices
fell 48% from December 1976 to September 1981. The risk of
bonds declining in value, however, may be offset in whole or in
part by the higher level of income that bonds provide.
While the Fund invests in stocks, bonds and money market
instruments in varying proportions, investors should not
construe the Fund as a balanced investment program offering
relatively stable allocations among these asset classes.
Because the allocation strategy of the adviser may, at certain
times, result in a portfolio with a primary emphasis on common
stocks, the Fund may from time to time exhibit a level of
volatility which is more consistent with a common stock
portfolio than a balanced portfolio. However, under normal
circumstances, the volatility of the Fund's total return is
expected to be less than that of a common stock portfolio, as
represented, for example, by the S&P 500 Index.
The adviser may Investors should also be aware that the investment results of
fail to the Fund depend upon the adviser's ability to anticipate
anticipate correctly the relative performance and risk of stocks, bonds
market and money market instruments. Historical evidence indicates
advances or that correctly timing portfolio allocations among these asset
declines classes has been an extremely difficult strategy to implement
successfully. While the adviser has substantial experience in
asset allocation, there can be no assurance that the adviser
will correctly anticipate relative asset class performance in
the future on a consistent basis. The Fund's short-term
investment results would suffer, for example, if only a small
portion of the Fund's assets were allocated to stocks during a
significant stock market advance, or if a major portion of its
assets were allocated to stocks during a market decline.
Similarly, the Fund's short-term investment results would also
suffer if the Fund were substantially invested in bonds at a
time when interest rates increased.
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5
<PAGE>
WHO SHOULD The Fund is designed for investors seeking maximum total return
INVEST through an investment vehicle which provides an actively
managed mix of stocks, bonds and money market instruments.
Long-term Because the Fund can and may have a large percentage of its
investors portfolio invested in common stocks, investors in the Fund
seeking should be willing to accept the risk of an all-stock portfolio,
maximum total including the potential for sudden, sometimes substantial
return declines in market value.
Due to the risks associated with common stock and bond
investments, the Fund is intended to be a long-term investment
vehicle and is not designed to provide investors with a means
of speculating on short-term stock and bond market movements.
Investors who engage in excessive account activity generate
additional costs which are borne by all of the Fund's
shareholders. In order to minimize such costs the Fund has
adopted the following policies. The Fund reserves the right to
reject any purchase request (including exchange purchases from
other Vanguard portfolios) that is reasonably deemed to be
disruptive to efficient portfolio management, either because of
the timing of the investment or previous excessive trading by
the investor. Additionally, the Fund has adopted exchange
privilege limitations as described in the section "Exchange
Privilege Limitations." Finally, the Fund reserves the right to
suspend the offering of its shares.
No assurance can be given that the Fund will achieve its
objective or that shareholders will be protected from the risk
of loss that is inherent in equity investing. Also, there can
be no guarantee that the adviser will correctly anticipate
fluctuations in the stock and bond markets in its effort to
maximize total return while minimizing risk.
The Fund should be considered part of a well-rounded investment
program and not its sole component. Investors may wish to
reduce the potential risk of investing in the Fund by
purchasing shares on a regular, periodic basis (dollar-cost
averaging) rather than making an investment in one lump sum.
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IMPLEMENTATION In an effort to maximize its total investment return, the Fund
OF POLICIES utilizes a number of investment practices.
The Fund may The Fund invests in stocks, bonds and money market instruments
invest in in varying proportions. For common stocks, the Fund will invest
stocks, bonds in a diversified portfolio of common stocks selected to
and money parallel theinvestment performance of the S&P 500 Index. The
market Fund may also invest in stock index futures and options to a
instruments limited extent, as described on page 7.
Bond investments for the Fund will consist of long-term U.S.
Treasury bonds (those with maturities generally in excess of 20
years) and, as described below, futures contracts and options
on such bonds. As part of its bond portfolio, the Fund may also
invest in other long-term "full faith and credit" obligations
of the U.S. Government.
6
<PAGE>
The money market instruments held by the Fund will have an
average weighted maturity of less than 90 days. Money market
instruments may include obligations of the United States
Government and its agencies and instrumentalities; commercial
paper, bank certificates of deposit, and bankers' acceptances;
and repurchase agreements collateralized by these securities.
The Fund, along with other Vanguard Funds, may deposit its
daily cash reserves into a joint account which invests such
reserves in repurchase agreements and other short-term
instruments. CoreStates Bank, NA is the custodian for the joint
account.
A repurchase agreement is a means of investing monies for a
short period. In a repurchase agreement, a seller -- a U.S.
commercial bank or recognized U.S. securities dealer -- sells
securities to the Fund and agrees to repurchase the securities
at the Fund's cost plus interest within a specified period
(normally one day). In these transactions, the securities
acquired by the Fund will have a total value equal to, or in
excess of, the value of the repurchase agreement, and will be
held by the custodian bank for the joint account until
repurchased.
The Fund may The Fund may lend its investment securities to qualified
lend its institutional investors for either short-term or long-term
securities purposes of realizing additional income. Loans of securities by
the Fund will be collateralized by cash, letters of credit, or
securities issued or guaranteed by the U.S. Government or its
agencies. The collateral will equal at least 100% of the
current market value of the loaned securities.
The Fund may The Fund may borrow money, subject to the limitations set forth
borrow money below, for temporary or emergency purposes, including the
under unusual meeting of redemption requests which might otherwise require
circumstances selling securities at a loss.
Portfolio Due to the active asset allocation approach employed by the
turnover Fund, the Fund's portfolio turnover rate may be high,
may be high approximately 100% per year. A 100% portfolio turnover rate
would occur, for example, if all of the Fund's securities were
replaced within one year.
Derivative Derivatives are instruments whose values are linked to or
Investing derived from an underlying security or index. The most common
and conventional types of derivative securities are futures and
options.
The Fund may The Fund may utilize stock and bond futures contracts and
use futures options to a limited extent. Specifically, the Fund may enter
contracts and into futures contracts provided that not more than 5% of its
options gross assets are required as a futures contract deposit; in
addition, the Fund may enter into futures contracts and options
only to the extent that obligations under such contracts or
transactions represent not more than 50% of the Fund's gross
assets. However, under unusual circumstances, the Fund may
maintain futures positions that are equivalent in value to up
to 100% of the Fund's gross assets, so that the Fund may remain
effectively fully invested in proportions consistent with the
adviser's current asset allocation strategy.
7
<PAGE>
Futures contracts and options may be used for several reasons:
to reallocate the Fund's assets among stocks, bonds and money
market instruments while minimizing transaction costs; to
maintain cash reserves while simulating full investment; to
facilitate trading; or to seek higher investment returns when a
futures contract is priced more attractively than the
underlying security or index.
For example, in order to reallocate 10% of the Fund's assets
from stocks to bonds while minimizing transaction costs, the
adviser may sell stock index futures and purchase bond futures.
Because the transaction costs of futures contracts and options
may be lower than the costs of investing in stocks or bonds
directly, it is expected that the use of futures contracts and
options may reduce the Fund's total transaction costs. Also,
because futures contracts only require a small initial margin
deposit, the Fund would then be able to simultaneously maintain
a cash reserve for potential redemptions and simulate full
investment. In the event of net redemptions from the Fund,
sufficient futures contracts would be sold to avoid any
leveraging of the Fund's assets.
Futures The primary risks associated with the use of futures contracts
contracts and and options are: (i) imperfect correlation between the change
options pose in market value of the securities held by the Fund and the
certain risks prices of futures contracts and options; and (ii) possible lack
of a liquid secondary market for a futures contract and the
resulting inability to close a futures position prior to its
maturity date. The risk of imperfect correlation will be
minimized by investing only in those contracts whose behavior
is expected to resemble that of the Fund's underlying
securities. The risk that the Fund will be unable to close out
a futures position will be minimized by entering into such
transactions on a national exchange with an active and liquid
secondary market. While futures contracts and options can be
used as leveraged instruments, the Fund may not use futures
contracts or options to leverage its net assets.
The risk of loss in trading futures contracts in some
strategies can be substantial, due both to the low margin
deposits required and the extremely high degree of leverage
involved in futures pricing. As a result, a relatively small
price movement in a futures contract may result in immediate
and substantial loss (or gain) to the investor. When investing
in futures contracts, the Fund will segregate cash or other
liquid portfolio securities in the amount of the underlying
obligation.
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INVESTMENT The Fund has adopted fundamental limitations on some of its
LIMITATIONS investment policies. Some of these limitations are that the
Fund may not:
The Fund has (a) with respect to 75% of the value of its total assets,
adopted certain purchase the securities of any issuer (except obligations of
fundamental the United States government and its instrumentalities) if as
limitations a result the Fund would hold more than 10% of the outstanding
voting securities of the issuer, or more than 5% of the value
of the Fund's total assets would be invested in the securities
of such issuer;
(b) invest more than 25% of its assets in any one industry;
(c) borrow money except from banks (or through reverse
repurchase agreements) for temporary or emergency purposes (not
leveraging), and then only in
8
<PAGE>
an amount not in excess of 15% of the value of the Fund's net
assets at the time the borrowing is made. Whenever borrowing
exceeds 5% of the value of the Fund's assets, the Fund will not
make any additional investments; and
(d) pledge, mortgage or hypothecate any of its assets to an
extent greater than 5% of its total assets.
A complete list of applicable investment limitations can be
found in the Statement of Additional Information; these are
fundamental and may be changed only by approval of a majority
of the Fund's shareholders.
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MANAGEMENT OF The Fund is a member of The Vanguard Group of Investment
THE FUND Companies, a family of more than 30 investment companies with
more than 95 distinct investment portfolios and total assets in
Vanguard excess of $310 billion. Through their jointly-owned subsidiary,
administers and The Vanguard Group, Inc. ("Vanguard"), the Fund and the other
distributes the funds in the Group obtain at cost virtually all of their
Fund corporate management, administrative and distribution
services. Vanguard also provides investment advisory services
on an at-cost basis to certain Vanguard funds. As a result of
Vanguard's unique corporate structure, the Vanguard funds have
costs substantially lower than those of most competing mutual
funds. In 1996, the average expense ratio (annual costs
including advisory fees divided by average net assets) for the
Vanguard funds amounted to approximately .29% compared to an
average of 1.22% for the mutual fund industry (data provided by
Lipper Analytical Services).
Vanguard employs a supporting staff of management and
administrative personnel needed to provide the requisite
services to the funds and also furnishes the funds with
necessary office space, furnishings and equipment. Each fund
pays a share of Vanguard's total expenses, which are allocated
among the funds under methods approved by the Board of
Directors (Trustees) of each fund. In addition, each fund bears
its own direct expenses, such as legal, auditing and custodian
fees.
The Officers of the Fund manage its day-to-day operations and
are responsible to the Fund's Board of Directors. The Directors
set broad policies for the Fund and choose its Officers. A list
of of the Fund and a statement of their
present positions and principal occupations during the past
five years can be found in the Statement of Additional
Information.
Vanguard provides distribution and marketing services to the
funds. However, each fund bears its share of the Group's
distribution costs.
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INVESTMENT The Fund employs Mellon Capital Management Corporation, 595
ADVISER Market St., Suite 3000, San Francisco, CA 94105, as its
investment adviser. Under an investment advisory agreement
Mellon Capital dated July 1, 1997, the adviser manages the investment and
Management reinvestment of the assets of the Fund and continuously
manages the reviews, supervises and administers the Fund's investment
Fund's program. The adviser discharges its responsibilities subject to
investments the control of the Officers and Directors of the Fund.
9
<PAGE>
The adviser is a professional counseling firm which manages
well-diversified stock and bond portfolios for institutional
clients. As of September 30, 1997 the adviser provided
investment advisory services to 227 clients and managed assets
with an approximate value of $64.9 billion. The adviser's asset
allocation strategy was developed by the adviser's co-founder,
William Fouse, in 1972, and is used by 109 of its clients and
accounts for approximately $20.2 billion of the assets that it
manages. For its asset allocation clients, including the Fund,
the adviser employs a proprietary asset allocation model in
managing client investment portfolios and an indexing approach
in selecting individual equity securities. The Fund is one of
the adviser's two investment company clients.
The adviser was founded in October 1983 by William Fouse and
Thomas Loeb. They have been responsible for overseeing the
implementation of the firm's strategy for the Fund since the
Fund's inception in 1988. The adviser is a wholly-owned
subsidiary of MBC Investment Corporation, which itself is a
subsidiary of Mellon Bank Corporation.
The Fund pays the adviser a basic fee at the end of each fiscal
quarter, calculated by applying a quarterly rate, based on the
following annual percentage rates, to the Fund's average
month-end net assets for the quarter:
Net Assets Rate
---------- ----
First $100 million .200%
Next $900 million .150%
Next $500 million .125%
Over $1.5 billion .100%
This fee may be increased or decreased by applying an
adjustment formula based on the performance of the Fund
relative to the investment record of a "Combined-Index", 65% of
which shall be comprised of the Standard & Poor's 500 Composite
Price Index and 35% of which shall be comprised of the Lehman
Brothers Long-Term U.S. Treasury Index. The fee payment will be
increased (decreased) by an incentive (penalty) of 0.05% of
average net assets if the Fund's cumulative investment
performance for the thirty-six months preceding the end of the
quarter is at least six percentage points above (below) the
cumulative investment record of the Combined Index for the same
period. For the purpose of determining the fee adjustment for
investment performance, as described above, the net assets
of the Fund will be averaged over the same period as the
performance of the Fund and the investment record of the
Combined Index are computed. For the year ended September 30,
1997, the investment advisory fee paid by the Fund represented
an effective annual rate of 0.12% of the Fund's average net
assets, before a decrease of 0.03% based on performance.
The adviser is authorized to choose brokers or dealers to
handle the purchase and sale of the Fund's securities, and is
directed to get the best available price and most favorable
execution from these brokers with respect to all transactions.
At times, the adviser may choose brokers who charge higher
commissions in the
10
<PAGE>
interests of obtaining better execution of a transaction. If
more than one broker can obtain the best available price and
favorable execution of a transaction, then the adviser is
authorized to choose a broker who, in addition to executing the
transaction, will provide research services to the adviser or
the Fund. However, the adviser will not pay higher commissions
specifically for the purpose of obtaining research services.
The Fund may direct the adviser to use a particular broker for
certain transactions in exchange for commission rebates or
research services provided to the Fund.
The Fund has authorized the adviser to pay higher commissions
in recognition of brokerage services felt necessary for the
achievement of better execution, provided the adviser believes
this to be in the best interest of the Fund. Although the Fund
does not market its shares through intermediary brokers or
dealers, the Fund may place orders with qualified
broker-dealers who recommend the Fund to clients if the
Officers of the Fund believe that the quality of the
transaction and the commission are comparable to what they
would be with other qualified brokerage firms.
The Fund's Board of Directors may, without the approval of
shareholders, provide for: (a) the employment of a new
investment adviser pursuant to the terms of a new advisory
agreement, either as a replacement for an existing adviser or
as an additional adviser; (b) a change in the terms of an
advisory agreement; and (c) the continued employment of an
existing adviser on the same advisory contract terms where a
contract has been assigned because of a change in control of
the adviser. Any such change will only be made upon not less
than 30 days prior written notice to shareholders of the Fund
which shall include substantially the information concerning
the adviser that would have normally been included in a proxy
statement.
- -------------------------------------------------------------------------------
PERFORMANCE The table on page 12 provides investment results for the Fund
RECORD for several periods throughout the Fund's lifetime. The results
shown represent "total return" investment performance, which
assumes the reinvestment of all capital gains and income
dividends for the indicated periods. Also included is
comparative information with respect to the unmanaged Standard
& Poor's 500 Composite Stock Price Index, a widely-used
barometer of stock market activity, and the Consumer Price
Index, a statistical measure of changes in the prices of goods
and services. The tables do not make any allowance for federal,
state or local income taxes, which shareholders must pay on a
current basis.
The results should not be considered a representation of the
total return from an investment made in the Fund today. This
information is provided to help investors better understand the
Fund and may not provide a basis for comparison with other
investments or mutual funds which use a different method to
calculate performance.
11
<PAGE>
Average Annual Return for Vanguard Asset Allocation Fund
Fiscal Periods Vanguard Asset S&P 500 Consumer
Ended 9/30/97 Allocation Fund Index Price Index
-------------- --------------- --------- -----------
1 Year +29.4% +40.4% +2.2%
5 Years +16.7 +20.8 +2.7
Lifetime* +15.7 +18.1 --
* November 3, 1988, to September 30, 1997.
- --------------------------------------------------------------------------------
DIVIDENDS, The Fund expects to pay dividends semi-annually from ordinary
CAPITAL GAINS income. Net capital gains distributions, if any, will be
AND TAXES distributed annually.
The Fund pays In addition, in order to satisfy certain distribution
semi-annual requirements of the Tax Reform Act of 1986, the Fund may
dividends and declare special year-end dividend and capital gains
any capital distributions during December. Such distributions, if received
gains by shareholders by January 31, are deemed to have been paid by
annually the Fund and received by shareholders on December 31 of the
prior year.
Dividend and capital gains distributions may be automatically
reinvested or received in cash. See "Choosing a Distribution
Option" for a description of these distribution methods.
The Fund intends to continue to qualify for taxation as a
"regulated investment company" under the Internal Revenue Code
so that it will not be subject to federal income tax to the
extent its income is distributed to shareholders. Dividends
paid by the Fund from net investment income and net short-term
capital gains, whether received in cash or reinvested in
additional shares, will be taxable to shareholders as ordinary
income. For corporate investors, dividends from net investment
income and net short-term capital gains will generally qualify
in part for the intercorporate dividends-received deduction.
However, the portion of the dividends so qualified depends on
the aggregate taxable qualifying dividend income received by
the Fund from domestic (U.S.) sources.
Distributions paid by the Fund from long-term capital gains,
whether received in cash or reinvested in additional shares,
are taxable as long-term capital gains, regardless of the
length of time you have owned shares in the Fund. Long-term
gains may be taxed at different rates depending on how long the
Fund held the securities. Capital gains distributions are made
when the Fund realizes net capital gains on sales of portfolio
securities during the year. The Fund does not seek to realize
any particular amount of capital gains during a year; rather,
realized gains are a by-product of portfolio management
activities. Consequently, capital gains distributions may be
expected to vary considerably from year to year; there will be
no capital gains distributions in years when the Fund realizes
net capital losses.
Note that if you accept capital gains distributions in cash,
instead of reinvesting them in additional shares, you are in
effect reducing the capital at work for you in the Fund. Also,
keep in mind that if you purchase shares in the Fund shortly
12
<PAGE>
before the record date for a dividend or capital gains
distribution, a portion of your investment will be returned to
you as a taxable distribution, regardless of whether you are
reinvesting your distributions or receiving them in cash.
The Fund will notify you annually as to the tax status of
dividend and capital gains distributions paid by the Fund.
A capital gain A sale of shares of the Fund is a taxable event and may result
or loss may be in a capital gain or loss. A capital gain or loss may be
realized upon realized from an ordinary redemption of shares or an exchange
exchange or of shares between two mutual funds (or two portfolios of a
redemption mutual fund).
Dividend distributions, capital gains distributions, and
capital gains or losses from redemptions and exchanges may be
subject to state and local taxes.
The Fund is required to withhold 31% of taxable dividends,
capital gains distributions, and redemptions paid to
shareholders who have not complied with IRS taxpayer
identification regulations. You may avoid this withholding
requirement by certifying on your Account Registration Form
your proper Social Security or taxpayer identification number
and by certifying that you are not subject to backup
withholding.
The Fund has obtained a Certificate of Authority to do business
as a foreign corporation in Pennsylvania and does business and
maintains an office in that state. In the opinion of counsel,
the shares of the Fund are exempt from Pennsylvania personal
property taxes.
The tax discussion set forth above is included for general
information only. Prospective investors should consult their
own tax advisers concerning the tax consequences of an
investment in the Fund. The Fund is managed without regard to
tax ramifications.
- -------------------------------------------------------------------------------
THE SHARE PRICE The Fund's share price, or "net asset value" per share, is
OF THE FUND calculated by dividing the total assets of the Fund, less all
liabilities, by the total number of shares outstanding. The net
asset value is determined as of the close of the New York Stock
Exchange (generally 4:00 p.m. Eastern time) on each day that
the exchange is open for trading.
Fund securities for which market quotations are readily
available (includes those securities listed on national
securities exchanges, as well as those quoted on the NASDAQ
Stock Market) will be valued at the last quoted sales price on
the day the valuation is made. Such securities which are not
traded on the valuation date are valued at the mean of the bid
and ask prices. Price information on exchange-listed securities
is taken from the exchange where the security is primarily
traded. Any foreign securities are valued at the latest quoted
sales price available before the time when assets are valued.
Securities may be valued on the basis of prices provided by a
pricing service when such prices are believed to reflect the
fair market value of such securities.
13
<PAGE>
Short-term instruments (those with remaining maturities of 60
days or less) may be valued at cost, plus or minus any
amortized discount or premium, which approximates market value.
Bonds and other fixed income securities may be valued on the
basis of prices provided by a pricing service when such prices
are believed to reflect the fair market value of such
securities. The prices provided by a pricing service may be
determined without regard to bid or last sale prices of each
security, but take into account institutional-size transactions
in similar groups of securities as well as any developments
related to specific securities.
Other assets and securities for which no quotations are readily
available or which are restricted as to sale (or resale) are
valued by such methods as the Board of Directors deems in good
faith to reflect fair value.
The share price for the Fund can be found daily in the mutual
fund listings of most major newspapers under the heading of
Vanguard Funds.
- -------------------------------------------------------------------------------
GENERAL The Fund is a Maryland corporation. The Articles of
INFORMATION Incorporation permit the Directors to issue 1,000,000,000
shares of common stock, with a $.001 par value. The Board of
Directors has the power to designate one or more classes
("series") of shares of common stock and to classify or
reclassify any unissued shares with respect to such series.
Currently the Fund is offering one class of shares.
The shares of the Fund are fully paid and non-assessable; have
no preference as to conversion, exchange, dividends, retirement
or other features; and have no pre-emptive rights. Such shares
have non-cumulative voting rights, meaning that the holders of
more than 50% of the shares voting for the election of
Directors can elect 100% of the Directors if they so choose.
Annual meetings of shareholders will not be held except as
required by the Investment Company Act of 1940 and other
applicable law. An annual meeting will be held to vote on the
removal of a Director or Directors of the Fund if requested in
writing by the holders of not less than 10% of the outstanding
shares of the Fund.
All securities and cash are held by State Street Bank and Trust
Company, Boston, MA. The Vanguard Group, Inc., Valley Forge,
PA, serves as the Fund's Transfer and Dividend Disbursing
Agent. Price Waterhouse LLP, serves as independent accountants
for the Fund and audits its financial statements annually. The
Fund is not involved in any litigation.
- -------------------------------------------------------------------------------
14
<PAGE>
SHAREHOLDER GUIDE
OPENING AN You may open a regular (non-retirement) account, either by mail
ACCOUNT AND or wire. Simply complete and return an Account Registration
PURCHASING Form and any required legal documentation, indicating the
SHARES amount you wish to invest. Your purchase must be equal to or
greater than the $3,000 minimum initial investment requirement
($1,000 for Uniform Gifts/Transfers to Minors Act accounts).
You must open a new Individual Retirement Account by mail (IRAs
may not be opened by wire) using a Vanguard IRA Adoption
Agreement. Your purchase must be equal to or greater than the
$1,000 minimum initial investment requirement for IRAs, but no
more than $2,000 if you are making a regular IRA contribution.
Rollover contributions are generally limited to the amount
withdrawn within the past 60 days from an IRA or other
qualified Retirement Plan. If you need assistance with the
forms or have any questions about the Fund, please call our
Investor Information Department at 1-800-662-7447.
Note: For other types of account registrations (e.g.
corporations, associations, other organizations, trusts or
powers of attorney), please call us to determine which
additional forms you may need.
The Fund's shares are purchased at the next-determined net
asset value after your investment has been received. The Fund
is offered on a no-load basis (i.e., there are no sales
commissions or 12b-1 fees).
Purchase 1) Because of the risks associated with common stock and bond
Restrictions investments, the Fund is intended to be a long-term
investment vehicle and is not designed to provide investors
with a means of speculating on short-term market movements.
Consequently, the Fund reserves the right to reject any
specific purchase (and exchange purchase) request. The Fund
also reserves the right to suspend the offering of shares
for a period of time.
2) Vanguard will not accept third-party checks to purchase
shares of the Fund. Please be sure your purchase check is
made payable to the Vanguard Group.
Additional Subsequent investments to regular accounts may be made by mail
Investments ($100 minimum), wire ($1,000 minimum), exchange from another
Vanguard Fund account, or Vanguard Fund Express. Subsequent
investments to Individual Retirement Accounts may be made by
mail ($100 minimum) or exchange from another Vanguard Fund
account. In some instances, contributions may be made by wire
or Vanguard Fund Express. Please call us for more information
on these options.
------------------------------------------------------------
15
<PAGE>
<TABLE>
<CAPTION>
<S> <C> <C>
ADDITIONAL INVESTMENTS
NEW ACCOUNT TO EXISTING ACCOUNTS
Purchasing By Mail Please include the amount of your Additional investments should
Complete and sign the initial investment on the registra- include the Invest-by-Mail remit-
enclosed Account tion form, make your check pay- tance form attached to your Fund
Registration Form able to The Vanguard Group-78 confirmation statements. Please
and mail to: make your check payable to The
Vanguard Group-78, write your
Vanguard Financial Center account number on your check
P.O. Box 2600 and, using the return envelope pro-
Valley Forge, PA 19482-2600 vided, mail to the address indicated
on the Invest-by-Mail Form.
For Express Vanguard Financial Center All written requests should be
or registered mail, 455 Devon Park Drive mailed to one of the addresses indi-
send to: Wayne, PA 19087-1815 cated for new accounts. Do not
send registered or express mail to
the post office box address.
</TABLE>
------------------------------------------------------------
Purchasing By Wire CORESTATES BANK, N.A.
Money should be ABA 031000011
wired to: CORESTATES NO. 0101 9897
ATTN VANGUARD
Before Wiring VANGUARD ASSET ALLOCATION FUND
Please contact ACCOUNT NUMBER
Client Services ACCOUNT REGISTRATION
(1-800-662-2739)
To ensure proper receipt, please be sure your bank includes the
name of the Fund, the account number Vanguard has assigned to
you and the eight-digit CoreStates number. If you are opening a
new account, please complete the Account Registration Form and
mail it to the "New Account" address after completing your wire
arrangement. Note: Federal Funds wire purchase orders will be
accepted only when the Fund and Custodian Bank are open for
business.
------------------------------------------------------------
Purchasing By You may open an account or purchase additional shares by making
Exchange (from an exchange from another Vanguard Fund account. However, the
a Vanguard Fund reserves the right to refuse any exchange purchase
account) request. Call our Client Services Department toll-free at
1-800-662-2739. The new account will have the same registration
as the existing account.
------------------------------------------------------------
Purchasing By The Fund Express Special Purchase option lets you move money
Fund Express from your bank account to your Vanguard account at your
Special request. Or if you choose the Automatic Investment option,
Purchase and money will be moved from your bank account to your Vanguard
Automatic account on the schedule (monthly, bimonthly [every other
Investment month],
16
<PAGE>
quarterly, semiannually or yearly) you select. To establish
these Fund Express options, please provide the appropriate
information on the Account Registration Form. We will send you
a confirmation of your Fund Express service; please wait two
weeks before using the service.
- --------------------------------------------------------------------------------
CHOOSING A You must select one of three distribution options:
DISTRIBUTION
OPTION 1. Automatic Reinvestment Option -- Both dividend and capital
gains distributions will be reinvested in additional Fund
shares. This option will be selected for you unless you
specify one of the other options.
2.Cash Dividend Option -- Your dividends will be paid in cash
and your capital gains will be reinvested in additional Fund
shares.
3.All Cash Option -- Both dividend and capital gains
distributions will be paid in cash.
You may change your option by calling our Client Services
Department (1-800-662-2739).
If a shareholder has chosen to receive dividend and/or capital
gains distributions in cash, and the postal or other delivery
service is unable to deliver checks to the shareholder's
address of record, we will change the distribution option so
that all dividends and other distributions are automatically
reinvested in additional shares. We will not pay interest on
uncashed distribution checks.
In addition, an option to invest your cash dividend and/or
capital gains distributions in another Vanguard Fund account is
available. Please call our Client Services Department
(1-800-662-2739) for information. You may also elect Vanguard
Dividend Express which allows you to transfer your cash
dividend and/or capital gain distributions automatically to
your bank account. Please see "Other Vanguard Services" for
more information.
- --------------------------------------------------------------------------------
TAX CAUTION Under Federal tax laws, the Fund is required to distribute net
capital gains and dividend income to Fund shareholders. These
Investors distributions are made to all shareholders who own Fund shares
should ask as of the distribution's record date, regardless of how long
about the the shares have been owned. Purchasing shares just prior to the
timing record date could have a significant impact on your tax
of capital liability for the year. For example, if you purchase shares
gains immediately prior to the record date of a sizable capital gain
and dividend or income dividend distribution, you will be assessed taxes on
distributions the amount of the capital gain and/or dividend distribution
before later paid even though you owned the Fund shares for just a
investing short period of time. (Taxes are due on the distributions even
if the dividend or gain is reinvested in additional Fund
shares.) While the total value of your investment will be the
same after the distribution -- the amount of the distribution
will offset the drop in the net asset value of the shares --
you should be aware of the tax implications the timing of your
purchase may have.
17
<PAGE>
Prospective investors should, therefore, inquire about
potential distributions before investing. The Fund's annual
capital gain distributions normally occur in December, while
income dividends are generally paid semi-annually in June and
December. In addition, the Fund may occasionally be required to
make supplemental dividend or capital gains distributions at
some other time during the year. For additional information on
distributions and taxes, see the section titled "Dividends,
Capital Gains and Taxes."
- -------------------------------------------------------------------------------
IMPORTANT The easiest way to establish optional Vanguard services on
INFORMATION your account is to select the options you desire when you
complete your Account Registration Form.
Optional ServicesIf you wish to add shareholder options later, you may need
to provide Vanguard with additional information and a
signature guarantee. Please call our Client Services
Department (1-800-662-2739) for further assistance.
Signature For our mutual protection, we may require a signature
Guarantees guarantee on certain written transaction requests. A
signature guarantee verifies the authenticity of your
signature and may be obtained from banks, brokers and any
other guarantor that Vanguard deems acceptable. A signature
guarantee cannot be provided by a notary public.
Certificates Share certificates will be issued upon request. If a
certificate is lost, you may incur an expense to replace it.
Broker-Dealer If you purchase shares in Vanguard Funds through a
Purchases registered broker-dealer or investment adviser, the
broker-dealer or adviser may charge a service fee.
Cancelling The Fund will not cancel any trade (e.g., a purchase,
Trades exchange, or redemption) believed to be authentic, received
in writing or by telephone, once the trade has been
received.
Electronic You may receive a prospectus for the Fund or any of the
Prospectus Vanguard Funds in an electronic format through Vanguard's
Delivery website at www.vanguard.com. For additional information
please see "Other Vanguard Services-Computer Access."
- --------------------------------------------------------------------------------
WHEN YOUR Your trade date is the date on which your account is
ACCOUNT WILL BE credited. If your purchase is made by check, Federal Funds
CREDITED wire, or exchange, and is received by the close of trading
on the New York Stock Exchange (generally 4:00 p.m. Eastern
time), your trade date is the day of receipt. If your
purchase is received after the close of the Exchange, your
trade date is the next business day. Your shares are
purchased at the net asset value determined on your trade
date.
In order to prevent lengthy processing delays caused by the
clearing of foreign checks, Vanguard will only accept a
foreign check which has been drawn in U.S. dollars and has
been issued by a foreign bank with a U.S. correspondent
bank. The name of the U.S. correspondent bank must be
printed on the face of the foreign check.
- --------------------------------------------------------------------------------
18
<PAGE>
SELLING YOUR You may withdraw any portion of the funds in your account
SHARES by redeeming shares at any time (please see "Important
Redemption Information"). You generally may initiate a request
by writing or by telephoning. Your redemption proceeds are
normally mailed within two business days after the receipt of
the request in Good Order. No interest will accrue on amounts
represented by uncashed redemption checks.
------------------------------------------------------------
Selling By Mail Requests should be mailed to Vanguard Financial Center,
Vanguard Asset Allocation Fund, P.O. Box 1120, Valley
Forge, PA 19482-1120. (For express or registered mail, send
your request to Vanguard Financial Center, Vanguard Asset
Allocation Fund, 455 Devon Park Drive, Wayne, PA
19087-1815.)
The redemption price of shares will be the Fund's net asset
value next determined after Vanguard has received all
required documents in Good Order.
------------------------------------------------------------
Definition of Good Order means that the request includes the following:
Good Order
1. The account number and Fund name.
2. The amount of the transaction (specified in dollars or
shares).
3. Signatures of all owners exactly as they are registered
on the account.
4. Any required signature guarantees.
5. Other supporting legal documentation that may be
required in the case of estates, corporations, trusts and
certain other accounts.
6. Any certificates you hold for the account.
If you have questions about this definition as it pertains
to your request, please call our Client Services Department
at 1-800-662-2739.
------------------------------------------------------------
Selling By To sell shares by telephone, you or your pre-authorized
Telephone representative may call our Client Services Department at
1-800-662-2739. The proceeds will be sent to you by mail.
Please Note: As a protection against fraud, your telephone
mail redemption privilege will be suspended for 15 calendar
days following any expedited address change to your account.
An expedited address change is one that is made by telephone
or in writing, without the signatures of all account owners.
Please see "Important Information About Telephone
Transactions."
------------------------------------------------------------
Selling By Fund If you select the Fund Express Automatic Withdrawal option,
Express money will be automatically moved from your Vanguard Fund
account to your bank account according to the schedule you
Automatic have selected. The Special Redemption option lets you move
Withdrawal money from your Vanguard account to your bank account on
& Special your request. You may elect Fund Express on the Account
Redemption Registration Form or call our Investor Information
Department at 1-800-662-7447 for a Fund Express application.
19
<PAGE>
Selling By You may sell shares by making an exchange to another Vanguard
Exchange Fund account. Please see "Exchanging Your Shares" for details.
------------------------------------------------------------
Important Shares purchased by check or Fund Express may be redeemed at
Redemption any time. However, your redemption proceeds will not be paid
Information until payment for the purchase is collected, which may take up
to ten calendar days.
---------------------------------------------------------------
Delivery of Redemption requests received by telephone prior to the close of
Redemption trading on the New York Stock Exchange (generally 4:00 p.m.
Proceeds Eastern time) are processed on the day of receipt and the
redemption proceeds are normally sent on the following business
day.
Redemption requests received by telephone after the close of
the Exchange are processed on the business day following
receipt and the proceeds are normally sent on the second
business day following receipt. The Fund reserves the right to
revise or terminate the telephone redemption privilege at any
time.
Redemption proceeds must be sent to you within seven days of
receipt of your request in Good Order except as described in
"Important Redemption Information."
If you experience difficulty in making a telephone redemption
during periods of drastic economic or market changes, your
redemption request may be made by regular or express mail. It
will be implemented at the net asset value next determined
after your request has been received by Vanguard in Good Order.
The Fund may suspend the redemption right or postpone payment
at times when the New York Stock Exchange is closed or under
any emergency circumstances as determined by the United States
Securities and Exchange Commission.
If the Board of Directors determines that it would be
detrimental to the best interests of the Fund's remaining
shareholders to make payment in cash, the Fund may pay
redemption proceeds in whole or in part by a distribution in
kind of readily marketable securities.
------------------------------------------------------------
Vanguard's If you make a redemption from a qualifying account, Vanguard
Average will send you an Cost Statement Average which provides you with
Cost Statement the cost and tax basis of the shares you redeemed. Please see
"Statements and Reports" for additional information.
------------------------------------------------------------
Low Balance Fee Due to the relatively high cost of maintaining smaller
and Minimum accounts, the Fund will automatically deduct a $10 annual fee
Account Balance in either June or December from non-retirement accounts with
Requirement balances falling below $2,500 ($500 for Uniform Gifts/Transfers
to Minors Act accounts). The fee generally will be waived for
investors whose aggregate Vanguard assets exceed $50,000. In
addition, the Fund reserves the right to liquidate any
non-retirement account that is below the minimum initial
investment. In such a case, you may be notified that the value
of your account is below the Fund's minimum account balance
requirement. You would then be allowed 60 days to make an
additional investment before the
20
<PAGE>
account is liquidated. Proceeds would be promptly paid to the
registered shareholder.
Vanguard will not liquidate your account if it has fallen below
$3,000 solely as a result of declining markets (i.e., a decline
in the Fund's net asset value).
---------------------------------------------------------------
EXCHANGING YOUR Should your investment goals change, you may exchange your
SHARES shares of Vanguard Asset Allocation Fund for those of other
available Vanguard Funds.
Exchanging by In addition to the details below, please see "Important
Telephone Information About Telephone Transactions."
Call Client When exchanging shares by telephone, please have ready the Fund
Services name, account number, Social Security number or employer
(1-800-662-2739) identification number listed on the account, and the exact name
and address in which the account is registered. Only the
registered shareowner (or his or her preauthorized
representative) may complete such an exchange. Requests for
telephone exchanges received prior to the close of trading on
the New York Stock Exchange (generally 4:00 p.m. Eastern time)
are processed at the close of business that same day.
Requests received after the close of the Exchange are processed
the next business day. Telephone exchanges are not accepted
into or from non-IRA investments in Vanguard Index Trust,
Vanguard Balanced Index Fund, Vanguard International Equity
Index Fund, Vanguard STAR Fund-Total International Portfolio,
Vanguard Growth and Income Portfolio (formerly known as
Vanguard Quantitative Portfolios) and Vanguard REIT Index
Portfolio. If you experience difficulty in making a telephone
exchange, your exchange request may be made by regular or
express mail, and it will be implemented at the closing net
asset value on the date received by Vanguard provided the
request is received in Good Order.
Neither the Fund nor Vanguard is responsible for the
authenticity of exchange instructions received by telephone.
Investors bear the full risk of any loss arising from
unauthorized telephone exchanges. To prohibit telephone
exchanges on your account, please notify the Fund in writing.
Otherwise, the telephone exchange privilege will be
automatically established for your account.
---------------------------------------------------------------
Exchanging By Please be sure to include on your exchange request the name and
Mail account number of your current Fund, the name of the Fund you
wish to exchange into, the amount you wish to exchange, and the
signatures of all registered account holders. Send your request
to Vanguard Financial Center, Vanguard Asset Allocation Fund,
P.O. Box 1120, Valley Forge, PA 19482-1120. (For express or
registered mail, send your request to Vanguard Financial
Center, Vanguard Asset Allocation Fund, 455 Devon Park Drive,
Wayne, PA 19087-1815.)
---------------------------------------------------------------
Exchanging You may use your personal computer to exchange shares of most
Online Vanguard funds by accessing Vanguard's website
(www.vanguard.com). To establish this service on your account,
you must first register through our website. We will then send
to you by mail, an account access password that will enable you
to make online exchanges.
21
<PAGE>
The Vanguard funds that you cannot purchase or sell through
online exchange are Vanguard Index Trust, Vanguard Balanced
Index Fund, Vanguard International Equity Index Fund, Vanguard
REIT Index Portfolio, Vanguard Total International Portfolio,
and Vanguard Growth and Income Portfolio (formerly known as
Vanguard Quantitative Portfolios). These funds do permit online
exchanges within IRAs and other retirement accounts.
---------------------------------------------------------------
Important Before you make an exchange, you should consider the following:
Exchange
Information o Please read the Fund's prospectus before making an exchange.
For a copy and for answers to any questions you may have,
call our Investor Information Department (1-800-662-7447).
o An exchange is treated as a redemption and a purchase.
Therefore, you could realize a taxable gain or loss on the
transaction.
o Exchanges by telephone are accepted only if the registrations
and the taxpayer identification numbers of the two accounts
are identical.
o In order to exchange into an account with a different
registration (including a different name, address, or
taxpayer identification number), you must obtain the
guaranteed signatures of all current account owners on your
written instructions.
o The shares to be exchanged must be on deposit and not held in
certificate form.
o New accounts are not currently accepted in Vanguard/Windsor
Fund.
o The redemption price of shares redeemed by exchange is the
net asset value next determined after Vanguard has received
the required documentation in Good Order.
o When opening a new account by exchange, you must meet the
minimum investment requirement of the new Fund.
Every effort will be made to maintain the exchange privilege.
However, the Fund reserves the right to revise or terminate its
provisions, limit the amount of, or reject any exchange, as
deemed necessary, at any time.
The exchange privilege is only available in states in which the
shares of the Fund are registered for sale. The Fund's shares
are currently registered for sale in all 50 states and the Fund
intends to maintain such registration.
- --------------------------------------------------------------------------------
EXCHANGE The Fund's exchange privilege is not intended to afford
PRIVILEGE shareholders a way to speculate on short-term movements in the
LIMITATIONS market. Accordingly, in order to prevent excessive use of the
exchange privilege that may potentially disrupt the management
of the Fund and increase transaction costs, the Fund has
established a policy of limiting excessive exchange activity.
Exchange activity generally will not be deemed excessive if
limited to two substantive exchange redemptions (at least 30
days apart) from the Fund during any twelve month period.
"Substantive" means either a dollar amount large
22
<PAGE>
enough to have a negative impact on the Fund or a series of
movements between Vanguard portfolios. Notwithstanding these
limitations, the Fund reserves the right to reject any purchase
request (including exchange purchases from other Vanguard
portfolios) that is reasonably deemed to be disruptive to
efficient portfolio management.
- --------------------------------------------------------------------------------
IMPORTANT The ability to initiate redemptions (except wire or Fund
INFORMATION Express redemptions) and exchanges by telephone is
ABOUT TELEPHONE automatically established on your account unless you request in
TRANSACTIONS writing that telephone transactions on your account not be
permitted.
To protect your account from losses resulting from unauthorized
or fraudulent telephone instructions, Vanguard adheres to the
following security procedures:
1. Security Check. To request a transaction by telephone, the
caller must know (i) the name of the Portfolio; (ii) the
10-digit account number; (iii) the exact name and address
used in the registration; and (iv) the Social Security or
employer identification number listed on the account.
2. Payment Policy. The proceeds of any telephone redemption by
mail will be made payable to the registered shareowner and
mailed to the address of record, only.
Neither the Fund nor Vanguard will be responsible for the
authenticity of transaction instructions received by telephone,
provided that reasonable security procedures have been
followed. Vanguard believes that the security procedures
described above are reasonable and that if such procedures are
followed, you will bear the risk of any losses resulting from
unauthorized or fraudulent telephone transactions on your
account.
- --------------------------------------------------------------------------------
TRANSFERRING You may transfer the registration of any of your Fund shares to
REGISTRATION another person by completing a transfer form and sending it to:
Vanguard Financial Center, P.O. Box 1110, Valley Forge, PA
19482-1110, Attention: Transfers Department. The request must
be in Good Order. To receive a transfer form and full
instructions, please call our Client Services Department
(1-800-662-2739).
- --------------------------------------------------------------------------------
STATEMENTS AND Vanguard will send you a confirmation statement each time you
REPORTS initiate a transaction in your account, except for
checkwriting redemptions from Vanguard money market accounts.
You will also receive a comprehensive account statement at the
end of each calendar quarter. The fourth-quarter statement will
be a year-end statement, listing all transaction activity for
the entire calendar year.
Vanguard's Average Cost Statement provides you with the average
cost of shares redeemed from your account during the calendar
year, using the average cost single category method. This
service is available for most taxable accounts opened since
January 1, 1986. In general, investors who redeemed shares from
a qualifying Vanguard account may expect to receive their
Average Cost Statement along
23
<PAGE>
with their Portfolio Summary Statement. Please call our Client
Services Department (1-800-662-2739) for information.
Financial reports on the Fund will be mailed to you
semi-annually, according to the Fund's fiscal year-end.
- --------------------------------------------------------------------------------
OTHER VANGUARD For more information about any of these services, please call
SERVICES our Investor Information Department at 1-800-662-7447.
Vanguard Direct With Vanguard's Direct Deposit Service, most U.S. Government
Deposit Service checks (including Social Security and military pension checks)
and private payroll checks may be automatically deposited into
your Vanguard Fund account. Separate brochures and forms are
available for direct deposit of U.S. Government and private
payroll checks.
Vanguard Vanguard's Automatic Exchange Service allows you to move money
Automatic automatically among your Vanguard Fund accounts. For instance,
Exchange the service can be used to "dollar cost average" from a money
Service market portfolio into a stock or bond fund or to contribute to
an IRA or other retirement plan. Please contact our Client
Services Department at 1-800-662-2739 for additional
information.
Vanguard Fund Vanguard's Fund Express allows you to transfer money between
Express your Fund account and your account at a bank, savings and loan
association, or a credit union that is a member of the
Automated Clearing House (ACH) system. You may elect this
service on the Account Registration Form or call our Investor
Information Department (1-800-662-7447) for a Fund Express
application.
Special rules govern how your Fund Express purchases or
redemptions are credited to your account. In addition, some
services of Fund Express cannot be used with specific Vanguard
Funds. For more information, please refer to the Vanguard Fund
Express brochure.
Vanguard Vanguard's Dividend Express allows you to transfer your
Dividend dividend and/or capital gains distributions automatically from
Express your Fund account, one business day after the Fund's payable
date, to your account at a bank, savings and loan association,
or credit union that is a member of the Automated Clearing
House (ACH) network. You may elect this service on the Account
Registration Form or call our Investor Information Department
(1-800-662-7447) for a Vanguard Dividend Express application.
Vanguard Vanguard's Tele-Account is a convenient, automated service that
Tele-Account(R) provides share price, price change and yield quotations on
Vanguard Funds through any TouchTone(TM) telephone. This
service also lets you obtain information about your account
balance, your last transaction, and your most recent dividend
or capital gains payment. In addition, you may perform
investment exchanges of Vanguard Fund shares and redemptions by
check using Tele-Account. To contact Vanguard's Tele-Account
service, dial 1-800-ON-BOARD (1-800-662-6273). A brochure
offering detailed operating instructions is available from our
Investor Information Department (1-800-662-7447).
24
<PAGE>
Computer Access
Vanguard Online Use your personal computer to learn more about Vanguard funds
www.vanguard.com and services; keep in touch with your Vanguard accounts; map
out a long-term investment strategy; initiate certain
transactions; and ask questions, make suggestions, and send
messages to Vanguard.
Our education-oriented website provides timely news and
information about Vanguard funds and services; an online
"university" that offers a variety of mutual fund classes; and
easy-to-use, interactive tools to help you create your own
investment and retirement strategies.
- --------------------------------------------------------------------------------
25
<PAGE>
(This page intentionally left blank.)
26
<PAGE>
- -----------------
The Vanguard Group
Vanguard Financial Center
P.O. Box 2600
Valley Forge, PA 19482
Investor Information
Department:
1-800-662-7447 (SHIP)
P R O S P E C T U S
Client Services
Department:
1-800-662-2739 (CREW)
JANUARY 16, 1998
Tele-Account for
24-Hour Access:
1-800-662-6273 (ON-BOARD)
Telecommunication Service
for the Hearing-Impaired:
1-800-662-2738
Transfer Agent:
The Vanguard Group, Inc.
Vanguard Financial Center
Valley Forge, PA 19482
P078
<PAGE>
PART B
VANGUARD ASSET ALLOCATION FUND, INC.
STATEMENT OF ADDITIONAL INFORMATION
January 16, 1998
This Statement is not a prospectus but should be read in conjunction with
the Fund's current Prospectus (dated January 16, 1998). To obtain the
Prospectus please call:
Investor Information Department
1-800-662-7447 (SHIP)
TABLE OF CONTENTS
Page
------
Futures Contracts and Options .................. B-1
Portfolio Transactions ........................ B-4
Description of U.S. Government Securities ...... B-5
Description of Repurchase Agreements ............ B-5
Investment Limitations ........................ B-5
Purchase of Shares .............................. B-7
Redemption of Shares ........................... B-8
Management of the Fund ........................ B-9
Performance Measures ........................... B-12
Total Return .................................... B-14
Investment Advisory Services .................. B-14
Glossary ....................................... B-17
Financial Statements ........................... B-18
INVESTMENT OBJECTIVES AND POLICIES
The following policies supplement the Fund's investment objectives and
policies set forth in the Prospectus:
FUTURES CONTRACTS AND OPTIONS
The Fund may enter into stock index and fixed-income futures contracts,
stock index and fixed income options, and options on such futures contracts to
remain fully invested, or to reduce transactions costs. Futures contracts
provide for the future sale by one party and purchase by another party of a
specified amount of a specific security or index at a specified future time and
at a specified price. Futures contracts which are standardized as to maturity
date and underlying financial instrument are traded on national futures
exchanges. Futures exchanges and trading are regulated under the Commodity
Exchange Act by the Commodity Futures Trading Commission ("CFTC"), a U.S.
Government Agency. Assets committed to futures contracts will be segregated at
the Fund's custodian bank to the extent required by law.
Although many fixed-income futures contracts call for actual delivery or
acceptance of the underlying securities at a specified date (stock index futures
contracts do not permit delivery of securities), the contracts are normally
closed out before the settlement date without the making or taking of delivery.
Closing out an open futures position is done by taking an opposite position
("buying" a contract which has previously been "sold," "selling" a contract
previously "purchased") in an identical contract to terminate the position.
Brokerage commissions are incurred when a futures contract is bought or sold.
B-1
<PAGE>
Futures traders are required to make a good faith margin deposit in cash or
government securities with a broker or custodian to initiate and maintain open
positions in futures contracts. A margin deposit is intended to assure
completion of the contract (delivery or acceptance of the underlying security)
if it is not terminated prior to the specified delivery date. Minimal initial
margin requirements are established by the futures exchange and may be changed.
Brokers may establish deposit requirements which are higher than the exchange
minimums. Futures contracts are customarily purchased and sold on margin which
may range upward from less than 5% of the value of the contract being traded.
After a futures contract position is opened, the value of the contract is
marked to market daily. If the futures contract price changes to the extent that
the margin on deposit does not satisfy margin requirements, payment of
additional "variation" margin will be required. Conversely, change in the
contract value may reduce the required margin, resulting in a repayment of
excess margin to the contract holder. Variation margin payments are made to and
from the futures broker for as long as the contract remains open. The Fund
expects to earn interest income on its margin deposits.
Traders in futures contracts may be broadly classified as either "hedgers"
or "speculators." Hedgers use the futures markets primarily to offset
unfavorable changes (anticipated or potential) in the value of securities
currently owned or expected to be acquired by them. Speculators are less
inclined to own the securities underlying the futures contracts which they
trade, and use futures contracts with the expectation of realizing profits from
fluctuations in the value of the underlying securities. The Fund intends to use
futures contracts only for bona fide hedging purposes.
Regulations of the CFTC applicable to the Portfolio require that all of its
futures transactions constitute bona fide hedging transactions except to the
extent that the aggregate initial margins and premiums required to establish any
non-hedging positions do not exceed five percent of the value of the Fund's
portfolio. The Portfolio will only sell futures contracts to protect securities
it owns against price declines or purchase contracts to protect against an
increase in the price of securities it intends to purchase. As evidence of this
hedging interest, the Portfolio expects that approximately 75% of its futures
contract purchases will be "completed," that is, equivalent amounts of related
securities will have been purchased or are being purchased by the Fund upon sale
of open futures contracts.
Restrictions on the Use of Futures Contracts and Options
The Fund will not enter into futures contract transactions to the extent
that, immediately thereafter, the sum of its initial margin deposits on open
contracts exceeds 5% of the Portfolio's total assets.
Risk Factors in Futures Transactions
Positions in futures may be closed out only on an Exchange which provides a
secondary market for such futures. However, there can be no assurance that a
liquid secondary market will exist for any particular futures contract at any
specific time. Thus, it may not be possible to close a futures position. In the
event of adverse price movements, the Fund would continue to be required to make
daily cash payments to maintain its required margin. In such situations, if the
Fund has insufficient cash, it may have to sell portfolio securities to meet
daily margin requirements at a time when it may be disadvantageous to do so. The
inability to close options and futures positions also could have an adverse
impact on the ability to hedge effectively.
A Fund will minimize the risk that it will be unable to close out a futures
contract by only entering into futures which are traded on national futures
exchanges and for which there appears to be a liquid secondary market.
B-2
<PAGE>
The risk of loss in trading futures contracts in some strategies can be
substantial, due both to the low margin deposits required, and the extremely
high degree of leverage involved in futures contracts. As a result, a relatively
small price movement in a futures contract may result in immediate and
substantial loss (or gain) to the investor. For example, if at the time of
purchase, 10% of the value of the futures contract is deposited as margin, a
subsequent 10% decrease in the value of the futures contract would result in a
total loss of the margin deposit, before any deduction for the transaction
costs, if the account were then closed out. A 15% decrease would result in a
loss equal to 150% of the original margin deposit if the contract were closed
out. Thus, a purchase or sale of a futures contract may result in losses in
excess of the amount invested in the contract. The Fund also bears the risk that
the Adviser will incorrectly predict future market trends. However, because the
futures strategies of the Portfolio are engaged in only for hedging purposes,
the adviser does not believe that the Fund is subject to the risks of loss
frequently associated with futures transactions. The Fund would presumably have
sustained comparable losses if, instead of the futures contract, it had invested
in the underlying financial instrument and sold it after the decline.
Utilization of futures transactions by the Fund does involve the risk of
imperfect or no correlation where the securities underlying futures contracts
have different maturities than the portfolio securities being hedged. It is also
possible that the Fund could both lose money on futures contracts and also
experience a decline in value of its portfolio securities. There is also the
risk of loss by the Fund of margin deposits in the event of bankruptcy of a
broker with whom the Fund has an open position in a futures contract or related
option.
Most futures exchanges limit the amount of fluctuation permitted in some
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 a trading session.
Once the daily limit has been reached in a particular type of contract, no
trades may be made on that day at a price beyond that limit. The daily limit
governs only price movement during a particular trading day and therefore does
not limit potential losses, because the limit may prevent the liquidation of
unfavorable positions. Futures contract prices have occasionally moved to the
daily limit for several consecutive trading days with little or no trading,
thereby preventing prompt liquidation of future positions and subjecting some
futures traders to substantial losses.
Federal Tax Treatment of Futures Contracts
The Fund is required for Federal income tax purposes to recognize as income
for each taxable year its net unrealized gains and losses on futures contracts
as of the end of the year as well as those actually realized during the year. In
most cases, any gain or loss recognized with respect to a futures contract is
considered to be 60% long-term capital gain or loss and 40% short-term capital
gain or loss, without regard to the holding period of the contract. Furthermore,
sales of futures contracts which are intended to hedge against a change in the
value of securities held by the Fund may affect the holding period of such
securities and, consequently, the nature of the gain or loss on such securities
upon disposition. The Fund may be required to defer the recognition of losses on
futures contracts to the extent of any unrecognized gains on related positions
held by the Fund.
In order for the Fund to continue to qualify for Federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income; i.e., dividends,
interest income derived from loans of securities, and gains from the sale of
securities or foreign currencies, or other income derived with respect to its
business of investing in such securities or currencies. It is anticipated that
any net gain realized from the closing out of futures contracts will be
considered gain from the sale of securities and therefore be qualifying income
for purposes of the 90% requirement.
B-3
<PAGE>
The Fund will distribute to shareholders annually any net capital gains
which have been recognized for Federal income tax purposes including unrealized
gains at the end of the Fund's fiscal year on futures transactions. Such
distributions will be combined with distributions of capital gains realized on
the Fund's other investments and shareholders will be advised on the nature of
the payments.
PORTFOLIO TRANSACTIONS
The investment advisory agreement authorizes the Adviser (with the approval
of the Fund's Board of Directors) to select the brokers or dealers that will
execute the purchases and sales of portfolio securities for the Fund and directs
the Adviser to use its best efforts to obtain the best available price and most
favorable execution as to all transactions for the Fund. The Adviser undertakes
to execute each investment transaction at a price and commission which provides
the most favorable total cost or proceeds reasonably obtainable under the
circumstances.
In placing portfolio transactions, the Adviser will use its best judgment
to choose the broker most capable of providing the brokerage services necessary
to obtain best available price and most favorable execution. The full range and
quality of brokerage services available will be considered in making these
determinations. In those instances where it is reasonably determined that more
than one broker can offer the brokerage services needed to obtain the best
available price and most favorable execution, consideration may be given to
those brokers which supply investment research and statistical information and
provide other services in addition to execution services to the Fund and/or the
Adviser. The Adviser considers such information useful in the performance of its
obligations under the agreement, but is unable to determine the amount by which
such services may reduce its expenses.
The investment advisory agreement also incorporates the concepts of Section
28(e) of the Securities Exchange Act of 1934 by providing that, subject to the
approval of the Fund's Board of Directors, the Adviser may cause the Fund to pay
a broker-dealer which furnishes brokerage and research services a higher
commission than that which might be charged by another broker-dealer for
effecting the same transaction; provided that such commission is deemed
reasonable in terms of either that particular transaction or the overall
responsibilities of the Adviser to the Fund.
Currently, it is the Fund's policy that the Adviser may at times pay higher
commissions in recognition of brokerage services felt necessary for the
achievement of better execution of certain securities transactions that
otherwise might not be available. The Adviser will only pay such higher
commissions if it believes this to be in the best interest of the Fund. Some
brokers or dealers who may receive such higher commissions in recognition of
brokerage services related to execution of securities transactions are also
providers of research information to the Adviser and/or the Fund. However, the
Adviser has informed the Fund that it will not pay higher commission rates
specifically for the purpose of obtaining research services.
Since the Fund does not market its shares through intermediary brokers or
dealers, it is not the Fund's practice to allocate brokerage or principal
business on the basis of sales of its shares which may be through such firms.
However, the Fund may place portfolio orders with qualified broker-dealers who
recommend the Fund to other clients, or who act as agent in the purchase of the
Fund's shares for their clients, and may, when a number of brokers and dealers
can provide comparable best price and execution on a particular transaction,
consider the sale of Fund shares by a broker or dealer in selecting among
qualified broker-dealers.
The total brokerage commissions paid by the Fund for the fiscal years ended
September 30, 1995, September 30, 1996 and September 30, 1997, totaled
$92,177, $127,528 and $113,938 respectively.
Some securities considered for investment by the Fund may also be
appropriate for other clients served by the Adviser. If purchases or sales of
securities consistent with the investment policies of the Fund and one or more
of these other clients serviced by the Adviser are considered at or about the
same time, transactions in such securities will be allocated among the Fund and
such other clients in a manner deemed equitable by the Adviser.
B-4
<PAGE>
Description of U.S. Government Securities
As used in this prospectus, the term "U.S. Government Securities" refers to
a variety of securities which are issued or guaranteed by the United States
Treasury, by various agencies of the United States Government, and by various
instrumentalities which have been established or sponsored by the United States
Government. The term also refers to "repurchase agreements" collateralized by
such securities.
U.S. Treasury Securities are backed by the "full faith and credit" of the
United States. Securities issued or guaranteed by Federal agencies and U.S.
Government sponsored instrumentalities may or may not be backed by the full
faith and credit of the United States. In the case of securities not backed by
the full faith and credit of the United States, the investor must look
principally to the agency or instrumentality issuing or guaranteeing the
obligation for ultimate repayment, and may not be able to assert a claim against
the United States itself in the event the agency or instrumentality does not
meet its commitment.
Some of the U.S. Government agencies that issue or guarantee securities
include the Export-Import Bank of the United States, Farmers Home
Administration, Federal Housing Administration, Maritime Administration, Small
Business Administration, and The Tennessee Valley Authority.
An instrumentality of the U.S. Government is a government agency organized
under Federal charter with government supervision. Instrumentalities issuing or
guaranteeing securities include, among others, Federal Home Loan Banks, the
Federal Land Banks, Central Bank for Cooperatives, Federal Intermediate Credit
Banks, and the Federal National Mortgage Association.
Description of Repurchase Agreements
Repurchase agreements are transactions by which a person purchases a
security and simultaneously commits to resell that security to the seller (a
member bank of the Federal Reserve System or recognized securities dealer) at an
agreed upon price on an agreed upon date within a number of days (usually not
more than seven) from the date of purchase. The resale price reflects the
purchase price plus an agreed upon market rate of interest which is unrelated to
the coupon rate or maturity of the purchased security. A repurchase agreement
involves the obligation of the seller to pay the agreed upon price, which
obligation is in effect secured by the value of the underlying security.
The use of repurchase agreements involves certain risks. For example, if
the seller of the agreement defaults on its obligation to repurchase the
underlying securities at a time when the value of these securities has declined,
the Portfolio may incur a loss upon disposition of them. If the seller of the
agreement becomes insolvent and subject to liquidation or reorganization under
the Bankruptcy Code or other laws, a bankruptcy court may determine that the
underlying securities are collateral not within the control of the Portfolio and
therefore subject to sale by the trustee in bankruptcy. Finally, it is possible
that the Portfolio may not be able to substantiate its interest in the
underlying securities. While the Fund's management acknowledges these risks, it
is expected that they can be controlled through stringent security selection
criteria and careful monitoring procedures.
INVESTMENT LIMITATIONS
The following restrictions supplement the Fund's investment limitations set
forth in the Prospectus. Except as otherwise indicated, these restrictions are
fundamental policies of the Fund which cannot be changed without the approval of
a majority (as defined in the Investment Company Act of 1940 (the "1940 Act") of
the Fund's outstanding voting shares. The Fund may not under any circumstances:
B-5
<PAGE>
1) Borrow money, except from banks (or through reverse repurchase
agreements) for temporary or emergency purposes (not leveraging), and
then only in an amount not in excess of 15% of the value of the Fund's
net assets at the time the borrowing is made. Whenever borrowing exceeds
5% of the value of the Fund's assets, the Fund will not make any
additional investments;
2) With respect to 75% of the value of its total assets, purchase the
securities of any issuer (except obligations of the United States
government and its instrumentalities) if as a result the Fund would hold
more than 10% of the outstanding voting securities of the issuer, or
more than 5% of the value of the Fund's total assets would be invested
in the securities of such issuer;
3) Invest for the purpose of exercising control of management of any
company;
4) Purchase the securities of any other investment company, except as they
may be acquired as part of a merger, consolidation or acquisition of
assets or otherwise to the extent permitted by Section 12 of the 1940
Act. The Fund will invest only in investment companies which have
investment objectives consistent with those of the Fund;
5) The Fund will not engage in the business of underwriting securities
issued by other persons except to the extent that the Fund may
technically be deemed to be an underwriter under the Securities Act of
1933 in disposing of portfolio securities. Additionally, the Fund will
not purchase or otherwise acquire any security if, as a result, more
than 15% of its net assets would be invested in securities that are
illiquid (included in this limitation is the Fund's investment in The
Vanguard Group, Inc.);
6) Invest in commodities, except that the Fund may invest in futures
contracts, options and options on futures contracts to the extent that
not more than 5% of the Fund's assets are required as margin deposit for
futures contracts;
7) Invest in real estate or real estate limited partnership interests
although the Fund may purchase and sell securities of companies which
invest in real estate, or interests therein;
8) Purchase securities on margin or sell any securities short except as
specified in investment limitation No. 6 above;
9) Make loans except (i) by purchasing bonds, debentures or similar
obligations (including repurchase agreements) which are either publicly
distributed or customarily purchased by institutional investors, and
(ii) by lending its securities to banks, brokers, dealers and other
financial institutions so long as such loans are not inconsistent with
the Investment Company Act or the Rules and Regulations or
interpretations of the Securities and Exchange Commission thereunder. No
loan of securities will be made if, as a result the aggregate of such
loans in the Fund would exceed 33 1/3% of the value of the Fund's total
assets;
10) Pledge, mortgage, or hypothecate any of its assets to an extent greater
than 5% of its total assets; and
11) Invest more than 25% of the value of its total assets in any one
industry.
The investment limitations set forth above are considered at the time that
investment securities are purchased. If a percentage restriction is adhered to
at the time the investment is made, a later increase in percentage resulting
from a change in the market value of assets will not constitute a violation of
such restriction.
Notwithstanding these limitations, the Fund may own all or any portion of
the securities of, or make loans to, or contribute to the costs or other
financial requirements of any company which will be wholly-owned by the Fund and
one or more other investment companies and is primarily engaged in the business
of providing, at-cost, management, administrative, distribution or related
services to the Fund and other investment companies. See "Management of the
Fund."
B-6
<PAGE>
PURCHASE OF SHARES
The Fund reserves the right in its sole discretion (i) to suspend the
offerings of its shares, (ii) to reject purchase orders when in the judgment of
management such rejection is in the best interest of the Fund, and (iii) to
reduce or waive the minimum investment for or any other restrictions on initial
and subsequent investments for certain fiduciary accounts or under circumstances
where certain economies can be achieved in sales of the Fund's shares.
REDEMPTION OF SHARES
The Fund may suspend redemption privileges or postpone the date of payment
(i) during any period that the New York Stock Exchange is closed, or trading on
the Exchange is restricted as determined by the Securities and Exchange
Commission (the "Commission"), (ii) during any period when an emergency exists
as defined by the rules of the Commission as a result of which it is not
reasonably practicable for the Fund to dispose of securities owned by it, or
fairly to determine the value of its assets, and (iii) for such other periods as
the Commission may permit.
The Fund has made an election with the Commission to pay in cash all
redemptions requested by any shareholder of record limited in amount during any
90-day period to the lesser of $250,000 or 1% of the net assets of the Fund at
the beginning of such period. Such commitment is irrevocable without the prior
approval of the Commission. Redemptions in excess of the above limits may be
paid in whole or in part, in investment securities or in cash, as the Directors
may deem advisable; however, payment will be made wholly in cash unless the
Directors believe that economic or market conditions exist which would make such
a practice detrimental to the best interests of the Fund. If redemptions are
paid in investment securities, such securities will be valued as set forth in
the Prospectus under "The Fund's Share Price" and a redeeming shareholder would
normally incur brokerage expenses if he converted these securities to cash.
No charge is made by the Fund for redemptions. Any redemption may be more
or less than the shareholder's cost depending on the market value of the
securities held by the Fund.
B-7
<PAGE>
MANAGEMENT OF THE FUND
Directors and Officers
The Officers of the Fund manage its day-to-day operations and are
responsible to the Fund's Board of Directors. The Directors set broad policies
for the Fund and choose its Officers. The following is a list of Directors and
Officers of the Fund and a statement of their present positions and principal
occupations during the past five years. The mailing address of the Directors and
Officers of the Fund is Post Office Box 876, Valley Forge, PA 19482.
JOHN C. BOGLE, (DOB: 5/8/1929) Chairman and Director*
Chairman and Director of The Vanguard Group, Inc., and of each of the
investment companies in The Vanguard Group; Director of the Mead
Corporation, General Accident Insurance, and Chris-Craft Industries, Inc.
JOHN J. BRENNAN, (DOB: 7/29/1954) President, Chief Executive Officer & Director*
President, Chief Executive Officer and Director of The Vanguard Group, Inc.,
and of each of the investment companies in The Vanguard Group.
ROBERT E. CAWTHORN, (DOB: 9/28/1935) Director
Chairman Emeritus and Director of Rhone-Poulenc Rorer, Inc; Managing Director
of Global Health Care Partners/DLJ Merchant Banking Partners; Director of
Sun Company, Inc., and Westinghouse Electric Corporation.
BARBARA BARNES HAUPTFUHRER, (DOB: 10/11/1928) Director
Director of The Great Atlantic and Pacific Tea Company, IKON Office Solutions,
Inc., Raytheon Company, Knight-Ridder, Inc., Massachusetts Mutual Life
Insurance Co., and Ladies Professional Golf Association; Trustee Emerita of
Wellesley College.
BRUCE K. MACLAURY, (DOB: 5/7/1931) Director
President Emeritus of The Brookings Institution; Director of American Express
Bank Ltd., The St. Paul Companies, Inc., and National Steel Corporation.
BURTON G. MALKIEL, (DOB: 8/28/1932) Director
Chemical Bank Chairman's Professor of Economics, Princeton University;
Director of Prudential Insurance Co. of America, Amdahl Corporation, Baker
Fentress & Co., The Jeffrey Co., and Southern New England
Telecommunications Company.
<PAGE>
ALFRED M. RANKIN, Jr., (DOB: 10/8/1941) Director
Chairman, President, Chief Executive Officer, and Director of NACCO
Industries, Inc.; Director of The BFGoodrich Company, and The Standard
Products Company.
JOHN C. SAWHILL, (DOB: 6/12/1936) Director
President and Chief Executive Officer of The Nature Conservancy; formerly,
Director and Senior Partner of McKinsey & Co., and President of New York
University; Director of Pacific Gas and Electric Company, Procter & Gamble
Company, and NACCO Industries.
JAMES O. WELCH, JR., (DOB: 5/13/1931) Director
Retired Chairman of Nabisco Brands, Inc.; retired Vice Chairman and Director of
RJR Nabisco; Director of TECO Energy, Inc., and Kmart Corporation.
J. LAWRENCE WILSON, (DOB: 3/2/1936) Director
Chairman and Chief Executive Officer of Rohm & Haas Company; Director of
Cummins Engine Company, and The Mead Corporation; and Trustee of
Vanderbilt University.
RAYMOND J. KLAPINSKY, (DOB: 12/7/1938) Secretary*
Managing Director and Secretary of The Vanguard Group, Inc.; Secretary of each
of the investment companies in The Vanguard Group.
RICHARD F. HYLAND, (DOB: 3/22/1937) Treasurer*
Treasurer of The Vanguard Group, Inc., and of each of the investment companies
in The Vanguard Group.
KAREN E. WEST, (DOB: 9/13/1946) Controller*
Principal of The Vanguard Group, Inc.; Controller of each of the investment
companies in The Vanguard Group.
- ------------------------
* Officers of the Fund are "interested persons" as defined in the Investment
Company Act of 1940.
B-8
<PAGE>
The Fund is a member of The Vanguard Group of Investment Companies. Through
their jointly-owned subsidiary, The Vanguard Group, Inc. ("Vanguard"), the Fund
and the other Funds in the Group obtain at cost virtually all of their corporate
management, administrative and distribution services. Vanguard also provides
investment advisory services on an at-cost basis to certain of the Vanguard
Funds.
Vanguard employs a supporting staff of management and administrative
personnel needed to provide the requisite services to the Funds and also
furnishes the Funds with necessary office space, furnishings and equipment. Each
Fund pays its share of Vanguard's total expenses which are allocated among the
Funds under methods approved by the Board of Directors (Trustees) of each Fund.
In addition, each Fund bears its own direct expenses such as legal, auditing and
custodian fees.
The Fund's officers are also officers and employees of Vanguard. No officer
or employee owns, or is permitted to own, any securities of any external adviser
for the Funds.
The Vanguard Group adheres to a Code of Ethics established pursuant to Rule
17j-1 under the Investment Company Act of 1940. The Code is designed to prevent
unlawful practices in connection with the purchase or sale of securities by
persons associated with Vanguard. Under Vanguard's Code of Ethics certain
officers and employees of Vanguard who are considered access persons are
permitted to engage in personal securities transactions. However, such
transactions are subject to procedures and guidelines substantially similar to
those recommended by the mutual fund industry and approved by the U.S.
Securities and Exchange Commission.
The Vanguard Group was established and operates under a Funds' Service
Agreement which was approved by the shareholders of each of the Funds. The
amounts which each of the Funds have invested are adjusted from time to time in
order to maintain the proportionate relationship between each Fund's relative
net assets and its contribution to Vanguard's capital. The Fund's Service
Agreement provides that: (a) each Vanguard Fund may invest up to .40% of its
current assets in Vanguard, and (b) there is no limit on the amount that each
Vanguard Fund may contribute to Vanguard's capitalization. At September 30,
1997, the Fund had contributed capital of $251,000, representing 1.3% of
Vanguard's capitalization.
Management
Corporate management and administrative services include: (1) executive
staff; (2) accounting and financial; (3) legal and regulatory; (4) shareholder
account maintenance; (5) monitoring and control of custodian relationships; (6)
shareholder reporting; and (7) review and evaluation of advisory and other
services provided to the Funds by third parties. During the fiscal year ended
September 30, 1997, the Fund's allocated share of Vanguard's actual net costs of
operations relating to management and administrative services (including
transfer agency) totaled approximately $10,632,000.
Distribution
Vanguard provides all distribution and marketing activities for the Funds
in the Group. Vanguard Marketing Corporation, a wholly-owned subsidiary of
Vanguard, acts as Sales Agent for the shares of the Funds in connection with any
sales made directly to investors in the states of Florida, Missouri, New York,
Ohio, Texas and such other states as it may be required.
The principal distribution expenses are for advertising, promotional
materials and marketing personnel. Distribution services may also include
organizing and offering to the public, from time to time, one or more new
investment companies which will become members of the Group. The Directors and
Officers of Vanguard determine the amount to be spent annually on distribution
activities, the manner and amount to be spent on each Fund, and whether to
organize new investment companies.
B-9
<PAGE>
One-half of the distribution expenses of a marketing and promotional nature
is allocated among the Funds based upon relative net assets. The remaining
one-half of those expenses is allocated among the Funds based upon each Fund's
sales for the preceding 24 months relative to the total sales of the Funds as a
Group, provided, however, that no Fund's aggregate quarterly rate of
contribution for distribution expenses of a marketing and promotional nature
shall exceed 125% of average distribution expense rate for the Group, and that
no Fund shall incur annual distribution expenses in excess of 20/100 of 1% of
its average month-end net assets. During the fiscal year ended September 30,
1997, the Fund paid approximately $683,000 of the Group's distribution and
marketing expenses, which represented an effective annual rate of .02 of 1% of
the Fund's average net assets.
Investment Advisory Services
Vanguard provides investment advisory services to Vanguard Money Market
Reserves, Vanguard Municipal Bond Fund, several Portfolios of Vanguard Fixed
Income Securities Fund, Vanguard California Tax-Free Fund, Vanguard Florida
Insured Tax-Free Fund, Vanguard New Jersey Tax-Free Fund, Vanguard New York
Tax-Free Fund, Vanguard Pennsylvania Tax-Free Fund, Vanguard Ohio Tax-Free Fund,
Vanguard Admiral Funds, Vanguard Tax-Managed Fund, Vanguard Balanced Index Fund,
Vanguard Bond Index Fund, Vanguard Index Trust, Vanguard International Equity
Index Fund, Total International Portfolio of Vanguard STAR Fund, Aggressive
Growth Portfolio of Vanguard Horizon Fund, several Portfolios of Vanguard
Variable Insurance Fund, a portion of Vanguard/Windsor II, Vanguard
Institutional Index Fund, Vanguard REIT Index Portfolio of Vanguard Specialized
Portfolios, and a portion of Vanguard/Morgan Growth Fund as well as several
indexed separate accounts. These services are provided on an at-cost basis from
a money management staff employed directly by Vanguard. The compensation and
other expenses of this staff are paid by the Funds utilizing these services.
Remuneration of Directors and Officers
The Fund pays each Director who is not also an Officer, an annual fee plus
travel and other expenses incurred in attending Board meetings. The Fund's
Officers and employees are paid by Vanguard which, in turn, is reimbursed by the
Fund, and each other Fund in the Group, for its proportionate share of Officers'
and employees' salaries and retirement benefits. During the year ended September
30, 1997 the Fund's proportionate share of remuneration paid to all Officers of
the Fund, as a group, was approximately $72,216 including Directors.
Retired Directors who are not officers are paid an annual fee based on the
number of years of service. The fee is equal to $1,000 for each year of service
and each investment company member of The Vanguard Group contributes a
proportionate amount to this fee based on its relative net assets. Under its
retirement plan, Vanguard contributes annually an amount equal to 10% of each
eligible officer's annual compensation plus 5.7% of that part of an eligible
officer's compensation during the year, if any, that exceeds the Social Security
Taxable Wage Base then in effect. Under its thrift plan, all eligible officers
are permitted to make pre-tax contributions in an amount up to 4% of total
compensation, subject to federal tax limitations, which are matched by Vanguard
on a 100% basis. The Fund's proportionate share of retirement contributions made
by Vanguard under its retirement and thrift plans on behalf of all Officers of
the Fund, as a group, during the 1997 fiscal year was approximately $1,950.
B-10
<PAGE>
The following table provides detailed information with respect to the
amounts paid or accrued for the Directors for the fiscal year ended September
30, 1997.
VANGUARD ASSET ALLOCATION FUND
COMPENSATION TABLE
<TABLE>
<CAPTION>
Pension or Retirement Estimated
Aggregate Benefits Accrued as Annual Benefits Total Compensation
Compensation Part of Fund Upon From All Vanguard Funds
Names of Directors From Fund Expenses Retirement Paid to Directors(2)
- ------------------ -------------- ----------------------- ----------------- ------------------------
<S> <C> <C> <C> <C>
John C. Bogle(1) -- -- -- --
John J. Brennan(1) -- -- -- --
Barbara Barnes Hauptfuhrer $807 $116 $15,000 $70,000
Robert E. Cawthorn $807 $ 97 $13,000 $70,000
Bruce K. MacLaury $861 $112 $12,000 $65,000
Burton G. Malkiel $812 $ 78 $15,000 $70,000
Alfred M. Rankin, Jr. $807 $ 61 $15,000 $70,000
John C. Sawhill $807 $ 73 $15,000 $70,000
James O. Welch, Jr. $807 $ 90 $15,000 $70,000
J. Lawrence Wilson $807 $ 65 $15,000 $70,000
</TABLE>
- ------------
(1) As "Interested Directors," Messrs. Bogle and Brennan receive no
compensation for their service as Directors.
(2) The amounts reported in this column reflect the total compensation paid to
each Director for their service as Director or Trustee of 35 Vanguard Funds
(34 in the case of Mr. Malkiel; 28 in the case of Mr. MacLaury).
PERFORMANCE MEASURES
Vanguard may use reprinted material discussing The Vanguard Group, Inc. or
any of the member funds of The Vanguard Group of Investment Companies.
Each of the investment company members of The Vanguard Group, including
Vanguard Asset Allocation Fund, may, from time to time, use one or more of the
following unmanaged indices for comparative performance purposes.
Standard & Poor's 500 Composite Stock Price Index -- is a well diversified list
of 500 companies representing the U.S. Stock Market.
Standard & Poor's MidCap 400 Index -- is composed of 400 medium sized domestic
stocks.
Standard & Poor's/BARRA 600 Value Index -- contains stocks of the S&P SmallCap
600 Index which have a lower than average price-to-book ratio.
Standard & Poor's/BARRA 600 Growth Index -- contains stocks of the S&P SmallCap
600 Index which have a higher than average price-to-book ratio.
Russell 1000 Value Index -- consists of the stocks in the Russell 1000 Index
(comprising the 1,000 largest U.S.-based companies measured by total market
capitalization) with the lowest price-to-book ratios, comprising 50% of the
market capitalization of the Russell 1000.
Wilshire 5000 Equity Index -- consists of nearly 7,000 common equity securities,
covering all stocks in the U.S. for which daily pricing is available.
Wilshire 4500 Equity Index -- consists of all stocks in the Wilshire 5000 except
for the 500 stocks in the Standard and Poor's 500 Index.
B-11
<PAGE>
Morgan Stanley Capital International EAFE Index -- is an arithmetic, market
value-weighted average of the performance of over 900 securities listed on the
stock exchanges of countries in Europe, Australia, Asia and the Far East.
Goldman Sachs 100 Convertible Bond Index -- currently includes 71 bonds and 29
preferreds. The original list of names was generated by screening for
convertible issues of $100 million or greater in market capitalization. The
index is priced monthly.
Salomon Brothers GNMA Index -- includes pools of mortgages originated by private
lenders and guaranteed by the mortgage pools of the Government National Mortgage
Association.
Salomon Brothers High-Grade Corporate Bond Index -- consists of publicly issued,
non-convertible corporate bonds rated AA or AAA. It is a value-weighted, total
return index, including approximately 800 issues with maturities of 12 years or
greater.
Lehman Brothers Aggregate Bond Index -- is a market weighted index that contains
over 4,000 individually priced U.S. Treasury, agency, corporate, and mortgage
pass-through securities corporate rated BBB - or better. The Index has a market
value of over $4 trillion.
Lehman Brothers Mutual Fund Short (1-5) Government/Corporate Index -- is a
market weighted index that contains over 1,500 individually priced U.S.
Treasury, agency, and corporate investment grade bonds rated BBB - or better
with maturities between 1 and 5 years. The index has a market value of over $1.6
trillion.
Lehman Brothers Mutual Fund Intermediate (5-10) Government/Corporate Index -- is
a market weighted index that contains over 1,500 individually priced U.S.
Treasury, agency, and corporate securities rated BBB - or better with maturities
between 5 and 10 years. The index has a market value of over $700 billion.
Lehman Brothers Mutual Fund Long (10+) Government/Corporate Index -- is a market
weighted index that contains over 1,900 individually priced U.S. Treasury,
agency, and corporate securities rated BBB - or better with maturities greater
than 10 years. The index has a market value of over $900 billion.
Lehman Long-Term Treasury Bond Index -- is composed of all bonds covered by the
Shearson Lehman Hutton Treasury Bond Index with maturities of 10 years or
greater.
Merrill Lynch Corporate & Government Bond Index -- consists of over 4,500 U.S.
Treasury, Agency and investment grade corporate bonds.
Lehman Corporate (Baa) Bond Index -- all publicly offered fixed rate,
nonconvertible domestic corporate bonds rated Baa by Moody's, with a maturity
longer than 1 year and with more than $25 million outstanding. This index
includes over 1,000 issues.
Lehman Brothers Long-Term Corporate Bond Index -- is a subset of the Lehman
Corporate Bond Index covering all corporate, publicly issued, fixed-rate,
nonconvertible U.S. debt issues rated at least Baa, with at least $50 million
principal outstanding and maturity greater than 10 years.
Bond Buyer Municipal Bond Index -- is a yield index on current coupon high grade
general obligation municipal bonds.
Standard & Poor's Preferred Index -- is a yield index based upon the average
yield of four high grade, noncallable preferred stock issues.
NASDAQ Industrial Index -- is composed of more than 3,000 industrial issues. It
is a value-weighted index calculated on price change only and does not include
income.
B-12
<PAGE>
Composite Index -- 70% Standard & Poor's 500 Index and 30% NASDAQ Industrial
Index.
Composite Index -- 65% Standard & Poor's 500 Index and 35% Lehman Long-Term
Corporate AA or Better Bond Index.
Composite Index -- 65% Lehman Long-Term Corporate AA or Better Bond Index and a
35% weighting in a blended equity composite (75% Standard & Poor's/BARRA Value
Index, 12.5% Standard & Poor's Utilities Index and 12.5% Standard & Poor's
Telephone Index).
Lehman Long-Term Corporate AA or Better Bond Index -- consists of all publicly
issued, fixed rate, nonconvertible investment grade, dollar-denominated,
SEC-registered corporate debt rated AA or AAA.
TOTAL RETURN
The average annual total return for the Fund for one and five years ended
September 30, 1997 and for the period from inception (November 3, 1988) to
September 30, 1997 was +29.42%, +16.74% and +15.69%, respectively.
Total return is computed by determining the average compounded rates of
return over the periods set forth above that would equate an initial amount
invested at the beginning of the periods to the ending redeemable value of the
investment.
INVESTMENT ADVISORY SERVICES
The Fund employs Mellon Capital Management Corporation ("MCM"), 595 Market
St., Suite 3000, San Francisco, California (the "Adviser") under an investment
advisory agreement dated as of July 1, 1997 to manage the investment and
reinvestment of the assets of the Fund and to continuously review, supervise and
administer the Fund's investment program. The Adviser discharges its
responsibilities subject to the control of the Officers and Directors of the
Fund.
The Fund pays the Adviser a Basic fee at the end of each fiscal quarter,
calculated by applying a quarterly rate, based on the following annual
percentage rates, to the Fund's average month-end net assets for the quarter:
Net Assets Rate
---------- ------
First $100 million ........................... .200%
Next $900 million ........................... .150%
Next $500 million ........................... .125%
Over $1.5 billion ........................... .100%
This fee may be increased or decreased by applying an adjustment formula
based on the performance of the Fund's portfolio relative to the investment
record of a "Combined Index", 65% of which shall be comprised of the Standard &
Poor's 500 Composite Price Index and 35% of which shall be comprised of the
Lehman Brothers Long-Term U.S. Treasury Index. The fee payment will be increased
(decreased) by an incentive (penalty) of 0.05% of average net assets, if the
Fund's cumulative investment performance for the thirty-six months preceding the
end of the quarter is at least six percentage points above (below) the
cumulative investment record of the S&P 500 Index for the same period. For the
purpose of determining the fee adjustment for investment performance, as
described above, the net assets of the Fund will be averaged over the same
period as the performance of the Fund and the investment record of the Combined
Index are computed.
B-13
<PAGE>
Under the rules of the Securities and Exchange Commission, the new
incentive/penalty fee will not be fully operable until the quarter ending March
31, 2000. Until that date, a "blended" fee rate consisting of varying
percentages of (i) the performance adjustment based on the schedule set forth
above (the "New Rate"1), and (ii) the performance adjustment based on the
schedule set forth in the Fund's previous investment advisory agreement with the
adviser2 (the "Previous Rate") shall be used as follows:
1. Quarter Ending June 30, 1997. The incentive/penalty fee was calculated
as the sum of 8.3% (e.g., one of 12 quarters) of the fee payable under the New
Rate plus 91.7% (e.g., 11 of 12 quarters) of the fee payable under the Previous
Rate.
2. Quarter Ending September 30, 1997. The incentive/penalty fee was
calculated as the sum of 16.6% of the fee payable under the New Rate plus 83.4%
of the fee payable under the Previous Rate.
3. Quarter Ending December 31, 1997. The incentive/penalty fee was
calculated as the sum of 25% of the fee payable under the New Rate plus 75% of
the fee payable under the Previous Rate.
4. Quarter Ending March 31, 1998. The incentive/penalty fee shall be
calculated as the sum of 33.3% of the fee payable under the New Rate plus 66.7%
of the fee payable under the Previous Rate.
5. Quarter Ending June 30, 1998. The incentive/penalty fee shall be
calculated as the sum of 41.6% of the fee payable under the New Rate plus 58.4%
of the fee payable under the Previous Rate.
6. Quarter Ending September 30, 1998. The incentive/penalty fee shall be
calculated as the sum of 50% of the fee payable under the New Rate plus 50% of
the fee payable under the Previous Rate.
7. Quarter Ending December 31, 1998. The incentive/penalty fee shall be
calculated as the sum of 58.4% of the fee payable under the New Rate plus 41.6%
of the fee payable under the Previous Rate.
8. Quarter Ending March 31, 1999. The incentive/penalty fee shall be
calculated as the sum of 66.7% of the fee payable under the New Rate plus 33.3%
of the fee payable under the Previous Rate.
9. Quarter Ending June 30, 1999. The incentive/penalty fee shall be
calculated as the sum of 75% of the fee payable under the New Rate plus 25% of
the fee payable under the Previous Rate.
10. Quarter Ending September 30, 1999. The incentive/penalty fee shall be
calculated as the sum of 83.4% of the fee payable under the New Rate plus 16.6%
of the fee payable under the Previous Rate.
11. Quarter Ending December 31, 1999. The incentive/penalty fee shall be
calculated as the sum of 91.7% of the fee payable under the New Rate plus 8.3%
of the fee payable under the Previous Rate.
12. Quarter Ending March 31, 2000. New Rate fully operable.
For the purpose of determining the fee adjustment for investment
performance, as described above, the net assets of the Fund shall be averaged
over the same period as the investment performance of the Fund and the
investment record of the Combined Index are computed. The "investment
performance" of the Fund
- ------------
1 The benchmark used for the new rate calculation will consist of linking the
return of the "new" benchmark (a "Combined Index", 65% of which is comprised
of the Standard & Poor's 500 Composite Price Index and 35% of which is
comprised of the Lehman Brothers Long-Term U.S. Treasury Index) to the return
of the "previous" benchmark (Standard & Poor's 500 Composite Price Index) in
the same varying percentages that are listed below.
2 The previous incentive/penalty fee structure provided that the Basic Fee be
increased or decreased by an amount equal to .05% of the average month-end
assets of the Fund if the Fund's investment performance for the thirty-six
months preceding the end of the quarter was six percentage points or more
above or below, respectively, the investment record of the Standard & Poor's
500 Composite Price Index.
B-14
<PAGE>
for the period, expressed as a percentage of the Fund's net asset value per
share at the beginning of the period shall be the sum of: (i) the change in the
Fund's net asset value per share during such period; (ii) the value of the
Fund's cash distributions per share having an ex-dividend date occurring within
the period; and (iii) the per share amount of capital gains taxes paid or
accrued during such period by the Fund for undistributed realized long-term
capital gains.
The "investment record" of the Stock Index for the period, expressed as a
percentage of the Stock Index level at the beginning of the period, shall be the
sum of (i) the change in the level of the Stock Index during the period and (ii)
the value, computed consistently with the Stock Index, of cash distributions
having an ex-dividend date occurring within the period made by companies whose
securities comprise the Stock Index. The "investment record" of the Bond Index
for the period, expressed as a percentage of the Bond Index level at the
beginning of such period shall be the sum of (i) the change in the level of the
Bond Index during the period and (ii) the value of the interest accrued or paid
on the bonds included in the Bond Index, assuming the reinvestment of such
interest on a monthly basis. Computation of these two components as the Combined
Index shall be made on the basis of 65% in the Stock Index and 35% in the Bond
Index at the beginning of each quarter.
The agreement will continue until June 30, 1998 and will be renewable
thereafter for successive one-year periods, only if each renewal is specifically
approved by a vote of the Fund's Board of Directors, including the affirmative
votes of a majority of the Directors who are not parties to the contract or
"interested persons" (as defined in the Investment Company Act of 1940) of any
such party, cast in person at a meeting called for the purpose of considering
such approval. In addition, the question of continuance shall be effected only
if approved by the affirmative vote of a majority of the outstanding voting
securities of the Fund. The agreement is automatically terminated if assigned,
and may be terminated without penalty at any time (1) either by vote of the
Board of Directors of the Fund or by vote of its outstanding voting securities
on 60 days' written notice to the Adviser, or (2) by the Adviser upon 90 days'
written notice to the Fund.
The Fund's Board of Directors may, without the approval of shareholders,
provide for:
A. The employment of a new investment adviser pursuant to the terms of a
new advisory agreement, either as a replacement for an existing adviser or as an
additional adviser.
B. A change in the terms of an advisory agreement.
C. The continued employment of an existing adviser on the same advisory
contract terms where a contract has been assigned because of a change in control
of the adviser.
Any such change will only be made upon not less than 30 days' prior written
notice to shareholders, which shall include the information concerning the
adviser that would have normally been included in a proxy statement.
Because the Adviser provides only investment advisory services to the Fund
and has no control over the Fund's expenses, the Adviser has not undertaken to
guarantee expenses of the Fund. The Officers of the Fund have worked out
alternative arrangements with state authorities which do require an expense
guarantee.
Description of the Adviser. The Adviser is a professional counseling firm
which manages well diversified stock and bond portfolios for institutional
clients. As of September 30, 1997 the Adviser provided investment advisory
services to 227 clients and managed assets with an approximate value of $64.9
billion. The Adviser's asset allocation strategy was developed by the Adviser's
co-founder, William Fouse, in 1972, and is used by 109 of its clients and
accounts for approximately $20.2 billion of the assets that it manages. The
Adviser is a wholly-owned subsidiary of MBC Investment Corporation, which itself
is a wholly-owned subsidiary of Mellon Bank Corporation. For the fiscal years
ended September 30, 1995, September 30, 1996
B-15
<PAGE>
and September 30, 1997, the Fund paid approximately $1,954,000 (before a
decrease of $131,000 based on performance), $2,691,000 (before a decrease of
$515,000 based on performance), and $3,723,000 (before a decrease of $921,000
based on performance) respectively, to the Adviser for investment advisory
services. The basic fee paid to the Adviser for the fiscal year ended September
30, 1996 reflects a fee waiver of $146,000 during the period October 1, 1995 to
March 31, 1996.
Glossary
a. Historical Market Returns -- Total returns of broad asset class benchmarks.
As examples, the returns of well-known benchmarks for domestic stocks, bonds,
and money market instruments are given below.
<TABLE>
<CAPTION>
Money Market
Asset Class Common Stocks Bonds Instruments
Standard & Poor's
500 Composite Stock Lehman Brothers 90 Day
Benchmark Price Index Long Treasury Index U.S. Treasury Bills
---------- ------------------- ------------------- -------------------
<S> <C> <C> <C>
1980 32.4 -2.9 11.4
1981 -4.9 0.4 14.7
1982 21.5 41.8 10.9
1983 22.5 2.0 9.0
1984 6.2 14.8 10.0
1985 31.6 31.6 7.8
1986 18.6 24.1 6.2
1987 5.2 -2.7 5.9
1988 16.5 9.2 6.8
1989 31.6 18.9 8.6
1990 -3.1 6.3 7.9
1991 30.4 18.5 5.8
1992 7.6 8.0 3.6
1993 10.1 17.3 3.1
1994 1.3 -7.6 4.2
1995 37.6 30.7 5.8
1996 23.0 -0.9 5.2
1997(9/30) 29.6 8.1 3.9
</TABLE>
b. Asset Allocation -- Asset allocation -- in its most generic sense -- is the
allotment of an investor's monies to broad asset classes such as stocks or
bonds. Investors establish percentage allocation guidelines for stocks,
bonds, and money market instruments which are consistent with their
particular long-term investment needs. These needs will include current
income, potential growth in capital, and willingness to accept risk.
In implementing their asset allocation targets, some investors attempt to
maintain a stable mix -- such as 50% stocks and 50% bonds -- while others will
actively manage the stock/bond mix in pursuit of higher returns, lower risk, or
other investment objectives. The key difference between investors who maintain a
stable mix and those who actively change allocations is their willingness to
forecast the risks and returns of individual asset classes, their forecasting
abilities, and their comfort in making investment decisions based upon such
forecasts. Historically, investors who actively managed the mix based upon
conjecture have often underperformed both investors with relatively stable
allocations and investors with logical, disciplined methods for assessing
relative value and risk. Institutional investors commonly refer to active asset
allocation approaches which are based upon disciplined methodologies as tactical
asset allocation.
B-16
<PAGE>
FINANCIAL STATEMENTS
The Fund's financial statements, including the financial highlights for
each of the five fiscal years in the period ended September 30, 1997, appearing
in the Fund's 1997 Annual Report to Shareholders and the report thereon of Price
Waterhouse LLP, independent accountants, also appearing therein, are
incorporated by reference into this Statement of Additional Information. The
Fund's 1997 Annual Report to Shareholders is enclosed with this Statement of
Additional Information.
B-17
