SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
PROSPECTUS
August 1, 1995
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
Smith Breeden Series Fund (the "Fund") is a no-load, open-end,
diversified management investment company registered under the
Investment Company Act of 1940 (the "Investment Company Act") whose
shares are offered in two separate series- the Smith Breeden Short
Duration U.S. Government Series and the Smith Breeden Intermediate
Duration U.S. Government Series. Each series generally operates as
a separate fund with its own investment objectives and policies to
meet its specific investment goals.
The Smith Breeden Short Duration U.S. Government Series, (the
"Short Series") seeks a high level of current income, consistent
with low volatility of net asset value. The Short Series seeks to
match the interest -rate risk of a portfolio that invests
exclusively in six month U.S. Treasury securities on a constant
maturity basis. The dollar-weighted average maturity of the
portfolio securities of the Portfolio may significantly exceed six
months at times. See "Investment Objectives and Policies."
The Smith Breeden Intermediate Duration U.S. Government Series
(the "Intermediate Series") seeks a total return in excess of the
total return of the major market indices for Mortgage-Backed
securities. The major market indices for Mortgage-Backed
securities include, but are not limited to, the Salomon Brothers
Mortgage Index and the Lehman Brothers Mortgage Index. These
indices include all outstanding government sponsored fixed rate
Mortgage-Backed securities, weighted in proportion to their current
market capitalization. The duration, or interest-rate risk, of
these indices is similar to that of intermediate-term U.S. Treasury
Notes and, typically, will range between three and five years. The
Intermediate Series consistently seeks to achieve a volatility of
net asset value similar to that of a portfolio that invests
exclusively in Mortgage-Backed securities, as weighted in the major
mortgage market indices.
The Short Series and Intermediate Series (the "Short and
Intermediate Series") seek to achieve their objectives through
investing at least 70% of their respective assets in securities
which are issued or guaranteed by the U.S. Government, its agencies
or instrumentalities and by employing various hedging techniques.
The Short and Intermediate Series may invest a substantial portion
of their respective assets in Mortgage-Backed securities that
directly or indirectly represent a participation in, or are
collateralized by and payable from, mortgage loans on real
property. The Short and Intermediate Series may employ various
hedging techniques to achieve their investment objectives. On
occasion, the Short and Intermediate Series may borrow or purchase
additional securities with borrowed funds, which may result in a
leveraged capital structure. The net asset values of the Short and
Intermediate Series will respond to increases and decreases in the
values of their respective securities.
An investment in the Short or Intermediate Series is neither
insured nor guaranteed by the U.S. Government. There can be no
assurance that the Short or Intermediate Series' investment
objectives will be achieved. The investment objectives of the
Short and Intermediate Series are fundamental and cannot be changed
without shareholder approval. Shares of the Short or Intermediate
Series may be purchased at net asset value with no sales charge
with a minimum initial investment of $1000.
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This Prospectus is intended to set forth in a clear and concise
manner information about the Short and Intermediate Series that a
prospective investor should know before investing. Please retain
this Prospectus for future reference. A Statement of Additional
Information dated August 1, 1995, provides additional information
about each of the Short and Intermediate Series. It has been filed
with the Securities and Exchange Commission and is incorporated
herein by reference. Copies are available without charge from the
Fund at 100 Europa Drive, Suite 200, Chapel Hill, NC 27514, or by
calling (800) 221-3138.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY
STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF
THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
Table of Contents
Expense Table. . . . . . . . . . . . . . . . . . . . . . 3
Financial Highlights - Short Series. . . . . . . . . . . 5
Financial Highlights - Intermediate Series . . . . . . . 6
The Short and Intermediate Series. . . . . . . . . . . . 7
Management of the Fund . . . . . . . . . . . . . . . . . 22
Purchase and Redemption of Shares. . . . . . . . . . . . 28
Dividends, Distributions and Taxes . . . . . . . . . . . 33
Valuation of Fund Shares . . . . . . . . . . . . . . . . 35
Performance. . . . . . . . . . . . . . . . . . . . . . . 36
Reports to Depository Institutions . . . . . . . . . . . 36
Appendix A . . . . . . . . . . . . . . . . . . . . . . . 37
This Prospectus is not an offering of the securities described
herein in any state in which the offering is unauthorized. No
sales representative, dealer or other person is authorized to give
any information or make any representations other than those
contained in this Prospectus.
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EXPENSE TABLE
The purpose of this table is to assist an investor in
understanding the various costs and expenses, as a percentage of
the average net assets of each of the Series, that a shareholder
will bear in connection with an investment in the Short or
Intermediate Series.
SHAREHOLDER TRANSACTION EXPENSES Short Intermediate
Series Series
Maximum Sales Charge Imposed on Purchases None None
(as percentage of offering price)
Maximum Sales Charge Imposed on None None
Reinvested Dividends
(as percentage of offering price)
Deferred Sales Charge None None
Redemption Fees None1 None1
(as percentage of amount redeemed)
ANNUAL SERIES OPERATING EXPENSES
(as percentage of average net assets)
Management Fee .70% .70%
Other Expenses .08% .20%
(after expense limitation)
Total Operating Expenses2 .78% .90%
(after expense limitation)
_____________________________
1 A transaction cost of $9 may be imposed on redemptions by
wire transfer.
2 The Other Expenses in the table and Total
Series Operating Expenses reflect undertakings
by the Adviser to bear expenses of each of the
Series and/or waive its fees to the extent
necessary to limit Total Operating Expenses to
0.78% and 0.90% for the Short and Intermediate
Series, respectively, through March 31, 1996,
and are estimates which are based upon Total
Series Operating Expenses for the fiscal year
ended March 31, 1995. Absent the expense
limitation, Other Expenses and Total Series
Operating Expenses would be 0.22% and 0.92% for
the Short Series and 0.50% and 1.20% for the
Intermediate Series. Actual Total Operating
Expenses both direct and indirect for the
fiscal year ended March 31, 1995 were 0.78% and
0.90%, respectively.
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The following example illustrates the expenses that apply to
a $1,000 investment in the Short or Intermediate Series over
various time periods assuming (1) a 5% annual rate of return and
(2) redemption or no redemption at the end of each time period.
Except as noted in the table above, the Series charge no redemption
fees.
Short Duration Series
1 Year 3 Years 5 Years 10 Years
$ 8 $ 25 $ 44 $ 96
Intermediate Duration Series
1 Year 3 Years 5 Years 10 Years
$ 9 $ 29 $ 50 $ 112
This example is based on the annual operating expenses shown
above and should not be considered a representation of past or
future expenses or performance. Actual expenses may be greater or
less than those shown. The annual rate of return may be more or
less than 5%.
* * * *
The Short and Intermediate Series may be recommended by
registered investment advisors for use by investors. Such advisors
customarily impose advisory fees which would be in addition to any
fees and expenses presented in the above table. According to
recent financial articles, such fees may be as high as 2% of assets
per year. Neither the Short nor Intermediate Series nor the
Adviser may exercise any control over such advisory fees and may
not be informed of the level of such fees related to particular
investments.
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<PAGE>
SHORT DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the
periods from March 31, 1992 through March 31, 1995 and are a part
of the Short Series' financial statements which have been audited
by Deloitte & Touche LLP, independent auditors. This data should
be read in conjunction with the Short Series' most recent annual
audited financial statements and the report of Deloitte & Touche
LLP thereon which appear in the Statement of Additional
Information.
Year Ended Year Ended Year Ended
March 31, 1995 March 31, 1994 March 31, 1993 1
Net Asset Value,
Beginning of Period $ 9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income 0.628 0.432 0.552
Net realized and
unrealized gain
(loss) on investments -- (0.070) 0.002
Total from
investment
operations 0.628 0.362 0.554
Less Distributions
Dividends from net
investment income (0.628) (0.462) (0.554)
Total Distributions (0.628) (0.462) (0.554)
Net Asset Value,
End of Period $ 9.90 $ 9.90 $10.00
Total Return 6.58% 3.67% 5.67%
______________________________________________
Ratios/Supplemental
Data
Net assets, end of
period $218,431,665 $218,167,491 $48,531,206
Ratio of direct
expenses to
average net assets
Before expense
limitation 0.17% 0.45% 1.63%
After expense
limitation 0.11% 0.29% 0.27%
Ratio of net income
to average net assets
Before expense
limitation 6.26% 3.72% 3.17%
After expense
limitation 6.33% 4.17% 4.53%
Portfolio turnover
rate 47% 112% 3%
Additional performance information is presented in the Short
Series' Annual Report which will be made available without charge
upon request.
1 The Short Series commenced operations on March 31, 1992.<PAGE>
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INTERMEDIATE DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the
periods from March 31, 1992 through March 31, 1995 and are a part
of the Intermediate Series' financial statements which have been
audited by Deloitte & Touche LLP, independent auditors. This data
should be read in conjunction with the Intermediate Series' most
recent annual audited financial statements and the report of
Deloitte & Touche LLP thereon which appear in the Statement of
Additional Information.
Year Ended Year Ended Year Ended
March 31, 1995 March 31, 1994 March 31, 19931
Net Asset Value,
Beginning of Period $ 10.01 $10.62 $10.00
Income From Investment
Operations
Net investment income 0.664 1.050 0.826
Net loss on securities
(both realized and
unrealized) (0.049) (0.601) 0.621
Total from investment
operations 0.615 0.449 1.447
Less Distributions
Dividends from net
investment income (0.664) (1.044) (0.826)
Dividends in excess of
net investment income (0.108) -- --
Distributions from net
realized gains
on investments -- (0.015) --
Distributions in excess
of net realized gains
on investments (0.022) -- --
Total distributions (0.794) (1.059) (0.826)
Net Asset Value,
End of Period $ 9.83 $10.01 $10.62
Total Return 6.10% 4.11% 14.93%
______________________________________________
Ratios/Supplemental
Data
Net assets, end of
period $34,797,496 $6,779,666 $2,923,913
Ratio of direct
expenses to
average net assets
Before expense
limitation 1.35% 1.30% 14.80%
After expense
limitation 0.78% 0.00% 0.31%
Ratio of net investment
income to average
net assets
Before expense
limitation 5.64% 6.43% (6.31)%
After expense
limitation 6.20% 7.74% 8.18%
Portfolio turnover
rate 557% 84% 42%
Additional performance information is presented in the Intermediate
Series' Annual Report which will be made available without charge
upon request.
1 The Intermediate Series commenced operations on March 31,1992.<PAGE>
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THE SHORT AND INTERMEDIATE SERIES
General
The Short and Intermediate Series are series of the Smith
Breeden Series Fund (the "Fund") , an open-end, diversified
management investment company organized as a Massachusetts business
trust on October 3, 1991. The Fund currently issues shares in two
series, which are the Short and Intermediate Series. The Trustees
have authority to issue shares in an unlimited number of series,
the assets and liabilities of which will each be separate and
distinct. All shares, when issued, are fully paid, non assessable,
and redeemable and have equal voting, dividend and liquidation
rights.
Shareholders of the separate series will vote together in
electing trustees and in certain other matters. Shareholders in
each series should be aware that the outcome of the election of
trustees and of certain other matters could be controlled by the
shareholders of another series. The shares have noncumulative
voting rights, which means that holders of more than 50% of the
shares voting for the election of the trustees can elect 100% of
the trustees if they choose to do so.
The Fund is not required to hold annual meetings and does not
intend to do so; it may, however, hold special shareholder meetings
for such purposes as changing fundamental policies or new
management agreements. A meeting may also be called by a majority
of the Board of Trustees or by shareholders holding at least 10% of
the shares entitled to vote at the meeting. Shareholders may
receive assistance in communicating with other shareholders in
connection with the election or removal of trustees similar to the
provisions contained in Section 16(c) of the 1940 Act.
Under Massachusetts law, shareholders of a business trust may,
under certain circumstances, be held personally liable as partners
for its obligations. However, the risk of a shareholder incurring
financial loss on account of shareholder liability is limited to
circumstances in which both (i) any liability was greater than the
Short or Intermediate Series' insurance coverage and (ii) a Series
itself was unable to meet its obligations.
Shares of each of the Short and Intermediate Series may be
purchased at net asset value. Generally, the minimum initial
investment is $1,000, with a minimum of $50.00 for subsequent
investments. A minimum initial investment of $1,000 is required
for Fund-sponsored Individual Retirement Accounts. A minimum
initial investment of $50 is required an for Automatic Investment
Plan. See "Purchase and Redemption of Shares."
Smith Breeden Associates, Inc., Overland Park, Kansas 66210,
a registered investment adviser, acts as the investment adviser
(the "Adviser") to the Portfolios.
Investment Objectives
The Short and Intermediate Series each have a different
investment objective and different investment policies and are
designed to meet different investment needs. The investment
objective and certain investment policies of each Series, as well
as certain investment restrictions, are fundamental and may not be
changed without a vote of shareholders of either of the Series.
There can be no assurance that the Short or Intermediate Series
will be successful in achieving their respective investment
objectives. An investment in the Short or Intermediate Series does
not constitute a complete investment program.
Short Duration Series
The Short Series' investment objective is to provide investors
with a high level of current income, consistent with a volatility
of net asset value similar to that of a portfolio which invests
exclusively in six-month U.S. Treasury securities on a constant
maturity basis. There is no assurance that the Short Series will
be able to maintain a low volatility of net asset value.
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Under normal circumstances the Short Series will seek to
achieve an interest-rate risk or duration similar to that of a six-
month U.S. Treasury security on a constant maturity basis.. The
Short Series expects that, under normal circumstances, the
dollar-weighted average life (or period until the next reset date)
of its portfolio securities will be longer than six months,
sometimes significantly. This is because the maturity of a
security measures only the time until final payment is due; it
takes no account of the pattern of a security's cash flows over
time, including how cash flow is affected by prepayments and by
changes in interest rates. This method of computing duration is
known as option-adjusted duration. The Adviser may use the
following techniques to lengthen or shorten the option-adjusted
duration of the portfolio assets: the acquisition of debt
obligations at a premium or discount, mortgage and interest-rate
swaps, interest-rate caps and floors and interest-rate futures and
options and options on such futures.
The Adviser believes that by investing in mortgage securities
from a variety of market sectors on a selective basis and adjusting
the overall option-adjusted duration of the portfolio to
approximate that of a six-month Treasury security, the Short
Series will achieve a more consistent and less volatile net asset
value than is characteristic of mutual funds that invest primarily
in mortgage securities paying a fixed rate of interest or
exclusively in adjustable rate mortgage securities. The securities
in which the Short Series may invest may not yield as high a level
of income as other securities which can be invested in by other
funds. However, such other securities may be more volatile and may
be issued by issuers which are less credit worthy.
The Short Series seeks to minimize risk of loss as a result of
default on any securities held by the Short Series by investing
only in high credit quality instruments. Like all investors in
interest bearing securities, however, the Short Series is exposed
to the risk that the prices of individual securities held by the
Short Series can fluctuate, in some cases significantly, in
response to changes in prevailing interest rates. There can also
be no assurance that the Short Series will achieve at all times its
targeted option-adjusted duration, with the risk that the expected
relationship between general interest rate movements and the net
asset value of the Short Series will differ from what would be
expected from an investment in a six-month U.S. Treasury bill.
This is because the Short Series' computation of option-adjusted
duration is based on estimated rather than known factors (which
typically affect investments in Mortgage-Backed Securities),
including expected prepayment rates, valuation of homeowners'
prepayment options, and the correlation of changes between the
markets for securities and the hedge instruments owned by the Short
Series (as described in Appendix A).
Intermediate Duration Series
The Intermediate Series' investment objective is to provide
investors with a total return in excess of the total return of
the major market indices for Mortgage-Backed securities. The major
market indices for Mortgage-Backed securities include, but are not
limited to, the Salomon Brothers Mortgage Index and the Lehman
Brothers Mortgage Index. These indices include all outstanding
government sponsored fixed rate Mortgage-Backed securities,
weighted in proportion to their current market capitalization.
Total return is the change of value of the investment assuming
reinvestment of all distributions. Under normal circumstances,
the Intermediate Series will seek to achieve an interest-rate risk
or duration similar to that of a portfolio that invests exclusively
in mortgage-backed securities, as weighted in the major market
indices. The duration, or interest-rate risk, of these indices is
similar to that of intermediate-term U.S. Treasury Notes and,
typically, will range between 3 to 5 years. There is no assurance
that the Intermediate Series will be able to maintain a total
return in excess of the total return of major market indices for
Mortgage-Backed securities or that it will match the interest-rate
risk of a portfolio investing exclusively in these securities.
The Intermediate Series' duration is a measure of the price
sensitivity of the portfolio, including expected cash flow and
mortgage prepayments under a wide range of interest rate scenarios.
The maturity of a security measures only the time until final
payment is due; it takes no account of the pattern of a security's
cash flows over time, including how cash flow is affected by
prepayments and by changes in interest rates. In computing the
duration of the Intermediate Series' portfolio, the Adviser will
estimate the duration of obligations that are subject to
prepayment or redemption by the issuer taking into account
the influence of interest rates on
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prepayments and coupon flows. As previously stated with respect
to the Short Series, this method of computing duration is known
as option-adjusted duration. The Adviser may use the following
techniques to lengthen or shorten the option-adjusted
duration of its portfolio so as to achieve a Series' targeted
option-adjusted duration: the acquisition of debt obligations at
a premium or discount, mortgage and interest rate swaps,
interest rate caps and floors and interest rate futures and
options on such futures.
There can be no assurance that at all times the targeted
option-adjusted duration will be achieved by the Intermediate
Series, with the risk that the expected relationship between
general interest rate movements and the net asset value of the
Intermediate Series will differ from what would be expected from an
investment in a portfolio investing in Mortgage-Backed securities
as weighted by the major mortgage market indices. This is because
the Intermediate Series' computation of option-adjusted duration is
based on estimated rather than known factors (which typically
affect investments in Mortgage-Backed Securities), including
expected prepayment rates, valuation of homeowners' prepayment
options, and the correlation of changes between the markets for
securities and the hedge instruments owned by the Series (as
described in Appendix A). The Intermediate Series expects that,
under normal circumstances, the dollar-weighted average life (or
period until the next reset date) of the Intermediate Series'
portfolio securities will be somewhat shorter or longer than that
of a portfolio that invests exclusively in Mortgage-Backed
securities, as weighted in the major mortgage indices.
When market interest rates decline, the value of a portfolio
invested in intermediate-term fixed rate obligations can be
expected to rise. Conversely, when market interest rates rise, the
value of a portfolio invested in intermediate-term fixed rate
obligations can be expected to fall. The Intermediate Series seeks
to minimize risk of loss as a result of default on any securities
held by the Intermediate Series by investing only in high credit
quality instruments. Like all investors in interest bearing
securities, however, the Intermediate Series is exposed to the risk
that the prices of individual securities held by it can fluctuate,
in some cases significantly, in response to changes in prevailing
interest rates.
Investment Policies
The Short and Intermediate Series each seek to achieve their
investment objective by investing, under normal circumstances, at
least 70% of their total assets in fixed-income U.S. Government
securities, including U.S. Treasury Bills, Notes, Bonds and other
debt securities issued by the U.S. Treasury, and obligations issued
or guaranteed by the U.S. Government, its agencies and
instrumentalities, including, but not limited to Government
National Mortgage Association ("GNMA"), Federal National Mortgage
Association ("FNMA") and Federal Home Loan Mortgage Corporation
("FHLMC") securities. With respect to their remaining assets, the
Short and Intermediate Series may invest in fixed rate and
adjustable rate Mortgage-Backed Securities issued by private
originators of, or investors in, mortgage loans issued by private
entities that are rated AAA by Standard & Poor's Corporation
("S&P") or Aaa by Moody's Investors Service ("Moody's") or of
credit quality deemed equivalent by the Adviser and money market
instruments of a comparable short-term rating or credit quality.
The Short and Intermediate Series both may employ certain active
management techniques to hedge the interest rate risks associated
with portfolio securities and to seek to minimize fluctuation in
net asset values in accordance with their investment objectives.
These investment policies are fundamental and may not be changed
without shareholder approval.
Both the Short and Intermediate Series will hedge the interest
rate risks associated with their securities and to seek to minimize
fluctuation in net asset value in accordance with their investment
objectives and targeted option-adjusted duration. Each Series may
enter into mortgage and interest rate swaps, interest rate futures
and options on such futures, engage in short sales and purchase
interest rate caps, floors and collars in order to hedge against
interest rate fluctuations. In addition, the Short and
Intermediate Series may use stripped Mortgage-Backed Securities to
reduce the option-adjusted duration. Both Series may also employ
loans of portfolio securities, dollar rolls and reverse repurchase
agreements as investment techniques. These techniques will be
undertaken to enhance income in the Short Series and total return
in the Intermediate Series.
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As a matter of fundamental policy, which may not be changed
except by vote of the majority of shareholders, the Short and
Intermediate Series will both limit purchases to any and all of
the following classes of assets:
1.Securities issued directly or guaranteed by the U.S. Government
or its agencies or instrumentalities;
2.Mortgage-Backed Securities rated AAA by S&P or Aaa by Moody's or
unrated but deemed of equivalent quality by the Adviser;
3.Assets fully collateralized by assets in either of the above
classes;
4.Assets which would qualify as liquidity items under federal
regulations if held by a commercial bank or savings institution; or
5.Hedge instruments, which may only be used for risk management
purposes. Any securities described in the "Hedging" section and
any stripped Mortgage-Backed Securities may only be used for risk
management purposes.
Characteristics of Securities in Which the Short and Intermediate
Series Invest
MORTGAGE-BACKED SECURITIES
Mortgage-Backed Securities are securities that directly or
indirectly represent a participation in, or are collateralized by
and payable from, mortgage loans secured by real property. The
term Mortgage-Backed Securities, as used herein, includes
adjustable-rate mortgage securities, fixed-rate mortgage
securities, and derivative mortgage products such as collateralized
mortgage obligations, stripped Mortgage-Backed Securities and other
instruments described below.
There are currently three basic types of Mortgage-Backed
Securities: (i) those issued or guaranteed by the U.S. Government
or one of its agencies or instrumentalities, such as GNMA, FNMA and
FHLMC, described below; (ii) those issued by private issuers that
represent an interest in or are collateralized by Mortgage-Backed
Securities issued or guaranteed by the U.S. Government or one of
its agencies or instrumentalities; and (iii) those issued by
private issuers that represent an interest in or are collateralized
by whole mortgage loans or Mortgage-Backed Securities without a
government guarantee but usually having some form of private credit
enhancement.
The Short and Intermediate Series will only purchase Mortgage-
Backed Securities which constitute "Mortgage Related Securities"
for purposes of the Secondary Mortgage Enhancement Act of 1984.
The Nature of Adjustable and Fixed Rate Mortgage Loans
The following is a general description of the two general types of
mortgage loans which may be expected to underlie the Mortgage-
Backed Securities in which the Short and Intermediate Series may
invest: fixed-rate and adjustable-rate mortgages.
Adjustable-Rate Mortgage Loans ("ARMs")
ARMs eligible for inclusion in a mortgage pool will generally
provide for a fixed initial mortgage interest rate for a specified
period of time, generally for either the first three, six, twelve,
thirteen, thirty-six or sixty scheduled monthly payments.
Thereafter, the interest rates are subject to periodic adjustment
based on changes in the index rate applicable to the individual
loans.
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ARMs contain minimum and maximum rates beyond which the
mortgage interest rate may not vary over the lifetime of the loan.
In addition, certain ARMs provide for additional limitations on the
maximum amount by which the mortgage interest rate may adjust for
any single adjustment period. Alternatively, certain ARMs
("Negatively Amortizing ARMs") may provide limitations on changes
in the required monthly payment. Limitations on monthly payments
can result in monthly payments which are greater or less than the
amount necessary to amortize a Negatively Amortizing ARM by its
maturity at the interest rate in effect in any particular month.
In the event that a monthly payment is not sufficient to pay the
interest accruing on a Negatively Amortizing ARM, any such excess
interest is added to the principal balance of the loan, causing
negative amortization, and will be repaid through future monthly
payments. It may take borrowers under Negatively Amortizing ARMs
longer periods of time to increase their net equity in the
mortgaged properties and may increase the likelihood of default by
such borrowers. In the event that a monthly payment exceeds the
sum of the interest accrued at the current rate and the principal
payment which would have been necessary to amortize the outstanding
principal balance over the remaining term of the loan, the excess
further reduces the principal balance of the ARM. Negatively
Amortizing ARMs do not provide for the extension of their original
maturity to accommodate changes in their mortgage interest rates.
As a result, unless there is a periodic recalculation of the
payment amount, the final payment may be substantially larger than
the other payments. Generally, Negatively Amortizing ARMs do
provide for periodic recalculation of the payment amount.
Limitations on periodic increases in interest rates and on changes
in monthly payments protect borrowers from unlimited interest rate
and payment increases.
There are two types of indices which provide the basis for rate
adjustments on ARMs: those based on market rates and those based on
a calculated measure such as a cost of funds index or a moving
average of mortgage rates. Commonly utilized indices include the
one-year, three-year and five-year constant maturity U.S. Treasury
rates (as reported by the Federal Reserve Board), the three-month
Treasury Bill rate, the 180-day Treasury Bill rate, rates on
longer-term Treasury securities, the Eleventh District Federal Home
Loan Bank Cost of Funds Index ("COFI"), the National Median Cost of
Funds, the one-month, three-month, six-month or one year London
Interbank Offered Rate ("LIBOR"), the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-
year constant maturity Treasury rate or three-month LIBOR, are
highly correlated with changes in market interest rates. Other
indices, such as COFI, tend to lag changes in market rates and tend
to be somewhat less volatile over short periods of time.
A discussion of the risk considerations of ARMs as compared to
other mortgage-backed securities is included in the section
entitled "Yield, Market Value and Risk Considerations of Mortgage-
Backed Securities".
Fixed Rate Mortgage Loans
Generally, fixed rate mortgage loans eligible for inclusion in
a mortgage pool will bear simple interest at fixed rates and have
original terms ranging from five to forty years. These loans
generally provide for monthly payments of principal and interest in
substantially equal installments for the contractual term of the
mortgage note in sufficient amounts to fully amortize principal by
maturity although certain fixed rate mortgage loans provide for a
large final "balloon" payment at maturity.
Regulation of Mortgage Loans
Mortgage loans are subject to a variety of state and federal
regulations designed to protect mortgagors, which may impair the
ability of the mortgage lender to enforce its rights under the
mortgage documents. These regulations include legal restraints on
foreclosures, homeowner rights of redemption after foreclosure,
federal and state bankruptcy and debtor relief laws, restrictions
on enforcement of mortgage loan "due on sale" clauses and state
usury laws. Even though the Short and Intermediate Series
will invest in Mortgage-Backed Securities issued or
guaranteed by the U.S. Government, its agencies or
instrumentalities, these regulations may adversely
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affect the two Series' investments by delaying their receipt of
principal or interest on mortgage loans affected by such regulations.
Government Agency Mortgage Pass-Through Securities
The Short and Intermediate Series will invest in Mortgage-
Backed Securities which are issued or guaranteed by the United
States Government or one of its agencies or instrumentalities,
including but not limited to GNMA, FNMA and FHLMC. Under normal
circumstances, such Mortgage-Backed Securities (along with other
securities issued or guaranteed by the U.S. Government or its
agencies and instrumentalities) will comprise at least 70% of the
Portfolio. GNMA securities are backed by the full faith and credit
of the U.S. Government, which means that the U.S. Government
guarantees that the interest and principal will be paid when due.
FNMA securities and FHLMC securities are not backed by the full
faith and credit of the U.S. Government; however, the payment of
principal and interest is guaranteed by FNMA and FHLMC, as the case
may be, both of which may borrow from the U.S. Treasury at the
discretion of the Secretary of the Treasury. These guarantees do
not extend to the securities' yield or value, which are likely
(except in the case of certain stripped Mortgage-Backed Securities
and CMO bonds) to vary inversely with fluctuations in interest
rates, nor do the guarantees extend to the yield or value of the
Short and Intermediate Series' shares.
U.S. Government Agency Mortgage-Backed Securities provide for
the pass-through to investors of their pro rata share of monthly
payments (including any prepayments) made by the individual
borrowers on the pooled mortgage loans, net of any fees paid to the
guarantor of such securities and the servicer of the underlying
mortgage loans.
GNMA Certificates
GNMA is a wholly-owned corporate instrumentality of the United
States within the Department of Housing and Urban Development.
GNMA is authorized to guarantee the timely payment of the principal
of and interest on certificates that are based on and backed by a
pool of mortgage loans insured by the Federal Housing
Administration ("FHA Loans"), or guaranteed by the Veterans
Administration ("VA Loans"), or by pools of other eligible mortgage
loans. The National Housing Act of 1934, as amended, provides that
the full faith and credit of the U.S. Government is pledged to the
payment of all amounts that may be required to be paid under any
guaranty. In order to meet its obligations under any guaranty,
GNMA is authorized to borrow from the United States Treasury in an
unlimited amount.
FNMA Certificates
FNMA is a stockholder-owned corporation chartered under an act
of the United States Congress. Each FNMA Certificate is issued and
guaranteed by FNMA and represents an undivided interest in a pool
of mortgage loans (a "Pool") formed by FNMA. Each Pool consists of
residential mortgage loans either previously owned by FNMA or
purchased by it in connection with the formation of the Pool. The
mortgage loans may be either conventional mortgage loans (i.e., not
insured or guaranteed by any U.S. Government agency) or mortgage
loans that are either insured by the Federal Housing Administration
or guaranteed by the Veterans Administration. The lenders
originating and servicing the mortgage loans are subject to certain
eligibility requirements established by FNMA.
FNMA has certain contractual responsibilities. With respect
to each Pool, FNMA is obligated to distribute scheduled monthly
installments of principal and interest after FNMA's servicing and
guaranty fee, whether or not received, to Certificate holders.
FNMA also is obligated to distribute to holders of Certificates an
amount equal to the full principal balance of any foreclosed
mortgage loan in the Pool, whether or not such principal balance is
actually recovered. The obligations of FNMA under its guaranty of
its Certificates are obligations solely of FNMA.
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FHLMC Certificates
FHLMC is a corporate instrumentality of the United States. The
principal activity of FHLMC currently is the purchase of first
lien, conventional, residential mortgage loans and participation
interests in such mortgage loans and their resale in the form of
mortgage securities, primarily FHLMC Certificates. A FHLMC
Certificate represents a pro rata interest in a group of mortgage
loans or participation in mortgage loans purchased by FHLMC.
FHLMC guarantees to each registered holder of a FHLMC
Certificate the timely payment of interest at the rate provided for
by such Certificate (whether or not received on the underlying
loans). FHLMC also guarantees to each registered Certificate
holder ultimate collection of all principal of the related mortgage
loans, without any offset or deduction, but does not, generally,
guarantee the timely payment of scheduled principal. However,
FHLMC now issues certain mortgage-backed securities, called "Gold
PCs," which guarantee timely payment of principal reductions. The
obligations of FHLMC under its guaranty of FHLMC Certificates are
obligations solely of FHLMC.
Private Mortgage Pass-Through Securities
Private mortgage pass-through securities are structured
similarly to GNMA, FNMA and FHLMC mortgage pass-through securities
and are issued by originators of and investors in mortgage loans,
including depository institutions, mortgage banks, investment banks
and special purpose subsidiaries of these entities. These
securities usually are backed by a pool of conventional fixed rate
or adjustable rate mortgage loans. Since private mortgage pass-
through securities typically are not guaranteed by an entity having
the credit status of GNMA, FNMA and FHLMC, such securities
generally are structured with one or more types of credit
enhancement. The Series will invest in private mortgage pass-
through securities only if they are rated AAA by S&P or Aaa by
Moody's or securities are unrated but deemed to be of comparable
credit quality by the Adviser.
Private mortgage pass-through securities are often backed by
a pool of assets representing the obligations of a number of
different parties. To lessen the effect of failures by obligers on
underlying assets to make payments, those securities may contain
elements of credit support, which fall into two categories: (i)
liquidity protection and (ii) protection against losses resulting
from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provision of advances, generally
by the entity administering the pool of assets, to ensure that the
receipt of payments on the underlying pool occurs in a timely
fashion. Protection against losses resulting from default ensures
ultimate payment of the obligations on at least a portion of the
assets in the pool. This protection may be provided through
guarantees, insurance policies or letters of credit obtained by the
issuer or sponsor from third parties, through various means of
structuring the transaction or through a combination of such
approaches. The degree of credit support provided for each issue
is generally based on historical information respecting the level
of credit risk associated with the underlying assets.
Delinquencies or losses in excess of those anticipated could
adversely affect the return on an investment in a security. The
Short and Intermediate Series will not pay any additional fees for
credit support. The existence of credit support may increase the
price of a security to reflect its credit protection and lower
risk. If the Short or Intermediate Series invests in securities
backed by credit support, they may realize a lower yield on a
higher-grade security which contains credit support than on a
lower-grade security which does not.
Multiple Class Pass-Through Securities and Collateralized Mortgage
Obligations
Multiple class pass-through securities are interests in a trust
composed of GNMA, FNMA or FHLMC Certificates or whole loans or
private mortgage pass-through securities (such collateral
collectively hereinafter referred to as "Mortgage Assets"). Types
of multiple class pass-through securities include, among others,
collateralized mortgage obligations ("CMOs"), real estate
mortgage investment conduit ("REMIC") pass-through or
participation certificates, and stripped mortgage-backed
securities ("SMBS"), which are discussed below. A
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REMIC is a CMO that qualifies for special tax treatment under
the Internal Revenue Code and invests in certain mortgages
principally secured by interests in real property and other
permitted investments.
CMOs and guaranteed REMIC pass-through certificates ("REMIC
Certificates") issued by FNMA and FHLMC are types of multiple class
pass-through securities. Investors may purchase "regular"
beneficial interests in REMICs. The REMIC Certificates represent
beneficial ownership interests in a REMIC trust, generally
consisting of mortgage loans or FNMA, FHLMC or GNMA guaranteed
pass-through certificates. The obligations of FNMA or FHLMC under
their respective guaranty of the REMIC Certificates are obligations
solely of FNMA or FHLMC.
FNMA REMIC Certificates are issued and guaranteed as to timely
distribution of principal and interest by FNMA. In addition, FNMA
will be obligated to distribute on a timely basis to holders of
FNMA REMIC Certificates required installments of principal and
interest and to distribute the principal balance of each class of
REMIC Certificates in full, whether or not sufficient funds are
otherwise available.
For FHLMC REMIC Certificates, FHLMC guarantees the timely
payment of interest and also guarantees the payment of principal as
payments are required to be made on the underlying mortgage
participation certificates ("PCs"). PCs represent undivided
interests in specified level payment, residential mortgages or
participation therein purchased by FHLMC and placed in a PC pool.
With respect to principal payments on PCs, FHLMC generally
guarantees ultimate collection of all principal of the related
mortgage loans without offset or deduction. FHLMC also guarantees
timely payment of principal on Gold PCs.
CMOs and REMIC Certificates are issued in multiple classes.
Each class of CMO or REMIC Certificates, often referred to as a
"tranche," is issued at a specific adjustable or fixed interest
rate and must be fully retired no later than its final distribution
date. Principal payments on the Mortgage Assets underlying the
CMOs or REMIC Certificates may cause some or all of the classes of
CMOs or REMIC Certificates to be retired substantially earlier than
their final distribution dates. Generally, interest is paid or
accrues on all classes of CMOs or REMICs on a monthly or quarterly
basis.
The principal of and interest on the Mortgage Assets may be
allocated among the several classes of CMOs or REMIC Certificates
in several ways. In certain structures (known as "sequential pay"
CMOs or REMIC Certificates), payments of principal, including any
principal prepayments, on the Mortgage Assets generally are applied
to the classes of CMOs or REMIC Certificates in the order of their
respective final distribution dates. Thus no payment of principal
will be made on any class of sequential pay CMOs or REMIC
Certificates until all other classes having an earlier final
distribution date have been paid in full.
Additional structures of CMOs and REMIC Certificates include,
among others, "parallel pay" CMOs and REMIC Certificates. Parallel
pay CMOs and REMIC Certificates are those which are structured to
apply principal payments and prepayments of the Mortgage Assets to
two or more classes concurrently on a proportionate or
disproportionate basis. These simultaneous payments are taken into
account in calculating the final distribution date of each class.
A wide variety of REMIC Certificates may be issued in the
parallel pay or sequential pay structures. These securities
include accrual certificates (also known as "Z-Bonds"), which only
accrue interest at a specified rate until all other certificates
having an earlier final distribution date have been retired and are
converted thereafter to an interest-paying security, and planned
amortization class ("PAC") certificates, which are parallel pay
REMIC Certificates which generally require that specified amounts
of principal be applied on each payment date to one or more classes
of REMIC Certificates (the "PAC Certificates"), even though all
other principal payments and prepayments of the Mortgage Assets are
then required to be applied to one or more other classes of
Certificates. The scheduled principal payments for the PAC
Certificates generally have the highest priority on each payment
date after interest due has been paid to all classes entitled to
receive interest currently. Shortfalls, if any, are added to the
amount payable on the next payment date. The PAC Certificate payment
-14-
schedule is taken into account in calculating the final
distribution date of each PAC. In order to create PACs, one or
more tranches generally must be created that absorb most of the
volatility in the underlying mortgage assets. These tranches tend
to have market prices and yields that are much more volatile than
the PACs.
In reliance on an interpretation by the Securities and Exchange
Commission ("SEC"), the Short and Intermediate Series' investments
in certain qualifying CMOs and REMICs are not subject to the
Investment Company Act's limitation on acquiring interests in other
investment companies. See "Investment Restrictions" in the
Statement of Additional Information. CMOs and REMICs issued by an
agency or instrumentality of the U.S. Government are considered
U.S. Government securities for purposes of this Prospectus.
Stripped Mortgage-Backed Securities ("SMBS")
The Short and Intermediate Series may invest in SMBS, which are
derivative multi-class mortgage securities. In addition to SMBS
issued by the U.S. Government, its agencies or instrumentalities,
the Short and Intermediate Series may purchase SMBS issued by
private originators of, or investors in, mortgage loans, including
depository institutions, mortgage banks, investment banks and
special purpose subsidiaries of these entities. The Short and
Intermediate Series will purchase only SMBS that are collateralized
by U.S. Government Agency Mortgage-Backed Securities.
SMBS are usually structures with two classes that receive
different proportions of the interest and principal distributions
from a pool of Mortgage Assets. A common type of SMBS will have one
class receiving all of the interest from the Mortgage Assets, while
the other class will receive all of the principal. However, in some
instances, one class will receive some of the interest and most of
the principal while the other class will receive most of the
interest and the remainder of the principal. If the underlying
Mortgage Assets experience greater than anticipated prepayments of
principal, the Short or Intermediate Series may fail to fully
recover its initial investment in these securities, even if the
SMBS are rated AAA by S&P or Aaa by Moody's. SMBS are unusually
volatile in response to changes in interest rates and, in respect
of SMBS that receive all or most of their interest from Mortgage
Assets, there is a risk that the initial investment will not be
fully recouped. The Adviser will seek to manage these risks (and
potential benefits) by investing in a variety of such securities
and by using certain hedging techniques, as described below in
"Hedging." The Adviser expects that interest-only SMBS will be
purchased by the Series for their hedging characteristics. Such
SMBS will reduce the variance of the Series' respective net asset
values from targeted option-adjusted duration.
Under no circumstances will the Short or Intermediate Series
purchase SMBS if such purchase would cause SMBS to exceed 5% of the
assets of the Series.
New instruments and variations of existing Mortgage-Backed
Securities continue to be developed. The Short and Intermediate
Series may invest in any such instruments or variations as may be
developed, to the extent consistent with their investment
objectives and policies and applicable regulatory requirements.
YIELD, MARKET VALUE AND RISK CONSIDERATIONS OF
MORTGAGE-BACKED SECURITIES
The Short and Intermediate Series may invest in certain
Mortgage-Backed Securities, such as interest-only SMBS, that are
extremely sensitive to changes in prepayments and interest rates.
Even though such securities may be rated in the highest rating
categories by S&P or Moody's or be guaranteed by an agency or
instrumentality of the U.S. Government, under certain interest rate
or prepayment rate scenarios, the Short and Intermediate Series may
fail to fully recover their investment in such securities. The
Short and Intermediate Series will purchase only SMBS that are
collateralized by U.S. Government Agency Mortgage-Backed
Securities.
The investment characteristics of adjustable and fixed rate
Mortgage-Backed Securities differ from those of traditional
fixed income securities. The major differences include the
payment of interest and principal on
-15-
Mortgage-Backed Securities on a more frequent (usually monthly)
schedule, and the possibility that principal may be prepaid at any
time due to prepayments on the underlying mortgage loans or other
assets. These differences can result in significantly greater price
and yield volatility than is the case with traditional fixed income
securities. As a result, if the Short or Intermediate Series
purchases Mortgage-Backed Securities at a premium, a faster than
expected prepayment rate will reduce both the market value and the
yield to maturity from those which were anticipated. A prepayment
rate that is slower than expected will have the opposite effect of
increasing yield to maturity and market value. Conversely, if the
Short or Intermediate Series purchases Mortgage-Backed Securities at a
discount, faster than expected prepayments will increase, while
slower than expected prepayments will reduce, yield to maturity and
market value. The Adviser will seek to manage these potential
risks and benefits by investing in a variety of Mortgage-Backed
Securities and by using certain hedging techniques. See "Hedging."
Prepayments on a pool of mortgage loans are influenced by a
variety of factors, including changes in mortgagors' housing needs,
job transfers, unemployment, mortgagors' net equity in the mortgage
properties and servicing decisions. The timing and level of
prepayments cannot be predicted with certainty. As with fixed
mortgage loans, adjustable rate mortgage loans may be subject to
greater prepayment rates in a declining interest rate environment.
The mortgage loans underlying the Mortgage-Backed Securities
generally may be prepaid at any time without penalty. In a
fluctuating interest rate environment, a predominant factor
affecting the prepayment rate on a pool of mortgage loans is the
difference between the interest rates on the mortgage loans and
prevailing mortgage loan interest rates (giving consideration to
the cost of any refinancing). In general, if mortgage loan
interest rates fall sufficiently below the interest rates on fixed
rate mortgage loans underlying mortgage pass-through securities,
the rate of prepayment would be expected to increase. Conversely,
if mortgage loan interest rates rise above the interest rates on
the fixed rate mortgage loans underlying the Mortgage-Backed
Securities, the rate of prepayment may be expected to decrease.
Since prepayments on fixed rate mortgage loans generally are likely
to increase during a period of falling mortgage interest rates, the
amounts of prepayments available for reinvestment by the Short and
Intermediate Series are likely to be greater during a period of
falling mortgage rates. If general interest rates also decline
during such a period, these higher prepayments are likely to be
reinvested at lower rates than that which the Short or Intermediate
Series were earning on the Mortgage-Backed Securities that were
prepaid. Like most traditional fixed-income securities, most
Mortgage-Backed Securities, including those backed by ARMs,
decrease in value as a result of increases in interest rates.
However, many Mortgage-Backed Securities may benefit less than
other fixed income securities from declining interest rates because
of the risk of prepayment.
In general, changes in both prepayment rates and interest rates
will change the yield on Mortgage-Backed Securities backed by ARMs.
The rate of principal prepayments with respect to ARMs has
fluctuated in recent years. As is the case with fixed rate
mortgage loans, ARMs may be subject to a greater rate of principal
prepayments in a declining interest rate environment. For example,
if prevailing interest rates fall significantly, ARMs could be
subject to higher prepayment rates than if prevailing interest
rates remain constant because the availability of fixed rate
mortgage loans at competitive interest rates may encourage
mortgagors to refinance their ARMs to obtain a lower fixed interest
rate. Conversely, if prevailing interest rates rise significantly,
ARMs may prepay at lower rates than if prevailing rates were to
remain at or below those in effect at the time such ARMs were
originated. There can be no certainty as to the rate of
prepayments on the ARMs in either stable or changing interest rate
environments. In addition, there can be no certainty as to whether
increases in the principal balances of the ARMs due to the addition
of deferred interest may result in a default rate higher than that
on ARMs that do not provide for negative amortization. Other
factors affecting prepayment of ARMs include changes in mortgagors'
housing needs, job transfers, unemployment, mortgagors' net equity
in the mortgage properties and servicing decisions. Unlike
investments in fixed-income mortgages which decline in value during
periods of rising interest rates, investments in ARM-backed
securities will allow the Short and Intermediate Series to
participate in increases in interest rates through periodic
adjustments in the coupons of the underlying mortgages, resulting
in both higher current yields and lower price fluctuations.
However, the Short and Intermediate Series will not benefit from
increases in interest rates if interest rates rise to the point
which would cause the current interest rates on the ARMs
underlying the Series' Mortgage-Backed Securities
-16-
to exceed the maximum allowable annual or lifetime reset limits,
as described above. The Adviser will seek to manage these risks
(and potential benefits) by using certain hedging techniques. See
"Hedging."
To the extent the Short and Intermediate Series invest in ARMs,
the adjustable rate feature of ARMs generally will act as a buffer
to reduce sharp changes in each Series' respective net asset values
in response to normal interest rate fluctuations. As the interest
rates on the ARMs underlying each Series' investments are reset
periodically, the yields of each Series' adjustable rate Mortgage-
Backed Securities will gradually align themselves to reflect
changes in market rates. As a result, adjustable rate Mortgage-
Backed Securities, on a stand-alone basis, should fluctuate less
dramatically in price than each Series' investments in fixed rate
Mortgage-Backed Securities on a stand-alone basis. Although having
less risk of decline during periods of rising market interest
rates, adjustable rate Mortgage-Backed Securities, because their
coupon rates will decline in response to market interest rate
declines, generally have less potential for market appreciation
than fixed rate Mortgage-Backed Securities. As described in
"Hedging" below, the Adviser will seek to manage the expected price
fluctuations of each Series' securities on an aggregate basis, and
therefore of each Series' net asset values, by using certain
hedging techniques. See "Hedging."
The Short and Intermediate Series' reinvestment of principal
payments and prepayments received on a mortgage pass-through
security may be made at rates higher or lower than the rate payable
on such security, thus affecting the realized return.. In
addition, the receipt of interest payments monthly rather than
semi-annually by the Short or Intermediate Series has a compounding
effect that may increase the yield relative to that received on
debt obligations that pay interest semi-annually. Due to these
factors, Mortgage-Backed Securities may also be less effective than
U.S. Treasury securities of similar maturity at maintaining yields
during periods of declining interest rates. Prepayments may have
a disproportionate effect on certain Mortgage-Backed Securities
such as SMBS and certain other multiple class pass-through
securities. The Short and Intermediate Series may purchase
Mortgage-Backed Securities at a premium or at a discount.
Negatively Amortizing ARMs that are not guaranteed as to full
and timely payment of principal and interest may be subject to
increasing credit exposure. ARMs that are guaranteed as to full
and timely payment of principal and interest may be subject to
additional prepayment risk resulting from increased default rates.
All of the Mortgage-Backed Securities in which the Short or
Intermediate Series may invest are traded in over-the-counter
markets rather than on exchanges. The size of spreads between bid
and ask prices in over-the-counter markets for Mortgage-Backed
Securities depends upon a number of factors, including the
outstanding principal amount of the particular security, the number
of dealers making markets in the security, the length of time that
a particular type of security has been trading in the market and
the perceived volatility of the price of the security. Some of the
Mortgage-Backed Securities in which the Short and Intermediate
Series may invest, in particular certain SMBS and private mortgage
pass-through securities, may trade with a wider spread between the
bid and ask quotations than do other fixed-income securities, such
as U.S. Government securities or Mortgage-Backed Securities having
current market fixed coupons.
The spread between the bid and ask quotations is taken into
account, among other things, in the determination of the value of
each security and, therefore, in the determination of the net asset
value per share of each of the Series. See "Valuation of Fund
Shares". If the Short or Intermediate Series are forced on short
notice to sell securities for which the spread between bid and ask
quotations is wide, as a result of requests for redemption of a
large number of shares or for some other reason, the Short or
Intermediate Series may not be able to obtain the same price for
such security as it would if it were able to take a longer period
of time to seek the most efficient execution of its proposed sale.
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ILLIQUID SECURITIES
Each of the Series may invest up to 15% of its net assets in
securities for which there are legal or contractual restrictions on
resale or for which there is no readily available market or other
illiquid securities, including non-terminable repurchase agreements
having maturities of more than seven days. See "Investment
Restrictions" in the Statement of Additional Information. The
Adviser will monitor the illiquidity of such restricted securities
under the supervision of the Board of Trustees. The determination
of whether interest-only and principal-only SMBS issued by the U.S.
Government and backed by fixed rate mortgages are liquid shall be
made by the Adviser under guidelines established by the Board of
Trustees. Pursuant to SEC policy, privately-issued SMBS shall be
considered illiquid for purposes of the limitation on investments
in illiquid securities. The staff of the SEC has taken the
position that OTC options, interest-rate swaps, caps, floors and
collars (as discussed in Appendix A) are illiquid securities. The
Adviser disagrees with this position. Nevertheless, the Short and
Intermediate Series have agreed to treat OTC options, interest-rate
swaps, caps, floors and collars as illiquid securities so long as
the SEC maintains this position.
HEDGING
The Short and Intermediate Series may employ certain active
management techniques to achieve their duration objectives as
described above in "Investment Objectives and Investment Policies"
and to hedge the interest rate risks associated with the securities
in accordance with such objectives. Since some of the securities
may have longer durations than the Short and Intermediate Series'
duration objectives and some of the securities may have shorter
durations, hedging may be required either to lengthen or to shorten
the duration of the aggregate portfolio to reduce the variance from
the duration objectives. Rather than seeking to profit from
changes or "trends" in general interest rate levels, the Short and
Intermediate Series will seek continually to manage duration within
a narrow range.
The Short and Intermediate Series intend to use hedging
transactions as a hedge against interest rate fluctuations and not
as speculative transactions. Hedging transactions may also be used
as a temporary substitute for purchasing particular securities.
Each Series may enter into mortgage and interest rate swaps, or may
purchase or sell interest rate floors, caps or collars, and enter
into interest rate futures contracts and related options, and
engage in short sales to hedge against interest rate fluctuations.
In addition, the Short and Intermediate Series expect to use SMBS
to reduce their respective targeted option-adjusted durations.
Any or all of these techniques may be used at one time. Use
of any particular transaction is a function of market conditions.
The hedging transactions that the Short and Intermediate Series
currently contemplate using are described in detail in Appendix A.
Hedging transactions pose certain risks, which are described
in Appendix A.
OTHER INVESTMENTS AND PRACTICES
Repurchase Transactions
The Short and Intermediate Series may invest in repurchase
agreements, which are agreements pursuant to which securities are
acquired from a third party with the commitment that they will be
repurchased by the seller at a fixed price on an agreed upon date.
These agreements may be made with respect to any of the portfolio
securities in which the Short or Intermediate Series are authorized
to invest. Repurchase agreements may be characterized as loans
secured by the underlying securities. The resale price reflects
the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or date of maturity of the
purchased security. The securities underlying the repurchase
agreement will be held by the Custodian at all times in an amount
at least equal to the repurchase price, including accrued interest
earned on the underlying securities. If the seller defaults on its
obligation to repurchase the underlying securities, as a result of its
-18-
bankruptcy or otherwise, and the value of the collateral
securing the repurchase agreement declines, the Short and
Intermediate Series may incur a loss.
Repurchase agreements facilitate portfolio management and allow
the two Series to earn additional revenue. The Short and
Intermediate Series may enter into repurchase agreements in order
to increase liquidity or as a temporary investment in anticipation
of acquiring suitable long term investments. The Series may enter
into repurchase agreements with (i) member banks of the Federal
Reserve System having total assets in excess of $500 million and
(ii) securities dealers, provided that such banks or dealers meet
the creditworthiness standards established by the Fund's Board of
Trustees ("Qualified Institutions"). The Adviser will monitor the
continued creditworthiness of Qualified Institutions, subject to
the oversight of the Fund's Board of Trustees.
The use of repurchase agreements involves certain risks. For
example, if the seller of securities under a repurchase agreement
defaults, the Short and Intermediate Series will seek to dispose of
such securities, which action could involve costs or delays.
Reverse Repurchase Agreements and Dollar Roll Agreements
The Short and Intermediate Series may enter into reverse
repurchase agreements and dollar roll agreements with Qualified
Institutions to seek to enhance returns.
Reverse repurchase agreements involve sales by the Short and
Intermediate Series of portfolio assets concurrently with an
agreement to repurchase the same assets at a later date at a fixed
price. During the reverse repurchase agreement period, the Short
and Intermediate Series continue to receive principal and interest
payments on these securities.
The Short and Intermediate Series may enter into dollar rolls
whereby the Short or Intermediate Series could sell securities for
delivery in the current month and simultaneously contract to
repurchase substantially similar (same type and coupon) securities
on a specified future date. During the roll period, the Short or
Intermediate Series would forgo principal and interest paid on the
securities. The Short or Intermediate Series would be compensated
by the difference between the current sales price and the forward
price for the future purchase (often referred to as the "drop") as
well as by the interest earned on the cash proceeds of the initial
sale.
The Short or Intermediate Series will establish a segregated
account with their respective custodians in which each will
maintain cash, U.S. Government securities or other liquid high-
grade debt obligations equal in value to their respective
obligations in respect of reverse repurchase agreements and dollar
rolls. Reverse repurchase agreements and dollar rolls involve the
risk that the market value of the securities retained by a Series
may decline below the price of the securities a Series would have
sold but is obligated to repurchase under the agreement. In the
event the buyer of securities under a reverse repurchase agreement
files for bankruptcy or becomes insolvent, the Short or
Intermediate Series' use of the proceeds of the agreement may be
restricted pending a determination by the other party, or its
trustee or receiver, whether to enforce either Series' obligation
to repurchase the securities. Reverse repurchase agreements and
dollar rolls are considered borrowings.
When-issued and Delayed Delivery Securities and Forward Commitments
From time to time, in the ordinary course of business, the
Short and Intermediate Series may purchase securities on a when-
issued or delayed delivery basis or may purchase or sell securities
on a forward commitment basis. When such transactions are
negotiated, the price is fixed at the time of the commitment, but
delivery and payment can take place a month or more after the date
of the commitment. While the Short and Intermediate Series will
purchase only securities on a when-issued, delayed delivery or
forward commitment basis with the intention of acquiring the
securities, the Short or Intermediate Series may sell the
securities before the settlement date, if it is deemed
advisable. At the time the Short or Intermediate Series
makes the commitment to purchase
-19-
securities on a when-issued or delayed delivery basis,
the Short or Intermediate Series will record the transaction and
thereafter reflect the value, each day, of such security in
determining its net asset value.. At the time of delivery of the
securities, the value may be more or less than the purchase price.
An increase in the percentage of each of the Series' assets
committed to the purchase of securities on a when-issued, delayed
delivery or forward commitment basis may increase the volatility of
each of the Series' net asset value. Any increased volatility will
be factored into the Adviser's evaluation of the net option-
adjusted duration of net assets and offsetting positions will
generally be present. At the time either of the Series enters into
a transaction on a when-issued or forward commitment basis, a
segregated account consisting of cash, U.S. Government securities
or other liquid high-grade debt securities equal to at least 100%
of the value of the when-issued or forward commitment securities
will be established and maintained with the custodian. Subject to
this requirement, the Series may purchase securities on such basis
without limit.
Settlements in the ordinary course, which may take
substantially more than five business days for Mortgage-Backed
Securities, are not treated by either Series as when-issued or
forward commitment transactions and, accordingly, are not subject
to the foregoing limitations even though some of the risks
described above may be present in such transactions.
Lending of Portfolio Securities
The Short or Intermediate Series may lend their respective
portfolio securities to Qualified Institutions. By lending their
portfolio securities, the Short or Intermediate Series will attempt
to increase income through the receipt of interest on the loan.
Any gain or loss in the market price of the securities loaned that
may occur during the term of the loan will be for the account of
the Short or Intermediate Series. Under present regulatory
policies, the borrower must pledge and maintain with either Series
collateral consisting of cash, cash equivalents, U.S. Government
securities or other liquid high-grade debt securities in an amount
not less than 100% of the value of the loaned securities.
Neither the Short nor the Intermediate Series will lend
portfolio securities if, as a result, the aggregate of such loans
exceeds 33 1/3% of the total asset value (including such loans).
All relevant facts and circumstances, including the
creditworthiness of the Qualified Institution, will be monitored by
the Adviser, and will be considered in making decisions with
respect to lending of securities, subject to review by the Fund's
Board of Trustees. The Series may pay reasonable negotiated fees
in connection with loaned securities, so long as such fees are set
forth in a written contract and their reasonableness is determined
by the Fund's Board of Trustees.
Other Investments
The Short or Intermediate Series may also invest in other
instruments including obligations of the United States, notes,
bonds, and discount notes of other U.S. Government agencies or
instrumentalities, including but not limited to: Federal National
Mortgage Association, Government National Mortgage Association,
Federal Home Loan Mortgage Corporation, Federal Home Loan Banks,
Bank for Cooperatives, Farm Credit Banks, Tennessee Valley
Authority, Federal Financing Bank, Small Business Administration
and Federal Agricultural Mortgage Corporation. The Series may also
invest in time and savings deposits (including fixed or adjustable
rate certificates of deposit) in commercial banks or in
institutions whose accounts are insured by the FDIC, BIF or SAIF.
Borrowing
The Short or Intermediate Series may borrow from banks and
enter into reverse repurchase agreements or dollar rolls up to 33
1/3% of the value of the total assets for each of the Series
(computed at the time the loan is made) to take advantage of
investment opportunities and for temporary, extraordinary or
emergency purposes, or for the clearance of transactions.
A Series may pledge up to 33 1/3% of the total assets for
each of the Series to secure these borrowings. If a
Series' asset coverage for borrowings falls below 300%, the Series
-20-
will take prompt action to reduce its borrowings even though it
may be disadvantageous at that time from an investment point of
view. The Short and Intermediate Series will incur borrowing
costs when it leverages, including payment of interest and
any fee necessary to maintain a line of credit, and may be
required to maintain a minimum average balance. If the income
and appreciation on assets acquired with borrowed funds exceed
their borrowing cost, the Short or Intermediate Series' investment
performances will increase, whereas if the income and appreciation
on assets acquired with borrowed funds are less than their
borrowing costs, investment performances will decrease. In
addition, if the Short or Intermediate Series borrows
to invest in securities, any investment gains made on the
securities in excess of the costs of the borrowing, and any gain or
loss on hedging, will cause the net asset value of the shares of
each of the Series to rise faster than would otherwise be the case.
On the other hand, if the investment performance of the additional
securities purchased fails to cover their cost (including any
interest paid on the money borrowed) to each of the Series, the net
asset value of each of the Series' shares will decrease faster than
would otherwise be the case. This is the speculative
characteristic known as "leverage."
INVESTMENT RESTRICTIONS
The Short and Intermediate Series are subject to certain
investment restrictions which, as described in more detail in the
Statement of Additional Information, have been adopted by the
Trustees on behalf of each of the Series as fundamental policies
that cannot be changed without the approval of a majority of the
outstanding shares of the respective Series.
PORTFOLIO TURNOVER
Neither of the Series has a fixed policy with respect to
portfolio turnover. The portfolio turnover rate is calculated by
dividing the lesser of sales or purchases of portfolio securities
by the average monthly value of the portfolio securities, excluding
securities having a maturity at the date of purchase of one year or
less. While the Short or Intermediate Series will pay commissions
in connection with its options and future transactions, the other
securities in which a Series will invest are generally traded on a
"net" basis with dealers acting as principals for their own account
without a stated commission. Nevertheless, high portfolio turnover
may involve correspondingly greater brokerage commissions and other
transaction costs which will be borne directly by a Series. See
"Portfolio Transactions" in the Statement of Additional
Information. Another potential consequence of high portfolio
turnover is that, if 30% or more of each of the Series' gross
income for a taxable year were derived from gains from the sale or
other disposition of securities and certain other investments held
for less than three months, neither of the Series would qualify as
a regulated investment company and, therefore, a Series would be
subject to corporate income tax during that taxable year. The
Adviser endeavors to manage the investment compositions of the
Series and to adjust the portfolio turnover of each of the Series,
if necessary, to insure the Series' treatment as regulated
investment companies. See "Additional Information Regarding
Taxation -- Taxation of the Fund" in the Statement of Additional
Information. The Portfolio turnover rates for the last fiscal
period are shown in the tables under the heading Financial
Highlights.
-21-
<PAGE>
MANAGEMENT OF THE FUND
Trustees and Officers
The Fund's Board of Trustees is responsible for deciding matters of
general policy and reviewing the actions of the Adviser,
distributor and transfer agent. The officers of the Series conduct
and supervise the Fund's daily business operations. The Fund's
trustees and officers are identified below. The Fund's trustees
also serve as trustees of other mutual funds in the Smith Breeden
Family of Funds.
BOARD OF TRUSTEES
AFFILIATED WITH
TRUSTEE ADVISER SINCE
Douglas T. Breeden* 1982
Dr. Breeden, the Chairman of the Board of Smith Breeden Associates,
co-founded the firm in 1982. Dr. Breeden has served on business
school faculties at Duke University, Stanford University and the
University of Chicago, and as a visiting professor at Yale
University and at the Massachusetts Institute of Technology. He is
the Editor of the Journal of Fixed Income. Dr. Breeden has served
as Associate Editor for five journals in financial economics, and
was elected to the Board of Directors of the American Finance
Association. He has published several well-cited articles in
finance and economics journals. He holds a Ph.D. in Finance from
the Stanford University Graduate School of Business, and a B.S. in
Management Science from the Massachusetts Institute of Technology.
Dr. Breeden taught in the Portfolio Management Program at the
Nomura School of Advanced Management in Tokyo from 1987 to 1992.
He serves as Chairman of the Board for Roosevelt Bank of St. Louis.
He also serves as Chairman of Harrington Financial Group, the
holding company for Harrington Bank, F.S.B., of Richmond, Indiana.
Michael J. Giarla* 1985
Principal, Executive Vice President, Director and Chief Operating
Officer, Smith Breeden Associates, Inc., President, Smith Breeden
Family of Funds, Associate Editor, Journal of Fixed Income 1991-
1993. He has published several book chapters and articles regarding
mortgage-backed securities investments, risk management and
hedging. MBA with concentration in Finance, Arjay Miller Scholar,
Stanford University. BS in statistics, summa cum laude, Phi Beta
Kappa, Harvard Club of Boston Scholar, Harvard University.
Trustee, the Roxbury Latin School, Boston, MA.
Stephen M. Schaefer
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at
London Business School. Previously on the Faculty of the Graduate
School of Business of Stanford University, he has also taught at
the Universities of California (Berkeley), Chicago, British
Columbia and Venice. His research interests focus on capital
markets and financial regulation. He has served on the editorial
board of a number of professional journals including, currently,
the Journal of Fixed Income, the Review of Derivative Research and
Ricerche Economiche. He consults for a number of leading financial
institutions and is an Independent Board Member of the Securities
and Futures Authority of Great Britain.
-22-
Myron S. Scholes
Myron S. Scholes is the Frank E. Buck Professor of Finance at the
Graduate School of Business Stanford University (since 1983); a
Senior Research Fellow at the Hoover Institution (since 1987); and
is currently on leave as a Professor of Law, Stanford Law School.
He is a principal in the money management firm, Long-Term Capital
Management Co. (since 1993). He is a Research Associate of the
National Bureau of Economic Research and is a member of the
Econometric Society. Professor Scholes was also a managing
director and co-head of the fixed income derivatives group at
Salomon Brothers between 1991-1993. Prior to coming to Stanford
University, Professor Scholes was the Edward Eagle Brown Professor
of Finance at the Graduate School of Business, University of
Chicago (1974-1983). He served as the Director of the University
of Chicago's Center for Research in Security Prices from 1974-1980.
Prior to coming to the University of Chicago, Professor Scholes was
first an Assistant Professor then an Associate Professor at the
Sloan School of Management, at M.I.T. from 1968 to 1973. He
received his PhD in 1969 from the Graduate School of Business,
University of Chicago. He has honorary Doctor of Law degrees from
the University of Paris and McMaster University. He is a past
president of the American Finance Association (1990).
Dr. Scholes has published numerous articles in academic journals
and in professional volumes. He is most noted as the co-originator
of the Black-Scholes Options Pricing Model as described in a paper,
"The Pricing of Options and Corporate Liabilities," published in
the Journal of Political Economy (May 1973) (with Fischer Black).
His other papers include such topics as risk-return relations, the
effects of dividend policy on stock prices, the effects of taxes
and tax policy on corporate decision making. His book with Mark
Wolfson (Stanford University) "Taxes and Business Strategy: A
Planning Approach" was published by Prentice Hall in 1991.
William F. Sharpe
William F. Sharpe is the STANCO 25 Professor of Finance at Stanford
University's Graduate School of Business. He is best known as one
of the developers of the Capital Asset Pricing Model, including the
beta and alpha concepts used in risk analysis and performance
measurement. He developed the widely-used binomial method for the
valuation of options and other contingent claims. He also
developed the computer algorithm used in many asset allocation
procedures. Dr. Sharpe has published articles in a number of
professional journals. He has also written six books, including
Portfolio Theory and Capital Markets, (McGraw-Hill, 1970), Asset
Allocation Tools, (Scientific Press, 1987), Fundamentals of
Investments (with Gordon J. Alexander and Jeffery Bailey, Prentice-
Hall, 1993) and Investments (with Gordon J. Alexander and Jeffery
Bailey, Prentice-Hall, 1995). Dr. Sharpe is a past President of
the American Finance Association. He has also served as consultant
to a number of corporations and investment organizations. He is
also a member of the Board of Trustees of Rosenberg Series Trust,
an investment company, and a director at CATS Software and Stanford
Management Company. He received the Nobel Prize in Economic
Sciences in 1990.
*Interested party<PAGE>
-23-
OFFICERS
Affiliated With
Officer Title Adviser Since
Douglas T. Breeden Chairman 1982
Michael J. Giarla President and Chief 1985
Executive Officer
Daniel C. Dektar Vice President, 1986
Portfolio Manager
Director of Trading, Executive Vice-President, Principal and
Director of Smith Breeden Associates, Inc. Mr. Dektar has been
primarily responsible for the day-to-day management of the Short
and Intermediate Series from their commencement of operations in
1992. Previously employed in investment banking capacities at
Morgan Stanley & Co. Earned an MBA with a concentration in
Finance, Arjay Miller Scholar, Stanford University, and a B.S. in
Business Administration, summa cum laude, Phi Beta Kappa, Phi Eta
Sigma, White Award as top student in finance and Regents Scholar at
the University of California at Berkeley.
Marianthe S. Mewkill Vice President, 1992
Secretary, Treasurer, and
Chief Accounting Officer
Principal, Smith Breeden Associates, Inc. She was previously
employed as a Controller for the Hunt Alternatives Fund and as an
Associate at Goldman Sachs & Co. and Senior Auditor at Arthur
Anderson & Co. She earned an M.B.A. with concentrations in Finance
and Accounting from New York University, and graduated from
Wellesley College, magna cum laude with a B.A. in History and
French, and a minor in Economics.
<PAGE>
-24-
Investment Management
Smith Breeden Associates, Inc., Overland Park, Kansas 66210, a
registered investment adviser (the "Adviser"), acts as the
investment adviser to each Series. The Adviser also serves as the
investment adviser to the other fund in the Smith Breeden Family of
Funds. Douglas T. Breeden, Chairman and President of the Adviser,
owns approximately 71% of the Adviser's voting stock as of March
31, 1995.
Under its Investment Advisory Agreements with each of the
Series, the Adviser, subject to the general supervision of the
Board of Trustees, manages each Series and provides for the
administration of each of the Series' other affairs. It is the
responsibility of the Adviser to place purchase and sale orders for
each of the Series' security transactions. Daniel C. Dektar, a
Principal of the Adviser, is the portfolio manager for both the
Short and Intermediate Series and has been primarily responsible
for the day-to-day investment management of the two Series since
their inception in 1992.
The Adviser has extensive experience providing investment
advisory services on a discretionary and non-discretionary basis to
financial institutions, insurance, pension and charitable
foundation clients. The Adviser has provided such services since
1982 with assets under management exceeding $1 billion since 1984.
Current mortgage security assets under management exceed $10
billion. In addition, a number of governmental agencies have
engaged the Adviser to provide services in the areas of securities
risk analysis, securities disposition and portfolio management.
The Adviser has advised the Smith Breeden Family of Funds since
1992.
The Federal Deposit Insurance Corporation, Federal Savings and
Loan Insurance Corporation, Resolution Trust Corporation, Office of
Thrift Supervision and various Federal Home Loan Regional Banks
have engaged the Adviser for various securities-related projects.
One of the most significant governmental agency projects involved
the disposition of CMO residuals, whose original cost totalled
approximately $700 million, purchased by the former Silverado
Savings Bank of Denver. The Adviser is currently advising the
Federal Home Loan Bank of Boston regarding a mortgage-backed
security portfolios totalling over $3 billion. None of the
government project activity is included in the advisory assets
discussed above.
The Adviser was one of the first market participants to develop
effective option adjusted evaluation models. For over twelve
years, the Adviser has developed and traded on proprietary mortgage
prepayment projections. Such projections are available only to
advisory clients and, in contrast to prepayment projections
developed by securities firms, are not used for any broker trading
or arbitrage operations.
The principals and staff of the Adviser collectively have
accumulated over 100 years of experience analyzing, investing in
and controlling the risks of mortgage securities while in the
employ of the Adviser. Key employees of the Adviser who may
contribute investment ideas, research and analysis for the benefit
of each of the Series and who are not officers or Trustees of the
Fund are:
Associated With
Adviser Since
Michael L. Bamburg 1986
Principal, Smith Breeden Associates, Inc. Mr. Bamburg assists in
analyzing, trading, designing, and hedging mortgage asset
portfolios for clients of Smith Breeden Associates. He supervises
client data for consistency and integrity. He also supervises
monthly analyses, including total rate of return, mark-to-market
net worth, spread income and hedge performance. Mr. Bamburg is
also involved in marketing Smith Breeden Associates' mutual funds
to institutional investors. Previously was a corporate management
associate with Volume Shoe Corporation, a division of the May
Company, and worked on a mortgage market study for Citicorp.
Earned an MBA and a BS with concentrations in Finance, University
of Kansas. Received the Ford Finance Scholarship for graduate
business studies at Kansas University.
-25-
Carl D. Bell 1991
Principal, Smith Breeden Associates, Inc. Mr. Bell develops
computer programs to value and hedge interest rate sensitive
securities and provides research support to the client service and
trading functions. Mr. Bell manages Smith Breeden's library of
analytical software and is active in the analysis and modeling of
mortgage prepayment behavior. Previously, Mr. Bell has been a
Staff Consultant at Andersen Consulting and a Research Assistant
with Putnam, Hayes & Bartlett. He received a Master of Business
Administration with a Concentration in Finance from the Fuqua
School of Business, Duke University, where he received the Hanes
Scholarship and was designated a Fuqua Scholar. Mr. Bell holds a
Bachelor of Science in Mathematics with a Minor in Industrial
Management from Carnegie Mellon University.
Craig J. Cerny 1985
Executive Vice President, Principal and Director of Smith Breeden
Associates, Inc. President of Harrington Financial Group, the
holding company for Harrington Bank, Richmond, Indiana. He also
serves as Chairman and CEO of Harrington Bank, FSB. Mr. Cerny has
made numerous presentations to financial institutions and federal
regulators regarding investments and risk management. While with
Smith Breeden, he has participated in trade and portfolio analysis
in support of the management of twenty-five mortgage security
portfolios. Previously was the Director of Financial
Planning/Analysis and Region Controller for field operations for
Pizza Hut, Inc., a division of Pepsico. Earned an MBA in Finance
with Distinction and BS in Finance, Honors Convocation from Arizona
State University.
Stephen A. Eason, C.F.A. 1988
Executive Vice President, Principal and Director of Smith Breeden
Associates, Inc. While with Smith Breeden, Mr. Eason has
participated in trade and portfolio decisions regarding the
management of twelve mortgage security portfolios. Previously,
Vice President-Institutional Sales, specializing in thrift mortgage
sales, at Salomon Brothers and Assistant Treasurer at Chase
Manhattan Bank., N.A. Earned an MBA with a concentration in
Finance, The Wharton School, a BS with highest honors in Business
Administration, University of Arkansas, and won the Wall Street
Journal Award as outstanding finance student.
Sharon E. Fankhauser 1986
Principal and Chief Financial Officer of Smith Breeden Associates,
Inc. Ms. Fankhauser handles financial reporting, budgeting, tax
research and planning for Smith Breeden Associates's four offices.
She ensures compliance with agency regulations and administers the
company's internal trading and other policies. Previously was a
Certified Public Accountant for Mayer Hoffman McCann of Kansas
City, Missouri. Earned an MBA with a concentration in Accounting
at California State University, and a BA with honors in Sociology
from Drake University. She was awarded the Elijah Watts Sells
Award for the top 100 candidates passing the Certified Public
Accountant Exam.
Lawrence E. Golaszewski 1987
Principal, Smith Breeden Associates, Inc. Mr. Golasweski provides
investment and risk management consulting services for several
institutional clients and mutual funds. He is actively involved in
the analysis, trading and hedging of complex mortgage securities.
His other special projects have included the analysis of a proposed
hedging program for two Southwest Plan thrifts, the analysis and
liquidation of a portfolio of complex mortgage securities, and the
comprehensive balance sheet analysis of a multi-billion dollar
savings bank for FDIC and OTS regional offices. Earned an MBA with
a concentration in Finance, University of Chicago and a BS in
Finance and Accounting, summa cum laude, New York State Regents
Scholar, State University of New York at Buffalo.
-26-
Gerald J. Madigan 1984
Executive Vice President, Principal and Director of Smith Breeden
Associates, Inc. President, Smith Breeden Mutual Funds 1992 to
1994. Chairman, Peoples Federal Savings Association, Richmond,
Indiana 1989 to 1992. Mr. Madigan has provided portfolio advice to
ten of Smith Breeden's financial institution clients. He oversaw
the disposition of the complex mortgage securities portfolio of
Silverado Banking. Previously employed by Touche Ross & Co. as
Senior Management Consultant, Hallmark Cards Incorporated, Arthur
Andersen & Co., Indiana University as an instructor, and Federal
Deposit Insurance Corporation. MBA, concentration in Finance, with
distinction from the Honors Program, Indiana University. BS in
Accounting with High Distinction, Indiana University. Phi Eta
Sigma, Beta Alpha Psi and Beta Gamma Sigma, Indiana University.
William F. Quinn 1986
Principal, Director of Client Services, Smith Breeden Associates,
Inc. Mr. Quinn provides investment and risk management advice to
a number of institutional clients. He specializes in the
analytical, trading, tax and accounting aspects of complex mortgage
securities and hedging instruments. He is actively involved in the
formulation and implementation of investment and risk management
policies and procedures as well as clients' strategic plans and
business plans. Earned an MS with concentrations in Finance, MIS
and System Dynamics, Sloan School of Management, M.I.T, and a BS in
Management Science from M.I.T.
Timothy D. Rowe 1988
Principal, Smith Breeden Associates. Mr. Rowe has expertise in
mortgage portfolio management, portfolio restructuring, financial
institution loan and deposit pricing, and the profitability of
branch operations. He currently advises three mortgage securities
portfolios and has advised three other mortgage security
portfolios. Previously was an Assistant Economist at the Federal
Reserve Bank of Richmond, Virginia. Earned an MBA with a
concentration in Finance, University of Chicago, a BA in Economics
and History, magna cum laude, Class Honors and National Merit
Scholar, Duke University.
John B. Sprow 1987
Portfolio Adviser for the Smith Breeden Market Tracking Fund,
Principal, Smith Breeden Associates, Inc. Mr. Sprow is the trading
coordinator for all client investments. He has been primarily
responsible for the day-to-day management of the Market Tracking
Fund since its inception in 1992. Mr. Sprow currently advises
three mortgage securities portfolios. He previously was a research
assistant at Duke University and Cornell University. Earned an MBA
with a concentration in Finance, Duke University and a BS in
Materials Science and Engineering from Cornell University where he
was awarded the Carpenter Technology Scholarship for three
consecutive years.
* * * *
As compensation for the services rendered to each of the
Series by the Adviser pursuant to the Investment Advisory
Agreement, and the assumption by the Adviser of the related
expenses, each of the Series pays the Adviser a fee, computed daily
and payable monthly, at an annual rate equal to 0.70% of each of
the Series' average daily net asset values. As part of the
advisory fee, the Adviser provides administration services to each
Series.
-27-
Transfer Agent, Custodian and Principal Underwriter
Fund/Plan Services, Inc. (the "Transfer Agent") serves each of
the Series as transfer agent, acts as each Series' dividend
disbursing agent and performs certain shareholder service
activities. Fund/Plan Services Inc.'s main office is at #2 West
Elm Street, P.O. Box 874, Conshohocken, Pennsylvania 19428-0874.
In addition, Fund/Plan Services, Inc. maintains certain records of
each of the Series pursuant to an Accounting Services Agreement.
The Bank of New York acts as the custodian of each of the
Series' assets including its portfolio securities and cash. The
Bank of New York's office is at 48 Wall Street, New York, New York,
10286.
Fund/Plan Broker Services (the "Principal Underwriter") serves
as underwriter for each of the Series. The Principal Underwriter's
offices are located at #2 West Elm Street P.O. Box 874,
Conshohocken PA, 19428-0894.
Expenses
The Short and Intermediate Series each pay all of their
respective expenses, including: the compensation of their
respective Trustees who are not affiliated with the Adviser;
governmental fees; interest charges; brokerage commissions; taxes;
membership dues in the Investment Company Institute allocable to
each Series; fees and expenses of independent auditors, tax
preparers and tax consultants, of legal counsel and of the transfer
and dividend disbursing agent and custodian; insurance premiums;
amortization of organizational expenses; expenses of calculating
the net asset value of the shares of each of the Series; and the
investment management fees paid by the Series to the Adviser. Each
of the Series also pays all expenses of issuing and redeeming
shares and servicing shareholder accounts; expenses of preparing,
printing and mailing prospectuses, reports, notices, proxy
statements and reports to shareholders and to governmental offices
and commissions; expenses of shareholder meetings; and expenses
relating to the registration and qualification of shares of each of
the Series.
The Adviser has voluntarily agreed to bear the normal
operating expenses of the Series and, if necessary, to waive the
advisory fees for the Series, for the period ending March 31, 1996
so that the total normal operating expenses would not exceed 0.78%
of the average net assets of the Short Series and .90% of the
Intermediate Series. Normal operating expenses do not include
litigation costs, indemnification or other extraordinary expenses.
Each of the Series has entered into a separate underwriting
agreement with the Principal Underwriter pursuant to which the
Principal Underwriter receives a fee of $5,000 that is paid by the
Adviser under each Series' Distributions and Services Plan
discussed below.
PURCHASE AND REDEMPTION OF SHARES
Shares of either of the Series may be purchased at net asset
value (with no sales charge) on a continuous basis. The minimum
initial investment is $1,000 and subsequent investments must be $50
or more. The Series and the Principal Underwriter reserve the
right to refuse any order for the purchase of shares.
Investments may be made by mail or wire. Direct purchase
orders received by the Transfer Agent by 4:00 p.m., Eastern time,
and accompanied by check or wire, are confirmed at that day's net
asset value. Direct purchase orders accompanied by check or wire
received by the Transfer Agent after 4:00 p.m., Eastern time are
confirmed at the net asset value determined on the following
business day.
Federal funds wires should be sent to United Missouri Bank,
KC, N.A., ABA #10-10-00695, for credit to Fund/Plan Services, Inc.
A/C 98-7037-071-9, for further credit to: Smith Breeden Short
Duration U.S. Government Series (include shareholder name and
shareholder account number) or the Smith Breeden
28-
Intermediate Duration U.S. Government Series (include shareholder name
and shareholder account number). To obtain a number for a new account,
an investor should call the Transfer Agent at (800) 221-3137 by
12:00 noon, Eastern time.
Shares of either of the Series may be purchased through
investment dealers who, as part of the services they provide, must
transmit orders promptly. They may charge for these services. The
Fund will refer shareholders to a dealer upon the shareholder's
request. Wire orders for shares of either of the Series received
by dealers prior to 4:00 p.m., Eastern time, and received by the
Transfer Agent before 7:00 p.m., Eastern time, on the same day are
confirmed at that day's net asset value. Orders received by
dealers after 4:00 p.m., Eastern time, are confirmed at the net
asset value on the following business day. It is the dealer's
obligation to place the order with the Transfer Agent before
7:00 p.m., Eastern time.
Confirmations
Shareholders will receive confirmation statements each time
there is a transaction which affects an account. The reinvestment
of dividends will be reported on regular monthly statements which
will also show the total number of shares of the Short or
Intermediate Series owned by a shareholder.
Share Certificates
Shares for an initial investment as well as subsequent
investments, including the reinvestment of dividends and capital
gain distributions, are generally credited to an account in the
name of an investor, without the issuance of a share certificate.
Maintaining shares in uncertificated form (also known as "plan
balance") minimizes the risk of loss or theft of a share
certificate. A certificate will be issued if requested in writing
by the shareholder or by his broker.
Telephone Transactions
The privilege to initiate telephone transactions by telephone
will be made available automatically to shareholders unless they
indicate they do not want the privilege by checking the appropriate
box on the Shareholder Account Application. The Fund, on behalf of
each Series, will employ reasonable procedures to ensure that
instructions communicated by telephone are genuine. These
procedures include, but are not limited to, recording telephone
instructions and requesting verification of account number,
registration, and tax identification number. In the event of a
fraudulent telephone transaction, the Fund will not be liable
unless the Fund did not employ reasonable procedures to ensure that
the instructions were genuine.
Automatic Investment Plan
The plan provides a convenient method by which an investor may
have amounts deducted directly from his or her checking account for
investment in either the Short or Intermediate Series. The minimum
initial investment is $50 per month with subsequent investments of
at least $50 each.
Purchasing Shares of the Series in Connection with Retirement Plans
Shares of either of the Series may be used in a Fund-sponsored
individual retirement account ("IRA") providing for tax-deferred
investments for individuals. Shareholders wishing to establish an
IRA account should consult their tax adviser regarding (1) their
individual qualifying status and (2) any current changes to the tax
regulations governing these accounts. A shareholder may hold
shares of a Series in an IRA sponsored by the Fund for a $12.00
annual fee. The Short or Intermediate Series also may be used as
an investment for a variety of other retirement programs.
-29-
Purchases Through Securities Dealers
Shares of the Short or Intermediate Series may be purchased
through investment dealers who, as part of the services they
provide, must transmit orders promptly. They may charge for these
services. The Fund, on behalf of each Series, will refer
shareholders to a dealer upon the shareholder's request.
Securities dealers and other firms provide varying
arrangements for their clients to purchase and redeem shares in the
Short or Intermediate Series. Some may establish higher minimum
investment requirements than set forth above. Firms may arrange
with their clients for other investment or administrative services.
Such firms may independently establish and charge additional
amounts to their clients for such services, which charges would
reduce the clients' return. Firms also may hold shares in the
Short or Intermediate Series in nominee or street name as agent for
and on behalf of their customers. In such instances, the transfer
agent for the Short and Intermediate Series will have no
information with respect to or control over accounts of specific
shareholders. Such shareholders may obtain access to their
accounts and information about their accounts only from their firm.
Certain of these firms may receive compensation from the Series'
shareholder service agent for record keeping and other expenses
relating to these nominee accounts. In addition, certain
privileges with respect to the purchase and redemption of shares or
the reinvestment of dividends may not be available through such
firms. Some firms may participate in a program allowing them
access to their clients' accounts for servicing including, without
limitation, transfers of registration and dividend payee changes;
and may perform functions such as generation of confirmation
statements and disbursement of cash dividends. This Prospectus
should be read in connection with such firms' material regarding
their fees and services.
Systematic Withdrawal Plan
A shareholder may establish a Systematic Withdrawal Plan and
receive regular periodic payments from the account. An initial
balance of $10,000 is required to establish an account under the
plan. There are no service charges for establishing or maintaining
a Systematic Withdrawal Plan. The minimum amount which the
shareholder may withdraw periodically is $100. Capital gain
distributions and income dividends to the shareholder's account are
received in additional shares at net asset value. Payments are
then made from the liquidation of shares at net asset value to meet
the specified withdrawals. Liquidation of shares may reduce or
possibly exhaust the shares in the shareholder's account, to the
extent withdrawals exceed shares earned through dividends and
distributions, particularly in the event of a market decline. No
payment pursuant to a Systematic Withdrawal Plan will be made if
there are insufficient shares on deposit on the date of the
scheduled distribution. A subsequent deposit of shares will not
result in a payment under the plan retroactive to the distribution
date. As with other redemptions, a liquidation to make a
withdrawal payment is a sale for federal income tax purposes. The
entire Systematic Withdrawal Plan payment cannot be considered as
actual yield or income since part of such a Systematic Withdrawal
Plan payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated on written
notice by the shareholder or the Fund on behalf of each Series, and
it will terminate automatically if all shares are liquidated or
withdrawn from the account, or upon the Fund's receipt of
notification of the death or incapacity of the shareholder.
Shareholders may change the amount (but not below the specified
minimums), and schedule of withdrawal payments, or suspend such
payments, by giving written notice to the Transfer Agent at least
seven business days prior to the end of the month preceding a
scheduled payment. Share certificates may not be issued while a
Systematic Withdrawal Plan is in effect.
Exchange Privilege
Shares of either of the Series may be exchanged for shares of
any other fund in the Smith Breeden Family of Funds if it is
eligible for sale in the shareholder's state of residence.
Exchanges are made on the basis of the relative net asset values.
Because the exchange is considered a redemption and purchase of
shares, the shareholder may recognize a gain or loss for federal
income tax purposes. Backup withholding and information
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reporting may also apply. Additional information regarding the
possible tax consequences of such an exchange is included under
the caption "Additional Information on Distributions and Taxation"
in the Statement of Additional Information.
There are differences among funds. Before making an exchange,
a shareholder should obtain and review a current prospectus of the
fund into which the shareholder wishes to transfer. When
exchanging shares, shareholders should be aware that the funds may
have different dividend payment dates. The dividend payment
schedules should be checked before exchanging shares. The amount
of any accumulated, but unpaid dividend is included in the net
asset value per share. Exchanges will be effected upon receipt of
written instructions signed by all account owners and accompanied
by any outstanding share certificates properly endorsed. However,
shareholders can elect to adopt the privilege to initiate
telephone exchanges from either
Series into an identically registered account in another mutual
fund in the Smith Breeden Family of Funds. The Telephone Exchange
Privilege is available only for uncertificated shares.
During periods of drastic economic or market changes, it is
possible that the Telephone Exchange Privilege may be difficult to
implement. In this event, shareholders should follow the other
exchange procedures discussed in this section, including the
procedures for processing exchanges through broker/dealers. The
Telephone Exchange Privilege may be modified or discontinued by the
Fund, on behalf of each Series, at any time upon 60 days' notice
to shareholders. Exchanges out of any single series will be
limited to four per calendar year. This limit does not include
reinvestment of dividends in a different fund.
Exchanges Through Securities Dealers.
As is the case with all purchases and redemptions of the Short
or Intermediate Series shares, the Fund will accept exchange orders
by telephone or other means of electronic transmission from
securities dealers who execute a dealer agreement with the
Principal Underwriter. Such a dealer-ordered exchange will be
effective only for uncertificated shares on deposit in the
shareholder's account or for which certificates have previously
been deposited with Fund/Plan Services. A securities dealer may
charge a fee for handling an exchange. The use of the exchange
program may be discontinued or modified by the Fund at any time
upon 60 day's written notice to shareholders.
Distribution and Services Plans
The Fund has adopted a Distribution and Services Plan (the
"Plans") for each of the Series pursuant to Rule 12b-1 under the
1940 Act. The purpose of the Plans is to permit the Adviser to
compensate investment dealers and other persons involved in
servicing shareholder accounts for services provided and expenses
incurred in promoting the sale of shares of the Short or
Intermediate Series, reducing redemptions, or otherwise maintaining
or improving services provided to shareholders by such dealers or
other persons. The Plans provide for payments by the Adviser out
of its advisory fee to dealers and other persons at the annual rate
of up to 0.25% of the average net assets of either the Short or
Intermediate Series subject to the authority of the Board of
Trustees to reduce the amount of payments permitted under the Plans
or to suspend the Plans for such periods as they may determine.
Subject to these limitations, the amount of such payments and the
purposes for which they are made shall be determined by the
Adviser. (Pursuant to the terms of the Plans, the Adviser
currently pays the Principal Underwriter $5,000 per annum for each
of the Series as compensation for its distribution and servicing
activities.)
Any distribution and servicing related payments made by the
Adviser to investment dealers or other persons under a Plan is
subject to the continuation of such Plans, the terms of any related
service agreements, and any applicable limits imposed by the
National Association of Securities Dealers, Inc.
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How to Sell Shares
If a shareholder has not elected the privilege to initiate
transactions by telephone, a shareholder may liquidate shares owned
at any time and receive from the Fund, on behalf of each Series,
the value of the shares redeemed by forwarding a written request
signed by all registered owners to Fund/Plan Services, Inc., P. O.
Box 874, #2 West Elm Street, Conshohocken, Pennsylvania 19428-
0874. The shareholder will then receive the value of the shares
based upon the net asset value per share of the respective Series
next computed after the written request in proper form is received
by Fund/Plan Services, Inc. less the redemption fee, if any.
Redemption requests received after the time at which the net asset
value is calculated each day (as described herein) will receive the
price calculated on the following business day. In order to be in
proper form, the shareholder's written request must be accompanied
by share certificates which have been issued, if any, properly
endorsed and in order for transfer.
To be considered in proper form, signature(s) must be
guaranteed if the redemption request involves any of the following:
(1) the proceeds of the redemption are over $25,000;
(2) the proceeds (in any amount) are to be paid to
someone other than the registered owner(s) of
the account;
(3) the proceeds (in any amount) are to be sent to
any address other than the shareholder's
address of record, pre-authorized bank account
or brokerage firm account; or
(4) share certificates, if the redemption proceeds
are in excess of $25,000.
A shareholder will be charged $9 for redemptions by wire.
Signatures must be guaranteed by an "eligible guarantor
institution" as defined in Rule 17Ad-15 under the Securities
Exchange Act of 1934. Eligible guarantor institutions include
banks, brokers, dealers, credit unions, national securities
exchanges, registered securities associations, clearing agencies
and savings associations. A broker-dealer guaranteeing signatures
must be a member of a clearing corporation or maintain net capital
of at least $100,000. Credit unions must be authorized to issue
signature guarantees. Signature guarantees will be accepted from
any eligible guarantor institution which participates in a
signature guarantee program. A notarized signature will not be
sufficient for the request to be in proper form.
The signature guarantee of a redemption may be waived for
certain broker-dealers, institutions, or service organizations
which have been previously approved by the Fund.
Where shares to be redeemed are represented by share
certificates, the request for redemption must be accompanied by the
share certificate and a share assignment form signed by the
registered shareholders exactly as the account is registered, with
the signature(s) guaranteed as referenced above. Shareholders are
advised, for their own protection, to send the share certificate
and assignment form in separate envelopes if they are being mailed
in for redemption.
Liquidation requests of corporate, partnership, trust and
custodianship accounts, accounts under court jurisdiction and
retirement plan accounts may require additional documentation to be
in proper form.
The redemption price is the net asset value per share next
determined after receipt of the redemption request in the
proper form described above, less the redemption fee, if any;
however, wire redemption requests
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received by dealers prior to 4:00 p.m., Eastern time, and received
by the Transfer Agent before 7:00 p.m., Eastern time, on the same
day are confirmed at that day's net asset value per share.
Payment for redeemed shares will be sent to the shareholder
within seven days after receipt of the request in proper form,
except that the Fund may delay the mailing of the redemption check,
or a portion thereof, until the Fund's depository bank has made
fully available for withdrawal the check used to purchase Fund
shares, which may take up to 15 days or more. Although the use of
a certified or cashier's check will generally reduce this delay,
shares purchased with these checks will also be held pending
clearance. Shares purchased by federal funds wire are available
for immediate redemption. In addition, the right of redemption may
be suspended or the date of payment postponed if the New York Stock
Exchange is closed (other than customary closing) or upon the
determination of the SEC that trading on the New York Stock
Exchange is restricted or an emergency exists, or if the SEC
permits it, by order, for the protection of shareholders. Of
course, the amount received may be more or less than the amount
invested by the shareholder, depending on fluctuations in the
market value of securities owned by either Series.
In order to reduce its expenses, the Fund, on behalf of the
Short or Intermediate Series may, from time to time (not more than
semi-annually) upon the authorization of the Board of Trustees,
redeem at its option the shares of any shareholder whose account
has been in existence for at least 12 months and whose account
contains, due to redemptions, less than a minimum amount to be
determined by the Board of Trustees (but not to exceed $1,000). In
the event it is determined that such a redemption should be made by
the Series, at least two months' written notice of the Series'
intention to redeem will be given, during which period the
shareholder can increase the value of its account to the minimum
amount, thereby avoiding the redemption of its account.
Selling Shares Through Securities Dealers
Shares of a Series may also be sold by contacting your
securities dealer or investment firm (by telephone or in writing).
Securities dealers and investment firms that have entered into a
selling group agreement with the Principal Underwriter can effect
redemptions on the shareholder's behalf by telephone or other
expedited means at the net asset value next calculated after
receiving the shareholder's request in proper form. The securities
dealer or investment firm is responsible for prompt transmission of
redemption request to the Transfer Agent, and may charge a fee for
handling such requests.
Shareholder Inquiries
Any questions or communications regarding a shareholder's
account should be directed to Fund/Plan Services, Inc., #2 West Elm
Street, P. O. Box 874, Conshohocken, Pennsylvania 19428-0874, or
by calling 1-800-221-3137, Monday through Friday, from 9 a.m. to 7
p.m., Eastern time.
DIVIDENDS, DISTRIBUTIONS AND TAXES
Distributions to Shareholders
Each Series intends to make monthly distributions to its
shareholders of net investment income. Each Series reserves the
right to include net short-term gains, if any, in such monthly
distributions.
The amount of income dividend payments by a Series is
dependent upon the amount of net investment income received by the
Series from its portfolio securties, is not guaranteed and is
subject to the discretion of the Board of Trustees. Thus, the
amount of dividends paid likely will vary month to month. Monthly
notices will be provided in accordance with Section 19(a) of the
1940 Act.
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The Short Series' shares are quoted ex-dividend on the
business day after the record date. Shareholders may request to
have their dividends paid out monthly in cash with a dividend
payment date generally one week after record date.
The Intermediate Series will declare daily dividends. Shares
begin accruing dividends on the business day after federal funds
(funds credited to a member bank's account at the Federal Reserve
Bank) are available from the purchase payment for such shares and
continue to accrue dividends through, and including, the day the
redemption order for the shares is executed. Net realized capital
gains ( including short-term capital gains), if any, will be
declared and distributed by the Intermediate Series at least
annually. Reinvested distributions are payable in the form of
additional shares of the Intermediate Series which are valued at
the net asset value per share at the close of business on the
payment date. If an investor closes his account, any accrued
dividends through, and including, the day of redemption will be
paid as part of the redemption proceeds.
Long-term capital gains and previously undistributed net
short-term gains, if any, will be distributed at least once
annually. "Net investment income," as used above, includes all
dividends, interest and other income earned by a Series, net of a
Series' expenses and is the income from which income dividends may
be distributed. The Short and Intermediate Series will each send
written notices to shareholders regarding the tax status of all
distributions made during each calendar year.
In order to be entitled to a dividend or a distribution, an
investor must acquire a Series' shares on or before the record
date. Caution should be exercised, however, before purchasing
shares immediately prior to a distribution record date. Because
the value of the Series' shares is based directly on the amount of
its net assets, rather than on the principle of supply and demand,
any distribution of income or capital gain will result in a
decrease in the value of its shares equal to the amount of the
distribution. While a dividend or capital gain distribution
received shortly after purchasing shares represents, in effect, a
return of the shareholder's investment, it may be taxable as
dividend income or capital gain.
Tax Matters
The following discussion reflects some of the provisions of
the tax considerations that affect mutual funds and their
shareholders.
Taxation of the Series. Each Series intends to qualify as a
regulated investment company under Subchapter M of the Internal
Revenue Code of 1986, as amended, (the "Code"), so that by
distributing substantially all of its net investment income and any
net realized short-term and long-term capital gains for a taxable
year, a Series will not be liable for federal income or excise
taxes. Because the Short Series' current policy is to declare
distributions monthly on the record date and to pay cash dividends
generally one week after the record date, the Series may be subject
to a 4% excise tax during a calendar year to the extent that the
actual amount distributed during that year falls short of the
amount required to be distributed in order to avoid the excise tax.
Under present law, the Series will not be subject to any
excise or income taxes in Massachusetts as long as they qualify as
regulated investment companies under the Code.
Taxation of Shareholders. For federal income tax purposes,
any income dividends received from the Short or Intermediate
Series, as well as any distributions derived from the excess of net
short-term capital gain over net long-term capital loss, are
treated as ordinary income whether received in cash or in
additional shares. Distributions derived from the excess of net
long-term capital gain over net short-term capital loss are treated
as long-term capital gain regardless of the length of time a
shareholder may have owned a Series' shares and regardless of
whether distributions were received in cash or in additional
shares. It is not expected that any of the distributions to be
paid by the Short or Intermediate Series will qualify either for
the corporate dividends-received deduction or tax-exempt interest
income. The Short and Intermediate Series will inform shareholders
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of the source of dividends and distributions at the time they are
paid and will promptly after the close of each calendar year advise
shareholders of the status for federal income tax purposes of such
dividends and distributions.
Distributions also may be subject to state and local taxes
depending on each shareholder's tax situation. While many states
grant tax-free status to dividends paid to shareholders of mutual
funds from interest income earned from direct obligations of the
U.S. Government, none of the distributions of the Short or
Intermediate Series generally are expected to qualify for such tax-
free treatment. Investments in mortgage-backed securities
(including GNMA, FNMA and FHLMC securities) and repurchase
agreements collateralized by U.S. Government securities do not
qualify as direct federal obligations in most states. Shareholders
should consult their tax advisers with respect to the applicability
of state and local income taxes to distributions and redemption
proceeds received from a Series.
Shareholders who are not U.S. persons for purposes of federal
income taxation should consult with their financial or tax advisers
regarding the applicability of U.S. withholding taxes to
distributions received by them from the Series. Such distributions
generally will be subject to U.S. withholding tax.
The Short or Intermediate Series may be required to report to
the Internal Revenue Service ("IRS") any taxable dividend or other
reportable payment (including share redemption proceeds) and
withhold the required tax on any such payments made to individuals
and other non-exempt shareholders who have not provided a correct
taxpayer identification number and made certain required
certifications that appear in the Shareholder Application. A
shareholder may also be subject to backup withholding if the IRS or
a broker notifies the Short or Intermediate Series that the number
furnished by the shareholder is incorrect or that the shareholder
is subject to backup withholding for previous under reporting of
interest or dividend income.
The foregoing discussion is a general summary of certain of
the current federal income tax laws regarding the two Series and
investment in their shares. The discussion does not purport to
deal with all of the federal income tax consequences applicable to
an investment in either the Short or Intermediate Series, or to all
categories of investors, some of which may be subject to special
rules. Investors should consult their own tax advisors regarding
the tax consequences to them of investments in shares in either
Series.
VALUATION OF FUND SHARES
The net asset values per share of the Short and Intermediate
Series are determined as of the close of trading (currently 4:00
p.m., Eastern time) each day that the Adviser and Transfer Agent
are open for business and on which there is a sufficient degree of
trading in their securities that the net asset value of each
Series' shares might be affected. As of the date of this
Prospectus, current holiday schedules indicate that the net asset
value will not be calculated on the day after New Year's Day,
Presidents' Day, Martin Luther King Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Columbus Day, Veteran's Day,
Thanksgiving Day, the day following Thanksgiving, Christmas Eve,
and Christmas Day.
The net asset value per share of each of the Series is
determined in the following manner. The aggregate of all
liabilities, including accrued expenses and taxes and any necessary
reserves, are deducted from the aggregate gross value of all
assets, and the difference is divided by the number of shares of
the Series outstanding at the time. For the purposes of
determining the aggregate net assets of the Short or Intermediate
Series, cash and receivables will be valued at their realizable
amounts. Interest will be recorded as accrued. Under procedures
approved by the Board of Trustees, a Series' securities are valued
at current market value provided by a pricing service, bank or
broker/dealer experienced in such matters, when over-the-counter
market quotations are readily available. Securities and other
assets for which market prices are not readily available are valued
at fair market value as determined following procedures approved by
the Board of Trustees.
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PERFORMANCE
Advertisements, sales literature and communications to
shareholders may contain various measures of the Short or
Intermediate Series' performance including current yield, various
expressions of total return and current distribution rate. They
may occasionally cite statistics to reflect the Short or
Intermediate Series' volatility or risk.
Average annual total return figures, as prescribed by the SEC,
represent the average annual percentage change in the value of
$1,000 for one, five and ten year periods, or portion thereof, to
the extent applicable, through the end of the most recent calendar
quarter, assuming reinvestment of all distributions. The Fund may
also furnish total return quotations for other periods, based on
investments at net asset value. For such purposes total return
equals the total of all income and capital gain paid to
shareholders, assuming reinvestment of all distributions, plus (or
minus) the change in the value of the original investment,
expressed as a percentage of the purchase price.
Current yield reflects the income per share earned by the
Short or Intermediate Series' portfolio investments; it is
calculated by dividing a Series' net investment income per share
during a recent 30-day period by a Series' net asset value on the
last day of that period and annualizing the result.
Yield, which is calculated according to a formula prescribed
by the SEC (see the Statement of Additional Information), is not
indicative of the dividends or distributions which were or will be
paid to a Series' shareholders. Dividends or distributions paid to
shareholders are reflected in the current distribution rate which
may be quoted to shareholders.
In each case performance figures normally are based upon past
performance and reflect all recurring charges against the Short or
Intermediate Series' income; if, at any time, gross returns are
compared to gross returns of other portfolios, specific disclosure
to that respect will be made. The investment results of the Short
and Intermediate Series, like all others, will fluctuate over time;
thus, performance figures should not be considered to represent
what an investment may earn in the future or what a Series' yield,
distribution rate or total return may be in any future period.
REPORTS TO DEPOSITORY INSTITUTIONS
Upon a shareholder's written notification to the Adviser that
it is a depository institution, the Adviser will deliver to the
shareholder monthly and quarterly reports which analyze the Short
or Intermediate Series' investments according to regulatory risk-
based asset categories. Due to regulatory requirements applicable
to each depository financial institution, each such shareholder
should consult with legal counsel regarding its investment in the
Short or Intermediate Series.
<PAGE>
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APPENDIX A
Hedging Transactions
Mortgage Swaps, Interest Rate Swaps, Caps, Floors and Collars
Interest rate swaps involve the exchange by a Series with
another party of their respective commitments to pay or receive
interest, for example, an exchange of floating rate payments for
fixed rate payments. Mortgage swaps are similar to interest rate
swaps in that they represent commitments to pay and receive
interest. The notional principal amount, however, is tied to a
reference pool or pools of mortgages. The purchase of an interest
rate cap entitles the purchaser, to the extent that a specified
index exceeds a predetermined interest rate, to receive payments of
interest on a notional principal amount from the party selling such
interest rate cap. The purchase of an interest rate floor entitles
the purchaser, to the extent that a specified index falls below a
predetermined interest rate, to receive payments of interest on a
notional principal amount from the party selling such interest rate
floor. An interest rate collar combines the elements of purchasing
a cap and selling a floor. The collar protects against an interest
rate rise above the maximum amount but gives up the benefits of an
interest rate decline below the minimum amount.
The Short or Intermediate Series will enter into interest
rate swaps only on a net basis, i.e., the two payment streams are
netted out, with a Series receiving or paying, as the case may be,
only the net amount of the two payments. Inasmuch as these hedging
transactions are entered into for good faith hedging purposes, the
Adviser and the Series believe such obligations do not constitute
senior securities and, accordingly, will not treat them as being
subject to its borrowing restrictions. The net amount of the
excess, if any, of a Series' obligations over its entitlement with
respect to each interest rate swap will be accrued on a daily basis
and an amount of cash or liquid debt securities having an aggregate
net asset value at least equal to the accrued excess will be
maintained in a segregated account by a custodian that satisfies
the requirements of the 1940 Act. A Series will not write
interest rate caps, floors and collars and will not enter into any
interest rate swap, cap, floor or collar transaction unless the
unsecured commercial paper, unsecured senior debt or the claims-
paying ability of the other party thereto is rated either AA or A-1
or better by Standard & Poor's Corporation or Aa or P-1 or better
by Moody's Investors Service, Inc., at the time of entering into
such transaction. If there is a default by the other party to such
a transaction, a Series will have contractual remedies pursuant to
the agreements related to the transaction. There is no assurance
that interest-rate swap, cap, floor or collar counterparties will
be able to meet their obligations pursuant to their contracts, or
that, in the event of default, a Series will succeed in pursuing
contractual remedies. The Short or Intermediate Series thus
assumes the risk that it may be delayed in or prevented from
obtaining payments owed to it pursuant to interest rate swaps,
caps, floors or collars. The swap market has grown substantially
in recent years with a large number of banks and investment banking
firms acting both as principals and as agents utilizing
standardized swap documentation. As a result, the swap market has
become relatively liquid, although the Short and Intermediate
Series still treat swaps as illiquid investments subject to the
limitation on such investments described in the Prospectus as
"Illiquid Securities". Caps, floors and collars are more recent
innovations for which standardized documentation has not yet been
developed and, accordingly, they are less liquid than swaps. Caps,
floors and collars are accordingly also considered to be illiquid
investments subject to the same limitation.
There can be no assurance that the Short or Intermediate
Series will be able to enter into interest rate swaps, caps,
floors or collars on favorable terms. Furthermore, there can be no
assurance that either Series will be able to terminate an interest
rate swap or sell or offset interest rate caps, floors or collars
notwithstanding any terms in the agreements providing for such
termination.
Hedging and risk management techniques require different
skills from those involved in the selection of portfolio
securities. One such skill is the ability to predict the
correlation of interest rate changes between markets. The Adviser
has been engaged in hedging target duration portfolios for more
than ten years. There can be no assurance that the Adviser will
accurately predict market movements which accompany interest rate
-37-
changes, in which event a Series' overall performance may be less
than if it had not entered into hedging transactions.
Short Sales
A Series may make short sales of securities. A short sale is
a transaction in which a Series sells a security it does not own in
anticipation that the market price of that security will decline.
A Series expects to make short sales both as a form of hedging to
shorten the overall duration of the portfolio and in order to
maintain portfolio flexibility.
When the Short or Intermediate Series makes a short sale, it
may have to 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 Series may have to pay a fee to borrow particular
securities and is often obligated to pay over any payments received
on such borrowed securities.
Until the Short or Intermediate Series owns the security which
it sold short or replaces a borrowed security, it will maintain
daily a segregated account with an institution (other than a
broker) containing cash, U.S. Government securities or other liquid
high-grade debt securities, at such a level that (i) the amount
deposited in the account plus any cash, U.S. Government securities
or other liquid high-grade debt securities deposited with the
broker as collateral will equal the current value of the security
sold short and (ii) the amount deposited in the segregated account
plus the amount deposited with the broker as collateral will not be
less than the market value of the security at the time it was sold
short. Depending on arrangements made with the broker-dealer from
which it borrowed the security regarding payment over of any
payments received by a Series on such security, a Series may not
receive any payments (including interest) on its collateral
deposited with such broker-dealer.
If the price of the security sold short increases between the
time of the short sale and the time a Series replaces the borrowed
security, the Series will incur a loss; conversely, if the price
declines, the Portfolio will realize a capital gain. Although a
Series' gain is limited to the price at which it sold the security
short, its potential loss is limited only by the maximum attainable
price of the security less the price at which the security was
sold. Unless market interest rates become negative, for a fixed
income security this maximum attainable price is equal to the
undiscounted sum of the largest possible payments of principal and
interest.
The Short or Intermediate Series will not make a short sale
if, after giving effect to such sale, the market value of all
securities sold short exceeds 25% of the value of its net assets or
the aggregate short sales of a particular class of securities
exceeds 25% of the outstanding securities of that class. A Series
may also make short sales "against the box" without respect to such
limitations. In this type of short sale, at the time of the sale,
the Short or Intermediate Series would own or has the immediate and
unconditional right to acquire at no additional cost the identical
security.
Calls and Puts on Securities; Futures and Related Options
In order to reduce fluctuations in net asset value relative to
its targeted option-adjusted duration, the Short or Intermediate
Series may purchase call or put options (or sell options which it
owns) on United States Treasury securities, Mortgage-Backed
Securities and Eurodollar instruments that are traded on United
States and foreign-securities exchanges and in over-the-counter
markets ("OTC Options"). A Series will not sell options which it
does not own. Some contracts are "cash settled" (i.e., the seller
pays the difference between the call and market price in cash when
the market price is higher).
The Short and Intermediate Series will not purchase a put or call
option on U.S. Government securities or Mortgage-Backed Securities if,
as a result of such purchase, more than 10% of its total assets would be
-38-
invested in such options. The Short or Intermediate Series' ability
to purchase put and call options may be limited by the Code's
requirements for qualification as a regulated investment company.
The Adviser monitors the creditworthiness of dealers with whom
a Series would enter into OTC option transactions under the general
supervision of the Board of Trustees. The Short and Intermediate
Series will engage in OTC option transactions only with primary
United States government securities dealers recognized by the
Federal Reserve Bank of New York.
The general characteristics and risks of calls and puts on
securities and futures are described below.
In order to reduce fluctuations in net asset value relative to
its targeted option-adjusted duration or to employ temporary
substitutes for anticipated future transactions, the Short or
Intermediate Series may buy or sell financial futures contracts or
purchase options (or sell options which it owns) on such futures.
A Series' use of futures and options on futures contracts will
in all cases be consistent with applicable regulatory requirements
and in particular the rules and regulations of the Commodity
Futures Trading Commission with which a Series must comply in
order not to be deemed a commodity pool operator within the meaning
and intent of the Commodity Exchange Act and the regulations
promulgated thereunder. As a practical matter, these regulations
are not expected to impose substantive limits.
Options and futures transactions involve costs and may result
in losses. The loss from investing in futures is potentially
unlimited. The effective use of options and futures strategies
depends on the Short or Intermediate Series' ability to terminate
options and futures positions at times when the Advisor deems it
desirable to do so. This ability to terminate positions when the
Adviser deems it desirable to do so may be hindered by the lack of
the existence of a liquid secondary market. Although the Fund will
take an option or futures contract position only if the Adviser
believes there is a liquid secondary market for the option or
futures contract, there is no assurance that the Fund will be able
to effect closing transactions at any particular time or acceptable
price.
The use of options and futures strategies also involves the
risk of imperfect correlation among movements in the values of the
securities underlying the futures and options purchased and sold by
a Series, of the option and futures contract itself, and of the
securities which are the subject of a hedge. A Series therefore
bears the risk that prices of hedged securities will not move to
the same degree as the hedging instrument or that price movements
in the hedging instrument will not accurately reflect price
movements in the security underlying the hedging instrument. It is
also possible that there may be a negative correlation between the
securities underlying the hedging instrument and the hedged
securities, which would result in a loss on both the hedged
securities and the hedging instrument.
At times, a Series may sell interest rate futures in a
different dollar amount than the dollar amount of securities being
hedged depending on the expected relationship between the
volatility of the prices of such securities and the volatility of
the futures contracts, based on duration calculations by the
Adviser. If the actual price movements of the securities and
futures are inconsistent with their durations as so calculated, the
hedge may not be fully effective.
A Series will not maintain open short positions in interest
rate futures contracts if, in the aggregate, the value of the open
positions (marked to market) exceeds the current market value of
its securities portfolio plus or minus the unrealized gain or loss
on those open positions, adjusted for the expected volatility
relationship between the portfolio and the futures contracts based
on duration calculations. If this limitation should be exceeded at
any time, a Series will take prompt action to close out the
appropriate number of open contracts to bring its open futures
position into compliance with this limitation.
-39-
The Short or Intermediate Series' ability to engage in options
and futures transactions and to sell related securities may be
limited by tax considerations and by certain regulatory
requirements. See "Additional Information Regarding Taxation" in
the Statement of Additional Information.
-40-
SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ADDITIONAL INFORMATION
AUGUST 1, 1995
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
Smith Breeden Series Fund (the "Fund") is a no-load open-end
management investment company offering redeemable shares of
beneficial interest in two separate series, the Smith Breeden
Short Duration U.S. Government Series (the "Short Series") and
the Smith Breeden Intermediate Duration U.S. Government Series (
the "Intermediate Series").
Each Series generally operates as a separate fund with its
own investment objectives and policies to meet its specific
investment goals.
A Prospectus for the Short and Intermediate Series, dated
August 1, 1995, as may be amended from time to time, provides the
basic information an investor should know before investing in the
Short or Intermediate Series and may be obtained without charge
from the Fund at the address listed above or from Fund/Plan
Broker Services, Inc., #2 West Elm Street, P.O. Box 874,
Conshohocken, Pennsylvania 19428-0874.
This Statement of Additional Information is not a
prospectus. It contains information in addition to and in more
detail than set forth in the Prospectus. This Statement is
intended to provide investors with additional information
regarding the activities and operations of the Short and
Intermediate Series, and should be read in conjunction with the
Series' Prospectus.
Contents Page
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS . . . . . 2
INVESTMENT RESTRICTIONS. . . . . . . . . . . . . . . . . . . . . . . 4
TRUSTEES AND OFFICERS. . . . . . . . . . . . . . . . . . . . . . . . 6
INVESTMENT ADVISORY AND OTHER SERVICES . . . . . . . . . . . . . . . 7
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS . . . . . . 8
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS. . . . . . 9
ADDITIONAL INFORMATION REGARDING PURCHASES AND REDEMPTIONS
OF FUND SHARES. . . . . . . . . . . . . . . . . . . . . . . . . . 10
ADDITIONAL INFORMATION REGARDING TAXATION. . . . . . . . . . . . . . 11
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . . . . . . . . . . 14
ADDITIONAL INFORMATION FOR INSTITUTIONAL
INVESTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
EXPERTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . 17
APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
-1-
<PAGE>
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS
Investment Policies
The following supplements the information contained in the
Prospectus about the investment policies of the Short and
Intermediate Series are invested. Terms used herein have the
same meanings as in the Prospectus.
General Characteristics and Risks of Options and Futures
Options
A put option gives the purchaser of the option the right to
sell and the writer the obligation, if the purchaser exercises
his right, to buy the underlying security at the exercise price
during the option period. A call option gives the purchaser of
the option the right to buy and the writer the obligation, if the
purchaser exercises his right, to sell the underlying security at
the exercise price during the option period. Listed options are
issued by the Options Clearing Corporation ("OCC") which
guarantees the performance of the obligations of the parties to
such options.
The purchaser of an option risks losing his entire
investment in a short period of time. If an option is not sold
while it has remaining value, or if during the life of an option
the underlying interest does not appreciate, in the case of a
call option, or depreciate, in the case of a put option, the
purchaser of such option may lose his entire investment. On the
other hand, given the same market conditions, if the potential
purchaser of a call option purchases the underlying interest
directly without purchasing a call option or if the potential
purchaser of a put option decides not to purchase the put option,
such potential purchaser might have less of a loss. An option
purchaser does not have the choice of "waiting out" an unexpected
decrease or increase in the underlying instrument's price beyond
the expiration date of the option. The more that an option is
out-of-the-money and the shorter its remaining term to
expiration, the greater the risk that a purchaser of the option
will lose all or part of his investment. Further, except where
the value of the remaining life of an option may be realized in
the secondary market, for an option purchase to be profitable the
market price of the underlying interest must exceed or, as
applicable, be below the exercise price by more than the premium
and transaction costs paid in connection with the purchase of the
option and its sale or exercise.
A Series' ability to close out its position as a purchaser
of an exchange-listed option is dependent upon the existence of a
liquid secondary market on option exchanges. Among the possible
reasons for the absence of a liquid secondary market on an
exchange are (i) insufficient trading interest in certain
options; (ii) restrictions on transactions imposed by an
exchange; (iii) trading halts, suspensions or other restrictions
imposed with respect to particular classes or series of options
or underlying securities; (iv) interruption of the normal
operations on an exchange; (v) inadequacy of the facilities of an
exchange or the OCC to handle current trading volume, or (vi) a
decision by one or more exchanges to discontinue the trading of
options (or a particular class or series of options), in which
event the secondary market on that exchange (or in that class or
series of options) would cease to exist, although outstanding
options on that exchange that had been listed by the OCC as a
result of trades on that exchange would generally continue to be
exercisable in accordance with their terms. OTC Options are
purchased from or sold to dealers or financial institutions which
have entered into direct agreement a Series. With OTC Options,
such variables as expiration date, exercise price and premium
will be agreed upon between the Series and the transacting
dealer, without the intermediation of a third party such as the
OCC. If the transacting dealer fails to make or take delivery of
the securities underlying an option it has written, in accordance
with the terms of that option as written, a Series would lose the
premium paid for the option as well as any anticipated benefit of
the transaction. OTC Options and their underlying securities are
considered illiquid. A Series will engage in OTC Option transactions
only with primary United States government securities dealers
recognized by the Federal Reserve Bank of New York.
-2-
The Adviser monitors the creditworthiness of dealers with
whom the a Series enters into OTC options transactions under the
general supervision of the Fund's Board of Trustees.
The hours of trading for options on debt securities may not
conform to the hours during which the underlying securities are
traded. To the extent that the option markets close before the
markets for the underlying securities, significant price and rate
movements can take place in the underlying markets that cannot be
reflected in the option markets.
Futures Contracts and Related Options
As a purchaser of an interest rate futures contract, a
Series incurs an obligation to take delivery of a specified
amount of the obligation underlying the futures contract at a
specified time in the future for a specified price or, in "cash
settlement" futures contracts, to pay to (or receive from) the
seller in cash the difference between the original price in the
futures contract and the market price of the instrument on the
specified date, if the market price is lower (or higher, as the
case may be). A futures contract sale creates an obligation by a
Series, as seller, to deliver the specified type of financial
instrument called for in the contract at a specified future time
for a specified price or, in "cash settlement" futures contracts,
to pay to (or receive from) the buyer in cash the difference
between the original price in the futures contract and the market
price of the instrument on the specified date, if the market
price is higher (or lower, as the case may be). Options on
futures contracts are similar to options on securities except
that an option on a futures contract gives the purchaser the
right in return for the premium paid to assume a position in a
futures contract (a long position if the option is a call and
short position if the option is a put).
Although most futures contracts call for actual delivery or
acceptance of securities, the contracts usually are closed out
before the settlement date without the making or taking of
delivery. A futures contract sale is closed out by effecting a
futures contract purchase for the same aggregate amount of the
specific type of security and the same delivery date. If the
sale price exceeds the offsetting purchase price, the seller
would be paid the difference and would realize a gain. If the
offsetting purchase price exceeds the sale price, the seller
would pay the difference and would realize a loss. Similarly, a
futures contract purchase is closed out by effecting a futures
contract sale for the same aggregate amount of the specific type
of security and the same delivery date. If the offsetting sale
price exceeds the purchase price, the purchaser would realize a
gain, whereas if the purchase price exceeds the offsetting sale
price, the purchaser would realize a loss. There is no assurance
that the Short or Intermediate Series will be able to enter into
a closing transaction.
Initial margin in futures transactions is different from
margin in securities transactions in that initial margin does not
involve the borrowing of funds by a broker's client but is,
rather, a good faith deposit on the futures contract which will
be returned to the Short or Intermediate Series upon the proper
termination of the futures contract. The margin deposits made
are marked to market daily and a Series may be required to make
subsequent deposits into the segregated account, maintained at
its Custodian for that purpose, or cash, U.S. Government
securities or other liquid high-grade debt securities, called
"variation margin", in the name of the broker, which are
reflective of price fluctuations in the futures contract.
Currently, interest rate futures contracts can be purchased on
debt securities such as U.S. Treasury Bills and Bonds, Eurodollar
instruments, U.S. Treasury Notes and GNMA Certificates.
Exchanges limit the amount by which the price of a futures
contract may move on any day. If the price moves equal the daily
limit on successive days, then it may prove impossible to
liquidate a futures position until the daily limit moves have
ceased. In the event of adverse price movements, a Series would
continue to be required to make daily cash payments of variation
margin on open futures positions. In such situations, if a
Series has insufficient cash, it may be disadvantageous to do so.
In addition, a Series may be required to take or make delivery of
the instruments underlying interest rate futures contracts it
holds at a time when it is disadvantageous to do so. An
inability to close out options and futures positions could also
have an adverse impact on a Series' ability to effectively hedge
its portfolio.
-3-
In the event of the bankruptcy of a broker through which the
Short or Intermediate Series engages in transactions in futures
or options, either Series could experience delays and/or losses
in liquidating open positions purchased or sold through the
broker and/or incur a loss of all or part of its margin deposits
with the broker. Transactions are entered into by a Series only
with broker or financial institutions deemed creditworthy by the
Adviser.
The variable degree of correlation between price movements
of futures contracts and price movements in the position being
hedged creates the possibility that losses on the hedge may be
greater than gains in the value of the Short or Intermediate
Series' futures position. In addition, futures and futures
option markets may not be liquid in all circumstances. As a
result, in volatile markets, a Series may not be able to close
out a transaction without incurring losses substantially greater
than the initial deposit. Although the contemplated use of these
contracts should tend to minimize the risk of loss due to a
decline in the value of the hedged position, at the same time
they tend to limit any potential gain which might result from an
increase in the value of such position. The ability of the Short
or Intermediate Series to hedge successfully will depend on the
Adviser's ability to forecast pertinent market movements, which
cannot be assured. In order to achieve its investment objective,
the a Series may sell interest rate futures in a different
dollar amount than the dollar amount of securities being hedged
depending on the expected relationship between the volatility of
the prices of such securities and the volatility of the futures
contracts, based on duration calculations by the Adviser. If the
actual price movements of the securities and futures are
inconsistent with their durations as so calculated, the hedge may
not be fully effective.
The Short and Intermediate Series will not maintain open
short positions in interest rate futures contracts if, in the
aggregate, the value of the open positions (marked to market)
exceeds the current market value of its securities portfolio plus
or minus the unrealized gain or loss on those open positions,
adjusted for the expected volatility relationship between the
Series and the futures contracts based on duration calculations.
If this limitation should be exceeded at any time, the Short or
Intermediate Series will take prompt action to close out the
appropriate number of open contracts to bring its open futures
position into compliance with this limitation. For open long
positions in interest rate futures, the Short or Intermediate
Series will maintain a segregated account of cash, U.S.
Government securities or other high-grade debt securities equal
in value to the market value of the long futures contract which
will be marked to market daily.
Finally, the daily deposit requirements in futures contracts
create an ongoing greater potential financial risk than do
options transactions, where the exposure is limited to the cost
of the initial premium. Losses due to hedging transactions may
reduce net asset value. Income earned by the Short or
Intermediate Series from its hedging activities generally will be
treated as capital gains.
INVESTMENT RESTRICTIONS
The following restrictions (except as noted) have been
adopted as fundamental policies for both the Short and
Intermediate Series, which means that they may not be changed
without the approval of a majority of the outstanding shares of
each of the Series, as the case may be (as defined in the
Investment Company Act). A Series may not (except that none of
the following investment restrictions shall prevent a Series from
investing all of its assets (other than assets which are not
"investment securities" as defined in the Investment Company Act)
in an open-end investment company with substantially the same
investment objectives):
1. Issue senior securities, borrow money or pledge its
assets, except that the Short or Intermediate Series may borrow
from banks or through reverse repurchase agreements or dollar
rolls up to 33 1/3% of the value of its respective total assets
(calculated when the loan is made) for temporary, extraordinary
or emergency purposes and to take advantage of investment
opportunities and may pledge up to 33 1/3% of the value of its
total assets to secure such borrowings. For purposes of this
restriction, the purchase or sale of securities on a "when-
issued" or delayed delivery basis, the purchase and sale of
futures contracts, the entry into reverse repurchase agreements
and dollar roll transactions, short sales, interest rate
swaps, mortgage swaps, over-the-counter options, and collateral
arrangements with respect thereto are not
-4-
deemed to be a pledge of assets and none of such transactions or
arrangements nor obligations of a Series to Trustees pursuant to
deferred compensation arrangements are deemed to be the issuance
of a senior security.
2. Act as underwriter except to the extent that, in
connection with the disposition of portfolio securities, it may
be deemed to be an underwriter under certain federal securities
laws.
3. Purchase any security (other than obligations of the
U.S. Government, its agencies and instrumentalities) if as a
result: (i) with respect to 75% of its total assets, more than 5%
of the Short or Intermediate Series' total assets (determined at
the time of investment) would then be invested in securities of a
single issuer, or (ii) 25% or more of a Series' total assets
(determined at the time of investment) would be invested in one
or more issuers having their principal business activities in the
same industry.
4. Purchase the securities of any issuer which would
result in owning more than 10% of any class of the outstanding
voting securities of such issuer.
5. Purchase any security, other than Mortgage-Backed
Securities, or obligations of the U.S. Government, its agencies
or instrumentalities, if as a result the Short or Intermediate
Series would have invested more than 5% of its respective total
assets in securities of issuers (including predecessors) having a
record of less than three years of continuous operation; except
for investments in regulated investment companies with the same
objective.
6. Acquire, lease or hold real estate. (Does not preclude
investments in securities collateralized by real estate or
interests therein.)
7. Purchase or sell commodities or commodity contracts
except for hedging purposes.
8. Invest in interests in oil, gas or other mineral
exploration or development program.
9. Invest in companies for the purpose of exercising
control or management.
10. Purchase securities of other investment companies,
except to the extent permitted by the Investment Company Act.
11. Make loans of money or property to any person, except
through loans of portfolio securities to Qualified Institutions,
the purchase of debt obligations in which the Short or
Intermediate Series may invest consistently with its investment
objectives and policies and investment limitations or the
investment in repurchase agreements with Qualified Institutions.
The Short or Intermediate Series will not lend portfolio
securities if, as a result, the aggregate of such loans exceeds
33 1/3% of the value of a Series' respective total assets
(including such loans).
12. Purchase securities on margin (but the Short or Intermediate
Series may obtain such short-term credits as may be necessary for
the clearance of transactions); provided that the deposit or
payment by a Series of initial or variation margin in connection
with options or futures contracts is not considered the purchase
of a security on margin.
13. Make short sales of securities or maintain a short position
if, when added together, more than 25% of the value of the Short
or Intermediate Series' net assets would be (i) deposited as
collateral for the obligation to replace securities borrowed to
effect short sales, and (ii) allocated to segregated accounts in
connection with short sales. Short sales "against-the box" are
not subject to this limitation.
Whenever any fundamental investment policy or investment
restriction states a maximum percentage of assets, it is intended
that if the percentage limitation is met at the time the
investment is made, a later change in percentage resulting
from changing total or net asset values will not be considered
a violation of
-5-
such policy. However, in the event that the asset
coverage for borrowings falls below 300%, the Short and
Intermediate Series will take prompt action to reduce its
borrowings as required by applicable laws.
In order to change any of the foregoing restrictions which
are fundamental policies, approval must be obtained by
shareholders of the Short or Intermediate Series, as the case may
be. Such approval requires the affirmative vote of the lesser of
(i) 67% or more of the voting securities present at a meeting if
the holders of more than 50% of voting securities are represented
at that meeting or (ii) more than 50% of the outstanding voting
securities of either the Short or Intermediate Series.
In addition, as non-fundamental policies, the Short and
Intermediate Series each may not:
(a) sell over-the-counter options which it does not own;
(b) sell options on futures contracts which options it does
not own; or
(c) invest in residual interests in a REMIC or a CMO.
Other Policies
There are no restrictions or limitations on investments in
obligations of the United States, or of corporations chartered by
Congress as federal government instrumentalities. The underlying
assets of the Short or Intermediate Series may be retained in
cash, including cash equivalents which are Treasury bills, and
short-term bank obligations such as certificates of deposit,
bankers' acceptances and repurchase agreements. However, it is
intended that only so much of the underlying assets of the the
Short or Intermediate Series be retained in cash as is deemed
desirable or expedient under then-existing market conditions. As
noted in the Prospectus, a Series may invest up to 15% of its
respective total net assets in illiquid securities.
In order to comply with certain "blue sky" restrictions, a
Short and Intermediate Series will not as a matter of operating
policy, invest in securities of any issuer if, to the knowledge
of a Series, any officer or Trustee of the Fund or the Adviser
issuer, and such officers and Trustees who own more than one half of 1%
own in the aggregate more than 5% of the outstanding securities
of such issuer.
The Short and Intermediate Series may make commitments more
restrictive than the restrictions listed above so as to permit
the sale of shares of a Series in certain states. Should the
Fund determine that a commitment is no longer in the best
interest of the Fund and its shareholders, the Short or
Intermediate Series will revoke the commitment by terminating the
sale of shares of the Series in the state involved.
TRUSTEES AND OFFICERS
The Board of Trustees has the responsibility for the overall
management of the Fund and each of the Short and Intermediate
Series, including general supervision and review of its
investment activities. The Trustees, in turn, elect the officers
of the Fund who are responsible for administering the day-to-day
operations of the Fund. Trustees and officers of the Fund are
identified in the Prospectus.
The Fund's Declaration of Trust provides that it will
indemnify its Trustees and officers against liabilities and
expenses incurred in connection with litigation in which they may
be involved because of their offices with the Fund, unless it is
determined that they had acted with willful misfeasance, bad
faith, gross negligence or reckless disregard of the duties
involved in their offices or had not acted in good faith in the
reasonable belief that their actions were in the best interests
of the Fund.
-6-
INVESTMENT ADVISORY AND OTHER SERVICES
The investment manager of each Series is Smith Breeden
Associates, Inc. (the "Adviser"). The table in the Prospectus
indicates which officers and Trustees are affiliated persons of
the Adviser.
Pursuant to an Investment Advisory Agreement with each
Series (the "Advisory Agreement"), the Adviser provides
investment research and portfolio management services, including
the selection of securities to purchase, hold or sell, and the
selection of brokers and dealers through whom portfolio
transactions are executed. The Adviser's activities are subject
to the review and supervision of the Board of Trustees to whom
the Adviser renders periodic reports of the two Series'
investment activities. The Adviser, at its own expense,
furnishes the Short and Intermediate Series with office space
and office furnishings, facilities and equipment required for
managing the business affairs of the Series; maintains all
internal bookkeeping, clerical, secretarial and administrative
personnel and services; carries fidelity insurance on its own
officers and directors for the protection of the Series; and
provides certain telephone and other mechanical services. Except
for the expense limitation in place through March 31, 1995, each
Series bears all expenses related to its operation not borne by
the Adviser, as discussed in the Prospectus.
The Advisory Agreement is in effect until August 1, 1996.
Thereafter, it may continue in effect for successive periods not
exceeding one year, providing such continuance is specifically
approved at least annually by a vote of the Fund's Board of
Trustees or by a vote of the holders of a majority of each of the
Series' outstanding voting securities, and in either event by a
majority of the Fund's' Trustees who are not parties to the
Agreement or interested persons of any such party (other than as
Trustees of the Fund), cast in person at a meeting called for
that purpose. Each Advisory Agreement may be terminated without
penalty at any time by the Fund, on behalf of each Series, or by
the Adviser on sixty days' written notice and will automatically
terminate in the event of its assignment as defined in the
Investment Company Act. The Advisory Agreement provides that the
Adviser will not be liable for any error of judgment or for any
loss suffered by either Series in connection with matters to
which the Advisory Agreement relates, except a loss resulting
from willful misfeasance, bad faith gross negligence or reckless
disregard of duty.
As compensation for the services rendered to each Series by
the Adviser pursuant to the Advisory Agreement, and the
assumption by the Adviser of the related expenses, the Short and
Intermediate Series each pays the Adviser a fee, computed daily
and payable monthly, at an annual rate equal to 0.70% of the
respective Series' average daily net asset value. In aggregate,
over the last three fiscal years ended March 31, 1995, the
Adviser has received $ 0 and $132,174, respectively from the
Short and Intermediate Series under the terms of the investment
advisory contracts. The Short Series, prior to April 1, 1995,
indirectly bore investment advisory fees through its investment
in the Smith Breeden Short Duration U.S. Government Fund. On
March 31, 1995, this two-tier structure was consolidated,
resulting in the Short Series becoming a stand-alone fund. During
the three year period ended March 31, 1995, the Adviser
reimbursed the Short and Intermediate Series in aggregate
$464,601 and $346,051 respectively under expense limitation
provisions.
Under the terms of its Advisory agreement with each Series,
the Adviser also provides administrative services:
Fund/Plan Services, Inc. is the shareholder servicing,
accounting, transfer and dividend paying-agent. Each Series'
pays its own expenses, including, but not limited to auditing,
legal, tax preparation and consulting, insurance, custodial,
accounting, shareholder servicing and shareholder report
expenses. Fees paid to Fund/Plan Services are determined by
contract as approved by the Trustees.
Bank of New York, 48 Wall Street, New York, NY, 10286 acts
as custodian of the securities and other assets of the Portfolio.
The custodian does not participate in decisions relating to the
purchase and sale of portfolio securities.
Deloitte & Touche LLP, 117 Campus Drive, Princeton, New
Jersey 08540, are the Fund's independent auditors, and Ropes &
Gray, One International Place, Boston, Massachusetts 02110-2624,
are legal counsel to the Fund.
-7-
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those
shareholders who, as of June 30, 1995, owned 5% or more of the
shares of the Short Duration Series.
Shareholder Percentage Owned
Carver Federal Savings Bank 23.83%
2815 Atlantic Avenue
Brooklyn, NY 11207
Watsonville Federal Savings & Loan 9.57%
35 East Lake Avenue
Watsonville, CA 95076
Humana, Inc. 7.42%
500 W. Main Street
Louisville, KY 40202
Hemet Federal Savings & Loan 5.71%
445 E. Florida Ave.
Hemet, CA 92543
The Officers and Trustees of the Fund together as a group owned
less than 1.00% of the shares of the Short Duration Series as of
June 30, 1995.
Listed below are the names and addresses of those shareholders,
who as of June 30, 1995, owned 5% or more of shares of the
Intermediate Series.
Shareholder Percentage Owned
Roosevelt Bank 73.27%
900 Roosevelt Pkwy
Chesterfield, MO 63017
Public School Retirement System 18.10%
1 Mercantile Ctr./ #2607
St. Louis, MO 63101
The Officers and Trustees of the Fund together as a group owned
less than 1.00% of the shares of the Intermediate Duration Series
as of June 30, 1995.
Potential Conflicts of Interest
Principals of the Adviser as individuals own 99% of the
common stock of Harrington Financial Group, the holding company
for Harrington Bank, FSB (the "Association"). As of March 31,
1995, the Association had total assets of $263 million.
Douglas T. Breeden, in combination with immediate family
members, controls over 75% of the common stock of Community First
Financial Group, Inc., the holding company for English State Bank
of English, Indiana (the "Bank"). As of March 31, 1995, the
Bank had total assets of $76 million. The Adviser
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furnishes certain Investment Advisory Services to the Bank and
Association. The Fund will transact no business directly or
indirectly with either the Bank or the Association. The Bank
and Association invest in assets of the same types as those to be
held by the Fund.
The Adviser may also manage advisory accounts with
investment objectives similar to or the same as those of the
Short or Intermediate Series, or different from the two Series,
but trading in the same type of securities and instruments..
Portfolio decisions and results of the two Series' investments
may differ from those of such accounts managed by the Adviser.
When two or more accounts managed by the Adviser seek to purchase
or sell the same assets, the assets actually purchased or sold
may be allocated among the accounts on a basis determined by the
Adviser in its good faith discretion to be equitable. In some
cases, this system may adversely affect the size or the price of
the position obtainable for the Short or Intermediate Series.
POLICIES REGARDING BROKERS
USED IN PORTFOLIO TRANSACTIONS
Under the Advisory Agreement, the selection of brokers and
dealers to execute transactions on behalf of the Portfolio is
made by the Adviser in accordance with criteria set forth in the
Advisory Agreement and any directions which the Board of Trustees
may give. However, the Short and Intermediate Series do not
anticipate that it will incur a significant amount of brokerage
expense because brokerage commissions are not normally incurred
on investments in Mortgage Securities, which are generally traded
on a "net" basis, that is, in principal amounts without the
addition or deduction of brokerage commissions. The Short and
Intermediate Series paid $80,496 and $3,147, respectively, in
brokerage commissions on futures and options for the year end
March 31, 1995.
When placing a portfolio transaction, the Adviser attempts
to obtain the best net price and execution of the transaction.
On portfolio transactions which are done on a securities
exchange, the amount of commission paid by the Short or
Intermediate Series is negotiated between the Adviser and the
broker executing the transaction. The Adviser seeks to obtain
the lowest commission rate available from brokers which are felt
to be capable of efficient execution of the transactions. The
determination and evaluation of the reasonableness of the
brokerage commissions paid in connection with portfolio
transactions are based to a large degree on the professional
opinions of the persons responsible for the placement and review
of such transactions. These opinions are formed on the basis of,
among other things, the experience of these individuals in the
securities industry and information available to them concerning
the level of commissions being paid by other institutional
investors of comparable size.
Securities may be purchased directly from issuers or from
underwriters. Where possible, purchase and sale transactions
will be effected through dealers (including banks) which
specialize in the types of securities which the Portfolio will be
holding, unless better executions are available elsewhere.
Dealers and underwriters usually act as principal for their own
account. Purchases from underwriters will include a concession
paid by the issuer to the underwriter and purchases from dealers
will include the spread between the bid and the asked price. No
broker or dealer affiliated with the Portfolio or with the
Adviser may purchase securities from, or sell securities to, the
Portfolio.
When it is felt that several brokers or dealers are equally
able to provide the best net price and execution, the Adviser may
decide to execute transactions through brokers or dealers who
provide quotations and other services to the Short or
Intermediate Series, specifically including the quotations
necessary to determine each of the Series' net assets, in such
amount of total brokerage as may reasonably be required in light
of such services, and through brokers and dealers who supply
statistical and other data to the two Series in such amount of
total brokerage as may reasonably be required.
The Adviser conducts extensive proprietary fixed income
research with emphasis on mortgage-backed securities. The
Adviser is not dependent on any broker for such research and
analysis and, thus is able to transact business with brokers
regardless of the brokers' research capabilities or provision of
such research to brokerage customers. The Adviser uses multiple
electronic quotation services for trading and
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pricing purposes. The Adviser pays for these services directly
out of its advisory fees. The Adviser is not involved in any
soft dollar arrangements. The Adviser does utilize broker pricing
guidance for certain assets not consistently available through
electronic quotation services.
ADDITIONAL INFORMATION REGARDING
PURCHASES AND REDEMPTIONS OF FUND SHARES
All checks, drafts, wires and other payment mediums used for
purchasing or redeeming shares of either Series must be
denominated in U.S. Dollars. The Fund reserves the right, in its
sole discretion, to either (a) reject any order for the purchase
or sale of shares denominated in any other currency, or (b) to
honor the transaction or make adjustments to shareholder's
account for the transaction as of a date and with a foreign
currency exchange factor determined by the drawee bank.
Dividend checks which are returned to the Fund marked
"unable to forward" by the postal service will be deemed to be a
request to change the dividend option and the proceeds will be
reinvested in additional shares at the current net asset value
until new instructions are received.
Redemptions in Kind
The Short and Intermediate Series have committed themselves
to pay in cash all requests for redemption by any shareholder of
record, limited in amount, however, during any 90-day period to
the lesser of $250,000 or 1% of the value of the either Series'
net assets at the beginning of such period. Such commitment is
irrevocable without the prior approval of the Securities and
Exchange Commission. In the case of requests for redemption in
excess of such amounts, the Trustees reserve the right to make
payments in whole or in part in securities or other assets of
either Series in case of an emergency, or if the payment of such
redemption in cash would be detrimental to the existing
shareholders of either Series. In such circumstances, the
securities distributed would be valued at the price used to
compute the Short or Intermediate Series' net assets. Should the
Short or Intermediate Series do so, a shareholder may incur
brokerage fees or other transaction costs in converting the
securities to cash.
Principal Underwriter
Fund/Plan Broker Services, Inc. (the "Principal
Underwriter"), #2 West Elm Street, P. O. Box 874, Conshohocken,
Pennsylvania 19428-0874, is the principal underwriter for the
Fund. The Principal Underwriter is registered as a broker-dealer
under the Securities Exchange Act of 1934 and is a member of the
National Association of Securities Dealers, Inc. The offering of
the Fund's shares is continuous.
The Fund's underwriting agreement with the Principal
Underwriter provides that the Fund will pay all fees and expenses
in connection with: registering and qualifying its shares under
the various state "blue sky" laws; preparing, setting in type,
printing, and mailing its prospectuses and reports to
shareholders; and issuing its shares, including expenses of
confirming purchase orders. See the description of the
Distribution Plan in the Prospectus.
The Principal Underwriter acts as the agent of both the
Short and Intermediate Series in connection with the sale of
their shares in all states in which the shares are qualified and
in which the Principal Underwriter is qualified as a broker-
dealer. Under the underwriting agreement, the Principal
Underwriter may accept orders for either Series shares at the
offering price. The Principal Underwriter may enter into
agreements with other broker-dealers for the sale of Short or
Intermediate Series shares by them.
The Principal Underwriter is paid $5,000 by the Adviser for
its services. In addition, for the year ended March 31, 1995,
the Principal Underwriter received no sales charges or
commissions.
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Calculation of Net Asset Value
As noted in the Prospectus, the Short and Intermediate
Series will generally calculate their net asset value as of the
close of trading each Monday through Friday that the Adviser and
Transfer Agent are open for business and sufficient trading takes
place to impact the value of the Short or Intermediate Series
assets. As of the date of this Statement, current holiday
schedules indicate that the net asset value will not be
calculated on: New Year's Day, Presidents' Day, Martin Luther
King Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Columbus Day, Veteran's Day, Thanksgiving Day, the day following
Thanksgiving, Christmas Eve, and Christmas Day.
Reinvestment Date
The dividend reinvestment date is the date on which the
additional shares are purchased for the investor who has his
dividends reinvested. This date will vary from month to month
and is not necessarily the same date as the record date or the
payable date for cash dividends.
Ownership and Authority Disputes
In the event of disputes involving multiple claims of
ownership or authority to control a shareholder's account, the
Fund has the right (but has no obligation) to (a) require the
written agreement of all persons deemed by the Fund to have a
potential property interest in the account, prior to executing
instructions regarding the account; (b) interplead disputed funds
or account with a court of competent jurisdiction or (c)
surrender ownership of all or a portion of the account to the
Internal Revenue Service in response to a Notice of Levy.
ADDITIONAL INFORMATION REGARDING TAXATION
Taxation of the Series
For federal income tax purposes, each Series will be treated
as a separate corporation. Each of the Short and Intermediate
Series intend to qualify each year and elect to be treated as
regulated investment companies ("RICs") for federal income tax
purposes. To so qualify, the Short and Intermediate Series must,
among other things: (i) derive at least 90% of their gross income
for each taxable year from dividends, interest, payments with
respect to loans of securities and gains from the sale or other
disposition of securities or certain other related income; (ii)
generally derive less than 30% of their gross income for each
taxable year from gains from the sale or other disposition of
securities and certain other investments held for less than three
months; and (iii)diversify their holdings so that at the end of
each quarter of the taxable year (A) at least 50% of the value of
each of the Short and Intermediate Series' assets would be
represented by cash, U.S. Government securities, securities of
other RICs, and other securities which, with respect to any one
issuer, do not represent more than 5% of the value of each of the
Series' assets nor more than 10% of the voting securities of such
issuer and (B) not more than 25% of the value of each of the
Series' assets are invested in the securities of any one issuer
(other than U.S. Government securities or the securities of other
RICs).
The requirement that each Series derive less than 30% of its
gross income from gains from the sale or other disposition of
securities and certain other investments held for less than three
months (the "Short-Short Rule") may cause the Short or
Intermediate Series to (i) hold certain investments that it
otherwise would have sold or (ii) sell certain investments that
it otherwise would have held. In addition, if the Short or
Intermediate Series were to experience a large quantity of share
redemptions during a taxable year, either Series may have
difficulty satisfying the Short-Short Rule during that year. If
the Short or Intermediate Series fails to satisfy the Short-
Short Rule in a taxable year, it would lose its RIC status for
that year. Each Series, however, will endeavor to select
investments for sale during a taxable year in such a way that
they will satisfy the Short-Short Rule.
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If the Short and Intermediate Series qualify as a RICs and
distribute to their shareholders at least 90% of its net
investment income (including tax-exempt interest and net short-
term capital gain but not net capital gain, which is the excess
of net long-term capital gains over net short-term capital
losses), then the Short and Intermediate Series will not be
subject to federal income tax on the income so distributed.
However, the Short and Intermediate Series will be subject to
corporate income tax on any undistributed income. In addition,
either Series would be subject to a nondeductible 4% excise tax
on the amount by which the income it distributed in any calendar
year would be less than a minimum distribution amount. The
minimum distribution amount required to avoid the excise tax for
a calendar year equals the sum of (i) 98% of a Series' ordinary
income (excluding tax-exempt interest income) for such calendar
year; (ii) 98% of the excess of capital gains over capital losses
for the one-year period ending on October 31 (or another date if
elected by a Series) of each year; and (iii) 100% of the
undistributed ordinary income and gains from prior years. For
purposes of the excise tax, any income or capital gains retained
by, and taxed in the hands of, either Series will be treated as
having been distributed.
Both the Short and Intermediate Series intend to distribute
sufficient income so as to avoid both corporate income tax and
excise tax. The Short Series may be subject to a 4% excise tax
to the extent that the amount of ordinary income distributed
during the calendar year is less than 98% of the ordinary income
(excluding tax-exempt interest income) for the year. The Short
Series will endeavor to pay dividends in such a manner that an
excise tax will not be incurred. The Series also may elect to
retain all or a portion of their net capital gain, as described
under "Taxation of Shareholders Distributions" below.
Any capital losses resulting from the disposition of
securities can be used only to offset capital gains and cannot be
used to reduce a Series' ordinary income. Such capital losses
may be carried forward for eight years. If any capital losses
have not been utilized at the time a Series terminates, such
capital losses will become unusable.
Taxation of Shareholders
Distributions. In general, all distributions to
shareholders attributable to the Short or Intermediate Series'
net investment income (including any tax-exempt interest income
distributed) will be taxable as ordinary dividend income whether
paid in cash or in additional shares.
To the extent either the Short or Intermediate Series does
realize net capital gains, it intends to distribute such gains at
least annually and designate them as capital gain dividends.
Capital gain dividends are taxable as capital gains, whether paid
in cash or in additional shares, regardless of how long the
shares have been held. The Short or Intermediate Series may
elect to retain net capital gains and pay corporate income tax
thereon. In such event, the Short or Intermediate Series would
most likely make an election that would require each shareholder
of record on the last day of the Series' taxable year to include
in income for tax purposes his proportionate share of the Series'
undistributed net capital gain. If such an election is made,
each shareholder would be entitled to credit his proportionate
share of the tax paid by the Series against his federal income
tax liabilities and to claim refunds to the extent that the
credit exceeds such liabilities. In addition, the shareholder
would be entitled to increase the basis of his shares for federal
tax purposes by an amount equal to 66% of his proportionate share
of the undistributed net capital gain.
Shareholders receiving distributions in the form of
additional shares will be treated for federal income tax purposes
as receiving an equivalent amount of cash. In general, the basis
of such shares will equal the amount of cash that the shareholder
would have received if he had elected to receive distributions in
cash.
Liquidating distributions which in the aggregate exceed a
shareholder's basis in shares will be treated as gain from the
sale of shares. If a shareholder receives, in the aggregate,
liquidating distributions which are less than such basis, such
shareholder will recognize a loss to that extent. Dividends and
other distributions by either the Short or Intermediate Series
are generally taxable to the shareholders at the time the
dividend or distribution is made.
-12-
If a shareholder purchases shares at a cost that reflects an
anticipated dividend, such dividend will be taxable even though
it represents economically a return of part of the purchase
price. Investors should consider the tax implications of buying
shares shortly prior to a distribution.
Sales of Shares. In general, if a share is sold, the seller
will recognize gain or loss equal to the difference between the
amount realized on the sale and the seller's adjusted basis in
the share. However, any loss recognized by a shareholder within
six months of purchasing the shares will be treated as a long-
term loss to the extent of any long-term capital gain
distributions received by the shareholder and the shareholder's
share of undistributed long-term capital gains. In addition, any
loss realized on a sale of shares will be disallowed to the
extent the shares disposed of are replaced within a period of 61
days beginning 30 days before the disposition of the shares. In
such a case, the basis of the shares acquired will be adjusted to
reflect the disallowed loss. Any gain or loss realized upon a
sale of shares by a shareholder who is not a dealer in securities
will be treated as capital gain or loss.
If a shareholder exchanges shares of one fund in the Smith
Breeden Family of Funds for shares of another fund, the
shareholder generally will recognize gain or loss as if the
shares had been redeemed..
Tax-Exempt Investors. If a shareholder that is a benefit
plan investor (e.g., an individual retirement account, pension
plan 401(k) plan, or Keogh plan) or charitable organization (a
"Tax-Exempt Investor") incurs debt to finance the acquisition of
its shares, a portion of the income received by the Tax-Exempt
Investor with respect to its shares would constitute unrelated
business taxable income ("UBTI"). In that case, the UBTI portion
of the Tax-Exempt Investor's income from its investment in the
Short or Intermediate Series for the year would equal the total
income recognized by the Tax-Exempt Investor in that year
multiplied by the ratio of the Tax-Exempt Investor's average
acquisition debt balance to the average tax basis of its shares
for the year. A Tax-Exempt Investor generally is subject to
federal income tax to the extent that its UBTI for a taxable year
exceeds its annual $1,000 exclusion.
Consequences of Certain Fund Investments
Hedging Transactions. Each Series intends to engage in
various hedging transactions. Under various provisions of the
Code, the result of such investments and transactions may be to
change the character of recognized gains and losses, accelerate
the recognition of certain gains and losses, and defer the
recognition of certain losses. For example, the tax treatment of
futures contracts entered into by a Series as well as listed non-
equity options written or purchased by a Series on U.S. exchanges
(including options on debt securities and options on futures
contracts) will be governed by section 1256 of the Code. Absent
a tax election for "mixed straddles" (described below), each such
position held by a Series on the last business day of each
taxable year of the Series will be marked to market (i.e.,
treated as if it were closed out), and all resulting gain or loss
will be treated as 60% long-term capital gain or loss and 40%
short-term capital gain or loss, with subsequent adjustments made
to any gain or loss realized upon an actual disposition of such
positions. When a Series holds an option or contract governed by
section 1256 which substantially diminishes the Series' risk of
loss with respect to another position of the Portfolio not
governed by section 1256 (as might occur in some hedging
transactions), that combination of positions generally will be a
"mixed straddle" that is subject to the straddles rules of
section 1092 of the Code. The application of Section 1092 might
result in deferral of losses, adjustments in the holding periods
of the Series' securities and conversion of short-term capital
losses into long-term capital losses. Either Series may make
certain tax elections for its "mixed straddles" that could alter
certain effects of section 1256 or section 1092. The extent to
which a Series is able to use such hedging techniques may be
limited by the Short-Short Rule, which is discussed above. In
determining compliance with the Short-Short Rule, however, gains
from certain types of hedging positions that are part of
designated hedges and are held by a Series for less than three
months will be netted against losses (whether recognized or
unrecognized) incurred with respect to the offsetting position in
the designated hedge. That special netting provision, if
employed by a Series, could reduce the risk that active hedging
techniques will run afoul of the Short-Short Rule.
The character of the Short or Intermediate Series' taxable
income will in most cases be determined on the basis of reports
made to the Series by the issuers of the securities in which
they invest. The tax
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treatment of certain securities in which a Series may invest is
not free from doubt and it is possible that an IRS examination
of the issuers of such securities could result in adjustments to
the income of a Series.
The foregoing discussion is a general summary of certain of
the current federal income tax laws regarding the both Sereies
and investors in the shares. The discussion does not purport to
deal with all of the federal income tax consequences applicable
to the Series or to all categories of investors, some of which
maybe subject to special rules. Investors should consult their
own tax advisers regarding the tax consequences to them of
investments in shares.
STANDARD PERFORMANCE MEASURES
Performance
As noted in the Prospectus, the Fund may from time to time
quote various performance figures to illustrate the past
performance of either Series. It may occasionally cite
statistics to reflect its volatility or risk.
Performance quotations by investment companies are subject
to rules adopted by the Securities and Exchange Commission
("SEC"). These rules require the use of standardized performance
quotations or alternatively, that every non-standardized
performance quotation furnished by the Fund be accompanied by
certain standardized performance information computed as required
by the SEC. Current yield and average annual compounded total
return quotations used by the Fund are based on the standardized
methods of computing performance mandated by the SEC. An
explanation of those and other methods used by the Fund to
compute or express performance follows.
Total Return
The average annual total return is determined by finding the
average annual compounded rates of return over one, five, and ten
year periods that would equate an initial hypothetical $1,000
investment to its ending redeemable value. The calculation
assumes no sales charge is deducted from the initial $1,000
purchase order, capital gains and all income dividends are
reinvested at net asset value on the reinvestment dates during
the period. The quotation assumes the account was completely
redeemed at the end of each one, five and ten year period and the
deduction of all applicable charges and fees.
The Series' average annual compounded rate of return is
determined by reference to a hypothetical $1,000 investment,
according to the following formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical
$1,000 payment made at the beginning of the
1, 5, or 10 year periods at the end of said
1, 5, or 10 year periods (or fractional
portion thereof).
As discussed in the Prospectus, the Fund may quote total
rates of return in addition to its average annual total return.
Such quotations are computed in the same manner as the Fund's
average annual compounded rate, except that such quotations will
be based on the Fund's actual aggregate return for a specified
period as opposed to its average return over one, five, and ten
year periods.
-14-
Yield
Current yield reflects the income per share earned by the
Fund's portfolio investments. Current yield is determined by
dividing the net investment income per share earned during a 30-
day base period by the offering price or net asset value per
share, as the case may be, on the last day of the period and
analyzing the result, according to the following formula:
Yield = 2 [(a-b + 1)6 -1]
cd
where:
a = dividends and interest earned
during the period.
b = expenses accrued for the period
(net of reimbursements).
c = the average daily number of shares
outstanding during the period that
were entitled to receive dividends.
d = the maximum offering price or net
asset value per share, as the case
may be, on the last day of the
period.
The following table shows the average annual total return
for the periods stated, and yield for the Short and Intermediate
Series for the 30 day period ended March 31, 1995.
AVERAGE ANNUAL
TOTAL RETURN
ONE YEAR SINCE INCEPTION YIELD
SHORT SERIES 6.58% 5.30% 6.34%
INTERMEDIATE
SERIES 6.10% 8.28% 6.90%
The investment results of the Short and Intermediate Series,
like all others, fluctuate over time. Thus, performance figures
should not be considered to represent what an investment may earn
in the future or what the Short or Intermediate Series' yield or
total return may be for any future period.
Current Distribution Rate
Yield which is calculated according to a formula prescribed
by the SEC is not indicative of the amounts which will be paid to
the Series' shareholders. Amounts paid to shareholders are
reflected in the quoted "current distribution rate." The current
distribution rate is computed by dividing the total amount of
dividends, excluding long-term capital gains, per share paid by a
Series during the past twelve months by a current net asset
value. Under certain circumstances, such as when there has been
a change in the amount of dividend payout, or a fundamental
change in investment policies, it might be appropriate to
annualize the dividends paid over the period such policies were
in effect, rather than using the dividends during the past twelve
months. The current distribution rate differs from the current
yield computation because it may include distributions to
shareholders from sources other than dividends and interest, such
as short-term capital gains and net equalization credits and is
calculated over a different period of time.
Volatility
Occasionally statistics may be used to specify a Series
volatility or risk. Measures of volatility or risk are generally
used to compare fund net asset value or performance relative to a
market index. One measure of volatility is beta. The ratio of
the expected excess return on a Series to the expected excess
return on the market index is called beta. Equity funds commonly
use the S&P 500 as their market index. A beta of more than 1.00
indicates volatility greater than the market, and a beta of
less that 1.00 indicates volatility less than
-15-
the market. Another measure of volatility or risk is standard
deviation. Standard deviation is used to measure variability of
net asset value or total return around an average, over a
specified period of time. The premise is that greater volatility
connotes greater risk undertaken in achieving performance.
A statistic often used by sophisticated institutional
investors when comparing the relative performance of portfolios
is the Sharpe Ratio. This statistic is a Series' excess return
(relative to T-Bills) divided by the standard deviation of its
returns.
Comparisons and Advertisements
To help investors better evaluate how an investment in a
Series might satisfy their objective, advertisements regarding
either Series may discuss various measures of a Series'
performance as reported by various financial publications.
Advertisements may also compare performance (as calculated above)
to performance as reported by other investments, indices, and
averages. The following publications, indices, and averages may
be used:
a) Lipper - Mutual Fund Performance Analysis, Lipper-Fixed
Income Analysis, and Lipper Mutual Fund Indices - measures total
return and average current yield for the mutual fund industry and
ranks individual mutual fund performance over specified time
periods assuming reinvestment of all distributions, exclusive of
sales charges.
b) CDA Mutual Fund Report, published by CDA Investment
Technologies, Inc. - analyzes price, current yield, risk, total
return, and average rate of return (average annual compounded
growth rate) over specified time periods for the mutual fund
industry.
c) Mutual Fund Source book, published by Morningstar,
Inc. - analyzes price, yield, risk, and total return for equity
and fixed income funds.
d) Financial publications: Barron's, Business Week,
Changing Times, Financial World, Forbes, Fortune, and Money
magazines - rate fund performance over specified time periods.
e) Consumer Price Index (or Cost Of Living Index),
published by the U.S. Bureau of Labor Statistics - a statistical
measure of change, over time, in the price of goods and services,
in major expenditure groups.
f) Stocks, Bonds, Bills, and Inflation, published by
Ibbotson Associates - historical measure of yield, price, and
total return for common and small company stock, long-term
government bonds, treasury bills, and inflation.
g) Savings and Loan Historical Interest Rates - as
published in the U.S. Savings & Loan League Fact Book.
h) Salomon Brothers Broad Bond Index - The Broad Index
measures yield, price, and total return for Treasury, Agency,
Corporate, and Mortgage bonds. All issues mature in one year or
more and have at least $50 million outstanding, with the
exception of mortgages. The entry criteria for mortgage issues
is $200 million for each coupon.
i) Salomon Brothers Mortgage Index - The Salomon Brothers
Mortgage Index measures only the mortgage component of the
Salomon Brothers Broad Bond Index.
j) Salomon Brothers Composite High Yield Index or its
component indices - The High Yield Index measures yield, price
and total return for Long-Term High-Yield Index, Intermediate-
Term High-Yield Index and Long-Term Utility High-Yield Index.
k) Lehman Brothers Aggregate Bond Index or its component
indices - The Aggregate Bond Index measures yield, price and
total return for Treasury, Agency, Corporate, Mortgage, and
Yankee bonds.
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l) Lehman Brothers Government/Corporate Bond Index.
m) Standard & Poor's Bond Indices - measure yield and
price of Corporate, Municipal, and Government bonds.
n) Other taxable investments including certificates of
deposit (CD's), money market deposit accounts (MMDA's), checking
accounts, savings accounts, money market mutual funds, repurchase
agreements, and government securities.
o) Historical data supplied by the research departments of
Lehman Brothers, First Boston Corporation, Morgan Stanley,
Salomon Brothers, Merrill Lynch, Goldman Sachs, Prudential
Securities and Donaldson Lufkin and Jenrette.
p) Donoghues's Money Fund Report - industry averages for
7-day annualized and compounded yields of taxable, tax-free and
government money funds.
q) Total returns and yields for Treasury Securities and
fixed income indices as published by Ryan Laboratories or other
suppliers.
In assessing such comparisons of performance, an investor
should keep in mind that the composition of the investments in
the reported indices and averages is not identical, and in some
cases is very different, to a Series' portfolio, that the
averages are generally unmanaged and that the items included in
the calculations of such averages may not be identical to the
formula used by a Series to calculate its figures. In addition
there can be no assurance that a Series will continue its
performance as compared to such other averages.
Shareholders should note that the investment results of the
Short or Intermediate Series will fluctuate over time, and any
presentation of a Series' current yield or total return for any
period should not be considered as a representation of what an
investment may earn or what a shareholder's yield or total return
may be in any future period. Shareholders should also note that
although the Series believe that there are substantial benefits
to be realized by investing in its shares, such investments also
involve certain risks. (See "Investment Objectives and Policies
of the Fund - Risks of Mortgage Securities" in the Fund's
Prospectus.)
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS
As the investments permitted to the Series are primarily in
mortgage securities issued or guaranteed by the U.S. Government
or its agencies and instrumentalities, the shares of either the
Short or Intermediate Series may be eligible for investment by
federally chartered credit unions, federally chartered thrifts,
and national banks. Either Series may be a permissible
investment for certain state chartered institutions as well,
including state and local government authorities and agencies.
Any financial institution or agency considering an investment in
either Series should refer to the applicable laws and regulations
governing its operations in order to determine if a Series is a
permissible investment.
EXPERTS
The financial statements of both the Short and Intermediate
Series and related notes thereto included in this Statement of
Additional Information have been so included in reliance upon the
input of Deloitte & Touche LLP, independent auditors, given in
authority of said firm as experts in auditing and accounting.
FINANCIAL STATEMENTS
The financial statements of the Fund are attached and follow the
Appendix.<PAGE>
-17-
APPENDIX
Description of Moody's Investors Service, Inc.'s corporate bond
ratings:
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 risks appear somewhat larger
than in 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 sometime 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 predominantly
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.
Caa - Bonds which are rated Caa are of poor standing. Such
issues may be in default or there may be present elements of
danger with respect to principal or interest.
Ca - Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default
or have other marked shortcomings.
Description of Standard & Poor's Corporation's corporate bond
ratings:
AAA - This is the highest rating assigned by Standard & Poor's to
a debt obligation and indicates an extremely strong capacity to
pay principal and interest.
AA - Bonds rated AA also qualify as high-quality debt
obligations. Capacity to pay principal and interest is very
strong, and in the majority of instances they differ from AAA
issues only in small degree.
A - Bonds rated A have a strong capacity to pay principal and
interest, although they are somewhat more susceptible to the
adverse effects of changes in circumstances and economic
conditions.
BBB - Bonds rated BBB are regarded as having an adequate
capacity to pay principal and interest. Whereas they normally
exhibit protection parameters, adverse economic conditions
or changing circumstances are
-18-
more likely to lead to a weakened capacity to
pay principal and interest for bonds in this capacity than for
bonds in the A category.
BB, B, CCC, CC - Bonds rated BB, B, CCC and CC are regarded, on
balance, predominantly speculative with respect to the issuer's
capacity to pay interest and repay principal in accordance with
the terms of the obligations. BB indicates the lowest degree of
speculation and CC the highest degree of speculation. While such
bonds will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or
major risk exposures to adverse conditions.
-19-
SMITH BREEDEN INTERMEDIATE DURATION SERIES ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Intermediate Duration U.S. Government Series
("Series") provided a total return of 6.10% for the year ended
March 31, 1995. The Series' return was in excess of that of its
benchmark, the Salomon Brothers Mortgage Index (the "SBMI"), by .09%.
Since the Series' inception, its return has exceeded that of its benchmark
by 3.19%, and on an annualized basis by .91%. The graph below plots the
Series' return versus its benchmark, which as noted in the title of the
graph, changed effective January 1, 1994.
The year ended March 31, 1995, was a tumultuous one for the fixed income
markets. The Federal Reserve Board raised the discount rate, the rate at
which banks borrow from the Federal Reserve to meet reserve requirements
and temporary liquidity needs, four times. The rate on March 31, 1994
was 3%, but rose to 5.25% by March 1995. These increases, and the market's
anticipation of the Federal Reserve's actions over the course of the year,
boosted short and intermediate-term yields and increased interest rate
volatility. From March 31, 1994 to March 31, 1995, short-term U.S. Treasury
yields rose over 200 basis points (100 basis points equals one percent),
intermediate-term U.S. Treasury yields rose 85 to 160 basis points, and
long-term yields rose less than 50 basis points. Over the course of the
fiscal year, intermediate and long-term interest rates had actually peaked
at much higher levels: for example, in early January 1995, the five year
U.S. Treasury Note yield was 80 basis points over its closing yield
on March 31, 1995.
IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T, THE FOLLOWING IS
A DESCRIPTION OF THE GRAPH PRESENTED HERE IN THE TEXT IN COMPLIANCE WITH
ITEM 5a. OF FORM N-1A:
The graph presented compares the change for the period from March 31, 1992
through March 31, 1995 of a $10,000 investment in the Series versus its
benchmark. For the period from the Series' inception, March 31, 1992,
through March 31, 1995, the Series' benchmark was the Five Year US Treasury, as
tracked by Salomon Brothers, Inc. After December 31, 1993, upon approval of a
majority of the shareholders, the Series' benchmark was changed to the Salomon
Brothers Mortgage Index. The Series average annual return for the one year
period was 6.10% and 8.28% for the three year period. The dollar value of a
$10,000 invested in the Series and benchmark, at the end of the three year
period, were $12,699 and $12,380, respectively.
Rising interest rates, volatility and extending durations hurt mortgage
security returns during the first part of the Series' fiscal year. In its
first three quarters, the Intermediate Series returned only .38%.
Performance turned around in the last quarter, however, primarily due to
two reasons. Intermediate-term rates declined in January of 1995
(five-year U.S. Treasury Note yields fell 0.32%), and the Intermediate
Series returned 2.51%, .27% in excess of its benchmark, the SBMI. The
January SBMI return was the best single monthly return for this index since
May of 1990. In February, the Intermediate Series continued to benefit from
declining rates, and returned 2.5%. In March, the Series returned only .38%,
reflecting the stability of market rates and mortgage yield spreads.
The fine performance of the Intermediate Series and SBMI in the first
quarter of 1995 reflects the fact that not only did rates decline, but
mortgages also performed extremely well versus U.S. Treasury securities. In
the first quarter, the five-year U.S. Treasury returned only 4.95% versus
5.39% for the Series. Adjustable-rate mortgages ("ARMS") underperformed
generic fixed-rate mortgages during most of 1994, so the Series took
advantage of the opportunity by increasing its position in ARMS issued by
GNMA. In the first quarter of 1995, investors realized that ARMS had been
considerably undervalued and bid up prices of ARMS relative to the mortgage
securities market in general. During this time, fixed-rate mortgages also
performed well.
The Series' approach to investment in the mortgage markets is to hold
relatively liquid, easy to price, government mortgage securities in a portfolio
with minimal interest-rate risk relative to its benchmark. With only small
exposures to credit and liquidity risk, the Intermediate Series seeks
actively to take advantage of changes in relative value among liquid
mortgage securities markets. This portfolio management style is reflected
in the Series' 557% portfolio turnover rate for the year ended
March 31, 1995. The markets in which the Series executes most of its
transactions are so liquid that transaction costs are relatively small,
especially in relation to the return advantage gained from these transactions.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31, 1995
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 99.86%
FEDERAL HOME LOAN MORTGAGE CORPORATION - 8.47% *
FHLMC:
$2,955,733 8.00%, due 08/01/09-09/01/24....................... $2,945,358
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $2,917,339)................................... 2,945,358
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 45.44% *
FNMA:
3,673,326 7.00%, due 08/01/23-06/01/24........................ 3,461,890
9,950,191 8.50%, due 09/14/24-02/01/25........................ 10,052,158
2,000,000 9.50%, due (a)...................................... 2,083,750
FNMA ARM:
211,869 6.92%, due 06/01/20................................. 215,907
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $15,455,743).................................. 15,813,705
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 45.78% *
GNMA:
7,813,813 7.00%, due 12/15/23-03/15/24........................ 7,315,089
1,944,841 8.00%, due 11/15/06-04/15/09........................ 1,962,845
GNMA ARM:
939,767 5.50%, due 05/20/23................................. 913,115
1,972,848 6.00%, due 08/20/22................................. 1,948,582
2,625,493 6.125%, due 11/20/22................................ 2,584,272
1,200,000 7.00%, due (a)...................................... 1,208,250
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $15,823,677).................................. 15,932,153
UNITED STATES TREASURY BILLS - 0.17% **
50,000 5.66% due 06/29/95.................................. 49,301
10,000 5.69% due 06/29/95.................................. 9,859
TOTAL UNITED STATES TREASURY BILLS (Cost $59,160)... 59,160
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $34,255,920).................................. 34,750,376
TOTAL INVESTMENTS (Cost $34,255,920) - 99.86%....... 34,750,376
CASH AND OTHER ASSETS LESS LIABILITIES - 0.14%...... 47,120
NET ASSETS - 100.00%................................$34,797,496
* Mortgage-backed obligations are subject to principal paydowns as a result
of prepayments or refinancings of the underlying securities instruments. As a
result, the average life may be substantially less than the original maturity.
The interest rate shown is the rate in effect at March 31, 1995. ARM's have
coupon rates which adjust periodically. The adjusted rate is determined by
adding a spread to a specified index.
** The interest rate shown is the discount rate paid at the time of purchase
by the Fund.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1995
ASSETS:
Investments at market value
(identified cost $34,255,920)(Note 1)............... $34,750,376
Cash and cash equivalents.............................. 3,197,511
Interest receivable.................................... 213,911
Prepaid expenses....................................... 21,528
Deferred organization expenses (Note 1)................ 19,587
Due from adviser (Note 3).............................. 17,137
TOTAL ASSETS...................................... 38,220,050
LIABILITIES:
Variation margin on futures contracts.................. 3,625
Accrued expenses....................................... 41,821
Securities purchased payable........................... 3,229,302
Distributions payable.................................. 147,806
TOTAL LIABILITIES................................. 3,422,554
NET ASSETS:
(Applicable to outstanding shares of 3,538,283;
unlimited number of shares of beneficial
interest authorized; no stated par)................. $34,797,496
Net asset value, offering price and redemption
price per share ($34,797,496 / 3,538,283)........... $ 9.83
SOURCE OF NET ASSETS:
Paid in capital........................................ $35,250,723
Overdistributed net investment income.................. (109,925)
Accumulated net realized loss on investments........... (831,188)
Net unrealized appreciation (depreciation) of investments
and futures contract............................... 487,886
NET ASSETS............................................. $34,797,496
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1995
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization....................................... $1,516,801
EXPENSES:
Advisory fees (Note 3)................................ 132,174
Accounting and pricing services fees.................. 26,079
Distribution fees (Note 3)............................ 7,074
Custodian fees....................................... 16,614
Audit & tax preparation fees......................... 18,395
Legal fees........................................... 20,663
Amortization of organization expenses (Note 1)....... 9,248
Transfer agent fees.................................. 30,431
Registration fees.................................... 20,558
Trustees fees........................................ 4,701
Insurance............................................ 3,459
Other................................................ 3,956
TOTAL EXPENSES BEFORE REIMBURSEMENT.............. 293,352
Expenses reimbursed by Adviser (Note 3).......... (123,390)
NET EXPENSES..................................... 169,962
NET INVESTMENT INCOME ........................... 1,346,839
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized loss on investments..................... (248,302)
Change in unrealized appreciation (depreciation) of
investments and futures contracts................. 778,903
Net realized and unrealized gain on inestments....... 530,601
Net increase in net assets resulting from operations. $1,877,440
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
OPERATIONS: March 31, 1995 March 31, 1994
Net investment income......................... $1,346,839 $598,297
Net realized gain (loss) on investments....... (248,302) 37,266
Change in unrealized appreciation (depreciation)
of investments and futures contracts........ 778,903 (361,010)
Net increase in net assets resulting from
operations.................................. 1,877,440 274,553
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income.......... (1,346,839) (594,276)
Dividends in excess of net investment income.. (140,634) -
Distributions from net realized capital gains. - (5,416)
Distributions in excess of net realized capital
gains....................................... (28,444) -
Total distributions........................... (1,515,917) (599,692)
CAPITAL SHARE TRANSACTIONS:
Shares sold.................................. 31,506,439 9,608,109
Shares issued on reinvestment of
distributions............................. 669,611 569,108
Shares redeemed.............................. (4,519,742) (5,996,326)
Increase in net assets resulting from capital
share transactions (a).................... 27,656,308 4,180,891
TOTAL INCREASE IN NET ASSETS.............. 28,017,831 3,855,752
NET ASSETS:
Beginning of period ......................... 6,779,665 2,923,913
End of period................................ $34,797,496 $6,779,665
(a) Transactions in capital shares were as follows:
Shares sold.............................. 3,257,497 902,154
Shares issued on reinvestment of
distributions......................... 68,948 53,947
Shares redeemed.......................... (465,316) (554,342)
Net increase............................. 2,861,129 401,759
Beginning balance ....................... 677,154 275,395
Ending balance........................... 3,538,283 677,154
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
Year Ended Year Ended Period Ended
March 31, 1995 March 31, 1994 March 31, 1993 (3)
Net Asset Value, Beginning
of Period......... $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment
income.......... 0.664 1.050 0.826
Net loss on securities
(both realized and
unrealized)...... (0.049) (0.601) 0.621
Total from investment
operations....... 0.615 0.449 1.447
Less Distributions
Dividends from net
investment
income.......... (0.664) (1.044) (0.826)
Dividends in excess of
net investment
income........... (0.108) - -
Distributions from net
realized gains on
investments...... - (0.015) -
Distributions in excess of
net realized gains on
investments...... (0.022) - -
Total distributions.. (0.794) (1.059) (0.826)
Net Asset Value,
End of Period...... $9.83 $10.01 $10.62
Total Return......... 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of
period........... $34,797,496 6,779,666 $2,923,913
Ratio of expenses to
average net assets (1). 0.78% 0.00% 0.31%
Ratio of net investment
income to average
net assets (2)... 6.20% 7.74% 8.18%
Portfolio turnover
rate............. 557% 84% 42%
______________________
1 The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Advisor was 1.35%, 1.30% and 14.80%
for the years ended March 31, 1995 and March 31, 1994 and for the
period ended March 31, 1993, respectively.
2 The annualized ratio of net investment income to average net assets
prior to reimbursement of expenses by the Adviser was 5.64%, 6.43%
and (6.31)% for the years ended March 31, 1995 and March 31, 1994 and
for the period ended March 31, 1993, respectively.
3 The Intermediate Duration U.S. Government Series commenced operations
on March 31, 1992.
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Smith Breeden Series Fund (the "Fund") is an open-end, diversified management
investment company registered under the Investment Company Act of 1940, as
amended. The Fund offers shares in two series: Smith Breeden Short Duration
U.S. Government Series and the Smith Breeden Intermediate Duration U.S.
Government Series ("Intermediate Series" or "Series"). The following is a
summary of significant accounting policies consistently followed by the
Intermediate Series.
A. Security Valuation: Portfolio securities are valued at current market
value provided by a pricing service or by a bank or broker/dealer experienced
in such matters, when over-the-counter market quotations are readily available.
Securities and other assets for which market prices are not readily available
are valued at fair market value as determined in accordance with procedures
approved by the Board of Trustees. All money market instruments and debt
securities originally purchased with remaining maturities of 60 days or less
shall be valued at their amortized cost.
B. Distributions and Taxes: The Intermediate Series intends to continue to
qualify for and elect the special tax treatment afforded regulated investment
companies under Subchapter M of the Internal Revenue Code, thereby relieving
the Series of Federal income taxes. To so qualify, the Series intends to
distribute substantially all of its net investment income and net realized
capital gains, if any, less any available capital loss carry forward. As of
March 31, 1995, the Series had a capital loss carry forward of $659,858 of
which $484,264 expires March 31, 2002, and $175,594 expires March 31, 2003.
C. Repurchase Agreements: The Intermediate Series may enter into
repurchase agreements with member banks of the Federal Reserve System having
total assets in excess of $500 million and securities dealers, provided that
such banks or dealers meet the credit guidelines of the Series' Board of
Trustees. In a repurchase agreement, the Series acquires securities from a
third party with the commitment that they will be repurchased by the seller
at a fixed price on an agreed upon date. The Intermediate Series' custodian
maintains control or custody of these securities collateralizing the
repurchase agreements until maturity of the repurchase agreements. The
value of the collateral is monitored daily, and if necessary, additional
collateral is received to ensure that the market value of the underlying
assets remains sufficient to protect the Series in the event of the seller's
default. However, in the event of default or bankruptcy of the seller,
the Series' right to the collateral may be subject to legal proceedings.
D. Reverse Repurchase Agreements: A reverse repurchase agreement involves
the sale by the Intermediate Series of portfolio assets concurrently with an
agreement by the Series to repurchase the same assets at a later date at a
fixed price. The Series will maintain a segregated account with its
custodian, which will be marked to market daily, consisting of cash, U.S.
Government securities or other liquid high-grade debt obligations equal in
value to its obligations under reverse repurchase agreements. In the event
the buyer of securities under a reverse repurchase agreement files for
bankruptcy or becomes insolvent, the Series' use of the proceeds of the
agreement may be restricted pending a determination by the other party,
or its trustee or receiver whether to enforce the Series' obligation to
repurchase the securities.
E. Dollar Roll Agreements: The Intermediate Series may enter into dollar
rolls in which the Series sells securities for delivery in the current month
and simultaneously contracts to repurchase substantially similar (same type
and coupon) securities on a specified future date. During the roll period,
the Series foregoes principal and interest paid on these securities. The
Series is compensated by the difference between the current sales price and
the forward price for the future purchase (often referred to as the "drop")
as well as by the interest earned on the cash proceeds of the initial sale.
F. Determination Of Gains Or Losses On Sales Of Securities: Gains or
losses on the sale of securities are calculated for accounting and tax
purposes on the identified cost basis.
G. Deferred Organizational Expenses: Deferred organizational expenses are
being amortized on a straight-line basis over five years.
H. Securities Transactions and Investment Income: Interest income is
accrued daily on both long-term bonds and short-term investments. Interest
income also includes net amortization from the purchase of fixed-income
securities. Transactions are recorded on the first business day following
the trade date. Realized gains and losses from security transactions
are determined and accounted for on the basis of identified cost.
2. FINANCIAL INSTRUMENTS
A. Derivative Financial Instruments Held or Issued for Purposes other
than Trading: The Intermediate Series uses interest rate futures contracts
for risk management purposes in order to reduce fluctuation of the Series'
net asset value relative to its targeted option-adjusted duration.
Upon entering into a futures contract, the Series is required to deposit
either cash or securities in an amount (initial margin) equal to a certain
percentage of the contract value. Subsequent payments (variation margin)
are made or received by the Series each day. The variation margin
payments are equal to the daily changes in the contract value and are
recorded as unrealized gains or losses. The Series recognizes a realized
gain or loss when the contract is closed or expires equal to the difference
between the value of the contract at the time it was opened and the value
at the time it was closed.
The Intermediate Series had the following open futures contracts as of
March 31, 1995:
Principal Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 year $2,000,000 Long June 1995 $80,535
Treasury
3 month
Eurodollar $22,000,000 Short March 1998 (36,856)
3 month
Eurodollar $6,000,000 Short March 1999 (13,377)
3 month
Eurodollar $16,000,000 Short March 2000 (36,872)
($ 6,570)
Futures transactions involve costs and may result in losses. The effective
use of futures strategies depends on the Series' ability to terminate futures
positions at times when the Series' investment adviser deems it desirable to
do so. The use of futures also involves the risk of imperfect correlation
among movements in the values of the securities underlying the futures
purchased and sold by the Series, of the futures contract itself, and of the
securities which are the subject of a hedge.
The aggregate market value of investments pledged to cover margin requirements
for the open positions at March 31, 1995 was $59,175.
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered investment
adviser, provides the Series with investment management services. As
compensation for these services, the Intermediate Series pays the Adviser
a fee computed daily and payable monthly, at an annual rate equal to 0.70%
of the Series' average daily net asset value.
The Adviser has voluntarily agreed to reduce or otherwise limit other
expenses of the Intermediate Series (excluding advisory fees and litigation,
indemnification and other extraordinary expenses) to 0.90% of the Series'
average daily net assets. This voluntary agreement may be terminated or
modified at any time by the Adviser in its sole discretion. The Adviser has
agreed to reduce the fees payable (to the extent of such fees) by the amount
the Series' expenses would, absent the fee reduction, exceed the applicable
expense limitations imposed by state securities administrators. For the
year ended March 31, 1995, the Adviser received fees of $132,174 and
reimbursed the Series $123,391.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940, the
Intermediate Series adopted a distribution plan pursuant to which Fund/Plan
Broker Services, Inc., the Series' principal underwriter (the "Principal
Underwriter") received a fee, accrued daily and paid monthly, at an annual
rate of 0.25% of the Series' average daily net assets, regardless of the
amount of expenses incurred by the Principal Underwriter, to compensate the
Principal Underwriter for services provided in connection with sales of
shares of the Series, including bearing the cost of printing of prospectuses
used for sales, advertising expenses, and marketing allowances, promotional
incentives and other compensation paid to its employees or other dealers
that sell shares of the Series. For the four months ended July 31, 1994,
the Series paid the Principal Underwriter $7,074 for such fees. This plan
terminated August 1, 1994, at which point the Series adopted a different
distribution and services plan (the "Plan") pursuant to Rule 12b-1 under
the 1940 Act.
The purpose of the Plan is to permit the Adviser to compensate investment
dealers and other persons involved in servicing shareholder accounts for
services provided and expenses incurred in promoting the sale of shares of
the Series, reducing redemptions, or otherwise maintaining or improving
services provided to shareholders by such dealers or other persons.
The Plan provides for payments by the Adviser, out of its advisory fee, to
dealers and other persons at the annual rate of up to 0.25% of the
Intermediate Series' average net assets subject to the authority of the
Trustees of the Series to reduce the amount of payments permitted under the
Plan or to suspend the Plan for such periods as they may determine. Subject
to these limitations, the amount of such payments and the purposes for which
they are made shall be determined by the Adviser.
Certain officers and trustees of the Series are also officers and directors
of the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1995, purchases and proceeds from sales of
securities, other than short-term investments, aggregated $158,263,181 and
$131,617,023, respectively. The purchases and proceeds shown above do not
include dollar roll agreements which are considered borrowings by the
Intermediate Series. The cost of securities for federal income tax purposes
is $34,255,920. Net unrealized appreciation of investments and futures
contracts consists of:
Gross unrealized appreciation...... $700,358
Gross unrealized depreciation...... (212,472)
Net unrealized appreciation........ $487,886
5. LIQUIDATION OF THE INSTITUTIONAL INTERMEDIATE FUND
Pursuant to a plan of liquidation adopted by the Trustees of the Smith Breeden
Institutional Intermediate U.S. Government Fund (the "Institutional Fund"),
on August 1, 1994, the Intermediate Series redeemed in-kind its shares in the
Smith Breeden Institutional Fund. The value of the securities and cash
received by the Intermediate Series totalled $8,563,933.
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Intermediate Duration U.S. Government Series
of the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden Intermediate
Duration U.S. Government Series of the Smith Breeden Series Fund as of
March 31, 1995, and the related statements of operations for the year
ended and changes in net assets for each of the years in the two-year
period then ended and financial highlights for each of the years in the
two-year period then ended and the period March 31, 1992 (commencement
of operations) to March 31, 1993. These financial statements and financial
highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and
financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned at March 31, 1995 by correspondence with the custodian
and brokers. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of the Smith
Breeden Intermediate Duration U.S. Government Series of the Smith Breeden
Series Fund as of March 31, 1995, the results of its operations, the
changes in net assets, and financial highlights for the respective stated
periods in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1995
ANNUAL REPORT SMITH BREEDEN SHORT DURATION U.S GOVERNMENT SERIES
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Series (the "Series")
provided a total return of 6.58% for the year ended March 31, 1995. The
Series' return exceeded its benchmark, the six-month U.S. Treasury Bill,
by a significant margin, 1.16%. Since the Series' inception, its return
has exceeded that of its benchmark by 3.60%, and on an annualized basis
by 1.09%. The graph below plots the Series' return versus its benchmark.
The Series had invested all of its assets in the Short Duration U.S.
Government Fund (the "Portfolio") through March 31, 1995. At the close
of business on March 31, 1995, the Portfolio liquidated its assets by a
distribution in kind to its shareholders. The Series received mortgage
securities and other assets with a market value of $218,431,665.
The year ended March 31, 1995, was a tumultuous one for the fixed
income markets. The Federal Reserve Board raised the discount rate, the
rate at which banks borrow from the Federal Reserve to meet reserve
requirements and temporary liquidity needs, four times. The rate on
March 31, 1994 was 3%, but rose to 5.25% by March 1995. These increases,
and the market's anticipation of the Federal Reserve's actions over the
course of the year, boosted short-term and intermediate-term yields and
increased interest-rate volatility. From March 31, 1994 to March 31, 1995,
short-term U.S. Treasury yields rose over 200 basis points (100 basis
points equals one percent), intermediate-term U.S. Treasury yields rose
85 to 160 basis points, and long-term yields rose less than 50 basis
points. Over the course of the fiscal year, intermediate and long-term
interest rates had actually peaked at much higher levels: for example,
in early January 1995, the five-year U.S. Treasury Note yield was 80
basis points over its closing yield on March 31,1995.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE SERIES' INDEX
ACCORDING TO ITEM 5a. OF FORM N1-A IS LOCATED HERE IN THE TEXT AND IS
DESCRIBED BELOW IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000 INVESTMENT IN THE
SHORT SERIES VERSUS THAT OF ITS BENCHMARK, THE SIX MONTH US TREASURY
BILL. FROM INCEPTION OF MARCH 31, 1992 THROUGH MARCH 31, 1995, AN
INVESTMENT OF $10,000 IN THE SERIES WOULD HAVE GROWN TO $11,676, VERSUS
$11,317, IF INVESTED IN THE SIX MONTH US TREASURY BILL. THE RETURN IN
THE SERIES IS NET OF FEES AND SALES CHARGES; THE RETURN OF THE
SIX MONTH US TREASURY DOES NOT REFLECT FEES OR TRANSACTION COSTS.
THE ANNUALIZED ONE YEAR RETURN FOR THE SERIES IS 6.58%, AND 5.30%
ANNUALIZED SINCE INCEPTION.
As interest rates rose, the effective maturities (durations) of
mortgage securities lengthened. This happened for two predictable
reasons. First, homeowners were less likely to prepay their mortgages
(primarily due to refinancing or moving). This lengthened the expected
time to receipt of a mortgage investor's principal payments and made a
mortgage security investment longer-term in nature. Second, as
variable-rate mortgage coupons began to reset upward (indexed, as they
are, to short-term rates), they began to be subject to caps on their
periodic adjustments, and their rates moved closer to their contractual
lifetime maximum rates. This made adjustable-rate mortgages (ARMs) more
fixed-rate and less adjustable-rate in nature, extending their durations
and making them more sensitive to subsequent changes in interest rates.
Although the "extension" of mortgage securities in 1994's rising rate
environment was predictable (and well prepared for by the Series, by virtue
of its investment in the Portfolio), investors in general appeared to be
surprised, or at least disappointed, as many left the market. ARM mutual
funds shrank dramatically during the year as many funds failed to deliver
on promises or expectations of price stability. Government mortgage mutual
funds also experienced very substantial outflows during the year; and banks
curtailed their purchases of ARMs as the market depreciation of their
existing holdings was deducted from their reported capital.
Rising volatility and extending durations hurt mortgage security returns
during the first part of the Series' fiscal year. Through November 1994,
the Series had outperformed its benchmark by only 17 basis points.
Adjustable-rate mortgages underperformed generic fixed-rate mortgages during
most of 1994, so the Portfolio, and the Series, by virtue of its investment
in the Portfolio, took advantage of the opportunity by increasing its position
in ARMs issued by GNMA. In December 1994 and January 1995, investors realized
that ARMs had become considerably undervalued and bid up the prices of ARMs
relative to the mortgage securities market in general. During this time,
fixed-rate mortgages also performed well. In these two months, the Series
earned 110 basis points over its six-month U.S. Treasury Bill benchmark.
In February and March 1995 the mortgage markets were "treading water" as
rates declined and spreads held relatively firm. The Portfolio took advantage
of the strength of the earlier mortgage performance to reduce ARM holdings
in the first months of 1995 and to increase the its cash position for future
opportunities.
The Series' and Portfolio's approach to investment in the mortgage
markets is to hold relatively liquid, easy to price, government mortgage
securities in a portfolio with minimal interest rate risk relative to its
benchmark. With only small exposures to credit risk, interest-rate risk
and liquidity risk, the Series seeks actively to take advantage of changes
in relative value among liquid mortgage securities markets. This portfolio
management style is reflected in the Portfolio's 438% portfolio turnover
for the year ended March 31, 1995. The markets in which the Series executes
most of its transactions are so liquid that transactions costs are
relatively small, especially in relation to the return advantage gained
from these transactions.
The Series' and Portfolio's strong risk management discipline stood it
in good stead during the fiscal year. Because the Series' risk is always
targeted to a six-month duration, we proactively prepare for the change in
the portfolio's effective maturity that we expect will occur should interest
rates either rise or fall. We therefore had in place hedge instruments
which counteracted the effects of rising interest rates during the fiscal
year. Gains on the Portfolio's hedge instruments significantly offset
depreciation of the core investments, enabling the Series and Portfolio to
deliver the low risk profile specified in the Prospectus and to outperform
the benchmark at the same time.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS March 31, 1995
Market
Face amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 102.55%
FEDERAL HOME LOAN MORTGAGE CORP. - 33.11% *
FHLMC GOLD:
$24,933,273 7.50%, due 06/01/24-07/01/24............... $24,143,753
20,989,707 8.00%, due 09/01/24 to (a)................. 20,786,732
20,000,000 8.50%, due (a)............................. 20,218,750
FHLMC FLOATING-RATE REMIC:
7,308,287 6.83%, due 03/15/24 (b).................... 7,158,124
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $72,466,365) 72,307,359
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 16.62% *
FNMA:
20,383,132 8.50%, due 01/01/25 ....................... 20,592,011
FNMA ARM & FLOATING-RATE REMIC:
11,962,925 6.78%, due 02/25/24 (b)................. 11,710,114
468,440 6.89%, due 12/01/15........................ 471,392
847,476 6.99%, due 06/01/20........................ 863,629
239,776 7.08%, due 12/01/26 ....................... 246,864
1,065,438 7.45%, due 01/01/16 ....................... 1,100,566
555,568 7.50%, due 01/01/18 ....................... 565,379
FNMA INTEREST ONLY **:
2,338,485 9.00%, due 07/25/21........................ 752,693
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $35,548,396 36,302,648
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 52.55% *
GNMA:
28,722,855 7.00%, due 11/15/22-03/15/24............... 26,889,586
2,059,451 9.50%, due 07/15/09 to 09/15/21............ 2,165,604
GNMA ARM:
3,052,322 6.13%, due 11/20/22......................... 2,997,014
82,150,000 7.00%, due (a).............................. 82,714,781
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION 114,766,985
UNITED STATES TREASURY BILLS - 0.27%
UNITED STATES TREASURY BILL ***
20,000 5.71%, due 06/29/95 ........................ 19,725
50,000 5.69%, due 06/29/95 ........................ 49,312
20,000 5.68%, due 06/29/95 ........................ 19,725
500,000 5.65%, due 06/29/95 ....................... 493,125
TOTAL UNITED STATES TREASURY BILLS
(Cost $581,743) 581,887
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $223,617,515) 223,958,879
Notional Amount INTEREST RATE SWAP CONTRACTS - 1.88%
$20,000,000 Contract dated 06/22/93 with Prudential Global Funding,
Expires 06/22/98.................................. 938,753
20,000,000 Contract dated 08/31/93 with Salomon Swapco,
Expires 08/31/00.................................1,740,853
20,000,000 Contract dated 12/02/93 with Morgan Guaranty,
Expires 12/02/00.................................1,432,554
TOTAL INTEREST RATE SWAP CONTRACTS............ 4,112,160
Market
Notional amount Security Value
THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS - 3.84
$50,000,000 Contract with Credit Suisse Financial Products, expi
Strike rate 7.00%................................$1,685,000
75,000,000 Contract with Credit Suisse Financial Products, expi
Strike rate 9.00%...................................997,500
40,000,000 Contract with Morgan Guaranty, expires 10/15/98,
Strike rate 5.00%.................................2,655,600
40,000,000 Contract with Salomon SwapCo, expires 11/01/96,
Strike rate 5.00%.................................1,098,360
40,000,000 Contract with Salomon SwapCo, expires 11/15/97,
Strike rate 5.00%.................................1,960,240
TOTAL THREE-MO. LIBOR INTEREST RATE CAP CONTRACTS
(Cost $5,328,180) 8,396,700
Contracts TEN YEAR NOTE PUT OPTION CONTRACTS - 0.02%
50 Expires 6/95, Strike Price $98....................... 1,563
50 Expires 6/95, Strike Price $103......................32,813
TOTAL TEN YEAR NOTE PUT OPTION CONTRACTS
(Cost $75,450 34,376
TOTAL INVESTMENTS (Cost $229,021,146).......... 236,502,115
Face Amount REPURCHASE AGREEMENTS- 48.03%
$59,000,000 Morgan Stanley, 6.10%, due 04/04/95 dated 03/28/95
Collateralized by $60,189,173 FNMA ARM, 6.25%,
5.56%, 5.37% due 12/01/18-05/01/19 with
a market value of $60,179,105 59,000,000
45,900,000 Nomura, 6.15%, due 04/07/95 dated 03/31/95
Collateralized by $47,492,878 FNMA FRM, 6.0%, 8.0%,
due 06/01/08-11/01/21 with a market value of
$46,997,288 45,900,000
TOTAL REPURCHASE AGREEMENTS (Cost $104,900,000)..104,900,000
TOTAL INVESTMENTS AND REPURCHASE AGREEMENTS
(Cost $333,921,146) - 156.32%................341,402,115
OTHER LIABILITIES LESS CASH AND OTHER ASSETS
-(56.32%) (122,970,450)
NET ASSETS - 100.00% $218,431,665
* Mortgage-backed obligations are subject to principal paydowns as a result
of prepayments or refinancings of the underlying mortgage instruments. As a
result,the average life may be substantially less than the original maturity.
The interest rate shown is the rate in effect at March 31, 1995.
ARM's have coupon rates which adjust periodically.
The adjusted rate is determined by adding a spread to a specified index.
** Represents an interest only stripped mortgage-backed security.
*** The interest rate shown is the discount rate paid at the time of purchase
by the Fund.
(a) To be announced.
(b) Real Estate Mortgage Investment Conduit
Portfolio Abbreviations
ARM- Adjustable-rate mortgage
FHLMC- Federal Home Loan Mortgage Corporation
FNMA- Federal National Mortgage Association
GNMA- Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1995
ASSETS:
Investments at market value
(identified cost $229,021,146)(Note 1)............ $236,502,115
Repurchase agreements (cost $104,900,000)(Note 1).. 104,900,000
Cash .............................................. 72,897
Receivables:
Interest........................................ 1,364,434
Miscellaneous................................... 15,028
Securities sold................................. 219,933
Prepaid expenses................................... 45,539
Deferred organization expenses..................... 19,177
TOTAL ASSETS.................................. 343,139,123
LIABILITIES:
Variation margin on futures contracts (Note 1)..... 21,998
Accrued expenses................................... 100,968
Payables:
Securities purchased............................. 121,598,606
Payable for shares redeemed..................... 2,910,348
Due to adviser (Note 3)......................... 75,538
TOTAL LIABILITIES............................. 124,707,458
NET ASSETS:
(Applicable to outstanding shares of 22,050,739
unlimited number of shares of beneficial
interest authorized; no stated par)............. $218,431,665
Net asset value, offering price and redemption
price per share ($218,431,665 / 22,050,739)..... $9.90
SOURCE OF NET ASSETS:
Paid in capital.................................... $222,111,273
Accumulated net realized loss on investments....... (10,954,167)
Net unrealized appreciation(depreciation) of
investments, interest rate swap and
futures contracts.................................. 7,274,559
NET ASSETS.................................... $218,431,665
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1995
INVESTMENT INCOME:
Dividends...................................... $13,729,868
EXPENSES:
Distribution fees (Note 3)..................... 188,180
Registration fees.............................. 20,118
Transfer agent fees............................ 28,093
Custodian fees................................. 4,712
Legal fees..................................... 31,305
Accounting and pricing......................... 26,336
Amortization of organization expenses (Note 1). 9,603
Trustees fees and expenses..................... 43,414
Insurance...................................... 15,191
Other.......................................... 4,904
TOTAL EXPENSES BEFORE REIMBURSEMENT........ 371,856
Expenses reimbursed by Adviser (Note 3).... (146,256)
NET EXPENSES............................... 225,600
NET INVESTMENT INCOME ..................... 13,504,268
REALIZED AND UNREALIZED LOSS ON INVESTMENTS:
Net realized loss on investments............... (1,414,168)
Change in unrealized appreciation(depreciation)
of investments............................... 1,365,349
Net realized and unrealized loss on
investments.................................. (48,819)
Net increase in net assets resulting from
operations................................... $13,455,449
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1995 March 31, 1994
OPERATIONS:
Net investment income.............. $13,504,268 $4,653,713
Net realized loss on investments... (1,414,168) (382,998)
Change in unrealized appreciation
(depreciation) of investments... 1,365,349 (1,572,884)
Net increase in net assets
resulting from operations...... 13,455,449 2,697,831
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income......................... (13,504,268) (4,702,281)
Dividends in excess of net
investment income.............. (90) -
Total distributions................ (13,504,358) (4,702,281)
CAPITAL SHARE TRANSACTIONS:
Shares sold........................ 94,549,923 292,685,905
Shares issued on reinvestment of
distributions................... 4,346,125 2,411,081
Shares redeemed.................... (98,582,965) (123,456,251)
Increase in net assets resulting
from capital share
transactions (a)................ 313,083 171,640,735
TOTAL INCREASE IN NET ASSETS... 264,174 169,636,285
NET ASSETS:
Beginning of period ............... 218,167,491 48,531,206
End of period...................... $218,431,665 $218,167,491
(a) Transactions in capital shares
were as follows:
Shares sold................... 9,582,171 29,296,974
Shares issued on reinvestment
of distributions............ 441,809 241,234
Shares redeemed............... (10,018,137) (12,346,115)
Net increase.................. 5,843 17,192,093
Beginning balance ............ 2,044,896 4,852,803
Ending balance................ 22,050,739 22,044,896
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental
information have been derived from information
provided in the financial statements.
Year Year For the Period
Ended Ended March 31, 1992 to
March 31, 1995 March 31, 1994 March 31, 1993(1)
Net Asset Value,
Beginning of Period....... $9.90 $10.00 $10.00
Income From Investment Operations
Net investment income..... 0.628 0.432 0.552
Net realized and unrealized
gain (loss)
on investments.......... - (0.070) 0.002
Total from investment
operations............ 0.628 0.362 0.554
Less Distributions
Dividends from net investment
income.................. (0.628) (0.462) (0.554)
Total distributions... (0.628) (0.462) (0.554)
Net Asset Value,
End of Period............... $9.90 $9.90 $10.00
Total Return ............... 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of period. $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to
average net assets (2).. 0.11% 0.29% 0.27%
Ratio of net investment
income to average
net assets (3)........... 6.33% 4.17% 4.53%
Portfolio turnover rate.... 47% 112% 3%
______________________
(1) Commencement of operations.
(2) The annualized operating expense ratios prior to reimbursment of
expenses by the Adviser were 0.17%, 0.45% and 1.63% for the Short
Duration U.S. Government Series for the years ended
March 31, 1995, March 31, 1994, and period ended March 31, 1993,
respectively.
(3) The annualized net investment income ratios prior to reimbursment
of expenses by the Adviser were 6.26%, 3.72%, and 3.17% for the
Short Duration U.S. Government Series for the years ended
March 31, 1995, March 31, 1994, and period ended March 31, 1993,
respectively.
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Smith Breeden Series Fund (the "Fund") is an open-end, diversified
management investment company registered under the Investment Company
Act of 1940, as amended. The Fund offers shares in two series:
Smith Breeden Short Duration U.S. Government Series (the "Short Series"
or "Series") and Smith Breeden Intermediate Duration U.S. Government
Series ("Intermediate Duration Series"). For the year ended March 31,
1995, the Short Series sought to achieve its investment objective by
investing all of its assets in Smith Breeden Short Duration U.S.
Government Fund (the "Short Fund"), an open-end, diversified management
investment company having the same investment objective as the Series.
However, at the close of business on March 31, 1995, pursuant to a plan
of liquidation adopted March 1, 1995 by the Board of Trustees of the
Short Fund, and approved by the Board of Trustees of the Short Series,
the Short Series redeemed in-kind its shares of the Short Fund. The
assets of the Short Fund were transferred in proportion to the Short
Series' ownership of the Short Fund in cancellation of its shares.
Accordingly, the Schedule of Investments for the Short Series, which is
included in this report, reflects the transfer of the assets from the
Short Fund to the Short Series at the close of business on March 31, 1995
and the cancellation of the Short Series' shares. The following is a
summary of significant accounting policies consistently followed by
either the Short Fund or Short Series (the "Funds").
A. Security Valuation: Securities are valued at current market value
provided by a pricing service or by a bank or broker/dealer experienced
in such matters, when over-the-counter market quotations are readily
available. Securities and other assets for which market prices are not
readily available are valued at fair market value as determined in
accordance with the procedures approved by the Board of Trustees. All
money market instruments and debt securities originally purchased with
remaining maturities of 60 days or less shall be valued at their amortized
cost.
B. Repurchase Agreements: Repurchase agreements may be entered into
with member banks of the Federal Reserve System having total assets in
excess of $500 million and securities dealers, provided that such banks
or dealers meet the credit guidelines of the Funds' Board of Trustees. In
a repurchase agreement, securities are acquired from a third party with the
commitment that they will be repurchased by the seller at a fixed price on
an agreed upon date. The custodian maintains control or custody of
securities collateralizing repurchase agreements until maturity of the
repurchase agreements. The value of the collateral will be monitored
daily, and if necessary, additional collateral is received to ensure that
the market value of the underlying assets remains sufficient to protect the
Series in the event of the seller's default. However, in the event of
default or bankruptcy of the seller, the right to the collateral may be
subject to legal proceedings.
C. Reverse Repurchase Agreements: A reverse repurchase agreement involves
the sale of portfolio assets concurrently with an agreement to repurchase
the same assets at a later date at a fixed price. Assets will be
maintained in a segregated account with the custodian, which will be
marked to market daily, consisting of cash, U.S. Government securities or
other liquid high-grade debt obligations equal in value to the obligations
under the reverse repurchase agreements. In the event the buyer of
securities under a reverse repurchase agreement files for bankruptcy or
becomes insolvent, the use of the proceeds under the agreement may be
restricted pending a determination by the other party, or its trustee or
receiver whether to enforce the obligation to repurchase the securities.
D. Dollar Roll Agreements: A dollar roll is an agreement to sell
securities for delivery in the current month and simultaneously contract
to repurchase substantially similar (same type and coupon) securities on
a specified future date. During the roll period, principal and interest
paid on these securities are not received. Compensation under the dollar
roll agreement is represented by the difference between the current sales
price and the forward price for the future purchase (often referred to as
the "drop") as well as by the interest earned on the cash proceeds of the
initial sale.
E. Investment Income: The Short Series earned income, net of expenses,
on its investment in the Short Fund.
F. Distributions and Taxes: The Short Series intends to continue to
qualify for and elect the special tax treatment afforded regulated
investment companies under Subchapter M of the Internal Revenue Code,
thereby relieving the Series of Federal income taxes. To so qualify,
the Series intends to distribute substantially all of its net investment
income and net realized capital gains, if any, less any available
capital loss carry forward. As of March 31, 1995, the Series had a
net capital loss carry forward of $981,362 with $589 expiring
on March 31, 2001 and $75,461 expiring on March 31, 2002 and $905,312
expiring on March 31, 2003.
G. Determination of Gains or Losses on Sales of Securities: Gains or
losses on the sale of securities are calculated for accounting and tax
purposes on the identified cost basis.
H. Deferred Organization Expenses: Deferred organization expenses are
being amortized on a straight-line basis over five years.
I. Securities Transactions and Investment Income: Interest income is
accrued daily on both long-term bonds and short-term investments.
Interest income also includes net amortization from the purchase of
fixed-income securities. Transactions are recorded on the first business
day following the trade date. Realized gains and losses from security
transactions are determined and accounted for on the basis of identified
cost.
2. FINANCIAL INSTRUMENTS
Derivative Financial Instruments Held or Issued for Purposes other than
Trading: Interest rate futures, swaps, caps and options contracts are
used for risk management purposes in order to reduce fluctuations in
net asset value relative to the targeted option-adjusted duration.
A. Futures Contracts: Upon entering into a futures contract, either
cash or securities in an amount (initial margin) equal to a certain
percentage of the contract value is required to be deposited in a
segregated account. Subsequent payments (variation margin) are made
or received each day. The variation margin payments are equal to the
daily changes in the contract value and are recorded as unrealized
gains or losses. A realized gain or loss is recognized when the
contract is closed or expires equal to the difference between the
value of the contract at the time it was opened and the value at the
time it was closed.
The following open futures contracts had been assigned by the Short Fund
to the Short Series as of the close of business on March 31, 1995:
Principal Expiration Unrealized
Type Amount Position Month Gain/(Loss)
5 year Treasury $ 29,900,000 Long June, 1995 $ ( 44,455)
10 year Treasury $ 8,500,000 Short June, 1995 1,071
6 month Treasury $ 100,000,000 Long June, 1995 3,301
3 month Eurodollar $ 350,000,000 Long March, 1995 255,964
3 month Eurodollar $ 47,000,000 Short March, 1996 9,088
3 month Eurodollar $ 47,000,000 Short March, 1997 17,588
3 month Eurodollar $ 107,000,000 Short March, 1998 3,618
3 month Eurodollar $ 161,000,000 Short March, 1999 ( 41,819)
3 month Eurodollar $ 182,000,000 Short March, 2000 ( 66,370)
3 month Eurodollar $ 208,000,000 Short March, 2001 (109,456)
3 month Eurodollar $ 65,000,000 Short March, 2002 ( 46,990)
3 month Eurodollar $100,000,000 Short March, 2003 (187,950)
$ (206,410)
Futures transactions involve costs and may result in losses. The effective
use of futures strategies depends on the Series' ability to terminate
futures positions at times when the Series' investment adviser deems it
desirable to do so. The use of futures also involves the risk of imperfect
correlation among movements in the values of the securities underlying the
futures purchased and sold by the Series, of the futures contract itself,
and of the securities which are the subject of a hedge.
The aggregate market value of instruments pledged to cover margin
requirements for the open position at March 31, 1995 was $581,452.
B. Interest Rate Swap Contracts: Interest rate swaps involve the exchange
by one party with another party of their respective commitments to pay or
receive interest. The interest rate swap contracts assigned by the Short
Fund to the Short Series had been entered into on a net basis, i.e., the
two payment streams are netted out, with the Short Series receiving or
paying, as the case may be, only the net amount of the two payments. As
of March 31, 1995, the Short Series had been assigned by the Short Fund
three interest rate swap contracts. In each of the contracts, the Short
Fund had agreed to pay a fixed rate and receive a floating rate. The
floating rate on the three contracts resets quarterly and is the three
month London Interbank Offered Rate ("LIBOR"). Interest rate swap
contracts will not be entered into unless the unsecured commercial paper,
unsecured senior debt or the claims-paying ability of the other party
thereto is rated either AA or A-1 or better by Standard & Poor's
Corporation or Aa or P-1 or better by Moody's Investors Service, Inc.
(or is otherwise acceptable to either agency) at the time of entering into
such transaction. If there is a default by the other party to the swap
transaction, the Short Series will be limited to contractual remedies
pursuant to the agreements related to the transaction. There is no
assurance that interest rate swap contract counterparties will be able to
meet their obligations pursuant to the swap contracts or that, in the
event of default, the Short Series will succeed in pursuing contractual
remedies. The Short Series thus assumes the risk that it may be delayed
in, or prevented from, obtaining payments owed to it pursuant to the swap
contracts.
The Short Series' interest receivable on the interest rate swap contracts
was $27,967. No collateral is required to be maintained on these contracts.
C. Interest Rate Cap Contracts: The purchase of an interest rate cap
entitles the purchaser, to the extent that a specified index exceeds a
predetermined interest rate, to receive payments of interest on a notional
principal amount from the party selling such interest rate caps. The Short
Series' interest receivable on the interest rate cap contracts at
March 31, 1995 was $254,445.
3. TRANSACTIONS WITH AFFILIATES
The Short Fund and the Series each paid their respective expenses in the year
ended March 31, 1995 and the Series will continue to do so. Smith Breeden
Associates, Inc. (the "Adviser"), a registered investment adviser, provided
the Short Fund with investment management services. As all of the Fund's
assets were invested in the Short Fund for the year ended March 31, 1995, the
Series did not directly pay advisory fees. Fees of the Adviser were paid by
the Short Fund. However, as of the close of business on March 31, 1995, the
Adviser will provide investment management services to the Short Series, and
the Series will the pay the Adviser directly.
The Adviser voluntarily agreed to reimburse normal business expenses of the
Short Series through March 31, 1995 so that total direct and indirect operating
expenses would not exceed 0.78% of its average net assets. This voluntary
agreement may be terminated at any time by the Adviser in its sole discretion
after March 31, 1995. The Adviser has also agreed to reduce its fees payable
(to the extent of such fees) by the amount the Series' direct and indirect
expenses would, absent the fee reduction, exceed the applicable expenses
limitations imposed by state securities administrators. For the year ended
March 31, 1995, the Adviser received no fees and reimbursed the Short Series
$146,256.
Certain officers and trustees of the Fund are also officers and directors of
the Adviser.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940 ("1940 Act"),
the Series adopted a distribution plan pursuant to which Fund/Plan Broker
Services, Inc., the Series' principal underwriter (the "Principal
Underwriter") would receive a fee, accrued daily and paid monthly, at an
annual rate of 0.25% of the Short Series' average daily net assets, regardless
of the amount of expenses incurred by the Principal Underwriter, to
compensate the Principal Underwriter for services provided in connection with
sales of shares of the Series, including bearing the cost of printing of
prospectuses used for sales, advertising expenses, and marketing allowances,
promotional incentives and other compensation paid to its employees or other
dealers that sell shares of the Series. For the four months ended
July 31, 1994, the Series paid the Principal Underwriter $188,180 for such
fees.
This plan terminated August 1, 1994, at which point the Series adopted a
different Distribution and Services Plan ( the "Plan") pursuant to Rule 12b-1
under the 1940 Act. The Short Fund had also adopted an identical Plan.
The purpose of the Plan is to permit the Adviser to compensate investment
dealers and other persons involved in servicing shareholder accounts for
services provided and expenses incurred in promoting the sale of shares of
the Short Fund or Series, as the case may be, reducing redemptions, or
otherwise maintaining or improving services provided to shareholders by
such dealers or other persons. The Plan provides for payments by the
Adviser, out of the advisory fee paid to it by the Short Fund or Series,
as the case may be, to dealers and other persons at the annual rate of up
to 0.25% of the Short Fund's or Series' average net assets, as the case
may be, subject to the authority the Trustees of the Short Fund or Series,
as the case may be, to reduce the amount of payments permitted under the
Plan or to suspend the Plan for such periods as they may determine.
Subject to these limitations, the amount of such payments and the purposes
for which they are made shall be determined by the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1995, purchases and proceeds from sales of
securities, other than short-term investments, aggregated $99,328,403 and
$100,371,923 respectively for the Series. The cost of securities assigned
by the Short Fund to the Short Series for federal income tax purposes at
March 31, 1995, is $333,921,145. Net unrealized appreciation consists of:
Gross unrealized appreciation $ 9,448,111
Gross unrealized depreciation (2,173,552)
Net unrealized appreciation . $ 7,274,559
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Short Duration U.S. Government Series
of the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden Short Duration
U.S. Government Series of the Smith Breeden Series Fund as of March 31, 1995,
and the related statements of operations for the year ended and changes in
net assets for each of the years in the two- year period then ended and
financial highlights for each of the years in the two-year period then ended
and the period March 31, 1992 (commencement of operations) to March 31, 1993.
These financial statements and financial highlights are the responsibility
of the Fund's management. Our responsibility is to express an opinion on
these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned at March 31, 1995 by correspondence with the custodian and
brokers. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of the Smith
Breeden Short Duration U.S. Government Series of the Smith Breeden Series
Fund as of March 31, 1995, the results of its operations, the changes
in net assets, and financial highlights for the respective stated periods
in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1995
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Fund (the "Fund")
provided a total return of 6.75% for the year ended March 31, 1995. The
Fund's return exceeded its benchmark, the six-month U.S. Treasury Bill,
by a significant margin, 1.33%. Since the Fund's inception, its return
has exceeded that of its benchmark by 5.56%. The graph below plots the
Fund's return versus its benchmark.
The year ended March 31, 1995, was a tumultuous one for the fixed
income markets. The Federal Reserve Board raised the discount rate, the
rate at which banks borrow from the Federal Reserve to meet reserve
requirements and temporary liquidity needs, four times. The rate on
March 31, 1994 was 3%, but rose to 5.25% by March 1995. These increases,
and the market's anticipation of the Federal Reserve's actions over the
course of the year, boosted short-term and intermediate-term yields and
increased interest-rate volatility. From March 31, 1994 to March 31, 1995,
short-term U.S. Treasury yields rose over 200 basis points (100 basis points
equals one percent), intermediate-term U.S. Treasury yields rose 85 to 160
basis points, and long-term yields rose less than 50 basis points. Over
the course of the fiscal year, intermediate and long-term interest rates
had actually peaked at much higher levels: for example, in early January
1995, the five-year U.S. Treasury Note yield was 80 basis points over its
closing yield on March 31,1995.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE FUND'S INDEX ACCORDING TO
ITEM 5A. OF FORM N1-A IS LOCATED HERE IN THE TEXT AND IS DESCRIBED BELOW
IN ACCORDANCE WITH REG 232.304 OF REGULATION S-T:
The graph depicts the change in value of a $10,000 investment in the
Short Fund versus that of its benchmark, the six month US Treasury Bill.
From inception of February 25, 1992 through March 31, 1995, an investment of
$10,000 would have grown to $11,913, if invested in the Fund and $11,357, if
invested in the six month US Treasury Bill. The return in the Fund is
net of fees and sales charges; the return of the six month US Treasury Bill
does not reflect fees or transaction costs. The annualized one year return
for the Fund is 6.75%, the three year annualized return is 5.67% and since
inception, the annualized return is 5.82%.
As interest rates rose, the effective maturities (durations) of mortgage
securities lengthened. This happened for two predictable reasons. First,
homeowners were less likely to prepay their mortgages (primarily due to
refinancing or moving). This lengthened the expected time to receipt of a
mortgage investor's principal payments and made a mortgage security investment
longer-term in nature. Second, as variable-rate mortgage coupons began to
reset upward (indexed, as they are, to short-term rates), they began to be
subject to caps on their periodic adjustments, and their rates moved closer
to their contractual lifetime maximum rates. This made adjustable-rate
mortgages (ARMs) more fixed-rate and less adjustable-rate in nature,
extending their durations and making them more sensitive to subsequent
changes in interest rates. Although the "extension" of mortgage securities
in 1994's rising rate environment was predictable (and well prepared for by
the Fund, investors in general appeared to be surprised, or at least
disappointed, as many left the market. ARM mutual funds shrank dramatically
during the year as many funds failed to deliver on promises or expectations
of price stability. Government mortgage mutual funds also experienced very
substantial outflows during the year; and banks curtailed their purchases
of ARMs as the market depreciation of their existing holdings was deducted
from their reported capital.
Rising volatility and extending durations hurt mortgage security
returns during the first part of the Fund's fiscal year. Through November
1994, the Fund had outperformed its benchmark by only 35 basis points.
Adjustable-rate mortgages underperformed generic fixed-rate mortgages
during most of 1994, so the Fund took advantage of the opportunity by
increasing its position in ARMs issued by GNMA. In December 1994 and
January 1995, investors realized that ARMs had become considerably
undervalued and bid up the prices of ARMs relative to the mortgage
securities market in general. During this time, fixed-rate mortgages also
performed well. In these two months, the Fund earned 109 basis points
over its six-month U.S. Treasury Bill benchmark.
In February and March 1995 the mortgage markets were "treading water"
as rates declined and spreads held relatively firm. The Fund took advantage
of the strength of the earlier mortgage performance to reduce ARM holdings
in the first months of 1995 and to increase the its cash position for
future opportunities.
The Fund's approach to investment in the mortgage markets is to hold
relatively liquid, easy to price, government mortgage securities in a
portfolio with minimal interest rate risk relative to its benchmark. With
only small exposures to credit risk, interest-rate risk and liquidity risk,
the Fund sought actively to take advantage of changes in relative value
among liquid mortgage securities markets. This portfolio management style
is reflected in the Fund's 438% portfolio turnover for the year ended
March 31, 1995.
At the close of business on March 31, 1995, pursuant to a plan of
liquidation adopted by the Fund's Board of Trustees on March 1, 1995, the
Fund liquidated by distributing its assets to its shareholders in
cancellation of their shares.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1995
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization...................................... $15,327,100
EXPENSES:
Advisory fees (Note 2)................................ 1,420,528
Registration fees..................................... 350
Custodian fees........................................ 103,428
Accounting and pricing services fees.................. 74,135
S&P rating fees....................................... 17,603
Legal fees............................................ 49,078
Amortization of organization expenses (Note 1)........ 8,997
Transfer agent fees................................... 23,104
Insurance expense..................................... 28,856
Trustees fees and expenses............................ 52,477
Audit and tax preparation fees........................ 66,730
Other................................................. 15,171
TOTAL EXPENSES BEFORE REIMBURSEMENT................ 1,860,457
Expenses reimbursed by adviser (Note 2)............ (200,239)
NET EXPENSES...................................... 1,660,218
NET INVESTMENT INCOME............................. 13,666,882
NET REALIZED AND UNREALIZED GAIN/(LOSS) ON INVESTMENTS:
Net realized loss on investments...................... (6,464,271)
Change in unrealized appreciation(depreciation) on
investments, interest rate swaps, caps and
futures contracts................................. 8,760,104
Net realized and unrealized gain on investments....... 2,295,833
Net increase in net assets resulting from operations.. $15,962,715
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1995 March 31, 1994
OPERATIONS:
Net investment income................. $13,666,882 $6,924,161
Net realized loss on investments.... (6,464,271) (348,058)
Change in unrealized appreciation
(depreciation) of investments,
interest rate swaps and
futures contracts................. 8,760,104 (2,058,637)
Net increase in net assets
resulting from operations......... 15,962,715 4,517,466
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income............................ (13,666,882) (6,186,157)
Dividends in excess of net
investment income................. (1,466,847) -
Distributions from net
realized gains on investments..... (680,487) (795,530)
Distributions in excess of net
realized gains on investments..... (269,036) -
Total distributions................. (16,083,252) (6,981,687)
CAPITAL SHARE TRANSACTIONS:
Shares sold......................... 99,295,926 314,099,209
Shares issued on reinvestment of
distributions..................... 1,345,997 1,606,285
Shares redeemed..................... (142,419,513) (139,146,610)
Shares liquidated................... (221,304,914) -
Increase(decrease) in net assets
resulting from capital share
transactions (a).................. (263,082,504) 176,558,884
TOTAL INCREASE IN NET ASSETS.... (263,203,041) 174,094,663
NET ASSETS:
Beginning of period ................ 263,203,041 89,108,378
End of period....................... $0 $263,203,041
(a) Transactions in capital shares
were as follows:
Shares sold.................... 10,000,237 31,217,127
Shares issued on reinvestment
of distributions.............. 135,812 159,542
Shares redeemed................ (14,353,946) (13,820,630)
Shares liquidated.............. (22,190,031) -
Net increase................... (26,407,928) 17,556,039
Beginning balance ............. 26,407,928 8,851,889
Ending balance................. 0 26,407,928
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental
information have been derived from information provided in
the financial statements.
For the Period
Year Ended Year Ended February 25, 1992 (1)
March 31, 1995 March 31, 1994 to March 31, 1993
Net Asset Value,
Beginning of Period.... $9.97 $10.07 $10.00
INCOME FROM INVESTMENT
OPERATIONS
Net investment income.. 0.515 0.421 0.595
Net realized and
unrealized gain/(loss)
on investments....... 0.134 (0.037) 0.130
Total from investment
operations........... 0.649 0.384 0.725
LESS DISTRIBUTIONS
Dividends from net
investment income.... (0.515) (0.425) (0.547)
Dividends in excess of net
investment income.... (0.107) - -
Distributions from net
realized capital gains
on investments....... (0.027) (0.058) (0.108)
Liquidating distribution
in-kind.............. (9.973) - -
Total distributions.... (10.622) (0.483) (0.655)
Net Asset Value,
End of Period.......... $0.00 $9.97 $10.07
Total Return............. 6.75% 3.86% 7.44%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of
period............... $0 $263,203,041 $89,108,378
Ratio of expenses to
average net
assets (2)........... 0.67% 0.49% 0.55%
Ratio of net investment
income to average
net assets (3)....... 5.52% 4.51% 6.79%
Portfolio turnover rate 438% 412% 126%
(1) Commencement of operations.
(2) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 0.75%, 0.55%, and 0.95%
for the years ended March 31, 1995, and March 31, 1994, and period
ended March 31, 1993, respectively.
(3) The annualized ratio of net investment income to average net assets
prior to reimbursement of expenses by the Adviser was 5.44%, 4.45%
and 6.39% for the years ended March 31, 1995, and March 31, 1994,
and period ended March 31, 1993, respectively.
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Short Duration U.S. Government Fund (the "Fund") is
a no-load, open-end, diversified management investment company registered
under the Investment Company Act of 1940, as amended. Pursuant to a plan
of liquidation adopted by the Trustees of the Fund on March 1, 1995, at
the close of business on March 31, 1995, the Fund was liquidated by a
distribution of its assets in kind to its shareholders. The following is
a summary of significant accounting policies consistently followed by the
Fund.
A. Distributions and Taxes: The Fund intends to qualify for and elect
the special tax treatment afforded regulated investment companies under
Subchapter M of the Internal Revenue Code, thereby relieving the Fund of
Federal income taxes. To so qualify, the Fund distributed all of its
net investment income and net realized capital gains, if any, less any
available capital loss carry forward. As of March 31, 1995, the Fund had
no capital loss carry forward.
B. Determination of Gains or Losses on Sales of Securities: Gains or
losses on the sale of securities are calculated for accounting and tax
purposes on the identified cost basis.
C. Deferred Organizational Expenses: Deferred organizational expenses
were being amortized on a straight-line basis over five years. Pursuant
to the plan of liquidation, the balance of unamortized organizational
expenses as of March 31, 1995 was reimbursed to the Fund by the Adviser.
D. Securities Transactions and Investment Income: Interest income
is accrued daily on both long-term bonds and short-term investments.
Interest income also includes net amortization from the purchase of
fixed-income securities. Transactions are recorded on the first
business day following the trade date. Realized gains and losses
from security transactions are determined and accounted for on the basis
of identified cost.
2. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered investment
adviser, provides the Fund with investment management services. As
compensation for these services, the Fund pays the Adviser a fee
computed daily and payable monthly, at an annual rate equal to 0.70%
of the Fund's average daily net assets.
The Adviser has voluntarily agreed to reduce or otherwise limit other
expenses of the Fund (excluding advisory fees and litigation,
indemnification and other extraordinary expenses) to 0.78% annually
of the Fund's average daily net assets. This voluntary agreement may
be terminated or modified at any time by the Adviser in its sole
discretion, however the Adviser has agreed to limit expenses to 0.78%
annually through at least March 31, 1995. The Adviser has agreed to
reduce the fees payable (to the extent of such fees) by the amount the
Fund's expenses would, absent the fee reduction, exceed the applicable
expense limitations imposed by state securities administrators. For the
year ended March 31, 1995, the Adviser received fees of $1,420,528 and
reimbursed the Fund $200,239.
Certain officers and trustees of the Fund are also officers and directors
of the Adviser.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940
("1940 Act"), the Fund adopted a distribution plan effective August 1,
1994. The Plan permitted the Adviser to compensate investment dealers
and other persons involved in servicing shareholder accounts for services
provided and expenses incurred in promoting the sale of shares of Fund,
reducing redemptions, or otherwise maintaining or improving services
provided to shareholders by such dealers or other persons. The Plan
provided for payments by the Adviser, out of the advisory fee paid to it
by the Fund, to dealers and other persons at the annual rate of up to
0.25% of the Fund's average net assets subject to the authority the
Trustees of the Fund to reduce the amount of payments permitted under
the Plan or to suspend the Plan for such periods as they may determine.
Subject to these limitations, the amount of such payments and the
purposes for which they are made are determined by the Adviser.
3. INVESTMENT TRANSACTIONS
During the year ended March 31, 1995, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$1,179,282,195 and $1,355,911,248 respectively. The purchases and
proceeds do not include dollar roll agreements which are considered
to be borrowings by the Fund.
4. LIQUIDATION
Pursuant to a plan of liquidation adopted by the Trustees of the Fund on
March 1, 1995, at the close of business on March 31, 1995, the Fund was
liquidated by a distribution of its assets in-kind to its shareholders.
INDEPENDENT AUDITORS' REPORT
The Board of Trustees,
Smith Breeden Short Duration
U.S. Government Fund:
We have audited the Smith Breeden Short Duration U.S. Government Fund's
statements of operations for the year ended March 31, 1995 and changes in
net assets for each of the years in the two-year period then ended, and
financial highlights for each of the years in the two-year period then
ended and the period February 25, 1992 (commencement of operations) to
March 31, 1993. These statements of operations, changes in net assets and
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these statements of operations,
changes in net assets and financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the statements of operations,
changes in net assets and financial highlights are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, such statements of operations, changes in net assets
and financial highlights present fairly, in all material respects, the
results of its operations, the changes in net assets and financial
highlights of the Smith Breeden Short Duration U.S. Government Fund for
the respective stated periods in conformity with generally accepted
accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1995
