AUGUST 1, 1996
SMITH BREEDEN MUTUAL FUNDS
Smith Breeden Short Duration U.S. Government Series
Smith Breeden Intermediate Duration U.S. Government Series
Smith Breeden Equity Plus Fund
Supplement dated August 1, 1996
to Prospectus dated August 1, 1996
Effective August 31, 1996, as described in the accompanying prospectus,
the investment objective of the Smith Breeden Equity Plus Fund (formerly
the Smith Breeden Market Tracking Fund) will be changed to the following:
"to provide a total return exceeding the Standard & Poor's 500 Composite
Stock Price Index ("S&P 500 Index") without additional equity market risk."
Prior to that date, the Fund's objective will continue to be "to provide
a total return approximating the S&P 500 Index." The change in objective
will not affect how the Fund is currently managed, and is meant merely to
clarify the Fund's investment goals.
SMITH BREEDEN MUTUAL FUNDS
PROSPECTUS
The Smith Breeden Mutual Funds consist of three no-load, registered
investment companies (the "Funds" or a "Fund"). Smith Breeden
Associates, Inc. (the "Adviser") serves as the investment adviser to the Funds.
Smith Breeden Equity Plus Fund (the "Equity Plus Fund") seeks to provide
a total return exceeding the Standard & Poor's 500 Composite Stock Price
Index without additional equity market risk. The previous name of the
Equity Plus Fund was the Smith Breeden Market Tracking Fund.
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 Fund's securities may significantly exceed six months
at times.
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.
An investment in any of the Funds is neither insured nor guaranteed by the
U.S. Government. There can be no assurance that any of the Funds will meet
their investment objectives. This Prospectus sets forth concisely the
information about the Funds that you should know before investing. You are
advised to read this Prospectus carefully and keep it for future reference.
A Statement of Additional Information, dated August 1, 1996 which is
incorporated herein by reference, has been filed with the Securities and
Exchange Commission with respect to each Fund. The Statements of Additional
Information, which may be revised from time to time, contain further
information about the Funds, and are available without charge by writing to
the Funds at 100 Europa Drive, Chapel Hill, North Carolina 27514 or by
calling 1-800-221-3138.
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 PASSED UPON THE ACCURACY OR
ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
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TABLE OF CONTENTS
Expense Table. . . . . . . . . . . . . . . . . . . . . . . . .3
Financial Highlights--Equity Plus Fund . . . . . . . . . . . .5
Financial Highlights--Short Series . . . . . . . . . . . . . .6
Financial Highlights--Intermediate Series. . . . . . . . . . .7
Smith Breeden Mutual Funds.... . . . . . . . . . . . . . . . .8
Investment Objectives, Policies and Risk
Considerations . . . . . . . . . . . . . . . . . . . . . . . .8
Other Investment Practices and Risk Considerations . . . . . 20
Management of the Funds . . .. . . . . . . . . . . . . . . . 22
Pricing of Fund Shares . . . . . . . . . . . . . . . . . . . 26
How to Purchase Shares . . . . . . . . . . . . . . . . . . . 27
How to Exchange Shares . . . . . . . . . . . . . . . . . . . 29
How to Redeem Shares . . . . . . . . . . . . . . . . . . . . 30
Dividends and Distributions. . . . . . . . . . . . . . . . . 33
Shareholder Reports and Information. . . . . . . . . . . . . 34
Retirement Plans . . . . . . . . . . . . . . . . . . . . . . 34
Service and Distribution Plans . . . . . . . . . . . . . . . 35
Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Capital Structure. . . . . . . . . . . . . . . . . . . . . . 36
Transfer, Dividend Disbursing Agent, Custodian and
Independent Auditors. . . . . . . . . . . . . . . . . . . 37
Fund Performance . . . . . . . . . . . . . . . . . . . . . . 37
No person has been authorized to give any information
or to make any representations not contained in this
Prospectus and, if given or made, such information or
representations must not be relied upon as having been
authorized by the Funds. The Prospectus does not
constitute an offering by the Funds in any
jurisdiction in which such offering may not be
lawfully made.
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EXPENSE TABLE
The following table is designed to assist you in
understanding the expenses you will bear as a
shareholder in the Funds. Shareholder Transaction
Expenses are charges that you pay when buying or
selling shares of a Fund. Annual Fund Operating
Expenses are paid out of a Fund's assets and include
fees for portfolio management, maintenance of
shareholder accounts, shareholder servicing,
accounting and other services. The expenses shown
below are based on each Fund's expenses for the past
fiscal year.
Short Intermediate Equity Plus
Series Series Fund
Shareholder
Transaction Expenses
Maximum Sales Load
Imposed on Purchases None None None
Maximum Sales Load
Imposed on Reinvested
Dividends None None None
Deferred Sales Load
Imposed on Redemptions None None None
Redemption Fees1 None None None
Exchange Fees None None None
Annual Fund Operating
Expenses
(as a percentage of
average net assets)
Management Fees2 0.70% 0.70% 0.70%
Other Expenses (net
of reimbursement) 0.18% 0.08% 0.18%
Total Fund Operating
Expenses (net of
reimbursement)3 0.88% 0.78% 0.88%
_____________________________
1 A transaction cost of $9 may be imposed on redemptions by wire transfer.
2 Pursuant to a distribution and services plan in respect of each
Fund, the Adviser may pay annual distribution and servicing fees of
up to 0.25% of each of the Funds' net assets out of its management
fee. See "Service and Distribution Plans."
3 The Other Expenses in the table and Total Fund Operating Expenses
reflect undertakings by the Adviser to bear expenses of each of the
Funds and/or waive its fees to the extent necessary to limit Total
Fund Operating Expenses to 0.78% for the Short Series and 0.88% for
each of the Equity Plus Fund and Intermediate Series through March
31, 1997 and are estimates which are based upon Total Fund Operating
Expenses for the fiscal year ended March 31, 1996. Absent the
expense limitation, Other Expenses and Total Fund Operating Expenses
would be 0.23% and 0.93% for the Short Series, 0.44% and 1.14% for
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the Intermediate Series, and 3.88% and 4.58% for the Equity Plus
Fund. Actual Total Fund Operating Expenses for the fiscal year
ended March 31, 1996 were 0.78% for the Short Series and 0.90% for
each of the Equity Plus Fund and Intermediate Series.
The following examples illustrate the expenses that
apply to a $500 investment in each Fund 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
Funds charge no redemption fees.
Short Duration Series
1 Year 3 Years 5 Years 10 Years
$ 4 $ 13 $ 22 $ 48
Intermediate Duration Series and Equity Plus Fund
1 Year 3 Years 5 Years 10 Years
$ 5 $ 15 $ 24 $ 53
These examples are 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 Funds may be recommended to investors by
registered investment advisors. Such advisors
customarily impose 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
Funds, nor the Adviser, exercise any control over such
advisory fees and may not be informed of the level of
such fees.
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EQUITY PLUS FUND
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods from
June 30, 1992, the date the Fund commenced operations, through March 31, 1996
and are a part of the Fund's financial statements which have been audited by
Deloitte & Touche LLP,independent auditors. This data should be read in
conjunction with the Fund's most recent annual audited financial statements
and the report of Deloitte & Touch LLP thereon which appear in the Fund's
Statement of Additional Information. (The Equity Plus Fund was previously
named The Market Tracking Fund.)
Year Ended Year Ended Year Ended Period Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31, 1993
Net Asset Value,
Beginning of Period... $10.84 $9.88 $10.85 $10.00
Income From Investment
Operations
Net investment income. 0.615 0.568 0.476 0.355
Net realized and
unrealized gain (loss)
on investments........ 2.768 1.081 (0.216) 1.281
Total from investment
operations............ 3.383 1.649 0.260 1.636
Less Distributions
Dividends from net
investment income..... (0.583) (0.568) (0.472) (0.311)
Dividends in excess of
net investment income. -- (0.001) -- --
Distributions from net
realized gains on
investments........... (1.370) (0.047) (0.701) (0.420)
Distributions in excess
of net realized gains
on investments........ -- (0.073) (0.057) (0.055)
Total distributions... (1.953) (0.689) (1.230) (0.786)
Net Asset Value,
End of Period......... $12.27 $10.84 $9.88 $10.85
Total Return.......... 32.30% 17.18% 2.19% 22.59%*
Ratios/Supplemental Data
Net assets, end of
period................$4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to
average net assets
Before expense
limitation.......... 4.58% 7.75% 7.08% 28.48%*
After expense
limitation.......... 0.90% 0.90% 0.90% 0.57%*
Ratio of net income to
average net assets
Before expense
limitation.......... 1.85% 0.59% 1.84% (22.63%)*
After expense
limitation.......... 5.53% 7.44% 8.02% 5.28%*
Portfolio turnover rate 107% 120% 119% 271%
* Annualized
Additional performance information is presented in the Fund's Annual Report,
which is available without charge upon request.
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SHORT DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods from
March 31, 1992, the date the Fund commenced operations, through March 31, 1996
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 Fund's Statement of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31,1996 March 31, 1995 March 31,1994 March 31,1993
Net Asset Value,
Beginning of Period.... $9.90 $9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income.. 0.621 0.628 0.432 0.552
Net gain (loss) on
securities (both realized
and unrealized)........ (0.148) -- (0.070) 0.002
Total from investment
operations............. 0.473 0.628 0.362 0.554
Less Distributions
Dividends from net
investment income...... (0.621) (0.628) (0.462) (0.554)
Dividends in excess of
investment income...... (0.012) -- -- --
Total distributions.... (0.633) (0.628) (0.462) (0.554)
Net Asset Value, End of
Period................. $9.74 $9.90 $9.90 $10.00
Total Return........... 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of
period................. $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to
average net assets
Before expense
limitation........... 0.93% 0.92% 1.00% 2.58%
After expense
limitation........... 0.78% 0.78% 0.78% 0.78%
Ratio of net income to
average net assets
Before expense
limitation........... 6.13% 6.18% 3.95% 2.73%
After expense
limitation........... 6.29% 6.33% 4.17% 4.53%
Portfolio turnover rate 225% 47% 112% 3%
Additional performance information is presented in the Short Series' Annual
Report, which is available without charge upon request.
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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 fiscal periods from
March 31, 1992, the date the Fund commenced operations, through March 31, 1996
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 Fund's Statement of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31,1996 March 31,1995 March 31,1994 March 31,1993
Net Asset Value,
Beginning of Period.... $9.83 $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment income.. 0.660 0.664 1.05 0.826
Net gain (loss) on
securities (both
realized and unrealized) 0.277 (0.049) (0.601) 0.621
Total from investment
operations............. 0.937 0.615 0.449 1.447
Less Distributions
Dividends from net
investment income...... (0.656) (0.664) (1.044) (0.826)
Dividends in excess of
net investment income.. -- (0.108) -- --
Distributions from net
realized gains on
investments.......... (0.101) -- (0.015) --
Distributions in excess
of net realized gains on
investments............ -- (0.022) -- --
Total distributions.... (0.757) (0.794) (1.059) (0.826)
Net asset value, end
of period.............. $10.01 $9.83 $10.01 $10.62
Total Return........... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of
period................. $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to
average net assets
Before expense
limitation.......... 1.14% 2.33% 2.34% 17.52%
After expense
limitation.......... 0.90% 0.90% 0.90% 0.82%
Ratio of net income to
average net assets
Before expense
limitation.......... 6.26% 4.77% 6.30% (8.52)%
After expense
limitation.......... 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate 193% 557% 84% 42%
Additional performance information is presented in the Intermediate Series'
Annual Report, which is available without charge upon request.
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SMITH BREEDEN MUTUAL FUNDS
The Short and Intermediate Series are series of the Smith Breeden Series Fund
(the "Series Fund"), an open-end diversified management investment company,
registered under the Investment Company Act of 1940 (the "1940 Act"). The
Series Fund currently issues shares in two series, which are the Short and
Intermediate Series. The Equity Plus Fund is currently the only series of the
Smith Breeden Trust (the "Trust"), also an open-end diversified management
investment company registered under the 1940 Act.
Smith Breeden Associates, Inc. ("Smith Breeden" or the "Adviser") acts as
investment adviser to the Funds. Smith Breeden is a money management and
consulting firm founded in 1982 whose clients include pension funds,
financial institutions, corporations, government entities and charitable
foundations. The firm specializes in mortgage securities, interest-rate risk
management, and the application of option pricing to investments and banking.
Smith Breeden currently advises, or manages on a discretionary basis, assets
totalling over $20 billion.
INVESTMENT OBJECTIVES, POLICIES, AND RISK CONSIDERATIONS
Each of the Funds has a different investment objective and a different
investment policy since each Fund is designed to meet different investment
needs.
The investment objectives and certain investment policies of the Short and
Intermediate Series are fundamental and may not be changed without a vote of
shareholders of the relevant Fund. The investment objective of the Equity
Plus Fund is not fundamental, and may be changed without a vote of the
majority of the shareholders of the Equity Plus Fund. Shareholders of the
Equity Plus Fund will receive a written notification at least thirty days
prior to any change in the Equity Plus Fund's investment objective. If such
a change in the investment objective of the Equity Plus Fund occurs, such
changes may result in the Fund having an investment objective different from
the objective which the shareholders considered appropriate at the time of
their investment in the Equity Plus Fund.
Because shares of each Fund represent an investment in securities with
fluctuating market prices, you should understand that the net asset value per
share of each Fund will vary as the aggregate value of a Fund's portfolio
securities increases or decreases. Because of the risks inherent in all
investments, there can be no assurance that the objectives of the Funds will
be met. The descriptions that follow are designed to help you choose the
Fund or combination of Funds that best fits your investment objectives.
Short 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.
Under normal circumstances the Short Series will seek to achieve an
interest-rate risk or option-adjusted duration similar to that of a six-month
U.S. Treasury security on a constant maturity basis. Option-adjusted duration
-8-
is a measure of the price sensitivity (in percentage) of a portfolio to
changes in interest rates, taking into account the changing nature of
expected cash flows, as influenced by mortgage prepayments and other factors.
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.
The maturity of a security measures only the time until final payment is due,
whereas option-adjusted duration takes into account the pattern of all
payments of interest and principal on a security over time, including how
these payments are affected by prepayments and by changes in interest rates.
In computing the duration of the Short 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 changes in
interest rates on prepayments and coupon flows. The Adviser will use certain
hedging techniques (discussed in more detail in Appendix A and in "Investment
Policies of the Short and Intermediate Series and Fixed Income Segment of the
Equity Plus Fund") to lengthen or shorten the option-adjusted duration of the
Short Series' portfolio so that it targets the interest-rate risk of a six-
month U.S. Treasury security.
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
U.S. 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
those that invest 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 in which other funds may invest. However,
such higher yielding securities may be more volatile and may be issued by
less creditworthy entities.
Intermediate 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 in value of the investment assuming reinvestment of all
distributions. Under normal circumstances, the Intermediate Series will seek
to achieve an interest-rate risk or option-adjusted 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 the that of intermediate-term U.S. Treasury
Notes, and typically will range between three and five years. 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.
Option-adjusted duration is a measure of the price sensitivity (in
percentage) of a portfolio to changes in interest rates, taking into account
the changing nature of expected cash flows, as influenced by mortgage
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prepayments and other factors. The maturity of a security measures only the
time until final payment is due, whereas option-adjusted duration takes into
account the pattern of all payments of interest and principal on a security
over time, including how these payments are 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 changes in interest rates on prepayments and coupon flows.
The Adviser may use certain hedging techniques (as described in more detail
in Appendix A and in "Investment Policies of the Short and Intermediate
Series and Fixed Income Segment of the Equity Plus Fund") to lengthen or
shorten the option-adjusted duration of the Intermediate Series so that it
targets the interest-rate risk of a portfolio that invests exclusively in
mortgage-backed securities, as weighted in the major mortgage indices.
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.
Equity Plus Fund
The Equity Plus Fund seeks to provide a total return exceeding the Standard
& Poor's Composite Stock Price Index (the "S&P 500 Index") without additional
equity market risk. (The former name of the Equity Plus Fund was the Smith
Breeden Market Tracking Fund.) Total return is a measure of investment
performance which includes all of the interest, dividends and other income,
net of expenses, paid on the Fund's investments, as well as all realized and
unrealized capital gains and losses. The S&P 500 Index is composed of 500
common stocks, most of which are listed on the New York Stock Exchange.
Standard & Poor's, which is not a sponsor of or in any other way affiliated
with the Fund, chooses the 500 stocks included in the S&P 500 Index on the
basis of market value and industry diversification. The S&P 500 Index
assigns relative values to the stocks included in the index, weighted
according to each stock's total market value relative to the total market
value of the other stocks included in the index.
The Equity Plus Fund seeks to achieve its objective by dividing its portfolio
into two separate segments, an "Equity Simulation Segment" and a "Fixed
Income Segment." The Equity Plus Fund's Equity Simulation Segment will
invest in a combination of Equity Swap Contracts (described more fully
below), futures contracts on the S&P 500 Index and on other stock indices,
including, but not limited to the New York Stock Exchange Composite Index
("S&P 500 and Other Stock Index Futures"), and a combination of common stocks
whose return (before deducting allocated costs) is expected to track
movements in the S&P 500 Index. In the Equity Simulation Segment, the Equity
Plus Fund expects its use of stock index futures other than S&P 500 Stock
Index Futures to be minimal.
The Equity Plus Fund's Fixed Income Segment will seek a total return greater
than the expenses of the Fund (including the expenses associated with the
Equity Simulation Segment such as those relating to the Equity Swap Contracts
and S&P 500 and Other Stock Index Futures) by investing in fixed-income
securities and futures, options, floors, caps and swaps related thereto.
Through these investments, the Fixed Income Segment seeks to generate income
(consisting primarily of interest income) and gains which exceed the expenses
of operating the entire Equity Plus Fund. Thus, whether the Fund outperforms
-10-
or underperforms the S&P 500 Index will depend on whether the total return on
the Fixed Income Segment is greater or less than the Fund's total operating
expenses (including transaction costs and the costs of the equity derivative
instruments held in the Equity Simulation Segment), respectively.
Investment Policies of the Equity Simulation Segment of the Equity Plus Fund
As stated above, the Equity Plus Fund's Equity Simulation Segment will invest
in a combination of Equity Swap Contracts, S&P 500 and other Stock Index
Futures, and a combination of common stocks whose return is expected to track
movements in the S&P 500 Index. By employing such a strategy, the Equity
Plus Fund seeks to achieve the same opportunity and risk profile for the
Equity Simulation Segment as that of a hypothetical portfolio, equal in size
to the Fund, invested in the common stocks comprising the S&P 500 Index (in
proportion to their respective weight in the S&P 500 Index.)
Set forth below is an example of a hypothetical portfolio allocation for the
Fund, assuming total assets of $100 million. The Fund might:
1. Enter into an Equity Swap Contract with a notional amount of $50 million;
2. Purchase S&P 500 Index Futures contracts with a total value of $45
million; and
3. Purchase $5 million worth of common stocks comprising the S&P 500 Index
in proportion to their respective weightings in the S&P 500 Index.
The Fixed Income Segment would invest $100 million in various fixed income
assets with appropriate hedging strategies. If, during the course of the
year, the stocks comprising the S&P 500 Index appreciate 10% on average and
pay a 4% dividend, and if the interest on the Equity Swap Contract's notional
amount is 6%, at the end of the year the following would occur:
1. The counterparty to the equity swap contract will be required to pay
the Fund $4 million ($7 million appreciation and dividends minus $3
million interest);
2. The S&P 500 Index Futures contract would be closed out at a gain of $3.6
million ($6.3 million S&P 500 Index appreciation less $2.7 million for
the S&P 500 Futures implicit cost of carry);
3. Dividend income and gain on the common stocks would total $0.7 million
and in sum;
4. The Fund's return, before Fund operating expenses, would total $8.3
million dollars or 8.3%.
The Fund's total operating expenses (other than brokerage expenses and the
interest on the notional amount of the Equity Swap contract as described
above) are 0.88% of total net assets or $0.88 million dollars. After
consideration of these expenses, the Fund's return would total 7.42%.
Therefore, the Fund will achieve a total return equal to the S&P 500 Index
only if the Fixed Income Segment has a total return equal to 6.58% per annum.
If the Fixed Income Segment achieves this result, then the Fund's total net
assets will be $114 million - an increase of 14% and a total return equal to
the S&P 500 Index. If the Fixed Income Segment's total return is greater or
less than 6.58% per annum, the Fund's total return will, in turn, be greater
or less than the S&P 500 Index.
The Equity Simulation Segment's actual opportunities for gain and loss will
tend to be greater than a hypothetical portfolio invested in the stocks
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comprising the S&P 500 Index if the Fund's exposure to the S&P 500 Index is
higher or lower than the Fund's total assets. For example, the total
notional amount of the Fund's Equity Swap Contracts (less the notional
amount of any Reverse Equity Swap Contracts) plus the face amount of the
Fund's S&P 500 or Other Stock Index Futures plus the market value of common
stocks owned by the Fund may exceed the Fund's total net assets from time to
time, due to purchases and redemptions which will frequently affect the
Fund's total assets and because S&P 500 Index Futures can only be purchased
in multiples of 500 times the S&P 500 Index. Under normal market conditions,
the Fund expects that such variations in exposure to the S&P 500 Index will
generally be up to 5% greater or less than the Fund's total net assets.
Also, the ability of the Equity Simulation Segment of the Fund's portfolio to
replicate the opportunity and risk profile of a hypothetical stock portfolio
may be diminished by imperfect correlations between price movements of the
S&P 500 Index itself with price movements of S&P 500 and Other Stock Index
Futures and/or the common stocks purchased by the Fund. In addition, the
purchase and sale of common stocks and S&P 500 and Other Stock Index Futures
involve transaction costs and Equity Swap Contracts require the Fund to pay
interest on the notional amount of the contract. Therefore, if the aggregate
face amount of the Fund's S&P 500 and Other Stock Index Futures, the
notional amount of the Fund's Equity Swap Contracts (less the notional amount
of any Reverse Equity Swap Contracts) and the value of the Fund's common
stocks is equal to the Fund's total net assets, and if there is exact price
movement correlation between the Fund's common stocks and/or S&P 500 Index
and Other Stock Index Futures and the S&P 500 Index, the Fund will outperform
the S&P 500 Index only if the total net return on the Fixed Income Segment of
the Fund's portfolio exceeds the sum of (1) the Fund's transaction costs on
S&P 500 and Other Stock Index Futures and common stock transactions, (2) the
interest payments under the Fund's Equity Swap Contracts and (3) all the
Fund's operating expenses as described more fully under "Management of the
Fund."
The Equity Plus Fund will not enter into any Equity Swap Contract or Reverse
Equity Swap Contract unless, at the time of entering into such transaction,
the unsecured senior debt of the counterparty is rated at least A by Moody's
Investors Service, Inc. ("Moody's") or Standard & Poor's ("S&P"). In
addition, the staff of the SEC considers Equity Swap Contracts and Reverse
Equity Swap Contracts to be illiquid securities. Consequently, while the
staff maintains this position, the Fund will not invest in Equity Swap
Contracts or Reverse Equity Swap Contracts if, as a result of the investment,
the total value of such investments together with that of all other illiquid
securities which the Fund owns would exceed 15% of the Fund's total assets.
The Adviser and the Equity Plus Fund do not believe that the Fund's
obligations under Equity Swap Contracts or Reverse Equity Swap Contracts are
senior securities, so long as a segregated account is maintained, and,
accordingly, the Fund will not treat them as being subject to its borrowing
restrictions. The net amount of the excess, if any, of the Fund's
obligations over its entitlements with respect to each Equity Swap Contract
and each Reverse Equity Swap Contract will be accrued on a daily basis and an
amount of cash, U.S. Government Securities or other liquid high quality debt
securities having an aggregate market value at least equal to the accrued
excess will be maintained in a segregated account by the Fund's custodian.
The Equity Plus Fund will not purchase S&P 500 or Other Stock Index Futures,
except for bona fide hedging purposes, if as a result the Fund's aggregate
initial margin deposits and premiums would be greater than 5% of the Fund's
-12-
total assets. In addition to margin deposits, when the Fund purchases an S&P
500 or Other Stock Index Futures Contract, it is required to maintain at all
times while the contract is held by the Fund, cash, U.S. government
securities or other liquid high quality debt obligations in a segregated
account with its Custodian, in an amount which, together with the initial
margin deposit on the futures contract, is equal to the current delivery or
cash settlement value of the futures contract.
The Fund will not use Equity Swap Contracts, or S&P 500 or Other Stock Index
Futures for leverage.
Characteristics of the Securities in which the Equity Segment of the Equity
Plus Fund may invest.
Equity Swap Contracts. The Equity Simulation Segment will use equity swap
contracts whose return (before deducting interest costs) is expected to track
closely the return of the S&P 500 Index ("Equity Swap Contracts"). The
counterparty to an Equity Swap Contract will typically be a bank, investment
banking firm or broker/dealer. The counterparty generally agrees to pay the
Fund the amount, if any, by which the notional amount of the Equity Swap
Contract would have increased in value had it been invested in the stocks
comprising the S&P 500 Index in proportion to the composition of the Index,
plus the dividends that would have been received on those stocks. The Fund
agrees to pay to the counterparty a floating rate of interest (typically the
London Inter Bank Offered Rate) on the notional amount of the Equity Swap
Contract plus the amount, if any, by which that notional amount would have
decreased in value had it been invested in such stocks. Therefore, the
return to the Fund on any Equity Swap Contract should be the gain or loss on
the notional amount plus dividends on the stocks comprising the S&P 500 Index
(as if the Fund had invested the notional amount in stocks comprising the S&P
500 Index) less the interest paid by the Fund on the notional amount. The
Fund will enter into Equity Swap Contracts only on a net basis, i.e., where
the two parties' obligations are netted out, with the Fund paying or
receiving, as the case may be, only the net amount of any payments.
Payments under an Equity Swap Contract may be made at the conclusion of the
contract or periodically during its term. If there is a default by the
counterparty to an Equity Swap Contract, the Fund will be limited to
contractual remedies pursuant to the agreements related to the transaction.
There is no assurance that Equity Swap Contract counterparties will be able
to meet their obligations pursuant to Equity Swap Contracts or that, in the
event of default, the Fund will succeed in pursuing contractual remedies.
The Fund thus assumes the risk that it may be delayed in or prevented from
obtaining payments owed to it pursuant to Equity Swap Contracts. The Fund
will closely monitor the credit of Equity Swap Contract counterparties in
order to minimize this risk.
The Fund may from time to time enter into the opposite side of Equity Swap
Contracts (i.e., where the Fund is obligated to pay the increase (net of
interest) or receive the decrease (plus interest) on the S&P 500 Index) to
reduce the amount of the Fund's equity market exposure consistent with the
Fund's objective. These positions are sometimes referred to as "Reverse
Equity Swap Contracts".
S&P 500 Index and Other Stock Index Futures. The Equity Simulation Segment
of the Fund may also invest in S&P 500 and Other Stock Index Futures to track
the return of the S&P 500 Index.
-13-
S&P 500 and Other Stock Index Futures represent contracts to buy a number of
units of the S&P 500 Index or some other stock index at a specified future
date at a price agreed upon when the contract is made. Upon entering into a
contract, the Fund will be required to deposit with its custodian in a
segregated account in the name of the futures broker a specified amount of
cash or securities, generally not exceeding 5% of the face amount of the
contract. This amount is known as "initial margin" and is in the nature of
a performance bond or good faith deposit on the contract which is returned to
the Fund upon termination of the futures contract, assuming all contractual
obligations have been satisfied. Subsequent payments, called "variation
margin" to and from the broker will be made on a daily basis as the price of
the S&P 500 or Other Stock Index Future fluctuates.
Long positions in S&P 500 or Other Stock Index Futures may be closed out only
by entering into a futures contract sale with the same terms as the contract
to be closed out on the futures exchange on which the futures are traded.
The liquidity of the market in S&P 500 or Other Stock Index Futures could be
adversely affected by "daily price fluctuation limits" established by an
exchange which limit the amount of fluctuation in the price of an S&P 500 or
Other Stock Index Futures contract during a single trading day. In such
case, it may not be possible for the Fund to close out its futures contract
position, and, in the event of adverse price movements, the Fund would
continue to be required to make daily cash payments of variation margin.
Common Stocks. When S&P 500 or Other Stock Index Futures and/or Equity Swap
Contracts are, in the judgement of the Adviser, overpriced relative to the
common stocks underlying the S&P 500 Index, the Fund may also invest directly
in the common stocks represented by the S&P 500 Index. The Fund will
generally not own all 500 issues, but will attempt to purchase a basket of
common stocks which the Adviser expects will, on average, match movements in
the S&P 500 Index. Subject to limits on the Fund's investments in other
investment companies, the Fund may also invest in these stocks indirectly by
purchasing interests in asset pools investing in such stocks. To the extent
that the Fund purchases interests in other investment companies, shareholders
of the Fund may be subject to a layering of expenses because they may
indirectly bear a proportionate share of the expenses of such investment
companies (including advisory fees) in addition to bearing the direct
expenses of the Fund.
Investment Policies of the Short and Intermediate Series and the Fixed Income
Segment of the Equity Plus Fund
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. The Fixed Income
Segment of the Equity Plus Fund will also invest substantially in U.S.
Government securities." U.S. Government Securities" include U.S. Treasury
Bills, Notes, Bonds, discount notes 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.
(Other U.S. Government agencies or instrumentalities include Federal Home
Loan Banks, Bank for Cooperatives, Farm Credit Banks, Tennessee Valley
Authority, Federal Financing Bank, Small Business Administration, and Federal
Agricultural Mortgage Corporation.) It is anticipated that the Funds will
invest substantially in FNMA, FHLMC, and GNMA mortgage-backed certificates
-14-
and other U.S. Government Securities representing ownership interests in
mortgage pools.
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 ("S&P") or Aaa by Moody's
Investors Service ("Moody's") or, if unrated, determined by the Adviser to be
of comparable quality. The two Series may also invest in money market
instruments of a comparable short-term rating or credit quality, as well as
in time and savings deposits (including fixed-rate or adjustable-rate
certificates of deposit) in commercial banks or in institutions whose
accounts are insured by the FDIC, BIF or SAIF. The Short and Intermediate
Series will not pay any additional fees for credit support and will not
invest in private mortgage pass-through securities unless they are rated AAA
by S&P or Aaa by Moody's, or are unrated but deemed to be of comparable
credit quality by the Adviser. In addition, the Short and Intermediate
Series will only purchase mortgage-backed securities which constitute
"Mortgage Related Securities" for purposes of the Secondary Mortgage Market
Enhancement Act of 1984.
With respect to the remaining assets of the Equity Plus Fund, its Fixed
Income Segment may invest a portion of its assets in bank certificates of
deposit, corporate debt obligations, and mortgage-backed and other asset-
backed securities of non-governmental issuers. At the time of purchase, with
the exception of mortgage-backed and asset-backed securities, the Fund's
Fixed Income Segment's investments will be either of investment grade (as
rated by S&P or Moody's), or, if unrated, determined by the Adviser to be of
comparable quality. Its investment in mortgage-backed and other asset-backed
securities will be rated at least A by Moody's and S&P. The lowest quality
investment grade fixed income securities are rated BBB by Moody's or Baa by
S&P, have certain speculative characteristics, and are more susceptible to
adverse changes in circumstances and economic conditions than higher rated
fixed income securities. The Adviser will monitor the Equity Plus Fund's
investments in fixed income securities and will cause the Equity Plus Fund to
dispose of any such security whose rating is reduced to below investment
grade.
While certain U.S. Government securities such as U.S. Treasury obligations
and GNMAs are backed by the full faith and credit of the U.S. Government,
other securities in which the Funds may invest are subject to varying degrees
of risk of default. These risk factors include the creditworthiness of the
issuer and, in the case of mortgage-backed and asset-backed securities, the
ability of the mortgagor or other borrower to meet its obligations. The
Short and Intermediate Series will seek to minimize this credit risk by
investing in securities of the highest credit quality instruments, while the
Equity Plus Fund will seek to minimize this risk of default by investing in
securities of investment grade. The individual securities continue to be
subject to the risk that their prices can fluctuate, in some cases
significantly, due to changes in prevailing interest rates.
The Short and Intermediate Series may employ certain active management
techniques both 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 and targeted option-adjusted
durations. In addition, the Fixed Income Segment of the Equity Plus Fund
will engage in various hedging strategies so that its volatility will be
-15-
similar to that of a one-year Treasury Bill. Such investment techniques and
hedging strategies include mortgage and interest rate swaps, interest rate
futures and options on such futures, short sales and interest rate caps,
floors and collars. In addition, the Short and Intermediate Series may use
stripped mortgage-backed securities to reduce the option-adjusted duration.
Appendix A provides information about these hedging techniques.
There can be no assurance that the hedging techniques employed by the Short
and Intermediate Series and the Fixed Income Segment of the Equity Plus Fund
will be successful. As a result, the Funds may not achieve, and may at times
exceed, their targeted option-adjusted duration. The Funds' hedging
techniques may not be successful because the Adviser's computation of
option-adjusted duration is based on estimates of expected prepayment rates,
valuation of homeowners' prepayment options, and the correlation of changes
in the market prices of the securities and the hedge instruments owned by the
Funds (as described in Appendix A).
Both of the Series, as well as the Fixed Income Segment of the Equity Plus
Fund, may also engage in loans of portfolio securities, dollar rolls and
reverse repurchase agreements as investment techniques. These techniques
will be undertaken to enhance income and total return.
Characteristics of the Securities in which the Short and Intermediate Series
and Fixed Income Segment of the Equity Plus Fund Invest.
Mortgage-Backed and Other Asset-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; (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 Equity Plus Fund may invest in other mortgage-backed and asset-backed
securities. Asset-backed securities are structured like mortgage-backed
securities, but instead of mortgage loans or interests in mortgage loans, the
underlying assets may include, but are not limited to, pools of automobile
loans, educational loans and credit card receivables.
Mortgage-backed and asset-backed securities have yield and maturity
characteristics corresponding to their underlying assets. Unlike traditional
debt securities, which may pay a fixed rate of interest until maturity when
the entire principal amount comes due, payments on certain mortgage-backed
and asset-backed securities include both interest and a partial payment of
principal. This partial payment of principal may be comprised of a scheduled
principal payment as well as an unscheduled payment from the voluntary
-16-
prepayment, refinancing, or foreclosure of the underlying loans. As a result
of these unscheduled payments of principal, or prepayments on the underlying
securities, the price and yield of mortgage-backed securities can be
adversely affected. For example, during periods of declining interest rates,
prepayments can be expected to accelerate, and the Funds would be required to
reinvest the proceeds at the lower interest rates then available.
Prepayments of mortgages which underlie securities purchased at a premium
could result in capital losses because the premium may not have been fully
amortized at the time the obligation is prepaid. In addition, like other
interest-bearing securities, the values of mortgage-backed securities
generally fall when interest rates rise, but when interest rates fall, their
potential for capital appreciation is limited due to the existence of the
prepayment feature. In order to hedge against possible prepayment, the Funds
may purchase certain options and options on futures contracts as described
more fully in Appendix A.
Adjustable-Rate Securities. Adjustable-rate securities are securities that
have interest rates that are reset at periodic intervals, usually by
reference to some interest rate index or market interest rate. Some
adjustable-rate securities are backed by pools of mortgage loans. The Short
and Intermediate Series will only invest in adjustable-rate securities backed
by pools of mortgage loans ("ARMs"). The Fixed Income Segment of the Equity
Plus Fund may invest in adjustable-rate securities backed by assets other
than mortgage pools.
Although the rate adjustment feature may act as a buffer to reduce large
changes in the value of adjustable-rate securities, these securities are
still subject to changes in value based on changes in market interest rates
or changes in the issuer's creditworthiness. Because the interest rate is
reset only periodically, changes in the interest rates on adjustable-rate
securities may lag changes in prevailing market interest rates. Also, some
adjustable-rate securities (or the underlying mortgages or other underlying
loans or receivables) are subject to caps or floors that limit the maximum
change in interest rate during a specified period or over the life of the
security. Because of the resetting of interest rates, adjustable-rate
securities are less likely than non-adjustable-rate securities of comparable
quality and maturity to increase significantly in value when market interest
rates fall. Adjustable-rate securities are also subject to the prepayment
risks associated with mortgage-backed securities generally.
Collateralized Mortgage Obligations ("CMOs") A CMO is a security backed by
a portfolio of mortgages or mortgage-backed securities held under an
indenture. The issuer's obligation to make interest and principal payments
is secured by the underlying portfolio of mortgages or mortgage-backed
securities. CMOs are issued with a number of classes or series which have
different maturities representing interests in some or all of the interest or
principal on the underlying collateral or a combination thereof. Payments of
interest or principal on some classes or series of CMOs may be subject to
contingencies, or some classes or series may bear some or all of the risk of
default on the underlying mortgages. CMOs of different classes are generally
retired in sequence as the underlying mortgage loans in the mortgage pools
are repaid. In the event of sufficient early prepayments on such mortgages,
the class or series of CMO first to mature generally will be retired prior to
its stated maturity. Thus, the early retirement of a particular class or
series of a CMO held by the Funds would have the same effect as the
prepayment of mortgages underlying a mortgage-backed pass-through security.
Another type of CMO is a real estate mortgage investment conduit ("REMIC")
-17-
which 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 also include securities representing the interest in any excess cash
flow and/or the value of any collateral remaining after the issuer has
applied cash flow from the underlying mortgages or mortgage-backed securities
to the payment of principal of and interest on all other CMOs and the
administrative expenses of the issuer ("Residuals"). Residuals have value
only to the extent that income from such underlying mortgages or
mortgage-backed securities exceeds the amounts necessary to satisfy the
issuer's debt obligations represented by all other outstanding classes or
series of the CMOs. In addition, if a CMO bears interest at an adjustable-
rate, the cash flows on the related Residual will also be extremely sensitive
to the level of the index upon which the rate adjustments are based. As a
non-fundamental policy (meaning it can be changed without the vote of the
shareholders), the Short and Intermediate Series will not invest in
Residuals.
In reliance on an interpretation by the Securities and Exchange Commission
("SEC"), the Funds' investments in certain qualifying CMOs and REMICs are not
subject to the 1940 Act's limitations on acquiring interests in other
investment companies. See "Investment Restrictions" in the Statement of
Additional Information with respect to each Fund. CMOs and REMICs issued by
an agency or instrumentality of the U.S. Government are considered U.S.
Government securities for the purposes of this Prospectus.
Stripped Securities ("STRIPS"). The Funds may invest in STRIPS. The Short
and Intermediate Series may invest only in stripped mortgage-backed
securities ("SMBS") which are STRIPS represented by 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. However, the Short and
Intermediate Series will purchase only SMBS that are collateralized by
mortgage-backed securities that are issued or guaranteed by the U.S.
Government or its agencies or instrumentalities. The Equity Plus Fund may
invest in STRIPS collateralized by other fixed income securities, including
other types of asset-backed securities.
STRIPS are usually structured with two classes that receive different
proportions of the interest and principal distributions from a pool of
underlying assets. A common type of STRIP will have one class receiving all
of the interest from the underlying assets ("interest-only" or "IO" class),
while the other class will receive all of the principal ("principal-only" or
"PO" class). 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. STRIPS are unusually
volatile in response to changes in interest rates. The yield to maturity on
an IO class of STRIPS is extremely sensitive not only to changes in
prevailing interest rates but also to the rate of principal payments
(including prepayments) on the underlying assets. A rapid rate of principal
prepayments may have a measurably adverse effect on a Fund's yield to
maturity to the extent it invests in IOs. Conversely, POs tend to increase
in value if prepayments are greater than anticipated and decline if
prepayments are slower than anticipated. Thus, if the underlying assets
-18-
experience greater than anticipated prepayments of principal, a Fund may fail
to fully recover its initial investment in these securities, even if the
STRIPS were rated of the highest credit quality by S&P or Moody's,
respectively. 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 Instruments" and in
Appendix A. In addition, the secondary market for STRIPS may be less liquid
than that for other mortgage-backed or asset-backed securities, potentially
limiting a Fund's ability to buy or sell those securities at any particular
time.
The Adviser expects that IO SMBS will be purchased by the Short and
Intermediate Series for their hedging characteristics. Such SMBS will reduce
the variance of the Funds' respective net asset values from their targeted
option-adjusted durations. Under no circumstances will the Short or
Intermediate Series purchase SMBS if such purchase would cause SMBS to exceed
5% of the assets of a Fund.
New instruments and variations of existing mortgage-backed securities
continue to be developed. The Funds may invest in any such instruments or
variations to the extent consistent with their investment objectives and
policies and applicable regulatory requirements.
Zero Coupon Securities. The Funds may also invest in "zero coupon"
securities (which are issued at a significant discount from face value and
pay interest only at maturity rather than at intervals during the life of the
security). Zero coupon securities tend to be more volatile than other
securities with similar stated maturities, but which make regular payments of
either principal or interest.
The Funds are required to accrue and distribute income from zero coupon
securities on a current basis, even though a Fund does not receive the income
currently. Thus, a Fund may have to sell other investments to obtain cash
needed to make income distributions, which may reduce a Fund's assets and may
thereby increase its expense ratio and decrease its rate of return.
Hedging Instruments. The Funds may employ certain active management
techniques to achieve their duration objectives and to hedge the interest-
rate risks associated with their fixed-income securities in accordance with
such objectives. Since some of the securities may have longer or shorter
durations than a Fund's specified duration objectives, hedging may be
required either to lengthen or to shorten the duration of a Fund's portfolio.
The Funds will seek continually to manage duration within a narrow range.
The Funds intend to use hedging transactions primarily to protect against
interest-rate fluctuations and not as speculative transactions. The Funds
may also use hedging transactions as a temporary substitute for purchasing
particular securities. Each Fund may enter into mortgage and interest-rate
swaps, purchase or sell interest-rate floors, caps or collars, enter into
interest-rate futures contracts and related options, and engage in short
sales to hedge against interest rate fluctuations. In addition, the Funds
may use SMBS to better maintain 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 Funds currently contemplate using are described in
detail in Appendix A, including a discussion of their respective risks.
-19-
As a matter of fundamental policy, the Short and Intermediate Series will
limit purchases to 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; and
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.
OTHER INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Funds may also engage in the following investment practices, each of
which may involve certain special risks. The Statement of Additional
Information for each Fund contains more detailed information about these
practices, including limitations designed to reduce these risks.
Securities Loans, Repurchase Agreements and Forward Commitments. The Funds
may lend portfolio securities to broker-dealers and may enter into repurchase
agreements. These transactions must be fully collateralized at all times but
involve some risk to the Funds if the other party should default on its
obligations and a Fund is delayed or prevented from recovering the
collateral. None of the Funds 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.) The Funds will only enter into repurchase agreements
with or lend securities to (i) member banks of the Federal Reserve System
having total assets in excess of $500 million and (ii) securities dealers,
provided such banks or dealers meet the creditworthiness standards
established by the Board of Trustees ("Qualified Institutions"). The Adviser
will monitor the continued creditworthiness of Qualified Institutions,
subject to the oversight of the Board of Trustees.
The Funds may also purchase securities for future delivery, which may
increase overall investment exposure and involves a risk of loss if the value
of the securities declines prior to the settlement date. At the time a Fund
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 Funds' custodian. Subject to this requirement, the Funds
may purchase securities on such basis without limit. Settlements in the
ordinary course, which may be substantially more than three business days for
mortgage-backed securities, are not treated as when-issued or forward
commitment transactions, and are not subject to the foregoing limitations,
although some of the risks described above may exist.
Reverse Repurchase Agreements, Dollar Roll Agreements and Borrowing. In
order to increase income, the Funds may enter into reverse repurchase
agreements or dollar roll agreements with commercial banks and registered
broker-dealers in amounts up to 33 1/3% of their assets. The Short and
Intermediate Series may only enter into these transactions with commercial
banks and registered broker-dealers which are also Qualified Institutions.
-20-
The Statement of Additional Information for each Fund contains a more
detailed explanation of these practices. Reverse repurchase agreements and
dollar rolls are considered borrowings by a Fund and require segregation of
assets with a Fund's custodian in an amount equal to the Fund's obligations
pending completion of such transactions. Each Fund may also borrow money
from banks in an amount up to 33 1/3% of a Fund's total assets to realize
investment opportunities, for extraordinary or emergency purposes, or for the
clearance of transactions. Borrowing from banks usually involves certain
transaction and ongoing costs and may require a Fund to maintain minimum bank
account balances. Use of these borrowing techniques to purchase securities
is a speculative practice known as "leverage." Depending on whether the
performance of the investments purchased with borrowed funds is sufficient to
meet the costs of borrowing, a Fund's net asset value per share will increase
or decrease, as the case may be, more rapidly than if the Fund did not employ
leverage.
Short Sales. The Funds may make short sales of securities. A short sale is
a transaction in which the Fund sells a security it does not own in
anticipation that the market price of that security will decline. The Funds
expect to engage in short sales as a form of hedging to shorten the overall
duration of the portfolio and in order to maintain portfolio flexibility.
When a Fund makes a short sale, it must 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 completion of the
transaction. A Fund may have to pay a fee to borrow particular securities
and is often obligated to relinquish any payments received on such borrowed
securities.
Until a Fund replaces a borrowed security, it will maintain daily a
segregated account with its custodian containing cash, U.S. Government
securities, or other liquid high-grade debt obligations, such that the amount
deposited in the account plus any amount deposited with the broker as
collateral will equal the current value of the security sold short.
Depending on arrangements made with the broker, a Fund may not receive any
payments (including interest) on collateral deposited with the broker. If the
price of the security sold short increases between the time of the short sale
and the time a Fund replaces the borrowed security, the Fund will incur a
loss; conversely, if the price declines, the Fund will realize a gain.
Although a Fund's gain is limited to the amount 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.
A Fund will not make a short sale if, after giving effect to such sale, the
market value of all securities sold exceeds 25% of the value of the Fund's
total net assets. A Fund may also effect short sales where the Fund owns or
has the right to acquire at no additional cost the identical security (a
technique known as a short sale "against the box").
Illiquid Securities. A Fund 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 for each Fund. The Adviser will monitor a Fund's investments in
illiquid securities under the supervision of the Trustees. The determination
of whether certain IO/PO Strips issued by the U.S. Government and backed by
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fixed-rate mortgages or any other securities in which a Fund desires to
invest are liquid shall be made by the Trustees or the Adviser under
guidelines established by the Trustees in accordance with applicable
pronouncements of the SEC. At present, all other IO/PO Strips, other
residual interests of CMOs and OTC options are treated as illiquid
securities. The SEC staff also currently takes the position that the
interest rate swaps, caps and floors discussed in Appendix A, as well as
Equity Swap Contracts and Reverse Equity Swap Contracts, are illiquid.
Portfolio Turnover. The Adviser buys and sells securities for a Fund
whenever it believes it is appropriate to do so. Portfolio turnover
generally involves some expense to a Fund, including brokerage commissions or
dealer mark-ups and other transaction costs on the sale of securities and
reinvestment in other securities. Such transactions may result in
realization of taxable capital gains. The portfolio turnover rate for each
Fund's previous fiscal periods is shown in the table under the heading
"Financial Highlights".
While the Funds will pay commissions in connection with options and future
transactions and, for the Equity Plus Fund only, possibly in relation to any
purchase of common stocks, most of the securities in which the Funds 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 Fund.
Another potential consequence of high portfolio turnover is that if 30% or
more of a Fund's gross income for a taxable year is derived from gains from
the sale of securities held for less than three months, the Fund would not
qualify as a regulated investment company and, therefore, would be subject
to corporate income tax during that taxable year. The Adviser endeavors to
manage the investment composition of the Funds and to adjust the portfolio
turnover, if necessary, to ensure that each Fund will be eligible for
treatment as a regulated investment company.
MANAGEMENT OF THE FUNDS
The business affairs of the Funds are managed by its Board of Trustees. Each
of the Funds has entered into an investment advisory agreement with Smith
Breeden Associates, Inc., 100 Europa Drive, Chapel Hill, North Carolina,
27514 ( the "Investment Advisory Agreements"). Pursuant to such investment
advisory agreements, the Adviser furnishes continuous investment advisory
services to each of the Funds.
Trustees and Officers
The following is a listing of the Trustees and officers of the Series Fund
and Trust, the legal entities that have issued shares in the Funds. Unless
otherwise indicated, all of the named individuals serve in their capacities
for both the Series Fund and Trust.
Douglas T. Breeden* Trustee and Chairman
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
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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. He is a Director of
Roosevelt Bank of St. Louis, the nation's tenth largest thrift, and served
as Chairman in 1995-96. He also is a principal investor and strategist for
Community First Financial Group, a commercial bank holding company with three
small banks located in Indiana and California. He serves as Chairman of
Harrington Financial Group, the holding company for Harrington Bank, F.S.B.,
of Richmond, Indiana.
Michael J. Giarla* Trustee and President
Mr. Giarla, is an Executive Vice President, a Director and the Chief
Operating Officer of Smith Breeden Associates. He also serves as a Director
of Harrington Financial Group, the holding company for Harrington Bank,
F.S.B., of Richmond, Indiana. Formerly Smith Breeden's Director of Research,
he was involved in research and programming, particularly in the development
and implementation of models to evaluate and hedge mortgage securities. He
also consults with institutional clients and conducts special projects.
Before joining Smith Breeden Associates, Mr. Giarla was a Summer Associate in
Goldman Sachs & Company's Equity Strategy Group in New York. Mr. Giarla has
published a number of articles and book chapters regarding MBS investment,
risk management and hedging. He served as an Associate Editor of The Journal
of Fixed Income from 1991-1993. Mr. Giarla holds a Master of Business
Administration with Concentration in Finance from the Stanford University
Graduate School of Business, where he was an Arjay Miller Scholar. He earned
a Bachelor of Arts in Statistics, summa cum laude, from Harvard University,
where he was elected to Phi Beta Kappa and was a Harvard Club of Boston
Scholar. Mr. Giarla is a Trustee of the Roxbury Latin School, West Roxbury,
Massachusetts.
Stephen M. Schaefer Trustee
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at the 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.
Myron S. Scholes Trustee
Myron S. Scholes is the Frank E. Buck Professor of Finance at the Graduate
School of Business at 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
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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 Ph.D. 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 the 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 relationships, the effects of dividend policy on stock
prices, and 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 Trustee
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, and a procedure for estimating the style of an
investment manager from its historic returns. 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 Jeffrey Bailey, Prentice-Hall,
1990). 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.
Daniel C. Dektar Vice President, Smith Breeden Series Fund
Portfolio Manager, Short and Intermediate
Series
Principal, Executive Vice President, Director of Portfolio Management, and
Director of Smith Breeden Associates. Mr. Dektar has been primarily
responsible for the day-to-day management of the Short and Intermediate
Series from their commencement of their operations in 1992. As head of Smith
Breeden Associates' portfolio management group, Mr. Dektar is constantly in
touch with developments on Wall Street. He serves as a liaison among the
portfolio management, client service, and research groups to ensure accurate
-24-
analysis and timely execution of portfolio management opportunities. Mr.
Dektar consults with institutional clients in the areas of investments and
risk management. He has made several presentations on mortgage investments
and risk management at seminars for institutional investors. Mr. Dektar was
an Associate in the Mergers and Acquisitions Group of Montgomery Securities
in San Francisco, California and a Financial Analyst in the Investment
Banking Division of Morgan Stanley & Co., Incorporated, New York before
joining Smith Breeden Associates. He holds a Master of Business
Administration with Concentration in Finance from Stanford University
Graduate School of Business, where he was an Arjay Miller Scholar. Mr.
Dektar received a Bachelor of Science in Business Administration, summa cum
laude, from the University of California at Berkeley, where he was University
of California Regent's Scholar, was elected to Phi Beta Kappa and Phi Eta
Sigma, and won the White Award as the top student in finance.
John B. Sprow Vice President, Smith Breeden Trust
Portfolio Manager, Equity Plus Fund
Principal and Vice President, Smith Breeden Associates. Mr. Sprow has been
primarily responsible for the day-to-day management of the Equity Plus Fund
from the commencement of its operations in 1992. Mr. Sprow is a senior
portfolio manager who works primarily with discretionary pension accounts.
In addition to traditional mortgage accounts, he manages S&P 500 indexed
accounts. Prior to directly managing discretionary accounts, Mr. Sprow's
research and programming efforts assisted in the development of the Adviser's
models for pricing and hedging mortgage-related securities, risky commercial
debt, and forecasting mortgage prepayment behavior. Mr. Sprow came to Smith
Breeden Associates from the Fuqua School of Business, Duke University, where
he was Research Assistant. Previously, Mr. Sprow was a Research Assistant to
the Department Head of the Materials Science Department, Cornell University.
He received a Master of Business Administration with Emphasis in Finance from
the Fuqua School of Business, Duke University. Mr. Sprow holds a Bachelor of
Science in Materials Science and Engineering from Cornell University, where
he was awarded the Carpenter Technology Scholarship three successive years.
Marianthe S. Mewkill Vice President, Secretary, Treasurer, and
Chief Accounting Officer
Principal, Vice President and Chief Financial Officer, Smith Breeden
Associates. Ms. Mewkill handles financial reporting, budgeting, tax research
and planning for the Smith Breeden Family of Funds and for Smith Breeden
Associates, Inc.. She ensures compliance with agency regulations and
administers the company's internal trading and other policies. She was
previously employed as a Controller for the Hunt Alternatives Fund, as an
Associate at Goldman Sachs & Co., and as a Senior Auditor at Arthur Andersen
& Co. She earned a Master of Business Administration with Concentrations in
Finance and Accounting from New York University and graduated from Wellesley
College, magna cum laude with a Bachelor of Arts degree in History and French
and a Minor in Economics.
* Interested Party
Investment Adviser
Smith Breeden Associates, Inc., a registered investment adviser, acts as
investment adviser to the Funds. Approximately 71% of the Adviser's voting
stock is owned by Douglas T. Breeden, its Chairman and President. Under its
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Investment Advisory Agreement with each Fund, the Adviser, subject to the
general supervision of the Board of Trustees, manages the Funds' portfolios
and provides for the administration of all of the Funds' other affairs. For
these services, the Adviser receives a fee, computed daily, and payable
monthly, at the annual rate of 0.70% of the Funds' average daily net assets.
Until March 31, 1997, the Adviser has voluntarily agreed to reduce its
compensation, and to the extent necessary absorb other expenses of the Funds,
such that the total expenses (exclusive of ordinary brokerage commissions,
investment transaction taxes and extraordinary expenses) do not exceed 0.88%
of the average net assets for each of the Equity Plus Fund and the
Intermediate Series, and 0.78% of the average net assets of the Short Series.
The Adviser places all orders for purchases and sales of the Funds'
securities. Subject to seeking the most favorable price and execution
available, the Adviser may consider sales of shares of the Funds as a factor
in the selection of broker-dealers.
Distribution
Fund/Plan Broker Services, Inc. ( the "Principal Underwriter") acts as
distributor for the Funds for which the Adviser pays the Principal
Underwriter a fee of $25,000. Shares also may be sold by authorized dealers
who have entered into dealer agreements with the Principal Underwriter or the
Adviser.
Expenses
The Funds pay all of their own expenses, including without limitation, the
cost of preparing and printing their registration statements required under
the Securities Act of 1933 and the 1940 Act and any amendments thereto, the
expense of registering their shares with the Securities and Exchange
Commission and the various states, the printing and distribution costs of
prospectuses mailed to existing investors, reports to investors, reports to
government authorities and proxy statements, fees paid to directors who are
not interested persons of the Adviser, interest charges, taxes, legal
expenses, association membership dues, auditing services, insurance premiums,
brokerage commissions and expenses in connection with portfolio transactions,
fees and expenses of the custodian of their assets, printing and mailing
expenses and charges and expenses of dividend disbursing agents, accounting
services agents, registrars and stock transfer agents.
PRICING OF FUND SHARES
The price you pay when buying a Fund's shares, and the price you receive when
selling (redeeming) a Fund's shares, is the net asset value of the shares
next determined after receipt of a purchase or redemption request in proper
form. No front end sales charge or commission of any kind is added by the
Fund upon a purchase and no charge is deducted upon a redemption. The Funds
currently charge a $9 fee for each redemption made by wire. See "How to
Redeem Shares."
The per share net asset value of a Fund is determined by dividing the total
value of its assets, less its liabilities, by the total number of its shares
outstanding at that time. The net asset value is determined as of the close
of regular 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 a Fund's securities such that the net asset
value of a Fund's shares might be affected. Accordingly, Purchase
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Applications accepted or redemption requests received in proper form by the
Transfer Agent, or other agent designated by the Funds, prior to 4:00 p.m.
Eastern time, each day that the Adviser and Transfer Agent are open for
business, will be confirmed at that day's net asset value. Purchase
Applications accepted or redemption requests received in proper form after 4
p.m Eastern Time by the Transfer Agent, or other agent designated by the
Funds, will be confirmed at the net asset value of the following business
day.
Current holiday schedules indicate that the Funds' net asset values will not
be calculated on New Year's Day, President's Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, the day following
Thanksgiving, Christmas Eve and Christmas Day. In addition, the Short and
Intermediate Series will not be priced on Martin Luther King Day, Columbus
Day and Veterans' Day.
Under procedures approved by the Board of Trustees, a Fund's securities for
which market quotations are readily available are valued at current market
value provided by a pricing service, bank or broker/dealer experienced in
such matters. Short-term investments that will mature in 60 days or less may
be valued at amortized cost, which approximates market value. All other
securities and assets are valued at fair market value as determined following
procedures approved by the Board of Trustees.
HOW TO PURCHASE SHARES
All of the Funds are no-load, so you may purchase, redeem or exchange shares
directly at net asset value without paying a sales charge. Because the Funds'
net asset value changes daily, your purchase price will be the next net asset
value determined after the Funds' Transfer Agent, or other agent designated
by the Funds, receives and accepts your purchase order. See "Pricing of Fund
Shares."
Initial Minimum Additional Minimum
Type of Account Investment Investment
Regular $500 $50
Automatic Investment Plan $50 $50
Individual Retirement Account $500 $50
Gift to Minors $500 $50
Each Fund reserves the right to reject any order for the purchase of its
shares or to limit or suspend, without prior notice, the offering of its
shares. The required minimum investments may be waived in the case of
qualified retirement plans.
How to Open Your Account by Mail. Please complete the Purchase Application.
You can obtain additional copies of the Purchase Application and a copy of
the IRA Purchase Application from the Funds by calling 1-800-221-3138.
(Please note that you must use a different application than the one provided
in the prospectus for an IRA.)
Your completed Purchase Application should be mailed directly to:
Smith Breeden Mutual Funds
2 West Elm Street
P.O. Box 874
Conshohocken, PA 19428
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All applications must be accompanied by payment in the form of a check or
money order made payable to "Smith Breeden Mutual Funds." All purchases
must be made in U.S. dollars and checks must be drawn on U.S. banks. No cash,
credit cards or third party checks will be accepted. When a purchase is made
by check and a redemption is made shortly thereafter, the Funds will delay
the mailing of a redemption check until the purchase check has cleared your
bank, which may take up to 10 calendar days from the purchase date. If you
contemplate needing access to your investment shortly after purchase, you
should purchase the shares by wire as discussed below.
How to Open Your Account by Wire. You may make purchases by direct wire
transfers. To ensure proper credit to your account, please call the Funds at
1-800-221-3137 for instructions prior to wiring funds. Funds should be wired
through the Federal Reserve System as follows:
United Missouri Bank
A.B.A. Number 10-10-00695
For the account of Fund/Plan Services, Inc.
Account Number 98-7037-071-9
For credit to (identify which Fund to purchase)
For further credit to: (investor account number)
(name or account registration)
(Social Security or Tax Identification Number)
Following such wire transfer, you must promptly complete a Purchase
Application and mail it to the Funds at the following address: Smith Breeden
Mutual Funds, 2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428.
Shares will not be redeemed until the Funds receive a properly completed and
executed Purchase Application.
Telephone Transactions. The privilege to initiate redemption or exchange
transactions by telephone will be made available to shareholders when opening
an account, if they check the appropriate boxes on the Purchase Application.
Each Fund will employ reasonable procedures to ensure that instructions
communicated by telephone are genuine. If reasonable procedures are not
implemented, the Funds may be liable for any loss due to unauthorized or
fraudulent transactions. In all other cases, you are liable for any loss for
unauthorized transactions. The Funds reserve the right to refuse a telephone
transaction if they believe it advisable to do so.
If you have any questions, please call the Funds at 1-800-221-3137.
How to Add to Your Account. You may make additional investments by mail or by
wire in an amount equal to or greater than $50. When adding to an account by
mail, you should send the Funds your check, together with the additional
investment form from a recent statement. If this form is unavailable, you
should send a signed note giving the full name of the account and the account
number. For additional investments made by wire transfer, you should use the
wiring instructions listed above. Be sure to include your account number.
Automatic Investment Plan. You may make purchases of shares of each Fund
automatically on a regular basis ($50 minimum per transaction). You must meet
the Automatic Investment Plan's ("the Plan") minimum initial investment of
$50 before the Plan may be established. Under the Plan, your designated bank
or other financial institution debits a preauthorized amount from your
account each month and applies the amount to the purchase of Fund shares. The
Plan can be implemented with any financial institution that is a member of
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the Automated Clearing House. No service fee is currently charged by the
Funds for participation in the Plan. A $20 fee will be imposed by the Funds
if sufficient funds are not available in your account or if your account has
been closed at the time of the automatic transaction. You may adopt the Plan
at the time an account is opened by completing the appropriate section of the
Purchase Application. You may obtain an application to establish the
Automatic Investment Plan after an account is opened by calling the Funds at
1-800-221-3138. In the event you discontinue participation in the Plan, the
Funds reserve the right to redeem your Fund account involuntarily, upon sixty
days' written notice, if the account's net asset value is $500 or less.
Purchasing Shares Through Other Institutions. If you purchase shares through
a program of services offered or administered by a broker-dealer, financial
institution, or other service provider, you should read the program
materials, including information relating to fees, in addition to this
Prospectus. Certain services of a Fund may not be available or may be
modified in connection with the program of services provided, and service
providers may establish higher minimum investment amounts. The Funds may only
accept requests to purchase additional shares into a broker-dealer street
name account from the broker-dealer.
Certain broker-dealers, financial institutions, or other service providers
that have entered into an agreement with the Adviser or Principal Underwriter
may enter purchase orders on behalf of their customers by phone, with payment
to follow within several days as specified in the agreement. The Funds may
effect such purchase orders at the net asset value next determined after
receipt of the telephone purchase order. It is the responsibility of the
broker-dealer, financial institution, or other service provider to place the
order with the Funds on a timely basis. If payment is not received within the
time specified in the agreement, the broker-dealer, financial institution, or
other service provider could be held liable for any resulting fees or losses.
Miscellaneous. The Funds will charge a $20 service fee against your account
for any check or electronic funds transfer that is returned unpaid. You will
also be responsible for any losses suffered by the Funds as a result. In
order to relieve you of responsibility for the safekeeping and delivery of
stock certificates, the Funds do not currently issue certificates.
HOW TO EXCHANGE SHARES
Shares of any Fund may be exchanged for shares of another Fund at any time.
This exchange offer is available only in states where shares of such other
Fund may be legally sold. You may open a new account, or purchase additional
shares in an existing account, by making an exchange from an identically
registered Smith Breeden Fund account. A new account will have the same
registration as the existing account from which the exchange was made, and is
subject to the same initial investment minimum ($500).
Exchanges may be made either in writing or by telephone. Written
instructions should be mailed to 2 West Elm Street, Conshohocken, PA 19428
and must be signed by all account owners, and accompanied by any properly
endorsed outstanding share certificates, if applicable. The telephone
exchange privilege can be adopted by checking the appropriate box on the
Purchase Application. The telephone exchange privilege is available only for
uncertificated shares. During periods of drastic economic or market changes,
it is possible that exchanges by telephone may be difficult to implement. In
this event, shareholders should follow the written exchange procedures. The
-29-
telephone exchange privilege may be modified or discontinued by the Funds at
any time upon 60 days' notice to the shareholders. To exchange by telephone,
you must follow the instructions below under "How to Redeem by Telephone."
The Funds will accept exchange orders by telephone or other means of
electronic transmission from broker-dealers, financial institutions or other
service providers who execute an agreement with the Adviser or Principal
Underwriter. It is the responsibility of the broker-dealer, financial
institution or other service provider to place the exchange order on a timely
basis.
Exchanges are made on the basis of the Funds' 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 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 Funds' Statements of Additional Information.
There are differences among the Funds. Before making an exchange, a
shareholder should obtain and review the 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.
If you buy shares by check, you may not exchange those shares for up to 10
calendar days to ensure your check has cleared. If you intend to exchange
shares soon after their purchase, you should purchase the shares by wire or
contact the Funds at 1-800-221-3137 for further information.
The Funds reserve the right to temporarily or permanently terminate, with or
without advance notice, the exchange privilege of any investor who makes
excessive use of the exchange privilege (e.g., more than five exchanges per
calendar year).
Additional documentation may be required for exchange requests if shares are
registered in the name of a corporation, partnership or fiduciary. Please
contact the Funds for additional information concerning the exchange
privilege.
HOW TO REDEEM SHARES
You may redeem shares of the Funds at any time. The price at which the shares
will be redeemed is the net asset value per share next determined after
proper redemption instructions are received by the Transfer Agent or other
agent designated by the Funds. See "Pricing of Fund Shares." There are no
charges for the redemption of shares except that a fee of $9 is charged for
each wire redemption. Depending upon the redemption price you receive, you
may realize a capital gain or loss for federal income tax purposes.
How to Redeem by Mail to Receive Proceeds by Check. To redeem shares by mail,
simply send an unconditional written request to the Funds specifying the
number of shares or dollar amount to be redeemed, the name of the Fund, the
name(s) on the account registration and the account number. A request for
redemption must be signed exactly as the shares are registered. If the amount
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requested is greater than $25,000, or the proceeds are to be sent to a person
other than the recordholder or to a location other than the address of
record, each signature must be guaranteed by a commercial bank or trust
company in the United States, a member firm of the National Association of
Securities Dealers, Inc. or other eligible guarantor institution. A notary
public is not an acceptable guarantor. Guarantees must be signed by an
authorized signatory of the bank, trust company, or member firm and
"Signature Guaranteed" must appear with the signature. Additional
documentation may be required for the redemption of shares held in corporate,
partnership or fiduciary accounts. In case of any questions, please contact
the Funds in advance.
A Fund will mail payment for redemption within seven days after receiving
proper instructions for redemption. However, the Funds will delay payment for
10 calendar days on redemptions of recent purchases made by check. This
allows the Funds to verify that the check used to purchase Fund shares will
not be returned due to insufficient funds and is intended to protect the
remaining investors from loss.
How to Redeem by Telephone. To redeem shares by telephone, you must have
selected this option on the Purchase Application. Once this feature has been
requested, shares may be redeemed by calling the Funds at 1-800-221-3137.
Proceeds redeemed by telephone will be mailed to your address, or wired or
credited to your preauthorized bank account. To establish wire redemption
privileges, you must select the appropriate box on the Purchase Application
and enclose a voided check.
In order to arrange for telephone redemptions after your account has been
opened or to change the bank account or address designated to receive
redemption proceeds, you must send a written request to your Fund. The
request must be signed by each registered holder of the account with the
signatures guaranteed by a commercial bank or trust company in the United
States, a member firm of the National Association of Securities Dealers, Inc.
or other eligible guarantor institution. A notary public is not an acceptable
guarantor. Further documentation as provided above may be requested from
corporations, executors, administrators, trustees and guardians.
Payment of the redemption proceeds for Fund shares redeemed by telephone
where you request wire payment will normally be made in federal funds on the
next business day. The Funds reserve the right to delay payment for a period
of up to seven days after receipt of the redemption request. There is
currently a $9 fee for each wire redemption. It will be deducted from your
account.
The Funds reserve the right to refuse a telephone redemption or exchange
transaction if it believes it is advisable to do so. Procedures for redeeming
or exchanging shares of the Funds by telephone may be modified or terminated
by the Funds at any time. In an effort to prevent unauthorized or fraudulent
redemption or exchange requests by telephone, the Funds have implemented
procedures designed to reasonably assure that telephone instructions are
genuine. These procedures include: requesting verification of certain
personal information; recording telephone transactions; confirming
transactions in writing; and restricting transmittal of redemption proceeds
only to preauthorized designations. Other procedures may be implemented from
time to time. If reasonable procedures are not implemented, the Funds may be
liable for any loss due to unauthorized or fraudulent transactions. In all
other cases, you are liable for any loss for unauthorized transactions.
-31-
You should be aware that during periods of substantial economic or market
change, telephone or wire redemptions may be difficult to implement. If you
are unable to contact the Funds by telephone, you may also redeem shares by
delivering or mailing the redemption request to: Smith Breeden Mutual Funds,
2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428.
The Funds reserve the right to suspend or postpone redemptions during any
period when trading on the New York Stock Exchange ("Exchange") is
restricted, as determined by the Securities and Exchange Commission ("SEC"),
or the Exchange is closed for other than customary weekend and holiday
closing; the SEC has by order permitted such suspension; or an emergency, as
determined by the SEC, exists, making disposal of portfolio securities or
valuation of net assets of a Fund not reasonably practicable.
Due to the relatively high cost of maintaining small accounts, if your
account balance falls below the $500 minimum as a result of a redemption or
exchange or if you discontinue the Automatic Investment Plan before your
account balance reaches the required minimum, you will be given a 60-day
notice to reestablish the minimum balance or activate an Automatic Investment
Plan. If this requirement is not met, your account may be closed and the
proceeds sent to you.
Check Writing. In addition to telephone and written redemption requests, the
Short Series offers redemption through check writing. Shareholders electing
this option will receive checks that may be used like personal or business
checks. There is no limit on the number of checks you may write. Checks
must be at least $100 and may not exceed $25,000. There is a $30 fee for
returned checks. Because dividends declared on shares held in a
shareholder's account, prior redemptions, and possible changes in net asset
value may cause the value of the account to change, shareholders should not
write a check for the entire value of the account or close the account by
writing a check.
In using the check writing privilege, shareholders bear the responsibility of
ensuring that the check amount does not exceed the value of their account on
the day the check is presented to the Transfer Agent for payment. The day
the check is presented for payment is the day the redemption of Fund shares
takes place. If insufficient shares are in the account, the check will be
returned and no shares will be redeemed. The clearing agent for the check
writing facility is United Missouri Bank. Shareholders utilizing check
writing are subject to United Missouri Bank's rules governing checking
accounts. However, this check writing facility is purely a means to redeem
Fund shares. No facilities characteristic of bank accounts, such as deposit
insurance, are being provided along with the check writing option.
If you would like to initiate check writing, please call Shareholder Services
at 1-800-221-3137 or check the appropriate box on the Purchase Application.
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 a Systematic Withdrawal
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
-32-
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 the Plan's payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated upon written notice by the
shareholder, or by a Fund on 30 days written notice, 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 five business days prior
to the next scheduled payment. Share certificates may not be issued while a
Systematic Withdrawal Plan is in effect.
DIVIDENDS AND DISTRIBUTIONS
The Short and Intermediate Series intend to make monthly distributions to
their shareholders of net investment income. The Equity Plus Fund intends to
make quarterly distributions of net investment income. All Funds will
distribute net realized gains at least annually. Each Fund may make
additional distributions if necessary to avoid imposition of a 4% excise tax
or other tax on undistributed income and gains.
The monthly distributions for the Short Series' shares are quoted ex-dividend
on the business day after record date (the "ex-date"). Record date is
usually the first or second business day of the month. If a shareholder
elects to reinvest dividends, the date the dividends are reinvested is also
the ex-date. Dividends are paid in cash by the Short Series generally one
week after the ex-date.
The Intermediate Series will declare daily dividends for shareholders of
record. The Intermediate Series' dividend payable date, and the day that
dividends are reinvested for shareholders who have made this election is the
last business day of the month. 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. 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.
Dividends and capital gains distributions may be declared more or less
frequently at the direction of the Trustees. In order to be entitled to a
dividend or a distribution, an investor must acquire a Fund's 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 a Fund's 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
-33-
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. You may separately elect to reinvest
income dividends and capital gains distributions in shares of a Fund or
receive cash as designated on the Purchase Application. You may change your
election at any time by sending written notification to your Fund. The
election is effective for distributions with a dividend record date on or
after the date that the Funds receive notice of the election. If you do not
specify an election, all income dividends and capital gains distributions
will automatically be reinvested in full and fractional shares of a Fund.
Reinvested dividends and distributions receive the same tax treatment as
those paid in cash.
SHAREHOLDER REPORTS AND INFORMATION
The Funds will provide the following statements and reports:
Confirmation and Account Statements. After each transaction that affects
the account balance or account registration, including the payment of
dividends, you will receive a confirmation statement.
Form 1099. By January 31 of each year, all shareholders will receive Form
1099 which will report the amount and tax status of distributions paid to you
by the Funds for the preceding calendar year.
Financial Reports. Financial reports are provided to shareholders
semiannually. Annual reports will include audited financial statements. To
reduce the Funds' expenses, one copy of each report will be mailed to each
Taxpayer Identification Number even though the investor may have more than
one account in a Fund.
Reports to Depository Institutions. Shareholders of the Short or
Intermediate Series who are financial institutions may request receipt of
monthly or quarterly reports which provide information about the Short or
Intermediate Series' investments considering regulatory risk-based asset
categories.
If you need additional copies of previous statements, you may order
statements for the current and preceding year at no charge. Call
1-800-221-3137 to order past statements. If you need information on your
account with the Funds or if you wish to submit any applications, redemption
requests, inquiries or notifications, please contact: Smith Breeden Family of
Funds Inc.,#2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428 or call
1-800-221-3137.
RETIREMENT PLANS
The Funds have a program under which you may establish an Individual
Retirement Account ("IRA") with the Funds and purchase shares through such
account. Shareholders wishing to establish an IRA should consult their tax
adviser regarding (1) their individual qualifying status and (2) the tax
regulations governing these accounts. The minimum initial investment in each
Fund for an IRA is $500. There is a $12 annual maintenance fee charged to
process an account. You may obtain additional information regarding
establishing such an account by calling the Funds at 1-800-221-3138.
-34-
The Funds may be used as investment vehicles for established defined
contribution plans, including simplified employee (including SAR-SEPs),
401(k), profit-sharing and money purchase pension plans ("Retirement Plans").
For details concerning Retirement Plans, please call 1-800-221-3138.
SERVICE AND DISTRIBUTION PLANS
Each Fund has adopted a Distribution and Services Plan (the "Plans") 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 Funds, 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 an annual rate of up to 0.25% of
a Fund's average net assets, subject to the authority of the Trustees 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.
Any distribution and servicing related payments made by the Adviser to
investment dealers or other persons are subject to the continuation of the
Plans, the terms of any related service agreements, and any applicable limits
imposed by the National Association of Securities Dealers, Inc.
TAXES
Each Fund intends to qualify as a regulated investment company under the
Internal Revenue Code. In each taxable year that a Fund so qualifies, such
Fund (but not its shareholders) will be relieved of federal income tax on the
part of its net investment income and net capital gain that is distributed to
shareholders. Each Fund will distribute annually substantially all of its
net investment income and net capital gains on a current basis.
All Fund distributions from net investment income (whether paid in cash or
reinvested in additional shares) will be taxable to its shareholders as
ordinary income, except that any distributions of a Fund's net long-term
capital gain will be taxable to its shareholders as long-term capital gain,
regardless of how long they have held their Fund shares. Each Fund provides
federal tax information to its shareholders annually about distributions paid
during the preceding year.
It is not anticipated that any of the Funds' distributions will qualify for
either the corporate dividends-received deduction or tax-exempt interest
income. Distributions will also probably be subject to state and local taxes
depending on each shareholder's tax situation. While many states grant tax-
free status to mutual fund distributions paid from interest income earned
from direct obligations of the U.S. Government, none of the Short or
Intermediate Series' distributions are expected to qualify for such tax-free
treatment, and only an insignificant amount of the Equity Plus Fund's
distributions are expected to so qualify.
The Funds will be required to withhold federal income tax at a rate of 31%
("backup withholding") from distribution payments and redemption and exchange
proceeds if you fail to properly complete the Purchase Application.
-35-
The foregoing is only a summary of some of the important federal tax
considerations generally affecting each Fund and its shareholders. See
"Taxes" in the relevant Statement of Additional Information for further
discussion. There may be other federal, state or local tax considerations
applicable to you as an investor. You therefore are urged to consult your
tax adviser regarding any tax-related issues.
CAPITAL STRUCTURE
The Smith Breeden Trust, which issues shares in the Equity Plus Fund, and the
Smith Breeden Series Fund, which issues shares in the Short and Intermediate
Series, are both Massachusetts business trusts. The Trust was organized
under an Agreement and Declaration of Trust, dated December 18, 1991. The
Series Fund was organized under an Agreement and Declaration of Trust dated
October 3, 1991. Copies of both Agreements, which are governed by
Massachusetts law, are on file with the Secretary of State of the
Commonwealth of Massachusetts. The Trust and the Series Fund have the same
Trustees.
The Trustees have the authority to issue shares in an unlimited number of
series of either the Series Fund or Trust. Each such series of shares may be
further divided into classes. The assets and liabilities of each such series
will 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 of the Series Fund or Trust will vote
together in electing trustees and in certain other matters. Shareholders in
each series of the Series Fund should be aware that the outcome of the
election of trustees and of certain other matters could be controlled by the
shareholders of the other 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.
Although neither the Series Fund nor the Trust is required to hold annual
meetings of its shareholders, shareholders have the right to call a meeting
to elect or remove trustees, or to take other actions as provided in the
respective Declaration of Trust. Upon written request by the holders of at
least 1% of the outstanding shares stating that such shareholders wish to
communicate with the other shareholders for the purpose of obtaining the
signatures necessary to demand a meeting to consider the removal of a
trustee, both the Series Fund and Trust have undertaken to provide a list of
shareholders or to disseminate appropriate materials (at the expense of the
requesting shareholders).
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 a Fund's insurance coverage and (ii) a Fund itself
was unable to meet its obligations.
-36-
TRANSFER AND DIVIDEND DISBURSING
AGENT, CUSTODIAN AND
INDEPENDENT ACCOUNTANTS
Fund/Plan Services, Inc. ("Fund/Plan Services" or the "Transfer Agent"), 2
West Elm Street, Conshohocken, PA 19428, acts as each Fund's Transfer and
Dividend Disbursing Agent. See "Management of the Funds." The Bank of New
York acts as the custodian of each Fund's assets. The Bank of New York's
address is 48 Wall Street, New York, New York 10286. Neither the Transfer and
Dividend Disbursing Agent nor the Custodian has any part in deciding the
Funds' investment policies or which securities are to be purchased or sold
for the Funds' portfolios. Deloitte & Touche, LLP, has been selected to serve
as independent auditors of the Company for the fiscal year ending March 31,
1997.
FUND PERFORMANCE
Each Fund may quote the Fund's average annual total and/or aggregate total
return for various time periods in advertisements or communications to
shareholders. An average annual total return refers to the rate of return
which, if applied to an initial investment at the beginning of a stated
period and compounded over that period, would result in the redeemable value
of the investment at the end of the period assuming reinvestment of all
dividends and distributions and reflecting the effect of all recurring fees.
An investor's principal in each Fund and the Fund's return are not guaranteed
and will fluctuate according to market conditions. When considering "average"
total return figures for periods longer than one year, you should note that
a Fund's annual total return for any one year in the period might have been
greater or less than the average for the entire period. Each Fund also may
use "aggregate" total return figures for various periods, representing the
cumulative change in value of an investment in the Fund for a specific period
(again reflecting changes in the Fund's share price and assuming reinvestment
of dividends and distributions).
The Short and Intermediate Series may also advertise current yield and
distribution rate information. Current yield reflects the income per share
earned by the Short or Intermediate Series' portfolio investments, and is
calculated by dividing a Fund's net investment income per share during a
recent 30-day period by a Fund's net asset value on the last day of that
period and annualizing the result. The current yield (or "SEC Yield"), which
is calculated according to a formula prescribed by the SEC (see the relevant
Statement of Additional Information), is not indicative of the dividends or
distributions which were or will be paid to a Series' shareholders. SEC
regulations require that net investment income be calculated on a "yield-to-
maturity" basis, which has the effect of amortizing any premiums or discounts
in the current market value of fixed income securities. Dividends or
distributions paid to shareholders are reflected in the current distribution
rate which may be quoted to shareholders, and may not reflect amortization in
the same manner.
The Fund may also compare its performance to that of other mutual funds and
to stock and other relevant indices or to rankings prepared by independent
services or industry publications. For example, a Fund's total return may be
compared to data prepared by Lipper Analytical Services, Inc., Morningstar,
Inc., Value Line Mutual Fund Survey and CDA Investment Technologies, Inc.
Total return data as reported in such national financial publications as The
Wall Street Journal, The New York Times, Investor's Business Daily, USA
Today, Barron's, Money and Forbes as well as in publications of a local or
-37-
regional nature, may be used in comparing Fund performance.
The Equity Plus Fund's total return may also be compared to the returns of
such indices as the Dow Jones Industrial Average, Standard & Poor's 500
Composite Stock Price Index, Nasdaq Composite OTC Index or Nasdaq Industrials
Index, Consumer Price Index and Russell 2000 Index. The Short Series' total
return may also be compared that of taxable money funds as quoted in
Donaghue's Money Fund Report and to total returns for the six month U.S.
Treasury as published by Merrill Lynch or other suppliers. The Intermediate
Series' return will most likely be compared to the total return of the
Salomon Brothers Mortgage Index, or the total return of intermediate U.S.
Treasury Notes as published by various brokerage firms and others. Further
information on performance measurement may be found in the relevant Statement
of Additional Information.
Performance quotations of a Fund represent the Fund's past performance and
should not be considered representative of future results. The investment
return and principal value of an investment in a Fund will fluctuate so that
an investor's shares, when redeemed, may be worth more or less than their
original cost. The methods used to compute a Fund's total return and yield
are described in more detail in the relevant Statement of Additional
Information.
-38-
APPENDIX A
Hedging Instruments and Transactions (Short and Intermediate Series and
Equity Plus Fund's Fixed Income Segment)
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 changes, in which
event a Fund's overall performance may be less than if the Fund had not
entered into hedging transactions.
Interest Rate and Mortgage Swaps, Caps, Floors and Collars. Interest rate
swaps involve the exchange by a Fund 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 Short or Intermediate Series will enter into interest rate swaps only on
a net basis, i.e., where the two payment streams are netted out, with a Fund
receiving or paying, as the case may be, only the net amount of the two
payments. The Fixed Income Segment of the Equity Plus Fund may enter into
interest rate swaps on other than a net basis.
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. There can
be no assurance that the Funds will be able to enter into interest rate
swaps, caps, floors or collars on favorable terms. Furthermore, there can be
no assurance that any of the Funds 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.
Inasmuch as these hedging transactions are entered into for hedging purposes,
the Adviser and the Funds believe swaps, caps, floors and collars 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 Fund's 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
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. To the extent that the Fixed
Income Segment of the Equity Plus Fund enters into interest rate swaps on
other than a net basis, the amount maintained in its segregated account will
be the full amount of the Fund's obligations, if any, with respect to such
interest rate swaps, accrued on a daily basis.
-39-
The Short and Intermediate 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 is rated either AA or
A-1 or better by Standard & Poor's or Aa or P-1 or better by Moody's
Investors Service, Inc., at the time of entering into such transaction. The
Fixed Income Segment of the Equity Plus Fund may enter into such transactions
with counterparties who are rated at least A by Moody's and S&P at the time
of entering into the contract. The Funds and the Adviser will closely
monitor, subject to the oversight of the Board of Trustees, the
creditworthiness of the contract counterparties in order to minimize risk.
If there is a default by the other party to such a transaction, the Funds
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 Fund will succeed in
pursuing contractual remedies. The Funds thus assume the risk that one of
them may be delayed in or prevented from obtaining payments owed to it
pursuant to interest rate swaps, caps, floors or collars.
The swap, cap, floor and collar 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 documentation. As a
result, this market has become relatively liquid, although the Funds will
still treat these instruments as illiquid investments subject to the
limitation on such investments described in the Prospectus at "Illiquid
Securities".
Calls and Puts on Securities. In order to reduce fluctuations in net asset
value and portfolio holdings relative to their targeted option-adjusted
duration, a Fund may purchase call or put options or sell options where it
owns the security which is the subject of the option (a "covered option") 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 Fund will not sell
options which are not covered. The premiums paid on call options purchased
and any related transaction costs will increase the cost of securities
acquired upon exercise of the option, and unless the price of the underlying
security rises sufficiently, the options may expire worthless to the Funds.
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 invested in such
options. A Fund's ability to purchase put and call options may be limited by
Internal Revenue Code requirements.
The Adviser monitors the creditworthiness of dealers with whom a Fund would
enter into OTC option transactions under the general supervision of the
Board of Trustees. The Funds will engage in OTC option transactions only
with primary United States government securities dealers recognized by the
Federal Reserve Bank of New York.
Futures and Related Options. In order to reduce fluctuations in net asset
value of portfolio holdings relative to their targeted option-adjusted
durations or to employ temporary substitutes for anticipated future
transactions, the Funds may buy or sell financial futures contracts, purchase
-40-
call or put options, or sell covered call options on such futures. There is
no overall limitation on the percentage of a Fund's assets which may be
subject to a hedge position.
Options and futures transactions involve costs and may result in losses. The
effective use of options and futures strategies depends on a Fund's ability
to terminate options and futures positions at times when the Adviser 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 existence of a
liquid secondary market. Although a Fund will take an options 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 a Fund
will be able to effect closing transactions at any particular time or at an
acceptable price.
The use of options and futures strategies also involves the risk of imperfect
correlation between movements in the values of the securities underlying the
futures and options purchased and sold by a Fund, of the option and futures
contract itself, and of the securities which are the subject of a hedge. A
Fund, 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 for a Fund
to incur a loss on both the hedged securities and the hedging instrument.
At times, a Fund 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 Fund 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 these 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 Fund will take prompt action to close out the
appropriate number of open contracts to bring its open futures position into
compliance with this limitation.
The Funds' 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 relevant Statement of Additional Information.
Other Portfolio Strategies (Equity Plus Fund's Equity Simulation Segment)
Any investment in warrants, valued at the lower of cost or market, may not
exceed 5% of the value of the Equity Plus Fund's net assets. Included within
that amount, but not to exceed 2% of the value of the Equity Plus Fund's net
assets, may be warrants which are not listed on the New York or American
Stock Exchange. Warrants acquired by the Equity Plus Fund in units or
attached to securities may be deemed to be without value.
-41-
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, 1996
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
This Statement of Additional Information contains information pertaining to
the Smith Breeden Series Fund (the "Fund"), 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"). This Statement of Additional contains information
which may be useful to investors and which is not included in the
Prospectus of the Smith Breeden Mutual Funds.
This Statement of Additional Information is not a prospectus
and is only authorized for distribution when accompanied or preceded
by the Prospectus of the Smith Breeden Mutual Funds dated August 1, 1996,
as may be amended from time to time. This Statement should be read with the
Prospectus.
Contents Page
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS . . .
. . . . 1
INVESTMENT RESTRICTIONS. . . . . . . . . . . . . . . . . . . . . . . . . 6
TRUSTEES AND OFFICERS. . . . . . . . . . . . . . . . . . . . . . . . . . 9
INVESTMENT ADVISORY AND OTHER SERVICES . . . . . . . . . . . . . . . . . 9
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS. . . . . . .
. .11
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS. . . . .
. . .12
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES. . . . . . . . . . . . . . . . . . .14
ADDITIONAL INFORMATION REGARDING TAXATION. . . . . . . . . . . . . . . .16
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . . . . . . . . . . . .19
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS . . . . . . . . . .
.24
EXPERTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . .24
APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
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 (the "Series"). Terms used herein have the
same meanings as in the Prospectus.
The Fund's Prospectus states that the Series may engage in each of
the following investment practices. However, the fact that the
Series may engage in a particular practice does not necessarily
mean that it will actually do so.
Repurchase Agreements. The Series may invest in repurchase
agreements. A repurchase agreement is a contract under which a
Series acquires a security for a relatively short period (usually
not more than one week) subject to the obligation of the seller to
repurchase and the Series to resell such security at a fixed time
and price (representing the Series' cost plus interest). It is the
Series' present intention to enter into repurchase agreements only
with commercial banks and registered broker-dealers and only with
respect to obligations of the U.S. Government or its agencies or
instrumentalities. Repurchase agreements may also be viewed as
loans made by a Series which are collateralized by the securities
subject to repurchase. The Adviser will monitor such transactions
to determine that the value of the underlying securities is at
least equal at all times to the total amount of the repurchase
obligation, including the interest factor. If the seller defaults,
the Series could realize a loss on the sale of the underlying
security to the extent that the proceeds of sale including accrued
interest are less than the resale price provided in the agreement
including interest. In addition, if the seller should be involved
in bankruptcy or insolvency proceedings, the Series may incur delay
and costs in selling the underlying security or may suffer a loss
of principal and interest if the Series is treated as an unsecured
creditor and required to return the underlying collateral to the
seller's estate.
Forward Commitments. The Series may enter into contracts to
purchase securities for a fixed price at a future date beyond
customary settlement time ("forward commitments" and "when issued"
and "delayed delivery" securities) if a Series holds until the
settlement date, in a segregated account, cash or high-grade debt
obligations in an amount sufficient to meet the purchase price, or
if a Series enters into offsetting contracts for the forward sale
of other securities it owns. Forward commitments may be considered
securities in themselves, and involve a risk of loss if the value
of the security to be purchased declines prior to the settlement
date. Where such purchases are made through dealers, a Series
relies on the dealer to consummate the sale. The dealer's failure
to do so may result in the loss to the Series of an advantageous
return or price. Although a Series will generally enter into
forward commitments with the intention of acquiring securities for
its portfolio or for delivery pursuant to options contracts it has
entered into, the Series may dispose of a commitment prior to
settlement if the Adviser deems it appropriate to do so. A Series
may realize short-term profits or losses upon the sale of forward
commitments.
-1-
Securities Loans. The Series may make secured loans of the Series'
securities amounting to not more than 33 1/3% of a Series' total
assets thereby realizing additional income. The risks in lending
portfolio securities, as with other extensions of credit, consist
of possible delay in recovery of the securities or possible loss of
rights in the collateral should the borrower fail financially. As
a matter of policy, securities loans are made to broker-dealers
pursuant to agreement requiring that loans be continuously secured
by collateral in cash or short-term debt obligations at least equal
at all times to the value of the securities on loan. The borrower
pays to a Series an amount equal to any dividends or interest
received on securities lent. A Series retains all or a portion of
the interest received on investment of the cash collateral or
receives a fee from the borrower. Although voting rights, or
rights to consent, with respect to the loaned securities pass to
the borrower, a Series retains the right to call the loans at any
time on reasonable notice, and it will do so in order that the
securities may be voted by the Series if the holders of such
securities are asked to vote upon or consent to matters materially
affecting the investment. A Series may also call such loans in
order to sell the securities involved.
Borrowing. The Series may borrow from banks and enter into reverse
repurchase agreements or dollar rolls (as described in Appendix A
of the Prospectus) up to 33 1/3% of the value of a Series' total
assets (computed at the time the loan is made) to take advantage of
investment opportunities and for extraordinary or emergency
purposes, or for the clearance of transactions. A Series may pledge
up to 33 1/3% of its total assets to secure these borrowings. If
a Series' asset coverage for borrowings falls below 300%, the
Series will take prompt action to reduce its borrowings even though
it may be disadvantageous at that time from an investment point of
view. A 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, a Series' investment
performance will increase, whereas if the income and appreciation
on assets acquired with borrowed funds are less than their
borrowing costs, investment performance will decrease. In
addition, if a 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 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 a Series,
the net asset value of the Series' shares will decrease faster than
would otherwise be the case. This speculative characteristic is
known as "leverage."
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
-2-
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
with 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
-3-
engage in OTC Option transactions only with primary United States
Government securities dealers recognized by the Federal Reserve
Bank of New York. The Adviser monitors the creditworthiness of
dealers with whom 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
-4-
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.
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 Series' 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, 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
-5-
movements of the securities and futures are inconsistent with
their durations as so calculated, the hedge may not be fully
effective.
The 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.
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 the 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, he
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 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
-6-
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
-7-
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 such
policy. However, in the event that the asset coverage for
borrowings falls below 300%, the 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 Series 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 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, the 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 owns more than 1/2 of 1% of the
-8-
outstanding securities of such issuer, and such officers and
Trustees who own more than 1/2 of 1% own in the aggregate more than
5% of the outstanding securities of such issuer.
The 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 required or 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 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 table below shows the fees paid to each Director by each Series
for 1996 fiscal year. The Trustees do not receive pension or
retirement benefits. The Trustees did receive compensation from the
other Fund in the Smith Breeden Family of Funds in addition to the
compensation listed below.
Director Aggregate Compensation Aggregate Compensation
from Short Series from Intermediate Series
Stephen M. Schaefer $31,250 $6,500
Myron S. Scholes $33,250 $2,500
William F. Sharpe $32,250 $1,250
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.
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 both Series' investment activities. The Adviser, at its own
-9-
expense, furnishes the 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, 1997, each Series bears all expenses
related to its operation not borne by the Adviser, as discussed in
the Prospectus.
Each Advisory Agreement is in effect until August 1, 1997.
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 under the terms of the Advisory Agreement, and the
assumption by the Adviser of the related expenses, each Series 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. For the last three fiscal years ended March 31, the
Adviser received no fees from the Short Series in 1994 or 1995, and
received $1,717,748 for the fiscal year ended March 31, 1996. 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. The Adviser received no fees from the
Intermediate Series for the fiscal year ended March 31, 1994, but
received $132,174 from the Intermediate Series for the fiscal year
ended March 31, 1995 and $256,075 for the fiscal year ended March
31, 1996.
The Intermediate Series prior to August 1, 1994 indirectly bore
investment advisory fees through its investment in the Smith
Breeden Institutional Intermediate Duration U.S. Government Fund.
On August 1, 1994, this two-tier was eliminated, resulting in the
Intermediate Series becoming a stand-alone fund. During the three
year period ended March 31, the Adviser reimbursed the Short Series
$179,527, $146,256, $364,865 for the periods ended 1994, 1995, and
1996, respectively, under expense limitation provisions. The
-10-
Intermediate Series was reimbursed $100,750, $123,390, and $85,364
for the same periods under expense limitation provisions.
Under the terms of its Advisory agreement with each Series, the
Adviser also provides certain 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. A
custodian's responsibilities include generally safeguarding and
controlling a Series' cash and securities, handling the receipt and
delivery of securities, and collecting interest and dividends on a
Series' investments. The custodian does not participate in
decisions relating to the purchase and sale of portfolio
securities.
Deloitte & Touche, 117 Campus Drive, Princeton, New Jersey 08540,
are the Fund's independent auditors, providing audit services, tax
return preparation and other tax consulting services, and
assistance and consultation in connection with the review of
various Securities and Exchange commission filings. Ropes & Gray,
One International Place, Boston, Massachusetts, 02110-2624, are
legal counsel to the Fund.
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those shareholders who,
to the best knowledge of the Fund, as of June 30, 1996, owned 5% or
more of the shares of the Short Duration Series.
Carver Federal Savings Bank
2815 Atlantic Avenue
Brooklyn, NY 11207 28.14%
Cascade Savings Bank
2828 Colby Avenue
Everett WA 98201 9.31%
Dell USA L.P
2112 Kramer Lane
Austin Texas, 78758 5.68%
Hemet Federal Savings & Loan
445 E. Florida Ave.
Hemet, CA 92543 6.75%
Watsonville Federal
Savings & Loan
35 East Lake Avenue
Watsonville, CA 95076 6.49%
The Officers and Trustees of the Fund together as a group owned
-11-
less than 1.00% of the shares of the Short Duration Series as of
June 30, 1996.
Listed below are the names and addresses of those shareholders, who
as of March 31, 1996, to the best knowledge of the Fund, owned 5%
or more of shares of the Intermediate Series.
Roosevelt Bank
900 Roosevelt Pkwy
Chesterfield, MO 70.72%
Public School Retirement System
1 Mercantile Ctr.
St. Louis, MO 18.79%
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, 1996.
Potential Conflicts of Interest
Principals of the Adviser as individuals own approximately 67% of
the common stock of Financial Research Corporation, the holding
company for Harrington Bank, FSB (the "Association"). As of May
31, 1996, the Association had total assets of $356 million. The
Association invests in assets of the same types as those to be held
by the Series.
Douglas T. Breeden, in combination with immediate family members,
controls over 75% of the common stock of Community First Financial
Group, Inc., ("CFFG") the holding company for certain banks and
thrifts, to which the Adviser renders certain Investment Advisory
Services. The Fund will transact no business directly or
indirectly with either CFFG or the banks and thrifts which it owns.
CFFG and its subsidiaries invest in assets of the same types as
those to be held by the Series.
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 both Series, but trading in
the same type of securities and instruments. Portfolio decisions
and results of both 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 a Series 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, each of the Series do not anticipate that it will incur a
-12-
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 $46,156 and
$3,483, respectively, in brokerage commissions on futures and
options for the year end March 31, 1996. For the year end March
31, 1995, the Short and Intermediate Series paid $0 and $3,483,
respectively in brokerage commissions. Neither Series paid any
brokerage commissions for the year ended March 31, 1994. Prior to
March 31, 1995, the Short Series paid brokerage commissions
indirectly by virtue of its investment in the Smith Breeden Short
Duration U.S. Government Fund. Prior to August 1, 1994, the
Intermediate Series paid brokerage commissions indirectly by virtue
of its investment in the Smith Breeden Institutional Intermediate
U.S. Government Fund. (See "Investment Advisory and Other
Services".)
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 both
Series in such amount of total brokerage as may reasonably be
required.
-13-
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 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 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 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, and is
acting on a best efforts basis. 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
-14-
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 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 PrincipalUnderwriter may enter into agreements with other
broker-dealers for the sale of Short or Intermediate Series shares by them.
The Principal Underwriter is paid approximately $17,000 in total by
the Adviser for its services to the two Series. In addition, for
the year March 31, 1996, the Principal Underwriter received no
sales charges or commissions.
Calculation of Net Asset Value
As noted in the Prospectus, the 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.
-15-
ADDITIONAL INFORMATION REGARDING TAXATION
Taxation of the Series
For federal income tax purposes, each Series will be treated as a
separate corporation. Each 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 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 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 Series' assets nor more than 10% of the voting securities of
such issuer and (B) not more than 25% of the value of each 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.
If the Series qualify as 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 Series will not be subject to
federal income tax on the income so distributed. However, the
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
-16-
retained by, and taxed in the hands of, either Series will be
treated as having been distributed.
Both Series intend to distribute sufficient income so as to avoid
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 Short
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 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 recieve distributions in cash.
Liquidating distributions which in the aggregate exceed a
shareholder's basis in shares will be treated as gain from the sale
-17-
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.
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
-18-
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 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 both Series 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.
-19-
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 (or for the life of a Series, if shorter) that would
equate an initial hypothetical $500 investment to its ending
redeemable value. The calculation assumes no sales charge is
deducted from the initial $500 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 $500 investment, according to the
following formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of $500
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $500
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 certain periods.
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:
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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
alue 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 Series for the 30-day period
ended March 31, 1996.
AVERAGE ANNUAL TOTAL RETURN
ONE YEAR THREE YEARS INCEPTION 30-DAY YIELD
SHORT SERIES 4.95% 5.06% 5.20% 5.81%
INTERMEDIATE
SERIES 9.69% 6.61% 8.62% 6.41%
The investment results of the 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 its 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
-21-
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
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.
-22-
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.
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.
-23-
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 report 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.
-24-
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.
-25-
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 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.
-26-
SMITH BREEDEN SHORT DURATION
U.S. GOVERNMENT SERIES
ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Series provided a
total return of 4.95% in the year ended March 31, 1996, while the
return on the Series' benchmark, the six month U.S. Treasury Bill,
was 5.96%. The Series' annualized return from inception on March
31, 1992 through March 31, 1996 was 5.20%, while the benchmark six
month Treasury Bill's annualized return over the same period was
4.58%.
The Series underperformed its benchmark by 1.01% in the year ending
March 31, 1996. The Series invests in mortgage securities, and its
performance relative to its benchmark is adversely affected when
the price of mortgage securities appreciates by less than the price
of Treasury securities in a falling interest rate environment.
This is what occurred during 1995. The yield on the ten year U.S.
Treasury Note fell from 7.19% in March 1995 to 5.58% in December
1995, or 1.61% in total. Over the same period the yield on par
coupon FNMA thirty year fixed-rate mortgages (that is, mortgage
securities which are priced at 100 or par) fell 1.46% from 8.26% to
6.80%. Mortgage securities underperformed U.S. Treasury securities
due to investors' concerns about prepayment risk. Prepayment risk
is the risk that homeowners will take advantage of lower interest
rates to prepay their mortgages. The mortgage investor is at a
disadvantage since the funds from these payments can be reinvested
only at a lower yield.
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, 1996, AN INVESTMENT
OF $10,000 IN THE SERIES WOULD HAVE GROWN TO $12,254, VERSUS $11,964, 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 4.95%, THE ANNUALIZED THREE YEAR RETURN IS
5.06%, AND THE ANNUALIZED RETURN SINCE INCEPTION IS 5.20%.
During the first quarter of 1996 the yield on the ten year U.S.
Treasury Note began to climb, rising to 6.32% on March 31, 1996.
The Series' performance for the quarter was in line with its benchmark,
providing a return of 1.26% as compared with the U.S. Treasury Bill
return of 1.20%. Prepayment concerns dissipated somewhat with the
increase in interest rates, but yields on mortgages remained at
relatively high levels when compared with U.S. Treasury securities,
which precluded the Series' outperforming the benchmark by a large
margin. The short duration of the Series provided superior performance
in the quarter relative to the universe of bonds, however, as rising
interest rates produced losses for investors holding U.S. Treasury
securities with maturities of three years or more.
The portfolio turnover rate for the Series was 225% for the year.
This measure, which is calculated by dividing the lesser of
portfolio purchases and sales for the year by average net assets,
provides an indication of how much active trading is conducted in
a portfolio. In order to meet the Series' objective of providing
a return exceeding that of the Series' benchmark, while maintaining
the same approximate interest rate risk as the benchmark, the
Series aims to own at any given time those mortgage securities
offering a superior risk-adjusted yield. Hence, short term
opportunities to exchange mortgage securities with a lower
risk-adjusted yield for those with a higher risk-adjusted yield are
exploited whenever it is economical and prudent to do so. Equally,
when the mortgage securities sector as a whole offers a superior
yield to U.S. Treasury securities, the Series will increase its
holdings of mortgages as a percentage of net assets. Accordingly,
the Series took advantage of rising yield spreads to increase its
holdings of mortgages, and the Series' holdings of mortgages as a
percent of net assets rose from 107% in March 1995 to 122% in March
1996. The weight of GNMA adjustable-rate securities in the
portfolio also increased as the yields offered on these securities
relative to estimated prepayment risk increased.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk target
at a level approximating that of the six month U.S. Treasury Bill.
In the next fiscal year, the Series will continue to maintain this
strategy, which has resulted in a positive return over all calendar
quarters since the Series' inception.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31, 1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 120.94%
FEDERAL HOME LOAN MORTGAGE CORP. - 24.92% *
FHLMC GOLD:
$44,000,000 6.50%, due (a) ............................ $41,896,250
7,000,000 7.00%, due (a) ............................ 6,833,750
3,909,482 7.50%, due 6/1/24 to 10/1/25 .............. 3,906,185
1,142,037 8.00%, due 9/1/24 to 5/1/25 ............... 1,163,917
1,470,825 8.50% Balloon Mortgages,
due 4/1/96 to 11/1/96 .............. 1,471,228
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $56,327,564)........................ 55,271,330
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 14.96% *
FNMA:
30,808,916 7.50%, due 8/01/25 to 9/1/25 .............. 30,763,387
FNMA ARM:
410,630 7.136%, due 12/1/15 ....................... 416,551
546,625 7.571%, due 1/1/18 ........................ 558,693
634,882 7.692%, due 6/20/20 ....................... 654,061
200,693 7.839%, due 12/1/26 ....................... 208,135
FNMA INTEREST ONLY **:
1,988,264 9.00%, due 7/25/21 ........................ 590,476
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $32,977,247)........................ 33,191,303
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 81.06% *
GNMA:
27,238,097 7.00%, due 11/15/22 to 3/15/24 ............ 26,560,093
1,689,664 9.50%, due 7/15/09 to 4/15/25 ............. 1,832,898
GNMA ARM:
98,681,809 5.50%, due 10/20/25 to 3/20/26 ............ 97,726,368
33,917,962 6.00%, due 7/20/25 to 9/20/25 ............. 34,109,528
19,212,423 7.00%, due 5/20/25 ........................ 19,589,106
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $180,387,686)....................... 179,817,993
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $269,692,497)....................... 268,280,626
Notional
Amount INTEREST RATE SWAP CONTRACTS - 0.24%
$20,000,000 Contract dated 6/22/93 with Prudential
Global Funding,Expires 6/22/98 ............ 197,553
20,000,000 Contract dated 8/31/93 with Salomon Swapco,
Expires 8/31/00 ........................... 725,807
20,000,000 Contract dated 12/2/93 with Morgan Guaranty,
Expires 12/2/00 ........................... 387,516
40,000,000 Contract dated 5/15/95 with Salomon Swapco,
Expires 5/15/05 ........................... (786,983)
TOTAL INTEREST RATE SWAP CONTRACTS ........ 523,893
THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS - 0.76
$40,000,000 Contract with Salomon SwapCo, expires 11/1/96,
Strike rate 5.00% ......................... 113,600
40,000,000 Contract with Salomon SwapCo, expires 11/15/97,
Strike rate 5.00% ......................... 504,360
40,000,000 Contract with Morgan Guaranty, expires 10/15/98,
Strike rate 5.00% ......................... 1,060,800
TOTAL THREE-MO. LIBOR INTEREST RATE CAP CONTRACTS
(Cost $1,875,834)......................... 1,678,760
Contracts FUTURES OPTION CONTRACTS - 0.35%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $116............ 781
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $117............ 781
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $109............ 117,187
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $110............ 173,438
50 Put on 10 Year UST Note futures,
expires 6/96, strike price $111............ 121,094
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $112............ 325,000
50 Put on 30 Year UST Bond futures,
expires 6/96, strike price $108............ 28,125
TOTAL FUTURES OPTION CONTRACTS
(Cost $249,908) .......................... 766,406
TOTAL INVESTMENTS (Cost $271,818,239) ..... 271,249,685
Face Amount REVERSE REPURCHASE AGREEMENTS- (0.45%):
($1,000,000) FHLMC, 5.51%, due 4/4/96 dated 3/29/96 .... (1,000,000)
TOTAL REVERSE REPURCHASE AGREEMENTS ....... (1,000,000)
OTHER LIABILITIES LESS CASH AND OTHER ASSETS -
(21.84%).................................. (48,424,549)
NET ASSETS - 100.00% $221,825,136
* 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, 1996. ARMs 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.
(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 SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value (identified
cost $271,818,239)(Note 1)...................... $271,249,685
Cash............................................... 514,603
Receivables:
Variation margin on futures contracts (Note 1).. 58,000
Interest........................................ 1,352,131
Deferred organization expenses (Note 1)............ 9,548
TOTAL ASSETS.................................. 273,183,967
LIABILITIES:
Reverse repurchase agreement (Note 1).............. 1,000,000
Payables:
Securities purchased............................ 50,014,306
Swap interest................................... 92,380
Due to adviser (Note 3)......................... 113,212
Accrued expenses................................... 138,933
TOTAL LIABILITIES............................. 51,358,831
NET ASSETS:
(Applicable to outstanding shares of 22,769,456
unlimited number of shares of beneficial
interest authorized; no stated par)............. $221,825,136
Net asset value, offering price and redemption
price per share ($221,825,136 / 22,769,456)..... $9.74
SOURCE OF NET ASSETS:
Paid in capital.................................... $229,328,831
Accumulated net realized loss on investments....... (6,435,945)
Net unrealized depreciation of investments......... (1,067,750)
NET ASSETS.................................... $221,825,136
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, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) .... $17,326,843
EXPENSES:
Advisory fees (Note 3)......................... 1,717,748
Accounting and pricing services fees........... 73,827
Custodian fees................................. 76,145
Audit and tax preparation fees................. 92,199
Legal fees..................................... 80,126
Amortization of organization expenses (Note 1). 9,629
Transfer agent fees............................ 33,767
Registration fees.............................. 24,996
Trustees fees and expenses..................... 103,888
Insurance...................................... 31,961
Other.......................................... 34,641
TOTAL EXPENSES BEFORE REIMBURSEMENT........ 2,278,927
Expenses reimbursed by Adviser (Note 3).... (364,865)
NET EXPENSES............................... 1,914,062
NET INVESTMENT INCOME ..................... 15,412,781
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments............... 4,639,312
Change in unrealized appreciation of
investments.................................. (8,342,309)
Net realized and unrealized loss on
investments.................................. (3,702,997)
Net increase in net assets resulting
from operations.............................. $11,709,784
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
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............. $15,412,781 $13,504,268
Net realized gain (loss)
on investments.................... 4,639,312 (1,414,168)
Change in unrealized appreciation
(depreciation) of investments..... (8,342,309) 1,365,349
Net increase in net assets
resulting from operations......... 11,709,784 13,455,449
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income............................ (15,412,781) (13,504,268)
Dividends in excess of net
investment income................. (269,331) (90)
Total distributions............... (15,682,112) (13,504,358)
CAPITAL SHARE TRANSACTIONS:
Shares sold....................... 93,214,276 94,549,923
Shares issued on reinvestment of
distributions..................... 3,773,450 4,346,125
Shares redeemed................... (89,621,927) (98,582,965)
Increase in net assets resulting
from capital share
transactions (a).................. 7,365,799 313,083
TOTAL INCREASE IN NET ASSETS............... 3,393,471 264,174
NET ASSETS:
Beginning of year................. 218,431,665 218,167,491
End of year....................... $221,825,136 $218,431,665
(a) Transactions in capital shares were as follows:
Shares sold....................... 9,500,348 9,582,171
Shares issued on reinvestment
of distributions.................. 386,101 441,809
Shares redeemed................... (9,167,732) (10,018,137)
Net increase...................... 718,717 5,843
Beginning balance ................ 22,050,739 22,044,896
Ending balance.................... 22,769,456 22,050,739
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from operations.... $11,709,784
Net realized and unrealized loss on investments......... 3,702,997
Net investment income................................. 15,412,781
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Interest rate cap and interest-only strip amortization.. 643,641
Paydown gains and losses................................ (15,635)
Increase in interest receivable......................... (430,707)
Decrease in other assets................................ 74,098
Increase in other liabilities........................... 168,021
Net cash provided by operating activities............. 15,852,199
Cash flows from investing activities:
Payments for futures variations......................... (2,465,409)
Proceeds from sales of long-term investments............ 291,400,731
Proceeds from sales of short-term investments........... 2,807,926
Proceeds from maturities of short-term investments...... 1,539,970,000
Proceeds from paydowns of long-term investments......... 19,239,211
Purchases of long-term investments...................... (423,241,572)
Purchases of short-term investments.....................(1,435,805,067)
Net cash used in investing activities................. (8,094,180)
Cash flows from financing activities:
Increase in collateralized borrowings................... 1,000,000
Purchase of shares tendered............................. 3,592,349
Dividends from net investment income.................... (11,908,662)
Net cash used in financing activities................. (7,316,313)
Net increase in cash.................................. 441,706
Cash at beginning of year.................................. 72,897
Cash at end of year........................................ $514,603
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends..................... $3,773,450
Supplemental disclosure:
Interest paid........................................... $373,480
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 Year For the Period
Ended Ended Ended March 31, 1992 (1)
March 31, 1996 March 31, 1995 March 31, 1994 to March 31, 1993
Net Asset Value,
Beginning of
Period....... $9.90 $9.90 $10.00 $10.00
Income From
Investment Operations
Net investment
income..... 0.621 0.628 0.432 0.552
Net realized
and unrealized
gain (loss) on
investments. (0.148) - (0.070) 0.002
Total from
investment
operations. 0.473 0.628 0.362 0.554
Less Distributions
Dividends from
net investment
income....... (0.621) (0.628) (0.462) (0.554)
Dividends in
excess of
investment
income....... (0.012) - - -
Total
distributions (0.633) (0.628) (0.462) (0.554)
Net Asset Value,
End of Period.. $9.74 $9.90 $9.90 $10.00
Total Return .. 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end
of period..... $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses
to average
net assets (2) 0.78% 0.78% 0.78% 0.78%
Ratio of net
investment
income to average
net assets (3) 6.29% 6.33% 4.17% 4.53%
Portfolio turnover
rate.......... 225% 47% 112% 3%
______________________
(1) Commencement of operations.
(2) The annualized operating expense ratios prior to reimbursement of
expenses by the Adviser were 0.93%, 0.92%, 1.00%, and 2.58% for the
Short Duration U.S. Government Series for the years ended March 31,
1996, March 31, 1995, March 31, 1994 and the period ended March 31,
1993, respectively. Expense ratios include both the direct expenses
of the Short Duration U.S.Government Series, and the indirect expenses
incurred through the Series' investment in the Short Duration U.S.
Government Fund (Note 1).
(3) The annualized net investment income ratios prior to reimbursement of
both direct and indirect expenses by the Adviser were 6.13%, 6.18%,
3.95%, and 2.73% for the Short Duration U.S. Government Series for the
years ended March 31, 1996, March 31, 1995, March 31, 1994, and the
period ended March 31, 1993, respectively.
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The 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: the Smith Breeden Short Duration U.S. Government
Series (the "Short Series" or "Series") and the Smith Breeden
Intermediate Duration U.S. Government Series ("Intermediate
Duration Series"). Prior to April 1, 1995, the Short Series sought
to achieve its investment objective by investing all of its assets
in the 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.
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.
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. 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 carryforward. As of March 31,
1996, the Series had a net capital loss carryforward of $2,340,576,
with $589 expiring on March 31, 2001, $75,461 expiring on March 31,
2002, $905,312 expiring on March 31, 2003, and $1,359,214 expiring
on March 31, 2004.
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 Organization Expenses: Deferred organization
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
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 Short Series had the following open futures contracts as of
March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 year Treasury $ 4,000,000 Short June, 1996 $ 9,820
3 month Treasury 70,000,000 Long June, 1996 (87,815)
3 month Eurodollar 77,000,000 Long June, 1996 (76,021)
3 month Eurodollar 75,000,000 Long September, 1996 (99,712)
3 month Eurodollar 52,000,000 Short March, 1997 (28,584)
3 month Eurodollar 6,000,000 Short March, 1998 3,573
3 month Eurodollar 34,000,000 Short March, 1999 20,247
3 month Eurodollar 77,000,000 Short March, 2000 (199,897)
3 month Eurodollar 28,000,000 Short March, 2001 (57,526)
3 month Eurodollar 32,000,000 Short March, 2002 (36,394)
3 month Eurodollar 30,000,000 Short March, 2003 53,115
$ (499,194)
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.
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,
1996, the Short Series had open 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 payable on the interest rate swap
contracts was $92,380, and swap contract interest receivable was
$478. 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, 1996 was $91,632.
3. TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser, provides the Short Series with investment
management services.
The Adviser voluntarily agreed to reimburse normal business
expenses of the Short Series through March 31, 1996 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,
1996. 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, 1996, the Adviser
received $1,717,748 in fees and reimbursed the Short Series $364,865.
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, effective August 1, 1994, a
Distribution and Services Plan (the "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 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 the advisory fee paid to it by the Short Series, to
dealers and other persons at the annual rate of up to 0.25% of the
Short Series' average net assets, subject to the authority the
Trustees of the Short 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.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$690,002,566 and $690,050,141 respectively for the Series. The
cost of the Short Series' securities for federal income tax
purposes at March 31, 1996, is $271,818,239. Net unrealized
depreciation of investments and futures contracts consists of:
Gross unrealized appreciation $ 2,957,098
Gross unrealized depreciation (4,024,848)
Net unrealized depreciation $ (1,067,750)
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, 1996, and the related statements of operations and cash
flows for the year then ended, the statements of changes in net assets
for each of the years in the two-year period then ended and the financial
highlights for each of the years in the three-year period then ended and
the period March 31, 1992 (commencement of operations) to March 31, 1993.
These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express
an opinion on these financial statements and the 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 the
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, 1996 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, the financial statements and financial highlights referred
to above 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, 1996, the results of its operations
and its cash flows, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with generally
accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Intermediate Duration U.S. Government Series
provided a total return of 9.69% in the year ended March 31,
1996, while the return on the Series' benchmark, the Salomon
Brothers Mortgage Index, was 10.51%.
The period from March 1995 to December 1995 saw a strong rally
in bonds, as inflation fears lessened and the Federal Reserve
lowered its target rate for Federal Funds from 6.0% in March to
5.5% in December. The Series return from March through December
1995 was 10.39%. The return on the five year U.S. Treasury
Note, which has roughly the same duration as the Series, was
11.66%. The return on the Salomon Brothers Mortgage Index over
the same period was 10.91%.
During the nine month period ended December 31, 1995, mortgage
securities underperformed U.S. Treasury Notes of comparable
duration because of investors' concerns about prepayment risk.
Prepayment risk is the risk that homeowners will take advantage
of lower interest rates to prepay their mortgages. The mortgage
investor is at a disadvantage since the funds from these
payments can be invested only at a lower yield.
The advantage enjoyed by U.S. Treasury securities in 1995 was
reversed in the first quarter of 1996. The five year U.S.
Treasury Note yield rose 0.69% from 5.39% to 6.08% as a series
of strong employment statistics reawakened fears of inflation
among investors.
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 N1-A:
THE GRAPH PRESENTED COMPARES THE CHANGE FOR THE PERIOD FROM
MARCH 31, 1992 THROUGH MARCH 31, 1996 OF A $10,000 INVESTMENT IN
THE SERIES VERSUS ITS BENCHMARK. FOR THE PERIOD FROM THE SERIES'
INCEPTION, MARCH 31, 1992, THROUGH MARCH 31, 1996, 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 SHAREHOLDERS, THE SERIES' BENCHMARK WAS CHANGED TO THE SALOMON
BROTHERS MORTGAGE INDEX. THE SERIES AVERAGE ANNUAL RETURN WAS 9.69%
FOR THE ONE YEAR PERIOD, 6.61% FOR THE THREE YEAR PERIOD, AND 8.62%
FOR THE PERIOD SINCE INCEPTION. FROM INCEPTION OF MARCH 31, 1992
THROUGH MARCH 31, 1996, AN INVESTMENT OF $10,000 IN THE SERIES WOULD
HAVE GROWN TO $13,927, VERSUS $13,686, IF INVESTED IN THE BENCHMARK.
Interestingly, the Federal Reserve Board didn't
seem to share those inflation fears, and it actually cut the
target rate for Federal Funds to 5.25% in January 1996. The five
year U.S. Treasury Note posted a loss of 1.54% in the first
quarter, while the Intermediate Series posted a loss of 0.63%,
and the Salomon Brothers Mortgage Index loss was 0.37%. Mortgage
securities outperformed U.S. Treasury securities in the first
quarter as investor's fears about prepayment risk lessened.
The portfolio turnover rate for the Series was 193% for the
year. This measure, which is calculated by dividing the lesser
of portfolio purchases and sales for the year by average net
assets, provides an indication of how much active trading is
conducted in a portfolio. In order to meet the Series'
objective of providing a return exceeding that of the Series'
benchmark, while also covering the 0.90% annual fund expense
ratio, and maintaining the same approximate interest rate risk
as the benchmark, the Series aims to own at any given time those
mortgage securities offering a superior risk-adjusted yield.
Hence, short term opportunities to exchange mortgage securities
with a lower risk-adjusted yield for those with a higher risk-
adjusted yield are exploited whenever it is economical and
prudent to do so. Equally, when the mortgage securities sector
as a whole offers an attractive risk-adjusted yield advantage
over U.S. Treasury securities the Series will increase its
holdings of mortgages as a percentage of net assets.
Accordingly, the Series took advantage of rising yield spreads
of mortgages to U.S. Treasury securities to increase its
holdings of mortgages as a percent of net assets, which rose
from 100% in March 1995 to 134% in March 1996. The weighting of
GNMA adjustable-rate securities in the portfolio was also
increased from 19% of net assets in March 1995 to 36% in March
1996, as the risk-adjusted yields offered on these securities
increased relative to U.S. Treasury securities. Although
adjustable-rate mortgages are not included in the Salomon
Brothers Mortgage Index, the Series will hold adjustable-rate
mortgages in its portfolio when they offer a risk-adjusted yield
advantage over fixed-rate mortgages.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
and can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk at
approximately the same level as that of the Salomon Brothers
Mortgage Index. In the next fiscal year, the Series will
continue its strategy of purchasing securities in the mortgage
sector which offer superior risk-adjusted yields. This strategy
has enabled the Series to provide an annualized total return
from inception of 8.62%, comfortably exceeding the return of
8.15% on its benchmark, while maintaining a similar level of
interest rate risk.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31, 1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 134.39%
FEDERAL HOME LOAN MORTGAGE CORP. - 41.74% *
FHLMC GOLD:
$7,000,000 6.50, due (a) ......................... $6,719,063
6,000,000 7.00%, due (a) ........................ 5,857,500
2,578,648 8.00%, due 9/1/24 to 10/19/24.......... 2,635,324
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $15,456,817)..................... 15,211,887
FEDERAL NATIONAL MORTGAGE ASSOC. - 32.09% *
FNMA ARM:
1,369,074 5.98%, due 9/1/25 ..................... 1,403,379
158,720 7.692%, due 8/25/22 ................... 163,515
FNMA:
3,491,642 7.00%, due 8/1/23 to 6/1/24 ........... 3,406,702
3,631,118 7.50%, due 8/1/25 ..................... 3,625,752
1,277,596 8.50%, due 9/14/24 to 2/1/25 .......... 1,322,721
1,643,028 9.50%, due 7/1/16 to 5/1/22 ........... 1,773,567
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC.
(Cost $11,368,709)..................... 11,695,636
GOVERNMENT NATIONAL MORTGAGE ASSOC. - 60.13% *
GNMA ARM:
7,472,926 5.50%, due 10/20/25 to 1/20/26 ........ 7,400,934
5,726,103 6.00%, due 9/20/25 .................... 5,758,443
GNMA:
7,189,552 7.00%, due 11/21/14 to 3/15/24 ........ 7,010,593
1,686,432 8.00%, due 12/15/06 to 4/15/09 ........ 1,747,195
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(Cost $21,694,608)..................... 21,917,165
UNITED STATES TREASURY BILLS - 0.43% **
140,000 5.02 due 6/27/96 ...................... 138,309
20,000 4.96 due 6/27/96 ...................... 19,760
TOTAL UNITED STATES TREASURY BILLS
(Cost $158,062) ....................... 158,069
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $48,678,196)..................... 48,982,757
Contracts FUTURES OPTION CONTRACTS- 0.01%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $115........ 1,562
30 Call on 10 Year UST Note futures,
expires 6/96, strike price $116........ 469
TOTAL FUTURES OPTION CONTRACTS
(Cost $69,423) ........................ 2,031
TOTAL INVESTMENTS (Cost $48,747,619) -
134.40% ............................... 48,984,788
CASH AND OTHER ASSETS LESS LIABILITIES -
(34.40%) .............................. (12,537,848)
NET ASSETS - 100.00% .................... $36,446,940
* 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, 1996. ARMs 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, 1996
ASSETS:
Investments at market value
(identified cost $48,747,619)(Note 1)............... $48,984,788
Cash................................................ 312,247
Receivables:
Variation margin on futures contracts............ 25,950
Interest......................................... 232,324
Prepaid expenses.................................... 6,057
Deferred organization expenses (Note 1)............. 10,159
TOTAL ASSETS................................... 49,571,525
LIABILITIES:
Payables:
Securities purchased............................. 12,938,923
Distributions payable............................ 135,382
Due to advisor (Note 3).......................... 15,102
Accrued expenses.................................... 35,178
TOTAL LIABILITIES.............................. 13,124,585
NET ASSETS:
(Applicable to outstanding shares of 3,639,328;
unlimited number of shares of beneficial
interest authorized; no stated par).............. $36,446,940
Net asset value, offering price and redemption
price per share ($36,446,940 /3,639,328)........ $10.01
SOURCE OF NET ASSETS:
Paid in capital..................................... $36,286,422
Overdistributed net investment income............... (98,690)
Accumulated net realized gain on investments........ 28,769
Net unrealized appreciation of investments.......... 230,439
NET ASSETS..................................... $36,446,940
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, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) ......... $2,698,898
EXPENSES:
Advisory fees (Note 3) ............................. 256,075
Accounting and pricing services fees ............... 38,954
Custodian fees ..................................... 22,593
Audit & tax preparation fees ....................... 11,452
Legal fees ......................................... 8,987
Amortization of organization expenses (Note 1) ..... 9,428
Transfer agent fees ................................ 28,915
Registration fees .................................. 20,004
Trustees fees and expenses ......................... 11,365
Insurance .......................................... 3,576
Other .............................................. 3,242
TOTAL EXPENSES BEFORE REIMBURSEMENT ............ 414,591
Expenses reimbursed by Adviser (Note 3) ........ (85,364)
NET EXPENSES ................................... 329,227
NET INVESTMENT INCOME .......................... 2,369,671
REALIZED AND UNREALIZED GAIN ON INVESTMENTS:
Net realized gain on investments ................... 1,227,064
Change in unrealized appreciation of investments.... (257,447)
Net realized and unrealized gain on investments .... 969,617
Net increase in net assets resulting from operations $3,339,288
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
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............... $2,369,671 $1,346,839
Net realized gain (loss) on investments 1,227,064 (248,302)
Change in unrealized appreciation
(depreciation) of investments....... (257,447) 778,903
Net increase in net assets resulting
from operations..................... 3,339,288 1,877,440
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income. (2,358,436) (1,346,839)
Dividends in excess of net investment
income.............................. - (140,634)
Distributions from net realized
capital gains....................... (367,107) -
Distributions in excess of net
realized capital gains.............. - (28,444)
Total distributions................. (2,725,543) (1,515,917)
CAPITAL SHARE TRANSACTIONS:
Shares sold......................... 1,030,079 31,506,439
Shares issued on reinvestment of
distributions....................... 702,855 669,611
Shares redeemed..................... (697,235) (4,519,742)
Increase in net assets resulting
from capital share transactions (a) 1,035,699 27,656,308
TOTAL INCREASE IN NET ASSETS.... 1,649,444 28,017,831
NET ASSETS:
Beginning of year................... 34,797,496 6,779,665
End of year......................... $36,446,940 $34,797,496
(a) Transactions in capital shares
were as follows:
Shares sold.................... 100,992 3,257,497
Shares issued on
reinvestment of distributions.. 69,235 68,948
Shares redeemed................ (69,182) (465,316)
Net increase................... 101,045 2,861,129
Beginning balance ............. 3,538,283 677,154
Ending balance................. 3,639,328 3,538,283
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from
operations....................................... $3,339,288
Net realized and unrealized gain on investments.. (969,617)
Net investment income.......................... 2,369,671
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and losses..................... (40,951)
Increase in interest receivable.................. (36,556)
Decrease in other assets......................... 3,025
Increase in other liabilities.................... 25,598
Net cash provided by operating activities...... 2,320,787
Cash flows from investing activities:
Proceeds from futures variations................. 157,418
Proceeds from sales of long-term investments..... 55,165,384
Proceeds from sales of short-term investments.... 20,254
Proceeds from maturities of short-term
investments...................................... 81,940,000
Proceeds from paydowns of long-term investments.. 3,311,979
Purchases of long-term investments............... (61,937,619)
Purchases of short-term investments.............. (82,161,200)
Net cash used in investing activities.......... (3,503,784)
Cash flows from financing activities:
Purchase of shares tendered...................... 332,844
Dividends from net investment income and
realized capital gains........................... (2,035,111)
Net cash used in financing activities........ (1,702,267)
Net decrease in cash......................... (2,885,264)
Cash at beginning of year.......................... 3,197,511
Cash at end of year................................ $312,247
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends.............. $702,855
Supplemental disclosure:
Interest paid.................................... $191,436
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 Year Year Period
Ended Ended Ended Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31, 1993*
Net Asset Value,
Beginning
of Period..... $9.83 $10.01 $10.62 $10.00
Income From
Investment
Operations
Net investment
income....... 0.660 0.664 1.050 0.826
Net gain (loss)
on securities
(both realized
and unrealized) 0.227 (0.049) (0.601) 0.621
Total from
investment
operations.. 0.937 0.615 0.449 1.447
Less Distributions
Dividends from
net investment
income........ (0.656) (0.664) (1.044) (0.826)
Dividends in
excess of net
investment
income........ - (0.108) - -
Distributions
from net realized
gains on
investments... (0.101) - (0.015) -
Distributions in
excess of net
realized gains on
investments... - (0.022) - -
Total
distributions (0.757) (0.794) (1.059) (0.826)
Net Asset Value,
End of Period.. $10.01 $9.83 $10.01 $10.62
Total Return... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end
of period.... $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses
to average net
assets (1)... 0.90% 0.90% 0.90% 0.82%
Ratio of net
investment income
to average net
assets (2)... 6.49% 6.20% 7.74% 8.18%
Portfolio
turnover rate 193% 557% 84% 42%
______________________
(1) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 2.28%, 2.33%, 2.34%,
and 17.52% for the years ended March 31, 1996, March 31, 1995 and
March 31, 1994, and for the period ended March 31, 1993, respectively.
Expense ratios include both the direct expenses of the Intermediate
Duration U.S. Government Series, and the indirect expenses incurred
through the Series' investment in the Institutional Intermediate
Duration U.S. Government Fund (Note 5).
(2) The annualized ratio of net investment income to average net assets
prior to reimbursement of both direct and indirect expenses by the
Adviser was 6.26%, 4.77%, 6.30% and (8.52)% for the years ended
March 31, 1996, March 31, 1995 and March 31, 1994, and for the period
ended March 31, 1993, respectively.
* The Intermediate Duration U.S. Government Series commenced operations
on March 31, 1992.
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The 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: the 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.
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
carryforward. As of March 31, 1996, the Series had no capital loss
carryforward.
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
periods.
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, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 Year
Treasury $ 7,200,000 Long June, 1996 $ 184,176
3 Month
Eurodollar 22,000,000 Short March, 1998 (94,607)
3 month
Eurodollar 6,000,000 Short March, 1999 (27,027)
3 month
Eurodollar 16,000,000 Short March, 2000 (69,272)
$ (6,730)
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, 1996 was $158,069.
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, 1996, the Adviser received fees of
$256,075 and reimbursed the Series $85,364.
Effective August 1, 1994, the Series adopted a 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, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$87,639,428 and $87,338,696, 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 $48,747,619. Net
unrealized appreciation of investments and futures contracts
consists of:
Gross unrealized appreciation .................. $773,535
Gross unrealized depreciation .................. (543,096)
Net unrealized appreciation .................... $230,439
5. LIQUIDATION OF THE INSTITUTIONAL INTERMEDIATE FUND
From its inception until August 1, 1994, the Intermediate
Series sought to achieve its investment obective by investing
all of its assets in the Smith Breeden Institutional
Intermediate Duration U.S. Government Fund (the "Institutional
Fund"), an open-end, diversified management investment company
having the same investment objective as the Series. However,
at the close of business on August 1, 1994, pursuant to a plan
of liquidation adopted by the Trustees of the Institutional
Fund, and approved by the Trustees of the Intermediate Series,
the Intermediate Series redeemed in-kind its shares of the
Institutional Fund. The assets of the Institutional Fund were
transferred in proportion to the Intermediate Series' ownership
of the Institutional Fund in cancellation of its shares.
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, 1996, and the related
statements of operations and cash flows for the year then ended,
the statements of changes in net assets for each of the years in
the two-year period then ended and the financial highlights for
each of the years in the three-year period then ended and the
period March 31, 1992 (commencement of operations) to March 31,
1993. These financial statements and the financial highlights
are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial
statements and the 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 the 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, 1996 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, the financial statements and financial
highlights referred to above 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, 1996, the results of its
operations and its cash flows, the changes in its net assets,
and the financial highlights for the respective stated periods
in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
