FEBRUARY 18, 1997
SMITH BREEDEN MUTUAL FUNDS
The Smith Breeden Mutual Funds consists of three no-load,
registered investment companies (the "Funds" or a
"Fund"). Smith Breeden Associates, Inc. (the "Adviser")
serves as the investment adviser to the Funds.
Smith Breeden Equity Plus Fund (the "Equity Plus Fund")
seeks to provide a total return exceeding the Standard &
Poor's 500 Composite Stock Price Index without additional
equity market risk. The previous name of the Equity Plus
Fund was the Smith Breeden Market Tracking Fund.
Smith Breeden Short Duration U.S. Government Series (the
"Short Series") seeks a high level of current income,
consistent with low volatility of net asset value. The
Short Series seeks to match the interest-rate risk of a
portfolio that invests exclusively in six month U.S.
Treasury securities on a constant maturity basis. The
dollar weighted average maturity of the Fund's securities
may significantly exceed six months at times.
Smith Breeden Intermediate Duration U.S. Government
Series (the "Intermediate Series") seeks a total return
in excess of the total return of the major market indices
for mortgage-backed securities. The major market indices
for mortgage-backed securities include, but are not
limited to, the Salomon Brothers Mortgage Index and the
Lehman Brothers Mortgage Index. These indices include
all outstanding government sponsored fixed-rate
mortgage-backed securities, weighted in proportion to their
current market capitalization. The duration, or
interest-rate risk, of these indices is similar to that
of intermediate-term U.S. Treasury Notes, and typically
will range between three and five years. The
Intermediate Series consistently seeks to achieve a
volatility of net asset value similar to that of a
portfolio that invests exclusively in mortgage-backed
securities, as weighted in the major mortgage market
indices.
An investment in any of the Funds is neither insured nor
guaranteed by the U.S. Government. There can be no
assurance that any of the Funds will meet their
investment objectives. This Prospectus sets forth
concisely the information about the Funds that you should
know before investing. You are advised to read this
Prospectus carefully and keep it for future reference.
A Statement of Additional Information, dated February 18,
1997 which is incorporated herein by reference, has been
filed with the Securities and Exchange Commission with
respect to each Fund. The Statements of Additional
Information, which may be revised from time to time,
contain further information about the Funds, and are
available without charge by writing to the Funds at 100
Europa Drive, Chapel Hill, North Carolina 27514 or by
calling 1-800-221-3138.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY
THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE
SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
TABLE OF CONTENTS
Expense Table. . . . . . . . . . . . . . . . . . . . .3
Financial Highlights--Equity Plus Fund . . . . . . . .5
Financial Highlights--Short Series . . . . . . . . . .6
Financial Highlights--Intermediate Series. . . . . . .7
Smith Breeden Mutual Funds . . . . . . . . . . . . . .8
Investment Objectives, Policies and Risk
Considerations. . . . . . . . . . . . . . . . . . . .8
Other Investment Practices and Risk Considerations . 22
Management of the Funds. . . . . . . . . . . . . . . 25
Pricing of Fund Shares . . . . . . . . . . . . . . . 30
How to Purchase Shares . . . . . . . . . . . . . . . 31
How to Exchange Shares . . . . . . . . . . . . . . . 34
How to Redeem Shares . . . . . . . . . . . . . . . . 35
Dividends and Distributions. . . . . . . . . . . . . 38
Shareholder Reports and Information. . . . . . . . . 39
Retirement Plans . . . . . . . . . . . . . . . . . . 40
Service and Distribution Plans . . . . . . . . . . . 40
Taxes. . . . . . . . . . . . . . . . . . . . . . . . 41
Capital Structure. . . . . . . . . . . . . . . . . . 42
Transfer, Dividend Disbursing Agent, Custodian and
Independent Auditors. . . . . . . . . . . . . . . 43
Fund Performance . . . . . . . . . . . . . . . . . . 43
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.
<PAGE>
EXPENSE TABLE
The following table is designed to assist you in
understanding the expenses you will bear as a shareholder
in the Funds. Shareholder Transaction Expenses are
charges that you pay when buying or selling shares of a
Fund. Annual Fund Operating Expenses are paid out of a
Fund's assets and include fees for portfolio management,
maintenance of shareholder accounts, shareholder
servicing, accounting and other services. The expenses
shown below are based on each Fund's expenses for the
past fiscal year.
Equity Plus Short Intermediate
Fund Series Series
Shareholder Transaction
Expenses
Maximum Sales Load Imposed
on Purchases None None None
Maximum Sales Load Imposed on
Reinvested Dividends None None None
Deferred Sales Load Imposed on
Redemptions None None None
Redemption Fees1 None None None
Exchange Fees None None None
Annual Fund Operating Expenses
(as a percentage of average
net assets)
Management Fees2 0.70% 0.70% 0.70%
Other Expenses (net of
reimbursement) 0.18% 0.08% 0.18%
Total Fund Operating Expenses
(net of reimbursement)3 0.88% 0.78% 0.88%
_____________________________
1 A transaction cost of $9 may be imposed on redemptions by wire
transfer.
2 Pursuant to a distribution and services plan in respect of each
Fund, the Adviser may pay annual distribution and servicing fees
of up to 0.25% of each of the Funds' net assets out of its
management fee. See "Service and Distribution Plans."
3 The Other Expenses in the table and Total Fund Operating
Expenses reflect undertakings by the Adviser to bear expenses of
each of the Funds and/or waive its fees to the extent necessary
to limit Total Fund Operating Expenses to 0.78% for the Short
Series and 0.88% for each of the Equity Plus Fund and
Intermediate Series through March 31, 1997 and are estimates
which are based upon Total Fund Operating Expenses for the
fiscal year ended March 31, 1996. Absent the expense
limitation, Other Expenses and Total Fund Operating Expenses
would be 0.23% and 0.93% for the Short Series, 0.44% and 1.14%
for the Intermediate Series, and 3.88% and 4.58% for the Equity
Plus Fund. Actual Total Fund Operating Expenses for the fiscal
year ended March 31, 1996 were 0.78% for the Short Series and
0.90% for each of the Equity Plus Fund and Intermediate Series.
<PAGE>
The following examples illustrate the expenses that apply
to a $250 investment in each Fund over various time
periods assuming (1) a 5% annual rate of return and (2)
redemption or no redemption at the end of each time
period. Except as noted in the table above, the Funds
charge no redemption fees.
Short Duration Series
1 Year 3 Years 5 Years 10 Years
$ 2 $ 7 $ 11 $ 24
Intermediate Duration Series and Equity Plus Fund
1 Year 3 Years 5 Years 10 Years
$ 3 $ 8 $ 12 $ 27
These examples are based on the annual operating expenses
shown above and should not be considered a representation
of past or future expenses or performance. Actual
expenses may be greater or less than those shown. The
annual rate of return may be more or less than 5%.
The Funds may be recommended to investors by registered
investment advisors. Such advisors customarily impose
fees which would be in addition to any fees and expenses
presented in the above table. According to recent
financial articles, such fees may be as high as 2% of
assets per year. Neither the Funds, nor the Adviser,
exercise any control over such advisory fees and may not
be informed of the level of such fees.
<PAGE>
EQUITY PLUS FUND
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal
periods from June 30, 1992, the date the Fund commenced operations,
through March 31, 1996 and are a part of the Fund's financial statements
which have been audited by Deloitte & Touche LLP, independent auditors.
This data should be read in conjunction with the Fund's most recent
annual audited financial statements and the report of Deloitte & Touch
LLP thereon which appear in the Fund's Statement of Additional
Information. (The Equity Plus Fund was previously named The Market
Tracking Fund.)
Year Ended Year Ended Year Ended Period Ended
March 31, 1996 March 31, 1995 March 31,1994 March 31, 1993
Net Asset Value,
Beginning of Period $10.84 $9.88 $10.85 $10.00
Income From Investment
Operations
Net investment income.... 0.615 0.568 0.476 0.355
Net realized and
unrealized gain (loss)
on investments......... 2.768 1.081 (0.216) 1.281
Total from investment
operations 3.383 1.649 0.260 1.636
Less Distributions
Dividends from net
investment income (0.583) (0.568) (0.472) (0.311)
Dividends in excess of net
investment income...... -- (0.001) -- --
Distributions from net
realized gains on
investments...... (1.370) (0.047) (0.701) (0.420)
Distributions in excess
of net realized gains
on investments...... -- (0.073) (0.057) (0.055)
Total distributions. (1.953) (0.689) (1.230) (0.786)
Net Asset Value,
End of Period.... $12.27 $10.84 $9.88 $10.85
Total Return... 32.30% 17.18% 2.19% 22.59%*
Ratios/Supplemental Data
Net assets, end
of period.............$4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to
average net assets
Before expense
limitation....... 4.58% 7.75% 7.08% 28.48%*
After expense
limitation....... 0.90% 0.90% 0.90% 0.57%*
Ratio of net income to
average net assets
Before expense
limitation....... 1.85% 0.59% 1.84% (22.63%)*
After expense
limitation....... 5.53% 7.44% 8.02% 5.28%*
Portfolio turnover rate. 107% 120% 119% 271%
* Annualized
Additional performance information is presented in the Fund's Annual
Report, which is available without charge upon request.<PAGE>
SHORT DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal
periods from March 31, 1992, the date the Fund commenced operations,
through March 31, 1996 and are a part of the Short Series' financial
statements which have been audited by Deloitte & Touche LLP, independent
auditors. This data should be read in conjunction with the Short
Series' most recent annual audited financial statements and the report
of Deloitte & Touche LLP thereon which appear in the Fund's Statement
of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31,1996 March 31, 1995 March 31,1994 March 31,1993
Net Asset Value,
Beginning of Period. $9.90 $9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income 0.621 0.628 0.432 0.552
Net gain (loss) on
securities (both
realized and
unrealized)......... (0.148) -- (0.070) 0.002
Total from investment
operations........... 0.473 0.628 0.362 0.554
Less Distributions
Dividends from net
investment income.... (0.621) (0.628) (0.462) (0.554)
Dividends in excess of
investment income.... (0.012) -- -- --
Total distributions. (0.633) (0.628) (0.462) (0.554)
Net Asset Value,
End of Period........ $9.74 $9.90 $9.90 $10.00
Total Return........ 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of
period.............. $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to
average net assets
Before expense
limitation.. 0.93% 0.92% 1.00% 2.58%
After expense
limitation... 0.78% 0.78% 0.78% 0.78%
Ratio of net income to
average net assets
Before expense
limitation 6.13% 6.18% 3.95% 2.73%
After expense
limitation 6.29% 6.33% 4.17% 4.53%
Portfolio turnover
rate................. 225% 47% 112% 3%
Additional performance information is presented in the Short Series'
Annual Report, which is available without charge upon request.
<PAGE>
INTERMEDIATE DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal
periods from March 31, 1992, the date the Fund commenced operations,
through March 31, 1996 and are a part of the Intermediate Series'
financial statements which have been audited by Deloitte & Touche LLP,
independent auditors. This data should be read in conjunction with the
Intermediate Series' most recent annual audited financial statements and
the report of Deloitte & Touche LLP thereon which appear in the Fund's
Statement of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31, 1993
Net Asset Value,
Beginning of Period. $9.83 $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment income. 0.660 0.664 1.05 0.826
Net gain (loss) on
securities
(both realized and
unrealized)......... 0.277 (0.049) (0.601) 0.621
Total from investment
operations............ 0.937 0.615 0.449 1.447
Less Distributions
Dividends from net
investment income..... (0.656) (0.664) (1.044) (0.826)
Dividends in excess of
net investment income.. -- (0.108) -- --
Distributions from net
realized gains on
investments........ (0.101) -- (0.015) --
Distributions in excess
of net realized gains
on investments...... -- (0.022) -- --
Total distributions. (0.757) (0.794) (1.059) (0.826)
Net asset value,
end of period........ $10.01 $9.83 $10.01 $10.62
Total Return......... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end
of period............ $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to
average net assets
Before expense
limitation........ 1.14% 2.33% 2.34% 17.52%
After expense
limitation........ 0.90% 0.90% 0.90% 0.82%
Ratio of net income to
average net assets
Before expense
limitation........ 6.26% 4.77% 6.30% (8.52)%
After expense
limitation....... 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate 193% 557% 84% 42%
Additional performance information is presented in the Intermediate Series'
Annual Report, which is available without charge upon request.<PAGE>
SMITH BREEDEN MUTUAL FUNDS
The Short and Intermediate Series are series of the Smith
Breeden Series Fund ( the "Series Fund"), an open-end
diversified management investment company, registered under the
Investment Company Act of 1940 (the "1940 Act"). The Series Fund
currently issues shares in two series, which are the Short and
Intermediate Series. The Equity Plus Fund is currently the only
series of the Smith Breeden Trust (the "Trust"), also an open-end
diversified management investment company registered under the 1940 Act.
Smith Breeden Associates, Inc. ("Smith Breeden" or the
"Adviser") acts as investment adviser to the Funds. Smith
Breeden is a money management and consulting firm founded in
1982 whose clients include pension funds, financial
institutions, corporations, government entities and charitable
foundations. The firm specializes in mortgage securities,
interest-rate risk management, and the application of option
pricing to investments and banking. Smith Breeden currently
advises, or manages on a discretionary basis, assets totalling
over $20 billion.
INVESTMENT OBJECTIVES, POLICIES, AND RISK CONSIDERATIONS
Each of the Funds has a different investment objective and a
different investment policy since each Fund is designed to meet
different investment needs.
The investment objectives and certain investment policies of the
Short and Intermediate Series are fundamental and may not be
changed without a vote of shareholders of the relevant Fund.
The investment objective of the Equity Plus Fund is not
fundamental, and may be changed without a vote of the majority
of the shareholders of the Equity Plus Fund. Shareholders of
the Equity Plus Fund will receive a written notification at
least thirty days prior to any change in the Equity Plus Fund's
investment objective. If such a change in the investment
objective of the Equity Plus Fund occurs, such changes may
result in the Fund having an investment objective different from
the objective which the shareholders considered appropriate at
the time of their investment in the Equity Plus Fund.
Because shares of each Fund represent an investment in
securities with fluctuating market prices, you should understand
that the net asset value per share of each Fund will vary as the
aggregate value of a Fund's portfolio securities increases or
decreases. Because of the risks inherent in all investments,
there can be no assurance that the objectives of the Funds will
be met. The descriptions that follow are designed to help you
choose the Fund or combination of Funds that best fits your
investment objectives.
Short Series
The Short Series' investment objective is to provide investors
with a high level of current income, consistent with a
volatility of net asset value similar to that of a portfolio
which invests exclusively in six-month U.S. Treasury securities
on a constant maturity basis. There is no assurance that the
Short Series will be able to maintain a low volatility of net
asset value.
Under normal circumstances the Short Series will seek to achieve
an interest-rate risk or option-adjusted duration similar to
that of a six-month U.S. Treasury security on a constant
maturity basis. Option-adjusted duration is a measure of the
price sensitivity (in percentage) of a portfolio to changes in
interest rates, taking into account the changing nature of
expected cash flows, as influenced by mortgage prepayments and
other factors. The Short Series expects that, under normal
circumstances, the dollar-weighted average life (or period until
the next reset date) of its portfolio securities will be longer
than six months, sometimes significantly. The maturity of a
security measures only the time until final payment is due,
whereas option-adjusted duration takes into account the pattern
of all payments of interest and principal on a security over
time, including how these payments are affected by prepayments
and by changes in interest rates. In computing the duration of
the Short Series' portfolio, the Adviser will estimate the
duration of obligations that are subject to prepayment, or
redemption by the issuer, taking into account the influence of
changes in interest rates on prepayments and coupon flows. The
Adviser will use certain hedging techniques (discussed in more
detail in Appendix A and in "Investment Policies of the Short
and Intermediate Series and Fixed Income Segment of the Equity
Plus Fund") to lengthen or shorten the option-adjusted duration
of the Short Series' portfolio so that it targets the
interest-rate risk of a six-month U.S. Treasury security.
The Adviser believes that by investing in mortgage securities
from a variety of market sectors on a selective basis and
adjusting the overall option-adjusted duration of the portfolio
to approximate that of a six-month U.S. Treasury security, the
Short Series will achieve a more consistent and less volatile
net asset value than is characteristic of mutual funds that
invest primarily in mortgage securities paying a fixed rate of
interest or those that invest exclusively in adjustable-rate
mortgage securities. The securities in which the Short Series
may invest may not yield as high a level of income as other
securities in which other funds may invest. However, such
higher yielding securities may be more volatile and may be
issued by less creditworthy entities.
Intermediate Series
The Intermediate Series' investment objective is to provide
investors with a total return in excess of the total return of
the major market indices for mortgage-backed securities. The
major market indices for mortgage-backed securities include, but
are not limited to, the Salomon Brothers Mortgage Index and the
Lehman Brothers Mortgage Index. These indices include all
outstanding government sponsored fixed-rate mortgage-backed
securities, weighted in proportion to their current market
capitalization. Total return is the change in value of the
investment assuming reinvestment of all distributions. Under
normal circumstances, the Intermediate Series will seek to
achieve an interest-rate risk or option-adjusted duration
similar to that of a portfolio that invests exclusively in
mortgage-backed securities, as weighted in the major market
indices. The duration, or interest-rate risk, of these indices
is similar to the that of intermediate-term U.S. Treasury Notes,
and typically will range between three and five years. When
market interest rates decline, the value of a portfolio invested
in intermediate-term fixed-rate obligations can be expected to
rise. Conversely, when market interest rates rise, the value of
a portfolio invested in intermediate-term fixed-rate obligations
can be expected to fall.
Option-adjusted duration is a measure of the price sensitivity
(in percentage) of a portfolio to changes in interest rates,
taking into account the changing nature of expected cash flows,
as influenced by mortgage prepayments and other factors. The
maturity of a security measures only the time until final
payment is due, whereas option-adjusted duration takes into
account the pattern of all payments of interest and principal on
a security over time, including how these payments are affected
by prepayments and by changes in interest rates. In computing
the duration of the Intermediate Series' portfolio, the Adviser
will estimate the duration of obligations that are subject to
prepayment, or redemption by the issuer, taking into account the
influence of changes in interest rates on prepayments and coupon
flows. The Adviser may use certain hedging techniques (as
described in more detail in Appendix A and in "Investment
Policies of the Short and Intermediate Series and Fixed Income
Segment of the Equity Plus Fund") to lengthen or shorten the
option-adjusted duration of the Intermediate Series so that it
targets the interest-rate risk of a portfolio that invests
exclusively in mortgage-backed securities, as weighted in the
major mortgage indices.
There is no assurance that the Intermediate Series will be able
to maintain a total return in excess of the total return of
major market indices for mortgage-backed securities or that it
will match the interest-rate risk of a portfolio investing
exclusively in these securities.
Equity Plus Fund
The Equity Plus Fund seeks to provide a total return exceeding
the Standard & Poor's Composite Stock Price Index (the "S&P 500
Index") without additional equity market risk. (The former name
of the Equity Plus Fund was the Smith Breeden Market Tracking
Fund.) Total return is a measure of investment performance
which includes all of the interest, dividends and other income,
net of expenses, paid on the Fund's investments, as well as all
realized and unrealized capital gains and losses. The S&P 500
Index is composed of 500 common stocks, most of which are listed
on the New York Stock Exchange. Standard & Poor's, which is not
a sponsor of or in any other way affiliated with the Fund,
chooses the 500 stocks included in the S&P 500 Index on the
basis of market value and industry diversification. The S&P 500
Index assigns relative values to the stocks included in the
index, weighted according to each stock's total market value
relative to the total market value of the other stocks included
in the index.
The Equity Plus Fund seeks to achieve its objective by dividing
its portfolio into two separate segments, an "Equity Simulation
Segment" and a "Fixed Income Segment." The Equity Plus Fund's
Equity Simulation Segment will invest in a combination of Equity
Swap Contracts (described more fully below), futures contracts
on the S&P 500 Index and on other stock indices, including, but
not limited to the New York Stock Exchange Composite Index ("S&P
500 and Other Stock Index Futures"), and a combination of common
stocks whose return (before deducting allocated costs) is
expected to track movements in the S&P 500 Index. In the Equity
Simulation Segment, the Equity Plus Fund expects its use of
stock index futures other than S&P 500 Stock Index Futures to be
minimal.
The Equity Plus Fund's Fixed Income Segment will seek a total
return greater than the expenses of the Fund (including the
expenses associated with the Equity Simulation Segment such as
those relating to the Equity Swap Contracts and S&P 500 and
Other Stock Index Futures) by investing in fixed-income
securities and futures, options, floors, caps and swaps related
thereto. Through these investments, the Fixed Income Segment
seeks to generate income (consisting primarily of interest
income) and gains which exceed the expenses of operating the
entire Equity Plus Fund. Thus, whether the Fund outperforms or
underperforms the S&P 500 Index will depend on whether the total
return on the Fixed Income Segment is greater or less than the
Fund's total operating expenses (including transaction costs and
the costs of the equity derivative instruments held in the
Equity Simulation Segment), respectively.
Investment Policies of the Equity Simulation Segment of the
Equity Plus Fund
As stated above, the Equity Plus Fund's Equity Simulation
Segment will invest in a combination of Equity Swap Contracts,
S&P 500 and other Stock Index Futures, and a combination of
common stocks whose return is expected to track movements in the
S&P 500 Index. By employing such a strategy, the Equity Plus
Fund seeks to achieve the same opportunity and risk profile for
the Equity Simulation Segment as that of a hypothetical
portfolio, equal in size to the Fund, invested in the common
stocks comprising the S&P 500 Index (in proportion to their
respective weight in the S&P 500 Index.)
Set forth below is an example of a hypothetical portfolio
allocation for the Fund, assuming total assets of $100 million.
The Fund might:
1. Enter into an Equity Swap Contract with a notional amount
of $50 million;
2. Purchase S&P 500 Index Futures contracts with a total value
of $45 million; and
3. Purchase $5 million worth of common stocks comprising the
S&P 500 Index in proportion to their respective weightings in
the S&P 500 Index.
The Fixed Income Segment would invest $100 million in various
fixed income assets with appropriate hedging strategies. If,
during the course of the year, the stocks comprising the S&P
500 Index appreciate 10% on average and pay a 4% dividend, and
if the interest on the Equity Swap Contract's notional amount is
6%, at the end of the year the following would occur:
1. The counterparty to the equity swap contract will be
required to pay the Fund $4 million ($7 million appreciation and
dividends minus $3 million interest);
2. The S&P 500 Index Futures contract would be closed out at
a gain of $3.6 million ($6.3 million S&P 500 Index appreciation
less $2.7 million for the S&P 500 Futures implicit cost of
carry);
3. Dividend income and gain on the common stocks would total
$0.7 million and in sum;
4. The Fund's return, before Fund operating expenses, would
total $8.3 million dollars or 8.3%.
The Fund's total operating expenses (other than brokerage
expenses and the interest on the notional amount of the Equity
Swap contract as described above) are 0.88% of total net assets
or $0.88 million dollars. After consideration of these
expenses, the Fund's return would total 7.42%. Therefore, the
Fund will achieve a total return equal to the S&P 500 Index only
if the Fixed Income Segment has a total return equal to 6.58%
per annum. If the Fixed Income Segment achieves this result,
then the Fund's total net assets will be $114 million - an
increase of 14% and a total return equal to the S&P 500 Index.
If the Fixed Income Segment's total return is greater or less
than 6.58% per annum, the Fund's total return will, in turn, be
greater or less than the S&P 500 Index.
The Equity Simulation Segment's actual opportunities for gain
and loss will tend to be greater than a hypothetical portfolio
invested in the stocks comprising the S&P 500 Index if the
Fund's exposure to the S&P 500 Index is higher or lower than the
Fund's total assets. For example, the total notional amount of
the Fund's Equity Swap Contracts (less the notional amount of
any Reverse Equity Swap Contracts) plus the face amount of the
Fund's S&P 500 or Other Stock Index Futures plus the market
value of common stocks owned by the Fund may exceed the Fund's
total net assets from time to time, due to purchases and
redemptions which will frequently affect the Fund's total assets
and because S&P 500 Index Futures can only be purchased in
multiples of 500 times the S&P 500 Index. Under normal market
conditions, the Fund expects that such variations in exposure to
the S&P 500 Index will generally be up to 5% greater or less
than the Fund's total net assets. Also, the ability of the
Equity Simulation Segment of the Fund's portfolio to replicate
the opportunity and risk profile of a hypothetical stock
portfolio may be diminished by imperfect correlations between
price movements of the S&P 500 Index itself with price movements
of S&P 500 and Other Stock Index Futures and/or the common
stocks purchased by the Fund. In addition, the purchase and
sale of common stocks and S&P 500 and Other Stock Index Futures
involve transaction costs and Equity Swap Contracts require the
Fund to pay interest on the notional amount of the contract.
Therefore, if the aggregate face amount of the Fund's S&P 500
and Other Stock Index Futures, the notional amount of the
Fund's Equity Swap Contracts (less the notional amount of any
Reverse Equity Swap Contracts) and the value of the Fund's
common stocks is equal to the Fund's total net assets, and if
there is exact price movement correlation between the Fund's
common stocks and/or S&P 500 Index and Other Stock Index Futures
and the S&P 500 Index, the Fund will outperform the S&P 500
Index only if the total net return on the Fixed Income Segment
of the Fund's portfolio exceeds the sum of (1) the Fund's
transaction costs on S&P 500 and Other Stock Index Futures and
common stock transactions, (2) the interest payments under the
Fund's Equity Swap Contracts and (3) all the Fund's operating
expenses as described more fully under "Management of the Fund."
The Equity Plus Fund will not enter into any Equity Swap
Contract or Reverse Equity Swap Contract unless, at the time of
entering into such transaction, the unsecured senior debt of the
counterparty is rated at least A by Moody's Investors Service,
Inc. ("Moody's") or Standard & Poor's ("S&P"). In addition, the
staff of the SEC considers Equity Swap Contracts and Reverse
Equity Swap Contracts to be illiquid securities. Consequently,
while the staff maintains this position, the Fund will not
invest in Equity Swap Contracts or Reverse Equity Swap Contracts
if, as a result of the investment, the total value of such
investments together with that of all other illiquid securities
which the Fund owns would exceed 15% of the Fund's total assets.
The Adviser and the Equity Plus Fund do not believe that the
Fund's obligations under Equity Swap Contracts or Reverse Equity
Swap Contracts are senior securities, so long as a segregated
account is maintained, and, accordingly, the Fund will not treat
them as being subject to its borrowing restrictions. The net
amount of the excess, if any, of the Fund's obligations over its
entitlements with respect to each Equity Swap Contract and each
Reverse Equity Swap Contract will be accrued on a daily basis
and an amount of cash, U.S. Government Securities or other
liquid high quality debt securities having an aggregate market
value at least equal to the accrued excess will be maintained in
a segregated account by the Fund's custodian.
The Equity Plus Fund will not purchase S&P 500 or Other Stock
Index Futures, except for bona fide hedging purposes, if as a
result the Fund's aggregate initial margin deposits and premiums
would be greater than 5% of the Fund's total assets. In
addition to margin deposits, when the Fund purchases an S&P 500
or Other Stock Index Futures Contract, it is required to
maintain at all times while the contract is held by the Fund,
cash, U.S. government securities or other liquid high quality
debt obligations in a segregated account with its Custodian, in
an amount which, together with the initial margin deposit on the
futures contract, is equal to the current delivery or cash
settlement value of the futures contract.
The Fund will not use Equity Swap Contracts, or S&P 500 or Other
Stock Index Futures for leverage.
Characteristics of the Securities in which the Equity Segment of
the Equity Plus Fund may invest.
Equity Swap Contracts. The Equity Simulation Segment will use
equity swap contracts whose return (before deducting interest
costs) is expected to track closely the return of the S&P 500
Index ("Equity Swap Contracts"). The counterparty to an Equity
Swap Contract will typically be a bank, investment banking firm
or broker/dealer. The counterparty generally agrees to pay the
Fund the amount, if any, by which the notional amount of the
Equity Swap Contract would have increased in value had it been
invested in the stocks comprising the S&P 500 Index in
proportion to the composition of the Index, plus the dividends
that would have been received on those stocks. The Fund agrees
to pay to the counterparty a floating rate of interest
(typically the London Inter Bank Offered Rate) on the notional
amount of the Equity Swap Contract plus the amount, if any, by
which that notional amount would have decreased in value had it
been invested in such stocks. Therefore, the return to the Fund
on any Equity Swap Contract should be the gain or loss on the
notional amount plus dividends on the stocks comprising the S&P
500 Index (as if the Fund had invested the notional amount in
stocks comprising the S&P 500 Index) less the interest paid by
the Fund on the notional amount. The Fund will enter into
Equity Swap Contracts only on a net basis, i.e., where the two
parties' obligations are netted out, with the Fund paying or
receiving, as the case may be, only the net amount of any
payments. Payments under an Equity Swap Contract may be made at
the conclusion of the contract or periodically during its term.
If there is a default by the counterparty to an Equity Swap
Contract, the Fund will be limited to contractual remedies
pursuant to the agreements related to the transaction. There is
no assurance that Equity Swap Contract counterparties will be
able to meet their obligations pursuant to Equity Swap Contracts
or that, in the event of default, the Fund will succeed in
pursuing contractual remedies. The Fund thus assumes the risk
that it may be delayed in or prevented from obtaining payments
owed to it pursuant to Equity Swap Contracts. The Fund will
closely monitor the credit of Equity Swap Contract
counterparties in order to minimize this risk.
The Fund may from time to time enter into the opposite side of
Equity Swap Contracts (i.e., where the Fund is obligated to pay
the increase (net of interest) or receive the decrease (plus
interest) on the S&P 500 Index) to reduce the amount of the
Fund's equity market exposure consistent with the Fund's
objective. These positions are sometimes referred to as
"Reverse Equity Swap Contracts".
S&P 500 Index and Other Stock Index Futures. The Equity
Simulation Segment of the Fund may also invest in S&P 500 and
Other Stock Index Futures to track the return of the S&P 500
Index.
S&P 500 and Other Stock Index Futures represent contracts to buy
a number of units of the S&P 500 Index or some other stock index
at a specified future date at a price agreed upon when the
contract is made. Upon entering into a contract, the Fund will
be required to deposit with its custodian in a segregated
account in the name of the futures broker a specified amount of
cash or securities, generally not exceeding 5% of the face
amount of the contract. This amount is known as "initial
margin" and is in the nature of a performance bond or good faith
deposit on the contract which is returned to the Fund upon
termination of the futures contract, assuming all contractual
obligations have been satisfied. Subsequent payments, called
"variation margin" to and from the broker will be made on a
daily basis as the price of the S&P 500 or Other Stock Index
Future fluctuates.
Long positions in S&P 500 or Other Stock Index Futures may be
closed out only by entering into a futures contract sale with
the same terms as the contract to be closed out on the futures
exchange on which the futures are traded. The liquidity of the
market in S&P 500 or Other Stock Index Futures could be
adversely affected by "daily price fluctuation limits"
established by an exchange which limit the amount of fluctuation
in the price of an S&P 500 or Other Stock Index Futures contract
during a single trading day. In such case, it may not be
possible for the Fund to close out its futures contract
position, and, in the event of adverse price movements, the Fund
would continue to be required to make daily cash payments of
variation margin.
Common Stocks. When S&P 500 or Other Stock Index Futures and/or
Equity Swap Contracts are, in the judgement of the Adviser,
overpriced relative to the common stocks underlying the S&P 500
Index, the Fund may also invest directly in the common stocks
represented by the S&P 500 Index. The Fund will generally not
own all 500 issues, but will attempt to purchase a basket of
common stocks which the Adviser expects will, on average, match
movements in the S&P 500 Index. Subject to limits on the Fund's
investments in other investment companies, the Fund may also
invest in these stocks indirectly by purchasing interests in
asset pools investing in such stocks. To the extent that the
Fund purchases interests in other investment companies,
shareholders of the Fund may be subject to a layering of
expenses because they may indirectly bear a proportionate share
of the expenses of such investment companies (including advisory
fees) in addition to bearing the direct expenses of the Fund.
Investment Policies of the Short and Intermediate Series and the
Fixed Income Segment of the Equity Plus Fund.
The Short and Intermediate Series each seek to achieve their
investment objective by investing, under normal circumstances,
at least 70% of their total assets in fixed-income U.S.
Government securities. The Fixed Income Segment of the Equity
Plus Fund will also invest substantially in U.S. Government
securities." U.S. Government Securities" include U.S. Treasury
Bills, Notes, Bonds, discount notes and other debt securities
issued by the U.S. Treasury, and obligations issued or
guaranteed by the U.S. Government, its agencies and
instrumentalities, including, but not limited to Government
National Mortgage Association ("GNMA"), Federal National
Mortgage Association ("FNMA") and Federal Home Loan Mortgage
Corporation ("FHLMC") securities. (Other U.S. Government
agencies or instrumentalities include Federal Home Loan Banks,
Bank for Cooperatives, Farm Credit Banks, Tennessee Valley
Authority, Federal Financing Bank, Small Business
Administration, and Federal Agricultural Mortgage Corporation.)
It is anticipated that the Funds will invest substantially in
FNMA, FHLMC, and GNMA mortgage-backed certificates and other
U.S. Government Securities representing ownership interests in
mortgage pools.
With respect to their remaining assets, the Short and
Intermediate Series may invest in fixed-rate and adjustable-rate
mortgage-backed securities issued by private originators of, or
investors in, mortgage loans issued by private entities that are
rated AAA by Standard & Poor's ("S&P") or Aaa by Moody's
Investors Service ("Moody's") or, if unrated, determined by the
Adviser to be of comparable quality. The two Series may also
invest in money market instruments of a comparable short-term
rating or credit quality, as well as in time and savings
deposits (including fixed-rate or adjustable-rate certificates
of deposit) in commercial banks or in institutions whose
accounts are insured by the FDIC, BIF or SAIF. The Short and
Intermediate Series will not pay any additional fees for credit
support and will not invest in private mortgage pass-through
securities unless they are rated AAA by S&P or Aaa by Moody's,
or are unrated but deemed to be of comparable credit quality by
the Adviser. In addition, the Short and Intermediate Series
will only purchase mortgage-backed securities which constitute
"Mortgage Related Securities" for purposes of the Secondary
Mortgage Market Enhancement Act of 1984.
With respect to the remaining assets of the Equity Plus Fund,
its Fixed Income Segment may invest a portion of its assets in
bank certificates of deposit, corporate debt obligations, and
mortgage-backed and other asset-backed securities of
non-governmental issuers. At the time of purchase, with the
exception of mortgage-backed and asset-backed securities, the
Fund's Fixed Income Segment's investments will be either of
investment grade (as rated by S&P or Moody's), or, if unrated,
determined by the Adviser to be of comparable quality. Its
investment in mortgage-backed and other asset-backed securities
will be rated at least A by Moody's and S&P. The lowest quality
investment grade fixed income securities are rated BBB by
Moody's or Baa by S&P, have certain speculative
characteristics, and are more susceptible to adverse changes in
circumstances and economic conditions than higher rated fixed
income securities. The Adviser will monitor the Equity Plus
Fund's investments in fixed income securities and will cause the
Equity Plus Fund to dispose of any such security whose rating is
reduced to below investment grade.
While certain U.S. Government securities such as U.S. Treasury
obligations and GNMAs are backed by the full faith and credit of
the U.S. Government, other securities in which the Funds may
invest are subject to varying degrees of risk of default. These
risk factors include the creditworthiness of the issuer and, in
the case of mortgage-backed and asset-backed securities, the
ability of the mortgagor or other borrower to meet its
obligations. The Short and Intermediate Series will seek to
minimize this credit risk by investing in securities of the
highest credit quality instruments, while the Equity Plus Fund
will seek to minimize this risk of default by investing in
securities of investment grade. The individual securities
continue to be subject to the risk that their prices can
fluctuate, in some cases significantly, due to changes in
prevailing interest rates.
The Short and Intermediate Series may employ certain active
management techniques both to hedge the interest rate risks
associated with portfolio securities and to seek to minimize
fluctuation in net asset values in accordance with their
investment objectives and targeted option-adjusted durations.
In addition, the Fixed Income Segment of the Equity Plus Fund
will engage in various hedging strategies so that its volatility
will be similar to that of a one-year Treasury Bill. Such
investment techniques and hedging strategies include mortgage
and interest rate swaps, interest rate futures and options on
such futures, short sales and interest rate caps, floors and
collars. In addition, the Short and Intermediate Series may
use stripped mortgage-backed securities to reduce the
option-adjusted duration. Appendix A provides information about
these hedging techniques.
There can be no assurance that the hedging techniques employed
by the Short and Intermediate Series and the Fixed Income
Segment of the Equity Plus Fund will be successful. As a
result, the Funds may not achieve, and may at times exceed,
their targeted option-adjusted duration. The Funds' hedging
techniques may not be successful because the Adviser's
computation of option-adjusted duration is based on estimates of
expected prepayment rates, valuation of homeowners' prepayment
options, and the correlation of changes in the market prices of
the securities and the hedge instruments owned by the Funds (as
described in Appendix A).
Both of the Series, as well as the Fixed Income Segment of the
Equity Plus Fund, may also engage in loans of portfolio
securities, dollar rolls and reverse repurchase agreements as
investment techniques. These techniques will be undertaken to
enhance income and total return.
Characteristics of the Securities in which the Short and
Intermediate Series and Fixed Income Segment of the Equity Plus
Fund Invest.
Mortgage-Backed and Other Asset-Backed Securities.
Mortgage-backed securities are securities that directly or
indirectly represent a participation in, or are collateralized
by and payable from, mortgage loans secured by real property.
The term "mortgage-backed securities", as used herein, includes
adjustable-rate mortgage securities, fixed-rate mortgage
securities, and derivative mortgage products such as
collateralized mortgage obligations, stripped mortgage-backed
securities and other instruments described below.
There are currently three basic types of mortgage-backed
securities: (i) those issued or guaranteed by the U.S.
Government or one of its agencies or instrumentalities, such as
GNMA, FNMA and FHLMC; (ii) those issued by private issuers that
represent an interest in or are collateralized by
mortgage-backed securities issued or guaranteed by the U.S.
Government or one of its agencies or instrumentalities; and
(iii) those issued by private issuers that represent an interest
in or are collateralized by whole mortgage loans or
mortgage-backed securities without a government guarantee but
usually having some form of private credit enhancement.
The Equity Plus Fund may invest in other mortgage-backed and
asset-backed securities. Asset-backed securities are
structured like mortgage-backed securities, but instead of
mortgage loans or interests in mortgage loans, the underlying
assets may include, but are not limited to, pools of automobile
loans, educational loans and credit card receivables.
Mortgage-backed and asset-backed securities have yield and
maturity characteristics corresponding to their underlying
assets. Unlike traditional debt securities, which may pay a
fixed rate of interest until maturity when the entire principal
amount comes due, payments on certain mortgage-backed and
asset-backed securities include both interest and a partial payment of
principal. This partial payment of principal may be comprised
of a scheduled principal payment as well as an unscheduled
payment from the voluntary prepayment, refinancing, or
foreclosure of the underlying loans. As a result of these
unscheduled payments of principal, or prepayments on the
underlying securities, the price and yield of mortgage-backed
securities can be adversely affected. For example, during
periods of declining interest rates, prepayments can be expected
to accelerate, and the Funds would be required to reinvest the
proceeds at the lower interest rates then available.
Prepayments of mortgages which underlie securities purchased at
a premium could result in capital losses because the premium may
not have been fully amortized at the time the obligation is
prepaid. In addition, like other interest-bearing securities,
the values of mortgage-backed securities generally fall when
interest rates rise, but when interest rates fall, their
potential for capital appreciation is limited due to the
existence of the prepayment feature. In order to hedge against
possible prepayment, the Funds may purchase certain options and
options on futures contracts as described more fully in Appendix
A.
Adjustable-Rate Securities. Adjustable-rate securities are
securities that have interest rates that are reset at periodic
intervals, usually by reference to some interest rate index or
market interest rate. Some adjustable-rate securities are
backed by pools of mortgage loans. The Short and Intermediate
Series will only invest in adjustable-rate securities backed by
pools of mortgage loans ("ARMs"). The Fixed Income Segment of
the Equity Plus Fund may invest in adjustable-rate securities
backed by assets other than mortgage pools.
Although the rate adjustment feature may act as a buffer to
reduce large changes in the value of adjustable-rate securities,
these securities are still subject to changes in value based on
changes in market interest rates or changes in the issuer's
creditworthiness. Because the interest rate is reset only
periodically, changes in the interest rates on adjustable-rate
securities may lag changes in prevailing market interest rates.
Also, some adjustable-rate securities (or the underlying
mortgages or other underlying loans or receivables) are subject
to caps or floors that limit the maximum change in interest rate
during a specified period or over the life of the security.
Because of the resetting of interest rates, adjustable-rate
securities are less likely than non-adjustable-rate securities
of comparable quality and maturity to increase significantly in
value when market interest rates fall. Adjustable-rate
securities are also subject to the prepayment risks associated
with mortgage-backed securities generally.
Collateralized Mortgage Obligations ("CMOs") A CMO is a
security backed by a portfolio of mortgages or mortgage-backed
securities held under an indenture. The issuer's obligation to
make interest and principal payments is secured by the
underlying portfolio of mortgages or mortgage-backed securities.
CMOs are issued with a number of classes or series which have
different maturities representing interests in some or all of
the interest or principal on the underlying collateral or a
combination thereof. Payments of interest or principal on some
classes or series of CMOs may be subject to contingencies, or
some classes or series may bear some or all of the risk of
default on the underlying mortgages. CMOs of different classes
are generally retired in sequence as the underlying mortgage
loans in the mortgage pools are repaid. In the event of
sufficient early prepayments on such mortgages, the class or
series of CMO first to mature generally will be retired prior to
its stated maturity. Thus, the early retirement of a particular
class or series of a CMO held by the Funds would have the same
effect as the prepayment of mortgages underlying a
mortgage-backed pass-through security. Another type of CMO is
a real estate mortgage investment conduit ("REMIC") which
qualifies for special tax treatment under the Internal Revenue
Code and invests in certain mortgages principally secured by
interests in real property and other permitted investments.
CMOs also include securities representing the interest in any
excess cash flow and/or the value of any collateral remaining
after the issuer has applied cash flow from the underlying
mortgages or mortgage-backed securities to the payment of
principal of and interest on all other CMOs and the
administrative expenses of the issuer ("Residuals"). Residuals
have value only to the extent that income from such underlying
mortgages or mortgage-backed securities exceeds the amounts
necessary to satisfy the issuer's debt obligations represented
by all other outstanding classes or series of the CMOs. In
addition, if a CMO bears interest at an adjustable-rate, the
cash flows on the related Residual will also be extremely
sensitive to the level of the index upon which the rate
adjustments are based. As a non-fundamental policy (meaning it
can be changed without the vote of the shareholders), the Short
and Intermediate Series will not invest in Residuals.
In reliance on an interpretation by the Securities and Exchange
Commission ("SEC"), the Funds' investments in certain qualifying
CMOs and REMICs are not subject to the 1940 Act's limitations on
acquiring interests in other investment companies. See
"Investment Restrictions" in the Statement of Additional
Information with respect to each Fund. CMOs and REMICs issued
by an agency or instrumentality of the U.S. Government are
considered U.S. Government securities for the purposes of this
Prospectus.
Stripped Securities ("STRIPS"). The Funds may invest in
STRIPS. The Short and Intermediate Series may invest only in
stripped mortgage-backed securities ("SMBS") which are STRIPS
represented by derivative multi-class mortgage securities. In
addition to SMBS issued by the U.S. Government, its agencies or
instrumentalities, the Short and Intermediate Series may
purchase SMBS issued by private originators of, or investors in,
mortgage loans, including depository institutions, mortgage
banks, investment banks and special purpose subsidiaries of
these entities. However, the Short and Intermediate Series will
purchase only SMBS that are collateralized by mortgage-backed
securities that are issued or guaranteed by the U.S. Government
or its agencies or instrumentalities. The Equity Plus Fund may
invest in STRIPS collateralized by other fixed income
securities, including other types of asset-backed securities.
STRIPS are usually structured with two classes that receive
different proportions of the interest and principal
distributions from a pool of underlying assets. A common type of
STRIP will have one class receiving all of the interest from the
underlying assets ("interest-only" or "IO" class), while the
other class will receive all of the principal ("principal-only"
or "PO" class). However, in some instances, one class will
receive some of the interest and most of the principal while the
other class will receive most of the interest and the remainder
of the principal. STRIPS are unusually volatile in response to
changes in interest rates. The yield to maturity on an IO class
of STRIPS is extremely sensitive not only to changes in
prevailing interest rates but also to the rate of principal
payments (including prepayments) on the underlying assets. A
rapid rate of principal prepayments may have a measurably
adverse effect on a Fund's yield to maturity to the extent it
invests in IOs. Conversely, POs tend to increase in value if
prepayments are greater than anticipated and decline if
prepayments are slower than anticipated. Thus, if the
underlying assets experience greater than anticipated
prepayments of principal, a Fund may fail to fully recover its
initial investment in these securities, even if the STRIPS were
rated of the highest credit quality by S&P or Moody's,
respectively. The Adviser will seek to manage these risks (and
potential benefits) by investing in a variety of such securities
and by using certain hedging techniques, as described below in
"Hedging Instruments" and in Appendix A. In addition, the
secondary market for STRIPS may be less liquid than that for
other mortgage-backed or asset-backed securities, potentially
limiting a Fund's ability to buy or sell those securities at any
particular time.
The Adviser expects that IO SMBS will be purchased by the Short
and Intermediate Series for their hedging characteristics. Such
SMBS will reduce the variance of the Funds' respective net asset
values from their targeted option-adjusted durations. Under no
circumstances will the Short or Intermediate Series purchase
SMBS if such purchase would cause SMBS to exceed 5% of the
assets of a Fund.
New instruments and variations of existing mortgage-backed
securities continue to be developed. The Funds may invest in
any such instruments or variations to the extent consistent with
their investment objectives and policies and applicable
regulatory requirements.
Zero Coupon Securities. The Funds may also invest in "zero
coupon" securities (which are issued at a significant discount
from face value and pay interest only at maturity rather than at
intervals during the life of the security). Zero coupon
securities tend to be more volatile than other securities with
similar stated maturities, but which make regular payments of
either principal or interest.
The Funds are required to accrue and distribute income from zero
coupon securities on a current basis, even though a Fund does
not receive the income currently. Thus, a Fund may have to sell
other investments to obtain cash needed to make income
distributions, which may reduce a Fund's assets and may thereby
increase its expense ratio and decrease its rate of return.
Hedging Instruments. The Funds may employ certain active
management techniques to achieve their duration objectives and
to hedge the interest-rate risks associated with their
fixed-income securities in accordance with such objectives. Since
some of the securities may have longer or shorter durations than
a Fund's specified duration objectives, hedging may be required
either to lengthen or to shorten the duration of a Fund's
portfolio. The Funds will seek continually to manage duration
within a narrow range.
The Funds intend to use hedging transactions primarily to
protect against interest-rate fluctuations and not as
speculative transactions. The Funds may also use hedging
transactions as a temporary substitute for purchasing particular
securities. Each Fund may enter into mortgage and
interest-rate swaps, purchase or sell interest-rate floors, caps or
collars, enter into interest-rate futures contracts and related
options, and engage in short sales to hedge against interest
rate fluctuations. In addition, the Funds may use SMBS to
better maintain their respective targeted option-adjusted
durations.
Any or all of these techniques may be used at one time. Use of
any particular transaction is a function of market conditions.
The hedging transactions that the Funds currently contemplate
using are described in detail in Appendix A, including a
discussion of their respective risks.
As a matter of fundamental policy, the Short and Intermediate
Series will limit purchases to the following classes of assets:
1. Securities issued directly or guaranteed by the U.S. Government or
its agencies or instrumentalities;
2. Mortgage-Backed Securities rated AAA by S&P or Aaa by Moody's or
unrated but deemed of equivalent quality by the Adviser;
3. Assets fully collateralized by assets in either of the above classes;
4. Assets which would qualify as liquidity items under federal
regulations if held by a commercial bank or savings institution; and
5. Hedge instruments,which may only be used for risk management
purposes. Any securities described in the "Hedging" section
and any stripped Mortgage-Backed Securities may only be used for risk
management purposes.
OTHER INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Funds may also engage in the following investment practices,
each of which may involve certain special risks. The Statement
of Additional Information for each Fund contains more detailed
information about these practices, including limitations
designed to reduce these risks.
Securities Loans, Repurchase Agreements and Forward Commitments.
The Funds may lend portfolio securities to broker-dealers and
may enter into repurchase agreements. These transactions must
be fully collateralized at all times but involve some risk to
the Funds if the other party should default on its obligations
and a Fund is delayed or prevented from recovering the
collateral. None of the Funds will lend portfolio securities
if, as a result, the aggregate of such loans exceeds 33 1/3% of
the total asset value (including such loans.) The Funds will
only enter into repurchase agreements with or lend securities to
(i) member banks of the Federal Reserve System having total
assets in excess of $500 million and (ii) securities dealers,
provided such banks or dealers meet the creditworthiness
standards established by the Board of Trustees ("Qualified
Institutions"). The Adviser will monitor the continued
creditworthiness of Qualified Institutions, subject to the
oversight of the Board of Trustees.
The Funds may also purchase securities for future delivery,
which may increase overall investment exposure and involves a
risk of loss if the value of the securities declines prior to
the settlement date. At the time a Fund enters into a
transaction on a when-issued or forward commitment basis, a
segregated account consisting of cash, U.S. Government
securities or other liquid high grade debt securities equal to
at least 100% of the value of the when-issued or forward
commitment securities will be established and maintained with
the Funds' custodian. Subject to this requirement, the Funds
may purchase securities on such basis without limit.
Settlements in the ordinary course, which may be substantially
more than three business days for mortgage-backed securities,
are not treated as when-issued or forward commitment
transactions, and are not subject to the foregoing limitations,
although some of the risks described above may exist.
Reverse Repurchase Agreements, Dollar Roll Agreements and
Borrowing. In order to increase income, the Funds may enter
into reverse repurchase agreements or dollar roll agreements
with commercial banks and registered broker-dealers in amounts
up to 33 1/3% of their assets. The Short and Intermediate Series
may only enter into these transactions with commercial banks and
registered broker-dealers which are also Qualified Institutions.
The Statement of Additional Information for each Fund contains
a more detailed explanation of these practices. Reverse
repurchase agreements and dollar rolls are considered borrowings
by a Fund and require segregation of assets with a Fund's
custodian in an amount equal to the Fund's obligations pending
completion of such transactions. Each Fund may also borrow
money from banks in an amount up to 33 1/3% of a Fund's total
assets to realize investment opportunities, for extraordinary or
emergency purposes, or for the clearance of transactions.
Borrowing from banks usually involves certain transaction and
ongoing costs and may require a Fund to maintain minimum bank
account balances. Use of these borrowing techniques to purchase
securities is a speculative practice known as "leverage."
Depending on whether the performance of the investments
purchased with borrowed funds is sufficient to meet the costs of
borrowing, a Fund's net asset value per share will increase or
decrease, as the case may be, more rapidly than if the Fund did
not employ leverage.
Short Sales. The Funds may make short sales of securities. A
short sale is a transaction in which the Fund sells a security
it does not own in anticipation that the market price of that
security will decline. The Funds expect to engage in short
sales as a form of hedging to shorten the overall duration of
the portfolio and in order to maintain portfolio flexibility.
When a Fund makes a short sale, it must borrow the security sold
short and deliver it to the broker-dealer through which it made
the short sale as collateral for its obligation to deliver the
security upon completion of the transaction. A Fund may have to
pay a fee to borrow particular securities and is often obligated
to relinquish any payments received on such borrowed securities.
Until a Fund replaces a borrowed security, it will maintain
daily a segregated account with its custodian containing cash,
U.S. Government securities, or other liquid high-grade debt
obligations, such that the amount deposited in the account plus
any amount deposited with the broker as collateral will equal
the current value of the security sold short. Depending on
arrangements made with the broker, a Fund may not receive any
payments (including interest) on collateral deposited with the
broker. If the price of the security sold short increases
between the time of the short sale and the time a Fund replaces
the borrowed security, the Fund will incur a loss; conversely,
if the price declines, the Fund will realize a gain. Although
a Fund's gain is limited to the amount at which it sold the
security short, its potential loss is limited only by the
maximum attainable price of the security less the price at which
the security was sold.
A Fund will not make a short sale if, after giving effect to
such sale, the market value of all securities sold exceeds 25%
of the value of the Fund's total net assets. A Fund may also
effect short sales where the Fund owns or has the right to
acquire at no additional cost the identical security (a
technique known as a short sale "against the box").
Illiquid Securities. A Fund may invest up to 15% of its net
assets in securities for which there are legal or contractual
restrictions on resale or for which there is no readily
available market or other illiquid securities, including
non-terminable repurchase agreements having maturities of more
than seven days. See "Investment Restrictions" in the Statement
of Additional Information for each Fund. The Adviser will
monitor a Fund's investments in illiquid securities under the
supervision of the Trustees. The determination of whether
certain IO/PO Strips issued by the U.S. Government and backed by
fixed-rate mortgages or any other securities in which a Fund
desires to invest are liquid shall be made by the Trustees or
the Adviser under guidelines established by the Trustees in
accordance with applicable pronouncements of the SEC. At
present, all other IO/PO Strips, other residual interests of
CMOs and OTC options are treated as illiquid securities. The
SEC staff also currently takes the position that the interest
rate swaps, caps and floors discussed in Appendix A, as well as
Equity Swap Contracts and Reverse Equity Swap Contracts, are
illiquid.
Portfolio Turnover. The Adviser buys and sells securities for
a Fund whenever it believes it is appropriate to do so.
Portfolio turnover generally involves some expense to a Fund,
including brokerage commissions or dealer mark-ups and other
transaction costs on the sale of securities and reinvestment in
other securities. Such transactions may result in realization
of taxable capital gains. The portfolio turnover rate for each
Fund's previous fiscal periods is shown in the table under the
heading "Financial Highlights".
While the Funds will pay commissions in connection with options
and future transactions and, for the Equity Plus Fund only,
possibly in relation to any purchase of common stocks, most of
the securities in which the Funds invest are generally traded on
a "net" basis with dealers acting as principals for their own
account without a stated commission. Nevertheless, high
portfolio turnover may involve correspondingly greater brokerage
commissions and other transaction costs which will be borne
directly by a Fund.
Another potential consequence of high portfolio turnover is that
if 30% or more of a Fund's gross income for a taxable year is
derived from gains from the sale of securities held for less
than three months, the Fund would not qualify as a regulated
investment company and, therefore, would be subject to
corporate income tax during that taxable year. The Adviser
endeavors to manage the investment composition of the Funds and
to adjust the portfolio turnover, if necessary, to ensure that
each Fund will be eligible for treatment as a regulated
investment company.
MANAGEMENT OF THE FUNDS
The business affairs of the Funds are managed by its Board of
Trustees. Each of the Funds has entered into an investment
advisory agreement with Smith Breeden Associates, Inc., 100
Europa Drive, Chapel Hill, North Carolina, 27514 ( the
"Investment Advisory Agreements"). Pursuant to such investment
advisory agreements, the Adviser furnishes continuous investment
advisory services to each of the Funds.
Trustees and Officers
The following is a listing of the Trustees and officers of the
Series Fund and Trust, the legal entities that have issued
shares in the Funds. Unless otherwise indicated, all of the
named individuals serve in their capacities for both the Series
Fund and Trust.
<PAGE>
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 has served as Associate Editor for five journals in
financial economics, and was elected to the Board of Directors
of the American Finance Association. He has published several
well-cited articles in finance and economics journals. He holds
a Ph.D. in Finance from the Stanford University Graduate School
of Business, and a B.S. in Management Science from the
Massachusetts Institute of Technology. He is a Director of
Roosevelt Bank of St. Louis, the nation's tenth largest thrift,
and served as Chairman in 1995-96. He also is a principal
investor and strategist for Community First Financial Group, a
commercial bank holding company with three small banks located
in Indiana and California. He serves as Chairman of Harrington
Financial Group, the holding company for Harrington Bank,
F.S.B., of Richmond, Indiana.
Michael J. Giarla* Trustee and President
Mr. Giarla is 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 1991-1993. Mr. Giarla holds a
Master of Business Administration with Concentration in Finance
from the Stanford University Graduate School of Business, where
he was an Arjay Miller Scholar. He earned a Bachelor of Arts in
Statistics, summa cum laude, from Harvard University, where he
was elected to Phi Beta Kappa and was a Harvard Club of Boston
Scholar. Mr. Giarla is a Trustee of the Roxbury Latin School,
West Roxbury, Massachusetts.
Stephen M. Schaefer Trustee
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at
the London Business School. Previously on the Faculty of the
Graduate School of Business of Stanford University, he has also
taught at the Universities of California (Berkeley), Chicago,
British Columbia and Venice. His research interests focus on
capital markets and financial regulation. He has served on the
editorial board of a number of professional journals including,
currently, the Journal of Fixed Income, the Review of Derivative
Research, and Ricerche Economiche. He consults for a number of
leading financial institutions and is a former Independent Board
Member of the Securities and Futures Authority of Great Britain.
<PAGE>
Myron S. Scholes Trustee
Myron S. Scholes is the Frank E. Buck Professor of Finance at
the Graduate School of Business at Stanford University (since
1983); a Senior Research Fellow at the Hoover Institution (since
1987); and is currently on leave as a Professor of Law, Stanford
Law School. He is a Principal in the money management firm
Long-Term Capital Management Co. (since 1993). He is a Research
Associate of the National Bureau of Economic Research and is a
member of the Econometric Society. Professor Scholes was also
a Managing Director and co-head of the fixed income derivatives
group at Salomon Brothers between 1991-1993. Prior to coming to
Stanford University, Professor Scholes was the Edward Eagle
Brown Professor of Finance at the Graduate School of Business,
University of Chicago (1974-1983). He served as the Director of
the University of Chicago's Center for Research in Security
Prices from 1974-1980. Prior to coming to the University of
Chicago, Professor Scholes was first an Assistant Professor then
an Associate Professor at the Sloan School of Management at
M.I.T. from 1968 to 1973. He received his Ph.D. in 1969 from
the Graduate School of Business, University of Chicago. He has
honorary Doctor of Law degrees from the University of Paris and
McMaster University. He is a past president of the American
Finance Association (1990).
Dr. Scholes has published numerous articles in academic journals
and in professional volumes. He is most noted as the
co-originator of the Black-Scholes Options Pricing Model as
described in the paper, "The Pricing of Options and Corporate
Liabilities," published in the Journal of Political Economy (May
1973) (with Fischer Black). His other papers include such
topics as risk-return relationships, the effects of dividend
policy on stock prices, and the effects of taxes and tax policy
on corporate decision making. His book with Mark Wolfson
(Stanford University) Taxes and Business Strategy: A Planning
Approach was published by Prentice Hall in 1991.
William F. Sharpe Trustee
William F. Sharpe is the STANCO 25 Professor of Finance at
Stanford University's Graduate School of Business. He is best
known as one of the developers of the Capital Asset Pricing
Model, including the beta and alpha concepts used in risk
analysis and performance measurement. He developed the
widely-used binomial method for the valuation of options and
other contingent claims. He also developed the computer
algorithm used in many asset allocation procedures, and a
procedure for estimating the style of an investment manager from
its historic returns. Dr. Sharpe has published articles in a
number of professional journals. He has also written six books,
including Portfolio Theory and Capital Markets, (McGraw-Hill,
1970), Asset Allocation Tools, (Scientific Press, 1987),
Fundamentals of Investments (with Gordon J. Alexander and
Jeffery Bailey, Prentice-Hall, 1993) and Investments (with
Gordon J. Alexander and Jeffrey Bailey, Prentice-Hall, 1990).
Dr. Sharpe is a past President of the American Finance
Association. He has also served as consultant to a number of
corporations and investment organizations. He is also a member
of the Board of Trustees of Rosenberg Series Trust, an
investment company, and a director at CATS Software and Stanford
Management Company. He received the Nobel Prize in Economic
Sciences in 1990.
<PAGE>
Daniel C. Dektar Vice President, Smith Breeden Series Fund
Portfolio Manager, Short and Intermediate Series
Principal, Executive Vice President, Director of Portfolio
Management, and Director of Smith Breeden Associates. Mr.
Dektar has been primarily responsible for the day-to-day
management of the Short and Intermediate Series from their
commencement of 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 has made several presentations on mortgage
investments and risk management at seminars for institutional
investors. Mr. Dektar was an Associate in the Mergers and
Acquisitions Group of Montgomery Securities in San Francisco,
California and a Financial Analyst in the Investment Banking
Division of Morgan Stanley & Co., Incorporated, New York before
joining Smith Breeden Associates. He holds a Master of Business
Administration with Concentration in Finance from Stanford
University Graduate School of Business, where he was an Arjay
Miller Scholar. Mr. Dektar received a Bachelor of Science in
Business Administration, summa cum laude, from the University of
California at Berkeley, where he was University of California
Regent's Scholar, was elected to Phi Beta Kappa and Phi Eta
Sigma, and won the White Award as the top student in finance.
John B. Sprow Vice President, Smith Breeden Trust
Portfolio Manager, Equity Plus Fund
Principal, Director and Executive Vice President, Smith Breeden
Associates. Mr. Sprow has been primarily responsible for the
day-to-day management of the Equity Plus Fund from the
commencement of its operations in 1992. Mr. Sprow is a senior
portfolio manager who works primarily with discretionary pension
accounts. In addition to traditional mortgage accounts, he
manages S&P 500 indexed accounts. Prior to directly managing
discretionary accounts, Mr. Sprow's research and programming
efforts assisted in the development of the Adviser's models for
pricing and hedging mortgage-related securities, risky
commercial debt, and forecasting mortgage prepayment behavior.
Mr. Sprow came to Smith Breeden Associates from the Fuqua School
of Business, Duke University, where he was Research Assistant.
Previously, Mr. Sprow was a Research Assistant to the Department
Head of the Materials Science Department, Cornell University.
He received a Master of Business Administration with Emphasis in
Finance from the Fuqua School of Business, Duke University. Mr.
Sprow holds a Bachelor of Science in Materials Science and
Engineering from Cornell University, where he was awarded the
Carpenter Technology Scholarship three successive years.
Marianthe S. Mewkill Vice President, Secretary, Treasurer,
and Chief Accounting Officer
Principal, Vice President and Chief Financial Officer, Smith
Breeden Associates. Ms. Mewkill handles financial reporting,
budgeting, tax research and planning for the Smith Breeden
Mutual Funds and for Smith Breeden Associates, Inc.. She
ensures compliance with agency regulations and administers the
company's internal trading and other policies. She was
previously employed as a Controller for the Hunt Alternatives
Fund, as an Associate at Goldman Sachs & Co., and as a Senior
Auditor at Arthur Andersen & Co. She earned a Master of
Business Administration with Concentrations in Finance and
Accounting from New York University and graduated from Wellesley
College, magna cum laude with a Bachelor of Arts degree in
History and French and a Minor in Economics.
* Interested Party
Investment Adviser
Smith Breeden Associates, Inc., a registered investment adviser,
acts as investment adviser to the Funds. Approximately 66% of
the Adviser's voting stock is owned by Douglas T. Breeden, its
Chairman and President. 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
affairs. For these services, the Adviser receives a fee,
computed daily, and payable monthly, at the annual rate of 0.70%
of the Funds' average daily net assets. Until March 31, 1997,
the Adviser has voluntarily agreed to reduce its compensation,
and to the extent necessary absorb other expenses of the Funds,
such that the total expenses (exclusive of ordinary brokerage
commissions, investment transaction taxes and extraordinary
expenses) do not exceed 0.88% of the average net assets for each
of the Equity Plus Fund and the Intermediate Series, and 0.78%
of the average net assets of the Short Series.
The Adviser places all orders for purchases and sales of the
Funds' securities. Subject to seeking the most favorable price
and execution available, the Adviser may consider sales of
shares of the Funds as a factor in the selection of broker-dealers.
Distribution
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 also may be sold
by authorized dealers who have entered into dealer agreements
with the Principal Underwriter or the Adviser.
Expenses
The Funds pay all of their own expenses, including without
limitation, the cost of preparing and printing their
registration statements required under the Securities Act of
1933 and the 1940 Act and any amendments thereto, the expense of
registering their shares with the Securities and Exchange
Commission and the various states, the printing and distribution
costs of prospectuses mailed to existing investors, reports to
investors, reports to government authorities and proxy
statements, fees paid to directors who are not interested
persons of the Adviser, interest charges, taxes, legal expenses,
association membership dues, auditing services, insurance
premiums, brokerage commissions and expenses in connection with
portfolio transactions, fees and expenses of the custodian of
their assets, printing and mailing expenses and charges and
expenses of dividend disbursing agents, accounting services
agents, registrars and stock transfer agents.
<PAGE>
PRICING OF FUND SHARES
The price you pay when buying a Fund's shares, and the price you
receive when selling (redeeming) a Fund's shares, is the net
asset value of the shares next determined after receipt of a
purchase or redemption request in proper form. No front end
sales charge or commission of any kind is added by the Fund upon
a purchase and no charge is deducted upon a redemption. The
Funds currently charge a $9 fee for each redemption made by
wire. See "How to Redeem Shares."
The per share net asset value of a Fund is determined by
dividing the total value of its assets, less its liabilities, by
the total number of its shares outstanding at that time. The net
asset value is determined as of the close of regular trading
(currently 4:00 p.m. Eastern time) each day that the Adviser and
Transfer Agent are open for business and on which there is a
sufficient degree of trading in a Fund's securities such that
the net asset value of a Fund's shares might be affected.
Accordingly, Purchase Applications accepted or redemption
requests received in proper form by the Transfer Agent, or other
agent designated by the Funds, prior to 4:00 p.m. Eastern time,
each day that the Adviser and Transfer Agent are open for
business, will be confirmed at that day's net asset value.
Purchase Applications accepted or redemption requests received
in proper form after 4 p.m Eastern Time by the Transfer Agent,
or other agent designated by the Funds, will be confirmed at the
net asset value of the following business day.
Current holiday schedules indicate that the Funds' net asset
values will not be calculated on New Year's Day, President's
Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day, the day following Thanksgiving, Christmas Eve
and Christmas Day. In addition, the Short and Intermediate
Series will not be priced on Martin Luther King Day, Columbus
Day and Veterans' Day.
Under procedures approved by the Board of Trustees, a Fund's
securities for which market quotations are readily available are
valued at current market value provided by a pricing service,
bank or broker/dealer experienced in such matters. Short-term
investments that will mature in 60 days or less may be valued at
amortized cost, which approximates market value. All other
securities and assets are valued at fair market value as
determined following procedures approved by the Board of
Trustees.
HOW TO PURCHASE SHARES
All of the Funds are no-load, so you may purchase, redeem or
exchange shares directly at net asset value without paying a
sales charge. Because the Funds' net asset value changes daily,
your purchase price will be the next net asset value determined
after the Funds' Transfer Agent, or other agent designated by
the Funds, receives and accepts your purchase order. See
"Pricing of Fund Shares."
Initial Minimum
Minimum Additional
Type of Account Investment Investment
Regular $250 $50
Automatic Investment Plan $50 $50
Individual Retirement ]
Account $250 $50
Gift to Minors $250 $50
Each Fund reserves the right to reject any order for the
purchase of its shares or to limit or suspend, without prior
notice, the offering of its shares. The required minimum
investments may be waived in the case of qualified retirement
plans.
How to Open Your Account by Mail. Please complete the Purchase
Application. You can obtain additional copies of the Purchase
Application and a copy of the IRA Purchase Application from the
Funds by calling 1-800-221-3138. (Please note that you must use
a different application than the one provided in the prospectus
for an IRA.)
Your completed Purchase Application should be mailed directly
to:
Smith Breeden Mutual Funds
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, Inc.
Account Number 98-7037-071-9
For credit to (identify which Fund to purchase)
For further credit to: (investor account number)
(name or account registration)
(Social Security or Tax Identification Number)
Following such wire transfer, you must promptly complete a
Purchase Application and mail it to the Funds at the following
address: Smith Breeden Mutual Funds, 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 will be made available to
shareholders when opening an account, if they check the
appropriate boxes on the Purchase Application. Each Fund will
employ reasonable procedures to ensure that instructions
communicated by telephone are genuine. If reasonable procedures
are not implemented, the Funds may be liable for any loss due to
unauthorized or fraudulent transactions. In all other cases, you
are liable for any loss for unauthorized transactions. The
Funds reserve the right to refuse a telephone transaction if
they believe it advisable to do so.
If you have any questions, please call the Funds at
1-800-221-3137.
How to Add to Your Account. You may make additional investments
by mail or by wire in an amount equal to or greater than $50.
When adding to an account by mail, you should send the Funds
your check, together with the additional investment form from a
recent statement. If this form is unavailable, you should send
a signed note giving the full name of the account and the
account number. For additional investments made by wire
transfer, you should use the wiring instructions listed above.
Be sure to include your account number.
Automatic Investment Plan. You may make purchases of shares of
each Fund automatically on a regular basis ($50 minimum per
transaction). You must meet the Automatic Investment Plan's
("the Plan") minimum initial investment of $50 before the Plan
may be established. Under the Plan, your designated bank or
other financial institution debits a preauthorized amount from
your account each month and applies the amount to the purchase
of Fund shares. The Plan can be implemented with any financial
institution that is a member of the Automated Clearing House. No
service fee is currently charged by the Funds for participation
in the Plan. A $20 fee will be imposed by the Funds if
sufficient funds are not available in your account or if your
account has been closed at the time of the automatic
transaction. You may adopt the Plan at the time an account is
opened by completing the appropriate section of the Purchase
Application. You may obtain an application to establish the
Automatic Investment Plan after an account is opened by calling
the Funds at 1-800-221-3138. In the event you discontinue
participation in the Plan, the Funds reserve the right to redeem
your Fund account involuntarily, upon sixty days' written
notice, if the account's net asset value is $250 or less.
Purchasing Shares Through Other Institutions. If you purchase
shares through a program of services offered or administered by
a broker-dealer, financial institution, or other service
provider, you should read the program materials, including
information relating to fees, in addition to this Prospectus.
Certain services of a Fund may not be available or may be
modified in connection with the program of services provided,
and service providers may establish higher minimum investment
amounts. The Funds may only accept requests to purchase
additional shares into a broker-dealer street name account from
the broker-dealer.
Certain broker-dealers, financial institutions, or other service
providers that have entered into an agreement with the Adviser
or Principal Underwriter may enter purchase orders on behalf of
their customers by phone, with payment to follow within several
days as specified in the agreement. The Funds may effect such
purchase orders at the net asset value next determined after
receipt of the telephone purchase order. It is the
responsibility of the broker-dealer, financial institution, or
other service provider to place the order with the Funds on a
timely basis. If payment is not received within the time
specified in the agreement, the broker-dealer, financial
institution, or other service provider could be held liable for
any resulting fees or losses.
Miscellaneous. The Funds will charge a $20 service fee against
your account for any check or electronic funds transfer that is
returned unpaid. You will also be responsible for any losses
suffered by the Funds as a result. In order to relieve you of
responsibility for the safekeeping and delivery of stock
certificates, the Funds do not currently issue certificates.
<PAGE>
HOW TO EXCHANGE SHARES
Shares of any Fund may be exchanged for shares of another Fund
at any time. This exchange offer is available only in states
where shares of such other Fund may be legally sold. You may
open a new account, or purchase additional shares in an existing
account, by making an exchange from an identically registered
Smith Breeden Fund account. A new account will have the same
registration as the existing account from which the exchange was
made, and is subject to the same initial investment minimum
($250).
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
privilege can be adopted by checking the appropriate box on the
Purchase Application. The telephone exchange privilege is
available only for uncertificated shares. During periods of
drastic economic or market changes, it is possible that
exchanges by telephone may be difficult to implement. In this
event, shareholders should follow the written exchange
procedures. The telephone exchange privilege may be modified or
discontinued by the Funds at any time upon 60 days' notice to
the shareholders. To exchange by telephone, you must follow the
instructions below under "How to Redeem by Telephone."
The Funds will accept exchange orders by telephone or other
means of electronic transmission from broker-dealers, financial
institutions or other service providers who execute an agreement
with the Adviser or Principal Underwriter. It is the
responsibility of the broker-dealer, financial institution or
other service provider to place the exchange order on a timely
basis.
Exchanges are made on the basis of the Funds' relative net asset
values. Because the exchange is considered a redemption and
purchase of shares, the shareholder may recognize a gain or loss
for federal income tax purposes. Backup withholding and
information reporting may also apply. Additional information
regarding the possible tax consequences of such an exchange is
included under the caption "Additional Information on
Distributions and Taxation" in the Funds' Statements of
Additional Information.
There are differences among the Funds. Before making an
exchange, a shareholder should obtain and review the current
prospectus of the Fund into which the shareholder wishes to
transfer. When exchanging shares, shareholders should be aware
that the Funds may have different dividend payment dates. The
dividend payment schedules should be checked before exchanging
shares. The amount of any accumulated, but unpaid, dividend is
included in the net asset value per share.
If you buy shares by check, you may not exchange those shares
for up to 10 calendar days to ensure your check has cleared. If
you intend to exchange shares soon after their purchase, you
should purchase the shares by wire or contact the Funds at
1-800-221-3137 for further information.
The Funds reserve the right to temporarily or permanently
terminate, with or without advance notice, the exchange
privilege of any investor who makes excessive use of the
exchange privilege (e.g., more than five exchanges per calendar
year).
Additional documentation may be required for exchange requests
if shares are registered in the name of a corporation,
partnership or fiduciary. Please contact the Funds for
additional information concerning the exchange privilege.
HOW TO REDEEM SHARES
You may redeem shares of the Funds at any time. The price at
which the shares will be redeemed is the net asset value per
share next determined after proper redemption instructions are
received by the Transfer Agent or other agent designated by the
Funds. See "Pricing of Fund Shares." There are no charges for
the redemption of shares except that a fee of $9 is charged for
each wire redemption. Depending upon the redemption price you
receive, you may realize a capital gain or loss for federal
income tax purposes.
How to Redeem by Mail to Receive Proceeds by Check. To redeem
shares by mail, simply send an unconditional written request to
the Funds specifying the number of shares or dollar amount to be
redeemed, the name of the Fund, the name(s) on the account
registration and the account number. A request for redemption
must be signed exactly as the shares are registered. If the
amount requested is greater than $25,000, or the proceeds are to
be sent to a person other than the recordholder or to a location
other than the address of record, each signature must be
guaranteed by a commercial bank or trust company in the United
States, a member firm of the National Association of Securities
Dealers, Inc. or other eligible guarantor institution. A notary
public is not an acceptable guarantor. Guarantees must be signed
by an authorized signatory of the bank, trust company, or member
firm and "Signature Guaranteed" must appear with the signature.
Additional documentation may be required for the redemption of
shares held in corporate, partnership or fiduciary accounts. In
case of any questions, please contact the Funds in advance.
A Fund will mail payment for redemption within seven days after
receiving proper instructions for redemption. However, the Funds
will delay payment for 10 calendar days on redemptions of recent
purchases made by check. This allows the Funds to verify that
the check used to purchase Fund shares will not be returned due
to insufficient funds and is intended to protect the remaining
investors from loss.
How to Redeem by Telephone. To redeem shares by telephone, you
must have selected this option on the Purchase Application. Once
this feature has been requested, shares may be redeemed by
calling the Funds at 1-800-221-3137. Proceeds redeemed by
telephone will be mailed to your address, or wired or credited
to your preauthorized bank account. To establish wire
redemption privileges, you must select the appropriate box on
the Purchase Application and enclose a voided check.
In order to arrange for telephone redemptions after your account
has been opened or to change the bank account or address
designated to receive redemption proceeds, you must send a
written request to your Fund. The request must be signed by each
registered holder of the account with the signatures guaranteed
by a commercial bank or trust company in the United States, a
member firm of the National Association of Securities Dealers,
Inc. or other eligible guarantor institution. A notary public is
not an acceptable guarantor. Further documentation as provided
above may be requested from corporations, executors,
administrators, trustees and guardians.
Payment of the redemption proceeds for Fund shares redeemed by
telephone where you request wire payment will normally be made
in federal funds on the next business day. The Funds reserve the
right to delay payment for a period of up to seven days after
receipt of the redemption request. There is currently a $9 fee
for each wire redemption. It will be deducted from your account.
The Funds reserve the right to refuse a telephone redemption or
exchange transaction if it believes it is advisable to do so.
Procedures for redeeming or exchanging shares of the Funds by
telephone may be modified or terminated by the Funds at any
time. In an effort to prevent unauthorized or fraudulent
redemption or exchange requests by telephone, the Funds have
implemented procedures designed to reasonably assure that
telephone instructions are genuine. These procedures include:
requesting verification of certain personal information;
recording telephone transactions; confirming transactions in
writing; and restricting transmittal of redemption proceeds only
to preauthorized designations. Other procedures may be
implemented from time to time. If reasonable procedures are not
implemented, the Funds may be liable for any loss due to
unauthorized or fraudulent transactions. In all other cases, you
are liable for any loss for unauthorized transactions.
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 the $250 minimum as a result
of a redemption or exchange or if you discontinue the Automatic
Investment Plan before your account balance reaches the required
minimum, you will be given a 60-day notice to reestablish the
minimum balance or activate an Automatic Investment Plan. If
this requirement is not met, your account may be closed and the
proceeds sent to you.
Check Writing. In addition to telephone and written redemption
requests, the Short Series offers redemption through check
writing. Shareholders electing this option will receive checks
that may be used like personal or business checks. There is no
limit on the number of checks you may write. Checks must be at
least $100 and may not exceed $25,000. There is a $30 fee for
returned checks. Because dividends declared on shares held in
a shareholder's account, prior redemptions, and possible changes
in net asset value may cause the value of the account to change,
shareholders should not write a check for the entire value of
the account or close the account by writing a check.
In using the check writing privilege, shareholders bear the
responsibility of ensuring that the check amount does not exceed
the value of their account on the day the check is presented to
the Transfer Agent for payment. The day the check is presented
for payment is the day the redemption of Fund shares takes
place. If insufficient shares are in the account, the check
will be returned and no shares will be redeemed. The clearing
agent for the check writing facility is United Missouri Bank.
Shareholders utilizing check writing are subject to United
Missouri Bank's rules governing checking accounts. However,
this check writing facility is purely a means to redeem Fund
shares. No facilities characteristic of bank accounts, such as
deposit insurance, are being provided along with the check
writing option.
If you would like to initiate check writing, please call
Shareholder Services at 1-800-221-3137 or check the appropriate
box on the Purchase Application.
Systematic Withdrawal Plan. A shareholder may establish a
Systematic Withdrawal Plan and receive regular periodic payments
from the account. An initial balance of $10,000 is required to
establish a Systematic Withdrawal Plan. There are no service
charges for establishing or maintaining a Systematic Withdrawal
Plan. The minimum amount which the shareholder may withdraw
periodically is $100. Capital gain distributions and income
dividends to the shareholder's account are received in
additional shares at net asset value. Payments are then made
from the liquidation of shares at net asset value to meet the
specified withdrawals. Liquidation of shares may reduce or
possibly exhaust the shares in the shareholder's account, to the
extent withdrawals exceed shares earned through dividends and
distributions, particularly in the event of a market decline.
No payment pursuant to a Systematic Withdrawal Plan will be made
if there are insufficient shares on deposit on the date of the
scheduled distribution. A subsequent deposit of shares will not
result in a payment under the plan retroactive to the
distribution date. As with other redemptions, a liquidation to
make a withdrawal payment is a sale for federal income tax
purposes. The entire Systematic Withdrawal Plan payment cannot
be considered as actual yield or income since part of the Plan's
payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated upon written
notice by the shareholder, or by a Fund on 30 days written
notice, and it will terminate automatically if all shares are
liquidated or withdrawn from the account or upon the Fund's
receipt of notification of the death or incapacity of the
shareholder. Shareholders may change the amount (but not below
the specified minimums), and schedule of withdrawal payments, or
suspend such payments, by giving written notice to the Transfer
Agent at least five business days prior to the next scheduled
payment. Share certificates may not be issued while a
Systematic Withdrawal Plan is in effect.
DIVIDENDS AND DISTRIBUTIONS
The Short and Intermediate Series intend to make monthly
distributions to their shareholders of net investment income.
The Equity Plus Fund intends to make quarterly distributions of
net investment income. All Funds will distribute net realized
gains at least annually. Each Fund may make additional
distributions if necessary to avoid imposition of a 4% excise
tax or other tax on undistributed income and gains.
The monthly distributions for the Short Series' shares are
quoted ex-dividend on the business day after record date (the
"ex-date"). Record date is usually the first or second business
day of the month. If a shareholder elects to reinvest
dividends, the date the dividends are reinvested is also the ex-date.
Dividends are paid in cash by the Short Series generally
one week after the ex-date.
The Intermediate Series will declare daily dividends for
shareholders of record. The Intermediate Series' dividend
payable date, and the day that dividends are reinvested for
shareholders who have made this election is the last business
day of the month. Shares begin accruing dividends on the
business day after federal funds (funds credited to a member
bank's account at the Federal Reserve Bank) are available from
the purchase payment for such shares and continue to accrue
dividends through, and including, the day the redemption order
for the shares is executed. If an investor closes his account,
any accrued dividends, through and including the day of
redemption, will be paid as part of the redemption proceeds.
Dividends and capital gains distributions may be declared more
or less frequently at the direction of the Trustees. In order
to be entitled to a dividend or a distribution, an investor must
acquire a Fund's shares on or before the record date. Caution
should be exercised, however, before purchasing shares
immediately prior to a distribution record date. Because the
value of a Fund's shares is based directly on the amount of its
net assets, rather than on the principle of supply and demand,
any distribution of income or capital gain will result in a
decrease in the value of its shares equal to the amount of the
distribution. While a dividend or capital gain distribution
received shortly after purchasing shares represents, in effect,
a return of the shareholder's investment, it may be taxable as
dividend income or capital gain. You may separately elect to
reinvest income dividends and capital gains distributions in
shares of a Fund or receive cash as designated on the Purchase
Application. You may change your election at any time by sending
written notification to your Fund. The election is effective for
distributions with a dividend record date on or after the date
that the Funds receive notice of the election. If you do not
specify an election, all income dividends and capital gains
distributions will automatically be reinvested in full and
fractional shares of a Fund. Reinvested dividends and
distributions receive the same tax treatment as those paid in
cash.
SHAREHOLDER REPORTS AND INFORMATION
The Funds will provide the following statements and reports:
Confirmation and Account Statements. After each transaction
that affects the account balance or account registration,
including the payment of dividends, you will receive a
confirmation statement.
Form 1099. By January 31 of each year, all shareholders will
receive Form 1099 which will report the amount and tax status of
distributions paid to you by the Funds for the preceding
calendar year.
Financial Reports. Financial reports are provided to
shareholders semiannually. Annual reports will include audited
financial statements. To reduce the Funds' expenses, one copy of
each report will be mailed to each Taxpayer Identification
Number even though the investor may have more than one account
in a Fund.
Reports to Depository Institutions. Shareholders of the Short
or Intermediate Series who are financial institutions may
request receipt of monthly or quarterly reports which provide
information about the Short or Intermediate Series' investments
considering regulatory risk-based asset categories.
If you need additional copies of previous statements, you may
order statements for the current and preceding year at no
charge. Call 1-800-221-3137 to order past statements. If you
need information on your account with the Funds or if you wish
to submit any applications, redemption requests, inquiries or
notifications, please contact: Smith Breeden Mutual Funds, 3200
Horizon Drive, P.O. Box 61503, King of Prussia, PA 19406-0903 or
call 1-800-221-3137.
<PAGE>
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. 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
(including SAR-SEPs), 401(k), profit-sharing and money purchase
pension plans ("Retirement Plans"). For details concerning
Retirement Plans, please call 1-800-221-3138.
SERVICE AND DISTRIBUTION PLANS
Each Fund has adopted a Distribution and Services Plan (the
"Plans") pursuant to Rule 12b-1 under the 1940 Act. The purpose
of the Plans is to permit the Adviser to compensate investment
dealers and other persons involved in servicing shareholder
accounts for services provided and expenses incurred in
promoting the sale of shares of the Funds, reducing redemptions,
or otherwise maintaining or improving services provided to
shareholders by such dealers or other persons. The Plans
provide for payments by the Adviser out of its advisory fee to
dealers and other persons at an annual rate of up to 0.25% of a
Fund's average net assets, subject to the authority of the
Trustees to reduce the amount of payments permitted under the
Plan or to suspend the Plan for such periods as they may
determine. Subject to these limitations, the amount of such
payments and the purposes for which they are made shall be
determined by the Adviser.
Any distribution and servicing related payments made by the
Adviser to investment dealers or other persons are subject to
the continuation of the Plans, the terms of any related service
agreements, and any applicable limits imposed by the National
Association of Securities Dealers, Inc.
TAXES
Each Fund intends to qualify as a regulated investment company
under the Internal Revenue Code. In each taxable year that a
Fund so qualifies, such Fund (but not its shareholders) will be
relieved of federal income tax on the part of its net investment
income and net capital gain that is distributed to shareholders.
Each Fund will distribute annually substantially all of its net
investment income and net capital gains on a current basis.
All Fund distributions from net investment income (whether paid
in cash or reinvested in additional shares) will be taxable to
its shareholders as ordinary income, except that any
distributions of a Fund's net long-term capital gain will be
taxable to its shareholders as long-term capital gain,
regardless of how long they have held their Fund shares. Each
Fund provides federal tax information to its shareholders
annually about distributions paid during the preceding year.
It is not anticipated that any of the Funds' distributions will
qualify for either the corporate dividends-received deduction or
tax-exempt interest income. Distributions will also probably be
subject to state and local taxes depending on each shareholder's
tax situation. While many states grant tax-free status to
mutual fund distributions paid from interest income earned from
direct obligations of the U.S. Government, none of the Short or
Intermediate Series' distributions are expected to qualify for
such tax-free treatment, and only an insignificant amount of the
Equity Plus Fund's distributions are expected to so qualify.
The Funds will be required to withhold federal income tax at a
rate of 31% ("backup withholding") from distribution payments
and redemption and exchange proceeds if you fail to properly
complete the Purchase Application.
The foregoing is only a summary of some of the important federal
tax considerations generally affecting each Fund and its
shareholders. See "Taxes" in the relevant Statement of
Additional Information for further discussion. There may be
other federal, state or local tax considerations applicable to
you as an investor. You therefore are urged to consult your tax
adviser regarding any tax-related issues.
CAPITAL STRUCTURE
The Smith Breeden Trust, which issues shares in the Equity Plus
Fund, and the Smith Breeden Series Fund, which issues shares in
the Short and Intermediate Series, are both Massachusetts
business trusts. The Trust was organized under an Agreement and
Declaration of Trust, dated December 18, 1991. The Series Fund
was organized under an Agreement and Declaration of Trust dated
October 3, 1991. Copies of both Agreements, which are governed
by Massachusetts law, are on file with the Secretary of State of
the Commonwealth of Massachusetts. The Trust and the Series
Fund have the same Trustees.
The Trustees have the authority to issue shares in an unlimited
number of series of either the Series Fund or Trust. Each such
series of shares may be further divided into classes. The assets
and liabilities of each such series will be separate and
distinct. All shares when issued are fully paid, non
assessable, and redeemable and have equal voting, dividend and
liquidation rights.
Shareholders of the separate series of the Series Fund or Trust
will vote together in electing trustees and in certain other
matters. Shareholders in each series of the Series Fund should
be aware that the outcome of the election of trustees and of
certain other matters could be controlled by the shareholders of
the other series. The shares have noncumulative voting rights,
which means that holders of more than 50% of the shares voting
for the election of the trustees can elect 100% of the trustees
if they choose to do so.
Although neither the Series Fund nor the Trust is required to
hold annual meetings of its shareholders, shareholders have the
right to call a meeting to elect or remove trustees, or to take
other actions as provided in the respective Declaration of
Trust. Upon written request by the holders of at least 1% of
the outstanding shares stating that such shareholders wish to
communicate with the other shareholders for the purpose of
obtaining the signatures necessary to demand a meeting to
consider the removal of a trustee, both the Series Fund and
Trust have undertaken to provide a list of shareholders or to
disseminate appropriate materials (at the expense of the
requesting shareholders).
Under Massachusetts law, shareholders of a business trust may,
under certain circumstances, be held personally liable as
partners for its obligations. However, the risk of a
shareholder incurring financial loss on account of shareholder
liability is limited to circumstances in which both (i) any
liability was greater than a Fund's insurance coverage and (ii)
a Fund itself was unable to meet its obligations.
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 which securities are
to be purchased or sold for the Funds' portfolios. Deloitte &
Touche, LLP, has been selected to serve as independent auditors
of the Company for the fiscal year ending March 31, 1997.
FUND PERFORMANCE
Each Fund may quote the Fund's average annual total and/or
aggregate total return for various time periods in
advertisements or communications to shareholders. An average
annual total return refers to the rate of return which, if
applied to an initial investment at the beginning of a stated
period and compounded over that period, would result in the
redeemable value of the investment at the end of the period
assuming reinvestment of all dividends and distributions and
reflecting the effect of all recurring fees. An investor's
principal in each Fund and the Fund's return are not guaranteed
and will fluctuate according to market conditions. When
considering "average" total return figures for periods longer
than one year, you should note that a Fund's annual total return
for any one year in the period might have been greater or less
than the average for the entire period. Each Fund also may use
"aggregate" total return figures for various periods,
representing the cumulative change in value of an investment in
the Fund for a specific period (again reflecting changes in the
Fund's share price and assuming reinvestment of dividends and
distributions).
The Short and Intermediate Series may also advertise current
yield and distribution rate information. Current yield reflects
the income per share earned by the Short or Intermediate Series'
portfolio investments, and is calculated by dividing a Fund's
net investment income per share during a recent 30-day period by
a Fund's net asset value on the last day of that period and
annualizing the result. The current yield (or "SEC Yield"),
which is calculated according to a formula prescribed by the SEC
(see the relevant Statement of Additional Information), is not
indicative of the dividends or distributions which were or will
be paid to a Series' shareholders. SEC regulations require that
net investment income be calculated on a "yield-to-maturity"
basis, which has the effect of amortizing any premiums or
discounts in the current market value of fixed income
securities. Dividends or distributions paid to shareholders are
reflected in the current distribution rate which may be quoted
to shareholders, and may not reflect amortization in the same
manner.
The Fund may also compare its performance to that of other
mutual funds and to stock and other relevant indices or to
rankings prepared by independent services or industry
publications. For example, a Fund's total return may be compared
to data prepared by Lipper Analytical Services, Inc.,
Morningstar, Inc., Value Line Mutual Fund Survey and CDA
Investment Technologies, Inc. Total return data as reported in
such national financial publications as The Wall Street Journal,
The New York Times, Investor's Business Daily, USA Today,
Barron's, Money and Forbes as well as in publications of a local
or regional nature, may be used in comparing Fund performance.
The Equity Plus Fund's total return may also be compared to the
returns of such indices as the Dow Jones Industrial Average,
Standard & Poor's 500 Composite Stock Price Index, Nasdaq
Composite OTC Index or Nasdaq Industrials Index, Consumer Price
Index and Russell 2000 Index. The Short Series' total return may
also be compared that of taxable money funds as quoted in
Donaghue's Money Fund Report and to total returns for the six
month U.S. Treasury as published by Merrill Lynch or other
suppliers. The Intermediate Series' return will most likely be
compared to the total return of the Salomon Brothers Mortgage
Index, or the total return of intermediate U.S. Treasury Notes
as published by various brokerage firms and others. Further
information on performance measurement may be found in the
relevant Statement of Additional Information.
Performance quotations of a Fund represent the Fund's past
performance and should not be considered representative of
future results. The investment return and principal value of an
investment in a Fund will fluctuate so that an investor's
shares, when redeemed, may be worth more or less than their
original cost. The methods used to compute a Fund's total return
and yield are described in more detail in the relevant Statement
of Additional Information.
<PAGE>
APPENDIX A
Hedging Instruments and Transactions (Short and Intermediate
Series and Equity Plus Fund's Fixed Income Segment)
Hedging and risk management techniques require different skills
from those involved in the selection of portfolio securities.
One such skill is the ability to predict the correlation of
interest rate changes between markets. The Adviser has been
engaged in hedging target duration portfolios for more than ten
years. There can be no assurance that the Adviser will
accurately predict market movements which accompany interest
rate changes, in which event a Fund's overall performance may be
less than if the Fund had not entered into hedging transactions.
Interest Rate and Mortgage Swaps, Caps, Floors and Collars.
Interest rate swaps involve the exchange by a Fund with another
party of their respective commitments to pay or receive
interest, for example, an exchange of floating-rate payments for
fixed-rate payments. Mortgage swaps are similar to interest
rate swaps in that they represent commitments to pay and receive
interest. The notional principal amount, however, is tied to a
reference pool or pools of mortgages.
The Short or Intermediate Series will enter into interest rate
swaps only on a net basis, i.e., where the two payment streams
are netted out, with a Fund receiving or paying, as the case may
be, only the net amount of the two payments. The Fixed Income
Segment of the Equity Plus Fund may enter into interest rate
swaps on other than a net basis.
The purchase of an interest rate cap entitles the purchaser, to
the extent that a specified index exceeds a predetermined
interest rate, to receive payments of interest on a notional
principal amount from the party selling such interest rate cap.
The purchase of an interest rate floor entitles the purchaser,
to the extent that a specified index falls below a predetermined
interest rate, to receive payments of interest on a notional
principal amount from the party selling such interest rate
floor. An interest rate collar combines the elements of
purchasing a cap and selling a floor. The collar protects
against an interest rate rise above the maximum amount but gives
up the benefits of an interest rate decline below the minimum
amount. There can be no assurance that the Funds will be able to
enter into interest rate swaps, caps, floors or collars on
favorable terms. Furthermore, there can be no assurance that
any of the Funds will be able to terminate an interest rate swap
or sell or offset interest rate caps, floors or collars
notwithstanding any terms in the agreements providing for such
termination.
Inasmuch as these hedging transactions are entered into for
hedging purposes, the Adviser and the Funds believe swaps, caps,
floors and collars do not constitute senior securities and,
accordingly, will not treat them as being subject to its
borrowing restrictions. The net amount of the excess, if any,
of a Fund's obligations over its entitlement with respect to
each interest rate swap will be accrued on a daily basis and an
amount of cash or liquid securities having an aggregate net
asset value at least equal to the accrued excess will be
maintained in a segregated account by a custodian that satisfies
the requirements of the 1940 Act. To the extent that the Fixed
Income Segment of the Equity Plus Fund enters into interest rate
swaps on other than a net basis, the amount maintained in its
segregated account will be the full amount of the Fund's
obligations, if any, with respect to such interest rate swaps,
accrued on a daily basis.
The Short and Intermediate Series will not write interest rate
caps, floors and collars and will not enter into any interest
rate swap, cap, floor or collar transaction unless the unsecured
commercial paper, unsecured senior debt or the claims-paying
ability of the other party is rated either AA or A-1 or better
by Standard & Poor's or Aa or P-1 or better by Moody's Investors
Service, Inc., at the time of entering into such transaction.
The Fixed Income Segment of the Equity Plus Fund may enter into
such transactions with counterparties who are rated at least A
by Moody's and S&P at the time of entering into the contract.
The Funds and the Adviser will closely monitor, subject to the
oversight of the Board of Trustees, the creditworthiness of the
contract counterparties in order to minimize risk.
If there is a default by the other party to such a transaction,
the Funds will have contractual remedies pursuant to the
agreements related to the transaction. There is no assurance
that interest-rate swap, cap, floor or collar counterparties
will be able to meet their obligations pursuant to their
contracts, or that, in the event of default, a Fund will succeed
in pursuing contractual remedies. The Funds thus assume the
risk that one of them may be delayed in or prevented from
obtaining payments owed to it pursuant to interest rate swaps,
caps, floors or collars.
The swap, cap, floor and collar market has grown substantially
in recent years with a large number of banks and investment
banking firms acting both as principals and as agents utilizing
standardized documentation. As a result, this market has become
relatively liquid, although the Funds will still treat these
instruments as illiquid investments subject to the limitation on
such investments described in the Prospectus at "Illiquid
Securities".
Calls and Puts on Securities. In order to reduce fluctuations
in net asset value and portfolio holdings relative to their
targeted option-adjusted duration, a Fund may purchase call or
put options or sell options where it owns the security which is
the subject of the option (a "covered option") on United States
Treasury securities, mortgage-backed securities and Eurodollar
instruments that are traded on United States and
foreign-securities exchanges and in over-the-counter markets
("OTC Options"). A Fund will not sell options which are not
covered. The premiums paid on call options purchased and any
related transaction costs will increase the cost of securities
acquired upon exercise of the option, and unless the price of
the underlying security rises sufficiently, the options may
expire worthless to the Funds.
The Short and Intermediate Series will not purchase a put or
call option on U.S. Government securities or mortgage-backed
securities if, as a result of such purchase, more than 10% of
its total assets would be invested in such options. A Fund's
ability to purchase put and call options may be limited by
Internal Revenue Code requirements.
The Adviser monitors the creditworthiness of dealers with whom
a Fund would enter into OTC option transactions under the
general supervision of the Board of Trustees. The Funds will
engage in OTC option transactions only with primary United
States government securities dealers recognized by the Federal
Reserve Bank of New York.
Futures and Related Options. In order to reduce fluctuations in
net asset value of portfolio holdings relative to their targeted
option-adjusted durations or to employ temporary substitutes for
anticipated future transactions, the Funds may buy or sell
financial futures contracts, purchase call or put options, or
sell covered call options on such futures. There is no overall
limitation on the percentage of a Fund's assets which may be
subject to a hedge position.
Options and futures transactions involve costs and may result in
losses. The effective use of options and futures strategies
depends on a Fund's ability to terminate options and futures
positions at times when the Adviser deems it desirable to do so.
This ability to terminate positions when the Adviser deems it
desirable to do so may be hindered by the lack of existence of
a liquid secondary market. Although a Fund will take an options
or futures contract position only if the Adviser believes there
is a liquid secondary market for the option or futures contract,
there is no assurance that a Fund will be able to effect
closing transactions at any particular time or at an acceptable
price.
The use of options and futures strategies also involves the risk
of imperfect correlation between movements in the values of the
securities underlying the futures and options purchased and sold
by a Fund, of the option and futures contract itself, and of
the securities which are the subject of a hedge. A Fund,
therefore, bears the risk that prices of hedged securities will
not move to the same degree as the hedging instrument or that
price movements in the hedging instrument will not accurately
reflect price movements in the security underlying the hedging
instrument. It is also possible for a Fund to incur a loss on
both the hedged securities and the hedging instrument.
At times, a Fund may sell interest rate futures in a different
dollar amount than the dollar amount of securities being hedged,
depending on the expected relationship between the volatility of
the prices of such securities and the volatility of the futures
contracts, based on duration calculations by the Adviser. If
the actual price movements of the securities and futures are
inconsistent with their durations as so calculated, the hedge
may not be fully effective.
A Fund will not maintain open short positions in interest rate
futures contracts if, in the aggregate, the value of the open
positions (marked to market) exceeds the current market value of
its securities portfolio plus or minus the unrealized gain or
loss on these open positions, adjusted for the expected
volatility relationship between the portfolio and the futures
contracts based on duration calculations. If this limitation
should be exceeded at any time, a Fund will take prompt action
to close out the appropriate number of open contracts to bring
its open futures position into compliance with this limitation.
The Funds' ability to engage in options and futures transactions
and to sell related securities may be limited by tax
considerations and by certain regulatory requirements. See
"Additional Information Regarding Taxation" in the relevant
Statement of Additional Information.
Other Portfolio Strategies (Equity Plus Fund's Equity Simulation
Segment)
Any investment in warrants, valued at the lower of cost or
market, may not exceed 5% of the value of the Equity Plus Fund's
net assets. Included within that amount, but not to exceed 2%
of the value of the Equity Plus Fund's net assets, may be
warrants which are not listed on the New York or American Stock
Exchange. Warrants acquired by the Equity Plus Fund in units or
attached to securities may be deemed to be without value.
SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ADDITIONAL INFORMATION
FEBRUARY 18, 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 "Fund"), a no-load open-end management investment
company offering redeemable shares of beneficial interest
in two separate series, the Smith Breeden Short Duration
U.S. Government Series (the "Short Series") and the Smith
Breeden Intermediate Duration U.S. Government Series (the
"Intermediate Series"). This Statement of Additional
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
February 18, 1997, as may be amended from time to time.
This Statement should be read with the Prospectus.
Contents Page
MISCELLANEOUS INVESTMENT PRACTICES AND RISK
CONSIDERATIONS . . . . . . . . . . . . . . . . . . . 2
INVESTMENT RESTRICTIONS. . . . . . . . . . . . . . . 5
TRUSTEES AND OFFICERS. . . . . . . . . . . . . . . . 7
INVESTMENT ADVISORY AND OTHER SERVICES . . . . . . . 7
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING
PERSONS . . . . . . . . . . . . . . . . . . . . . . 9
POLICIES REGARDING BROKERS USED IN PORTFOLIO
TRANSACTIONS . . . . . . . . . . . . . . . . . . . .10
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES. . . . . . . . .11
ADDITIONAL INFORMATION REGARDING TAXATION. . . . . .12
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . .14
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS .18
EXPERTS. . . . . . . . . . . . . . . . . . . . . . .18
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . .18
APPENDIX . . . . . . . . . . . . . . . . . . . . . .19
<PAGE>
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS
Investment Policies
The following supplements the information contained in
the Prospectus about the investment policies of the
Short and Intermediate Series (the "Series"). Terms used
herein have the same meanings as in the Prospectus.
The Fund's Prospectus states that the Series may engage
in each of the following investment practices. However,
the fact that the Series may engage in a particular
practice does not necessarily mean that it will actually
do so.
Repurchase Agreements. The Series may invest in
repurchase agreements. A repurchase agreement is a
contract under which a Series acquires a security for a
relatively short period (usually not more than one week)
subject to the obligation of the seller to repurchase and
the Series to resell such security at a fixed time and
price (representing the Series' cost plus interest). It
is the Series' present intention to enter into repurchase
agreements only with commercial banks and registered
broker-dealers and only with respect to obligations of
the U.S. Government or its agencies or instrumentalities.
Repurchase agreements may also be viewed as loans made by
a Series which are collateralized by the securities
subject to repurchase. The Adviser will monitor such
transactions to determine that the value of the
underlying securities is at least equal at all times to
the total amount of the repurchase obligation, including
the interest factor. If the seller defaults, the Series
could realize a loss on the sale of the underlying
security to the extent that the proceeds of sale
including accrued interest are less than the resale price
provided in the agreement including interest. In
addition, if the seller should be involved in bankruptcy
or insolvency proceedings, the Series may incur delay and
costs in selling the underlying security or may suffer a
loss of principal and interest if the Series is treated
as an unsecured creditor and required to return the
underlying collateral to the seller's estate.
Forward Commitments. The Series may enter into contracts
to purchase securities for a fixed price at a future date
beyond customary settlement time ("forward commitments"
and "when issued" and "delayed delivery" securities) if
a Series holds until the settlement date, in a segregated
account, cash or high-grade debt obligations in an amount
sufficient to meet the purchase price, or if a Series
enters into offsetting contracts for the forward sale of
other securities it owns. Forward commitments may be
considered securities in themselves, and involve a risk
of loss if the value of the security to be purchased
declines prior to the settlement date. Where such
purchases are made through dealers, a Series relies on
the dealer to consummate the sale. The dealer's failure
to do so may result in the loss to the Series of an
advantageous return or price. Although a Series will
generally enter into forward commitments with the
intention of acquiring securities for its portfolio or
for delivery pursuant to options contracts it has entered
into, the Series may dispose of a commitment prior to
settlement if the Adviser deems it appropriate to do so.
A Series may realize short-term profits or losses upon
the sale of forward commitments.
Securities Loans. The Series may make secured loans of
the Series' securities amounting to not more than 33 1/3%
of a Series' total assets thereby realizing additional
income. The risks in lending portfolio securities, as
with other extensions of credit, consist of possible
delay in recovery of the securities or possible loss of
rights in the collateral should the borrower fail
financially. As a matter of policy, securities loans are
made to broker-dealers pursuant to agreement requiring
that loans be continuously secured by collateral in cash
or short-term debt obligations at least equal at all
times to the value of the securities on loan. The
borrower pays to a Series an amount equal to any
dividends or interest received on securities lent. A
Series retains all or a portion of the interest received
on investment of the cash collateral or receives a fee
from the borrower. Although voting rights, or rights to
consent, with respect to the loaned securities pass to
the borrower, a Series retains the right to call the
loans at any time on reasonable notice, and it will do so
in order that the securities may be voted by the Series
if the holders of such securities are asked to vote upon
or consent to matters materially affecting the
investment. A Series may also call such loans in order
to sell the securities involved.
Borrowing. The Series may borrow from banks and enter
into reverse repurchase agreements or dollar rolls (as
described in Appendix A of the Prospectus) up to 33 1/3%
of the value of a Series' total assets (computed at the
time the loan is made) to take advantage of investment
opportunities and for extraordinary or emergency
purposes, or for the clearance of transactions. A Series
may pledge up to 33 1/3% of its total assets to secure
these borrowings. If a Series' asset coverage for
borrowings falls below 300%, the Series will take prompt
action to reduce its borrowings even though it may be
disadvantageous at that time from an investment point of
view. A Series will incur borrowing costs when it
leverages, including payment of interest and any fee
necessary to maintain a line of credit, and may be
required to maintain a minimum average balance. If the
income and appreciation on assets acquired with borrowed
funds exceed their borrowing cost, a Series' investment
performance will increase, whereas if the income and
appreciation on assets acquired with borrowed funds are
less than their borrowing costs, investment performance
will decrease. In addition, if a Series borrows to
invest in securities, any investment gains made on the
securities in excess of the costs of the borrowing, and
any gain or loss on hedging, will cause the net asset
value of the shares to rise faster than would otherwise
be the case. On the other hand, if the investment
performance of the additional securities purchased fails
to cover their cost (including any interest paid on the
money borrowed) to a Series, the net asset value of the
Series' shares will decrease faster than would otherwise
be the case. This speculative characteristic is known as
"leverage."
General Characteristics and Risks of Options and Futures
Options. A put option gives the purchaser of the option
the right to sell and the writer the obligation, if the
purchaser exercises his right, to buy the underlying
security at the exercise price during the option period.
A call option gives the purchaser of the option the right
to buy and the writer the obligation, if the purchaser
exercises his right, to sell the underlying security at
the exercise price during the option period. Listed
options are issued by the Options Clearing Corporation
("OCC") which guarantees the performance of the
obligations of the parties to such options.
The purchaser of an option risks losing his entire
investment in a short period of time. If an option is
not sold while it has remaining value, or if during the
life of an option the underlying interest does not
appreciate, in the case of a call option, or depreciate,
in the case of a put option, the purchaser of such option
may lose his entire investment. On the other hand, given
the same market conditions, if the potential purchaser of
a call option purchases the underlying interest directly
without purchasing a call option or if the potential
purchaser of a put option decides not to purchase the put
option, such potential purchaser might have less of a
loss. An option purchaser does not have the choice of
"waiting out" an unexpected decrease or increase in the
underlying instrument's price beyond the expiration date
of the option. The more that an option is
out-of-the-money and the shorter its remaining term to
expiration, the greater the risk that a purchaser of the
option will lose all or part of his investment. Further,
except where the value of the remaining life of an option
may be realized in the secondary market, for an option
purchase to be profitable the market price of the
underlying interest must exceed or, as applicable, be
below the exercise price by more than the premium and
transaction costs paid in connection with the purchase of
the option and its sale or exercise.
A Series' ability to close out its position as a
purchaser of an exchange-listed option is dependent upon
the existence of a liquid secondary market on option
exchanges. Among the possible reasons for the absence of
a liquid secondary market on an exchange are (i)
insufficient trading interest in certain options; (ii)
restrictions on transactions imposed by an exchange;
(iii) trading halts, suspensions or other restrictions
imposed with respect to particular classes or series of
options or underlying securities; (iv) interruption of
the normal operations on an exchange; (v) inadequacy of
the facilities of an exchange or the OCC to handle
current trading volume, or (vi) a decision by one or more
exchanges to discontinue the trading of options (or a
particular class or series of options), in which event
the secondary market on that exchange (or in that class
or series of options) would cease to exist, although
outstanding options on that exchange that had been listed
by the OCC as a result of trades on that exchange would
generally continue to be exercisable in accordance with
their terms. OTC Options are purchased from or sold to
dealers or financial institutions which have entered into
direct agreement with a Series. With OTC Options, such
variables as expiration date, exercise price and premium
will be agreed upon between the Series and the
transacting dealer, without the intermediation of a third
party such as the OCC. If the transacting dealer fails
to make or take delivery of the securities underlying an
option it has written, in accordance with the terms of
that option as written, a Series would lose the premium
paid for the option as well as any anticipated benefit of
the transaction. OTC Options and their underlying
securities are considered illiquid. A Series will
engage in OTC Option transactions only with primary
United States Government securities dealers recognized by
the Federal Reserve Bank of New York. The Adviser
monitors the creditworthiness of dealers with whom a
Series enters into OTC options transactions under the
general supervision of the Fund's Board of Trustees.
The hours of trading for options on debt securities may
not conform to the hours during which the underlying
securities are traded. To the extent that the option
markets close before the markets for the underlying
securities, significant price and rate movements can take
place in the underlying markets that cannot be reflected
in the option markets.
Futures Contracts and Related Options. As a purchaser of
an interest rate futures contract, a Series incurs an
obligation to take delivery of a specified amount of the
obligation underlying the futures contract at a specified
time in the future for a specified price or, in "cash
settlement" futures contracts, to pay to (or receive
from) the seller in cash the difference between the
original price in the futures contract and the market
price of the instrument on the specified date, if the
market price is lower (or higher, as the case may be).
A futures contract sale creates an obligation by a
Series, as seller, to deliver the specified type of
financial instrument called for in the contract at a
specified future time for a specified price or, in "cash
settlement" futures contracts, to pay to (or receive
from) the buyer in cash the difference between the
original price in the futures contract and the market
price of the instrument on the specified date, if the
market price is higher (or lower, as the case may be).
Options on futures contracts are similar to options on
securities except that an option on a futures contract
gives the purchaser the right in return for the premium
paid to assume a position in a futures contract (a long
position if the option is a call and short position if
the option is a put).
Although most futures contracts call for actual delivery
or acceptance of securities, the contracts usually are
closed out before the settlement date without the making
or taking of delivery. A futures contract sale is closed
out by effecting a futures contract purchase for the same
aggregate amount of the specific type of security and the
same delivery date. If the sale price exceeds the
offsetting purchase price, the seller would be paid the
difference and would realize a gain. If the offsetting
purchase price exceeds the sale price, the seller would
pay the difference and would realize a loss. Similarly,
a futures contract purchase is closed out by effecting a
futures contract sale for the same aggregate amount of
the specific type of security and the same delivery date.
If the offsetting sale price exceeds the purchase price,
the purchaser would realize a gain, whereas if the
purchase price exceeds the offsetting sale price, the
purchaser would realize a loss. There is no assurance
that the Short or Intermediate Series will be able to
enter into a closing transaction.
Initial margin in futures transactions is different from
margin in securities transactions in that initial margin
does not involve the borrowing of funds by a broker's
client but is, rather, a good faith deposit on the
futures contract which will be returned to the Short or
Intermediate Series upon the proper termination of the
futures contract. The margin deposits made are marked to
market daily and a Series may be required to make
subsequent deposits into the segregated account,
maintained at its Custodian for that purpose, or cash,
U.S. Government securities or other liquid high-grade
debt securities, called "variation margin", in the name
of the broker, which are reflective of price fluctuations
in the futures contract. Currently, interest rate
futures contracts can be purchased on debt securities
such as U.S. Treasury Bills and Bonds, Eurodollar
instruments, U.S. Treasury Notes and GNMA Certificates.
Exchanges limit the amount by which the price of a
futures contract may move on any day. If the price moves
equal the daily limit on successive days, then it may
prove impossible to liquidate a futures position until
the daily limit moves have ceased. In the event of
adverse price movements, a Series would continue to be
required to make daily cash payments of variation margin
on open futures positions. In such situations, if a
Series has insufficient cash, it may be disadvantageous
to do so. In addition, a Series may be required to take
or make delivery of the instruments underlying interest
rate futures contracts it holds at a time when it is
disadvantageous to do so. An inability to close out
options and futures positions could also have an adverse
impact on a Series' ability to effectively hedge its
portfolio.
In the event of the bankruptcy of a broker through which
the Short or Intermediate Series engages in transactions
in futures or options, either Series could experience
delays and/or losses in liquidating open positions
purchased or sold through the broker and/or incur a loss
of all or part of its margin deposits with the broker.
Transactions are entered into by a Series only with
broker or financial institutions deemed creditworthy by
the Adviser.
The variable degree of correlation between price
movements of futures contracts and price movements in the
position being hedged creates the possibility that losses
on the hedge may be greater than gains in the value of
the Series' position. In addition, futures and futures
option markets may not be liquid in all circumstances.
As a result, in volatile markets, a Series may not be
able to close out a transaction without incurring losses
substantially greater than the initial deposit. Although
the contemplated use of these contracts should tend to
minimize the risk of loss due to a decline in the value
of the hedged position, at the same time they tend to
limit any potential gain which might result from an
increase in the value of such position. The ability of
the Short or Intermediate Series to hedge successfully
will depend on the Adviser's ability to forecast
pertinent market movements, which cannot be assured.
In order to achieve its investment objective, a Series
may sell interest rate futures in a different dollar
amount than the dollar amount of securities being hedged
depending on the expected relationship between the
volatility of the prices of such securities and the
volatility of the futures contracts, based on duration
calculations by the Adviser. If the actual price
movements of the securities and futures are inconsistent
with their durations as so calculated, the hedge may not
be fully effective.
The Series will not maintain open short positions in
interest rate futures contracts if, in the aggregate, the
value of the open positions (marked to market) exceeds
the current market value of its securities portfolio plus
or minus the unrealized gain or loss on those open
positions, adjusted for the expected volatility
relationship between the Series and the futures contracts
based on duration calculations. If this limitation
should be exceeded at any time, the Short or
Intermediate Series will take prompt action to close out
the appropriate number of open contracts to bring its
open futures position into compliance with this
limitation.
Finally, the daily deposit requirements in futures
contracts create an ongoing greater potential financial
risk than do options transactions, where the exposure is
limited to the cost of the initial premium. Losses due
to hedging transactions may reduce net asset value.
Income earned by the Short or Intermediate Series from
its hedging activities generally will be treated as
capital gains.
INVESTMENT RESTRICTIONS
The following restrictions (except as noted) have been
adopted as fundamental policies for the Series, which
means that they may not be changed without the approval
of a majority of the outstanding shares of each of the
Series, as the case may be (as defined in the Investment
Company Act). A Series may not (except that none of the
following investment restrictions shall prevent a Series
from investing all of its assets (other than assets which
are not "investment securities" as defined in the
Investment Company Act) in an open-end investment company
with substantially the same investment objectives):
1. Issue senior securities, borrow money or pledge its
assets, except that the Short or Intermediate
Series may borrow from banks or through reverse
repurchase agreements or dollar rolls up to 33 1/3%
of the value of its respective total assets
(calculated when the loan is made) for temporary,
extraordinary or emergency purposes and to take
advantage of investment opportunities and may
pledge up to 33 1/3% of the value of its total
assets to secure such borrowings. For purposes of
this restriction, the purchase or sale of
securities on a "when-issued" or delayed delivery
basis, he purchase and sale of futures contracts,
the entry into reverse repurchase agreements and
dollar roll transactions, short sales, interest
rate swaps, mortgage swaps, over-the-counter
options, and collateral arrangements with respect
thereto are not deemed to be a pledge of assets and
none of such transactions or arrangements nor
obligations of a Series to Trustees pursuant to
deferred compensation arrangements are deemed to be
the issuance of a senior security.
2. Act as underwriter except to the extent that, in
connection with the disposition of portfolio
securities, it may be deemed to be an underwriter
under certain federal securities laws.
3. Purchase any security (other than obligations of
the U.S. Government, its agencies and
instrumentalities) if as a result: (i) with respect
to 75% of its total assets, more than 5% of the
Short or Intermediate Series' total assets
(determined at the time of investment) would then
be invested in securities of a single issuer, or
(ii) 25% or more of a Series' total assets
(determined at the time of investment) would be
invested in one or more issuers having their
principal business activities in the same industry.
4. Purchase the securities of any issuer which would
result in owning more than 10% of any class of the
outstanding voting securities of such issuer.
5. Purchase any security, other than Mortgage-Backed
Securities, or obligations of the U.S. Government,
its agencies or instrumentalities, if as a result
the Short or Intermediate Series would have
invested more than 5% of its respective total
assets in securities of issuers (including
predecessors) having a record of less than three
years of continuous operation; except for
investments in regulated investment companies with
the same objective.
6. Acquire, lease or hold real estate. (Does not
preclude investments in securities collateralized
by real estate or interests therein.)
7. Purchase or sell commodities or commodity contracts
except for hedging purposes.
8. Invest in interests in oil, gas or other mineral
exploration or development program.
9. Invest in companies for the purpose of exercising
control or management.
10. Purchase securities of other investment companies,
except to the extent permitted by the Investment
Company Act.
11. Make loans of money or property to any person,
except through loans of portfolio securities to
Qualified Institutions, the purchase of debt
obligations in which the Short or Intermediate
Series may invest consistently with its investment
objectives and policies and investment limitations
or the investment in repurchase agreements with
Qualified Institutions. The Short or Intermediate
Series will not lend portfolio securities if, as a
result, the aggregate of such loans exceeds 33 1/3%
of the value of a Series' respective total assets
(including such loans).
12. Purchase securities on margin (but the Short or
Intermediate Series may obtain such short-term
credits as may be necessary for the clearance of
transactions); provided that the deposit or payment
by a Series of initial or variation margin in
connection with options or futures contracts is not
considered the purchase of a security on margin.
13. Make short sales of securities or maintain a short
position if, when added together, more than 25% of
the value of the Short or Intermediate Series' net
assets would be (i) deposited as collateral for the
obligation to replace securities borrowed to effect
short sales, and (ii) allocated to segregated
accounts in connection with short sales. Short
sales "against-the box" are not subject to this
limitation.
Whenever any fundamental investment policy or investment
restriction states a maximum percentage of assets, it is
intended that if the percentage limitation is met at the
time the investment is made, a later change in percentage
resulting from changing total or net asset values will
not be considered a violation of such policy. However,
in the event that the asset coverage for borrowings falls
below 300%, the Series will take prompt action to reduce
its borrowings as required by applicable laws.
In order to change any of the foregoing restrictions
which are fundamental policies, approval must be obtained
by shareholders of the Short or Intermediate Series, as
the case may be. Such approval requires the affirmative
vote of the lesser of (i) 67% or more of the voting
securities present at a meeting if the holders of more
than 50% of voting securities are represented at that
meeting or (ii) more than 50% of the outstanding voting
securities of either the Short or Intermediate Series.
In addition, as non-fundamental policies, the Series may
not:
(a) sell over-the-counter options which it does
not own;
(b) sell options on futures contracts which
options it does not own; or
(c) invest in residual interests in a REMIC or a
CMO.
Other Policies
There are no restrictions or limitations on investments
in obligations of the United States, or of corporations
chartered by Congress as federal government
instrumentalities. The underlying assets of the Short or
Intermediate Series may be retained in cash, including
cash equivalents which are Treasury bills, and short-term
bank obligations such as certificates of deposit,
bankers' acceptances and repurchase agreements. However,
it is intended that only so much of the underlying assets
of the Short or Intermediate Series be retained in cash
as is deemed desirable or expedient under then-existing
market conditions. As noted in the Prospectus, a Series
may invest up to 15% of its respective total net assets
in illiquid securities.
In order to comply with certain "blue sky" restrictions,
the Series will not as a matter of operating policy,
invest in securities of any issuer if, to the knowledge
of a Series, any officer or Trustee of the Fund or the
Adviser owns more than 1/2 of 1% of the outstanding
securities of such issuer, and such officers and Trustees
who own more than 1/2 of 1% own in the aggregate more
than 5% of the outstanding securities of such issuer.
The Series may make commitments more restrictive than the
restrictions listed above so as to permit the sale of
shares of a Series in certain states. Should the Fund
determine that a commitment is no longer required or in
the best interest of the Fund and its shareholders, the
Short or Intermediate Series will revoke the commitment
by terminating the sale of shares of the Series in the
state involved.
TRUSTEES AND OFFICERS
The Board of Trustees has the responsibility for the
overall management of the Fund and each of the Series,
including general supervision and review of its
investment activities. The Trustees, in turn, elect the
officers of the Fund who are responsible for
administering the day-to-day operations of the Fund.
Trustees and officers of the Fund are identified in the
Prospectus.
The table below shows the fees paid to each Director by
each Series for 1996 fiscal year. The Trustees do not
receive pension or retirement benefits. The Trustees did
receive compensation from the other Fund in the Smith
Breeden Mutual Funds in addition to the compensation
listed below.
Director Aggregate Compensation Aggregate
from Short Series Compensation
from Intermediate Series
Stephen M. Schaefer $31,250 $6,500
Myron S. Scholes $33,250 $2,500
William F. Sharpe $32,250 $1,250
The Fund's Declaration of Trust provides that it will
indemnify its Trustees and officers against liabilities
and expenses incurred in connection with litigation in
which they may be involved because of their offices with
the Fund, unless it is determined that they had acted
with willful misfeasance, bad faith, gross negligence or
reckless disregard of the duties involved in their
offices or had not acted in good faith in the reasonable
belief that their actions were in the best interests of
the Fund.
INVESTMENT ADVISORY AND OTHER SERVICES
The investment manager of each Series is Smith Breeden
Associates, Inc. (the "Adviser"). The table in the
Prospectus indicates which officers and Trustees are
affiliated persons of the Adviser.
Pursuant to an Investment Advisory Agreement with each
Series (the "Advisory Agreement"), the Adviser provides
investment research and portfolio management services,
including the selection of securities to purchase, hold
or sell, and the selection of brokers and dealers through
whom portfolio transactions are executed. The Adviser's
activities are subject to the review and supervision of
the Board of Trustees to whom the Adviser renders
periodic reports of both Series' investment activities.
The Adviser, at its own expense, furnishes the Series
with office space and office furnishings, facilities and
equipment required for managing the business affairs of
the Series; maintains all internal bookkeeping, clerical,
secretarial and administrative personnel and services;
carries fidelity insurance on its own officers and
directors for the protection of the Series; and provides
certain telephone and other mechanical services. Except
for the expense limitation in place through March 31,
1997, each Series bears all expenses related to its
operation not borne by the Adviser, as discussed in the
Prospectus.
Each Advisory Agreement is in effect until August 1,
1997. Thereafter, it may continue in effect for
successive periods not exceeding one year, providing such
continuance is specifically approved at least annually by
a vote of the Fund's Board of Trustees or by a vote of
the holders of a majority of each of the Series'
outstanding voting securities, and in either event by a
majority of the Fund's Trustees who are not parties to
the Agreement or interested persons of any such party
(other than as Trustees of the Fund), cast in person at
a meeting called for that purpose. Each Advisory
Agreement may be terminated without penalty at any time
by the Fund, on behalf of each Series, or by the Adviser
on sixty days' written notice and will automatically
terminate in the event of its assignment as defined in
the Investment Company Act. The Advisory Agreement
provides that the Adviser will not be liable for any
error of judgment or for any loss suffered by either
Series in connection with matters to which the Advisory
Agreement relates, except a loss resulting from willful
misfeasance, bad faith gross negligence or reckless
disregard of duty.
As compensation for the services rendered to each Series
by the Adviser under the terms of the Advisory Agreement,
and the assumption by the Adviser of the related
expenses, each Series pays the Adviser a fee, computed
daily and payable monthly, at an annual rate equal to
0.70% of the respective Series' average daily net asset
value. For the last three fiscal years ended March 31,
the Adviser received no fees from the Short Series in
1994 or 1995, and received $1,717,748 for the fiscal year
ended March 31, 1996. The Short Series, prior to April 1,
1995, indirectly bore investment advisory fees through
its investment in the Smith Breeden Short Duration U.S.
Government Fund. On March 31, 1995, this two-tier
structure was consolidated, resulting in the Short Series
becoming a stand-alone fund. The Adviser received no fees
from the Intermediate Series for the fiscal year ended
March 31, 1994, but received $132,174 from the
Intermediate Series for the fiscal year ended March 31,
1995 and $256,075 for the fiscal year ended March 31,
1996.
The Intermediate Series prior to August 1, 1994
indirectly bore investment advisory fees through its
investment in the Smith Breeden Institutional
Intermediate Duration U.S. Government Fund. On August 1,
1994, this two-tier was eliminated, resulting in the
Intermediate Series becoming a stand-alone fund. During
the three year period ended March 31, the Adviser
reimbursed the Short Series $179,527, $146,256, $364,865
for the periods ended 1994, 1995, and 1996, respectively,
under expense limitation provisions. The Intermediate
Series was reimbursed $100,750, $123,390, and $85,364 for
the same periods under expense limitation provisions.
Under the terms of its Advisory agreement with each
Series, the Adviser also provides certain administrative
services. FPS Services, Inc. is the shareholder
servicing, accounting, transfer and dividend
paying-agent. Each Series' pays its own expenses,
including, but not limited to auditing, legal, tax
preparation and consulting, insurance, custodial,
accounting, shareholder servicing and shareholder report
expenses. Fees paid to 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
the Portfolio. A custodian's responsibilities include
generally safeguarding and controlling a Series' cash and
securities, handling the receipt and delivery of
securities, and collecting interest and dividends on a
Series' investments. The custodian does not participate
in decisions relating to the purchase and sale of
portfolio securities.
Deloitte & Touche, 117 Campus Drive, Princeton, New
Jersey 08540, are the Fund's independent auditors,
providing audit services, tax return preparation and
other tax consulting services, and assistance and
consultation in connection with the review of various
Securities and Exchange commission filings. Ropes & Gray,
One International Place, Boston, Massachusetts,
02110-2624, are legal counsel to the Fund.
<PAGE>
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those
shareholders who, to the best knowledge of the Fund, as
of June 30, 1996, owned 5% or more of the shares of the
Short Duration Series.
Carver Federal Savings Bank
2815 Atlantic Avenue
Brooklyn, NY 11207 28.14%
Cascade Savings Bank
2828 Colby Avenue
Everett WA 98201 9.31%
Dell USA L.P
2112 Kramer Lane
Austin Texas, 78758 5.68%
Hemet Federal Savings & Loan
445 E. Florida Ave.
Hemet, CA 92543 6.75%
Watsonville Federal
Savings & Loan
35 East Lake Avenue
Watsonville, CA 95076 6.49%
The Officers and Trustees of the Fund together as a group
owned less than 1.00% of the shares of the Short Duration
Series as of June 30, 1996.
Listed below are the names and addresses of those
shareholders, who as of March 31, 1996, to the best
knowledge of the Fund, owned 5% or more of shares of the
Intermediate Series.
Roosevelt Bank
900 Roosevelt Pkwy
Chesterfield, MO 70.72%
Public School Retirement
System
1 Mercantile Ctr.
St. Louis, MO 18.79%
The Officers and Trustees of the Fund together as a group
owned less than 1.00% of the shares of the Intermediate
Duration Series as of June 30, 1996.
Potential Conflicts of Interest
Principals of the Adviser as individuals own
approximately 67% of the common stock of Financial
Research Corporation, the holding company for Harrington
Bank, FSB (the "Association"). As of May 31, 1996, the
Association had total assets of $356 million. The
Association invests in assets of the same types as those
to be held by the Series.
Douglas T. Breeden, in combination with immediate family
members, controls over 75% of the common stock of
Community First Financial Group, Inc., ("CFFG") the
holding company for certain banks and thrifts, to which
the Adviser renders certain Investment Advisory Services.
The Fund will transact no business directly or
indirectly with either CFFG or the banks and thrifts
which it owns. CFFG and its subsidiaries invest in
assets of the same types as those to be held by the
Series.
The Adviser may also manage advisory accounts with
investment objectives similar to or the same as those of
the Short or Intermediate Series, or different from both
Series, but trading in the same type of securities and
instruments. Portfolio decisions and results of both
Series' investments may differ from those of such
accounts managed by the Adviser. When two or more
accounts managed by the Adviser seek to purchase or sell
the same assets, the assets actually purchased or sold
may be allocated among the accounts on a basis determined
by the Adviser in its good faith discretion to be
equitable. In some cases, this system may adversely
affect the size or the price of the position obtainable
for the Short or Intermediate Series.
POLICIES REGARDING BROKERS USED IN PORTFOLIO
TRANSACTIONS
Under the Advisory Agreement, the selection of brokers
and dealers to execute transactions on behalf of a Series
is made by the Adviser in accordance with criteria set
forth in the Advisory Agreement and any directions which
the Board of Trustees may give. However, each of the
Series do not anticipate that it will incur a significant
amount of brokerage expense because brokerage commissions
are not normally incurred on investments in Mortgage
Securities, which are generally traded on a "net" basis;
that is, in principal amounts without the addition or
deduction of brokerage commissions. The Short and
Intermediate Series paid $46,156 and $3,483,
respectively, in brokerage commissions on futures and
options for the year end March 31, 1996. For the year
end March 31, 1995, the Short and Intermediate Series
paid $0 and $3,483, respectively in brokerage
commissions. Neither Series paid any brokerage
commissions for the year ended March 31, 1994. Prior to
March 31, 1995, the Short Series paid brokerage
commissions indirectly by virtue of its investment in the
Smith Breeden Short Duration U.S. Government Fund. Prior
to August 1, 1994, the Intermediate Series paid brokerage
commissions indirectly by virtue of its investment in the
Smith Breeden Institutional Intermediate U.S. Government
Fund. (See "Investment Advisory and Other Services".)
When placing a portfolio transaction, the Adviser
attempts to obtain the best net price and execution of
the transaction. On portfolio transactions which are
done on a securities exchange, the amount of commission
paid by the Short or Intermediate Series is negotiated
between the Adviser and the broker executing the
transaction. The Adviser seeks to obtain the lowest
commission rate available from brokers which are felt to
be capable of efficient execution of the transactions.
The determination and evaluation of the reasonableness of
the brokerage commissions paid in connection with
portfolio transactions are based to a large degree on the
professional opinions of the persons responsible for the
placement and review of such transactions. These
opinions are formed on the basis of, among other things,
the experience of these individuals in the securities
industry and information available to them concerning the
level of commissions being paid by other institutional
investors of comparable size.
Securities may be purchased directly from issuers or from
underwriters. Where possible, purchase and sale
transactions will be effected through dealers (including
banks) which specialize in the types of securities which
the Portfolio will be holding, unless better executions
are available elsewhere. Dealers and underwriters
usually act as principal for their own account.
Purchases from underwriters will include a concession
paid by the issuer to the underwriter and purchases from
dealers will include the spread between the bid and the
asked price. No broker or dealer affiliated with the
Portfolio or with the Adviser may purchase securities
from, or sell securities to, the Portfolio.
When it is felt that several brokers or dealers are
equally able to provide the best net price and execution,
the Adviser may decide to execute transactions through
brokers or dealers who provide quotations and other
services to the Short or Intermediate Series,
specifically including the quotations necessary to
determine each of the Series' net assets, in such amount
of total brokerage as may reasonably be required in light
of such services, and through brokers and dealers who
supply statistical and other data to both Series in such
amount of total brokerage as may reasonably be required.
The Adviser conducts extensive proprietary fixed income
research with emphasis on mortgage-backed securities.
The Adviser is not dependent on any broker for such
research and analysis and, thus is able to transact
business with brokers regardless of the brokers' research
capabilities or provision of such research to brokerage
customers. The Adviser uses multiple electronic
quotation services for trading and pricing purposes. The
Adviser pays for these services directly out of its
advisory fees. The Adviser is not involved in any soft
dollar arrangements. The Adviser does utilize broker
pricing guidance for certain assets not consistently
available through electronic quotation services.
ADDITIONAL INFORMATION REGARDING
PURCHASES AND REDEMPTIONS OF FUND SHARES
All checks, drafts, wires and other payment mediums used
for purchasing or redeeming shares of either Series must
be denominated in U.S. Dollars. The Fund reserves the
right, in its sole discretion, to either (a) reject any
order for the purchase or sale of shares denominated in
any other currency, or (b) to honor the transaction or
make adjustments to shareholder's account for the
transaction as of a date and with a foreign currency
exchange factor determined by the drawee bank.
Dividend checks which are returned to the Fund marked
"unable to forward" by the postal service will be deemed
to be a request to change the dividend option and the
proceeds will be reinvested in additional shares at the
current net asset value until new instructions are
received.
Redemptions in Kind
The Series have committed themselves to pay in cash all
requests for redemption by any shareholder of record,
limited in amount, however, during any 90-day period to
the lesser of $250,000 or 1% of the value of either
Series' net assets at the beginning of such period. Such
commitment is irrevocable without the prior approval of
the Securities and Exchange Commission. In the case of
requests for redemption in excess of such amounts, the
Trustees reserve the right to make payments in whole or
in part in securities or other assets of either Series in
case of an emergency, or if the payment of such
redemption in cash would be detrimental to the existing
shareholders of either Series. In such circumstances,
the securities distributed would be valued at the price
used to compute the Short or Intermediate Series' net
assets. Should the Short or Intermediate Series do so,
a shareholder may incur brokerage fees or other
transaction costs in converting the securities to cash.
Principal Underwriter
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 Fund,
and is acting on a best efforts basis. The Principal
Underwriter is registered as a broker-dealer under the
Securities Exchange Act of 1934 and is a member of the
National Association of Securities Dealers, Inc. The
offering of the Fund's shares is continuous.
The Fund's underwriting agreement with the Principal
Underwriter provides that the Fund will pay all fees and
expenses in connection with: registering and qualifying
its shares under the various state "blue sky" laws;
preparing, setting in type, printing, and mailing its
prospectuses and reports to shareholders; and issuing its
shares, including expenses of confirming purchase orders.
See the description of the Distribution Plan in the
Prospectus. The Principal Underwriter acts as the agent
of both the Series in connection with the sale of their
shares in all states in which the shares are qualified
and in which the Principal Underwriter is qualified as a
broker-dealer. Under the underwriting agreement, the
Principal Underwriter may accept orders for either Series
shares at the offering price. The Principal Underwriter
may enter into agreements with other broker-dealers for
the sale of Short or Intermediate Series shares by them.
The Principal Underwriter is paid approximately $17,000
in total by the Adviser for its services to the two
Series. In addition, for the year March 31, 1996, the
Principal Underwriter received no sales charges or
commissions.
Calculation of Net Asset Value
As noted in the Prospectus, the Series will generally
calculate their net asset value as of the close of
trading each Monday through Friday that the Adviser and
Transfer Agent are open for business and sufficient
trading takes place to impact the value of the Short or
Intermediate Series assets. As of the date of this
Statement, current holiday schedules indicate that the
net asset value will not be calculated on:
New Year's Day, Presidents' Day, Martin Luther King Day,
Good Friday, Memorial Day, Independence Day, Labor Day,
Columbus Day, Veteran's Day, Thanksgiving Day, the day
following Thanksgiving, Christmas Eve, and Christmas
Day.
Reinvestment Date
The dividend reinvestment date is the date on which the
additional shares are purchased for the investor who has
his dividends reinvested. This date will vary from month
to month and is not necessarily the same date as the
record date or the payable date for cash dividends.
Ownership and Authority Disputes
In the event of disputes involving multiple claims of
ownership or authority to control a shareholder's
account, the Fund has the right (but has no obligation)
to (a) require the written agreement of all persons
deemed by the Fund to have a potential property interest
in the account, prior to executing instructions regarding
the account; (b) interplead disputed funds or account
with a court of competent jurisdiction or (c) surrender
ownership of all or a portion of the account to the
Internal Revenue Service in response to a Notice of Levy.
ADDITIONAL INFORMATION REGARDING TAXATION
Taxation of the Series
For federal income tax purposes, each Series will be
treated as a separate corporation. Each Series intend
to qualify each year and elect to be treated as regulated
investment companies ("RICs") for federal income tax
purposes. To so qualify, the Series must, among other
things: (i) derive at least 90% of their gross income
for each taxable year from dividends, interest,payments
with respect to loans of securities and gains from the
sale or other disposition of securities or certain other
related income; (ii) generally derive less than 30% of
their gross income for each taxable year from gains from
the sale or other disposition of securities and certain
other investments held for less than three months; and
(iii) diversify their holdings so that at the end of each
quarter of the taxable year (A) at least 50% of the value
of each Series' assets would be represented by cash, U.S.
Government securities, securities of other RICs, and
other securities which, with respect to any one issuer,
do not represent more than 5% of the value of each
Series' assets nor more than 10% of the voting securities
of such issuer and (B) not more than 25% of the value of
each Series' assets are invested in the securities of any
one issuer (other than U.S. Government securities or the
securities of other RICs).
The requirement that each Series derive less than 30% of
its gross income from gains from the sale or other
disposition of securities and certain other investments
held for less than three months (the "Short-Short Rule")
may cause the Short or Intermediate Series to (i) hold
certain investments that it otherwise would have sold or
(ii) sell certain investments that it otherwise would
have held. In addition, if the Short or Intermediate
Series were to experience a large quantity of share
redemptions during a taxable year, either Series may
have difficulty satisfying the Short-Short Rule during
that year. If the Short or Intermediate Series fails to
satisfy the Short-Short Rule in a taxable year, it would
lose its RIC status for that year. Each Series, however,
will endeavor to select investments for sale during a
taxable year in such a way that they will satisfy the
Short-Short Rule.
If the Series qualify as RICs and distribute to their
shareholders at least 90% of its net investment income
(including tax-exempt interest and net short-term capital
gain but not net capital gain, which is the excess of net
long-term capital gains over net short-term capital
losses), then the Series will not be subject to federal
income tax on the income so distributed. However, the
Series will be subject to corporate income tax on any
undistributed income. In addition, either Series would
be subject to a nondeductible 4% excise tax on the amount
by which the income it distributed in any calendar year
would be less than a minimum distribution amount. The
minimum distribution amount required to avoid the excise
tax for a calendar year equals the sum of (i) 98% of a
Series' ordinary income (excluding tax-exempt interest
income) for such calendar year; (ii) 98% of the excess of
capital gains over capital losses for the one-year period
ending on October 31 (or another date if elected by a
Series) of each year; and (iii) 100% of the undistributed
ordinary income and gains from prior years. For purposes
of the excise tax, any income or capital gains retained
by, and taxed in the hands of, either Series will be
treated as having been distributed.
Both Series intend to distribute sufficient income so as
to avoid corporate income tax and excise tax. The Short
Series may be subject to a 4% excise tax to the extent
that the amount of ordinary income distributed during the
calendar year is less than 98% of the ordinary income
(excluding tax-exempt interest income) for the year. The
Short Series will endeavor to pay dividends in such a
manner that an excise tax will not be incurred. The
Short Series also may elect to retain all or a portion of
their net capital gain, as described under "Taxation of
Shareholders Distributions" below.
Any capital losses resulting from the disposition of
securities can be used only to offset capital gains and
cannot be used to reduce a Series' ordinary income. Such
capital losses may be carried forward for eight years.
If any capital losses have not been utilized at the time
a Series terminates, such capital losses will become
unusable.
Taxation of Shareholders
Distributions. In general, all distributions to
shareholders attributable to the Short or Intermediate
Series' net investment income (including any tax-exempt
interest income distributed) will be taxable as ordinary
dividend income whether paid in cash or in additional
shares.
To the extent either Series does realize net capital
gains, it intends to distribute such gains at least
annually and designate them as capital gain dividends.
Capital gain dividends are taxable as capital gains,
whether paid in cash or in additional shares, regardless
of how long the shares have been held. The Short or
Intermediate Series may elect to retain net capital gains
and pay corporate income tax thereon. In such event, the
Short or Intermediate Series would most likely make an
election that would require each shareholder of record on
the last day of the Series' taxable year to include in
income for tax purposes his proportionate share of the
Series' undistributed net capital gain. If such an
election is made, each shareholder would be entitled to
credit his proportionate share of the tax paid by the
Series against his federal income tax liabilities and to
claim refunds to the extent that the credit exceeds such
liabilities. In addition, the shareholder would be
entitled to increase the basis of his shares for federal
tax purposes by an amount equal to 66% of his
proportionate share of the undistributed net capital
gain.
Shareholders receiving distributions in the form of
additional shares will be treated for federal income tax
purposes as receiving an equivalent amount of cash. In
general, the basis of such shares will equal the amount
of cash that the shareholder would have received if he
had elected to recieve distributions in cash.
Liquidating distributions which in the aggregate exceed
a shareholder's basis in shares will be treated as gain
from the sale of shares. If a shareholder receives, in
the aggregate, liquidating distributions which are less
than such basis, such shareholder will recognize a loss
to that extent. Dividends and other distributions by
either the Short or Intermediate Series are generally
taxable to the shareholders at the time the dividend or
distribution is made.
If a shareholder purchases shares at a cost that reflects
an anticipated dividend, such dividend will be taxable
even though it represents economically a return of part
of the purchase price. Investors should consider the tax
implications of buying shares shortly prior to a
distribution.
Sales of Shares. In general, if a share is sold, the
seller will recognize gain or loss equal to the
difference between the amount realized on the sale and
the seller's adjusted basis in the share. However, any
loss recognized by a shareholder within six months of
purchasing the shares will be treated as a long-term loss
to the extent of any long-term capital gain distributions
received by the shareholder and the shareholder's share
of undistributed long-term capital gains. In addition,
any loss realized on a sale of shares will be disallowed
to the extent the shares disposed of are replaced within
a period of 61 days beginning 30 days before the
disposition of the shares. In such a case, the basis of
the shares acquired will be adjusted to reflect the
disallowed loss. Any gain or loss realized upon a sale
of shares by a shareholder who is not a dealer in
securities will be treated as capital gain or loss.
If a shareholder exchanges shares of one fund in the
Smith Breeden Mutual Funds for shares of another fund,
the shareholder generally will recognize gain or loss as
if the shares had been redeemed.
Tax-Exempt Investors. If a shareholder that is a benefit
plan investor (e.g., an individual retirement account,
pension plan 401(k) plan, or Keogh plan) or charitable
organization (a "Tax-Exempt Investor") incurs debt to
finance the acquisition of its shares, a portion of the
income received by the Tax-Exempt Investor with respect
to its shares would constitute unrelated business taxable
income ("UBTI"). In that case, the UBTI portion of the
Tax-Exempt Investor's income from its investment in the
Short or Intermediate Series for the year would equal the
total income recognized by the Tax-Exempt Investor in
that year multiplied by the ratio of the Tax-Exempt
Investor's average acquisition debt balance to the
average tax basis of its shares for the year. A
Tax-Exempt Investor generally is subject to federal
income tax to the extent that its UBTI for a taxable year
exceeds its annual $1,000 exclusion.
Consequences of Certain Fund Investments
Hedging Transactions. Each Series intends to engage in
various hedging transactions. Under various provisions
of the Code, the result of such investments and
transactions may be to change the character of recognized
gains and losses, accelerate the recognition of certain
gains and losses, and defer the recognition of certain
losses. For example, the tax treatment of futures
contracts entered into by a Series as well as listed
non-equity options written or purchased by a Series on
U.S. exchanges (including options on debt securities and
options on futures contracts) will be governed by section
1256 of the Code. Absent a tax election for "mixed
straddles" (described below), each such position held by
a Series on the last business day of each taxable year of
the Series will be marked to market (i.e., treated as if
it were closed out), and all resulting gain or loss will
be treated as 60% long-term capital gain or loss and 40%
short-term capital gain or loss, with subsequent
adjustments made to any gain or loss realized upon an
actual disposition of such positions. When a Series
holds an option or contract governed by section 1256
which substantially diminishes the Series' risk of loss
with respect to another position of the Portfolio not
governed by section 1256 (as might occur in some hedging
transactions), that combination of positions generally
will be a "mixed straddle" that is subject to the
straddles rules of section 1092 of the Code. The
application of Section 1092 might result in deferral of
losses, adjustments in the holding periods of the Series'
securities and conversion of short-term capital losses
into long-term capital losses. Either Series may make
certain tax elections for its "mixed straddles" that
could alter certain effects of section 1256 or section
1092. The extent to which a Series is able to use such
hedging techniques may be limited by the Short-Short
Rule, which is discussed above. In determining
compliance with the Short-Short Rule, however, gains from
certain types of hedging positions that are part of
designated hedges and are held by a Series for less than
three months will be netted against losses (whether
recognized or unrecognized) incurred with respect to the
offsetting position in the designated hedge. That special
netting provision, if employed by a Series, could reduce
the risk that active hedging techniques will run afoul of
the Short-Short Rule.
The character of the Short or Intermediate Series'
taxable income will in most cases be determined on the
basis of reports made to the Series by the issuers of the
securities in which they invest. The tax treatment of
certain securities in which a Series may invest is not
free from doubt and it is possible that an IRS
examination of the issuers of such securities could
result in adjustments to the income of a Series.
The foregoing discussion is a general summary of certain
of the current federal income tax laws regarding both
Series and investors in the shares. The discussion does
not purport to deal with all of the federal income tax
consequences applicable to the Series or to all
categories of investors, some of which maybe subject to
special rules. Investors should consult their own tax
advisers regarding the tax consequences to them of
investments in shares.
STANDARD PERFORMANCE MEASURES
Performance
As noted in the Prospectus, the Fund may from time to
time quote various performance figures to illustrate the
past performance of either Series. It may occasionally
cite statistics to reflect its volatility or risk.
Performance quotations by investment companies are
subject to rules adopted by the Securities and Exchange
Commission ("SEC"). These rules require the use of
standardized performance quotations or alternatively,
that every non-standardized performance quotation
furnished by the Fund be accompanied by certain
standardized performance information computed as required
by the SEC. Current yield and average annual compounded
total return quotations used by the Fund are based on the
standardized methods of computing performance mandated by
the SEC. An explanation of those and other methods used
by the Fund to compute or express performance follows.
Total Return
The average annual total return is determined by finding
the average annual compounded rates of return over one,
five, and ten year periods (or for the life of a Series,
if shorter) that would equate an initial hypothetical
$250 investment to its ending redeemable value. The
calculation assumes no sales charge is deducted from the
initial $250 purchase order, capital gains and all income
dividends are reinvested at net asset value on the
reinvestment dates during the period. The quotation
assumes the account was completely redeemed at the end of
each one, five and ten year period and the deduction of
all applicable charges and fees.
The Series' average annual compounded rate of return is
determined by reference to a hypothetical $250
investment, according to the following formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of
$250
T = average annual total return
n = number of years
ERV = ending redeemable value of a
hypothetical $250 payment made at
the beginning of the 1, 5, or 10
year periods at the end of said 1,
5, or 10 year periods (or
fractional portion thereof).
As discussed in the Prospectus, the Fund may quote total
rates of return in addition to its average annual total
return. Such quotations are computed in the same manner
as the Fund's average annual compounded rate, except that
such quotations will be based on the Fund's actual
aggregate return for a specified period as opposed to its
average return over certain periods.
Yield
Current yield reflects the income per share earned by the
Fund's portfolio investments. Current yield is determined
by dividing the net investment income per share earned
during a 30-day base period by the offering price or net
asset value per share, as the case may be, on the last
day of the period and analyzing the result, according to
the following formula:
Yield = 2 [(a-b + 1)6 -1]
cd
where:
a = dividends and interest earned
during the period.
b = expenses accrued for the period
(net of reimbursements).
c = the average daily number of
shares outstanding during the
period that were entitled to
receive dividends.
d = the maximum offering price or
net asset alue per share, as
the case may be, on the last
day of the period.
The following table shows the average annual total return
for the periods stated, and yield for the Series for the
30-day period ended March 31, 1996.
<PAGE>
AVERAGE ANNUAL TOTAL RETURN
ONE YEAR THREE YEARS INCEPTION 30-DAY
YIELD
SHORT SERIES 4.95% 5.06% 5.20% 5.81%
INTERMEDIATE
SERIES 9.69% 6.61% 8.62% 6.41%
The investment results of the Series, like all others,
fluctuate over time. Thus, performance figures should not
be considered to represent what an investment may earn in
the future or what the Short or Intermediate Series'
yield or total return may be for any future period.
Current Distribution Rate
Yield which is calculated according to a formula
prescribed by the SEC is not indicative of the amounts
which will be paid to the Series' shareholders. Amounts
paid to shareholders are reflected in the quoted "current
distribution rate." The current distribution rate is
computed by dividing the total amount of dividends,
excluding long-term capital gains, per share paid by a
Series during the past twelve months by its current net
asset value. Under certain circumstances, such as when
there has been a change in the amount of dividend payout,
or a fundamental change in investment policies, it might
be appropriate to annualize the dividends paid over the
period such policies were in effect, rather than using
the dividends during the past twelve months. The current
distribution rate differs from the current yield
computation because it may include distributions to
shareholders from sources other than dividends and
interest, such as short-term capital gains and net
equalization credits and is calculated over a different
period of time.
Volatility
Occasionally statistics may be used to specify a Series
volatility or risk. Measures of volatility or risk are
generally used to compare fund net asset value or
performance relative to a market index. One measure of
volatility is beta. The ratio of the expected excess
return on a Series to the expected excess return on the
market index is called beta. Equity funds commonly use
the S&P 500 as their market index. A beta of more than
1.00 indicates volatility greater than the market, and a
beta of less that 1.00 indicates volatility less than the
market. Another measure of volatility or risk is
standard deviation. Standard deviation is used to
measure variability of net asset value or total return
around an average, over a specified period of time. The
premise is that greater volatility connotes greater risk
undertaken in achieving performance.
A statistic often used by sophisticated institutional
investors when comparing the relative performance of
portfolios is the Sharpe Ratio. This statistic is a
Series' excess return (relative to T-Bills) divided by
the standard deviation of its returns.
Comparisons and Advertisements
To help investors better evaluate how an investment in a
Series might satisfy their objective, advertisements
regarding either Series may discuss various measures of
a Series' performance as reported by various financial
publications. Advertisements may also compare
performance (as calculated above) to performance as
reported by other investments, indices, and averages.
The following publications, indices, and averages may be
used:
a) Lipper - Mutual Fund Performance Analysis,
Lipper-Fixed Income Analysis, and Lipper Mutual
Fund Indices - measures total return and average
current yield for the mutual fund industry and
ranks individual mutual fund performance over
specified time periods assuming reinvestment of all
distributions, exclusive of sales charges.
b) CDA Mutual Fund Report, published by CDA Investment
Technologies, Inc. - analyzes price, current yield,
risk, total return, and average rate of return
(average annual compounded growth rate) over
specified time periods for the mutual fund
industry.
c) Mutual Fund Source book, published by Morningstar,
Inc. - analyzes price, yield, risk, and total
return for equity and fixed income funds.
d) Financial publications: Barron's, Business Week,
Changing Times, Financial World, Forbes, Fortune,
and Money magazines - rate fund performance over
specified time periods.
e) Consumer Price Index (or Cost Of Living Index),
published by the U.S. Bureau of Labor Statistics -
a statistical measure of change, over time, in the
price of goods and services, in major expenditure
groups.
f) Stocks, Bonds, Bills, and Inflation, published by
Ibbotson Associates -historical measure of yield,
price, and total return for common and small
company stock, long-term government bonds, treasury
bills, and inflation.
g) Savings and Loan Historical Interest Rates - as
published in the U.S. Savings & Loan League Fact
Book.
h) Salomon Brothers Broad Bond Index - The Broad Index
measures yield, price, and total return for
Treasury, Agency, Corporate, and Mortgage bonds.
All issues mature in one year or more and have at
least $50 million outstanding, with the exception
of mortgages. The entry criteria for mortgage
issues is $200 million for each coupon.
i) Salomon Brothers Mortgage Index - The Salomon
Brothers Mortgage Index measures only the mortgage
component of the Salomon Brothers Broad Bond Index.
j) Salomon Brothers Composite High Yield Index or its
component indices -The High Yield Index measures
yield, price and total return for Long-Term
High-Yield Index, Intermediate-Term High-Yield
Index and Long-Term Utility High-Yield Index.
k) Lehman Brothers Aggregate Bond Index or its
component indices - The Aggregate Bond Index
measures yield, price and total return for
Treasury, Agency, Corporate, Mortgage, and Yankee
bonds.
l) Lehman Brothers Government/Corporate Bond Index.
m) Standard & Poor's Bond Indices - measure yield and
price of Corporate, Municipal, and Government
bonds.
n) Other taxable investments including certificates of
deposit (CD's), money market deposit accounts
(MMDA's), checking accounts, savings accounts,
money market mutual funds, repurchase agreements,
and government securities.
o) Historical data supplied by the research
departments of Lehman Brothers, First Boston
Corporation, Morgan Stanley, Salomon Brothers,
Merrill Lynch, Goldman Sachs, Prudential Securities
and Donaldson Lufkin and Jenrette.
p) Donoghues's Money Fund Report - industry averages
for 7-day annualized and compounded yields of
taxable, tax-free and government money funds.
q) Total returns and yields for Treasury Securities
and fixed income indices as published by Ryan
Laboratories or other suppliers.
In assessing such comparisons of performance, an investor
should keep in mind that the composition of the
investments in the reported indices and averages is not
identical, and in some cases is very different, to a
Series' portfolio, that the averages are generally
unmanaged and that the items included in the calculations
of such averages may not be identical to the formula used
by a Series to calculate its figures. In addition there
can be no assurance that a Series will continue its
performance as compared to such other averages.
Shareholders should note that the investment results of
the Short or Intermediate Series will fluctuate over
time, and any presentation of a Series' current yield or
total return for any period should not be considered as
a representation of what an investment may earn or what
a shareholder's yield or total return may be in any
future period. Shareholders should also note that
although the Series believe that there are substantial
benefits to be realized by investing in its shares, such
investments also involve certain risks. (See "Investment
Objectives and Policies of the Fund - Risks of Mortgage
Securities" in the Fund's Prospectus.)
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS
As the investments permitted to the Series are primarily
in mortgage securities issued or guaranteed by the U.S.
Government or its agencies and instrumentalities, the
shares of either the Short or Intermediate Series may be
eligible for investment by federally chartered credit
unions, federally chartered thrifts, and national banks.
Either Series may be a permissible investment for
certain state chartered institutions as well, including
state and local government authorities and agencies. Any
financial institution or agency considering an investment
in either Series should refer to the applicable laws and
regulations governing its operations in order to
determine if a Series is a permissible investment.
EXPERTS
The financial statements of both the Short and
Intermediate Series and related notes thereto included in
this Statement of Additional Information have been so
included in reliance upon the report of Deloitte & Touche
LLP, independent auditors, given in authority of said
firm as experts in auditing and accounting.
FINANCIAL STATEMENTS
The financial statements of the Fund are attached and
follow the Appendix.
<PAGE>
APPENDIX
Description of Moody's Investors Service, Inc.'s
corporate bond ratings:
Aaa - Bonds which are rated Aaa are judged to be of
the best quality. They carry the smallest
degree of investment risk and are generally
referred to as "gilt-edged." Interest
payments are protected by a large or by an
exceptionally stable margin and principal is
secure. While the various protective elements
are likely to change, such changes as can be
visualized are most unlikely to impair the
fundamentally strong position of such issues.
Aa - Bonds which are rated Aa are judged to be of high
quality by all standards. Together with the Aaa
group they comprise what are generally known as
high grade bonds. They are rated lower than the
best bonds because margins of protection may not be
as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or
there may be other elements present which make the
long-term risks appear somewhat larger than in Aaa
securities.
A - Bonds which are rated A possess many favorable
investment attributes and are to be considered as
upper medium grade obligations. Factors giving
security to principal and interest are considered
adequate but elements may be present which suggest
a susceptibility to impairment sometime in the
future.
Baa - Bonds which are rated Baa are considered as
medium grade obligations, i.e., they are
neither highly protected nor poorly secured.
Interest payments and principal security
appear adequate for the present but certain
protective elements may be lacking or may be
characteristically unreliable over any great
length of time. Such bonds lack outstanding
investment characteristics and in fact have
speculative characteristics as well.
Ba - Bonds which are rated Ba are judged to have
predominantly speculative elements; their future
cannot be considered as well assured. Often the
protection of interest and principal payments may
be very moderate and thereby not well safeguarded
during both good and bad times over the future.
Uncertainty of position characterizes bonds in this
class.
B - Bonds which are rated B generally lack
characteristics of the desirable investment.
Assurance of interest and principal payments or of
maintenance of other terms of the contract over any
long period of time may be small.
Caa - Bonds which are rated Caa are of poor
standing. Such issues may be in default or
there may be present elements of danger with
respect to principal or interest.
Ca - Bonds which are rated Ca represent obligations
which are speculative in a high degree. Such
issues are often in default or have other marked
shortcomings.
Description of Standard & Poor's Corporation's corporate
bond ratings:
AAA - This is the highest rating assigned by
Standard & Poor's to a debt obligation and
indicates an extremely strong capacity to pay
principal and interest.
AA - Bonds rated AA also qualify as high-quality debt
obligations. Capacity to pay principal and
interest is very strong, and in the majority of
instances they differ from AAA issues only in small
degree.
A - Bonds rated A have a strong capacity to pay
principal and interest, although they are somewhat
more susceptible to the adverse effects of changes
in circumstances and economic conditions.
BBB - Bonds rated BBB are regarded as having an
adequate capacity to pay principal and
interest. Whereas they normally exhibit
protection parameters, adverse economic
conditions or changing circumstances are more
likely to lead to a weakened capacity to pay
principal and interest for bonds in this
capacity than for bonds in the A category.
BB, B, CCC, CC -
Bonds rated BB, B, CCC and CC are regarded, on
balance, predominantly speculative with respect to
the issuer's capacity to pay interest and repay
principal in accordance with the terms of the
obligations. BB indicates the lowest degree of
speculation and CC the highest degree of
speculation. While such bonds will likely have
some quality and protective characteristics, these
are outweighed by large uncertainties or major risk
exposures to adverse conditions.
SMITH BREEDEN SHORT DURATION
U.S. GOVERNMENT SERIES
ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Series provided a
total return of 4.95% in the year ended March 31, 1996, while the
return on the Series' benchmark, the six month U.S. Treasury Bill,
was 5.96%. The Series' annualized return from inception on March
31, 1992 through March 31, 1996 was 5.20%, while the benchmark six
month Treasury Bill's annualized return over the same period was
4.58%.
The Series underperformed its benchmark by 1.01% in the year ending
March 31, 1996. The Series invests in mortgage securities, and its
performance relative to its benchmark is adversely affected when
the price of mortgage securities appreciates by less than the price
of Treasury securities in a falling interest rate environment.
This is what occurred during 1995. The yield on the ten year U.S.
Treasury Note fell from 7.19% in March 1995 to 5.58% in December
1995, or 1.61% in total. Over the same period the yield on par
coupon FNMA thirty year fixed-rate mortgages (that is, mortgage
securities which are priced at 100 or par) fell 1.46% from 8.26% to
6.80%. Mortgage securities underperformed U.S. Treasury securities
due to investors' concerns about prepayment risk. Prepayment risk
is the risk that homeowners will take advantage of lower interest
rates to prepay their mortgages. The mortgage investor is at a
disadvantage since the funds from these payments can be reinvested
only at a lower yield.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE SERIES' INDEX ACCORDING
TO ITEM 5a. OF FORM N1-A IS LOCATED HERE IN THE TEXT AND IS DESCRIBED
BELOW IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000 INVESTMENT IN THE
SHORT SERIES VERSUS THAT OF ITS BENCHMARK, THE SIX MONTH US TREASURY BILL.
FROM INCEPTION OF MARCH 31, 1992 THROUGH MARCH 31, 1996, AN INVESTMENT
OF $10,000 IN THE SERIES WOULD HAVE GROWN TO $12,254, VERSUS $11,964, IF
INVESTED IN THE SIX MONTH US TREASURY BILL. THE RETURN IN THE SERIES IS
NET OF FEES AND SALES CHARGES; THE RETURN OF THE SIX MONTH US TREASURY
DOES NOT REFLECT FEES OR TRANSACTION COSTS. THE ANNUALIZED ONE YEAR
RETURN FOR THE SERIES IS 4.95%, THE ANNUALIZED THREE YEAR RETURN IS
5.06%, AND THE ANNUALIZED RETURN SINCE INCEPTION IS 5.20%.
During the first quarter of 1996 the yield on the ten year U.S.
Treasury Note began to climb, rising to 6.32% on March 31, 1996.
The Series' performance for the quarter was in line with its benchmark,
providing a return of 1.26% as compared with the U.S. Treasury Bill
return of 1.20%. Prepayment concerns dissipated somewhat with the
increase in interest rates, but yields on mortgages remained at
relatively high levels when compared with U.S. Treasury securities,
which precluded the Series' outperforming the benchmark by a large
margin. The short duration of the Series provided superior performance
in the quarter relative to the universe of bonds, however, as rising
interest rates produced losses for investors holding U.S. Treasury
securities with maturities of three years or more.
The portfolio turnover rate for the Series was 225% for the year.
This measure, which is calculated by dividing the lesser of
portfolio purchases and sales for the year by average net assets,
provides an indication of how much active trading is conducted in
a portfolio. In order to meet the Series' objective of providing
a return exceeding that of the Series' benchmark, while maintaining
the same approximate interest rate risk as the benchmark, the
Series aims to own at any given time those mortgage securities
offering a superior risk-adjusted yield. Hence, short term
opportunities to exchange mortgage securities with a lower
risk-adjusted yield for those with a higher risk-adjusted yield are
exploited whenever it is economical and prudent to do so. Equally,
when the mortgage securities sector as a whole offers a superior
yield to U.S. Treasury securities, the Series will increase its
holdings of mortgages as a percentage of net assets. Accordingly,
the Series took advantage of rising yield spreads to increase its
holdings of mortgages, and the Series' holdings of mortgages as a
percent of net assets rose from 107% in March 1995 to 122% in March
1996. The weight of GNMA adjustable-rate securities in the
portfolio also increased as the yields offered on these securities
relative to estimated prepayment risk increased.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk target
at a level approximating that of the six month U.S. Treasury Bill.
In the next fiscal year, the Series will continue to maintain this
strategy, which has resulted in a positive return over all calendar
quarters since the Series' inception.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31, 1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 120.94%
FEDERAL HOME LOAN MORTGAGE CORP. - 24.92% *
FHLMC GOLD:
$44,000,000 6.50%, due (a) ............................ $41,896,250
7,000,000 7.00%, due (a) ............................ 6,833,750
3,909,482 7.50%, due 6/1/24 to 10/1/25 .............. 3,906,185
1,142,037 8.00%, due 9/1/24 to 5/1/25 ............... 1,163,917
1,470,825 8.50% Balloon Mortgages,
due 4/1/96 to 11/1/96 .............. 1,471,228
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $56,327,564)........................ 55,271,330
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 14.96% *
FNMA:
30,808,916 7.50%, due 8/01/25 to 9/1/25 .............. 30,763,387
FNMA ARM:
410,630 7.136%, due 12/1/15 ....................... 416,551
546,625 7.571%, due 1/1/18 ........................ 558,693
634,882 7.692%, due 6/20/20 ....................... 654,061
200,693 7.839%, due 12/1/26 ....................... 208,135
FNMA INTEREST ONLY **:
1,988,264 9.00%, due 7/25/21 ........................ 590,476
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $32,977,247)........................ 33,191,303
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 81.06% *
GNMA:
27,238,097 7.00%, due 11/15/22 to 3/15/24 ............ 26,560,093
1,689,664 9.50%, due 7/15/09 to 4/15/25 ............. 1,832,898
GNMA ARM:
98,681,809 5.50%, due 10/20/25 to 3/20/26 ............ 97,726,368
33,917,962 6.00%, due 7/20/25 to 9/20/25 ............. 34,109,528
19,212,423 7.00%, due 5/20/25 ........................ 19,589,106
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $180,387,686)....................... 179,817,993
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $269,692,497)....................... 268,280,626
Notional
Amount INTEREST RATE SWAP CONTRACTS - 0.24%
$20,000,000 Contract dated 6/22/93 with Prudential
Global Funding,Expires 6/22/98 ............ 197,553
20,000,000 Contract dated 8/31/93 with Salomon Swapco,
Expires 8/31/00 ........................... 725,807
20,000,000 Contract dated 12/2/93 with Morgan Guaranty,
Expires 12/2/00 ........................... 387,516
40,000,000 Contract dated 5/15/95 with Salomon Swapco,
Expires 5/15/05 ........................... (786,983)
TOTAL INTEREST RATE SWAP CONTRACTS ........ 523,893
THREE MONTH LIBOR INTEREST RATE CAP CONTRACTS - 0.76
$40,000,000 Contract with Salomon SwapCo, expires 11/1/96,
Strike rate 5.00% ......................... 113,600
40,000,000 Contract with Salomon SwapCo, expires 11/15/97,
Strike rate 5.00% ......................... 504,360
40,000,000 Contract with Morgan Guaranty, expires 10/15/98,
Strike rate 5.00% ......................... 1,060,800
TOTAL THREE-MO. LIBOR INTEREST RATE CAP CONTRACTS
(Cost $1,875,834)......................... 1,678,760
Contracts FUTURES OPTION CONTRACTS - 0.35%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $116............ 781
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $117............ 781
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $109............ 117,187
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $110............ 173,438
50 Put on 10 Year UST Note futures,
expires 6/96, strike price $111............ 121,094
100 Put on 10 Year UST Note futures,
expires 6/96, strike price $112............ 325,000
50 Put on 30 Year UST Bond futures,
expires 6/96, strike price $108............ 28,125
TOTAL FUTURES OPTION CONTRACTS
(Cost $249,908) .......................... 766,406
TOTAL INVESTMENTS (Cost $271,818,239) ..... 271,249,685
Face Amount REVERSE REPURCHASE AGREEMENTS- (0.45%):
($1,000,000) FHLMC, 5.51%, due 4/4/96 dated 3/29/96 .... (1,000,000)
TOTAL REVERSE REPURCHASE AGREEMENTS ....... (1,000,000)
OTHER LIABILITIES LESS CASH AND OTHER ASSETS -
(21.84%).................................. (48,424,549)
NET ASSETS - 100.00% $221,825,136
* Mortgage-backed obligations are subject to principal paydowns as a
result of prepayments or refinancings of the underlying mortgage
instruments. As a result, the average life may be substantially
less than the original maturity. The interest rate shown is the rate
in effect at March 31, 1996. ARMs have coupon rates which adjust
periodically. The adjusted rate is determined by adding a spread
to a specified index.
** Represents an interest only stripped mortgage-backed security.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value (identified
cost $271,818,239)(Note 1)...................... $271,249,685
Cash............................................... 514,603
Receivables:
Variation margin on futures contracts (Note 1).. 58,000
Interest........................................ 1,352,131
Deferred organization expenses (Note 1)............ 9,548
TOTAL ASSETS.................................. 273,183,967
LIABILITIES:
Reverse repurchase agreement (Note 1).............. 1,000,000
Payables:
Securities purchased............................ 50,014,306
Swap interest................................... 92,380
Due to adviser (Note 3)......................... 113,212
Accrued expenses................................... 138,933
TOTAL LIABILITIES............................. 51,358,831
NET ASSETS:
(Applicable to outstanding shares of 22,769,456
unlimited number of shares of beneficial
interest authorized; no stated par)............. $221,825,136
Net asset value, offering price and redemption
price per share ($221,825,136 / 22,769,456)..... $9.74
SOURCE OF NET ASSETS:
Paid in capital.................................... $229,328,831
Accumulated net realized loss on investments....... (6,435,945)
Net unrealized depreciation of investments......... (1,067,750)
NET ASSETS.................................... $221,825,136
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) .... $17,326,843
EXPENSES:
Advisory fees (Note 3)......................... 1,717,748
Accounting and pricing services fees........... 73,827
Custodian fees................................. 76,145
Audit and tax preparation fees................. 92,199
Legal fees..................................... 80,126
Amortization of organization expenses (Note 1). 9,629
Transfer agent fees............................ 33,767
Registration fees.............................. 24,996
Trustees fees and expenses..................... 103,888
Insurance...................................... 31,961
Other.......................................... 34,641
TOTAL EXPENSES BEFORE REIMBURSEMENT........ 2,278,927
Expenses reimbursed by Adviser (Note 3).... (364,865)
NET EXPENSES............................... 1,914,062
NET INVESTMENT INCOME ..................... 15,412,781
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments............... 4,639,312
Change in unrealized appreciation of
investments.................................. (8,342,309)
Net realized and unrealized loss on
investments.................................. (3,702,997)
Net increase in net assets resulting
from operations.............................. $11,709,784
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............. $15,412,781 $13,504,268
Net realized gain (loss)
on investments.................... 4,639,312 (1,414,168)
Change in unrealized appreciation
(depreciation) of investments..... (8,342,309) 1,365,349
Net increase in net assets
resulting from operations......... 11,709,784 13,455,449
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income............................ (15,412,781) (13,504,268)
Dividends in excess of net
investment income................. (269,331) (90)
Total distributions............... (15,682,112) (13,504,358)
CAPITAL SHARE TRANSACTIONS:
Shares sold....................... 93,214,276 94,549,923
Shares issued on reinvestment of
distributions..................... 3,773,450 4,346,125
Shares redeemed................... (89,621,927) (98,582,965)
Increase in net assets resulting
from capital share
transactions (a).................. 7,365,799 313,083
TOTAL INCREASE IN NET ASSETS............... 3,393,471 264,174
NET ASSETS:
Beginning of year................. 218,431,665 218,167,491
End of year....................... $221,825,136 $218,431,665
(a) Transactions in capital shares were as follows:
Shares sold....................... 9,500,348 9,582,171
Shares issued on reinvestment
of distributions.................. 386,101 441,809
Shares redeemed................... (9,167,732) (10,018,137)
Net increase...................... 718,717 5,843
Beginning balance ................ 22,050,739 22,044,896
Ending balance.................... 22,769,456 22,050,739
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from operations.... $11,709,784
Net realized and unrealized loss on investments......... 3,702,997
Net investment income................................. 15,412,781
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Interest rate cap and interest-only strip amortization.. 643,641
Paydown gains and losses................................ (15,635)
Increase in interest receivable......................... (430,707)
Decrease in other assets................................ 74,098
Increase in other liabilities........................... 168,021
Net cash provided by operating activities............. 15,852,199
Cash flows from investing activities:
Payments for futures variations......................... (2,465,409)
Proceeds from sales of long-term investments............ 291,400,731
Proceeds from sales of short-term investments........... 2,807,926
Proceeds from maturities of short-term investments...... 1,539,970,000
Proceeds from paydowns of long-term investments......... 19,239,211
Purchases of long-term investments...................... (423,241,572)
Purchases of short-term investments.....................(1,435,805,067)
Net cash used in investing activities................. (8,094,180)
Cash flows from financing activities:
Increase in collateralized borrowings................... 1,000,000
Purchase of shares tendered............................. 3,592,349
Dividends from net investment income.................... (11,908,662)
Net cash used in financing activities................. (7,316,313)
Net increase in cash.................................. 441,706
Cash at beginning of year.................................. 72,897
Cash at end of year........................................ $514,603
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends..................... $3,773,450
Supplemental disclosure:
Interest paid........................................... $373,480
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
Year Year Year For the Period
Ended Ended Ended March 31, 1992 (1)
March 31, 1996 March 31, 1995 March 31, 1994 to March 31, 1993
Net Asset Value,
Beginning of
Period....... $9.90 $9.90 $10.00 $10.00
Income From
Investment Operations
Net investment
income..... 0.621 0.628 0.432 0.552
Net realized
and unrealized
gain (loss) on
investments. (0.148) - (0.070) 0.002
Total from
investment
operations. 0.473 0.628 0.362 0.554
Less Distributions
Dividends from
net investment
income....... (0.621) (0.628) (0.462) (0.554)
Dividends in
excess of
investment
income....... (0.012) - - -
Total
distributions (0.633) (0.628) (0.462) (0.554)
Net Asset Value,
End of Period.. $9.74 $9.90 $9.90 $10.00
Total Return .. 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end
of period..... $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses
to average
net assets (2) 0.78% 0.78% 0.78% 0.78%
Ratio of net
investment
income to average
net assets (3) 6.29% 6.33% 4.17% 4.53%
Portfolio turnover
rate.......... 225% 47% 112% 3%
______________________
(1) Commencement of operations.
(2) The annualized operating expense ratios prior to reimbursement of
expenses by the Adviser were 0.93%, 0.92%, 1.00%, and 2.58% for the
Short Duration U.S. Government Series for the years ended March 31,
1996, March 31, 1995, March 31, 1994 and the period ended March 31,
1993, respectively. Expense ratios include both the direct expenses
of the Short Duration U.S.Government Series, and the indirect expenses
incurred through the Series' investment in the Short Duration U.S.
Government Fund (Note 1).
(3) The annualized net investment income ratios prior to reimbursement of
both direct and indirect expenses by the Adviser were 6.13%, 6.18%,
3.95%, and 2.73% for the Short Duration U.S. Government Series for the
years ended March 31, 1996, March 31, 1995, March 31, 1994, and the
period ended March 31, 1993, respectively.
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified management investment company registered under the
Investment Company Act of 1940, as amended. The Fund offers shares
in two series: the Smith Breeden Short Duration U.S. Government
Series (the "Short Series" or "Series") and the Smith Breeden
Intermediate Duration U.S. Government Series ("Intermediate
Duration Series"). Prior to April 1, 1995, the Short Series sought
to achieve its investment objective by investing all of its assets
in the Smith Breeden Short Duration U.S. Government Fund (the
"Short Fund"), an open-end, diversified management investment
company having the same investment objective as the Series.
However, at the close of business on March 31, 1995, pursuant to a
plan of liquidation adopted March 1, 1995 by the Board of Trustees
of the Short Fund, and approved by the Board of Trustees of the
Short Series, the Short Series redeemed in-kind its shares of the
Short Fund. The assets of the Short Fund were transferred in
proportion to the Short Series' ownership of the Short Fund in
cancellation of its shares.
A. Security Valuation: Securities are valued at current market
value provided by a pricing service or by a bank or broker/dealer
experienced in such matters, when over-the-counter market
quotations are readily available. Securities and other assets for
which market prices are not readily available are valued at fair
market value as determined in accordance with the procedures
approved by the Board of Trustees.
B. Repurchase Agreements: Repurchase agreements may be entered
into with member banks of the Federal Reserve System having total
assets in excess of $500 million and securities dealers, provided
that such banks or dealers meet the credit guidelines of the Funds'
Board of Trustees. In a repurchase agreement, securities are
acquired from a third party with the commitment that they will be
repurchased by the seller at a fixed price on an agreed upon date.
The custodian maintains control or custody of securities
collateralizing repurchase agreements until maturity of the
repurchase agreements. The value of the collateral will be
monitored daily, and if necessary, additional collateral is
received to ensure that the market value of the underlying assets
remains sufficient to protect the Series in the event of the
seller's default. However, in the event of default or bankruptcy
of the seller, the right to the collateral may be subject to legal
proceedings.
C. Reverse Repurchase Agreements: A reverse repurchase agreement
involves the sale of portfolio assets concurrently with an
agreement to repurchase the same assets at a later date at a fixed
price. Assets will be maintained in a segregated account with the
custodian, which will be marked to market daily, consisting of
cash, U.S. Government securities or other liquid high-grade debt
obligations equal in value to the obligations under the reverse
repurchase agreements. In the event the buyer of securities under
a reverse repurchase agreement files for bankruptcy or becomes
insolvent, the use of the proceeds under the agreement may be
restricted pending a determination by the other party, or its
trustee or receiver whether to enforce the obligation to repurchase
the securities.
D. Dollar Roll Agreements: A dollar roll is an agreement to sell
securities for delivery in the current month and simultaneously
contract to repurchase substantially similar (same type and coupon)
securities on a specified future date. During the roll period,
principal and interest paid on these securities are not received.
Compensation under the dollar roll agreement is represented by the
difference between the current sales price and the forward price
for the future purchase (often referred to as the "drop") as well
as by the interest earned on the cash proceeds of the initial sale.
E. Distributions and Taxes: The Short Series intends to continue
to qualify for and elect the special tax treatment afforded
regulated investment companies under Subchapter M of the Internal
Revenue Code, thereby relieving the Series of Federal income taxes.
To so qualify, the Series intends to distribute substantially all
of its net investment income and net realized capital gains, if
any, less any available capital loss carryforward. As of March 31,
1996, the Series had a net capital loss carryforward of $2,340,576,
with $589 expiring on March 31, 2001, $75,461 expiring on March 31,
2002, $905,312 expiring on March 31, 2003, and $1,359,214 expiring
on March 31, 2004.
F. Determination of Gains or Losses on Sales of Securities:
Gains or losses on the sale of securities are calculated for
accounting and tax purposes on the identified cost basis.
G. Deferred Organization Expenses: Deferred organization
expenses are being amortized on a straight-line basis over five
years.
H. Securities Transactions and Investment Income: Interest
income is accrued daily on both long-term bonds and short-term
investments. Interest income also includes net amortization from
the purchase of fixed-income securities. Transactions are recorded
on the first business day following the trade date. Realized gains
and losses from security transactions are determined and accounted
for on the basis of identified cost.
2. FINANCIAL INSTRUMENTS
Derivative Financial Instruments Held or Issued for Purposes other
than Trading: Interest rate futures, swaps, caps and options
contracts are used for risk management purposes in order to reduce
fluctuations in net asset value relative to the targeted option-
adjusted duration.
A. Futures Contracts: Upon entering into a futures contract,
either cash or securities in an amount (initial margin) equal to a
certain percentage of the contract value is required to be
deposited in a segregated account. Subsequent payments (variation
margin) are made or received each day. The variation margin
payments are equal to the daily changes in the contract value and
are recorded as unrealized gains or losses. A realized gain or
loss is recognized when the contract is closed or
expires equal to the difference between the value of the contract
at the time it was opened and the value at the time it was closed.
The Short Series had the following open futures contracts as of
March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 year Treasury $ 4,000,000 Short June, 1996 $ 9,820
3 month Treasury 70,000,000 Long June, 1996 (87,815)
3 month Eurodollar 77,000,000 Long June, 1996 (76,021)
3 month Eurodollar 75,000,000 Long September, 1996 (99,712)
3 month Eurodollar 52,000,000 Short March, 1997 (28,584)
3 month Eurodollar 6,000,000 Short March, 1998 3,573
3 month Eurodollar 34,000,000 Short March, 1999 20,247
3 month Eurodollar 77,000,000 Short March, 2000 (199,897)
3 month Eurodollar 28,000,000 Short March, 2001 (57,526)
3 month Eurodollar 32,000,000 Short March, 2002 (36,394)
3 month Eurodollar 30,000,000 Short March, 2003 53,115
$ (499,194)
Futures transactions involve costs and may result in losses. The
effective use of futures strategies depends on the Series' ability
to terminate futures positions at times when the Series' investment
adviser deems it desirable to do so. The use of futures also
involves the risk of imperfect correlation among movements in the
values of the securities underlying the futures purchased and sold
by the Series, of the futures contract itself, and of the
securities which are the subject of a hedge.
B. Interest Rate Swap Contracts: Interest rate swaps involve the
exchange by one party with another party of their respective
commitments to pay or receive interest. The interest rate swap
contracts assigned by the Short Fund to the Short Series had been
entered into on a net basis, i.e., the two payment streams are
netted out, with the Short Series receiving or paying, as the case
may be, only the net amount of the two payments. As of March 31,
1996, the Short Series had open three interest rate swap contracts.
In each of the contracts, the Short Fund had agreed to pay a fixed
rate and receive a floating rate. The floating rate on the three
contracts resets quarterly and is the three month London Interbank
Offered Rate ("LIBOR"). Interest rate swap contracts will not be
entered into unless the unsecured commercial paper, unsecured senior debt
or the claims-paying ability of the other party thereto is rated
either AA or A-1 or better by Standard & Poor's Corporation or Aa
or P-1 or better by Moody's Investors Service, Inc. (or is otherwise
acceptable to either agency) at the time of entering into such
transaction. If there is a default by the other party to the swap
transaction, the Short Series will be limited to contractual
remedies pursuant to the agreements related to the transaction.
There is no assurance that interest rate swap contract counterparties
will be able to meet their obligations pursuant to the swap contracts
or that, in the event of default, the Short Series will succeed in
pursuing contractual remedies. The Short Series thus assumes the
risk that it may be delayed in, or prevented from, obtaining payments
owed to it pursuant to the swap contracts.
The Short Series' interest payable on the interest rate swap
contracts was $92,380, and swap contract interest receivable was
$478. No collateral is required to be maintained on these
contracts.
C. Interest Rate Cap Contracts: The purchase of an interest rate
cap entitles the purchaser, to the extent that a specified index
exceeds a predetermined interest rate, to receive payments of
interest on a notional principal amount from the party selling such
interest rate caps. The Short Series' interest receivable on the
interest rate cap contracts at March 31, 1996 was $91,632.
3. TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser, provides the Short Series with investment
management services.
The Adviser voluntarily agreed to reimburse normal business
expenses of the Short Series through March 31, 1996 so that total
direct and indirect operating expenses would not exceed 0.78% of
its average net assets. This voluntary agreement may be terminated
at any time by the Adviser in its sole discretion after March 31,
1996. The Adviser has also agreed to reduce its fees payable (to
the extent of such fees) by the amount the Series' direct and
indirect expenses would, absent the fee reduction, exceed the
applicable expenses limitations imposed by state securities
administrators. For the year ended March 31, 1996, the Adviser
received $1,717,748 in fees and reimbursed the Short Series $364,865.
Certain officers and trustees of the Fund are also officers and
directors of the Adviser.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940
("1940 Act"), the Series adopted, effective August 1, 1994, a
Distribution and Services Plan (the "Plan"). The purpose of the
Plan is to permit the Adviser to compensate investment dealers and
other persons involved in servicing shareholder accounts for
services provided and expenses incurred in promoting the sale of
shares of the Short Series, reducing redemptions, or otherwise
maintaining or improving services provided to shareholders by such
dealers or other persons. The Plan provides for payments by the
Adviser, out of the advisory fee paid to it by the Short Series, to
dealers and other persons at the annual rate of up to 0.25% of the
Short Series' average net assets, subject to the authority the
Trustees of the Short Series, to reduce the amount of payments
permitted under the Plan or to suspend the Plan for such periods as
they may determine. Subject to these limitations, the amount of
such payments and the purposes for which they are made shall be
determined by the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$690,002,566 and $690,050,141 respectively for the Series. The
cost of the Short Series' securities for federal income tax
purposes at March 31, 1996, is $271,818,239. Net unrealized
depreciation of investments and futures contracts consists of:
Gross unrealized appreciation $ 2,957,098
Gross unrealized depreciation (4,024,848)
Net unrealized depreciation $ (1,067,750)
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Short Duration U.S. Government Series
of the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of the Smith Breeden Short
Duration U.S. Government Series of the Smith Breeden Series Fund as
of March 31, 1996, and the related statements of operations and cash
flows for the year then ended, the statements of changes in net assets
for each of the years in the two-year period then ended and the financial
highlights for each of the years in the three-year period then ended and
the period March 31, 1992 (commencement of operations) to March 31, 1993.
These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express
an opinion on these financial statements and the financial highlights
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and the
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned at March 31, 1996 by correspondence with the custodian
and brokers. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide
a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred
to above present fairly, in all material respects, the financial position
of the Smith Breeden Short Duration U.S. Government Series of the Smith
Breeden Series Fund as of March 31, 1996, the results of its operations
and its cash flows, the changes in its net assets, and the financial
highlights for the respective stated periods in conformity with generally
accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Intermediate Duration U.S. Government Series
provided a total return of 9.69% in the year ended March 31,
1996, while the return on the Series' benchmark, the Salomon
Brothers Mortgage Index, was 10.51%.
The period from March 1995 to December 1995 saw a strong rally
in bonds, as inflation fears lessened and the Federal Reserve
lowered its target rate for Federal Funds from 6.0% in March to
5.5% in December. The Series return from March through December
1995 was 10.39%. The return on the five year U.S. Treasury
Note, which has roughly the same duration as the Series, was
11.66%. The return on the Salomon Brothers Mortgage Index over
the same period was 10.91%.
During the nine month period ended December 31, 1995, mortgage
securities underperformed U.S. Treasury Notes of comparable
duration because of investors' concerns about prepayment risk.
Prepayment risk is the risk that homeowners will take advantage
of lower interest rates to prepay their mortgages. The mortgage
investor is at a disadvantage since the funds from these
payments can be invested only at a lower yield.
The advantage enjoyed by U.S. Treasury securities in 1995 was
reversed in the first quarter of 1996. The five year U.S.
Treasury Note yield rose 0.69% from 5.39% to 6.08% as a series
of strong employment statistics reawakened fears of inflation
among investors.
IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T, THE FOLLOWING
IS A DESCRIPTION OF THE GRAPH PRESENTED HERE IN THE TEXT IN
COMPLIANCE WITH ITEM 5a. OF FORM N1-A:
THE GRAPH PRESENTED COMPARES THE CHANGE FOR THE PERIOD FROM
MARCH 31, 1992 THROUGH MARCH 31, 1996 OF A $10,000 INVESTMENT IN
THE SERIES VERSUS ITS BENCHMARK. FOR THE PERIOD FROM THE SERIES'
INCEPTION, MARCH 31, 1992, THROUGH MARCH 31, 1996, THE SERIES'
BENCHMARK WAS THE FIVE YEAR US TREASURY, AS TRACKED BY SALOMON
BROTHERS, INC. AFTER DECEMBER 31, 1993, UPON APPROVAL OF A MAJORITY
OF SHAREHOLDERS, THE SERIES' BENCHMARK WAS CHANGED TO THE SALOMON
BROTHERS MORTGAGE INDEX. THE SERIES AVERAGE ANNUAL RETURN WAS 9.69%
FOR THE ONE YEAR PERIOD, 6.61% FOR THE THREE YEAR PERIOD, AND 8.62%
FOR THE PERIOD SINCE INCEPTION. FROM INCEPTION OF MARCH 31, 1992
THROUGH MARCH 31, 1996, AN INVESTMENT OF $10,000 IN THE SERIES WOULD
HAVE GROWN TO $13,927, VERSUS $13,686, IF INVESTED IN THE BENCHMARK.
Interestingly, the Federal Reserve Board didn't
seem to share those inflation fears, and it actually cut the
target rate for Federal Funds to 5.25% in January 1996. The five
year U.S. Treasury Note posted a loss of 1.54% in the first
quarter, while the Intermediate Series posted a loss of 0.63%,
and the Salomon Brothers Mortgage Index loss was 0.37%. Mortgage
securities outperformed U.S. Treasury securities in the first
quarter as investor's fears about prepayment risk lessened.
The portfolio turnover rate for the Series was 193% for the
year. This measure, which is calculated by dividing the lesser
of portfolio purchases and sales for the year by average net
assets, provides an indication of how much active trading is
conducted in a portfolio. In order to meet the Series'
objective of providing a return exceeding that of the Series'
benchmark, while also covering the 0.90% annual fund expense
ratio, and maintaining the same approximate interest rate risk
as the benchmark, the Series aims to own at any given time those
mortgage securities offering a superior risk-adjusted yield.
Hence, short term opportunities to exchange mortgage securities
with a lower risk-adjusted yield for those with a higher risk-
adjusted yield are exploited whenever it is economical and
prudent to do so. Equally, when the mortgage securities sector
as a whole offers an attractive risk-adjusted yield advantage
over U.S. Treasury securities the Series will increase its
holdings of mortgages as a percentage of net assets.
Accordingly, the Series took advantage of rising yield spreads
of mortgages to U.S. Treasury securities to increase its
holdings of mortgages as a percent of net assets, which rose
from 100% in March 1995 to 134% in March 1996. The weighting of
GNMA adjustable-rate securities in the portfolio was also
increased from 19% of net assets in March 1995 to 36% in March
1996, as the risk-adjusted yields offered on these securities
increased relative to U.S. Treasury securities. Although
adjustable-rate mortgages are not included in the Salomon
Brothers Mortgage Index, the Series will hold adjustable-rate
mortgages in its portfolio when they offer a risk-adjusted yield
advantage over fixed-rate mortgages.
As actively as the Series may trade in the mortgage market, the
securities purchased and sold are of the highest credit quality,
and can be priced using reliable sources. Transaction costs are
therefore relatively small, especially in relation to the yield
advantage. In addition, whenever a trade is executed, and on a
daily basis, the hedges in the portfolio are evaluated to ensure
that the Series continues to maintain its interest rate risk at
approximately the same level as that of the Salomon Brothers
Mortgage Index. In the next fiscal year, the Series will
continue its strategy of purchasing securities in the mortgage
sector which offer superior risk-adjusted yields. This strategy
has enabled the Series to provide an annualized total return
from inception of 8.62%, comfortably exceeding the return of
8.15% on its benchmark, while maintaining a similar level of
interest rate risk.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS MARCH 31, 1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 134.39%
FEDERAL HOME LOAN MORTGAGE CORP. - 41.74% *
FHLMC GOLD:
$7,000,000 6.50, due (a) ......................... $6,719,063
6,000,000 7.00%, due (a) ........................ 5,857,500
2,578,648 8.00%, due 9/1/24 to 10/19/24.......... 2,635,324
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $15,456,817)..................... 15,211,887
FEDERAL NATIONAL MORTGAGE ASSOC. - 32.09% *
FNMA ARM:
1,369,074 5.98%, due 9/1/25 ..................... 1,403,379
158,720 7.692%, due 8/25/22 ................... 163,515
FNMA:
3,491,642 7.00%, due 8/1/23 to 6/1/24 ........... 3,406,702
3,631,118 7.50%, due 8/1/25 ..................... 3,625,752
1,277,596 8.50%, due 9/14/24 to 2/1/25 .......... 1,322,721
1,643,028 9.50%, due 7/1/16 to 5/1/22 ........... 1,773,567
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC.
(Cost $11,368,709)..................... 11,695,636
GOVERNMENT NATIONAL MORTGAGE ASSOC. - 60.13% *
GNMA ARM:
7,472,926 5.50%, due 10/20/25 to 1/20/26 ........ 7,400,934
5,726,103 6.00%, due 9/20/25 .................... 5,758,443
GNMA:
7,189,552 7.00%, due 11/21/14 to 3/15/24 ........ 7,010,593
1,686,432 8.00%, due 12/15/06 to 4/15/09 ........ 1,747,195
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(Cost $21,694,608)..................... 21,917,165
UNITED STATES TREASURY BILLS - 0.43% **
140,000 5.02 due 6/27/96 ...................... 138,309
20,000 4.96 due 6/27/96 ...................... 19,760
TOTAL UNITED STATES TREASURY BILLS
(Cost $158,062) ....................... 158,069
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $48,678,196)..................... 48,982,757
Contracts FUTURES OPTION CONTRACTS- 0.01%
50 Call on 10 Year UST Note futures,
expires 6/96, strike price $115........ 1,562
30 Call on 10 Year UST Note futures,
expires 6/96, strike price $116........ 469
TOTAL FUTURES OPTION CONTRACTS
(Cost $69,423) ........................ 2,031
TOTAL INVESTMENTS (Cost $48,747,619) -
134.40% ............................... 48,984,788
CASH AND OTHER ASSETS LESS LIABILITIES -
(34.40%) .............................. (12,537,848)
NET ASSETS - 100.00% .................... $36,446,940
* Mortgage-backed obligations are subject to principal paydowns as
a result of prepayments or refinancings of the underlying securities
instruments. As a result, the average life may be substantially
less than the original maturity. The interest rate shown is the rate
in effect at March 31, 1996. ARMs have coupon rates which adjust
periodically. The adjusted rate is determined by adding a spread
to a specified index.
** The interest rate shown is the discount rate paid at the time of
purchase by the Fund.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC- Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value
(identified cost $48,747,619)(Note 1)............... $48,984,788
Cash................................................ 312,247
Receivables:
Variation margin on futures contracts............ 25,950
Interest......................................... 232,324
Prepaid expenses.................................... 6,057
Deferred organization expenses (Note 1)............. 10,159
TOTAL ASSETS................................... 49,571,525
LIABILITIES:
Payables:
Securities purchased............................. 12,938,923
Distributions payable............................ 135,382
Due to advisor (Note 3).......................... 15,102
Accrued expenses.................................... 35,178
TOTAL LIABILITIES.............................. 13,124,585
NET ASSETS:
(Applicable to outstanding shares of 3,639,328;
unlimited number of shares of beneficial
interest authorized; no stated par).............. $36,446,940
Net asset value, offering price and redemption
price per share ($36,446,940 /3,639,328)........ $10.01
SOURCE OF NET ASSETS:
Paid in capital..................................... $36,286,422
Overdistributed net investment income............... (98,690)
Accumulated net realized gain on investments........ 28,769
Net unrealized appreciation of investments.......... 230,439
NET ASSETS..................................... $36,446,940
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1996
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest expense (Note 1) ......... $2,698,898
EXPENSES:
Advisory fees (Note 3) ............................. 256,075
Accounting and pricing services fees ............... 38,954
Custodian fees ..................................... 22,593
Audit & tax preparation fees ....................... 11,452
Legal fees ......................................... 8,987
Amortization of organization expenses (Note 1) ..... 9,428
Transfer agent fees ................................ 28,915
Registration fees .................................. 20,004
Trustees fees and expenses ......................... 11,365
Insurance .......................................... 3,576
Other .............................................. 3,242
TOTAL EXPENSES BEFORE REIMBURSEMENT ............ 414,591
Expenses reimbursed by Adviser (Note 3) ........ (85,364)
NET EXPENSES ................................... 329,227
NET INVESTMENT INCOME .......................... 2,369,671
REALIZED AND UNREALIZED GAIN ON INVESTMENTS:
Net realized gain on investments ................... 1,227,064
Change in unrealized appreciation of investments.... (257,447)
Net realized and unrealized gain on investments .... 969,617
Net increase in net assets resulting from operations $3,339,288
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............... $2,369,671 $1,346,839
Net realized gain (loss) on investments 1,227,064 (248,302)
Change in unrealized appreciation
(depreciation) of investments....... (257,447) 778,903
Net increase in net assets resulting
from operations..................... 3,339,288 1,877,440
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income. (2,358,436) (1,346,839)
Dividends in excess of net investment
income.............................. - (140,634)
Distributions from net realized
capital gains....................... (367,107) -
Distributions in excess of net
realized capital gains.............. - (28,444)
Total distributions................. (2,725,543) (1,515,917)
CAPITAL SHARE TRANSACTIONS:
Shares sold......................... 1,030,079 31,506,439
Shares issued on reinvestment of
distributions....................... 702,855 669,611
Shares redeemed..................... (697,235) (4,519,742)
Increase in net assets resulting
from capital share transactions (a) 1,035,699 27,656,308
TOTAL INCREASE IN NET ASSETS.... 1,649,444 28,017,831
NET ASSETS:
Beginning of year................... 34,797,496 6,779,665
End of year......................... $36,446,940 $34,797,496
(a) Transactions in capital shares
were as follows:
Shares sold.................... 100,992 3,257,497
Shares issued on
reinvestment of distributions.. 69,235 68,948
Shares redeemed................ (69,182) (465,316)
Net increase................... 101,045 2,861,129
Beginning balance ............. 3,538,283 677,154
Ending balance................. 3,639,328 3,538,283
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets resulting from
operations....................................... $3,339,288
Net realized and unrealized gain on investments.. (969,617)
Net investment income.......................... 2,369,671
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and losses..................... (40,951)
Increase in interest receivable.................. (36,556)
Decrease in other assets......................... 3,025
Increase in other liabilities.................... 25,598
Net cash provided by operating activities...... 2,320,787
Cash flows from investing activities:
Proceeds from futures variations................. 157,418
Proceeds from sales of long-term investments..... 55,165,384
Proceeds from sales of short-term investments.... 20,254
Proceeds from maturities of short-term
investments...................................... 81,940,000
Proceeds from paydowns of long-term investments.. 3,311,979
Purchases of long-term investments............... (61,937,619)
Purchases of short-term investments.............. (82,161,200)
Net cash used in investing activities.......... (3,503,784)
Cash flows from financing activities:
Purchase of shares tendered...................... 332,844
Dividends from net investment income and
realized capital gains........................... (2,035,111)
Net cash used in financing activities........ (1,702,267)
Net decrease in cash......................... (2,885,264)
Cash at beginning of year.......................... 3,197,511
Cash at end of year................................ $312,247
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends.............. $702,855
Supplemental disclosure:
Interest paid.................................... $191,436
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION
U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
have been derived from information provided in the financial statements.
Year Year Year Period
Ended Ended Ended Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31, 1993*
Net Asset Value,
Beginning
of Period..... $9.83 $10.01 $10.62 $10.00
Income From
Investment
Operations
Net investment
income....... 0.660 0.664 1.050 0.826
Net gain (loss)
on securities
(both realized
and unrealized) 0.227 (0.049) (0.601) 0.621
Total from
investment
operations.. 0.937 0.615 0.449 1.447
Less Distributions
Dividends from
net investment
income........ (0.656) (0.664) (1.044) (0.826)
Dividends in
excess of net
investment
income........ - (0.108) - -
Distributions
from net realized
gains on
investments... (0.101) - (0.015) -
Distributions in
excess of net
realized gains on
investments... - (0.022) - -
Total
distributions (0.757) (0.794) (1.059) (0.826)
Net Asset Value,
End of Period.. $10.01 $9.83 $10.01 $10.62
Total Return... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end
of period.... $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses
to average net
assets (1)... 0.90% 0.90% 0.90% 0.82%
Ratio of net
investment income
to average net
assets (2)... 6.49% 6.20% 7.74% 8.18%
Portfolio
turnover rate 193% 557% 84% 42%
______________________
(1) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 2.28%, 2.33%, 2.34%,
and 17.52% for the years ended March 31, 1996, March 31, 1995 and
March 31, 1994, and for the period ended March 31, 1993, respectively.
Expense ratios include both the direct expenses of the Intermediate
Duration U.S. Government Series, and the indirect expenses incurred
through the Series' investment in the Institutional Intermediate
Duration U.S. Government Fund (Note 5).
(2) The annualized ratio of net investment income to average net assets
prior to reimbursement of both direct and indirect expenses by the
Adviser was 6.26%, 4.77%, 6.30% and (8.52)% for the years ended
March 31, 1996, March 31, 1995 and March 31, 1994, and for the period
ended March 31, 1993, respectively.
* The Intermediate Duration U.S. Government Series commenced operations
on March 31, 1992.
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified management investment company registered under the
Investment Company Act of 1940, as amended. The Fund offers shares
in two series: the Smith Breeden Short Duration U.S. Government
Series and the Smith Breeden Intermediate Duration U.S. Government
Series ("Intermediate Series" or "Series"). The following is a
summary of significant accounting policies consistently followed by
the Intermediate Series.
A. Security Valuation: Portfolio securities are valued at
current market value provided by a pricing service or by a bank or
broker/dealer experienced in such matters, when over- the-counter
market quotations are readily available. Securities and other
assets for which market prices are not readily available are valued
at fair market value as determined in accordance with procedures
approved by the Board of Trustees.
B. Distributions and Taxes: The Intermediate Series intends to
continue to qualify for and elect the special tax treatment
afforded regulated investment companies under Subchapter M of the
Internal Revenue Code, thereby relieving the Series of Federal
income taxes. To so qualify, the Series intends to distribute
substantially all of its net investment income and net realized
capital gains, if any, less any available capital loss
carryforward. As of March 31, 1996, the Series had no capital loss
carryforward.
C. Repurchase Agreements: The Intermediate Series may enter into
repurchase agreements with member banks of the Federal Reserve
System having total assets in excess of $500 million and securities
dealers, provided that such banks or dealers meet the credit
guidelines of the Series' Board of Trustees. In a repurchase
agreement, the Series acquires securities from a third party with
the commitment that they will be repurchased by the seller at a
fixed price on an agreed upon date. The Intermediate Series'
custodian maintains control or custody of these securities
collateralizing the repurchase agreements until maturity of the
repurchase agreements. The value of the collateral is monitored
daily, and if necessary, additional collateral is received to
ensure that the market value of the underlying assets remains
sufficient to protect the Series in the event of the seller's
default. However, in the event of default or bankruptcy of the
seller, the Series' right to the collateral may be subject to legal
proceedings.
D. Reverse Repurchase Agreements: A reverse repurchase agreement
involves the sale by the Intermediate Series of portfolio assets
concurrently with an agreement by the Series to repurchase the same
assets at a later date at a fixed price. The Series will maintain
a segregated account with its custodian, which will be marked to
market daily, consisting of cash, U.S. Government securities or
other liquid high-grade debt obligations equal in value to its
obligations under reverse repurchase agreements. In the event the
buyer of securities under a reverse repurchase agreement files for
bankruptcy or becomes insolvent, the Series' use of the proceeds of
the agreement may be restricted pending a determination by the other
party, or its trustee or receiver whether to enforce the Series'
obligation to repurchase the securities.
E. Dollar Roll Agreements: The Intermediate Series may enter
into dollar rolls in which the Series sells securities for delivery
in the current month and simultaneously contracts to repurchase
substantially similar (same type and coupon) securities on a
specified future date. During the roll period, the Series foregoes
principal and interest paid on these securities. The Series is
compensated by the difference between the current sales price and
the forward price for the future purchase (often referred to as the
"drop") as well as by the interest earned on the cash proceeds of
the initial sale.
F. Determination Of Gains Or Losses On Sales Of Securities:
Gains or losses on the sale of securities are calculated for
accounting and tax purposes on the identified cost basis.
G. Deferred Organizational Expenses: Deferred organizational
expenses are being amortized on a straight-line basis over five
periods.
H. Securities Transactions and Investment Income: Interest
income is accrued daily on both long-term bonds and short-term
investments. Interest income also includes net amortization from
the purchase of fixed-income securities. Transactions are recorded
on the first business day following the trade date. Realized gains
and losses from security transactions are determined and accounted
for on the basis of identified cost.
2. FINANCIAL INSTRUMENTS
A. Derivative Financial Instruments Held or Issued for Purposes
other than Trading:
The Intermediate Series uses interest rate futures contracts for
risk management purposes in order to reduce fluctuation of the
Series' net asset value relative to its targeted option-adjusted
duration. Upon entering into a futures contract, the Series is
required to deposit either cash or securities in an amount (initial
margin) equal to a certain percentage of the contract value.
Subsequent payments (variation margin) are made or received by the
Series each day. The variation margin payments are equal to the
daily changes in the contract value and are recorded as unrealized
gains or losses. The Series recognizes a realized gain or loss
when the contract is closed or expires equal to the difference
between the value of the contract at the time it was opened and the
value at the time it was closed.
The Intermediate Series had the following open futures contracts as
of March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
10 Year
Treasury $ 7,200,000 Long June, 1996 $ 184,176
3 Month
Eurodollar 22,000,000 Short March, 1998 (94,607)
3 month
Eurodollar 6,000,000 Short March, 1999 (27,027)
3 month
Eurodollar 16,000,000 Short March, 2000 (69,272)
$ (6,730)
Futures transactions involve costs and may result in losses. The
effective use of futures strategies depends on the Series' ability
to terminate futures positions at times when the Series' investment
adviser deems it desirable to do so. The use of futures also
involves the risk of imperfect correlation among movements in the
values of the securities underlying the futures purchased and sold
by the Series, of the futures contract itself, and of the
securities which are the subject of a hedge.
The aggregate market value of investments pledged to cover margin
requirements for the open positions at March 31, 1996 was $158,069.
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser, provides the Series with investment management
services. As compensation for these services, the Intermediate
Series pays the Adviser a fee computed daily and payable monthly,
at an annual rate equal to 0.70% of the Series' average daily net
asset value.
The Adviser has voluntarily agreed to reduce or otherwise limit
other expenses of the Intermediate Series (excluding advisory fees
and litigation, indemnification and other extraordinary expenses)
to 0.90% of the Series' average daily net assets. This voluntary
agreement may be terminated or modified at any time by the Adviser
in its sole discretion. The Adviser has agreed to reduce the fees
payable (to the extent of such fees) by the amount the Series'
expenses would, absent the fee reduction, exceed the applicable
expense limitations imposed by state securities administrators.
For the year ended March 31, 1996, the Adviser received fees of
$256,075 and reimbursed the Series $85,364.
Effective August 1, 1994, the Series adopted a Distribution and
Services Plan (the "Plan") pursuant to Rule 12b-1 under the 1940
Act. The purpose of the Plan is to permit the Adviser to
compensate investment dealers and other persons involved in
servicing shareholder accounts for services provided and expenses
incurred in promoting the sale of shares of the Series, reducing
redemptions, or otherwise maintaining or improving services
provided to shareholders by such dealers or other persons.
The Plan provides for payments by the Adviser, out of its advisory
fee, to dealers and other persons at the annual rate of up to 0.25%
of the Intermediate Series' average net assets subject to the
authority of the Trustees of the Series to reduce the amount of
payments permitted under the Plan or to suspend the Plan for such
periods as they may determine. Subject to these limitations, the
amount of such payments and the purposes for which they are made
shall be determined by the Adviser.
Certain officers and trustees of the Series are also officers and
directors of the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1996, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$87,639,428 and $87,338,696, respectively. The purchases and
proceeds shown above do not include dollar roll agreements which
are considered borrowings by the Intermediate Series. The cost of
securities for federal income tax purposes is $48,747,619. Net
unrealized appreciation of investments and futures contracts
consists of:
Gross unrealized appreciation .................. $773,535
Gross unrealized depreciation .................. (543,096)
Net unrealized appreciation .................... $230,439
5. LIQUIDATION OF THE INSTITUTIONAL INTERMEDIATE FUND
From its inception until August 1, 1994, the Intermediate
Series sought to achieve its investment obective by investing
all of its assets in the Smith Breeden Institutional
Intermediate Duration U.S. Government Fund (the "Institutional
Fund"), an open-end, diversified management investment company
having the same investment objective as the Series. However,
at the close of business on August 1, 1994, pursuant to a plan
of liquidation adopted by the Trustees of the Institutional
Fund, and approved by the Trustees of the Intermediate Series,
the Intermediate Series redeemed in-kind its shares of the
Institutional Fund. The assets of the Institutional Fund were
transferred in proportion to the Intermediate Series' ownership
of the Institutional Fund in cancellation of its shares.
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Intermediate Duration U.S. Government Series of
the Smith Breeden Series Fund:
We have audited the accompanying statement of assets and
liabilities, including the schedule of investments, of the Smith
Breeden Intermediate Duration U.S. Government Series of the
Smith Breeden Series Fund as of March 31, 1996, and the related
statements of operations and cash flows for the year then ended,
the statements of changes in net assets for each of the years in
the two-year period then ended and the financial highlights for
each of the years in the three-year period then ended and the
period March 31, 1992 (commencement of operations) to March 31,
1993. These financial statements and the financial highlights
are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial
statements and the financial highlights based on our audits.
We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements and the financial highlights are free
of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation
of securities owned at March 31, 1996 by correspondence with the
custodian and brokers. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial
highlights referred to above present fairly, in all material
respects, the financial position of the Smith Breeden
Intermediate Duration U.S. Government Series of the Smith
Breeden Series Fund as of March 31, 1996, the results of its
operations and its cash flows, the changes in its net assets,
and the financial highlights for the respective stated periods
in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
