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STATEMENT OF ADDITIONAL INFORMATION
SCHWAB INVESTMENTS
SCHWAB SHORT-TERM BOND MARKET INDEX FUND
SCHWAB TOTAL BOND MARKET INDEX FUND
NOVEMBER 15, 2000
AS AMENDED DECEMBER 11, 2000
The Statement of Additional Information (SAI) is not a prospectus. It should be
read in conjunction with a fund's prospectus dated November 15, 2000 (as amended
from time to time).
To obtain a copy of the prospectus, please contact SchwabFunds(R) at
800-435-4000, day or night, or write to the fund at P.O. Box 7575, San
Francisco, CA 94120-7575. For TDD service call 800-345-2550, day or night. The
prospectus also may be available on the Internet at:
http://www.schwab.com/schwabfunds.
The funds are a series of Schwab Investments (the trust).
The funds' most recent annual report is a separate document supplied with the
SAI and includes the funds' audited financial statements, which are incorporated
by reference into this SAI.
Prior to November 1, 1997, Schwab Short-Term Bond Market Index Fund was named
Schwab Short/Intermediate Government Bond Fund, and Schwab Total Bond Market
Index Fund was named Schwab Long-Term Government Bond Fund.
TABLE OF CONTENTS
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INVESTMENT OBJECTIVE, SECURITIES, RISKS AND LIMITATIONS............. 2
MANAGEMENT OF THE FUNDS............................................. 27
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES................. 31
INVESTMENT ADVISORY AND OTHER SERVICES.............................. 32
BROKERAGE ALLOCATION AND OTHER PRACTICES............................ 33
DESCRIPTION OF THE TRUST............................................ 35
PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER REPORTS
AND PRICING OF SHARES............................................... 36
TAXATION............................................................ 37
CALCULATION OF PERFORMANCE DATA..................................... 38
APPENDIX - RATINGS OF INVESTMENT SECURITIES......................... 41
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INVESTMENT OBJECTIVE, SECURITIES, RISKS AND LIMITATIONS
INVESTMENT OBJECTIVE
Each fund's investment objective is to attempt to provide a high level of
current income consistent with preservation of capital by seeking to track the
investment results of a particular bond index through the use of an indexing
strategy.
There is no guarantee a fund will achieve its investment objective.
The indexes are the Lehman Brothers Mutual Fund Short (1-5 Year) U.S.
Government/Credit Index for the Schwab Short-Term Bond Market Index Fund (the
Short-Term Index), and the Lehman Brothers U.S. Aggregate Bond Index for the
Schwab Total Bond Market Index Fund (the U.S. Aggregate Bond Index).
The Short-Term Index is a market-capitalization weighted index of
investment-grade debt securities with maturities between one and five years.
The U.S. Aggregate Bond Index is a market-weighted index of investment-grade
debt securities with maturities of greater than one year.
The securities in each index also are required to be publicly issued and have a
par amount outstanding of at least $150 million and a fixed interest rate.
Each fund's investment objective may be changed by vote of a majority of its
outstanding voting shares. A majority vote of outstanding securities of a fund
means the vote, at an annual or a special meeting of shareholders of a fund
where (a) of 67% or more of the voting securities present at the meeting, if the
shareholders of more than 50% of the outstanding securities of a fund are
present or represented by proxy, or (b) of more than 50% of the outstanding
voting securities of a fund, whichever is less.
The following descriptions of investment securities, risks and limitations
supplement those set forth in the prospectus and may be changed without
shareholder approval unless otherwise noted. Also, policies and limitations that
state a maximum percentage of assets that may be invested in a security or other
asset, or that set forth a quality standard, shall be measured immediately after
and as a result of a fund's acquisition of such security or asset unless
otherwise noted. Any subsequent change in values, net assets or other
circumstances will not be considered when determining whether the investment
complies with a fund's investment policies and limitations. Not all investment
securities or techniques discussed below are eligible investments for each fund.
Each fund will invest in securities or engage in techniques that are intended to
help achieve its investment objective.
INVESTMENT SECURITIES AND RISKS
BANKERS' ACCEPTANCES or notes are credit instruments evidencing a bank's
obligation to pay a draft drawn on it by a customer. These instruments reflect
the obligation both of the bank and of the drawer to pay the full amount of the
instrument upon maturity. A fund will invest only in bankers' acceptances of
banks that have capital, surplus and undivided profits in excess of $100
million.
BOND SUBSTITUTION is a strategy whereby a fund may, from time to time,
substitute one type of
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investment-grade bond for another. This means that, as an example, a fund may
have a higher weighting in corporate bonds and a lower weighting in U.S.
Treasury securities than its Index in order to increase income. This particular
substitution -- a corporate bond substitution -- may increase a fund's credit
risk, although this may be mitigated through increased diversification in the
corporate sector of the bond market.
BORROWING may subject a fund to interest costs, which may exceed the interest
received on the securities purchased with the borrowed funds. A fund normally
may borrow at times to meet redemption requests rather than sell portfolio
securities to raise the necessary cash. Borrowing can involve leveraging when
securities are purchased with the borrowed money. Each fund may borrow money
from banks and make other investments or engage in other transactions
permissible under the 1940 Act which may be considered a borrowing (such as
mortgage dollar rolls and reverse repurchase agreements). However, each fund may
not purchase securities when bank borrowings exceed 5% of a fund's total assets.
Each fund may establish lines-of-credit (lines) with certain banks by which it
may borrow funds for temporary or emergency purposes. A borrowing is presumed to
be for temporary or emergency purposes if it is repaid by a fund within 60 days
and is not extended or renewed. Each fund intends to use the lines to meet large
or unexpected redemptions that would otherwise force a fund to liquidate
securities under circumstances which are unfavorable to the fund's remaining
shareholders. Each fund will pay a fee to the bank for using the lines.
CERTIFICATES OF DEPOSIT or time deposits are issued against funds deposited in a
banking institution for a specified period of time at a specified interest rate.
A fund will invest only in certificates of deposit of banks that have capital,
surplus and undivided profits in excess of $100 million.
COMMERCIAL PAPER consists of short-term, promissory notes issued by banks,
corporations and other institutions to finance short-term credit needs. These
securities generally are discounted but sometimes may be interest bearing.
Commercial paper, which also may be unsecured, is subject to credit risk.
CONCENTRATION means that substantial amounts of assets are invested in a
particular industry or group of industries. Concentration increases investment
exposure. For example, the automobile industry may have a greater exposure to a
single risk factor, such as an increase in the price of oil, which may adversely
affect the sale of automobiles and, as a result, the value of the industry's
securities. Based on the primary characteristics of non-U.S. (foreign) banks,
each fund has identified each foreign country as a separate bank industry for
purposes of a fund's concentration policy. Each fund will limit its investments
in securities issued by foreign banks in each country to less than 25% of its
net assets.
Based on the primary characteristics of the various types of asset-backed
securities, for purposes of a fund's concentration policy, the following
asset-backed securities industries have been selected: credit card receivables,
automobile receivables, trade receivables and diversified financial assets. Each
fund will limit its investments in each such industry to less than 25% of its
net assets.
CONVERTIBLE SECURITIES are typically preferred stock or bonds that are
exchangeable for a specific number of another form of security (usually the
issuer's common stock) at a specified price or ratio. A corporation may issue a
convertible security that is subject to redemption after a specified date and
usually under certain circumstances. A holder of a convertible security that is
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called for redemption would be required to tender it for redemption to the
issuer, convert it to the underlying common stock or sell it to a third party.
Convertible bonds typically pay a lower interest rate than nonconvertible bonds
of the same quality and maturity, because of the convertible feature. This
structure allows the holder of the convertible bond to participate in share
price movements in the company's common stock. The actual return on a
convertible bond may exceed its stated yield if the company's common stock
appreciates in value and the option to convert to common shares becomes more
valuable.
Convertible securities typically trade at prices above their conversion value,
which is the current market value of the common stock received upon conversion,
because of their higher yield potential than the underlying common stock. The
difference between the conversion value and the price of a convertible security
will vary depending on the value of the underlying common stock and interest
rates. When the underlying value of the common stocks decline, the price of the
issuer's convertible securities will tend not to fall as much because the
convertible security's income potential will act as a price support. While the
value of a convertible security also tends to rise when the underlying common
stock value rises, it will not rise as much because their conversion value is
more narrow. The value of convertible securities also is affected by changes in
interest rates. For example, when interest rates fall, the value of convertible
securities may rise because of their fixed income component.
CREDIT AND LIQUIDITY SUPPORTS may be employed by issuers or the fund to reduce
the credit risk of their securities. Credit supports include letters of credit,
insurance, total return and credit swap agreements and guarantees provided by
foreign and domestic entities. Liquidity supports include puts, demand features,
and lines of credit. Most of these arrangements move the credit risk of an
investment from the issuer of the security to the support provider. Changes in
the credit quality of a support provider could cause losses to a fund.
DEBT SECURITIES are obligations issued by domestic and foreign entities,
including governments and corporations, in order to raise money. They are
basically "IOUs," but are commonly referred to as bonds or money market
securities. These securities normally require the issuer to pay a fixed,
variable or floating rate of interest on the amount of money borrowed (the
"principal") until it is paid back upon maturity.
Debt securities experience price changes when interest rates change. For
example, when interest rates fall, the prices of debt securities generally rise.
Also, issuers tend to pre-pay their outstanding debts and issue new ones paying
lower interest rates. This is especially true for bonds with sinking fund
provisions, which commit the issuer to set aside a certain amount of money to
cover timely repayment of principal and typically allow the issuer to annually
repurchase certain of its outstanding bonds from the open market or at a pre-set
call price.
Conversely, in a rising interest rate environment, prepayment on outstanding
debt securities generally will not occur. This is known as extension risk and
may cause the value of debt securities to depreciate as a result of the higher
market interest rates. Typically, longer-maturity securities react to interest
rate changes more severely than shorter-term securities (all things being
equal), but generally offer greater rates of interest.
Debt securities also are subject to the risk that the issuers will not make
timely interest and/or principal payments or fail to make them at all. This is
called credit risk. Corporate debt securities (bonds) tend to have higher credit
risk generally than U.S. government debt securities. Debt securities also may be
subject to price volatility due to market perception of future interest rates,
the creditworthiness of the issuer and general market liquidity (market risk).
Investment-
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grade debt securities are considered medium- or/and high-quality securities,
although some still possess varying degrees of speculative characteristics and
risks. Debt securities rated below investment-grade are riskier, but may offer
higher yields. These securities are sometimes referred to as high yield
securities or "junk bonds."
See the Appendix for a full description of the various ratings assigned to debt
securities by various nationally recognized statistical rating organizations
(NRSROs).
DELAYED-DELIVERY TRANSACTIONS include purchasing and selling securities on a
delayed-delivery or when-issued basis. These transactions involve a commitment
to buy or sell specific securities at a predetermined price or yield, with
payment and delivery taking place after the customary settlement period for that
type of security. When purchasing securities on a delayed-delivery basis, a fund
assumes the rights and risks of ownership, including the risk of price and yield
fluctuations. Typically, no interest will accrue to a fund until the security is
delivered. Each fund will segregate appropriate liquid assets to cover its
delayed-delivery purchase obligations. When a fund sells a security on a
delayed-delivery basis, the fund does not participate in further gains or losses
with respect to that security. If the other party to a delayed-delivery
transaction fails to deliver or pay for the securities, a fund could suffer
losses.
DEMAND FEATURES, which may include guarantees, are used to shorten a security's
effective maturity and/or enhance its creditworthiness. If a demand feature
provider were to refuse to permit the feature's exercise or otherwise terminate
its obligations with respect to such feature, however, the security's effective
maturity may be lengthened substantially, and/or its credit quality may be
adversely impacted. In either event, the fund may experience an increase in
share price volatility. This also could lengthen the fund's overall average
effective maturity.
DEPOSITARY RECEIPTS include American or European Depositary Receipts (ADRs or
EDRs), Global Depositary Receipts or Shares (GDRs or GDSs) or other similar
global instruments that are receipts representing ownership of shares of a
foreign-based issuer held in trust by a bank or similar financial institution.
These securities are designed for U.S. and European securities markets as
alternatives to purchasing underlying securities in their corresponding national
markets and currencies. Depositary receipts can be sponsored or unsponsored.
Sponsored depositary receipts are certificates in which a bank or financial
institution participates with a custodian. Issuers of unsponsored depositary
receipts are not contractually obligated to disclose material information in the
United States. Therefore, there may not be a correlation between such
information and the market value of an unsponsored depositary receipt.
DIVERSIFICATION involves investing in a wide range of securities and thereby
spreading and reducing the risks of investment. Each fund is a series of an
open-end investment management company. Each fund is a diversified mutual fund.
DURATION was developed as a more precise alternative to the concept of
"maturity." Traditionally, a debt obligation's maturity has been used as a proxy
for the sensitivity of the security's price to changes in interest rates (which
is the "interest rate risk" or "volatility" of the security). However, maturity
measures only the time until a debt obligation provides its final payment,
taking no account of the pattern of the security's payments prior to maturity.
In contrast, duration incorporates a bond's yield, coupon interest payments,
final maturity, call and put features and prepayment exposure into one measure.
Duration is the magnitude of the change in the price of a bond relative to a
given change in market interest rates. Duration management is one of the
fundamental tools used by the investment adviser.
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Duration is a measure of the expected life of a debt obligation on a present
value basis. Duration takes the length of the time intervals between the present
time and the time that the interest and principal payments are scheduled or, in
the case of a callable bond, the time the principal payments are expected to be
received, and weights them by the present values of the cash to be received at
each future point in time. For debt obligations with interest payments occurring
prior to the payment of principal, duration will usually be less than maturity.
In general, all else being equal, the lower the stated or coupon rate of the
interest of a fixed income security, the longer the duration of the security;
conversely, the higher the stated or coupon rate of a fixed income security, the
shorter the duration of the security.
Holding long futures or call option positions will lengthen the duration of a
fund's portfolio. Holding short futures or put options will shorten the duration
of a fund's portfolio.
A swap agreement on an asset or group of assets may affect the duration of the
portfolio depending on the attributes of the swap. For example, if the swap
agreement provides the fund with a floating rate of return in exchange for a
fixed rate of return, the duration of the fund would be modified to reflect the
duration attributes of a similar security that the fund is permitted to buy.
There are some situations where even the standard duration calculation does not
properly reflect the interest rate exposure of a security. For example,
floating- and variable-rate securities often have final maturities of ten or
more years; however, their interest rate exposure corresponds to the frequency
of the coupon reset. Another example where the interest rate exposure is not
properly captured by maturity is mortgage pass-through securities. The stated
final maturity of such securities is generally 30 years, but current prepayment
rates are more critical in determining the securities' interest rate exposure.
Finally, the duration of the debt obligation may vary over time in response to
changes in interest rates and other market factors.
FOREIGN SECURITIES involve additional risks, including foreign currency exchange
rate risks, because they are issued by foreign entities, including foreign
governments, banks, corporations or because they are traded principally
overseas. Foreign securities in which a fund may invest include foreign entities
that are not subject to uniform accounting, auditing and financial reporting
standards, practices and requirements comparable to those applicable to U.S.
corporations. In addition, there may be less publicly available information
about foreign entities. Foreign economic, political and legal developments, as
well as fluctuating foreign currency exchange rates and withholding taxes, could
have more dramatic effects on the value of foreign securities. For example,
conditions within and around foreign countries, such as the possibility of
expropriation or confiscatory taxation, political or social instability,
diplomatic developments, change of government or war could affect the value of
foreign investments. Moreover, individual foreign economies may differ favorably
or unfavorably from the U.S. economy in such respects as growth of gross
national product, rate of inflation, capital reinvestment, resource
self-sufficiency and balance of payments position.
Foreign securities typically have less volume and are generally less liquid and
more volatile than securities of U.S. companies. Fixed commissions on foreign
securities exchanges are generally higher than negotiated commissions on U.S.
exchanges, although a fund will endeavor to achieve the most favorable overall
results on portfolio transactions. There is generally less government
supervision and regulation of foreign securities exchanges, brokers, dealers and
listed companies than in the United States, thus increasing the risk of delayed
settlements of portfolio transactions or loss of certificates for portfolio
securities. There may be difficulties in obtaining or enforcing judgments
against foreign issuers as well. These factors and others may increase the risks
with
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respect to the liquidity of a fund, and its ability to meet a large number of
shareholder redemption requests.
Foreign markets also have different clearance and settlement procedures and, in
certain markets, there have been times when settlements have been unable to keep
pace with the volume of securities transactions, making it difficult to conduct
such transactions. Such delays in settlement could result in temporary periods
when a portion of the assets of a fund is uninvested and no return is earned
thereon. The inability to make intended security purchases due to settlement
problems could cause a fund to miss attractive investment opportunities. Losses
to a fund arising out of the inability to fulfill a contract to sell such
securities also could result in potential liability for a fund.
Investments in the securities of foreign issuers may be made and held in foreign
currencies. In addition, a fund may hold cash in foreign currencies. These
investments may be affected favorably or unfavorably by changes in currency
rates and in exchange control regulations, and may cause a fund to incur costs
in connection with conversions between various currencies. The rate of exchange
between the U.S. dollar and other currencies is determined by the forces of
supply and demand in the foreign exchange market as well as by political and
economic factors. Changes in the foreign currency exchange rates also may affect
the value of dividends and interest earned, gains and losses realized on the
sale of securities, and net investment income and gains, if any, to be
distributed to shareholders by a fund.
On January 1, 1999, 11 of the 15 member states of the European union introduced
the "euro" as a common currency. During a three-year transitional period, the
euro will coexist with each member state's currency. By July 1, 2002, the euro
will have replaced the national currencies of the following member countries:
Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the
Netherlands, Portugal and Spain. During the transition period, each fund will
treat the euro as a separate currency from that of any member state.
Currently, the exchange rate of the currencies of each of these countries is
fixed to the euro. The euro trades on currency exchange and is available for
non-cash transactions. The participating countries currently issue sovereign
debt exclusively in euro. By July 1, 2002, euro-denominated bills and coins will
replace the bills and coins of the participating countries.
The new European Central Bank has control over each country's monetary policies.
Therefore, the participating countries no longer control their own monetary
policies by directing independent interest rates for their currencies. The
national governments of the participating countries, however, have retained the
authority to set tax and spending policies and public debt levels.
The conversion may impact the trading in securities of issuers located in, or
denominated in the currencies of, the member states, as well as foreign
exchanges, payments, the settlement process, custody of assets and accounting.
The introduction of the euro is also expected to affect derivative and other
financial contracts in which the funds may invest in so far as price sources
such as day-count fractions or settlement dates applicable to underlying
instruments may be changed to conform to the conventions applicable to euro
currency.
The overall impact of the transition of the member states' currencies to the
euro cannot be determined with certainty at this time. In addition to the
effects described above, it is likely that more general short and long-term
consequences can be expected, such as changes in economic environment and change
in behavior of investors, all of which will impact a fund's euro-
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denominated investments.
FORWARD CONTRACTS are sales contracts between a buyer (holding the "long",
position and the seller (holding the "short" position) for an asset with
delivery deferred to a future date. The buyer agrees to pay a fixed price at the
agreed future date and the seller agrees to deliver the asset. The seller hopes
that the market price on the delivery date is less than the agreed upon price,
while the buyer hopes for the contrary. The change in value of a forward-based
derivative generally is roughly proportional to the change in value of the
underlying asset.
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS involve the purchase or sale of
foreign currency at an established exchange rate, but with payment and delivery
at a specified future time. Many foreign securities markets do not settle trades
within a time frame that would be considered customary in the U.S. stock market.
Therefore, a fund may engage in forward foreign currency exchange contracts in
order to secure exchange rates for portfolio securities purchased or sold, but
waiting settlement. These transactions do not seek to eliminate any fluctuations
in the underlying prices of the securities involved. Instead, the transactions
simply establish a rate of exchange that can be expected when a fund settles its
securities transactions in the future.
A fund also may engage in forward foreign currency exchange contracts to protect
the value of specific portfolio positions, which is called "position hedging."
When engaging in position hedging, a fund may enter into forward foreign
currency exchange transactions to protect against a decline in the values of the
foreign currencies in which portfolio securities are denominated (or against an
increase in the value of currency for securities that a fund expects to
purchase).
Buying and selling foreign currency exchange contracts involve costs and may
result in losses. The ability of a fund to engage in these transactions may be
limited by tax considerations. Although these techniques tend to minimize the
risk of loss due to decline in the value of the hedged currency, they tend to
limit any potential gain that might result from an increase in the value of such
currency. Transactions in these contracts involve certain other risks.
Unanticipated fluctuations in currency prices may result in a poorer overall
performance for a fund than if it had not engaged in any such transactions.
Moreover, there may be imperfect correlation between a fund's holdings of
securities denominated in a particular currency and forward contracts into which
a fund enters. Such imperfect correlation may cause a fund to sustain losses,
which will prevent it from achieving a complete hedge or expose it to risk of
foreign exchange loss. Losses to a fund will affect its performance.
FUTURES CONTRACTS are securities that represent an agreement between two parties
that obligates one party to buy and the other party to sell specific securities
at an agreed-upon price on a stipulated future date. In the case of futures
contracts relating to an index or otherwise not calling for physical delivery at
the close of the transaction, the parties usually agree to deliver the final
cash settlement price of the contract. Each fund may purchase and sell futures
contracts based on securities, securities indices and foreign currencies,
interest rates or any other futures contracts traded on U.S. exchanges or boards
of trade that the Commodities Future Trading Commission (the "CFTC") licenses
and regulates on foreign exchanges.
Each fund must maintain a small portion of its assets in cash to process
shareholder transactions in and out of it to pay its expenses. In order to
reduce the effect this otherwise uninvested cash would have on its performance a
fund may purchase futures contracts. Such transactions allow a fund's cash
balance to produce a return similar to that of the underlying security or index
on which the futures contract is based. Also, each fund may purchase or sell
futures contracts on a specified foreign currency to "fix" the price in U.S.
dollars of the foreign security it has acquired
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or sold or expects to acquire or sell. Each fund may enter into futures
contracts for these or other reasons.
When buying or selling futures contracts, each fund must place a deposit with
its broker equal to a fraction of the contract amount. This amount is known as
"initial margin" and must be in the form of liquid debt instruments, including
cash, cash-equivalents and U.S. government securities. Subsequent payments to
and from the broker, known as "variation margin" may be made daily, if
necessary, as the value of the futures contracts fluctuate. This process is
known as "marking-to-market." The margin amount will be returned to a fund upon
termination of the futures contracts assuming all contractual obligations are
satisfied. Each fund's aggregate initial and variation margin payments required
to establish its futures positions may not exceed 5% of its net assets. Because
margin requirements are normally only a fraction of the amount of the futures
contracts in a given transaction, futures trading can involve a great deal of
leverage. In order to avoid this, a fund will segregate assets for any
outstanding futures contracts as may be required by the federal securities laws.
While each fund may purchase and sell futures contracts in order to simulate
full investment, there are risks associated with these transactions. Adverse
market movements could cause a fund to experience substantial losses when buying
and selling futures contracts. Of course, barring significant market
distortions, similar results would have been expected if a fund had instead
transacted in the underlying securities directly. There also is the risk of
losing any margin payments held by a broker in the event of its bankruptcy.
Additionally, a fund incurs transaction costs (i.e. brokerage fees) when
engaging in futures trading.
When interest rates are rising or securities prices are falling, a fund may
seek, through the sale of futures contracts, to offset a decline in the value of
its current portfolio securities. When rates are falling or prices are rising, a
fund, through the purchase of futures contracts, may attempt to secure better
rates or prices than might later be available in the market when they effect
anticipated purchases. Similarly, a fund may sell futures contracts on a
specified currency to protect against a decline in the value of that currency
and its portfolio securities that are denominated in that currency. Each fund
may purchase futures contracts on a foreign currency to fix the price in U.S.
dollars of a security denominated in that currency that a fund has acquired or
expects to acquire.
Futures contracts normally require actual delivery or acquisition of an
underlying security or cash value of an index on the expiration date of the
contract. In most cases, however, the contractual obligation is fulfilled before
the date of the contract by buying or selling, as the case may be, identical
futures contracts. Such offsetting transactions terminate the original contracts
and cancel the obligation to take or make delivery of the underlying securities
or cash. There may not always be a liquid secondary market at the time a fund
seeks to close out a futures position. If a fund is unable to close out its
position and prices move adversely, a fund would have to continue to make daily
cash payments to maintain its margin requirements. If a fund had insufficient
cash to meet these requirements it may have to sell portfolio securities at a
disadvantageous time or incur extra costs by borrowing the cash. Also, a fund
may be required to make or take delivery and incur extra transaction costs
buying or selling the underlying securities. Each fund would seek to reduce the
risks associated with futures transactions by buying and selling futures
contracts that are traded on national exchanges or for which there appears to be
a liquid secondary market.
HIGH YIELD SECURITIES, also called lower quality bonds ("junk bonds"), are
frequently issued by companies without long track records of sales and earnings,
or by those of questionable credit
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strength, and are more speculative and volatile (though typically higher
yielding) than investment grade bonds. Adverse economic developments could
disrupt the market for high yield securities, and severely affect the ability of
issuers, especially highly-leveraged issuers, to service their debt obligations
or to repay their obligations upon maturity.
Also, the secondary market for high yield securities at times may not be as
liquid as the secondary market for higher-quality debt securities. As a result,
the investment adviser could find it difficult to sell these securities or
experience difficulty in valuing certain high yield securities at certain times.
Prices realized upon the sale of such lower rated securities, under these
circumstances, may be less than the prices at which a fund purchased them.
Thus, high yield securities are more likely to react to developments affecting
interest rates and market and credit risk than are more highly rated securities,
which primarily react to movements in the general level of interest rates. When
economic conditions appear to be deteriorating, medium- to lower-quality debt
securities may decline in value more than higher-quality debt securities due to
heightened concern over credit quality, regardless of prevailing interest rates.
Prices for high yield securities also could be affected by legislative and
regulatory developments. These laws could adversely affect a fund's net asset
value and investment practices, the secondary market value for high yield
securities, the financial condition of issuers of these securities and the value
of outstanding high yield securities.
ILLIQUID SECURITIES generally are any securities that cannot be disposed of
promptly and in the ordinary course of business at approximately the amount at
which a fund has valued the instruments. The liquidity of a fund's investments
is monitored under the supervision and direction of the board of trustees.
Investments currently not considered liquid include repurchase agreements not
maturing within seven days and certain restricted securities.
INDEX PARTICIPATIONS and index participation contracts provide the equivalent of
a position in the securities comprising an index, with each security's
representation equaling its index weighting. Moreover, their holders are
entitled to payments equal to the dividends paid by the underlying index
securities. Generally, the value of an index participation or index
participation contract will rise and fall along with the value of the related
index. A fund will invest in index participation contracts only if a liquid
market for them appears to exist.
INDEXING STRATEGIES involve tracking the investments and, therefore, performance
of an index. Each fund normally will invest 65% of its total assets in the
securities of its index. Moreover, each fund will invest so that its portfolio
performs similarly to that of its index. Each fund tries to generally match its
holdings in a particular security to its weight in the index. Each fund will
seek a correlation between its performance and that of its index of 0.90 or
better. A perfect correlation of 1.0 is unlikely as the funds incur operating
and trading expenses unlike their indices. A fund may rebalance its holdings in
order to track its index more closely. In the event its intended correlation is
not achieved, the board of trustees will consider alternative arrangements for a
fund.
INTERNATIONAL BONDS are certain obligations or securities of foreign issuers,
including Eurodollar Bonds, which are U.S. dollar denominated bonds issued by
foreign issuers payable in Eurodollars (U.S. dollars held in banks located
outside the United States, primarily Europe), Yankee Bonds, which are U.S.
dollar-denominated bonds issued in the U.S. by foreign banks and corporations,
and EuroBonds, which are bonds denominated in U.S. dollars and usually issued by
large underwriting groups composed of banks and issuing houses from many
countries. Investments in
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securities issued by foreign issuers, including American Depositary Receipts and
securities purchased on foreign securities exchanges, may subject a fund to
additional investment risks, such as adverse political and economic
developments, possible seizure, nationalization or expropriation of foreign
investments, less stringent disclosure requirements, non-U.S. withholding taxes
and the adoption of other foreign governmental restrictions.
Additional risks include less publicly available information, the risk that
companies may not be subject to the accounting, auditing and financial reporting
standards and requirements of U.S. companies, the risk that foreign securities
markets may have less volume and therefore may be less liquid and their prices
more volatile than U.S. securities, and the risk that custodian and transaction
costs may be higher. Foreign issuers of securities or obligations are often
subject to accounting requirements and engage in business practices different
from those respecting domestic issuers of similar securities or obligations.
Foreign branches of U.S. banks and foreign banks may be subject to less
stringent reserve requirements than those applicable to domestic branches of
U.S. banks.
LENDING of portfolio securities is a common practice in the securities industry.
A fund may engage in security lending arrangements with the primary objective of
increasing its income. For example, a fund may receive cash collateral and it
may invest it in short-term, interest-bearing obligations, but will do so only
to the extent that it will not lose the tax treatment available to mutual funds.
Lending portfolio securities involves risks that the borrower may fail to return
the securities or provide additional collateral. Also, voting rights with
respect to the loaned securities may pass with the lending of the securities and
efforts to call such securities promptly may be unsuccessful, especially for
foreign securities.
A fund may loan portfolio securities to qualified broker-dealers or other
institutional investors provided: (1) the loan is secured continuously by
collateral consisting of U.S. government securities, letters of credit, cash or
cash-equivalents or other appropriate instruments maintained on a daily
marked-to-market basis in an amount at least equal to the current market value
of the securities loaned; (2) a fund may at any time call the loan and obtain
the return of the securities loaned; (3) a fund will receive any interest or
dividends paid on the loaned securities; and (4) an aggregate market value of
securities loaned will not at any time exceed one-third of the total assets of a
fund, including collateral received from the loan (at market value computed at
the time of the loan).
Although voting rights with respect to loaned securities pass to the borrower,
the lender retains the right to recall a security (or terminate a loan) for the
purpose of exercising the security's voting rights. Efforts to recall such
securities promptly may be unsuccessful, especially for foreign securities or
thinly traded securities such as small-cap stocks. In addition, because
recalling a security may involve expenses to a fund, it is expected that a fund
will do so only where the items being voted upon are, in the judgment of the
investment adviser, either material to the economic value of the security or
threaten to materially impact the issuer's corporate governance policies or
structure.
LOAN INTERESTS, and other direct debt instruments or interests therein, may be
acquired by a fund. A loan interest is typically originated, negotiated, and
structured by a U.S. or foreign commercial bank, insurance company, finance
company, or other financial institution ("Agent") for a lending syndicate of
financial institutions. The Agent typically administers and enforces the loan on
behalf of the other lenders in the syndicate. In addition, an institution
typically but not always the Agent ("Collateral Bank"), holds collateral (if
any) on behalf of the lenders. When a Collateral Bank holds collateral, such
collateral typically consists of one or more of the following
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asset types: inventory, accounts receivable, property, plant and equipment,
intangibles, common stock of subsidiaries or other investments. These loan
interests may take the form of participation interests in, assignments of or
novations of a loan during its second distribution, or direct interests during a
primary distribution. Such loan interests may be acquired from U.S. or foreign
banks, insurance companies, finance companies, or other financial institutions
who have made loans or are members of a lending syndicate or from other holders
of loan interests. A fund may also acquire loan interests under which a fund
derives its rights directly from the borrower. Such loan interests are
separately enforceable by a fund against the borrower and all payments of
interest and principal are typically made directly to a fund from the borrower.
In the event that a fund and other lenders become entitled to take possession of
shared collateral, it is anticipated that such collateral would be held in the
custody of Collateral Bank for their mutual benefit. A fund may not act as an
Agent, a Collateral Bank, a guarantor or sole negotiator or structurer with
respect to a loan.
The investment adviser will analyze and evaluate the financial condition of the
borrower in connection with the acquisition of any Loan Interest. Credit ratings
are typically assigned to Loan Interests in the same manner as with other fixed
income debt securities, and the investment adviser analyzes and evaluates these
ratings, if any, in deciding whether to purchase a Loan Interest. The investment
adviser also analyzes and evaluates the financial condition of the Agent and, in
the case of Loan Interests in which a fund does not have privity with the
borrower, those institutions from or through whom a fund derives its rights in a
loan ("Intermediate Participants").
In a typical loan, the Agent administers the terms of the loan agreement. In
such cases, the Agent is normally responsible for the collection of principal
and interest payments from the borrower and the apportionment of these payments
to the credit of all the institutions which are parties to the loan agreement. A
fund will generally rely upon the Agent or Intermediate Participant to receive
and forward to a fund its portion of the principal and interest payments on the
loan. Furthermore, unless under the terms of a participation agreement a fund
has direct recourse against the borrower, a fund will rely on the Agent and the
other members of the lending syndicate to use appropriate credit remedies
against the borrower. The Agent is typically responsible for monitoring
compliance with covenants contained in the loan agreement based upon reports
prepared by the borrower. The seller of the Loan Interest usually does, but is
often not obligated to, notify holders of Loan Interests of any failures of
compliance. The Agent may monitor the value of the collateral and, if the value
of the collateral declines, may accelerate the loan, may give the borrower an
opportunity to provide additional collateral or may seek other protection for
the benefit of the participants in the loan. The Agent is compensated by the
borrower for providing these services under a loan agreement, and such
compensation may include special fees paid upon structuring and funding the loan
and other fees paid on a continuing basis. With respect to Loan Interests for
which the Agent does not perform such administrative and enforcement functions,
a fund will perform such tasks on its own behalf, although a Collateral Bank
will typically hold any collateral on behalf of a fund and the other holders
pursuant to the applicable loan agreement.
A financial institution's appointment as Agent may usually be terminated in the
event that it fails to observe the requisite standard of care or becomes
insolvent, enters Federal Deposit Insurance Corporation ("FDIC") receivership,
or, if not FDIC insured, enters into bankruptcy proceedings. A successor agent
generally would be appointed to replace the terminated Agent, and assets held by
the Agent under the loan agreement should remain available to holders of Loan
Interests. However, if assets held by the Agent for the benefit of a fund were
determined to be subject to the claims of the Agent's general creditors, a fund
might incur certain costs and delays in
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realizing payment on a loan interest, or suffer a loss of principal and/or
interest. In situations involving Intermediate Participants, similar risks may
arise.
Purchasers of Loan Interests depend primarily upon the creditworthiness of the
borrower for payment of principal and interest. If a fund does not receive a
scheduled interest or principal payment on such indebtedness, a fund's share
price and yield could be adversely affected. Loans that are fully secured offer
a fund more protections than an unsecured loan in the event of non-payment of
scheduled interest or principal. However, there is no assurance that the
liquidation of collateral from a secured loan would satisfy the borrower's
obligation, or that the collateral can be liquidated. Indebtedness of borrowers
whose creditworthiness is poor involves substantially greater risks, and may be
highly speculative. Borrowers that are in bankruptcy or restructuring may never
pay off their indebtedness, or may pay only a small fraction of the amount owed.
Direct indebtedness of developing countries also will involve a risk that the
governmental entities responsible for the repayment of the debt may be unable,
or unwilling, to pay interest and repay principal when due.
The Loan Interests market is in a developing phase with increased participation
among several investor types. The dealer community has become increasingly
involved in this secondary market. If, however, a particular Loan Interest is
deemed to be illiquid, it would be valued using procedures adopted by the board
of Trustees. In such a situation, there is no guarantee that the fund will be
able to sell such Loan Interests, which could lead to a decline in the value of
the Loan Interests and the value of the fund's shares.
MATURITY OF INVESTMENTS will generally be determined using the portfolio
securities' final maturity dates. However for certain securities, maturity will
be determined using the security's effective maturity date. The effective
maturity date for a security subject to a put or demand feature is the demand
date, unless the security is a variable- or floating-rate security. If it is a
variable-rate security, its effective maturity date is the earlier of its demand
date or next interest rate change date. For variable-rate securities not subject
to a put or demand feature and floating-rate securities, the effective maturity
date is the next interest rate change date. The effective maturity of
mortgage-backed and certain other asset-backed securities is determined on an
"expected life" basis by the investment adviser. For an interest rate swap
agreement, its effective maturity would be equal to the difference in the
effective maturity of the interest rates "swapped." Securities being hedged with
futures contracts may be deemed to have a longer maturity, in the case of
purchases of future contracts, and a shorter maturity, in the case of sales of
futures contracts, than they would otherwise be deemed to have. In addition, a
security that is subject to redemption at the option of the issuer on a
particular date ("call date"), which is prior to, or in lieu of, the security's
stated maturity, may be deemed to mature on the call date rather than on its
stated maturity date. The call date of a security will be used to calculate
average portfolio maturity when the investment adviser reasonably anticipates,
based upon information available to it, that the issuer will exercise its right
to redeem the security. The average portfolio maturity of a fund is
dollar-weighted based upon the market value of a fund's securities at the time
of the calculation. A fund may invest in securities with final or effective
maturities of any length.
MONEY MARKET SECURITIES are high-quality, short-term debt securities that may be
issued by entities such as the U.S. government, corporations and financial
institutions (like banks). Money market securities include commercial paper,
certificates of deposit, banker's acceptances, notes and time deposits.
Money market securities pay fixed, variable or floating rates of interest and
are generally subject
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to credit and interest rate risks. The maturity date or price of and financial
assets collateralizing a security may be structured in order to make it qualify
as or act like a money market security. These securities may be subject to
greater credit and interest rate risks than other money market securities
because of their structure. Money market securities may be issued with puts or
these can be sold separately.
MORTGAGE-BACKED SECURITIES ("MBS") and other ASSET-BACKED SECURITIES may be
purchased by a fund. MBS represent participations in mortgage loans, and include
pass-through securities, collateralized mortgage obligations and stripped
mortgage-backed securities. MBS may be issued or guaranteed by U.S. government
agencies or instrumentalities, such as the Government National Mortgage
Association (GNMA or Ginnie Mae) and Fannie Mae or the Federal National Home
Loan Mortgage Corporation (FHLMC or Freddie Mac), or by private issuers,
generally originators and investors in mortgage loans, including savings
associations, mortgage banks, commercial banks, and special purpose entities
(collectively, "private lenders"). MBS are based on different types of mortgages
including those on commercial real estate and residential property. MBS issued
by private lenders may be supported by pools of mortgage loans or other MBS that
are guaranteed, directly or indirectly, by the U.S. government or one of its
agencies or instrumentalities, or they may be issued without any governmental
guarantee of the underlying mortgage assets but with some form of credit
enhancement.
Asset-backed securities ("ABS") have structural characteristics similar to MBS.
Asset-backed debt obligations represent direct or indirect participation in
assets such as automobile loans, credit card receivables, trade receivables,
home equity loans (which sometimes are categorized as MBS) or other financial
assets. Therefore, repayment depends largely on the cash flows generated by the
assets backing the securities. The credit quality of most ABS depends primarily
on the credit quality of the assets underlying such securities, how well the
entity issuing the security is insulated from the credit risk of the originator
or any other affiliated entities, and the amount and quality of any credit
enhancement of the securities. Payments or distributions of principal and
interest on asset-backed debt obligations may be supported by credit
enhancements including letters of credit, an insurance guarantee, reserve funds
and overcollateralization.
COMMERCIAL MORTGAGE-BACKED SECURITIES include securities that reflect an
interest in, and are secured by, mortgage loans on commercial real property. The
market for commercial mortgage-backed securities developed more recently and in
terms of total outstanding principal amount of issues is relatively small
compared to the market for residential single-family MBS. Many of the risks of
investing in commercial mortgage-backed securities reflect the risks of
investing in the real estate securing the underlying mortgage loans. These risks
reflect the effects of local and other economic conditions on real estate
markets, the ability of tenants to make loan payments, and the ability of a
property to attract and retain tenants. Commercial mortgage-backed securities
may be less liquid and exhibit greater price volatility than other types of
mortgage- or asset-backed securities.
A COLLATERALIZED MORTGAGE OBLIGATION ("CMO") is a hybrid between a
mortgage-backed bond and a mortgage pass-through security. Similar to a bond,
interest and prepaid principal is paid, in most cases, on a monthly basis. CMOs
may be collateralized by whole mortgage loans, but are more typically
collateralized by portfolios of mortgage pass-through securities guaranteed by
the Government National Mortgage Association (GNMA or Ginnie Mae), Federal Home
Loan Mortgage Corporation (FHLMC or Freddie Mac), Fannie Mae, and their income
streams.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral. CMOs
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provide for a modified form of call protection through a de facto breakdown of
the underlying pool of mortgages according to how quickly the loans are repaid.
Monthly payment of principal received from the pool of underlying mortgages,
including prepayments, is first returned to investors holding the shortest
maturity class. Investors holding the longer maturity classes receive principal
only after the first class has been retired. An investor is partially guarded
against a sooner than desired return of principal because of the sequential
payments.
In a typical CMO transaction, a corporation ("issuer") issues multiple series
(e.g., A, B, C, Z) of CMO bonds ("Bonds"). Proceeds of the Bond offering are
used to purchase mortgages or mortgage pass-through certificates ("Collateral").
The Collateral is pledged to a third party trustee as security for the Bonds.
Principal and interest payments from the Collateral are used to pay principal on
the Bonds in the order A, B, C, Z. The Series A, B, and C Bonds all bear current
interest. Interest on the Series Z Bond is accrued and added to principal and a
like amount is paid as principal on the Series A, B, or C Bond currently being
paid off. When the Series A, B, and C Bonds are paid in full, interest and
principal on the Series Z Bond begins to be paid currently. With some CMOs, the
issuer serves as a conduit to allow loan originators (primarily builders or
savings and loan associations) to borrow against their loan portfolios.
The rate of principal payment on MBS and ABS generally depends on the rate of
principal payments received on the underlying assets which in turn may be
affected by a variety of economic and other factors. As a result, the price and
yield on any MBS or ABS is difficult to predict with precision and price and
yield to maturity may be more or less than the anticipated yield to maturity. If
a fund purchases these securities 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 the yield to
maturity. Conversely, if a fund purchases these securities at a discount, a
prepayment rate that is faster than expected will increase yield to maturity,
while a prepayment rate that is slower than expected will reduce yield to
maturity. Amounts available for reinvestment by a fund are likely to be greater
during a period of declining interest rates and, as a result, are likely to be
reinvested at lower interest rates than during a period of rising interest
rates.
While many MBS and ABS are issued with only one class of security, many are
issued in more than one class, each with different payment terms. Multiple class
MBS and ABS are issued as a method of providing credit support, typically
through creation of one or more classes whose right to payments on the security
is made subordinate to the right to such payments of the remaining class or
classes. In addition, multiple classes may permit the issuance of securities
with payment terms, interest rates, or other characteristics differing both from
those of each other and from those of the underlying assets. Examples include
stripped securities, which are MBS and ABS entitling the holder to
disproportionate interest or principal compared with the assets backing the
security, and securities with classes having characteristics different from the
assets backing the securities, such as a security with floating interest rates
with assets backing the securities having fixed interest rates. The market value
of such securities and CMO's generally is more or less sensitive to changes in
prepayment and interest rates than is the case with traditional MBS and ABS, and
in some cases such market value may be extremely volatile.
MUNICIPAL LEASES are obligations issued to finance the construction or
acquisition of equipment or facilities. These obligations may take the form of a
lease, an installment purchase contract, a conditional sales contract or a
participation interest in any of these obligations. Municipal leases may be
considered illiquid investments. Additionally, municipal leases are subject to
"nonappropriation risk," which is the risk that the municipality may terminate
the lease because funds have not been allocated to make the necessary lease
payments. The lessor would then be
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entitled to repossess the property, but the value of the property may be less to
private sector entities than it would be to the municipality.
MUNICIPAL SECURITIES are debt securities issued by a state, its counties,
municipalities, authorities and other subdivisions, or the territories and
possessions of the United States and the District of Columbia, including their
subdivisions, agencies and instrumentalities and corporations. These securities
may be issued to obtain money for various public purposes, including the
construction of a wide range of public facilities such as airports, bridges,
highways, housing, hospitals, mass transportation, public utilities, schools,
streets, and water and sewer works. Other public purposes include refunding
outstanding obligations, obtaining funds for general operating expenses and
obtaining funds to loan to other public institutions and facilities.
Municipal securities also may be issued to finance various private activities,
including certain types of private activity bonds ("industrial development
bonds" under prior law). These securities may be issued by or on behalf of
public authorities to obtain funds to provide certain privately owned or
operated facilities.
Municipal securities may be owned directly or through participation interests,
and include general obligation or revenue securities, tax-exempt commercial
paper, notes and leases.
Municipal securities generally are classified as "general obligation" or
"revenue" and may be purchased directly or through participation interests.
General obligation securities typically are secured by the issuer's pledge of
its full faith and credit and taxing power for the payment of principal and
interest. Revenue securities typically 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 tax or other specific revenue source. Private
activity bonds and industrial development bonds are, in most cases, revenue
bonds and generally do not constitute the pledge of the credit of the issuer of
such bonds. The credit quality of private activity bonds is frequently related
to the credit standing of private corporations or other entities.
Examples of municipal securities that are issued with original maturities of 397
days or less are short-term tax anticipation notes, bond anticipation notes,
revenue anticipation notes, construction loan notes, pre-refunded municipal
bonds and tax-free commercial paper. Tax anticipation notes typically are sold
to finance working capital needs of municipalities in anticipation of the
receipt of property taxes on a future date. Bond anticipation notes are sold on
an interim basis in anticipation of a municipality's issuance of a longer-term
bond in the future. Revenue anticipation notes are issued in expectation of the
receipt of other types of revenue, such as that available under the Federal
Revenue Sharing Program. Construction loan notes are instruments insured by the
Federal Housing Administration with permanent financing by Fannie Mae or Ginnie
Mae at the end of the project construction period. Pre-refunded municipal bonds
are bonds that are not yet refundable, but for which securities have been placed
in escrow to refund an original municipal bond issue when it becomes refundable.
Tax-free commercial paper is an unsecured promissory obligation issued or
guaranteed by a municipal issuer. A fund may purchase other municipal securities
similar to the foregoing that are or may become available, including securities
issued to pre-refund other outstanding obligations of municipal issuers.
A fund also may invest in moral obligation securities, which are normally issued
by special purpose public authorities. If the issuer of a moral obligation
security is unable to meet its obligation from current revenues, it may draw on
a reserve fund. The state or municipality that created the entity has only a
moral commitment, not a legal obligation, to restore the reserve fund.
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The value of municipal securities may be affected by uncertainties with respect
to the rights of holders of municipal securities in the event of bankruptcy or
the taxation of municipal securities as a result of legislation or litigation.
For example, under federal law, certain issuers of municipal securities may be
authorized in certain circumstances to initiate bankruptcy proceedings without
prior notice to or the consent of creditors. Such action could result in
material adverse changes in the rights of holders of the securities. In
addition, litigation challenging the validity under the state constitutions of
present systems of financing public education has been initiated or adjudicated
in a number of states, and legislation has been introduced to effect changes in
public school finances in some states. In other instances, there has been
litigation challenging the issuance of pollution control revenue bonds or the
validity of their issuance under state or federal law, which ultimately could
affect the validity of those municipal securities or the tax-free nature of the
interest thereon.
Municipal securities pay fixed, variable or floating rates of interest, which
may be exempt from federal income tax and, typically, personal income tax of a
state or locality. Some municipal securities are taxable. These securities are
issued by state and local governments and instrumentalities thereof that pay
interest that is not exempt from federal income tax. States and municipalities
issue taxable instruments for various reasons, relating in some cases to the
nature of the project being financed and to various specific ceilings on debt
issuance in others. The rate of interest payable on such instruments typically
reflects its taxable nature.
OPTIONS CONTRACTS generally provide the right to buy or sell a security,
commodity, futures contract or foreign currency in exchange for an agreed upon
price. If the right is not exercised after a specified period, the option
expires and the option buyer forfeits the money paid to the option seller.
A call option gives the buyer the right to buy a specified number of shares of a
security at a fixed price on or before a specified date in the future. For this
right, the call option buyer pays the call option seller, commonly called the
call option writer, a fee called a premium. Call option buyers are usually
anticipating that the price of the underlying security will rise above the price
fixed with the call writer, thereby allowing them to profit. If the price of the
underlying security does not rise, the call option buyer's losses are limited to
the premium paid to the call option writer. For call option writers, a rise in
the price of the underlying security will be offset by the premium received from
the call option buyer. If the call option writer does not own the underlying
security, however, the losses that may ensue if the price rises could be
potentially unlimited. If the call option writer owns the underlying security or
commodity, this is called writing a covered call. All call options written by
the funds will be covered, which means that the funds will own the securities
subject to the option so long as the option is outstanding.
A put option is the opposite of a call option. It gives the buyer the right to
sell a specified number of shares of a security at a fixed price on or before a
specified date in the future. Put option buyers are usually anticipating a
decline in the price of the underlying security, and wish to offset those losses
when selling the security at a later date. All put options a fund writes will be
covered, which means that a fund will deposit with its custodian cash, U.S.
government securities or other high-grade debt securities (i.e., securities
rated in one of the top three categories by Moody's Investor Service ("Moody's")
or Standard & Poor's ("S&P") or, if unrated, determined by the investment
adviser to be of comparable credit quality) with a value at least equal to the
exercise price of the put option. The purpose of writing such options is to
generate additional income for a fund. However, in return for the option
premium, a fund accepts the risk that it may be required to purchase the
underlying securities at a price in excess of the
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securities market value at the time of purchase.
A fund may purchase and write put and call options on any securities in which it
may invest or any securities index based on securities in which it may invest. A
fund may purchase and write such options on securities that are listed on
domestic or foreign securities exchanges or traded in the over-the-counter
market. Like futures contracts, option contracts are rarely exercised. Option
buyers usually sell the option before it expires. Option writers may terminate
their obligations under a written call or put option by purchasing an option
identical to the one it has written. Such purchases are referred to as "closing
purchase transactions." A fund may enter into closing sale transactions in order
to realize gains or minimize losses on options it has purchased or written.
An exchange-traded currency option position may be closed out only on an options
exchange that provides a secondary market for an option of the same series.
Although a fund generally will purchase or write only those options for which
there appears to be an active secondary market, there is no assurance that a
liquid secondary market will exist for any particular option or at any
particular time. If a fund is unable to effect a closing purchase transaction
with respect to options it has written, it will not be able to sell the
underlying securities or dispose of assets held in a segregated account until
the options expire or are exercised. Similarly, if a fund is unable to effect a
closing sale transaction with respect to options it has purchased, it would have
to exercise the options in order to realize any profit and will incur
transaction costs upon the purchase or sale of underlying securities.
Reasons for the absence of a liquid secondary market on an exchange include the
following: (1) there may be insufficient trading interest in certain options;
(2) an exchange may impose restrictions on opening transactions or closing
transactions or both; (3) trading halts, suspensions or other restrictions may
be imposed with respect to particular classes or series of options; (4) unusual
or unforeseen circumstances may interrupt normal operations on an exchange; (5)
the facilities of an exchange or the Options Clearing Corporation (the "OCC")
may not at all times be adequate to handle current trading volume; or (6) 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), although outstanding options on that exchange that had been
issued by the OCC as a result of trades on that exchange would continue to be
exercisable in accordance with their terms.
The ability to terminate over-the-counter options is more limited than with
exchange-traded options and may involve the risk that broker-dealers
participating in such transactions will not fulfill their obligations. Until
such time as the staff of the Securities and Exchange Commission (the "SEC")
changes its position, a fund will treat purchased over-the-counter options and
all assets used to cover written over-the-counter options as illiquid
securities, except that with respect to options written with primary dealers in
U.S. government securities pursuant to an agreement requiring a closing purchase
transaction at a formula price, the amount of illiquid securities may be
calculated with reference to a formula the staff of the SEC approves.
Additional risks are involved with options trading because of the low margin
deposits required and the extremely high degree of leverage that may be involved
in options trading. There may be imperfect correlation between the change in
market value of the securities held by a fund and the prices of the options,
possible lack of a liquid secondary markets, and the resulting inability to
close such positions prior to their maturity dates.
A fund may write or purchase an option only when the market value of that
option, when
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aggregated with the market value of all other options transactions made on
behalf of a fund, does not exceed 5% of its total assets.
PREFERRED STOCKS are nonvoting equity securities that pay a stated fixed or
variable rate dividend. Although the preferred shareholders generally have no
right to receive discretionary dividends, they must receive the preferred
dividend at the stated rate prior to any dividends being paid on the common
stock. Since the preferred stockholder receives a fixed dividend payment, the
holder's position is much like that of the bondholder. Due to their fixed income
features, preferred stocks provide higher income potential than issuers' common
stocks, but typically are more sensitive to interest rate changes than an
underlying common stock. In the event of liquidation, bondholders have claims on
company assets senior to those of stockholders; preferred stockholders have
claims senior to those of common stockholders. Preferred stocks are rated like
fixed income securities and a fund will only invest in investment-grade
preferred stock that has a call feature that the investment manager expects to
be exercised by the issuer on the call date or that has a specified redemption
date.
PROMISSORY NOTES are written agreements committing the maker or issuer to pay
the payee a specified amount either on demand or at a fixed date in the future,
with or without interest. These are sometimes called negotiable notes or
instruments and are subject to credit risk. Bank notes are notes used to
represent obligations issued by banks in large denominations.
PUTS are agreements that allow the buyer to sell a security at a specified price
and time to the seller or "put provider." When a fund buys a security with a put
feature, losses could occur if the put provider does not perform as agreed. If a
put provider fails to honor its commitment upon a fund's attempt to exercise the
put, a fund may have to treat the security's final maturity as its effective
maturity. If that occurs, the security's price may be negatively impacted, and
its sensitivity to interest rate changes may be increased, possibly contributing
to increased share price volatility for a fund. This also could lengthen a
fund's overall average effective maturity. Standby commitments are types of
puts.
QUALITY OF INVESTMENTS will be principally investment-grade for each fund's
assets. Investment-grade quality securities are rated by at least one NRSRO in
one of the four highest rating categories (within which there may be
sub-categories or gradations indicating relative standing) or have been
determined to be of equivalent quality by the investment adviser pursuant to
procedures adopted by the board of trustees. Sometimes an investment-grade
quality security may be down-graded to a below investment-grade quality rating.
If a security no longer has at least one investment-quality rating from an
NRSRO, the investment adviser would reanalyze the security in light of the
downgrade and determine whether a fund should continue to hold the security.
However, such downgrade would not require the investment adviser to sell the
security on behalf of a fund. Sometimes lower-quality securities may be
downgraded to an even lower quality. If any of a fund's lower-quality securities
were down-graded to below the sixth rating category, the investment adviser will
promptly sell the security on behalf of a fund.
The investment adviser may also elect to purchase high-yield securities for
either fund, subject to an aggregate limit of 5% of the investing fund's assets
and only in circumstances where the investment adviser believes that the credit
quality of the security (or issuer thereof) is reasonably likely to be upgraded
to investment-grade in the foreseeable future. If such an upgrade were to occur
under these circumstances, the value of the security would likely increase,
thereby raising the potential for the investing fund to realize a gain on its
investment and/or track the performance of its index. There is no guarantee that
any such upgrade will occur, however, and all such high-yield securities are
subject to the risks associated with non-investment grade
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<PAGE> 20
instruments. In order to limit a funds' exposure in this regard, the investment
manager will not purchase for a fund's high-yield securities that are rated (at
the time of purchase) below B or the equivalent by Moody's or S&P. In addition,
if a high-yield security that is held by either fund is downgraded to below B or
the equivalent by Moody's or S&P, the investment adviser will promptly dispose
of the security.
REPURCHASE AGREEMENTS involve a fund buying securities (usually U.S. government
securities) from a seller and simultaneously agreeing to sell them back at an
agreed-upon price (usually higher) and time. There are risks that losses will
result if the seller does not perform as agreed. Under certain circumstances,
repurchase agreements that are fully collateralized by U.S. government
securities may be deemed to be investments in U.S. government securities.
RESTRICTED SECURITIES are securities that are subject to legal restrictions on
their sale. Restricted securities may be considered to be liquid if an
institutional or other market exists for these securities. In making this
determination, a fund, under the direction and supervision of the board of
trustees, will take into account the following factors: (1) the frequency of
trades and quotes for the security; (2) the number of dealers willing to
purchase or sell the security and the number of potential purchasers; (3) dealer
undertakings to make a market in the security; and (4) the nature of the
security and marketplace trades (e.g., the time needed to dispose of the
security, the method of soliciting offers and the mechanics of transfer). To the
extent a fund invests in restricted securities that are deemed liquid, the
general level of illiquidity in a fund's portfolios may be increased if
qualified institutional buyers become uninterested in purchasing these
securities.
REVERSE REPURCHASE AGREEMENTS AND MORTGAGE DOLLAR ROLLS may be used by a fund. A
fund may engage in reverse repurchase agreements to facilitate portfolio
liquidity, a practice common in the mutual fund industry, or for arbitrage
transactions as discussed below. In a reverse repurchase agreement, a fund would
sell a security and enter into an agreement to repurchase the security at a
specified future date and price. A fund generally retains the right to interest
and principal payments on the security. Because a fund receives cash upon
entering into a reverse repurchase agreement, it may be considered a borrowing.
When required by guidelines of the SEC, a fund will set aside permissible liquid
assets in a segregated account to secure its obligations to repurchase the
security.
A fund also may enter into mortgage dollar rolls, in which a fund would sell MBS
for delivery in the current month and simultaneously contract to purchase
substantially similar securities on a specified future date. While a fund would
forego principal and interest paid on the MBS during the roll period, a fund
would be compensated by the difference between the current sales price and the
lower price for the future purchase as well as by any interest earned on the
proceeds of the initial sale. A fund also could be compensated through the
receipt of fee income equivalent to a lower forward price. At the time a fund
would enter into a mortgage dollar roll, it would set aside permissible liquid
assets in a segregated account to secure its obligation for the forward
commitment to buy MBS. Mortgage dollar roll transactions may be considered a
borrowing by a fund.
The mortgage dollar rolls and reverse repurchase agreements entered into by a
fund may be used as arbitrage transactions in which a fund will maintain an
offsetting position in short duration investment grade debt obligations. Since a
fund will receive interest on the securities or repurchase agreements in which
it invests the transaction proceeds, such transactions may involve leverage.
However, since such securities or repurchase agreements will be high quality and
short duration, the investment adviser believes that such arbitrage transactions
present lower
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<PAGE> 21
risks to a fund than those associated with other types of leverage. There can be
no assurance that a fund's use of the cash it receives from a mortgage dollar
roll will provide a positive return.
RISK MANAGEMENT TECHNIQUES used by a fund may include buying and selling futures
and options contracts, entering into total return, asset and credit swaps,
credit-linked notes and wrap agreements and investing in various types of
derivative instruments. A fund may use risk management techniques, including
derivative instruments, for any lawful purpose consistent with its investment
objective, such as hedging or managing risk. Derivative instruments are commonly
defined to include securities or contracts whose values depend on (or "derive"
from) the value of one or more other assets such as securities, currencies, or
commodities. These "other assets" are commonly referred to as "underlying
assets."
A derivative instrument generally consists of, is based upon, or exhibits
characteristics similar to options or forward contracts. Options and forward
contracts are considered to be the basic "building blocks" of derivatives. For
example, forward-based derivatives include forward contracts, as well as
exchange-traded futures. Option-based derivatives include privately negotiated,
over-the-counter ("OTC") options (including caps, floors, collars, and options
on forward and swap contracts) and exchange-traded options on futures. Diverse
types of derivatives may be created by combining options or forward contracts in
different ways, and applying these structures to a wide range of underlying
assets.
Risk management strategies include investment techniques designed to facilitate
the sale of portfolio securities, manage the average duration of the portfolio
or create or alter exposure to certain asset classes, such as equity, other debt
or foreign securities.
In addition to the derivative instruments and strategies described in the SAI,
the investment adviser expects to discover additional derivative instruments and
other hedging or risk management techniques. The investment adviser may utilize
these new derivative instruments and techniques to the extent that they are
consistent with a fund's investment objective and permitted by a fund's
investment limitations, operating policies, and applicable regulatory
authorities.
SECURITIES OF OTHER INVESTMENT COMPANIES may be purchased and sold by a fund and
those issued by foreign investment companies. Mutual funds are registered
investment companies, which may issue and redeem their shares on a continuous
basis (open-end mutual funds) or may offer a fixed number of shares usually
listed on an exchange (closed-end mutual funds). Mutual funds generally offer
investors the advantages of diversification and professional investment
management, by combining shareholders' money and investing it in various types
of securities, such as stocks, bonds and money market securities. Mutual funds
also make various investments and use certain techniques in order to enhance
their performance. These may include entering into delayed-delivery and
when-issued securities transactions or swap agreements; buying and selling
futures contracts, illiquid and restricted securities and repurchase agreements
and borrowing or lending money and/or portfolio securities. The risks of
investing in mutual funds generally reflect the risks of the securities in which
the mutual funds invest and the investment techniques they may employ. Also,
mutual funds charge fees and incur operating expenses.
If a fund decides to purchase securities of other investment companies, a fund
intends to purchase shares of mutual funds in compliance with the requirements
of federal law or any applicable exemptive relief received from the SEC. Mutual
fund investments for a fund are currently restricted under federal regulations,
and therefore, the extent to which a fund may invest in another mutual fund may
be limited. In addition, a fund intends to vote any proxies of
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<PAGE> 22
underlying mutual funds in accordance with the instructions received, or in the
same proportion as the vote of all other shareholders of the underlying mutual
fund.
Funds in which a fund also may invest include unregistered or privately-placed
funds, such as hedge funds and off-shore funds, and unit investment trusts.
Hedge funds and off-shore funds are not registered with the SEC, and therefore
are largely exempt from the regulatory requirements that apply to registered
investment companies (mutual funds). As a result, these funds may have greater
ability to make investments or use investment techniques that offer a higher
degree of investment return, such as leveraging, which also may subject fund
assets to substantial risk to the investment principal. These funds, while not
regulated by the SEC like mutual funds, may be indirectly supervised by the
sources of their assets, which tend to be commercial and investment banks and
other financial institutions. Investments in these funds also may be more
difficult to sell, which could cause losses to a fund. For example, hedge funds
typically require investors to keep their investment in a hedge fund for some
period of time, such as one month. This means investors would not be able to
sell their shares of a hedge fund until such time had past.
SHORT SALES may be used by a fund as a quantitative technique to assemble a
portfolio whose performance, average maturity and average duration is expected
to track that of the index. This technique would be used to provide a more
effective hedge against interest rate risk than other types of hedging
transactions, such as selling futures contracts. This technique may be used if
the fund owns the security, or the right to obtain the security or equivalent
securities, or covers such short sales with liquid assets as required by the
current rules and positions of the SEC or its staff. When a fund makes a short
sale, it may borrow the security sold short and deliver it to the broker-dealer
through which it made the short sale as collateral for its obligation to deliver
the security upon conclusion of the sale. A fund may have to pay a fee to borrow
particular securities and is often obligated to pay over any accrued interest
and dividends on such borrowed securities.
If the price of the security sold short increases between the time of the short
sale and the time a fund replaces the borrowed security, a fund will incur a
loss; conversely, if the price declines, a fund will realize a capital gain. Any
gain will be decreased, and any loss increased, by the transaction costs
described above. Selling securities short against the box involves selling a
security that a fund owns or has the right to acquire, for the delivery at a
specified date in the future. If a fund sells securities short against the box,
it may protect unrealized gains, but will lose the opportunity to profit on such
securities if the price rises. The successful use of short selling may be
adversely affected by imperfect correlation between movements in the price of
the security sold short and the securities being hedged.
SINKING FUNDS may be established by bond issuers to set aside a certain amount
of money to cover timely repayment of bondholders' principal raised through a
bond issuance. By creating a sinking fund, the issuer is able to spread
repayment of principal to numerous bondholders while reducing reliance on its
then current cash flows. A sinking fund also may allow the issuer to annually
repurchase certain of its outstanding bonds from the open market or repurchase
certain of its bonds at a call price named in a bond's sinking fund provision.
This call provision will allow bonds to be prepaid or called prior to a bond's
maturity. The likelihood of this occurring is substantial during periods of
falling interest rates.
SPREAD TRANSACTIONS may be used for hedging or managing risk. A fund may
purchase covered spread options from securities dealers. Such covered spread
options are not presently exchange-listed or exchange-traded. The purchase of a
spread option gives a fund the right to put, or sell, a security that it owns at
a fixed dollar spread or fixed yield spread in relation to another security
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<PAGE> 23
that a fund does not own, but which is used as a benchmark. The risk to a fund
in purchasing covered spread options is the cost of the premium paid for the
spread option and any transaction costs. In addition, there is no assurance that
closing transactions will be available. The purchase of spread options will be
used to protect a fund against adverse changes in prevailing credit quality
spreads, i.e., the yield spread between high quality and lower quality
securities. Such protection is only provided during the life of the spread
option.
STRIPPED SECURITIES are securities whose income and principal components are
detached and sold separately. While risks associated with stripped securities
are similar to other fixed income securities, stripped securities are typically
subject to greater changes in value. U.S. Treasury securities that have been
stripped by a Federal Reserve Bank are obligations of the U.S. Treasury.
SWAP AGREEMENTS can be structured to increase or decrease a fund's exposure to
long- or short-term interest rates, corporate borrowing rates and other
conditions, such as changing security prices and inflation rates. They also can
be structured to increase or decrease a fund's exposure to specific issuers or
specific sectors of the bond market such as mortgage securities. For example, if
a fund agreed to pay a longer-term fixed rate in exchange for a shorter-term
floating rate while holding longer-term fixed-rate bonds, the swap would tend to
decrease a fund's exposure to longer-term interest rates. Swap agreements tend
to increase or decrease the overall volatility of a fund's investments and its
share price and yield. Changes in interest rates, or other factors determining
the amount of payments due to and from a fund, can be the most significant
factors in the performance of a swap agreement. If a swap agreement calls for
payments from a fund, a fund must be prepared to make such payments when they
are due. In order to help minimize risks, a fund will segregate appropriate
assets for any accrued but unpaid net amounts owed under the terms of a swap
agreement entered into on a net basis. All other swap agreements will require a
fund to segregate appropriate assets in the amount of the accrued amounts owed
under the swap. A fund could sustain losses if a counterparty does not perform
as agreed under the terms of the swap. A fund will enter into swap agreements
with counterparties deemed creditworthy by the investment adviser.
U.S. GOVERNMENT SECURITIES are issued by the U.S. Treasury or issued or
guaranteed by the U.S. government or any of its agencies or instrumentalities.
Not all U.S. government securities are backed by the full faith and credit of
the United States. Some U.S. government securities, such as those issued by
Fannie Mae, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac),
the Student Loan Marketing Association (SLMA or Sallie Mae), and the Federal
Home Loan Banks (FHLB), are supported by a line of credit the issuing entity has
with the U.S. Treasury. Others are supported solely by the credit of the issuing
agency or instrumentality such as obligations issued by the Federal Farm Credit
Banks Funding Corporation (FFCB). There can be no assurance that the U.S.
government will provide financial support to U.S. government securities of its
agencies and instrumentalities if it is not obligated to do so under law. Of
course U.S. government securities, including U.S. Treasury securities, are among
the safest securities, however, not unlike other debt securities, they are still
sensitive to interest rate changes, which will cause their prices to fluctuate.
VARIABLE- AND FLOATING-RATE DEBT SECURITIES pay an interest rate, which is
adjusted either periodically or at specific intervals or which floats
continuously according to a formula or benchmark. Although these structures
generally are intended to minimize the fluctuations in value that occur when
interest rates rise and fall, some structures may be linked to a benchmark in
such a way as to cause greater volatility to the security's value.
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<PAGE> 24
Some variable-rate securities may be combined with a put or demand feature
(variable-rate demand securities) that entitles the holder to the right to
demand repayment in full or to resell at a specific price and/or time. While the
demand feature is intended to reduce credit risks, it is not always
unconditional, and may make the securities more difficult to sell quickly
without losses. There are risks involved with these securities because there may
be no active secondary market for a particular variable-rate demand security
purchased by a fund. In addition, a fund may exercise its demand rights only at
certain times. A fund could also suffer losses in the event that the issuer
defaults on its obligation.
WARRANTS are a type of security usually issued with bonds and preferred stock
that entitles the holder to a proportionate amount of common stock at specified
price for a specific period of time. The prices of warrants do not necessarily
move parallel to the prices of the underlying common stock. Warrants have no
voting rights, receive no dividends and have no rights with respect to the
assets of the issuer. If a warrant is not exercised within the specified time
period, it will become worthless and a fund will lose the purchase price it paid
for the warrant and the right to purchase the underlying security.
WRAP AGREEMENTS may be entered into by a fund with insurance companies, banks or
other financial institutions (wrapper providers). A wrap agreement typically
obligates the wrapper provider to maintain the value of the assets covered under
the agreement (covered assets) up to a specified maximum dollar amount upon the
occurrence of certain specified events. The value is pre-determined using the
purchase price of the securities plus interest at a specified rate minus an
adjustment for any defaulted securities. The specified interest rate may be
adjusted periodically under the terms of the agreement. While the rate typically
will reflect movements in the market rates of interest, it may at times be less
or more than the actual rate of income earned on the covered assets. The rate
also can be impacted by defaulted securities and by purchase and redemption
levels in a fund. A fund also pays a fee under the agreement, which reduces the
rate as well.
Wrap agreements may be used as a risk management technique intended to help
minimize fluctuations in a fund's NAV. However, a fund's NAV will typically
fluctuate at least minimally, and may fluctuate more at times when interest
rates are fluctuating. Additionally, wrap agreements do not protect against
losses a fund may incur if the issuers of portfolio securities do not make
timely payments of interest and/or principal. A wrap agreement provider also
could default on its obligations under the agreement. Therefore, the funds will
only invest in a wrap provider with an investment-grade credit rating. There is
no active trading market for wrap agreements and none is expected to develop.
Therefore, wrap agreements are considered illiquid investments. There is no
guarantee that a fund will be able to purchase any wrap agreements or replace
ones that defaulted. Wrap agreements are valued using procedures adopted by the
board of trustees. There are risks that the value of a wrap agreement may not be
sufficient to minimize the fluctuations in a fund's NAV. All of these factors
might result in a decline in the value of a fund's shares.
ZERO-COUPON, STEP-COUPON, AND PAY-IN-KIND SECURITIES are debt securities that do
not make regular cash interest payments. Zero-coupon and step-coupon securities
are sold at a deep discount to their face value. Pay-in-kind securities pay
interest through the issuance of additional securities. Because such securities
do not pay current cash income, the price of these securities can be volatile
when interest rates fluctuate. While these securities do not pay current cash
income, federal income tax law requires the holders of zero-coupon, step-coupon,
and pay-in-kind securities to include in income each year the portion of the
original issue discount (or deemed discount) and other non-cash income on such
securities accruing that year. In order to
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continue to qualify as a "regulated investment company" or "RIC" under the
Internal Revenue Code and avoid a certain excise tax, a fund may be required to
distribute a portion of such discount and income and may be required to dispose
of other portfolio securities, which may occur in periods of adverse market
prices, in order to generate cash to meet these distribution requirements.
INVESTMENT LIMITATIONS
The following investment limitations are fundamental investment polices and
restrictions and may be changed only by vote of a majority of a fund's
outstanding voting shares.
EACH FUND MAY:
1) Lend or borrow money to the extent permitted by the Investment Company
Act of 1940 or rule or regulations thereunder, as such statute, rules
or regulations may be amended from time to time.
2) Pledge, mortgage or hypothecate any of its assets to the extent
permitted by the Investment Company Act of 1940 or the rules or
regulations thereunder, as such statute, rules or regulations may be
amended from time to time.
3) Not concentrate investments in a particular industry or group of
industries, or within one state (except to the extent that the index
which each fund seeks to track is also so concentrated) as
concentration is defined under the Investment Company Act of 1940 or
the rules or regulations thereunder, as such statute, rules or
regulations may be amended from time to time.
4) Underwrite securities to the extent permitted by the Investment Company
Act of 1940 or the rules or regulations thereunder, as such statute,
rules or regulations may be amended from time to time.
5) Not purchase securities of an issuer, except as consistent with the
maintenance of its status as an open-end diversified company under the
1940 Act, the rules or regulations thereunder or any exemption
therefrom, as such statute, rules or regulations may be amended or
interpreted from time to time.
6) Not purchase securities of other investment companies, except as
permitted by the Investment Company Act of 1940.
7) Issue senior securities to the extent permitted by the Investment
Company Act of 1940 or the rules or regulations thereunder, as such
statute, rules or regulations may be amended from time to time.
8) Purchase or sell commodities, commodities contracts, futures contracts,
or real estate to the extent permitted by the Investment Company Act of
1940 or rules or regulations thereunder, as such statute, rules or
regulations may be amended from time to time.
THE FOLLOWING DESCRIPTIONS OF THE 1940 ACT MAY ASSIST INVESTORS IN UNDERSTANDING
THE ABOVE POLICIES AND RESTRICTIONS.
Concentration. The SEC has presently defined concentration as investing 25% or
more of an
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investment company's net assets in an industry or group of industries, with
certain exceptions.
Borrowing. The 1940 Act presently allows a fund to borrow from any bank
(including pledging, mortgaging or hypothecating assets) in an amount up to
33 1/3% of its total assets (not including temporary borrowings not in excess
of 5% of its total assets).
Lending. Under the 1940 Act, a fund may only make loans if expressly permitted
by its investment policies. Each fund's non-fundamental investment policy on
lending is set forth below.
Underwriting. Under the 1940 Act, underwriting securities involves a fund
purchasing securities directly from an issuer for the purpose of selling
(distributing) them or participating in any such activity either directly or
indirectly. Under the 1940 Act, a diversified fund may not make any commitment
as underwriter, if immediately thereafter the amount of its outstanding
underwriting commitments, plus the value of its investments in securities of
issuers (other than investment companies) of which it owns more than 10% of the
outstanding voting securities, exceeds 25% of the value of its total assets.
Senior Securities. Senior securities may include any obligation or instrument
issued by a fund evidencing indebtedness. The 1940 Act generally prohibits funds
from issuing senior securities, although it provides allowances for certain
borrowings and certain other investments, such as short sales, reverse
repurchase agreements, firm commitment agreements and standby commitments, with
appropriate segregation of assets.
The following are non-fundamental investment policies and restrictions and may
be changed by the board of trustees.
EACH FUND MAY NOT:
1) Purchase more than 10% of any class of securities of any issuer if, as
a result of such purchase, it would own more than 10% of such issuer's
outstanding voting securities.
2) Invest more than 5% of its total assets in securities of issuers (other
than obligations of, or guaranteed by the U.S. government, its agencies
or instrumentalities) that with their predecessors have a record of
less than three years continuous operation.
3) Purchase securities that would cause more than 5% of its net assets to
be invested in restricted securities, excluding restricted securities
eligible for resale pursuant to Rule 144A under the Securities Act of
1933 that have been determined to be liquid under procedures adopted by
the trust's board of trustees based upon the trading markets for the
securities.
4) Invest more than 5% of its net assets in warrants, valued at the lower
of cost or market, and no more than 40% of this 5% may be invested in
warrants that are not listed on the New York Stock Exchange or the
American Stock Exchange, provided, however, that for purposes of this
restriction, warrants acquired by a fund in units or attached to other
securities are deemed to be without value.
5) Purchase puts, calls, straddles, spreads or any combination thereof if
by reason of such purchase the value of its aggregate investment in
such securities would exceed 5% of a fund's total assets.
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<PAGE> 27
6) Sell securities short unless it owns the security or the right to
obtain the security or equivalent securities, or unless it covers such
short sale as required by current SEC rules and positions (transactions
in futures contracts, options and other derivative instruments are not
considered selling securities short).
7) Purchase or sell interests in oil, gas or other mineral development
programs or leases, although it may invest in companies that own or
invest in such interests or leases.
8) Purchase securities on margin, except such short-term credits as may be
necessary for the clearance of purchases and sales of securities.
9) Lend money to any person, except that each fund may (1) purchase a
portion of an issue of short-term debt securities or similar
obligations (including repurchase agreements) that are publicly
distributed or customarily purchased by institutional investors, and
(2) lend its portfolio securities.
10) Borrow money, except from banks for temporary purposes to satisfy
redemption requests or for extraordinary or emergency purposes and then
only in an amount not to exceed one-third of the value of its total
assets (including the amount borrowed), provided that each fund will
not purchase securities while borrowings represent more than 5% of its
total assets.
11) Pledge, mortgage or hypothecate any of its assets, except that to
secure allowable borrowing, each fund may do so with respect to no more
than one-third of the value of its total assets.
12) Underwrite securities issued by others, except to the extent it may be
deemed to be an underwriter, under the federal securities laws, in
connection with the disposition of securities from its investment
portfolio.
13) Purchase securities of any other issuer (other than U.S. government
securities) if, as a result, more than 25% of its total assets would
be invested in the securities if an issuer from a single industry or
group of industries.
14) Purchase the securities of any issuer if, as a result more than 15% of
its net assets would be invested in illiquid securities.
15) Purchase or sell commodities or real estate, including interests in
real estate limited partnerships, provided that each fund may (1)
purchase securities of companies that deal in real estate or interests
therein, and (2) purchase or sell futures contracts, options contracts,
equity index participations and index participations contracts.
16) As to 75% of its assets, purchase securities of any issuer (other than
obligations of, or guaranteed by, the U.S. government, its agencies or
instrumentalities) if, as a result more than 5% of the value of its
total assets would be invested in the securities of such issuer.
17) Invest for the purpose of exercising control or management of another
issuer.
MANAGEMENT OF THE FUNDS
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The officers and trustees, their principal occupations during the past five
years and their affiliations, if any, with The Charles Schwab Corporation,
Charles Schwab & Co., Inc. and Charles Schwab Investment Management, Inc., are
as follows:
<TABLE>
<CAPTION>
POSITION(S) WITH PRINCIPAL OCCUPATIONS &
NAME/DATE OF BIRTH THE TRUST AFFILIATIONS
--------------------------------------- ------------------------- -------------------------------------------------
<S> <C> <C>
CHARLES R. SCHWAB* Chairman, Chief Chairman and Co-Chief Executive Officer,
July 29, 1937 Executive Officer and Director, The Charles Schwab Corporation; Chief
Trustee Executive Officer, Director, Charles Schwab
Holdings, Inc.; Chairman, Director, Charles
Schwab & Co., Inc., Charles Schwab Investment
Management, Inc.; Director, The Charles Schwab
Trust Company; Chairman, Schwab Retirement Plan
Services, Inc.; Chairman and Director until
January 1999, Mayer & Schweitzer, Inc. (a
securities brokerage subsidiary of The Charles
Schwab Corporation); Director, The Gap, Inc. (a
clothing retailer), Audiobase, Inc. (full-service
audio solutions for the Internet), Vodaphone
AirTouch PLC (a telecommunications company) and
Siebel Systems (a software company).
JOHN P. COGHLAN* President and Trustee Vice Chairman and Executive Vice President, The
May 6, 1951 Charles Schwab Corporation; Vice Chairman and
Enterprise President, Retirement Plan Services
and Services for Investment Managers, Charles
Schwab & Co., Inc.; Chief Executive Officer and
Director, Charles Schwab Investment Management,
Inc.; President and Chief Executive Officer,
Director, The Charles Schwab Trust Company;
Director, Charles Schwab Asset Management
(Ireland) Ltd.; Director, Charles Schwab
Worldwide Funds PLC.
</TABLE>
--------
* This trustee is an "interested person" of the trusts.
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<PAGE> 29
<TABLE>
<S> <C> <C>
DONALD F. DORWARD Trustee Chief Executive Officer, Dorward & Associates
September 23, 1931 (corporate management, marketing and
communications consulting firm). From 1996 to
1999, Executive Vice President and Managing
Director, Grey Advertising. From 1990 to 1996,
Mr. Dorward was President and Chief Executive
Officer, Dorward & Associates (advertising and
marketing/consulting firm).
ROBERT G. HOLMES Trustee Chairman, Chief Executive Officer and Director,
May 15, 1931 Semloh Financial, Inc. (international financial
services and investment advisory firm).
DONALD R. STEPHENS Trustee Managing Partner, D.R. Stephens & Company
June 28, 1938 (investments). Prior to 1996, Chairman and
Chief Executive Officer of North American
Trust (real estate investment trust).
MICHAEL W. WILSEY Trustee Chairman and Chief Executive Officer, Wilsey
August 18, 1943 Bennett, Inc. (truck and air transportation,
real estate investment and management, and
investments).
JEREMIAH H. CHAFKIN* Executive Vice Executive Vice President, Asset Management
May 9, 1959 President, Chief Products and Services, Charles Schwab & Co.,
Operating Officer and Inc.; President and Chief Operating Officer,
Trustee Charles Schwab Investment Management, Inc.
Prior to September 1999, Mr. Chafkin was Senior
Managing Director, Bankers Trust Company.
</TABLE>
--------
* This trustee is an "interested person" of the trusts.
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<PAGE> 30
<TABLE>
<S> <C> <C>
MARIANN BYERWALTER Trustee Vice President for Business Affairs and Chief
August 13, 1960 Financial Officer, Stanford University (higher
education). Prior to February 1996, Ms.
Byerwalter was Chief Financial Officer of
Eureka Bank (savings and loans) and Chief
Financial Officer and Chief Operating Officer
of America First Eureka Holdings, Inc. (holding
company). Ms. Byerwalter also is on the Board
of Directors of America First Companies, Omaha,
NE (venture capital/fund management) and
Redwood Trust, Inc. (mortgage finance), and is
a Director of Stanford Hospitals and Clinics,
SRI International (research) and LookSmart,
Ltd. (an Internet infrastructure company).
WILLIAM A. HASLER Trustee Co-Chief Executive Officer, Aphton Corporation
November 22, 1941 (bio-pharmaceuticals). Prior to August 1998,
Mr. Hasler was Dean of the Haas School of
Business at the University of California,
Berkeley (higher education). Mr. Hasler also
is on the Board of Directors of Solectron
Corporation (manufacturing), Tenera, Inc.
(services and software), Airlease Ltd.
(aircraft leasing) and Mission West Properties
(commercial real estate).
GERALD B. SMITH Trustee Chairman and Chief Executive Officer and
September 28, 1950 founder of Smith Graham & Co. (investment
advisors). Mr. Smith is also on the Board of
Directors of Pennzoil-Quaker State Company (oil
and gas) and Rorento N.V. (investments -
Netherlands), and is a member of the audit
committee of Northern Border Partners, L.P., a
subsidiary of Enron Corp. (energy).
TAI-CHIN TUNG Treasurer and Principal Senior Vice President, Treasurer, Controller
March 7, 1951 Financial Officer and Chief Financial Officer, Charles Schwab
Investment Management, Inc. From 1994 to 1996,
Ms. Tung was Controller for Robertson Stephens
Investment Management, Inc.
STEPHEN B. WARD Senior Vice President Senior Vice President and Chief Investment
April 5, 1955 and Chief Investment Officer, Charles Schwab Investment Management,
Officer Inc.
</TABLE>
30
<PAGE> 31
<TABLE>
<S> <C> <C>
KOJI E. FELTON Secretary Vice President, Chief Counsel and Assistant
March 13, 1961 Corporate Secretary, Charles Schwab Investment
Management, Inc. Prior to June 1998, Mr. Felton
was a Branch Chief in Enforcement at the U.S.
Securities and Exchange Commission in San Francisco.
</TABLE>
Each of the above-referenced officers and/or trustees also serves in the same
capacity as described for the trust, for The Charles Schwab Family of Funds,
Schwab Capital Trust and Schwab Annuity Portfolios. The address of each
individual listed above is 101 Montgomery Street, San Francisco, California
94104.
Each fund is overseen by a board of trustees. The board of trustees meets
regularly to review a fund's activities, contractual arrangements and
performance. The board of trustees is responsible for protecting the interests
of a fund's shareholders. The following table provides information concerning
compensation of the trustees.
<TABLE>
<CAPTION>
($)
Total
($) Pension or Retirement Compensation
Aggregate Compensation Benefits Accrued as from Fund
Name of Trustee from each Fund 1 Part of Fund Expenses Complex 2
Short-Term Total Bond
Bond Market
---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Charles R. Schwab 0 0 N/A 0
Steven L. Scheid 3 0 0 N/A 0
William J. Klipp 4 0 0 N/A 0
John P. Coghlan 5 0 0 N/A 0
Jeremiah H. Chafkin 6 0 0 N/A 0
Mariann Byerwalter 6 376 487 N/A 38,870
Donald F. Dorward 1,854 2,299 N/A 134,600
William A. Hasler 6 376 487 N/A 38,870
Robert G. Holmes 1,854 2,299 N/A 134,600
Gerald B. Smith 6 376 487 N/A 38,870
Donald R. Stephens 1,854 2,299 N/A 134,600
Michael W. Wilsey 1,748 2,170 N/A 124,600
</TABLE>
1 For the fiscal year ended August 31, 2000.
2 Unless otherwise stated, information is for the fund complex, which included
44 funds as of August 31, 2000.
3 Resigned from the Board effective November 21, 2000.
4 Mr. Klipp departed Charles Schwab & Co., Inc. in 1999 and resigned from the
Board of Trustees effective April 30, 2000.
5 Elected to the Board on November 21, 2000.
6 This trustee was first elected by shareholders on June 1, 2000.
DEFERRED COMPENSATION PLAN
Trustees who are not "interested persons" of a trust ("independent trustees")
may enter into a fee
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<PAGE> 32
deferral plan. Under this plan, deferred fees will be credited to an account
established by the trust as of the date that such fees would have been paid to
the trustee. The value of this account will equal the value that the account
would be if the fees credited to the account had been invested in the shares of
SchwabFunds selected by the trustee. Currently, none of the independent trustees
has elected to participate in this plan.
CODE OF ETHICS
The funds, their investment adviser and Schwab have adopted a Code of Ethics
(Code) as required under the 1940 Act. Subject to certain conditions or
restrictions, the Code permits the trustees, directors, officers or advisory
representatives of the funds or the investment adviser or the directors or
officers of Schwab to buy or sell securities for their own accounts. This
includes securities that may be purchased or held by the funds. Securities
transactions by some of these individuals may be subject to prior approval of
the investment adviser's Chief Compliance Officer or alternate. Most securities
transactions are subject to quarterly reporting and review requirements.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of October 16, 2000, the officers and trustees of Schwab Total Bond Market
Index Fund, as a group owned of record or beneficially less than 1% of the
outstanding voting securities of the fund.
As of October 16, 2000, the officers and trustees of Schwab Short-Term Bond
Market Index Fund owned of record or beneficially less than 1% of the
outstanding voting securities of the fund, excluding Charles R. Schwab as
reported below.
As of October 16, 2000, Charles R. Schwab, 101 Montgomery Street, San Francisco,
CA 94119, directly or beneficially owned 13.20% of shares of the Schwab
Short-Term Bond Market Index Fund.
As of the same date, Charles Schwab & Co., Inc. - Retirement Plan Services,
MarketTrack Growth II Portfolio, MarketTrack Balanced Portfolio, MarketTrack
Conservative Portfolio and MarketTrack Growth Portfolio in the aggregate,
directly or beneficially owned 65.41% of the shares of Schwab Total Bond Market
Index Fund.
INVESTMENT ADVISORY AND OTHER SERVICES
INVESTMENT ADVISER
Charles Schwab Investment Management, Inc. (CSIM or the investment adviser), a
wholly owned subsidiary of The Charles Schwab Corporation, 101 Montgomery
Street, San Francisco CA 94104, serves as each fund's investment adviser and
administrator pursuant to Investment Advisory and Administration Agreements
(Advisory Agreements) between it and the trust. Charles Schwab & Co., Inc.
(Schwab) is an affiliate of the investment adviser and is the trust's
distributor, shareholder services agent and transfer agent. Charles R. Schwab is
the founder, Chairman, Co-Chief Executive Officer and Director of The Charles
Schwab Corporation. As a result of his ownership of and interests in The Charles
Schwab Corporation, Mr. Schwab may be deemed to be a controlling person of the
investment adviser and Schwab.
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<PAGE> 33
For its advisory and administrative services to each fund, the investment
adviser is entitled to receive a graduated annual fee payable monthly based on
each fund's average daily net assets as described below.
First $500 million - 0.30%
More than $500 million - 0.22%
Prior to November 15, 1999 for its advisory and administrative services for each
fund, the investment adviser was entitled to receive an annual fee, payable
monthly from each fund of 0.41% of each fund's daily net assets.
For the fiscal years ended August 31, 1998, 1999 and 2000, the investment
advisory fees incurred by the Schwab Short-Term Bond Market Index Fund were
$25,000 (fees were reduced by $561,000), $0 (fees were reduced by $760,000), and
$0 (fees were reduced by $705,000) respectively.
For the fiscal years ended August 31, 1998, 1999 and 2000, the investment
advisory fees incurred by the Schwab Total Bond Market Index Fund, were $0 (fees
were reduced by $580,000), $76,000 (fees were reduced by $1,498,000), and
$221,000 (fees were reduced by $1,525,000) respectively.
The investment adviser and Schwab have contractually guaranteed that, through at
least November 15, 2001, total operating expenses (excluding interest, taxes and
certain non-routine expenses) of the Schwab Short-Term Bond Market Index Fund
and Schwab Total Bond Market Index Fund will not exceed 0.35%, of each fund's
average daily net assets.
DISTRIBUTOR
Pursuant to a Distribution Agreement, Schwab is the principal underwriter for
shares of a fund and is the trust's agent for the purpose of the continuous
offering of a fund's shares. Each fund pays the cost of the prospectuses and
shareholder reports to be prepared and delivered to existing shareholders.
Schwab pays such costs when the described materials are used in connection with
the offering of shares to prospective investors and for supplemental sales
literature and advertising. Schwab receives no fee under the Distribution
Agreement.
SHAREHOLDER SERVICES AND TRANSFER AGENT
Schwab provides fund information to shareholders, including share price,
reporting shareholder ownership and account activities and distributing a fund's
prospectuses, financial reports and other informational literature about the
fund. Schwab maintains the office space, equipment and personnel necessary to
provide these services. Schwab also distributes and markets SchwabFunds and
provides other services. At its own expense, Schwab may engage third party
entities, as appropriate, to perform some or all of these services.
For the services performed as transfer agent under the contract with a fund,
Schwab is entitled to receive an annual fee, payable monthly from each fund, in
the amount of 0.05% of a fund's average daily net assets. For the services
performed as shareholder services agent under its contract with a fund, Schwab
is entitled to receive an annual fee, payable monthly from the funds, in the
amount of 0.20% of the average daily net assets of each fund.
33
<PAGE> 34
CUSTODIAN AND FUND ACCOUNTANT
PFPC Trust Company, 8800 Tinicum Blvd., Third Floor Suite 200, Philadelphia, PA
19153, serves as custodian for the funds and PFPC, Inc., 400 Bellevue Parkway,
Wilmington, DE 19809, serves as fund accountant.
The custodian is responsible for the daily safekeeping of securities and cash
held or sold by the funds. The accountant maintains all books and records
related to each fund's transactions.
INDEPENDENT ACCOUNTANT
The funds' independent accountant, PricewaterhouseCoopers LLP, audits and
reports on the annual financial statements of each series of the trust and
reviews certain regulatory reports and each fund's federal income tax return.
They also perform other professional accounting, auditing, tax and advisory
services when the trust engages them to do so. Their address is 333 Market
Street, San Francisco, CA 94105. Each fund's audited financial statements for
the fiscal year ending August 31, 2000, will be included in the fund's annual
report that is supplied with the SAI.
BROKERAGE ALLOCATION AND OTHER PRACTICES
PORTFOLIO TURNOVER
For reporting purposes, a fund's turnover rate is calculated by dividing the
value of purchases or sales of portfolio securities for the fiscal year,
whichever is less, by the monthly average value of portfolio securities a fund
owned during the fiscal year. When making the calculation, all securities whose
maturities at the time of acquisition were one year or less ("short-term
securities") are excluded.
The portfolio turnover rates for the Schwab Total Bond Market Index Fund for the
fiscal years ended August 31, 1999 and 2000 were 174% and 135%, respectively.
The portfolio turnover rates for the Schwab Short-Term Bond Index Fund for the
fiscal years ended August 31, 1999 and 2000 were 195% and 129%, respectively.
PORTFOLIO TRANSACTIONS
The funds paid no brokerage commissions in the last three fiscal years.
In effecting securities transactions for a fund, the investment adviser seeks to
obtain best execution. Subject to the supervision of the board of trustees, the
investment adviser will select brokers and dealers for a fund on the basis of a
number of factors, including, for example, price paid for securities, clearance,
settlement, reputation, financial strength and stability, efficiency of
execution and error resolution, block trading and block positioning
capabilities, willingness to execute related or unrelated difficult transactions
in the future, and order of call.
When the execution capability and price offered by two or more broker-dealers
are comparable, the investment adviser may, in its discretion, in agency
transactions (and not principal transactions) utilize the services of
broker-dealers that provide it with investment information and other research
resources. Such resources also may be used by the investment adviser when
34
<PAGE> 35
providing advisory services to its clients.
A fund expects that purchases and sales of portfolio securities will usually be
principal transactions. Securities will normally be purchased directly from the
issuer or from an underwriter or market maker for the securities. Purchases from
underwriters will include a commission or concession paid by the issuer to the
underwriter, and purchases from dealers serving as market makers will include
the spread between the bid and asked prices.
The investment decisions for a fund are reached independently from those for
other accounts managed by the investment adviser. Such other accounts also may
make investments in instruments or securities at the same time as a fund. When
two or more accounts managed by the investment adviser have funds available for
investment in similar instruments, available instruments are allocated as to
amount in a manner considered equitable to each account. In some cases, this
procedure may affect the size or price of the position obtainable for a fund.
However, it is the opinion of the board of trustees that the benefits conferred
by the investment adviser outweigh any disadvantages that may arise from
exposure to simultaneous transactions.
In an attempt to obtain best execution for a fund, the investment adviser may
place orders directly with market makers or with third market brokers such as
Instinet, which is a computer subscriber service, or brokers on an agency basis.
Placing orders with third market brokers or through Instinet may enable a fund
to trade directly with other institutional holders on a net basis. At times,
this may allow a fund to trade larger blocks than would be possible trading
through a single market maker.
DESCRIPTION OF THE TRUST
Each fund is a series of Schwab Investments. Schwab Investments was organized
under Massachusetts law on October 26, 1990.
The Declaration of Trust provides that shares may be automatically redeemed if
held by a shareholder in an amount less than the minimum required by a fund or
share class. Each fund's initial and subsequent minimum investment and balance
requirements are set forth in the prospectus. These minimums may be waived for
certain investors, including trustees, officers and employees of Schwab, or
changed without prior notice.
Each fund may hold special meetings, which may cause the funds to incur
non-routine expenses. These meetings may be called for purposes such as electing
trustees, changing fundamental policies and amending management contracts.
Shareholders are entitled to one vote for each share owned and may vote by proxy
or in person. Proxy materials will be mailed to shareholders prior to any
meetings, and will include a voting card and information explaining the matters
to be voted upon.
The bylaws of the trust provides that a majority of shares entitled to vote
shall be a quorum for the transaction of business at a shareholders' meeting,
except that where any provision of law, or of the Declaration of Trust or of the
bylaws permits or requires that (1) holders of any series shall vote as a
series, then a majority of the aggregate number of shares of that series
entitled to vote shall be necessary to constitute a quorum for the transaction
of business by that series, or (2) holders of any class shall vote as a class,
then a majority of the aggregate number of shares of that class entitled to vote
shall be necessary to constitute a quorum for the transaction of business by
that class. Any lesser number shall be sufficient for adjournments. Any
adjourned session or
35
<PAGE> 36
sessions may be held, within a reasonable time after the date set for the
original meeting, without the necessity of further notice. The Declaration of
Trust specifically authorizes the board of trustees to terminate the trust (or
any of its investment portfolios) by notice to the shareholders without
shareholder approval.
Under Massachusetts law, shareholders of a Massachusetts business trust could,
under certain circumstances, be held personally liable for the trust's
obligations. The Declaration of Trust, however, disclaims shareholder liability
for the trust's acts or obligations and requires that notice of such disclaimer
be given in each agreement, obligation or instrument entered into or executed by
the trust or the trustees. In addition, the Declaration of Trust provides for
indemnification out of the property of an investment portfolio in which a
shareholder owns or owned shares for all losses and expenses of such shareholder
or former shareholder if he or she is held personally liable for the obligations
of the trust solely by reason of being or having been a shareholder. Moreover,
the trust will be covered by insurance which the trustees consider adequate to
cover foreseeable tort claims. Thus, the risk of a shareholder incurring
financial loss on account of shareholder liability is considered remote, because
it is limited to circumstances in which a disclaimer is inoperative and the
trust itself is unable to meet its obligations. There is a remote possibility
that a fund could become liable for a misstatement in the prospectus or SAI
about another fund.
As more fully described in the Declaration of Trust, the trustees may each year,
or more frequently, distribute to the shareholders of each series accrued income
less accrued expenses and any net realized capital gains less accrued expenses.
Distributions of each year's income of each series shall be distributed pro rata
to shareholders in proportion to the number of shares of each series held by
each of them. Distributions will be paid in cash or shares or a combination
thereof as determined by the trustees. Distributions paid in shares will be paid
at the net asset value as determined in accordance with the bylaws.
PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER REPORTS AND
PRICING OF SHARES
PURCHASING AND REDEEMING SHARES OF THE FUNDS
As long as a fund or Schwab follow reasonable procedures to confirm that your
telephone or internet order is genuine, they will not be liable for any losses
an investor may experience due to unauthorized or fraudulent instructions. These
procedures may include requiring a form of personal identification or other
confirmation before acting upon any telephone or internet order, providing
written confirmation of telephone or internet orders and tape recording all
telephone orders.
Share certificates will not be issued in order to avoid additional
administrative costs, however, share ownership records are maintained by Schwab.
EXCHANGING SHARES OF THE FUNDS
Shares of any Schwab Fund, including any class of shares, may be sold and shares
of any other Schwab Fund or class purchased, provided the minimum investment and
any other requirements of the fund or class purchased are satisfied. Without
limiting this privilege, "an exchange order," which is a simultaneous order to
sell shares of one fund or class and automatically invest the proceeds in
another fund or class, may not be executed between shares of Sweep
Investments(TM)
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<PAGE> 37
and shares of non-Sweep Investments. Shares of Sweep Investments may be bought
and sold automatically pursuant to the terms and conditions of your account
agreement or by direct order as long as you meet the minimums for direct
investments.
DELIVERY OF SHAREHOLDER DOCUMENTS
Typically once a year, an updated prospectus will be mailed to shareholders
describing each fund's investment strategies, risks and shareholder policies.
Twice a year, financial reports will be mailed to shareholders describing each
fund's performance and investment holdings. In order to eliminate duplicate
mailings of shareholder documents, each household may receive one copy of these
documents, under certain conditions. This practice is commonly called
"householding." If you want to receive multiple copies, you may write or call
your fund at the address or telephone number on the front of this SAI. Your
instructions will be effective within 30 days of receipt by Schwab.
PRICING OF SHARES
Securities traded on stock exchanges are valued at the last-quoted sales price
on the exchange on which such securities are primarily traded, or, lacking any
sales, at the mean between the bid and ask prices. Securities traded in the
over-the-counter market are valued at the last sales price that day, or if no
sales that day, at the mean between the bid and ask prices. Securities for which
market quotations or closing values are not readily available (including
restricted securities that are subject to limitations on their sale and illiquid
securities) are valued at fair value as determined in good faith pursuant to
guidelines and procedures adopted by the board of trustees. These procedures
require that securities be valued on the basis of prices provided by approved
pricing services, except when a price appears manifestly incorrect or events
occurring between the time a price is furnished by a service and the time a fund
calculates its share price materially affect the furnished price. The board of
trustees regularly reviews fair values assigned to portfolio securities under
these circumstances and also when no prices from approved pricing services are
available.
TAXATION
FEDERAL TAX INFORMATION FOR THE FUNDS
It is each fund's policy to qualify for taxation as a "regulated investment
company" (RIC) by meeting the requirements of Subchapter M of the Internal
Revenue Code of 1986, as amended (the Code). By qualifying as a RIC, a fund
expects to eliminate or reduce to a nominal amount the federal income tax to
which it is subject. If a fund does not qualify as a RIC under the Code, it will
be subject to federal income tax, at regular corporate rates on its net income,
including any net realized capital gains.
The Code imposes a non-deductible excise tax on RICs that do not distribute in a
calendar year (regardless of whether they otherwise have a non-calendar taxable
year) an amount equal to 98% of their "ordinary income" (as defined in the Code)
for the calendar year plus 98% of their net capital gain for the one-year period
ending on October 31 of such calendar year, plus any undistributed amounts from
prior years. The non-deductible excise tax is equal to 4% of the deficiency. For
the foregoing purposes, a fund is treated as having distributed any amount on
which it is subject to income tax for any taxable year ending in such calendar
year.
A fund's transactions in futures contracts, options and certain other investment
activities may be
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<PAGE> 38
restricted by the Code and are subject to special tax rules. In a given case,
these rules may accelerate income to a fund, defer its losses, cause adjustments
in the holding periods of a fund's assets, convert short-term capital losses
into long-term capital losses or otherwise affect the character of a fund's
income. These rules could therefore affect the amount, timing and character of
distributions to shareholders. A fund will endeavor to make any available
elections pertaining to these transactions in a manner believed to be in the
best interest of a fund and its shareholders.
FEDERAL INCOME TAX INFORMATION FOR SHAREHOLDERS
The discussion of federal income taxation presented below supplements the
discussion in a fund's prospectus and only summarizes some of the important
federal tax considerations generally affecting shareholders of a fund.
Accordingly, prospective investors (particularly those not residing or domiciled
in the United States) should consult their own tax advisers regarding the
consequences of investing in a fund.
Any dividends declared by a fund in October, November or December and paid the
following January are treated, for tax purposes, as if they were received by
shareholders on December 31 of the year in which they were declared. Long-term
capital gains distributions are taxable as long-term capital gains, regardless
of how long you have held your shares. However, if you receive a long-term
capital gains distribution with respect to fund shares held for six months or
less, any loss on the sale or exchange of those shares shall, to the extent of
the long-term capital gains distribution, be treated as a long-term capital
loss. Because a fund's income is expected to consist of interest rather than
dividends, it is anticipated that no portion of its distributions will generally
be eligible for the dividends-received deduction. Distributions by a fund also
may be subject to state, local and foreign taxes, and its treatment under
applicable tax laws may differ from the federal income tax treatment.
Each fund will be required in certain cases to withhold and remit to the U.S.
Treasury 31% of taxable dividends paid to any shareholder who (1) fails to
provide a correct taxpayer identification number certified under penalty of
perjury; (2) is subject to withholding by the Internal Revenue Service for
failure to properly report all payments of interest or dividends; or (3) fails
to provide a certified statement that he or she is not subject to "backup
withholding." Backup withholding is not an additional tax and any amounts
withheld may be credited against the shareholder's ultimate U.S. tax liability.
Foreign shareholders (i.e., nonresident alien individuals and foreign
corporations, partnerships, trusts and estates) are generally subject to U.S.
withholding tax at the rate of 30% (or a lower tax treaty rate) on distributions
derived from net investment income and short-term capital gains. Distributions
to foreign shareholders of long-term capital gains and any gains from the sale
or other disposition of shares of the funds generally are not subject to U.S.
taxation, unless the recipient is an individual who either (1) meets the Code's
definition of "resident alien" or (2) who is physically present in the U.S. for
183 days or more. Different tax consequences may result if the foreign
shareholder is engaged in a trade or business within the United States. In
addition, the tax consequences to a foreign shareholder entitled to claim the
benefits of a tax treaty may be different than those described above.
GENERAL STATE AND LOCAL TAX INFORMATION
Many states grant tax-free status to dividends paid to you from interest earned
on direct obligations of the U.S. government, subject in some states to minimum
investment requirements that must be met by a fund. Investment in Ginnie Mae or
Fannie Mae securities, banker's
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<PAGE> 39
acceptances, commercial paper and repurchase agreements collateralized by U.S.
government securities do not generally qualify for such tax-free treatment. The
rules on exclusion of this income are different for corporate shareholders.
Shareholders are urged to consult their tax advisors as to the consequences of
these and other state and local tax rules affecting investments in the funds.
CALCULATION OF PERFORMANCE DATA
Average annual total return is a standardized measure of performance calculated
using methods prescribed by SEC rules. It is calculated by determining the
ending value of a hypothetical initial investment of $1,000 made at the
beginning of a specified period. The ending value is then divided by the initial
investment, which is annualized and expressed as a percentage. It is reported
for periods of one, five and 10 years or since commencement of operations for
periods not falling on those intervals. In computing average annual total
return, a fund assumes reinvestment of all distributions at net asset value on
applicable reinvestment dates.
Standardized Total Return
<TABLE>
<CAPTION>
Average Annual Total Average Annual Total Average Annual Total
Return for 1 year Return for 5 years Return from
ended August 31, ended August 31, commencement of
2000 2000 operations to
August 31, 2000*
<S> <C> <C> <C>
Schwab Short-Term 5.97% 5.51% 5.62%
Bond Fund
Schwab Total Bond 7.36% 6.25% 6.17%
Market Index Fund
</TABLE>
* November 5, 1991 for Schwab Short-Term Bond Market Index Fund and March
5, 1993 for the Schwab Total Bond Market Index Fund.
Each fund also may advertise its cumulative total return since inception. This
number is calculated using the same formula that is used for average annual
total return except that, rather than calculating the total return based on a
one-year period, cumulative total return is calculated from commencement of
operations to the end of the fiscal year.
Nonstandardized Cumulative Total Return
<TABLE>
<CAPTION>
Fund Cumulative Total Return as of
August 31, 2000*
<S> <C>
Schwab Short-Term Bond Market Index Fund 62.02%
Schwab Total Bond Market Index Fund 56.66%
</TABLE>
* November 5, 1991 for Schwab Short-Term Bond Market Index Fund and March
5, 1993 for the Schwab Total Bond Market Index Fund.
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<PAGE> 40
A 30-day yield is calculated by dividing the net investment income per share
earned during a 30-day period by a fund's share price on the last day of the
period.
30-Day Yield
<TABLE>
<CAPTION>
Fund 30-day period ended August 31, 2000
<S> <C>
Schwab Short-Term Bond Market Index Fund 6.65%
Schwab Total Bond Market Index Fund 6.87%
</TABLE>
The performance of a fund may be compared with the performance of other mutual
funds by comparing the ratings of mutual fund rating services, various indices,
U.S. government obligations, bank certificates of deposit, the consumer price
index and other investments and measures for which reliable data is available.
An index's performance data assumes the reinvestment of dividends but does not
reflect deductions for administrative, management and trading expenses. A fund
will be subject to these costs and expenses, while an index does not have these
expenses. In addition, various factors, such as holding a cash balance, may
cause a fund's performance to be higher or lower than that of an index.
COMPARATIVE INDEX PERFORMANCE
Each fund's performance may be compared to various unmanaged bond indexes in
addition to the Lehman Brothers Mutual Fund Short (1-5 Year) U.S.
Government/Credit Index and the unmanaged Lehman Brothers U.S. Aggregate Bond
Index, including but not limited to, Salomon Smith Barney Broad Investment-Grade
Bond Index, the Lehman Brothers Government/Credit Bond Index, the Merrill Lynch
Domestic Master Index and to Lipper, Inc. averages and Morningstar, Inc.
rankings.
The following tables illustrate the historical total return of securities
comprising the indexes beginning calendar year end December 31, 1989 through
calendar year end December 30, 1999. This historical information is not
indicative of any future trend of the funds or the particular market sectors
that the Indexes represent.
<TABLE>
<CAPTION>
DATE U.S. AGGREGATE BOND INDEX SHORT (1-5 Year)
GOVERNMENT/CREDIT INDEX
<S> <C> <C>
Dec. 31, 1989 14.53 11.70
Dec. 31, 1990 8.96 9.69
Dec. 31, 1991 16.00 13.14
Dec. 31, 1992 7.40 6.83
Dec. 31, 1993 9.75 7.10
Dec. 31, 1994 -2.92 -0.72
Dec. 31, 1995 18.47 12.88
Dec. 31, 1996 3.63 4.67
Dec. 31, 1997 9.65 7.13
Dec. 31, 1998 8.67 7.64
Dec. 31, 1999 -0.82 2.09
</TABLE>
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<PAGE> 41
APPENDIX - RATINGS OF INVESTMENT SECURITIES
From time to time, a fund may report the percentage of its assets that fall into
the rating categories set forth below.
BONDS
MOODY'S INVESTORS SERVICE
Aaa Bonds which are rated Aaa are judged to be of the best quality. They carry
the smallest degree of investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or by an exceptionally stable
margin and principal is secure. While the various protective elements are likely
to change, such changes as can be visualized are most unlikely to impair the
fundamentally strong position of such issues.
Aa Bonds which are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high-grade
bonds. They are rated lower than the best bonds because margins of protection
may not be as large as in Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other elements present which make
the long-term risk appear somewhat larger than the Aaa securities.
A Bonds which are rated A 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 some time in the future.
Baa Bonds which are rated Baa are considered as 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 Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well-assured. Often the protection of interest
and principal payments may be very moderate and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
STANDARD & POOR'S CORPORATION
INVESTMENT GRADE
AAA Debt rated 'AAA' has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.
AA Debt rated 'AA' has a very strong capacity to pay interest and repay
principal and differs from the highest rated debt only in small degree.
A Debt rated 'A' has a strong capacity to pay interest and repay principal,
although it is
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somewhat more susceptible to adverse effects of changes in circumstances and
economic conditions than debt in higher-rated categories.
BBB Debt rated 'BBB' is regarded as having an adequate capacity to pay interest
and repay principal. Whereas it normally exhibits 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.
SPECULATIVE GRADE
Debt rated 'BB' and 'B' is regarded as having predominantly speculative
characteristics with respect to capacity to pay interest and repay principal.
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 rated 'BB' has less near-term vulnerability to default than other
speculative grade debt. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions that 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 rate 'B' has greater vulnerability to default but presently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial, or economic conditions would likely impair capacity or willingness to
pay interest and repay principal. The 'B' rating category also is used for debt
subordinated to senior debt that is assigned an actual or implied 'BB' or 'BB-'
rating.
FITCH, INC.
INVESTMENT GRADE BOND
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 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
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higher ratings.
SPECULATIVE GRADE BOND
BB Bonds are considered speculative. The obligor's ability to pay interest
and repay principal may be affected over time by adverse economic
changes. However, business and financial alternatives can be identified
which could assist the obligor in satisfying its debt service
requirements.
B Bonds are considered highly speculative. While bonds in this class are
currently meeting debt service requirements, the probability of
continued timely payment of principal and interest reflects the
obligor's limited margin of safety and the need for reasonable business
and economic activity throughout the life of the issue.
DESCRIPTION OF THOMSON BANKWATCH'S LONG-TERM DEBT RATINGS
INVESTMENT GRADE
AAA The highest category; indicates that the ability to repay principal and
interest on a timely basis is very high.
AA The second-highest category; indicates a superior ability to repay
principal and interest on a timely basis, with limited incremental risk
compared to issues rated in the highest category.
A The third-highest category; indicates 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 The lowest investment-grade category; 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.
NON-INVESTMENT GRADE
BB While not investment grade, the "BB" rating suggests that the
likelihood of default is considerably less than for lower-rated issues.
However, there are significant uncertainties that could affect the
ability to adequately service debt obligations.
B Issues rated "B" show a higher degree of uncertainty and therefore
greater likelihood of default than higher-rated issues. Adverse
developments could well negatively affect the payment of interest and
principal on a timely basis.
SHORT-TERM NOTES AND VARIABLE RATE DEMAND OBLIGATIONS
MOODY'S INVESTORS SERVICE
Short-term notes/variable rate demand obligations bearing the designations
MIG-1/VMIG-1 are considered to be of the best quality, enjoying strong
protection from established cash flows, superior liquidity support or
demonstrated broad-based access to the market for refinancing.
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Obligations rated MIG-2/VMIG-3 are of high quality and enjoy ample margins of
protection although not as large as those of the top rated securities.
STANDARD & POOR'S CORPORATION
An S&P SP-1 rating indicates that the subject securities' issuer has a strong
capacity to pay principal and interest. Issues determined to possess very strong
safety characteristics are given a plus (+) designation. S&P's determination
that an issuer has a satisfactory capacity to pay principal and interest is
denoted by an SP-2 rating.
FITCH, INC.
Obligations supported by the highest capacity for timely repayment are rated
F1+. An F1 rating indicates that the obligation is supported by a very strong
capacity for timely repayment. Obligations rated F2 are supported by a good
capacity for timely repayment, although adverse changes in business, economic,
or financial conditions may affect this capacity.
COMMERCIAL PAPER
MOODY'S INVESTORS SERVICE
Prime-1 is the highest commercial paper rating assigned by Moody's. Issuers (or
related supporting institutions) of commercial paper with this rating are
considered to have a superior ability to repay short-term promissory
obligations. Issuers (or related supporting institutions) of securities rated
Prime-2 are viewed as having a strong capacity to repay short-term promissory
obligations. This capacity will normally be evidenced by many of the
characteristics of issuers whose commercial paper is rated Prime-1 but to a
lesser degree.
STANDARD & POOR'S CORPORATION
A Standard & Poor's Corporation ("S&P") A-1 commercial paper rating indicates a
strong degree of safety regarding timely payment of principal and interest.
Issues determined to possess overwhelming safety characteristics are denoted
A-1+. Capacity for timely payment on commercial paper rated A-2 is satisfactory,
but the relative degree of safety is not as high as for issues designated A-1.
FITCH, INC.
F-1+ is the highest category, and indicates the strongest degree of assurance
for timely payment. Issues rated F-1 reflect an assurance of timely payment only
slightly less than issues rated F-1+. Issues assigned an F-2 rating have a
satisfactory degree of assurance for timely payment, but the margin of safety is
not as great as for issues in the first two rating categories.
COMMERCIAL PAPER, SHORT-TERM OBLIGATIONS
AND DEPOSIT OBLIGATIONS ISSUED BY BANKS
THOMSON BANKWATCH (TBW)
TBW-1 is the highest category and indicates the degree of safety regarding
timely repayment of principal and interest is very high. TBW-2 is the second
highest category and while the degree of safety regarding timely repayment of
principal and interest is strong, the relative degree of safety is not as high
as for issues rated "TBW-1."
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