JULY 23, 1997
SMITH BREEDEN MUTUAL FUNDS
PROSPECTUS
The Smith Breeden Mutual Funds consist of three no
load, diversified registered investment companies (the
"Funds"). 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 Fund is a series
fund of the Smith Breeden Trust. The Equity Plus
Fund does not generally invest in the common stocks that
make up the S&P 500 Index or any other index. The
Equity Plus Fund utilizes index futures contracts and
equity swap contracts to track the return of the S&P 500
Index, and invests substantially all of its assets in
fixed-income securities and related hedging instruments.
Whether the Fund's total return equals or exceeds the
performance of the S&P 500 Index depends on whether the
total return on the Equity Plus Fund's fixed-income
investments equals or exceeds the Fund's total operating
expenses, as well as other factors. See "Investment
Objectives, Policies, and Risk Considerations -
Equity Plus Fund."
Smith Breeden Short Duration U.S. Government Fund
(the "Short Fund", formerly known as the Smith Breeden Short
Duration U.S. Government Series) seeks a high level of current
income consistent with low volatility of net asset value.
The Short Fund 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 at times significantly exceed six
months.
Smith Breeden Intermediate Duration U.S. Government
Fund (the "Intermediate Fund", formerly known as the Smith Breeden
Intermediate Duration U.S. Government 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 currently
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 mortgagebacked securities,
weighted in proportion to their current market
capitalization. The duration, or interest-rate risk,
of these indices is similar to that of intermediateterm
U.S. Treasury Notes, and typically will range between
three and five years. The Intermediate Fund 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.
1
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. Please read this
Prospectus carefully and keep it for future reference.
A Statement of Additional Information, dated July 23,
1997, which is incorporated herein by reference, has
been filed with the Securities and Exchange Commission
with respect to each Fund and is available on the
Commission's Web site (http://www.sec.gov). 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.
TABLE OF CONTENTS
Expense Table 3
Financial Highlights--Equity Plus Fund 5
Financial Highlights--Short Fund 6
Financial Highlights--Intermediate Fund 7
Smith Breeden Mutual Funds 8
Investment Objectives, Policies and Risk Considerations 8
Other Investment Practices and Risk Considerations 21
Management of the Funds 24
Pricing of Fund Shares 28
How to Purchase Shares 29
How to Exchange Shares 32
How to Redeem Shares 33
Dividends and Distributions 36
Shareholder Reports and Information 37
Retirement Plans 38
Service and Distribution Plans 38
Taxes 39
Capital Structure 40
Transfer, Dividend Disbursing Agent, Custodian and
Independent Accountants 40
Fund Performance 41
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.
2
EXPENSE TABLE
The following table is designed to assist you
in understanding the expenses you will bear as a shareholder
of 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.
Equity Short Intermediate
Plus
Fund Fund 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% 0.18% 0.18%
Total Fund Operating Expenses
(net of reimbursement)3 0.78% 0.88% 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 Fund's 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 Fund and 0.88% for each of the Equity Plus
Fund and Intermediate Fund through August 1,
1998. Absent the expense limitation, Other
Expenses and Total Fund Operating Expenses would
be 0.23% and 0.93% for the Short
Fund, 0.46% and 1.16% for the Intermediate Fund, and
1.90% and 2.60% for the Equity Plus Fund.
3
The following examples illustrate the expenses that
apply to a $750 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 Fund
1 Year 3 Years 5 Years 10 Years
$ 6 $ 18 $ 31 $67
Intermediate Duration Fund and Equity Plus Fund
Year 3 Years 5 Years 10 Years
$ 7 $ 21 $ 35 $75
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 that would be in addition to any fees and
expenses presented in the above table. Certain broker
dealers may also charge a fee for purchase or
redemption of shares through their network. Neither the
Funds, nor the Adviser, exercise any control over such
advisory or broker-dealer fees and may not be informed of
the level of such fees.
4
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, 1997, 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 & Touche LLP thereon which
appear in the Fund's Statement of Additional Information.
<TABLE>
Selected Financial Data
<CAPTION>
Year Ended Year Ended Year Ended Year Ended Period
March 31, March 31, March 31, March 31, March 31,
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
Net Asset Value, Beginning of $12.27 $10.84 $9.88 $10.85 $10.00
Period
Income From Investment
Operations
Net investment income 0.592 0.615 0.568 0.476 0.355
Net realized and unrealized
gain (loss) on investments 1.813 2.768 1.081 (0.216) 1.281
Total from investment
operations 2.405 3.383 1.649 0.260 1.636
Less Distributions
Dividends from net
investment income (0.590) (0.583) (0.568) (0.472) (0.311)
Dividends in excess of
net investment income -- -- (0.001) -- --
Distributions from net
realized gains on investments (1.525) (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 (2.115) (1.953) (0.689) (1.230) (0.786)
Net Asset Value,
End of Period $12.56 $12.27 $10.84 $9.88 $10.85
Total Return 21.41% 32.30% 17.18% 2.19% 22.59%*
Ratios/Supplemental Data
Net assets, end of period $13,507,377 $4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to average net assets
Before expense limitation 2.60% 4.58% 7.75% 7.08% 28.48%*
After expense limitation 0.88% 0.90% 0.90% 0.90% 0.57%*
Ratio of net income to average net assets
Before expense limitation 3.58% 1.85% 0.59% 1.84% (22.63%)*
After expense limitation 5.30% 5.53% 7.44% 8.02% 5.28%*
Portfolio turnover rate 182% 107% 120% 119% 271%
* Annualized
Additional performance information is presented in the Fund's Annual Report,
which is available without charge upon request.
</TABLE>
5
SHORT DURATION FUND
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,
1997 and are a part of the Short Fund's financial statements which have been
audited by Deloitte & Touche LLP, independent auditors. This data should be
read in conjunction with the Short Fund's most recent annual audited
financial statements and the report of Deloitte & Touche LLP thereon which
appear in the Fund's Statement of Additional Information.
<TABLE>
Selected Financial Data
<CAPTION>
Year Ended Year Ended Year Ended Year Ended Period
March 31, March 31, March 31, March 31, March 31,
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
Net Asset Value, Beginning of
Period $9.74 $9.90 $9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income 0.476 0.621 0.628 0.432 0.552
Net gain (loss) on securities
(both realized and unrealized) 0.146 (0.148) -- (0.070) 0.002
Total from investment
operations 0.622 0.473 0.628 0.362 0.554
Less Distributions
Dividends from net investment
income (0.476) (0.621) (0.628) (0.462) (0.554)
Dividends in excess of net
investment income (0.056) (0.012) -- -- --
Total distributions (0.532) (0.633) (0.628) (0.462) (0.554)
Net Asset Value, End of
period $9.83 $9.74 $9.90 $9.90 10.00
Total Return 6.57% 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of
period $118,988,609 $221,825,136 $218,431,665 $218,167,491 48,531,206
Ratio of expenses to average net assets
Before expense limitation 0.93% 0.93% 0.92% 1.00% 2.58%
After expense limitation 0.78% 0.78% 0.78% 0.78% 0.78%
Ratio of net income to
average net assets
Before expense limitation 4.90% 6.13% 6.18% 3.95% 2.73%
After expense limitation 5.04% 6.29% 6.33% 4.17% 4.53%
Portfolio turnover rate 556% 225% 47% 112% 3%
</TABLE>
Additional performance information is presented in the Short Fund's Annual
Report, which is available without charge upon request.
6
INTERMEDIATE DURATION FUND
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,
1997 and are a part of the Intermediate Fund's financial statements which have
been audited by Deloitte & Touche LLP, independent auditors. This data
should be read in conjunction with the Intermediate Fund's most recent
annual audited financial statements and the report of Deloitte & Touche
LLP thereon which appear in the Fund's Statement of Additional Information.
<TABLE>
Selected Financial Data
<CAPTION>
Year Ended Year Ended Year Ended Year Ended Period
March 31, March 31, March 31, March 31, March 31,
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
Net Asset Value,
Beginning of Period $10.01 $9.83 $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment
income 0.599 0.660 0.664 1.05 0.826
Net gain (loss) on securities
(both realized and unrealized) (0.024) 2.77 (0.049) (0.601) 0.621
Total from investment
operations 0.575 0.937 0.615 0.449 1.447
Less Distributions
Dividends from net investment
income (0.604) (0.656) (0.664) (1.044) (0.826)
Dividends in excess of
net investment income ---- ---- (0.108) ---- --
Distributions from net
realized gains on investments (0.251) (0.101) -- (0.015) --
Distributions in excess of
net realized gains on investments -- -- (0.022) -- --
Total distributions (0.855) (0.757) (0.794) (1.059) (0.826)
Net Asset Value, End of Period $9.73 $10.01 $9.83 $10.01 $10.62
Total Return 5.92% 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of period $37,735,525 $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to average
net assets
Before expense limitation 1.16% 1.14% 2.33% 2.34% 17.52%
After expense limitation 0.88% 0.90% 0.90% 0.90% 0.82%
Ratio of net income to
average net assets
Before expense limitation 5.92% 6.26% 4.77% 6.30% (8.52%)
After expense limitation 6.19% 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate 409% 193% 557% 84% 42%
</TABLE>
Additional performance information is presented in the Intermediate Fund's
Annual Report, which is available without charge upon request.
7
SMITH BREEDEN MUTUAL FUNDS
The Short and Intermediate Funds are funds of the Smith
Breeden Series Fund (the "Series Fund"), an open-end diversified
management investment company. The Equity Plus Fund is currently
the only fund of the Smith Breeden Trust (the "Trust"), an open-
end diversified management investment company.
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 assets totaling over $20 billion.
INVESTMENT OBJECTIVES, POLICIES, AND RISK CONSIDERATIONS
Each of the Funds has a different investment objective
and different investment policies, and is designed to meet
different investment needs.
The investment objectives and certain investment policies of
the Short and Intermediate Funds 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.
Since shares of each Fund represent an investment in
securities with fluctuating market prices, the net asset value
per share of each Fund will vary as the aggregate value of a
Fund's portfolio securities increases or decreases. Due to 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 Fund
The Short Fund's 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
Fund will be able to maintain a low volatility of net asset
value.
8
The Short Fund will seek its investment objective by
investing, under normal circumstances, at least 70% of its total
assets in U.S. Government Securities. The Fund will also invest
in fixedrate and adjustable-rate mortgage-backed securities
issued by nongovernmental issuers. The Fund may hold a portion of
its assets in money market instruments and in time and
savings deposits (including fixed-rate or adjustable certificates
of deposit) in commercial banks or institutions whose accounts
are insured by the FDIC, BIF or SAIF.
Under normal circumstances the Short Fund 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. However, the Short Fund 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 longer.
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 Fund 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 Fund 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 Fund
The Intermediate Fund's 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 Intermediate Fund will seek its investment
objective by investing, under normal circumstances, at least 70%
of its total assets in U.S. Government Securities. The Fund
will also invest in fixedrate and adjustable rate mortgage-
backed securities issued by nongovernmental issuers. The Fund may
hold a portion of its assets in money market instruments and
in time and savings deposits (including fixed-rate or
adjustable-rate certificates of deposit) in commercial banks or
institutions whose accounts are insured by the FDIC, BIF, or
SAIF.
The major market indices for mortgage-backed securities
currently 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 Fund
will seek to achieve an interest-rate risk or option-adjusted
duration (see below) 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
9
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.
There is no assurance that the Intermediate Fund 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.
U.S. Government Securities. The U.S. Government
Securities in which the Funds may invest 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, the
Government National Mortgage Association ("GNMA"), Federal
National Mortgage Association ("FNMA") and Federal Home Loan
Mortgage Corporation ("FHLMC"). (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 all
of their assets in FNMA, FHLMC, and GNMA mortgage-backed
certificates and other U.S. Government Securities representing
ownership interests in mortgage pools.
Privately-issued Mortgage Backed Securities. The Short
and Intermediate Funds 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
Short and Intermediate Funds 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 Funds will only purchase
mortgage-backed securities which constitute "Mortgage
Related Securities" for purposes of the Secondary Mortgage
Market Enhancement Act of 1984.
Option-adjusted Duration. Option-adjusted duration is a
measure of the price sensitivity of a portfolio to changes in
interest rates. The maturity of a security, another commonly
used measure of price sensitivity, 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 a Fund's
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
10
more detail in Appendix A) to lengthen or shorten the option-
adjusted duration of a Fund.
Fundamental Policies. As a matter of fundamental policy,
the Short and Intermediate Funds 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.
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 Fund does not invest principally in the common stocks
that make up the S&P 500 Index or any other index. The Fund
utilizes index futures contracts and equity swap contracts to
track the return of the S&P 500 Index, and invests
substantially all of its assets in fixed-income securities and
related hedging and other instruments. Whether the Fund's
total return equals or exceeds the performance of the S&P 500
Index depends on whether the total return on the Fund's
fixed-income investments equals or exceeds the Fund's total
operating expenses, as well as other factors.
The S&P 500 Index is an unmanaged index 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 its objective by dividing its
portfolio into two segments: an "Equity Simulation Segment"
and a "Fixed Income Segment." Through the Equity Simulation
Segment, the Fund invests in a combination of equity
swap contracts, 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, and
common stocks whose return (before deducting allocated costs)
11
is expected to track movements in the S&P 500 Index. By
employing this strategy, the Equity Plus Fund seeks to
achieve the same investment 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. 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.
Through the Fixed Income Segment, the Fund invests in fixed
income securities and uses related hedging techniques such
as futures, options, floors, caps and swaps. The Fixed-Income
Segment will invest substantially all of its assets in
U.S. Government Securities (as defined above), and may
also invest in bank certificates of deposit, corporate debt
obligations, and mortgagebacked and other asset-backed
securities of non-governmental issuers.
The Fund may also engage in loans of portfolio
securities, dollar rolls, and reverse repurchase agreements
to enhance income and total return. With these investments,
the Fund seeks to generate income (consisting primarily of
interest income) and gains which exceed the total costs of
operating the Fund (including the costs associated with
the Equity Simulation Segment). Thus, whether the Fund's
total return equals or exceeds the performance of the S&P 500
Index depends on whether the total return on the Fund's
Fixed-Income Segment equals or exceeds the Fund's total
operating expenses, as well as other factors described below.
The Equity Simulation Segment's actual opportunities for gain
or loss may be greater than a hypothetical portfolio invested
in the stocks comprising the S&P 500 Index depending upon
the Fund's exposure to the S&P 500 Index, which could at times
be higher or lower than the Fund's total assets. For
example, the total net notional amount of the Fund's equity
swap contracts, 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 as a result of
purchases and redemptions of Fund shares. In addition, since
S&P 500 Index futures can only be purchased for specific
amounts, the Fund might not be able to match accurately a
notional amount of futures contracts to the Fund's total net
assets. Under normal market conditions, the Fund expects that
such variations in S&P 500 Index exposure 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 investment opportunity
and risk profile of a hypothetical stock portfolio may be
diminished by imperfect correlations between price movements of
the S&P 500 Index 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. Equity swap contracts require the Fund to pay
interest on the notional amount of the contract. Therefore,
assuming the Fund has successfully tracked the movement of
12
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 (to the extent applicable)
(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) the
Fund's operating expenses as described more fully under
"Management of the Fund."
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 basket of stocks comprising the S&P 500
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 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 the equity swap contract
counterparties will be able to meet their obligations 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 these contracts. The Fund
will closely monitor the credit of equity swap contract
counterparties in order to minimize this risk. The Fund will
not use equity swap contracts for leverage.
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. These positions are
sometimes referred to as "reverse equity swap contracts".
The Equity Plus Fund will not enter into any 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
13
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
such 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.
S&P 500 Index and Other Stock Index Futures. 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 to and from the broker, called "variation margin",
will be made on a daily basis as the value of the futures
contract fluctuates. Purchased futures contracts 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 futures
contracts could be adversely affected by daily price
fluctuation limits established by an exchange which limit
the amount of fluctuation in the price of a 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. The Fund will not use futures
contracts for leverage.
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 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 appropriate
14
securities 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 amounts on
deposit will constitute a portion of the Fund's Fixed
Income Segment.
Common Stocks. When index futures contracts and/or equity
swap contracts are, in the judgment of the Adviser, overpriced
relative to the common stocks underlying the S&P 500 Index,
the Fund may invest directly in the common stocks represented
by the S&P 500 Index. The Fund will 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.
Fixed Income Instruments. 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 of investment grade (rated at least Baa by S&P or
BBB by 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 or S&P. Securities rated Baa and BBB or
below 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.
Example. Set forth below is an example of how the Equity Plus
Fund might invest a $100 million portfolio:
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
contract 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.
Because equity swap contracts and futures contracts may
generally be initially entered into without making cash
payments, the Fixed Income Segment would invest $95 million
in various fixed income securities 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:
15
1. The counterparty to the equity swap contract would 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 Equity Simulation Segment's return, before
related 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 Equity Simulation Segment's return would
total 7.42%. Therefore, the Fund would achieve a total return
equal to the S&P 500 Index only if the Fixed Income Segment
has a total return equal to 6.93% per annum. If the Fixed
Income Segment achieves this result, then the Fund's total net
assets would 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 6.93% per
annum, the Fund's total return would, in turn, be greater or
less than the S&P 500 Index.
Characteristics and Risks of the Securities in which the Short
and Intermediate Funds 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
16
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 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 mortgagebacked 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
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 Funds
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 rate on adjustable-rate securities may lag
changes in prevailing market interest rates. Also, some
adjustablerate 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
17
generally with mortgage-backed securities.
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") 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 Fund 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 Funds may invest only
in stripped mortgage-backed securities ("SMBS") which are
18
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
Funds 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 Funds 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 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 Funds 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 Funds
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
19
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.
Credit Risks. 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 assetbacked securities, the ability of the
mortgagor or other borrower to meet its obligations. The Short
and Intermediate Funds 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.
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 to either lengthen or
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 interestrate fluctuations, 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
interestrate 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.
There can be no assurance that the hedging techniques employed
by the Funds will be successful. As a result, the Funds
may not achieve, and may at times exceed, their targeted
optionadjusted 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
20
options, and the correlation of changes in the market prices
of the securities and the hedge instruments owned by the Funds.
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.
OTHER INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Funds may also engage in the following investment practices
for hedging purposes or to increase investment returns, 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 in 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
21
in amounts up to 33 1/3% of their assets. The Short and
Intermediate Funds may only enter into these transactions
with commercial banks and registered broker-dealers which are
also Qualified Institutions. 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 in order to shorten the
overall duration of the portfolio and 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.
22
A Fund will not make a short sale if, after giving affect 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 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
23
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 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 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 serves as Chairman
Harrington Financial Group, the holding company for Harrington Bank, F.S.B., of
Richmond, Indiana.
Michael J. Giarla* Trustee and President
Mr. Giarla is Chief Operating Officer, President and Director
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 19911993. Mr.
Giarla holds a Master of Business Administration with
Concentration in Finance from the Stanford University Graduate
24
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 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 a former Independent Board Member of
the Securities and Futures Authority of Great Britain.
Myron S. Scholes Trustee
Myron S. Scholes is a Principal in the money management
firm Long-Term Capital Management Co. (since 1993). He is the
Frank E. Buck Professor of Finance Emeritus at the Graduate School
of Business at Stanford University (since 1983. He is a member
of the Econometric Society. Professor Scholes was also a
Managing Director and co-head of the fixed income
derivatives group at Salomon Brothers between 1991-1993.
Prior to coming to Stanford University in 1983, 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
cooriginator 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 (with Fischer Black, May 1973). 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.
25
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
widelyused binomial method for the valuation of options and
other contingent claims. He also developed the computer
algorithm used in many asset allocation procedures, a
procedure for estimating the style of an investment manager
from its historic returns, and the Sharpe ratio for
measuring investment performance. 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 also served as
consultant to a number of corporations and investment
organizations. He is Trustee of the Barr Rosenberg mutual
funds, a Director of Stanford Management Company and the
Chairman of the Board of Financial Engines, a company
providing electronic portfolio advice. He received the Nobel
Prize in Economic Sciences in 1990.
Daniel C. Dektar Vice President, Smith Breeden Series Fund
Portfolio Manager, Short and Intermediate Funds
Daniel C. Dektar is a 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 Funds since their commencement of
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 analysis and timely execution of
portfolio management opportunities. Mr. Dektar consults with
institutional clients in the areas of investments and risk
management. He 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.
26
John B. Sprow Vice President, Smith Breeden Trust
Portfolio Manager, Equity Plus Fund
John B.Sprow is a Principal, Director and Executive Vice
President of 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 also manages S&P 500
indexed accounts. Prior to directly managing discretionary
accounts, Mr. Sprow 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
Marianthe S. Mewkill is a Principal, Vice President and
Chief Financial Officer of Smith Breeden Associates. Ms.
Mewkill handles financial reporting, budgeting, tax research
and planning for the Smith Breeden Mutual Funds and for Smith
Breeden Associates, Inc.. She ensures compliance with agency
regulations and administers the Adviser'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 66% of the Adviser's voting stock is owned
by Douglas T. Breeden, its
Chairman. Under its 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
27
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 the
renewal date of its contracts with the Funds, August 1,
1998, 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 Fund, and 0.78% of the average net assets
of the Short Fund.
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
FPS 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 may also 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.
These charges may apply if you purchase or sell shares
through certain broker-dealers. The Funds currently charge a
$9 fee for each redemption made by wire. See "How to Redeem
Shares."
28
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 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, Martin Luther
King Day, President's Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, the day
following Thanksgiving, Christmas Eve and Christmas Day. In
adddition, the Short and Intermediate Funds will not be be
priced on 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 by 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 $750 $50
Automatic Investment Plan $50 $50
Individual Retirement Account $250 $50
Gift to Minors $250 $50
29
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 also be waived.
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 with the prospectus for an IRA.)
Your completed Purchase Application should be mailed directly to:
Smith Breeden Mutual Funds
3200 Horizon Drive
P.O. Box 61503
King of Prussia, PA 19406-0903
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 FPS Services,
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, 3200 Horizon
Drive, P.O. Box 61503, King of Prussia, PA 19406-0903. 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 is made automatically
available to shareholders when opening an account, unless
they indicate otherwise by checking 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
30
loss due to unauthorized transactions. The Funds reserve the
right to refuse a telephone transaction if they believe it
is advisable to do so.
If you have any questions, please call the Funds at 1-800-221
3138.
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. You have two options under the Plan
to make investments. One is by automatic payroll deduction.
Under this method, you authorize your employer to direct a portion of
each paycheck to be invested in the Fund of your choice. Your
employer must be using direct deposit to process its payroll
in order for you to elect this method. Under the other method,
your bank debits a preauthorized amount from your checking or
savings account each month and applies the amount to your
investment in Fund shares. In
order to have your bank account debited automatically
for investment into the Funds, your financial institution must be
a member of the Automated Clearing House. No service fee is
currently charged by the Funds for participation in either
method under the Plan. A $20 fee will be imposed by the Funds
if sufficient funds are not available in your bank account, or
if your bank account has been closed at the time of the
automatic transaction. You may adopt either method under the
Plan at the time an account is opened by completing the
appropriate section of the Purchase Application. Enclosed with
the application are the necessary forms to deliver to your
employer to set up the payroll deduction. 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-
31
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 minimums.
Exchanges may be made either in writing or by telephone.
Written instructions should be mailed to 3200 Horizon
Drive, King of Prussia, PA 19406 and must be signed by all
account owners, and accompanied by any properly endorsed
outstanding share certificates, if applicable. The telephone exchange
is automatically accepted unless checked otherwise. 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 telephone
exchange privilege may be modified or discontinued by the
Funds at any time upon a 60 day 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.
32
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 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
33
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. The redemption of shares by
telephone is available automatically unless you elected to
refuse this redemption privilege on your Purchase Application.
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, which will be
deducted from your account.
The Funds reserve the right to refuse a telephone redemption
or exchange transaction if they believe 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
34
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
frausfulent transactions. In all other cases, you are liable for any loss
for unauthorized transactions.
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, 3200 Horizon Drive, P.O. Box 61503, King of Prussia, PA
19406-0903.
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 $500 as a result of a
redemption or exchange, or if you discontinue the Automatic
Investment Plan before your account balance reaches $500, you
may be given a 60-day notice to bring your balance to $500 or
reactivate 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 Fund 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 written for at least $100. 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
35
shares. No facilities characteristic of bank accounts, such
as deposit insurance, are 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 to 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 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 a 30 day written
notice, and it will terminate automatically if all shares
are liquidated or withdrawn from the account or upon the
Fund's receipt 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 Funds 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 Fund's shares are quoted
exdividend 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-
36
date. Dividends are paid in cash by the Short Fund generally
one week after the ex-date.
The Intermediate Fund will declare daily dividends for
shareholders of record. The Intermediate Fund's 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. Since 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
capial 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 reveive 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 the Fund from which they were paid.
Shareholders may also elect to have dividends automatically reinvested
in a fund different than the one from which the dividends were paid.
A shareholder may write the transfer agent, or complete the appropriate
section of the Purchase Application, to designate such an election, but must
have already established an account in the other fund. Reinvested dividends
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.
37
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 Funds who are financial institutions may
request receipt of monthly or quarterly reports which provide
information about the Short or Intermediate Fund's
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 Mutual Funds, 3200 Horizon Drive,
P.O. Box 61503, King of Prussia, PA 19406-0903 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 $250. There is a $12
annual maintenance fee charged to process an account. This fee
is waived for accounts greater than $10,000. You may obtain
additional information regarding establishing such an account
by calling the Funds at 1-800-221-3138.
The Funds may be used as investment vehicles for
established defined contribution plans, including simplified
employee, 401(k), profit-sharing, money purchase, and
simple 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
38
which they are made shall be determined by the Adviser.
Any distribution and service 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 Fund's 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.
The foregoing is only a summary of some of the important
federal tax considerations generally affecting each Fund and its
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.
39
CAPITAL STRUCTURE
The Smith Breeden Trust and the Smith Breeden Series Fund 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 funds of either the Series Fund or
Trust. Each such fund's shares may be further divided into
classes. The assets and liabilities of each such fund 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 funds of the Series Fund or Trust
will vote together in electing trustees and in certain other
matters. Shareholders in each fund 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 another fund. 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.
TRANSFER AND DIVIDEND DISBURSING
AGENT, CUSTODIAN AND
INDEPENDENT ACCOUNTANTS
FPS Services, Inc. ("FPS Services" or the "Transfer Agent"),
3200 Horizon Drive, King of Prussia, PA 19406, 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
40
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 Funds for
the fiscal year ending March 31, 1998.
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 Funds may also advertise current
yield and distribution rate information. Current yield
reflects the income per share earned by the Short or
Intermediate Fund's 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 Fund's
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 regional nature, may be used
41
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
Fund's total return may also be compared to 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 Fund's 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.
APPENDIX A
Hedging Instruments and Transactions (Short and Intermediate
Funds 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 that 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 Funds 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.
42
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.
The Short and Intermediate Funds 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
claimspaying 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 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.
43
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 under "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 Funds 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 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
44
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.
45
Part B: Information Required in
Statement of Additional Information
N-1A
Item No. Item Location in the Registration
Statement
10. Cover Page Cover Page
11. Table of Contents "Table of Contents"
12. General Information
and History See Part A Item 4.
13. Investment Objective "Miscellaneous
and Policies Investment Practices and
Risk Considerations"
14. Management of the
Registrant "Management of the Fund
15. Control Persons and
Principal Holders of "Principal Holders of Securities
Securities and Controlling Persons"
16. Investment Advisory "The Investment Advisory
and Other Services Agreement and Other Services"
17. Brokerage Allocation "The Investment Advisory
Agreement and Other
Services"
18. Capital Stock and "Additional Information
Other Securities Regarding Purchases and
Redemptions of Fund Shares"
19. Purchase, Redemption "Additional Information
and Pricing of Regarding Purchases and
Securities Being Redemptions of Fund
Offered Shares"
20. Tax Status "Taxes"
21. Underwriters Additional Information
Regarding Purchases and
Redemptions of Fund
Shares"
22. Calculation of
Performance Data "Standard Performance
Measures"
23. Financial Statements "Report of Independent
Auditors and Financial
Statements"
SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S.
GOVERNMENT FUND SMITH BREEDEN INTERMEDIATE
DURATION U.S. GOVERNMENT FUND
STATEMENT OF ADDITIONAL
INFORMATION JULY 23,
1997
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
"Series 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 Fund (the "Short Fund") and the Smith Breeden
Intermediate Duration U.S. Government Fund (the "Intermediate
Fund"). This Statement of Additional Information 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 July 23, 1997, as may be amended from time to time.
This Statement should be read with the Prospectus.
1
Contents
Page
MISCELLANEOUS INVESTMENT PRACTICES AND RISK
CONSIDERATIONS . . . . . . . . . . . . . . . . . . 3
INVESTMENT RESTRICTIONS. . . . . . . . . . . . . . . . . 9
TRUSTEES AND OFFICERS. . . . . . . . . . . . . . . . . .12
INVESTMENT ADVISORY AND OTHER SERVICES . . . . . . . . .13
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING
PERSONS . . . . . . . . . . . . . . . . . . . .. .15
POLICIES REGARDING BROKERS USED IN PORTFOLIO
TRANSACTIONS . . . . . . . . . . . . . . . . . . .16
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES. . . . . . . . . . . 18
ADDITIONAL INFORMATION REGARDING TAXATION. . . . . . . .20
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . . . .24
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS . . .28
EXPERTS. . . . . . . . . . . . . . . . . . . . . . . . .29
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . .29
APPENDIX . . . . . . . . . . . . . . . . . . . . . . . .29
2
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 Funds (the "Funds"). Terms used herein have the
same meanings as in the Prospectus.
The Funds' Prospectus states that the Funds may engage in
each of the following investment practices. However, the
fact that the Funds may engage in a particular practice does
not necessarily mean that they will actually do so.
Repurchase Agreements. A Fund may invest in repurchase
agreements. A repurchase agreement is a contract under which
a Fund 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 Fund to resell such security
at a fixed time and price (representing the Fund's cost plus
interest). It is the Funds' 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 the Funds 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, a Fund could
realize a loss on the sale of the underlying security to the
extent that the proceeds of the 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, a
Fund may incur delay and costs in selling the underlying
security or may suffer a loss of principal and interest if
the Fund is treated as an unsecured creditor and required to
return the underlying collateral to the seller's estate.
Forward Commitments. A Fund may enter into contracts to
purchase securities for a fixed price at a future date beyond
customary settlement time ("forward commitments," "when
issued" and "delayed delivery" securities) if a Fund holds
until the settlement date, in a segregated account, cash or
highgrade debt obligations in an amount sufficient to meet
the purchase price, or if a Fund 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 Fund
relies on the dealer to consummate the sale. The dealer's
failure to do so may result in the loss to the Fund of an
3
advantageous return or price. Although a Fund will generally
enter into a forward commitment with the intention of
acquiring securities for its portfolio or for delivery
pursuant to options contracts it has entered into, the Fund
may dispose of a commitment prior to settlement if the
Adviser deems it appropriate to do so. A Fund may realize
short-term profits or losses upon the sale of forward
commitments.
Securities Loans. A Fund may make secured loans of its
securities amounting to not more than 33 1/3% of its 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 the Fund an amount equal to any
dividends or interest received on securities lent.
The Fund 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,
the Fund 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 Fund if the holders of such
securities are asked to vote upon or consent to matters
materially affecting the investment. The Fund may also call
such loans in order to sell the securities involved.
Borrowing. A Fund 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 Fund's total assets (computed at the time the loan is
made) in order to take advantage of investment opportunities,
for extraordinary or emergency purposes, or for the clearance
of transactions. A Fund may pledge up to 33 1/3% of its total
assets to secure these borrowings. If a Fund's asset
coverage for borrowings falls below 300%, the Fund will take
prompt action to reduce its borrowings even though it may be
disadvantageous at that time from an investment point of
view. A Fund will incur borrowing costs when it leverages,
including payment of interest and any fee necessary to
maintain a line of credit, and may be required to maintain a
minimum average balance. If the income and appreciation on
assets acquired with borrowed funds exceed their borrowing
cost, the Fund's 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 Fund
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
4
the additional securities purchased fails to cover their cost
(including any interest paid on the money borrowed) to the
Fund, the net asset value of the Fund's shares will decrease
faster than would otherwise be the case. This speculative
characteristic is known as "leverage."
Reverse Repurchase Agreements and Dollar Roll Agreements.
A Fund may enter into reverse repurchase agreements and
dollar roll agreements with commercial banks and registered
brokerdealers to seek to enhance returns.
Reverse repurchase agreements involve sales by a Fund of
portfolio assets concurrently with an agreement by the Fund
to repurchase the same assets at a later date at a fixed
price. During the reverse repurchase agreement period, a Fund
continues to receive principal and interest payments on these
securities and also has the opportunity to earn a return on
the collateral furnished by the counterparty to secure its
obligation to redeliver the securities. Dollar rolls are
transactions in which a Fund 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 Fund
forgoes principal and interest paid on the securities. The
Fund 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. The Fund
will establish a segregated account with its custodian in
which it will maintain cash, U.S. Government securities or
other liquid high grade debt obligations equal in value to
its obligations in respect of reverse repurchase agreements
and dollar rolls. Reverse repurchase agreements and dollar
rolls involve the risk that the market value of the
securities retained by the Fund may decline below the price
of the securities the Fund has sold but is obligated to
repurchase under the agreement. In the event the buyer of
securities under a reverse repurchase agreement or dollar
roll files for bankruptcy or becomes insolvent, the Fund's
use of the proceeds of the agreement may be restricted
pending a determination by the other party, or its trustee or
receiver, whether or not to enforce the Fund's obligation to
repurchase the securities. Reverse repurchase agreements and
dollar rolls are considered borrowings by a Fund.
General Characteristics and Risks of Options and Futures
Options. A put option gives the purchaser of the option the
right to sell and the writer the obligation, if the purchaser
exercises his right, to buy the underlying security at the
exercise price during the option period. A call option gives
the purchaser of the option the right to buy and the writer
the obligation, if the purchaser exercises his right, to sell
the underlying security at the exercise price during the
option period. Listed options are issued by the Options
Clearing Corporation ("OCC") which guarantees the performance
of the obligations of the parties to such options.
5
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 a 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 Fund's 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 Fund. With OTC Options,
such variables as expiration date, exercise price and premium
will be agreed upon between the Fund 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, the Fund 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. 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. The
Adviser monitors the creditworthiness of dealers with whom a
6
Fund 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 Fund 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 Fund, 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 Fund 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
rather, a good faith deposit on the futures contract which
will be returned to the Short or Intermediate Fund upon the
7
proper termination of the futures contract. The margin
deposits made are marked to market daily and the Funds 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 highgrade
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, the
Funds would continue to be required to make daily cash
payments of variation margin on open futures positions. In
such situations, if the Funds have insufficient cash, it may
be disadvantageous to do so. In addition, the Funds 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 Fund's ability to effectively hedge its
portfolio.
In the event of the bankruptcy of a broker through which
the Short or Intermediate Fund engages in transactions in
futures or options, either Fund 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 the Funds 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 a Fund's position.
In addition, futures and futures option markets may not be
liquid in all circumstances. As a result, in volatile
markets, a Fund 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 Fund 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 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,
8
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 those open
positions, adjusted for the expected volatility relationship
between the Fund and the futures contracts based on duration
calculations. If this limitation should be exceeded at any
time, the Short or Intermediate 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. Finally, the daily deposit requirements in
futures contracts create a greater ongoing 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 Fund 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 Funds, which means
that they may not be changed without the approval of a
majority of the outstanding shares of each of the Funds, as
the case may be (as defined in the Investment Company Act).
A Fund may not (except that none of the following investment
restrictions shall prevent a Fund 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 Fund may
borrow from banks or through reverse repurchase
agreements or dollar rolls up to 33 1/3% of the value of
its respective total assets (calculated when the loan is
made) for temporary, extraordinary or emergency purposes
and to take advantage of investment opportunities, and
may pledge up to 33 1/3% of the value of its total
assets to secure such borrowings. For purposes of this
restriction, the purchase or sale of securities on a
"when issued" or "delayed delivery" basis, the purchase
and sale of futures contracts, the entry into reverse
repurchase agreements and dollar roll transactions,
short sales, interest rate swaps, mortgage swaps, over-
the-counter options, and collateral arrangements with
respect thereto are not deemed to be a pledge of assets
and none of such transactions or arrangements nor
obligations of the Funds to Trustees pursuant to
9
deferred compensation arrangements are deemed to be the
issuance of a senior security.
2. Act as underwriter except to the extent that, in
connection with the disposition of portfolio securities,
it may be deemed to be an underwriter under certain
federal securities laws.
3. Purchase any security (other than obligations of the
U.S. Government, its agencies and instrumentalities) if
as a result: (i) with respect to 75% of its total assets
more than 5% of the Short or Intermediate Fund's 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 Fund's 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 Fund 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 Fund 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 Fund
will not lend portfolio securities if, as a result, the
aggregate of such loans exceeds 33 1/3% of the value of
10
a Fund's respective total assets (including such loans).
12. Purchase securities on margin (though the Short or
Intermediate Fund may obtain such short-term credits as
may be necessary for the clearance of transactions);
provided that the deposit or payment by a Fund of
initial or variation margin in connection with options
or futures contracts is not considered the purchase of a
security on margin.
13. Make short sales of securities or maintain a short
position if, when added together, more than 25% of the
value of the Short or Intermediate Fund's 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
Funds 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 Fund, 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 Fund.
In addition, as non-fundamental policies, a Fund 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 Fund may be retained in cash, including cash
equivalents which are Treasury bills, 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 Fund be retained in cash as is deemed
11
desirable or expedient under then-existing market conditions.
As noted in the Prospectus, a Fund may invest up to 15% of
its respective total net assets in illiquid securities.
In order to comply with certain "blue sky" restrictions, a
Fund will not, as a matter of operating policy, invest in
securities of any issuer if, to the knowledge of the Fund,
any officer or Trustee of the Fund or the Adviser owns more
than 1/2 of 1% of the 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 Funds may make commitments more restrictive than the
restrictions listed above so as to permit the sale of shares
of a Fund in certain states. Should a Fund determine that a
commitment is no longer required or in the best interest of
the Fund and its shareholders, the Short or Intermediate Fund
will revoke the commitment by terminating the sale of shares
of the Fund in the state involved.
TRUSTEES AND OFFICERS
The Board of Trustees has the responsibility for the
overall management of the Series Fund and each of the Funds,
including general supervision and review of the Funds'
investment activities. The Trustees, in turn, elect the
officers who are responsible for administering the day-to-day
operations of the Funds. Trustees and officers of the Series
Fund are identified in the Prospectus.
The table below shows the fees paid to each Trustee by
each Fund for the fiscal year ending March 31, 1997. The
Trustees do not receive pension or retirement benefits. The
Trustees did receive compensation from the other Fund in the
Smith Breeden Mutual Funds in addition to the compensation
listed below.
Director Aggregate Compensation Aggregate
from Short Fund Compensation from
Intermediate Fund
Stephen M. Schaefer $31,250 $4,127
Myron S. Scholes $33,750 $5,000
William F. Sharpe $32,350 $5,000
The Series 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 Series
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 Series Fund or the Funds.
12
INVESTMENT ADVISORY AND OTHER SERVICES
The investment manager of each of the Funds 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 of
the Funds (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
Funds' investment activities. The Adviser, at its own
expense, furnishes the Funds with office space and office
furnishings, facilities and equipment required for managing
the business affairs of the Funds; 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 Funds; and
provides certain telephone and other mechanical services.
Except for the expense limitation in place through August 1,
1998, each of the Funds 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, 1998.
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
Funds' Board of Trustees or by a vote of the holders of a
majority of each of the Funds' 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
each Fund, 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 Fund 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 of the
Funds by the Adviser under the terms of the Advisory
Agreement, and the assumption by the Adviser of the related
expenses, each Fund pays the Adviser a fee, computed daily
and payable monthly, at an annual rate equal to 0.70% of the
respective Fund's average daily net asset value. For the
13
last three fiscal years ended March 31, the Adviser received
no fees from the Short Fund for the year ended March 31,
1995, and received $1,717,748, and $1,417,921 for the fiscal
years ended March 31, 1996 and March 31, 1997, respectively.
The Short Fund, prior to April 1, 1995, indirectly bore
investment advisory fees through its investment in the Smith
Breeden Institutional Short Duration U.S. Government Fund.
On March 31, 1995, this two-tier structure was consolidated,
which resulted in the Short Fund becoming a stand-alone fund.
The Adviser received received $132,174 from the Intermediate
Fund for the fiscal year ended March 31, 1995, $256,075 for
the fiscal year ended March 31, 1996, and $259,767 for the
fiscal year ended March 31, 1997.
Prior to August 1, 1994, the Intermediate Fund 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 structure
was eliminated, which resulted in the Intermediate Fund
becoming a stand-alone fund. During the three year period
ended March 31, the Adviser reimbursed the Short Fund
$146,256, $364,865, and $301,998 for the periods ended 1995,
1996, and 1997, respectively, under expense limitation
provisions. The Intermediate Fund was reimbursed $123,390,
$85,364, and $101,379 for the same periods under expense
limitation provisions.
Under the terms of its Advisory agreement with each of the
Funds, the Adviser also provides certain administrative
services. FPS Services, Inc. is the shareholder servicing,
accounting, transfer and dividend paying agent. Each of the
Funds 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 FPS 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 each of
the Funds. A custodian's responsibilities include generally
safeguarding and controlling a Fund's cash and securities,
handling the receipt and delivery of securities, and
collecting interest and dividends on a Fund's 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 Funds' 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 Series
Fund and each of the Funds.
14
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those
shareholders who, to the Short Fund's best knowledge, as
of June 30, 1997, owned 5% or more of the shares of the Fund.
Dell USA L.P.
2112 Kramer Lane
Austin, TX 78758 20.82%
First Federal Savings Bank
605 State Street
LaCrosse, WI 54601 7.99%
Monterey Bank
35 East Lake Avenue
Watsonville, CA 95076 13.41%
Sun World Savings Bank
PO Box 20222
El Paso, TX 79998 5.46%
The Officers and Trustees of the Short Fund together as a
group owned less than 1.00% of the shares of the Short
Duration Fund as of June 30, 1997.
Listed below are the names and addresses of those
shareholders, who as of June 30, 1997, to the best knowledge
of the Intermediate Fund, owned 5% or more of shares of the
Fund.
Roosevelt Bank
900 Roosevelt Pkwy
Chesterfield, MO 62.80%
Public School Retirement
System
1 Mercantile Ctr.
St. Louis, MO 18.17%
The Officers and Trustees of the Intermediate Fund
together as a group owned less than 1.00% of the shares of
the Fund as of June 30, 1997.
Potential Conflicts of Interest
Principals of the Adviser as individuals own approximately
61% of the common stock of Harrington Financial Group, the
holding company for Harrington Bank, FSB (the "Association").
As of June 30, 1997, the Association had total assets of $485
million. The Association invests in assets of the same types
15
as those to be held by the Funds.
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
Funds.
The Adviser may also manage advisory accounts with
investment objectives similar to or the same as those of the
Short or Intermediate Fund, or different from both Funds, but
trading in the same type of securities and instruments.
Portfolio decisions and results of both Funds' 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 Fund.
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS
Under the Advisory Agreement, the selection of brokers and
dealers to execute transactions on behalf of a Fund 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 Funds does not
anticipate that it will incur a significant amount of
brokerage expense because brokerage commissions are not
normally incurred on investments in Mortgage Securities,
which are generally traded on a "net" basis; that is, in
principal amounts without the addition or deduction of
brokerage commissions. The Short and Intermediate Funds paid
$51,367 and $4,203 respectively in brokerage commissions on
futures and options trades in the year ended March 31, 1997.
In the year ended March 31, 1996, the Short and Intermediate
Funds paid $46,156 and $3,483, respectively, in brokerage
commissions on futures and options. In the year end March
31, 1995, the Short and Intermediate Funds paid $0 and
$3,483, respectively in brokerage commissions. Neither Fund
paid any brokerage commissions for the year ended March 31,
1994. Prior to March 31, 1995, the Short Fund 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 Fund 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").
16
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 Fund 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 Funds will be holding, unless
better executions are available elsewhere. Dealers and
underwriters usually act as principals 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 Funds or with the
Adviser may purchase securities from, or sell securities to,
the Funds. 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 Fund, specifically including
the quotations necessary to determine each of the Fund's 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
Funds in such amount of total brokerage as may reasonably be
required.
The Adviser conducts extensive proprietary fixed income
research with emphasis on mortgage-backed securities. The
Adviser is not dependent on any broker for such research and
analysis and, thus is able to transact business with brokers
regardless of the brokers' research capabilities or provision
of such research to brokerage customers. The Adviser uses
multiple electronic quotation services for trading and
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.
17
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 of the Funds
must be denominated in U.S. Dollars. Each 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 a 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 Funds 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 Fund's 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 of the Funds in case of an emergency, or if the
payment of such redemption in cash would be detrimental to
the existing shareholders of either of the Funds. In such
circumstances, the securities distributed would be valued at
the price used to compute the Short or Intermediate Fund's
net assets. Should the Short or Intermediate Fund do so, a
shareholder may incur brokerage fees or other transaction
costs in converting the securities to cash.
Principal Underwriter
FPS Broker Services, Inc. (the "Principal Underwriter"),
3200 Horizon Drive, P.O. Box 61503, King of Prussia, PA 19406
0903, is the principal underwriter for the Funds, 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 Dealers, Inc.. The offering of the Funds' shares
is continuous. The underwriting agreement with the Principal
Underwriter provides that each 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
18
of the Distribution Plan in the Prospectus). The Principal
Underwriter acts as the agent of both the Funds 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 Fund's shares at the offering price. The Principal
Underwriter may enter into agreements with other broker-
dealers for the sale of Short or Intermediate Fund shares by
them.
The Principal Underwriter is paid approximately $17,000 in
total by the Adviser for its services to the two Funds. In
addition, for the year March 31, 1997, the Principal
Underwriter received no sales charges or commissions.
Calculation of Net Asset Value
As noted in the Prospectus, the Funds 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 Fund
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, Dr. Martin
Luther King Day Jr. 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,
each Fund has the right (but 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.
19
ADDITIONAL INFORMATION REGARDING TAXATION
Taxation of the Funds
For federal income tax purposes, each of the Funds will be
treated as a separate corporation. Each of the Funds
intends to qualify each year and elects to be treated as
regulated investment companies ("RICs") for federal income
tax purposes. To so qualify, the Funds must, among other
things: (i) derive at least 90% of their gross income for
each taxable year from dividends, interest, payments with
respect to loans of securities and gains from the sale or
other disposition of securities or certain other related
income; (ii) generally derive less than 30% of their gross
income for each taxable year from gains from the sale or
other disposition of securities and certain other investments
held for less than three months; and (iii) diversify their
holdings so that at the end of each quarter of the taxable
year (A) at least 50% of the value of each of the Fund's
assets would be represented by cash, U.S. Government
securities, securities of other RICs, and other securities
which, with respect to any one issuer, do not represent more
than 5% of the value of each of the Fund's assets nor more
than 10% of the voting securities of such issuer and (B) not
more than 25% of the value of each of the Fund's 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 of the Funds 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 Fund 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 Fund were to
experience a large quantity of share redemptions during a
taxable year, either Fund may have difficulty satisfying the
Short-Short Rule during that year. If the Short or
Intermediate Fund fails to satisfy the Short-Short Rule in a
taxable year, it would lose its RIC status for that year.
Each of the Funds, however, will endeavor to select
investments for sale during a taxable year in such a way that
it will satisfy the Short-Short Rule.
If the Funds 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 Funds will not be subject to federal income tax on
the income so distributed. However, the Funds will be subject
to corporate income tax on any undistributed income. In
addition, either of the Funds would be subject to a
nondeductible 4% excise tax on the amount by which the income
20
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 Fund's 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 Fund) of each year; and (iii) 100% of the undistributed
ordinary income and gains from prior years. For purposes of
the excise tax, any income or capital gains retained by, and
taxed in the hands of, either of the Funds will be treated as
having been distributed.
Both Funds intend to distribute sufficient income so as
to avoid corporate income tax and excise tax. The Short Fund
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 Fund will
endeavor to pay dividends in such a manner that an excise tax
will not be incurred. The Short Fund also may elect to
retain all or a portion of its 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 Fund's ordinary income. Such
capital losses may be carried forward for eight years. If any
capital losses have not been utilized at the time a Fund
terminates, such capital losses will become unusable.
Taxation of Shareholders
Distributions. In general, all distributions to
shareholders attributable to the Short or Intermediate Fund's
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 of the Funds 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 Fund may elect to
retain net capital gains and pay corporate income tax
thereon. In such event, the Short or Intermediate Fund would
most likely make an election that would require each
shareholder of record on the last day of the Fund's taxable
year to include in income for tax purposes his proportionate
share of the Fund's 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 Fund
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
21
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 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 Fund 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 a 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 longterm 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 Mutual Funds for shares of another fund, the
shareholder generally will recognize a 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 Fund 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
22
debt balance to the average tax basis of its shares for the
year. A Tax Exempt Investor is generally 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 of the Funds intends to
engage in various hedging transactions. Under various
provisions of the Code, the result of such investments and
transactions may be to change the character of recognized
gains and losses, accelerate the recognition of certain gains
and losses, and defer the recognition of certain losses. For
example, the tax treatment of futures contracts entered into
by a Fund as well as listed nonequity options written or
purchased by a Fund 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 Fund on the last business day of each taxable year
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 Fund holds an option or contract governed by section
1256 which substantially diminishes the Fund's risk of loss
with respect to another position of its 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 a Fund's securities and conversion of
short term capital losses into long-term capital losses.
Either Fund 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 Fund 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 Fund 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 Fund,
could reduce the risk that active hedging techniques will run
afoul of the Short Short Rule.
The character of the Short or Intermediate Fund's taxable
income will, in most cases, be determined on the basis of
reports made to the Funds by the issuers of the securities in
which they invest. The tax treatment of certain securities
in which a Fund 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
Fund. The foregoing discussion is a general summary of
certain of the current federal income tax laws regarding
23
both Funds and investors in the shares. The discussion does
not purport to deal with all of the federal income tax
consequences applicable to the Funds 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, a Fund may from time to time
quote various performance figures to illustrate its past
performance. It may occasionally cite statistics to reflect
its volatility or risk.<R/>
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 a 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 a Fund are
based on the standardized methods of computing performance
mandated by the SEC. An explanation of those and other
methods used by a 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 Fund, if shorter)
that would equate an initial hypothetical $1,000 investment to
its ending redeemable value. The calculation assumes no sales
charge is deducted from the initial $1,000 purchase order,
capital gains and all income dividends are reinvested at net
asset value on the reinvestment dates during the period. The
quotation assumes the account was completely redeemed at the
end of each one, five and ten year period and the deduction
of all applicable charges and fees.
A Fund's average annual compounded rate of return is
determined by reference to a hypothetical $1,000 investment,
according to the following formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of
$1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a
hypothetical $1,000 payment made at the
24
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, a Fund may quote total rates
of return in addition to its average annual total return.
Such quotations are computed in the same manner as a Fund's
average annual compounded rate, except that such quotations
will be based on a 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 a
Fund's portfolio investments. Current yield is determined by
dividing the net investment income per share earned during a
30day base period by the offering price or net asset value
per share, as the case may be, on the last day of the period
and analyzing the result, according to the following formula:
Yield = 2 [(a-b + 1)^6 -1]
cd
where:
a = dividends and interest earned during
the period.
b = expenses accrued for the period
(net of reimbursements).
c = the average daily number of shares
outstanding during the period that
were entitled to receive dividends.
d = the maximum offering price or net
asset value per share, as the case
may be, on the last day of the
period.
The following table shows the average annual total return for
the periods stated, and yield for the Funds for the 30 day
period ended March 31, 1997.
AVERAGE ANNUAL TOTAL RETURN
ONE YEAR FIVE YEARS INCEPTION 30DAY YIELD
SHORT FUND 6.57% 5.48% 5.48% 6.25%
INTERMEDIATE
FUND 5.92% 8.08% 8.08% 5.82%
The investment results of the Funds, 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 Fund's yield or
total return may be for any future period.
25
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 a Fund's 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 Fund 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 shortterm
capital gains and net equalization credits and is calculated
over a different period of time.
Volatility
Occasionally statistics may be used to specify a Fund's
volatility or risk. Measures of volatility or risk are
generally used to compare fund net asset value or performance
relative to a market index. One measure of volatility is
beta. The ratio of the expected excess return on a Fund 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 Fund's 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 Fund
might satisfy their objective, advertisements regarding
either of the Funds may discuss various measures of a Fund's
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 -
measure total return and average current yield for the
26
mutual fund industry and rank 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 - a historical measure of yield,
price, and total return for common and small company
stock, long-term government bonds, treasury bills, and
inflation.
g) Savings and Loan Historical Interest Rates - as
published in the U.S. Savings & Loan League Fact Book.
h) Salomon Brothers Broad Bond Index - 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 - measures only the
mortgage component of the Salomon Brothers Broad Bond
Index.
j) Salomon Brothers Composite High Yield Index or its
component indices - 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 - 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.
27
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 Fund's 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 Fund to calculate its figures. In
addition, there can be no assurance that a Fund will continue
its performance as compared to such other averages.
Shareholders should note that the investment results of
the Short or Intermediate Fund will fluctuate over time, and
any presentation of a Fund's 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 Funds
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 Funds'
Prospectus).
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS
As the investments permitted to the Funds 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 Fund may be eligible for
investment by federally chartered credit unions, federally
chartered thrifts, and national banks. Either of the Funds
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
28
considering an investment in either of the Funds should refer
to the applicable laws and regulations governing its
operations in order to determine if a Fund is a permissible
investment.
EXPERTS
The financial statements of both the Short and
Intermediate Funds and related notes thereto attached to this
Statement of Additional Information have been so attached 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 Funds are attached and
follow the Appendix.
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 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.
29
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 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 desireable investment. Assurance of interest and principal
payments or of maintenance of other terms of the contract over any
long period of time may be small.
Caa - Bonds which are rated Caa are of poor standing. Such issues
may be in default, or there may be present elements of danger
with respect to principal or interest.
Ca - Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default
or have other marked shortcomings.
Description of Standard & Poor's Corporation's corporate bond
ratings:
AAA - Bonds rated AAA are given the highest rating
assigned by Standard & Poor's to a debt obligation,
which 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
30
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.
SMITH BREEDEN MUTUAL FUNDS
ANNUAL REPORTS
Smith Breeden Short Duration U.S. Government Series
Smith Breeden Intermediate Duration U.S. Government Series
March 31, 1997
Effective July 10, 1997, the Short Duration U.S Government Series
changed its name to the Smith Breeden Short Duration U.S. Government Fund.
Effective July 10, 1997, the Intermediate Duration U.S. Government Series
changed its name to the Smith Breeden Intermediate Duration U.S. Government
Fund.
1
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
ANNUAL REPORT AND PERFORMANCE REVIEW
Performance Review
The Smith Breeden Short Duration U.S. Government Series provided a total
return of 6.57% in the year ended March 31, 1997. The Series' return
exceeded its benchmark, the six-month U.S. Treasury Bill, by a significant
margin, 1.16%. Since the Series' inception, its return has exceeded that of
its benchmark by 4.48%, and on an annualized basis by 0.74%. The graph below
plots the Series' return versus both its benchmarks and the average return of
Morningstar, Inc.'s Ultrashort Bond Fund category.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE SHORT 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 TWO BENCHMARKS, THE SIX MONTH US TREASURY BILL AND
MORNINGSTAR INC.'S ULTRASHORT BOND FUND CATEGORY. FROM INCEPTION OF MARCH 31,
1992 THROUGH MARCH 31, 1997, AN INVESTMENT OF $10,000 IN THE SHORT SERIES WOULD
HAVE GROWN TO $13,959, VERSUS $12,623 IN THE AVERAGE OF THE FUNDS IN THE
ULTRASHORT CATEGORY AND VERSUS $12,610 IN THE SIX MONTH US TREASURY BILL.
SHORT SERIES AND MORNINGSTAR RETURNS ARE 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 SHORT SERIES IS 6.57%, ANNUALIZED THREE
RETURN IS 6.03%, ANNUALIZED FIVE YEAR RETURN IS 5.48% AND ANNUALIZED RETURN
FROM INCEPTION IS 5.48%. THE ANNUALIZED RETURNS FOR THE AVERAGE OF THE FUNDS
IN MORNINGSTAR'S ULTRASHORT BOND FUND CATEGORY ARE AS FOLLOWS: ONE YEAR 5.62%,
THREE YEAR 5.17%, FIVE YEAR 4.77%, AND INCEPTION 4.77%. THE ANNUALIZED RETURNS
FOR THE SIX MONTH US TREASURY ARE AS FOLLOWS: ONE YEAR 5.41%, THREE YEAR 5.46%
FIVE YEAR 4.74%, AND INCEPTION 4.74%.
The Series' outstanding performance for the fiscal year owes mostly to
declines in interest rate volatility, both on a realized and an expected basis.
Most of the Series' holdings are mortgage-backed securities (MBS), which
perform better when volatility is low because investors have greater certainty
about the timing of their cashflows. MBS cashflows are inherently uncertain,
because homeowners change their refinancing behavior in response to changes
in interest rates. When rates fall, refinancing activity rises; when rates
rise, refinancing activity falls. Investors in MBS require a substantial yield
premium over US Treasury securities, most of which is to compensate them for
the uncertainty of MBS cashflows (in contrast, Treasury cashflows are fixed).
When interest rate volatility is low, investors require less of a yield premium
and MBS perform well relative to Treasury securities, as they have over the
past year.
2
The excellent return of the Series reflects more than just the good
overall performance of the MBS market, however. We were able to add value
in other ways as well, using three general techniques:
(1) we raised and lowered the overall mortgage weight in response
to short-term changes in the relative attractiveness of the MBS market;
(2) we changed portfolio sector weights frequently as relative value
changed, for example selling fixed-rate MBS to purchase adjustable-rate MBS;
and
(3) we took advantage of opportunities to move within MBS
sectors, for example selling low-coupon fixed-rate MBS to purchase middle-
coupon MBS. Smith Breeden's extensive coverage of the MBS market and
our proprietary valuation models enabled us to make these portfolio
adjustments in a timely and profitable fashion.
Since the Series' holdings are very liquid, we are able to reposition
the portfolio frequently to produce excess return. The transaction costs are
small in relation to the advantage gained through the repositioning. This high-
liquidity, actively-managed style does result in relatively high portfolio
turnover, which totaled 556% for the year. Much of the turnover resulted
from transactions among very similar securities, however. Selling a GNMA
7% passthrough to purchase a GNMA 8% passthrough creates "turnover," but
the change in the portfolio's characteristics is much smaller than, for example,
if a stock fund were to sell Ford stock to purchase Intel.
The Series' strong risk management discipline stood it in good stead during the
fiscal year and will continue to do so in the months to come, which many
expect to be fairly unpredictable, in both the fixed income and stock markets.
As the Series' performance demonstrated not only over the past year but over
its five-year history, our attention to risk management, combined with our
skills in mortgage investing, have enabled the Series to provide steady,
superior returns in rising and falling interest rate environments.
3
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS 31-Mar-97
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 123.30 %
FEDERAL HOME LOAN MORTGAGE CORP. - 34.22% *
FHLMC GOLD:
$23,728,869 7.50%, due 7/01/24 to 6/01/27 ...............$ 23,273,767
944,252 8.00%, due 9/01/24 to 5/01/25........... 952,924
16,057,726 8.50%, due 11/01/24 to 8/01/26 ........... 16,493,947
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $40,870,754 ) 40,720,638
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 0.46% *
FNMA INTEREST ONLY **:
1,649,849 9.00%, due 7/25/21 ............................... 543,088
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $227,375) 543,088
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 88.11% *
GNMA ARM:
19,286,497 5.00%, due 1/20/27 to 2/20/27 .......... .......18,658,334
20,600,000 5.50%, due (a) .......................... .....20,128,625
2,985,894 5.50%, 12/20/26........................... 2,948,412
12,901,392 6.00%, due 2/20/27***...................... 12,850,847
4,500,000 6.00%, due (a) ..................................4,462,031
3,652,376 6.50%, due 3/20/21 to 9/20/26 ............. 3,705,068
3,779,910 7.125%, due 7/20/17 to 4/01/24 .............. 3,869,279
GNMA:
36,563,907 8.00%, due 6/1/26 to 1/1/27................. 36,769,416
1,349,922 9.50%, due 7/15/09 to 4/15/25......... ..... 1,450,502
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $105,238,843) 104,842,514
U.S. GOVERNMENT OBLIGATIONS - 0.51%
U.S. TREASURY BILL ****
610,000 5.39% and 5.02%, due 5/29/97 ................. ... 604,890
TOTAL U.S. GOVERNMENT OBLIGATIONS
(Cost $604,767)........... 604,890
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $146,941,739) . 146,711,130
Notional Amount INTEREST RATE SWAP CONTRACTS - 1.81%
$20,000,000 Contract dated 6/22/93 with Prudential Global Funding,
Expires 6/22/98, pay rate 5.458% .. .............. 212,603
20,000,000 Contract dated 8/31/93 with Salomon Swapco,
Expires 8/30/00, pay rate 5.34% .. ............... 884,505
20,000,000 Contract dated 12/2/93 with Morgan Guaranty Trust Company,
Expires 12/2/00, pay rate 5.69% ................. 677,160
40,000,000 Contract dated 5/15/95 with Salomon Swapco,
Expires 5/15/05, pay rate 6.951% ................ 381,282
TOTAL INTEREST RATE SWAP CONTRACTS .............. 2,155,550
Notional Market
Amount Security Value
THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS - 1.17%
$50,000,000 Contract with Salomon Swapco, expires 4/23/03,
Strike rate 7.50%................................ $1,393,000
TOTAL THREE-MO. LIBOR INTEREST RATE CAP CONTRACTS
(Cost $1,585,644) .. 1,393,000
Contracts OPTION CONTRACTS - 0.27%
130 Call on 10 Year US Treasury Note futures, expires 5/97,
strike price $109 .. 8,125
50 Call on 10 Year US Treasury Note futures, expires 5/97,
strike price $111 781
100 Call on 10 Year US Treasury Note futures, expires 5/97,
strike price $112 1,563
130 Put on 10 Year US Treasury Note futures, expires 5/97,
strike price $105 . 95,469
100 Put on 10 Year US Treasury Note futures, expires 5/97,
strike price $106 . 120,313
50 Put on 10 Year US Treasury Note futures, expires 5/97,
strike price $107 . 92,187
TOTAL OPTION CONTRACTS (Cost $243,144) ............... 318,438
TOTAL INVESTMENTS- 126.55% (Cost $148,770,527) .....150,578,118
Face Amount REPURCHASE AGREEMENTS - 18.49%:
$22,000,000 Morgan Stanley, 5.55% and 5.63%, due 4/01/97 and 4/3/97
dated 3/25/97 and 3/27/97 $22,000,000
TOTAL REPURCHASE AGREEMENTS (Cost $22,000,000)... 22,000,000
REVERSE REPURCHASE AGREEMENTS - (10.08%):
12,000,000 FHLMC, 6.60%, due 4/01/97 dated 3/31/97......... (12,000,000)
TOTAL REVERSE REPURCHASE AGREEMENTS ......... (12,000,000)
SHORT SALES - (17.06%)
21,106,250 GNMA 6.5% due (a)................................ (20,301,875)
TOTAL SHORT SALES (Proceeds $20,350,000)........... (20,301,875)
OTHER LIABILITIES LESS CASH AND OTHER
ASSETS - (17.90%). (21,287,634)
NET ASSETS - 100.00% $118,988,609
* 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, 1997. 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.
*** This security is held as collateral under a reverse repurchase agreement.
**** Security is segregated as collateral.
(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.
5
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
31-Mar-97
ASSETS:
Investments at market value (identified cost $148,770,527)
(Note 1).. $150,578,118
Cash.............................................................. 676,200
Repurchase agreement (cost $22,000,000) (Note 1)............ 22,000,000
Receivables:
Subscriptions............................................ 1,152,765
Interest................................................. 762,909
Securities sold......................................... 80,444,418
TOTAL ASSETS.......................................... 255,614,410
LIABILITIES:
Reverse repurchase agreement (Note 1)....................... 12,000,000
Short sales at market value (Proceeds $20,350,000)......... 20,301,875
Payables:
Variation margin on futures contracts (Note 2)............ 9,191
Redemptions................................. .................. 20,470
Distribution................................. ................. 676,913
Securities purchased.................................... 103,345,618
Swap interest............................... ................ 72,393
Due to adviser (Note 3)..................... .......... 80,755
Accrued expenses....................................... 118,586
TOTAL LIABILITIES....................................... 136,625,801
NET ASSETS:
(Applicable to outstanding shares of 12,106,419
unlimited number of shares of beneficial
interest authorized; no stated par)..................... $118,988,609
Net asset value, offering price and redemption
price per share ($118,988,609/12,106,419).. ................. $9.83
SOURCE OF NET ASSETS:
Paid in capital...............................................$124,434,880
Overdistributed net investment income........................... (676,914)
Accumulated net realized loss on investments................. (5,589,259)
Net unrealized appreciation of investments, interest rate swaps,
short sales and futures contracts............. ............... 819,902
NET ASSETS............................................. $118,988,609
The accompanying notes are an integral part of these financial statements.
6
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1997
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest
expense (Note 1) ................................. $11,805,901
EXPENSES:
Advisory fees (Note 3).............................. 1,417,921
Accounting and pricing services fees....................69,655
Custodian fees..........................................74,731
Audit and tax preparation fees..........................57,500
Legal fees..............................................65,580
Amortization of organization expenses (Note 1).......... 9,548
Transfer agent fees.....................................32,778
Registration fees.......................................18,228
Trustees fees and expenses.............................102,499
Insurance...............................................22,309
Other...................................................11,220
TOTAL EXPENSES BEFORE REIMBURSEMENT..............1,881,969
Expenses reimbursed by Adviser (Note 3)...........(301,998)
NET EXPENSES.....................................1,579,971
NET INVESTMENT INCOME ......................... 10,225,930
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments........................846,686
Change in unrealized appreciation (depreciation)
of investments, interest rate swaps,
caps, and futures contracts............................1,887,652
Net realized and unrealized gain on investments........2,734,338
Net increase in net assets resulting from operations.$12,960,268
The accompanying notes are an integral part of these financial statements.
7
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
31-Mar-97 31-Mar-96
OPERATIONS:
Net investment income.............................$10,225,930 $15,412,781
Net realized gain on investments.................... 846,686 4,639,312
Change in unrealized appreciation
(depreciation) of investments,
interest rate swaps, caps and futures contracts......1,887,652 (8,342,309)
Net increase in net assets resulting from
operations..........................................12,960,268 11,709,784
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income...............(10,225,930) (15,412,781)
Dividends in excess of net investment income..........(929,596) (269,331)
Total distributions......................... ......(11,155,526) (15,682,112)
CAPITAL SHARE TRANSACTIONS:
Shares sold........................................ 59,328,830 93,214,276
Shares issued on reinvestment of distributions.......2,816,807 3,773,450
Shares redeemed...................................(166,786,906) (89,621,927)
(Decrease) increase in net assets
resulting from capital
share transactions (a)..........................(104,641,269) 7,365,799
TOTAL INCREASE (DECREASE) IN NET ASSETS......(102,836,527) 3,393,471
NET ASSETS:
Beginning of year.................................221,825,136 218,431,665
End of year......................................$118,988,609 $221,825,136
(a) Transactions in capital shares were as follows:
Shares sold.....................................6,065,723 9,500,348
Shares issued on reinvestment of distributions....289,222 386,101
Shares redeemed...............................(17,017,982) (9,167,732)
Net (decrease) increase ......................(10,663,037) 718,717
Beginning balance .............................22,769,456 22,050,739
Ending balance.................................12,106,419 22,769,456
The accompanying notes are an integral part of these financial statements.
8
SMITH BREEDEN SHORT DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1997
Year Ended
31-Mar-97
Cash flows from operating activities:
Net increase in net assets resulting from operations.......$12,960,268
Net realized and unrealized gain on investments......... (2,734,338)
Net investment income.....................................10,225,930
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Interest rate cap and interest-only strip amortization...... 225,006
Net paydown gains and losses................................... 34,366
Decrease in interest receivable. ............... 793,222
Increase in other assets............. ...................... (9,643)
Decrease in other liabilities......... ........... (72,793)
Net cash provided by operating activities................ 11,196,088
Cash flows from investing activities:
Payments for futures variations.... ............. (265,747)
Proceeds from sales of long-term investments.. .......... 462,741,835
Proceeds from sales of short-term investments.. ......... 508,493
Proceeds from sales of options..................... 833,807
Proceeds from maturities of short-term investments..... 2,076,065,225
Proceeds from paydowns of long-term investments......... 12,247,008
Purchases of long-term investments........................(352,732,116)
Purchases of short-term investments.....................(2,099,153,718)
Purchases of options...................................... (2,768,588)
Net cash provided by investing activities................(97,476,199)
Cash flows from financing activities:
Increase in collateralized borrowings......................11,000,000
Proceeds from shares tendered........... ........... 55,359,258
Payments for shares redeemed........................... (166,766,436)
Dividends from net investment income..... ......... (7,661,806)
Net cash used in financing activities............... (108,068,984)
Net increase in cash................... ....... (603,303)
Cash at beginning of year..... .......................... 72,897
Cash at end of year.................. ................. $676,200
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends....................... $2,816,807
Supplemental disclosure:
Interest paid.................................................$61,491
The accompanying notes are an integral part of these financial statements.
9
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
<TABLE>
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
<CAPTION>
Year Year Year Year Year
Ended Ended Ended Ended 3/31/92 <F1>
3/31/97 3/31/96 3/31/95 3/31/94 to 3/31/93
<S> <C> <C> <C> <C> <C>
Net Asset Value, Beginning of Period $9.74 $9.90 $9.90 $10.00 $10.00
Income From Investment Operations
Net investment income.............. 0.476 0.621 0.628 0.432 0.552
Net realized and unrealized
gain (loss) on investments......... 0.146 (0.148) - (0.07) 0.002
Total from investment operations. 0.622 0.473 0.628 0.362 0.554
Less Distributions
Dividends from net
investment income................... (0.476) (0.621) (0.628) (0.462) (0.554)
Dividends in excess of
investment income.................... (0.056) (0.012) - - -
Total distributions............ (0.532) (0.633) (0.628) (0.462) (0.554)
Net Asset Value, End of Period....... $9.83 $9.74 $9.90 $9.90 $10.00
Total Return .......................... 6.57% 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of period....... $118,988,609 $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to average net assets <F2> 0.78% 0.78% 0.78% 0.78% 0.78%
Ratio of net investment income to
average net assets <F3>... 5.04% 6.29% 6.33% 4.17% 4.53%
<FN>
<F1>
Commencement of operations.
</FN>
<FN>
<F2>
The annualized operating expense ratios prior to reimbursement of expenses by the Adviser were 0.93%, 0.93%, 0.92%, 1.00%, and
2.58% for the Short Duration U.S. Government Series for the years ended March 31, 1997, March 31, 1996, March 31, 1995, March 31,
1994, and the period ended 1993, respectively. Through March 31, 1995, 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).
</FN>
<FN>
<F3>
The annualized net investment income ratios prior to reimbursement of both direct and indirect expenses by the Adviser were 4.90%,
6.13%, 6.18%, 3.95% and 2.73% for the Short Duration U.S. Government Series for the years ended March 31, 1997, March 31, 1996,
March 31, 1995, March 31, 1994, and the period ended March 31, 1993, respectively.
</FN>
</TABLE>
The accompanying notes are an integral part of these financial statements.
10
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.
11
NOTES TO FINANCIAL STATEMENTS (cont.)
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: Dividends to shareholders are recorded on
the ex-dividend date. 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, 1997, the Series had a net capital loss carryforward of
$3,170,133 with $589 expiring on March 31, 2001, $75,461
expiring on March 31, 2002, $905,312 expiring on March 31, 2003,
$1,359,214 expiring on March 31, 2004, and $829,557 expiring on March
31, 2005.
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. Discounts and premiums on securities purchased are amortized
over the life of the respective 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, swap, cap and option contracts are used for
risk management purposes in order to reduce fluctuations in net asset value
relative to the Series' 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.
12
NOTES TO FINANCIAL STATEMENTS (cont.)
The Short Series had the following open futures contracts as of March 31,
1997:
Type Notional Expiration Unrealized
Amount Position Month Gain/(Loss)
5 Year Treasury $ 22,400,000 Long June, 1997 $(432,132)
10 Year Treasury 16,700,000 Long June, 1997 (405,658)
3 Month Eurodollar 98,000,000 Long September, 1997 ( 41,779)
3 Month Eurodollar 150,000,000 Long June, 1997 (133,425)
3 Month Eurodollar 154,000,000 Long March, 1998 (25,443)
3 Month Eurodollar 40,000,000 Short March, 1999 820
3 Month Eurodollar 38,000,000 Short March, 2000 779
3 Month Eurodollar 30,000,000 Short March, 2001 615
3 Month Eurodollar 20,000,000 Short March, 2002 410
Total $(1,035,813)
Futures transactions involve costs and may result in losses. The effective use
of strategies using futures 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 to cover margin requirements for
the open positions was $604,890.
B. Interest Rate Swap Contracts: The Fund may enter into over-the-
counter transactions swapping interest rates. Interest rate swaps represent an
agreement between counterparties to exchange cash flows based on the
difference between two interest rates, applied to a notional principal amount
for a specified period. The most common type of interest rate swap involves
the exchange of fixed-rate cash flows for variable-rate cash flows. Interest
rate swaps do not involve the exchange of principal between the parties.
The Series' interest rate swap contracts have 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, 1997, the Short Series had four open interest
rate swap contracts. In each of the contracts, the Short Series has agreed to
pay a fixed rate and receive a floating rate. The floating rate on the
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.
13
NOTES TO FINANCIAL STATEMENTS (cont.)
The Short Series' interest payable on the interest rate swap contracts as of
March 31, 1997 was $72,393, and swap contract interest receivable was
$2,935. 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 had one interest rate cap contract open at March 31, 1997.
3. TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered investment
adviser, provides the Short Series with investment management services.
The Adviser has voluntarily agreed to reimburse normal business expenses of
the Short Series through March 31, 1998 so that total direct and indirect
operating expenses do 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, 1998. 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
expense limitations imposed by state securities administrators. For the year
ended March 31, 1997, the Adviser received $1,417,921 in fees and
reimbursed the Short Series $301,998.
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 of 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.
14
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1997, purchases and proceeds from sales of
securities, other than short-term investments, aggregated $1,226,155,709 and
$1,357,342,232 respectively for the Series. The cost of the Short Series'
securities for federal income tax purposes at March 31, 1997, is
$148,770,527. Net unrealized appreciation of investments, short sales and
futures contracts consists of:
Gross unrealized appreciation $ 3,190,281
Gross unrealized depreciation (2,370,379)
Net unrealized appreciation $ 819,902
15
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, 1997, 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 four-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, 1997 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, 1997, 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 12, 1997
16
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
ANNUAL REPORT AND PERFORMANCE REVIEW
Performance Review
The Smith Breeden Intermediate Duration U.S. Government Series
provided a total return of 5.92% in the year ending March 31, 1997. The
Series' return exceeded that of its benchmark, the Salomon Brothers
Mortgage Index by 0.03%. Since the Series' inception, its return has
exceeded that of its benchmark by 2.60%, and on an annualized basis by
0.39%. The graph below plots the Series' return versus its benchmark,
which as noted in the graph, changed effective January 1, 1994. The graph
also shows the Series' return versus the average return of the Morningstar,
Inc.'s Government Bond Mortgage fund category, of which the
Intermediate Series was the number one performing fund over the five-year
period ended March 31, 1997.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE INTERMEDIATE 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 INTERMEDIATE SERIES VERSUS ITS STATED BENCHMARK AND VERSUS THE AVERAGE OF
THE FUNDS IN MORNINGSTAR'S GOVERNMENT BOND MORTGAGE CATEGORY. FOR THE PERIOD
FROM THE SERIES' INCEPTION MARCH 31, 1992 THROUGH DECEMBER 31, 1993, THE SERIES
STATED BENCHMARK WAS THE FIVE YEAR US TREASURY AS TRACKED BY SALOMON BROTHERS,
INC. AFTER DECEMBER 31, 1993, UPON APPROVAL OF A MAJORITY OF THE SHAREHOLDERS,
THE SERIES' BENCHMARK WAS CHANGED TO THE SALOMON BROTHERS MORTGAGE INDEX.
THE SERIES' AVERAGE ANNUAL RETURN WAS 5.92% FOR THE ONE YEAR PERIOD, 7.21% FOR
THE THREE YEAR PERIOD, 8.08% FOR THE FIVE YEAR PERIOD, AND 8.08% FOR THE PERIOD
SINCE INCEPTION. THE AVERAGE ANNUAL RETURN OF THE STATED BENCHMARK WAS 5.89%
FOR THE ONE YEAR PERIOD, 7.45% FOR THE THREE YEAR PERIOD, 7.69% FOR THE FIVE
YEAR PERIOD, AND 7.69% FOR THE PERIOD FROM INCEPTION. THE AVERAGE ANNUAL
RETURN OF THE AVERAGE OF THE FUNDS IN MORNINGSTAR'S GOVERNMENT BOND MORTGAGE
CATEGORY WAS 4.78% FOR THE ONE YEAR PERIOD, 5.99% FOR THE THREE YEAR PERIOD,
AND 6.01% FOR THE FIVE YEAR AND SINCE INCEPTION RETURNS.
FROM INCEPTION THROUGH MARCH 31, 1997, AN INVESTMENT
OF $10,000 IN THE INTERMEDIATE SERIES WOULD HAVE GROWN TO $14,748, VERSUS
$14,486 IN ITS BENCHMARK, AND $13,389 IN THE AVERAGE OF THE FUNDS IN
MORNINGSTAR'S GOVERNMENT BOND MORTGAGE CATEGORY.
The Salomon Brothers Mortgage Index, and the Intermediate
Series, performed outstandingly well over the last twelve months. For the
year, the Series' performance exceeded that of the five-year U.S. Treasury
Note by 2.77% and the three-year Note by 1.22%. Compared to the Lehman
Intermediate Aggregate Bond Index, the Series' performance was 0.69%
ahead.
17
The reason for the outstanding performance of mortgages relates
mostly to declines in interest rate volatility, both on a realized and an
expected basis. Mortgage-backed securities (MBS) perform better when
volatility is low because investors have greater certainty about the timing of
their cashflows. MBS cashflows are inherently uncertain, because
homeowners change their refinancing behavior in response to changes in
interest rates. When rates fall, refinancing activity rises; when rates rise,
refinancing activity falls. Investors in MBS require a substantial yield
premium over US Treasury securities, most of which is to compensate for
the uncertainty of MBS cashflows (in contrast, Treasury cashflows are
fixed). When interest rate volatility is low, investors require less of a yield
premium and MBS perform well relative to Treasury securities, as they
have over the past year.
While the benchmark of the Intermediate Series is the Salomon
Brothers Mortgage Index ("SBMI"), the Series will invest in mortgages
not included in the SBMI. In so doing, the Series seeks to generate excess
returns, on a risk-adjusted basis, which after fund expenses, will contribute
to the fund's incremental performance. As the Intermediate Series' moves
in and out of different mortgage sectors, this can drive up the fund's
portfolio turnover rate. The portfolio turnover rate for the fiscal year 1996
was 409%. However, since the Intermediate Series limits its investment in
these sectors to those that are the most liquid and of AAA credit quality,
transaction costs related to this portfolio turnover are relatively small.
18
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS 31-Mar-97
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 113.17%
FEDERAL HOME LOAN MORTGAGE CORP. - 43.24 % *
FHLMC GOLD:
$14,500,000 7.50%, due (a) ................... $14,198,906
2,089,955 8.00%, due 9/01/24 to 10/19/24 .......2,116,804
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $16,381,165) 16,315,710
FEDERAL NATIONAL MORTGAGE ASSOC. - 11.82% *
FNMA:
3,199,150 7.00%, due 8/1/23 to 6/01/24 ......... 3,078,697
1,282,714 9.50%, due 7/01/16 to 5/01/22........ 1,381,554
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC.
(Cost $4,282,274) 4,460,251
GOVERNMENT NATIONAL MORTGAGE ASSOC. - 57.69% *
GNMA:
59,603 7.00%, due 3/15/26 ..................... 56,926
9,241,972 8.00%, due 11/15/06 to 12/15/26 .... 9,320,120
GNMA ARM:
990,000 5.00%, due 3/20/27 ............. ....... 957,230
3,942,410 5.50%, due 11/20/26 ........... 3,889,964
2,858,832 6.00%, due 11/20/26 to 1/20/27... 2,848,303
293,950 6.88%, due 11/20/17 ....................300,234
1,823,924 6.50%, due 2/20/23 ................... 1,857,098
2,479,666 7.125%, due 8/20/17 to 4/20/22.........2,540,041
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(Cost $21,663,823) 21,769,916
UNITED STATES TREASURY BILLS - 0.42% **
160,000 5.39%, due 5/29/97 ***................ 158,660
TOTAL UNITED STATES TREASURY BILLS
(Cost $158,612) 158,660
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $42,485,874) 42,704,537
Contracts OPTION CONTRACTS - 0.02%
10 Call on 10 Year US Treasury Note futures, expires 5/97,
strike price $109 625
10 Call on 10 Year US Treasury Note futures, expires 5/97,
strike price $105 7,343
TOTAL OPTION CONTRACTS (Cost $9,778) .... 7,968
TOTAL INVESTMENTS
(Cost $42,495,652) - 113.19% .. 42,712,505
Face Amount REPURCHASE AGREEMENTS - 18.55%:
$7,000,000 Morgan Stanley, 5.63%, due 4/3/97
dated 3/27/97 . .... 7,000,000
TOTAL REPURCHASE AGREEMENTS
(Cost $7,000,000). .. 7,000,000
SHORT SALES - (7.36%)
3,000,000 GNMA 6.50%, due (a)....................(2,777,813)
TOTAL SHORT SALES
(Proceeds $2,836,992).. ....... (2,777,813)
CASH AND OTHER ASSETS LESS LIABILITIES - (24.38%) (9,199,167)
NET ASSETS - 100.00% ............................ $37,735,525
19
* 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, 1997.
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.
*** Security is segregated as collateral.
(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.
20
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
31-Mar-97
ASSETS:
Investments at market value (identified cost $42,495,652)
(Note 1) $42,712,505
Repurchase agreement (cost $7,000,000) (Note 1)............. 7,000,000
Cash.......... ............................................... 2,270,462
Receivables:
Subscriptions. . ........................................... 8,800
Interest......... ........................................ 206,189
Securities sold......... .......................... 12,215,707
Deferred organization expenses (Note 1). .................. 757
TOTAL ASSETS............................................ 64,414,420
LIABILITIES:
Short sales at market value (Proceeds $2,836,992)........... 2,777,813
Payables:
Variation margin on futures contracts (Note 2). ............... 2,469
Securities purchased........................................ 23,738,701
Distributions..................................... ......... 124,309
Due to advisor (Note 3)................................. ...... 14,992
Accrued expenses.............................................. 20,611
TOTAL LIABILITIES........................................ 26,678,895
NET ASSETS:
(Applicable to outstanding shares of 3,878,010;
unlimited number of shares of beneficial
interest authorized; no stated par)........................ $37,735,525
Net asset value, offering price and redemption
price per share ($37,735,525/3,878,010) $9.73
SOURCE OF NET ASSETS:
Paid in capital.............................................. $38,554,091
Overdistributed net investment income........................ (124,309)
Accumulated net realized loss on investments...................... (830,703)
Net unrealized appreciation of investments... ................... 136,446
NET ASSETS............................................. $37,735,525
The accompanying notes are an integral part of these financial statements.
21
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1997
INVESTMENT INCOME:
Interest and discount earned, net of premium amortization and interest
expense (Note 1) ............................................. $2,632,266
EXPENSES:
Advisory fees (Note 3) ...................... .................. 259,767
Accounting and pricing services fees ........................... 39,224
Custodian fees ................................................. 21,512
Audit & tax preparation fees ................. ......... 14,500
Legal fees ..................................................... 10,251
Amortization of organization expenses (Note 1) ................. 9,402
Transfer agent fees ................................ .......... 29,735
Registration fees .............................................. 20,200
Trustees fees and expenses ......................... ........... 13,324
Insurance ...................................................... 10,541
Other .......................................................... 1,888
TOTAL EXPENSES BEFORE REIMBURSEMENT ................ 430,344
Expenses reimbursed by Adviser (Note 3) .................. (101,379)
NET EXPENSES ............................. ................. 328,965
NET INVESTMENT INCOME .............................. 2,303,301
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized loss on investments . ............... ........... (82,705)
Change in unrealized appreciation of investments................ (93,993)
Net realized and unrealized loss on investments ............... (176,698)
Net increase in net assets resulting from operations ........ $2,126,603
The accompanying notes are an integral part of these financial statements.
22
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1997 March 31, 1996
OPERATIONS:
Net investment income......................... $2,303,301 $2,369,671
Net realized (loss) gain on investments....... (82,705) 1,227,064
Change in unrealized appreciation (depreciation)
of investments............. (93,993) (257,447)
Net increase in net assets resulting from
operations............ 2,126,603 3,339,288
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income........ (2,260,030) (2,358,436)
Distributions from net realized gains on
investments... ... (943,662) (367,107)
Total distributions...................... (3,203,692) (2,725,543)
CAPITAL SHARE TRANSACTIONS:
Shares sold.... ............................ 1,730,791 1,030,079
Shares issued on reinvestment of distributions 935,335 702,855
Shares redeemed. ........................... (300,452) (697,235)
Increase in net assets resulting from capital
share transactions(a). .... 2,365,674 1,035,699
TOTAL INCREASE IN NET ASSETS........... 1,288,585 1,649,444
NET ASSETS:
Beginning of year... ...................... 36,446,940 34,797,496
End of year........... .................... $37,735,525 $36,446,940
(a) Transactions in capital shares were as follows:
Shares sold........ ................... 174,344 100,992
Shares issued on reinvestment of
distributions.............. ... 94,439 69,235
Shares redeemed..................... . (30,101) (69,182)
Net increase......................... . 238,682 101,045
Beginning balance ................... . 3,639,328 3,538,283
Ending balance ........................ 3,878,010 3,639,328
The accompanying notes are an integral part of these financial statements.
23
SMITH BREEDEN INTERMEDIATE DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1997
Year Ended
31-Mar-97
Cash flows from operating activities:
Net increase in net assets resulting from operations....... $2,126,603
Net realized and unrealized loss on investments............ 176,698
Net investment income.................................... 2,303,301
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and losses........................................(37,392)
Decrease in interest receivable.................................... 53,993
Decrease in other assets........................................... 18,904
Decrease in other liabilities...................................... (14,677)
Net cash provided by operating activities... ............ 2,324,129
Cash flows from investing activities:
Payments for futures variations. .......................... (60,974)
Proceeds from sales of long-term investments....... 56,055,128
Proceeds from sales of short-term investments..................... 159,527
Proceeds from sales of options................ .................... 5,223
Proceeds from maturities of short-term investments..............232,680,862
Proceeds from paydowns of long-term investments............... 3,435,588
Purchases of long-term investments........................ (51,848,780)
Purchases of short-term investments........................ (239,832,318)
Purchases of options....................................... (102,279)
Net cash provided by investing activities................ 491,977
Cash flows from financing activities:
Proceeds from shares tendered.....................................1,721,991
Payments for shares redeemed.......................................(300,452)
Dividends from net investment income and
realized gains on investments.....................................(2,279,430)
Net cash used in financing activities...........................(857,891)
Net increase in cash.................................... 1,958,215
Cash at beginning of year............................................. 312,247
Cash at end of year.............................................. $2,270,462
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends............................... $935,335
Supplemental disclosure:
Interest paid.................................................. $ 3,079
The accompanying notes are an integral part of these financial statements.
24
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
<TABLE>
The following average per share data, ratios and supplemental information have
been derived from information provided in the financial statements.
<CAPTION>
Year Year Year Year Period
Ended Ended Ended Ended 3/31/92 <F3>
3/31/97 3/31/96 3/31/95 3/31/94 to 3/31/93
<S> <C> <C> <C> <C> <C>
Net Asset Value,
Beginning of Period $10.01 $9.83 $10.01 $10.62 $10.00
Income From Investment Operations
Net investment income............................................0.599 0.66 0.664 1.05 0.826
Net realized and unrealized (loss) gain on investments..........(0.024) 0.277 (0.049) (0.601) 0.621
Total from investment operations.............................0.575 0.937 0.615 0.449 1.447
Less Distributions
Dividends from net investment income............................(0.604) (0.656) (0.664) (1.044) (0.826)
Dividends in excess of net investment income......................- - (0.108) - -
Distributions from net realized gains on investments............(0.251) (0.101) - (0.015) -
Distributions in excess of net realized gains on investments......- - (0.022) - -
Total distributions........................................ (0.855) (0.757) (0.794) (1.059) (0.826)
Net Asset Value, End of Period....................................$9.73 $10.01 $9.83 $10.01 $10.62
Total Return.......................................................5.92% 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of period......................................$37,735,525 $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to average net assets <F1>.......................0.88% 0.90% 0.90% 0.90% 0.82%
Ratio of net investment income to average net assets <F2>..........6.19% 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate.......................................... 409% 193% 557% 84% 42%
<FN>
<F1>
(1)The annualized ratio of expenses to average net assets prior to reimbursement of expenses by the Adviser was 1.16%, 1.14%,
2.33%, 2.34%, and 17.52% for the years ended March 31, 1997, March 31, 1996, March 31, 1995 and March 31, 1994 and for the
period ended March 31, 1993, respectively. Through August 1, 1994, 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).
</FN>
<FN>
<F2>
(2) The annualized ratio of net investment income to average net assets prior to reimbursement of both direct and indirect expenses
by the Advisor was 6.26%, 4.77%, 6.30% and (8.52)% for the years ended March 31, 1997, March 31, 1996, March 31, 1995 and March 31,
1994, and for the period March 31, 1993, respectively.
</FN>
<FN>
<F3>
(3) Commencement of operations.
</FN>
</TABLE>
The accompanying notes are an integral part of these financial statements.
25
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: Dividends to shareholders are recorded on
the ex-dividend date. 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, 1997,
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
26
NOTES TO FINANCIAL STATEMENTS (cont.)
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. Discounts and premiums on securities purchased are amortized over
the life of the respective 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.
27
NOTES TO FINANCIAL STATEMENTS (cont.)
The Intermediate Series had the following open futures contracts as of
March31, 1997:
Type Notionanal Position Expiration Unrealized
Amount Month Gain/ (Loss)
5 Year Treasury $1,500,000 Long June, 1997 $ 32,817
10 Year Treasury 3,200,000 Long June, 1997 (106,769)
Total $ (139,586)
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, 1997 was $158,660.
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 0.88% 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, 1997, the Adviser received fees of $259,767 and reimbursed
the Series $101,379.
28
NOTES TO FINANCIAL STATEMENTS (cont.)
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, 1997, purchases and proceeds from sales of
securities, other than short-term investments, aggregated $174,835,826 and
$180,397,654, 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
$42,495,652. Net unrealized appreciation of investments, short sales and
futures contracts consists of:
Gross unrealized appreciation $ 431,474
Gross unrealized depreciation (295,028)
Net unrealized appreciation $ 136,446
29
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, 1997, 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 four-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, 1997 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, 1997, 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 12, 1997
30
