<PAGE>
BLACKROCK FUNDS/SM/
(FORMERLY, COMPASS CAPITAL FUNDS/SM/)
STATEMENT OF ADDITIONAL INFORMATION
This Statement of Additional Information provides supplementary information
pertaining to shares representing interests in the Money Market, Municipal Money
Market, U.S. Treasury Money Market (formerly, the Government Money Market
Portfolio), Ohio Municipal Money Market, Pennsylvania Municipal Money Market,
North Carolina Municipal Money Market, Virginia Municipal Money Market, New
Jersey Municipal Money Market, Large Cap Value Equity (formerly, the Value
Equity Portfolio), Large Cap Growth Equity (formerly, the Growth Equity
Portfolio), Index Equity, Small Cap Value Equity, Mid-Cap Value Equity, Micro-
Cap Equity, International Equity, International Emerging Markets, International
Small Cap Equity, Balanced, Small Cap Growth Equity, Mid-Cap Growth Equity,
Select Equity (formerly, the Core Equity Portfolio), Managed Income, Tax-Free
Income, Intermediate Government Bond (formerly, the Intermediate Government
Portfolio), Ohio Tax-Free Income, Pennsylvania Tax-Free Income, Low Duration
Bond (formerly, the Short Government Bond Portfolio), Intermediate Bond
(formerly, the Intermediate-Term Bond Portfolio), Government Income,
International Bond (formerly, the International Fixed Income Portfolio), New
Jersey Tax-Free Income and Core Bond Portfolios (collectively, the "Portfolios")
of BlackRock Funds (the "Fund"). The Money Market, Municipal Money Market, U.S.
Treasury Money Market, Ohio Municipal Money Market, Pennsylvania Municipal Money
Market, North Carolina Municipal Money Market, Virginia Municipal Money Market
and New Jersey Municipal Money Market Portfolios are called "Money Market
Portfolios," and the other Portfolios are called "Non-Money Market Portfolios."
This Statement of Additional Information is not a prospectus, and should be read
only in conjunction with the Prospectuses of the Fund relating to the Portfolios
dated January 28, 1998, as amended from time to time (the "Prospectuses").
Prospectuses may be obtained from the Fund's distributor by calling toll-free
(800) 441-7379. This Statement of Additional Information is dated January 28,
1998. Capitalized terms used herein and not otherwise defined have the same
meanings as are given to them in the Prospectuses.
<PAGE>
CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Investment Policies.................................................... 3
Special Considerations for State-Specific
Portfolios............................................................ 24
Trustees and Officers.................................................. 61
Shareholder and Trustee Liability of the Fund.......................... 72
Investment Advisory, Administration,
Distribution and Servicing Arrangements............................... 73
Expenses............................................................... 100
Portfolio Transactions................................................. 101
Purchase and Redemption Information.................................... 106
Valuation of Portfolio Securities...................................... 113
Performance Information................................................ 117
Taxes.................................................................. 146
Additional Information Concerning Shares............................... 154
Miscellaneous.......................................................... 156
Financial Statements................................................... 160
Appendix A (Description of Securities Ratings)......................... A-1
Appendix B (Description of Futures).................................... B-1
</TABLE>
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS STATEMENT OF ADDITIONAL INFORMATION OR THE
PROSPECTUSES IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUSES AND, IF
GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS
HAVING BEEN AUTHORIZED BY THE FUND OR ITS DISTRIBUTOR. THE PROSPECTUSES DO NOT
CONSTITUTE AN OFFERING BY THE FUND OR BY THE FUND'S DISTRIBUTOR IN ANY
JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE MADE.
-2-
<PAGE>
INVESTMENT POLICIES
The following supplements information contained in the Prospectuses
concerning the Portfolios' investment policies. Except as indicated, the
information below relates only to those Portfolios that are authorized to invest
in the instruments or securities described below.
The Index Equity Portfolio invests all of its investable assets in The U.S.
Large Company Series (the "Index Master Portfolio") of The DFA Investment Trust
Company (the "Trust"). Accordingly, the following discussion relates to: (i)
the investment policies of all the Portfolios including the Index Equity
Portfolio; and (ii) where indicated the investment policies of the Index Master
Portfolio.
ADDITIONAL INFORMATION ON INVESTMENT STRATEGY
The Large Cap Value Equity, Large Cap Growth Equity, Mid-Cap Value Equity
and Mid-Cap Growth Equity Portfolios will invest primarily in securities of
established companies. For this purpose, an established company is one which,
together with its predecessors, has at least three years of continuous operating
history.
The Low Duration Bond Portfolio will seek to maintain a duration for its
portfolio in a range of +/-20% of the current duration of the Merrill Lynch 1-3
Year Treasury Index. The Government Income Portfolio will seek to maintain an
interest rate sensitivity within a range comparable to that of 7 to 10 year U.S.
Treasury bonds.
ADDITIONAL INFORMATION ON PORTFOLIO INVESTMENTS.
REVERSE REPURCHASE AGREEMENTS. Each Portfolio (including the Index Master
Portfolio) other than the Municipal Money Market, Ohio Municipal Money Market,
Pennsylvania Municipal Money Market, North Carolina Municipal Money Market,
Virginia Municipal Money Market and New Jersey Municipal Money Market Portfolios
(the "Municipal Money Market Portfolios") may invest in reverse repurchase
agreements. Reverse repurchase agreements involve the sale of securities held
by a Portfolio pursuant to a Portfolio's agreement to repurchase the securities
at an agreed upon price, date and interest rate. Such agreements are considered
to be borrowings under the Investment Company Act of 1940 (the "1940 Act").
While reverse repurchase transactions are outstanding, a Portfolio will maintain
in a segregated account liquid assets in an amount at least equal to the
repurchase price.
VARIABLE AND FLOATING RATE INSTRUMENTS. With respect to purchasable
variable and floating rate instruments, the adviser or sub-adviser will consider
the earning power, cash flows and
-3-
<PAGE>
liquidity ratios of the issuers and guarantors of such instruments and, if the
instruments are subject to a demand feature, will monitor their financial status
to meet payment on demand. Such instruments may include variable amount master
demand notes that permit the indebtedness thereunder to vary in addition to
providing for periodic adjustments in the interest rate. The absence of an
active secondary market with respect to particular variable and floating rate
instruments could make it difficult for a Portfolio to dispose of a variable or
floating rate note if the issuer defaulted on its payment obligation or during
periods that the Portfolio is not entitled to exercise its demand rights, and
the Portfolio could, for these or other reasons, suffer a loss with respect to
such instruments. In determining average-weighted portfolio maturity, an
instrument will be deemed to have a maturity equal to either the period
remaining until the next interest rate adjustment or the time the Portfolio
involved can recover payment of principal as specified in the instrument,
depending on the type of instrument involved. Each of the Equity Portfolios of
the Fund does not intend to invest more than 5% of its net assets in variable
and floating rate instruments.
MONEY MARKET OBLIGATIONS OF DOMESTIC BANKS, FOREIGN BANKS AND FOREIGN
BRANCHES OF U.S. BANKS. Each Portfolio may purchase bank obligations, such as
certificates of deposit, bankers' acceptances and time deposits, including
instruments issued or supported by the credit of U.S. or foreign banks or
savings institutions having total assets at the time of purchase in excess of $1
billion. The assets of a bank or savings institution will be deemed to include
the assets of its domestic and foreign branches for purposes of each Portfolio's
investment policies. Investments in short-term bank obligations may include
obligations of foreign banks and domestic branches of foreign banks, and also
foreign branches of domestic banks. Each of the Equity Portfolios of the Fund
does not intend to invest more than 5% of its net assets in bank
obligations.
The Index Master Portfolio may purchase obligations of U.S. banks and
savings and loan associations and dollar-denominated obligations of U.S.
subsidiaries and branches of foreign banks, such as certificates of deposit
(including marketable variable rate certificates of deposit) and bankers'
acceptances. Bank certificates of deposit will only be acquired by the Index
Master Portfolio if the bank has assets in excess of $1 billion.
MORTGAGE-RELATED SECURITIES. There are a number of important differences
among the agencies and instrumentalities of the U.S. Government that issue
mortgage-related securities and among the securities that they issue. Mortgage-
related securities guaranteed by the Government National Mortgage Association
("GNMA") include GNMA Mortgage Pass-Through
-4-
<PAGE>
Certificates (also known as "Ginnie Maes") which are guaranteed as to the timely
payment of principal and interest by GNMA and such guarantee is backed by the
full faith and credit of the United States. GNMA is a wholly-owned U.S.
Government corporation within the Department of Housing and Urban Development.
GNMA certificates also are supported by the authority of GNMA to borrow funds
from the U.S. Treasury to make payments under its guarantee. Mortgage-related
securities issued by the Federal National Mortgage Association ("FNMA") include
FNMA guaranteed Mortgage Pass-Through Certificates (also known as "Fannie Maes")
which are solely the obligations of the FNMA, are not backed by or entitled to
the full faith and credit of the United States and are supported by the right of
the issuer to borrow from the Treasury. FNMA is a government-sponsored
organization owned entirely by private stockholders. Fannie Maes are guaranteed
as to timely payment of principal and interest by FNMA. Mortgage-related
securities issued by the Federal Home Loan Mortgage Corporation ("FHLMC")
include FHLMC Mortgage Participation Certificates (also known as "Freddie Macs"
or "Pcs"). FHLMC is a corporate instrumentality of the United States, created
pursuant to an Act of Congress, which is owned entirely by Federal Home Loan
Banks. Freddie Macs are not guaranteed by the United States or by any Federal
Home Loan Banks and do not constitute a debt or obligation of the United States
or of any Federal Home Loan Bank. Freddie Macs entitle the holder to timely
payment of interest, which is guaranteed by the FHLMC. FHLMC guarantees either
ultimate collection or timely payment of all principal payments on the
underlying mortgage loans. When FHLMC does not guarantee timely payment of
principal, FHLMC may remit the amount due on account of its guarantee of
ultimate payment of principal at any time after default on an underlying
mortgage, but in no event later than one year after it becomes payable.
The Managed Income, Intermediate Government, Low Duration Bond,
Intermediate Bond, Government Income, International Bond, Core Bond, Tax-Free
Income, Pennsylvania Tax-Free Income, New Jersey Tax-Free Income and Ohio Tax-
Free Income Portfolios (the "Bond Portfolios") and the Balanced Portfolio may
invest in multiple class pass-through securities, including collateralized
mortgage obligations ("CMOs") and real estate mortgage investment conduit
("REMIC") pass-through or participation certificates ("REMIC Certificates").
These multiple class securities may be issued by U.S. Government agencies or
instrumentalities, including FNMA and FHLMC, or by trusts formed by private
originators of, or investors in, mortgage loans. In general, CMOs and REMICs
are debt obligations of a legal entity that are collateralized by, and multiple
class pass-through securities represent direct ownership interests in, a pool of
residential or commercial mortgage loans or mortgage pass-through securities
(the "Mortgage Assets"), the payments on which are used to make payments on the
CMOs or multiple pass-through securities.
-5-
<PAGE>
Investors may purchase beneficial interests in CMOs and REMICs, which are known
as "regular" interests or "residual" interests. The residual in a CMO or REMIC
structure generally represents the interest in any excess cash flow remaining
after making required payments of principal of and interest on the CMOs or
REMICs, as well as the related administrative expenses of the issuer. Residual
interests generally are junior to, and may be significantly more volatile than,
"regular" CMO and REMIC interests. The Portfolios do not currently intend to
purchase residual interests. The markets for CMOs and REMICs may be more
illiquid than those of other securities.
Each class of CMOs or REMIC Certificates, often referred to as a "tranche,"
is issued at a specific adjustable or fixed interest rate and must be fully
retired no later than its final distribution date. Principal prepayments on the
Mortgage Assets underlying the CMOs or REMIC Certificates may cause some or all
of the classes of CMOs or REMIC Certificates to be retired substantially earlier
than their final distribution dates. Generally, interest is paid or accrues on
all classes of CMOs or REMIC Certificates on a monthly basis.
The principal of and interest on the Mortgage Assets may be allocated among
the several classes of CMOs or REMIC Certificates in various ways. In certain
structures (known as "sequential pay" CMOs or REMIC Certificates), payments of
principal, including any principal prepayments, on the Mortgage Assets generally
are applied to the classes of CMOs or REMIC Certificates in the order of their
respective final distribution dates. Thus, no payment of principal will be made
on any class of sequential pay CMOs or REMIC Certificates until all other
classes having an earlier final distribution date have been paid in full.
Additional structures of CMOs or REMIC Certificates include, among others,
"parallel pay" CMOs and REMIC Certificates. Parallel pay CMOs or REMIC
Certificates are those which are structured to apply principal payments and
prepayments of the Mortgage Assets to two or more classes concurrently on a
proportionate or disproportionate basis. These simultaneous payments are taken
into account in calculating the final distribution date of each class.
A wide variety of REMIC Certificates may be issued in the parallel pay or
sequential pay structures. These securities include accrual certificates (also
known as "Z-Bonds"), which only accrue interest at a specified rate until all
other certificates having an earlier final distribution date have been retired
and are converted thereafter to an interest-paying security, and planned
amortization class ("PAC") certificates, which are parallel pay REMIC
Certificates which generally require that specified amounts of principal be
applied on each payment date to one or more classes of REMIC Certificates (the
"PAC
-6-
<PAGE>
Certificates"), even though all other principal payments and prepayments of the
Mortgage Assets are then required to be applied to one or more other classes of
the Certificates. The scheduled principal payments for the PAC Certificates
generally have the highest priority on each payment date after interest due has
been paid to all classes entitled to receive interest currently. Shortfalls, if
any, are added to the amount payable on the next payment date. The PAC
Certificate payment schedule is taken into account in calculating the final
distribution date of each class of PAC. In order to create PAC tranches, one or
more tranches generally must be created that absorb most of the volatility in
the underlying Mortgage Assets. These tranches tend to have market prices and
yields that are much more volatile than the PAC classes.
FNMA REMIC Certificates are issued and guaranteed as to timely distribution
of principal and interest by FNMA. In addition, FNMA will be obligated to
distribute on a timely basis to holders of FNMA REMIC Certificates required
installments of principal and interest and to distribute the principal balance
of each class of REMIC Certificates in full, whether or not sufficient funds are
otherwise available.
For FHLMC REMIC Certificates, FHLMC guarantees the timely payment of
interest, and also guarantees the ultimate payment of principal as payments are
required to be made on the underlying mortgage participation certificates
("Pcs"). Pcs represent undivided interests in specified level payment,
residential mortgages or participations therein purchased by FHLMC and placed in
a PC pool. With respect to principal payments on Pcs, FHLMC generally
guarantees ultimate collection of all principal of the related mortgage loans
without offset or deduction. FHLMC also guarantees timely payment of principal
on certain Pcs, referred to as "Gold Pcs."
ASSET-BACKED SECURITIES. Asset-backed securities are generally issued as
pass-through certificates, which represent undivided fractional ownership
interests in an underlying pool of assets, or as debt instruments, which are
also known as collateralized obligations, and are generally issued as the debt
of a special purpose entity organized solely for the purpose of owning such
assets and issuing such debt. Asset-backed securities are often backed by a
pool of assets representing the obligations of a number of different parties.
The yield characteristics of asset-backed securities differ from
traditional debt securities. A major difference is that the principal amount of
the obligations may be prepaid at any time because the underlying assets (i.e.,
----
loans) generally may be prepaid at any time. As a result, if an asset-backed
security is purchased at a premium, a prepayment rate that is faster than
expected may reduce yield to maturity, while a
-7-
<PAGE>
prepayment rate that is slower than expected may have the opposite effect of
increasing yield to maturity. Conversely, if an asset-backed security is
purchased at a discount, faster than expected prepayments may increase, while
slower than expected prepayments may decrease, yield to maturity. The
relationship between prepayments and interest rates may give some high-yielding
asset-backed securities less potential for growth in value than conventional
bonds with comparable maturities.
In general, the collateral supporting non-mortgage asset-backed securities
is of shorter maturity than mortgage-related securities. Like other fixed-
income securities, when interest rates rise the value of an asset-backed
security generally will decline; however, when interest rates decline, the value
of an asset-backed security with prepayment features may not increase as much as
that of other fixed-income securities.
U.S. GOVERNMENT OBLIGATIONS. Examples of the types of U.S. Government
obligations which the Portfolios may hold include U.S. Treasury bills, Treasury
instruments and Treasury bonds and the obligations of Federal Home Loan Banks,
Federal Farm Credit Banks, Federal Land Banks, the Federal Housing
Administration, the Farmers Home Administration, the Export-Import Bank of the
United States, the Small Business Administration, FNMA, GNMA, the General
Services Administration, the Student Loan Marketing Association, the Central
Bank for Cooperatives, FHLMC, the Federal Intermediate Credit Banks, the
Maritime Administration, the International Bank for Reconstruction and
Development (the "World Bank"), the Asian-American Development Bank and the
Inter-American Development Bank. Each of the Equity Portfolios of the Fund does
not intend to invest more than 5% of its net assets in U.S. Government
obligations.
The Index Master Portfolio may purchase (i) debt securities issued by the
U.S. Treasury which are direct obligations of the U.S. Government, including
bills, notes and bonds, and (ii) obligations issued or guaranteed by U.S.
Government-sponsored instrumentalities and federal agencies, including FNMA,
Federal Home Loan Bank and the Federal Housing Administration.
SUPRANATIONAL ORGANIZATION OBLIGATIONS. The Portfolios may purchase debt
securities of supranational organizations such as the European Coal and Steel
Community, the European Economic Community and the World Bank, which are
chartered to promote economic development. Each of the Equity Portfolios of the
Fund does not intend to invest more than 5% of its net assets in supranational
organization obligations.
LEASE OBLIGATIONS. The Portfolios may hold participation certificates in a
lease, an installment purchase contract, or a conditional sales contract ("lease
obligations").
-8-
<PAGE>
The Sub-Adviser will monitor the credit standing of each municipal borrower
and each entity providing credit support and/or a put option relating to lease
obligations. In determining whether a lease obligation is liquid, the Sub-
Adviser will consider, among other factors, the following: (i) whether the lease
can be cancelled; (ii) the degree of assurance that assets represented by the
lease could be sold; (iii) the strength of the lessee's general credit (e.g.,
its debt, administrative, economic, and financial characteristics); (iv) the
likelihood that the municipality would discontinue appropriating funding for the
leased property because the property is no longer deemed essential to the
operations of the municipality (e.g., the potential for an "event of
nonappropriation"); (v) legal recourse in the event of failure to appropriate;
(vi) whether the security is backed by a credit enhancement such as insurance;
and (vii) any limitations which are imposed on the lease obligor's ability to
utilize substitute property or services other than those covered by the lease
obligation.
The Municipal Money Market, Pennsylvania Municipal Money Market, Ohio
Municipal Money Market, North Carolina Municipal Money Market, Virginia
Municipal Money Market and New Jersey Municipal Money Market Portfolios will
only invest in lease obligations with puts that (i) may be exercised at par on
not more than seven days notice, and (ii) are issued by institutions deemed by
the sub-adviser to present minimal credit risks. Such obligations will be
considered liquid. However, a number of puts are not exercisable at the time
the put would otherwise be exercised if the municipal borrower is not
contractually obligated to make payments (e.g., an event of nonappropriation
with a "nonappropriation" lease obligation). Under such circumstances, the
lease obligation while previously considered liquid would become illiquid, and a
Portfolio might lose its entire investment in such obligation.
Municipal leases, like other municipal debt obligations, are subject to the
risk of non-payment. The ability of issuers of municipal leases to make timely
lease payments may be adversely impacted in general economic downturns and as
relative governmental cost burdens are allocated and reallocated among federal,
state and local governmental units. Such non-payment would result in a
reduction of income to a Portfolio, and could result in a reduction in the value
of the municipal lease experiencing non-payment and a potential decrease in the
net asset value of a Portfolio. Issuers of municipal securities might seek
protection under the bankruptcy laws. In the event of bankruptcy of such an
issuer, a Portfolio could experience delays and limitations with respect to the
collection of principal and interest on such municipal leases and a Portfolio
may not, in all circumstances, be able to collect all principal and interest to
which it is entitled. To enforce its rights in the event of a default in lease
payments, the Fund might take possession of and
-9-
<PAGE>
manage the assets securing the issuer's obligations on such securities, which
may increase a Portfolio's operating expenses and adversely affect the net asset
value of a Portfolio. When the lease contains a non-appropriation clause,
however, the failure to pay would not be a default and a Portfolio would not
have the right to take possession of the assets. Any income derived from a
Portfolio's ownership or operation of such assets may not be tax-exempt. In
addition, a Portfolio's intention to qualify as a "regulated investment company"
under the Internal Revenue Code of 1986, as amended, may limit the extent to
which a Portfolio may exercise its rights by taking possession of such assets,
because as a regulated investment company a Portfolio is subject to certain
limitations on its investments and on the nature of its income.
COMMERCIAL PAPER. The Money Market Portfolios may purchase commercial
paper rated in one of the two highest rating categories of a nationally
recognized statistical rating organization ("NRSRO"). The Non-Money Market
Portfolios, except the Index Master Portfolio, may purchase commercial paper
rated (at the time of purchase) "A-1" by S&P or "Prime-1" by Moody's or, when
deemed advisable by a Portfolio's adviser or sub-adviser, "high quality" issues
rated "A-2" or "Prime-2" by S&P or Moody's, respectively. The Index Master
Portfolio may purchase commercial paper rated (at the time of purchase) "A-1" or
better by S&P or "Prime-1" by Moody's, or, if not rated, issued by a corporation
having an outstanding unsecured debt issue rated "Aaa" by Moody's or "AAA" by
S&P, and having a maximum maturity of nine months. These ratings symbols are
described in Appendix A.
Commercial paper purchasable by each Portfolio includes "Section 4(2)
paper," a term that includes debt obligations issued in reliance on the "private
placement" exemption from registration afforded by Section 4(2) of the
Securities Act of 1933. Section 4(2) paper is restricted as to disposition
under the Federal securities laws, and is frequently sold (and resold) to
institutional investors such as the Fund through or with the assistance of
investment dealers who make a market in the Section 4(2) paper, thereby
providing liquidity. Certain transactions in Section 4(2) paper may qualify for
the registration exemption provided in Rule 144A under the Securities Act of
1933. Each of the Equity Portfolios of the Fund does not intend to invest more
than 5% of its net assets in commercial paper.
REPURCHASE AGREEMENTS. Each Portfolio may invest in repurchase agreements.
The repurchase price under the repurchase agreements described in the
Prospectuses generally equals the price paid by a Portfolio involved plus
interest negotiated on the basis of current short-term rates (which may be more
or less than the rate on securities underlying the repurchase agreement).
-10-
<PAGE>
The financial institutions with which a Portfolio may enter into repurchase
agreements will be banks and non-bank dealers of U.S. Government securities that
are listed on the Federal Reserve Bank of New York's list of reporting dealers,
if such banks and non-bank dealers are deemed creditworthy by the Portfolio's
adviser or sub-adviser. A Portfolio's adviser or sub-adviser will continue to
monitor creditworthiness of the seller under a repurchase agreement, and will
require the seller to maintain during the term of the agreement the value of the
securities subject to the agreement to equal at least the repurchase price
(including accrued interest). In addition, the Portfolio's adviser or sub-
adviser will require that the value of this collateral, after transaction costs
(including loss of interest) reasonably expected to be incurred on a default, be
equal to or greater than the repurchase price (including accrued premium)
provided in the repurchase agreement. The accrued premium is the amount
specified in the repurchase agreement or the daily amortization of the
difference between the purchase price and the repurchase price specified in the
repurchase agreement. The Portfolio's adviser or sub-adviser will mark-to-
market daily the value of the securities. Securities subject to repurchase
agreements will be held by the Fund's custodian (or sub-custodian) in the
Federal Reserve/Treasury book-entry system or by another authorized securities
depository. Repurchase agreements are considered to be loans by the Portfolios
under the 1940 Act.
The use of repurchase agreements involves certain risks. For example, if
the seller of securities under a repurchase agreement defaults on its obligation
to repurchase the underlying securities, as a result of its bankruptcy or
otherwise, a Portfolio will seek to dispose of such securities, which action
could involve costs or delays. If the seller becomes insolvent and subject to
liquidation or reorganization under applicable bankruptcy or other laws, a
Portfolio's ability to dispose of the underlying securities may be restricted.
Finally, it is possible that a Portfolio may not be able to substantiate its
interest in the underlying securities. To minimize this risk, the securities
underlying the repurchase agreement will be held by the custodian at all times
in an amount at least equal to the repurchase price, including accrued interest.
If the seller fails to repurchase the securities, a Portfolio may suffer a loss
to the extent proceeds from the sale of the underlying securities are less than
the repurchase price.
The Index Master Portfolio may enter into repurchase agreements, but will
not enter into a repurchase agreement with a duration of more than seven days
if, as a result, more than 10% of the value of its total assets would be so
invested. The Index Master Portfolio will also only invest in repurchase
agreements with a bank if the bank has at least $1 billion in assets and is
approved by the Investment Committee of DFA. DFA will monitor
-11-
<PAGE>
the market value of transferred securities plus any accrued interest thereon so
that the value of such securities will at least equal the repurchase price. The
securities underlying the repurchase agreements will be limited to U. S.
Government and agency obligations described under "U.S. Government Obligations"
above.
INVESTMENT GRADE DEBT OBLIGATIONS. Each of the Money Market Portfolios may
invest in securities in the two highest rating categories of NRSROs. The Non-
Money Market Portfolios, except the Index Master Portfolio and the Low Duration
Bond, Intermediate Government Bond and Government Income Portfolios, may invest
in "investment grade securities," which are securities rated in the four highest
rating categories of an NRSRO. The Intermediate Government Bond and Government
Income Portfolios may invest in debt securities rated Aaa by Moody's or AAA by
S&P. It should be noted that debt obligations rated in the lowest of the top
four ratings (i.e., "Baa" by Moody's or "BBB" by S&P) are considered to have
some speculative characteristics and are more sensitive to economic change than
higher rated securities.
The Index Master Portfolio may invest in non-convertible corporate debt
securities which are issued by companies whose commercial paper is rated "Prime-
1" by Moody's or "A-1" by S&P and dollar-denominated obligations of foreign
issuers issued in the U.S. If the issuer's commercial paper is unrated, then
the debt security would have to be rated at least "AA" by S&P or "Aa2" by
Moody's. If there is neither a commercial paper rating nor a rating of the debt
security, then the Index Master Portfolio's investment adviser must determine
that the debt security is of comparable quality to equivalent issues of the same
issuer rated at least "AA" or "Aa2."
See Appendix A to this Statement of Additional Information for a
description of applicable securities ratings.
NON-INVESTMENT GRADE SECURITIES. The Low Duration Bond Portfolio may
invest in non-investment grade or "high yield" fixed income or convertible
securities commonly known to investors as "junk bonds" when the Portfolio's sub-
adviser believes that the investment characteristics of such securities make
them desirable in light of the Portfolio's investment objective and current
portfolio mix, so long as under normal market conditions, no more than 20% of
its total assets are invested in non-investment grade debt securities, and such
securities are rated "B" or higher at the time of purchase by at least one major
rating agency.
High yield securities are bonds that are issued by a company whose credit
rating (based on rating agencies' evaluation of the likelihood of repayment)
necessitates offering a higher coupon and yield on its issues when selling them
to investors who may
-12-
<PAGE>
otherwise be hesitant in purchasing the debt of such a company. While generally
providing greater income and opportunity for gain, non-investment grade debt
securities may be subject to greater risks than securities which have higher
credit ratings, including a high risk of default, and their yields will
fluctuate over time. High yield securities will generally be in the lower
rating categories of recognized rating agencies (rated "Ba" or lower by Moody's
or "BB" or lower by Standard & Poor's) or will be non-rated. The credit rating
of a high yield security does not necessarily address its market value risk, and
ratings may from time to time change, positively or negatively, to reflect
developments regarding the issuer's financial condition. High yield securities
are considered to be speculative with respect to the capacity of the issuer to
timely repay principal and pay interest or dividends in accordance with the
terms of the obligation and may have more credit risk than higher rated
securities.
While the market values of high yield securities tend to react less to
fluctuations in interest rates than do those of higher rated securities, the
values of high yield securities often reflect individual corporate developments
and have a high sensitivity to economic changes to a greater extent than do
higher rated securities. Issuers of high yield securities are often in the
growth stage of their development and/or involved in a reorganization or
takeover. The companies are often highly leveraged (have a significant amount
of debt relative to shareholders' equity) and may not have available to them
more traditional financing methods, thereby increasing the risk associated with
acquiring these types of securities. In some cases, obligations with respect to
high yield securities are subordinated to the prior repayment of senior
indebtedness, which will potentially limit a Portfolio's ability to fully
recover principal or to receive interest payments when senior securities are in
default. Thus, investors in high yield securities have a lower degree of
protection with respect to principal and interest payments then do investors in
higher rated securities.
During an economic downturn, a substantial period of rising interest rates
or a recession, highly leveraged issuers of high yield securities may experience
financial distress possibly resulting in insufficient revenues to meet their
principal and interest payment obligations, to meet projected business goals and
to obtain additional financing. An economic downturn could also disrupt the
market for lower-rated securities and adversely affect the value of outstanding
securities, the Portfolio's net asset value and the ability of the issuers to
repay principal and interest. If the issuer of a security held by a Portfolio
defaulted, the Portfolio may not receive full interest and principal payments
due to it and could incur additional expenses if it chose to seek recovery of
its investment.
-13-
<PAGE>
The secondary markets for high yield securities are not as liquid as the
secondary markets for higher rated securities. The secondary markets for high
yield securities are concentrated in relatively few market makers and
participants in the markets are mostly institutional investors, including
insurance companies, banks, other financial institutions and mutual funds. In
addition, the trading volume for high yield securities is generally lower than
that for higher rated securities and the secondary markets could contract under
adverse market or economic conditions independent of any specific adverse
changes in the condition of a particular issuer. Under certain economic and/or
market conditions, a Portfolio may have difficulty disposing of certain high
yield securities due to the limited number of investors in that sector of the
market. An illiquid secondary market may adversely affect the market price of
the high yield security, which may result in increased difficulty selling the
particular issue and obtaining accurate market quotations on the issue when
valuing a Portfolio's assets. Market quotations on high yield securities are
available only from a limited number of dealers, and such quotations may not be
the actual prices available for a purchase or sale.
The high yield markets may react strongly to adverse news about an issuer
or the economy, or to the perception or expectation of adverse news, whether or
not it is based on fundamental analysis. Additionally, prices for high yield
securities may be affected by legislative and regulatory developments. These
developments could adversely affect a Portfolio's net asset value and investment
practices, the secondary market for high yield securities, the financial
condition of issuers of these securities and the value and liquidity of
outstanding high yield securities, especially in a thinly traded market. For
example, federal legislation requiring the divestiture by federally insured
savings and loan associations of their investments in high yield bonds and
limiting the deductibility of interest by certain corporate issuers of high
yield bonds adversely affected the market in recent years.
When the secondary market for high yield securities becomes more illiquid,
or in the absence of readily available market quotations for such securities,
the relative lack of reliable objective data makes it more difficult to value a
Portfolio's securities, and judgment plays a more important role in determining
such valuations. Increased illiquidity in the junk bond market, in combination
with the relative youth and growth of the market for such securities, also may
affect the ability of a Portfolio to dispose of such securities at a desirable
price. Additionally, if the secondary markets for high yield securities
contract due to adverse economic conditions or for other reasons, certain of a
Portfolio's liquid securities may become illiquid
-14-
<PAGE>
and the proportion of the Portfolio's assets invested in illiquid securities may
significantly increase.
The Low Duration Bond Portfolio may invest in securities rated "B" and
above or determined by the sub-adviser to be of comparable quality. Such
securities are considered to have the current capacity to meet interest and
principal payments, but have a greater vulnerability to default than higher
rated securities. Adverse business, financial or economic conditions will
likely impair capacity or willingness to pay interest and principal.
The rating assigned by a rating agency evaluates the safety of a non-
investment grade security's principal and interest payments, but does not
address market value risk. Because such ratings of the ratings agencies may not
always reflect current conditions and events, in addition to using recognized
rating agencies and other sources, the sub-adviser performs its own analysis of
the issuers whose non-investment grade securities the Portfolio holds. Because
of this, the Portfolio's performance may depend more on the sub-adviser's own
credit analysis than in the case of mutual funds investing in higher-rated
securities. For a description of these ratings, see Appendix A.
In selecting non-investment grade securities, the sub-adviser considers
factors such as those relating to the creditworthiness of issuers, the ratings
and performance of the securities, the protections afforded the securities and
the diversity of the Portfolio. The sub-adviser continuously monitors the
issuers of non-investment grade securities held by the Portfolio for their
ability to make required principal and interest payments, as well as in an
effort to control the liquidity of the Portfolio so that it can meet redemption
requests. If a security's rating is reduced below the minimum credit rating
that is permitted for a Portfolio, the Portfolio's sub-adviser will consider
whether the Portfolio should continue to hold the security.
In the event that a Portfolio investing in high yield securities
experiences an unexpected level of net redemptions, the Portfolio could be
forced to sell its holdings without regard to the investment merits, thereby
decreasing the assets upon which the Portfolio's rate of return is based.
The costs attributable to investing in the high yield markets are usually
higher for several reasons, such as higher investment research costs and higher
commission costs.
WHEN-ISSUED PURCHASES AND FORWARD COMMITMENTS. The Portfolios may enter
into "when-issued" and "forward" commitments, including "TBA" (to be announced)
purchase commitments, to purchase or sell securities at a fixed price at a
-15-
<PAGE>
future date. When a Portfolio agrees to purchase securities on this basis, the
custodian will set aside liquid assets equal to the amount of the commitment in
a separate account. Normally, the custodian will set aside portfolio securities
to satisfy a purchase commitment, and in such a case the Portfolio may be
required subsequently to place additional assets in the separate account in
order to ensure that the value of the account remains equal to the amount of the
Portfolio's commitments. It may be expected that the market value of a
Portfolio's net assets will fluctuate to a greater degree when it sets aside
portfolio securities to cover such purchase commitments than when it sets aside
cash. Because a Portfolio's liquidity and ability to manage its portfolio might
be affected when it sets aside cash or portfolio securities to cover such
purchase commitments, each Portfolio expects that its forward commitments and
commitments to purchase when-issued or TBA securities will not exceed 25% of the
value of its total assets absent unusual market conditions.
If deemed advisable as a matter of investment strategy, a Portfolio may
dispose of or renegotiate a commitment after it has been entered into, and may
sell securities it has committed to purchase before those securities are
delivered to the Portfolio on the settlement date. In these cases the Portfolio
may realize a taxable capital gain or loss.
When a Portfolio engages in when-issued, TBA or forward commitment
transactions, it relies on the other party to consummate the trade. Failure of
such party to do so may result in the Portfolio's incurring a loss or missing an
opportunity to obtain a price considered to be advantageous.
The market value of the securities underlying a commitment to purchase
securities, and any subsequent fluctuations in their market value, is taken into
account when determining the market value of a Portfolio starting on the day the
Portfolio agrees to purchase the securities. The Portfolio does not earn
interest on the securities it has committed to purchase until they are paid for
and delivered on the settlement date.
RIGHTS OFFERINGS AND WARRANTS TO PURCHASE. Each equity Portfolio (except
the Index Master Portfolio) and the Balanced Portfolio may participate in rights
offerings and may purchase warrants, which are privileges issued by corporations
enabling the owners to subscribe to and purchase a specified number of shares of
the corporation at a specified price during a specified period of time.
Subscription rights normally have a short life span to expiration. The purchase
of rights or warrants involves the risk that a Portfolio could lose the purchase
value of a right or warrant if the right to subscribe to additional shares is
not exercised prior to the rights' and warrants' expiration. Also, the purchase
of rights and/or warrants involves the risk that the effective price paid for
the right and/or warrant added
-16-
<PAGE>
to the subscription price of the related security may exceed the value of the
subscribed security's market price such as when there is no movement in the
level of the underlying security. A Portfolio will not invest more than 5% of
its net assets, taken at market value, in warrants, or more than 2% of its net
assets, taken at market value, in warrants not listed on the New York or
American Stock Exchanges. Warrants acquired by a Portfolio in units or attached
to other securities are not subject to this restriction.
FOREIGN CURRENCY TRANSACTIONS. Forward foreign currency exchange contracts
involve an obligation to purchase or sell a specified currency at a future date
at a price set at the time of the contract. Forward currency contracts do not
eliminate fluctuations in the values of portfolio securities but rather allow a
Portfolio to establish a rate of exchange for a future point in time. A
Portfolio may use forward foreign currency exchange contracts to hedge against
movements in the value of foreign currencies (including the "ECU" used in the
European Community) relative to the U.S. dollar in connection with specific
portfolio transactions or with respect to portfolio positions. A Portfolio may
enter into forward foreign currency exchange contracts when deemed advisable by
its adviser or sub-adviser under two circumstances. First, when entering into a
contract for the purchase or sale of a security, a Portfolio may enter into a
forward foreign currency exchange contract for the amount of the purchase or
sale price to protect against variations, between the date the security is
purchased or sold and the date on which payment is made or received, in the
value of the foreign currency relative to the U.S. dollar or other foreign
currency.
Second, when a Portfolio's adviser or sub-adviser anticipates that a
particular foreign currency may decline relative to the U.S. dollar or other
leading currencies, in order to reduce risk, the Portfolio may enter into a
forward contract to sell, for a fixed amount, the amount of foreign currency
approximating the value of some or all of the Portfolio's securities denominated
in such foreign currency. With respect to any forward foreign currency
contract, it will not generally be possible to match precisely the amount
covered by that contract and the value of the securities involved due to the
changes in the values of such securities resulting from market movements between
the date the forward contract is entered into and the date it matures. In
addition, while forward contracts may offer protection from losses resulting
from declines in the value of a particular foreign currency, they also limit
potential gains which might result from increases in the value of such currency.
A Portfolio will also incur costs in connection with forward foreign currency
exchange contracts and conversions of foreign currencies and U.S. dollars.
-17-
<PAGE>
A Portfolio may also engage in proxy hedging transactions to reduce the
effect of currency fluctuations on the value of existing or anticipated holdings
of portfolio securities. Proxy hedging is often used when the currency to which
the Portfolio is exposed is difficult to hedge or to hedge against the dollar.
Proxy hedging entails entering into a forward contract to sell a currency whose
changes in value are generally considered to be linked to a currency or
currencies in which some or all of the Portfolio's securities are, or are
expected to be, denominated, and to buy U.S. dollars. Proxy hedging involves
some of the same risks and considerations as other transactions with similar
instruments. Currency transactions can result in losses to the Portfolio if the
currency being hedged fluctuates in value to a degree or in a direction that is
not anticipated. In addition, there is the risk that the perceived linkage
between various currencies may not be present or may not be present during the
particular time that a Portfolio is engaging in proxy hedging. A Portfolio may
also cross-hedge currencies by entering into forward contracts to sell one or
more currencies that are expected to decline in value relative to other
currencies to which the Portfolio has or in which the Portfolio expects to have
portfolio exposure. For example, a Portfolio may hold both French government
bonds and German government bonds, and the Adviser or Sub-Adviser may believe
that French francs will deteriorate against German marks. The Portfolio would
sell French francs to reduce its exposure to that currency and buy German marks.
This strategy would be a hedge against a decline in the value of French francs,
although it would expose the Portfolio to declines in the value of the German
mark relative to the U.S. dollar.
In general, currency transactions are subject to risks different from those
of other portfolio transactions, and can result in greater losses to a Portfolio
than would otherwise be incurred, even when the currency transactions are used
for hedging purposes.
A separate account of a Portfolio consisting of liquid assets equal to the
amount of the Portfolio's assets that could be required to consummate forward
contracts entered into under the second circumstance, as set forth above, will
be established with the Fund's custodian. For the purpose of determining the
adequacy of the securities in the account, the deposited securities will be
valued at market or fair value. If the market or fair value of such securities
declines, additional cash or securities will be placed in the account daily so
that the value of the account will equal the amount of such commitments by the
Portfolio.
OPTIONS. Options trading is a highly specialized activity which entails
greater than ordinary investment risks. Options on particular securities may be
more volatile than the underlying
-18-
<PAGE>
securities, and therefore, on a percentage basis, an investment in the
underlying securities themselves. A Portfolio will write call options only if
they are "covered." In the case of a call option on a security, the option is
"covered" if a Portfolio owns the security underlying the call or has an
absolute and immediate right to acquire that security without additional cash
consideration (or, if additional cash consideration is required, liquid assets
in such amount as are held in a segregated account by its custodian) upon
conversion or exchange of other securities held by it. For a call option on an
index, the option is covered if a Portfolio maintains with its custodian liquid
assets equal to the contract value. A call option is also covered if a
Portfolio holds a call on the same security or index as the call written where
the exercise price of the call held is (i) equal to or less than the exercise
price of the call written, or (ii) greater than the exercise price of the call
written provided the difference is maintained by the Portfolio in liquid assets
in a segregated account with its custodian.
When a Portfolio purchases a put option, the premium paid by it is recorded
as an asset of the Portfolio. When a Portfolio writes an option, an amount
equal to the net premium (the premium less the commission) received by the
Portfolio is included in the liability section of the Portfolio's statement of
assets and liabilities as a deferred credit. The amount of this asset or
deferred credit will be subsequently marked-to-market to reflect the current
value of the option purchased or written. The current value of the traded
option is the last sale price or, in the absence of a sale, the mean between the
last bid and asked prices. If an option purchased by a Portfolio expires
unexercised the Portfolio realizes a loss equal to the premium paid. If the
Portfolio enters into a closing sale transaction on an option purchased by it,
the Portfolio will realize a gain if the premium received by the Portfolio on
the closing transaction is more than the premium paid to purchase the option, or
a loss if it is less. If an option written by a Portfolio expires on the
stipulated expiration date or if the Portfolio enters into a closing purchase
transaction, it will realize a gain (or loss if the cost of a closing purchase
transaction exceeds the net premium received when the option is sold) and the
deferred credit related to such option will be eliminated. If an option written
by a Portfolio is exercised, the proceeds of the sale will be increased by the
net premium originally received and the Portfolio will realize a gain or loss.
There are several risks associated with transactions in options on
securities and indexes. For example, there are significant differences between
the securities and options markets that could result in an imperfect correlation
between these markets, causing a given transaction not to achieve its
objectives. In addition, a liquid secondary market for particular options,
whether traded over-the-counter or on a
-19-
<PAGE>
national securities exchange ("Exchange") may be absent for reasons which
include the following: there may be insufficient trading interest in certain
options; restrictions may be imposed by an Exchange on opening transactions or
closing transactions or both; trading halts, suspensions or other restrictions
may be imposed with respect to particular classes or series of options or
underlying securities; unusual or unforeseen circumstances may interrupt normal
operations on an Exchange; the facilities of an Exchange or the Options Clearing
Corporation may not at all times be adequate to handle current trading volume;
or one or more Exchanges could, for economic or other reasons, decide or be
compelled at some future date to discontinue the trading of options (or a
particular class or series of options), in which event the secondary market on
that Exchange (or in that class or series of options) would cease to exist,
although outstanding options that had been issued by the Options Clearing
Corporation as a result of trades on that Exchange would continue to be
exercisable in accordance with their terms.
FUTURES CONTRACTS AND RELATED OPTIONS. Each Non-Money Market Portfolio
(including the Index Master Portfolio) may invest in futures contracts and
options thereon (interest rate futures contracts or index futures contracts, as
applicable). These instruments are described in Appendix B to this Statement of
Additional Information.
STAND-BY COMMITMENTS. Under a stand-by commitment for a Municipal
Obligation, a dealer agrees to purchase at the Portfolio's option a specified
Municipal Obligation at a specified price. Stand-by commitments for Municipal
Obligations may be exercisable by a Portfolio at any time before the maturity of
the underlying Municipal Obligations and may be sold, transferred or assigned
only with the instruments involved. It is expected that such stand-by
commitments will generally be available without the payment of any direct or
indirect consideration. However, if necessary or advisable, a Portfolio may pay
for such a stand-by commitment either separately in cash or by paying a higher
price for Municipal Obligations which are acquired subject to the commitment for
Municipal Obligations (thus reducing the yield to maturity otherwise available
for the same securities). The total amount paid in either manner for
outstanding stand-by commitments for Municipal Obligations held by a Portfolio
will not exceed 1/2 of 1% of the value of such Portfolio's total assets
calculated immediately after each stand-by commitment is acquired.
Stand-by commitments will only be entered into with dealers, banks and
broker-dealers which, in a sub-adviser's opinion, present minimal credit risks.
A Portfolio will acquire stand-by commitments solely to facilitate portfolio
liquidity and not to exercise its rights thereunder for trading purposes.
Stand-by commitments will be valued at zero in determining net asset
-20-
<PAGE>
value. Accordingly, where a Portfolio pays directly or indirectly for a stand-
by commitment, its cost will be reflected as an unrealized loss for the period
during which the commitment is held by such Portfolio and will be reflected as a
realized gain or loss when the commitment is exercised or expires.
TAX-EXEMPT DERIVATIVES. The Municipal Money Market Portfolios and the Tax-
Free Income, Ohio Tax-Free Income, Pennsylvania Tax-Free Income and New Jersey
Tax-Free Income Portfolios (collectively, the "Money and Non-Money Market
Municipal Portfolios") may hold tax-exempt derivatives which may be in the form
of tender option bonds, participations, beneficial interests in a trust,
partnership interests or other forms. A number of different structures have
been used. For example, interests in long-term fixed-rate municipal debt
obligations, held by a bank as trustee or custodian, are coupled with tender
option, demand and other features when the tax-exempt derivatives are created.
Together, these features entitle the holder of the interest to tender (or put)
the underlying municipal debt obligation to a third party at periodic intervals
and to receive the principal amount thereof. In some cases, municipal debt
obligations are represented by custodial receipts evidencing rights to receive
specific future interest payments, principal payments, or both, on the
underlying securities held by the custodian. Under such arrangements, the
holder of the custodial receipt has the option to tender the underlying
securities at their face value to the sponsor (usually a bank or broker dealer
or other financial institution), which is paid periodic fees equal to the
difference between the securities' fixed coupon rate and the rate that would
cause the securities, coupled with the tender option, to trade at par on the
date of a rate adjustment. The Money and Non-Money Market Municipal Portfolios
may hold tax-exempt derivatives, such as participation interests and custodial
receipts, for municipal debt obligations which give the holder the right to
receive payment of principal subject to the conditions described above. The
Internal Revenue Service has not ruled on whether the interest received on tax-
exempt derivatives in the form of participation interests or custodial receipts
is tax-exempt, and accordingly, purchases of any such interests or receipts are
based on the opinions of counsel to the sponsors of such derivative securities.
Neither the Fund nor its investment adviser or sub-advisers will review the
proceedings related to the creation of any tax-exempt derivatives or the basis
for such opinions.
SECURITIES LENDING. A Portfolio would continue to accrue interest on
loaned securities and would also earn income on investment collateral for such
loans. Any cash collateral received by a Portfolio in connection with such
loans may be invested in a broad range of high quality, U.S. dollar-denominated
money market instruments that meet Rule 2a-7 restrictions for money market
funds. Specifically, cash
-21-
<PAGE>
collateral may be invested in any of the following instruments: (a) securities
issued or guaranteed as to principal and interest by the U.S. Government or by
its agencies or instrumentalities and related custodial receipts; (b) "first
tier" quality commercial paper and other obligations issued or guaranteed by
U.S. and foreign corporations and other issuers rated (at the time of purchase)
in the highest rating category by at least two NRSRO's, or one if only rated by
one NRSRO; (c) U.S. dollar-denominated obligations issued or supported by the
credit of U.S. or foreign banks or savings institutions with total assets in
excess of $1 billion (including obligations of foreign branches of such banks)
(i.e. CD's, BA's and time deposits); (d) repurchase agreements relating to the
above instruments, as well as corporate debt; and (e) unaffiliated money market
funds. Any such investments must be rated "first tier" and must have a maturity
of 397 days or less from the date of purchase.
While the Index Master Portfolio may earn additional income from lending
securities, such activity is incidental to the investment objective of the Index
Master Portfolio. The value of securities loaned may not exceed 33 1/3% of the
value of the Index Master Portfolio's total assets. In connection with such
loans, the Index Master Portfolio will receive collateral consisting of cash or
U.S. Government securities, which will be maintained at all times in an amount
equal to at least 100% of the current market value of the loaned securities. In
addition, the Index Master Portfolio will be able to terminate the loan at any
time, will receive reasonable interest on the loan, as well as amounts equal to
any dividends, interest or other distributions on the loaned securities. In the
event of the bankruptcy of the borrower, the Trust could experience delay in
recovering the loaned securities. Management of the Trust believes that this
risk can be controlled through careful monitoring procedures.
YIELDS AND RATINGS. The yields on certain obligations are dependent on a
variety of factors, including general market conditions, conditions in the
particular market for the obligation, the financial condition of the issuer, the
size of the offering, the maturity of the obligation and the ratings of the
issue. The ratings of Moody's, Duff & Phelps Credit Co. ("Duff & Phelps"),
Fitch Investor Services, Inc. ("Fitch") and S&P represent their respective
opinions as to the quality of the obligations they undertake to rate. Ratings,
however, are general and are not absolute standards of quality. Consequently,
obligations with the same rating, maturity and interest rate may have different
market prices. Subsequent to its purchase by a Portfolio, a rated security may
cease to be rated. A Portfolio's adviser or sub-adviser will consider such an
event in determining whether the Portfolio should continue to hold the security.
-22-
<PAGE>
INTEREST RATE TRANSACTIONS AND CURRENCY SWAPS. The Bond Portfolios may
enter into interest rate swaps, caps and floors on either an asset-based or
liability-based basis, depending on whether a Portfolio is hedging its assets or
its liabilities. Interest rate swaps involve the exchange by a Portfolio with
another party of their respective commitments to pay or receive interest (e.g.,
an exchange of floating rate payments for fixed rate payments). The purchase of
an interest rate floor entitles the purchaser, to the extent that a specified
index falls below a predetermined interest rate, to receive payments of interest
on a notional principal amount from the party selling such interest rate floor.
The purchase of an interest rate cap entitles the purchaser, to the extent that
a specified index exceeds a predetermined interest rate, to receive payments of
interest on a notional principal amount from the party selling such interest
rate cap. The International Bond Portfolio may also enter into currency swaps,
which involve the exchange of the rights of a Portfolio and another party to
make or receive payments in specified currencies.
A Portfolio will usually enter into interest rate swaps on a net basis,
i.e., the two payment streams are netted out, with the Portfolio receiving or
paying, as the case may be, only the net amount of the two payments. In
contrast, currency swaps usually involve the delivery of the entire principal
value of one designated currency in exchange for the other designated currency.
A Portfolio will accrue the net amount of the excess, if any, of its
obligations over its entitlements with respect to each interest rate or currency
swap on a daily basis and will deliver an amount of liquid assets having an
aggregate net asset value at least equal to the accrued excess to a custodian
that satisfies the requirements of the 1940 Act. If the other party to an
interest rate swap defaults, a Portfolio's risk of loss consists of the net
amount of interest payments that the Portfolio is contractually entitled to
receive. Because currency swaps usually involve the delivery of the entire
principal value of one designated currency in exchange for the other designated
currency, the entire principal value of a currency swap is subject to the risk
that the other party to the swap will default on its contractual delivery
obligations. A Portfolio will not enter into any interest rate or currency swap
unless the unsecured commercial paper, senior debt or claims paying ability of
the other party is rated either "A" or "A-1" or better by S&P, Duff & Phelps or
Fitch, or "A" or "P-1" or better by Moody's.
A Portfolio will enter into currency or interest rate swap, cap and floor
transactions only with institutions deemed the creditworthy by the Portfolio's
adviser or sub-adviser. If there is a default by the other party to such a
transaction, a
-23-
<PAGE>
Portfolio will have contractual remedies pursuant to the agreements related to
the transaction. The swap market has grown substantially in recent years with a
large number of banks and investment banking firms acting both as principals and
as agents utilizing standardized swap documentation. As a result, the swap
market has become relatively liquid. Caps and floors are more recent innovations
and, accordingly, they are less liquid than swaps.
INVESTMENT COMPANIES. Each Portfolio, other than the Index Equity
Portfolio, currently intends to limit its investments so that, as determined
immediately after a securities purchase is made: (i) not more than 5% of the
value of its total assets will be invested in the securities of any one
investment company; (ii) not more than 10% of the value of its total assets will
be invested in the aggregate in securities of investment companies as a group;
and (iii) not more than 3% of the outstanding voting stock of any one investment
company will be owned by the Portfolio or by the Fund as a whole.
SPECIAL CONSIDERATION REGARDING THE OHIO TAX-FREE INCOME PORTFOLIO. The
Ohio Tax-Free Income Portfolio will not trade its securities for the purpose of
seeking profits. For purposes of this policy, the Portfolio may vary its
portfolio securities if (i) there has been an adverse change in a security's
credit rating or in that of its issuer or in the adviser's or sub-adviser's
credit analysis of the security or its issuer; (ii) there has been, in the
opinion of the adviser and sub-adviser, a deterioration or anticipated
deterioration in general economic or market conditions affecting issuers of Ohio
Municipal Obligations, or a change or anticipated change in interest rates;
(iii) adverse changes or anticipated changes in market conditions or economic or
other factors temporarily affecting the issuers of one or more portfolio
securities make necessary or desirable the sale of such security or securities
in anticipation of the Portfolio's repurchase of the same or comparable
securities at a later date; or (iv) the adviser or sub-adviser engages in
temporary defensive strategies.
SPECIAL CONSIDERATIONS FOR STATE-SPECIFIC PORTFOLIOS
The following information regarding the State-Specific Portfolios is
derived from official statements of certain issuers published in connection with
their issuance of securities and from other publicly available information, and
is believed to be accurate. No independent verification has been made of any of
the following information.
SPECIAL CONSIDERATIONS REGARDING INVESTMENTS IN OHIO STATE-SPECIFIC
OBLIGATIONS. The Ohio Tax-Free Money Market and Ohio Tax-Free Income Portfolios
(the "Ohio Portfolios") will each invest most of its net assets in securities
issued by or on
-24-
<PAGE>
behalf of (or in certificates of participation in lease-purchase obligations of)
the State of Ohio, political subdivisions of the State, or agencies or
instrumentalities of the State or its political subdivisions ("Ohio State-
Specific Obligations"). The Ohio Portfolios are therefore susceptible to general
or particular economic, political or regulatory factors that may affect issuers
of Ohio State-Specific Obligations. The following information constitutes only a
brief summary of some of the many complex factors that may have an effect. The
information does not apply to "conduit" obligations on which the public issuer
itself has no financial responsibility.
Generally, the creditworthiness of Ohio State-Specific Obligations of local
issuers is unrelated to that of obligations of the State itself, and the State
has no responsibility to make payments on those local obligations.
There may be specific factors that at particular times apply in connection
with investment in particular Ohio State-Specific Obligations or in those
obligations of particular Ohio issuers. It is possible that the investment may
be in particular Ohio State-Specific Obligations, or in those of particular
issuers, as to which those factors apply. However, the information below is
intended only as a general summary, and is not intended as a discussion of any
specific factors that may affect any particular obligation or issuer.
Ohio is the seventh most populous state. The 1990 Census count of
10,847,000 indicated a 0.5% population increase from 1980. The Census estimate
for 1996 is 11,173,000.
While diversifying more into the service and other non-manufacturing areas,
the Ohio economy continues to rely in part on durable goods manufacturing
largely concentrated in motor vehicles and equipment, steel, rubber products and
household appliances. As a result, general economic activity, as in many other
industrially-developed states, tends to be more cyclical than in some other
states and in the nation as a whole. Agriculture is an important segment of the
economy, with over half the State's area devoted to farming and approximately
16% of total employment in agribusiness.
In prior years, the State's overall unemployment rate was commonly somewhat
higher than the national figure. For example, the reported 1990 average monthly
State rate was 5.7%, compared to the 5.5% national figure. However, for the last
six years the State rates were below the national rates (4.9% versus 5.4% in
1996). The unemployment rate and its effects vary among geographic areas of the
State.
There can be no assurance that future national, regional or state-wide
economic difficulties, and the resulting impact on
-25-
<PAGE>
State or local government finances generally, will not adversely affect the
market value of Ohio State-Specific Obligations held in the Ohio Portfolios or
the ability of particular obligors to make timely payments of debt service on
(or lease payments relating to) those Obligations.
The State operates on the basis of a fiscal biennium for its appropriations
and expenditures, and is precluded by law from ending its July 1 to June 30
fiscal year (FY) or fiscal biennium in a deficit position. Most State
operations are financed through the General Revenue Fund (GRF), for which the
personal income and sales-use taxes are the major sources. Growth and depletion
of GRF ending fund balances show a consistent pattern related to national
economic conditions, with the ending FY balance reduced during less favorable
and increased during more favorable economic periods. The State has well-
established procedures for, and has timely taken, necessary actions to ensure
resource/expenditure balances during less favorable economic periods. Those
procedures included general and selected reductions in appropriations spending.
The 1992-93 biennium presented significant challenges to State finances.
To allow time to resolve certain budget differences, an interim appropriations
act was enacted effective July 1, 1991; it included GRF debt service and lease
rental appropriations for the entire 1992-93 biennium, while continuing most
other appropriations for a month. Pursuant to the general appropriations act
for the entire biennium, passed on July 11, 1991, $200 million was transferred
from the Budget Stabilization Fund ("BSF", a cash and budgetary management fund)
to the GRF in FY 1992.
Based on updated results and forecasts in the course of that FY, both in
light of a continuing uncertain nationwide economic situation, there was
projected, and then timely addressed a FY 1992 imbalance in GRF resources and
expenditures. In response, the Governor ordered most State agencies to reduce
GRF spending in the last six months of FY 1992 by a total of approximately $184
million; the $100.4 million BSF balance and additional amounts from certain
other funds were transferred late in the FY to the GRF; and adjustments were
made in the timing of certain tax payments.
A significant GRF shortfall (approximately $520 million) was then projected
for FY 1993. It was addressed by appropriate legislative and administrative
actions, including the Governor's ordering $300 million in selected GRF spending
reductions and subsequent executive and legislative action (a combination of tax
revisions and additional spending reductions). The June 30, 1993 ending GRF
fund balance was approximately $111 million, of which, as a first step to BSF
replenishment, $21 million was deposited in the BSF.
-26-
<PAGE>
None of the spending reductions were applied to appropriations needed for
debt service on or lease rentals relating to any State obligations.
The 1994-95 biennium presented a more affirmative financial picture. Based
on June 30, 1994 balances, an additional $260 million was deposited in the BSF.
The biennium ended June 30, 1995 with a GRF ending fund balance of $928 million,
of which $535.2 million was transferred into the BSF. The significant GRF fund
balance, after leaving in the GRF an unreserved and undesignated balance of $70
million, was transferred to the BSF and other funds including school assistance
funds and, in anticipation of possible federal program changes, a human services
stabilization fund.
From a higher than forecast 1996-97 mid-biennium GRF fund balance, $100
million was transferred for elementary and secondary school computer network
purposes and $30 million to a new State transportation infrastructure fund.
Approximately $400.8 million served as a basis for temporary 1996 personal
income tax reductions aggregating that amount. The 1996-97 biennium-ending GRF
fund balance was $834.9 million. Of that, $250 million goes to school building
construction and renovation, $94 million to the school computer network, $44.2
million for school textbooks and instructional materials and a distance learning
program, and $34 million to the BSF (which had a December 30, 1997 balance of
$862.7 million), with the $263 million balance to a State income tax reduction
fund.
The GRF appropriations act for the current 1997-98 biennium was passed on
June 25, 1997 and promptly signed (after selective vetoes) by the Governor. All
necessary GRF appropriations for State debt service and lease rental payments
then projected for the biennium were included in that act.
The State's incurrence or assumption of debt without a vote of the people
is, with limited exceptions, prohibited by current State constitutional
provisions. The State may incur debt, limited in amount to $750,000, to cover
casual deficits or failures in revenues or to meet expenses not otherwise
provided for. The Constitution expressly precludes the State from assuming the
debts of any local government or corporation. (An exception is made in both
cases for any debt incurred to repel invasion, suppress insurrection or defend
the State in war.)
By 14 constitutional amendments approved from 1921 to date (the latest
adopted in 1995), Ohio voters authorized the incurrence of State debt and the
pledge of taxes or excises to its payment. At December 30, 1997, $948 million
(excluding certain highway bonds payable primarily from highway use receipts) of
this debt was outstanding. The only such State debt at that date still
authorized to be incurred were portions of the
-27-
<PAGE>
highway bonds, and the following: (a) up to $100 million of obligations for coal
research and development may be outstanding at any one time ($30.9 million
outstanding); (b) $240 million of obligations authorized for local
infrastructure improvements, no more than $120 million of which may be issued in
any calendar year ($826.8 million outstanding); and (c) up to $200 million in
general obligation bonds for parks, recreation and natural resources purposes
which may be outstanding at any one time ($90.9 million outstanding, with no
more than $50 million to be issued in any one year).
The electors in 1995 approved a constitutional amendment extending the
local infrastructure bond program (authorizing an additional $1.2 billion of
State full faith and credit obligations to be issued over 10 years for the
purpose), and authorizing additional highway bonds (expected to be payable
primarily from highway use receipts). The latter supersedes the prior $500
million outstanding authorization, and authorizes not more than $1.2 billion to
be outstanding at any time and not more than $220 million to be issued in a
fiscal year.
The Constitution also authorizes the issuance of State obligations for
certain purposes, the owners of which do not have the right to have excises or
taxes levied to pay debt service. Those special obligations include obligations
issued by the Ohio Public Facilities Commission and the Ohio Building Authority,
and certain obligations issued by the State Treasurer, over $4.8 billion of
which were outstanding or sold and awaiting delivery at December 30, 1997.
A 1990 constitutional amendment authorizes greater State and political
subdivision participation (including financing) in the provision of housing.
The General Assembly may for that purpose authorize the issuance of State
obligations secured by a pledge of all or such portion as it authorizes of State
revenues or receipts (but not by a pledge of the State's full faith and credit).
A 1994 constitutional amendment pledges the full faith and credit and
taxing power of the State to meeting certain guarantees under the State's
tuition credit program which provides for purchase of tuition credits, for the
benefit of State residents, guaranteed to cover a specified amount when applied
to the cost of higher education tuition. (A 1965 constitutional provision that
authorized student loan guarantees payable from available State moneys has never
been implemented, apart from a "guarantee fund" approach funded essentially
from program revenues.)
State and local agencies issue obligations that are payable from revenues
from or relating to certain facilities (but not
-28-
<PAGE>
from taxes). By judicial interpretation, these obligations are not "debt" within
constitutional provisions. In general, payment obligations under lease-purchase
agreements of Ohio public agencies (in which certificates of participation may
be issued) are limited in duration to the agency's fiscal period, and are
renewable only upon appropriations being made available for the subsequent
fiscal period.
Local school districts in Ohio receive a major portion (state-wide
aggregate approximately 44% in recent years) of their operating moneys from
State subsidies, but are dependent on local property taxes, and in 119 districts
from voter-authorized income taxes, for significant portions of their budgets.
Litigation, similar to that in other states, is pending questioning the
constitutionality of Ohio's system of school funding. The Ohio Supreme Court
has recently concluded that aspects of the system (including basic operating
assistance and the loan program referred to below) are unconstitutional, and
ordered the State to provide for and fund a system complying with the Ohio
Constitution, staying its order for a year (to March 1998) to permit time for
responsive corrective actions. A small number of the State's 612 local school
districts have in any year required special assistance to avoid year-end
deficits. A program has provided for school district cash need borrowing
directly from commercial lenders, with diversion of State subsidy distributions
to repayment if needed. Recent borrowings under this program totalled $41.1
million for 28 districts in FY 1994, and $71.1 million for 29 districts in FY
1995 (including $29.5 million for one), $87.2 million for 20 districts in fiscal
year 1996 (including $42.1 million for one), and $113.2 million for 12 districts
in 1997 (including $90 million to one for restructuring its prior loans).
Ohio's 943 incorporated cities and villages rely primarily on property and
municipal income taxes for their operations. With other subdivisions, they also
receive local government support and property tax relief moneys distributed by
the State.
For those few municipalities and school districts that on occasion have
faced significant financial problems, there are statutory procedures for a joint
State/local commission to monitor the fiscal affairs and for development of a
financial plan to eliminate deficits and cure any defaults. (Similar procedures
have recently been extended to counties and townships.) Since inception for
municipalities in 1979, these "fiscal emergency" procedures have been applied to
24 cities and villages; for 18 of them the fiscal situation was resolved and the
procedures terminated (one village is in preliminary "fiscal watch" status). As
of January 5, 1998, the 1996 school district "fiscal emergency" provision had
been applied to five districts, and ten were on preliminary "fiscal watch"
status.
-29-
<PAGE>
At present the State itself does not levy ad valorem taxes on real or
tangible personal property. Those taxes are levied by political subdivisions
and other local taxing districts. The Constitution has since 1934 limited to 1%
of true value in money the amount of the aggregate levy (including a levy for
unvoted general obligations) of property taxes by all overlapping subdivisions,
without a vote of the electors or a municipal charter provision, and statutes
limit the amount of that aggregate levy to 10 mills per $1 of assessed valuation
(commonly referred to as the "ten-mill limitation"). Voted general obligations
of subdivisions are payable from property taxes that are unlimited as to amount
or rate.
SPECIAL CONSIDERATIONS REGARDING INVESTMENT IN PENNSYLVANIA STATE-SPECIFIC
OBLIGATIONS. The concentration of investments in Pennsylvania State-Specific
Obligations by the Pennsylvania Municipal Money Market and Pennsylvania Tax-Free
Income Portfolios raises special investment considerations. In particular,
changes in the economic condition and governmental policies of the Commonwealth
of Pennsylvania and its municipalities could adversely affect the value of those
Portfolios and their portfolio securities. This section briefly describes
current economic trends in Pennsylvania.
Pennsylvania has historically been dependent on heavy industry, although
recent declines in the coal, steel and railroad industries have led to
diversification of the Commonwealth's economy. Recent sources of economic
growth in Pennsylvania are in the service sector, including trade, medical and
health services, education and financial institutions. Agriculture continues to
be an important component of the Commonwealth's economic structure, with nearly
one-third of the Commonwealth's total land area devoted to cropland, pasture and
farm woodlands.
The population of Pennsylvania experienced a slight increase in the period
1987 through 1996, and has a high proportion of persons 65 or older. The
Commonwealth is highly urbanized, with almost 79% of the 1990 census population
residing in metropolitan statistical areas. The two largest metropolitan
statistical areas, those containing the Cities of Philadelphia and Pittsburgh,
together comprise approximately 44% of the Commonwealth's total population.
The Commonwealth utilizes the fund method of accounting and over 150 funds
have been established for purposes of recording receipts and disbursements of
the Commonwealth, of which the General Fund is the largest. Most of the
Commonwealth's operating and administrative expenses are payable from the
General Fund. The major tax sources for the General Fund are the sales tax, the
personal income tax and the corporate net income tax. Major expenditures of the
Commonwealth include
-30-
<PAGE>
funding for education, public health and welfare and transportation.
The constitution of the Commonwealth provides that operating budget
appropriations of the Commonwealth may not exceed the estimated revenues and
available surplus in the fiscal year for which funds are appropriated. Annual
budgets are enacted for the General Fund (the principal operating fund of the
Commonwealth) and for certain special revenue funds which together represent the
majority of expenditures of the Commonwealth. Although a negative balance was
experienced applying generally accepted accounting principles ("GAAP") in the
General Fund for fiscal 1990 and 1991, tax increases and spending decreases have
resulted in surpluses in subsequent years; and as of June 30, 1996, the General
Fund had a surplus of $635.2 million. The deficit in the Commonwealth's
unreserved/undesignated funds also had been eliminated.
Certain litigation is pending against the Commonwealth that could adversely
affect the ability of the Commonwealth to pay debt service on its obligations
including suits relating to the following matters: (a) the ACLU has filed suit
in Federal court demanding additional funding for child welfare services; the
Commonwealth settled a similar suit in the Commonwealth Court of Pennsylvania
and is seeking the dismissal of the federal suit, inter alia, because of that
----- ----
settlement. After its earlier denial was reversed by the Third Circuit Court of
Appeals, the district court granted class certification to the ACLU, and the
parties are proceeding with discovery; (b) in 1987, the Supreme Court of
Pennsylvania held the statutory scheme for county funding of the judicial system
to be in conflict with the constitution of the Commonwealth, but stayed judgment
pending enactment by the legislature of funding consistent with the opinion, and
the legislature has yet to consider legislation implementing the judgment. In
1992, a new action in mandamus was filed seeking to compel the Commonwealth to
comply with the original decision; (c) litigation has been filed in both state
and Federal court by an association of rural and small schools and several
individual school districts and parents challenging the constitutionality of the
Commonwealth's system for funding local school districts --the Federal case has
been stayed pending resolution of the state case. Trial of the state case was
completed in September 1997 and a decision is pending; and (d) both the
Commonwealth and the City of Philadelphia are involved in cases currently before
the Pennsylvania Supreme Court that may result in their being required to fund
remedies for the unintentional racial segregation in the Philadelphia public
schools.
The City of Philadelphia (the "City") experienced severe financial
difficulties during the early 1990's which impaired its access to public credit
markets. The City experienced a
-31-
<PAGE>
series of General Fund deficits for fiscal years 1988 through 1992. Legislation
was enacted in 1991 to create an Intergovernmental Cooperation Authority (the
"Authority") to provide deficit reduction financing and fiscal oversight for
Philadelphia. In order for the Authority to issue bonds on behalf of the City,
the City and the Authority entered into an intergovernmental cooperation
agreement providing the Authority with certain oversight powers with respect to
the fiscal affairs of the City. Philadelphia currently is operating under a five
year plan approved by the Authority on May 20, 1997. The unaudited balance of
the City's General Fund as of June 30, 1997 was approximately $120.0
million.
The Authority's power to issue further bonds to finance capital projects or
deficit expired on December 31, 1994, and its power to issue debt to finance a
cash flow deficit expired December 31, 1996. Its ability to refund outstanding
bonds is unrestricted. The Authority had $1,102.4 million in special revenue
bonds outstanding as of June 30, 1997.
Most recently, Moody's has rated the long-term general obligation bonds of
the Commonwealth "Aa3," Standard & Poor's has rated such bonds "AA-" and Fitch
has rated such bonds "AA." There can be no assurance that the economic
conditions on which these ratings are based will continue or that particular
bond issues may not be adversely affected by changes in economic or political
conditions.
SPECIAL CONSIDERATIONS REGARDING INVESTMENT IN NORTH CAROLINA STATE-
SPECIFIC OBLIGATIONS. The concentration of investments in North Carolina State-
Specific Obligations by the North Carolina Municipal Money Market Portfolio
raises special investment considerations. In particular, changes in the
economic condition and governmental policies of North Carolina and its political
subdivisions, agencies, instrumentalities, and authorities could adversely
affect the value of the Portfolio and its portfolio securities. This section
briefly describes current economic trends in North Carolina.
The State of North Carolina has three major operating funds: the General
Fund, the Highway Fund and the Highway Trust Fund. North Carolina derives most
of its revenue from taxes, including individual income tax, corporation income
tax, sales and use taxes, corporation franchise tax, alcoholic beverage tax,
insurance tax, inheritance tax, tobacco products tax and soft drink tax
(currently being phased out). North Carolina receives other non-tax revenues
which are also deposited in the General Fund. The most important are Federal
funds collected by North Carolina agencies, university fees and tuition,
interest earned by the North Carolina Treasurer on investments of General Fund
moneys and revenues from the judicial branch. The proceeds from
-32-
<PAGE>
the motor fuel tax, highway use tax and motor vehicle license tax are deposited
in the Highway Fund and the Highway Trust Fund.
Fiscal year 1996 ended with a positive General Fund balance of
approximately $573.4 million. An additional $153.1 million was available from a
reserved fund balance. Of this aggregate amount, $77.3 million was reserved in
the Savings Reserve (bringing the total reserve to $500.9 million) and $130.0
million was reserved in the Reserve for Repair and Renovation of State
Facilities (bringing the total reserve to $151.3 million after prior
withdrawals). An additional $47.1 million was transferred to a newly-created
Clean Water Management Trust Fund, $39.5 million was reserved in a Capital
Improvement Reserve, and $26.2 million was transferred to newly-created Federal
Retiree Refund and Administration Accounts, leaving an unreserved General Fund
balance at June 30, 1996 of approximately $406.1 million.
Fiscal year 1997 ended with a positive General Fund balance of
approximately $874.8 million. Along with additional reserves, $135 million was
reserved in the Reserve for Repair and Renovation of State Facilities, in
addition to a supplemental reserve of $39.3 million for repairs and renovations
(bringing the total reserve to $221.2 million after prior withdrawals). An
additional $49.4 million was transferred to the Clean Water Management Trust
Fund (bringing the total reserve to $49.4 million after prior withdrawals) and
$115 million and $156 million were reserved in newly-created Disaster Relief and
Intangible Tax Refund Reserves, respectively. The Disaster Relief Reserve was
used to cover disaster relief funds spent during fiscal year 1997. An
additional $61 million was reserved for the State to acquire the shares of the
North Carolina Railroad Company not held by the State. No additional amounts
were transferred to the Savings Reserve for the year (the existing balance of
$500.9 million having met the statutory reserve requirements). After additional
reserves, the unreserved General Fund balance at the end of fiscal year 1997 was
approximately $318.7 million.
The foregoing results are presented on a budgetary basis. Accounting
principles applied to develop data on a budgetary basis differ significantly
from those principles used to present financial statements in conformity with
generally accepted accounting principles (GAAP). Based on a modified accrual
basis (GAAP), the General Fund balance at June 30, 1996 and 1997 was $1,422.1
million and $1,703.9 million, respectively.
On August 28, 1997, the North Carolina General Assembly adopted the
biennium budget for 1997 to 1999. The $11.4 billion budget for fiscal year 1998
included a 7.6% increase in spending over the fiscal year 1997 budget.
Highlights of the new budget
-33-
<PAGE>
included increased spending for education, with $181 million in funding for
teacher pay raises averaging 6.5% and $92 million to implement the newly-enacted
Excellent Schools Act, which raises teacher salaries to the national average
over four years and requires teachers at low-performing schools to pass
competency tests. Money was also reserved for schools that achieve or surpass
academic goals, school technology funds, new school buses, staff development
programs, community college job training programs, and other education purposes.
The General Assembly also passed a welfare reform program, adopted a streamlined
process for cleaning up brownfields for reuse as industrial and commercial
sites, and cut the North Carolina sales tax on food by 1% beginning in
1998.
The General Assembly adjusted downward the General Fund appropriation
support for the continuation budgets by $425.4 million and $242.2 million in
fiscal years 1998 and 1998, respectively, and authorized continuation funding of
$10,439.4 million for fiscal year 1998 and $10,957.5 million for fiscal year
1999. The adjustments included reductions of expenditures resulting from
supporting revenues sources being reclassified from tax and nontax revenues to
departmental receipts, increases in departmental receipts and federal receipts,
reductions of projected operating costs, and other efficiencies and savings.
Increases of $798.7 million for fiscal year 1998 and $574.5 million for fiscal
year 1999 were approved for operating budgets.
The North Carolina budget is based upon a number of existing and assumed
State and non-State factors, including State and national economic conditions,
international activity, Federal government policies and legislation and the
activities of the State's General Assembly. Such factors are subject to change
which may be material and affect the budget. The Congress of the United States
is considering a number of matters affecting the federal government's
relationship with State governments that, if enacted into law, could affect
fiscal and economic policies of the states, including North Carolina.
During recent years North Carolina has moved from an agricultural to a
service and goods producing economy. According to the North Carolina Employment
Security Commission (the "Commission"), in July 1997, North Carolina ranked
tenth among the states in non-agricultural employment and eighth in
manufacturing employment. The Commission estimated North Carolina's seasonally
adjusted unemployment rate in November 1997 to be 3.5% of the labor force, as
compared with an unemployment rate of 4.6% nationwide.
The following are certain cases pending in which the State of North
Carolina faces the risk of either a loss of revenue or an unanticipated
expenditure which, in the opinion of the North Carolina Department of State
Treasurer, would not materially
-34-
<PAGE>
adversely affect the State's ability to meet its financial obligations:
1. Swanson v. State of North Carolina and Patton v. State of North
Carolina -- State Tax Refunds - Federal Retirees. In Davis v. Michigan (1989),
-----------------
the United States Supreme Court ruled that a Michigan income tax statute which
taxed federal retirement benefits while exempting those paid by state and local
governments violated the constitutional doctrine of intergovernmental tax
immunity. At the time of the Davis decision, North Carolina law contained
-----
similar exemptions in favor of state and local retirees. Those exemptions were
repealed prospectively, beginning with the 1989 tax year. All public pension and
retirement benefits are now entitled to a $4,000 annual exclusion.
Following Davis, federal retirees filed a class action suit in federal
-----
court in 1989 seeking damages equal to the North Carolina income tax paid on
federal retirement income by the class members (Swanson). A companion suit was
-------
filed in state court in 1990. The complaints alleged that the amount in
controversy exceeded $140 million. The North Carolina Department of Revenue
estimate of refunds and interest liability is $280.89 million as of June 30,
1994. In 1991, the North Carolina Supreme Court ruled in favor of the State in
the state court action, concluding that Davis could only be applied
-----
prospectively and that the taxes collected from the federal retirees were thus
not improperly collected. In 1993, the United States Supreme Court vacated that
decision and remanded the case back to the North Carolina Supreme Court. The
North Carolina Supreme Court then ruled in favor of the State on the grounds
that the federal retirees had failed to comply with state procedures for
challenging unconstitutional taxes. Plaintiffs petitioned the United States
Supreme Court for review of that decision, which petition was denied. The
United States District Court ruled in favor of the defendants in the companion
federal case, and a petition for reconsideration was denied. Plaintiffs
appealed to the United States Court of Appeals, which concurred with the lower
court's ruling. The United States Supreme Court rejected an appeal, ruling that
the lawsuit was a state matter, leaving the North Carolina Supreme Court's
ruling in force. Despite these victories in court, the General Assembly in its
1996 Special Session adopted legislation allowing for a refund of taxes for
federal retirees. Effective for tax years beginning on or after January 1,
1996, federal retirees are entitled to a North Carolina income tax credit for
taxes paid on their pension benefits during tax years 1985 through 1988. In the
alternative, a partial refund may be claimed in lieu of a credit for eligible
taxpayers.
An additional lawsuit was filed in 1995 in State Court by federal
pensioners to recover State income taxes paid on federal
-35-
<PAGE>
retirement benefits (Patton). This case grew out of a claim by federal
------
pensioners in the original federal court case in Swanson. In the new lawsuit,
-------
the plaintiffs allege that when the State granted an increase in retirement
benefits to State retirees in the same legislation that equalized tax treatment
between state and federal retirees, the increased benefits to State retirees
constituted an indirect violation of Davis. The lawsuit seeks a refund of taxes
-----
paid by federal retirees on federal retirement benefits received in the years
1989 through 1993 and refunds or monetary relief sufficient to equalize the
alleged on-going discriminatory treatment for those years. Potential refunds
exceed $300 million. This case has been suspended pending final judgment in
Bailey (discussed below), and no court date has been set. Should plaintiffs
- ------
prevail in Bailey, such a result, the Federal retirees allege, would reestablish
the disparity of treatment between State and Federal pension income that was
held unconstitutional in Davis. The North Carolina Attorney General believes
-----
that sound legal authority and arguments support the denial of this claim.
Potential refunds and interest are estimated to be $585.09 million for the
period through fiscal year 1997. Until this matter is resolved, any additional
potential refunds and interest will continue to accrue.
2. Bailey v. State of North Carolina -- State Tax Refunds - State
Retirees. State and local governmental retirees filed a class action suit in
1990 as a result of the repeal of the income tax exemptions for state and local
government retirement benefits. The original suit was dismissed after the North
Carolina Supreme Court ruled in 1991 that the plaintiffs had failed to comply
with state law requirements for challenging unconstitutional taxes and the
United States Supreme Court denied review. In 1992, many of the same plaintiffs
filed a new lawsuit alleging essentially the same claims, including breach of
contract, unconstitutional impairment of contract rights by the State in taxing
benefits that were allegedly promised to be tax-exempt and violation of several
state constitutional provisions.
On May 31, 1995 the Superior Court issued an order ruling in favor of the
plaintiffs. Under the terms of the order, the Superior Court found that the act
of the General Assembly that repealed the tax exemption on State and local
government retirement benefits is null, void, and unenforceable and that
retirement benefits which were vested before August 1989 are exempt from
taxation. The North Carolina Attorney General has appealed this order, which
appeal is pending in the North Carolina Supreme Court.
Potential refunds and interest are estimated to be $287.56 million for the
period through fiscal year 1997. Until this matter is resolved, any additional
potential refunds and interest will continue to accrue. Furthermore, if the
order of
-36-
<PAGE>
the Superior Court is upheld, its provisions would apply prospectively
to prevent future taxation of State and local government retirement benefits
that were vested before August 1989. The North Carolina Attorney General's
Office believes that sound legal arguments support the State's position on the
merits.
In its 1996 Short Session, the North Carolina General Assembly approved
additional North Carolina general obligation bonds in the amount of $950 million
for highways and $1.8 billion for schools. These bonds were approved by the
voters of the State in November, 1996. In March 1997, North Carolina issued
$450 million of the authorized school bonds (Public School Building Bonds). In
November 1997, North Carolina issued $250 million of the authorized highway
bonds (Highway Bonds). The offering of the remaining $2.05 billion of these
authorized bonds is anticipated to occur over the next two-five years.
Currently, Moody's, S&P and Fitch rate North Carolina general obligation
bonds "Aaa," "AAA," and "AAA," respectively. See Appendix A.
SPECIAL CONSIDERATIONS REGARDING INVESTMENT IN VIRGINIA STATE-SPECIFIC
OBLIGATIONS. The Virginia State-Specific Money Market Portfolio will invest
primarily in Virginia State-Specific Obligations. For this reason, the
Portfolio is affected by political, economic, regulatory or other developments
that constrain the taxing, revenue-collecting and spending authority of Virginia
issuers or otherwise affect the ability of Virginia issuers to pay interest,
principal or any premium. The following information constitutes only a brief
summary of certain of these developments and does not purport to be a complete
description of them. The information has been obtained from recent official
statements prepared by the Commonwealth of Virginia relating to its securities,
and no independent investigation has been undertaken to verify its accuracy.
Moreover, the information relates only to the state itself and not to the
numerous special purpose or local government units whose issues may also be held
by the Portfolio. The credits represented by such issues may be affected by a
wide variety of local factors or structuring concerns, and no disclosure is made
here relating to such matters.
The rate of economic growth in the Commonwealth of Virginia has increased
steadily over the past decade. Per capita income in Virginia has been
consistently above national levels during that time. The services sector in
Virginia generates the largest number of jobs, followed by wholesale and retail
trade, state and local government and manufacturing. Because of Northern
Virginia, with its proximity to Washington, D.C. and Hampton Roads, which has
the nation's largest concentration of military installations, the Federal
government has a greater economic
-37-
<PAGE>
impact on Virginia relative to its size than any state other than Alaska and
Hawaii.
According to statistics published by the U.S. Department of Labor, Virginia
typically has one of the lowest unemployment rates in the nation. This is
generally attributed to the balance among the various sectors represented in the
economy. Virginia is one of twenty states with a right-to-work law and is
generally regarded as having a favorable business climate marked by few strikes
or work stoppages. Virginia is also one of the least unionized among the
industrialized states.
Virginia's state government operates on a two-year budget. The
Constitution vests the ultimate responsibility and authority for levying taxes
and appropriating revenue in the General Assembly, but the Governor has broad
authority to manage the budgetary process. Once an appropriation act becomes
law, revenue collections and expenditures are constantly monitored by the
Governor, assisted by the Secretary of Finance and the Department of Planning
and Budget, to ensure that a balanced budget is maintained. If projected
revenue collections fall below amounts appropriated at any time, the Governor
must reduce expenditures and withhold allotments of appropriations (other than
for debt service and other specified purposes) to restore balance. An amendment
to the Constitution, effective January 1, 1993, established a Revenue
Stabilization Fund. This Fund is used to offset a portion of anticipated
shortfalls in revenues in years when appropriations based on previous forecasts
exceed expected revenues in subsequent forecasts. The Revenue Stabilization
Fund consists of an amount not to exceed 10 percent of Virginia's average annual
tax revenues derived from taxes on income and retail sales for the three
preceding fiscal years.
General Fund revenues are principally comprised of direct taxes. In recent
fiscal years, most of the total tax revenues have been derived from five major
taxes imposed by Virginia on individual and fiduciary income, sales and use,
corporate income, public service corporations and premiums of insurance
companies.
In September 1991, the Debt Capacity Advisory Committee was created by the
Governor through an executive order. The committee is charged with annually
estimating the amount of tax-supported debt that may prudently be authorized,
consistent with the financial goals, capital needs and policies of Virginia.
The committee annually reviews the outstanding debt of all agencies,
institutions, boards and authorities of Virginia for which Virginia has either a
direct or indirect pledge of tax revenues or moral obligation. The Committee
provides its recommendations on the prudent use of such obligations to the
Governor and the General Assembly.
-38-
<PAGE>
The Constitution of Virginia prohibits the creation of debt by or on behalf
of Virginia that is backed by Virginia's full faith and credit, except as
provided in Section 9 of Article X. Section 9 of Article X contains several
different provisions for the issuance of general obligation and other debt, and
Virginia is well within its limit for each:
Section 9(a)(2) provides that the General Assembly may incur general
obligation debt to meet certain types of emergencies, subject to limitations on
amount and duration; to meet casual deficits in the revenue or in anticipation
of the collection of revenues of Virginia; and to redeem a previous debt
obligation of Virginia. Total indebtedness issued pursuant to this Section may
not exceed 30 percent of an amount equal to 1.15 times the annual tax revenues
derived from taxes on income and retail sales, as certified by the Auditor of
Public Accounts for the preceding fiscal year.
Section 9(b) provides that the General Assembly may authorize the creation
of general obligation debt for capital projects. Such debt is required to be
authorized by an affirmative vote of a majority of each house of the General
Assembly and approved in a statewide election. The outstanding amount of such
debt is limited to an amount equal to 1.15 times the average annual tax revenues
derived from taxes on income and retail sales, as certified by the Auditor of
Public Accounts for the three preceding fiscal years less the total amount of
bonds outstanding. The amount of 9(b) debt that may be authorized in any single
fiscal year is limited to 25 percent of the limit on all 9(b) debt less the
amount of 9(b) debt authorized in the current and prior three fiscal years.
Section 9(c) provides that the General Assembly may authorize the creation
of general obligation debt for revenue-producing capital projects (so-called
"double-barrel" debt). Such debt is required to be authorized by an affirmative
vote of two-thirds of each house of the General Assembly and approved by the
Governor. The Governor must certify before the enactment of the authorizing
legislation and again before the issuance of the debt that the net revenues
pledged are expected to be sufficient to pay principal of and interest on the
debt. The outstanding amount of 9(c) debt is limited to an amount equal to 1.15
times the average annual tax revenues derived from taxes on income and retail
sales, as certified by the Auditor of Public Accounts for the three preceding
fiscal years. While the debt limits under Sections 9(b) and 9(c) are each
calculated as the same percentage of the same average tax revenues, these debt
limits are separately computed and apply separately to each type of debt.
Section 9(d) provides that the restrictions of Section 9 are not applicable
to any obligation incurred by
-39-
<PAGE>
Virginia or any of its institutions, agencies or authorities if the full faith
and credit of Virginia is not pledged or committed to the payment of such
obligation. There are currently outstanding various types of such 9(d) revenue
bonds. Certain of these bonds, however, are paid in part or in whole from
revenues received as appropriations by the General Assembly from general tax
revenues, while others are paid solely from revenues of the applicable project.
The repayment of debt issued by the Virginia Public Building Authority, the
Virginia Port Authority, the Virginia College Building Authority Equipment
Leasing Program and the Innovative Technology Authority is supported in large
part by General Fund appropriations.
The Commonwealth Transportation Board is a substantial issuer of bonds for
highway projects. These bonds are secured by and are payable from funds
appropriated by the General Assembly from the Transportation Trust Fund for such
purpose. The Transportation Trust Fund was established by the General Assembly
in 1986 as a special non-reverting fund administered and allocated by the
Transportation Board to provide increased funding for construction, capital and
other needs of state highways, airports, mass transportation and ports. The
Virginia Port Authority has also issued bonds that are secured by a portion of
the Transportation Trust Fund.
Virginia is involved in numerous leases that are subject to appropriation
of funding by the General Assembly. Virginia also finances the acquisition of
certain personal property and equipment through installment purchase agreements.
Bonds issued by the Virginia Housing Development Authority, the Virginia
Resources Authority and the Virginia Public School Authority are designed to be
self-supporting from their individual loan programs. A portion of the Virginia
Housing Development Authority and Virginia Public School Authority bonds and all
of the Virginia Resources Authority bonds are secured in part by a moral
obligation pledge of Virginia. Should the need arise, Virginia may consider
funding deficiencies in the respective debt service reserves for such moral
obligation debt. To date, none of these authorities has advised Virginia that
any such deficiencies exist.
Local government in Virginia is comprised of 95 counties, 40 incorporated
cities, and 190 incorporated towns. Virginia is unique among the several states
in that cities and counties are independent, and their land areas do not
overlap. The largest expenditures by local governments in Virginia are for
education, but local governments also provide other services such as water and
sewer, police and fire protection and recreational facilities. The Virginia
Constitution imposes numerous restrictions on local indebtedness, affecting both
its incurrence and amount.
-40-
<PAGE>
In Davis v. Michigan (decided March 28, 1989), the United States Supreme
Court ruled unconstitutional states' exempting from state income tax the
retirement benefits paid by the state or local governments without exempting
retirement benefits paid by the Federal government. At that time, Virginia
exempted state and local retirement benefits but not Federal retirement
benefits. At a Special Session held in April 1989, the General Assembly repealed
the exemption of state and local retirement benefits. Following Davis, at least
five suits, some with multiple plaintiffs, for refunds of Virginia income taxes,
were filed by Federal retirees. These suits were consolidated under the name of
Harper v. Virginia Department of Taxation.
In a Special Session, the Virginia General Assembly on July 9, 1994, passed
emergency legislation to provide payments in five annual installments to Federal
retirees in a settlement of the retirees' claims as a result of Davis. In 1995
and 1996, the General Assembly passed legislation allowing more retirees to
participate in the settlement. As of April 15, 1996, the estimated total cost to
Virginia for the settlement was approximately $316.2 million.
On September 15, 1995, the Supreme Court of Virginia rendered its decision
in Harper, reversing the judgment of the trial court, entering final judgment in
favor of the taxpayers, and directing that the amounts unlawfully collected be
refunded with statutory interest. Virginia issued refund checks on November 9,
1995, and interest stopped accruing as of November 3, 1995. The cost of
refunding all Virginia income taxes paid on Federal government pensions for
taxable years 1985, 1986, 1987 and 1988 to Federal government pensioners who
opted out of the settlement was approximately $78.7 million, including interest
earnings.
The total cost of refunding all Virginia income taxes paid on Federal
pensions on account of the settlement (approximately $316.2 million) and the
judgment ($78.7 million) is approximately $394.9 million, of which $266.4
million ($124.5 million in respect of the settlement and the entire $78.7
million in respect of the judgment and $63.2 million in fiscal year 1997) has
been paid, leaving $128.5 million payable in respect of the settlement --
approximately $62.5 million on March 31, 1998 and (subject to appropriation) $66
million on March 31, 1999.
Most recently, Moody's has rated the long-term general obligation bonds of
Virginia Aaa, and Standard & Poor's has rated such bonds AAA. There can be no
assurance that the economic conditions on which these ratings are based will
continue or that particular bond issues may not be adversely affected by changes
in economic or political conditions.
-41-
<PAGE>
SPECIAL CONSIDERATIONS REGARDING INVESTMENT IN NEW JERSEY STATE-SPECIFIC
OBLIGATIONS. The following information constitutes only a brief summary, does
not purport to be a complete description and is largely based on information
drawn from official statements relating to securities offerings of New Jersey
municipal obligations available as of the date of this Statement of Additional
Information. The accuracy and completeness of the information contained in such
offering statements has not been independently verified.
State Finance/Economic Information. New Jersey is the ninth largest
state in population and the fifth smallest in land area. With an average of
1,077 people per square mile, it is the most densely populated of all the
states. New Jersey's economic base is diversified, consisting of a variety of
manufacturing, construction and service industries, supplemented by rural areas
with selective commercial agriculture. Historically, New Jersey's average per
capita income has been well above the national average, and in 1996 New Jersey
ranked second among the states in per capita personal income ($31,053).
By the beginning of the national recession (which officially started
in July 1990 according to the National Bureau of Economic Research),
construction activity had already been declining in New Jersey for nearly two
years. The onset of recession caused an acceleration of New Jersey's job losses
in construction and manufacturing, as well as an employment downturn in such
previously growing sectors as wholesale trade, retail trade, finance, utilities,
trucking and warehousing.
Reflecting the economic downturn, the rate of unemployment in New
Jersey rose from 3.6% during the first quarter of 1989 to a recessionary peak of
8.5% during 1992. Since then, the unemployment rate fell to an average of 6.2%
in 1996 and 5.5% for the six month period from January 1997.
For the recovery period as a whole, May 1992 to June 1997, service-
producing employment in New Jersey has expanded by 283,500 jobs. In the
manufacturing sector, employment losses slowed between 1992 and 1994. During
1995 and 1996, however, manufacturing job losses increased slightly to 10,100
and 13,900 respectively, reflecting a slowdown in national manufacturing
production activity. Conditions have slowly improved in the construction
industry, where employment has risen by 18,600 since its low in May 1992.
New Jersey's Budget and Appropriation System. New Jersey operates on a
fiscal year ending on June 30. The General Fund is the fund into which all New
Jersey revenues not otherwise restricted by statute are deposited and from which
appropriations are made. The largest part of the total financial operations of
New Jersey is accounted for in the General Fund, which includes
-42-
<PAGE>
revenues received from taxes and unrestricted by statute, most federal revenues,
and certain miscellaneous revenue items. The Appropriation Acts enacted by the
New Jersey Legislature and approved by the Governor provide the basic framework
for the operation of the General Fund. The undesignated General Fund balance at
year end for fiscal year 1994 was $1,264.6 million, for fiscal year 1995 was
$950.2 million and for fiscal year 1996 was $882.2 million. For fiscal year
1997, the undesignated balance in the General Fund was $1,078.3 million, subject
to change upon completion of the year-end audit. The estimated undesignated
balance for fiscal year 1998 is $553.5 million, based on the amounts contained
in the fiscal year 1998 Appropriations Acts. The fund balances are available for
appropriation in succeeding fiscal years.
During the course of the fiscal year, the Governor may take steps to
reduce State expenditures if it appears that revenues have fallen below those
originally anticipated. There are additional means by which the Governor may
ensure that the State does not incur a deficit. Under the State Constitution, no
supplemental appropriation may be enacted after adoption of an appropriations
act except where there are sufficient revenues on hand or anticipated, as
certified by the Governor, to meet such appropriation.
General Obligation Bonds. New Jersey finances capital projects
primarily through the sale of its general obligation bonds. These bonds are
backed by the full faith and credit of New Jersey. Tax revenues and certain
other fees are pledged to meet the principal and interest payments required to
pay the debt fully.
The aggregate outstanding general obligation bonded indebtedness of
New Jersey as of June 30, 1997 was $3.437 billion. The appropriation for the
debt service obligation on outstanding indebtedness is $483.7 million for fiscal
year 1998.
In addition to payment from bond proceeds, capital construction can
also be funded by appropriation of current revenues on a pay-as-you-go basis.
For fiscal year 1998, the amount appropriated to this purpose is $516.0
million.
Tax and Revenue Anticipation Notes. In fiscal year 1992 New Jersey
initiated a program under which it issued tax and revenue anticipation notes to
aid in providing effective cash flow management to fund balances which occur in
the collection and disbursement of the General Fund and Property Tax Relief Fund
revenues. There are presently $800 million of tax and revenue anticipation notes
outstanding. These notes mature on June 15, 1998. Such notes constitute special
obligations of New Jersey payable solely from moneys on deposit in the General
Fund and Property Tax Relief Fund and legally available for such payment.
-43-
<PAGE>
Lease Financing. New Jersey has entered into a number of leases
relating to the financing of certain real property and equipment. New Jersey
leases the Richard J. Hughes Justice Complex in Trenton from the Mercer County
Improvement Authority (the "MCIA"). Under the lease agreements with the New
Jersey Economic Development Authority (the "EDA"), New Jersey leases (i) office
buildings that house the New Jersey Division of Motor Vehicles, New Jersey
Network, a branch of the United States Postal Service and a parking facility,
(ii) approximately 13 acres of real property and certain infrastructure
improvements thereon located in the city of Newark, (iii) certain energy saving
equipment which shall be installed in various buildings around New Jersey and
(iv) the New Jersey Performing Arts Center Facility in the City of Newark. New
Jersey also leases several office buildings, facilities and improvements from
the New Jersey Building Authority (the "NJBA"). Rental payments under each of
the foregoing leases are sufficient to pay debt service on the related bonds
issued by MCIA, EDA and NJBA, and in each case are subject to annual
appropriation by the New Jersey Legislature.
Beginning in April 1984, New Jersey, acting through the Director of
the Division of Purchase and Property, entered into a series of lease purchase
agreements which provide for the acquisition of equipment, services and real
property to be used by various departments and agencies of New Jersey. To date,
New Jersey has completed eleven lease purchase agreements which have resulted in
the issuance of Certificates of Participation totaling $749,350,000. The
agreements relating to these transactions provide for semi-annual rental
payments. New Jersey's obligation to pay rentals due under these leases is
subject to annual appropriations being made by the New Jersey Legislature.
State Supported School and County College Bonds. Legislation provides
for future appropriations for New Jersey aid to local school districts equal to
debt service on a maximum principal amount of $280,000,000 of bonds issued by
such local school districts for construction and renovation of school facilities
and for New Jersey aid to counties equal to debt service on up to $80,000,000 of
bonds issued by counties for construction of county college facilities. The New
Jersey Legislature is not legally bound to make such future appropriations, but
has done so to date on all outstanding obligations issued under these laws.
"Moral Obligation" Financing. The authorizing legislation for certain
New Jersey entities provides for specific budgetary procedures with respect to
certain obligations issued by such entities. Pursuant to such legislation, a
designated official is required to certify any deficiency in a debt service
reserve fund maintained to meet payments of principal of and interest on the
obligations, and a New Jersey appropriation in
-44-
<PAGE>
the amount of the deficiency is to be made. However, the New Jersey Legislature
is not legally bound to make such an appropriation. Bonds issued pursuant to
authorizing legislation of this type are sometimes referred to as "moral
obligation" bonds. There is no statutory limitation on the amount of "moral
obligation" bonds which may be issued by eligible New Jersey entities. As of
June 30, 1997, outstanding "moral obligation" bonded indebtedness issued by New
Jersey entities totaled $614,324,305 and maximum annual debt service subject to
"moral obligation" is $67,502,366.04.
Higher Education Assistance Authority. The Higher Education Assistance
Authority ("HEAA") has issued $149,996,064 aggregate principal amount of revenue
bonds. It is anticipated that the HEAA's revenues will be sufficient to cover
debt service on its bonds.
New Jersey Housing and Mortgage Finance Agency. Neither the New Jersey
Housing and Mortgage Finance Agency nor its predecessors, the New Jersey Housing
Finance Agency and the New Jersey Mortgage Finance Agency, have had a deficiency
in a debt service reserve fund which required New Jersey to appropriate funds to
meet its "moral obligation". It is anticipated that this agency's revenues will
continue to be sufficient to cover debt service on its bonds.
South Jersey Port Corporation. New Jersey has periodically provided
the South Jersey Port Corporation (the "Port Corporation") with funds to cover
all debt service and property tax requirements, when earned revenues are
anticipated to be insufficient to cover these obligations. For calendar years
1986 through 1997, New Jersey has made appropriations totaling $49,560,536.25
which covered deficiencies in revenues of the Port Corporation, for debt service
and property tax payments.
New Jersey Sports and Exposition Authority. On March 2, 1992, the New
Jersey Sports and Exposition Authority (the "Sports Authority") issued
$147,490,000 in New Jersey guaranteed bonds and defeased all previously
outstanding New Jersey guaranteed bonds of the Sports Authority. New Jersey
officials have stated the belief that the revenue of the Sports Authority will
be sufficient to provide for the payment of debt service on these obligations
without recourse to New Jersey's guarantee.
Legislation enacted in 1992 authorizes the Sports Authority to issue
bonds for various purposes payable from New Jersey appropriations. Pursuant to
this legislation, the Sports Authority and the New Jersey Treasurer have entered
into an agreement (the "State Contract") pursuant to which the Sports Authority
will undertake certain projects, including the refunding of certain outstanding
bonds of the Sports Authority,
-45-
<PAGE>
and the New Jersey Treasurer will credit to the Sports Authority Fund amounts
from the General Fund sufficient to pay debt service and other costs related to
the bonds. The payment of all amounts under the State Contract is subject to and
dependent upon appropriations being made by the New Jersey Legislature. As of
June 30, 1997 there are approximately $458,890,000 aggregate principal amount of
Sports Authority bonds outstanding, the debt service on which is payable from
amounts credited to the Sports Authority Fund pursuant to the State
Contract.
New Jersey Transportation Trust Fund Authority. In July 1984, New
Jersey created the New Jersey Transportation Trust Fund Authority (the "TTFA"),
an instrumentality of New Jersey organized and existing under the New Jersey
Transportation Trust Fund Authority Act of 1984, as amended (the "TTFA Act") for
the purpose of funding a portion of New Jersey's share of the cost of
improvements to New Jersey's transportation system. Pursuant to the TTFA Act,
the TTFA, the New Jersey Treasurer and the Commissioner of Transportation
executed a contract (the "TTFA Contract") which provides for the payment of
these revenues to the TTFA. The payment of all such amounts is subject to and
dependent upon appropriations being made by the New Jersey Legislature and there
is no requirement that the Legislature make such appropriation. On May 30, 1995,
the New Jersey Legislature amended the TTFA Act to provide, among other things,
for (i) the issuance of debt in an aggregate principal amount in excess of the
statutory debt limitation in effect prior to the enactment of the 1995
amendments, (ii) an increase in the amount of revenues available to the TTFA and
(iii) broadening the scope of transportation projects.
Pursuant to the Act, the aggregate principal amount of TTFA's bonds,
notes or other obligations outstanding at any one time may not exceed $700
million plus amounts carried over from prior fiscal years. These bonds are
special obligations of the TTFA payable from payments made by New Jersey
pursuant to the TTFA Contract.
Economic Recovery Fund Bonds. Legislation enacted during 1992 by New
Jersey authorizes the EDA to issue bonds for various economic development
purposes. Pursuant to that legislation, EDA and the New Jersey Treasurer have
entered into an agreement (the "ERF Contract") through which EDA has agreed to
undertake the financing of certain projects and the New Jersey Treasurer has
agreed to credit to the Economic Recovery Fund from the General Fund amounts
equivalent to payments due to New Jersey under an agreement with the Port
Authority of New York and New Jersey. The payment of all amounts under the ERF
Contract is subject to and dependent upon appropriations being made by the New
Jersey Legislature.
-46-
<PAGE>
Counties and Municipalities. New Jersey law also regulates the
issuance of debt by local units. The Local Budget Law limits the amount of tax
anticipation notes that may be issued by local units and requires the repayment
of such notes within 120 days of the end of the fiscal year (six months in the
case of the counties) in which issued. The Local Bond Law (N.J.S.A. 4OA:2-1 I.)
governs the issuance of bonds and notes by the local units. No local unit is
permitted to issue bonds for the payment of current expenses (other than Fiscal
Year Adjustment Bonds described more fully below). Local units may not issue
bonds to pay outstanding bonds, except for refunding purposes, and then only
with the approval of the Local Finance Board. Local units may issue bond
anticipation notes for temporary periods not exceeding in the aggregate
approximately ten years from the date of first issue. The debt that any local
unit may authorize is limited to a percentage of its equalized valuation basis,
which is the average of the equalized value of all taxable real property and
improvements within the geographic boundaries of the local unit, as annually
determined by the Director of the Division of Taxation, for each of the three
most recent years. In the calculation of debt capacity, the Local Bond Law and
certain other statutes permit the deduction of certain classes of debt
("statutory deductions") from all authorized debt of the local unit ("gross
capital debt") in computing whether a local unit has exceeded its statutory debt
limit. Statutory deductions from gross capital debt consist of bonds or notes
(i) authorized for school purposes by a regional school district or by a
municipality or a school district with boundaries coextensive with such
municipality to the extent permitted under certain percentage limitations set
forth in the School Bond Law (as hereinafter defined); (ii) authorized for
purposes which are self-liquidating, but only to the extent permitted by the
Local Bond Law; (iii) authorized by a public body other than a local unit the
principal of and interest on which is guaranteed by the local unit, but only to
the extent permitted by law; (iv) that are bond anticipation notes; (v) for
which provision for payment has been made; or (vi) authorized for any other
purpose for which a deduction is permitted by law. Authorized net capital debt
(gross capital debt minus statutory deductions) is limited to 3.5 percent of the
equalized valuation basis in the case of municipalities and 2 percent of the
equalized valuation basis in the case of counties. The debt limit of a county or
municipality, with certain exceptions, may be exceeded only with the approval of
the Local Finance Board.
State Pension Funding Bonds. Legislation enacted in June 1997
authorizes the EDA to issue bonds to pay a portion of New Jersey's unfunded
accrued pension liability for New Jersey's retirement systems (the "Unfunded
Accrued Pension Liability"), which, together with amounts derived from the
revaluation of the pension assets pursuant to companion legislation enacted at
the same time, will be sufficient to fully fund the Unfunded Accrued
-47-
<PAGE>
Pension Liability. On June 30, 1997 the EDA issued $2,803,042,498.56 aggregate
principal amount of State Pension Funding Bonds, Series 1997A-1997C. The EDA and
the New Jersey Treasurer have entered into an agreement which provides for the
payment to the EDA of monies sufficient to pay debt service on the bonds. Such
payments are subject to and dependent upon appropriations being made by the New
Jersey Legislature.
School District Bonds. School district bonds and temporary notes are
issued in conformity with N.J.S.A. 18A:24-1 et seq. (the "School Bond Law").
Although school districts are exempted from the 5 percent down payment provision
generally applied to bonds issued by municipalities and counties, they are
subject to debt limits (which vary depending on the type of school system
provided) and to New Jersey regulation of their borrowing. The debt limitation
on school district bonds depends upon the classification of the school district,
but may be as high as 4 percent of the average equalized valuation basis of the
constituent municipality. In certain cases involving school districts in cities
with populations exceeding 100,000, the debt limit is 8 percent of the average
equalized valuation basis of the constituent municipality, and in cities with
populations in excess of 80,000 the debt limit is 6 percent of the aforesaid
average equalized valuation.
School District Lease Purchase Financings. In 1982, school districts
were given an alternative to the traditional method of bond financing capital
improvements pursuant to N.J.S.A. 18A:20-4.2(f) (the "Lease Purchase Law"). The
Lease Purchase Law permits school districts to acquire a site and school
building through a lease purchase agreement with a private lessor corporation.
The lease purchase agreement does not require voter approval. The rent payments
attributable to the lease purchase agreement are subject to annual appropriation
by the school district and are required, pursuant to N.J.A.C. 6:22A- 1.2(h), to
be included in the annual current expense budget of the school district.
Furthermore, the rent payments attributable to the lease purchase agreement do
not constitute debt of the school district and therefore do not impact on the
school district's debt limitation. Lease purchase agreements in excess of five
years require the approval of the Commissioner and the Local Finance Board.
Qualified Bonds. In 1976, legislation was enacted (P.L. 1976, c.38 and
c.39) which provides for the issuance by municipalities and school districts of
"qualified bonds". Whenever a local board of education or the governing body of
a municipality determines to issue bonds, it may file an application with the
Local Finance Board and, in the case of a local board of education, the
Commissioner, to qualify bonds pursuant to P.L. 1976, c.38 or c.39. Upon
approval of such an application and after receipt of a certificate stating the
name
-48-
<PAGE>
and address of the paying agent for such bonds, the maturity schedule, interest
rates and payment dates, the New Jersey Treasurer shall, in the case of
qualified bonds for school districts, withhold from the school aid payable to
such municipality or school district and, in the case of qualified bonds for
municipalities, withhold from the amount of business personal property tax
replacement revenues, gross receipts tax revenues, municipal purposes tax
assistance fund distributions, New Jersey urban aid, New Jersey revenue sharing,
and any other funds appropriated as New Jersey aid and not otherwise dedicated
to specific municipal programs, payable to such municipalities, an amount
sufficient to cover debt service on such bonds. These "qualified bonds" are not
direct, guaranteed or moral obligations of New Jersey, and debt service on such
bonds will be provided by New Jersey only if the above-mentioned appropriations
are made by New Jersey. Total outstanding indebtedness for "qualified bonds"
consisted of $224,492,700 by various school districts as of June 30, 1995 and
$903,760,316 by various municipalities as of June 30, 1995.
New Jersey School Bond Reserve Act. The New Jersey School Bond Reserve
Act (N.J.S.A. 18A:56-17 et seq.) establishes a school bond reserve within the
constitutionally dedicated Fund for the Support of Free Public Schools. Under
this law the reserve is maintained at an amount equal to 1.5 percent of the
aggregate outstanding bonded indebtedness of counties, municipalities or school
districts for school purposes (exclusive of bonds whose debt service is provided
by New Jersey appropriations), but not in excess of monies available in such
fund. If a municipality, county or school district is unable to meet payment of
the principal of or interest on any of its school bonds, the trustee of the
school bond reserve will purchase such bonds at the face amount thereof or pay
the holders thereof the interest due or to become due. At June 30, 1995, the
book value of the Fund's assets aggregated $88,736,798 and the reserve, computed
as of June 30, 1995, amounted to $38,811,015. There has never been an occasion
to call upon this fund. New Jersey provides support of certain bonds of
counties, municipalities and school districts through various statutes.
Local Financing Authorities. The Local Authorities Fiscal Control Law
(N.J.S.A. 40A:5A-1 et seq.) provides for state supervision of the fiscal
operations and debt issuance practices of independent local authorities and
special taxing districts by the New Jersey Department of Community Affairs. The
Local Authorities Fiscal Control Law applies to all autonomous public bodies
created by counties or municipalities, which are empowered to issue bonds, to
impose facility or service charges, or to levy taxes in their districts. This
encompasses most autonomous local authorities (sewerage, municipal utilities,
parking, pollution control, improvement, etc.) and special taxing districts
(fire, water, etc.). Authorities which are subject to differing New
-49-
<PAGE>
Jersey or federal financial restrictions are exempted, but only to the extent of
that difference.
Financial control responsibilities over local authorities and special
districts are assigned to the Local Finance Board and the Director of the
Division of Local Government Services. The Local Finance Board exercises
approval power over the creation of new authorities and special districts as
well as their dissolution. The Local Finance Board also reviews, conducts public
hearings and issues findings and recommendations on any proposed project
financing of an authority or district, and on any proposed financing agreement
between an municipality or county and an authority or special district. The
Local Finance Board prescribes minimum audit requirements to be followed by
authorities and special districts in the conduct of their annual audits. The
Director reviews and approves annual budgets of authorities and special
districts.
Litigation. At any given time, there are various numbers of claims and
cases pending against the State of New Jersey, New Jersey agencies and
employees, seeking recovery of monetary damages that are primarily paid out of
the fund created pursuant to the New Jersey Tort Claims Act (N.J.S.A. 59:1-1 et
seq.). New Jersey does not formally estimate its reserve representing potential
exposure for these claims and cases. New Jersey is unable to estimate its
exposure for these claims and cases.
New Jersey routinely receives notices of claim seeking substantial sums of
money. The majority of those claims have historically proven to be of
substantially less value than the amount originally claimed. Under the New
Jersey Tort Claims Act, any tort litigation against New Jersey must be preceded
by a notice of claim, which affords New Jersey the opportunity for a six-month
investigation prior to the filing of any suit against it. At any given time,
there are various numbers of claims and cases pending against the University of
Medicine and Dentistry and its employees, seeking recovery of monetary damages
that are primarily paid out of the Self Insurance Reserve Fund created pursuant
to the New Jersey Tort Claims Act. An independent study estimated an aggregate
potential exposure of $90,800,000 for tort and medical malpractice claims
pending as of June 30, 1997. In addition, at any given time, there are various
numbers of contract and other claims against the University of Medicine and
Dentistry, seeking recovery of monetary damages or other relief which, if
granted, would require the expenditure of funds. New Jersey is unable to
estimate its exposure for these claims.
Other lawsuits presently pending or threatened in which New Jersey has the
potential for either a significant loss of revenue or a significant
unanticipated expenditures include the following:
-50-
<PAGE>
New Jersey Education Association v. State of New Jersey challenging
amendments enacted in 1994 affecting the funding of the Teachers Pension and
Annuity Fund, the Public Employees' Retirement System, the Police and Fireman's
Retirement System, the State Police Retirement System and the Judicial
Retirement System. The matter was stayed pending the adoption of the
Appropriations Act for Fiscal Year 1998 and has been closed on a stipulation of
dismissal entered by the court upon consent of all the parties with no payment
made by any of the parties.
County of Passaic v. State of New Jersey the County of Passaic, Passaic
County Utilities Authority and Passaic County Pollution Control Financing
Authority alleged tort and contract claims against New Jersey and the New Jersey
Department of Environmental Protection associated with a resource recovery
facility which the plaintiffs had once planned to build. The complaint alleged
$30 million in damages for an alleged violation of a 1984 consent order
concerning the construction of the resource recovery facility. The court granted
New Jersey's motion for summary judgment and the appellate division affirmed on
October 17, 1997. The time for filing of a petition for recertification has
elapsed.
Interfaith Community Organization v. Shinn, a suit filed by a coalition of
churches and church leaders in Hudson County against the Governor, the
Commissioners of the Department of Environmental Protection and the Department
of Health, concerning chromium contamination in Liberty State Park in Jersey
City.
American Trucking Associations, Inc. and Tri-State Motor Transit Co. v.
State of New Jersey challenging the constitutionality of annual hazardous and
solid waste licensure fees collected by the Department of Environmental
Protection, seeking permanent injunction enjoining future collection of fees and
refund of all renewal fees, fines and penalties collected.
Abbott v. Burke, a decision by the New Jersey Supreme Court on July 12,
1994 requires that a funding formula be enacted by December 31, 1996 which would
close the spending gap between poor urban school districts and wealthy suburban
school districts by fiscal year 1998. On December 20, 1996, the Comprehensive
Education Improvement and Financing Act ("CEIFA") was enacted. On January 6,
1997 the Education Law Center filed a motion in aid of litigant's rights with
the New Jersey Supreme Court requesting, in part, relief in the form of 100%
spending parity or state aid in the amount of approximately $200 million to be
redistributed to the special needs school districts. On May 14, 1997, the
Supreme Court held the CEIFA unconstitutional as applied to 28 districts and
ordered New Jersey to appropriate additional funds beginning with the 1997-98
school year so that each district would be able to spend at the average of the
wealthy suburban districts and remanded to the Superior Court to
-51-
<PAGE>
oversee a study and report of the Commission of Education on the special
education needs and facilities of those districts.
Affiliated FM Insurance Company v. State of New Jersey, an action by
certain members of the New Jersey Property-Liability Insurance Guaranty
Association challenging the constitutionality of assessments used for the Market
Transition Fund and seeking repayment of assessments paid since 1990.
In the Matter of the 1997 Assessment Made by the New Jersey Property
Liability Insurance Guaranty Association Pursuant to N.J.S.A. 17:30A-4, in a
case related to the case above, the American Insurance Association and the
Alliance of American Insurers filed an appeal of an administrative action
seeking an emergent stay of their obligation to pay assessments to the New
Jersey Property-Liability Insurance Guaranty Association. The plaintiffs allege
that the assessment of $160 million per calendar year is without statutory
authority. On July 28, 1997, the court denied the plaintiffs' application for
emergent relief and denied New Jersey's motion for summary disposition.
C.F. v. Fauver, a class action in federal district court by prisoners with
serious mental disorders who are confined within the facilities of the New
Jersey Department of Corrections seeking injunctive relief in the form of
changes to the manner in which the mental health services are provided to
inmates.
Cleary v. Waldman, the plaintiffs claim that the Medicare Catastrophic
Coverage Act, providing funds to spouses of institutionalized individuals
sufficient funds to live in the community, requires that a certain system be
used to provide the funds and another system is being used instead. Estimate of
exposure if the court were to find for the plaintiffs are in the area of $50
million per year from both New Jersey and Federal sources combined. Plaintiffs
motion for a preliminary injunction was denied and is being appealed.
United Hospitals v. State of New Jersey, 18 New Jersey hospitals are
challenging the Medicaid reimbursements made since February 1995 claiming that
New Jersey failed to comply with certain federal requirements, the reimbursement
regulations are arbitrary, capricious and unreasonable, rates were incorrectly
calculated, the hospitals were denied due process, the Medicaid reimbursement
provisions violate the New Jersey Constitution, and Medicaid State Plan was
violated by the New Jersey Department of Human Services implementation of
hospital rates in 1995 and 1996.
Trump Hotels & Casino Resorts, Inc. v. Mirage Resorts Incorporated, the
plaintiff is suing Mirage Resorts and New Jersey in an attempt to enjoin their
efforts to build a highway and tunnel funded by Mirage Resorts and $55 million
in bonds collateralized by future casino obligations, claiming that the
-52-
<PAGE>
project violates the New Jersey Constitution provision that requires all
revenues the state receives from gaming operations to benefit the elderly and
disabled. The plaintiff also claims (i) the failure to disclose this
constitutional infirmity is a material omission within the meaning of Rule 10b-5
of the Securities and Exchange Act of 1934, (ii) the defendants have sought to
avoid the requirements of the Clean Water Act, Clean Air Act, Federal Highway
Act and the New Jersey Coastal Area Facility Review Act. On May 1, 1997, the
federal district court granted the defendants' motion to dismiss and appeal is
pending in the Third Circuit. In a related action, State of New Jersey v. Trump
Hotels & Casino Resorts, Inc., New Jersey filed a declaratory judgment action
seeking a declaration that the use of certain funds New Jersey statutory
provisions existed that permitted use of certain funds to be used for other
purposes than the elderly or disabled. Declaratory judgment was entered in favor
of New Jersey on May 14, 1997 and the matter is now in the Appellate
Division.
United Alliance v. State of New Jersey, plaintiffs allege that the Casino
Reinvestment Development Authority funding mechanisms are illegal including the
gross receipts tax, the parking tax, and the Atlantic City fund. This matter has
been placed on the inactive list. Five additional cases have been filed in
opposition to the road and tunnel project which also contain related challenges:
Bryant v. New Jersey Department of Transportation, Merolla and Brady v. Casino
Reinvestment Development Authority, Middlesex County v. Casino Reinvestment
Development Authority, Gallagher v. Casino Reinvestment Development Authority
and George Harms v. State of New Jersey. Summary judgment has been granted in
favor of the New Jersey or its agencies in Merolla, Middlesex and Gallagher but
the plaintiffs have filed an appeal.
Blecker v. State of New Jersey, a class action filed on behalf of providers
of Medicare Part B services to Qualified Medicare Beneficiaries seeking
reimbursement for Medicare co-insurance and deductibles not paid by the New
Jersey Medicaid program from 1988 to February 10, 1995. Plaintiffs claim a
breach of contract and violation of federal civil rights laws. Arguments on the
State's motions to dismiss and for summary judgment are expected to take place
in late November or in December 1997.
Spadoro v. New Jersey Economic Development Authority, the plaintiff
challenges the funding of New Jersey's accrued unfunded liability on the State's
pension funds through $2,803,042,498.56 in bonds issued by the New Jersey
Economic Development Authority and authorized by the Pension Bond Financing Act
of 1997. This suit is a second attempt by the plaintiff who claims that
resolution authorizing the issuance of bonds was invalid because (i) the State
Treasurer and other ex officio members of the
-53-
<PAGE>
Authority had a conflict of interest, (ii) the actions of the Authority violated
the public policy of the State, and (iii) there were various procedural defects
in the conduct of the meeting. Oral argument on the defendants' motion for
summary judgment is scheduled for January 8, 1998.
Camden County Energy Recovery Associates v. New Jersey Department of
Environmental Protection, the plaintiff owns and operates a resource facility in
Camden County and has filed suit seeking to have the solid waste reprocurement
process halted to clarify bid specification. The court did not halt the bid
process but did require clarifications. Co-defendant Pollution Control Financing
Authority of Camden County counterclaimed, seeking reformation of the contract
between it and the plaintiff and cross-claimed against New Jersey for
contribution and indemnification.
ADDITIONAL INVESTMENT LIMITATIONS.
Each Portfolio is subject to the investment limitations enumerated in this
subsection which may be changed with respect to a particular Portfolio only by a
vote of the holders of a majority of such Portfolio's outstanding shares (as
defined below under "Miscellaneous"). The Index Master Portfolio's fundamental
investment limitations are described separately.
MONEY MARKET PORTFOLIOS:
1) Each of the Money Market, Municipal Money Market and U.S. Treasury
Money Market Portfolios may not purchase securities of any one issuer (other
than securities issued or guaranteed by the U.S. Government, its agencies or
instrumentalities or certificates of deposit for any such securities) if more
than 5% of the value of the Portfolio's total assets (taken at current value)
would be invested in the securities of such issuer, or more than 10% of the
issuer's outstanding voting securities would be owned by the Portfolio or the
Fund, except that up to 25% of the value of the Portfolio's total assets (taken
at current value) may be invested without regard to these limitations. For
purposes of this limitation, a security is considered to be issued by the entity
(or entities) whose assets and revenues back the security. A guarantee of a
security is not deemed to be a security issued by the guarantor when the value
of all securities issued and guaranteed by the guarantor, and owned by the
Portfolio, does not exceed 10% of the value of the Portfolio's total
assets.
2) No Portfolio may borrow money or issue senior securities, except that
each Portfolio may borrow from banks and (other than a Municipal Money Market
Portfolio) enter into reverse repurchase agreements for temporary purposes in
amounts up to one-third of the value of its total assets at the time of
-54-
<PAGE>
such borrowing; or mortgage, pledge or hypothecate any assets, except in
connection with any such borrowing and then in amounts not in excess of one-
third of the value of the Portfolio's total assets at the time of such
borrowing. No Portfolio will purchase securities while its aggregate borrowings
(including reverse repurchase agreements and borrowings from banks) in excess of
5% of its total assets are outstanding. Securities held in escrow or separate
accounts in connection with a Portfolio's investment practices are not deemed to
be pledged for purposes of this limitation.
3) Each of the Municipal Money Market, U.S. Treasury Money Market, Ohio
Municipal Money Market, Pennsylvania Municipal Money Market, North Carolina
Municipal Money Market, Virginia Municipal Money Market and New Jersey Municipal
Money Market Portfolios may not purchase securities which would cause 25% or
more of the value of its total assets at the time of purchase to be invested in
the securities of one or more issuers conducting their principal business
activities in the same industry. The Money Market Portfolio, on the other hand,
may not purchase any securities which would cause, at the time of purchase, less
than 25% of the value of its total assets to be invested in the obligations of
issuers in the banking industry, or in obligations, such as repurchase
agreements, secured by such obligations (unless the Portfolio is in a temporary
defensive position) or which would cause, at the time of purchase, more than 25%
of the value of its total assets to be invested in the obligations of issuers in
any other industry. In applying the investment limitations stated in this
paragraph, (i) there is no limitation with respect to the purchase of (a)
instruments issued (as defined in Investment Limitation number 1 above) or
guaranteed by the United States, any state, territory or possession of the
United States, the District of Columbia or any of their authorities, agencies,
instrumentalities or political subdivisions, (b) instruments issued by domestic
banks (which may include U.S. branches of foreign banks) and (c) repurchase
agreements secured by the instruments described in clauses (a) and (b); (ii)
wholly-owned finance companies will be considered to be in the industries of
their parents if their activities are primarily related to financing the
activities of the parents; and (iii) utilities will be divided according to
their services, for example, gas, gas transmission, electric and gas, electric
and telephone will be each considered a separate industry.
4) Each of the Ohio Municipal Money Market, Pennsylvania Municipal Money
Market, North Carolina Municipal Money Market, Virginia Municipal Money Market
and New Jersey Municipal Money Market Portfolios will invest at least 80% of its
net assets in AMT Paper and instruments the interest on which is exempt from
regular Federal income tax, except during defensive periods or during periods of
unusual market conditions.
-55-
<PAGE>
5) The Municipal Money Market Portfolio will invest at least 80% of its
net assets in instruments the interest on which is exempt from regular Federal
income tax and is not an item of tax preference for purposes of Federal
alternative minimum tax, except during defensive periods or during periods of
unusual market conditions.
NON-MONEY MARKET PORTFOLIOS:
Each of the Non-Money Market Portfolios (other than the Ohio Tax-Free
Income, Pennsylvania Tax-Free Income and New Jersey Tax-Free Income Portfolios)
may not:
1) Purchase securities of any one issuer (other than securities issued or
guaranteed by the U.S. Government, its agencies or instrumentalities or
certificates of deposit for any such securities) if more than 5% of the value of
the Portfolio's total assets would (taken at current value) be invested in the
securities of such issuer, or more than 10% of the issuer's outstanding voting
securities would be owned by the Portfolio or the Fund, except that up to 25% of
the value of the Portfolio's total assets may (taken at current value) be
invested without regard to these limitations. For purposes of this limitation, a
security is considered to be issued by the entity (or entities) whose assets and
revenues back the security. A guarantee of a security shall not be deemed to be
a security issued by the guarantors when the value of all securities issued and
guaranteed by the guarantor, and owned by the Portfolio, does not exceed 10% of
the value of the Portfolio's total assets.
Each of the Non-Money Market Portfolios may not:
2) Purchase any securities which would cause 25% or more of the value of
the Portfolio's total assets at the time of purchase to be invested in the
securities of one or more issuers conducting their principal business activities
in the same industry, provided that (a) there is no limitation with respect to
(i) instruments issued (as defined in Investment Limitation No. 1 above) or
guaranteed by the United States, any state, territory or possession of the
United States, the District of Columbia or any of their authorities, agencies,
instrumentalities or political subdivisions, and (ii) repurchase agreements
secured by the instruments described in clause (i); (b) wholly-owned finance
companies will be considered to be in the industries of their parents if their
activities are primarily related to financing the activities of the parents; and
(c) utilities will be divided according to their services; for example, gas, gas
transmission, electric and gas, electric and telephone will each be considered a
separate industry.
Each Non-Money Market Portfolio (other than the Managed Income,
Intermediate Government Bond, Low Duration Bond,
-56-
<PAGE>
Intermediate Bond, Government Income, International Bond, Core Bond and Balanced
Portfolios) may not:
3) Borrow money or issue senior securities, except that each Portfolio
may borrow from banks and enter into reverse repurchase agreements for temporary
purposes in amounts up to one-third of the value of its total assets at the time
of such borrowing; or mortgage, pledge or hypothecate any assets, except in
connection with any such borrowing and then in amounts not in excess of one-
third of the value of the Portfolio's total assets at the time of such
borrowing. No Portfolio will purchase securities while its aggregate borrowings
(including reverse repurchase agreements and borrowings from banks) in excess of
5% of its total assets are outstanding. Securities held in escrow or separate
accounts in connection with a Portfolio's investment practices are not deemed to
be pledged for purposes of this limitation.
None of the Managed Income, Intermediate Government Bond, Low Duration
Bond, Intermediate Bond, Government Income, Core Bond, International Bond and
Balanced Portfolios may:
4) Issue senior securities, borrow money or pledge its assets, except
that a Portfolio may borrow from banks or enter into reverse repurchase
agreements or dollar rolls in amounts aggregating not more than 33 1/3% of the
value of its total assets (calculated when the loan is made) to take advantage
of investment opportunities and may pledge up to 33 1/3% of the value of its
total assets to secure such borrowings. Each Portfolio is also authorized to
borrow an additional 5% of its total assets without regard to the foregoing
limitations for temporary purposes such as clearance of portfolio transactions
and share redemptions. For purposes of these restrictions, the purchase or sale
of securities on a "when-issued," delayed delivery or forward commitment basis,
the purchase and sale of options and futures contracts and collateral
arrangements with respect thereto are not deemed to be the issuance of a senior
security, a borrowing or a pledge of assets.
ALL PORTFOLIOS:
No Portfolio may:
1. Purchase or sell real estate, except that each Portfolio may
purchase securities of issuers which deal in real estate and may purchase
securities which are secured by interests in real estate.
2. Acquire any other investment company or investment company
security except in connection with a merger,
-57-
<PAGE>
consolidation, reorganization or acquisition of assets or where otherwise
permitted by the 1940 Act.
3. Act as an underwriter of securities within the meaning of the
Securities Act of 1933 except to the extent that the purchase of obligations
directly from the issuer thereof, or the disposition of securities, in
accordance with the Portfolio's investment objective, policies and limitations
may be deemed to be underwriting.
4. Write or sell put options, call options, straddles, spreads, or
any combination thereof, except for transactions in options on securities,
securities indices, futures contracts and options on futures contracts and, in
the case of the International Bond Portfolio, currencies.
5. Purchase securities of companies for the purpose of exercising
control.
6. Purchase securities on margin, make short sales of securities or
maintain a short position, except that (a) this investment limitation shall not
apply to a Portfolio's transactions in futures contracts and related options or
a Portfolio's sale of securities short against the box, and (b) a Portfolio may
obtain short-term credit as may be necessary for the clearance of purchases and
sales of portfolio securities.
7. Purchase or sell commodity contracts, or invest in oil, gas or
mineral exploration or development programs, except that each Portfolio may, to
the extent appropriate to its investment policies, purchase securities (publicly
traded securities in the case of each Money Market Portfolio) of companies
engaging in whole or in part in such activities and may enter into futures
contracts and related options.
8. Make loans, except that each Portfolio may purchase and hold debt
instruments and enter into repurchase agreements in accordance with its
investment objective and policies and may lend portfolio securities.
9. Purchase or sell commodities except that each Portfolio may, to
the extent appropriate to its investment policies, purchase securities of
companies engaging in whole or in part in such activities, may engage in
currency transactions and may enter into futures contracts and related
options.
10. Notwithstanding the investment limitations of the Index Equity
Portfolio, the Index Equity Portfolio may invest all of its assets in shares of
an open-end management investment company with substantially the same investment
objective, policies and limitations as the Portfolio.
-58-
<PAGE>
Although the foregoing investment limitations would permit the Money Market
Portfolios to invest in options, futures contracts and options on futures
contracts, and to sell securities short against the box, those Portfolios do not
currently intend to trade in such instruments or engage in such transactions
during the next twelve months (except to the extent a portfolio security may be
subject to a "demand feature" or "put" as permitted under SEC regulations for
money market funds). Prior to making any such investments, a Money Market
Portfolio would notify its shareholders and add appropriate descriptions
concerning the instruments and transactions to its Prospectus.
INDEX MASTER PORTFOLIO:
The investment limitations of the Index Master Portfolio, the Portfolio in
which the Index Equity Portfolio invests all of its investable assets, are
separate from those of the Index Equity Portfolio. The Index Master Portfolio
may not:
1. Invest in commodities or real estate, including limited partnership
interests therein, although it may purchase and sell securities of companies
which deal in real estate and securities which are secured by interests in real
estate, and may purchase or sell financial futures contracts and options
thereon;
2. Make loans of cash, except through the acquisition of repurchase
agreements and obligations customarily purchased by institutional
investors;
3. As to 75% of the total assets of the Index Master Portfolio, invest in
the securities of any issuer (except obligations of the U.S. Government and its
instrumentalities) if, as a result, more than 5% of the Index Master Portfolio's
total assets, at market, would be invested in the securities of such
issuer;
4. Purchase or retain securities of an issuer if those officers and
trustees of the Trust or officers and directors of the Trust's investment
adviser owning more than 1/2 of 1% of such securities together own more than 5%
of such securities;
5. Borrow, except from banks and as a temporary measure for extraordinary
or emergency purposes and then, in no event, in excess of 5% of the Index Master
Portfolio's gross assets valued at the lower of market or cost; provided that it
may borrow amounts not exceeding 33% of its net assets from banks and pledge not
more than 33% of such assets to secure such loans;
6. Pledge, mortgage, or hypothecate any of its assets to an extent
greater than 10% of its total assets at fair market value, except as described
in (5) above;
-59-
<PAGE>
7. Invest more than 10% of the value of its total assets in illiquid
securities which include certain restricted securities, repurchase agreements
with maturities of greater than seven days, and other illiquid investments;
8. Engage in the business of underwriting securities issued by
others;
9. Invest for the purpose of exercising control over management of any
company;
10. Invest its assets in securities of any investment company, except in
connection with a merger, acquisition of assets, consolidation or
reorganization;
11. Invest more than 5% of its total assets in securities of companies
which have (with predecessors) a record of less than three years' continuous
operation;
12. Acquire any securities of companies within one industry if, as a
result of such acquisition, more than 25% of the value of its total assets would
be invested in securities of companies within such industry;
13. Write or acquire options (except as described in (1) above) or
interests in oil, gas or other mineral exploration, leases or development
programs;
14. Purchase warrants; however, it may acquire warrants as a result of
corporate actions involving its holdings of other equity securities;
15. Purchase securities on margin or sell short; or
16. Acquire more than 10% of the voting securities of any issuer.
Although (2) above prohibits cash loans, the Index Master Portfolio is
authorized to lend portfolio securities. With respect to (7) above, pursuant to
Rule 144A under the 1993 Act, the Index Master Portfolio may purchase certain
unregistered (i.e. restricted) securities upon a determination that a liquid
institutional market exists for the securities. If it is decided that a liquid
market does exist, the securities will not be subject to the 10% limitation on
holdings of illiquid securities stated in (7) above. While maintaining
oversight, the Board of Trustees of the Trust has delegated the day-to-day
function of making liquidity determinations to DFA, the Index Master Portfolio's
adviser. For Rule 144A securities to be considered liquid, there must be at
least two dealers making a market in such securities. After purchase, the Board
of Trustees of the
-60-
<PAGE>
Trust and DFA will continue to monitor the liquidity of Rule 144A
securities.
For purposes of (12) above, utility companies will be divided according to
their services; e.g., gas, gas transmission, electric and gas, electric, water
and telephone will each be considered a separate industry.
Because the structure of the Index Master Portfolio is based on the
relative market capitalizations of eligible holdings, it is possible that the
Index Master Portfolio might include at least 5% of the outstanding voting
securities of one or more issuers. In such circumstances, the Trust and the
issuer would be deemed "affiliated persons" under the Investment Company Act of
1940, and certain requirements of the Act regulating dealings between affiliates
might become applicable.
TRUSTEES AND OFFICERS
THE FUND
The trustees and executive officers of the Fund, and their business
addresses and principal occupations during the past five years, are:
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
William O. Albertini Trustee Executive Vice President
Bell Atlantic Global and Chief Financial
Wireless Officer since August,
1717 Arch Street 1997, Bell Atlantic
29th Floor East Global Wireless (global
Philadelphia, PA 19103 wireless communications);
Age: 55 Executive Vice President,
Chief Financial Officer
and Director from
February 1995-August
1997, Vice President and
Chief Financial Officer
from January 1991 -
February 1995, Bell
Atlantic Corporation (a
diversified
telecommunications
company); Chairman,
President and Chief
Executive Officer from
August 1989 - January
1991, Bell Atlantic
Enterprises
International, Inc.;
</TABLE>
-61-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Director, Groupo
Iusacell, S.A. de C.V.
(cellular communications
company) since June 1994;
Director, American
Waterworks, Inc. (water
utility) since May 1990;
Trustee, The Carl E. &
Emily I. Weller
Foundation since October
1991.
Raymond J. Clark1 Trustee, Treasurer of Princeton
Office of the Treasurer President and University since 1987;
Princeton University Treasurer Trustee, The Compass
3 New South Building Capital Group of Funds
P.O. Box 35 from 1987 to 1996;
Princeton, New Jersey 08540 Trustee, United-Way
Age: 62 Princeton Area
Communities from 1992-
94; Trustee, Chemical
Bank, New Jersey
Advisory Board from 1994
until 1995; Trustee,
American Red Cross-
Mercer County Chapter
since 1995; Trustee,
Medical Center of
Princeton; and Trustee,
United Way-Greater
Mercer County from 1996-
1997.
Robert M. Hernandez Trustee Director since 1991, Vice
USX Corporation Chairman and Chief
600 Grant Street Financial Officer
6105 USX Tower since 1994, Executive
Pittsburgh, PA 15219 Vice President -
Age: 53 Accounting and Finance
and Chief Financial
Officer from 1991 to
1994, USX Corporation (a
</TABLE>
____________________
1. This trustee may be deemed an "interested person" of the Fund as defined in
the 1940 Act.
-62-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
diversified company
principally engaged in
energy and steel
businesses); Director
and Chairman of the
Executive Committee, ACE
Limited (insurance
company); Trustee,
Allegheny University
Hospitals, Allegheny
General; and Allegheny
Health, Education and
Research Foundation;
Director, Marinette
Marine Corporation;
Director, Pittsburgh
Baseball, Inc. from 1994-
96; Director, Transtar,
Inc. (transportation
company) since 1996; and
Director and Chairman of
the Board, RMI Titanium
Company.
Anthony M. Santomero Vice Chairman Deputy Dean from
The Wharton School of the Board 1990 to 1994, Richard
University of Pennsylvania K. Mellon Professor
Room 2344 of Finance since April
Steinberg Hall-Dietrich Hall 1984, Director, Wharton
Philadelphia, PA 19104-6367 Financial Institutions
Age: 51 Center, since July 1995,
and Dean's Advisory
Council Member since
July 1984, The Wharton
School, University of
Pennsylvania; Associate
Editor, Journal of
Banking and Finance
since June 1978;
Associate Editor,
Journal of Economics and
Business since October
1979; Associate Editor,
Journal of Money, Credit
and Banking since
January 1980; Editorial
Advisory Board, Open
Economics Review since
November 1990; Director,
The Zweig
</TABLE>
-63-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Fund and The Zweig Total
Return Fund; Director of
Municipal Fund for
California Investors,
Inc. and Municipal Fund
for New York Investors,
Inc.
David R. Wilmerding, Jr. Chairman of Chairman, Gee,
One Aldwyn Center the Board Wilmerding & Asso-
Villanova, PA 19085 ciates, Inc.
Age: 62 (investment advisers)
since February 1989;
Director, Beaver
Management Corporation;
Managing General
Partner, Chestnut Street
Exchange Fund; Director,
Independence Square
Income Securities, Inc.;
Director, The Mutual
Fire, Marine and Inland
Insurance Company;
Director, U.S.
Retirement Communities,
Inc.; Director, Trustee
or Managing General
Partner of a number of
investment companies
advised by PIMC and its
affiliates.
Karen H. Sabath Assistant President, Compass
BlackRock, Inc. Secretary Capital Group, Inc. since
345 Park Avenue 1995; Managing Director
New York, NY 10154 of BlackRock Financial
Age: 31 Management, Inc. since
1993; prior to 1993, Vice
President of BlackRock
Financial Management,
Inc.
Ellen L. Corson Assistant Vice President and
PFPC Inc. Treasurer Director of Mutual Fund
103 Bellevue Parkway Accounting and Adminis-
Wilmington, DE 19809 tration, PFPC Inc. since
Age: 33 November 1997; Assistant
Vice President, PFPC Inc.
from March 1997 to
November 1997; Senior
Accounting Officer, PFPC
Inc. from March 1993 to
March 1997.
</TABLE>
-64-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Brian P. Kindelan Secretary Senior Counsel, PNC Bank
PNC Bank Corp. Corp. since May 1995;
1600 Market Street, Associate, Stradley, Ronon,
28th Fl. Stevens & Young from March
Philadelphia, PA 19103 1990 to May 1995.
Age: 38
</TABLE>
The Fund pays trustees who are not affiliated with BlackRock, Inc.
(formerly PNC Asset Management Group, Inc.) or BlackRock Distributors, Inc.
("BDI" or "Distributor") $10,000 annually and $275 per Portfolio for each full
meeting of the Board that they attend. The Fund pays the Chairman and Vice
Chairman of the Board an additional $10,000 and $5,000 per year, respectively,
for their service in such capacities. Trustees who are not affiliated with
BlackRock, Inc. or the Distributor are reimbursed for any expenses incurred in
attending meetings of the Board of Trustees or any committee thereof. No
officer, director or employee of BlackRock, Inc., PNC Institutional Management
Corporation ("PIMC"), Provident Capital Management, Inc. ("PCM"), BlackRock
Financial Management, Inc. ("BlackRock"), PNC Equity Advisors Company ("PEAC"),
CastleInternational Asset Management Limited ("CastleInternational"), PFPC Inc.
("PFPC"), BDI (collectively with PFPC and BlackRock, Inc., the
"Administrators"), or PNC Bank, National Association ("PNC Bank" or the
"Custodian") currently receives any compensation from the Fund. As of the date
of this Statement of Additional Information, the trustees and officers of the
Fund, as a group, owned less than 1% of the outstanding shares of each class of
each Portfolio.
The table below sets forth the compensation actually received from the
Fund and the Fund Complex of which the Fund is a part by the trustees for the
fiscal year ended September 30, 1997:
<TABLE>
<CAPTION>
TOTAL
PENSION OR COMPENSATION
RETIREMENT FROM REGISTRANT
AGGREGATE BENEFITS ESTIMATED AND FUND
COMPENSATION ACCRUED AS ANNUAL COMPLEX/1/
NAME OF PERSON, FROM PART OF FUND BENEFITS UPON PAID TO
POSITION REGISTRANT EXPENSES RETIREMENT TRUSTEES
- -------- ---------- -------- ---------- --------
<S> <C> <C> <C> <C>
</TABLE>
-65-
<PAGE>
<TABLE>
<S> <C> <C> <C> <C>
Anthony M. $52,300 N/A N/A (3)/2/ $64,300
Santomero, Vice
Chairman of the
Board
David R. Wilmerding, $61,050 N/A N/A (3)/2/ $73,050
Jr., Chairman of the
Board
William O. $43,550 N/A N/A (1)/2/ $43,550
Albertini, Trustee
Raymond J. Clark, $43,550 N/A N/A (1)/2/ $43,550
Trustee
Robert M. Hernandez, $43,550 N/A N/A (1)/2/ $43,550
Trustee
</TABLE>
- --------------------
1. A Fund Complex means two or more investment companies that hold themselves
out to investors as related companies for purposes of investment and
investment services, or have a common investment adviser or have an
investment adviser that is an affiliated person of the investment adviser
of any of the other investment companies.
2. Total number of investment company boards trustees served on within the
Fund Complex.
-66-
<PAGE>
THE TRUST
The names, addresses and dates of birth of the trustees and officers of the
Trust and a brief statement of their present positions and principal occupations
during the past five years are set forth below. As used below, "DFA Entities"
refers to the following: Dimensional Fund Advisors Inc., Dimensional Fund
Advisors Ltd., DFA Australia Limited, DFA Investment Dimensions Group Inc.
(Registered Investment Company), Dimensional Emerging Markets Fund Inc.
(Registered Investment Company), Dimensional Investment Group Inc. (Registered
Investment Company) and DFA Securities Inc.
<TABLE>
<CAPTION>
Principal Occupation During
Trustees Position with Trust Last Five Years
- -------- ------------------- ---------------
<S> <C> <C>
David G. Booth* Trustee, President President, Chairman-Chief
Santa Monica, CA and Chairman-Chief Executive Officer and Director
Birthdate: Executive Officer of all DFA Entities, except
12/2/46 Dimensional Fund Advisors Ltd.,
of which he is Chairman and
Director
George M. Trustee Leo Melamed Professor of
Constantinides Finance, Graduate School of
Chicago, IL Business, University of Chicago.
Birthdate: Director, DFA Investment
9/22/47 Dimensions Group Inc.,
Dimensional Investment Group
Inc. and Dimensional Emerging
Markets Fund Inc.
John P. Gould Trustee Steven G. Rothmeier
Chicago, IL Distinguished Service Professor
Birthdate: of Economics, Graduate School of
1/19/39 Business, University of Chicago.
Trustee, First Prairie Funds
(registered investment
companies). Director, DFA
Investment Dimensions Group
Inc., Dimensional Investment
Group Inc., Dimensional Emerging
Markets Fund Inc. and Harbor
Investment Advisors. Executive
Vice President, Lexecon Inc.
(economics, law, strategy, and
finance consulting).
</TABLE>
-67-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation During
Trustees Position with Trust Last Five Years
- -------- ------------------- ---------------
<S> <C> <C>
Roger G. Trustee Professor in Practice of
Ibbotson Finance, Yale School of
New Haven, CT Management. Director, DFA
Birthdate: Investment Dimensions Group
5/27/43 Inc., Dimensional Investment
Group Inc., Dimensional Emerging
Markets Fund Inc., Hospital
Fund, Inc. (investment
management services) and BIRR
Portfolio Analysis, Inc.
(software products). Chairman
and President, Ibbotson
Associates, Inc., Chicago, IL
(software, data, publishing and
consulting).
Merton H. Miller Trustee Robert R. McCormick
Chicago, IL Distinguished Service Professor
Birthdate: Emeritus, Graduate School of
5/16/23 Business, University of Chicago.
Director, DFA Investment
Dimensions Group Inc.,
Dimensional Investment Group
Inc. and Dimensional Emerging
Markets Fund Inc. Public
Director, Chicago Mercantile
Exchange.
Myron S. Scholes Trustee Limited Partner, Long-Term
Greenwich, CT Capital Management L.P. (money
Birthdate:7/1/42 manager). Frank E. Buck
Professor Emeritus of Finance,
Graduate School of Business and
Professor of Law, Law School,
Senior Research Fellow, Hoover
Institution, (all) Stanford
University. Director, DFA
Investment Dimensions Group
Inc., Dimensional Investment
Group Inc., Dimensional
Emerging Markets Fund Inc.,
Benham Capital Management Group
of Investment Companies and
Smith Breedon Group of
Investment Companies.
</TABLE>
-68-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation During
Trustees Position with Trust Last Five Years
- -------- ------------------- ---------------
<S> <C> <C>
Trustee, Chairman Chairman-Chief Investment
Rex A. and Chief Officer and Director of all DFA
Sinquefield* Investment Officer Entities, except Dimensional
Santa Monica, CA Fund Advisors Ltd., of which he
Birthdate: is Chairman, Chief Executive
9/7/44 Officer and Director.
</TABLE>
*Interested
Trustee of the
Trust.
_____________
-69-
<PAGE>
<TABLE>
<CAPTION>
Principal Occupation During
Trustees Position with Trust Last Five Years
- -------- ------------------- ---------------
<S> <C> <C>
Arthur Barlow Vice President Vice President of all DFA
Santa Monica, CA Entities.
Birthdate:
11/7/55
Truman Clark Vice President Vice President of all DFA
Santa Monica, CA Entities. Consultant until
Birthdate: October 1995 and Principal and
4/8/41 Manager of Product Development,
Wells Fargo Nikko Investment
Advisors from 1990-1994.
Maureen Connors Vice President Vice President of all DFA
Santa Monica, CA Entities.
Birthdate:
11/17/36
Robert Deere Vice President Vice President of all DFA
Santa Monica, CA Entities.
Birthdate:
10/8/57
Irene R. Diamant Vice President, Vice President and Secretary of
Santa Monica, CA Secretary all DFA Entities, except
Birthdate: Dimensional Fund Advisors Ltd.,
7/16/50 for which she is Vice President.
Eugene Fama, Jr. Vice President Vice President of all DFA
Santa Monica, CA Entities.
Birthdate:
1/21/61
Kamyab Hashemi- Vice President, Vice President, Controller and
Nejad, Controller and Assistant Treasurer of all DFA
Santa Monica, CA Assistant Treasurer Entities.
Birthdate:
1/22/61
Stephen P. Vice President Managing Director, ANB
Manus, Investment Management and Trust
Santa Monica, Company from 1985-1993;
CA President, ANB Investment
Birthdate: Management and Trust Company
12/26/50 from 1993-1997. Vice President
of all DFA Entities.
Karen McGinley, Vice President Vice President of all DFA
Santa Monica, Entities.
CA
Birthdate:
3/10/66
Catherine L. Vice President and Associate, Morrison & Foerster,
Newell, Assistant Secretary LLP from 1989-1996. Vice
Santa Monica, President of all DFA Entities.
CA
Birthdate:
5/7/64
</TABLE>
-70-
<PAGE>
<TABLE>
<S> <C> <C>
David Plecha Vice President Vice President of all DFA
Santa Monica, Entities.
CA
Birthdate:
10/26/61
George Sands Vice President Vice President of all DFA
Santa Monica, CA Entities.
Birthdate:
2/8/56
Michael T. Vice President, Vice President, Chief Financial
Scardina Chief Financial Officer, and Treasurer of all
Santa Monica, CA Officer, and DFA Entities.
Birthdate: Treasurer
10/12/55
Jeanne C. Executive Vice Executive Vice President of all
Sinquefield, President DFA Entities.
Ph.D.
Santa Monica, CA
Birthdate:
12/2/46
Scott Thornton, Vice President Vice President of all DFA
Santa Monica, Entities.
CA
Birthdate:
3/1/63
Weston Vice President Vice President of all DFA
Wellington, Entities. Vice President,
Santa Monica, Director of Research, LPL
CA Financial Services, Inc.
Birthdate:
3/1/51
</TABLE>
Rex A. Sinquefield, Trustee, Chairman and Chief Investment Officer of the Trust
and Jeanne C. Sinquefield, Executive Vice President of the Trust, are husband
and wife.
Set forth below is a table listing, for each trustee of the Trust entitled
to receive compensation, the compensation received from the Trust during the
fiscal year ended November 30, 1997 and the total compensation received from all
four registered investment companies for
-71-
<PAGE>
which Dimensional Fund Advisors Inc. ("DFA") served as investment adviser during
that same fiscal year.
<TABLE>
<CAPTION>
TOTAL
PENSION OR COMPENSATION
RETIREMENT FROM
AGGREGATE BENEFITS ESTIMATED REGISTRANT AND
COMPENSATION ACCRUED AS ANNUAL TRUST COMPLEX1
NAME OF PERSON, FROM PART OF TRUST BENEFITS UPON PAID TO
POSITION REGISTRANT EXPENSES RETIREMENT TRUSTEES
- -------- ---------- -------- ---------- --------
<S> <C> <C> <C> <C>
George M. $5,000 N/A N/A $30,000
Constantinides,
Trustee
John P. Gould, $5,000 N/A N/A $30,000
Trustee
Roger G. Ibbotson, $5,000 N/A N/A $30,000
Trustee
Merton H. Miller, $5,000 N/A N/A $30,000
Trustee
Myron S. Scholes, $5,000 N/A N/A $30,000
Trustee
</TABLE>
SHAREHOLDER AND TRUSTEE LIABILITY OF THE FUND
Under Massachusetts law, shareholders of a business trust may, under certain
circumstances, be held personally liable as partners for the obligations of the
trust. However, the Fund's Declaration of Trust provides that shareholders shall
not be subject to any personal liability in connection with the assets of the
Fund for the acts or obligations of the Fund, and that every note, bond,
contract, order or other undertaking made by the Fund shall contain a provision
to the effect that the shareholders are not personally liable thereunder. The
Declaration of Trust provides for indemnification out of the trust property of
any shareholder held personally liable solely by reason of his being or having
been a shareholder and not because of his acts or omissions or some other
reason. The Declaration of Trust also provides that the Fund shall, upon
request, assume the defense of any claim made against any shareholder for any
act or obligation of the Fund, and shall satisfy any judgment thereon.
The Declaration of Trust further provides that all persons having any claim
against the trustees or Fund shall look solely to the trust property for
payment; that no trustee of the Fund shall be personally liable for or on
account of any contract,
_____________________
1 A Trust Complex means two or more investment companies that hold themselves
out to investors as related companies for purposes of investment and
investor services, or have a common investment adviser or have an
investment adviser that is an affiliated person of the investment adviser
of any of the other investment companies.
-72-
<PAGE>
debt, tort, claim, damage, judgment or decree arising out of or connected with
the administration or preservation of the trust property or the conduct of any
business of the Fund; and that no trustee shall be personally liable to any
person for any action or failure to act except by reason of his own bad faith,
willful misfeasance, gross negligence or reckless disregard of his duties as a
trustee. With the exception stated, the Declaration of Trust provides that a
trustee is entitled to be indemnified against all liabilities and expenses
reasonably incurred by him in connection with the defense or disposition of any
proceeding in which he may be involved or with which he may be threatened by
reason of his being or having been a trustee, and that the Fund will indemnify
officers, representatives and employees of the Fund to the same extent that
trustees are entitled to indemnification.
INVESTMENT ADVISORY, ADMINISTRATION,
DISTRIBUTION AND SERVICING ARRANGEMENTS
Advisory and Sub-Advisory Agreements. The advisory and sub- advisory
services provided by BlackRock, Inc., PIMC, BlackRock, PCM, PEAC,
CastleInternational and, with respect to the Index Master Portfolio, Dimensional
Fund Advisors Inc. ("DFA") and the fees received by each of them for such
services are described in the Prospectuses. As stated in the Prospectuses,
BlackRock, Inc. may from time to time voluntarily waive its advisory fees with
respect to a Portfolio and may voluntarily reimburse the Portfolios for
expenses.
BlackRock, Inc., a wholly-owned indirect subsidiary of PNC Bank Corp.,
renders advisory services to each of the Portfolios, except the Index Equity
Portfolio, pursuant to an Investment Advisory Agreement. From the commencement
of operations of each Portfolio (other than the New Jersey Municipal Money
Market, New Jersey Tax-Free Income, Core Bond, Low Duration Bond and
International Bond Portfolios) until January 4, 1996 (June 1, 1996 in the case
of the Index Equity Portfolio), PIMC served as adviser.
From July 1, 1991 to December 31, 1995, Midlantic Bank, N.A. ("Midlantic
Bank") served as investment adviser to the predecessor portfolios of the
International Bond, New Jersey Tax- Free Income and New Jersey Municipal Money
Market Portfolios. From January 1, 1996 through January 12, 1996 (February 12,
1996 with respect to the predecessor portfolio of the International Bond
Portfolio): (i) BlackRock, Inc. and Morgan Grenfell Investment Services Limited
("Morgan Grenfell") served as investment adviser and sub-adviser, respectively,
to the predecessor portfolio to the International Bond Portfolio; (ii) PIMC
served as investment adviser to the predecessor portfolio to the New Jersey
Municipal Money Market Portfolio; and (iii)
-73-
<PAGE>
BlackRock served as investment adviser to the predecessor portfolio to the New
Jersey Tax-Free Income Portfolio pursuant to interim advisory and sub-advisory
agreements approved by the shareholders of the Compass Capital Group of Funds.
From December 9, 1992 to January 13, 1996, BlackRock served as investment
adviser to the predecessor portfolio of the Core Bond Portfolio. From July 17,
1992 to January 13, 1996, BlackRock served as investment adviser to the
predecessor portfolio of the Low Duration Bond Portfolio.
PCM renders sub-advisory services to the Balanced, Large Cap Value Equity,
Mid-Cap Value Equity, Small Cap Value Equity and Select Equity Portfolios
pursuant to Sub-Advisory Agreements. CastleInternational renders sub-advisory
services to the International Equity, International Emerging Markets and
International Small Cap Equity Portfolios pursuant to Sub- Advisory Agreements.
PIMC renders sub-advisory services to the Money Market, U.S. Treasury Money
Market, Municipal Money Market, Ohio Municipal Money Market, Pennsylvania
Municipal Money Market, North Carolina Municipal Money Market, Virginia
Municipal Money Market and New Jersey Municipal Money Market Portfolios pursuant
to Sub-Advisory Agreements. BlackRock renders sub-advisory services to the
Balanced, Managed Income, Intermediate Government Bond, Tax-Free Income, Ohio
Tax-Free Income, Pennsylvania Tax- Free Income, Low Duration Bond, Intermediate
Bond, New Jersey Tax-Free Income, Core Bond, Government Income and International
Bond Portfolios pursuant to Sub-Advisory Agreements. PEAC renders sub-advisory
services to the Large Cap Growth Equity, Mid-Cap Growth Equity, Small Cap Growth
Equity and Micro-Cap Equity Portfolios pursuant to Sub-Advisory Agreements. DFA
renders advisory services to the Index Master Portfolio, the registered
investment company in which the Index Equity Portfolio invests all of its
assets, pursuant to an Investment Management Agreement. The Investment Advisory
Agreement with BlackRock, Inc., the Investment Management Agreement with DFA and
the above-referenced Sub-Advisory Agreements are collectively referred to as the
"Advisory Contracts."
From December 1, 1992 (commencement of operations) to March 29, 1995, PNC
Bank, Ohio, National Association ("PNC Bank Ohio") served as sub-adviser to the
Ohio Tax-Free Income Portfolio. From November 1, 1989 (commencement of
operations) to September 10, 1993, PNC Bank Ohio served as sub-adviser to the
Municipal Money Market Portfolio. From November 1, 1989 (commencement of
operations) to September 10, 1993, PNC Bank Ohio served as sub- adviser to the
Managed Income and Large Cap Growth Equity Portfolios. From April 20, 1992 to
September 10, 1993, PCM served as sub-adviser to the Intermediate Government
Bond Portfolio. From July 23, 1992 to March 29, 1995, PNC Bank served as sub-
adviser to the Index Equity Portfolio. From September 11, 1993 to March 29,
1995, PNC Bank served as sub-adviser to the
-74-
<PAGE>
Managed Income, Intermediate Government Bond and Large Cap Growth Equity
Portfolios. From December 1, 1992 (commencement of operations) to March 29,
1995, PNC Bank served as sub-adviser to the Ohio Tax-Free Income and
Pennsylvania Tax-Free Income Portfolios. From September 13, 1993 (commencement
of operations) to March 29, 1995, PNC Bank served as sub-adviser to the Select
Equity Portfolio. From September 14, 1993 (commencement of operations) to March
29, 1995, PNC Bank served as sub-adviser to the Small Cap Growth Equity
Portfolio. From September 17, 1993 (commencement of operations) to March 29,
1995, PNC Bank served as sub-adviser to the Intermediate Bond Portfolio. From
May 14, 1990 (commencement of operations) to July 1, 1995, PNC Bank served as
sub-adviser to the Tax-Free Income Portfolio. PCM served as sub-adviser to the
International Equity and International Emerging Markets Portfolios from
commencement of operations (April 27, 1992 in the case of the International
Equity Portfolio; June 17, 1994 in the case of the International Emerging
Markets Portfolio) to April 19, 1996.
PNC Bank served as sub-adviser for the Money Market Portfolio from October
4, 1989 (commencement of operations) to January 4, 1996; for the Municipal Money
Market Portfolio from September 10, 1993 to January 4, 1996; for the U.S.
Treasury Money Market Portfolio from November 1, 1989 (commencement of
operations) to January 4, 1996; for the Ohio Municipal Money Market Portfolio
from June 1, 1993 (commencement of operations) to January 4, 1996; for the
Pennsylvania Municipal Money Market Portfolio from June 1, 1993 (commencement of
operations) to January 4, 1996; for the North Carolina Municipal Money Market
Portfolio from May 4, 1993 (commencement of operations) to January 4, 1996; for
the Virginia Municipal Money Market Portfolio from July 25, 1994 (commencement
of operations) to January 4, 1996; and for the New Jersey Municipal Money Market
Portfolio from January 13, 1996 to June 6, 1996. From April 4, 1990
(commencement of operations) to January 4, 1996, PNC Bank served as sub-adviser
to the Balanced Portfolio. From March 1, 1993 to January 4, 1996, PEAC served as
sub-adviser to the Select Equity Portfolio. From March 29, 1995 to June 1, 1996,
PEAC served as sub-adviser to the Index Equity Portfolio. From July 1, 1996
through December 31, 1996, Morgan Grenfell served as sub- adviser to the
International Bond Portfolio.
Under the relevant Advisory Contracts, BlackRock, Inc., PIMC, PCM, PEAC,
BlackRock and CastleInternational are not liable for any error of judgment or
mistake of law or for any loss suffered by the Fund or a Portfolio in connection
with the performance of the Advisory Contracts. Under the Advisory Contracts,
BlackRock, Inc., PIMC, PCM, PEAC, BlackRock, CastleInternational and DFA are
liable for a loss resulting from willful misfeasance, bad faith or gross
negligence in the performance of their respective duties or from reckless
disregard of their respective duties and obligations thereunder. Each of
-75-
<PAGE>
the Advisory Contracts (except the Advisory Contract relating to the Index
Master Portfolio) is terminable as to a Portfolio by vote of the Fund's Board of
Trustees or by the holders of a majority of the outstanding voting securities of
the relevant Portfolio, at any time without penalty, on 60 days' written notice
to BlackRock, Inc., PIMC, PCM, PEAC, BlackRock or CastleInternational, as the
case may be. BlackRock, Inc., PIMC, PCM, PEAC, BlackRock and CastleInternational
may also terminate their advisory relationship with respect to a Portfolio on 60
days' written notice to the Fund. The Advisory Contract relating to the Index
Master Portfolio is terminable by vote of the Trust's Board of Trustees or by
the holders of a majority of the outstanding voting securities of the Index
Master Portfolio at any time without penalty on 60 days' written notice to DFA.
DFA may also terminate its advisory relationship with respect to the Index
Master Portfolio on 90 days' written notice to the Trust. Each of the Advisory
Contracts terminates automatically in the event of its assignment.
For the period from October 1, 1996 (December 27, 1996 in the case of the
Mid-Cap Growth Equity and Mid-Cap Value Equity Portfolios; and September 26,
1997 in the case of the International Small Cap Equity Portfolio) through
September 30, 1997, the Fund paid BlackRock, Inc. advisory fees, and BlackRock,
Inc. waived advisory fees and reimbursed expenses, as follows:
<TABLE>
<CAPTION>
Fees Paid
Portfolios (After Waivers) Waivers Reimbursements
- --------------------------------------------------------------- --------------- ------- --------------
<S> <C> <C> <C>
Money Market................................................... $2,648,951 $8,355,021 $ 0
U.S. Treasury Money Market..................................... 865,528 3,842,169 0
Municipal Money Market......................................... 247,591 1,482,338 0
New Jersey Municipal Money Market.............................. 67,821 483,238 0
North Carolina Municipal Money Market.......................... 94,458 602,236 0
Ohio Municipal Money Market.................................... 66,919 434,972 0
Pennsylvania Municipal Money Market............................ 378,571 2,048,282 0
Virginia Municipal Money Market................................ 4,280 267,307 18,025
Low Duration Bond.............................................. 599,206 517,845 0
Intermediate Government Bond................................... 462,943 308,628 0
Intermediate Bond.............................................. 973,237 648,825 0
Core Bond...................................................... 1,040,492 1,005,843 0
Government Income.............................................. 465 84,527 47,550
Managed Income................................................. 2,629,559 1,126,954 0
International Bond............................................. 220,526 12,573 0
Tax-Free Income................................................ 158,143 123,004 0
Pennsylvania Tax-Free Income................................... 268,228 178,819 0
New Jersey Tax-Free Income..................................... 254,415 179,069 0
Ohio Tax-Free Income........................................... 10,355 43,390 0
Large Cap Value Equity......................................... 6,487,065 480,085 0
Large Cap Growth Equity........................................ 3,718,080 233,396 0
Mid-Cap Value Equity........................................... 499,380 4,043 0
Mid-Cap Growth Equity.......................................... 499,026 4,087 0
</TABLE>
-76-
<PAGE>
<TABLE>
<S> <C> <C> <C>
Small Cap Value Equity......................................... 2,036,977 6,910 0
Small Cap Growth Equity........................................ 3,169,739 32,560 0
International Equity........................................... 4,101,006 556,548 0
International Small Cap Equity................................. 0 0 0
International Emerging Markets................................. 1,786,671 152,118 0
Select Equity.................................................. 2,562,623 154,197 0
Balanced....................................................... 1,486,866 92,278 0
</TABLE>
For the period from October 1, 1995 through January 4, 1996, the Fund paid
PIMC advisory fees, and PIMC waived advisory fees and reimbursed expenses, as
follows:
<TABLE>
<CAPTION>
FEES PAID
PORTFOLIOS (AFTER WAIVERS) WAIVERS REIMBURSEMENTS
- ---------- -------------- ---------- --------------
<S> <C> <C> <C>
Money Market $321,268 $1,818,401 $0
Municipal Money Market 46,804 304,226 0
U.S. Treasury Money Market 114,639 745,150 0
Ohio Municipal Money Market 11,052 71,841 0
Pennsylvania Municipal Money Market 64,257 417,675 0
North Carolina Municipal Money 11,026 71,666 0
Market
Virginia Municipal Money Market 0 7,024 0
Managed Income 520,724 223,168 0
Government Income 0 17,234 0
Tax-Free Income 3,933 11,137 0
Intermediate Government Bond 114,345 130,122 0
Ohio Tax-Free Income 723 10,100 0
Pennsylvania Tax-Free Income 43,145 37,663 0
Intermediate Bond 136,544 119,059 0
Large Cap Value Equity 829,764 147,027 0
Large Cap Growth Equity 361,240 95,914 0
Small Cap Growth Equity 304,284 23,327 0
Select Equity 369,071 97,791 0
Index Equity 4,647 88,292 0
Small Cap Value Equity 320,588 24,942 0
International Equity 697,319 127,354 0
International Emerging Markets 144,937 11,380 0
Balanced 201,642 53,929 0
</TABLE>
For the period from January 5, 1996 (February 1, 1996 in the case of the
New Jersey Tax-Free Income and New Jersey Municipal Money Market Portfolios;
February 13, 1996 in the case of the International Bond Portfolio; and April 1,
1996 in the case of the Core Bond and Low Duration Bond Portfolios) through
September 30, 1996 (June 1, 1996 in the case of the Index Equity Portfolio), the
Fund paid BlackRock, Inc. (PIMC in the case of the Index Equity Portfolio)
advisory fees, and BlackRock, Inc. (PIMC in the case of the Index Equity
Portfolio) waived advisory fees and reimbursed expenses, as follows:
-77-
<PAGE>
<TABLE>
<CAPTION>
Fees Paid
Portfolios (After Waivers) Waivers Reimbursements
- ---------- -------------- -------------- --------------
<S> <C> <C> <C>
Money Market $1,443,913 $6,290,596 $0
Municipal Money Market 158,379 1,029,459 0
U.S. Treasury Money Market 691,448 3,584,858 0
Ohio Municipal Money Market 32,275 209,784 0
Pennsylvania Municipal Money Market 240,350 1,562,271 0
North Carolina Municipal Money Market 45,997 298,983 0
Virginia Municipal Money Market 0 180,685 14,604
New Jersey Municipal Money Market 32,663 212,365 0
Managed Income 1,796,762 770,041 0
Government Income 0 52,817 7,027
Tax-Free Income 109,211 74,939 0
Intermediate Government Bond 425,069 283,380 0
Ohio Tax-Free Income 4,764 31,253 3,479
Pennsylvania Tax-Free Income 185,302 123,326 0
Intermediate Bond 514,322 342,880 0
New Jersey Tax-Free Income 184,448 122,966 0
International Bond 133,797 4,580 0
Core Bond 424,691 283,127 0
Low Duration Bond 338,287 225,525 0
Large Cap Value Equity 4,159,395 421,173 0
Large Cap Growth Equity 2,109,685 210,969 0
Small Cap Growth Equity 1,596,126 7,204 0
Select Equity 1,457,052 145,705 0
Index Equity 28,380 174,535 0
Small Cap Value Equity 1,223,651 0 0
International Equity 2,836,323 202,595 0
International Emerging Markets 740,140 63,810 0
Balanced 917,400 91,740 0
</TABLE>
-78-
<PAGE>
For the year or periods ended September 30, 1995, the Fund paid PIMC
advisory fees, and PIMC waived advisory fees and reimbursed expenses, as
follows:
<TABLE>
<CAPTION>
Fees Paid
Portfolios (After Waivers) Waivers Reimbursements
- ---------- --------------- -------------- --------------
<S> <C> <C> <C>
Money Market $1,051,446 $5,217,130 $0
Municipal Money Market 189,929 921,718 0
U.S. Treasury Money Market 489,209 2,327,266 0
Ohio Municipal Money Market 49,133 245,955 0
Pennsylvania Municipal Money Market 304,651 1,264,187 0
North Carolina Municipal Money
Market 46,472 369,591 4,999
Managed Income 1,790,332 767,285 0
Tax-Free Income 0 49,671 1,599
Intermediate Government Bond 379,534 569,302 0
Ohio Tax-Free Income 0 42,044 6,713
Pennsylvania Tax-Free Income 161,038 137,951 0
Intermediate Bond 342,301 335,908 0
Large Cap Value Equity 2,832,644 746,727 0
Large Cap Growth Equity 866,271 324,851 0
Small Cap Growth Equity 618,374 137,615 0
Select Equity 691,447 259,293 0
Index Equity 30,772 382,205 0
Small Cap Value Equity 1,143,071 114,307 0
International Equity 2,391,607 597,902 0
Balanced 642,763 241,037 0
Virginia Municipal Money Market 0 85,063 35,957
International Emerging Markets 258,648 52,186 0
Government Income/1/ 0 37,256 11,980
</TABLE>
/1/ For the period from commencement of operations (October 3, 1994) through
September 30, 1995.
For the period from October 1, 1996 (December 27, 1996 in the case of the
Mid-Cap Growth Equity and Mid-Cap Value Equity Portfolios; and September 26,
1997 in the case of the International Small Cap Equity Portfolio) through
September 30, 1997, BlackRock, Inc. paid sub-advisory fees to the specified
Portfolios' sub-advisers, after waivers, and such sub-advisers waived sub-
advisory fees as follows:
-79-
<PAGE>
<TABLE>
<CAPTION>
Fees Paid
Portfolios (After Waivers) Waivers
- ---------- --------------- --------------
<S> <C> <C>
Money Market $1,300,023 $9,370,873
U.S. Treasury Money Market 577,321 3,631,808
Municipal Money Market 212,376 1,325,338
New Jersey Municipal Money Market 75,204 414,553
North Carolina Municipal Money Market 81,568 536,785
Ohio Municipal Money Market 62,070 384,055
Pennsylvania Municipal Money Market 298,167 1,859,027
Virginia Municipal Money Market 350 241,044
Low Duration Bond 36,930 745,005
Intermediate Government Bond 14,450 525,649
Intermediate Bond 15,164 1,120,194
Core Bond 104,500 1,327,935
Government Income 0 59,494
Managed Income 86,420 2,542,897
International Bond 79,789 89,738
Tax-Free Income 48,652 148,151
Pennsylvania Tax-Free Income 34,191 278,742
New Jersey Tax-Free Income 26,000 277,439
Ohio Tax-Free Income 38,606 0
Large Cap Value Equity 583,448 4,590,272
Large Cap Growth Equity 172,041 2,701,759
Mid-Cap Value Equity 15,821 413,497
Mid-Cap Growth Equity 15,422 413,851
Small Cap Value Equity 383,789 1,102,690
Small Cap Growth Equity 725,498 1,603,447
International Equity 269,395 3,456,696
International Small Cap Equity 0 727
International Emerging Markets 107,739 1,598,368
Select Equity 105,481 1,870,387
Balanced 297,047 851,422
</TABLE>
-80-
<PAGE>
For the period from October 1, 1995 through January 4, 1996, PIMC paid sub-
advisory fees to the specified Portfolios' sub-advisers, after waivers, and such
sub-advisers waived sub-advisory fees as follows:
<TABLE>
<CAPTION>
FEES PAID
(AFTER
PORTFOLIOS WAIVERS) WAIVERS
- ---------- --------- -------
<S> <C> <C>
Money Market $0 $235,363
Municipal Money Market 0 38,613
U.S. Treasury Money Market 0 94,577
Ohio Municipal Money Market 0 9,118
Pennsylvania Municipal Money 0 53,013
Market
North Carolina Municipal Money 0 9,096
Market
Virginia Municipal Money Market 0 773
Managed Income 497,581 82,654
Government Income 0 12,063
Tax-Free Income 3,693 9,207
Intermediate Government 73,585 97,542
Bond
Ohio Tax-Free Income 3,258 4,318
Pennsylvania Tax-Free Income 24,323 32,242
Intermediate Bond 76,937 101,986
Large Cap Value Equity 213,057 0
Large Cap Growth Equity 333,722 0
Small Cap Growth Equity 239,156 0
Select Equity 340,809 0
Index Equity 12,385 73,920
Small Cap Value Equity 252,237 0
International Equity 659,738 0
International Emerging Markets 137,559 0
Balanced 186,567 0
</TABLE>
For the period from January 5, 1996 (February 1, 1996 in the case of the
New Jersey Tax-Free Income and New Jersey Municipal Money Market Portfolios;
February 13, 1996 in the case of the International Bond Portfolio; and April 1,
1996 in the case of the Core Bond and Low Duration Bond Portfolios) through
September 30, 1996 (June 1, 1996 in the case of the Index Equity Portfolio),
BlackRock, Inc. (PIMC in the case of the Index Equity Portfolio) paid sub-
advisory fees to the specified Portfolios' sub-advisers, after waivers, and such
sub-advisers waived sub- advisory fees as follows:
-81-
<PAGE>
<TABLE>
<CAPTION>
FEES PAID
(AFTER
PORTFOLIOS WAIVERS) WAIVERS
- ---------- ---------- -------
<S> <C> <C>
Money Market $1,443,913 $5,342,421
Municipal Money Market 158,382 897,064
U.S. Treasury Money Market 694,221 3,095,647
Ohio Municipal Money Market 32,275 182,796
Pennsylvania Municipal Money
Market 240,350 1,361,445
North Carolina Municipal Money 45,997 260,560
Market
Virginia Municipal Money Market 0 160,601
New Jersey Municipal Money 32,663 149,411
Market
Managed Income 1,488,836 248,415
Government Income 0 36,973
Tax-Free Income 95,609 50,559
Intermediate Government 412,698 2,499
Bond
Ohio Tax-Free Income 1,428 23,786
Pennsylvania Tax-Free Income 170,395 84,589
Intermediate Bond 402,873 188,333
New Jersey Tax-Free Income 153,707 61,483
International Bond 106,486 0
Core Bond 353,907 141,564
Low Duration Bond 281,905 112,763
Large Cap Value Equity 3,314,383 0
Large Cap Growth Equity 1,686,503 0
Small Cap Growth Equity 1,164,980 0
Select Equity 1,164,368 0
Index Equity 20,642 123,200
Small Cap Value Equity 888,986 0
International Equity 2,431,134 0
International Emerging Markets 707,475 0
Balanced 733,223 0
</TABLE>
For the year or periods ended September 30, 1995, PIMC paid sub-advisory
fees to the specified Portfolios' sub-advisers, after waivers, and such sub-
advisers waived sub-advisory fees as follows:
-82-
<PAGE>
<TABLE>
<CAPTION>
FEES PAID
(AFTER
PORTFOLIOS WAIVERS) WAIVERS
- ---------- --------- -------
<S> <C> <C>
Money Market $0 $721,072
Municipal Money Market 0 123,516
U.S. Treasury Money Market 0 312,942
Ohio Municipal Money Market 0 32,788
Pennsylvania Municipal Money
Market 0 174,315
North Carolina Municipal Money
Market 0 46,229
Managed Income 1,253,232 537,100
Tax-Free Income 0 34,770
Intermediate Government 265,674 398,511
Bond
Ohio Tax-Free Income 0 29,431
Pennsylvania Tax-Free Income 112,727 96,566
Intermediate Bond 239,611 235,136
Large Cap Value Equity 2,060,105 543,074
Large Cap Growth Equity 630,015 236,255
Small Cap Growth Equity 449,727 100,084
Select Equity 502,871 188,576
Index Equity 30,772 286,654
Small Cap Value Equity 831,324 83,132
International Equity 1,913,286 478,322
Balanced 467,464 175,299
Virginia Municipal Money Market 0 9,451
International Emerging Markets 227,610 45,924
Government Income/1/ 0 26,079
</TABLE>
/1/ Commenced operations October 3, 1994.
For the services it provides as investment adviser to the Index Master
Portfolio, DFA is paid a monthly fee calculated as a percentage of average net
assets of the Index Master Portfolio. For the fiscal years ending November 30,
1995, 1996 and 1997, the Index Master Portfolio paid advisory fees to DFA
totalling $18,816, $62,405 and $160,156, respectively. The Index Equity
Portfolio did not invest in the Index Master Portfolio until June 2, 1996.
The predecessor portfolio to the New Jersey Tax-Free Income Portfolio was
advised by Midlantic Bank from July 1, 1991 through December 31, 1995, and by
BlackRock from January 1, 1996 through January 12, 1996. For the period from
January 1, 1996 through January 12, 1996, the predecessor portfolio to the New
Jersey Tax-Free Income Portfolio paid $20,165 in advisory fees to BlackRock. For
the period from March 1, 1995 through December
-83-
<PAGE>
31, 1995 and for the fiscal years ended February 28, 1995 and 1994, the
predecessor portfolio to the New Jersey Tax-Free Income Portfolio paid $496,305,
$607,485 and $159,582, respectively, in investment advisory fees to Midlantic
Bank pursuant to its prior investment advisory contract. In addition, during the
period from March 1, 1995 through December 31, 1995 and during the fiscal year
ended February 28, 1995, Midlantic Bank waived $0 and $2,451, respectively, in
investment advisory fees. During the period from January 13, 1996 through
January 31, 1996, the New Jersey Tax-Free Income Portfolio paid BlackRock, Inc.
$12,779 in investment advisory fees, and BlackRock, Inc. waived $8,520 in
investment advisory fees. During the period from January 13, 1996 through
January 31, 1996, BlackRock, Inc. paid BlackRock $8,945 in sub-advisory fees
with respect to the New Jersey Tax- Free Income Portfolio and BlackRock waived
$5,964 in sub-advisory fees.
The predecessor portfolio to the International Bond Portfolio was advised
by Midlantic Bank from July 1, 1991 through December 31, 1995, and by BlackRock,
Inc. from January 1, 1996 through February 12, 1996. For the period from
February 1, 1996 through February 12, 1996, the predecessor portfolio to the
International Bond Portfolio paid $4,134 in advisory fees to BlackRock, Inc.,
and BlackRock, Inc. waived advisory fees and reimbursed expenses totalling $0
and $0, respectively. For the period from February 1, 1996 through February 12,
1996, BlackRock, Inc. paid Morgan Grenfell $4,898 in sub-advisory fees with
respect to the predecessor portfolio to the International Bond Portfolio, and
Morgan Grenfell waived sub-advisory fees totalling $0. For the period from
January 1, 1996 through January 31, 1996, the predecessor portfolio to the
International Bond Portfolio paid $24,832 in advisory fees to BlackRock, Inc..
For the period from January 1, 1996 through January 31, 1996, BlackRock, Inc.
paid Morgan Grenfell $20,176 in sub-advisory fees with respect to the
predecessor portfolio to the International Bond Portfolio. For the period from
March 1, 1995 through December 31, 1995 and for the fiscal year ended February
28, 1995, the predecessor portfolio to the International Bond Portfolio paid
$305,176 and $361,620, respectively, in investment advisory fees to Midlantic
Bank pursuant to its prior investment advisory contract.
The predecessor portfolio to the New Jersey Municipal Money Market
Portfolio was advised by Midlantic Bank from July 1, 1991 through December 31,
1995, and by PIMC from January 1, 1996 through January 12, 1996. For the period
from January 1, 1996 through January 12, 1996, the predecessor portfolio to the
New Jersey Municipal Money Market Portfolio paid $8,000 in advisory fees to
PIMC. For the period from March 1, 1995 through December 31, 1995 and for the
fiscal years ended February 28, 1995, the predecessor portfolio to the New
Jersey Municipal Money Market Portfolio paid $155,696 and $158,240,
respectively, in investment
-84-
<PAGE>
advisory fees to Midlantic Bank pursuant to its prior investment advisory
contract. During the period from January 13, 1996 through January 31, 1996, the
New Jersey Municipal Money Market Portfolio paid PIMC $2,128 in investment
advisory fees, and PIMC waived $13,826 in investment advisory fees. During the
period from January 13, 1996 through January 31, 1996, PNC Bank waived all of
the sub-advisory fees (in the amount of $1,125) with respect to the New Jersey
Municipal Money Market Portfolio.
The predecessor portfolio to the Core Bond Portfolio was advised by
BlackRock. For the period from July 1, 1995 through January 12, 1996, the
predecessor portfolio to the Core Bond Portfolio paid BlackRock $53,125 in
investment advisory fees and BlackRock waived $21,255 in investment advisory
fees. For the fiscal years ended June 30, 1995 and 1994, BlackRock waived its
investment advisory fee with respect to the predecessor portfolio to the Core
Bond Portfolio in the amounts of $56,894 and $34,010, respectively, and
reimbursed expenses amounting to $137,364 and $137,179, respectively. During the
period from January 13, 1996 through March 31, 1996, the Core Bond Portfolio
paid BlackRock, Inc. $182,709 in investment advisory fees, and BlackRock, Inc.
waived $121,806 in investment advisory fees. During the period from January 13,
1996 through March 31, 1996, BlackRock, Inc. paid BlackRock $127,896 in sub-
advisory fees with respect to the Core Bond Portfolio, and BlackRock waived
$85,264 in sub-advisory fees.
The predecessor portfolio to the Low Duration Bond Portfolio was advised by
BlackRock. For the period from July 1, 1995 through January 12, 1996, the
predecessor portfolio to the Low Duration Bond Portfolio paid BlackRock $56,481
in investment advisory fees and BlackRock waived $11,186 in investment advisory
fees. For the fiscal years ended June 30, 1995 and 1994, BlackRock waived its
investment advisory fee with respect to the predecessor portfolio to the Low
Duration Bond Portfolio in the amounts of $102,707 and $110,232, respectively,
and reimbursed expenses amounting to $61,195 and $55,582, respectively. During
the period from January 13, 1996 through March 31, 1996, the Low Duration Bond
Portfolio paid BlackRock, Inc. $149,488 in investment advisory fees, and
BlackRock, Inc. waived $99,659 in investment advisory fees. During the period
from January 13, 1996 through March 31, 1996, BlackRock, Inc. paid BlackRock
$104,642 in sub-advisory fees with respect to the Low Duration Bond Portfolio,
and BlackRock waived $69,761 in sub-advisory fees.
ADMINISTRATION AGREEMENTS. BlackRock, Inc., PFPC and BDI serve as the
Fund's co-administrators pursuant to administration agreements (collectively,
the "Administration Agreement"). PFPC and BDI have agreed to maintain office
facilities for the Fund; furnish the Fund with statistical and research data,
clerical, accounting, and bookkeeping services;
-85-
<PAGE>
provide and supervise the operation of an automated data processing system to
process purchase and redemption orders; provide information and distribute
written communications to shareholders; handle shareholder problems and calls;
research issues raised by financial intermediaries relating to investments in a
Portfolio's shares; review and provide advice with respect to communications for
a Portfolio's shares; monitor the investor programs that are offered in
connection with a Portfolio's shares; provide oversight and related support
services that are intended to ensure the delivery of quality service to the
holders of the Portfolio's shares; and provide certain other services required
by the Fund. As stated in the Prospectuses, the Administrators may from time to
time voluntarily waive administration fees with respect to a Portfolio and may
voluntarily reimburse the Portfolios for expenses.
BlackRock, Inc. serves as an Administrator to the Fund pursuant to a Co-
Administration Agreement. Under the Co- Administration Agreement, BlackRock,
Inc. is responsible for: (i) the supervision and coordination of the performance
of the Fund's service providers; (ii) the negotiation of service contracts and
arrangements between the Fund and its service providers; (iii) acting as liaison
between the trustees of the Fund and the Fund's service providers; and (iv)
providing ongoing business management and support services in connection with
the Fund's operations.
The Administration Agreement provides that BlackRock, Inc., PFPC and BDI
will not be liable for any error of judgment or mistake of law or for any loss
suffered by the Fund or a Portfolio in connection with the performance of the
Administration Agreement, except a loss resulting from willful misfeasance, bad
faith or gross negligence in the performance of their respective duties or from
reckless disregard of their respective duties and obligations thereunder.
PFPC serves as the administrative services agent for the Index Master
Portfolio pursuant to an Administration and Accounting Services Agreement. The
services provided by PFPC are subject to supervision by the executive officers
and the Board of Trustees of the Trust, and include day-to-day keeping and
maintenance of certain records, calculation of the offering price of the shares,
preparation of reports and acting as liaison with the Trust's custodians and
dividend and disbursing agents. For its services, PFPC is entitled to
compensation from the Index Master Portfolio at the annual rate of .015% of the
Index Master Portfolio's average daily net assets. The Index Equity Portfolio
bears its pro rata portion of the Index Master Portfolio's administrative
services expenses.
From February 1, 1993 until January 13, 1996, PFPC and Provident
Distributors, Inc. ("PDI") served as co-administrators
-86-
<PAGE>
to the Fund. From December 1, 1995 to January 28, 1998, Compass Capital Group,
Inc. ("CCG") served as Co-Administrator to the Fund. BlackRock, Inc. became Co-
Administrator to the Fund on January 28, 1998. For the purposes of the Following
Fee information CCG is also considered an "Administrator".
For the period from October 1, 1996 (December 27, 1996 in the case of the
Mid-Cap Growth Equity and Mid-Cap Value Equity Portfolios; and September 26,
1997 in the case of the International Small Cap Equity Portfolio) through
September 30, 1997, the Fund paid the Administrators combined administration
fees (after waivers), and the Administrators waived combined administration fees
and reimbursed expenses, as follows:
<TABLE>
<CAPTION>
Fees Paid
Portfolios (After Waivers) Waivers Reimbursements
- ---------- --------------- ------- --------------
<S> <C> <C> <C>
Money Market.............................................. $3,006,036 $161,687 0
U.S. Treasury Money Market................................ 1,391,777 83,462 0
Municipal Money Market.................................... 510,438 66,205 0
New Jersey Municipal Money Market......................... 134,020 49,666 0
North Carolina Municipal Money Market..................... 149,859 81,039 0
Ohio Municipal Money Market............................... 136,900 30,397 0
Pennsylvania Municipal Money Market....................... 701,182 105,262 0
Virginia Municipal Money Market........................... 13,709 76,820 0
Low Duration Bond......................................... 266,343 180,478 0
Intermediate Government Bond.............................. 136,304 172,324 0
Intermediate Bond......................................... 359,159 291,462 0
Core Bond................................................. 628,096 188,359 0
Government Income......................................... 910 33,087 0
Managed Income............................................ 696,869 755,201 0
International Bond........................................ 56,066 28,697 0
Tax-Free Income........................................... 36,907 75,552 0
Pennsylvania Tax-Free Income.............................. 84,673 94,146 0
New Jersey Tax-Free Income................................ 77,981 95,412 0
Ohio Tax-Free Income...................................... 9,942 11,556 0
Large Cap Value Equity.................................... 2,173,719 195,769 0
Large Cap Growth Equity................................... 1,146,084 247,130 0
Mid-Cap Value Equity...................................... 106,481 19,571 0
Mid-Cap Growth Equity..................................... 106,838 19,149 0
Small Cap Value Equity.................................... 713,311 29,928 0
Small Cap Growth Equity................................... 1,156,894 0 0
International Equity...................................... 1,149,080 68,733 0
International Small Cap Equity............................ 0 0 0
International Emerging Markets............................ 379,822 596 0
Select Equity............................................. 794,449 189,515 0
Index Equity.............................................. 134,085 549,869 0
Balanced.................................................. 501,727 72,507 0
</TABLE>
For the period from October 1, 1995 through January 13, 1996, the Fund
paid CCG, PFPC and PDI combined administration fees (after waivers), and CCG,
PFPC and PDI waived combined administration fees and reimbursed expenses, as
follows:
-87-
<PAGE>
<TABLE>
<CAPTION>
Fees Paid
(After Reimburse-
Portfolios Waivers) Waivers ments
- ---------- -------- ------- ----------
<S> <C> <C> <C>
Money Market $645,001 $51,681 $0
Municipal Money Market 117,010 8,088 0
U.S. Treasury Money Market 242,075 52,266 0
Ohio Municipal Money Market 17,189 12,366 0
Pennsylvania Municipal
Money Market 143,962 28,455 0
North Carolina Municipal
Money Market 11,644 17,455 0
Virginia Municipal Money
Market 0 12,768 0
Managed Income 226,271 82,078 0
Government Income 353 6,893 0
Tax-Free Income 1,455 4,890 0
Intermediate Government
Bond 69,369 33,385 0
Ohio Tax-Free Income 604 3,942 0
Pennsylvania Tax-Free
Income 23,054 10,922 0
Intermediate Bond 70,091 37,396 0
Large Cap Value Equity 287,181 75,970 0
Large Cap Growth Equity 142,578 32,289 0
Small Cap Growth Equity 105,681 19,886 0
Select Equity 150,292 28,337 0
Index Equity 32,455 65,337 0
Small Cap Value Equity 127,936 4,181 0
International Equity 200,396 30,791 0
International Emerging
Markets 26,329 0 0
Balanced 73,163 24,504 0
</TABLE>
For the period from January 14, 1996 (February 1, 1996 in the case of the
New Jersey Tax-Free Income and New Jersey Municipal Money Market Portfolios;
February 13, 1996 in the case of the International Bond Portfolio; and April 1,
1996 in the case of the Core Bond and Low Duration Bond Portfolios) through
September 30, 1996, the Fund paid the Administrators combined administration
fees (after waivers), and the Administrators waived combined administration fees
and reimbursed expenses, as follows:
-88-
<PAGE>
<TABLE>
<CAPTION>
Fees Paid
(After
Portfolios Waivers) Waivers Reimbursements
- ---------- --------- ------- --------------
<S> <C> <C> <C>
Money Market $2,319,935 $460,119 $ 0
Municipal Money Market 303,192 171,943 0
U.S. Treasury Money Market 1,325,463 264,620 0
Ohio Municipal Money Market 57,595 37,497 0
Pennsylvania Municipal
Money Market 576,488 139,781 0
North Carolina Municipal
Money Market 57,612 78,873 0
Virginia Municipal Money
Market 0 60,792 4,868
New Jersey Municipal Money
Market 47,930 52,585 0
Managed Income 740,845 412,076 0
Government Income 1,394 22,902 0
Tax-Free Income 47,371 37,838 0
Intermediate Government
Bond 207,399 118,488 0
Ohio Tax-Free Income 10,045 6,523 0
Pennsylvania Tax-Free
Income 85,441 56,528 0
Intermediate Bond 221,810 172,503 0
New Jersey Tax-Free Income 68,934 69,374 0
International Bond 27,454 28,993 0
Core Bond 196,853 128,743 0
Low Duration Bond 175,769 83,391 0
Large Cap Value Equity 1,589,313 235,958 0
Large Cap Growth Equity 729,234 236,170 0
Small Cap Growth Equity 652,784 17,700 0
Select Equity 471,931 198,312 0
Index Equity 55,265 345,636 0
Small Cap Value Equity 511,980 3,984 0
International Equity 727,738 201,501 0
International Emerging
Markets 147,927 0 0
Balanced 339,671 80,233 0
</TABLE>
-89-
<PAGE>
For the year or periods ended September 30, 1995, the Fund paid PFPC
and PDI combined administration fees (after waivers), and PFPC and PDI waived
combined administration fees and reimbursed expenses, as follows:
<TABLE>
<CAPTION>
Fees Paid
(After
Portfolios Waivers) Waivers Reimbursements
- ---------- ---------- ------- --------------
<S> <C> <C> <C>
Money Market $1,686,008 $200,348 $0
Municipal Money Market 208,246 162,303 0
U.S. Treasury Money Market 631,041 281,107 0
Ohio Municipal Money Market 43,263 55,100 0
Pennsylvania Municipal
Money Market 322,632 200,313 0
North Carolina Municipal
Money Market 24,058 114,630 1,666
Managed Income 751,452 267,310 0
Tax-Free Income 0 19,868 2,132
Intermediate Government 244,417 135,117 0
Bond
Ohio Tax-Free Income 0 16,817 8,950
Pennsylvania Tax-Free
Income 68,050 51,546 0
Intermediate Bond 139,960 131,323 0
Large Cap Value Equity 1,083,967 187,474 0
Large Cap Growth Equity 360,966 72,170 0
Small Cap Growth Equity 238,595 36,310 0
Select Equity 288,666 57,058 0
Index Equity 96,814 316,163 0
Small Cap Value Equity 359,637 97,592 0
International Equity 689,601 107,601 0
Balanced 216,630 104,752 0
Virginia Municipal Money
Market 0 28,354 11,986
International Emerging
Markets 41,383 8,350 0
Government Income1 0 14,903 15,973
</TABLE>
/1/ Commenced operations October 3, 1994.
The predecessor portfolios to the New Jersey Municipal Money Market,
International Bond and New Jersey Tax-Free Income Portfolios received
administrative services from SEI Financial Management Corporation ("SEI").
During the period from March 1, 1995 through January 12, 1996 and during the
fiscal year ended February 28, 1995, the predecessor portfolio to the New Jersey
Municipal Money Market Portfolio paid $73,663 and $44,863, respectively, in
administration fees to SEI pursuant to the prior administration agreement, and
SEI waived $0 and $26,345, respectively, in administration fees. During the
period from
-90-
<PAGE>
January 13, 1996 through January 31, 1996, the New Jersey Municipal Money Market
Portfolio paid the Administrators $3,050 in administration fees, and the
Administrators waived $3,691 in administration fees. During the period from
March 1, 1995 through January 12, 1996 and during the fiscal year ended February
28, 1995, the predecessor portfolio to the New Jersey Tax-Free Income Portfolio
paid $154,232 and $105,029, respectively, in administrative fees to SEI pursuant
to the prior administration agreement, and SEI waived $4 and $77,951,
respectively, in administrative fees. During the period from January 13, 1996
through January 31, 1996, the New Jersey Tax- Free Income Portfolio paid the
Administrators $4,443 in administration fees, and the Administrators waived
$5,347 in administration fees. During the period from March 1, 1995 through
January 12, 1996 and during the fiscal year ended February 28, 1995, the
predecessor portfolio to the International Bond Portfolio paid $77,924 and
$81,364, respectively, in administrative fees to SEI pursuant to the prior
administration agreement. During the period from January 13, 1996 through
January 31, 1996, the predecessor portfolio to the International Bond Portfolio
paid the Administrators $2,141 in administrative fees. During the period from
February 1, 1996 through February 12, 1996, the predecessor portfolio to the
International Bond Portfolio paid the Administrators $2,357 in administrative
fees, and the Administrators waived fees and reimbursed expenses totalling
$1,212 and $0, respectively.
The predecessor portfolios to the Low Duration Bond and Core Bond
Portfolios received administrative services from State Street Bank and Trust
Company ("State Street"). During the period from July 1, 1995 through January
12, 1996 and during the fiscal year ended June 30, 1995, the predecessor
portfolio to the Core Bond Portfolio paid $29,752 and $73,257, respectively, in
administrative fees to State Street pursuant to the prior administration
agreement, and State Street waived $0 and $0, respectively, in administrative
fees. During the period from January 13, 1996 through March 31, 1996, the Core
Bond Portfolio paid the Administrators $79,269 in administration fees, and the
Administrators waived $60,808 in administration fees. During the period from
July 1, 1995 through January 12, 1996 and during the fiscal year ended June 30,
1995, the predecessor portfolio to the Low Duration Bond Portfolio paid $31,578
and $69,234, respectively, in administrative fees to State Street pursuant to
the prior administration agreement. During the period from January 13, 1996
through March 31, 1996, the Low Duration Bond Portfolio paid the Administrators
$74,552 in administration fees, and the Administrators waived $40,055 in
administration fees.
The Fund and its service providers may engage third party plan
administrators who provide trustee, administrative and recordkeeping services
for certain employee benefit, profit-sharing and retirement plans as agent for
the Fund with
-91-
<PAGE>
respect to such plans, for the purpose of accepting orders for the purchase and
redemption of shares of the Fund.
CUSTODIAN AND TRANSFER AGENCY AGREEMENTS. PNC Bank is custodian of the Fund's
assets pursuant to a custodian agreement (the "Custodian Agreement"). Under the
Custodian Agreement, PNC Bank or a sub-custodian (i) maintains a separate
account or accounts in the name of each Portfolio, (ii) holds and transfers
portfolio securities on account of each Portfolio, (iii) accepts receipts and
makes disbursements of money on behalf of each Portfolio, (iv) collects and
receives all income and other payments and distributions on account of each
Portfolio's securities and (v) makes periodic reports to the Board of Trustees
concerning each Portfolio's operations. PNC Bank is authorized to select one or
more banks or trust companies to serve as sub-custodian on behalf of the Fund,
provided that, with respect to sub-custodians other than sub-custodians for
foreign securities, PNC Bank remains responsible for the performance of all its
duties under the Custodian Agreement and holds the Fund harmless from the acts
and omissions of any sub-custodian. Citibank, N.A. serves as the international
sub-custodian for various Portfolios of the Fund.
For its services to the Fund under the Custodian Agreement, PNC Bank
receives a fee which is calculated based upon each investment portfolio's
average gross assets, with a minimum monthly fee of $1,000 per investment
portfolio. PNC Bank is also entitled to out-of-pocket expenses and certain
transaction charges. PNC Bank has undertaken to waive its custody fees with
respect to the Index Equity Portfolio, which invests substantially all of its
assets in the Index Master Portfolio.
PFPC, which has its principal offices at 400 Bellevue Parkway,
Wilmington, DE 19809 and is an affiliate of PNC Bank, serves as the transfer and
dividend disbursing agent for the Fund pursuant to a Transfer Agency Agreement
(the "Transfer Agency Agreement"), under which PFPC (i) issues and redeems
Service, Investor, Institutional and BlackRock classes of shares in each
Portfolio, (ii) addresses and mails all communications by each Portfolio to
record owners of its shares, including reports to shareholders, dividend and
distribution notices and proxy materials for its meetings of shareholders, (iii)
maintains shareholder accounts and, if requested, sub-accounts and (iv) makes
periodic reports to the Board of Trustees concerning the operations of each
Portfolio. PFPC may, on 30 days' notice to the Fund, assign its duties as
transfer and dividend disbursing agent to any other affiliate of PNC Bank Corp.
For its services with respect to the Fund's Institutional and Service Shares
under the Transfer Agency Agreement, PFPC receives fees at the annual rate of
.03% of the average net asset value of outstanding Institutional and Service
Shares in each Portfolio, plus per account fees and disbursements. For its
services with respect to the Fund's BlackRock Shares under the Transfer Agency
Agreement, PFPC receives fees at the annual rate of .01% of the average net
asset value of outstanding BlackRock Shares in each Portfolio, plus per account
fees and disbursements. For its services under the Transfer Agency
-92-
<PAGE>
Agreement with respect to Investor Shares, PFPC receives per account fees, with
minimum annual fees of $24,000 for each series of Investor Shares in each
Portfolio, plus disbursements. Until further notice, the transfer agency fees
for each series of Investor Shares in each Portfolio will not exceed the annual
rate of .10% of the series' average daily net assets.
PNC Bank serves as the Trust's custodian and PFPC serves as the Trust's
transfer and dividend disbursing agent. The Index Equity Portfolio bears its pro
rata portion of the Index Master Portfolio's custody and transfer and dividend
disbursing fees and expenses.
DISTRIBUTOR AND DISTRIBUTION AND SERVICE PLAN. The Fund has entered
into a distribution agreement with the Distributor under which the Distributor,
as agent, offers shares of each Portfolio on a continuous basis. The Distributor
has agreed to use appropriate efforts to effect sales of the shares, but it is
not obligated to sell any particular amount of shares.
Pursuant to the Fund's Amended and Restated Distribution and Service
Plan (the "Plan"), the Fund may pay the Distributor and/or BlackRock, Inc. or
any other affiliate of PNC Bank fees for distribution and sales support
services. Currently, as described further below, only Investor A Shares,
Investor B Shares and Investor C Shares bear the expense of distribution fees
under the Plan. In addition, the Fund may pay BlackRock, Inc. fees for the
provision of personal services to shareholders and the processing and
administration of shareholder accounts. BlackRock, Inc., in turn, determines the
amount of the service fee and shareholder processing fee to be paid to brokers,
dealers, financial institutions and industry professionals (collectively,
"Service Organizations"). The Plan provides, among other things, that: (i) the
Board of Trustees shall receive quarterly reports regarding the amounts expended
under the Plan and the purposes for which such expenditures were made; (ii) the
Plan will continue in effect for so long as its continuance is approved at least
annually by the Board of Trustees in accordance with Rule 12b-1 under the 1940
Act; (iii) any material amendment thereto must be approved by the Board of
Trustees, including the trustees who are not "interested persons" of the Fund
(as defined in the 1940 Act) and who have no direct or indirect financial
interest in the operation of the Plan or any agreement entered into in
connection with the Plan (the "12b-1 Trustees"), acting in person at a meeting
called for said purpose; (iv) any amendment to increase materially the costs
which any class of shares may bear for distribution services pursuant to the
Plan shall be effective only upon approval by a
-93-
<PAGE>
vote of a majority of the outstanding shares of such class and by a majority of
the 12b-1 Trustees; and (v) while the Plan remains in effect, the selection and
nomination of the Fund's trustees who are not "interested persons" of the Fund
shall be committed to the discretion of the Fund's non-interested trustees.
The Plan is terminable as to any class of shares without penalty at any
time by a vote of a majority of the 12b-1 Trustees, or by vote of the holders of
a majority of the shares of such class.
With respect to Investor A Shares, the front-end sales charge and the
distribution fee payable under the Plan (at a maximum annual rate of .10% of the
average daily net asset value of each Portfolio's outstanding Investor A Shares)
are used to pay commissions and other fees payable to Service Organizations and
other broker/dealers who sell Investor A Shares.
With respect to Investor B Shares, Service Organizations and other
broker/dealers receive commissions from the Distributor for selling Investor B
Shares, which are paid at the time of the sale. The distribution fees payable
under the Plan (at a maximum annual rate of .75% of the average daily net asset
value of each Portfolio's outstanding Investor B Shares) are intended to cover
the expense to the Distributor of paying such up-front commissions, as well as
to cover ongoing commission payments to broker/dealers. The contingent deferred
sales charge is calculated to charge the investor with any shortfall that would
occur if Investor B Shares are redeemed prior to the expiration of the
conversion period, after which Investor B Shares automatically convert to
Investor A Shares.
With respect to Investor C Shares, Service Organizations and other
broker/dealers receive commissions from the Distributor for selling Investor C
Shares, which are paid at the time of the sale. The distribution fees payable
under the Plan (at a maximum annual rate of .75% of the average daily net asset
value of each Portfolio's outstanding Investor C Shares) are intended to cover
the expense to the Distributor of paying such up-front commissions, as well as
to cover ongoing commission payments to the broker/dealers. The contingent
deferred sales charge is calculated to charge the investor with any shortfall
that would occur if Investor C Shares are redeemed within 12 months of purchase.
The Fund is not required or permitted under the Plan to make
distribution payments with respect to Service, Institutional or BlackRock
Shares. However, the Plan permits BDI, BlackRock, Inc., the Administrators and
other companies that receive fees from the Fund to make payments relating to
distribution and sales support activities out of their past profits or other
sources available to them. The Distributor, BlackRock, Inc. and
-94-
<PAGE>
their affiliates may pay financial institutions, broker/dealers and/or their
salespersons certain compensation for the sale and distribution of shares of the
Fund or for services to the Fund. These payments ("Additional Payments") would
be in addition to the payments by the Fund described in the Fund's Prospectuses
and this Statement of Additional Information for distribution and shareholder
servicing and processing, and would also be in addition to the sales commissions
payable to dealers as set forth in the Prospectuses for Investor Shares. These
Additional Payments may take the form of "due diligence" payments for a dealer's
examination of the Portfolios and payments for providing extra employee training
and information relating to Portfolios; "listing" fees for the placement of the
Portfolios on a dealer's list of mutual funds available for purchase by its
customers; "finders" or "referral" fees for directing investors to the Fund;
"marketing support" fees for providing assistance in promoting the sale of the
Funds' shares; and payments for the sale of shares and/or the maintenance of
share balances. In addition, the Distributor, BlackRock, Inc. and their
affiliates may make Additional Payments for subaccounting, administrative and/or
shareholder processing services that are in addition to the shareholder
servicing and processing fees paid by the Fund. The Additional Payments made by
the Distributor, BlackRock, Inc. and their affiliates may be a fixed dollar
amount, may be based on the number of customer accounts maintained by a
financial institution or broker/dealer, or may be based on a percentage of the
value of shares sold to, or held by, customers of the financial institutions or
dealers involved, and may be different for different institutions and dealers.
Furthermore, the Distributor, BlackRock, Inc. and their affiliates may
contribute to various non-cash and cash incentive arrangements to promote the
sale of shares, and may sponsor various contests and promotions subject to
applicable NASD regulations in which participants may receive prizes such as
travel awards, merchandise and cash. The Distributor, BlackRock, Inc. and their
affiliates may also pay for the travel expenses, meals, lodging and
entertainment of broker/dealers, financial institutions and their salespersons
in connection with educational and sales promotional programs subject to
applicable NASD regulations.
Service Organizations may charge their clients additional fees for
account-related services.
The Fund intends to enter into service arrangements with Service
Organizations pursuant to which Service Organizations will render certain
support services to their customers ("Customers") who are the beneficial owners
of Service, Investor A, Investor B and Investor C Shares. Such services will be
provided to Customers who are the beneficial owners of Shares of such classes
and are intended to supplement the services provided by the Fund's
Administrators and transfer agent to the Fund's
-95-
<PAGE>
shareholders of record. In consideration for payment of a service fee of up to
.25% (on an annualized basis) of the average daily net asset value of the
Investor A, Investor B and Investor C Shares owned beneficially by their
Customers and .15% (on an annualized basis) of the average daily net asset value
of the Service Shares beneficially owned by their Customers, Service
Organizations may provide general shareholder liaison services, including, but
not limited to (i) answering customer inquiries regarding account status and
history, the manner in which purchases, exchanges and redemptions of shares may
be effected and certain other matters pertaining to the Customers' investments;
and (ii) assisting Customers in designating and changing dividend options,
account designations and addresses. In consideration for payment of a
shareholder processing fee of up to a separate .15% (on an annualized basis) of
the average daily net asset value of Service, Investor A, Investor B and
Investor C Shares owned beneficially by their Customers, Service Organizations
may provide one or more of these additional services to such Customers: (i)
providing necessary personnel and facilities to establish and maintain Customer
accounts and records; (ii) assistance in aggregating and processing purchase,
exchange and redemption transactions; (iii) placement of net purchase and
redemption orders with the Distributor; (iv) arranging for wiring of funds; (v)
transmitting and receiving funds in connection with Customer orders to purchase
or redeem shares; (vi) processing dividend payments; (vii) verifying and
guaranteeing Customer signatures in connection with redemption orders and
transfers and changes in Customer-designated accounts, as necessary; (viii)
providing periodic statements showing Customers' account balances and, to the
extent practicable, integrating such information with other Customer
transactions otherwise effected through or with a Service Organization; (ix)
furnishing (either separately or on an integrated basis with other reports sent
to a shareholder by a Service Organization) monthly and year-end statements and
confirmations of purchases, exchanges and redemptions; (x) transmitting on
behalf of the Fund, proxy statements, annual reports, updating prospectuses and
other communications from the Fund to Customers; (xi) receiving, tabulating and
transmitting to the Fund proxies executed by Customers with respect to
shareholder meetings; (xii) providing subaccounting with respect to shares
beneficially owned by Customers or the information to the Fund necessary for
subaccounting; (xiii) providing sub-transfer agency services; and (xiv)
providing such other similar services as the Fund or a Customer may request.
For the twelve months ended September 30, 1997 (from December 27, 1996
through September 30, 1997 in the case of the Mid-Cap Growth Equity and Mid-Cap
Value Equity Portfolios; and from September 26, 1997 through September 30, 1997
in the case of the International Small Cap Equity Portfolio), the Portfolios'
share classes bore the following distribution, shareholder
-96-
<PAGE>
servicing and shareholder processing fees under the Portfolios' current
plans:
<TABLE>
<CAPTION>
Distribution Shareholder Shareholder
Portfolios - Investor A Shares Fees Servicing Fees Processing Fees
- ------------------------------ ------------ -------------- ---------------
<S> <C> <C> <C>
Money Market.............................................. N/A $459,377 $275,626
U.S. Treasury Money Market................................ N/A 47,849 28,709
Municipal Money Market.................................... N/A 7,046 4,227
New Jersey Municipal Money Market......................... N/A 67,930 40,758
North Carolina Municipal Money Market..................... N/A 498 299
Ohio Municipal Money Market............................... N/A 22,520 13,512
Pennsylvania Municipal Money Market....................... N/A 252,489 151,493
Virginia Municipal Money Market........................... N/A 1,213 728
Low Duration Bond......................................... N/A 2,253 1,352
Intermediate Government Bond.............................. N/A 12,926 7,756
Intermediate Bond......................................... N/A 2,420 1,452
Core Bond................................................. N/A 2,091 1,255
Government Income......................................... N/A 8,699 5,219
Managed Income............................................ N/A 27,512 16,507
International Bond........................................ N/A 1,173 704
Tax-Free Income........................................... N/A 11,481 6,888
Pennsylvania Tax-Free Income.............................. N/A 79,632 47,779
New Jersey Tax-Free Income................................ N/A 2,089 1,254
Ohio Tax-Free Income...................................... N/A 5,927 3,556
Large Cap Value Equity.................................... N/A 82,231 49,339
Large Cap Growth Equity................................... N/A 47,342 28,405
Mid-Cap Value Equity...................................... N/A 1,270 762
Mid-Cap Growth Equity..................................... N/A 1,556 934
Small Cap Value Equity.................................... N/A 60,827 36,496
Small Cap Growth Equity................................... N/A 87,777 52,666
International Equity...................................... N/A 50,243 30,146
International Small Cap Equity............................ N/A 12 7
International Emerging Markets............................ N/A 8,082 4,849
Select Equity............................................. N/A 23,489 14,093
Index Equity.............................................. N/A 45,703 27,422
Balanced.................................................. N/A 177,097 106,258
</TABLE>
-97-
<PAGE>
<TABLE>
<CAPTION>
Distribution Shareholder Shareholder
Portfolios - Investor B Shares Fees Servicing Fees Processing Fees
- ------------------------------ ------------ -------------- ---------------
<S> <C> <C> <C>
Money Market.............................................. $286 $1,276 $0
U.S. Treasury Money Market................................ 0 0 0
Municipal Money Market.................................... 0 0 0
New Jersey Municipal Money Market......................... 30 89 0
North Carolina Municipal Money Market..................... 0 0 0
Ohio Municipal Money Market............................... 0 0 0
Pennsylvania Municipal Money Market....................... 0 0 0
Virginia Municipal Money Market........................... 0 0 0
Low Duration Bond......................................... 102 119 72
Intermediate Government Bond.............................. 103 121 73
Intermediate Bond......................................... 0 0 0
Core Bond................................................. 10,005 14,857 8,914
Government Income......................................... 42,389 59,913 35,948
Managed Income............................................ 10 80 48
International Bond........................................ 1,150 1,564 938
Tax-Free Income........................................... 1,279 1,735 1,041
Pennsylvania Tax-Free Income.............................. 32,624 46,409 27,846
New Jersey Tax-Free Income................................ 1,253 1,998 1,193
Ohio Tax-Free Income...................................... 1,336 1,989 1,193
Large Cap Value Equity.................................... 32,130 49,211 29,527
Large Cap Growth Equity................................... 14,820 22,498 13,499
Mid-Cap Value Equity...................................... 1,677 3,223 1,934
Mid-Cap Growth Equity..................................... 1,798 3,619 2,171
Small Cap Value Equity.................................... 14,589 21,446 12,868
Small Cap Growth Equity................................... 60,450 84,056 50,434
International Equity...................................... 12,419 18,209 10,926
International Small Cap Equity............................ 0 0 0
International Emerging Markets............................ 2,514 4,040 2,424
Select Equity............................................. 17,090 29,568 17,741
Index Equity.............................................. 60,788 78,885 47,331
Balanced.................................................. 42,515 64,488 38,693
</TABLE>
-98-
<PAGE>
<TABLE>
<CAPTION>
Distribution Shareholder Shareholder
Portfolios - Investor C Shares Fees Servicing Fees Processing Fees
- ------------------------------ ------------ -------------- ---------------
<S> <C> <C> <C>
Money Market.............................................. $645 $1,225 $0
U.S. Treasury Money Market................................ 0 0 0
Municipal Money Market.................................... 2 5 0
New Jersey Municipal Money Market......................... 0 0 0
North Carolina Municipal Money Market..................... 0 0 0
Ohio Municipal Money Market............................... 0 0 0
Pennsylvania Municipal Money Market....................... 0 0 0
Virginia Municipal Money Market........................... 0 0 0
Low Duration Bond......................................... 120 141 85
Intermediate Government Bond.............................. 79 92 55
Intermediate Bond......................................... 0 0 0
Core Bond................................................. 180 211 127
Government Income......................................... 653 750 450
Managed Income............................................ 0 0 0
International Bond........................................ 447 462 277
Tax-Free Income........................................... 0 1 1
Pennsylvania Tax-Free Income.............................. 0 0 0
New Jersey Tax-Free Income................................ 0 0 0
Ohio Tax-Free Income...................................... 0 0 0
Large Cap Value Equity.................................... 2,871 3,372 2,023
Large Cap Growth Equity................................... 186 217 130
Mid-Cap Value Equity...................................... 31 41 24
Mid-Cap Growth Equity..................................... 133 158 95
Small Cap Value Equity.................................... 1,796 2,104 1,263
Small Cap Growth Equity................................... 22,944 26,890 16,134
International Equity...................................... 147 172 103
International Small Cap Equity............................ 0 0 0
International Emerging Markets............................ 85 99 60
Select Equity............................................. 369 433 260
Index Equity.............................................. 36,025 41,362 24,817
Balanced.................................................. 95 111 67
</TABLE>
-99-
<PAGE>
<TABLE>
<CAPTION>
Distribution Shareholder Shareholder
Portfolios - Service Shares Fees Servicing Fees Processing Fees
- --------------------------- ------------ -------------- ---------------
<S> <C> <C> <C>
Money Market.............................................. N/A $2,425,112 $2,425,112
U.S. Treasury Money Market................................ N/A 1,280,124 1,280,124
Municipal Money Market.................................... N/A 493,398 493,398
New Jersey Municipal Money Market......................... N/A 141,044 141,044
North Carolina Municipal Money Market..................... N/A 15,790 15,790
Ohio Municipal Money Market............................... N/A 85,080 85,080
Pennsylvania Municipal Money Market....................... N/A 361,364 361,364
Virginia Municipal Money Market........................... N/A 15,542 15,542
Low Duration Bond......................................... N/A 127,215 127,215
Intermediate Government Bond.............................. N/A 73,283 73,283
Intermediate Bond......................................... N/A 73,197 73,197
Core Bond................................................. N/A 181,486 181,486
Government Income......................................... N/A 0 0
Managed Income............................................ N/A 320,482 320,482
International Bond........................................ N/A 10,859 10,859
Tax-Free Income........................................... N/A 63,453 63,453
Pennsylvania Tax-Free Income.............................. N/A 58,664 58,664
New Jersey Tax-Free Income................................ N/A 127,605 127,605
Ohio Tax-Free Income...................................... N/A 10,309 10,309
Large Cap Value Equity.................................... N/A 769,724 769,724
Large Cap Growth Equity................................... N/A 327,593 327,593
Mid-Cap Value Equity...................................... N/A 14,145 14,145
Mid-Cap Growth Equity..................................... N/A 14,097 14,097
Small Cap Value Equity.................................... N/A 137,408 137,408
Small Cap Growth Equity................................... N/A 249,073 249,073
International Equity...................................... N/A 256,801 256,801
International Small Cap Equity............................ N/A 0 0
International Emerging Markets............................ N/A 80,289 80,289
Select Equity............................................. N/A 208,609 208,609
Index Equity.............................................. N/A 214,177 214,177
Balanced.................................................. N/A 231,115 231,115
</TABLE>
EXPENSES
Expenses are deducted from the total income of each Portfolio before
dividends and distributions are paid. These expenses include, but are not
limited to, fees paid to BlackRock, Inc. and the Administrators, transfer agency
fees, fees and expenses of officers and trustees who are not affiliated with
BlackRock, Inc., the Distributor or any of their affiliates, taxes, interest,
legal fees, custodian fees, auditing fees, distribution fees, shareholder
processing fees, shareholder servicing fees, fees and expenses in registering
and qualifying the Portfolios and their shares for distribution under federal
and state securities laws, expenses of preparing prospectuses and statements of
additional information and of printing and distributing prospectuses and
statements of additional information to existing shareholders, expenses relating
to shareholder reports, shareholder meetings and proxy solicitations, fidelity
bond and trustees and officers liability
-100-
<PAGE>
insurance premiums, the expense of independent pricing services and other
expenses which are not expressly assumed by BlackRock, Inc. or the Fund's
service providers under their agreements with the Fund. Any general expenses of
the Fund that do not belong to a particular investment portfolio will be
allocated among all investment portfolios by or under the direction of the Board
of Trustees in a manner the Board determines to be fair and equitable.
BlackRock, Inc., the sub-advisers and the Administrators expect to waive
voluntarily a portion of their respective advisory, sub-advisory and
administration fees during the Portfolios' current fiscal year.
PORTFOLIO TRANSACTIONS
In executing portfolio transactions, the adviser and sub-advisers seek to
obtain the best price and most favorable execution for a Portfolio, taking into
account such factors as the price (including the applicable brokerage commission
or dealer spread), size of the order, difficulty of execution and operational
facilities of the firm involved. While the adviser and sub-advisers generally
seek reasonably competitive commission rates, payment of the lowest commission
or spread is not necessarily consistent with obtaining the best price and
execution in particular transactions. Payments of commissions to brokers who are
affiliated persons of the Fund, or the Trust with respect to the Index Master
Portfolio, (or affiliated persons of such persons) will be made in accordance
with Rule 17e-1 under the 1940 Act. With respect to the Index Master Portfolio,
commissions paid on such transactions would be commensurate with the rate of
commissions paid on similar transactions to brokers that are not so affiliated.
No Portfolio has any obligation to deal with any broker or group of brokers
in the execution of Portfolio transactions. The adviser and sub-advisers may,
consistent with the interests of a Portfolio, select brokers on the basis of the
research, statistical and pricing services they provide to a Portfolio and the
adviser's or sub-adviser's other clients. Information and research received from
such brokers will be in addition to, and not in lieu of, the services required
to be performed by the adviser and sub-advisers under their respective
contracts. A commission paid to such brokers may be higher than that which
another qualified broker would have charged for effecting the same transaction,
provided that the adviser or sub-adviser determines in good faith that such
commission is reasonable in terms either of the transaction or the overall
responsibility of the adviser or sub-adviser to a Portfolio and its other
clients and that the total commissions paid by a Portfolio will be reasonable in
relation to the benefits to a Portfolio over the
-101-
<PAGE>
long-term. With respect to the Index Master Portfolio, it will seek to acquire
and dispose of securities in a manner which would cause as little fluctuation in
the market prices of stocks being purchased or sold as possible in light of the
size of the transactions being effected, and brokers will be selected with this
goal in view. DFA monitors the performance of brokers which effect transactions
for the Index Master Portfolio to determine the effect that the Index Master
Portfolio's trading has on the market prices of the securities in which they
invest. DFA also checks the rate of commission being paid by the Index Master
Portfolio to its brokers to ascertain that they are competitive with those
charged by other brokers for similar services. Transactions also may be placed
with brokers who provide DFA with investment research, such as reports
concerning individual issuers, industries and general economic and financial
trends and other research services. The Investment Management Agreement permits
DFA knowingly to pay commissions on such transactions which are greater than
another broker might charge if DFA, in good faith, determines that the
commissions paid are reasonable in relation to the research or brokerage
services provided by the broker or dealer when viewed in terms of either a
particular transaction or DFA's overall responsibilities to the Trust.
Commission rates for brokerage transactions on foreign stock exchanges are
generally fixed. In addition, the adviser or sub-adviser may take into account
the sale of shares of the Fund in allocating purchase and sale orders for
portfolio securities to brokers (including brokers that are affiliated with them
or Distributor).
For the year or period ended September 30, 1997, the following Portfolios
paid brokerage commissions as follows:
<TABLE>
<CAPTION>
Portfolios Brokerage Commissions
- ---------- ---------------------
<S> <C>
Large Cap Value Equity $1,309,867
Large Cap Growth Equity 1,033,730
Mid-Cap Value Equity 199,394
Mid-Cap Growth Equity 152,521
Small Cap Value Equity 612,318
Small Cap Growth Equity 413,189
International Equity 1,884,858
International Small Cap Equity 57,239
International Emerging Markets 570,670
Select Equity 317,435
Balanced 75,685
</TABLE>
For the year or period ended September 30, 1996, the following Portfolios
paid brokerage commissions as follows:
-102-
<PAGE>
<TABLE>
<CAPTION>
Portfolios Brokerage Commissions
- ---------- ---------------------
<S> <C>
Large Cap Value Equity $1,455,318
Large Cap Growth Equity 696,494
Small Cap Growth Equity 165,153
Select Equity 443,114
Index Equity 44,380
Small Cap Value Equity 380,356
International Equity 1,912,522
Balanced 95,277
International Emerging Markets 588,860
</TABLE>
For the year or period ended September 30, 1995, the following Portfolios
paid brokerage commissions as follows:
<TABLE>
<CAPTION>
Portfolios Brokerage Commissions
- ---------- ---------------------
<S> <C>
Large Cap Value Equity $364,680
Large Cap Growth Equity 356,156
Small Cap Growth Equity 88,691
Select Equity 341,935
Index Equity 73,946
Small Cap Value Equity 251,396
International Equity 2,667,245
Balanced 144,451
International Emerging Markets 356,727
</TABLE>
For the Index Master Portfolio's fiscal years ended November 30, 1995, 1996
and 1997, the Index Master Portfolio paid brokerage commissions totalling
$15,289, $72,562 and $116,563, respectively.
Over-the-counter issues, including corporate debt and U.S. Government
securities, are normally traded on a "net" basis without a stated commission,
through dealers acting for their own account and not as brokers. The Portfolios
will primarily engage in transactions with these dealers or deal directly with
the issuer unless a better price or execution could be obtained by using a
broker. Prices paid to a dealer with respect to both foreign and domestic
securities will generally include a "spread," which is the difference between
the prices at which the dealer is willing to purchase and sell the specific
security at the time, and includes the dealer's normal profit.
Purchases of money market instruments by a Portfolio are made from dealers,
underwriters and issuers. The Portfolios do not currently expect to incur any
brokerage commission expense on such transactions because money market
instruments are generally traded on a "net" basis with dealers acting as
principal for
-103-
<PAGE>
their own accounts without a stated commission. The price of the security,
however, usually includes a profit to the dealer. Each Money Market Portfolio
intends to purchase only securities with remaining maturities of 13 months or
less as determined in accordance with the rules of the SEC. As a result, the
portfolio turnover rates of a Money Market Portfolio will be relatively high.
However, because brokerage commissions will not normally be paid with respect to
investments made by a Money Market Portfolio, the turnover rates should not
adversely affect the Portfolio's net asset values or net income.
Securities purchased in underwritten offerings include a fixed amount of
compensation to the underwriter, generally referred to as the underwriter's
concession or discount. When securities are purchased or sold directly from or
to an issuer, no commissions or discounts are paid.
The adviser or sub-advisers may seek to obtain an undertaking from issuers
of commercial paper or dealers selling commercial paper to consider the
repurchase of such securities from a Portfolio prior to maturity at their
original cost plus interest (sometimes adjusted to reflect the actual maturity
of the securities), if it believes that a Portfolio's anticipated need for
liquidity makes such action desirable. Any such repurchase prior to maturity
reduces the possibility that a Portfolio would incur a capital loss in
liquidating commercial paper, especially if interest rates have risen since
acquisition of such commercial paper.
Investment decisions for each Portfolio and for other investment accounts
managed by the adviser or sub-advisers are made independently of each other in
light of differing conditions. However, the same investment decision may be made
for two or more such accounts. In such cases, simultaneous transactions are
inevitable. Purchases or sales are then averaged as to price and allocated as to
amount in a manner deemed equitable to each such account. While in some cases
this practice could have a detrimental effect upon the price or value of the
security as far as a Portfolio is concerned, in other cases it could be
beneficial to a Portfolio. A Portfolio will not purchase securities during the
existence of any underwriting or selling group relating to such securities of
which BlackRock, Inc., PIMC, BlackRock, PNC Bank, PCM, PEAC,
CastleInternational, the Administrators, the Distributor or any affiliated
person (as defined in the 1940 Act) thereof is a member except pursuant to
procedures adopted by the Board of Trustees in accordance with Rule 10f-3 under
the 1940 Act. In no instance will portfolio securities be purchased from or sold
to BlackRock, Inc., PIMC, BlackRock, PNC Bank, PCM, PEAC, CastleInternational,
the Administrators, the Distributor or any affiliated person of the foregoing
entities except as permitted by SEC exemptive order or by applicable law.
-104-
<PAGE>
The portfolio turnover rate of a Portfolio is calculated by dividing the
lesser of a Portfolio's annual sales or purchases of portfolio securities
(exclusive of purchases or sales of securities whose maturities at the time of
acquisition were one year or less) by the monthly average value of the
securities held by the Portfolio during the year. The Index Master Portfolio
ordinarily will not sell portfolio securities except to reflect additions or
deletions of stocks that comprise the S&P 500 Index, including mergers,
reorganizations and similar transactions and, to the extent necessary, to
provide cash to pay redemptions of the Index Master Portfolio's shares.
The Fund is required to identify any securities of its regular brokers or
dealers (as defined in Rule 10b-1 under the 1940 Act) or their parents held by
the Fund as of the end of its most recent fiscal year. As of September 30, 1997,
the following Portfolios held the following securities:
<TABLE>
<CAPTION>
Portfolio Security Value
--------- -------- -----
<S> <C> <C>
Money Market
Morgan Stanley & Co., Inc. Commercial Paper $ 49,402,000
Morgan Stanley & Co., Inc. Variable Rate Obligation 36,997,742
Merrill Lynch & Co. Commercial Paper 128,081,269
Lehman Brothers, Inc. Commercial Paper 49,837,542
Lehman Brothers, Inc. Variable Rate Obligation 50,000,000
U.S. Treasury Money Market
Morgan Stanley & Co., Inc. Repurchase Agreement $ 247,000,000
Greenwich Capital Repurchase Agreement 225,000,000
Goldman, Sachs & Co. Repurchase Agreement 50,000,000
Merrill Lynch & Co. Repurchase Agreement 50,000,000
Swiss Bank Corp. Repurchase Agreement 50,000,000
Low Duration Bond
Morgan Stanley & Co., Inc. Mortgage Pass-Through $ 168,166
Lehman Brothers, Inc. Corporate Bond 3,689,617
Salomon Brothers, Inc. Mortgage Pass-Through 3,065,061
Salomon Brothers, Inc. Corporate Bond 4,037,134
Intermediate Government Bond
Merrill Lynch & Co. Mortgage Pass-Through $ 4,367,211
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,407,311
Intermediate Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 2,117,624
Salomon Brothers, Inc. Corporate Bond 527,865
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,577,526
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 3,266,973
Merrill Lynch & Co. Mortgage Pass-Through 10,190,099
Merrill Lynch & Co. Commercial Mortgage-Backed Security 1,236,217
</TABLE>
-105-
<PAGE>
<TABLE>
<CAPTION>
Portfolio Security Value
--------- -------- -----
<S> <C> <C>
Core Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 6,900,254
Salomon Brothers, Inc. Corporate Bond 5,701,504
Goldman, Sachs & Co. Commercial Mortgage-Backed Security 2,942,012
Merrill Lynch & Co. Mortgage Pass-Through 428,155
Merrill Lynch & Co. Commercial Mortgage-Backed Security 3,397,277
Merrill Lynch & Co. Asset Backed Security 303,703
Merrill Lynch & Co. Corporate Bond 4,226,051
Government Income
Salomon Brothers, Inc. Mortgage Pass-Through $ 632,894
Managed Income
Salomon Brothers, Inc. Corporate Bond $ 2,639,323
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,063,281
PaineWebber Jackson & Curtis, Inc. Corporate Bond 5,004,177
HSBC Securities Corporate Bond 7,852,743
Merrill Lynch & Co. Corporate Bond 8,250,862
Merrill Lynch & Co. Commercial Mortgage-Backed Security 12,884,829
Large Cap Value Equity
Morgan Stanley & Co., Inc. Common Stock $ 29,257,111
Mid-Cap Value Equity
Donaldson, Lufkin & Jenrette Securities Corp. Common Stock $ 1,073,437
Select Equity
Morgan Stanley & Co., Inc. Common Stock $ 7,595,781
Balanced
Morgan Stanley & Co., Inc. Common Stock $ 4,941,312
Salomon Brothers, Inc. Mortgage Pass-Through 1,593,589
Salomon Brothers, Inc. Corporate Bond 316,719
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,051,684
Merrill Lynch & Co. Corporate Bond 1,006,203
Merrill Lynch & Co. Commercial Mortgage-Backed Security 2,015,045
</TABLE>
PURCHASE AND REDEMPTION INFORMATION
Computation of Public Offering Prices for Investor A Shares of the Non-
Money Market Portfolios. An illustration of the computation of the public
offering price per Investor A Share of the respective Non-Money Market
Portfolios, based on the value of such Portfolios' net assets as of September
30, 1997 follows:
TABLE
<TABLE>
<CAPTION>
Low Intermediate Intermediate Core Government
Duration Government Bond Bond Income
Brand Portfolio Bond Portfolio Portfolio Portfolio Portfolio
--------------- -------------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Net Assets..................................... $1,078,619 $5,373,962 $1,115,865 $2,440,633 $4,875,820
Outstanding Shares............................. 109,020 531,600 117,568 248,559 464,801
Net Asset Value Per Share...................... $ 9.89 $ 10.11 $ 9.49 $ 9.82 $ 10.49
</TABLE>
-106-
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
Maximum Sales Charge, 4.00% of offering price
(4.17% of net asset value per share)*........ .31 .42 .40 .41 .49
------ ------ ----- ------ ------
Offering to Public............................. $10.20 $10.53 $9.89 $10.23 $10.98
====== ====== ===== ====== ======
</TABLE>
_____________________
* 3.00%/3.09% for Low Duration Bond Portfolio; 4.50%/4.71% for Government
Income Portfolio.
<TABLE>
<CAPTION>
PENNSYLVANIA NEW JERSEY
MANAGED INTERNATIONAL TAX-FREE TAX-FREE TAX-FREE
INCOME BOND INCOME INCOME INCOME
PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO
--------- ------------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Net Assets..................................... $15,231,004 $1,015,272 $5,529,698 $32,899,562 $1,547,924
Outstanding Shares............................. 1,463,584 92,713 487,696 3,054,223 132,824
=========== ========== ========== =========== ==========
Net Asset Value Per Share...................... $ 10.41 $10.95 $11.34 $10.77 $11.65
Maximum Sales Charge, 4.00% of offering price
(4.17% of net asset value per share)*........ .49 .58 .47 .45 .49
----------- ---------- ---------- ----------- ----------
Offering to Public............................. $10.90 $11.53 $11.81 $11.22 $12.14
=========== ========== ========== =========== ==========
</TABLE>
_____________________
* 4.50%/4.71% for Managed Income Portfolio; 5.00%/5.26% for International
Bond Portfolio.
<TABLE>
<CAPTION>
OHIO LARGE CAP LARGE CAP MID-CAP MID-CAP
TAX-FREE VALUE GROWTH VALUE GROWTH
INCOME EQUITY EQUITY EQUITY EQUITY
PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO
========= ========= ========= ========= =========
<S> <C> <C> <C> <C> <C>
Net Assets..................................... $2,613,993 $47,130,883 $25,574,775 $2,314,615 $2,649,715
Outstanding Shares............................. 248,893 2,690,305 1,352,284 181,200 218,185
========= ========== ========== ========= =========
Net Asset Value Per Share...................... $ 10.50 $ 17.52 $ 18.91 $ 12.77 $ 12.14
Maximum Sales Charge, 4.50% of offering price
(4.71% of net asset value per share)*........ .44 .82 .89 .60 .57
--------- ---------- ---------- --------- ---------
Offering to Public............................. $ 10.94 $ 18.34 $ 19.80 $ 13.37 $ 12.71
========= ========== ========== ========= =========
</TABLE>
_____________________
* 4.00%/4.17% for Ohio Tax-Free Income Portfolio.
<TABLE>
<CAPTION>
SMALL CAP INTERNATIONAL INTERNATIONAL
SMALL CAP GROWTH INTERNATIONAL SMALL CAP EMERGING
VALUE EQUITY EQUITY EQUITY EQUITY MARKETS
PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO PORTFOLIO
========= ========= ========= ========= =========
<S> <C> <C> <C> <C>
Net Assets..................................... $34,031,124 $57,323,064 $22,335,232 $325,738 $4,454,003
Outstanding Shares............................. 1,684,915 2,466,020 1,533,040 32,754 463,777
========== ========== ========== ======= =========
Net Asset Value Per Share...................... $20.20 $23.25 $14.57 $9.94 $9.60
Maximum Sales Charge, 5.00% of offering price
(5.26% of net asset value per share)*........ .95 1.10 .77 .52 .51
---------- ---------- ---------- -------- ---------
Offering to Public............................. $21.15 $24.35 $15.34 $10.46 $10.11
========== ========== ========== ======== =========
</TABLE>
_____________________
* 4.50%/4.71% for Small Cap Value Equity and Small Cap Growth Equity
Portfolios.
-107-
<PAGE>
<TABLE>
<CAPTION>
SELECT INDEX
EQUITY EQUITY BALANCED
PORTFOLIO PORTFOLIO PORTFOLIO
========= ========= =========
<S> <C> <C> <C>
Net Assets......................................................... $18,948,763 $33,933,239 $87,202,151
Outstanding Shares................................................. 1,082,651 1,852,190 4,785,456
========= ========= ==========
Net Asset Value Per Share.......................................... $17.50 $18.32 $18.22
Maximum Sales Charge, 4.50% of offering price (4.71% of net asset
value per share)*................................................. .82 .57 .86
---------- ---------- ----------
Offering to Public................................................. $18.32 $18.89 $19.08
========== ========== ==========
</TABLE>
_____________________
* 3.00%/3.09% for Index Equity Portfolio.
Total front-end sales charges paid by shareholders of Investor A Shares of the
Portfolios for the year or period ended September 30, 1997 (for the period from
December 27, 1996 through September 30, 1997 in the case of the Mid-Cap Growth
Equity and Mid-Cap Value Equity Portfolios; and for the period from September
26, 1997 through September 30, 1997 in the case of the International Small Cap
Equity Portfolio) were as follows:
<TABLE>
<CAPTION>
FRONT-END
PORTFOLIOS SALES CHARGES
- ---------- -------------
<S> <C>
Low Duration Bond $ 3,758
Intermediate Government Bond 11,644
Intermediate Bond 7,367
Core Bond 39,657
Government Income 32,856
Managed Income 68,493
International Bond 29,718
Tax-Free Income 19,830
Pennsylvania Tax-Free Income 80,642
New Jersey Tax-Free Income 4,104
Ohio Tax-Free Income 5,336
Large Cap Value Equity 277,224
Large Cap Growth Equity 146,897
Mid-Cap Value Equity 55,834
Mid-Cap Growth Equity 46,954
Small Cap Value Equity 107,051
Small Cap Growth Equity 668,832
International Equity 104,956
International Small Cap Equity 0
International Emerging Markets 49,056
Select Equity 272,796
Index Equity 159,501
Balanced 223,646
</TABLE>
Total front-end sales charges paid by shareholders of Investor A Shares of the
Portfolios for the year or period ended September 30, 1996 (for the period from
February 1, 1996 through September 30, 1996 in the case of the New Jersey Tax-
Free Income and International Bond Portfolios; for the period from April 1, 1996
through September 30, 1996 in the case of the Low Duration Bond and Core Bond
Portfolios) were as follows:
-108-
<PAGE>
through September 30, 1996 in the case of the Low Duration Bond and Core Bond
Portfolios) were as follows:
<TABLE>
<CAPTION>
PORTFOLIOS FRONT-END SALES CHARGES
- ---------- -----------------------
<S> <C>
Managed Income $ 43,417
Tax-Free Income 9,109
Intermediate Government Bond 22,989
Ohio Tax-Free Income 4,649
Pennsylvania Tax-Free Income 81,436
Intermediate Bond 8,598
Large Cap Value Equity 141,011
Large Cap Growth Equity 95,694
Small Cap Growth Equity 344,911
Select Equity 44,112
Index Equity 78,263
Small Cap Value Equity 51,676
International Equity 85,795
Balanced 143,547
International Emerging Markets 18,147
Government Income 30,034
Core Bond 8,481
New Jersey Tax Free Income 17,606
Low Duration Bond 6,294
International Bond $7,565
</TABLE>
Total front-end sales charges paid by shareholders of Investor A Shares of the
Portfolios for the year or period ended September 30, 1995 were as follows:
<TABLE>
<CAPTION>
PORTFOLIOS FRONT-END SALES CHARGES
- ---------- -----------------------
<S> <C>
Managed Income $ 37,132
Tax-Free Income 8,850
Intermediate Government Bond 42,765
Ohio Tax-Free Income 2,725
Pennsylvania Tax-Free Income 121,089
Intermediate Bond 1,513
Large Cap Value Equity 68,289
Large Cap Growth Equity 47,859
Small Cap Growth Equity 77,356
Select Equity 34,761
Index Equity 51,229
Small Cap Value Equity 61,709
International Equity 83,938
Balanced 144,255
International Emerging Markets 24,915
Government Income 69,712
</TABLE>
-109-
<PAGE>
For the period from January 13, 1996 through January 31, 1996, the
total front-end sales charges paid by the shareholders of Investor A Shares of
the New Jersey Tax-Free Income Portfolio were $435. For the period from January
13, 1996 through March 31, 1996, the total front-end sales charges paid by the
shareholders of Investor A Shares of the Low Duration Bond and Core Bond
Portfolios were $3,848 and $1,723, respectively.
There is no initial sales charge on purchases of $1,000,000 or more of
Investor A Shares of the Non-Money Market Portfolios. However, a contingent
deferred sales charge of 1.00% will be imposed on the lesser of the net offering
price or the asset value of the shares on the redemption date for Investor A
Shares purchased on a no-load basis and subsequently redeemed within 18 months
after purchase.
Investor A Shares of the Non-Money Market Portfolios will be made
available to plan participants at net asset value with the waiver of the initial
sales charge on purchases through an eligible 401(k) plan participating in a
Merrill Lynch 401(k) Program (an "ML 401(k) Plan") if:
(i) the ML 401(k) Plan is recordkept on a daily valuation basis by
Merrill Lynch and, on the date the ML 401(k) Plan sponsor signs the
Merrill Lynch Recordkeeping Service Agreement, the ML 401(k) Plan has
$3 million or more in assets invested in broker/dealer funds not
advised or managed by Merrill Lynch Asset Management, L.P. ("MLAM")
that are made available pursuant to a Services Agreement between
Merrill Lynch and the fund's principal underwriter or distributor and
in funds advised or managed by MLAM (collectively, the "Applicable
Investments"); or
(ii) the ML 401(k) Plan is recordkept on a daily valuation basis by an
independent recordkeeper whose services are provided through a contract
or alliance arrangement with Merrill Lynch, and on the date the ML
401(k) Plan sponsor signs the Merrill Lynch Recordkeeping Service
Agreement, the ML 401(k) Plan has $3 million or more in assets,
excluding money market funds, invested in Applicable Investments; or
(iii) the ML 401(k) Plan has 500 or more eligible employees, as
determined by the Merrill Lynch plan conversion manager, on the date
the ML 401(k) Plan sponsor signs the Merrill Lynch Recordkeeping
Service Agreement.
Investor B Shares of the Non-Money Market Portfolios are sold at the
net asset value per share next determined after a purchase order is received.
Investor B Shares of the Non-Money Market Portfolios are subject to a contingent
deferred sales charge which is payable on redemption of such Investor B Shares.
-110-
<PAGE>
Investor B Shares of the Non-Money Market Portfolios will be made
available to plan participants at net asset value with the waiver of the
contingent deferred sales charge if the shares were purchased through an ML
401(k) Plan if:
(i) the ML 401(k) Plan is recordkept on a daily valuation basis by
Merrill Lynch and, on the date the ML 401(k) Plan sponsor signs the
Merrill Lynch Recordkeeping Service Agreement, the ML 401(k) Plan has
less than $3 million in assets invested in Applicable Investments; or
(ii) the ML 401(k) Plan is recordkept on a daily valuation basis by an
independent recordkeeper whose services are provided through a contract
or alliance arrangement with Merrill Lynch, and on the date the ML
401(k) Plan sponsor signs the Merrill Lynch Recordkeeping Service
Agreement, the ML 401(k) Plan has less than $3 million in assets,
excluding money market funds, invested in Applicable Investments; or
(iii) the ML 401(k) Plan has less than 500 eligible employees, as
determined by the Merrill Lynch plan conversion manager, on the date
the ML 401(k) Plan sponsor signs the Merrill Lynch Recordkeeping
Service Agreement.
ML 401(k) Plans recordkept on a daily basis by Merrill Lynch or an
independent recordkeeper under a contract with Merrill Lynch that are currently
investing in Investor B shares of Non- Money Market Portfolios of the Fund
convert to Investor A shares once the ML 401(k) Plan has reached $5 million
invested in Applicable Investments. The ML 401(k) Plan will receive a plan-level
share conversion.
Investor C Shares of the Non-Money Market Portfolios are sold at the
net asset value per share next determined after a purchase order is received. In
addition, Investor C Shares of the Non-Money Market Portfolios are subject to a
contingent deferred sales charge which is payable on redemptions of such
Investor C Shares within 12 months of purchase.
Service and Institutional Shares of each Portfolio are sold at the net
asset value per share next determined after a purchase order is received without
a sales charge.
EXCHANGE PRIVILEGE. By use of the exchange privilege, the investor
authorizes the Fund's transfer agent to act on telephonic or written exchange
instructions from any person representing himself to be the investor and
believed by the Fund's transfer agent to be genuine. The records of the Fund's
transfer agent pertaining to such instructions are binding. The exchange
privilege may be modified or terminated at any time upon 60 days' notice to
affected shareholders. The exchange privilege is only available in states where
the exchange may legally be made.
-111-
<PAGE>
A front-end sales charge or a contingent deferred sales charge will be
imposed (unless an exemption from either sales charge applies) when Investor
Shares of a Money Market Portfolio are redeemed and the proceeds are used to
purchase Investor A Shares, Investor B Shares or Investor C Shares of a Non-
Money Market Portfolio.
MISCELLANEOUS. The Fund reserves the right, if conditions exist which
make cash payments undesirable, to honor any request for redemption or
repurchase of a Portfolio's shares by making payment in whole or in part in
securities chosen by the Fund and valued in the same way as they would be valued
for purposes of computing a Portfolio's net asset value. If payment is made in
securities, a shareholder may incur transaction costs in converting these
securities into cash. The Fund has elected, however, to be governed by Rule 18f-
1 under the 1940 Act so that a Portfolio is obligated to redeem its shares
solely in cash up to the lesser of $250,000 or 1% of its net asset value during
any 90-day period for any one shareholder of a Portfolio.
With respect to the Index Master Portfolio, when the Trustees of the
Trust determine that it would be in the best interests of the Index Master
Portfolio, the Index Master Portfolio may pay the redemption price in whole or
in part by a distribution of portfolio securities from the Index Master
Portfolio of the shares being redeemed in lieu of cash in accordance with Rule
18f-1 under the Investment Company Act of 1940. Investors, such as the Index
Equity Portfolio, may incur brokerage charges and other transaction costs
selling securities that were received in payment of redemptions.
The Fund will accept and process purchase and redemption orders with
respect to the Large Cap Value Equity, Large Cap Growth Equity, Index Equity,
Small Cap Value Equity, Small Cap Growth Equity, Mid-Cap Value Equity, Mid-Cap
Growth Equity, Select Equity, Micro-Cap Equity, International Equity,
International Emerging Markets, Balanced and International Small Cap Equity
Portfolios on days on which the Federal Reserve Bank of Philadelphia is closed
if the New York Stock Exchange (the "NYSE") is open for business.
Under the 1940 Act, a Portfolio may suspend the right to redemption or
postpone the date of payment upon redemption for any period during which the
NYSE is closed (other than customary weekend and holiday closings), or during
which trading on the NYSE is restricted, or during which (as determined by the
SEC by rule or regulation) an emergency exists as a result of which disposal or
valuation of portfolio securities is not reasonably practicable, or for such
other periods as the SEC may permit. (A Portfolio may also suspend or postpone
the recordation of the transfer of its shares upon the occurrence of any of the
foregoing conditions.)
-112-
<PAGE>
In addition to the situations described in the Prospectuses, the Fund
may redeem shares involuntarily to reimburse a Portfolio for any loss sustained
by reason of the failure of a shareholder to make full-payment for shares
purchased by the shareholder or to collect any charge relating to a transaction
effected for the benefit of a shareholder as provided in the Prospectus from
time to time. The Fund reserves the express right to redeem shares of each
Portfolio involuntarily at any time if the Fund's Board of Trustees determines,
in its sole discretion, that failure to do so may have adverse consequences to
the holders of shares in the Portfolio. Upon such redemption the holders of
shares so redeemed shall have no further right with respect thereto other than
to receive payment of the redemption price.
VALUATION OF PORTFOLIO SECURITIES
In determining the market value of portfolio investments, the Fund may
employ outside organizations, which may use, without limitation, a matrix or
formula method that takes into consideration market indexes, matrices, yield
curves and other specific adjustments. This may result in the securities being
valued at a price different from the price that would have been determined had
the matrix or formula method not been used. All cash, receivables and current
payables are carried on the Fund's books at their face value. Other assets, if
any, are valued at fair value as determined in good faith under the supervision
of the Board of Trustees.
MONEY MARKET PORTFOLIOS. The net asset value for each class of each
share of the Money Market Portfolios for the purpose of pricing purchase and
redemption orders is determined twice each day, once as of 12:00 noon (Eastern
Time) and once as of 4:00 p.m. (Eastern Time) on each Business Day. Each
Portfolio's net asset value per share is calculated by adding the value of all
securities, cash and other assets of the respective classes of the Portfolio,
subtracting the liabilities and dividing the result by the number of outstanding
shares of such classes. The net asset value per share of each class of each
Portfolio is determined independently of the other classes and the other
Portfolios.
The Fund seeks to maintain for each of the Money Market Portfolios a
net asset value of $1.00 per share for purposes of purchase and redemptions and
values their portfolio securities on the basis of the amortized cost method of
valuation.
Under this method the market value of an instrument is approximated by
amortizing the difference between the acquisition cost and value at maturity of
the instrument on a straight-line basis over the remaining life of the
instrument. The effect of changes in the market value of a security as a result
of fluctuating interest rates is not taken into account. The market
-113-
<PAGE>
value of debt securities usually reflects yields generally available on
securities of similar quality. When such yields decline, market values can be
expected to increase, and when yields increase, market values can be expected to
decline.
As indicated, the amortized cost method of valuation may result in the
value of a security being higher or lower than its market price, the price a
Money Market Portfolio would receive if the security were sold prior to
maturity. The Fund's Board of Trustees has established procedures for the
purpose of maintaining a constant net asset value of $1.00 per share for each
Money Market Portfolio, which include a review of the extent of any deviation of
net asset value per share, based on available market quotations, from the $1.00
amortized cost per share. Should that deviation exceed 1/2 of 1% for a Money
Market Portfolio, the Fund's Board of Trustees will promptly consider whether
any action should be initiated to eliminate or reduce material dilution or other
unfair results to shareholders. Such action may include redeeming shares in
kind, selling portfolio securities prior to maturity, reducing or withholding
dividends, shortening the average portfolio maturity, reducing the number of
outstanding shares without monetary consideration, and utilizing a net asset
value per share as determined by using available market quotations.
Each Money Market Portfolio will maintain a dollar-weighted average
portfolio maturity of 90 days or less, will not purchase any instrument with a
deemed maturity under Rule 2a-7 of the 1940 Act greater than 13 months, and will
limit portfolio investments, including repurchase agreements, to those
instruments that the adviser or sub-adviser determines present minimal credit
risks pursuant to guidelines adopted by the Fund's Board of Trustees. There can
be no assurance that a constant net asset value will be maintained for any Money
Market Portfolio.
EQUITY PORTFOLIOS. Net asset value is calculated separately for each
class of shares of each Equity Portfolio as of the close of regular trading
hours on the NYSE (currently 4:00 p.m. Eastern Time) on each Business Day by
dividing the value of all securities, cash and other assets owned by a Portfolio
that are allocated to a particular class of shares, less the liabilities charged
to that class, by the total number of outstanding shares of the class.
Valuation of securities held by each Equity Portfolio is as follows:
securities traded on a national securities exchange or on the NASDAQ National
Market System are valued at the last reported sale price that day; securities
traded on a national securities exchange or on the NASDAQ National Market System
for which there were no sales on that day and securities traded on other over-
the-counter markets for which market quotations are readily available are valued
at the mean of the bid and asked prices; an option or futures contract is valued
at the last sales
-114-
<PAGE>
price prior to 4:00 p.m. (Eastern Time), as quoted on the principal exchange or
board of trade on which such option or contract is traded, or in the absence of
a sale, the mean between the last bid and asked prices prior to 4:00 p.m.
(Eastern Time); and securities for which market quotations are not readily
available are valued at fair market value as determined in good faith by or
under the direction of the Fund's Board of Trustees. The amortized cost method
of valuation will also be used with respect to debt obligations with sixty days
or less remaining to maturity unless the investment adviser and/or sub-adviser
under the supervision of the Board of Trustees determines such method does not
represent fair value.
Valuation of securities of foreign issuers is as follows: to the extent
sale prices are available, securities which are traded on a recognized stock
exchange, whether U.S. or foreign, are valued at the latest sale price on that
exchange prior to the time when assets are valued or prior to the close of
regular trading hours on the NYSE. In the event that there are no sales, the
mean between the last available bid and asked prices will be used. If a security
is traded on more than one exchange, the latest sale price on the exchange where
the stock is primarily traded is used. An option or futures contract is valued
at the last sales price prior to 4:00 p.m. (Eastern Time), as quoted on the
principal exchange or board of trade on which such option or contract is traded,
or in the absence of a sale, the mean between the last bid and asked prices
prior to 4:00 p.m. (Eastern Time). In the event that application of these
methods of valuation results in a price for a security which is deemed not to be
representative of the market value of such security, the security will be valued
by, under the direction of or in accordance with a method specified by the Board
of Trustees as reflecting fair value. The amortized cost method of valuation
will be used with respect to debt obligations with sixty days or less remaining
to maturity unless the investment adviser and/or sub-adviser under the
supervision of the Board of Trustees determines such method does not represent
fair value. All other assets and securities held by the Portfolios (including
restricted securities) are valued at fair value as determined in good faith by
the Board of Trustees or by someone under its direction. Any assets which are
denominated in a foreign currency are translated into U.S. dollars at the
prevailing market rates.
Certain of the securities acquired by the International Equity,
International Emerging Markets and International Small Cap Equity Portfolios may
be traded on foreign exchanges or over-the-counter markets on days on which a
Portfolio's net asset value is not calculated. In such cases, the net asset
value of the Portfolio's shares may be significantly affected on days when
investors can neither purchase nor redeem shares of the Portfolio.
-115-
<PAGE>
A Portfolio may use a pricing service, bank or broker/dealer
experienced in such matters to value the Portfolio's securities.
The valuation of securities held by the Index Master Portfolio is
discussed in its Registration Statement.
BOND PORTFOLIOS. Net asset value is calculated separately for each
class of shares of each Bond Portfolio as of the close of regular trading hours
on the NYSE on each Business Day by dividing the value of all securities, cash
and other assets owned by a Portfolio that are allocated to a particular class
of shares, less the liabilities charged to that class, by the total number of
outstanding shares of the class.
Valuation of securities held by each Bond Portfolio is as follows:
domestic securities traded on a national securities exchange or on the NASDAQ
National Market system are valued at the last reported sale price that day;
domestic securities traded on a national securities exchange or on the NASDAQ
National Market System for which there were no sales on that day are valued at
the mean of the bid and asked prices; foreign securities traded on a recognized
stock exchange, whether U.S. or foreign, are valued at the latest sale price on
that exchange prior to the time when assets are valued or prior to the close of
regular trading hours on the NYSE (if a security is traded on more than one
exchange, the latest sale price on the exchange where the stock is primarily
traded is used); foreign securities traded on a recognized stock exchange for
which there were no sales on that day are valued at the mean of the bid and
asked prices; other securities are valued on the basis of valuations provided by
a pricing service approved by the Board of Trustees, provided that if the
investment adviser or sub-adviser concludes that the price provided by a pricing
service does not represent the fair value of a security, such security will be
valued at fair value determined by the adviser or sub-adviser based on
quotations or the equivalent thereof received from dealers; an option or futures
contract is valued at the last sales price prior to 4:00 p.m. (Eastern Time), as
quoted on the principal exchange or board of trade on which such option or
futures contract is traded, or in the absence of a sale, the mean between the
last bid and asked prices prior to 4:00 p.m. (Eastern Time); the amortized cost
method of valuation is used with respect to debt obligations with sixty days or
less remaining to maturity; and securities for which market quotations are not
readily available are valued at fair market value as determined in good faith by
or under the direction of the Fund's Board of Trustees. Any securities which are
denominated in a foreign currency are translated into U.S. dollars at the
prevailing market rates.
Certain of the securities acquired by the International Bond Portfolio
may be traded on foreign exchanges or over-the-counter markets on days on which
the Portfolio's net asset value is not calculated. In such cases, the net asset
value of the
-116-
<PAGE>
Portfolio's shares may be significantly affected on days when investors can
neither purchase nor redeem shares of the Portfolio.
PERFORMANCE INFORMATION
A Portfolio may quote performance in various ways. All performance
information supplied by a Portfolio in advertising is historical and is not
intended to indicate future returns.
MONEY MARKET PORTFOLIO PERFORMANCE. Each Money Market Portfolio's
current and effective yields for Service, Investor A, Investor B, Investor C and
Institutional Shares are computed separately using standardized methods required
by the SEC. The annualized yield for a class of Service, Investor A, Investor B,
Investor C or Institutional Shares is computed by: (a) determining the net
change in the value of a hypothetical account having a balance of one share at
the beginning of a seven-calendar day period; (b) dividing the net change by the
value of the account at the beginning of the period to obtain the base period
return; and (c) annualizing the results (i.e., multiplying the base period
return by 365/7). The net change in the value of the account reflects the value
of additional shares purchased with dividends declared and all dividends
declared on both the original share and such additional shares, but does not
include realized gains and losses or unrealized appreciation and depreciation.
Compound effective yields are computed by adding 1 to the base period return
(calculated as described above) raising the sum to a power equal to 365/7 and
subtracting 1. In addition, a standardized "tax-equivalent yield" may be quoted
for Service, Investor A, Investor B, Investor C and Institutional Shares in the
Municipal Money Market, Ohio Municipal Money Market, Pennsylvania Municipal
Money Market, North Carolina Municipal Money Market, Virginia Municipal Money
Market and New Jersey Municipal Money Market Portfolios, which is computed
separately for each class by: (a) dividing the portion of the Portfolio's yield
for shares (as calculated above) that is exempt from Federal or state income tax
by one minus a stated Federal or state income tax rate; and (b) adding the
figure resulting from (a) above to that portion, if any, of the yield that is
not exempt from Federal and state income tax.
The annualized yield information for each Money Market Portfolio for
the seven-day period ended September 30, 1997 before waivers was as follows:
-117-
<PAGE>
<TABLE>
<CAPTION>
TAX-EQUIVALENT
YIELD (ASSUMES A
FEDERAL INCOME
PORTFOLIOS YIELD EFFECTIVE YIELD TAX RATE OF 28%)
- ---------------------------------------- ------------- ---------------- -----------------
<S> <C> <C> <C>
Money Market
Institutional Shares 5.05% 5.18% 7.01%
Service Shares 4.75 4.86 6.60
Investor A Shares 4.67 4.78 6.49
Investor B Shares 3.98 4.06 5.53
Investor C Shares 3.98 4.06 5.53
U.S. Treasury Money Market
Institutional Shares 4.96% 5.08% 6.89%
Service Shares 4.66 4.77 6.47
Investor A Shares 4.49 4.59 6.24
Municipal Money Market
Institutional Shares 3.25% 3.30% 4.51%
Service Shares 2.95 2.99 4.10
Investor A Shares 2.78 2.82 3.86
Investor C Shares 2.19 2.21 3.04
New Jersey Municipal Money Market
Institutional Shares 3.02% 3.07% 4.19%
Service Shares 2.72 2.76 3.7
Investor A Shares 2.47 2.50 3.43
North Carolina Municipal Money Market
Institutional Shares 3.21% 3.26% 4.46%
Service Shares 2.91 2.95 4.04
Investor A Shares 2.74 2.78 3.81
Ohio Municipal Money Market
Institutional Shares 3.23% 3.28% 4.49%
Service Shares 2.93 2.97 4.07
Investor A Shares 2.75 2.79 3.82
Pennsylvania Municipal Money Market
Institutional Shares 3.24% 3.29% 4.50%
Service Shares 2.94 2.98 4.08
Investor A Shares 2.78 2.82 3.86
Virginia Municipal Money Market
Institutional Shares 3.15% 3.20% 4.38%
Service Shares 2.85 2.89 3.96
Investor A Shares 2.53 2.56 3.51
</TABLE>
The Investor B Class had not commenced operations as of September 30,
1997, except with respect to the Money Market Portfolio. The Investor C Class
had not commenced operations as of September 30,1997, except with respect to the
Money Market Portfolio and the Municipal Money Market Portfolio.
The annualized yield information for each Money Market Portfolio for
the seven-day period ended September 30, 1997 after waivers was as follows:
-118-
<PAGE>
<TABLE>
<CAPTION>
TAX-EQUIVALENT
YIELD (ASSUMES A
FEDERAL INCOME
PORTFOLIOS YIELD EFFECTIVE YIELD TAX RATE OF 28%)
- ---------------------------------------- ------------- ---------------- -----------------
<S> <C> <C> <C>
Money Market
Institutional Shares 5.38% 5.52% 7.47%
Service Shares 5.08 5.21 7.06
Investor A Shares 5.00 5.12 6.94
Investor B Shares 4.31 4.40 5.99
Investor C Shares 4.31 4.40 5.99
U.S. Treasury Money Market
Institutional Shares 5.34% 5.48% 7.42%
Service Shares 5.04 5.17 7.00
Investor A Shares 4.87 4.99 6.76
Municipal Money Market
Institutional Shares 3.66% 3.73% 5.08%
Service Shares 3.36 3.42 4.67
Investor A Shares 3.19 3.24 4.43
Investor C Shares 2.60 2.63 3.61
New Jersey Municipal Money Market
Institutional Shares 3.46% 3.52% 4.81%
Service Shares 3.16 3.21 4.3
Investor A Shares 2.91 2.95 4.04
North Carolina Municipal Money Market
Institutional Shares 3.66% 3.73% 5.08%
Service Shares 3.36 3.42 4.67
Investor A Shares 3.19 3.24 4.43
Ohio Municipal Money Market
Institutional Shares 3.65% 3.72% 5.07%
Service Shares 3.35 3.41 4.65
Investor A Shares 3.17 3.22 4.40
Pennsylvania Municipal Money Market
Institutional Shares 3.64% 3.71% 5.06%
Service Shares 3.34 3.40 4.64
Investor A Shares 3.18 3.23 4.42
Virginia Municipal Money Market
Institutional Shares 3.74% 3.81% 5.19%
Service Shares 3.44 3.50 4.78
Investor A Shares 3.12 3.17 4.33
</TABLE>
The Investor B Class had not commenced operations as of September 30,
1997, except with respect to the Money Market Portfolio. The Investor C Class
had not commenced operations as of September 30, 1997, except with respect to
the Money Market Portfolio and the Municipal Money Market Portfolio.
The fees which may be imposed by institutions on their Customers are
not reflected in the calculations of yields for the Money Market Portfolios.
Yields on Institutional Shares will generally be higher than yields on Service
Shares; yields on Service Shares will generally be higher than yields on
Investor A Shares; and yields on Investor A Shares will generally be higher than
yields on Investor B Shares and Investor C Shares.
From time to time, in advertisements, sale literature, reports to
shareholders and other materials, the yields of a Money Market Portfolio's
Service, Investor A, Investor B, Investor C or Institutional Shares may be
quoted and compared to
-119-
<PAGE>
those of other mutual funds with similar investment objectives and relevant
securities indexes. For example, the yield of a Portfolio's Service, Investor A,
Investor B, Investor C or Institutional Shares may be compared to the Donoghue's
Money Fund Average, which is an average compiled by IBC/Donoghue's MONEY FUND
REPORT(R), a widely-recognized independent publication that monitors the
performance of money market funds, the average yields reported by the Bank Rate
Monitor from money market deposit accounts offered by the 50 leading banks and
thrift institutions in the top five standard metropolitan statistical areas, or
to the data prepared by Lipper Analytical Services, Inc., a widely-recognized
independent service that monitors the performance of mutual funds. Yield may
also be compared to yields set forth in the weekly statistical release H.15(519)
or the monthly statistical release designated G.13(415) published by the Board
of Governors of the Federal Reserve system. In addition, each Money Market
Portfolio may quote from time to time its total return in accordance with SEC
regulations.
TOTAL RETURN. For purposes of quoting and comparing the performance of
shares of the Non-Money Market Portfolios to the performance of other mutual
funds and to stock or other relevant indexes in advertisements, sales
literature, communications to shareholders and other materials, performance may
be stated in terms of total return. The total return for each class of a Non-
Money Market Portfolio will be calculated independently of the other classes
within that Portfolio. Under the rules of the SEC, funds advertising performance
must include total return quotes calculated according to the following formula:
ERV 1/n
T = [(-----) - 1]
P
Where: T = average annual total return.
ERV = ending redeemable value at the end of the period
covered by the computation of a hypothetical $1,000
payment made at the beginning of the period.
P = hypothetical initial payment of $1,000.
n = period covered by the computation, expressed in terms
of years.
In calculating the ending redeemable value for Investor A Shares of the
Fund's Non-Money Market Portfolios, the maximum front-end sales charge is
deducted from the initial $1,000 payment and all dividends and distributions by
the particular Portfolio are assumed to have been reinvested at net asset value
as described in the particular Prospectus on the reinvestment dates during the
period. In calculating the ending redeemable value for Investor B Shares of the
Non-Money Market Portfolios,
-120-
<PAGE>
the maximum contingent deferred sales charge is deducted at the end of the
period and all dividends and distributions by the particular Portfolio are
assumed to have been reinvested at net asset value as described in the
particular Prospectus on the reinvestment dates during the period. In
calculating the ending redeemable value for Investor C Shares of the Fund's Non-
Money Market Portfolios, the maximum contingent deferred sales charge is
deducted at the end of the period, and all dividends and distributions by the
particular Portfolio are assumed to have been reinvested at net asset value as
described in the particular Prospectus on the reinvestment dates during the
period. Total return, or "T" in the formula above, is computed by finding the
average annual compounded rates of return over the specified periods that would
equate the initial amount invested to the ending redeemable value.
Performance information presented for the following Non-Money Market
Portfolios includes performance information for a corresponding predecessor
portfolio which transferred its assets and liabilities to the related Non-Money
Market Portfolio pursuant to a reorganization consummated on January 13, 1996
(February 13, 1996 with respect to the International Bond Portfolio):
<TABLE>
<CAPTION>
Commencement of
Non-Money Market Predecessor Operations of
Portfolio Portfolio Predecessor Portfolio
- --------- --------- ---------------------
<S> <C> <C>
New Jersey Tax-Free Income Compass Capital Group July 1, 1991
Portfolio New Jersey Municipal
Bond Fund
International Bond Portfolio Compass Capital Group July 1, 1991
International Fixed Income
Fund
Core Bond Portfolio BFM Institutional Trust December 9, 1992
Core Fixed Income
Portfolio
Low Duration Bond Portfolio BFM Institutional Trust July 17, 1992
Short Duration Portfolio
</TABLE>
Each Non-Money Market Portfolio presents performance information for
each class thereof since the commencement of operations of that Portfolio (or
the related predecessor portfolio), rather than the date such class was
introduced. Performance information for each class introduced after the
commencement of operations of the related Portfolio (or predecessor portfolio)
is therefore based on the performance history of a predecessor class or
predecessor classes. If a
-121-
<PAGE>
class of shares in a Portfolio (the "Subsequent Class") has more than one
predecessor class, the performance data predating the introduction of the
Subsequent Class is based initially on the performance of the Portfolio's first
operational predecessor class (the "Initial Class"); thereafter, the performance
of the Subsequent Class is based upon the performance of any other predecessor
class or classes which were introduced after the Initial Class and which had
total operating expenses more similar to those of the Subsequent Class.
Performance information is restated to reflect the current maximum front-end
sales charge (in the case of Investor A Shares) or the maximum contingent
deferred sales charge (in the case of Investor B Shares) when presented
inclusive of sales charges. Additional performance information is presented
which does not reflect the deduction of sales charges. Historical expenses
reflected in performance information are based upon the distribution,
shareholder servicing and processing fees and other expenses actually incurred
during the periods presented and have not been restated, in cases in which the
performance information for a particular class includes the performance history
of a predecessor class or predecessor classes, to reflect the ongoing expenses
currently borne by the particular class.
Based on the foregoing, the average annual total returns for each Non-
Money Market Portfolio for periods ended September 30, 1997 were as follows*:
-122-
<PAGE>
<TABLE>
<CAPTION>
Investor A Shares
-----------------
Investor A Shares
Total Return (NAV)
Fund Inception Class Intro Since Fund
Date Date 1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
---- ---- ------ ---------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
Large Cap Value Equity 04/20/92 05/02/92 37.01 27.40 21.11 18.95
Large Cap Growth Equity 11/01/89 03/14/92 33.18 26.71 17.07 13.70
Mid Cap Value Equity 12/27/96 12/27/96 N/A N/A N/A 39.03
Mid Cap Growth Equity 12/27/96 12/27/96 N/A N/A N/A 29.02
Small Cap Value Equity 04/13/92 06/02/92 46.85 24.39 21.57 19.87
Small Cap Growth Equity 09/14/93 09/15/93 15.28 35.19 N/A 25.42
International Equity 04/27/92 06/02/92 14.36 7.88 12.06 10.92
International Small Cap Equity 09/26/97 09/28/97 N/A N/A N/A (19.71)
International Emerging Markets 06/17/94 06/17/94 10.51 (2.04) N/A (0.28)
Select Equity 09/13/93 10/13/93 41.85 27.78 N/A 20.25
Index Equity 04/20/92 08/02/92 39.49 28.93 19.84 18.40
Balanced 05/14/90 05/14/90 27.93 20.45 14.42 13.73
Low Duration Bond 07/17/92 01/18/96 6.39 6.48 5.35 5.30
Intermediate Government Bond 04/20/92 05/11/92 7.87 7.28 4.97 5.89
Intermediate Bond 09/17/93 05/20/94 7.89 7.64 N/A 4.62
Core Bond 12/09/92 01/31/96 9.52 9.12 N/A 7.08
Government Income 10/03/94 10/04/94 10.48 N/A N/A 9.66
Managed Income 11/01/89 02/05/92 9.74 8.71 6.30 7.76
International Bond 07/01/91 04/22/96 11.02 12.77 9.44 9.59
Tax-Free Income 03/14/90 05/14/90 9.58 9.16 7.18 8.02
Pennsylvania Tax-Free Income 12/01/92 12/01/92 7.95 8.01 N/A 8.89
New Jersey Tax-Free Income 07/01/91 01/25/96 7.94 7.36 6.32 7.34
Ohio Tax-Free Income 12/01/92 12/01/92 8.03 8.04 N/A 5.98
<CAPTION>
Total Return (Load Adjusted)
---------------------------
Since Fund
1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
------ ---------- ---------- -------------
<S> <C> <C> <C> <C>
Large Cap Value Equity 30.88 25.45 20.00 17.96
Large Cap Growth Equity 27.22 24.70 15.99 13.04
Mid Cap Value Equity N/A N/A N/A 30.89
Mid Cap Growth Equity N/A N/A N/A 21.46
Small Cap Value Equity 40.26 22.49 20.46 18.86
Small Cap Growth Equity 10.11 33.12 (0.92) 24.00
International Equity 8.67 6.02 10.91 9.88
International Small Cap Equity N/A N/A N/A (98.16)
International Emerging Markets 4.97 (3.70) N/A (1.83)
Select Equity 35.55 25.84 N/A 18.89
Index Equity 35.31 27.63 19.11 17.74
Balanced 22.19 18.63 13.38 13.03
Low Duration Bond 3.20 5.41 4.72 4.68
Intermediate Government Bond 3.30 5.83 4.12 5.10
Intermediate Bond 3.56 6.18 N/A 3.57
Core Bond 5.14 7.65 (0.81) 6.18
Government Income 5.52 N/A N/A 7.99
Managed Income 4.76 7.06 5.33 7.14
International Bond 5.47 10.86 8.33 8.70
Tax-Free Income 5.21 7.68 6.31 7.42
Pennsylvania Tax-Free Income 7.95 8.01 N/A 6.60
New Jersey Tax-Free Income 3.62 5.91 5.45 6.64
Ohio Tax-Free Income 3.74 6.57 N/A 5.08
</TABLE>
-123-
<PAGE>
<TABLE>
<CAPTION>
Investor B Shares
Investor B Shares
Total Return (NAV)
Fund Inception Class Intro Since Fund
Date Date 1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
---- ---- ------ ---------- ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
Large Cap Value Equity 04/20/92 01/16/96 36.00 26.89 20.82 18.69
Large Cap Growth Equity 11/01/89 01/24/96 32.18 26.13 16.74 13.51
Mid Cap Value Equity 12/27/96 12/27/96 N/A N/A N/A 38.84
Mid Cap Growth Equity 12/27/96 12/27/96 N/A N/A N/A 26.60
Small Cap Value Equity 04/13/92 10/03/94 45.67 23.57 21.09 19.44
Small Cap Growth Equity 09/14/93 01/18/96 14.47 34.54 N/A 24.98
International Equity 04/27/92 10/03/94 13.63 7.16 11.62 10.52
International Small Cap Equity 09/26/97 09/26/97 N/A N/A N/A (19.71)
International Emerging Markets 06/17/94 04/25/96 9.78 (2.34) N/A (0.56)
Select Equity 09/13/93 03/27/96 40.70 27.28 N/A 19.90
Index Equity 04/20/92 02/07/96 38.31 28.43 19.56 18.14
Balanced 05/14/90 10/04/94 26.95 19.60 13.93 13.42
Low Duration Bond 07/17/92 11/18/96 5.73 6.26 5.22 6.17
Intermediate Government Bond 04/20/92 10/11/96 6.80 7.02 4.82 5.76
Intermediate Bond 09/17/93 10/01/97 7.89 7.64 N/A 4.62
Core Bond 12/09/92 03/18/96 8.71 8.72 N/A 6.83
Government Income 10/03/94 10/03/94 9.66 N/A N/A 8.90
Managed Income 11/01/89 07/15/97 9.67 8.69 6.30 7.76
International Bond 07/01/91 04/19/96 10.11 12.35 9.19 9.39
Tax-Free Income 05/14/90 07/18/96 8.77 8.83 6.97 7.88
Pennsylvania Tax-Free Income 12/01/92 10/03/94 7.12 7.22 N/A 6.14
New Jersey Tax-Free Income 07/01/91 07/02/96 7.14 7.02 6.12 7.18
Ohio Tax-Free Income 12/01/92 10/13/94 7.23 7.20 N/A 5.47
<CAPTION>
Total Return (Load Adjusted)
----------------------------
Since Fund
1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
------ ---------- ---------- -------------
<S> <C> <C> <C> <C>
Large Cap Value Equity 29.88 25.39 20.33 18.25
Large Cap Growth Equity 26.23 24.65 16.27 13.51
Mid Cap Value Equity N/A N/A N/A 30.43
Mid Cap Growth Equity N/A N/A N/A 21.12
Small Cap Value Equity 39.14 22.11 20.61 19.00
Small Cap Growth Equity 9.32 32.95 (0.40) 24.04
International Equity 8.50 5.89 11.17 10.11
International Small Cap Equity N/A N/A N/A (98.16)
International Emerging Markets 4.84 (3.66) (0.40) (1.83)
Select Equity 34.37 25.77 (0.40) 19.00
Index Equity 32.09 26.91 19.07 17.71
Balanced 21.21 18.19 13.47 13.42
Low Duration Bond 0.97 5.01 4.80 4.76
Intermediate Government Bond 1.99 5.76 4.40 5.36
Intermediate Bond 3.03 6.37 (0.40) 3.71
Core Bond 3.82 7.43 (0.40) 6.16
Government Income 4.73 N/A N/A 7.43
Managed Income 4.73 7.40 5.87 7.76
International Bond 5.16 11.02 8.75 9.22
Tax-Free Income 3.88 7.55 6.54 7.88
Pennsylvania Tax-Free Income 2.30 5.95 (0.40) 5.48
New Jersey Tax-Free Income 2.32 5.76 5.69 7.01
Ohio Tax-Free Income 2.40 5.94 (0.40) 4.81
</TABLE>
-124-
<PAGE>
Investor C Shares
- -----------------------------------------------------------------------
<TABLE>
<CAPTION>
Investor C Shares
Total Return (NAV)
------------------
Fund Inception Class Intro Since Fund
Date Date 1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
-------------- ------------ ------ ----------- ----------- --------------
<S> <C> <C> <C> <C> <C> <C>
Large Cap Value Equity 04/20/82 08/16/96 36.00 26.89 20.82 18.69
Large Cap Growth Equity 11/01/89 01/24/97 32.18 26.13 16.74 13.51
Mid Cap Value Equity 12/27/96 12/27/96 N/A N/A N/A 38.64
Mid Cap Growth Equity 12/27/96 12/27/96 N/A N/A N/A 28.60
Small Cap Value Equity 04/13/92 10/01/96 45.67 23.57 21.09 19.44
Small Cap Growth Equity 09/14/93 09/06/96 14.47 34.54 N/A 24.98
International Equity 04/27/92 12/05/96 13.63 7.16 11.62 10.52
International Small Cap Equity 09/26/97 09/26/97 N/A N/A N/A (19.71)
International Emerging Markets 06/17/94 03/21/97 9.78 (2.34) N/A (0.56)
Select Equity 09/13/93 09/27/96 40.70 27.28 N/A 19.90
Index Equity 04/20/92 08/14/96 38.31 28.43 19.56 18.14
Balanced 05/14/90 12/20/96 26.95 19.60 13.93 13.42
Low Duration Bond 07/17/92 06/03/97 5.73 6.26 5.22 5.17
Intermediate Government Bond 04/20/92 10/08/96 6.80 7.02 4.82 5.75
Intermediate Bond 09/17/93 N/A N/A N/A N/A N/A
Core Bond 12/09/92 05/01/97 8.71 8.72 N/A 8.83
Government Income 10/03/94 02/28/97 9.66 N/A N/A 8.90
Managed Income 11/01/89 N/A N/A N/A N/A N/A
International Bond 07/01/91 09/11/96 10.11 12.35 9.19 9.39
Tax-Free Income 05/14/90 02/28/97 8.77 8.83 6.97 7.88
Pennsylvania Tax-Free Income 12/01/92 N/A N/A N/A N/A N/A
New Jersey Tax-Free Income 07/01/91 N/A N/A N/A N/A N/A
Ohio Tax-Free Income 12/01/92 N/A N/A N/A N/A N/A
<CAPTION>
Total Return (Load Adjusted)
----------------------------
Since Fund
1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
------ ----------- ----------- --------------
<S> <C> <C> <C> <C>
Large Cap Value Equity 34.64 N/A N/A N/A
Large Cap Growth Equity 30.86 N/A N/A N/A
Mid Cap Value Equity (1.00) N/A N/A 35.64
Mid Cap Growth Equity (1.00) N/A N/A 26.93
Small Cap Value Equity 44.21 N/A N/A N/A
Small Cap Growth Equity 13.33 N/A N/A N/A
International Equity 12.49 N/A N/A N/A
International Small Cap Equity (1.00) N/A N/A (61.55)
International Emerging Markets 8.68 N/A N/A N/A
Select Equity 39.29 N/A N/A N/A
Index Equity 36.93 N/A N/A N/A
Balanced 25.68 N/A N/A N/A
Low Duration Bond 4.67 N/A N/A N/A
Intermediate Government Bond 21.35 N/A N/A N/A
Intermediate Bond N/A N/A N/A N/A
Core Bond 7.62 N/A N/A N/A
Government Income 8.56 N/A N/A N/A
Managed Income N/A N/A N/A N/A
International Bond 9.01 N/A N/A N/A
Tax-Free Income 7.68 N/A N/A N/A
Pennsylvania Tax-Free Income N/A N/A N/A N/A
New Jersey Tax-Free Income N/A N/A N/A N/A
Ohio Tax-Free Income N/A N/A N/A N/A
</TABLE>
-125-
<PAGE>
Service Shares
- ----------------------------------------------
<TABLE>
<CAPTION>
Service Shares
Total Return (NAV)
------------------
Fund Inception Class Intro Since Fund
Date Date 1 Year 3 Year Ann. 5 Year Ann. Inception Ann.
-------------- ----------- ------ ----------- ----------- --------------
<S> <C> <C> <C> <C> <C> <C>
00/00/00 00/00/00 00.00 00.00 00.00 (00.00)
Large Cap Value Equity 04/20/92 07/29/93 37.22 27.58 21.24 19.07
Large Cap Growth Equity 11/01/89 07/29/93 33.38 26.89 17.23 13.81
Mid Cap Value Equity 12/27/96 12/27/96 N/A N/A N/A 39.46
Mid Cap Growth Equity 12/27/96 12/27/96 N/A N/A N/A 29.44
Small Cap Value Equity 04/13/92 07/29/93 46.95 24.58 21.71 19.99
Small Cap Growth Equity 09/14/93 09/15/93 15.54 35.43 N/A 25.66
International Equity 04/27/92 07/29/93 14.52 8.03 12.19 11.03
International Small Cap Equity 09/26/97 09/26/97 N/A N/A N/A (19.71)
International Emerging Markets 06/17/94 06/17/94 10.74 (1.85) N/A (0.07)
Select Equity 09/13/93 09/15/93 42.12 27.96 N/A 20.43
Index Equity 04/20/92 07/29/93 39.58 29.08 19.96 18.51
Balanced 05/14/90 07/29/93 28.07 20.57 14.52 13.80
Low Duration Bond 07/17/92 01/12/96 6.57 6.59 5.35 5.35
Intermediate Government Bond 04/20/92 07/29/93 7.75 7.39 5.05 5.96
Intermediate Bond 09/17/93 09/23/93 8.07 7.75 N/A 4.72
Core Bond 12/09/92 01/12/96 9.71 9.24 N/A 7.15
Managed Income 11/01/89 07/29/93 9.93 8.92 6.48 7.87
International Bond 07/01/91 07/01/91 11.23 12.87 9.50 9.64
Tax-Free Income 05/14/90 07/29/93 9.77 9.37 7.35 8.14
Pennsylvania Tax-Free Income 12/01/92 07/29/93 8.10 8.18 N/A 6.69
New Jersey Tax-Free Income 07/01/91 07/01/91 8.11 7.47 6.39 7.39
Ohio Tax-Free Income 12/01/92 07/29/93 8.53 8.45 N/A 5.98
</TABLE>
-126-
<PAGE>
Institutional Shares
- -------------------------------------------------
<TABLE>
<CAPTION>
INSTITUTIONAL SHARES
--------------------
TOTAL RETURN (NAV)
------------------
FUND INCEPTION CLASS INTRO
DATE DATE 1 YEAR 3 YEAR ANN.
-------------- ----------- ------ ----------
<S> <C> <C> <C> <C>
Large Cap Value Equity 04/20/92 04/20/92 37.66 27.94
Large Cap Growth Equity 11/01/89 11/01/89 33.69 27.25
Mid Cap Value Equity 12/27/96 12/27/96 N/A N/A
Mid Cap Growth Equity 12/27/96 12/27/96 N/A N/A
Small Cap Value Equity 04/13/92 10/01/96 47.36 24.91
Small Cap Growth Equity 09/14/93 09/06/96 15.89 35.91
International Equity 04/27/92 04/27/92 14.88 8.34
International Small Cap Equity 09/26/97 09/26/97 N/A N/A
International Emerging Markets 06/17/94 06/17/94 11.16 (1.54)
Select Equity 09/13/93 09/13/93 42.50 28.33
Index Equity 04/20/92 04/20/92 39.98 29.44
Balanced 05/14/90 05/01/92 28.43 20.92
Low Duration Bond 07/17/92 07/17/92 6.89 6.78
Intermediate Government Bond 04/20/92 04/20/92 8.08 7.70
Intermediate Bond 09/17/93 09/17/93 8.40 8.06
Core Bond 12/09/92 12/09/92 10.03 9.40
Managed Income 11/01/89 11/01/89 10.25 9.22
International Bond 07/01/91 06/07/96 7.64 13.02
Tax-Free Income 05/14/90 01/21/93 10.09 9.68
Pennsylvania Tax-Free Income 12/01/92 12/01/92 8.43 8.50
New Jersey Tax-Free Income 07/01/91 10/01/97 8.11 7.47
Ohio Tax-Free Income 12/01/92 12/01/92 8.53 8.45
<CAPTION>
SINCE FUND
5 YEAR ANN. INCEPTION ANN.
----------- --------------
<S> <C> <C>
Large Cap Value Equity 21.51 19.32
Large Cap Growth Equity 17.47 13.96
Mid Cap Value Equity N/A 39.89
Mid Cap Growth Equity N/A 29.85
Small Cap Value Equity 21.98 20.24
Small Cap Growth Equity N/A 26.06
International Equity 12.45 11.28
International Small Cap Equity N/A (19.71)
International Emerging Markets N/A 0.24
Select Equity N/A 20.74
Index Equity 20.23 18.76
Balanced 14.80 13.99
Low Duration Bond 5.54 5.47
Intermediate Government Bond 5.29 6.18
Intermediate Bond N/A 5.02
Core Bond N/A 7.25
Managed Income 6.72 8.03
International Bond 9.59 9.71
Tax-Free Income 7.60 8.31
Pennsylvania Tax-Free Income N/A 6.91
New Jersey Tax-Free Income 6.39 7.39
Ohio Tax-Free Income N/A 6.22
</TABLE>
-127-
<PAGE>
*Notes
-----
Performance information presented for Investor A, Investor B,
Investor C and Service Shares of a Portfolio prior to their
introduction dates does not reflect shareholder servicing and
processing and/or distribution fees and certain other expenses
borne by these share classes which, if reflected, would reduce
the performance quoted. Performance information presented
assumes the reinvestment of dividends and distributions.
Performance information presented for Investor A, Investor B,
Investor C and Service Shares of a Portfolio prior to their
introduction as indicated in the table above is based upon
historical expenses of the predecessor class or classes which
do not reflect the actual expenses that an investor would
incur as a holder of shares of these classes of the
Portfolios. The ongoing fees and expenses borne by Investor B
Shares and Investor C Shares are greater than those borne by
Investor A Shares; the ongoing fees and expenses borne by a
Portfolio's Investor A, Investor B and Investor C Shares are
greater than those borne by the Portfolio's Service Shares;
the ongoing fees and expenses borne by a Portfolio's Investor
A, Investor B, Investor C and Service Shares are greater than
those borne by the Portfolio's Institutional Shares; and the
ongoing fees and expenses borne by a Portfolio's Investor A,
Investor B, Investor C, Service and Institutional Shares are
greater than those borne by the Portfolio's BlackRock Shares.
Performance information presented for Institutional Shares of
the Balanced, Tax-Free Income, New Jersey Tax-Free Income and
International Bond Portfolios prior to their introduction
dates is based upon historical expenses of predecessor classes
which are higher than the actual expenses that an investor
would incur as a holder of Institutional Shares of the above-
mentioned Portfolios. Accordingly, the performance information
may be used in assessing each Portfolio's performance history
but does not reflect how the distinct classes would have
performed on a relative basis prior to the introduction of
these classes, which would require an adjustment to the
ongoing expenses.
The original class or classes of shares of each Portfolio were
as follows: Balanced - Investor A Shares; Index Equity -
Institutional Shares; Select Equity - Institutional Shares;
Large Cap Growth Equity - Institutional Shares; Large Cap
Value Equity Institutional Shares; Small Cap Value Equity
Institutional Shares; Small Cap Growth Equity Institutional
Shares; International Equity Institutional Shares;
International Emerging Markets
-128-
<PAGE>
Investor A, Institutional and Service Shares; Low Duration
Bond - Institutional Shares; Intermediate Government Bond -
Institutional Shares; Intermediate Bond - Institutional
Shares; Core Bond - Institutional Shares; Managed Income -
Institutional Shares; Tax-Free Income - Investor A Shares; New
Jersey Tax-Free Income - Service Shares; Pennsylvania Tax-Free
Income Investor A and Institutional Shares; Ohio Tax-Free
Income - Investor A and Institutional Shares; Government
Income - Investor A Shares; International Bond - Service
Shares; Mid-Cap Growth Equity - Investor A, Investor B,
Investor C, Institutional and Service Shares; Mid-Cap Value
Equity - Investor A, Investor B, Investor C, Institutional and
Service Shares and International Small Cap Equity - Investor
A, Investor B, Investor C, Institutional and Service Shares.
The performance quoted reflects fee waivers that subsidize and
reduce the total operating expenses of each Portfolio. The
Portfolios' returns would have been lower if there were not
such waivers. BlackRock, Inc. and the Portfolio's
Administrators are under no obligation to waive or continue
waiving their fees, but have informed the Fund that they
expect to waive fees as necessary to maintain each Portfolio's
total operating expenses during the remainder of the current
fiscal year at the levels set forth in the applicable
Prospectus.
Each class of the Non-Money Market Portfolios may also from time to time
include in advertisements, sales literature, communications to shareholders and
other materials a total return figure that is not calculated according to the
formula set forth above in order to compare more accurately the performance of
each class of a Non-Money Market Portfolio's shares with other performance
measures. For example, in comparing the total return of a Non-Money Market
Portfolio's shares with data published by Lipper Analytical Services, Inc., CDA
Investment Technologies, Inc. or Weisenberger Investment Company Service, or
with the performance of the Standard & Poor's 500 Stock Index, EAFE, the Dow
Jones Industrial Average or the Shearson Lehman Hutton Government Corporate Bond
Index, as appropriate, a Non-Money Market Portfolio may calculate the aggregate
total return for its shares of a certain class for the period of time specified
in the advertisement or communication by assuming the investment of $10,000 in
such Non-Money Market Portfolio's shares and assuming the reinvestment of each
dividend or other distribution at net asset value on the reinvestment date.
Percentage increases are determined by subtracting the initial value of the
investment from the ending value and by dividing the remainder by the beginning
value. A Non-Money Market Portfolio may not, for these purposes, deduct from the
initial value invested or the ending value any amount representing front-end and
deferred sales
-129-
<PAGE>
charges charged to purchasers of Investor A, Investor B or Investor C Shares.
The Investor A, Investor B and Investor C classes of the Portfolio will,
however, disclose, if appropriate, the maximum applicable sales charges and will
also disclose that the performance data does not reflect sales charges and that
inclusion of sales charges would reduce the performance quoted.
In addition to average annual total returns, a Non-Money Market Portfolio
may quote unaveraged or cumulative total returns reflecting the simple change in
value of an investment over a stated period. Average annual and cumulative total
returns may be quoted as a percentage or as a dollar amount, and may be
calculated for a single investment, a series of investments, or a series of
redemptions, over any time period. Total returns may be broken down into their
components of income and capital (including capital gains and changes in share
price) in order to illustrate the relationship of these factors and their
contributions to total return. Total returns may be quoted on a before-tax or
after-tax basis and may be quoted with or without taking sales charges into
account. Excluding the sales charge from a total return calculation produces a
higher total return figure. Total returns, yields, and other performance
information may be quoted numerically or in a table, graph or similar
illustration.
NON-MONEY MARKET PORTFOLIO YIELD. The Balanced, Managed Income, Tax-Free
Income, Intermediate Government Bond, Ohio Tax- Free Income, Pennsylvania Tax-
Free Income, New Jersey Tax-Free Income, Low Duration Bond, Intermediate Bond,
Government Income, Core Bond and International Bond Portfolios may advertise the
yields on their Service, Investor A, Investor B, Investor C, Institutional and
BlackRock Shares. Under the rules of the SEC, each such Portfolio advertising
the respective yields for its Service, Investor A, Investor B, Investor C,
Institutional and BlackRock Shares must calculate yield using the following
formula:
a-b
YIELD = 2[(----- +1)6 - 1]
cd
Where: a = dividends and interest earned during
the period.
b = expenses accrued for the period (net of
reimbursements).
c = the average daily number of shares
outstanding during the period that were
entitled to receive dividends.
d = the maximum offering price per share on
the last day of the period.
-130-
<PAGE>
For the purpose of determining net investment income earned during the
period (variable "a" in the formula), dividend income on equity securities held
by a Portfolio is recognized by accruing 1/360th of the stated dividend rate of
the security each day that the security is in the Portfolio. Except as noted
below, interest earned on any debt obligations held by the Portfolio is
calculated by computing the yield to maturity of each obligation held by the
Portfolio based on the market value of the obligation (including actual accrued
interest) at the close of business on the last business day of each month, or,
with respect to obligations purchased during the month, the purchase price (plus
actual accrued interest) and dividing the result by 360 and multiplying the
quotient by the market value of the obligation (including actual accrued
interest) in order to determine the interest income on the obligation for each
day of the subsequent month that the obligation is held by the Portfolio. For
purposes of this calculation, it is assumed that each month contains 30 days.
The maturity of an obligation with a call provision is the next call date on
which the obligation reasonably may be expected to be called or, if none, the
maturity date.
With respect to debt obligations purchased at a discount or premium, the
formula generally calls for amortization of the discount or premium. However,
interest earned on tax-exempt obligations that are issued without original issue
discount and have a current market discount is calculated by using the coupon
rate of interest instead of the yield to maturity. In the case of tax-exempt
obligations that are issued with original issue discount but which have
discounts based on current market value that exceed the then-remaining portion
of the original issue discount (market discount), the yield to maturity is the
imputed rate based on the original issue discount calculation. On the other
hand, in the case of tax-exempt obligations that are issued with original issue
discount but which have discounts based on current market value that are less
than the then-remaining portion of the original issue discount (market premium),
the yield to maturity is based on the market value.
With respect to mortgage or other receivables-backed obligations which are
expected to be subject to monthly payments of principal and interest ("pay
downs"), (a) gain or loss attributable to actual monthly pay downs are accounted
for as an increase or decrease to interest income during the period; and (b) a
Portfolio may elect either (i) to amortize the discount and premium on the
remaining security, based on the cost of the security, to the weighted-average
maturity date, if such information is available, or to the remaining term of the
security, if any, if the weighted-average maturity date is not available, or
(ii) not to amortize discount or premium on the remaining security. The
amortization schedule will be adjusted monthly to reflect changes in the market
values of debt obligations.
-131-
<PAGE>
Undeclared earned income will be subtracted from the maximum offering price
per share (variable "d" in the formula). Undeclared earned income is the net
investment income which, at the end of the base period, has not been declared as
a dividend, but is reasonably expected to be and is declared and paid as a
dividend shortly thereafter. In the case of Investor A Shares of a Non-Money
Market Portfolio, a Portfolio's maximum offering price per share for purposes of
the formula includes the maximum front-end sales charge imposed by the
Portfolio -- currently as much as 5.00% of the per share offering price.
Each of the Tax-Free Income, Ohio Tax-Free Income, New Jersey Tax-Free
Income and Pennsylvania Tax-Free Income Portfolios may advertise the tax-
equivalent yield for shares of a specified class. Under the rules of the SEC, a
Portfolio advertising its tax-equivalent yield must calculate such tax-
equivalent yield by dividing that portion of the yield of the Portfolio which is
tax-exempt by one minus a stated income tax rate and adding the product to that
portion, if any, of the yield of the Portfolio which is not tax-exempt.
The annualized yield information for the 30-day period ended September 30,
1997 for the Portfolios referenced below was as follows:
<TABLE>
<CAPTION>
After Waivers Before Waivers
-------------------------------- ----------------------------------
Tax-Equivalent Tax-Equivalent
Yield (assumes a Yield (assumes a
Federal income Federal income
Portfolio Yield tax rate of 28%) Yield tax rate of 28%)
- ------------------------------------------------------- ---------- -------------------- --------- --------------------
<S> <C> <C> <C> <C>
Low Duration Bond
Institutional Shares 5.84 % 8.11 % 5.51 % 7.65 %
Service Shares 5.53 7.68 5.20 7.22
Investor A Shares 5.36 7.44 5.03 6.99
Investor B Shares 4.60 6.39 4.27 5.93
Investor C Shares 4.60 6.39 4.27 5.93
BlackRock Shares 5.99 8.32 5.66 7.86
Intermediate Government Bond
Institutional Shares 5.96 % 8.28 % 5.65 % 7.85 %
Service Shares 5.66 7.86 5.35 7.43
Investor A Shares 5.49 7.63 5.18 7.19
Investor B Shares 4.73 6.57 4.42 6.14
Investor C Shares 4.73 6.57 4.42 6.14
Intermediate Bond
Institutional Shares 6.28 % 8.72 % 5.99 % 8.32 %
Service Shares 5.98 8.31 5.69 7.90
Investor A Shares 5.81 8.07 5.52 7.67
Core Bond
Institutional Shares 6.32 % 8.78 % 6.03 % 8.38 %
Service Shares 6.01 8.35 5.72 7.94
Investor A Shares 5.84 8.11 5.55 7.71
Investor B Shares 5.09 7.07 4.80 6.67
Investor C Shares 5.09 7.07 4.80 6.67
BlackRock Shares 6.47 8.99 6.18 8.58
Government Income
Investor A Shares 6.83 % 9.49 % 6.11 % 8.49 %
Investor B Shares 6.08 8.44 5.36 7.44
</TABLE>
-132-
<PAGE>
<TABLE>
<CAPTION>
After Waivers Before Waivers
-------------------------------- ----------------------------------
Tax-Equivalent Tax-Equivalent
Yield (assumes a Yield (assumes a
Federal income Federal income
Portfolios Yield tax rate of 28%) Yield tax rate of 28%)
- ------------------------------------------------------- ---------- -------------------- --------- --------------------
<S> <C> <C> <C> <C>
Investor C Shares 6.08 8.44 5.36 7.44
Managed Income
Institutional Shares 6.78 % 9.42 % 6.53 % 9.07 %
Service Shares 6.48 9.00 6.23 8.65
Investor A Shares 6.31 8.76 6.06 8.42
Investor B Shares 5.55 7.71 5.30 7.36
International Bond
Institutional Shares 5.29 % 7.35 % 5.19 % 7.21 %
Service Shares 4.99 6.93 4.89 6.79
Investor A Shares 4.82 6.69 4.72 6.56
Investor B Shares 4.07 5.65 3.97 5.51
Investor C Shares 4.07 5.65 3.97 5.51
Tax-Free Income
Institutional Shares 5.00 % 6.94 % 4.65 % 6.46 %
Service Shares 4.70 6.53 4.35 6.04
Investor A Shares 4.53 6.29 4.18 5.81
Investor B Shares 3.77 5.24 3.42 4.75
Investor C Shares 3.77 5.24 3.42 4.75
Pennsylvania Tax-Free Income
Institutional Shares 5.07 % 7.04 % 4.76 % 6.61 %
Service Shares 4.77 6.63 4.46 6.19
Investor A Shares 4.63 6.43 4.32 6.00
Investor B Shares 3.84 5.33 3.53 4.90
New Jersey Tax-Free Income
Service Shares 4.64 % 6.44 % 4.32 % 6.00 %
Investor A Shares 4.47 6.21 4.15 5.76
Investor B Shares 3.71 5.15 3.39 4.71
Ohio Tax-Free Income
Institutional Shares 4.84 % 6.72 % 4.33 % 6.01 %
Service Shares 4.54 6.31 4.03 5.60
Investor A Shares 4.37 6.07 3.86 5.36
Investor B Shares 3.61 5.01 3.10 4.31
</TABLE>
Other Information Regarding Investment Returns. In addition to providing
performance information that demonstrates the total return or yield of shares of
a particular class of a Portfolio over a specified period of time, the Fund may
provide certain other information demonstrating hypothetical investment returns.
Such information may include, but is not limited to, illustrating the
compounding effects of dividends in a dividend reinvestment plan or the impact
of tax-free investing. The Fund may demonstrate, using certain specified
hypothetical data, the compounding effect of dividend reinvestment on
investments in a Non-Money Market Portfolio.
The Money and Non-Money Market Municipal Portfolios may illustrate in
advertising, sales literature, communications to shareholders and other
materials the benefits of tax-free investing. For example, Table 1 shows
taxpayers how to translate Federal tax savings from investments the income on
which is not subject to Federal income tax into an equivalent yield from a
taxable investment. Similarly, Tables 2, 3, 4, 5 and 6 show
-133-
<PAGE>
Pennsylvania, Ohio, North Carolina, Virginia and New Jersey shareholders the
approximate yield that a taxable investment must earn at various income brackets
to produce after-tax yields equivalent to those of the Pennsylvania Municipal
Money Market and Pennsylvania Tax-Free Income Portfolios, the Ohio Municipal
Money Market and Ohio Tax-Free Income Portfolios, the North Carolina Municipal
Money Market Portfolio, the Virginia Municipal Money Market Portfolio, and the
New Jersey Municipal Money Market and New Jersey Tax-Free Income Portfolios,
respectively. The yields below are for illustration purposes only and are not
intended to represent current or future yields for the Money and Non-Money
Market Municipal Portfolios, which may be higher or lower than the yields shown.
The following information regarding tax rates and tax-exempt yields is as of
January 1, 1998.
-134-
<PAGE>
TABLE 1 - Federal Only
- ------- ------------
<TABLE>
<CAPTION>
Federal TAX-EXEMPT YIELD
1998 Taxable Marginal
Income Bracket Tax Rate* 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0%
- ----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Single Return Joint Return
$ 0- $ 25,350 $ 0- $ 42,350 15.0% 3.529% 4.118% 4.706% 5.294% 5.882% 6.471% 7.059%
$25,351- $ 61,400 $ 42,351- $102,300 28.0% 4.167% 4.861% 5.556% 6.250% 6.944% 7.639% 8.333%
$61,401- $128,100 $102,301- $155,950 31.0% 4.348% 5.072% 5.797% 6.522% 7.246% 7.971% 8.696%
$128,101- $278,450 $155,951- $278,450 36.0% 4.688% 5.469% 6.250% 7.031% 7.812% 8.594% 9.375%
Over $278,450 Over $278,450 39.6% 4.967% 5.795% 6.623% 7.450% 8.278% 9.106% 9.934%
</TABLE>
*Rates do not include the phase out of personal exemptions or itemized
deductions. It is assumed that the investor is not subject to the alternative
minimum tax. Where applicable, investors should consider that the benefit of
certain itemized deductions and the benefit of personal exemptions are limited
in the case of higher income individuals. For 1998, taxpayers with adjusted
gross income in excess of a threshold amount of approximately $124,500 are
subject to an overall limitation on certain itemized deductions, requiring a
reduction in such deductions equal to the lesser of (i) 3% of adjusted gross
income in excess of the threshold of approximately $124,500 or (ii) 80% of the
amount of such itemized deductions otherwise allowable. The benefit of each
personal exemption is phased out at the rate of two percentage points for each
$2,700 (or fraction thereof) of adjusted gross income in the phase-out zone. For
single taxpayers the range of adjusted gross income comprising the phase-out
zone for 1998 is estimated to be from $124,500 to $247,000 and for married
taxpayers filing a joint return from $186,800 to $309,300. The Federal tax
brackets, the threshold amounts at which itemized deductions are subject to
reduction, and the range over which personal exemptions are phased out will be
further adjusted for inflation for each year after 1998.
-135-
<PAGE>
TABLE 2 - Federal and Pennsylvania
- ------- ------------------------
<TABLE>
<CAPTION>
Approx.
Combined
Federal
and PA TAX-EXEMPT YIELD
1998 Federal Marginal
Taxable Income Bracket Tax Rate* 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0%
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Single Return Joint Return
$ 0 - $ 25,350 $ 0 - $42,350 17.380% 3.631% 4.236% 4.841% 5.447% 6.052% 6.657% 7.262%
$25,351 - $ 61,400 $ 42,351 -$102,300 30.016% 4.287% 5.001% 5.716% 6.430% 7.144% 7.859% 8.573%
$61,401 - $128,100 $102,301 -$155,950 32.932% 4.473% 5.219% 5.964% 6.710% 7.455% 8.201% 8.946%
$128,101- $278,450 $155,951 -$278,450 37.792% 4.823% 5.626% 6.430% 7.234% 8.038% 8.841% 9.645%
Over $278,450 Over $278,450 41.291% 5.110% 5.962% 6.813% 7.665% 8.517% 9.368% 10.220%
</TABLE>
*The income amount shown is income subject to Federal income tax reduced by
adjustments to income, exemptions, and itemized deductions (including the
deduction for state income taxes). If the standard deduction is taken for
Federal income tax purposes, the taxable equivalent yield required to equal a
specified tax-exempt yield is at least as great as that shown in the table. It
is assumed that the investor is not subject to the alternative minimum tax.
Where applicable, investors should consider that the benefit of certain itemized
deductions and the benefit of personal exemptions are limited in the case of
higher income individuals. For 1998, taxpayers with adjusted gross income in
excess of a threshold amount of approximately $124,500 are subject to an overall
limitation on certain itemized deductions, requiring a reduction in such
deductions equal to the lesser of (i) 3% of adjusted gross income in excess of
the threshold of approximately $124,500 or (ii) 80% of the amount of such
itemized deductions otherwise allowable. The benefit of each personal exemption
is phased out at the rate of two percentage points for each $2,700 (or fraction
thereof) of adjusted gross income in the phase-out zone. For single taxpayers
the range of adjusted gross income comprising the phase-out zone for 1998 is
estimated to be from $124,500 to $247,000 and for married taxpayers filing a
joint return from $186,800 to $309,300. The Federal tax brackets, the threshold
amounts at which itemized deductions are subject to reduction, and the range
over which personal exemptions are phased out will be further adjusted for
inflation for each year after 1998.
-136-
<PAGE>
TABLE 3 - Federal and Ohio
- ------- ----------------
<TABLE>
<CAPTION>
TAX EXEMPT YIELD
3 3.5 4 4.5 5 5.5 6
1998
TAXABLE FEDERAL OHIO
INCOME MARGINAL MARGINAL COMBINED TAXABLE EQUIVALENT YIELD
BRACKETS* TAX RATE TAX RATE* RATE SINGLE RETURN
- ---------------- ----------- ----------- --------- ---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 25,350 15% 4.457% 18.79% 3.69% 4.31% 4.93% 5.54% 6.16% 6.77% 7.39%
25,351- 40,000 28% 4.457% 31.21% 4.36% 5.09% 5.81% 6.54% 7.27% 8.00% 8.72%
40,001- 61,400 28% 5.201% 31.74% 4.40% 5.13% 5.86% 6.59% 7.33% 8.06% 8.79%
61,401- 80,000 31% 5.201% 34.59% 4.59% 5.35% 6.12% 6.88% 7.64% 8.41% 9.17%
80,001- 100,000 31% 5.943% 35.10% 4.62% 5.39% 6.16% 6.93% 7.70% 8.47% 9.25%
100,001- 128,100 31% 6.900% 35.76% 4.67% 5.45% 6.23% 7.01% 7.78% 8.56% 9.34%
128,101- 200,000 36% 6.900% 40.42% 5.03% 5.87% 6.71% 7.55% 8.39% 9.23% 10.07%
200,001- 278,450 36% 7.500% 40.80% 5.07% 5.91% 6.76% 7.60% 8.45% 9.29% 10.14%
OVER 278,450 39.6% 7.500% 44.13% 5.37% 6.26% 7.16% 8.05% 8.95% 9.84% 10.74%
</TABLE>
-137-
<PAGE>
<TABLE>
<CAPTION>
1998 FEDERAL OHIO
TAXABLE INCOME MARGINAL MARGINAL COMBINED TAXABLE EQUIVALENT YIELD
BRACKETS* TAX RATE TAX RATE* RATE JOINT RETURN
- ----------------- -------- --------- --------- ------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 40,000 15% 4.457% 18.79% 3.69% 4.31% 4.93% 5.54% 6.16% 6.77% 7.39%
40,001 - 42,350 15% 5.201% 19.42% 3.72% 4.34% 4.96% 5.58% 6.20% 6.82% 7.45%
42,351 - 80,000 28% 5.201% 31.74% 4.40% 5.13% 5.86% 6.59% 7.33% 8.06% 8.79%
80,001 - 100,000 28% 5.943% 32.28% 4.43% 5.17% 5.91% 6.64% 7.38% 8.12% 8.86%
100,001- 102,300 28% 6.900% 32.97% 4.48% 5.22% 5.97% 6.71% 7.46% 8.21% 8.95%
102,301- 155,950 31% 6.900% 35.76% 4.67% 5.45% 6.23% 7.01% 7.78% 8.56% 9.34%
155,951- 200,000 36% 6.900% 40.42% 5.03% 5.87% 6.71% 7.55% 8.39% 9.23% 10.07%
200,001- 278,450 36% 7.500% 40.80% 5.07% 5.91% 6.76% 7.60% 8.45% 9.29% 10.14%
OVER 278,450 39.6% 7.500% 44.13% 5.37% 6.26% 7.16% 8.05% 8.95% 9.84% 10.74%
</TABLE>
*The income brackets applicable to the state of Ohio do not correspond to the
Federal taxable income brackets. In addition, Ohio taxable income will likely be
different than Federal taxable income because it is computed by reference to
Federal adjusted gross income with specifically-defined Ohio modifications and
exemptions, and does not consider many of the deductions allowed from Federal
adjusted gross income in computing Federal taxable income. No other state tax
credits, exemptions, or local taxes have been taken into account in arriving at
the combined marginal tax rate. In 1997, due to the state having surplus
revenue, a 3.987% across the board reduction in the Ohio income tax rates for
1997 only was effected pursuant to Ohio Revised Code sections 131.44 and
5747.02. It is not yet known whether a reduction in the Ohio income tax rates
will occur in 1998. A reduction in Ohio income tax rates, such as the 1997
reduction, has the effect of reducing the after-tax advantage of Ohio tax-exempt
securities relative to taxable securities. The income amount shown is income
subject to Federal income tax reduced by adjustments to income, exemptions, and
itemized deductions (including the deduction for state and local income taxes).
If the standard deduction is taken for Federal income tax purposes, the taxable
equivalent yield required to equal a specified tax-exempt yield is at least as
great as that shown in the table. It is assumed that the investor is not subject
to the alternative minimum tax. Where applicable, investors should consider that
the benefit of certain itemized deductions and the benefit of personal
exemptions are limited in the case of higher income individuals. For 1998,
taxpayers with adjusted gross income in excess of a threshold amount of
approximately $124,500 are subject to an overall limitation on certain itemized
deductions, requiring a reduction in such deductions equal to the lesser of (i)
3% of adjusted gross income in excess of the threshold of approximately $124,500
or (ii) 80% of the amount of such itemized deductions otherwise allowable. The
benefit of each personal exemption is phased out at the rate of two percentage
points for each $2,700 (or fraction thereof) of adjusted gross income in the
phase-out zone. For single taxpayers the range of adjusted gross income
comprising the phase-out zone for 1998 is estimated to be from $124,500 to
$247,000 and for married taxpayers filing a joint return from $186,800 to
$309,300. The Federal tax brackets, the threshold amounts at which itemized
deductions are subject to reduction, and the range over which personal
exemptions are phased out will be further adjusted for inflation for each year
after 1998.
-138-
<PAGE>
TABLE 4 - FEDERAL AND NORTH CAROLINA
- ------- --------------------------
<TABLE>
<CAPTION>
1998 Taxable North
Income Bracket Federal Carolina Combined Federal Tax-Exempt Yield
Marginal Marginal and North Carolina
Single Return Joint Return Tax Rate Tax Rate Marginal Tax Rate* 3.0% 3.5% 4.0% 4.5%
- ------------- ------------ -------- -------- ------------------ ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 12,750 $ 0 - 21,250 15.0% 6.00% 20.100% 3.755% 4.380% 5.006% 5.632%
12,751 - 25,350 21,000 - 42,350 15.0% 7.00% 20.950% 3.795% 4.428% 5.060% 5.693%
25,351 - 60,000 42,351 - 100,000 28.0% 7.00% 33.040% 4.480% 5.227% 5.974% 6.720%
60,001 - 61,400 100,001 - 102,300 28.0% 7.75% 33.580% 4.517% 5.269% 6.022% 6.775%
61,401 - 128,100 102,301 - 155,950 31.0% 7.75% 36.348% 4.713% 5.499% 6.284% 7.070%
128,101 - 278,450 155,951 - 278,450 36.0% 7.75% 40.960% 5.081% 5.928% 6.775% 7.622%
Over 278,450 Over 278,450 39.6% 7.75% 44.281% 5.384% 6.282% 7.179% 8.076%
<CAPTION>
Single Return 5.0% 5.5% 6.0%
- ------------- ---- ---- ----
<S> <C> <C> <C>
$ 0 - 12,750 6.258% 6.884% 7.509%
12,751 - 25,350 6.325% 6.598% 7.590%
25,351 - 60,000 7.467% 8.214% 8.961%
60,001 - 61,400 7.528% 8.281% 9.033%
61,401 - 128,100 7.855% 8.641% 9.426%
128,101 - 278,450 8.469% 9.316% 10.163%
Over 278,450 8.974% 9.871% 10.768%
</TABLE>
*The taxable income brackets applicable to North Carolina do not correspond to
the Federal taxable income brackets. The taxable income brackets presented in
this table represent the breakpoints for both the Federal and North Carolina
marginal tax rate changes. When applying these brackets, Federal taxable income
may be different than North Carolina taxable income. No state tax credits,
exemptions, or local taxes have been taken into account in arriving at the
combined marginal tax rate. The income amount shown is income subject to Federal
income tax reduced by adjustments to income, exemptions, and itemized deductions
(including the deduction for state and local income taxes). If the standard
deduction is taken for Federal income tax purposes, the taxable equivalent yield
required to equal a specified tax-exempt yield is at least as great as that
shown in the table. It is assumed that the investor is not subject to the
alternative minimum tax. Where applicable, investors should consider that the
benefit of certain itemized deductions and the benefit of personal exemptions
are limited in the case of higher-income individuals. For 1998, taxpayers with
adjusted gross income in excess of the threshold of approximately $124,500 are
subject to an overall limitation on certain itemized deductions, requiring a
reduction in such deductions equal to the lesser of (i) 3% of adjusted gross
income in excess of the threshold of approximately $124,500 or (ii) 80% of the
amount of such itemized deductions otherwise allowable. The benefit of each
personal exemption is phased out at the rate of two percentage points for each
$2,700 (or fraction thereof) of adjusted gross income in the phase-out zone. For
single taxpayers the range of adjusted gross income comprising the phase-out
zone for 1998 is estimated to be from $124,500 to $247,000 and for married
taxpayers filing a joint return from $186,800 to $309,300. The Federal tax
brackets, the threshold amounts at which itemized deductions are subject to
reduction, and the range over which personal exemptions are phased out will be
further adjusted for inflation for each year after 1998.
-139-
<PAGE>
TABLE 5 - FEDERAL AND VIRGINIA
- ------- --------------------
<TABLE>
<CAPTION>
1998 Taxable
Income Bracket Federal Virginia Combined Federal Tax-Exempt Yield
Marginal Marginal and Virginia
Single Return Joint Return Tax Rate Tax Rate Marginal Tax Rate* 3.0% 3.5% 4.0% 4.5%
- ------------- ------------ -------- -------- ------------------ ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 25,350 $ 0 - 42,350 15.0% 5.75% 19.888% 3.745% 4.369% 4.993% 5.617%
25,351 - 61,400 42,351 - 102,300 28.0% 5.75% 32.140% 4.421% 5.158% 5.894% 6.631%
61,401 - 128,100 102,301 - 155,950 31.0% 5.75% 34.968% 4.613% 5.382% 6.151% 6.920%
128,101 - 278,450 155,951 - 278,450 36.0% 5.75% 39.680% 4.973% 5.802% 6.631% 7.460%
OVER 278,450 OVER 278,450 39.6% 5.75% 43.073% 5.270% 6.148% 7.027% 7.905%
<CAPTION>
Single Return 5.0% 5.5% 6.0%
- ------------- ---- ---- ----
<S> <C> <C> <C>
$ 0 - 22,750 6.241% 6.865% 7.489%
22,751 - 55,100 7.368% 8.105% 8.842%
55,101 - 115,000 7.688% 8.457% 9.226%
115,001 - 250,000 8.289% 9.118% 9.947%
OVER 250,000 8.783% 9.661% 10.540%
</TABLE>
*The taxable income brackets applicable to Virginia do not correspond to the
Federal taxable income brackets. Because Virginia imposes a maximum tax rate of
5.75% on taxable income over $17,000, the taxable income brackets presented in
this table represent the breakpoints only for the Federal marginal tax rate
changes. When applying these brackets, Federal taxable income may be different
than Virginia taxable income. No state tax credits, exemptions, or local taxes
have been taken into account in arriving at the combined marginal tax rate. The
income amount shown is income subject to Federal income tax reduced by
adjustments to income, exemptions, and itemized deductions (including the
deduction for state and local income taxes). If the standard deduction is taken
for Federal income tax purposes, the taxable equivalent yield required to equal
a specified tax-exempt yield is at least as great as that shown in the table. It
is assumed that the investor is not subject to the alternative minimum tax.
Where applicable, investors should consider that the benefit of certain itemized
deductions and the benefit of personal exemptions are limited in the case of
higher income individuals. For 1998, taxpayers with adjusted gross income in
excess of a threshold amount of approximately $124,500 are subject to an overall
limitation on certain itemized deductions, requiring a reduction in such
deductions equal to the lesser of (i) 3% of adjusted gross income in excess of
the threshold of approximately $124,500 or (ii) 80% of the amount of such
itemized deductions otherwise allowable. The benefit of each personal exemption
is phased out at the rate of two percentage points for each $2,700 (or fraction
thereof) of adjusted gross income in the phase-out zone. For single taxpayers
the range of adjusted gross income comprising the phase-out zone for 1998 is
estimated to be from $124,500 to $247,000 and for married taxpayers filing a
joint return from $186,800 to $309,300. The Federal tax brackets, the threshold
amounts at which itemized deductions are subject to reduction, and the range
over which personal exemptions are phased out will be further adjusted for
inflation for each year after 1998.
-140-
<PAGE>
Table 6 - Federal and New Jersey
- ------- ----------------------
<TABLE>
<CAPTION>
Approximate
Federal NJ Combined Federal
1998 Taxable Marginal Marginal and NJ
Income Bracket* Tax Rate Tax Rate Marginal Tax Rate 3.0% 3.5%
- --------------- -------- -------- ----------------- ---- ----
Single Return
-------------
<S>
$ 0 - 20,000 15.0% 1.400% 16.190% 3.580% 4.176%
20,001 - 25,350 15.0% 1.750% 16.488% 3.592% 4.191%
25,351 - 35,000 28.0% 1.750% 29.260% 4.240% 4.948%
35,001 - 40,000 28.0% 3.500% 30.520% 4.318% 5.037%
40,001 - 61,400 28.0% 5.525% 31.978% 4.410% 5.145%
61,401 - 75,000 31.0% 5.525% 34.812% 4.602% 5.369%
75,001 - 128,100 31.0% 6.370% 35.395% 4.643% 5.418%
128,101 - 278,450 36.0% 6.370% 40.077% 5.006% 5.841%
OVER 278,450 39.6% 6.370% 43.447% 5.305% 6.189%
<CAPTION>
1998 Taxable
Income Bracket*
- ---------------
Single Return Tax-Exempt Yield
-------------
4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0%
---- ---- ---- ---- ---- ---- ----
Taxable Yield - Single Return
<S> <S> <C> <C> <C> <C> <C> <C>
$ 0 - 20,000 4.773% 5.369% 5.966% 6.562% 7.159% 7.756% 8.352%
20,001 - 25,350 4.790% 5.388% 5.987% 6.589% 7.185% 7.783% 8.382%
25,351 - 35,000 5.655% 6.361% 7.068% 7.775% 8.481% 9.189% 9.895%
35,001 - 40,000 5.757% 6.471% 7.196% 7.916% 8.636% 9.355% 10.075%
40,001 - 61,400 5.880% 6.616% 7.350% 8.086% 8.820% 9.556% 10.298%
61,401 - 75,000 6.136% 6.903% 7.670% 8.437% 9.204% 9.971% 10.738%
75,001 - 128,100 6.191% 6.965% 7.739% 8.513% 9.287% 10.061 10.835%
128,101 - 278,450 6.675% 7.510% 8.344% 9.178% 10.013% 10.847% 11.682%
OVER 278,450 7.073% 7.957% 8.841% 9.725% 10.610% 11.494% 12.378%
Joint Return Taxable Yield - Joint Return
- ------------
<S> <C> <C> <C> <C> <C> <C>
$ 0 - 20,000 15.0% 1.400% 16.190% 3.580% 4.176% 4.773%
20,001 - 42,350 15.0% 1.750% 16.488% 3.592% 4.191% 4.790%
42,351 - 50,000 28.0% 1.750% 29.260% 4.240% 4.948% 5.655%
50,001 - 70,000 28.0% 2.450% *29.764% 4.271% 4.983% 5.695%
70,001 - 80,000 28.0% 3.500% 30.520% 4.318% 5.037% 5.757%
80,001 - 102,300 28.0% 5.525% 31.978% 4.410% 5.145% 5.880%
102,301 - 150,000* 31.0% 5.525% 34.812% 4.602% 5.369% 6.136%
**150,001 - 151,750 36.0% 6.370% 40.077% 5.006% 5.841% 6.675%
151,751 - 278,450 36.0% 6.370% 40.077% 5.006% 5.841% 6.675%
OVER 278,450 39.6% 6.370% 43.447% 5.305% 6.189% 7.073%
<CAPTION>
Joint Return Taxable Yield - Joint Return
- ------------
<S> <C> <C> <C> <C> <C>
$ 0 - 20,000 5.369% 5.966% 6.562% 7.159% 7.756% 8.352%
20,001 - 42,350 5.388% 5.987% 6.589% 7.185% 7.783% 8.382%
42,351 - 50,000 6.361% 7.068% 7.775% 8.481% 9.189% 9.895%
50,001 - 70,000 6.407% 7.189% 7.831% 8.543% 9.255% 9.966%
70,001 - 80,000 6.471% 7.196% 7.916% 8.636% 9.355% 10.075%
80,001 - 102,300 6.616% 7.350% 8.086% 8.820% 9.556% 10.298%
102,301 - 150,000* 6.903% 7.670% 8.437% 9.204% 9.971% 10.738%
150,001 - 151,750** 7.510% 8.344% 9.178% 10.013% 10.847% 11.682%
151,751 - 278,450 7.510% 8.344% 9.178% 10.013% 10.847% 11.682%
OVER 278,450 7.957% 8.841% 9.725% 10.610% 11.494% 12.378%
</TABLE>
* The 31% Federal Taxable Income Bracket is $102,301 - $155,950.
The 5.525% New Jersey Taxable Income Bracket is $80,001 - $150,000.
** The 36% Federal Taxable income Bracket is $155,950 - $278,450.
The 6.370% New Jersey Taxable Income Bracket is $150,001 - $271,050.
-141-
<PAGE>
* The taxable income brackets applicable to New Jersey do not correspond to
the Federal taxable income brackets. The taxable income brackets presented
in this table represent the breakpoints for both the Federal and New Jersey
marginal tax rate changes. When applying these brackets, Federal taxable
income will be different than New Jersey taxable income because New Jersey
does not start with Federal taxable income in computing its own state income
tax base. No state tax credits, exemptions, or local taxes have been taken
into account in arriving at the combined marginal tax rate. The income
amount shown is income subject to Federal income tax reduced by adjustments
to income, exemptions, and itemized deductions (including the deduction for
state and local income taxes). If the standard deduction is taken for
Federal income tax purposes, the taxable equivalent yield required to equal
a specified tax-exempt yield is at least as great as that shown in the
table. It is assumed that the investor is not subject to the alternative
minimum tax. Where applicable, investors should consider that the benefit of
certain itemized deductions and the benefit of personal exemptions are
limited in the case of higher-income individuals. For 1998, taxpayers with
adjusted gross income in excess of a threshold amount of approximately
$124,500 are subject to an overall limitation on certain itemized
deductions, requiring a reduction in such deductions equal to the lesser of
(i) 3% of adjusted gross income in excess of the threshold of approximately
$124,500 or (ii) 80% of the amount of such itemized deductions otherwise
allowable. The benefit of each personal exemption is phased out at the rate
of two percentage points for each $2,700 (or fraction thereof) of adjusted
gross income in the phase-out zone. For single taxpayers the range of
adjusted gross income comprising the phase-out zone for 1998 is estimated to
be from $124,500 to $247,000, and for married taxpayers filing a joint
return from $186,800 to $309,300. The Federal tax brackets, the threshold
amounts at which itemized deductions are subject to reduction, and the range
over which personal exemptions are phased out will be further adjusted for
inflation for each year after 1998.
-142-
<PAGE>
MISCELLANEOUS. Yields on shares of a Portfolio may fluctuate daily and do
not provide a basis for determining future yields. Because such yields will
fluctuate, they cannot be compared with yields on savings account or other
investment alternatives that provide an agreed to or guaranteed fixed yield for
a stated period of time. In comparing the yield of one Portfolio to another,
consideration should be given to each Portfolio's investment policies, including
the types of investments made, lengths of maturities of the portfolio
securities, market conditions, operating expenses and whether there are any
special account charges which may reduce the effective yield. The fees which may
be imposed by Service Organizations and other institutions on their customers
are not reflected in the calculations of total returns or yields for the
Portfolios.
When comparing a Portfolio's performance to stock, bond, and money market
mutual fund performance indices prepared by Lipper or other organizations, it is
important to remember the risk and return characteristics of each type of
investment. For example, while stock mutual funds may offer higher potential
returns, they also carry the highest degree of share price volatility. Likewise,
money market funds may offer greater stability of principal, but generally do
not offer the higher potential returns from stock mutual funds.
From time to time, a Portfolio's performance may also be compared to other
mutual funds tracked by financial or business publications and periodicals. For
example a Portfolio may quote Morningstar, Inc. in its advertising materials.
Morningstar, Inc. is a mutual fund rating service that rates mutual funds on the
basis of risk-adjusted performance. Rankings that compare the performance of
Portfolios to one another in appropriate categories over specific periods of
time may also be quoted in advertising.
Ibbotson Associates of Chicago, Illinois ("Ibbotson") provides historical
returns of the capital markets in the United States, including common stocks,
small capitalization stocks, long-term corporate bonds, intermediate-term
government bonds, long-term government bonds, Treasury bills, the U.S. rate of
inflation (based on the Consumer Price Index), and combinations of various
capital markets. The performance of these capital markets is based on the
returns of different indices. Portfolios may use the performance of these
capital markets in order to demonstrate general risk-versus-reward investment
scenarios. Performance comparisons may also include the value of a hypothetical
investment in any of these capital markets. The risks associated with the
security types in any capital market may or may not correspond directly to those
of the Portfolios. The Portfolios may also compare performance to that of other
-143-
<PAGE>
compilations or indices that may be developed and made available in the future.
The Fund may also from time to time include discussions or illustrations of
the effects of compounding in advertisements. "Compounding" refers to the fact
that, if dividends or other distributions on a Portfolio investment are
reinvested by being paid in additional Portfolio shares, any future income or
capital appreciation of a Portfolio would increase the value, not only of the
original investment in the Portfolio, but also of the additional Portfolio
shares received through reinvestment. The Fund may also include discussions or
illustrations of the potential investment goals of a prospective investor,
(including materials that describe general principles of investing, such as
asset allocation, diversification, risk tolerance, and goal setting,
questionnaires designed to help create a personal financial profile, worksheets
used to project savings needs based on assumed rates of inflation and
hypothetical rates of return and action plans offering investment alternatives)
investment management techniques, policies or investment suitability of a
Portfolio (such as value investing, market timing, dollar cost averaging, asset
allocation, constant ratio transfer, automatic account rebalancing, the
advantages and disadvantages of investing in tax-deferred and taxable
investments), economic and political conditions and the relationship between
sectors of the economy and the economy as a whole, the effects of inflation and
historical performance of various asset classes, including but not limited to,
stocks, bonds and Treasury bills. From time to time advertisements, sales
literature, communications to shareholders or other materials may summarize the
substance of information contained in shareholder reports (including the
investment composition of a Portfolio), as well as the views of the Portfolios'
adviser and/or sub-advisers as to current market, economy, trade and interest
rate trends, legislative, regulatory and monetary developments, investment
strategies and related matters believed to be of relevance to a Portfolio. In
addition, selected indices may be used to illustrate historic performance of
select asset classes. The Fund may also include in advertisements, sales
literature, communications to shareholders or other materials, charts, graphs or
drawings which illustrate the potential risks and rewards of investment in
various investment vehicles, including but not limited to, stocks, bonds,
Treasury bills and shares of a Portfolio. In addition, advertisements, sales
literature, shareholder communications or other materials may include a
discussion of certain attributes or benefits to be derived by an investment in a
Portfolio and/or other mutual funds, benefits, characteristics or services
associated with a particular class of shares, shareholder profiles and
hypothetical investor scenarios, timely information on financial management, tax
and retirement planning and investment alternative to certificates of deposit
and other financial instruments. Such advertisements or communicators may
-144-
<PAGE>
include symbols, headlines or other material which highlight or summarize the
information discussed in more detail therein. Materials may include lists of
representative clients of the Portfolios' investment adviser and sub-advisers.
Materials may refer to the CUSIP numbers of the various classes of the
Portfolios and may illustrate how to find the listings of the Portfolios in
newspapers and periodicals. Materials may also include discussions of other
Portfolios, products, and services.
Charts and graphs using net asset values, adjusted net asset values, and
benchmark indices may be used to exhibit performance. An adjusted NAV includes
any distributions paid and reflects all elements of return. Unless otherwise
indicated, the adjusted NAVs are not adjusted for sales charges, if any.
A Portfolio may illustrate performance using moving averages. A long-term
moving average is the average of each week's adjusted closing NAV for a
specified period. A short-term moving average is the average of each day's
adjusted closing NAV for a specified period. Moving Average Activity Indicators
combine adjusted closing NAVs from the last business day of each week with
moving averages for a specified period to produce indicators showing when an NAV
has crossed, stayed above, or stayed below its moving average.
A Portfolio may quote various measures of volatility and benchmark
correlation in advertising. In addition, a Portfolio may compare these measures
to those of other funds. Measures of volatility seek to compare the historical
share price fluctuations or total returns to those of a benchmark. Measures of
benchmark correlation indicate how valid a comparative benchmark may be. All
measures of volatility and correlation are calculated using averages of
historical data.
Momentum indicators indicate a Portfolio's price movements over specific
periods of time. Each point on the momentum indicator represents the Portfolio's
percentage change in price movements over that period.
A Portfolio may advertise examples of the effects of periodic investment
plans, including the principle of dollar cost averaging. In such a program, an
investor invests a fixed dollar amount in a fund at periodic intervals, thereby
purchasing fewer shares when prices are high and more shares when prices are
low. While such a strategy does not assure a profit or guard against loss in a
declining market, the investor's average cost per share can be lower than if
fixed numbers of shares are purchased at the same intervals. In evaluating such
a plan, investors should consider their ability to continue purchasing shares
during periods of low price levels. A Portfolio may be available for purchase
through retirement plans or other programs offering
-145-
<PAGE>
deferral of, or exemption from, income taxes, which may produce superior after-
tax returns over time.
A Portfolio may advertise its current interest rate sensitivity, duration,
weighted average maturity or similar maturity characteristics.
Advertisements and sales materials relating to a Portfolio may include
information regarding the background, experience and expertise of the investment
adviser and/or portfolio manager for the Portfolio.
TAXES
The following is only a summary of certain additional tax considerations
generally affecting the Portfolios and their shareholders that are not described
in the Prospectuses. No attempt is made to present a detailed explanation of the
tax treatment of the Portfolios or their shareholders, and the discussion here
and in the Prospectuses is not intended as a substitute for careful tax
planning. Investors are urged to consult their tax advisers with specific
reference to their own tax situation.
Please note that for purposes of satisfying certain of the requirements for
taxation as a regulated investment company described below, the Index Equity
Portfolio is deemed to own a proportionate share of the assets and gross income
of the Index Master Portfolio in which the Index Equity Portfolio invests all of
its assets. Also, with respect to the Index Equity Portfolio, the discussion
below that relates to the taxation of futures contracts and other rules
pertaining to the timing and character of income apply to the Index Master
Portfolio.
Each Portfolio of the Fund has elected and intends to qualify for taxation
as a regulated investment company under Subchapter M of the Internal Revenue
Code of 1986, as amended (the "Code"). As a regulated investment company, each
Portfolio generally is exempt from federal income tax on its net investment
income (i.e., investment company taxable income as that term is defined in the
Code without regard to the deduction for dividends paid) and net capital gain
(i.e., the excess of net long-term capital gain over net short-term capital
loss) that it distributes to shareholders, provided that it distributes an
amount equal to at least the sum of (a) 90% of its net investment income and (b)
90% of its net tax-exempt interest income, if any, for the year (the
"Distribution Requirement") and satisfies certain other requirements of the Code
that are described below. Distributions of net investment income and net tax-
exempt interest income made during the taxable year or, under specified
circumstances, within twelve months after the
-146-
<PAGE>
close of the taxable year will satisfy the Distribution Requirement.
In addition to satisfaction of the Distribution Requirement, each Portfolio
must derive at least 90% of its gross income from dividends, interest, certain
payments with respect to securities loans and gains from the sale or other
disposition of stock or securities or foreign currencies (including, but not
limited to, gains from forward foreign currency exchange contacts), or from
other income derived with respect to its business of investing in such stock,
securities, or currencies (the "Income Requirement").
In addition to the foregoing requirements, at the close of each quarter of
its taxable year, at least 50% of the value of each Portfolio's assets must
consist of cash and cash items, U.S. government securities, securities of other
regulated investment companies, and securities of other issuers (as to which a
Portfolio has not invested more than 5% of the value of its total assets in
securities of such issuer and as to which a Portfolio does not hold more than
10% of the outstanding voting securities of such issuer), and no more than 25%
of the value of each Portfolio's total assets may be invested in the securities
of any one issuer (other than U.S. Government securities and securities of other
regulated investment companies), or in two or more issuers which such Portfolio
controls and which are engaged in the same or similar trades or businesses.
Each of the Money and Non-Money Market Municipal Portfolios is designed to
provide investors with tax-exempt interest income. Shares of the Money and Non-
Money Market Municipal Portfolios would not be suitable for tax-exempt
institutions and may not be suitable for retirement plans qualified under
Section 401 of the Code, H.R. 10 plans and individual retirement accounts
because such plans and accounts are generally tax-exempt and, therefore, not
only would not gain any additional benefit from the Portfolio's dividends being
tax-exempt but also such dividends would be taxable when distributed to the
beneficiary. In addition, the Money and Non-Money Market Municipal Portfolios
may not be an appropriate investment for entities which are "substantial users"
of facilities financed by private activity bonds or "related persons" thereof.
"Substantial user" is defined under U.S. Treasury Regulations to include a non-
exempt person who regularly uses a part of such facilities in his trade or
business and (a) whose gross revenues derived with respect to the facilities
financed by the issuance of bonds are more than 5% of the total revenues derived
by all users of such facilities, (b) who occupies more than 5% of the entire
usable area of such facilities, or (c) for whom such facilities or a part
thereof were specifically constructed, reconstructed or acquired. "Related
persons" include certain related natural persons,
-147-
<PAGE>
affiliated corporations, a partnership and its partners and an S corporation and
its shareholders.
In order for the Money and Non-Money Market Municipal Portfolios to pay
exempt interest dividends for any taxable year, at the close of each quarter of
the taxable year at least 50% of the value of each such Portfolio must consist
of exempt interest obligations. Exempt interest dividends distributed to
shareholders are not included in the shareholder's gross income for regular
Federal income tax purposes. However, gain realized by such Portfolios from the
disposition of a tax-exempt bond that was acquired after April 30, 1993 for a
price less than the principal amount of the bond is taxable to shareholders as
ordinary income to the extent of accrued market discount. Also, all shareholders
required to file a Federal income tax return are required to report the receipt
of exempt interest dividends and other exempt interest on their returns.
Moreover, while such dividends and interest are exempt from regular Federal
income tax, they may be subject to alternative minimum tax (currently imposed at
the rate of 26% (28% on the taxable excess over $175,000) or 28% in the case of
non-corporate taxpayers and at the rate of 20% in the case of corporate
taxpayers) in two circumstances. First, exempt interest dividends derived from
certain "private activity" bonds issued after August 7, 1986, generally will
constitute an item of tax preference for both corporate and non-corporate
taxpayers. Second, exempt interest dividends derived from all bonds, regardless
of the date of issue, must be taken into account by corporate taxpayers in
determining certain adjustments for alternative minimum tax purposes. Receipt of
exempt interest dividends may result in collateral Federal income tax
consequences to certain other taxpayers, including financial institutions,
property and casualty insurance companies, individual recipients of Social
Security or Railroad Retirement benefits, and foreign corporations engaged in
trade or business in the United States. Prospective investors should consult
their own tax advisors as to such consequences.
If a Money or Non-Money Market Municipal Portfolio distributes exempt
interest dividends during the shareholder's taxable year, no deduction generally
will be allowed for any interest expense on indebtedness incurred to purchase or
carry shares of such Portfolio.
Individuals and estates that are subject to Ohio personal income tax or
municipal or school district income taxes in Ohio will not be subject to such
taxes on distributions from the Ohio Municipal Money Market Portfolio or Ohio
Tax-Free Income Portfolio to the extent that such distributions are properly
attributable to interest on Ohio State-Specific Obligations or obligations
issued by the U.S. Government, its agencies, instrumentalities or territories if
the interest on such
-148-
<PAGE>
obligations is exempt from state income taxation under the laws of the United
States (collectively with Ohio State-Specific Obligations, the "Obligations") if
(a) the Portfolio continues to qualify as a regulated investment company for
Federal income tax purposes and (b) at all times at least 50% of the value of
the total assets of the Portfolio consists of Ohio State-Specific Obligations or
similar obligations of other states or their subdivisions. The Ohio Municipal
Money Market and Ohio Tax-Free Income Portfolios are not subject to the Ohio
personal income tax, school district income taxes in Ohio, the Ohio corporation
franchise tax, or the Ohio dealer in intangibles tax, provided that, with
respect to the Ohio corporation franchise tax and the Ohio dealer in intangibles
tax, the Fund timely files the annual report required by Section 5733.09 of the
Ohio Revised Code. The Ohio Tax Commissioner, however, has waived this annual
filing requirement for each year (and is expected to do so for 1998) since 1990,
the first tax year to which such requirement applied. Distributions with respect
to shares of the Ohio Municipal Money Market and Ohio Tax-Free Income Portfolios
properly attributable to proceeds of insurance paid to those Portfolios that
represent maturing or matured interest on defaulted Obligations held by those
Portfolios and that are excluded from gross income for Federal income tax
purposes will not be subject to Ohio personal income tax or municipal or school
district income taxes in Ohio, nor included in the net income base of the Ohio
corporation franchise tax.
Distributions of exempt-interest dividends, to the extent attributable to
interest on North Carolina State-Specific Obligations and to interest on direct
obligations of the United States (including territories thereof), are not
subject to North Carolina individual or corporate income tax. Distributions of
gains attributable to certain obligations of the State of North Carolina and its
political subdivisions issued prior to July 1, 1995 are not subject to North
Carolina individual or corporate income tax; however, distributions of gains
attributable to such types of obligations that were issued after June 30, 1995
will be subject to North Carolina individual or corporate income tax. An
investment in a Portfolio (including the North Carolina Municipal Money Market
Portfolio) by a corporation subject to the North Carolina franchise tax will be
included in the capital stock, surplus and undivided profits base in computing
the North Carolina franchise tax. Investors in a Portfolio including, in
particular, corporate investors which may be subject to the North Carolina
franchise tax, should consult their tax advisors with respect to the effects on
such tax of an investment in a Portfolio and with respect to their North
Carolina tax situation in general.
As a regulated investment company, the Virginia Municipal Money Market
Portfolio may distribute dividends that are exempt from the Virginia income tax
to its shareholders if the Portfolio
-149-
<PAGE>
satisfies all requirements for conduit treatment under Federal law and, at the
close of each quarter of its taxable year, at least 50% of the value of its
total assets consists of obligations the interest on which is exempt from
taxation under Federal law. If the Portfolio fails to qualify, no part of its
dividends will be exempt from the Virginia income tax. To the extent any portion
of the dividends are derived from taxable interest for Virginia purposes or from
net short-term capital gains, such portion will be taxable to the shareholders
as ordinary income. The character of long-term capital gains realized and
distributed by the Portfolio will follow through to its shareholders regardless
of how long the shareholders have held their shares. Generally, interest on
indebtedness incurred by shareholders to purchase or carry shares of the
Portfolio will not be deductible for Virginia income tax purposes.
To be classified as a qualified investment fund for New Jersey personal
income tax purposes, at least 80% of the investments of the New Jersey Municipal
Money Market Portfolio and New Jersey Tax-Free Income Portfolio must consist of
New Jersey State-Specific Obligations or direct U.S. Government obligations
excluding financial options, futures, forward contracts, or other similar
financial instruments related to interest-bearing obligations, obligations
issued at a discount or bond indexes related thereto to the extent such
instruments are authorized by the regulated investment company rules of the
Internal Revenue Code, cash and cash items, which cash items shall include
receivables; the Portfolios must have no investments other than interest-bearing
obligations, obligations issued at a discount, and cash and cash items
(including receivables and financial options, futures, forward contracts, or
other similar financial instruments related to interest-bearing obligations,
obligations issued at a discount or bond indexes related thereto; and the
Portfolios must satisfy certain reporting obligations and provide certain
information to shareholders.
Distributions of net investment income will be taxable (other than the
possible allowance of the dividends received deduction described below) to
shareholders as ordinary income, regardless of whether such distributions are
paid in cash or are reinvested in shares. Shareholders receiving any
distribution from a Portfolio in the form of additional shares will be treated
as receiving a taxable distribution in an amount equal to the fair market value
of the shares received, determined as of the reinvestment date. The Money and
Non-Money Market Municipal Portfolios may each purchase securities that do not
bear tax-exempt interest. Any income on such securities recognized by the
Portfolio will be distributed and will be taxable to its shareholders.
-150-
<PAGE>
Each Portfolio intends to distribute to shareholders any of its net capital
gain for each taxable year. Such gain is distributed as a capital gain dividend
and is taxable to shareholders as long-term capital gain, regardless of the
length of time the shareholder has held his shares, whether such gain was
recognized by the Portfolio prior to the date on which a shareholder acquired
shares of the Portfolio and whether the distribution was paid in cash or
reinvested in shares.
In the case of corporate shareholders, distributions (other than capital
gain dividends) of a Non-Money Market Portfolio for any taxable year generally
qualify for the dividends received deduction to the extent of the gross amount
of "qualifying dividends" received by such Portfolio for the year. Generally, a
dividend will be treated as a "qualifying dividend" if it has been received from
a domestic corporation. Distributions attributable to net investment income from
debt securities and net realized short-term capital gain will be taxable to
shareholders as ordinary income and will not be treated as "qualifying
dividends" for purposes of the dividends received deduction.
Under current law, ordinary income of individuals will be taxable at a
maximum marginal rate of 39.6%, but because of limitations on itemized
deductions otherwise allowable and the phase-out of personal exemptions, the
maximum effective marginal rate of tax for some taxpayers may be higher. Under
recently enacted legislation, long-term capital gains of individuals are taxed
at a maximum rate of 28% with respect to capital assets held for more than 12
months but less than 18 months and at a maximum rate of 20% with respect to
capital assets held for more than 18 months (10% for gains otherwise taxed at
15%). Capital gains and ordinary income of corporate taxpayers are both taxed at
a maximum nominal rate of 35%.
Investors should be aware that any loss realized upon the sale, exchange or
redemption of shares held for six months or less will be treated as a long-term
capital loss to the extent any capital gain dividends have been paid with
respect to such shares. For shareholders of the Non-Money Market Portfolios, any
loss incurred on the sale or exchange of a Portfolio's shares, held six months
or less, will be disallowed to the extent of exempt-interest dividends paid with
respect to such shares, and any loss not so disallowed will be treated as a
long-term capital loss to the extent of capital gain dividends received with
respect to such shares.
Each Non-Money Market Portfolio may engage in hedging or derivatives
transactions involving foreign currencies, forward contracts, options and
futures contracts (including options, futures and forward contracts on foreign
currencies) and short sales. Such transactions will be subject to special
provisions
-151-
<PAGE>
of the Code that, among other things, may affect the character of gains and
losses realized by the Portfolio (that is, may affect whether gains or losses
are ordinary or capital), accelerate recognition of income of the Portfolio and
defer recognition of certain of the Portfolio's losses. These rules could
therefore affect the character, amount and timing of distributions to
shareholders. In addition, these provisions (1) will require a Portfolio to
"mark-to-market" certain types of positions in its portfolio (that is, treat
them as if they were closed out) and (2) may cause a Portfolio to recognize
income without receiving cash with which to pay dividends or make distributions
in amounts necessary to satisfy the Distribution Requirement and avoid the 4%
excise tax (described below). Each Portfolio intends to monitor its
transactions, will make the appropriate tax elections and will make the
appropriate entries in its books and records when it acquires any option,
futures contract, forward contract or hedged investment in order to mitigate the
effect of these rules.
If a Portfolio purchases shares in a "passive foreign investment company"
(a "PFIC"), such Portfolio may be subject to U.S. federal income tax on a
portion of any "excess distribution" or gain from the disposition of such shares
even if such income is distributed as a taxable dividend by the Portfolio to its
shareholders. Additional charges in the nature of interest may be imposed on a
Portfolio in respect of deferred taxes arising from such distributions or gains.
If a Portfolio were to invest in a PFIC and elected to treat the PFIC as a
"qualified electing fund" under the Code (a "QEF"), in lieu of the foregoing
requirements, the Portfolio would be required to include in income each year a
portion of the ordinary earnings and net capital gain of the qualified electing
fund, even if not distributed to the Portfolio. Alternatively, under recently
enacted legislation, a Portfolio can elect to mark-to-market at the end of each
taxable year its shares in a PFIC; in this case, the Portfolio would recognize
as ordinary income any increase in the value of such shares, and as ordinary
loss any decrease in such value to the extent it did not exceed prior increases
included in income. Under either election, a Portfolio might be required to
recognize in a year income in excess of its distributions from PFICs and its
proceeds from dispositions of PFIC stock during that year, and such income would
nevertheless be subject to the Distribution Requirement and would be taken into
account for purposes of the 4% excise tax (described below).
Investment income that may be received by certain of the Portfolios from
sources within foreign countries may be subject to foreign taxes withheld at the
source. The United States has entered into tax treaties with many foreign
countries which entitle any such Portfolio to a reduced rate of, or exemption
from, taxes on such income. If more than 50% of the value of the
-152-
<PAGE>
total assets at the close of the taxable year of the International Equity
Portfolio, International Emerging Markets Portfolio, International Small Cap
Equity Portfolio and International Bond Portfolio consist of stock or securities
of foreign corporations, such Portfolio may elect to "pass through" to the
Portfolio's shareholders the amount of foreign taxes paid by such Portfolio. If
a Portfolio so elects, each shareholder would be required to include in gross
income, even though not actually received, his pro rata share of the foreign
taxes paid by the Portfolio, but would be treated as having paid his pro rata
share of such foreign taxes and would therefore be allowed to either deduct such
amount in computing taxable income or use such amount (subject to various Code
limitations) as a foreign tax credit against federal income tax (but not both).
For purposes of the foreign tax credit limitation rules of the Code, each
shareholder would treat as foreign source income his pro rata share of such
foreign taxes plus the portion of dividends received from the Portfolio
representing income derived from foreign sources. No deduction for foreign taxes
could be claimed by an individual shareholder who does not itemize deductions.
In certain circumstances, a shareholder that (i) has held shares of the
Portfolio for less than a specified minimum period during which it is not
protected from risk of loss or (ii) is obligated to make payments related to the
dividends, will not be allowed a foreign tax credit for foreign taxes deemed
imposed on dividends paid on such shares. Additionally, such Portfolio must also
meet this holding period requirement with respect to its foreign stocks and
securities in order for "creditable" taxes to flow-through. Each shareholder
should consult his own tax adviser regarding the potential application of
foreign tax credits.
Ordinary income dividends paid by a Portfolio will qualify for the 70%
dividends-received deduction generally available to corporations to the extent
of the amount of "qualifying dividends" received by a Portfolio from domestic
corporations for the taxable year. A dividend received by a Portfolio will not
be treated as a qualifying dividend (i) if it has been received with respect to
any share of stock that the Portfolio has held for less than 46 days (91 days in
the case of certain preferred stock) during the 90 day period beginning on the
date which is 45 days before the date on which such share becomes ex-dividend
with respect to such dividend (during the 180 day period beginning 90 days
before such date in the case of certain preferred stock), (ii) to the extent
that a Portfolio is under an obligation to make related payments with respect to
positions in substantially similar or related property or (iii) to the extent
the stock on which the dividend is paid is treated as debt-financed. Moreover,
the dividends-received deduction for a corporate shareholder may be disallowed
if the corporate shareholder fails to satisfy the foregoing requirements with
respect to its shares of a Portfolio.
-153-
<PAGE>
If for any taxable year any Portfolio does not qualify as a regulated
investment company, all of its taxable income will be subject to tax at regular
corporate rates without any deduction for distributions to shareholders, and all
distributions (including amounts derived from interest on Municipal Obligations)
will be taxable as ordinary dividends to the extent of such Portfolio's current
and accumulated earnings and profits. Such distributions will be eligible for
the dividends received deduction in the case of corporate shareholders.
A 4% non-deductible excise tax is imposed on regulated investment companies
that fail to currently distribute specified percentages of their ordinary
taxable income and capital gain net income (excess of capital gains over capital
losses). Each Portfolio intends to make sufficient distributions or deemed
distributions of its ordinary taxable income and any capital gain net income
prior to the end of each calendar year to avoid liability for this excise tax.
The Fund will be required in certain cases to withhold and remit to the
United States Treasury 31% of dividends and gross sale proceeds paid to any
shareholder (i) who has provided either an incorrect tax identification number
or no number at all, (ii) who is subject to backup withholding by the Internal
Revenue Service for failure to report the receipt of interest or dividend income
properly, or (iii) who has failed to certify to the Fund when required to do so
that he is not subject to backup withholding or that he is an "exempt
recipient."
Shareholders will be advised annually as to the Federal income tax
consequences of distributions made by the Portfolios each year.
The foregoing general discussion of federal income tax consequences is
based on the Code and the regulations issued thereunder as in effect on the date
of this Statement of Additional Information. Future legislative or
administrative changes or court decisions may significantly change the
conclusions expressed herein, and any such changes or decisions may have a
retroactive effect with respect to the transactions contemplated herein.
Although each Portfolio expects to qualify as a "regulated investment
company" and to be relieved of all or substantially all federal income taxes,
depending upon the extent of its activities in states and localities in which
its offices are maintained, in which its agents or independent contractors are
located or in which it is otherwise deemed to be conducting business, each
Portfolio may be subject to the tax laws of such states or localities.
Shareholders should consult their tax advisors about state and local tax
consequences, which may differ from the federal income tax consequences
described above.
-154-
<PAGE>
ADDITIONAL INFORMATION CONCERNING SHARES
Shares of the Fund have noncumulative voting rights and, accordingly, the
holders of more than 50% of the Fund's outstanding shares (irrespective of
class) may elect all of the trustees. Shares have no preemptive rights and only
such conversion and exchange rights as the Board may grant in its discretion.
When issued for payment as described in the Prospectus, shares will be fully
paid and non-assessable by the Fund.
There will normally be no meetings of shareholders for the purpose of
electing trustees unless and until such time as required by law. At that time,
the trustees then in office will call a shareholders meeting to elect trustees.
Except as set forth above, the trustees shall continue to hold office and may
appoint successor trustees. The Fund's Declaration of Trust provides that
meetings of the shareholders of the Fund shall be called by the trustees upon
the written request of shareholders owning at least 10% of the outstanding
shares entitled to vote.
Rule 18f-2 under the 1940 Act provides that any matter required by the
provisions of the 1940 Act or applicable state law, or otherwise, to be
submitted to the holders of the outstanding voting securities of an investment
company such as the Fund shall not be deemed to have been effectively acted upon
unless approved by the holders of a majority of the outstanding shares of each
investment portfolio affected by such matter. Rule 18f-2 further provides that
an investment portfolio shall be deemed to be affected by a matter unless the
interests of each investment portfolio in the matter are substantially identical
or the matter does not affect any interest of the investment portfolio. Under
the Rule, the approval of an investment advisory agreement, a distribution plan
subject to Rule 12b-1 under the 1940 Act or any change in a fundamental
investment policy would be effectively acted upon with respect to an investment
portfolio only if approved by a majority of the outstanding shares of such
investment portfolio. However, the Rule also provides that the ratification of
the appointment of independent accountants, the approval of principal
underwriting contracts and the election of Trustees may be effectively acted
upon by shareholders of the Fund voting together in the aggregate without regard
to a particular investment portfolio.
The proceeds received by each Portfolio for each issue or sale of its
shares, and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to and constitute the underlying assets of that Portfolio. The underlying assets
of each Portfolio will be segregated on the books of account, and will be
charged with the liabilities in respect to that Portfolio
-155-
<PAGE>
and with a share of the general liabilities of the Fund. As stated in the
Prospectuses, certain expenses of a Portfolio may be charged to a specific class
of shares representing interests in that Portfolio.
The Funds' Declaration of Trust authorizes the Board of Trustees, without
shareholder approval (unless otherwise required by applicable law), to: (i) sell
and convey the assets belonging to a class of shares to another management
investment company for consideration which may include securities issued by the
purchaser and, in connection therewith, to cause all outstanding shares of such
class to be redeemed at a price which is equal to their net asset value and
which may be paid in cash or by distribution of the securities or other
consideration received from the sale and conveyance; (ii) sell and convert the
assets belonging to one or more classes of shares into money and, in connection
therewith, to cause all outstanding shares of such class to be redeemed at their
net asset value; or (iii) combine the assets belonging to a class of shares with
the assets belonging to one or more other classes of shares if the Board of
Trustees reasonably determines that such combination will not have a material
adverse effect on the shareholders of any class participating in such
combination and, in connection therewith, to cause all outstanding shares of any
such class to be redeemed or converted into shares of another class of shares at
their net asset value. The Board of Trustees may authorize the liquidation and
termination of any Portfolio or class of shares. Upon any liquidation of a
Portfolio, Shareholders of each class of the Portfolio are entitled to share pro
rata in the net assets belonging to that class available for distribution.
MISCELLANEOUS
Effective January 31, 1998, the Fund has changed its name from Compass
Capital Funds/SM/ to BlackRock Funds/SM/.
COUNSEL. The law firm of Simpson Thacher & Bartlett (a partnership which
includes professional corporations), 425 Lexington Avenue, New York, New York
10017, serves as the Fund's counsel. The law firm of Stradley, Ronon, Stevens &
Young, LLP, 2600 One Commerce Square, Philadelphia, Pennsylvania 19103, serves
as the Trust's counsel.
INDEPENDENT ACCOUNTANTS. Coopers & Lybrand L.L.P., with offices located at
2400 Eleven Penn Center, Philadelphia, Pennsylvania, serves as the Fund's and
the Trust's independent accountants.
FIVE PERCENT OWNERS. The name, address and percentage ownership of each
person that on January 8, 1998 owned of record or beneficially 5% or more of
the outstanding shares of a
-156-
<PAGE>
Portfolio which had commenced operations as of that date was as follows:
Money Market Portfolio: PNC Bank, Airport Business Center/Int'l Court 2, 200
- ----------------------
Stevens Dr., Lester, PA 19113, 79.498%; BHC Securities Inc., One Commerce
Square, 2005 Market Street, Philadelphia, PA 19103-3212, 8.730%; U.S. Treasury
-------------
Money Market Portfolio: PNC Bank, Airport Business Center/Int'l Court 2, 200
- ----------------------
Stevens Dr., Lester, PA 19113, 81.731%; Large Cap Value Equity Portfolio: PNC
--------------------------------
Bank, Saxon & Co., Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester,
PA 19113, 82.888%; Intermediate Government Bond Portfolio: PNC Bank, Saxon &
--------------------------------------
Co., Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113,
92.482%; Municipal Money Market Portfolio: PNC Bank, Airport Business
--------------------------------
Center/Int'l Court 2, 200 Stevens Dr., Lester, PA 19113, 75.728%; PNC Bank
Pittsburgh, Treas Management-32nd Fl., Two PNC Place, Pittsburgh, PA 15222,
12.721%; Small Cap Value Equity Portfolio: PNC Bank, Saxon & Co., Attn: Income
--------------------------------
Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 69.236%; National
City Bank Kentucky, Humana Retirement/Savings Tr., P.O. Box 94777, Cleveland, OH
44101, 8.418%; Large Cap Growth Equity Portfolio: PNC Bank, Saxon & Co., Attn:
---------------------------------
Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 88.882%;
Managed Income Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections, 200
- ------------------------
Stevens Dr., Suite 260, Lester, PA 19113, 88.059%; Tax-Free Income Portfolio:
--------------------------
PNC Bank, Saxon & Co., Attn: Income Collections, 200 Stevens Dr., Suite 260,
Lester, PA 19113, 85.165%; Balanced Portfolio: PNC Bank, Saxon & Co., Attn:
------------------
Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 63.110%; BHC
Securities Inc., One Commerce Square, 2005 Market Street, Philadelphia, PA
19103-3212, 17.965%; International Equity Portfolio: PNC Bank, Saxon & Co.,
------------------------------
Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 91.267%;
Ohio Tax-Free Income Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections,
- ------------------------------
200 Stevens Dr., Suite 260, Lester, PA 19113, 69.768%; BHC Securities Inc., One
Commerce Square, 2005 Market Street, Philadelphia, PA 19103-3212, 17.283%;
Pennsylvania Tax-Free Income Portfolio: PNC Bank, Saxon & Co., Attn: Income
- --------------------------------------
Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 44.933%; BHC
Securities Inc., One Commerce Square, 2005 Market Street, Philadelphia, PA
19103-3212, 30.190%; North Carolina Municipal Money Market Portfolio: North
-----------------------------------------------
Carolina Trust Co., 301 North Elm St., P.O. Box 1108, Greensboro, NC 27402,
54.766%; Branch Banking and Trust Company, Wilbranch & Company, Trust
Department, P.O. Box 1847, Wilson, NC 27893, 15.722%; First Citizens Bank,
McWood & Company, P.O. Box 29522, Raleigh, NC 27626, 7.951%; Central Carolina
Bank & Trust Co., P.O. Box 30010, Durham, NC 27702-3010, 12.051%; Ohio Municipal
--------------
Money Market Portfolio: PNC Bank, Airport Business Center/Int'l Court 2, 200
- ----------------------
Stevens Dr., Lester, PA 19113, 45.378%; BHC Securities, One Commerce Square,
2005 Market St, Philadelphia, PA 19103-3212, 36.690%; Wayne County National
Bank, Wayco & Co., P.O. Box 757/1776 Beall Avenue, Wooster, OH 44691, 10.632%;
Low Duration Bond Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections,
- ---------------------------
200 Stevens Dr., Suite 260, Lester, PA 19113, 50.035%; BIT Acquisition
Corporation, 9 Parker, Irvine, CA 92718, 12.960%; U.S. Industries Inc., Master
Trust, c/o Bank of New York, One
-157-
<PAGE>
2
Wall Street, 12th Floor, New York, NY 10286, 11.437%; Vimrx Pharmaceuticals
Inc., 2751 Centerville Rd., Ste. 210, Wilmington, DE 19806, 5.234%; Intermediate
------------
Bond Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections, 200 Stevens
- --------------
Dr., Suite 260, Lester, PA 19113, 96.631%; Select Equity Portfolio: PNC Bank,
-----------------------
Saxon & Co., Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester, PA
19113, 88.395%; Small Cap Growth Equity Portfolio: PNC Bank, Saxon & Co., Attn:
---------------------------------
Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 55.016%;
Pennsylvania Municipal Money Market Portfolio: PNC Bank, Airport Business
- ---------------------------------------------
Center/Int'l Court 2, 200 Stevens Dr., Lester, PA 19113, 72.542%; Janney
Montgomery Scott, 1801 Market Street, 9th Floor, Philadelphia, PA 19103, 7.704%;
BHC Securities, Inc., One Commerce Square, 2005 Market St, Philadelphia, PA
19103-3212, 5.310%; Virginia Municipal Money Market Portfolio: First Virginia
-----------------------------------------
Bank Inc., Oldom & Company, 6400 Arlington Blvd., Falls Church, VA 22042,
57.973%; American National Bank & Trust Co, Ambro and Company, 628 Main St, P.O.
Box 191, Danville, VA 24543, 5.444%; Mentor Investment Group, as advisor for
Virginia State Non-Arbitrage Program, 901 East Byrd Street, 6th Fl., Richmond,
VA 23219, 15.720%; F&M Bank-Peoples Warrtrust & Co., P.O. Box 93, Warrenton, VA
22186, 6.799%; International Bond Portfolio: PNC Bank, Saxon & Co., 200 Stevens
----------------------------
Dr., Suite 260, Lester, PA 19113, 86.150%; International Emerging Markets
------------------------------
Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections, 200 Stevens Dr.,
- ---------
Suite 260, Lester, PA 19113, 93.154%; Government Income Portfolio: BHC
---------------------------
Securities, Inc., One Commerce Square, 2005 Market St, Phila., PA 19103-3212,
16.102%; New Jersey Municipal Money Market Portfolio: PNC Bank, Airport Business
-------------------------------------------
Center/Int'l Court 2, 200 Stevens Dr., Lester, PA 19113, 74.379%; Janney
Montgomery Scott, 1801 Market Street, 9th Fl., Phila., PA 19103, 14.569%; New
---
Jersey Tax-Free Income Portfolio: PNC Bank, Saxon & Co., Attn: Income
- --------------------------------
Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 58.461%; BHC
Securities, Inc., One Commerce Square, 2005 Market Street, Suite 1200,
Philadelphia, PA 19103-3212, 7.731%; Core Bond Portfolio: PNC Bank, Saxon & Co.,
-------------------
Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 83.187%;
Mid-Cap Value Portfolio: PNC Bank, Saxon & Co., 200 Stevens Dr., Suite 260,
- -----------------------
Lester, PA 19113, 89.033%; Mid-Cap Growth Portfolio: PNC Bank, Saxon & Co.,
------------------------
Attn: Income Collections, 200 Stevens Dr., Suite 260, Lester, PA 19113, 92.342%;
Index Equity Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections, 200
- ----------------------
Stevens Dr., Suite 260, Lester, PA 19113, 73.274%; International Small Cap
-----------------------
Equity Portfolio: PNC Bank, Saxon & Co., Attn: Income Collections, 200 Stevens
- ----------------
Drive, Suite 260, Lester, PA 19113, 84.196%; Merrill Lynch Pierce Fenner
Financial Data Services, Attn: Stock Powers, 4800 E. Deer Lake Dr., 3rd Fl.,
Jacksonville, FL 32246, 5.106%.
On January 23, 1998, PNC Bank, which has its principal offices at 1600
Market Street, Philadelphia, Pennsylvania 19103,
-158-
<PAGE>
held of record approximately 77% of the Fund's outstanding shares, and may be
deemed a controlling person of the Fund under the 1940 Act. PNC Bank is a
national bank organized under the laws of the United States. All of the capital
stock of PNC Bank is owned by PNC Bancorp, Inc. All of the capital stock of PNC
Bancorp, Inc. is owned by PNC Bank Corp., a publicly-held bank holding company.
BANKING LAWS. Banking laws and regulations currently prohibit a bank
holding company registered under the Federal Bank Holding Company Act of 1956 or
any bank or non-bank affiliate thereof from sponsoring, organizing, controlling
or distributing the shares of a registered, open-end investment company
continuously engaged in the issuance of its shares, and prohibit banks generally
from underwriting securities, but such banking laws and regulations do not
prohibit such a holding company or affiliate or banks generally from acting as
investment adviser, administrator, transfer agent or custodian to such an
investment company, or from purchasing shares of such a company as agent for and
upon the order of customers. BlackRock, Inc., PIMC, BlackRock, PCM, PEAC,
CastleInternational, PNC Bank and other institutions that are banks or bank
affiliates are subject to such banking laws and regulations.
BlackRock, Inc., PIMC, BlackRock, PCM, PEAC, CastleInternational and PNC
Bank believe they may perform the services for the Fund contemplated by their
respective agreements with the Fund without violation of applicable banking laws
or regulations. It should be noted, however, that there have been no cases
deciding whether bank and non-bank subsidiaries of a registered bank holding
company may perform services comparable to those that are to be performed by
these companies, and future changes in either Federal or state statutes and
regulations relating to permissible activities of banks and their subsidiaries
or affiliates, as well as further judicial or administrative decisions or
interpretations of present and future statutes and regulations, could prevent
these companies from continuing to perform such services for the Fund. If such
were to occur, it is expected that the Board of Trustees would recommend that
the Fund enter into new agreements or would consider the possible termination of
the Fund. Any new advisory or sub-advisory agreement would normally be subject
to shareholder approval. It is not anticipated that any change in the Fund's
method of operations as a result of these occurrences would affect its net asset
value per share or result in a financial loss to any shareholder.
SHAREHOLDER APPROVALS. As used in this Statement of Additional Information
and in the Prospectuses, a "majority of the outstanding shares" of a class,
series or Portfolio means, with respect to the approval of an investment
advisory agreement, a distribution plan or a change in a fundamental
investment
-159-
<PAGE>
policy, the lesser of (1) 67% of the shares of the particular class, series or
Portfolio represented at a meeting at which the holders of more than 50% of the
outstanding shares of such class, series or Portfolio are present in person or
by proxy, or (2) more than 50% of the outstanding shares of such class, series
or Portfolio.
FINANCIAL STATEMENTS
BLACKROCK FUNDS. The audited financial statements and notes thereto in the
Fund's Annual Report to Shareholders for the fiscal year ended September 30,
1997 (the "1997 Annual Report") are incorporated in this Statement of Additional
Information by reference. No other parts of the 1997 Annual Report are
incorporated by reference herein. The financial statements included in the 1997
Annual Report have been audited by the Fund's independent accountants, Coopers &
Lybrand, L.L.P., except for the statements of changes in net assets for the year
ended June 30, 1995 for the Core Bond Portfolio and Short Government Bond
Portfolio (now known as Low Duration Bond Portfolio) and the financial
highlights for the periods ended June 30, 1995, 1994 and 1993 for those same
Portfolios which have been audited by other auditors. The reports of Coopers &
Lybrand L.L.P. are incorporated herein by reference. Such financial statements
have been incorporated herein in reliance upon such reports given upon their
authority as experts in accounting and auditing. Additional copies of the 1997
Annual Report may be obtained at no charge by telephoning the Distributor at the
telephone number appearing on the front page of this Statement of Additional
Information.
The financial highlights included in the 1997 Annual Report for each of the
two years in the period ended June 30, 1995, and for the period from July 17,
1992 through June 30, 1993 for the Short Government Bond Portfolio (now known as
the Low Duration Bond Portfolio) and the period from December 9, 1992 through
June 30, 1993 for the Core Bond Portfolio, and the statements of changes in net
assets for the year ended June 30, 1995 for those same Portfolios have been
audited by the former independent accountants of the Predecessor BFM Portfolios,
Deloitte & Touche, L.L.P., whose report thereon is also incorporated herein by
reference. Such financial statements have been incorporated herein by reference
in reliance on the reports of Coopers & Lybrand L.L.P. and Deloitte & Touche,
L.L.P. given upon their authority as experts in accounting and auditing.
INDEX MASTER PORTFOLIO. The audited financial statements and notes thereto
for The U.S. Large Company Series of the Trust for the fiscal year ended
November 30, 1996 (the "1996 Index Master Report") and the
-160-
<PAGE>
unaudited financial statements and notes thereto for the Trust's U.S. Large
Company Series for the period ended September 30, 1997 (the "1997 Index Master
Report") contained in the Fund's 1997 Annual Report to Shareholders are
incorporated by reference into this Statement of Additional Information. No
other parts of the 1996 Index Master Report or 1997 Index Master Report are
incorporated by reference herein. The financial statements included in the 1996
Index Master Report have been audited by the Trust's independent accountants,
Coopers & Lybrand L.L.P., whose reports thereon are incorporated herein by
reference. Such financial statements have been incorporated herein by reference
in reliance upon such reports given upon their authority as experts in
accounting and auditing. Additional copies of the 1996 Index Master Report may
be obtained at no charge by telephoning the Trust at (310) 395-8005.
-161-
<PAGE>
APPENDIX A
----------
COMMERCIAL PAPER RATINGS
- ------------------------
A Standard & Poor's commercial paper rating is a current assessment of
the likelihood of timely payment of debt considered short-term in the relevant
market. The following summarizes the rating categories used by Standard and
Poor's for commercial paper:
"A-1" - Issue's degree of safety regarding timely payment is strong.
Those issues determined to possess extremely strong safety characteristics are
denoted "A-1+."
"A-2" - Issue's capacity for timely payment is satisfactory. However,
the relative degree of safety is not as high as for issues designated "A-1."
"A-3" - Issue has an adequate capacity for timely payment. It is,
however, somewhat more vulnerable to the adverse effects of changes in
circumstances than an obligation carrying a higher designation.
"B" - Issue has only a speculative capacity for timely payment.
"C" - Issue has a doubtful capacity for payment.
"D" - Issue is in payment default.
Moody's commercial paper ratings are opinions of the ability of
issuers to repay punctually promissory obligations not having an original
maturity in excess of 9 months. The following summarizes the rating categories
used by Moody's for commercial paper:
"Prime-1" - Issuer or related supporting institutions are considered
to have a superior capacity for repayment of short-term promissory obligations.
Prime-1 repayment capacity will normally be evidenced by the following
characteristics: leading market positions in well established industries; high
rates of return on funds employed; conservative capitalization structures with
moderate reliance on debt and ample asset protection; broad margins in earning
coverage of fixed financial charges and high internal cash generation; and well
established access to a range of financial markets and assured sources of
alternate liquidity.
"Prime-2" - Issuer or related supporting institutions are considered
to have a strong capacity for repayment of
A-1
<PAGE>
short-term promissory obligations. This will normally be evidenced by many of
the characteristics cited above but to a lesser degree. Earnings trends and
coverage ratios, while sound, will be more subject to variation. Capitalization
characteristics, while still appropriate, may be more affected by external
conditions. Ample alternative liquidity is maintained.
"Prime-3" - Issuer or related supporting institutions have an
acceptable capacity for repayment of short-term promissory obligations. The
effects of industry characteristics and market composition may be more
pronounced. Variability in earnings and profitability may result in changes in
the level of debt protection measurements and the requirement for relatively
high financial leverage. Adequate alternate liquidity is maintained.
"Not Prime" - Issuer does not fall within any of the Prime rating
categories.
The three rating categories of Duff & Phelps for investment grade
commercial paper and short-term debt are "D-1," "D-2" and "D-3." Duff & Phelps
employs three designations, "D- 1+," "D-1" and "D-1-," within the highest rating
category. The following summarizes the rating categories used by Duff & Phelps
for commercial paper:
"D-1+" - Debt possesses highest certainty of timely payment. Short-
term liquidity, including internal operating factors and/or access to
alternative sources of funds, is outstanding, and safety is just below risk-free
U.S. Treasury short-term obligations.
"D-1" - Debt possesses very high certainty of timely payment.
Liquidity factors are excellent and supported by good fundamental protection
factors. Risk factors are minor.
"D-1-" - Debt possesses high certainty of timely payment. Liquidity
factors are strong and supported by good fundamental protection factors. Risk
factors are very small.
"D-2" - Debt possesses good certainty of timely payment. Liquidity
factors and company fundamentals are sound. Although ongoing funding needs may
enlarge total financing requirements, access to capital markets is good. Risk
factors are small.
"D-3" - Debt possesses satisfactory liquidity, and other protection
factors qualify issue as investment grade. Risk factors are larger and subject
to more variation. Nevertheless, timely payment is expected.
A-2
<PAGE>
"D-4" - Debt possesses speculative investment characteristics.
Liquidity is not sufficient to ensure against disruption in debt service.
Operating factors and market access may be subject to a high degree of
variation.
"D-5" - Issuer has failed to meet scheduled principal and/or interest
payments.
Fitch short-term ratings apply to debt obligations that are payable on
demand or have original maturities of generally up to three years. The following
summarizes the rating categories used by Fitch for short-term obligations:
"F-1+" - Securities possess exceptionally strong credit quality.
Issues assigned this rating are regarded as having the strongest degree of
assurance for timely payment.
"F-1" - Securities possess very strong credit quality. Issues assigned
this rating reflect an assurance of timely payment only slightly less in degree
than issues rated "F-1+."
"F-2" - Securities possess good credit quality. Issues assigned this
rating have a satisfactory degree of assurance for timely payment, but the
margin of safety is not as great as the "F-1+" and "F-1" categories.
"F-3" - Securities possess fair credit quality. Issues assigned this
rating have characteristics suggesting that the degree of assurance for timely
payment is adequate; however, near-term adverse changes could cause these
securities to be rated below investment grade.
"F-S" - Securities possess weak credit quality. Issues assigned this
rating have characteristics suggesting a minimal degree of assurance for timely
payment and are vulnerable to near-term adverse changes in financial and
economic conditions.
"D" - Securities are in actual or imminent payment default.
Fitch may also use the symbol "LOC" with its short-term ratings to
indicate that the rating is based upon a letter of credit issued by a commercial
bank.
Thomson BankWatch short-term ratings assess the likelihood of an
untimely or incomplete payment of principal or interest of unsubordinated
instruments having a maturity of one year or less which are issued by United
States commercial banks, thrifts and non-bank banks; non-United States banks;
and broker-dealers. The following summarizes the ratings used by Thomson
BankWatch:
A-3
<PAGE>
"TBW-1" - This designation represents Thomson BankWatch's highest
rating category and indicates a very high degree of likelihood that principal
and interest will be paid on a timely basis.
"TBW-2" - This designation indicates that while the degree of safety
regarding timely payment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated "TBW-1."
"TBW-3" - This designation represents the lowest investment grade
category and indicates that while the debt is more susceptible to adverse
developments (both internal and external) than obligations with higher ratings,
capacity to service principal and interest in a timely fashion is considered
adequate.
"TBW-4" - This designation indicates that the debt is regarded as non-
investment grade and therefore speculative.
IBCA assesses the investment quality of unsecured debt with an
original maturity of less than one year which is issued by bank holding
companies and their principal bank subsidiaries. The following summarizes the
rating categories used by IBCA for short-term debt ratings:
"A1+" - Obligations which posses a particularly strong credit feature
are supported by the highest capacity for timely repayment.
"A1" - Obligations are supported by the highest capacity for timely
repayment.
"A2" - Obligations are supported by a satisfactory capacity for timely
repayment.
"A3" - Obligations are supported by a satisfactory capacity for timely
repayment.
"B" - Obligations for which there is an uncertainty as to the capacity
to ensure timely repayment.
"C" - Obligations for which there is a high risk of default or which
are currently in default.
A-4
<PAGE>
CORPORATE AND MUNICIPAL LONG-TERM DEBT RATINGS
- ----------------------------------------------
The following summarizes the ratings used by Standard & Poor's for
corporate and municipal debt:
"AAA" - This designation represents the highest rating assigned by
Standard & Poor's to a debt obligation and indicates an extremely strong
capacity to pay interest and repay principal.
"AA" - Debt is considered to have a very strong capacity to pay
interest and repay principal and differs from AAA issues only in small degree.
"A" - Debt is considered to have a strong capacity to pay interest and
repay principal although such issues are somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than debt in
higher-rated categories.
"BBB" - Debt is regarded as having an adequate capacity to pay
interest and repay principal. Whereas such issues normally exhibit adequate
protection parameters, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity to pay interest and repay principal
for debt in this category than in higher-rated categories.
"BB," "B," "CCC," "CC" and "C" - Debt is regarded, on balance, as
predominantly speculative with respect to capacity to pay interest and repay
principal in accordance with the terms of the obligation. "BB" indicates the
lowest degree of speculation and "C" the highest degree of speculation. While
such debt will likely have some quality and protective characteristics, these
are outweighed by large uncertainties or major risk exposures to adverse
conditions.
"BB" - Debt has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. The "BB"
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied "BBB-" rating.
"B" - Debt has a greater vulnerability to default but currently has
the capacity to meet interest payments and principal repayments. Adverse
business, financial or economic conditions will likely impair capacity or
willingness to pay interest and repay principal. The "B" rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
"BB" or "BB-" rating.
A-5
<PAGE>
"CCC" - Debt has a currently identifiable vulnerability to default,
and is dependent upon favorable business, financial and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial or economic conditions, it is not likely to have the
capacity to pay interest and repay principal. The "CCC" rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
"B" or "B-" rating.
"CC" - This rating is typically applied to debt subordinated to senior
debt that is assigned an actual or implied "CCC" rating.
"C" - This rating is typically applied to debt subordinated to senior
debt which is assigned an actual or implied "CCC-" debt rating. The "C" rating
may be used to cover a situation where a bankruptcy petition has been filed, but
debt service payments are continued.
"CI" - This rating is reserved for income bonds on which no interest
is being paid.
"D" - Debt is in payment default. This rating is used when interest
payments or principal payments are not made on the date due, even if the
applicable grace period has not expired, unless S & P believes that such
payments will be made during such grace period. "D" rating is also used upon the
filing of a bankruptcy petition if debt service payments are jeopardized.
PLUS (+) OR MINUS (-) - The ratings from "AA" through "CCC" may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories.
"r" - This rating is attached to highlight derivative, hybrid, and
certain other obligations that S & P believes may experience high volatility or
high variability in expected returns due to non-credit risks. Examples of such
obligations are: securities whose principal or interest return is indexed to
equities, commodities, or currencies; certain swaps and options; and interest
only and principal only mortgage securities. The absence of an "r" symbol should
not be taken as an indication that an obligation will exhibit no volatility or
variability in total return.
The following summarizes the ratings used by Moody's for corporate and
municipal long-term debt:
"Aaa" - Bonds are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or by an exceptionally stable
margin and principal is secure. While the various protective elements are
A-6
<PAGE>
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
"Aa" - Bonds are judged to be of high quality by all standards.
Together with the "Aaa" group they comprise what are generally known as high-
grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in "Aaa" securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risks appear somewhat larger than in "Aaa"
securities.
"A" - Bonds possess many favorable investment attributes and are to be
considered as upper medium-grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present which
suggest a susceptibility to impairment sometime in the future.
"Baa" - Bonds considered medium-grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payments and principal
security appear adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
"Ba," "B," "Caa," "Ca," and "C" - Bonds that possess one of these
ratings provide questionable protection of interest and principal ("Ba"
indicates some speculative elements; "B" indicates a general lack of
characteristics of desirable investment; "Caa" represents a poor standing; "Ca"
represents obligations which are speculative in a high degree; and "C"
represents the lowest rated class of bonds). "Caa," "Ca" and "C" bonds may be in
default.
Con. (---) - Bonds for which the security depends upon the completion
of some act or the fulfillment of some condition are rated conditionally. These
are bonds secured by (a) earnings of projects under construction, (b) earnings
of projects unseasoned in operation experience, (c) rentals which begin when
facilities are completed, or (d) payments to which some other limiting condition
attaches. Parenthetical rating denotes probable credit stature upon completion
of construction or elimination of basis of condition.
(P)... - When applied to forward delivery bonds, indicates that the
rating is provisional pending delivery of the bonds. The rating may be revised
prior to delivery if changes occur in the legal documents or the underlying
credit quality of the bonds.
A-7
<PAGE>
Note: Those bonds in the Aa, A, Baa, Ba and B groups which Moody's
believes possess the strongest investment attributes are designated by the
symbols, Aa1, A1, Ba1 and B1.
The following summarizes the long-term debt ratings used by Duff &
Phelps for corporate and municipal long-term debt:
"AAA" - Debt is considered to be of the highest credit quality. The
risk factors are negligible, being only slightly more than for risk-free U.S.
Treasury debt.
"AA" - Debt is considered of high credit quality. Protection factors
are strong. Risk is modest but may vary slightly from time to time because of
economic conditions.
"A" - Debt possesses protection factors which are average but
adequate. However, risk factors are more variable and greater in periods of
economic stress.
"BBB" - Debt possesses below average protection factors but such
protection factors are still considered sufficient for prudent investment.
Considerable variability in risk is present during economic cycles.
"BB," "B," "CCC," "DD," and "DP" - Debt that possesses one of these
ratings is considered to be below investment grade. Although below investment
grade, debt rated "BB" is deemed likely to meet obligations when due. Debt rated
"B" possesses the risk that obligations will not be met when due. Debt rated
"CCC" is well below investment grade and has considerable uncertainty as to
timely payment of principal, interest or preferred dividends. Debt rated "DD" is
a defaulted debt obligation, and the rating "DP" represents preferred stock with
dividend arrearages.
To provide more detailed indications of credit quality, the "AA," "A,"
"BBB," "BB" and "B" ratings may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within these major categories.
The following summarizes the highest four ratings used by Fitch for
corporate and municipal bonds:
"AAA" - Bonds considered to be investment grade and of the highest
credit quality. The obligor has an exceptionally strong ability to pay interest
and repay principal, which is unlikely to be affected by reasonably foreseeable
events.
"AA" - Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong, although not quite as strong as bonds rated "AAA." Because bonds rated
in the "AAA" and "AA" categories are not significantly vulnerable to foreseeable
future
A-8
<PAGE>
developments, short-term debt of these issuers is generally rated "F-1+."
"A" - Bonds considered to be investment grade and of high credit
quality. The obligor's ability to pay interest and repay principal is considered
to be strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
"BBB" - Bonds considered to be investment grade and of satisfactory
credit quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have an adverse impact on these
bonds, and therefore, impair timely payment. The likelihood that the ratings of
these bonds will fall below investment grade is higher than for bonds with
higher ratings.
"BB," "B," "CCC," "CC," "C," "DDD," "DD," and "D" Bonds that possess
one of these ratings are considered by Fitch to be speculative investments. The
ratings "BB" to "C" represent Fitch's assessment of the likelihood of timely
payment of principal and interest in accordance with the terms of obligation for
bond issues not in default. For defaulted bonds, the rating "DDD" to "D" is an
assessment of the ultimate recovery value through reorganization or liquidation.
To provide more detailed indications of credit quality, the Fitch
ratings from and including "AA" to "BBB" may be modified by the addition of a
plus (+) or minus (-) sign to show relative standing within these major rating
categories.
IBCA assesses the investment quality of unsecured debt with an
original maturity of more than one year which is issued by bank holding
companies and their principal bank subsidiaries. The following summarizes the
rating categories used by IBCA for long-term debt ratings:
"AAA" - Obligations for which there is the lowest expectation of
investment risk. Capacity for timely repayment of principal and interest is
substantial such that adverse changes in business, economic or financial
conditions are unlikely to increase investment risk substantially.
"AA" - Obligations for which there is a very low expectation of
investment risk. Capacity for timely repayment of principal and interest is
substantial, such that adverse changes in business, economic or financial
conditions may increase investment risk, albeit not very significantly.
"A" - Obligations for which there is a low expectation of investment
risk. Capacity for timely repayment of principal
A-9
<PAGE>
and interest is strong, although adverse changes in business, economic or
financial conditions may lead to increased investment risk.
"BBB" - Obligations for which there is currently a low expectation of
investment risk. Capacity for timely repayment of principal and interest is
adequate, although adverse changes in business, economic or financial conditions
are more likely to lead to increased investment risk than for obligations in
other categories.
"BB," "B," "CCC," "CC," and "C" - Obligations are assigned one of
these ratings where it is considered that speculative characteristics are
present. "BB" represents the lowest degree of speculation and indicates a
possibility of investment risk developing. "C" represents the highest degree of
speculation and indicates that the obligations are currently in default.
IBCA may append a rating of plus (+) or minus (-) to a rating to
denote relative status within major rating categories.
Thomson BankWatch assesses the likelihood of an untimely repayment of
principal or interest over the term to maturity of long term debt and preferred
stock which are issued by United States commercial banks, thrifts and non-bank
banks; non-United States banks; and broker-dealers. The following summarizes the
rating categories used by Thomson BankWatch for long-term debt ratings:
"AAA" - This designation represents the highest category assigned by
Thomson BankWatch to long-term debt and indicates that the ability to repay
principal and interest on a timely basis is extremely high.
"AA" - This designation indicates a very strong ability to repay
principal and interest on a timely basis with limited incremental risk compared
to issues rated in the highest category.
"A" - This designation indicates that the ability to repay principal
and interest is strong. Issues rated "A" could be more vulnerable to adverse
developments (both internal and external) than obligations with higher ratings.
"BBB" - This designation represents Thomson BankWatch's lowest
investment grade category and indicates an acceptable capacity to repay
principal and interest. Issues rated "BBB" are, however, more vulnerable to
adverse developments (both internal and external) than obligations with higher
ratings.
A-10
<PAGE>
"BB," "B," "CCC," and "CC," - These designations are assigned by
Thomson BankWatch to non-investment grade long-term debt. Such issues are
regarded as having speculative characteristics regarding the likelihood of
timely payment of principal and interest. "BB" indicates the lowest degree of
speculation and "CC" the highest degree of speculation.
"D" - This designation indicates that the long-term debt is in
default.
PLUS (+) OR MINUS (-) - The ratings from "AAA" through "CC" may
include a plus or minus sign designation which indicates where within the
respective category the issue is placed.
MUNICIPAL NOTE RATINGS
- ----------------------
A Standard and Poor's rating reflects the liquidity concerns and
market access risks unique to notes due in three years or less. The following
summarizes the ratings used by Standard & Poor's Ratings Group for municipal
notes:
"SP-1" - The issuers of these municipal notes exhibit very strong or
strong capacity to pay principal and interest. Those issues determined to
possess overwhelming safety characteristics are given a plus (+) designation.
"SP-2" - The issuers of these municipal notes exhibit satisfactory
capacity to pay principal and interest.
"SP-3" - The issuers of these municipal notes exhibit speculative
capacity to pay principal and interest.
Moody's ratings for state and municipal notes and other short-term
loans are designated Moody's Investment Grade ("MIG") and variable rate demand
obligations are designated Variable Moody's Investment Grade ("VMIG"). Such
ratings recognize the differences between short-term credit risk and long-term
risk. The following summarizes the ratings by Moody's Investors Service, Inc.
for short-term notes:
"MIG-1"/"VMIG-1" - Loans bearing this designation are of the best
quality, enjoying strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the market for
refinancing.
"MIG-2"/"VMIG-2" - Loans bearing this designation are of high quality,
with margins of protection ample although not so large as in the preceding
group.
"MIG-3"/"VMIG-3" - Loans bearing this designation are of favorable
quality, with all security elements accounted for
A-11
<PAGE>
but lacking the undeniable strength of the preceding grades. Liquidity and cash
flow protection may be narrow and market access for refinancing is likely to be
less well established.
"MIG-4"/"VMIG-4" - Loans bearing this designation are of adequate
quality, carrying specific risk but having protection commonly regarded as
required of an investment security and not distinctly or predominantly
speculative.
"SG" - Loans bearing this designation are of speculative quality and
lack margins of protection.
Fitch and Duff & Phelps use the short-term ratings described under
Commercial Paper Ratings for municipal notes.
A-12
<PAGE>
APPENDIX B
----------
As stated in the Prospectuses, certain Portfolios of the Fund may
enter into certain futures transactions. Such transactions are described in this
Appendix.
I. Interest Rate Futures Contracts
-------------------------------
Use of Interest Rate Futures Contracts. Bond prices are established in
--------------------------------------
both the cash market and the futures market. In the cash market, bonds are
purchased and sold with payment for the full purchase price of the bond being
made in cash, generally within five business days after the trade. In the
futures market, only a contract is made to purchase or sell a bond in the future
for a set price on a certain date. Historically, the prices for bonds
established in the futures markets have tended to move generally in the
aggregate in concert with the cash market prices and have maintained fairly
predictable relationships. Accordingly, a Portfolio may use interest rate
futures contracts as a defense, or hedge, against anticipated interest rate
changes and not for speculation. As described below, this would include the use
of futures contract sales to protect against expected increases in interest
rates and futures contract purchases to offset the impact of interest rate
declines.
A Portfolio could accomplish a similar result to that which it hopes
to achieve through the use of futures contracts by selling bonds with long
maturities and investing in bonds with short maturities when interest rates are
expected to increase, or conversely, selling short-term bonds and investing in
long-term bonds when interest rates are expected to decline. However, because of
the liquidity that is often available in the futures market, the protection is
more likely to be achieved, perhaps at a lower cost and without changing the
rate of interest being earned by the Portfolio, by using futures contracts.
Description of Interest Rate Futures Contracts. An interest rate
----------------------------------------------
futures contract sale would create an obligation by a Portfolio, as seller, to
deliver the specific type of financial instrument called for in the contract at
a specific future time for a specified price. A futures contract purchase would
create an obligation by a Portfolio, as purchaser, to take delivery of the
specific type of financial instrument at a specific future time at a specific
price. The specific securities delivered or taken, respectively, at settlement
date, would not be determined until at or near that date. The determination
would be in accordance with the rules of the exchange on which the futures
contract sale or purchase was made.
B-1
<PAGE>
Although interest rate futures contracts by their terms call for
actual delivery or acceptance of securities, in most cases the contracts are
closed out before the settlement date without the making or taking of delivery
of securities. Closing out a futures contract sale is effected by the Portfolio
entering into a futures contract purchase for the same aggregate amount of the
specific type of financial instrument and the same delivery date. If the price
of the sale exceeds the price of the offsetting purchase, the Portfolio is
immediately paid the difference and thus realizes a gain. If the offsetting
purchase price exceeds the sale price, the Portfolio pays the difference and
realizes a loss. Similarly, the closing out of a futures contract purchase is
effected by the Portfolio entering into a futures contract sale. If the
offsetting sale price exceeds the purchase price, the Portfolio realizes a gain,
and if the purchase price exceeds the offsetting sale price, the Portfolio
realizes a loss.
Interest rate futures contracts are traded in an auction environment
on the floors of several exchanges -- principally, the Chicago Board of Trade,
the Chicago Mercantile Exchange and the New York Futures Exchange. Each exchange
guarantees performance under contract provisions through a clearing corporation,
a nonprofit organization managed by the exchange membership.
A public market now exists in futures contracts covering various
financial instruments including long-term U.S. Treasury Bonds and Notes;
Government National Mortgage Association (GNMA) modified pass-through mortgage
backed securities; three-month U.S. Treasury Bills; and ninety-day commercial
paper. The Portfolios may trade in any interest rate futures contracts for which
there exists a public market, including, without limitation, the foregoing
instruments.
With regard to each Portfolio, the Adviser also anticipates engaging
in transactions, from time to time, in foreign stock index futures such as the
ALL-ORDS (Australia), CAC-40 (France), TOPIX (Japan) and the FTSE-100 (United
Kingdom).
II. Index Futures Contracts
-----------------------
General. A stock or bond index assigns relative values to the stocks
-------
or bonds included in the index, which fluctuates with changes in the market
values of the stocks or bonds included. Some stock index futures contracts are
based on broad market indexes, such as Standard & Poor's 500 or the New York
Stock Exchange Composite Index. In contrast, certain exchanges offer futures
contracts on narrower market indexes, such as the Standard & Poor's 100 or
indexes based on an industry or market indexes, such as Standard & Poor's 100 or
indexes based on an industry or market segment, such as oil and gas stocks.
Futures
B-2
<PAGE>
contracts are traded on organized exchanges regulated by the Commodity Futures
Trading Commission. Transactions on such exchanges are cleared through a
clearing corporation, which guarantees the performance of the parties to each
contract. With regard to each Portfolio, to the extent consistent with its
investment objective, the Adviser anticipates engaging in transactions, from
time to time, in foreign stock index futures such as the ALL-ORDS (Australia),
CAC-40 (France), TOPIX (Japan) and the FTSE-100 (United Kingdom).
A Portfolio may sell index futures contracts in order to offset a
decrease in market value of its portfolio securities that might otherwise result
from a market decline. A Portfolio may do so either to hedge the value of its
portfolio as a whole, or to protect against declines, occurring prior to sales
of securities, in the value of the securities to be sold. Conversely, a
Portfolio may purchase index futures contracts in anticipation of purchases of
securities. A long futures position may be terminated without a corresponding
purchase of securities.
In addition, a Portfolio may utilize index futures contracts in
anticipation of changes in the composition of its portfolio holdings. For
example, in the event that a Portfolio expects to narrow the range of industry
groups represented in its holdings it may, prior to making purchases of the
actual securities, establish a long futures position based on a more restricted
index, such as an index comprised of securities of a particular industry group.
A Portfolio may also sell futures contracts in connection with this strategy, in
order to protect against the possibility that the value of the securities to be
sold as part of the restructuring of the portfolio will decline prior to the
time of sale.
III. Futures Contracts on Foreign Currencies
---------------------------------------
A futures contract on foreign currency creates a binding obligation on
one party to deliver, and a corresponding obligation on another party to accept
delivery of, a stated quantity of foreign currency, for an amount fixed in U.S.
dollars (or another currency). Foreign currency futures may be used by a
Portfolio to hedge against exposure to fluctuations in exchange rates between
different currencies arising from multinational transactions.
IV. Margin Payments
---------------
Unlike purchase or sales of portfolio securities, no price is paid or
received by a Portfolio upon the purchase or sale of a futures contract.
Initially, a Portfolio will be required to deposit with the broker or in a
segregated account with a custodian an amount of liquid assets known as initial
margin, based on the value of the contract. The nature of
B-3
<PAGE>
initial margin in futures transactions is different from that of margin in
security transactions in that futures contract margin does not involve the
borrowing of funds by the customer to finance the transactions. Rather, the
initial margin is in the nature of a performance bond or good faith deposit on
the contract which is returned to the Portfolio upon termination of the futures
contract assuming all contractual obligations have been satisfied. Subsequent
payments, called variation margin, to and from the broker, will be made on a
daily basis as the price of the underlying instruments fluctuates making the
long and short positions in the futures contract more or less valuable, a
process known as marking-to-the-market. For example, when a particular Portfolio
has purchased a futures contract and the price of the contract has risen in
response to a rise in the underlying instruments, that position will have
increased in value and the Portfolio will be entitled to receive from the broker
a variation margin payment equal to that increase in value. Conversely, where
the Portfolio has purchased a futures contract and the price of the future
contract has declined in response to a decrease in the underlying instruments,
the position would be less valuable and the Portfolio would be required to make
a variation margin payment to the broker. Prior to expiration of the futures
contract, the Adviser may elect to close the position by taking an opposite
position, subject to the availability of a secondary market, which will operate
to terminate the Portfolio's position in the futures contract. A final
determination of variation margin is then made, additional cash is required to
be paid by or released to the Portfolio, and the Portfolio realizes a loss or
gain.
V. Risks of Transactions in Futures Contracts
------------------------------------------
There are several risks in connection with the use of futures by a
Portfolio as a hedging device. One risk arises because of the imperfect
correlation between movements in the price of the futures and movements in the
price of the instruments which are the subject of a hedge. The price of the
future may move more than or less than the price of the instruments being
hedged. If the price of the futures moves less than the price of the instruments
which are the subject of the hedge, the hedge will not be fully effective but,
if the price of the instruments being hedged has moved in an unfavorable
direction, the Portfolio would be in a better position than if it had not hedged
at all. If the price of the instruments being hedged has moved in a favorable
direction, this advantage will be partially offset by the loss on the futures.
If the price of the futures moves more than the price of the hedged instruments,
the Portfolio involved will experience either a loss or gain on the futures
which will not be completely offset by movements in the price of the instruments
which are the subject of the hedge. To compensate for the imperfect correlation
of movements in the price of instruments being hedged and movements in the price
of
B-4
<PAGE>
futures contracts, a Portfolio may buy or sell futures contracts in a greater
dollar amount than the dollar amount of instruments being hedged if the
volatility over a particular time period of the prices of such instruments has
been greater than the volatility over such time period of the futures, or if
otherwise deemed to be appropriate by the Adviser. Conversely, a Portfolio may
buy or sell fewer futures contracts if the volatility over a particular time
period of the prices of the instruments being hedged is less than the volatility
over such time period of the futures contract being used, or if otherwise deemed
to be appropriate by the Adviser. It is also possible that, where a Portfolio
has sold futures to hedge its portfolio against a decline in the market, the
market may advance and the value of instruments held in the Portfolio may
decline. If this occurred, the Portfolio would lose money on the futures and
also experience a decline in value in its portfolio securities.
When futures are purchased to hedge against a possible increase in the
price of securities or a currency before a Portfolio is able to invest its cash
(or cash equivalents) in an orderly fashion, it is possible that the market may
decline instead; if the Portfolio then concludes not to invest its cash at that
time because of concern as to possible further market decline or for other
reasons, the Portfolio will realize a loss on the futures contract that is not
offset by a reduction in the price of the instruments that were to be purchased.
In addition to the possibility that there may be an imperfect
correlation, or no correlation at all, between movements in the futures and the
instruments being hedged, the price of futures may not correlate perfectly with
movement in the cash market due to certain market distortions. Rather than
meeting additional margin deposit requirements, investors may close futures
contracts through off-setting transactions which could distort the normal
relationship between the cash and futures markets. Second, with respect to
financial futures contracts, the liquidity of the futures market depends on
participants entering into off-setting transactions rather than making or taking
delivery. To the extent participants decide to make or take delivery, liquidity
in the futures market could be reduced thus producing distortions. Third, from
the point of view of speculators, the deposit requirements in the futures market
are less onerous than margin requirements in the securities market. Therefore,
increased participation by speculators in the futures market may also cause
temporary price distortions. Due to the possibility of price distortion in the
futures market, and because of the imperfect correlation between the movements
in the cash market and movements in the price of futures, a correct forecast of
general market trends or interest rate movements by the adviser may still not
result in a successful hedging transaction over a short time frame.
B-5
<PAGE>
Positions in futures may be closed out only on an exchange or board of
trade which provides a secondary market for such futures. Although the
Portfolios intend to purchase or sell futures only on exchanges or boards of
trade where there appear to be active secondary markets, there is no assurance
that a liquid secondary market on any exchange or board of trade will exist for
any particular contract or at any particular time. In such event, it may not be
possible to close a futures investment position, and in the event of adverse
price movements, a Portfolio would continue to be required to make daily cash
payments of variation margin. However, in the event futures contracts have been
used to hedge portfolio securities, such securities will not be sold until the
futures contract can be terminated. In such circumstances, an increase in the
price of the securities, if any, may partially or completely offset losses on
the futures contract. However, as described above, there is no guarantee that
the price of the securities will in fact correlate with the price movements in
the futures contract and thus provide an offset on a futures contract.
Further, it should be noted that the liquidity of a secondary market
in a futures contract may be adversely affected by "daily price fluctuation
limits" established by commodity exchanges which limit the amount of fluctuation
in a futures contract price during a single trading day. Once the daily limit
has been reached in the contract, no trades may be entered into at a price
beyond the limit, thus preventing the liquidation of open futures positions. The
trading of futures contracts is also subject to the risk of trading halts,
suspensions, exchange or clearing house equipment failures, government
intervention, insolvency of a brokerage firm or clearing house or other
disruptions of normal activity, which could at times make it difficult or
impossible to liquidate existing positions or to recover excess variation margin
payments.
Successful use of futures by a Portfolio is also subject to the
Adviser's ability to predict correctly movements in the direction of the market.
For example, if a particular Portfolio has hedged against the possibility of a
decline in the market adversely affecting securities held by it and securities
prices increase instead, the Portfolio will lose part or all of the benefit to
the increased value of its securities which it has hedged because it will have
offsetting losses in its futures positions. In addition, in such situations, if
the Portfolio has insufficient cash, it may have to sell securities to meet
daily variation margin requirements. Such sales of securities may be, but will
not necessarily be, at increased prices which reflect the rising market. A
Portfolio may have to sell securities at a time when it may be disadvantageous
to do so.
The risk of loss in trading futures contracts in some strategies can
be substantial, due both to the low margin
B-6
<PAGE>
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 (as well as 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,
before any deduction for the transaction costs, 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.
VI. Options on Futures Contracts
----------------------------
A Portfolio may purchase and write options on the futures contracts
described above. A futures option gives the holder, in return for the premium
paid, the right to buy (call) from or sell (put) to the writer of the option a
futures contract at a specified price at any time during the period of the
option. Upon exercise, the writer of the option is obligated to pay the
difference between the cash value of the futures contract and the exercise
price. Like the buyer or seller of a futures contract, the holder, or writer, of
an option has the right to terminate its position prior to the scheduled
expiration of the option by selling, or purchasing an option of the same series,
at which time the person entering into the closing transaction will realize a
gain or loss. A Portfolio will be required to deposit initial margin and
variation margin with respect to put and call options on futures contracts
written by it pursuant to brokers' requirements similar to those described
above. Net option premiums received will be included as initial margin deposits.
As an example, in anticipation of a decline in interest rates, a Portfolio may
purchase call options on futures contracts as a substitute for the purchase of
futures contracts to hedge against a possible increase in the price of
securities which the Portfolio intends to purchase. Similarly, if the value of
the securities held by a Portfolio is expected to decline as a result of an
increase in interest rates, the Portfolio might purchase put options or sell
call options on futures contracts rather than sell futures contracts.
Investments in futures options involve some of the same considerations
that are involved in connection with investments in futures contracts (for
example, the existence of a liquid secondary market). In addition, the purchase
or sale of an option also entails the risk that changes in the value of the
underlying futures contract will not correspond to changes in the value of the
option purchased. Depending on the pricing of the option compared to either the
futures contract upon which it is
B-7
<PAGE>
based, or upon the price of the securities or currencies being hedged, an option
may or may not be less risky than ownership of the futures contract or such
securities or currencies. In general, the market prices of options can be
expected to be more volatile than the market prices on the underlying futures
contract. Compared to the purchase or sale of futures contracts, however, the
purchase of call or put options on futures contracts may frequently involve less
potential risk to a Portfolio because the maximum amount at risk is the premium
paid for the options (plus transaction costs). The writing of an option on a
futures contract involves risks similar to those risks relating to the sale of
futures contracts.
VII. Other Matters
-------------
Accounting for futures contracts will be in accordance with generally
accepted accounting principles.
B-8
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
BLACKROCK STRATEGIC PORTFOLIO I
BLACKROCK STRATEGIC PORTFOLIO II
This Statement of Additional Information provides supplementary information
pertaining to shares representing interests in BlackRock Strategic Portfolio I
and BlackRock Strategic Portfolio II (the "Portfolios") of BlackRock Funds/SM/
(the "Fund"). This Statement of Additional Information is not a prospectus, and
should be read only in conjunction with the Prospectus of the Fund relating to
the Portfolios dated January 28, 1998, as amended from time to time (the
"Prospectus"). The Prospectus may be obtained from the Fund's distributor by
calling toll-free (800) 441-7379. This Statement of Additional Information is
dated January 28, 1998. Capitalized terms used herein and not otherwise defined
have the same meanings as are given to them in the Prospectus.
CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
THE FUND......................................................... 2
INVESTMENT OBJECTIVE AND POLICIES................................ 2
INVESTMENT RESTRICTIONS.......................................... 15
TRUSTEES AND OFFICERS............................................ 16
INVESTMENT ADVISORY, ADMINISTRATION,
DISTRIBUTION AND SERVICE ARRANGEMENTS............................ 21
PORTFOLIO TRANSACTIONS........................................... 25
PURCHASE AND REDEMPTION INFORMATION.............................. 28
VALUATION OF PORTFOLIO SECURITIES................................ 29
PERFORMANCE INFORMATION.......................................... 30
TAXES............................................................ 34
ADDITIONAL INFORMATION CONCERNING SHARES......................... 38
MISCELLANEOUS.................................................... 39
APPENDIX A....................................................... A-1
APPENDIX B....................................................... B-1
</TABLE>
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS STATEMENT OF ADDITIONAL INFORMATION OR THE
PROSPECTUS IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS AND, IF GIVEN
OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING
BEEN AUTHORIZED BY THE FUND OR ITS DISTRIBUTOR. THE PROSPECTUS DOES NOT
CONSTITUTE AN OFFERING BY THE FUND OR BY THE FUND'S DISTRIBUTOR IN ANY
JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE MADE.
<PAGE>
2
THE FUND
The Fund was organized on December 22, 1988 as a Massachusetts business
trust.
The Fund also offers other investment portfolios which are described in
separate Prospectuses and separate Statements of Additional Information. For
information concerning these other portfolios, contact the Distributor at the
telephone number stated on the cover page of this Statement of Additional
Information.
INVESTMENT OBJECTIVE AND POLICIES
For a description of the objective and policies of the Portfolios, see
"Investment Objective and Policies" in the Prospectus. The following
information is provided for those investors desiring information in addition to
that contained in the Prospectus.
CURRENCY TRANSACTIONS. As discussed in the Prospectus, the Portfolios may
engage in currency transactions with counterparties in order to hedge the value
of portfolio holdings denominated in particular currencies against fluctuations
in relative value or to enhance potential gain. Currency transactions include
spot and forward currency contracts, exchange listed currency futures, exchange
listed and OTC options on currencies, and currency swaps. A forward currency
contract involves a privately negotiated obligation to purchase or sell (with
delivery generally required) a specific currency at a future date, which may be
any fixed number of days from the date of the contract agreed upon by the
parties, at a price set at the time of the contract. Currency swaps usually
involve the delivery of the entire principal value of one designated currency in
exchange for the other designated currency. Because currency swaps usually
involve the delivery of the entire principal value of one designated currency in
exchange for the other designated currency, the entire principal value of a
currency swap is subject to the risk that the other party to the swap will
default on its contractual delivery obligations. A Portfolio may enter into
over-the-counter currency transactions with counterparties which have received,
combined with any credit enhancements, a long-term debt rating of "A" by S&P or
Moody's, respectively, or that have an equivalent rating from a nationally
recognized statistical rating organization ("NRSRO") or (except for OTC currency
options) whose obligations are determined to be of equivalent credit quality by
the Adviser.
A Portfolio may also cross-hedge currencies by entering into transactions
to purchase or sell one or more currencies that are expected to decline in value
in relation to other currencies to which the Portfolio has or in which the
Portfolio expects to have exposure. For example, a Portfolio may hold both
French government bonds and German government bonds, and the Adviser may
<PAGE>
3
believe that French francs will deteriorate against German marks. The Portfolio
would sell French francs to reduce its exposure to that currency and buy German
marks. This strategy would be a hedge against a decline in the value of French
francs, although it would expose the Portfolio to declines in the value of the
German mark relative to the U.S. dollar.
To reduce the effect of currency fluctuations on the value of existing or
anticipated holdings of portfolio securities, the Portfolios may also engage in
proxy hedging. Proxy hedging is often used when the currency to which the
Portfolio is exposed is difficult to hedge or to hedge against the dollar.
Proxy hedging entails entering into a forward contract to sell a currency whose
changes in value are generally considered to be linked to a currency or
currencies in which certain of the Portfolio's securities are or are expected to
be denominated, and to buy U.S. dollars. Proxy hedging involves some of the
same risks and considerations as other transactions with similar instruments.
Currency transactions can result in losses to the Portfolio if the currency
being hedged fluctuates in value to a degree or in a direction that is not
anticipated. Further, there is the risk that the perceived linkage between
various currencies may not be present or may not be present during the
particular time that the Portfolio is engaging in proxy hedging. Whenever a
Portfolio enters into a currency hedging transaction, the Portfolio will comply
with the asset segregation requirements of the SEC.
Currency transactions are subject to risks different from those of other
portfolio transactions. Because currency control is of great importance to the
issuing governments and influences economic planning and policy, purchases and
sales of currency and related instruments can be negatively affected by
government exchange controls, blockages, and manipulations or exchange
restrictions imposed by governments. These can result in losses to a Portfolio
if it is unable to deliver or receive currency or funds in settlement of
obligations, and could also cause hedges it has entered into to be rendered
useless, resulting in full currency exposure as well as incurring transaction
costs. Buyers and sellers of currency futures are subject to the same risks
that apply to the use of futures generally. Further, settlement of a currency
futures contract for the purchase of most currencies must occur at an
institution based in the issuing nation. Trading options on currency futures is
relatively new, and the ability to establish and close out positions on such
options is subject to the maintenance of a liquid market which may not always be
available. Currency exchange rates may fluctuate based on factors extrinsic to
that country's economy.
REVERSE REPURCHASE AGREEMENTS. Each Portfolio may invest in reverse
repurchase agreements. Reverse repurchase agreements involve the sale of
securities held by a Portfolio pursuant to a Portfolio's agreement to repurchase
the securities at an agreed upon price, date and interest rate. Such agreements
are considered to be borrowings under the Investment Company Act of 1940 (the
"1940 Act"). While reverse repurchase transactions are
<PAGE>
4
outstanding, a Portfolio will segregate cash, U.S. Government securities or
other liquid assets in an amount at least equal to the repurchase price.
VARIABLE AND FLOATING RATE INSTRUMENTS. With respect to purchasable
variable and floating rate instruments, the Adviser will consider the earning
power, cash flows and liquidity ratios of the issuers and guarantors of such
instruments and, if the instruments are subject to a demand feature, will
monitor their financial status to meet payment on demand. Such instruments may
include variable amount master demand notes that permit the indebtedness
thereunder to vary in addition to providing for periodic adjustments in the
interest rate. The absence of an active secondary market with respect to
particular variable and floating rate instruments could make it difficult for a
Portfolio to dispose of a variable or floating rate note if the issuer defaulted
on its payment obligation or during periods that the Portfolio is not entitled
to exercise its demand rights, and the Portfolio could, for these or other
reasons, suffer a loss with respect to such instruments.
MONEY MARKET OBLIGATIONS OF DOMESTIC BANKS, FOREIGN BANKS AND FOREIGN
BRANCHES OF U.S. BANKS. Each Portfolio may purchase bank obligations, such as
certificates of deposit, bankers' acceptances and time deposits, including
instruments issued or supported by the credit of U.S. or foreign banks or
savings institutions having total assets at the time of purchase in excess of $1
billion. The assets of a bank or savings institution will be deemed to include
the assets of its domestic and foreign branches for purposes of each Portfolio's
investment policies. Investments in short-term bank obligations may include
obligations of foreign banks and domestic branches of foreign banks, and also
foreign branches of domestic banks.
MORTGAGE-RELATED SECURITIES. There are a number of important differences
among the agencies and instrumentalities of the U.S. Government that issue
mortgage-related securities and among the securities that they issue. Mortgage-
related securities guaranteed by the Government National Mortgage Association
("GNMA") include GNMA Mortgage Pass-Through Certificates (also known as "Ginnie
Maes") which are guaranteed as to the timely payment of principal and interest
by GNMA and such guarantee is backed by the full faith and credit of the United
States. GNMA is a wholly-owned U.S. Government corporation within the
Department of Housing and Urban Development. GNMA certificates also are
supported by the authority of GNMA to borrow funds from the U.S. Treasury to
make payments under its guarantee. Mortgage-related securities issued by the
Federal National Mortgage Association ("FNMA") include FNMA guaranteed Mortgage
Pass-Through Certificates (also known as "Fannie Maes") which are solely the
obligations of the FNMA, are not backed by or entitled to the full faith and
credit of the United States and are supported by the right of the issuer to
borrow from the Treasury. FNMA is a government-sponsored organization owned
entirely by private stockholders. Fannie Maes
<PAGE>
5
are guaranteed as to timely payment of principal and interest by FNMA.
Mortgage-related securities issued by the Federal Home Loan Mortgage Corporation
("FHLMC") include FHLMC Mortgage Participation Certificates (also known as
"Freddie Macs" or "Pcs"). FHLMC is a corporate instrumentality of the United
States, created pursuant to an Act of Congress, which is owned entirely by
Federal Home Loan Banks. Freddie Macs are not guaranteed by the United States
or by any Federal Home Loan Banks and do not constitute a debt or obligation of
the United States or of any Federal Home Loan Bank. Freddie Macs entitle the
holder to timely payment of interest, which is guaranteed by the FHLMC. FHLMC
guarantees either ultimate collection or timely payment of all principal
payments on the underlying mortgage loans. When FHLMC does not guarantee timely
payment of principal, FHLMC may remit the amount due on account of its guarantee
of ultimate payment of principal at any time after default on an underlying
mortgage, but in no event later than one year after it becomes payable.
The Portfolios may invest in multiple class pass-through securities,
including collateralized mortgage obligations ("CMOs") and real estate mortgage
investment conduit ("REMIC") pass-through or participation certificates ("REMIC
Certificates"). These multiple class securities may be issued by U.S.
Government agencies or instrumentalities, including FNMA and FHLMC, or by trusts
formed by private originators of, or investors in, mortgage loans. In general,
CMOs and REMICs are debt obligations of a legal entity that are collateralized
by, and multiple class pass-through securities represent direct ownership
interests in, a pool of residential or commercial mortgage loans or mortgage
pass-through securities (the "Mortgage Assets"), the payments on which are used
to make payments on the CMOs or multiple pass-through securities. Investors may
purchase beneficial interests in CMOs and REMICs, which are known as "regular"
interests or "residual" interests. The Portfolios do not intend to purchase
residual interests. The markets for CMOs and REMICs may be more illiquid than
those of other securities.
Each class of CMOs or REMIC Certificates, often referred to as a "tranche,"
is issued at a specific adjustable or fixed interest rate and must be fully
retired no later than its final distribution date. Principal prepayments on the
Mortgage Assets underlying the CMOs or REMIC Certificates may cause some or all
of the classes of CMOs or REMIC Certificates to be retired substantially earlier
than their final distribution dates. Generally, interest is paid or accrues on
all classes of CMOs or REMIC Certificates on a monthly basis.
The principal of and interest on the Mortgage Assets may be allocated among
the several classes of CMOs or REMIC Certificates in various ways. In certain
structures (known as "sequential pay" CMOs or REMIC Certificates), payments of
principal, including any principal prepayments, on the Mortgage Assets generally
are applied to the classes of CMOs or REMIC Certificates in the order of their
respective final distribution dates. Thus no payment of principal will be made
on any class of
<PAGE>
6
sequential pay CMOs or REMIC Certificates until all other classes having an
earlier final distribution date have been paid in full.
Additional structures of CMOs or REMIC Certificates include, among others,
"parallel pay" CMOs and REMIC Certificates. Parallel pay CMOs or REMIC
Certificates are those which are structured to apply principal payments and
prepayments of the Mortgage Assets to two or more classes concurrently on a
proportionate or disproportionate basis. These simultaneous payments are taken
into account in calculating the final distribution date of each class.
A wide variety of REMIC Certificates may be issued in the parallel pay or
sequential pay structures. These securities include accrual certificates (also
known as "Z-Bonds"), which only accrue interest at a specified rate until all
other certificates having an earlier final distribution date have been retired
and are converted thereafter to an interest-paying security, and planned
amortization class ("PAC") certificates, which are parallel pay REMIC
Certificates which generally require that specified amounts of principal be
applied on each payment date to one or more classes of REMIC Certificates (the
"PAC Certificates"), even though all other principal payments and prepayments of
the Mortgage Assets are then required to be applied to one or more other classes
of the Certificates. The scheduled principal payments for the PAC Certificates
generally have the highest priority on each payment date after interest due has
been paid to all classes entitled to receive interest currently. Shortfalls, if
any, are added to the amount payable on the next payment date. The PAC
Certificate payment schedule is taken into account in calculating the final
distribution date of each class of PAC. In order to create PAC tranches, one or
more tranches generally must be created that absorb most of the volatility in
the underlying Mortgage Assets. These tranches tend to have market prices and
yields that are much more volatile than the PAC classes.
FNMA REMIC Certificates are issued and guaranteed as to timely distribution
of principal and interest by FNMA. In addition, FNMA will be obligated to
distribute on a timely basis to holders of FNMA REMIC Certificates required
installments of principal and interest and to distribute the principal balance
of each class of REMIC Certificates in full, whether or not sufficient funds are
otherwise available.
For FHLMC REMIC Certificates, FHLMC guarantees the timely payment of
interest, and also guarantees the ultimate payment of principal as payments are
required to be made on the underlying Pcs. Pcs represent undivided interests in
specified level payment, residential mortgages or participation therein
purchased by FHLMC and placed in a Pc pool. With respect to principal payments
on Pcs, FHLMC generally guarantees ultimate collection of all principal of the
related mortgage loans without offset or deduction. FHLMC also guarantees
timely payment of principal on certain Pcs, referred to as "Gold Pcs."
<PAGE>
7
The average life of a mortgage-related instrument, in particular, is likely
to be substantially less than the original maturity of the mortgage pools
underlying the securities as the result of scheduled principal payments and
mortgage prepayments.
ASSET-BACKED SECURITIES. Asset-backed securities are generally issued as
pass-through certificates, which represent undivided fractional ownership
interests in an underlying pool of assets, or as debt instruments, which are
also known as collateralized obligations, and are generally issued as the debt
of a special purpose entity organized solely for the purpose of owning such
assets and issuing such debt. Asset-backed securities are often backed by a
pool of assets representing the obligations of a number of different parties.
The yield characteristics of asset-backed securities differ from
traditional debt securities. A major difference is that the principal amount of
the obligations may be prepaid at any time because the underlying assets (i.e.,
----
loans) generally may be prepaid at any time. As a result, if an asset-backed
security is purchased at a premium, a prepayment rate that is faster than
expected may reduce yield to maturity, while a prepayment rate that is slower
than expected may have the opposite effect of increasing yield to maturity.
Conversely, if an asset-backed security is purchased at a discount, faster than
expected prepayments may increase, while slower than expected prepayments may
decrease, yield to maturity. The relationship between prepayments and interest
rates may give some high-yielding asset-backed securities less potential for
growth in value than conventional bonds with comparable maturities.
In general, the collateral supporting non-mortgage asset-backed securities
is of shorter maturity than mortgage-related securities. Like other fixed-
income securities, when interest rates rise the value of an asset-backed
security generally will decline; however, when interest rates decline, the value
of an asset-backed security with prepayment features may not increase as much as
that of other fixed-income securities.
U.S. GOVERNMENT OBLIGATIONS. Examples of the types of U.S. Government
obligations which the Portfolios may hold include U.S. Treasury bills, Treasury
instruments and Treasury bonds and the obligations of Federal Home Loan Banks,
Federal Farm Credit Banks, Federal Land Banks, the Federal Housing
Administration, the Farmers Home Administration, the Export-Import Bank of the
United States, the Small Business Administration, FNMA, GNMA, the General
Services Administration, the Student Loan Marketing Association, the Central
Bank for Cooperatives, FHLMC, the Federal Intermediate Credit Banks, the
Maritime Administration, the International Bank for Reconstruction and
Development (the "World Bank"), the Asian-American Development Bank and the
Inter-American Development Bank.
SUPRANATIONAL ORGANIZATION OBLIGATIONS. The Portfolios may purchase debt
securities of supranational organizations such as
<PAGE>
8
the European Coal and Steel Community, the European Economic Community and the
World Bank, which are charted to promote economic development.
MUNICIPAL OBLIGATIONS. When deemed advisable by the Adviser, the
Portfolios may invest in obligations issued by a state or local government
("Municipal Obligations"). The two principal classifications of Municipal
Obligations are "general obligation" securities and "revenue" securities.
General obligation securities are secured by the issuer's pledge of its full
faith, credit and taxing power for the payment of principal and interest.
Revenue securities are payable only from the revenues derived from a particular
facility or class of facilities or, in some cases, from the proceeds of a
special excise tax or other specific revenue source such as the user of the
facility being financed. Revenue securities include private activity bonds
which are not payable from the unrestricted revenues of the issuer.
Consequently, the credit quality of private activity bonds is usually
directly related to the credit standing of the corporate user of the facility
involved. Municipal Obligations may also include "moral obligation" bonds,
which are normally issued by special purpose public authorities. If the issuer
of moral obligation bonds is unable to meet its debt service obligations from
current revenues, it may draw on a reserve fund the restoration of which is a
moral commitment but not a legal obligation of the state or municipality which
created the issuer.
The Portfolios may hold participation certificates in a lease, an
installment purchase contract, or a conditional sales contract ("lease
obligations"). In determining whether a lease obligation is liquid, the Adviser
will consider, among other factors, the following: (i) whether the lease can be
cancelled; (ii) the degree of assurance that assets represented by the lease
could be sold; (iii) the strength of the lessee's general credit (e.g., its
debt, administrative, economic, and financial characteristics); (iv) the
likelihood that the municipality would discontinue appropriating funding for the
leased property because the property is no longer deemed essential to the
operations of the municipality (e.g., the potential for an "event of
nonappropriation"); (v) legal recourse in the event of failure to appropriate;
(vi) whether the security is backed by a credit enhancement such as insurance;
and (vii) any limitations which are imposed on the lease obligor's ability to
utilize substitute property or services other than those covered by the lease
obligation.
Municipal leases, like other municipal debt obligations, are subject to the
risk of non-payment. The ability of issuers of municipal leases to make timely
lease payments may be adversely impacted in general economic downturns and as
relative governmental cost burdens are allocated and reallocated among federal,
state and local governmental units. Such non-payment would result in a
reduction of income to a Portfolio, and could
<PAGE>
9
result in a reduction in the value of the municipal lease experiencing non-
payment and a potential decrease in the net asset value of the Portfolio.
Issuers of municipal securities might seek protection under the bankruptcy laws.
In the event of bankruptcy of such an issuer, a Portfolio could experience
delays and limitations with respect to the collection of principal and interest
on such municipal leases and a Portfolio may not, in all circumstances, be able
to collect all principal and interest to which it is entitled. To enforce its
rights in the event of a default in lease payments, a Portfolio may take
possession of and manage the assets securing the issuer's obligations on such
securities, which may increase a Portfolio's operating expenses and adversely
affect the net asset value of the Portfolio. When the lease contains a non-
appropriation clause, however, the failure to pay would not be a default and the
Portfolio would not have the right to take possession of the assets. In
addition, a Portfolio's intention to qualify as a "regulated investment company"
under the Internal Revenue Code of 1986, as amended, may limit the extent to
which a Portfolio may exercise its rights by taking possession of such assets,
because as a regulated investment company a Portfolio is subject to certain
limitations on its investments and on the nature of its income.
COMMERCIAL PAPER. The Portfolios may purchase commercial paper rated in
one of the highest rating categories of an NRSRO. These ratings symbols are
described in Appendix A.
Commercial paper purchasable by each Portfolio includes "Section 4(2)
paper," a term that includes debt obligations issued in reliance on the "private
placement" exemption from registration afforded by Section 4(2) of the
Securities Act of 1933. Section 4(2) paper is restricted as to disposition
under the Federal securities laws, and is frequently sold (and resold) to
institutional investors such as the Portfolios through or with the assistance of
investment dealers who make a market in the Section 4(2) paper, thereby
providing liquidity. Certain transactions in Section 4(2) paper may qualify for
the registration exemption provided in Rule 144A under the Securities Act of
1933.
REPURCHASE AGREEMENTS. Each Portfolio may invest in repurchase agreements.
The repurchase price under the repurchase agreements described in the Prospectus
generally equals the price paid by a Portfolio involved plus interest negotiated
on the basis of current short-term rates (which may be more or less than the
rate on securities underlying the repurchase agreement). The financial
institutions with which a Portfolio may enter into repurchase agreements will be
banks and non-bank dealers of U.S. Government securities that are listed on the
Federal Reserve Bank of New York's list of reporting dealers, if such banks and
non-bank dealers are deemed creditworthy by the Adviser. The Adviser will
continue to monitor creditworthiness of the seller under a repurchase agreement,
and will require the seller to maintain during the term of the agreement the
value of the securities subject to the agreement at not less than the
<PAGE>
10
repurchase price (including accrued interest). In addition, the Adviser will
require that the value of this collateral, after transaction costs (including
loss of interest) reasonably expected to be incurred on a default, be equal to
or greater than the repurchase price (including accrued premium provided in the
repurchase agreement). The accrued premium is the amount specified in the
repurchase agreement or the daily amortization of the difference between the
purchase price and the repurchase price specified in the repurchase agreement.
The Adviser will mark-to-market daily the value of the securities. Securities
subject to repurchase agreements will be held by the Portfolios' custodian (or
sub-custodian) in the Federal Reserve/Treasury book-entry system or by another
authorized securities depository. Repurchase agreements are considered to be
loans by the Portfolios under the 1940 Act.
The use of repurchase agreements involves certain risks. For example, if
the seller of securities under a repurchase agreement defaults on its obligation
to repurchase the underlying securities, as a result of its bankruptcy or
otherwise, the Portfolio will seek to dispose of such securities, which action
could involve costs or delays. If the seller becomes insolvent and subject to
liquidation or reorganization under applicable bankruptcy or other laws, a
Portfolio's ability to dispose of the underlying securities may be restricted.
Finally, it is possible that a Portfolio may not be able to substantiate its
interest in the underlying securities. To minimize this risk, the securities
underlying the repurchase agreement will be held by the custodian at all times
in an amount at least equal to the repurchase price, including accrued interest.
If the seller fails to repurchase the securities, a Portfolio may suffer a loss
to the extent proceeds from the sale of the underlying securities are less than
the repurchase price.
INVESTMENT GRADE DEBT OBLIGATIONS. The Portfolios invest in "investment
grade securities," which are securities rated in the four highest rating
categories of an NRSRO. It should be noted that debt obligations rated in the
lowest of the top four ratings (i.e., "Baa" by Moody's or "BBB" by S&P) are
considered to have some speculative characteristics and are more sensitive to
economic change than higher rated securities. See Appendix A to this Statement
of Additional Information for a description of applicable securities ratings.
BRADY BONDS. Each of the Portfolios may invest in Brady Bonds. Brady
Bonds are securities created through the exchange of existing commercial bank
loans to sovereign entities for new obligations in connection with debt
restructuring under a debt restructuring plan introduced by former U.S.
Secretary of the Treasury, Nicholas F. Brady. Brady Bonds may be collateralized
or uncollateralized, are issued in various currencies (but primarily the U.S.
dollar), and are actively traded in the over-the-counter secondary market.
Brady Bonds are not considered to be U.S. Government obligations. There can be
no assurance that Brady Bonds acquired by a Portfolio will not be
<PAGE>
11
subject to restructuring arrangements or to requests for new credit, which may
cause the Portfolio to suffer a loss of interest or principal on any of its
holdings.
WHEN-ISSUED PURCHASES AND FORWARD COMMITMENTS. The Portfolios may enter
into "when-issued" and "forward" commitments, including "TBA" (to be announced)
purchase commitments, to purchase or sell securities at a fixed price at a
future date. When a Portfolio agrees to purchase securities on a when-issued or
forward commitment basis, the custodian will set aside liquid assets equal to
the amount of the commitment in a separate account. Normally, the custodian
will set aside portfolio securities to satisfy a purchase commitment, and in
such a case the Portfolio may be required subsequently to place additional
assets in the separate account in order to ensure that the value of the account
remains equal to the amount of the Portfolio commitments. It may be expected
that the market value of the Portfolios' net assets will fluctuate to a greater
degree when it sets aside portfolio securities to cover such purchase
commitments than when it sets aside cash. A Portfolio's liquidity and ability
to manage its portfolio might be affected when it sets aside cash or portfolio
securities to cover such purchase commitments.
If deemed advisable as a matter of investment strategy, a Portfolio may
dispose of or renegotiate a commitment after it has been entered into, and may
sell securities it has committed to purchase before those securities are
delivered to the Portfolio on the settlement date. In these cases the Portfolio
may realize a taxable capital gain or loss.
When a Portfolio engages in when-issued, TBA and forward commitment
transactions, it relies on the other party to consummate the trade. Failure of
such party to do so may result in the Portfolio's incurring a loss or missing an
opportunity to obtain a price considered to be advantageous.
The market value of the securities underlying a commitment to purchase
securities, and any subsequent fluctuations in their market value, is taken into
account when determining the market value of a Portfolio starting on the day the
Portfolio agrees to purchase the securities. The Portfolio does not earn
interest on the securities it has committed to purchase until they are paid for
and delivered on the settlement date.
OPTIONS. Options trading is a highly specialized activity which entails
greater than ordinary investment risks. Options on particular securities may be
more volatile than the underlying securities, and therefore, on a percentage
basis, an investment in the underlying securities themselves. A Portfolio will
write call options only if they are "covered." In the case of a call option on
a security, the option is "covered" if a Portfolio owns the security underlying
the call or has an absolute and immediate right to acquire that security without
additional cash consideration (or, if additional cash consideration is required,
<PAGE>
12
liquid assets in such amount are segregated by its custodian) upon conversion or
exchange of other securities held by it. For a call option on an index, the
option is covered if a Portfolio maintains with its custodian liquid assets
equal to the contract value. A call option is also covered if a Portfolio holds
a call on the same security or index as the call written where the exercise
price of the call held is (i) equal to or less than the exercise price of the
call written, or (ii) greater than the exercise price of the call written
provided the Portfolio segregates liquid assets in the amount of the difference.
When a Portfolio purchases a put option, the premium paid by it is recorded
as an asset of the Portfolio. When a Portfolio writes an option, an amount
equal to the net premium (the premium less the commission) received by the
Portfolio is included in the liability section of the Portfolio's statement of
assets and liabilities as a deferred credit. The amount of this asset or
deferred credit will be subsequently marked-to-market to reflect the current
value of the option purchased or written. The current value of the traded
option is the last sale price or, in the absence of a sale, the mean between the
last bid and asked prices. If an option purchased by a Portfolio expires
unexercised the Portfolio realizes a loss equal to the premium paid. If the
Portfolio enters into a closing sale transaction on an option purchased by it,
the Portfolio will realize a gain if the premium received by the Portfolio on
the closing transaction is more than the premium paid to purchase the option, or
a loss if it is less. If an option written by a Portfolio expires on the
stipulated expiration date or if the Portfolio enters into a closing purchase
transaction, it will realize a gain (or loss if the cost of a closing purchase
transaction exceeds the net premium received when the option is sold) and the
deferred credit related to such option will be eliminated. If an option written
by a Portfolio is exercised, the proceeds of the sale will be increased by the
net premium originally received and the Portfolio will realize a gain or loss.
There are several risks associated with transactions in options on
securities and indexes. For example, there are significant differences between
the securities (or currencies) and options markets that could result in an
imperfect correlation between these markets, causing a given transaction not to
achieve its objectives. In addition, a liquid secondary market for particular
options, whether traded over-the-counter or on a national securities exchange
("Exchange"), may be absent for reasons which include the following: there may
be insufficient trading interest in certain options; restrictions may be imposed
by an Exchange on opening transactions or closing transactions or both; trading
halts, suspensions or other restrictions may be imposed with respect to
particular classes or series of options or underlying securities; unusual or
unforeseen circumstances may interrupt normal operations on an Exchange; the
facilities of an Exchange or the Options Clearing Corporation may not at all
times be adequate to handle current trading volume; or one or more Exchanges
could, for economic or other reasons, decide or be
<PAGE>
13
compelled at some future date to discontinue the trading of options (or a
particular class or series of options), in which event the secondary market on
that Exchange (or in that class or series of options) would cease to exist,
although outstanding options that had been issued by the Options Clearing
Corporation as a result of trades on that Exchange would continue to be
exercisable in accordance with their terms.
FUTURES CONTRACTS AND RELATED OPTIONS. Each Portfolio may invest in
futures contracts and options thereon. These instruments are described in
Appendix B to this Statement of Additional Information.
SECURITIES LENDING. A Portfolio would continue to accrue interest on
loaned securities and would also earn income on investment collateral for such
loans. Any cash collateral received by a Portfolio in connection with such
loans may be invested in a broad range of high quality, U.S. dollar-denominated
money market instruments that meet Rule 2a-7 restrictions for money market
funds. Specifically, cash collateral may be invested in any of the following
instruments: (a) securities issued or guaranteed as to principal and interest by
the U.S. Government or by its agencies or instrumentalities and related
custodial receipts; (b) "first tier" quality commercial paper and other
obligations issued or guaranteed by U.S. and foreign corporations and other
issuers rated (at the time of purchase) in the highest rating category by at
least two NRSRO's, or one if only rated by one NRSRO; (c) U.S. dollar-
denominated obligations issued or supported by the credit of U.S. or foreign
banks or savings institutions with total assets in excess of $1 billion
(including obligations of foreign branches of such banks) (i.e. CD's, BA's and
time deposits); (d) repurchase agreements relating to the above instruments, as
well as corporate debt; and (e) unaffiliated money market funds. Any such
investments must be rated "first tier" and must have a maturity of 397 days or
less from the date of purchase.
YIELDS AND RATINGS. The yields on certain obligations are dependent on a
variety of factors, including general market conditions, conditions in the
particular market for the obligation, the financial condition of the issuer, the
size of the offering, the maturity of the obligation and the ratings of the
issue. The ratings of Moody's, Duff & Phelps Credit Co. ("Duff & Phelps"),
Fitch Investor Services, Inc. ("Fitch") and S&P represent their respective
opinions as to the quality of the obligations they undertake to rate. Ratings,
however, are general and are not absolute standards of quality. Consequently,
obligations with the same rating, maturity and interest rate may have different
market prices. Subsequent to its purchase by a Portfolio, a rated security may
cease to be rated. The Adviser will consider such an event in determining
whether the Portfolio should continue to hold the security.
INTEREST RATE TRANSACTIONS. The Portfolios may enter into interest rate
swaps, caps and floors on either an asset-based or
<PAGE>
14
liability-based basis, depending on whether a Portfolio is hedging its assets or
its liabilities. Interest rate swaps involve the exchange by a Portfolio with
another party of their respective commitments to pay or receive interest (e.g.,
an exchange of floating rate payments for fixed rate payments). The purchase of
an interest rate floor entitles the purchaser, to the extent that a specified
index falls below a predetermined interest rate, to receive payments of interest
on a notional principal amount from the party selling such interest rate floor.
The purchase of an interest rate cap entitles the purchaser, to the extent that
a specified index exceeds a predetermined interest rate, to receive payments of
interest on a notional principal amount from the party selling such interest
rate cap.
A Portfolio will usually enter into interest rate swaps on a net basis,
i.e., the two payments streams are netted out, with the Portfolio receiving or
paying, as the case may be, only the net amount of the two payments.
A Portfolio will accrue the net amount of the excess, if any, of its
obligations over its entitlements with respect to each interest rate swap on a
daily basis and will deliver an amount of liquid assets having an aggregate net
asset value at least equal to the accrued excess to a custodian that satisfies
the requirements of the 1940 Act. If the other party to an interest rate swap
defaults, a Portfolio's risk of loss consists of the net amount of interest
payments that the Portfolio is contractually entitled to receive. A Portfolio
may enter into transactions with counterparties which have received, combined
with any credit enhancements, a long-term debt rating of "A" by S&P or Moody's,
respectively, or that have an equivalent rating from an NRSRO or whose
obligations are determined to be of equivalent credit quality by the Adviser.
A Portfolio will enter into interest rate swap, cap and floor transactions
only with institutions deemed the creditworthy by the Adviser. If there is a
default by the other party to such a transaction, a Portfolio will have
contractual remedies pursuant to the agreements related to the transaction. The
swap market has grown substantially in recent years with a large number of banks
and investment banking firms acting both as principals and as agents utilizing
standardized swap documentation. As a result, the swap market has become
relatively liquid. Caps and floors are more recent innovations and,
accordingly, they are less liquid than swaps.
INVESTMENT COMPANIES. Each Portfolio currently intends to limit its
investments so that, as determined immediately after a securities purchase is
made: (i) not more than 5% of the value of its total assets will be invested in
the securities of any one investment company; (ii) not more than 10% of the
value of its total assets will be invested in the aggregate in securities of
investment companies as a group; and (iii) not more than 3% of the outstanding
voting stock of any one investment company will be owned by the Portfolio or by
the Fund as a whole.
<PAGE>
15
INVESTMENT RESTRICTIONS
Each Portfolio is subject to the investment limitations enumerated in this
subsection which may be changed only by a vote of the holders of a majority of
the Portfolio's outstanding shares (as defined below under "Miscellaneous").
Each Portfolio may not:
(1) Purchase any securities which would cause 25% or more of the
value of the Portfolio's total assets at the time of purchase to
be invested in the securities of one or more issuers conducting
their principal business activities in the same industry,
provided that (a) there is no limitation with respect to (i)
instruments issued or guaranteed by the United States, any state,
territory or possession of the United States, the District of
Columbia or any of their authorities, agencies, instrumentalities
or political subdivisions, and (ii) repurchase agreements secured
by the instruments described in clause (i); (b) wholly-owned
finance companies will be considered to be in the industries of
their parents if their activities are primarily related to
financing the activities of the parents; (c) utilities will be
divided according to their services, for example, gas, gas
transmission, electric and gas, electric and telephone will each
be considered a separate industry; and (d) securities issued or
guaranteed by foreign governments are not considered to belong to
a particular industry.
(2) Issue senior securities (including borrowed money, including on
margin if margin securities are owned) in excess of 33 1/3% of
its total assets (including the amount of senior securities
issued but excluding any liabilities and indebtedness not
constituting senior securities) except that the Portfolio may
borrow up to an additional 5% of its total assets for temporary
purposes; or pledge its assets other than to secure such
issuances or in connection with hedging transactions, short
sales, when-issued and forward commitment transactions, dollar
rolls, option and futures transactions, currency transactions and
similar investment strategies. A Portfolio's obligations under
interest rate and currency swaps are not treated as senior
securities.
(3) Makes loans, except that each Portfolio may purchase and hold
debt instruments and enter into repurchase agreements in
accordance with its
<PAGE>
16
investment objective and policies and may lend portfolio
securities.
(4) Act as an underwriter of securities within the meaning of the
Securities Act of 1933 except to the extent that the purchase of
obligations directly from the issuer thereof, or the disposition
of securities, in accordance with the Portfolio's investment
objective, policies and limitations may be deemed to be
underwriting.
(5) Purchase or sell real estate, except that each Portfolio may
purchase securities of issuers which deal in real estate and may
purchase securities which are secured by interests in real
estate.
(6) Purchase or sell commodities except that each Portfolio may, to
the extent appropriate to its investment policies, purchase
securities of companies engaging in whole or in part in such
activities, may engage in currency transactions and may enter
into futures contracts and related options.
TRUSTEES AND OFFICERS
THE FUND
The trustees and executive officers of the Fund, and their business
addresses and principal occupations during the past five years, are:
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
William O. Albertini Trustee Executive Vice President
Bell Atlantic Global Wireless and Chief Financial
1717 Arch Street Officer since August 1997,
29th Floor East Bell Atlantic Global Wireless
Philadelphia, PA 19103 (global wireless communications);
Age: 55 Executive Vice President,
Chief Financial
Officer and Director
from February
1995 - August 1997, Vice
President and
Chief Financial Officer
from January 1991 - February 1995, Bell
Atlantic Corporation (a diversified
telecommunications company); Chairman,
President and Chief Executive Officer
from August 1989 - January 1991, Bell
Atlantic Enterprises International,
Inc.; Director, Groupo Iusacell, S.A.
de C.V. (cellular communications
company) since June 1994;
</TABLE>
<PAGE>
17
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Director, American Waterworks,
Inc. (water utility) since May 1990;
Trustee, The Carl E. & Emily I. Weller
Foundation since October 1991.
Raymond J. Clark/1/ Trustee, Treasurer of Princeton
Office of the Treasurer President and University since 1987;
Princeton University Treasurer Trustee, The Compass
3 New South Building Capital Group of Funds
P.O. Box 35 from 1987 to 1996;
Princeton, New Jersey 08540 Trustee, United-Way
Age: 62 Princeton Area
Communities from 1992-94; Trustee,
Chemical Bank, New Jersey Advisory
Board from 1994 until 1995; Trustee,
Medical Center of Princeton; Trustee,
American Red Cross -Mercer County
Chapter since 1995; and Trustee, United
Way-Greater Mercer County from 1996-
1997.
Robert M. Hernandez Trustee Director since 1991, Vice
USX Corporation Chairman and Chief
600 Grant Street Financial Officer
6105 USX Tower since 1994, Executive
Pittsburgh, PA 15219 Vice President -
Age: 53 Accounting & Finance and
Chief Financial Officer from 1991 to
1994, USX Corporation (a diversified company
principally engaged in energy and steel
businesses); Director and Chairman of
the Executive Committee, ACE Limited
(insurance company); Trustee, Allegheny
University Hospitals, Allegheny General;
and Allegheny Health, Education and
Research Foundation; Director,
Marinette Marine Corporation;
Director, Pittsburgh Baseball, Inc.
from 1994-96; Director, Transtar, Inc.
(transportation company) since 1996;
and Director and Chairman of the Board,
RMI Titanium Company.
Anthony M. Santomero Vice Chairman Deputy Dean from
The Wharton School of the Board 1990 to 1994, Richard
University of Pennsylvania K. Mellon Professor
Room 2344 of Finance since April
Steinberg Hall-Dietrich Hall 1984, Director, Wharton
Philadelphia, PA 19104-6367 Financial Institutions
</TABLE>
____________________
/1/. This trustee may be deemed an "interested person" of the Fund as defined
in the 1940 Act.
<PAGE>
18
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Age: 51 Center, since July 1995, and
Dean's Advisory Council Member
since July 1984, The Wharton
School, University of
Pennsylvania; Associate
Editor, Journal of Banking and
Finance since June 1978;
Associate Editor, Journal of
Economics and Business since
October 1979; Associate
Editor, Journal of Money,
Credit and Banking since
January 1980; Editorial
Advisory Board, Open Economics
Review since November 1990;
Director, The Zweig Fund and
The Zweig Total Return Fund;
Director of Municipal Fund for
California Investors, Inc. and
Municipal Fund for New York
Investors, Inc.
David R. Wilmerding, Jr. Chairman of Chairman, Gee,
One Aldwyn Center the Board Wilmerding & Associates,
Villanova, PA 19085 Inc. (investment
Age: 62 advisers) since
February 1989; Director, Beaver
Management Corporation (land management
company); Managing General Partner,
Chestnut Street Exchange
Fund; Director, Independence Square
Income Securities, Inc.; Director, The
Mutual Fire, Marine and Inland
Insurance Company; Director, U.S.
Retirement Communities, Inc.; Director,
Trustee or Managing General Partner of
a number of investment companies
advised by PIMC and its affiliates.
Karen H. Sabath Assistant President, Compass
BlackRock, Inc. Secretary Capital Group, Inc.
345 Park Avenue since 1995; Managing
New York, NY 10154 Director of BlackRock
Age: 31 Financial Management,
Inc. since 1993; prior to
1993, Vice President of
BlackRock Financial
Management, Inc.
Ellen L. Corson Assistant Vice President and
PFPC Inc. Treasurer Director of Mutual Fund
103 Bellevue Parkway Accounting and Adminis-
Wilmington, DE 19809 tration, PFPC Inc. since
Age: 33 November 1997; Assistant Vice
President, PFPC Inc. from
March 1997 to November 1997; Senior
Accounting Officer, PFPC Inc. from March
1993 to March 1997.
</TABLE>
<PAGE>
19
<TABLE>
<CAPTION>
Principal Occupation
Name and Address Position with Fund During Past Five Years
- ---------------- ------------------ ----------------------
<S> <C> <C>
Brian P. Kindelan Secretary Senior Counsel, PNC Bank Corp.
PNC Bank Corp. since May 1995; Associate,
1600 Market Street Stradley, Ronon, Stevens &
28th Floor Young, LLP from March 1990
Philadelphia, PA 19103 to May 1995.
Age: 38
</TABLE>
The Fund pays trustees who are not affiliated with BlackRock or BlackRock
Distributors, Inc. ("BDI" or "Distributor") $10,000 annually and $275 per
investment portfolio of the Fund for each full meeting of the Board that they
attend. The Fund pays the Chairman and Vice Chairman an additional $10,000 and
$5,000, respectively, for their services in such capacities. Trustees who are
not affiliated with BlackRock or the Distributor are reimbursed for any expenses
incurred in attending meetings of the Board of Trustees or any committee
thereof. No officer, director or employee of BlackRock, any of the Fund's other
advisers or sub-advisers, PFPC Inc. ("PFPC"), BlackRock Distributors, Inc.
("BDI" and, collectively with PFPC and BlackRock, Inc., the "Administrators"),
or PNC Bank, National Association ("PNC Bank" or the "Custodian") currently
receives any compensation from the Fund. As of the date of this Statement of
Additional Information, the trustees and officers of the Fund, as a group, owned
less than 1% of the outstanding shares of each class of each investment
portfolio of the Fund.
[End of Page]
<PAGE>
20
The table below sets forth the compensation actually received from the Fund
Complex of which the Fund is a part by the trustees for the fiscal year ended
September 30, 1997:
<TABLE>
<CAPTION>
Total
Compensation
Pension or from
Retirement Registrant
Benefits Estimated and Fund
Aggregate Accrued as Annual Complex/1/
Name of Person, Compensation Part of Fund Benefits upon Paid to
Position from Registrant Expenses Retirement Trustees
- -------- --------------- -------- ---------- --------
<S> <C> <C> <C> <C>
Anthony M. Santomero, $52,300 N/A N/A (3)/2/ $64,300
Trustee
David R. Wilmerding, $61,050 N/A N/A (3)/2/ $73,050
Jr., Trustee
William O. Albertini, $43,550 N/A N/A (1)/2/ $43,550
Trustee
Raymond J. Clark, $43,550 N/A N/A (1)/2/ $43,550
Trustee
Robert M. Hernandez, $43,550 N/A N/A (1)/2/ $43,550
Trustee
</TABLE>
- -------------------------
1. A Fund Complex means two or more investment companies that hold themselves
out to investors as related companies for purposes of investment and
investor services, or have a common investment adviser or have an
investment adviser that is an affiliated person of the investment adviser
of any of the other investment companies.
2. Total number of investment company boards trustees served on within the
Fund Complex.
<PAGE>
21
SHAREHOLDER AND TRUSTEE LIABILITY. Under Massachusetts law, shareholders
of a business trust may, under certain circumstances, be held personally liable
as partners for the obligations of the trust. However, the Fund's Declaration
of Trust provides that shareholders shall not be subject to any personal
liability in connection with the assets of the Fund for the acts or obligations
of the Fund, and that every note, bond, contract, order or other undertaking
made by the Fund shall contain a provision to the effect that the shareholders
are not personally liable thereunder. The Declaration of Trust provides for
indemnification out of the trust property of any shareholder held personally
liable solely by reason of his being or having been a shareholder and not
because of his acts or omissions or some other reason. The Declaration of Trust
also provides that the Fund shall, upon request, assume the defense of any claim
made against any shareholder for any act or obligation of the Fund, and shall
satisfy any judgment thereon.
The Declaration of Trust further provides that all persons having any claim
against the trustees or Fund shall look solely to the trust property for
payment; that no trustee of the Fund shall be personally liable for or on
account of any contract, debt, tort, claim, damage, judgment or decree arising
out of or connected with the administration or preservation of the trust
property or the conduct of any business of the Fund; and that no trustee shall
be personally liable to any person for any action or failure to act except by
reason of his own bad faith, willful misfeasance, gross negligence or reckless
disregard of his duties as a trustee. With the exception stated, the
Declaration of Trust provides that a trustee is entitled to be indemnified
against all liabilities and expenses reasonably incurred by him in connection
with the defense or disposition of any proceeding in which he may be involved or
with which he may be threatened by reason of his being or having been a trustee,
and that the Fund will indemnify officers, representatives and employees of the
Fund to the same extent that trustees are entitled to indemnification.
INVESTMENT ADVISORY, ADMINISTRATION,
DISTRIBUTION AND SERVICE ARRANGEMENTS
ADVISORY AGREEMENT. The advisory services provided by BlackRock, an
indirect wholly-owned subsidiary of PNC Bank Corp., and the fees received by it
for such services are described in the Prospectus. As stated in the Prospectus,
BlackRock may from time to time voluntarily waive its advisory fees with respect
to the Portfolio and may voluntarily reimburse the Portfolio for expenses.
BlackRock renders advisory services to the Portfolios pursuant to an
Investment Advisory Agreement (the "Advisory Contract"). Under the Advisory
Contract, BlackRock is not liable for any error of judgment or mistake of law or
for any loss suffered by the Fund or the Portfolios in connection with the
<PAGE>
22
performance of the Advisory Contract, except a loss resulting from willful
misfeasance, bad faith or gross negligence on the part of BlackRock in the
performance of its duties or from reckless disregard of its duties and
obligations thereunder. The Advisory Contract is terminable as to a Portfolio
by vote of the Board of Trustees or by the holders of a majority of the
outstanding voting securities of the Portfolio involved, at any time without
penalty, on 60 days' written notice to BlackRock. BlackRock may also terminate
its advisory relationship with respect to either Portfolio on 60 days' written
notice to the Fund. The Advisory Contract terminates automatically in the event
of its assignment.
ADMINISTRATION AGREEMENTS. The Fund has entered into a Co-Administration
Agreement with BlackRock, Inc. and a separate Administration Agreement with PFPC
and BDI (the "Administration Agreements"). PFPC, whose principal offices are
located at 400 Bellevue Parkway, Wilmington, DE 19809 and BDI have agreed to
maintain office facilities for the Fund; furnish the Fund with statistical and
research data, clerical, accounting, and bookkeeping services; provide and
supervise the operation of an automated data processing system to process
purchase and redemption orders; provide information and distribute written
communications to shareholders; handle shareholder problems and calls; research
issues raised by financial intermediaries relating to investments in a
Portfolio's shares; review and provide advice with respect to communications for
a Portfolio's shares; monitor the investor programs that are offered in
connection with a Portfolio's shares; provide oversight and related support
services that are intended to ensure the delivery of quality service to the
holders of the Portfolio's shares; and provide certain other services required
by the Fund.
Under its Co-Administration Agreement, BlackRock, Inc. is responsible for:
(i) the supervision and coordination of the performance of the Fund's service
providers; (ii) the negotiation of service contracts and arrangements between
the Fund and its service providers; (iii) acting as liaison between the trustees
of the Fund and the Fund's service providers; and (iv) providing ongoing
business management and support services in connection with the Fund's
operations.
As compensation for these services, BlackRock, Inc. is entitled to receive
a fee, computed daily and payable monthly, at an annual rate of .03% of each
Portfolio's average daily net assets. PFPC and BDI are entitled to receive a
combined fee, computed daily and payable monthly, at the maximum annual
aggregate rate of .20% of the first $500 million of each Portfolio's average
daily net assets, .18% of the next $500 million of each Portfolio's average
daily net assets, and .16% of each Portfolio's average daily net assets in
excess of $1 billion. From time to time the Administrators may waive some or
all of their administration fees from a Portfolio and may voluntarily reimburse
a Portfolio for expenses.
<PAGE>
23
The Administration Agreements provide that the Administrators will not be
liable for any error of judgment or mistake of law or for any loss suffered by
the Fund or the Portfolios in connection with the performance of the
Administration Agreements, except a loss resulting from willful misfeasance, bad
faith or gross negligence in the performance of their respective duties or from
reckless disregard of their respective duties and obligations thereunder.
CUSTODIAN AND TRANSFER AGENCY AGREEMENTS. PNC Bank, National Association
("PNC Bank"), whose principal business address is 1600 Market Street,
Philadelphia, Pennsylvania 19103, is custodian of the Fund's assets pursuant to
a custodian agreement (the "Custodian Agreement"). Under the Custodian
Agreement, PNC Bank or a sub-custodian (i) maintains a separate account or
accounts in the name of each Portfolio, (ii) holds and transfers portfolio
securities on account of each Portfolio, (iii) accepts receipts and makes
disbursements of money on behalf of each Portfolio, (iv) collects and receives
all income and other payments and distributions on account of each Portfolio's
securities and (v) makes periodic reports to the Board of Trustees concerning
each Portfolio's operations. PNC Bank is authorized to select one or more banks
or trust companies to serve as sub-custodian on behalf of the Fund, provided
that, with respect to sub-custodians other than sub-custodians for foreign
securities, PNC Bank remains responsible for the performance of all its duties
under the Custodian Agreement and holds the Fund harmless from the acts and
omissions of any sub-custodian. Citibank, N.A. serves as the international sub-
custodian for each of the Portfolios.
For its services to the Fund under the Custodian Agreement, PNC Bank is
entitled to receive a fee which is calculated based upon each Portfolio's
average gross assets, with a minimum monthly fee of $1,000 per investment
portfolio. PNC Bank is also entitled to out-of-pocket expenses and certain
transaction charges.
PFPC, an affiliate of PNC Bank, serves as the transfer and dividend
disbursing agent for the Fund pursuant to a Transfer Agency Agreement (the
"Transfer Agency Agreement"), under which PFPC (i) issues and redeems shares in
each Portfolio, (ii) addresses and mails all communications by each Portfolio to
record owners of its shares, including reports to shareholders, dividend and
distribution notices and proxy materials for its meetings of shareholders, (iii)
maintains shareholder accounts and, if requested, sub-accounts and (iv) makes
periodic reports to the Board of Trustees concerning the operations of each
Portfolio. PFPC may, on 30 days' notice to the Fund, assign its duties as
transfer and dividend disbursing agent to any other affiliate of PNC Bank Corp.
For its services with respect to the Portfolios under the Transfer Agency
Agreement, PFPC is entitled to receive fees at the annual rate of .03% of the
average net asset value of outstanding shares in each Portfolio, plus per
account fees and disbursements.
<PAGE>
24
DISTRIBUTOR. The Fund has entered into a distribution agreement with the
Distributor under which the Distributor, as agent, offers shares of the
Portfolios on a continuous basis. The Distributor has agreed to use appropriate
efforts to effect sales of the shares, but it is not obligated to sell any
particular amount of shares.
The Fund has adopted an Amended and Restated Distribution and Service Plan
(the "Plan") pursuant to Rule 12b-1 under the 1940 Act on behalf of its
Institutional Shares. The Plan was approved by a majority of (i) the trustees
of the Fund and (ii) the trustees of the Fund who are not interested persons of
the Fund and who have no direct or indirect financial interest in the operation
of the Plan or in any agreement related to the Plan (the "Rule 12b-1
Trustees").
The Fund is not required or permitted under the Plan to make distribution
payments with respect to its Institutional Shares. However, the Plan permits
BDI, BlackRock, Inc., the Administrators and other companies that receive fees
from the Fund to make payments relating to distribution and sales support
activities out of their past profits or other sources available to them. The
Distributor, BlackRock, Inc. and their affiliates may pay financial
institutions, broker/dealers and/or their salespersons certain compensation for
the sale and distribution of shares of the Fund or for services to the Fund.
These payments ("Additional Payments") may take the form of "due diligence"
payments for a dealer's examination of a Portfolio and payments for providing
extra employee training and information relating to a Portfolio; "listing" fees
for the placement of a Portfolio on a dealer's list of mutual funds available
for purchase by its customers; "finders" or "referral" fees for directing
investors to the Fund; "marketing support" fees for providing assistance in
promoting the sale of the Funds' shares; and payments for the sale of shares
and/or the maintenance of share balances. In addition, the Distributor,
BlackRock, Inc. and their affiliates may make Additional Payments for
subaccounting, administrative and/or shareholder processing services. The
Additional Payments made by the Distributor, BlackRock, Inc. and their
affiliates may be a fixed dollar amount, may be based on the number of customer
accounts maintained by a financial institution or broker/dealer, or may be based
on a percentage of the value of shares sold to, or held by, customers of the
financial institutions or dealers involved, and may be different for different
institutions and dealers. Furthermore, the Distributor, BlackRock, Inc. and
their affiliates may contribute to various non-cash and cash incentive
arrangements to promote the sale of shares, and may sponsor various contests and
promotions subject to applicable NASD regulations in which participants may
receive prizes such as travel awards, merchandise and cash. The Distributor,
BlackRock, Inc. and their affiliates may also pay for the travel expenses,
meals, lodging and entertainment of broker/dealers, financial institutions and
their salespersons in connection with
<PAGE>
25
educational and sales promotional programs subject to applicable NASD
regulations.
The Plan will continue from year to year, provided that each such
continuance is approved at least annually by a vote of the Board of Trustees,
including a majority vote of the Rule 12b-1 Trustees, cast in person at a
meeting called for the purpose of voting on such continuance. The Plan may be
terminated with respect to a Portfolio at any time, without penalty, by the vote
of a majority of the Rule 12b-1 Trustees or by a vote of the holders of a
majority of the outstanding shares of a Portfolio. The Plan may not be amended
materially without the approval of the Board of Trustees, including a majority
of the Rule 12b-1 Trustees, cast in person at a meeting called for that purpose.
Any modification to the Plan which would materially increase the costs borne by
a Portfolio for distribution purposes pursuant to the Plan must also be
submitted to the stockholders of a Portfolio for approval. In addition, while
the Plan remains in effect, the selection and nomination of the Fund's trustees
who are not "interested persons" of the Fund shall be committed to the
discretion of the Fund's non-interested trustees.
PORTFOLIO TRANSACTIONS
The Adviser is responsible for decisions to buy and sell securities for the
Portfolios, the selection of brokers and dealers to effect the transactions and
the negotiation of prices and any brokerage commissions. The securities in
which the Portfolios invest are traded principally in the over-the-counter
market. In the over-the-counter market, securities are generally traded on a
"net" basis with dealers acting as principal for their own accounts without a
stated commission, although the price of the security usually includes a mark-up
to the dealer. Securities purchased in underwritten offerings generally
include, in the price, a fixed amount of compensation for the manager(s),
underwriter(s) and dealer(s). The Portfolios may also purchase certain money
market instruments directly from an issuer, in which case no commissions or
discounts are paid. Purchases and sales of debt securities on a stock exchange
are effected through brokers who charge a commission for their services.
The Adviser's primary considerations in selecting the manner of executing
securities transactions for the Portfolios will be prompt execution of orders,
the size and breadth of the market for the security, the reliability, integrity
and financial condition and execution capability of the firm, the size of and
difficulty in executing the order, and the best net price. There are many
instances when, in the judgment of the Adviser, more than one firm can offer
comparable execution services. In selecting among such firms, consideration is
given to those firms which supply research and other services in addition to
execution services. However, it is not the policy of the Adviser, absent
special circumstances, to pay higher commissions to a firm because it has
supplied such services.
<PAGE>
26
The Adviser is able to fulfill its obligations to furnish a continuous
investment program to the Portfolios without receiving such information from
brokers; however, it considers access to such information to be an important
element of financial management. Although such information is considered
useful, its value is not determinable, as it must be reviewed and assimilated by
the Adviser, and does not reduce the Adviser's normal research activities in
rendering investment advice under the Advisory Contract. It is possible that
the Adviser's expenses could be materially increased if it attempted to purchase
this type of information or generate it through its own staff.
One or more of the other accounts which the Adviser manages may own from
time to time the same investments as the Portfolios. Investment decisions for
the Portfolios are made independently from those of such other accounts;
however, from time to time, the same investment decision may be made for more
than one company or account. When two or more companies or accounts seek to
purchase or sell the same securities, the securities actually purchased or sold
will be allocated among the companies and accounts on a good faith equitable
basis by the Adviser in its discretion in accordance with the accounts' various
investment objectives. In some cases, this system may adversely affect the
price or size of the position obtainable for the Portfolios. In other cases,
however, the ability of the Portfolios to participate in volume transactions may
produce better execution for the Portfolios.
It is expected that under normal market conditions the annual portfolio
turnover rate of the Portfolios will not exceed 400%, excluding securities
having a maturity of one year or less. Because it is difficult to predict
accurately portfolio turnover rate, actual turnover may be higher or lower.
Higher portfolio turnover results in increased Portfolio expenses, including
brokerage commissions, dealer mark-ups and other transaction costs on the sale
of securities and on reinvestment in other securities. The Adviser will monitor
the tax status of the Portfolios under the Internal Revenue Code during periods
in which the annual turnover rate of a Portfolio exceeds 100%.
A Portfolio will not purchase securities during the existence of any
underwriting or selling group relating to such securities of which BlackRock,
the Administrators, the Distributor or any affiliated person (as defined in the
1940 Act) thereof is a member except pursuant to procedures adopted by the Board
of Trustees in accordance with Rule 10f-3 under the 1940 Act. In no instance
will portfolio securities be purchased from or sold to BlackRock, the
Administrators, the Distributor or any affiliated person of the foregoing
entities except as permitted by SEC exemptive order or by applicable law.
<PAGE>
27
The portfolio turnover rate of a Portfolio is calculated by dividing the
lesser of a Portfolio's annual sales or purchases of portfolio securities
(exclusive of purchases or sales of securities whose maturities at the time of
acquisition were one year or less) by the monthly average value of the
securities held by the Portfolio during the year.
The Fund is required to identify any securities of its regular brokers or
dealers (as defined in Rule 10b-1 under the 1940 Act) or their parents held by
the Fund as of the end of its most recent fiscal year. As of September 30,
1997, the following Portfolios held the following securities:
<TABLE>
<CAPTION>
PORTFOLIO SECURITY VALUE
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C>
Money Market
Morgan Stanley & Co., Inc. Commercial Paper $ 49,402,000
Morgan Stanley & Co., Inc. Variable Rate Obligation 36,997,742
Merrill Lynch & Co. Commercial Paper 128,081,269
Lehman Brothers, Inc. Commercial Paper 49,837,542
Lehman Brothers, Inc. Variable Rate Obligation 50,000,000
U.S. Treasury Money Market
Morgan Stanley & Co., Inc. Repurchase Agreement $ 247,000,000
Greenwich Capital Repurchase Agreement 225,000,000
Goldman, Sachs & Co. Repurchase Agreement 50,000,000
Merrill Lynch & Co. Repurchase Agreement 50,000,000
Swiss Bank Corp. Repurchase Agreement 50,000,000
Low Duration Bond
Morgan Stanley & Co., Inc. Mortgage Pass-Through $ 168,166
Lehman Brothers, Inc. Corporate Bond 3,689,617
Salomon Brothers, Inc. Mortgage Pass-Through 3,065,061
Salomon Brothers, Inc. Corporate Bond 4,037,134
Intermediate Government Bond
Merrill Lynch & Co. Mortgage Pass-Through $ 4,367,211
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,407,311
Intermediate Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 2,117,624
Salomon Brothers, Inc. Corporate Bond 527,865
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,577,526
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 3,266,973
Merrill Lynch & Co. Mortgage Pass-Through 10,190,099
Merrill Lynch & Co. Commercial Mortgage-Backed Security 1,236,217
</TABLE>
<PAGE>
28
<TABLE>
<CAPTION>
PORTFOLIO SECURITY VALUE
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Core Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 6,900,254
Salomon Brothers, Inc. Corporate Bond 5,701,504
Goldman, Sachs & Co. Commercial Mortgage-Backed Security 2,942,012
Merrill Lynch & Co. Mortgage Pass-Through 428,155
Merrill Lynch & Co. Commercial Mortgage-Backed Security 3,397,277
Merrill Lynch & Co. Asset Backed Security 303,703
Merrill Lynch & Co. Corporate Bond 4,226,051
Government Income
Salomon Brothers, Inc. Mortgage Pass-Through $ 632,894
Managed Income
Salomon Brothers, Inc. Corporate Bond $ 2,639,323
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,063,281
PaineWebber Jackson & Curtis, Inc. Corporate Bond 5,004,177
HSBC Securities Corporate Bond 7,852,743
Merrill Lynch & Co. Corporate Bond 8,250,862
Merrill Lynch & Co. Commercial Mortgage-Backed Security 12,884,829
Large Cap Value Equity
Morgan Stanley & Co., Inc. Common Stock $ 29,257,111
Mid-Cap Value Equity
Donaldson, Lufkin & Jenrette Securities Corp. Common Stock $ 1,073,437
Select Equity
Morgan Stanley & Co., Inc. Common Stock $ 7,595,781
Balanced
Morgan Stanley & Co., Inc. Common Stock $ 4,941,312
Salomon Brothers, Inc. Mortgage Pass-Through 1,593,589
Salomon Brothers, Inc. Corporate Bond 316,719
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,051,684
Merrill Lynch & Co. Corporate Bond 1,006,203
Merrill Lynch & Co. Commercial Mortgage-Backed Security 2,015,045
</TABLE>
PURCHASE AND REDEMPTION INFORMATION
Shares of the Portfolios are sold at the net asset value per share next
determined after a purchase order is received. The Fund reserves the right, if
conditions exist which make cash payments undesirable, to honor any request for
redemption or repurchase of the Portfolios' shares by making payment in whole or
in part in securities chosen by the Fund and valued in the same way as they
would be valued for purposes of computing the Portfolios' net asset values. If
payment is made in securities, a shareholder may incur transaction costs in
converting these securities into cash. The Fund has elected, however, to be
governed by Rule 18f-1 under the 1940 Act so that each Portfolio is obligated to
redeem its shares solely in cash up to the lesser of $250,000 or 1% of its net
asset value during any 90-day period for any one shareholder of the
Portfolio.
Under the 1940 Act, the Portfolios may suspend the right to redemption or
postpone the date of payment upon redemption for any period during which the New
York Stock Exchange (the "NYSE") is closed (other than customary weekend and
holiday closings), or
<PAGE>
29
during which trading on the NYSE is restricted, or during which (as determined
by the SEC by rule or regulation) an emergency exists as a result of which
disposal or valuation of portfolio securities is not reasonably practicable, or
for such other periods as the SEC may permit. (A Portfolio may also suspend or
postpone the recordation of the transfer of its shares upon the occurrence of
any of the foregoing conditions.)
In addition to the situations described in the Prospectus, the Fund may
redeem shares involuntarily to reimburse the Portfolios for any loss sustained
by reason of the failure of a shareholder to make full payment for shares
purchased by the shareholder or to collect any charge relating to a transaction
effected for the benefit of a shareholder as provided in the Prospectus from
time to time. The Fund reserves the express right to redeem shares of each
Portfolio involuntarily at any time if the Fund's Board of Trustees determines,
in its sole discretion, that failure to do so may have adverse consequences to
the holders of shares in the Portfolio. Upon such redemption the holders of
shares so redeemed shall have no further right with respect thereto other than
to receive payment of the redemption price.
VALUATION OF PORTFOLIO SECURITIES
Valuation of securities held by each Portfolio is as follows: domestic
securities traded on a national securities exchange or on the NASDAQ National
Market System are valued at the last reported sale price that day; domestic
securities traded on a national securities exchange or on the NASDAQ National
Market System for which there were no sales on that day are valued at the mean
of the bid and asked prices; foreign securities traded on a recognized stock
exchange, whether U.S. or foreign, are valued at the latest sale price on that
exchange prior to the time when assets are valued or prior to 3:00 p.m. (Eastern
Time) (if a security is traded on more than one exchange, the latest sale price
on the exchange where the stock is primarily traded is used); foreign securities
traded on a recognized stock exchange for which there were no sales on that day
are valued at the mean of the bid and asked prices; other securities are valued
on the basis of valuations provided by a pricing service approved by the Board
of Trustees, provided that if the Adviser concludes that the price provided by a
pricing service does not represent the fair value of a security, such security
will be valued at fair value determined by the Adviser based on quotations or
the equivalent thereof received from dealers; an option or futures contract is
valued at the last sales price prior to 3:00 p.m. (Eastern Time), as quoted on
the principal exchange or board of trade on which such option or futures
contract is traded, or in the absence of a sale, the mean between the last bid
and asked prices prior to 3:00 p.m. (Eastern Time); the amortized cost method of
valuation is used with respect to debt obligations with sixty days or less
remaining to maturity; and securities for which market quotations are not
<PAGE>
30
readily available are valued at fair market value as determined in good faith by
or under the direction of the Fund's Board of Trustees. Any securities which
are denominated in a foreign currency are translated into U.S. dollars at the
prevailing market rates.
Certain of the securities acquired by the Portfolios may be traded on
foreign exchanges or over-the-counter markets on days on which the Portfolios'
net asset values are not calculated. In such cases, the net asset value of a
Portfolio's shares may be significantly affected on days when investors can
neither purchase nor redeem shares of the Portfolios.
In determining the approximate market value of portfolio investments,
pricing services used by the Fund may use, without limitation, a matrix or
formula method that takes into consideration market indexes, matrices, yield
curves and other specific adjustments. This may result in the securities being
valued at a price different from the price that would have been determined had
the matrix or formula method not been used. All cash, receivables and current
payables are carried on the Fund's books at their face value.
PERFORMANCE INFORMATION
TOTAL RETURN. For purposes of quoting and comparing the performance of
shares of the Portfolios to the performance of other mutual funds and to stock
or other relevant indexes in advertisements, sales literature, communications to
shareholders and other materials, performance may be stated in terms of total
return. Under the rules of the SEC, funds advertising performance must include
total return quotes calculated according to the following formula:
ERV /1/n/
T = [(-----) - 1]
P
Where: T = average annual total return.
ERV = ending redeemable value at the end of the period
covered by the computation of a hypothetical
$1,000 payment made at the beginning of the
period.
P = hypothetical initial payment of $1,000.
n = period covered by the computation, expressed in
terms of years.
Total return, or "T" in the formula above, is computed by finding the
average annual compounded rates of return over the specified periods that would
equate the initial amount invested to the ending redeemable value.
<PAGE>
31
A Portfolio may also from time to time include in advertisements, sales
literature and communications to shareholders, and other materials a total
return figure that is not calculated according to the formula set forth above in
order to compare more accurately the performance of the Portfolio's shares with
other performance measures. For example, in comparing the total return of a
Portfolio's shares with data published by Lipper Analytical Services, Inc., CDA
Investment Technologies, Inc. or Weisenberger Investment Company Service, or
with the performance of the Salomon Broad Investment Grade Index, as
appropriate, a Portfolio may calculate the aggregate total return for its shares
for the period of time specified in the advertisement or communication by
assuming the investment of $10,000 in the Portfolio's shares and assuming the
reinvestment of each dividend or other distribution at net asset value on the
reinvestment date. Percentage increases are determined by subtracting the
initial value of the investment from the ending value and by dividing the
remainder by the beginning value.
In addition to average annual total returns, a Portfolio may quote
unaveraged or cumulative total returns reflecting the simple change in value of
an investment over a stated period. Average annual and cumulative total returns
may be quoted as a percentage or as a dollar amount, and may be calculated for a
single investment, a series of investments, or a series of redemptions, over any
time period. Total returns may be broken down into their components of income
and capital (including capital gains and changes in share price) in order to
illustrate the relationship of these factors and their contributions to total
return. Total returns may be quoted on a before-tax or after-tax basis. Total
returns, yields, and other performance information may be quoted numerically or
in a table, graph or similar illustration.
YIELD. Each Portfolio may advertise the yield on its shares. Under the
rules of the SEC, a Portfolio must calculate yield using the following formula:
a-b
YIELD = 2[(----- +1)/6/ - 1]
cd
Where: a = dividends and interest earned during the period.
b = expenses accrued for the period (net of
reimbursements).
c = the average daily number of shares outstanding during
the period that were entitled to receive dividends.
d = the maximum offering price per share on the last day of
the period.
<PAGE>
32
For the purpose of determining net investment income earned during the
period (variable "a" in the formula), dividend income on equity securities held
by each Portfolio is recognized by accruing 1/360th of the stated dividend rate
of the security each day that the security is in the Portfolio. Except as noted
below, interest earned on any debt obligations held by a Portfolio is calculated
by computing the yield to maturity of each obligation held by the Portfolio
based on the market value of the obligation (including actual accrued interest)
at the close of business on the last business day of each month, or, with
respect to obligations purchased during the month, the purchase price (plus
actual accrued interest) and dividing the result by 360 and multiplying the
quotient by the market value of the obligation (including actual accrued
interest) in order to determine the interest income on the obligation for each
day of the subsequent month that the obligation is held by the Portfolio. For
purposes of this calculation, it is assumed that each month contains 30 days.
The maturity of an obligation with a call provision is the next call date on
which the obligation reasonably may be expected to be called or, if none, the
maturity date.
With respect to debt obligations purchased at a discount or premium, the
formula generally calls for amortization of the discount or premium.
With respect to mortgage or other receivables-backed obligations which are
expected to be subject to monthly payments of principal and interest ("pay
downs"), (a) gain or loss attributable to actual monthly pay downs are accounted
for as an increase or decrease to interest income during the period; and (b) a
Portfolio may elect either (i) to amortize the discount and premium on the
remaining security, based on the cost of the security, to the weighted-average
maturity date, if such information is available, or to the remaining term of the
security, if any, if the weighted-average maturity date is not available, or
(ii) not to amortize discount or premium on the remaining security. The
amortization schedule will be adjusted monthly to reflect changes in the market
values of debt obligations.
Undeclared earned income will be subtracted from the maximum offering price
per share (variable "d" in the formula). Undeclared earned income is the net
investment income which, at the end of the base period, has not been declared as
a dividend, but is reasonably expected to be and is declared and paid as a
dividend shortly thereafter.
OTHER INFORMATION REGARDING INVESTMENT RETURNS. In addition to providing
performance information that demonstrates the total return or yield of shares of
a Portfolio over a specified period of time, the Fund may provide certain other
information demonstrating hypothetical investment returns. Such information may
include, but is not limited to, illustrating the compounding effects of a
dividend in a dividend reinvestment plan.
<PAGE>
33
MISCELLANEOUS. Performance information for the Portfolios assumes the
reinvestment of dividends and distributions. Performance information may
reflect fee waivers that subsidize and reduce the total operating expenses of a
Portfolio. In these cases, the Portfolios' returns would be lower if there were
not such waivers.
Yield on shares of a Portfolio will fluctuate daily and does not provide a
basis for determining future yield. Because yield will fluctuate, it cannot be
compared with yields on savings accounts or other investment alternatives that
provide an agreed to or guaranteed fixed yield for a stated period of time. In
comparing the yield of one fund to another, consideration should be given to
each fund's investment policies, including the types of investments made,
lengths of maturities of the portfolio securities, and whether there are any
special account charges which may reduce the effective yield. The fees which
may be imposed by the Adviser on its customer accounts are not reflected in the
calculations of total returns or yields for the Portfolios.
As stated above, the Fund may also from time to time include discussions or
illustrations of the effects of compounding in advertisements. "Compounding"
refers to the fact that, if dividends or other distributions on an investment in
a Portfolio are reinvested by being paid in additional Portfolio shares, any
future income or capital appreciation of the Portfolio would increase the value,
not only of the original investment in the Portfolio, but also of the additional
Portfolio shares received through reinvestment. The Fund may also include
discussions or illustrations of the potential investment goals of a prospective
investor, investment management techniques, policies or investment suitability
of a Portfolio, economic conditions, the effects of inflation and historical
performance of various asset classes, including but not limited to, stocks,
bonds and Treasury bills. From time to time advertisements or communications to
shareholders may summarize the substance of information contained in shareholder
reports (including the investment composition of a Portfolio), as well as the
views of BlackRock as to current market, economy, trade and interest rate
trends, legislative, regulatory and monetary developments, investment strategies
and related matters believed to be of relevance to a Portfolio. The Fund may
also include in advertisements charts, graphs or drawings which illustrate the
potential risks and rewards of investment in various investment vehicles,
including but not limited to, stocks, bonds, treasury bills and shares of a
Portfolio. In addition, advertisements or shareholder communications may
include a discussion of certain attributes or benefits to be derived by an
investment in a Portfolio. Such advertisements or communications may include
symbols, headlines or other material which highlight or summarize the
information discussed in more detail therein.
<PAGE>
34
TAXES
The following is only a summary of certain additional tax considerations
generally affecting the Portfolios and their shareholders that are not described
in the Prospectus. No attempt is made to present a detailed explanation of the
tax treatment of the Portfolios or their shareholders, and the discussion here
and in the Prospectuses is not intended as a substitute for careful tax
planning. Investors may wish to consult their tax advisers with specific
reference to their own tax situation.
The Portfolios will each elect to be taxed as a regulated investment
company under Part I of Subchapter M of the Internal Revenue Code of 1986, as
amended (the "Code"). As a regulated investment company, each Portfolio
generally is exempt from Federal income tax on its net investment income (i.e.,
----
its investment company taxable income as that term is defined in the Code
without regard to the deduction for dividends paid) and net capital gain (i.e.,
----
the excess of long-term capital gains over short-term capital losses) that it
distributes to shareholders, provided that it distributes at least 90% of its
net investment income (the "Distribution Requirement") and satisfies certain
other requirements of the Code that are described below. Distributions of net
investment income made during the taxable year or, under specified
circumstances, within twelve months after the close of the taxable year will
satisfy the Distribution Requirement.
In addition to satisfaction of the Distribution Requirement, each Portfolio
must derive at least 90% of its gross income from dividends, interest, certain
payments with respect to securities loans and gains from the sale or other
disposition of stock or securities or foreign currencies (including, but not
limited to, gains from forward foreign currency exchange contacts), or from
other income derived with respect to its business of investment in such stock,
securities, or currencies (the "Income Requirement") and, for taxable years
beginning on or before August 5, 1997, derive less than 30% of its gross income
from the sale or other disposition of stock, securities and certain other
investments (including securities and forward foreign currency exchange
contracts, but only to the extent that such contracts are not directly related
to the Portfolios' principal business of investing in stock or securities) held
for less than three months (the "Short-Short Gain Test"). The Short-Short Gain
Test has been repealed for taxable years beginning after August 5, 1997. Future
Treasury regulations may provide that foreign currency gains that are not
"directly related" to the Portfolios' principal business of investing in stock
or securities will not satisfy the Income Requirement.
In addition to the foregoing requirements, at the close of each quarter of
its taxable year, at least 50% of the value of each Portfolio's assets must
consist of cash and cash items, U.S. government securities, securities of other
regulated investment
<PAGE>
35
companies, and securities of other issuers (as to which the Portfolio has not
invested more than 5% of the value of its total assets in securities of such
issuer and as to which the Portfolio does not hold more than 10% of the
outstanding voting securities of such issuer), and no more than 25% of the value
of the Portfolio's total assets may be invested in the securities of any one
issuer (other than U.S. Government securities and securities of other regulated
investment companies), or in two or more issuers which such Portfolio controls
and which are engaged in the same or similar trades or businesses.
Distributions of net investment income will be taxable to shareholders as
ordinary income, regardless of whether such distributions are paid in cash or
are reinvested in shares. Shareholders receiving any taxable distribution from
the Portfolio in the form of additional shares will be treated as receiving a
taxable distribution in an amount equal to the fair market value of the shares
received, determined as of the reinvestment date.
Each Portfolio intends to distribute to shareholders all of its net capital
gain for each taxable year. Such gain is distributed as a capital gain dividend
and is taxable to shareholders as long-term capital gain, regardless of the
length of time the shareholder has held his or her shares, whether such gain was
recognized by the Portfolio prior to the date on which a shareholder acquired
shares of the Portfolio and whether the distribution was paid in cash or
reinvested in shares.
It is expected that distributions from each of the Portfolios will
generally not qualify for the "dividends received" deduction for corporate
shareholders. In addition, it is expected that dividends and certain interest
income earned by the Portfolios from foreign securities will be subject to
foreign withholding taxes or other taxes. If more than 50% of the value of a
Portfolio's total assets at the close of the taxable year in question consists
of stock or securities of foreign corporations, the Portfolio may elect, for
U.S. Federal income tax purposes, to treat certain foreign taxes paid by it,
including generally any withholding taxes and other foreign income taxes, as
paid by its shareholders. If this election were made, the amount of such
foreign taxes paid by a Portfolio would be included in its shareholders' income
pro rata (in addition to taxable distributions actually received by them), and
subject to applicable limitations each shareholder generally would be entitled
either (a) to credit a proportionate amount of such taxes against U.S. Federal
income tax liabilities, or (b) if a shareholder itemizes deductions, to deduct
such proportionate amounts from U.S. income. It is uncertain whether either
Portfolio will meet the test stated above necessary to make this tax election.
In certain circumstances, a shareholder that (i) has held shares of a Portfolio
for less than a specified minimum period during which it is not protected from
risk of loss or (ii) is obligated to make payments related to the dividends,
will not be allowed a foreign tax credit for foreign taxes deemed imposed
<PAGE>
36
on dividends paid on such shares. A Portfolio must also meet this holding
period requirement with respect to its foreign securities in order to flow
through "creditable" taxes.
If a Portfolio purchases shares in a "passive foreign investment company"
(a "PFIC"), such Portfolio may be subject to U.S. federal income tax on a
portion of any "excess distribution" or gain from the disposition of such shares
even if such income is distributed as a taxable dividend by the Portfolio to its
shareholders. Additional charges in the nature of interest may be imposed on a
Portfolio in respect of deferred taxes arising from such distributions or gains.
If a Portfolio were to invest in a PFIC and elected to treat the PFIC as a
"qualified electing fund" under the Code (a "QEF"), in lieu of the foregoing
requirements, the Portfolio would be required to include in income each year a
portion of the ordinary earnings and net capital gain of the qualified electing
fund, even if not distributed to the Portfolio. Alternatively, under recently
enacted legislation, a Portfolio can elect to mark-to-market at the end of each
taxable year its shares in a PFIC; in this case, the Portfolio would recognize
as ordinary income any increase in the value of such shares, and as ordinary
loss any decrease in such value to the extent it did not exceed prior increases
included in income. Under either election, a Portfolio might be required to
recognize in a year income in excess of its distributions from PFICs and its
proceeds from dispositions of PFIC stock during that year, and such income would
nevertheless be subject to the Distribution Requirement and would be taken into
account for purposes of the 4% excise tax (described below).
Ordinary income of individuals will be taxable at a maximum marginal rate
of 39.6%, but because of limitations on itemized deductions otherwise allowable
and the phase-out of personal exemptions, the maximum effective marginal rate of
tax for some taxpayers may be higher. Under recently enacted legislation, long-
term capital gains of individuals are taxed at a maximum rate of 28% with
respect to capital assets held for more than 12 months but less than 18 months
and at a maximum rate of 20% with respect to capital assets held for more than
18 months (10% for gains otherwise taxed at 15%). Capital gains and ordinary
income of corporate taxpayers are both taxed at a maximum nominal rate of 35%.
Investors should be aware that any loss realized upon the sale, exchange or
redemption of shares held for six months or less will be treated as a long-term
capital loss to the extent any capital gain dividends have been paid with
respect to such shares.
Each Portfolio may engage in hedging or derivatives transactions involving
foreign currencies, forward contracts, options and futures contracts (including
options, futures and forward contracts on foreign currencies) and short sales.
Such transactions will be subject to special provisions of the Code that, among
other things, may affect the character of gains and losses realized by the
Portfolio (that is, may affect whether gains or losses are ordinary or capital),
accelerate recognition
<PAGE>
37
of income of the Portfolio and defer recognition of certain of the Portfolio's
losses. These rules could therefore affect the character, amount and timing of
distributions to shareholders. In addition, these provisions (1) will require a
Portfolio to "mark-to-market" certain types of positions in its portfolio (that
is, treat them as if they were closed out) and (2) may cause a Portfolio to
recognize income without receiving cash with which to pay dividends or make
distributions in amounts necessary to satisfy the Distribution Requirement and
avoid the 4% excise tax (described below). Each Portfolio intends to monitor
its transactions, will make the appropriate tax elections and will make the
appropriate entries in its books and records when it acquires any option,
futures contract, forward contract or hedged investment in order to mitigate the
effect of these rules.
If for any taxable year a Portfolio does not qualify as a regulated
investment company, all of its taxable income will be subject to tax at regular
corporate rates without any deduction for distributions to shareholders, and all
distributions will be taxable as ordinary dividends to the extent of a
Portfolio's current and accumulated earnings and profits. Such distributions
will be eligible for the dividends received deduction in the case of corporate
shareholders.
A 4% non-deductible excise tax is imposed on regulated investment companies
that fail to currently distribute specified percentages of their ordinary
taxable income and capital gain net income (excess of capital gains over capital
losses). The Portfolios intend to make sufficient distributions or deemed
distributions of their ordinary taxable income and any capital gain net income
prior to the end of the each calendar year to avoid liability for this excise
tax.
A Portfolio will be required in certain cases to withhold and remit to the
United States Treasury 31% of dividends and gross sale proceeds paid to any
shareholder (i) who has provided either an incorrect tax identification number
or no number at all, (ii) who is subject to backup withholding by the Internal
Revenue Service for failure to report the receipt of interest or dividend income
properly, or (iii) who has failed to certify to the Fund that he is not subject
to backup withholding or that he is an "exempt recipient."
Shareholders will be advised annually as to the federal income tax
consequences of distributions made by a Portfolio each year.
The foregoing general discussion of federal income tax consequences is
based on the Code and the regulations issued thereunder as in effect on the date
of this Statement of Additional Information. Future legislative or
administrative changes or court decisions may significantly change the
conclusions expressed herein, and any such changes or decisions may have a
retroactive effect with respect to the transactions contemplated herein.
<PAGE>
38
Although each Portfolio expects to qualify as a "regulated investment
company" and to be relieved of all or substantially all federal income taxes,
depending upon the extent of its activities in states and localities in which
its offices are maintained, in which its agents or independent contractors are
located or in which it is otherwise deemed to be conducting business, a
Portfolio may be subject to the tax laws of such states or localities.
Shareholders should consult their tax advisors about state and local tax
consequences, which may differ from the federal income tax consequences
described above.
ADDITIONAL INFORMATION CONCERNING SHARES
Shares of the Fund have noncumulative voting rights and, accordingly, the
holders of more than 50% of the Fund's outstanding shares (irrespective of
Portfolio or class) may elect all of the trustees. Shares have no preemptive
rights and only such conversion and exchange rights as the Board may grant in
its discretion. When issued for payment as described in the Prospectus, shares
will be fully paid and non-assessable by the Fund.
There will normally be no meetings of shareholders for the purpose of
electing trustees unless and until such time as required by law. At that time,
the trustees then in office will call a shareholders meeting to elect trustees.
Except as set forth above, the trustees will continue to hold office and may
appoint successor trustees. The Fund's Declaration of Trust provides that
meetings of the shareholders of the Fund will be called by the trustees upon the
written request of shareholders owning at least 10% of the outstanding shares
entitled to vote.
Rule 18f-2 under the 1940 Act provides that any matter required by the
provisions of the 1940 Act or applicable state law, or otherwise, to be
submitted to the holders of the outstanding voting securities of an investment
company such as the Fund shall not be deemed to have been effectively acted upon
unless approved by the holders of a majority of the outstanding shares of each
investment portfolio affected by such matter. Rule 18f-2 further provides that
an investment portfolio shall be deemed to be affected by a matter unless the
interests of each investment portfolio in the matter are substantially identical
or the matter does not affect any interest of the investment portfolio. Under
the Rule, the approval of an investment advisory agreement, a distribution plan
subject to Rule 12b-1 under the 1940 Act or any change in a fundamental
investment policy would be effectively acted upon with respect to an investment
portfolio only if approved by a majority of the outstanding shares of such
investment portfolio. However, the Rule also provides that the ratification of
the appointment of independent accountants, the approval of principal
underwriting contracts and the election of Trustees may be effectively acted
upon by shareholders of the Fund voting together in the aggregate without regard
to a particular investment portfolio.
<PAGE>
39
The proceeds received by the Portfolios for each issue or sale of its
shares, and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to and constitute the underlying assets of that Portfolio. The underlying
assets of the Portfolios will be segregated on the books of account, and will be
charged with the liabilities in respect to that Portfolio and with a share of
the general liabilities of the Fund.
The Fund's Declaration of Trust authorizes the Board of Trustees, without
shareholder approval (unless otherwise required by applicable law), to: (i)
sell and convey the assets belonging to a class of shares to another management
investment company for consideration which may include securities issued by the
purchaser and, in connection therewith, to cause all outstanding shares of such
class to be redeemed at a price which is equal to their net asset value and
which may be paid in cash or by distribution of the securities or other
consideration received from the sale and conveyance; (ii) sell and convert the
assets belonging to one or more classes of shares into money and, in connection
therewith, to cause all outstanding shares of such class to be redeemed at their
net asset value; or (iii) combine the assets belonging to a class of shares with
the assets belonging to one or more other classes of shares if the Board of
Trustees reasonably determines that such combination will not have a material
adverse effect on the shareholders of any class participating in such
combination and, in connection therewith, to cause all outstanding shares of any
such class to be redeemed or converted into shares of another class of shares at
their net asset value. The Board of Trustees may authorize the termination of
any class of shares after the assets belonging to such class have been
distributed to its shareholders.
MISCELLANEOUS
Effective January 31, 1998, the fund has changed its name from Compass
Capital Funds/SM/ to BlackRock Funds/SM/.
COUNSEL. The law firm of Simpson Thacher & Bartlett (a partnership which
includes professional corporations), 425 Lexington Avenue, New York, New York
10017, serves as the Fund's counsel.
INDEPENDENT ACCOUNTANTS. Coopers & Lybrand, L.L.P., 2400 Eleven Penn
Center, Philadelphia, Pennsylvania 19103, serves as the Fund's independent
accountants.
SHAREHOLDER OWNERSHIP. The name, address and percentage ownership of each
person that on January 22, 1998, owned of record or beneficially 5% or more of
BlackRock Strategic Portfolio I is as follows:
ARMCO Inc., C/O BlackRock Financial Mgmt, 345 Park Avenue, 29th Floor, New York,
NY 10154, 7.96%; Federated Dept. Stores, C/O BlackRock Financial Mgmt, 345 Park
Avenue, 29th Floor, New York, NY 10154, 18.98%; Salaried Pension Plan, Ball
Corporation, C/O BlackRock Financial Mgmt, 345 Park Avenue, 29th Floor, New
York, NY 10154, 5.68%; Deere & Company, C/O BlackRock Financial Mgmt, 345 Park
Avenue, 29th Floor, New York, NY 10154, 11.61%; Defined Contribution Union Camp,
C/O BlackRock Financial Mgmt, 345 Park Avenue, 29th Floor, New York, NY 10154,
7.13%; Defined Benefit Union Camp, C/O BlackRock Financial Mgmt, 345 Park
Avenue, 29th Floor, New York, NY 10154, 16.18%; McCune Charitable Foundation,
C/O BlackRock Financial Mgmt, 345 Park Avenue, 29th Floor, New York, NY 10154,
5.36%; Alltel Fixed Income Portfolio (ATC), C/O BlackRock Financial Mgmt, 345
Park Avenue, 29th Floor, New York, NY 10154, 8.65%.
On January 23, 1998, PNC Bank held of record approximately 77% of the
Fund's outstanding shares, and may be deemed a controlling person of the Fund
under the 1940 Act. PNC Bank is a national bank organized under the laws of the
United States. All of the capital stock of PNC Bank is owned by PNC Bancorp,
Inc. All of the capital stock of PNC
<PAGE>
40
Bancorp, Inc. is owned by PNC Bank Corp., a publicly-held bank holding company.
BANKING LAWS. Banking laws and regulations currently prohibit a bank
holding company registered under the Federal Bank Holding Company Act of 1956 or
any bank or non-bank affiliate thereof from sponsoring, organizing, controlling
or distributing the shares of a registered, open-end investment company
continuously engaged in the issuance of its shares, and prohibit banks generally
from underwriting securities, but such banking laws and regulations do not
prohibit such a holding company or affiliate or banks generally from acting as
investment adviser, administrator, transfer agent or custodian to such an
investment company, or from purchasing shares of such a company as agent for and
upon the order of customers. BlackRock, BlackRock, Inc., PFPC and PNC Bank are
subject to such banking laws and regulations.
BlackRock, BlackRock, Inc., PFPC and PNC Bank believe they may perform the
services for the Fund contemplated by their respective agreements with the Fund
without violation of applicable banking laws or regulations. It should be
noted, however, that there have been no cases deciding whether bank and non-bank
subsidiaries of a registered bank holding company may perform services
comparable to those that are to be performed by these companies, and future
changes in either Federal or state statutes and regulations relating to
permissible activities of banks and their subsidiaries or affiliates, as well as
further judicial or administrative decisions or interpretations of present and
future statutes and regulations, could prevent these companies from continuing
to perform such services for the Fund. If such were to occur, it is expected
that the Board of Trustees would recommend that the Fund enter into new
agreements or would consider the possible termination of the Fund. Any new
advisory agreement would be subject to shareholder approval.
SHAREHOLDER APPROVALS. As used in this Statement of Additional Information
and in the Prospectus, a "majority of the outstanding shares" means, with
respect to the approval of a Portfolio's investment advisory agreement or a
change in a fundamental investment limitation, the lesser of (1) 67% of the
shares of that Portfolio represented at a meeting at which the holders of more
than 50% of the outstanding shares of the Portfolio are present in person or by
proxy, or (2) more than 50% of the outstanding shares of that Portfolio.
<PAGE>
APPENDIX A
COMMERCIAL PAPER RATINGS
- ------------------------
A Standard & Poor's commercial paper rating is a current assessment of
the likelihood of timely payment of debt considered short-term in the relevant
market. The following summarizes the highest rating category used by Standard
and Poor's for commercial paper:
"A-1" - Issue's degree of safety regarding timely payment is strong.
Those issues determined to possess extremely strong safety characteristics are
denoted "A-1+."
Moody's commercial paper ratings are opinions of the ability of
issuers to repay punctually promissory obligations not having an original
maturity in excess of 9 months. The following summarizes the highest rating
category used by Moody's for commercial paper:
"Prime-1" - Issuer or related supporting institutions are considered
to have a superior capacity for repayment of short-term promissory obligations.
Prime-1 repayment capacity will normally be evidenced by the following
characteristics: leading market positions in well established industries; high
rates of return on funds employed; conservative capitalization structures with
moderate reliance on debt and ample asset protection; broad margins in earning
coverage of fixed financial charges and high internal cash generation; and well
established access to a range of financial markets and assured sources of
alternate liquidity.
The highest rating category of Duff & Phelps for commercial paper and
short-term debt is "D-1". Duff & Phelps employs three designations, "D-1+," "D-
1" and "D-1-," within the highest rating category. The following summarizes the
highest rating categories used by Duff & Phelps for commercial paper:
"D-1+" - Debt possesses highest certainty of timely payment. Short-
term liquidity, including internal operating factors and/or access to
alternative sources of funds, is outstanding, and safety is just below risk-free
U.S. Treasury short-term obligations.
"D-1" - Debt possesses very high certainty of timely payment.
Liquidity factors are excellent and supported by good fundamental protection
factors. Risk factors are minor.
"D-1-" - Debt possesses high certainty of timely payment. Liquidity
factors are strong and supported by good fundamental protection factors. Risk
factors are very small.
A-1
<PAGE>
Fitch short-term ratings apply to debt obligations that are payable on
demand or have original maturities of generally up to three years. The
following summarizes the highest rating category used by Fitch for short-term
obligations:
"F-1+" - Securities possess exceptionally strong credit quality.
Issues assigned this rating are regarded as having the strongest degree of
assurance for timely payment.
"F-1" - Securities possess very strong credit quality. Issues
assigned this rating reflect an assurance of timely payment only slightly less
in degree than issues rated "F-1+."
Fitch may also use the symbol "LOC" with its short-term ratings to
indicate that the rating is based upon a letter of credit issued by a commercial
bank.
Thomson BankWatch short-term ratings assess the likelihood of an
untimely or incomplete payment of principal or interest of unsubordinated
instruments having a maturity of one year or less which are issued by United
States commercial banks, thrifts and non-bank banks; non-United States banks;
and broker-dealers. The following summarizes the highest rating used by Thomson
BankWatch:
"TBW-1" - This designation represents Thomson BankWatch's highest
rating category and indicates a very high degree of likelihood that principal
and interest will be paid on a timely basis.
IBCA assesses the investment quality of unsecured debt with an
original maturity of less than one year which is issued by bank holding
companies and their principal bank subsidiaries. The following summarizes the
highest rating category used by IBCA for short-term debt ratings:
"A1+" - Obligations possess a particularly strong credit feature and
are supported by the highest capacity for timely repayment.
"A1" - Obligations are supported by the highest capacity for timely
repayment.
CORPORATE AND MUNICIPAL LONG-TERM DEBT RATINGS
- ----------------------------------------------
The following summarizes the "investment grade" ratings used by
Standard & Poor's for corporate and municipal debt:
"AAA" - This designation represents the highest rating assigned by
Standard & Poor's to a debt obligation and indicates an extremely strong
capacity to pay interest and repay principal.
A-2
<PAGE>
"AA" - Debt is considered to have a very strong capacity to pay
interest and repay principal and differs from AAA issues only in small degree.
"A" - Debt is considered to have a strong capacity to pay interest and
repay principal although such issues are somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than debt in
higher-rated categories.
"BBB" - Debt is regarded as having an adequate capacity to pay
interest and repay principal. Whereas such issues normally exhibit adequate
protection parameters, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity to pay interest and repay principal
for debt in this category than in higher-rated categories.
PLUS (+) OR MINUS (-) - The ratings from "AA" through "BBB" may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories.
"r" - This rating is attached to highlight derivative, hybrid, and
certain other obligations that S&P believes may experience high volatility or
high variability in expected returns due to non-credit risks. Examples of such
obligations are: securities whose principal or interest return is indexed to
equities, commodities, or currencies; certain swaps and options; and interest
only and principal only mortgage securities. The absence of an "r" symbol
should not be taken as an indication that an obligation will exhibit no
volatility or variability in total return.
The following summarizes the "investment grade" ratings used by Moody's for
corporate and municipal long-term debt:
"Aaa" - Bonds are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
"Aa" - Bonds are judged to be of high quality by all standards.
Together with the "Aaa" group they comprise what are generally known as high-
grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in "Aaa" securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risks appear somewhat larger than in "Aaa"
securities.
A-3
<PAGE>
"A" - Bonds possess many favorable investment attributes and are to be
considered as upper medium-grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present which
suggest a susceptibility to impairment sometime in the future.
"Baa" - Bonds considered medium-grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payments and principal
security appear adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
Con. (---) - Bonds for which the security depends upon the completion
of some act or the fulfillment of some condition are rated conditionally. These
are bonds secured by (a) earnings of projects under construction, (b) earnings
of projects unseasoned in operation experience, (c) rentals which begin when
facilities are completed, or (d) payments to which some other limiting condition
attaches. Parenthetical rating denotes probable credit stature upon completion
of construction or elimination of basis of condition.
(P)... - When applied to forward delivery bonds, indicates that the
rating is provisional pending delivery of the bonds. The rating may be revised
prior to delivery if changes occur in the legal documents or the underlying
credit quality of the bonds.
Note: Those bonds in the Aa, A and Baa groups which Moody's believes
possess the strongest investment attributes are designated by the symbols, Aa1,
A1 and Baa1.
The following summarizes the "investment grade" long-term debt ratings
used by Duff & Phelps for corporate and municipal long-term debt:
"AAA" - Debt is considered to be of the highest credit quality. The
risk factors are negligible, being only slightly more than for risk-free U.S.
Treasury debt.
"AA" - Debt is considered of high credit quality. Protection factors
are strong. Risk is modest but may vary slightly from time to time because of
economic conditions.
"A" - Debt possesses protection factors which are average but
adequate. However, risk factors are more variable and greater in periods of
economic stress.
"BBB" - Debt possesses below average protection factors but such
protection factors are still considered sufficient for
A-4
<PAGE>
prudent investment. Considerable variability in risk is present during economic
cycles.
To provide more detailed indications of credit quality, the "AA," "A,"
"BBB," "BB" and "B" ratings may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within these major categories.
The following summarizes the highest four ratings used by Fitch for
corporate and municipal bonds:
"AAA" - Bonds considered to be investment grade and of the highest
credit quality. The obligor has an exceptionally strong ability to pay interest
and repay principal, which is unlikely to be affected by reasonably foreseeable
events.
"AA" - Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong, although not quite as strong as bonds rated "AAA." Because bonds rated
in the "AAA" and "AA" categories are not significantly vulnerable to foreseeable
future developments, short-term debt of these issuers is generally rated "F-1+."
"A" - Bonds considered to be investment grade and of high credit
quality. The obligor's ability to pay interest and repay principal is
considered to be strong, but may be more vulnerable to adverse changes in
economic conditions and circumstances than bonds with higher ratings.
"BBB" - Bonds considered to be investment grade and of satisfactory
credit quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have an adverse impact on these
bonds, and therefore, impair timely payment. The likelihood that the ratings of
these bonds will fall below investment grade is higher than for bonds with
higher ratings.
To provide more detailed indications of credit quality, the Fitch
ratings from and including "AA" to "BBB" may be modified by the addition of a
plus (+) or minus (-) sign to show relative standing within these major rating
categories.
IBCA assesses the investment quality of unsecured debt with an
original maturity of more than one year which is issued by bank holding
companies and their principal bank subsidiaries. The following summarizes the
"investment grade" rating categories used by IBCA for long-term debt ratings:
"AAA" - Obligations for which there is the lowest expectation of
investment risk. Capacity for timely repayment of principal and interest is
substantial such that adverse changes
A-5
<PAGE>
in business, economic or financial conditions are unlikely to increase
investment risk substantially.
"AA" - Obligations for which there is a very low expectation of
investment risk. Capacity for timely repayment of principal and interest is
substantial, such that adverse changes in business, economic or financial
conditions may increase investment risk, albeit not very significantly.
"A" - Obligations for which there is a low expectation of investment
risk. Capacity for timely repayment of principal and interest is strong,
although adverse changes in business, economic or financial conditions may lead
to increased investment risk.
"BBB" - Obligations for which there is currently a low expectation of
investment risk. Capacity for timely repayment of principal and interest is
adequate, although adverse changes in business, economic or financial conditions
are more likely to lead to increased investment risk than for obligations in
other categories.
IBCA may append a rating of plus (+) or minus (-) to a rating to
denote relative status within major rating categories.
Thomson BankWatch assesses the likelihood of an untimely repayment of
principal or interest over the term to maturity of long term debt and preferred
stock which are issued by United States commercial banks, thrifts and non-bank
banks; non-United States banks; and broker-dealers. The following summarizes
the "investment grade" rating categories used by Thomson BankWatch for long-term
debt ratings:
"AAA" - This designation represents the highest category assigned by
Thomson BankWatch to long-term debt and indicates that the ability to repay
principal and interest on a timely basis is extremely high.
"AA" - This designation indicates a very strong ability to repay
principal and interest on a timely basis with limited incremental risk compared
to issues rated in the highest category.
"A" - This designation indicates that the ability to repay principal
and interest is strong. Issues rated "A" could be more vulnerable to adverse
developments (both internal and external) than obligations with higher ratings.
"BBB" - This designation represents Thomson BankWatch's lowest
investment grade category and indicates an acceptable capacity to repay
principal and interest. Issues rated "BBB" are, however, more vulnerable to
adverse developments (both internal and external) than obligations with higher
ratings.
A-6
<PAGE>
PLUS (+) OR MINUS (-) - The ratings from "AAA" through "CC" may
include a plus or minus sign designation which indicates where within the
respective category the issue is placed.
MUNICIPAL NOTE RATINGS
- ----------------------
A Standard and Poor's rating reflects the liquidity concerns and
market access risks unique to notes due in three years or less. The following
summarizes the highest rating used by Standard & Poor's Ratings Group for
municipal notes:
"SP-1" - The issuers of these municipal notes exhibit very strong or
strong capacity to pay principal and interest. Those issues determined to
possess overwhelming safety characteristics are given a plus (+) designation.
Moody's ratings for state and municipal notes and other short-term
loans are designated Moody's Investment Grade ("MIG") and variable rate demand
obligations are designated Variable Moody's Investment Grade ("VMIG"). Such
ratings recognize the differences between short-term credit risk and long-term
risk. The following summarizes the highest rating by Moody's Investors Service,
Inc. for short-term notes:
"MIG-1"/"VMIG-1" - Loans bearing this designation are of the best
quality, enjoying strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the market for
refinancing.
Fitch and Duff & Phelps use the short-term ratings described under
Commercial Paper Ratings for municipal notes.
A-7
<PAGE>
APPENDIX B
As stated in the Prospectus, the Portfolios may enter into certain
futures transactions. Such transactions are described in this Appendix.
I. Interest Rate Futures Contracts
-------------------------------
Use of Interest Rate Futures Contracts. Bond prices are established
--------------------------------------
in both the cash market and the futures market. In the cash market, bonds are
purchased and sold with payment for the full purchase price of the bond being
made in cash, generally within five business days after the trade. In the
futures market, only a contract is made to purchase or sell a bond in the future
for a set price on a certain date. Historically, the prices for bonds
established in the futures markets have tended to move generally in the
aggregate in concert with the cash market prices and have maintained fairly
predictable relationships. Accordingly, as an example, a Portfolio may use
interest rate futures contracts as a defense, or hedge, against anticipated
interest rate changes. As described below, this would include the use of
futures contract sales to protect against expected increases in interest rates
and futures contract purchases to offset the impact of interest rate declines.
A Portfolio could accomplish a similar result to that which it hopes
to achieve through the use of futures contracts by selling bonds with long
maturities and investing in bonds with short maturities when interest rates are
expected to increase, or conversely, selling short-term bonds and investing in
long-term bonds when interest rates are expected to decline. However, because
of the liquidity that is often available in the futures market, the protection
is more likely to be achieved, perhaps at a lower cost and without changing the
rate of interest being earned by the Portfolio, by using futures contracts.
Description of Interest Rate Futures Contracts. An interest rate
----------------------------------------------
futures contract sale would create an obligation by a Portfolio, as seller, to
deliver the specific type of financial instrument called for in the contract at
a specific future time for a specified price. A futures contract purchase would
create an obligation by a Portfolio, as purchaser, to take delivery of the
specific type of financial instrument at a specific future time at a specific
price. The specific securities delivered or taken, respectively, at settlement
date, would not be determined until at or near that date. The determination
would be in accordance with the rules of the exchange on which the futures
contract sale or purchase was made.
Although interest rate futures contracts by their terms call for
actual delivery or acceptance of securities, in most cases the contracts are
closed out before the settlement date
B-1
<PAGE>
without the making or taking of delivery of securities. Closing out a futures
contract sale is effected by a Portfolio entering into a futures contract
purchase for the same aggregate amount of the specific type of financial
instrument and the same delivery date. If the price of the sale exceeds the
price of the offsetting purchase, the Portfolio is immediately paid the
difference and thus realizes a gain. If the offsetting purchase price exceeds
the sale price, the Portfolio pays the difference and realizes a loss.
Similarly, the closing out of a futures contract purchase is effected by the
Portfolio entering into a futures contract sale. If the offsetting sale price
exceeds the purchase price, the Portfolio realizes a gain, and if the purchase
price exceeds the offsetting sale price, the Portfolio realizes a loss.
Interest rate futures contracts are traded in an auction environment
on the floors of several exchanges --principally, the Chicago Board of Trade,
the Chicago Mercantile Exchange and the New York Futures Exchange. Each
exchange guarantees performance under contract provisions through a clearing
corporation, a nonprofit organization managed by the exchange membership.
A public market now exists in futures contracts covering various
financial instruments including long-term U.S. Treasury Bonds and Notes;
Government National Mortgage Association (GNMA) modified pass-through mortgage
backed securities; three-month U.S. Treasury Bills; and ninety-day commercial
paper. The Portfolios may trade in any interest rate futures contracts for
which there exists a public market, including, without limitation, the foregoing
instruments.
With regard to each Portfolio, the Adviser also anticipates engaging
in transactions, from time to time, in foreign index futures such as the ALL-
ORDS (Australia), CAC-40 (France), TOPIX (Japan) and the FTSE-100 (United
Kingdom).
II. Index Futures Contracts
-----------------------
A securities index assigns relative values to the securities included
in the index, which fluctuates with changes in the market values of the
securities included. Some index futures contracts are based on broad market
indexes, while other futures contracts are based on narrower market indexes
segment. As an example, a Portfolio might sell index futures contracts in order
to offset a decrease in market value of its portfolio securities that might
otherwise result from a market decline. A Portfolio might do so either to hedge
the value of its portfolio as a whole, or to protect against declines, occurring
prior to sales of securities, in the value of the securities to be sold.
Conversely, a Portfolio might purchase index futures contracts in anticipation
of purchases of securities. A long futures position may be terminated without a
corresponding purchase of securities.
B-2
<PAGE>
In addition, a Portfolio might utilize index futures contracts in
anticipation of changes in the composition of its portfolio holdings.
III. Futures Contracts on Foreign Currencies
---------------------------------------
A futures contract on foreign currency creates a binding obligation on
one party to deliver, and a corresponding obligation on another party to accept
delivery of, a stated quantity of foreign currency, for an amount fixed in U.S.
dollars (or another currency). Foreign currency futures may be used by a
Portfolio to hedge against exposure to fluctuations in exchange rates between
different currencies arising from multinational transactions, as well as for
other purposes as described in the Prospectus.
IV. Margin Payments
---------------
Unlike purchase or sales of portfolio securities, no price is paid or
received by a Portfolio upon the purchase or sale of a futures contract.
Initially, a Portfolio will be required to deposit with the broker or segregate
with a custodian an amount of liquid assets known as initial margin, based on
the value of the contract. The nature of initial margin in futures transactions
is different from that of margin in security transactions in that futures
contract margin does not involve the borrowing of funds by the customer to
finance the transactions. Rather, the initial margin is in the nature of a
performance bond or good faith deposit on the contract which is returned to the
Portfolio upon termination of the futures contract assuming all contractual
obligations have been satisfied. Subsequent payments, called variation margin,
to and from the broker, will be made on a daily basis as the price of the
underlying instruments fluctuates making the long and short positions in the
futures contract more or less valuable, a process known as marking-to-the-
market. For example, when a particular Portfolio has purchased a futures
contract and the price of the contract has risen in response to a rise in the
underlying instruments, that position will have increased in value and the
Portfolio will be entitled to receive from the broker a variation margin payment
equal to that increase in value. Conversely, where the Portfolio has purchased
a futures contract and the price of the future contract has declined in response
to a decrease in the underlying instruments, the position would be less valuable
and the Portfolio would be required to make a variation margin payment to the
broker. Prior to expiration of the futures contract, the Adviser may elect to
close the position by taking an opposite position, subject to the availability
of a secondary market, which will operate to terminate the Portfolio's position
in the futures contract. A final determination of variation margin is then
made, additional cash is required to be paid by or released to the Portfolio,
and the Portfolio realizes a loss or gain.
B-3
<PAGE>
V. Risks of Transactions in Futures Contracts
------------------------------------------
There are several risks in connection with the use of futures by a
Portfolio. One risk arises because of the imperfect correlation between
movements in the price of the futures and movements in the price of any
instruments which are the subject of a hedge. The price of the futures may move
more than or less than the price of the instruments being hedged. If the price
of the futures moves less than the price of the instruments which are the
subject of the hedge, the hedge will not be fully effective but, if the price of
the instruments being hedged has moved in an unfavorable direction, the
Portfolio would be in a better position than if it had not hedged at all. If
the price of the instruments being hedged has moved in a favorable direction,
this advantage will be partially offset by the loss on the futures. If the
price of the futures moves more than the price of the hedged instruments, the
Portfolio involved will experience either a loss or gain on the futures which
will not be completely offset by movements in the price of the instruments which
are the subject of the hedge. To compensate for the imperfect correlation of
movements in the price of instruments being hedged and movements in the price of
futures contracts, a Portfolio may buy or sell futures contracts in a greater
dollar amount than the dollar amount of instruments being hedged if the
volatility over a particular time period of the prices of such instruments has
been greater than the volatility over such time period of the future, or if
otherwise deemed to be appropriate by the Adviser. Conversely, a Portfolio may
buy or sell fewer futures contracts if the volatility over a particular time
period of the prices of the instruments being hedged is less than the volatility
over such time period of the futures contract being used, or if otherwise deemed
to be appropriate by the Adviser. It is also possible that, where a Portfolio
has sold futures to hedge its portfolio against a decline in the market, the
market may advance and the value of instruments held in the Portfolio may
decline. If this occurred, the Portfolio would lose money on the futures and
also experience a decline in value in its portfolio securities.
When futures are purchased to hedge against a possible increase in the
price of securities or a currency before a Portfolio is able to invest its cash
(or cash equivalents) in an orderly fashion, it is possible that the market may
decline instead; if the Portfolio then concludes not to invest its cash at that
time because of concern as to possible further market decline or for other
reasons, the Portfolio will realize a loss on the futures contract that is not
offset by a reduction in the price of the instruments that were to be purchased.
In addition to the possibility that there may be an imperfect
correlation, or no correlation at all, between movements in the futures and any
instruments being hedged, the price of futures may not correlate perfectly with
movement in the cash market due to certain market distortions. Rather than
B-4
<PAGE>
meeting additional margin deposit requirements, investors may close futures
contracts through off-setting transactions which could distort the normal
relationship between the cash and futures markets. Second, with respect to
financial futures contracts, the liquidity of the futures market depends on
participants entering into off-setting transactions rather than making or taking
delivery. To the extent participants decide to make or take delivery, liquidity
in the futures market could be reduced thus producing distortions. Third, from
the point of view of speculators, the deposit requirements in the futures market
are less onerous than margin requirements in the securities market. Therefore,
increased participation by speculators in the futures market may also cause
temporary price distortions. Due to the possibility of price distortion in the
futures market, and because of the imperfect correlation between the movements
in the cash market and movements in the price of futures, a correct forecast of
general market trends or interest rate movements by the adviser may still not
result in a successful hedging transaction over a short time frame.
Positions in futures may be closed out only on an exchange or board of
trade which provides a secondary market for such futures. Although the
Portfolios intend to purchase or sell futures only on exchanges or boards of
trade where there appear to be active secondary markets, there is no assurance
that a liquid secondary market on any exchange or board of trade will exist for
any particular contract or at any particular time. In such event, it may not be
possible to close a futures investment position, and in the event of adverse
price movements, a Portfolio would continue to be required to make daily cash
payments of variation margin. However, in the event futures contracts have been
used to hedge portfolio securities, such securities will not be sold until the
futures contract can be terminated. In such circumstances, an increase in the
price of the securities, if any, may partially or completely offset losses on
the futures contract. However, as described above, there is no guarantee that
the price of the securities will in fact correlate with the price movements in
the futures contract and thus provide an offset on a futures contract.
Further, it should be noted that the liquidity of a secondary market
in a futures contract may be adversely affected by "daily price fluctuation
limits" established by commodity exchanges which limit the amount of fluctuation
in a futures contract price during a single trading day. Once the daily limit
has been reached in the contract, no trades may be entered into at a price
beyond the limit, thus preventing the liquidation of open futures positions.
The trading of futures contracts is also subject to the risk of trading halts,
suspensions, exchange or clearing house equipment failures, government
intervention, insolvency of a brokerage firm or clearing house or other
disruptions of normal activity, which could at times make it difficult or
impossible to liquidate existing positions or to recover excess variation margin
payments.
B-5
<PAGE>
Successful use of futures by a Portfolio is also subject to the
Adviser's ability to predict correctly movements in the direction of the market.
For example, if a particular Portfolio has hedged against the possibility of a
decline in the market adversely affecting securities held by it and securities
prices increase instead, the Portfolio will lose part or all of the benefit to
the increased value of its securities which it has hedged because it will have
offsetting losses in its futures positions. In addition, in such situations, if
the Portfolio has insufficient cash, it may have to sell securities to meet
daily variation margin requirements. Such sales of securities may be, but will
not necessarily be, at increased prices which reflect the rising market. A
Portfolio may have to sell securities at a time when it may be disadvantageous
to do so.
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 (as well as 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, before any deduction for the
transaction costs, 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.
VI. Options on Futures Contracts
----------------------------
A Portfolio may purchase and write options on the futures contracts
described above. A futures option gives the holder, in return for the premium
paid, the right to buy (call) from or sell (put) to the writer of the option a
futures contract at a specified price at any time during the period of the
option. Upon exercise, the writer of the option is obligated to pay the
difference between the cash value of the futures contract and the exercise
price. Like the buyer or seller of a futures contract, the holder, or writer,
of an option has the right to terminate its position prior to the scheduled
expiration of the option by selling, or purchasing an option of the same series,
at which time the person entering into the closing transaction will realize a
gain or loss. A Portfolio will be required to deposit initial margin and
variation margin with respect to put and call options on futures contracts
written by it pursuant to brokers' requirements similar to those described
above. Net option premiums received will be included as initial margin
deposits.
Investments in futures options involve some of the same considerations
that are involved in connection with investments
B-6
<PAGE>
in futures contracts (for example, the existence of a liquid secondary market).
In addition, the purchase or sale of an option also entails the risk that
changes in the value of the underlying futures contract will not correspond to
changes in the value of the option purchased. Depending on the pricing of the
option compared to either the futures contract upon which it is based, or upon
the price of the underlying securities or currencies, an option may or may not
be less risky than ownership of the futures contract or such securities or
currencies. In general, the market prices of options can be expected to be more
volatile than the market prices on the underlying futures contract. Compared to
the purchase or sale of futures contracts, however, the purchase of call or put
options on futures contracts may frequently involve less potential risk to a
Portfolio because the maximum amount at risk is the premium paid for the options
(plus transaction costs). The writing of an option on a futures contract
involves risks similar to those risks relating to the sale of futures contracts.
VII. Other Matters
-------------
Accounting for futures contracts will be in accordance with generally
accepted accounting principles.
B-7
<PAGE>
BLACKROCK FUNDS/SM/
STATEMENT OF ADDITIONAL INFORMATION
MULTI-SECTOR MORTGAGE SECURITIES PORTFOLIO III
This Statement of Additional Information provides supplementary information
pertaining to Institutional Shares ("Shares") representing interests in the
Multi-Sector Mortgage Securities Portfolio III (the "Portfolio") of BlackRock
Funds (the "Fund"). This Statement of Additional Information is not a
prospectus, and should be read only in conjunction with the Prospectus of the
Fund relating to the Portfolio dated January 28, 1998, as amended from time to
time (the "Prospectus"). The Prospectus may be obtained from the Fund's
distributor by calling toll-free (800) 441-7379. This Statement of Additional
Information is dated January 28, 1998. Capitalized terms used herein and not
otherwise defined have the same meanings as are given to them in the
Prospectus.
CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
THE FUND.......................................................... 2
INVESTMENT OBJECTIVE AND POLICIES................................. 2
INVESTMENT RESTRICTIONS........................................... 13
TRUSTEES AND OFFICERS............................................. 14
INVESTMENT ADVISORY, ADMINISTRATION,
DISTRIBUTION AND SERVICING ARRANGEMENTS........................... 20
PORTFOLIO TRANSACTIONS............................................ 24
PURCHASE AND REDEMPTION INFORMATION............................... 28
VALUATION OF PORTFOLIO SECURITIES................................. 29
PERFORMANCE INFORMATION........................................... 29
TAXES............................................................. 34
ADDITIONAL INFORMATION CONCERNING SHARES.......................... 37
MISCELLANEOUS..................................................... 39
FINANCIAL STATEMENTS.............................................. 40
</TABLE>
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS STATEMENT OF ADDITIONAL INFORMATION OR THE
PROSPECTUS IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS AND, IF GIVEN
OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING
BEEN AUTHORIZED BY THE FUND OR ITS DISTRIBUTOR. THE PROSPECTUS DOES NOT
CONSTITUTE AN OFFERING BY THE FUND OR BY THE FUND'S DISTRIBUTOR
<PAGE>
IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE MADE.
THE FUND
The Fund was organized on December 22, 1988 as a Massachusetts business
trust. The Portfolio originally commenced operations on October 6, 1994 as a
separate investment portfolio (the "Predecessor Portfolio") of The BFM
Institutional Trust Inc., which was organized as a Maryland corporation. On
April 26, 1996 the assets and liabilities of the Predecessor Portfolio were
transferred to the Portfolio, which had no prior operating history.
The Fund also offers other investment portfolios which are described in
separate Prospectuses and separate Statements of Additional Information. For
information concerning these other portfolios contact the distributor at the
telephone number stated on the cover page of this Statement of Additional
Information.
INVESTMENT OBJECTIVE AND POLICIES
For a description of the objective and policies of the Portfolio, see
"Investment Policies" in the Prospectus. In accordance with the applicable
provisions of the Investment Company Act of 1940 (the "1940 Act"), the Portfolio
will maintain with its custodian a segregated account of liquid assets to the
extent the Portfolio's obligations require segregation from the use of
investment practices listed below. The following information is provided for
those investors desiring information in addition to that contained in the
Prospectus.
OTHER INVESTMENT PRACTICES
INTEREST RATE TRANSACTIONS. The Portfolio may enter into interest rate
swaps and the purchase or sale of interest rate caps and floors. The Portfolio
expects to enter into these transactions primarily to preserve a return or
spread on a particular investment or portion of its portfolio as a duration
management technique or to protect against any increase in the price of
securities that the Portfolio anticipates purchasing at a later date. The
Portfolio will use these transactions as a hedge or for duration or risk
management. The Portfolio will not sell interest rate caps or floors that it
does not own. Interest rate swaps involve the exchange by the Portfolio with
another party of their respective commitments to pay or receive interest e.g.,
----
an exchange of floating rate payments for fixed rate payments with respect to a
notional amount of principal. The purchase of an interest rate cap entitles the
purchaser, to the
-2-
<PAGE>
extent that a specified index exceeds a predetermined interest rate, to receive
payments of interest on a notional principal amount from the party selling such
interest rate cap. The purchase of an interest rate floor entitles the
purchaser, to the extent that a specified index falls below a predetermined
interest rate, to receive payments of interest on a notional principal amount
from the party selling such interest rate floor.
The Portfolio may enter into interest rate swaps, caps and floors on either
an asset-based or liability-based basis, and will usually enter into interest
rate swaps on a net basis, i.e., the two payment streams are netted out, with
----
the Portfolio receiving or paying, as the case may be, only the net amount of
the two payments on the payment dates. The Portfolio will accrue the net amount
of the excess, if any, of the Portfolio's obligations over its entitlements with
respect to each interest rate swap on a daily basis and will segregate with a
custodian an amount of cash or liquid securities having an aggregate net asset
value at all times at least equal to the accrued excess. If there is a default
by the other party to such a transaction, the Portfolio will have contractual
remedies pursuant to the agreements related to the transaction.
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS. The Portfolio may also
enter into contracts for the purchase or sale for future delivery ("futures
contracts") of debt securities, aggregates of debt securities or indices or
prices thereof, other financial indices and U.S. government debt securities or
options on the above. The Portfolio will ordinarily engage in such transactions
only for bona fide hedging, risk management (including duration management) and
other portfolio management purposes.
CALLS ON SECURITIES, INDICES AND FUTURES CONTRACTS. The Portfolio may sell
or purchase call options ("calls") on U.S. Treasury securities, mortgage-backed
securities, other debt securities, indices, and Eurodollar instruments that are
traded on U.S. and foreign securities exchanges and in the over-the-counter
markets, and future contracts. A call gives the purchaser of the option the
right to buy, and obligates the seller to sell, the underlying security, futures
contract or index at the exercise price at any time or at a specified time
during the option period. All such calls sold by the Portfolio must be
"covered" as long as the call is outstanding (i.e., the Portfolio must own the
----
securities or futures contract subject to the call or other securities
acceptable for applicable segregation requirements). A call sold by the
Portfolio exposes the Portfolio during the term of the option to possible loss
of opportunity to realize appreciation in the market price of the underlying
security, index or futures contract and may require the Portfolio to hold a
security or futures contract which it
-3-
<PAGE>
might otherwise have sold. The purchase of a call gives the Portfolio the right
to buy a security, futures contract or index at a fixed price. Calls on futures
on U.S. Treasury securities, Mortgage-Backed Securities, other debt securities
and Eurodollar instruments must also be covered by deliverable securities or the
futures contract or by liquid debt securities segregated to satisfy the
Portfolio's obligations pursuant to such instruments.
PUTS ON SECURITIES, INDICES AND FUTURES CONTRACTS. The Portfolio may
purchase put options ("puts") that relate to U.S. Treasury securities, Mortgage-
Backed Securities, other debt securities and Eurodollar instruments (whether or
not it holds such securities in its portfolio), indices or futures contracts.
The Portfolio may also sell puts on U.S. Treasury securities, Mortgage-Backed
Securities, other debt securities, Eurodollar instruments, indices or futures
contracts on such securities if the Portfolio's contingent obligations on such
puts are secured by segregated assets consisting of cash or liquid debt
securities having a value not less than the exercise price. The Portfolio will
not sell puts if, as a result, more than 50% of the Portfolio's assets would be
required to cover its potential obligations under its hedging and other
investment transactions. In selling puts, there is a risk that the Portfolio
may be required to buy the underlying instrument at a price higher than the
current market price.
WHEN-ISSUED AND FORWARD COMMITMENT SECURITIES. The Portfolio may also
purchase securities on a "when-issued" basis and may purchase or sell securities
on a "forward commitment" basis. When such transactions are negotiated, the
price, which is generally expressed in yield terms, is fixed at the time the
commitment is made, but delivery and payment for the securities take place at a
later date. When-issued securities and forward commitments may be sold prior to
the settlement date, but the Portfolio will enter into when-issued and forward
commitments only with the intention of actually receiving or delivering the
securities, as the case may be. If the Portfolio disposes of the right to
acquire a when-issued security prior to its acquisition or disposes of its right
to deliver or receive against a forward commitment, it can incur a gain or loss.
At the time the Portfolio enters into a transaction on a when-issued or forward
commitment basis, it will segregate with its custodian liquid assets with a
value not less than the value of the when-issued or forward commitment
securities. The value of these assets will be monitored daily to ensure that
their marked to market value will at all times equal or exceed the corresponding
obligations of the Portfolio. There is always a risk that the securities may
not be delivered and that the Portfolio may incur a loss. Settlements in the
ordinary course, which typically occur monthly for mortgage-related securities,
are not treated by the Portfolio as
-4-
<PAGE>
when-issued or forward commitment transactions and accordingly are not subject
to the foregoing restrictions.
REPURCHASE AGREEMENTS. The Portfolio may invest temporarily, without
limitation, in repurchase agreements, which are agreements pursuant to which
securities are acquired by the Portfolio from a third party with the
understanding that they will be repurchased by the seller at a fixed price on an
agreed date. These agreements may be made with respect to any of the portfolio
securities in which the Portfolio is authorized to invest. Repurchase
agreements may be characterized as loans secured by the underlying securities
and will be entered into in accordance with the requirements of the SEC.
The repurchase price under the repurchase agreements generally equals the
price paid by the Portfolio plus interest negotiated on the basis of current
short-term rates (which may be more or less than the rate on securities
underlying the repurchase agreement). The financial institutions with which the
Portfolio may enter into repurchase agreements will be banks and non-bank
dealers of U.S. Government securities that are listed on the Federal Reserve
Bank of New York's list of reporting dealers, if such banks and non-bank dealers
are deemed creditworthy by the Adviser. The Adviser will continue to monitor
creditworthiness of the seller under a repurchase agreement, and will require
the seller to maintain during the term of the agreement the value of the
securities subject to the agreement to equal at least the repurchase price
(including accrued interest). In addition, the Adviser will require that the
value of this collateral, after transaction costs (including loss of interest)
reasonably expected to be incurred on a default, be equal to or greater than the
repurchase price (including accrued premium) provided in the repurchase
agreement. The accrued premium is the amount specified in the repurchase
agreement or the daily amortization of the difference between the purchase price
and the repurchase price specified in the repurchase agreement. The Portfolio's
Adviser will mark-to-market daily the value of the securities. Securities
subject to repurchase agreements will be held by the Fund's custodian (or sub-
custodian) in the Federal Reserve/Treasury book-entry system or by another
authorized securities depository. Repurchase agreements are considered to be
loans by the Portfolio under the 1940 Act.
The use of repurchase agreements involves certain risks. For example, if
the seller of securities under a repurchase agreement defaults on its obligation
to repurchase the underlying securities, as a result of its bankruptcy or
otherwise, the Portfolio will seek to dispose of such securities, which action
could involve costs or delays. If the seller becomes insolvent and subject to
liquidation or reorganization under applicable
-5-
<PAGE>
bankruptcy or other laws, the Portfolio's ability to dispose of the underlying
securities may be restricted. Finally, it is possible that the Portfolio may not
be able to substantiate its interest in the underlying securities. To minimize
this risk, the securities underlying the repurchase agreement will be held by
the custodian at all times in an amount at least equal to the repurchase price,
including accrued interest. If the seller fails to repurchase the securities,
the Portfolio may suffer a loss to the extent proceeds from the sale of the
underlying securities are less than the repurchase price.
RESTRICTED AND ILLIQUID SECURITIES. The Portfolio may purchase certain
restricted securities ("Rule 144A securities") eligible for sale to qualified
institutional buyers as contemplated by Rule 144A under the Securities Act of
1933. Rule 144A provides an exemption from the registration requirements of the
Securities Act of 1933 for the resale of certain restricted securities to
qualified institutional buyers. One effect of Rule 144A is that certain
restricted securities may now be liquid, though no assurance can be given that a
liquid market for Rule 144A securities will develop or be maintained. The
Portfolio's holdings of Rule 144A securities which are liquid securities will
not be subject to its limitation on investment in illiquid securities. The
Fund's Board of Trustees has adopted policies and procedures for the purpose of
determining whether securities that are eligible for resale under Rule 144A are
liquid or illiquid. The Board of Trustees will periodically review the
Portfolio's purchases and sales of Rule 144A securities.
OTHER INVESTMENTS
U.S. GOVERNMENT SECURITIES
U.S. Government securities include:
1. U.S. Treasury bills (maturities of one year or less), U.S.
Treasury notes (maturities of one to ten years) and U.S. Treasury
bonds (generally maturities of greater than ten years), all of which
are direct obligations of the U.S. Government and, as such, are backed
by the "full faith and credit" of the United States.
2. Securities issued by agencies and instrumentalities of the
U.S. Government which are backed by the full faith and credit of the
United States. Among the agencies and instrumentalities issuing such
obligations are the Federal Housing Administration, the Government
National Mortgage Association ("GNMA"), the Department of Housing and
Urban Development, the Export-Import Bank, the Farmers
-6-
<PAGE>
Home Administration ("FHA"), the General Services Administration, the
Maritime Administration and the Small Business Administration. The
maturities of such obligations range from three months to 30 years.
3. Securities issued by agencies and instrumentalities which
are not backed by the full faith and credit of the United States, but
whose issuing agency or instrumentalities may borrow, to meet its
obligations, from the U.S. Treasury. Among the agencies and
instrumentalities issuing such obligations are the Tennessee Valley
Authority, the Federal National Mortgage Association ("FNMA"), the
Federal Home Loan Mortgage Corporation ("FHLMC") and the U.S. Postal
Service.
4. Securities issued by agencies and instrumentalities which
are not backed by the full faith and credit of the United States, but
which are backed by the credit of the issuing agency or
instrumentality. Among the agencies and instrumentalities issuing such
obligations are the Federal Farm Credit System and the Federal Home
Loan Bank.
Neither the value nor the yield of the Portfolio's shares or of the U.S.
Government securities which may be invested in by the Portfolio are guaranteed
by the U.S. Government. Such values and yield will fluctuate with changes in
prevailing interest rates and other factors. Generally, as prevailing interest
rates rise, the value of any U.S. Government securities held by the Portfolio
will fall. Such securities with longer maturities generally tend to produce
higher yields and are subject to greater market fluctuation, as a result of
changes in interest rates, than debt securities with shorter maturities.
MORTGAGE-BACKED SECURITIES
As discussed in the Prospectus, the Mortgage-Backed Securities purchased by
the Portfolio evidence an interest in a specific pool of mortgages. Such
securities are issued by GNMA, FNMA and FHLMC and by private issuers, such as
depository institutions, mortgage banks, investment banks and special purpose
subsidiaries of the foregoing.
GNMA CERTIFICATES. GNMA is a wholly-owned corporate instrumentality of the
United States within the Department of Housing and Urban Development. The
National Housing Act of 1934, as amended (the "Housing Act"), authorized GNMA to
guarantee the timely payment of the principal of and interest on certificates
that are based on and backed by a pool of mortgage loans insured
-7-
<PAGE>
by the Federal Housing Administration under the Housing Act, or Title V of the
Housing Act of 1949 ("FHA Loans"), or guaranteed by the Veterans' Administration
under the Servicemen's Readjustment Act of 1944, as amended ("VA Loans"), or by
pools of other eligible mortgage loans. The Housing Act provides that the full
faith and credit of the U.S. Government is pledged to the payment of all amounts
that may be required to be paid under the guarantee. In order to meet its
obligations under such guarantee, GNMA is authorized to borrow from the U.S.
Treasury with no limitations as to amount.
The GNMA certificates will represent a pro-rata interest in one or more
pools of the following types of mortgage loans: (i) fixed rate level payment
mortgage loans; (ii) fixed rate graduated payment mortgage loans; (iii) fixed
rate growing equity mortgage loans; (iv) fixed rate mortgage loans secured by
manufactured (mobile) homes; (v) mortgage loans on multi-family residential
properties under construction; (vi) mortgage loans on completed multi-family
projects; (vii) fixed rate mortgage loans as to which escrowed funds are used to
reduce the borrower's monthly payments during the early years of the mortgage
loans ("buydown" mortgage loans); (viii) mortgage loans that provide for
adjustments in payments based on periodic changes in interest rates or in other
payment terms of the mortgage loans; and (ix) mortgage-backed serial notes. All
of these mortgage loans will be FHA Loans or VA Loans and, except as otherwise
specified above, will be fully-amortizing loans secured by first liens on one-to
four-family housing units.
FNMA CERTIFICATES. FNMA is a federally chartered and privately owned
corporation organized and existing under the Federal National Mortgage
Association Charter Act. FNMA was originally established in 1938 as a U.S.
Government agency to provide supplemental liquidity to the mortgage market and
was transformed into a stockholder owned and privately managed corporation by
legislation enacted in 1968. FNMA provides funds to the mortgage market
primarily by purchasing home mortgage loans from local lenders, thereby
replenishing their funds for additional lending. FNMA acquires funds to
purchase home mortgage loans from many capital market investors that may not
ordinarily invest in mortgage loans directly, thereby expanding the total amount
of funds available for housing.
Each FNMA certificate will entitle the registered holder thereof to receive
amounts representing such holder's pro-rata interest in scheduled principal
payments and interest payments (at such FNMA certificate's pass-through rate,
which is net of any servicing and guarantee fees on the underlying mortgage
loans), and any principal prepayments on the mortgage loans in the pool
represented by such FNMA certificate and such holder's proportionate interest in
the full principal amount of any
-8-
<PAGE>
foreclosed or otherwise finally liquidated mortgage loan. The full and timely
payment of principal of and interest on each FNMA certificate will be guaranteed
by FNMA, which guarantee is not backed by the full faith and credit of the U.S.
Government.
Each FNMA certificate will represent a pro rata interest in one or more
pools of FHA Loans, VA Loans or conventional mortgage loans (i.e., mortgage
loans that are not insured or guaranteed by any governmental agency) of the
following types: (i) fixed rate level payment mortgage loans; (ii) fixed rate
graduated payment mortgage loans; and (iii) adjustable rate mortgage loans.
FHLMC CERTIFICATES. FHLMC is a corporate instrumentality of the United
States created pursuant to the Emergency Home Finance Act of 1970, as amended
(the "FHLMC Act"). FHLMC was established primarily for the purpose of
increasing the availability of mortgage credit for the financing of needed
housing. The principal activity of FHLMC currently consists of the purchase of
first lien, conventional, residential mortgage loans and participation interests
in such mortgage loans and the resale of the mortgage loans so purchased in the
form of mortgage securities, primarily FHLMC certificates.
FHLMC guarantees to each registered holder of a FHLMC certificate the
timely payment of interest at the rate provided for by such FHLMC certificate,
whether or not received. FHLMC also guarantees to each registered holder of a
FHLMC certificate ultimate collection of all principal of the related mortgage
loans, without any offset or deduction, but does not, generally, guarantee the
timely payment of scheduled principal. FHLMC may remit the amount due on
account of its guarantee of collection of principal at any time after default on
an underlying mortgage loan, but not later than 30 days following (i)
foreclosure sale, (ii) payment of a claim by any mortgage insurer or (iii) the
expiration of any right of redemption, whichever occurs later, but in any event
no later than one year after demand has been made upon the mortgagor for
accelerated payment of principal. The obligations of FHLMC under its guarantee
are obligations solely of FHLMC and are not backed by the full faith and credit
of the U.S. Government.
FHLMC certificates represent a pro rata interest in a group of mortgage
loans (a "FHLMC certificate group") purchased by FHLMC. The mortgage loans
underlying the FHLMC certificates will consist of fixed rate or adjustable rate
mortgage loans with original terms to maturity of between ten and thirty years,
substantially all of which are secured by first liens on one- to four-family
residential properties or multifamily projects. Each mortgage loan must meet
the applicable standards set forth in the FHLMC Act. A FHLMC certificate group
may include whole loans, participation interests in whole loans and undivided
interests in
-9-
<PAGE>
whole loans and participations comprising another FHLMC certificate group.
ADJUSTABLE RATE MORTGAGE SECURITIES. Adjustable rate mortgage securities
are pass-through mortgage securities collateralized by mortgages with adjustable
rather than fixed rates ("ARMs"). ARMs eligible for inclusion in a mortgage pool
generally provide for a fixed initial mortgage interest rate for either the
first three, six, twelve, thirteen, thirty-six or sixty scheduled monthly
payments. Thereafter, the interest rates are subject to periodic adjustment
based on changes to a designated benchmark index.
ARMs contain maximum and minimum rates beyond which the mortgage interest
rate may not vary over the lifetime of the mortgage. In addition, certain ARMs
provide for additional limitations on the maximum amount by which the mortgage
interest rate may adjust for any single adjustment period. Alternatively,
certain ARMs contain limitations on changes in the required monthly payment. In
the event that a monthly payment is not sufficient to pay the interest accruing
on an ARM, any such excess interest is added to the principal balance of the
mortgage loan, which is repaid through future monthly payments. If the monthly
payment for such an instrument exceeds the sum of the interest accrued at the
applicable mortgage interest rate and the principal payment required at such
point to amortize the outstanding principal balance over the remaining term of
the loan, the excess is utilized to reduce the then outstanding principal
balance of the ARM.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTI-CLASS PASS-THROUGH
SECURITIES. Collateralized mortgage obligations or "CMOs" are debt obligations
collateralized by mortgage loans or mortgage pass-through securities.
Typically, CMOs are collateralized by GNMA, FNMA or FHLMC certificates, but also
may be collateralized by whole loans or private mortgage pass-through securities
(collectively, "Mortgage Assets"). Multi-class pass-through securities are
equity interests in a trust composed of Mortgage Assets. Unless the context
indicates otherwise, all references herein to CMOs include multi-class pass-
through certificates. Payments of principal of and interest on the Mortgage
Assets, and any reinvestment income thereon, provide the funds to pay debt
service on the CMOs or make scheduled distributions on the multi-class pass-
through securities. CMOs may be issued by agencies or instrumentalities of the
U.S. Government, or by private originators of, or investors in, mortgage loans,
including depository institutions, mortgage banks, investment banks and special
purpose subsidiaries of the foregoing. The issuer of CMOs or multi-class pass-
through securities may elect to be treated as a Real Estate Mortgage Investment
Conduit ("REMIC").
-10-
<PAGE>
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
fixed or floating coupon rate and has a stated maturity or final distribution
date. Principal prepayments on the Mortgage Assets may cause the CMOs to be
retired substantially earlier than their stated maturities or final distribution
dates. Interest is paid or accrues on all classes of the CMOs on a monthly,
quarterly or semi-annual basis. The principal of and interest on the Mortgage
Assets may be allocated among the several classes of a CMO series in a number of
different ways. Generally, the purpose of the allocation of the cash flow of a
CMO to the various classes is to obtain a more predictable cash flow to the
individual tranches than exists with the underlying collateral of the CMO. As a
general rule, the more predictable the cash flow is on a CMO tranche, the lower
the anticipated yield will be on that tranche at the time of issuance relative
to prevailing market yields on Mortgage-Backed securities.
The Portfolio also may invest in, among other things, parallel-pay CMOs and
Planned Amortization Class CMOs ("PAC Bonds"). Parallel-pay CMOs are structured
to provide payments of principal on each payment date to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class, which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC Bonds generally require payments of a
specified amount of principal on each payment date. PAC Bonds are parallel-pay
CMOs with the required principal payment on such securities having the highest
priority after interest has been paid to all classes.
The Portfolio may invest in CMO residuals. The residual in a CMO structure
generally represents the interest in any excess cash flow remaining after making
required payments of principal of and interest on the CMOs and related
administrative expenses of the issuer.
TYPES OF CREDIT ENHANCEMENT
Mortgage-Backed Securities are often backed by a pool of assets
representing the obligations of a number of different parties. To lessen the
effect of failures by obligors on underlying assets to make payments, those
securities may contain elements of credit support, which fall into two
categories: (i) liquidity protection and (ii) protection against losses
resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provision of advances, generally by the
entity administering the pool of assets, to ensure that the receipt of payments
on the underlying pool occurs
-11-
<PAGE>
in a timely fashion. Protection against losses resulting from default ensures
ultimate payment of the obligations on at least a portion of the assets in the
pool. This protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or sponsor from third parties, through
various means of structuring the transaction or through a combination of such
approaches. The Portfolio will not pay any additional fees for credit support,
although the existence of credit support may increase the price of a security.
Examples of credit support arising out of the structure of the transaction
include "senior-subordinated securities" (multiple class securities with one or
more classes subordinate to other classes as to the payment of principal thereof
and interest thereon, with the result that defaults on the underlying assets are
borne first by the holders of the subordinated class), creation of "reserve
funds" (where cash or investments, sometimes funded from a portion of the
payments on the underlying assets, are held in reserve against future losses)
and "overcollateralization" (where the scheduled payments on, or the principal
amount of, the underlying assets exceeds that required to make payment of the
securities and pay any servicing or other fees). The degree of credit support
provided for each issue is generally based on historical information respecting
the level of credit risk associated with the underlying assets. Delinquencies
or losses in excess of those anticipated could adversely affect the return on an
investment in such issue.
RISK FACTORS RELATING TO MORTGAGE-BACKED SECURITIES
The yield characteristics of Mortgage-Backed Securities differ from
traditional debt securities. Among the major differences are that interest and
principal payments are made more frequently, usually monthly, and that principal
may be prepaid at any time because the underlying mortgage loans or other assets
generally may be prepaid at any time. As a result, if the Portfolio purchases
such a security at a premium, a prepayment rate that is faster than expected
will reduce yield to maturity, while a prepayment rate that is slower than
expected will have the opposite effect of increasing yield to maturity.
Alternatively, if the Portfolio purchases these securities at a discount, faster
than expected prepayments will increase, while slower than expected prepayments
will reduce, yield to maturity.
Although the extent of prepayments on a pool of mortgage loans depends on
various economic and other factors, as a general rule prepayments on fixed rate
mortgage loans will increase during a period of falling interest rates and
decrease during a period of rising interest rates. Accordingly, amounts
available for reinvestment by the Portfolio are likely to be greater during a
period of declining interest rates and, as a result, likely to
-12-
<PAGE>
be reinvested at lower interest rates than during a period of rising interest
rates. Mortgage-Backed Securities may decrease in value as a result of increases
in interest rates and may benefit less than other fixed income securities from
declining interest rates because of the risk of prepayment. The markets for
Mortgage-Backed Securities may be more illiquid than those of other securities.
INVESTMENT RESTRICTIONS
The Portfolio is subject to the investment limitations enumerated in this
subsection which may be changed only by a vote of the holders of a majority of
the Portfolio's outstanding shares (as defined below under "Miscellaneous").
The Portfolio may not:
(1) invest 25% or more of the value of its total assets in any one
industry (Mortgage-Backed Securities and other securities issued
or guaranteed by the U.S. government or any agency or
instrumentality thereof are not treated as industries); provided,
however, that the Portfolio will, except for temporary defensive
purposes, invest at least 25% of the value of its total assets
in securities which represent interests in mortgages or liens on
real property;
(2) issue senior securities (including borrowing money, including on
margin if margin securities are owned) in excess of 33 1/3% of
its total assets (including the amount of senior securities
issued but excluding any liabilities and indebtedness not
constituting senior securities) except that the Portfolio may
borrow up to an additional 5% of its total assets for temporary
purposes; or pledge its assets other than to secure such
issuances or in connection with hedging transactions, short
sales, when-issued and forward commitment transactions and
similar investment strategies. The Portfolio's obligations under
interest rate swaps are not treated as senior securities;
(3) make loans of money or property to any person, except through
loans of portfolio securities, the purchase of fixed income
securities consistent with the Portfolio's investment objective
and policies or the acquisition of securities subject to
repurchase agreements;
(4) underwrite the securities of other issuers, except to the extent
that in connection with the
-13-
<PAGE>
disposition of portfolio securities or the sale of its own shares
the Portfolio may be deemed to be an underwriter;
(5) invest for the purpose of exercising control over management of
any company other than issuers of collateralized mortgage
obligations;
(6) purchase real estate or interests therein other than Commercial
and Residential Mortgage-Backed Securities and similar
instruments;
(7) purchase or sell commodities or commodity contracts for any
purposes except as, and to the extent, permitted by applicable
law without the Portfolio becoming subject to registration with
the Commodity Futures Trading Commission as a commodity pool; or
(8) make any short sale of securities except in conformity with
applicable laws, rules and regulations and unless, giving effect
to such sale, the market value of all securities sold short does
not exceed 25% of the value of the Portfolio's total assets and
the Portfolio's aggregate short sales of a particular class of
securities does not exceed 25% of the then outstanding securities
of that class.
TRUSTEES AND OFFICERS
The trustees and executive officers of the Fund, and their business
addresses and principal occupations during the past five years, are:
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION
NAME AND ADDRESS POSITION WITH FUND DURING PAST FIVE YEARS
- ---------------- ------------------ ----------------------
<S> <C> <C>
William O. Albertini Trustee Executive Vice President
Bell Atlantic Global Wireless and Chief Financial
1717 Arch Street Officer since August,
29th Floor East 1997, Bell Atlantic
Philadelphia, PA 19103 Global Wireless (global
Age: 55 wireless communications);
Executive Vice President,
Chief Financial Officer
and Director from
February 1995 - August
1997, Vice President and
Chief Financial Officer
from January 1991 -
February 1995, Bell
Atlantic Corporation (a
diversified
telecommunications
company); Chairman,
President and Chief
Executive Officer from
August 1989 - January
1991, Bell Atlantic
Enterprises
International, Inc.;
Director, Groupo
Iusacell, S.A. de C.V.
(cellular communications
company) since June 1994;
Director, American
Waterworks, Inc. (water
utility) since May 1990;
Trustee, The Carl E. &
Emily I. Weller
Foundation since October
1991.
</TABLE>
-14-
<PAGE>
<TABLE>
<S> <C> <C>
Raymond J. Clark/1/ Trustee, Treasurer of Princeton
Office of the Treasurer President and Treasurer University since 1987;
Princeton University Trustee, The Compass
3 New South Building Capital Group of Funds
P.O. Box 35 from 1987 to 1996;
Princeton, New Jersey 08540 Trustee, United Way
Age: 62 Princeton Area
Communities from
1992-94; Trustee,
Chemical Bank, New
Jersey Advisory Board
from 1994 until 1995;
Trustee, American Red
Cross - Mercer County
Chapter since 1995; and
Trustee, United
Way-Greater Mercer
County from
1996-1997.
Robert M. Hernandez Trustee Director since 1991,
USX Corporation Vice Chairman and Chief
600 Grant Street Financial Officer
6105 USX Tower since 1994, Executive
Pittsburgh, PA 15219 Vice President -
Age: 53 Accounting & Finance and
Chief Financial Officer
from 1991 to 1994,
</TABLE>
________________________
1. This trustee may be deemed an "interested person" of the Fund as defined in
the 1940 Act.
-15-
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION
NAME AND ADDRESS POSITION WITH FUND DURING PAST FIVE YEARS
- ---------------- ------------------ ----------------------
<S> <C> <C>
USX Corporation (a
diversified company
principally engaged in
energy and steel
businesses); Director,
ACE Limited; Trustee,
Allegheny University
Hospitals, Allegheny
General; and Allegheny
Health, Education and
Research Foundation;
Director, Marinette
Marine Corporation;
Director, Pittsburgh
Baseball, Inc.; and
Director and Chairman of
the Board, RMI Titanium
Company.
Anthony M. Santomero Vice Chairman Deputy Dean from
The Wharton School of the Board 1990 to 1994, Richard
University of Pennsylvania K. Mellon Professor
Room 2344 of Finance since April
Steinberg Hall-Dietrich Hall 1984, Director, Wharton
Philadelphia, PA 19104-6367 Financial Institutions
Age: 51 Center, since July
1995, and Dean's
Advisory Council
Member since July
1984, The Wharton
School, University
of Pennsylvania;
Associate Editor,
Journal of Banking
and Finance since
June 1978;
Associate Editor,
Journal of
Economics and
Business since
October 1979;
Associate Editor,
Journal of Money,
Credit and Banking
since January
1980; Research
Associate, New
York University
Center for
Japan-U.S.
Business and
Economic Studies
since July 1989;
Editorial Advisory
</TABLE>
-16-
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION
NAME AND ADDRESS POSITION WITH FUND DURING PAST FIVE YEARS
- ---------------- ------------------ ----------------------
<S> <C> <C>
Board, Open
Economics Review
since November
1990; Director,
The Zweig Fund and
The Zweig Total
Return Fund;
Director of
Municipal Fund for
California
Investors, Inc.,
and Municipal Fund
for New York
Investors, Inc.
David R. Wilmerding, Jr. Chairman Chairman, Gee,
One Aldwyn Center of the Board Wilmerding &
Villanova, PA 19085 Associates, Inc.
Age: 62 (investment advisers)
since February 1989;
Director, Beaver
Management Corporation;
Managing General Partner,
Chestnut Street
Exchange Fund;
Director, Independence
Square Income
Securities, Inc.;
Director, The Mutual
Fire, Marine and
Inland Insurance Company;
Director, U.S. Retirement
Communities, Inc.; Director,
Trustee or Managing
General Partner of a
number of investment
companies advised by
PIMC and its affiliates.
Karen H. Sabath Assistant President, Compass
BlackRock, Inc. Secretary Capital Group, Inc.
345 Park Avenue since 1995; Managing
New York, NY 10154 Director of BlackRock
Age: 31 Financial Management,
Inc. since 1993; prior
to 1993, Vice President
of BlackRock Financial
Management, Inc.
</TABLE>
-17-
<PAGE>
<TABLE>
<CAPTION>
PRINCIPAL OCCUPATION
NAME AND ADDRESS POSITION WITH FUND DURING PAST FIVE YEARS
- ---------------- ------------------ ----------------------
<S> <C> <C>
Ellen L. Corson Assistant Vice President and
PFPC Inc. Treasurer Director of Mutual Fund
103 Bellevue Parkway Accounting and Adminis-
Wilmington, DE 19809 tration, PFPC Inc. since
Age: 33 November 1997; Assistant Vice
President, PFPC Inc. from
March 1997 to November 1997; Senior
Accounting Officer, PFPC Inc. from March
1993 to March 1997.
Brian P. Kindelan Secretary Senior Counsel, PNC Bank
PNC Bank Corp. Corp. since May 1995;
1600 Market Street, 28th Floor Associate, Stradley, Ronon,
Philadelphia, PA 19103 Stevens & Young from March
Age: 38 1990 to May 1995.
</TABLE>
The Fund pays trustees who are not affiliated with BlackRock, Inc. or
BlackRock Distributors, Inc. ("BDI" or "Distributor") $10,000 annually and $275
per Portfolio for each full meeting of the Board that they attend. The Fund pays
the Chairman and Vice Chairman an additional $10,000 and $5,000, respectively,
for their services in such capacities. Trustees who are not affiliated with
BlackRock, Inc. or the Distributor are reimbursed for any expenses incurred in
attending meetings of the Board of Trustees or any committee thereof. No
officer, director or employee of BlackRock, Inc., PNC Institutional Management
Corporation ("PIMC"), Provident Capital Management, Inc. ("PCM"), BlackRock
Financial Management, Inc. ("BlackRock"), PNC Equity Advisors Company ("PEAC"),
CastleInternational Asset Management Limited ("CastleInternational"), PFPC Inc.
("PFPC"), BlackRock Distributors, Inc. ("BDI" and, collectively with PFPC and
BlackRock, Inc., the "Administrators"), or PNC Bank, National Association ("PNC
Bank" or the "Custodian") currently receives any compensation from the Fund. As
of the date of this Statement of Additional Information, the trustees and
officers of the Fund, as a group, owned less than 1% of the outstanding shares
of each class of each investment portfolio of the Fund.
-18-
<PAGE>
The table below sets forth the compensation actually received from the Fund
Complex of which the Fund is a part by the trustees for the fiscal year ended
September 30, 1997:
<TABLE>
<CAPTION>
TOTAL
PENSION OR COMPENSATION
RETIREMENT FROM
AGGREGATE BENEFITS ESTIMATED REGISTRANT AND
COMPENSATION ACCRUED AS ANNUAL FUND COMPLEX/1/
NAME OF PERSON, FROM PART OF FUND BENEFITS UPON PAID TO
POSITION REGISTRANT EXPENSES RETIREMENT TRUSTEES
- -------------- ---------- -------- ---------- --------
<S> <C> <C> <C> <C>
Anthony M. $52,300 N/A N/A (3)/2/ $64,300
Santomero, Vice
Chairman of the
Board
David R. Wilmerding, $61,050 N/A N/A (3)/2/ $73,050
Jr., Chairman of the
Board
William O.
Albertini, Trustee $43,550 N/A N/A (1)/2/ $43,550
Raymond J. Clark,
Trustee, President $43,550 N/A N/A (1)/2/ $43,550
and Treasurer
Robert M. Hernandez,
Trustee $43,550 N/A N/A (1)/2/ $43,550
</TABLE>
SHAREHOLDER AND TRUSTEE LIABILITY. Under Massachusetts law, shareholders
of a business trust may, under certain circumstances, be held personally liable
as partners for the obligations of the trust. However, the Fund's Declaration
of Trust provides that shareholders shall not be subject to any personal
liability in connection with the assets of the Fund for the acts or obligations
of the Fund, and that every note, bond, contract, order or other undertaking
made by the Fund shall contain a provision to the effect that the shareholders
are not personally liable thereunder. The Declaration of Trust provides for
indemnification out of the trust property of any shareholder held personally
liable solely by reason of his being or having been a shareholder and not
because of his acts or omissions or
_________________
1. A Fund Complex means two or more investment companies that hold themselves
out to investors as related companies for purposes of investment and
investor services, or have a common investment adviser or have an
investment adviser that is an affiliated person of the investment adviser
of any of the other investment companies.
2. Total number of investment company boards trustees served on within the
Fund Complex.
-19-
<PAGE>
some other reason. The Declaration of Trust also provides that the Fund shall,
upon request, assume the defense of any claim made against any shareholder for
any act or obligation of the Fund, and shall satisfy any judgment thereon.
The Declaration of Trust further provides that all persons having any claim
against the trustees or Fund shall look solely to the trust property for
payment; that no trustee of the Fund shall be personally liable for or on
account of any contract, debt, tort, claim, damage, judgment or decree arising
out of or connected with the administration or preservation of the trust
property or the conduct of any business of the Fund; and that no trustee shall
be personally liable to any person for any action or failure to act except by
reason of his own bad faith, willful misfeasance, gross negligence or reckless
disregard of his duties as a trustee. With the exception stated, the Declaration
of Trust provides that a trustee is entitled to be indemnified against all
liabilities and expenses reasonably incurred by him in connection with the
defense or disposition of any proceeding in which he may be involved or with
which he may be threatened by reason of his being or having been a trustee, and
that the Fund will indemnify officers, representatives and employees of the Fund
to the same extent that trustees are entitled to indemnification.
-20-
<PAGE>
INVESTMENT ADVISORY, ADMINISTRATION,
DISTRIBUTION AND SERVICING ARRANGEMENTS
ADVISORY AGREEMENT. The advisory services provided by BlackRock, an
indirect wholly-owned subsidiary of PNC Bank Corp., and the fees received by it
for such services are described in the Prospectus. As stated in the Prospectus,
BlackRock may from time to time voluntarily waive its advisory fees with respect
to the Portfolio and may voluntarily reimburse the Portfolio for expenses.
BlackRock renders advisory services to the Portfolio pursuant to an
Investment Advisory Agreement (the "Advisory Contract"). Under the Advisory
Contract, BlackRock is not liable for any error of judgment or mistake of law or
for any loss suffered by the Fund or the Portfolio in connection with the
performance of the Advisory Contract, except a loss resulting from willful
misfeasance, bad faith or gross negligence on the part of BlackRock in the
performance of its duties or from reckless disregard of its duties and
obligations thereunder. The Advisory Contract is terminable as to the Portfolio
by vote of the Board of Trustees or by the holders of a majority of the
outstanding voting securities of the Portfolio, at any time without penalty, on
60 days' written notice to BlackRock. BlackRock may also terminate its advisory
relationship with respect to the Portfolio, on 60 days' written notice to the
Fund. The Advisory Contract terminates automatically in the event of its
assignment.
For the period from October 1, 1996 through September 30, 1997, the
Portfolio paid $323,455 in advisory fees to BlackRock and BlackRock waived
$45,000 in expenses. For the period from April 26, 1996 through September 30,
1996, the Portfolio paid $150,034 in advisory fees to BlackRock, and BlackRock
waived $31,063 in expenses.
The Predecessor Portfolio was also advised by BlackRock. For the period
from April 1, 1996 through April 25, 1996, the Portfolio paid $24,092 in
advisory fees to BlackRock, and BlackRock waived $344 in expenses. For the
fiscal period from July 1, 1995 to March 31, 1996 and the fiscal period from
October 6, 1994 (commencement of investment operations) through June 30, 1995,
the Predecessor Portfolio paid $213,047 and $189,677, respectively, in
investment advisory fees to BlackRock pursuant to the prior advisory agreement.
In addition, during the same periods, BlackRock waived $3,652 and $56,269,
respectively, in expenses.
ADMINISTRATION AGREEMENTS. The Fund has entered into a Co-Administration
Agreement with BlackRock, Inc. and a separate Administration Agreement with
PFPC, whose principal
-21-
<PAGE>
business address is 400 Bellevue Parkway, Wilmington, DE 19809, and BDI (the
"Administration Agreements"). PFPC and BDI have agreed to maintain office
facilities for the Fund; furnish the Fund with statistical and research data,
clerical, accounting, and bookkeeping services; provide and supervise the
operation of an automated data processing system to process purchase and
redemption orders; provide information and distribute written communications to
shareholders; handle shareholder problems and calls; research issues raised by
financial intermediaries relating to investments in a Portfolio's shares; review
and provide advice with respect to communications for a Portfolio's shares;
monitor the investor programs that are offered in connection with a Portfolio's
shares; provide oversight and related support services that are intended to
ensure the delivery of quality service to the holders of the Portfolio's shares;
and provide certain other services required by the Fund.
Under the Co-Administration Agreement, BlackRock, Inc. is responsible for:
(i) the supervision and coordination of the performance of the Fund's service
providers; (ii) the negotiation of service contracts and arrangements between
the Fund and its service providers; (iii) acting as liaison between the trustees
of the Fund and the Fund's service providers; and (iv) providing ongoing
business management and support services in connection with the Fund's
operations.
As compensation for these services, BlackRock, Inc. is entitled to receive
a fee, computed daily and payable monthly, at an annual rate of .03% of each
Portfolio's average daily net assets. PFPC and BDI are entitled to receive a
combined fee, computed daily and payable monthly, at the maximum annual
aggregate rate of .20% of the first $500 million of each Portfolio's average
daily net assets, .18% of the next $500 million of each Portfolio's average
daily net assets, and .16% of each Portfolio's average daily net assets in
excess of $1 billion. From time to time the Administrators may waive some or all
of their administration fees from a Portfolio.
The Administration Agreements provide that the Administrators will not be
liable for any error of judgment or mistake of law or for any loss suffered by
the Fund or the Portfolio in connection with the performance of the
Administration Agreements, except a loss resulting from willful misfeasance, bad
faith or gross negligence in the performance of their respective duties or from
reckless disregard of their respective duties and obligations thereunder.
For the period from October 1, 1996 through September 30, 1997, the
Portfolio paid $297,578 in administrative fees to Compass Capital Group, Inc.
("CCG", which served as Co-Administrator to the Fund from December 1, 1995 until
January 28, 1998), PFPC and BDI and CCG, PFPC and BDI waived fees totalling
$276,079. For the period from April 26, 1996 through September
-22-
<PAGE>
30, 1996, the Portfolio paid $86,204 in administrative fees to CCG, PFPC and
BDI, and CCG, PFPC and BDI waived fees totalling $54,252.
During the periods from April 1, 1996 through April 25, 1996 and January
13, 1996 through March 31, 1996, the Predecessor Portfolio paid $8,673 and
$8,620, respectively, in administrative fees to CCG, PFPC and BDI.
During the period from July 1, 1995 through January 12, 1996, the
Predecessor Portfolio received administrative services from PFPC. During that
period, the Predecessor Portfolio paid PFPC $55,878 in administrative fees
pursuant to a prior administrative agreement. Prior to July 1, 1995, the
Predecessor Portfolio received administrative services from State Street Bank
and Trust Company ("State Street"). During the fiscal period from October 6,
1994 (commencement of investment operations) through June 30, 1995, the
Predecessor Portfolio paid $32,948 in administrative fees to State Street
pursuant to a prior administration agreement.
CUSTODIAN AND TRANSFER AGENCY AGREEMENTS. PNC Bank, National Association
("PNC Bank"), whose principal business address is 1600 Market Street,
Philadelphia, Pennsylvania 19103, is custodian of the Fund's assets pursuant to
a custodian agreement (the "Custodian Agreement"). Under the Custodian
Agreement, PNC Bank or a sub-custodian (i) maintains a separate account or
accounts in the name of the Portfolio, (ii) holds and transfers portfolio
securities on account of the Portfolio, (iii) accepts receipts and makes
disbursements of money on behalf of the Portfolio, (iv) collects and receives
all income and other payments and distributions on account of the Portfolio's
securities and (v) makes periodic reports to the Board of Trustees concerning
the Portfolio's operations. PNC Bank is authorized to select one or more banks
or trust companies to serve as sub-custodian on behalf of the Fund, provided
that, with respect to sub-custodians other than sub-custodians for foreign
securities, PNC Bank remains responsible for the performance of all its duties
under the Custodian Agreement and holds the Fund harmless from the acts and
omissions of any sub-custodian. Citibank, N.A. serve as the international sub-
custodians for various portfolios of the Fund.
For its services to the Fund under the Custodian Agreement, PNC Bank
receives a fee which is calculated based upon the Portfolio's average gross
assets, with a minimum monthly fee of $1,000 per investment portfolio. PNC Bank
is also entitled to out-of-pocket expenses and certain transaction charges.
PFPC, an affiliate of PNC Bank, serves as the transfer and dividend
disbursing agent for the Fund pursuant to a Transfer
-23-
<PAGE>
Agency Agreement (the "Transfer Agency Agreement"), under which PFPC (i) issues
and redeems shares in the Portfolio, (ii) addresses and mails all communications
by the Portfolio to record owners of its shares, including reports to
shareholders, dividend and distribution notices and proxy materials for its
meetings of shareholders, (iii) maintains shareholder accounts and, if
requested, sub-accounts and (iv) makes periodic reports to the Board of Trustees
concerning the operations of the Portfolio. PFPC may, on 30 days' notice to the
Fund, assign its duties as transfer and dividend disbursing agent to any other
affiliate of PNC Bank Corp. For its services with respect to the Fund's
Institutional Shares under the Transfer Agency Agreement, PFPC is entitled to
receive fees at the annual rate of .03% of the average net asset value of
outstanding Institutional Shares in the Portfolio, plus per account fees and
disbursements.
DISTRIBUTOR AND DISTRIBUTION PLAN. The Fund has entered into a
distribution agreement with the Distributor under which the Distributor, as
agent, offers shares of the Portfolio on a continuous basis. The Distributor
has agreed to use appropriate efforts to effect sales of the shares, but it is
not obligated to sell any particular amount of shares.
The Fund has adopted an Amended and Restated Distribution and Service Plan
(the "Plan") pursuant to Rule 12b-1 under the 1940 Act on behalf of its
Institutional Shares. The Plan was approved by a majority of (i) the trustees
of the Fund and (ii) the trustees of the Fund who are not interested persons of
the Fund and who have no direct or indirect financial interest in the operation
of the Plan or in any agreement related to the Plan (the "Rule 12b-1 Trustees").
The Fund is not required or permitted under the Plan to make distribution
payments with respect to its Institutional Shares. However, the Plan permits
BDI, BlackRock, Inc., the Administrators and other companies that receive fees
from the Fund to make payments relating to distribution and sales support
activities out of their past profits or other sources available to them. The
Distributor, BlackRock, Inc. and their affiliates may pay financial
institutions, broker/dealers and/or their salespersons certain compensation for
the sale and distribution of shares of the Fund or for services to the Fund.
These payments ("Additional Payments") may take the form of "due diligence"
payments for a dealer's examination of the Portfolio and payments for providing
extra employee training and information relating to the Portfolio; "listing"
fees for the placement of the Portfolio on a dealer's list of mutual funds
available for purchase by its customers; "finders" or "referral" fees for
directing investors to the Fund; "marketing support" fees for providing
assistance in promoting the sale of the Funds' shares; and payments for the sale
of shares and/or the
-24-
<PAGE>
maintenance of share balances. In addition, the Distributor, BlackRock, Inc. and
their affiliates may make Additional Payments for subaccounting, administrative
and/or shareholder processing services. The Additional Payments made by the
Distributor, BlackRock, Inc. and their affiliates may be a fixed dollar amount,
may be based on the number of customer accounts maintained by a financial
institution or broker/dealer, or may be based on a percentage of the value of
shares sold to, or held by, customers of the financial institutions or dealers
involved, and may be different for different institutions and dealers.
Furthermore, the Distributor, BlackRock, Inc. and their affiliates may
contribute to various non-cash and cash incentive arrangements to promote the
sale of shares, and may sponsor various contests and promotions subject to
applicable NASD regulations in which participants may receive prizes such as
travel awards, merchandise and cash. The Distributor, BlackRock, Inc. and their
affiliates may also pay for the travel expenses, meals, lodging and
entertainment of broker/dealers, financial institutions and their salespersons
in connection with educational and sales promotional programs subject to
applicable NASD regulations.
The Plan will continue from year to year, provided that each such
continuance is approved at least annually by a vote of the Board of Trustees,
including a majority vote of the Rule 12b-1 Trustees, cast in person at a
meeting called for the purpose of voting on such continuance. The Plan may be
terminated with respect to the Portfolio at any time, without penalty, by the
vote of a majority of the Rule 12b-1 Trustees or by a vote of the holders of a
majority of the outstanding shares of the Portfolio. The Plan may not be
amended materially without the approval of the Board of Trustees, including a
majority of the Rule 12b-1 Trustees, cast in person at a meeting called for that
purpose. Any modification to the Plan which would materially increase the costs
borne by the Portfolio for distribution purposes pursuant to the Plan must also
be submitted to the stockholders of the Portfolio for approval. In addition,
while the Plan remains in effect, the selection and nomination of the Fund's
trustees who are not "interested persons" of the Fund shall be committed to the
discretion of the Fund's non-interested trustees.
PORTFOLIO TRANSACTIONS
The Adviser is responsible for decisions to buy and sell securities for the
Portfolio, the selection of brokers and dealers to effect the transactions and
the negotiation of prices and any brokerage commissions. The securities in which
the Portfolio invests are traded principally in the over-the-counter market. In
the over-the-counter market, securities are generally traded on a "net" basis
with dealers acting as principal for their own accounts without a stated
commission, although the
-25-
<PAGE>
price of the security usually includes a mark-up to the dealer. Securities
purchased in underwritten offerings generally include, in the price, a fixed
amount of compensation for the manager(s), underwriter(s) and dealer(s). The
Portfolio may also purchase certain money market instruments directly from an
issuer, in which case no commissions or discounts are paid. Purchases and sales
of debt securities on a stock exchange are effected through brokers who charge a
commission for their services.
The Adviser's primary considerations in selecting the manner of executing
securities transactions for the Portfolio will be prompt execution of orders,
the size and breadth of the market for the security, the reliability, integrity
and financial condition and execution capability of the firm, the size of and
difficulty in executing the order, and the best net price. There are many
instances when, in the judgment of the Adviser, more than one firm can offer
comparable execution services. In selecting among such firms, consideration is
given to those firms which supply research and other services in addition to
execution services. However, it is not the policy of the Adviser, absent
special circumstances, to pay higher commissions to a firm because it has
supplied such services.
The Adviser is able to fulfill its obligations to furnish a continuous
investment program to the Portfolio without receiving such information from
brokers; however, it considers access to such information to be an important
element of financial management. Although such information is considered
useful, its value is not determinable, as it must be reviewed and assimilated by
the Adviser, and does not reduce the Adviser's normal research activities in
rendering investment advice under the Advisory Contract. It is possible that
the Adviser's expenses could be materially increased if it attempted to purchase
this type of information or generate it through its own staff.
One or more of the other accounts which the Adviser manages may own from
time to time the same investments as the Portfolio. Investment decisions for
the Portfolio are made independently from those of such other accounts; however,
from time to time, the same investment decision may be made for more than one
company or account. When two or more companies or accounts seek to purchase or
sell the same securities, the securities actually purchased or sold will be
allocated among the companies and accounts on a good faith equitable basis by
the Adviser in its discretion in accordance with the accounts' various
investment objectives. In some cases, this system may adversely affect the price
or size of the position obtainable for the Portfolio. In other cases, however,
the ability of the Portfolio to participate in volume transactions may produce
better execution for the Portfolio.
-26-
<PAGE>
Although the Advisory Agreement contains no restrictions on portfolio
turnover, it is not the policy of the Portfolio to engage in transactions with
the objective of seeking profits from short-term trading. It is expected that
the annual portfolio turnover rate of the Portfolio will not exceed 400%,
excluding securities having a maturity of one year or less. Because it is
difficult to predict accurately portfolio turnover rate, actual turnover may be
higher or lower. Higher portfolio turnover results in increased Portfolio
expenses, including brokerage commissions, dealer mark-ups and other transaction
costs on the sale of securities and on reinvestment in other securities. The
Adviser will monitor the tax status of the Portfolio under the Internal Revenue
Code during periods in which the annual turnover rate of the Portfolio exceeds
100%. The portfolio turnover rate of the Portfolio is calculated by dividing the
lesser of the Portfolio's annual sales or purchases of portfolio securities
(exclusive of purchases or sales of securities whose maturities at the time of
acquisition were one year or less) by the monthly average value of the
securities held by the Portfolio during the year.
The Portfolio will not purchase securities during the existence of any
underwriting or selling group relating to such securities of which BlackRock,
Inc., PIMC, BlackRock, PNC Bank, PCM, PEAC, CastleInternational, the
Administrators, the Distributor or any affiliated person (as defined in the 1940
Act) thereof is a member except pursuant to procedures adopted by the Board of
Trustees in accordance with Rule 10f-3 under the 1940 Act. In no instance will
portfolio securities be purchased from or sold to BlackRock, Inc., PIMC,
BlackRock, PNC Bank, PCM, PEAC, CastleInternational, the Administrators, the
Distributor or any affiliated person of the foregoing entities except as
permitted by SEC exemptive order or by applicable law.
For the periods from October 1, 1996 through September 30, 1997, and April
26, 1996 through September 30, 1996, the Portfolio paid no brokerage
commissions. In addition, for the same periods, the portfolio turnover rate for
the Portfolio was 52% and 19%, respectively. For the period from April 1, 1996
through April 25, 1996, the period from July 1, 1995 through March 31, 1996 and
the period from October 6, 1994 (commencement of operations) through June 30,
1995, the Predecessor Portfolio paid no brokerage commissions. In addition, for
the same periods, the portfolio turnover rate for the Predecessor Portfolio was
4%, 119% and 215%, respectively.
-27-
<PAGE>
The Fund is required to identify any securities of its regular brokers or
dealers (as defined in Rule 10b-1 under the 1940 Act) or their parents held by
the Fund as of the end of its most recent fiscal year. As of September 30, 1997,
the following Portfolios held the following securities:
<TABLE>
<CAPTION>
PORTFOLIO SECURITY VALUE
--------- -------- -----
<S> <C> <C>
Money Market
Morgan Stanley & Co., Inc. Commercial Paper $ 49,402,000
Morgan Stanley & Co., Inc. Variable Rate Obligation 36,997,742
Merrill Lynch & Co. Commercial Paper 128,081,269
Lehman Brothers, Inc. Commercial Paper 49,837,542
Lehman Brothers, Inc. Variable Rate Obligation 50,000,000
U.S. Treasury Money Market
Morgan Stanley & Co., Inc. Repurchase Agreement $ 247,000,000
Greenwich Capital Repurchase Agreement 225,000,000
Goldman, Sachs & Co. Repurchase Agreement 50,000,000
Merrill Lynch & Co. Repurchase Agreement 50,000,000
Swiss Bank Corp. Repurchase Agreement 50,000,000
Low Duration Bond
Morgan Stanley & Co., Inc. Mortgage Pass-Through $ 168,166
Lehman Brothers, Inc. Corporate Bond 3,689,617
Salomon Brothers, Inc. Mortgage Pass-Through 3,065,061
Salomon Brothers, Inc. Corporate Bond 4,037,134
Intermediate Government Bond
Merrill Lynch & Co. Mortgage Pass-Through $ 4,367,211
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,407,311
Intermediate Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 2,117,624
Salomon Brothers, Inc. Corporate Bond 527,865
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,577,526
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 3,266,973
Merrill Lynch & Co. Mortgage Pass-Through 10,190,099
Merrill Lynch & Co. Commercial Mortgage-Backed Security 1,236,217
</TABLE>
-28-
<PAGE>
<TABLE>
<CAPTION>
PORTFOLIO SECURITY VALUE
--------- -------- -----
<S> <C> <C>
Core Bond
Salomon Brothers, Inc. Mortgage Pass-Through $ 6,900,254
Salomon Brothers, Inc. Corporate Bond 5,701,504
Goldman, Sachs & Co. Commercial Mortgage-Backed Security 2,942,012
Merrill Lynch & Co. Mortgage Pass-Through 428,155
Merrill Lynch & Co. Commercial Mortgage-Backed Security 3,397,277
Merrill Lynch & Co. Asset Backed Security 303,703
Merrill Lynch & Co. Corporate Bond 4,226,051
Government Income
Salomon Brothers, Inc. Mortgage Pass-Through $ 632,894
Managed Income
Salomon Brothers, Inc. Corporate Bond $ 2,639,323
Morgan Stanley & Co., Inc. Commercial Mortgage-Backed Security 1,063,281
PaineWebber Jackson & Curtis, Inc. Corporate Bond 5,004,177
HSBC Securities Corporate Bond 7,852,743
Merrill Lynch & Co. Corporate Bond 8,250,862
Merrill Lynch & Co. Commercial Mortgage-Backed Security 12,884,829
Large Cap Value Equity
Morgan Stanley & Co., Inc. Common Stock $ 29,257,111
Mid-Cap Value Equity
Donaldson, Lufkin & Jenrette Securities Corp. Common Stock $ 1,073,437
Select Equity
Morgan Stanley & Co., Inc. Common Stock $ 7,595,781
Balanced
Morgan Stanley & Co., Inc. Common Stock $ 4,941,312
Salomon Brothers, Inc. Mortgage Pass-Through 1,593,589
Salomon Brothers, Inc. Corporate Bond 316,719
PaineWebber Jackson & Curtis, Inc. Corporate Bond 1,051,684
Merrill Lynch & Co. Corporate Bond 1,006,203
Merrill Lynch & Co. Commercial Mortgage-Backed Security 2,015,045
</TABLE>
PURCHASE AND REDEMPTION INFORMATION
Institutional Shares of the Portfolio are sold at the net asset value per
share next determined after a purchase order is received.
The Fund reserves the right, if conditions exist which make cash payments
undesirable, to honor any request for redemption or repurchase of the
Portfolio's shares by making payment in whole or in part in securities chosen by
the Fund and valued in the same way as they would be valued for purposes of
computing the Portfolio's net asset value. If payment is made in securities, a
shareholder may incur transaction costs in converting these securities into
cash. The Fund has elected, however, to be governed by Rule 18f-1 under the 1940
Act so that the Portfolio is obligated to redeem its shares solely in cash up to
the lesser
-29-
<PAGE>
of $250,000 or 1% of its net asset value during any 90-day period for any one
shareholder of the Portfolio.
Under the 1940 Act, the Portfolio may suspend the right to redemption or
postpone the date of payment upon redemption for any period during which the New
York Stock Exchange (the "NYSE") is closed (other than customary weekend and
holiday closings), or during which trading on the NYSE is restricted, or during
which (as determined by the SEC by rule or regulation) an emergency exists as a
result of which disposal or valuation of portfolio securities is not reasonably
practicable, or for such other periods as the SEC may permit. (The Portfolio
may also suspend or postpone the recordation of the transfer of its shares upon
the occurrence of any of the foregoing conditions.)
In addition to the situations described in the Prospectus, the Fund may
redeem shares involuntarily to reimburse the Portfolio for any loss sustained by
reason of the failure of a shareholder to make full payment for shares purchased
by the shareholder or to collect any charge relating to a transaction effected
for the benefit of a shareholder as provided in the Prospectus from time to
time.
VALUATION OF PORTFOLIO SECURITIES
In determining the approximate market value of portfolio investments, the
Fund may employ outside organizations, which may use, without limitation, a
matrix or formula method that takes into consideration market indexes, matrices,
yield curves and other specific adjustments. This may result in the securities
being valued at a price different from the price that would have been determined
had the matrix or formula method not been used. All cash, receivables and
current payables are carried on the Fund's books at their face value. Other
assets, if any, are valued at fair value as determined in good faith under the
supervision of the Board of Trustees.
PERFORMANCE INFORMATION
TOTAL RETURN. For purposes of quoting and comparing the performance of
shares of the Portfolio to the performance of other mutual funds and to stock or
other relevant indexes in advertisements, sales literature, communications to
shareholders and other materials, performance may be stated in terms of total
return. Under the rules of the SEC, funds advertising performance must include
total return quotes calculated according to the following formula:
-30-
<PAGE>
ERV /1/n/
T = [(-----) - 1]
P
Where: T = average annual total return.
ERV = ending redeemable value at the end of the period
covered by the computation of a hypothetical $1,000
payment made at the beginning of the period.
P = hypothetical initial payment of $1,000.
n = period covered by the computation, expressed in terms
of years.
Total return, or "T" in the formula above, is computed by finding the
average annual compounded rates of return over the specified periods that would
equate the initial amount invested to the ending redeemable value.
The total returns for the Portfolio include performance information for the
Predecessor Portfolio for periods prior to April 26, 1996, the date on which the
assets and liabilities of the Predecessor Portfolio were transferred to the
Portfolio. Based on the foregoing, the total returns for the Portfolio were as
follows:
<TABLE>
<CAPTION>
AGGREGATE TOTAL AVERAGE ANNUAL
RETURN TOTAL RETURN
--------------- --------------
<S> <C>
FOR THE
TWELVE MONTHS FROM COMMENCEMENT
ENDED OF OPERATIONS TO
9/30/97 9/30/97/(1)/
12.67% 39.54%
</TABLE>
__________________
/(1)/ Predecessor Portfolio commenced investment operations on October
6, 1994.
The Portfolio may also from time to time include in advertisements, sales
literature, communications to shareholders and other materials a total return
figure that is not calculated according to the formula set forth above in order
to compare more accurately the performance of the Portfolio's shares with other
performance measures. For example, in comparing the total return of the
Portfolio's shares with data published by Lipper Analytical Services, Inc., CDA
Investment Technologies, Inc. or Weisenberger Investment Company Service, or
with the performance
-31-
<PAGE>
of the Salomon Broad Investment Grade Index, as appropriate, the Portfolio may
calculate the aggregate total return for its shares for the period of time
specified in the advertisement or communication by assuming the investment of
$10,000 in the Portfolio's shares and assuming the reinvestment of each dividend
or other distribution at net asset value on the reinvestment date. Percentage
increases are determined by subtracting the initial value of the investment from
the ending value and by dividing the remainder by the beginning value.
In addition to average annual total returns, the Portfolio may quote
unaveraged or cumulative total returns reflecting the simple change in value of
an investment over a stated period. Average annual and cumulative total returns
may be quoted as a percentage or as a dollar amount, and may be calculated for a
single investment, a series of investments, or a series of redemptions, over any
time period. Total returns may be broken down into their components of income
and capital (including capital gains and changes in share price) in order to
illustrate the relationship of these factors and their contributions to total
return. Total returns may be quoted on a before-tax or after-tax basis. Total
returns, yields, and other performance information may be quoted numerically or
in a table, graph or similar illustration.
YIELD. The Portfolio may advertise its yield on its Institutional Shares.
Under the rules of the SEC, the Portfolio must calculate yield using the
following formula:
a-b
YIELD = 2[(----- +1)/6/ - 1]
cd
Where: a = dividends and interest earned during the period.
b = expenses accrued for the period (net of
reimbursements).
c = the average daily number of shares outstanding during
the period that were entitled to receive dividends.
d = the maximum offering price per share on the last day of
the period.
For the purpose of determining net investment income earned during the
period (variable "a" in the formula), dividend income on equity securities held
by the Portfolio is recognized by accruing 1/360th of the stated dividend rate
of the security each
-32-
<PAGE>
day that the security is in the Portfolio. Except as noted below, interest
earned on any debt obligations held by the Portfolio is calculated by computing
the yield to maturity of each obligation held by the Portfolio based on the
market value of the obligation (including actual accrued interest) at the close
of business on the last business day of each month, or, with respect to
obligations purchased during the month, the purchase price (plus actual accrued
interest) and dividing the result by 360 and multiplying the quotient by the
market value of the obligation (including actual accrued interest) in order to
determine the interest income on the obligation for each day of the subsequent
month that the obligation is held by the Portfolio. For purposes of this
calculation, it is assumed that each month contains 30 days. The maturity of an
obligation with a call provision is the next call date on which the obligation
reasonably may be expected to be called or, if none, the maturity date.
With respect to debt obligations purchased at a discount or premium, the
formula generally calls for amortization of the discount or premium.
With respect to mortgage or other receivables-backed obligations which are
expected to be subject to monthly payments of principal and interest ("pay
downs"), (a) gain or loss attributable to actual monthly pay downs are accounted
for as an increase or decrease to interest income during the period; and (b) the
Portfolio may elect either (i) to amortize the discount and premium on the
remaining security, based on the cost of the security, to the weighted-average
maturity date, if such information is available, or to the remaining term of the
security, if any, if the weighted-average maturity date is not available, or
(ii) not to amortize discount or premium on the remaining security. The
amortization schedule will be adjusted monthly to reflect changes in the market
values of debt obligations.
Undeclared earned income will be subtracted from the maximum offering price
per share (variable "d" in the formula). Undeclared earned income is the net
investment income which, at the end of the base period, has not been declared as
a dividend, but is reasonably expected to be and is declared and paid as a
dividend shortly thereafter.
The annualized yield for the 30-day period ended September 30, 1997 for the
Portfolio was 7.31%.
OTHER INFORMATION REGARDING INVESTMENT RETURNS. In addition to providing
performance information that demonstrates the total return or yield of
Institutional Shares of the Portfolio over a specified period of time, the Fund
may provide certain other
-33-
<PAGE>
information demonstrating hypothetical investment returns. Such information may
include, but is not limited to, illustrating the compounding effects of a
dividend in a dividend reinvestment plan.
MISCELLANEOUS. Performance information for the Portfolio assumes the
reinvestment of dividends and distributions. Performance information may
reflect fee waivers that subsidize and reduce the total operating expenses of
the Portfolio. In these cases, the Portfolio's return would be lower if there
were not such waivers.
Yield on shares of the Portfolio will fluctuate daily and does not provide
a basis for determining future yield. Because yield will fluctuate, it cannot
be compared with yields on savings account or other investment alternatives that
provide an agreed to or guaranteed fixed yield for a stated period of time. In
comparing the yield of one fund to another, consideration should be given to
each fund's investment policies, including the types of investments made,
lengths of maturities of the portfolio securities, and whether there are any
special account charges which may reduce the effective yield. The fees which
may be imposed by authorized dealers and other institutions on their customers
are not reflected in the calculations of total returns or yields for the
Portfolio.
As stated above, the Fund may also from time to time include discussions or
illustrations of the effects of compounding in advertisements. "Compounding"
refers to the fact that, if dividends or other distributions on an investment in
the Portfolio are reinvested by being paid in additional Portfolio shares, any
future income or capital appreciation of the Portfolio would increase the value,
not only of the original investment in the Portfolio, but also of the additional
Portfolio shares received through reinvestment. The Fund may also include
discussions or illustrations of the potential investment goals of a prospective
investor, investment management techniques, policies or investment suitability
of the Portfolio, economic conditions, the effects of inflation and historical
performance of various asset classes, including but not limited to, stocks,
bonds and Treasury bills. From time to time advertisements or communications to
shareholders may summarize the substance of information contained in shareholder
reports (including the investment composition of the Portfolio), as well as the
views of BlackRock as to current market, economy, trade and interest rate
trends, legislative, regulatory and monetary developments, investment strategies
and related matters believed to be of relevance to the Portfolio. The Fund may
also include in advertisements charts, graphs or drawings which illustrate the
potential risks and rewards of investment in various investment vehicles,
including but not limited to, stocks, bonds, treasury
-34-
<PAGE>
bills and shares of the Portfolio. In addition, advertisements or shareholder
communications may include a discussion of certain attributes or benefits to be
derived by an investment in the Portfolio. Such advertisements or communications
may include symbols, headlines or other material which highlight or summarize
the information discussed in more detail therein.
TAXES
The following is only a summary of certain additional tax considerations
generally affecting the Portfolio and its shareholders that are not described in
the Prospectus. No attempt is made to present a detailed explanation of the tax
treatment of the Portfolio or its shareholders, and the discussion here and in
the Prospectuses is not intended as a substitute for careful tax planning.
Investors are urged to consult their tax advisers with specific reference to
their own tax situation.
The Portfolio will elect to be taxed as a regulated investment company
under Subchapter M of the Internal Revenue Code of 1986, as amended (the
"Code"). As a regulated investment company, the Portfolio generally is exempt
from federal income tax on its net investment income (i.e., its investment
company taxable income as that term is defined in the Code without regard to the
deduction for dividends paid) and net capital gain (i.e., the excess of net
long-term capital gain over net short-term capital loss) that it distributes to
shareholders, provided that it distributes an amount equal to at least 90% of
its net investment income (the "Distribution Requirement") and satisfies certain
other requirements of the Code that are described below. Distributions of net
investment income made during the taxable year or, under specified
circumstances, within twelve months after the close of the taxable year will
satisfy the Distribution Requirement.
In addition to satisfaction of the Distribution Requirement, the Portfolio
must derive at least 90% of its gross income from dividends, interest, certain
payments with respect to securities loans and gains from the sale or other
disposition of stock or securities or foreign currencies (including, but not
limited to, gains from forward foreign currency exchange contacts), or from
other income derived with respect to its business of investment in such stock,
securities, or currencies (the "Income Requirement").
In addition to the foregoing requirements, at the close of each quarter of
its taxable year, at least 50% of the value of the Portfolio's assets must
consist of cash and cash items, U.S. government securities, securities of other
regulated investment companies, and securities of other issuers (as to which the
-35-
<PAGE>
Portfolio has not invested more than 5% of the value of its total assets in
securities of such issuer and as to which the Portfolio does not hold more than
10% of the outstanding voting securities of such issuer), and no more than 25%
of the value of the Portfolio's total assets may be invested in the securities
of any one issuer (other than U.S. Government securities and securities of other
regulated investment companies), or in two or more issuers which such Portfolio
controls and which are engaged in the same or similar trades or businesses.
Distributions of net investment income will be taxable to shareholders as
ordinary income, regardless of whether such distributions are paid in cash or
are reinvested in shares. Shareholders receiving any taxable distribution from
the Portfolio in the form of additional shares will be treated as receiving a
taxable distribution in an amount equal to the fair market value of the shares
received, determined as of the reinvestment date.
The Portfolio intends to distribute to shareholders any of its net capital
gain for each taxable year. Net capital gain is distributed as a capital gain
dividend and is taxable to shareholders as long-term capital gain, regardless of
the length of time the shareholder has held his shares, whether net capital gain
was recognized by the Portfolio prior to the date on which a shareholder
acquired shares of the Portfolio and whether the distribution was paid in cash
or reinvested in shares.
It is expected that distributions from the Portfolio will generally not
qualify for the "dividends received" deduction for corporate shareholders.
Ordinary income of individuals will be taxable at a maximum marginal rate
of 39.6%, but because of limitations on itemized deductions otherwise allowable
and the phase-out of personal exemptions, the maximum effective marginal rate of
tax for some taxpayers may be higher. Under recently enacted legislation, long-
term capital gains of individuals are taxed at a maximum rate of 28% with
respect to capital assets held for more than 12 months but less than 18 months,
and at a maximum rate of 20% with respect to capital assets held for more than
18 months (10% for gains otherwise taxed at 15%). Capital gains and ordinary
income of corporate taxpayers are both taxed at a maximum nominal rate of 35%.
Investors should be aware that any loss realized upon the sale, exchange or
redemption of shares held for six months or less will be treated as a long-term
capital loss to the extent any capital gain dividends have been paid with
respect to such shares.
The Portfolio may engage in hedging or derivatives transactions involving
forward contracts, options and futures
-36-
<PAGE>
contracts and short sales. Such transactions will be subject to special
provisions of the Code that, among other things, may affect the character of
gains and losses realized by the Portfolio (that is, may affect whether gains or
losses are ordinary or capital), accelerate recognition of income of the
Portfolio and defer recognition of certain of the Portfolio's losses. These
rules could therefore affect the character, amount and timing of distributions
to shareholders. In addition, these provisions (1) will require the Portfolio to
"mark-to-market" certain types of positions in its portfolio (that is, treat
them as if they were closed out) and (2) may cause the Portfolio to recognize
income without receiving cash with which to pay dividends or make distributions
in amounts necessary to satisfy the Distribution Requirement and avoid the 4%
excise tax (described below). The Portfolio intends to monitor its transactions,
will make the appropriate tax elections and will make the appropriate entries in
its books and records when it acquires any option, futures contract, forward
contract or hedged investment in order to mitigate the effect of these
rules.
If for any taxable year the Portfolio does not qualify as a regulated
investment company, all of its taxable income will be subject to tax at regular
corporate rates without any deduction for distributions to shareholders, and all
distributions will be taxable as ordinary dividends to the extent of the
Portfolio's current and accumulated earnings and profits. Such distributions
will be eligible for the dividends received deduction in the case of corporate
shareholders.
A 4% non-deductible excise tax is imposed on regulated investment companies
that fail to currently distribute specified percentages of their ordinary
taxable income and capital gain net income (excess of capital gains over capital
losses). The Portfolio intends to make sufficient distributions or deemed
distributions of its ordinary taxable income and any capital gain net income
prior to the end of the each calendar year to avoid liability for this excise
tax.
The Fund will be required in certain cases to withhold and remit to the
United States Treasury 31% of dividends and gross sale proceeds paid to any
shareholder (i) who has provided either an incorrect tax identification number
or no number at all, (ii) who is subject to backup withholding by the Internal
Revenue Service for failure to report the receipt of interest or dividend income
properly, or (iii) who has failed to certify to the Fund that he is not subject
to backup withholding or that he is an "exempt recipient."
Shareholders will be advised annually as to the federal income tax
consequences of distributions made by the Portfolio each year.
-37-
<PAGE>
The foregoing general discussion of federal income tax consequences is
based on the Code and the regulations issued thereunder as in effect on the date
of this Statement of Additional Information. Future legislative or
administrative changes or court decisions may significantly change the
conclusions expressed herein, and any such changes or decisions may have a
retroactive effect with respect to the transactions contemplated herein.
Although the Portfolio expects to qualify as a "regulated investment
company" and to be relieved of all or substantially all Federal income taxes,
depending upon the extent of its activities in states and localities in which
its offices are maintained, in which its agents or independent contractors are
located or in which it is otherwise deemed to be conducting business, the
Portfolio may be subject to the tax laws of such states or localities.
Shareholders should consult their tax advisors about state and local tax
consequences, which may differ from the federal income tax consequences
described above.
ADDITIONAL INFORMATION CONCERNING SHARES
Shares of the Fund have noncumulative voting rights and, accordingly, the
holders of more than 50% of the Fund's outstanding shares (irrespective of
Portfolio or class) may elect all of the trustees. Shares have no preemptive
rights and only such conversion and exchange rights as the Board may grant in
its discretion. When issued for payment as described in the Prospectus, shares
will be fully paid and non-assessable by the Fund.
There will normally be no meetings of shareholders for the purpose of
electing trustees unless and until such time as required by law. At that time,
the trustees then in office will call a shareholders meeting to elect trustees.
Except as set forth above, the trustees will continue to hold office and may
appoint successor trustees. The Fund's Declaration of Trust provides that
meetings of the shareholders of the Fund will be called by the trustees upon the
written request of shareholders owning at least 10% of the outstanding shares
entitled to vote.
Rule 18f-2 under the 1940 Act provides that any matter required by the
provisions of the 1940 Act or applicable state law, or otherwise, to be
submitted to the holders of the outstanding voting securities of an investment
company such as the Fund shall not be deemed to have been effectively acted upon
unless approved by the holders of a majority of the outstanding shares of each
investment portfolio affected by such matter. Rule 18f-2 further provides that
an investment portfolio shall be deemed to be affected by a matter unless the
interests of each investment portfolio in the matter are substantially identical
or
-38-
<PAGE>
the matter does not affect any interest of the investment portfolio. Under the
Rule, the approval of an investment advisory agreement, a distribution plan
subject to Rule 12b-1 under the 1940 Act or any change in a fundamental
investment policy would be effectively acted upon with respect to an investment
portfolio only if approved by a majority of the outstanding shares of such
investment portfolio. However, the Rule also provides that the ratification of
the appointment of independent accountants, the approval of principal
underwriting contracts and the election of Trustees may be effectively acted
upon by shareholders of the Fund voting together in the aggregate without regard
to a particular investment portfolio.
The proceeds received by the Portfolio for each issue or sale of its
shares, and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to and constitute the underlying assets of the Portfolio. The underlying assets
of the Portfolio will be segregated on the books of account, and will be charged
with the liabilities in respect to the Portfolio and with a share of the general
liabilities of the Fund.
The Funds' Declaration of Trust authorizes the Board of Trustees, without
shareholder approval (unless otherwise required by applicable law), to: (i)
sell and convey the assets belonging to a class of shares to another management
investment company for consideration which may include securities issued by the
purchaser and, in connection therewith, to cause all outstanding shares of such
class to be redeemed at a price which is equal to their net asset value and
which may be paid in cash or by distribution of the securities or other
consideration received from the sale and conveyance; (ii) sell and convert the
assets belonging to one or more classes of shares into money and, in connection
therewith, to cause all outstanding shares of such class to be redeemed at their
net asset value; or (iii) combine the assets belonging to a class of shares with
the assets belonging to one or more other classes of shares if the Board of
Trustees reasonably determines that such combination will not have a material
adverse effect on the shareholders of any class participating in such
combination and, in connection therewith, to cause all outstanding shares of any
such class to be redeemed or converted into shares of another class of shares at
their net asset value. The Board of Trustees may authorize the termination of
any class of shares after the assets belonging to such class have been
distributed to its shareholders.
-39-
<PAGE>
MISCELLANEOUS
Effective January 31, 1998, the Fund has changed its name from Compass
Capital Funds/SM/ to BlackRock Funds/SM/.
COUNSEL. The law firm of Simpson Thacher & Bartlett (a partnership which
includes professional corporations), 425 Lexington Avenue, New York, New York
10017 serves as the Fund's counsel.
INDEPENDENT ACCOUNTANTS. Coopers & Lybrand L.L.P., 2400 Eleven Penn
Center, Philadelphia, Pennsylvania 19103, serves as the Fund's independent
accountants.
FIVE PERCENT OWNERS. The name, address and percentage ownership of each
person that on December 31, 1997 owned of record or beneficially 5% or more of
the outstanding shares of the Portfolio was as follows: Ameritech Pension Trust,
c/o Harris Trust & Savings Bank, 111 West Monroe 5W, Chicago, IL 60603,
99.97%.
On January 23, 1998, PNC Bank held of record approximately 77% of the
Fund's outstanding shares, and may be deemed a controlling person of the Fund
under the 1940 Act. PNC Bank is a national bank organized under the laws of the
United States. All of the capital stock of PNC Bank is owned by PNC Bancorp,
Inc. All of the capital stock of PNC Bancorp, Inc. is owned by PNC Bank Corp., a
publicly-held bank holding company.
BANKING LAWS. Banking laws and regulations currently prohibit a bank
holding company registered under the Federal Bank Holding Company Act of 1956 or
any bank or non-bank affiliate thereof from sponsoring, organizing, controlling
or distributing the shares of a registered, open-end investment company
continuously engaged in the issuance of its shares, and prohibit banks generally
from underwriting securities, but such banking laws and regulations do not
prohibit such a holding company or affiliate or banks generally from acting as
investment adviser, administrator, transfer agent or custodian to such an
investment company, or from purchasing shares of such a company as agent for and
upon the order of customers. BlackRock, BlackRock, Inc., PFPC and PNC Bank are
subject to such banking laws and regulations.
BlackRock, BlackRock, Inc., PFPC and PNC Bank believe they may perform the
services for the Fund contemplated by their respective agreements with the Fund
without violation of applicable banking laws or regulations. It should be
noted, however, that there have been no cases deciding whether bank and non-bank
subsidiaries of a registered bank holding company may perform services
comparable to those that are to be performed by
-40-
<PAGE>
these companies, and future changes in either Federal or state statutes and
regulations relating to permissible activities of banks and their subsidiaries
or affiliates, as well as further judicial or administrative decisions or
interpretations of present and future statutes and regulations, could prevent
these companies from continuing to perform such services for the Fund. If such
were to occur, it is expected that the Board of Trustees would recommend that
the Fund enter into new agreements or would consider the possible termination of
the Fund. Any new advisory or sub-advisory agreement would be subject to
shareholder approval.
SHAREHOLDER APPROVALS. As used in this Statement of Additional Information
and in the Prospectus, a "majority of the outstanding shares" means, with
respect to the approval of the Portfolio's investment advisory agreement, a
distribution plan or a change in a fundamental investment policy, the lesser of
(1) 67% of the shares of the Portfolio represented at a meeting at which the
holders of more than 50% of the outstanding shares of the Portfolio are present
in person or by proxy, or (2) more than 50% of the outstanding shares of the
Portfolio.
FINANCIAL STATEMENTS
The audited financial statements for the Portfolio contained in its Annual
Report to Shareholders for the period ended September 30, 1997 (the "1997 Annual
Report") are incorporated by reference in this Statement of Additional
Information. No other parts of the 1997 Annual Report are incorporated by
reference herein. The financial statements included in the 1997 Annual Report
have been audited by the Fund's independent accountant, Coopers & Lybrand
L.L.P., except for the financial statements and financial highlights covering
the periods ended March 31, 1996 and June 30, 1995 which have been audited by
other auditors. The reports of Coopers & Lybrand L.L.P. are incorporated herein
by reference. Such financial statements have been incorporated herein in
reliance upon such reports given upon their authority as experts in accounting
and auditing. Additional copies of the Annual Report may be obtained at no
charge by telephoning the Distributor at the telephone number appearing on the
front page of this Statement of Additional Information.
The financial statements included in the 1997 Annual Report for the period
from October 6, 1994 through June 30, 1995 and for the nine month period ended
March 31, 1996 have been audited by the former independent accountants of the
Predecessor Portfolio, Deloitte & Touche, L.L.P., whose report thereon is also
incorporated herein by reference. Such financial statements have been
incorporated herein by reference in reliance on the
-41-
<PAGE>
reports of Coopers & Lybrand L.L.P. and Deloitte & Touche, L.L.P. given upon
their authority as experts in accounting and auditing.
-42-
