As filed with the Securities and Exchange Commission
on December 16, 1997
File No. 33-43089
File No. 811-6431
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
F O R M N-1A
Registration Statement Under the Securities Act of 1933
Post-Effective Amendment No. 15
and
Registration Statement Under the Investment Company Act of
1940
Amendment No. 17
____________________
SMITH BREEDEN SERIES FUND
(Exact Name of Registrant as Specified in Charter)
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514
(Address of Principal Executive Office)
(919) 967-7221
(Registrant's Telephone Number, Including Area Code)
MICHAEL J. GIARLA
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514
(Name and Address of Agent for Service)
_______________
Please Send Copy of Communications to:
MARIANTHE S. MEWKILL
Smith Breeden Associates, Inc.
100 Europa Drive, Suite 200
Chapel Hill, NC 27514
(919)-967-7221
This filing shall become effective on December 22, 1997 pursuant to
paragraph (b)(1) of Rule 485 under the Securities Act of 1933.
The Registrant has previously registered an indefinite number of
shares of beneficial interest pursuant to Rule 24f-2 under the
Investment Company Act of 1940, as amended. The Rule 24f-2 notice for
the Registrant's most recent fiscal year was filed on May 29,
1997.
SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
(THE "SHORT FUND")
SMITH BREEDEN INTERMEDIATE DURATION U.S.
GOVERNMENT FUND
(THE "INTERMEDIATE FUND")
CROSS REFERENCE SHEET
FORM N-1A
Part A: Information Required in Prospectus
N-1A
Item No. Item Location in the
Registration Statement
by Prospectus Heading
1. Cover Page Cover Page
2. Synopsis Expense Table
3. Condensed Financial
Information Financial Highlights
4. General Description of Smith Breeden Mutual Funds
Registrant Investment Objectives,
Policies, and Risk
Considerations: The Short
Fund; The Intermediate
Fund
5. Management of the Fund Management of the Funds
5a. Management's Discussion
of Fund's Performance Contained in the Fund's
Annual Report to Shareholders
6. Capital Stock and Other Capital Structure
Securities Dividends and Distributions
7. Purchase of Securities Pricing of Fund Shares
Being Offered How to Purchase Shares
8. Redemption or Repurchase How to Redeem Shares
How to Exchange Shares
9. Pending Legal Proceedings Not Applicable
DECEMBER 22, 1997
SMITH BREEDEN MUTUAL FUNDS PROSPECTUS
The Smith Breeden Mutual Funds consist of four no-load, diversified
Series (the "Funds") of two management investment companies-Smith Breeden
Trust and Smith Breeden Series Fund. The investment adviser for the
Funds is Smith Breeden Associates, Inc. (the "Adviser").
Smith Breeden Equity Market Plus Fund (the "Equity Market Plus Fund", a
series of the Smith Breeden Trust) seeks to provide a total return
exceeding the Standard & Poor's 500 Composite Stock Index without
additional equity market risk. The Fund does not invest principally in the
common stocks that make up the S&P 500 Index (the "Index") or any other
index. Instead, the Fund uses S&P 500 futures and swaps in an effort to
maintain an equity market exposure similar to that which would be achieved
if all of the Fund's assets were invested in the stocks comprising the
Index. Since the Equity Market Plus Fund utilizes index futures contracts
and equity swap contracts to track the S&P 500 Index, it can invest
substantially all of its cash in fixed-income securities and related
hedging instruments. Whether the Fund's total return equals or exceeds the
performance of the S&P 500 Index depends largely on whether the total
return on the Equity Market Plus Fund's fixed-income investments equals or
exceeds the Fund's total operating expenses, as well as other factors.
Smith Breeden Financial Services Fund (the "Financial Services Fund", a
series of the Smith Breeden Trust) seeks capital appreciation. To pursue
this goal, the Fund invests in U.S. and foreign financial services
companies. These include banks, thrift, finance and leasing companies,
brokerage, investment banking and advisory firms, real estate related firms
and insurance companies.
Smith Breeden Short Duration U.S. Government Fund (the "Short Fund", a
series of the Smith Breeden Series Fund) seeks a high level of current
income consistent with low volatility of net asset value. The Short Fund
seeks to match the duration, or interest-rate risk, of a portfolio that
invests exclusively in six month U.S. Treasury securities on a constant
maturity basis. The dollar weighted average maturity of the Fund's
securities may at times significantly exceed six months.
Smith Breeden Intermediate Duration U.S. Government Fund (the "Intermediate
Fund", a series of the Smith Breeden Series Fund) seeks a total return in
excess of the total return of the major market indices for mortgage-backed
securities. The major market indices for mortgage-backed securities
currently include, but are not limited to, the Salomon Brothers Mortgage
Index and the Lehman Brothers Mortgage Index. These indices include all
outstanding government sponsored fixed-rate 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 Fund consistently seeks to achieve
a volatility of net asset value similar to that of a portfolio that invests
exclusively in mortgage-backed securities, as weighted in the major
mortgage market indices.
An investment in any of the Funds is neither insured nor guaranteed by the
U.S. Government. There can be no assurance that any of the Funds will meet
their investment objectives. This Prospectus sets forth concisely the
information about the Funds that you should know before investing. Please
read this Prospectus carefully and keep it for future reference.
Statements of Additional Information dated December 22, 1997, have been
filed with the Securities and Exchange Commission with respect to each
Trust and are legally part of this prospectus. The Statements of
Additional Information can be obtained 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.
<PAGE>
1
TABLE OF CONTENTS
Expense Table 3
Financial Highlights--Equity Market Plus Fund 5
Financial Highlights--Short Fund 6
Financial Highlights--Intermediate Fund 7
Smith Breeden Mutual Funds 8
Investment Objectives, Policies and Risk Considerations 8
Other Investment Practices and Risk Considerations 18
Management of the Funds 24
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 Accountants 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>
2
EXPENSE TABLE
The following table is designed to assist you in understanding the expenses
you will bear as a shareholder of a Fund. 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 annual fund
operating expenses shown below reflect expense limitations agreed to by the
Adviser, and are based on each Fund's expenses for the past fiscal year, if
applicable, or on good faith estimates provided by the Advisor.
Equity
Market Financial
Plus Services Short Intermediate
Fund Fund Fund Fund
Shareholder Transaction Expenses
Maximum Sales Load Imposed on
Purchases None None None None
Maximum Sales Load Imposed on
Reinvested Dividends None None None None
Deferred Sales Load Imposed on
Redemptions None None None None
Redemption Fees1 None None None None
Exchange Fees None None None None
Annual Fund Operating Expenses
(as a percentage of average net assets)
Management Fees2 0.70% 1.50% 0.70% 0.70%
Other Expenses
(net of reimbursement)3 0.18% 0.00% 0.08% 0.18%
Total Fund Operating Expenses
(net of reimbursement)3 0.88% 1.50% 0.78% 0.88%
_____________________________
1 A transaction charge of $9 may be imposed on redemptions by wire
transfer.
2 Pursuant to a distribution and services plan in respect of each Fund,
the Adviser may pay annual distribution and servicing fees of up to
0.25% of each of the Fund's net assets out of its management fee. See
"Service and Distribution Plans."
3 The Other Expenses and Total Fund Operating Expenses in the table
reflect undertakings by the Adviser to bear expenses of each of the
Funds and/or waive its fees to the extent necessary to limit Total
Fund Operating Expenses to 0.78% for the Short Fund and 0.88% for each
of the Equity Market Plus Fund and Intermediate Fund and to 1.50% for
the Financial Services Fund through August 1, 1998. Absent the
expense limitation, Other expenses and Total Fund Operating Expenses
for the past fiscal year would have been 0.23% and 0.93% for the Short
Fund, 0.46% and 1.16% for the Intermediate Fund, and 1.90% and 2.60%
for the Equity Market Plus Fund, and are estimated to be about 4.30%
and 5.00% for the Financial Services Fund.
<PAGE>
3
The following examples illustrate the expenses that apply to a $1,000
investment in each Fund over various time periods assuming: (1) a 5% annual
rate of return, and (2) redemption or no redemption at the end of each time
period. Except as noted in the table above, the Funds charge no redemption
fees.
Short Duration Fund
1 Year 3 Years 5 Years 10 Years
$ 8 $ 26 $ 45 $ 99
Intermediate Duration Fund and Equity Market Plus Fund
1 Year 3 Years 5 Years 10 Years
$ 9 $ 29 $ 50 $ 111
Financial Services Fund
1 Year 3 Years 5 Years 10 Years
$ 16 $ 49 $ 84 $ 184
These examples are based on the annual operating expenses shown above and
should not be considered a representation of past or future expenses or
performance. Actual expenses may be greater or less than those shown. The
annual rate of return may be more or less than 5%.
The Funds may be recommended to investors by registered investment
advisors. Such advisors customarily impose fees that would be in addition
to any fees and expenses presented in the above table. Certain broker-
dealers may also charge a fee for purchase or redemption of shares through
their network. Neither the Funds, nor the Adviser, exercise any control
over such advisory or broker-dealer fees and may not be informed of the
level of such fees.
<PAGE>
4
<TABLE>
EQUITY MARKET 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 September
30, 1997, and except for the six months ended September 30, 1997, are part of
the Fund's financial statements, which have been audited by Deloitte & Touche
LLP, independent auditors. This data should be read in conjunction with the
Fund's most recent annual audited financial statements and the report of
Deloitte & Touche LLP thereon, and unaudited semi-annual financial statements,
which appear in the Statement of Additional Information for the Smith Breeden
Trust.
<CAPTION>
Six Months Year Ended Year Ended Year Ended Year Ended Period
Ended March 31, March 31, March 31, March 31, Ended
September 1997 1996 1995 1994 March 31,
30, 1997 1993
<S> <C> <C> <C> <C> <C> <C>
Net Asset Value, $12.56 $12.27 $10.84 $9.88 $10.85 $10.00
Beginning of Period
Income From Investment
Operations
Net investment 0.250 0.592 0.615 0.568 0.476 0.355
income.................
Net realized and
unrealized gain (loss) 2.877 1.813 2.768 1.081 (0.216) 1.281
on Investments.........
Total from investment 3.127 2.405 3.383 1.649 0.260 1.636
operations.............
Less Distributions
Dividends from net (0.230) (0.590) (0.583) (0.568) (0.472) (0.311)
investment income......
Dividends in excess of -- -- -- (0.001) -- --
net investment income..
Distributions from net
realized gains on (0.247) (1.525) (1.370) (0.047) (0.701) (0.420)
Investments............
Distributions in excess
of net realized gains -- -- -- (0.073) (0.057) (0.055)
on Investments.........
Total distributions..... (0.477) (2.115) (1.953) (0.689) (1.230) (0.786)
Net Asset Value, End of $15.21 $12.56 $12.27 $10.84 $9.88 $10.85
Period..................
Total Return............ 25.08% 21.41% 32.30% 17.18% 2.19% 22.59%*
Ratios/Supplemental Data
Net assets, end of $61,086,390 $13,507,377 $4,766,534 $2,107,346 $1,760,519 $903,846
period.................
Ratio of expenses to
average net assets
Before expense 1.28%* 2.60% 4.58% 7.75% 7.08% 28.48%*
limitation..........
After expense 0.88%* 0.88% 0.90% 0.90% 0.90% 0.57%*
limitation..........
Ratio of net income to
average net assets
Before expense 4.54%* 3.58% 1.85% 0.59% 1.84% (22.63%)*
limitation..........
After expense 4.95%* 5.30% 5.53% 7.44% 8.02% 5.28%*
limitation..........
Portfolio turnover 196% 182% 107% 120% 119% 271%
rate...................
<FN>
<F1>
* Annualized
Additional performance information is presented in the Fund's Annual Report,
which is available without charge upon request.
</FN>
</TABLE>
<PAGE>
5
<TABLE>
SHORT DURATION FUND
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods
from March 31, 1992, the date the Fund commenced operations, through September
30, 1997 and except for the six months ended September 30, 1997, are part of
the Short Fund's financial statements which have been audited by Deloitte &
Touche LLP, independent auditors. This data should be read in conjunction
with the Short Fund's most recent annual audited financial statements and the
report of Deloitte & Touche LLP thereon, and unaudited semi-annual financial
statements, which appear in the Statement of Additional Information for the
Smith Breeden Series Fund.
<CAPTION>
Six Months Year Ended Year Ended Year Ended Year Ended Period
Ended March 31, March 31, March 31, March 31, Ended
September 1997 1996 1995 1994 March 31,
30, 1997 1993
<S> <C> <C> <C> <C> <C> <C>
Net Asset Value, $9.83 $9.74 $9.90 $9.90 $10.00 $10.00
Beginning of Period
Income From Investment
Operations
Net investment 0.261 0.476 0.621 0.628 0.432 0.552
income.................
Net gain (loss) on
securities 0.059 0.146 (0.148) -- (0.070) 0.002
(both realized and
unrealized)............
Total from investment 0.320 0.622 0.473 0.628 0.362 0.554
operations..............
Less Distributions
Dividends from net (0.260) (0.476) (0.621) (0.628) (0.462) (0.554)
investment income......
Dividends in excess of -- (0.056) (0.012) -- -- --
net investment income..
Total distributions..... (0.260) (0.532) (0.633) (0.628) (0.462) (0.554)
Net Asset Value, End of $9.89 $9.83 $9.74 $9.90 $9.90 $10.00
Period.................
Total Return............ 3.30% 6.57% 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of $103,238,834 $118,988,609 $221,825,136 $218,431,665 $218,167,491 $48,531,206
period.................
Ratio of expenses to
average net assets
Before expense 1.01%* 0.93% 0.93% 0.92% 1.00% 2.58%
limitation...........
After expense 0.78%* 0.78% 0.78% 0.78% 0.78% 0.78%
limitation...........
Ratio of net income to
average net assets
Before expense 5.39%* 4.90% 6.13% 6.18% 3.95% 2.73%
limitation...........
After expense 5.62%* 5.04% 6.29% 6.33% 4.17% 4.53%
limitation...........
Portfolio turnover 306% 556% 225% 47% 112% 3%
rate...................
<FN>
<F1>
*Annualized
Additional performance information is presented in the Short Fund's Annual
Report, which is available without charge upon request.
</FN>
</TABLE>
<PAGE>
6
<TABLE>
INTERMEDIATE DURATION FUND
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods
from March 31, 1992, the date the Fund commenced operations, through September
30, 1997, and except for the six months ended September 30, 1997, are part of
the Intermediate Fund's financial statements which have been audited by
Deloitte & Touche LLP, independent auditors. This data should be read in
conjunction with the Intermediate Fund's most recent annual audited financial
statements and the report of Deloitte & Touche LLP thereon, and unaudited semi-
financial statements, which appear in the Statement of Additional Information
for the Smith Breeden Series Fund.
<CAPTION>
Six Months Year Ended Year Ended Year Ended Year Ended Period
Ended March 31, March 31, March 31, March 31, Ended
September 1997 1996 1995 1994 March 31,
30, 1997 1993
<S> <C> <C> <C> <C> <C> <C>
Net Asset Value, $9.73 $10.01 $9.83 $10.01 $10.62 $10.00
Beginning of Period
Income From Investment
Operations
Net investment 0.284 0.599 0.660 0.664 1.05 0.826
income.................
Net gain (loss) on
securities 0.328 (0.024) 2.77 (0.049) (0.601) 0.621
(both realized and
unrealized)............
Total from investment 0.612 0.575 0.937 0.615 0.449 1.447
operations.............
Less Distributions
Dividends from net (0.280) (0.604) (0.656) (0.664) (1.044) (0.826)
investment income......
Dividends in excess of ---- ---- ---- (0.108) ---- --
net investment
income.................
Distributions from net
realized gains on -- (0.251) (0.101) -- (0.015) --
Investments............
Distributions in excess
of net realized gains -- -- -- (0.022) -- --
on Investments.........
Total distributions..... (0.280) (0.855) (0.757) (0.794) (1.059) (0.826)
Net Asset Value, End of 10.06 $9.73 $10.01 $9.83 $10.01 $10.62
Period.................
Total Return............ 6.33% 5.92% 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of $46,914,014 $37,735,525 $36,446,940 $34,797,496 $6,779,666 $2,923,913
period.................
Ratio of expenses to
average net assets
Before expense 1.04%* 1.16% 1.14% 2.33% 2.34% 17.52%
limitation...........
After expense 0.88%* 0.88% 0.90% 0.90% 0.90% 0.82%
limitation...........
Ratio of net income to
average net assets
Before expense 5.53%* 5.92% 6.26% 4.77% 6.30% (8.52%)
limitation...........
After expense 5.69%* 6.19% 6.49% 6.20% 7.74% 8.18%
limitation...........
Portfolio turnover 162% 409% 193% 557% 84% 42%
rate....................
<FN>
<F1>
*Annualized
Additional performance information is presented in the Intermediate Fund's
Annual Report, which is available without charge upon request.
</FN>
</TABLE>
<PAGE>
7
SMITH BREEDEN MUTUAL FUNDS
The Short and Intermediate Funds are funds of the Smith
Breeden Series Fund (the "Series Fund"), an open-end
diversified management investment company. The Equity Market
Plus and Financial Services Funds are series of the Smith
Breeden Trust (the "Trust"), an open-end diversified
management investment company.
Smith Breeden Associates, Inc. ("Smith Breeden" or the
"Adviser") acts as investment adviser to the Funds. Smith
Breeden is a money management and consulting firm founded in
1982 whose clients include pension funds, financial
institutions, corporations, government entities, and
charitable foundations.
INVESTMENT OBJECTIVES, POLICIES, AND RISK CONSIDERATIONS
Each of the Funds has a different investment objective and
different investment policies, and is designed to meet
different investment needs.
The investment objectives and certain investment policies
of the Short and Intermediate Funds are fundamental and may
not be changed without a vote of shareholders of the
relevant Fund. The investment objectives of the Equity
Market Plus and Financial Services Funds are not
fundamental. In order to comply with certain state
securities laws, the Smith Breeden Equity Market Plus Fund
had originally agreed to give its shareholders written
notification at least thirty days prior to any change in the
Fund's objective. As a result of the changes made by the
National Securities Market Improvement Act of 1996, however,
the Fund is no longer subject to such state securities law
requirements. Accordingly, while there is no current
intention to change the investment objective, this
prospectus constitutes notice that on or after January 21,
1998 the Equity Market Plus Fund may make changes to its
investment objective without giving shareholders written
notification.
Since shares of each Fund represent an investment in
securities with fluctuating market prices, the net asset
value per share of each Fund will vary as the aggregate
value of a Fund's portfolio securities increases or
decreases. Due to the risks inherent in all investments,
there can be no assurance that the objectives of the Funds
will be met. The descriptions that follow are designed to
help you choose the Fund or combination of Funds that best
fits your investment objectives.
Short Fund
The Short Fund's investment objective is to provide
investors with a high level of current income, consistent
with a volatility of net asset value similar to that of a
portfolio which invests exclusively in six-month U.S.
Treasury securities on a constant maturity basis. There is
no assurance that the Short Fund will be able to maintain a
<PAGE>
8
low volatility of net asset value.
The Short Fund will seek its investment objective by
investing, under normal circumstances, at least 70% of its
total assets in U.S. Government Securities (see "Investment
Objectives, Policies and Risk Considerations-Characteristics
and Risks of the Securities in which the Short and
Intermediate Funds and Fixed Income Segment of the Equity
Market Plus Fund Invest"). It is anticipated that the Short
Fund will invest primarily in mortgage-backed securities
issued by the U.S. Government, its agencies and
instrumentalities. The Fund will also invest in fixed-rate
and adjustable-rate mortgage-backed securities issued by non-
governmental issuers. The Fund may hold a portion of its
assets in money market instruments and in time and savings
deposits (including fixed-rate or adjustable certificates of
deposit) in commercial banks or institutions whose accounts
are insured by the FDIC, BIF or SAIF.
Under normal circumstances the Short Fund will seek to
achieve an interest-rate risk or option-adjusted duration
(See "Other Investment Practices and Risk Considerations-
Adjusting Investment and Interest Rate Risk Exposure")
similar to that of a six-month U.S. Treasury security on a
constant maturity basis. However, the Short Fund expects
that, under normal circumstances, the dollar-weighted
average life (or period until the next reset date) of its
portfolio securities will be longer than six months,
sometimes significantly longer.
The Adviser believes that by investing in mortgage
securities from a variety of market sectors on a selective
basis and adjusting the overall option-adjusted duration of
the portfolio to approximate that of a six-month U.S.
Treasury security, the Short Fund will achieve a more
consistent and less volatile net asset value than is
characteristic of mutual funds that invest primarily in
mortgage securities paying a fixed rate of interest or those
that invest exclusively in adjustable-rate mortgage
securities. The securities in which the Short Fund may
invest may not yield as high a level of income as other
securities in which other funds may invest. However, such
higher yielding securities may be more volatile and may be
issued by less creditworthy entities.
Intermediate Fund
The Intermediate Fund's investment objective is to provide
investors with a total return in excess of the total return
of the major market indices for mortgage-backed securities.
The Intermediate Fund will seek its investment objective by
investing, under normal circumstances, at least 70% of its
total assets in U.S. Government Securities. It is
anticipated that the Intermediate Fund will invest primarily
in mortgage-backed securities issued by the U.S. Government,
its agencies or instrumentalities. The Fund will also invest
in fixed-rate and adjustable rate mortgage-backed securities
issued by non-governmental issuers. The Fund may hold a
portion of its assets in money market instruments and in
<PAGE>
9
time and savings deposits (including fixed-rate or
adjustable-rate certificates of deposit) in commercial banks
or institutions whose accounts are insured by the FDIC, BIF,
or SAIF.
The major market indices for mortgage-backed securities
currently include, but are not limited to, the Salomon
Brothers Mortgage Index and the Lehman Brothers Mortgage
Index. These indices include all outstanding government
sponsored fixed-rate mortgage-backed securities, weighted in
proportion to their current market capitalization. Total
return is the change in value of the investment, assuming
reinvestment of all distributions. Under normal
circumstances, the Intermediate Fund will seek to achieve an
interest-rate risk or option-adjusted duration (see "Other
Investments and Risk Considerations") 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
believed by the Adviser to be 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.
There is no assurance that the Intermediate Fund will be
able to maintain a total return in excess of the total
return of major market indices for mortgage-backed
securities, or that it will match the interest rate risk of
a portfolio investing exclusively in these securities.
Fundamental Policies. As a matter of fundamental policy,
the Short and Intermediate Funds will limit purchases to
securities from 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. Securities fully collateralized by assets in either
of the above classes;
4.Assets which would qualify as liquidity items under
federal regulations if held by a commercial bank or
savings institution; and
5.Hedge instruments, which may only be used for risk
management purposes. Any securities described in the
"Hedging" section and any stripped Mortgage-Backed
Securities may only be used for risk management
purposes.
Equity Market Plus Fund
The Equity Market Plus Fund seeks to provide a total
return exceeding the Standard & Poor's 500 Composite Stock
Price Index (the "Index") without additional equity market
<PAGE>
10
risk. The Fund does not invest principally in the common
stocks that make up the Index or any other stock index.
Instead, the Fund uses S&P 500 futures and swaps in an
effort to maintain an equity market exposure similar to
that which would be achieved if all of the Fund's assets
were invested in the stocks comprising the Index. Since the
Equity Market Plus Fund utilizes index futures contracts and
equity swap contracts to track the S&P 500 Index, it can
invest substantially all of its cash in fixed-income
securities and related hedging instruments. Whether the
Fund's total return equals or exceeds the performance of the
S&P 500 Index depends largely on whether the total return on
the Equity Market Plus Fund's fixed-income investments
equals or exceeds the Fund's total operating expenses, as
well as other factors.
The S&P 500 Index is an unmanaged index composed of 500
common stocks, most of which are listed on the New York
Stock Exchange. Standard & Poor's, which is not a sponsor
of or in any other way affiliated with the Fund, chooses the
500 stocks included in the S&P 500 Index on the basis of
market value and industry diversification. The S&P 500
Index assigns relative values to the stocks included in the
index, weighted according to each stock's total market value
relative to the total market value of the other stocks
included in the index.
The Equity Market Plus Fund seeks its objective by dividing
its portfolio into two segments: an "S&P 500 Index Segment"
and a "Fixed Income Segment." Through the S&P 500 Index
Segment, the Fund invests in a combination of equity swap
contracts, futures contracts on the S&P 500 Index and on
other stock indices, including, but not limited to, the New
York Stock Exchange Composite Index, and common stocks whose
return (before deducting allocated costs) is expected to
track movements in the S&P 500 Index. By employing this
strategy, the Equity Market Plus Fund seeks to achieve the
same investment opportunity and risk profile for the S&P 500
Index 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
weightings in the S&P 500 Index.
When index futures contracts and/or equity swap contracts
are, in the judgment of the Adviser, overpriced relative to
the common stocks underlying the S&P 500 Index, the Fund may
invest directly in the common stocks represented by the S&P
500 Index. The Fund will not own all 500 issues, but will
attempt to purchase a basket of common stocks which the
Adviser expects will, on average, match movements in the S&P
500 Index. Subject to limits on the Fund's investments in
other investment companies, the Fund may also invest in
these stocks indirectly by purchasing interests in asset
pools investing in such stocks. To the extent that the Fund
purchases interests in other investment companies,
shareholders of the Fund may be subject to a layering of
expenses because they may indirectly bear a proportionate
share of the expenses of such investment companies
(including advisory fees) in addition to bearing the direct
<PAGE>
11
expenses of the Fund.
Through the Fixed Income Segment, the Fund invests in
fixed-income securities and uses related hedging techniques
such as futures, options, floors, caps and swaps. The Fixed-
Income Segment will invest substantially all of its assets
in U.S. Government Securities, and may also invest in bank
certificates of deposit, corporate debt obligations, and
mortgage-backed and other asset-backed securities of non-
governmental issuers. The Fund may also engage in loans of
portfolio securities, dollar rolls, and reverse repurchase
agreements to enhance income and total return. With these
investments, the Fund seeks to generate income (consisting
primarily of interest income) and gains which exceed the
total costs of operating the Fund (including the costs
associated with the S&P 500 Index Segment). Thus, whether
the Fund's total return equals or exceeds the performance of
the S&P 500 Index depends largely on whether the total
return on the Fund's Fixed-Income Segment equals or exceeds
the Fund's total operating expenses, as well as other
factors described below.
The S&P 500 Index Segment's actual opportunities for gain or
loss may be greater than a hypothetical portfolio invested
in the stocks comprising the S&P 500 Index depending upon
the Fund's exposure to the S&P 500 Index, which could at
times be higher or lower than the Fund's total assets. For
example, the total net notional amount of the Fund's equity
swap contracts, S&P 500 or other stock index futures plus
the market value of common stocks owned by the Fund may
exceed the Fund's total net assets as a result of purchases
and redemptions of Fund shares. In addition, since S&P 500
Index futures can only be purchased for specific amounts,
the Fund might not be able to match accurately a notional
amount of futures contracts to the Fund's total net assets.
Under normal market conditions, the Fund expects that such
variations in S&P 500 Index exposure will generally be up to
5% greater or less than the Fund's total net assets. Also,
the ability of the S&P 500 Index Segment of the Fund's
portfolio to replicate the investment opportunity and risk
profile of a hypothetical stock portfolio may be diminished
by imperfect correlations between price movements of the S&P
500 Index with price movements of S&P 500 and other stock
index futures and/or the common stocks purchased by the
Fund. In addition, the purchase and sale of common stocks
and S&P 500 and other stock index futures involve
transaction costs. Equity swap contracts require the Fund
to pay interest on the notional amount of the contract.
Therefore, assuming the Fund has successfully tracked the
movement of the S&P 500 Index, the Fund will outperform the
S&P 500 Index only if the total net return on the Fixed
Income Segment of the Fund's portfolio exceeds the sum of
(to the extent applicable) (1) the Fund's transaction costs
on S&P 500 and other stock index futures and common stock
transactions, (2) the interest payments under the Fund's
equity swap contracts and (3) the Fund's operating expenses
as described more fully under "Management of the Fund."
Example. Set forth below is an example of how the Equity
<PAGE>
12
Market Plus Fund might invest a $100 million portfolio:
1.Enter into an equity swap contract with a notional amount
of $50 million;
2.Purchase S&P 500 index futures contracts with a total
contract value of $45 million; and
3.Purchase $5 million worth of common stocks comprising the
S&P 500 Index in proportion to their respective weightings
in the S&P 500 Index.
Because equity swap contracts and futures contracts may
generally be initially entered into without making cash
payments, the Fixed Income Segment would have $95 million to
invest in various fixed income securities with appropriate
hedging strategies. If, during the course of the year, the
stocks comprising the S&P 500 Index appreciate 10% on
average and pay a 4% dividend, and if the interest on the
equity swap contract's notional amount is 6%, at the end of
the year the following would occur:
1.The counterparty to the equity swap contract would be
required to pay the Fund $4 million ($7 million
appreciation and dividends minus $3 million interest);
2.The S&P 500 index futures contract would be closed out at
a gain of $3.6 million ($6.3 million S&P 500 Index
appreciation less $2.7 million for the S&P 500 Futures
implicit cost of carry);
3.Dividend income and gain on the common stocks would total
$0.7 million and in sum;
4.The S&P 500 Index Segment's return, before related
operating expenses, would total $8.3 million dollars or
8.3%.
The Fund's total operating expenses (other than brokerage
expenses and the interest on the notional amount of the
equity swap contract as described above) are 0.88% of total
net assets, or $0.88 million dollars. After consideration
of these expenses, the S&P 500 Index Segment's return would
total 7.42%. Therefore, the Fund would achieve a total
return equal to the S&P 500 Index only if the Fixed Income
Segment has a total return equal to 6.93% per annum. If the
Fixed Income Segment achieves this result, then the Fund's
total net assets would be $114 million-an increase of 14%
and a total return equal to the S&P 500 Index. If the Fixed
Income Segment's total return were greater or less than
6.93% per annum, the Fund's total return would, in turn, be
greater or less than the S&P 500 Index.
Smith Breeden Financial Services Fund
The Financial Services Fund seeks capital appreciation. To
pursue this goal, the fund will invest at least 65% of its
assets in U.S. and foreign financial services companies.
These include banks, thrift, finance and leasing companies,
brokerage, investment banking and advisory firms, real
estate related firms and insurance companies. The Fund will
generally invest in common stock and in other equity
securities such as preferred stock and warrants. The Fund
may also engage in other investment practices. See "Other
<PAGE>
13
Investment Practices and Risk Considerations."
Because the Financial Services Fund invests in single
sector, its performance is largely dependent on the sector's
performance, which may differ from that of the overall stock
market. Changing interest rates or deteriorating economic
conditions can adversely affect the performance of financial
services companies' stocks. The Fund may buy or sell
interest rate futures and options to attempt to mitigate the
affect of changing interest rates upon the portfolio.
However, the use of interest rate futures in such a strategy
involves the risk that the price movements of the hedging
instrument will not accurately reflect price movements in
the security due to changing interest rates, so that the
hedge will not be fully effective or may result in losses.
The Fund may also buy or sell stock index futures or options
on such indices to adjust the risk and return
characteristics of the Fund's stock portfolio. If the
Adviser judges market conditions incorrectly or employs a
strategy that does not correlate well with the Fund's
investments, the use of stock index futures could result in
a loss, regardless of whether the intent was to reduce risk
or increase return. These techniques may also increase the
volatility of the Fund relative to the Financial Services
sector of the stock market. See also "Other Investment
Practices and Risk Considerations" and the Statement of
Additional Information for a discussion of the use of
financial futures and options and their risks.
Financial services companies are subject to extensive
government regulation which may limit both the amounts and
types of loans and other financial commitments they can
make, and the interest rates and fees they charge.
Profitability is largely dependent upon on the availability
and cost of capital funds, and can fluctuate significantly
when interest rates change. Credit losses resulting from
the financial difficulties of borrowers can negatively
impact the industry. Insurance companies may be subject to
severe price competition. Legislation is currently being
considered which would reduce the separation between
commercial and investment banking businesses. If enacted
this could significantly impact the financial services
sector and the Fund.
The Fund may purchase securities of foreign financial
services companies, which are subject to additional risks.
Currency fluctuations can adversely affect the returns on
investments held in foreign corporations. Other risks relate
to the fact that differences exist in accounting, auditing
and financial reporting standards. Political developments
may also have an adverse impact. There is also the
possibility of changes in investment or exchange control
regulations, restrictions on the flow of international
capital, and difficulties in pursuing legal remedies against
issuers. The Fund will primarily invest in foreign
financial securities through ADRs, which represent shares of
a foreign corporation held by an U.S. bank that entitles the
holder to all dividends and capital gains. ADRs are
<PAGE>
14
denominated in U.S. dollars and trade in the U.S. securities
markets. ADRs are still subject to the risks associated
with foreign investment generally described above. The
Financial Services Fund may hedge against fluctuations in
foreign exchange rates by entering into foreign currency
forward and futures contracts. For more discussion of these
contracts and their risks, see "Other Investment Practices
and Risk Considerations" and the Statement of Additional
Information.
Under regulations imposed by the Investment Company Act of
1940 and its rules (the "1940 Act"), the Fund may not
purchase more than 10% of the securities of any domestic or
foreign insurance company. The Fund may also not invest
more than 5% of its total assets in the equity securities of
any company that derives more than 15% of its revenues from
brokerage or investment management activities, unless such
investment is limited to not more than 5% of the equity
securities or 10% of the debt securities of such company,
and such investment represents not more than 5% of the net
assets of the Fund.
The Financial Services Fund intends to be a diversified
fund, as defined under the 1940 Act, and as such, with
respect to 75% of its assets, will not invest more than 5%
of its assets in any single issuer, and such 5% holding
cannot represent more than a 10% voting interest in the
acquired company.
Characteristics and Risks of the Securities in which the
Short and Intermediate Funds and Fixed Income Segment of the
Equity Market Plus Fund Invest
U.S. Government Securities. The U.S. Government Securities
in which the Funds may invest include U.S. Treasury Bills,
Notes, Bonds, discount notes and other debt securities
issued by the U.S. Treasury, and obligations issued or
guaranteed by the U.S. Government, its agencies and
instrumentalities including, but not limited to, the
Government National Mortgage Association ("GNMA"), Federal
National Mortgage Association ("FNMA") and Federal Home Loan
Mortgage Corporation ("FHLMC"). (Other U.S. Government
agencies or instrumentalities include Federal Home Loan
Banks, Bank for Cooperatives, Farm Credit Banks, Tennessee
Valley Authority, Federal Financing Bank, Small Business
Administration, and Federal Agricultural Mortgage
Corporation.) Mortgage-backed securities are explained more
fully below.
Credit Risks. While certain U.S. Government securities
such as U.S. Treasury obligations and GNMAs are backed by
the full faith and credit of the U.S. Government, other
securities in which the Funds may invest are subject to
varying degrees of risk of default. These risk factors
include the creditworthiness of the issuer and, in the case
of mortgage-backed and asset-backed securities, the ability
of the mortgagor or other borrower to meet its obligations.
The Short and Intermediate Funds will seek to minimize this
credit risk by investing in securities of the highest credit
<PAGE>
15
quality instruments, while the Equity Market Plus Fund will
seek to minimize this risk of default by investing in
securities of at least investment grade, except that the
Equity Market Plus Fund's investment in mortgage backed
securities will be rated at least A by Standard & Poors
("S&P"). 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.
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 Short and Intermediate Funds may only invest in
mortgage-backed securities issued by private originators of,
or investors in, mortgage loans issued by private entities
that are rated AAA by S&P or Aaa by Moody's Investors
Service ("Moody's"), or, if unrated, determined by the
Adviser to be of comparable quality. The Short and
Intermediate Funds will not pay any additional fees for
credit support and will not invest in private mortgage pass-
through securities unless they are rated AAA by S&P or Aaa
by Moody's, or are unrated but deemed to be of comparable
credit quality by the Adviser. In addition, the Short and
Intermediate Funds will only purchase mortgage-backed
securities which constitute "Mortgage Related Securities"
for purposes of the Secondary Mortgage Market Enhancement
Act of 1984.
The Equity Market Plus Fund may invest in other mortgage-
backed and asset-backed securities. Its investment in
mortgage-backed and other asset-backed securities will be
rated at least A by Moody's or S&P. 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
<PAGE>
16
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 "Other Investment Practices and Risk
Considerations" and the Statement of Additional Information.
Adjustable-Rate Securities. Adjustable-rate securities have
interest rates that are reset at periodic intervals, usually
by reference to some interest rate index or market interest
rate. Some adjustable-rate securities are backed by pools
of mortgage loans. The Short and Intermediate Funds will
only invest in adjustable-rate securities backed by pools of
mortgage loans ("ARMs"). The Fixed Income Segment of the
Equity Market Plus Fund may also invest in adjustable-rate
securities backed by assets other than mortgage pools.
Although the rate adjustment feature may act as a buffer to
reduce large changes in the value of adjustable-rate
securities, these securities are still subject to changes in
value based on changes in market interest rates or changes
in the issuer's creditworthiness. Because the interest rate
is reset only periodically, changes in the interest rate on
adjustable-rate securities may lag changes in prevailing
market interest rates. Also, some 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 generally with mortgage-backed securities.
Other Mortgage Backed Securities and Fixed Income
<PAGE>
17
Investments. The Short and Intermediate Funds and Fixed
Income Segment of the Equity Market Plus Fund may also
invest in other types of mortgage-backed and fixed income
securities including Collateralized Mortgage Obligations,
Stripped Securities, and zero coupon bonds. These types of
securities, including their risks, are described in detail
in the Statement of Additional Information. 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.
OTHER INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Statement of Additional Information for each Fund
contains more detailed information about the following
practices, including limitations designed to reduce their
risks.
Adjusting Investment and Interest Rate Risk Exposure. A Fund
can use various techniques to increase or decrease its
exposure to changing security prices and indices, currency
exchange rates, interest rates or other factors that affect
security value, or to employ temporary substitutes for
anticipated future transactions. These techniques include
buying or selling financial futures contracts, purchasing
call or put options, or selling covered call options on such
futures or entering into currency exchange contracts or swap
agreements. Any or all of these techniques may be used at
one time, except that only the Financial Services Fund may
enter into currency exchange futures, forward or swap
contracts. Use of any particular transaction is a function
of market conditions. There is no overall limitation on the
percentage of a Fund's assets which may be subject to a
hedge position.
Swap agreements are two-party contracts entered into
primarily by institutional investors for periods ranging
from a few weeks to more than one year. In a standard swap
transaction, two parties agree to exchange the returns (or
differentials in rates of return) earned or realized on
particular predetermined investments or instruments, which
may be adjusted for an interest factor. The gross returns to
be exchanged or "swapped" between the two parties are
generally calculated with respect to a "notional amount",
i.e., the return on or increase in value of a particular
dollar amount invested at a particular interest rate, in a
particular foreign currency, or in a "basket" of securities
representing a particular index. Whether a Fund's use of
swap agreements will be successful in furthering its
investment objective will depend on the Advisor's ability to
predict correctly whether certain types of investments are
likely to produce greater returns than other investments.
Because they are two-party contracts and because they may
have terms of greater than seven days, swap agreements are
currently considered illiquid investments. Moreover, a Fund
bears the risk of loss of the amount expected to be received
<PAGE>
18
under a swap agreement in the event of the default or
bankruptcy of a swap agreement counterparty. The Funds will
enter into swap agreements only with counterparties that
meet certain standards for creditworthiness (generally such
counterparties would have to be eligible counterparties
under the terms of the Funds' repurchase agreement
guidelines). Certain restrictions imposed on the Funds by
the Internal Revenue Code may limit the Funds' ability to
use swap agreements. The swaps market is a relatively new
market and is largely unregulated. It is possible that
developments in the swaps market, including potential
government regulation, could adversely affect a Fund's
ability to terminate existing swap agreements or to realized
amounts to be received under such agreements.
Options and futures transactions involve costs and may
result in losses. The losses from investing in futures
transactions are potentially unlimited. In addition, 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 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. For example, a Fund 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. In the case of the
Short and Intermediate Funds, and the Fixed Income segment
of the Equity Market Plus Fund, this means that they may not
achieve, and may at times exceed, their targeted option-
adjusted durations.
Option-adjusted duration is a measure of the price
sensitivity of a portfolio to changes in interest rates.
The maturity of a security, another commonly used measure of
price sensitivity, measures only the time until final
payment is due, whereas option-adjusted duration takes into
account the pattern of all payments of interest and
principal on a security over time, including how these
payments are affected by prepayments and by changes in
interest rates. In computing the duration of a Fund's
portfolio, the Adviser will estimate the duration of
obligations that are subject to prepayment or redemption by
the issuer, taking into account the influence of changes in
<PAGE>
19
interest rates on prepayments and coupon flows.
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 the
Adviser's estimates of their durations, the hedge may not be
effective.
The Short, Intermediate and Equity Market Plus 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 fixed income 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 Short and Intermediate Funds will not purchase a put or
call option on U.S. Government securities or mortgage-backed
securities if, as a result of such purchase, more than 10%
of its total assets would be invested in such options. The
Short and Intermediate Funds will engage in OTC option
transactions only with primary United States government
securities dealers recognized by the Federal Reserve Bank of
New York. The Short and Intermediate Funds will also not
sell options which are not covered.
The Equity Market Plus Fund will not purchase or sell 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 liquid securities in a segregated account with its
Custodian, in an amount which, together with the initial
margin deposit on the futures contract, is equal to the
current delivery or cash settlement value of the futures
contract. The Statement of Additional Information provides
additional information regarding equity swap contracts, S&P
500 and other stock index futures contracts and their
related risks.
In accordance with regulations established by the Commodity
Futures Trading Commission, each Funds' aggregate initial
margin and premiums on all futures and options contract
positions not held for bona fide hedging purposes, will not
exceed 5% of a Fund's net assets, after taking into account
unrealized profits and losses on such contracts.
The Funds' ability to engage in options and futures
<PAGE>
20
transactions and to sell related securities might also be
limited by tax considerations and by certain regulatory
requirements. See "Taxes" in the relevant Statement of
Additional Information.
Securities Lending, Repurchase Agreements and Forward
Commitments. The Funds may lend portfolio securities to
broker-dealers and may enter into repurchase agreements.
These transactions must be fully collateralized at all times
but involve some risk to the Funds if the other party should
default on its obligations and a Fund is delayed in or
prevented from recovering the collateral. None of the Funds
will lend portfolio securities if, as a result, the
aggregate of such loans exceeds 33 1/3% of the total asset
value (including such loans). The Funds will only enter into
repurchase agreements with or lend securities to (i) member
banks of the Federal Reserve System having total assets in
excess of $500 million and (ii) securities dealers, provided
such banks or dealers meet the creditworthiness standards
established by the Board of Trustees ("Qualified
Institutions"). The Adviser will monitor the continued
creditworthiness of Qualified Institutions, subject to the
oversight of the Board of Trustees.
The Funds may also purchase securities for future delivery,
which may increase overall investment exposure and involves
a risk of loss if the value of the securities declines prior
to the settlement date. At the time a Fund enters into a
transaction on a when-issued or forward commitment basis, a
segregated account consisting of liquid 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. 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 Funds may only
enter into these transactions with commercial banks and
registered broker-dealers which are also Qualified
Institutions. The Statement of Additional Information for
each Trust 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
<PAGE>
21
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 Short,
Intermediate, and Equity Market Plus Funds expect to engage
in short sales as a form of hedging in order to shorten the
overall duration of the portfolio and maintain portfolio
flexibility. The Financial Services Fund may make short
sales of securities to reduce the risk of the portfolio to
the market or to increase return. While a short sale may act
as effective hedge to reduce the market or interest rate
risk of a portfolio, it may also result in losses which can
reduce the portfolio's total return.
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 into which it
will deposit liquid securities 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"). Such transactions might accelerate the recognition
of gain. See "Taxes" in the relevant Statement of
Additional Information.
Illiquid Securities. A Fund may invest up to 15% of its net
<PAGE>
22
assets in illiquid securities. The term illiquid securities
for this purpose means securities that cannot be disposed of
within seven days in the ordinary course of business. The
SEC staff takes the position that this includes non-
terminable repurchase agreements having maturities of more
than seven days.
The Financial Services Fund may invest in restricted
securities, which represent securities that can be sold in
privately negotiated transactions, pursuant to an exemption
from registration under the Securities Act of 1933, or in
registered public offering. Restricted securities deemed to
be liquid under procedures established by the Board are not
subject to the limitations on illiquid securities.
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 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 the Statement of Additional
Information, 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". The Adviser expects that for the
Financial Services Fund, the portfolio turnover rate will
not exceed 400%.
The portfolio turnover rates reported in the "Financial
Highlights" for the Short and Intermediate Funds for the
fiscal year ended March 31, 1997 were relatively high.
Since the Short and Intermediate Funds' portfolio holdings
are very liquid, the Funds may reposition its holdings
between different mortgage sectors relatively frequently,
but without generating substantial transaction costs. The
mortgage securities in which the Short, Intermediate and
Equity Market Plus Funds invest are generally traded on a
"net" basis with dealers acting as principals for their own
account without a stated commission.
The Funds will pay commissions in connection with options
and future transactions and, for the Equity Market Plus Fund
and Financial Services Fund, in relation to any purchase of
common stocks or other equity securities.
Until March 31, 1998, for the Short, Intermediate, and
<PAGE>
23
Equity Market Plus Funds only, 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 will 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 these 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
Its Board of Trustees manages the business affairs of the
Funds. Each of the Funds has entered into an investment
advisory agreement with Smith Breeden Associates, Inc., 100
Europa Drive, Chapel Hill, North Carolina, 27514 (the
"Investment Advisory Agreements"). Pursuant to such
investment advisory agreements, the Adviser furnishes
continuous investment advisory services to each of the
Funds.
Trustees and Officers
The following is a listing of the Trustees and officers of
the Series Fund and Trust, the legal entities that have
issued shares in the Funds. Unless otherwise indicated, all
of the named individuals serve in their capacities for both
the Series Fund and Trust.
Douglas T. Breeden* Trustee and Chairman
Portfolio Manager, Financial
Services Fund
Dr. Breeden, the Chairman of the Board of Smith Breeden
Associates, co-founded the firm in 1982. In conjunction
with Michael J. Giarla and Robert B. Perry, he is
responsible for the day-to-day operations of the Financial
Services Fund. Dr. Breeden has served on business school
faculties at Duke University, Stanford University and the
University of Chicago, and as a visiting professor at Yale
University and at the Massachusetts Institute of Technology.
He is the Editor of the Journal of Fixed Income. Dr.
Breeden served as Associate Editor for five journals in
financial economics, and was elected to the Board of
Directors of the American Finance Association. He has
published several well-cited articles in finance and
economics journals. He holds a Ph.D. in Finance from the
Stanford University Graduate School of Business, and a B.S.
in Management Science from the Massachusetts Institute of
Technology. He serves as Chairman of Harrington Financial
Group, the holding company for Harrington Bank, F.S.B., of
Richmond, Indiana.
* Interested Person
<PAGE>
24
Michael J. Giarla* Trustee and President
Portfolio Manager, Financial
Services Fund
Mr. Giarla is Chief Operating Officer, President and
Director of Smith Breeden Associates. In conjunction with
Douglas T. Breeden and Robert B. Perry, he is responsible
for the day-to-day operations of the Financial Services
Fund. 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.
* Interested Person
Stephen M. Schaefer Trustee
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance
at the London Business School. Previously on the Faculty of
the Graduate School of Business of Stanford University, he
has also taught at the Universities of California
(Berkeley), Chicago, British Columbia and Venice. His
research interests focus on capital markets and financial
regulation. He served on the editorial board of a number of
professional journals including, currently, the Journal of
Fixed Income, the Review of Derivative Research, and
Ricerche Economiche. He consults for a number of leading
financial institutions and is a former Independent Board
Member of the Securities and Futures Authority of Great
Britain.
Myron S. Scholes Trustee
Myron S. Scholes is a Principal in the money management firm
Long-Term Capital Management Co. (since 1993). He is the
Frank E. Buck Professor of Finance Emeritus at the Graduate
School of Business at Stanford University (since 1983). He
is a member of the Econometric Society. Professor Scholes
was also a Managing Director and co-head of the fixed income
derivatives group at Salomon Brothers between 1991-1993.
Prior to coming to Stanford University in 1983, Professor
Scholes was the Edward Eagle Brown Professor of Finance at
<PAGE>
25
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 (with Fischer Black, May 1973), for which
he was awarded the Nobel Prize in Economic Sciences in 1997.
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, a
procedure for estimating the style of an investment manager
from its historic returns, and the Sharpe ratio for
measuring investment performance. Dr. Sharpe has published
articles in a number of professional journals. He has also
written six books, including Portfolio Theory and Capital
Markets, (McGraw-Hill, 1970), Asset Allocation Tools,
(Scientific Press, 1987), Fundamentals of Investments (with
Gordon J. Alexander and Jeffery Bailey, Prentice-Hall, 1993)
and Investments (with Gordon J. Alexander and Jeffrey
Bailey, Prentice-Hall, 1990). Dr. Sharpe is a past
President of the American Finance Association. He also
served as consultant to a number of corporations and
investment organizations. He is Trustee of the Barr
Rosenberg mutual funds, a director of Stanford Management
Company and the Chairman of the Board of Financial Engines,
a company providing electronic portfolio advice. He
received the Nobel Prize in Economic Sciences in 1990.
Daniel C. Dektar Vice President, Smith Breeden
Series Fund
Portfolio Manager, Short and
Intermediate Funds
<PAGE>
26
Daniel C. Dektar is a Principal, Executive Vice President,
Director of Portfolio Management, and Director of Smith
Breeden Associates. Mr. Dektar has been primarily
responsible for the day-to-day management of the Short and
Intermediate Funds since their commencement of operations in
1992. On December 31, 1997, Timothy D. Rowe will join Mr.
Dektar as co-Portfolio Manager of the Intermediate Fund, and
will thereafter share responsibility for the day-to-day
management of that Fund. As head of Smith Breeden
Associates' portfolio management group, Mr. Dektar is
constantly in touch with developments on Wall Street.
He serves as a liaison among the portfolio management,
client service, and research groups to ensure accurate
analysis and timely execution of portfolio management
opportunities. Mr. Dektar consults with institutional
clients in the areas of investments and risk management.
He made several presentations on mortgage investments and
risk management at seminars for institutional
investors. Mr. Dektar was an Associate in the Mergers and
Acquisitions Group of Montgomery Securities in San Francisco,
California and a Financial Analyst in the Investment
Banking Division of Morgan Stanley & Co., Incorporated,
New York before joining Smith Breeden Associates. He
holds a Master of Business Administration with Concentration
in Finance from Stanford University Graduate School of
Business, where he was an Arjay Miller Scholar. Mr. Dektar
received a Bachelor of Science in Business Administration,
summa cum laude, from the University of California
at Berkeley, where he was University of California
Regent's Scholar, was elected to Phi Beta Kappa and Phi Eta
Sigma, and won the White Award as the top student in finance.
Timothy D. Rowe Portfolio Manager, Intermediate Fund
(Effective December 31, 1997)
Timothy D. Rowe is a Principal, Director, and Vice President of
Smith Breeden Associates. Effective December 31, 1997, Mr. Rowe,
in conjunction with Daniel C. Dektar, will be responsible for the
day-to-day management of the Intermediate Fund. Mr. Rowe is a
senior portfolio manager working primarily with discretionary
separate account clients. He implements investment strategies
designed to generate portfolio returns superior to the broad
investment grade and mortgage market indices. Mr. Rowe joined
Smith Breeden in 1988. His prior experience includes three years
as Assistant Economist at the Federal Reserve Bank of Richmond,
Virginia. While at the Bank, he co-edited the sixth edition of
Instruments of the Money Market, and produced research papers for
publication in the Bank's Economic Review magazine. He holds a
Master of Business Administration with specialization in Finance
from the University of Chicago Graduate School of Business, and a
Bachelor of Arts in Economics and History from Duke University.
He graduated from Duke magna cum laude, earned Class Honors and
was a National Merit Scholar.
John B. Sprow Vice President, Smith Breeden
Trust
Portfolio Manager, Equity Market
Plus Fund
<PAGE>
27
John B. Sprow is a Principal, Director and Executive Vice
President of Smith Breeden Associates. Mr. Sprow has been
primarily responsible for the day-to-day management of the
Equity Market Plus Fund from the commencement of its
operations in 1992. Mr. Sprow is a senior portfolio manager
who works primarily with discretionary pension accounts. In
addition to traditional mortgage accounts, he also manages
S&P 500 indexed accounts. Prior to directly managing
discretionary accounts, Mr. Sprow assisted in the
development of the Adviser's models for pricing and hedging
mortgage-related securities, risky commercial debt, and
forecasting mortgage prepayment behavior. Mr. Sprow came to
Smith Breeden Associates from the Fuqua School of Business,
Duke University, where he was Research Assistant.
Previously, Mr. Sprow was a Research Assistant to the
Department Head of the Materials Science Department, Cornell
University. He received a Master of Business Administration
with Emphasis in Finance from the Fuqua School of Business,
Duke University. Mr. Sprow holds a Bachelor of Science in
Materials Science and Engineering from Cornell University,
where he was awarded the Carpenter Technology Scholarship
three successive years.
Robert B. Perry Vice President, Smith Breeden
Trust
Portfolio Manager, Financial
Services Fund
Robert B. Perry is a Principal at Smith Breeden Associates,
providing hedging and investment advice to Smith Breeden's
financial services clients. He is also responsible for
calculating market-to-market values and projected income of
institutions, and assesses the effects of interest rate and
economic changes. In conjunction with Douglas T. Breeden
and Michael J. Giarla, Mr. Perry is responsible for the day-
to-day operations of the Financial Services Fund. Prior to
joining Smith Breeden, Mr. Perry served as an interest rate
risk analyst for Centura Bank, and secretary to the ALCO
committee. He has also served as a Director for Community
First Financial Group, a multi-bank holding company located
in Indianapolis, Indiana. Mr. Perry earned his Bachelor of
Arts in Business Administration from North Carolina State
University.
Marianthe S. Mewkill Vice President, Secretary,
Treasurer, and
Chief Accounting Officer
Marianthe S. Mewkill is a Principal, Vice President and
Chief Financial Officer of Smith Breeden Associates. Ms.
Mewkill handles financial reporting, budgeting, tax research
and planning for the Smith Breeden Mutual Funds and for
Smith Breeden Associates, Inc. She ensures compliance with
agency regulations and administers the Adviser's internal
trading and other policies. She was previously employed as
a Controller for the Hunt Alternatives Fund, as an Associate
at Goldman Sachs & Co., and as a Senior Auditor at Arthur
Andersen & Co. She earned a Master of Business
Administration with Concentrations in Finance and Accounting
<PAGE>
28
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.
Investment Adviser
Smith Breeden Associates, Inc., a registered investment
adviser, acts as investment adviser to the Funds.
Approximately 66% of the Adviser's voting stock is owned by
Douglas T. Breeden, its Chairman. Under its Investment
Advisory Agreement with each Fund, the Adviser, subject to
the general supervision of the Board of Trustees, manages
the Funds' portfolios and provides for the administration of
all of the Funds' other affairs. For these services, the
Adviser receives a fee, computed daily and payable monthly,
at the annual rate of 0.70% of the Short, Intermediate and
Equity Market Plus Funds' average daily net assets. The
Adviser receives a fee at the rate of 1.50% for its
management of the Financial Services Fund. Until the renewal
date of its contracts with the Funds, August 1, 1998, the
Adviser has voluntarily agreed to reduce its compensation,
and to the extent necessary absorb other expenses of the
Funds, such that the total expenses (exclusive of ordinary
brokerage commissions, investment transaction taxes and
extraordinary expenses) do not exceed 0.88% of the average
net assets for each of the Equity Market Plus Fund and the
Intermediate Fund, 0.78% of the average net assets of the
Short Fund and 1.50% of the Financial Services Fund.
The Adviser places all orders for purchases and sales of the
Funds' securities. Subject to seeking the most favorable
price and execution available, the Adviser may consider
sales of shares of the Funds as a factor in the selection of
broker-dealers.
Distribution
FPS Broker Services, Inc. (the "Principal Underwriter") acts
as distributor for the Funds for which the Adviser pays the
Principal Underwriter an annual fee of $30,000. Shares may
also be sold by authorized dealers who have entered into
dealer agreements with the Principal Underwriter or the
Adviser.
Expenses
The Funds pay all of their own expenses, including, without
limitation, the cost of preparing and printing their
registration statements required under the Securities Act of
1933 and the 1940 Act and any amendments thereto, the
expense of registering their shares with the Securities and
Exchange Commission and the various states, the printing and
distribution costs of prospectuses mailed to existing
investors, reports to investors, reports to government
authorities and proxy statements, fees paid to directors who
are not interested persons of the Adviser, interest charges,
<PAGE>
29
taxes, legal expenses, association membership dues, auditing
services, insurance premiums, brokerage commissions and
expenses in connection with portfolio transactions, fees and
expenses of the custodian of their assets, printing and
mailing expenses and charges and expenses of dividend
disbursing agents, accounting services agents, registrars
and stock transfer agents.
PRICING OF FUND SHARES
The price you pay when buying a Fund's shares, and the price
you receive when selling (redeeming) a Fund's shares, is the
net asset value of the shares next determined after receipt
of a purchase or redemption request in proper form. No front-
end sales charge or commission of any kind is added by the
Fund upon a purchase, and no charge is deducted upon
redemption. These charges may apply if you purchase or sell
shares through certain broker-dealers. The Funds currently
charge a $9 fee for each redemption made by wire. See "How
to Redeem Shares."
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 (usually at 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 the close of regular trading 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 the close of regular trading by the
Transfer Agent, or other agent designated by the Funds, will
be confirmed at the net asset value of the following
business day.
Current holiday schedules indicate that the Funds' net
asset values will not be calculated on New Year's Day,
Martin Luther King Day, President's Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day,
the day following Thanksgiving, Christmas Eve and Christmas
Day. The Short and Intermediate Funds will also not be
priced on Columbus Day and Veterans' Day.
Under procedures approved by the Board of Trustees, a Fund's
securities for which market quotations are readily available
are valued at current market value provided by a pricing
service, bank or broker-dealer experienced in such matters.
Short-term investments that will mature in 60 days or less
are generally valued at amortized cost, which approximates
market value. All other securities and assets are valued at
fair market value as determined by following procedures
approved by the Board of Trustees.
<PAGE>
30
HOW TO PURCHASE SHARES
All of the Funds are no-load, so you may purchase, redeem
or exchange shares directly at net asset value without
paying a sales charge. Because the Funds' net asset value
changes daily, your purchase price will be the next net
asset value determined after the Funds' Transfer Agent, or
other agent designated by the Funds, receives and accepts
your purchase order. See "Pricing of Fund Shares."
Initial Minimum Additional Minimum
Type of Account Investment Investment
Regular $1000 $50
Automatic
Investment Plan None $50
Individual
Retirement
Account $250 $50
Gift to Minors $250 $50
Each Fund reserves the right to reject any orders 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.
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 15 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
<PAGE>
31
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 be redeemed with Federal tax withheld if the
Funds do not receive a properly completed and executed
Purchase Application.
Telephone Transactions. The privilege to initiate
redemption or exchange transactions by telephone is made
automatically available to shareholders when opening an
account, unless they indicate otherwise by checking the
appropriate boxes on the Purchase Application. Each Fund
will employ reasonable procedures to ensure that
instructions communicated by telephone are genuine. If
reasonable procedures are not implemented, the Funds may be
liable for any loss due to unauthorized or fraudulent
transactions. In all other cases, you are liable for any
loss due to unauthorized transactions. The Funds reserve
the right to refuse a telephone transaction if they believe
it is advisable to do so.
If you have any questions, please call the Funds at 1-800-
221-3138.
How to Add to Your Account. You may make additional
investments by mail or by wire in an amount equal to or
greater than $50. When adding to an account by mail, you
should send the Funds your check, together with the
additional investment form from a recent statement. If this
form is unavailable, you should send a signed note giving
the full name of the account and the account number. For
additional investments made by wire transfer, you should use
the wiring instructions listed above. Be sure to include
your account number.
Automatic Investment Plan. You may make purchases of
shares of each Fund automatically on a regular basis ($50
minimum per transaction). You have two options under the
Plan to make investments. One is by automatic payroll
deduction. Under this method, you authorize your employer
to direct a portion of each paycheck to be invested in the
Fund of your choice. Your employer must be using direct
deposit to process its payroll in order for you to elect
this method. Under the other method, your bank debits a pre-
authorized amount from your checking or savings account each
month and applies the amount to your investment in Fund
<PAGE>
32
shares. In order to have your bank account debited
automatically for investment into the Funds, your financial
institution must be a member of the Automated Clearing
House. No service fee is currently charged by the Funds for
participation in either method under the Plan. A $20 fee
will be imposed by the Funds if sufficient funds are not
available in your bank account, or if your bank account has
been closed at the time of the automatic transaction. You
may adopt either method under the Plan at the time an
account is opened by completing the appropriate section of
the Purchase Application. Enclosed with the application are
the necessary forms to deliver to your employer to set up
the payroll deduction. You may obtain an application to
establish the Automatic Investment Plan after an account is
opened by calling the Funds at 1-800-221-3138. In the event
you discontinue participation in the Plan, the Funds reserve
the right to redeem your Fund account involuntarily, upon
sixty days' written notice, if the account's net asset value
is $1000 or less.
Purchasing Shares Through Other Institutions. The Funds
have authorized dealers besides the Principal Underwriter to
accept on its behalf purchase and redemption orders. If you
purchase shares through a program of services offered or
administered by one of these broker-dealers, financial
institutions, 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 and
redemption orders on behalf of their customers by phone,
with payment to follow within several days as specified in
the agreement. These broker-dealers and service providers
may designate other intermediaries to accept purchase and
redemption orders on the Funds' behalf. The Funds will be
deemed to have effected such purchase or redemption orders
at the net asset value next determined after acceptance of
the telephone purchase order by the authorized broker or the
authorized broker's designee. 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
<PAGE>
33
safekeeping and delivery of stock certificates, the Funds do
not currently issue certificates.
HOW TO EXCHANGE SHARES
Shares of any Fund may be exchanged for shares of another
Fund at any time. This exchange offer is available only in
states where shares of such other Fund may be legally sold.
You may open a new account, or purchase additional shares in
an existing account, by making an exchange from an
identically registered Smith Breeden Fund account. A new
account will have the same registration as the existing
account from which the exchange was made, and is subject to
the same initial investment minimums.
Exchanges may be made either in writing or by telephone.
Written instructions should be mailed to 3200 Horizon Drive,
King of Prussia, PA 19406 and must be signed by all account
owners, and accompanied by any properly endorsed outstanding
share certificates, if applicable. The telephone exchange
is automatically accepted unless checked otherwise. The
telephone exchange privilege is available only for
uncertificated shares. During periods of drastic economic
or market changes, it is possible that exchanges by
telephone may be difficult to implement. In this event,
shareholders should follow the written exchange procedures.
The telephone exchange privilege may be modified or
discontinued by the Funds at any time upon a 60-day notice
to the shareholders. To exchange by telephone, you must
follow the instructions below under "How to Redeem by
Telephone."
The Funds will accept exchange orders by telephone or other
means of electronic transmission from broker-dealers,
financial institutions or other service providers who
execute an agreement with the Adviser or Principal
Underwriter. It is the responsibility of the broker-dealer,
financial institution or other service provider to place the
exchange order on a timely basis.
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 "Taxes" in the Funds' Statements of Additional
Information.
There are differences among the Funds. When exchanging
shares, shareholders should be aware that the Funds might
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
<PAGE>
34
shares for up to 15 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 four 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 15 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.
<PAGE>
35
How to Redeem by Telephone. The redemption of shares by
telephone is available automatically unless you elected to
refuse this redemption privilege on your Purchase
Application. Shares may be redeemed by calling the Funds at
1-800-221-3137. Proceeds redeemed by telephone will be
mailed to your address, or wired or credited to your pre-
authorized bank account. To establish wire redemption
privileges, you must select the appropriate box on the
Purchase Application and enclose a voided check.
In order to arrange for telephone redemptions after your
account has been opened, or to change the bank account or
address designated to receive redemption proceeds, you must
send a written request to your Fund. The request must be
signed by each registered holder of the account with the
signatures guaranteed by a commercial bank or trust company
in the United States, a member firm of the National
Association of Securities Dealers, Inc. or other eligible
guarantor institution. A notary public is not an acceptable
guarantor. Further documentation as provided above may be
requested from corporations, executors, administrators,
trustees and guardians.
Payment of the redemption proceeds for Fund shares redeemed
by telephone where you request wire payment will normally be
made in federal funds on the next business day. The Funds
reserve the right to delay payment for a period of up to
seven days after receipt of the redemption request. There is
currently a $9 fee for each wire redemption, which will be
deducted from your account.
The Funds reserve the right to refuse a telephone redemption
or exchange transaction if they believe it is advisable to
do so. Procedures for redeeming or exchanging shares of the
Funds by telephone may be modified or terminated by the
Funds at any time. In an effort to prevent unauthorized or
fraudulent redemption or exchange requests by telephone, the
Funds have implemented procedures designed to reasonably
assure that telephone instructions are genuine. These
procedures include: requesting verification of certain
personal information; recording telephone transactions;
confirming transactions in writing; and restricting
transmittal of redemption proceeds only to pre-authorized
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
<PAGE>
36
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 $1000 as a
result of a redemption or exchange, or if you discontinue
the Automatic Investment Plan before your account balance
reaches $1000, you may be given a 60-day notice to bring
your balance to $1000 or reactivate an Automatic Investment
Plan. If this requirement is not met, your account may be
closed and the proceeds sent to you.
Check Writing. In addition to telephone and written
redemption requests, the Short Fund offers redemption
through check writing. Shareholders electing this option
will receive checks that may be used like personal or
business checks. Checks are not ordered to be mailed to the
shareholder until 15 days after the account is opened, if
the account is opened by check by the shareholder. This
allows the Fund to verify that the check used to open the
account will not be returned due to insufficient funds.
There is no limit on the number of checks you may write.
Checks must be written for at least $100. There is a $30
fee for returned checks. Because dividends declared on
shares held in a shareholder's account, prior redemptions,
and possible changes in net asset value may cause the
value of the account to change, shareholders should not
write a check for the entire value of the account or close
the account by writing a check.
In using the check writing privilege, shareholders bear the
responsibility of ensuring that the check amount does not
exceed the value of their account on the day the check is
presented to the Transfer Agent for payment. The day the
check is presented for payment is the day the redemption of
Fund shares takes place. If insufficient shares are in the
account, the check will be returned and no shares will be
redeemed. The clearing agent for the check writing facility
is United Missouri Bank. Shareholders utilizing check
writing are subject to United Missouri Bank's rules
governing checking accounts. However, this check writing
facility is purely a means to redeem Fund shares. No
facilities characteristic of bank accounts, such as deposit
insurance, are provided along with the check writing option.
If you would like to initiate check writing, please call
Shareholder Services at 1-800-221-3137 or check the
appropriate box on the Purchase Application.
Systematic Withdrawal Plan. A shareholder may establish a
Systematic Withdrawal Plan to receive regular periodic
payments from the account. An initial balance of $10,000 is
required to establish a Systematic Withdrawal Plan. There
are no service charges for establishing or maintaining a
<PAGE>
37
Systematic Withdrawal Plan. The minimum amount which the
shareholder may withdraw periodically is $100. Capital gain
distributions and income dividends to the shareholder's
account are received in additional shares at net asset
value. Payments are then made from the liquidation of
shares at net asset value to meet the specified withdrawals.
Liquidation of shares may reduce or possibly exhaust the
shares in the shareholder's account, to the extent
withdrawals exceed shares earned through dividends and
distributions, particularly in the event of a market
decline. No payment pursuant to a Systematic Withdrawal
Plan will be made if there are insufficient shares on
deposit on the date of the scheduled distribution. A
subsequent deposit of shares will not result in a payment
under the plan retroactive to the distribution date. As
with other redemptions, a liquidation to make a withdrawal
payment is a sale for federal income tax purposes. The
entire Systematic Withdrawal Plan payment cannot be
considered as actual yield or income since part of the
Plan's payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated upon written
notice by the shareholder, or by a Fund on a 30 day written
notice, and it will terminate automatically if all shares
are liquidated or withdrawn from the account or upon the
Fund's receipt 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 Funds intend to make monthly
distributions to their shareholders of net investment
income. The Equity Market Plus Fund intends to make
quarterly distributions of net investment income. All Funds
will distribute net realized gains at least annually. The
Financial Services Fund will most likely make only this
annual distribution of net realized gains, and at this time,
will also distribute any net investment income. Each Fund
may make additional distributions if necessary to avoid
imposition of a 4% excise tax or other tax on undistributed
income and gains.
The monthly distributions for the Short Fund's shares are
quoted 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
Fund generally one week after the ex-date.
The Intermediate Fund will declare daily dividends for
shareholders of record. The Intermediate Fund's dividend
payable date, and the day that dividends are reinvested for
<PAGE>
38
shareholders who have made this election, is the last
business day of the month. Shares begin accruing dividends
on the business day after federal funds (funds credited to a
member bank's account at the Federal Reserve Bank) are
available from the purchase payment for such shares, and
continue to accrue dividends through and including the day
the redemption order for the shares is executed. If an
investor closes his account, any accrued dividends through
and including the day of redemption will be paid as part of
the redemption proceeds.
Dividends and capital gains distributions may be declared
more or less frequently at the direction of the Trustees.
In order to be entitled to a dividend or a distribution, an
investor must acquire a Fund's shares on or before the
record date. Caution should be exercised, however, before
purchasing shares immediately prior to a distribution record
date. Since the value of a Fund's shares is based directly
on the amount of its net assets, rather than on the
principle of supply and demand, any distribution of income
or capital gain will result in a decrease in the value of
its shares equal to the amount of the distribution. While a
dividend or 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
the Fund from which they were paid. Shareholders may also
elect to have dividends automatically reinvested in a fund
different than the one from which the dividends were paid. A
shareholder may write the transfer agent, or complete the
appropriate section of the Purchase Application, to
designate such an election, but must have already
established an account in the other fund. The transfer
agent's address is on the back of the Prospectus. 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
<PAGE>
39
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 Funds who are financial institutions
may request receipt of monthly or quarterly reports which
provide information about the Short or Intermediate Fund's
investments considering regulatory risk-based asset
categories.
If you need additional copies of previous statements, you
may order statements for the current and preceding year at
no charge. Call 1-800-221-3137 to order past statements. If
you need information on your account with the Funds or if
you wish to submit any applications, redemption requests,
inquiries or notifications, please contact: Smith Breeden
Mutual Funds, 3200 Horizon Drive, P.O. Box 61503, King of
Prussia, PA 19406-0903 or call 1-800-221-3137.
RETIREMENT PLANS
The Funds have a program under which you may establish an
Individual Retirement Account ("IRA") with the Funds and
purchase shares through such account. Shareholders wishing
to establish an IRA should consult their tax adviser
regarding (1) their individual qualifying status and (2) the
tax regulations governing these accounts. The minimum
initial investment in each Fund for an IRA is $250. There is
a $12 annual maintenance fee charged to process an account.
This fee is waived for accounts greater than $10,000. You
may obtain additional information regarding establishing
such an account by calling the Funds at 1-800-221-3138.
The Funds may be used as investment vehicles for established
defined contribution plans, including simplified employee,
401(k), 403(b), profit-sharing, money purchase, and simple
pension plans ("Retirement Plans"). For details concerning
Retirement Plans, please call 1-800-221-3138.
SERVICE AND DISTRIBUTION PLANS
Each Fund has adopted a Distribution and Services Plan (the
"Plans") pursuant to Rule 12b-1 under the 1940 Act. The
purpose of the Plans is to permit the Adviser to compensate
investment dealers and other persons involved in servicing
shareholder accounts for services provided and expenses
incurred in promoting the sale of shares of the Funds,
reducing redemptions, or otherwise maintaining or improving
services provided to shareholders by such dealers or other
persons. The Plans provide for payments by the Adviser out
of its advisory fee to dealers and other persons at an
<PAGE>
40
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 Adviser shall determine the amount of
such payments and the purposes for which they are made.
Any distribution and service related payments made by the
Adviser to investment dealers or other persons are subject
to the continuation of the Plans, the terms of any related
service agreements, and any applicable limits imposed by the
National Association of Securities Dealers, Inc.
TAXES
Each Fund intends to qualify as a regulated investment
company under the Internal Revenue Code. In each taxable
year that a Fund so qualifies, such Fund (but not its
shareholders) will be relieved of federal income tax on the
part of its net investment income and net capital gain that
is distributed to shareholders. Each Fund will distribute
at least annually substantially all of the sum of its
taxable net investment income, its net tax-exempt income and
the excess, if any, of net short-term capital gains over the
net long-term capital losses for such year.
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. Pursuant to the Taxpayer Relief Act of
1997, long-term capital gains are taxed at a maximum of 28%
or 20%, depending on the Fund's holding period in the
portfolio investments. Each Fund provides federal tax
information to its shareholders annually about distributions
paid during the preceding year.
It is not anticipated that any of the Funds' distributions
will qualify for either the corporate dividends-received
deduction or tax-exempt interest income. Distributions will
also probably be subject to state and local taxes, depending
on each shareholder's tax situation. While many states
grant tax-free status to mutual fund distributions paid from
interest income earned from direct obligations of the U.S.
Government, none of the Short or Intermediate Fund's
distributions are expected to qualify for such tax-free
treatment, and only an insignificant amount of the Equity
Market 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
<PAGE>
41
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 and the Smith Breeden Series Fund
are both Massachusetts business trusts. The Trust was
organized under an Agreement and Declaration of Trust, dated
December 18, 1991. The Series Fund was organized under an
Agreement and Declaration of Trust dated October 3, 1991.
Copies of both Agreements, which are governed by
Massachusetts law, are on file with the Secretary of State
of the Commonwealth of Massachusetts. The Trust and the
Series Fund have the same Trustees.
The Trustees have the authority to issue shares in an
unlimited number of funds of either the Series Fund or
Trust. Each such fund's shares may be further divided into
classes. The assets and liabilities of each such fund will
be separate and distinct. All shares when issued are fully
paid, non-assessable and redeemable, and have equal voting,
dividend and liquidation rights.
Shareholders of the separate funds of the Series Fund or
Trust will vote together in electing trustees and in certain
other matters. Shareholders in each fund of the Series Fund
should be aware that the outcome of the election of trustees
and of certain other matters could be controlled by the
shareholders of another fund. The shares have non-
cumulative 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.
<PAGE>
42
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, 1998.
FUND PERFORMANCE
Each Fund may quote the Fund's average annual total and/or
aggregate total return for various time periods in
advertisements or communications to shareholders. An
average annual total return refers to the rate of return
which, if applied to an initial investment at the beginning
of a stated period and compounded over that period, would
result in the redeemable value of the investment at the end
of the period assuming reinvestment of all dividends and
distributions and reflecting the effect of all recurring
fees. An investor's principal in each Fund and the Fund's
return are not guaranteed and will fluctuate according to
market conditions. When considering "average" total return
figures for periods longer than one year, you should note
that a Fund's annual total return for any one year in the
period might have been greater or less than the average for
the entire period. Each Fund also may use "aggregate" total
return figures for various periods, representing the
cumulative change in value of an investment in the Fund for
a specific period (again reflecting changes in the Fund's
share price and assuming reinvestment of dividends and
distributions).
The Short and Intermediate Funds may also advertise current
yield and distribution rate information. Current yield
reflects the income per share earned by the Short or
Intermediate Fund's portfolio investments, and is calculated
by dividing a Fund's net investment income per share during
a recent 30-day period by a Fund's net asset value on the
last day of that period and annualizing the result. The
current yield (or "SEC Yield"), which is calculated
according to a formula prescribed by the SEC (see the
relevant Statement of Additional Information), is not
indicative of the dividends or distributions which were or
will be paid to a Fund's shareholders. SEC regulations
require that net investment income be calculated on a "yield-
to-maturity" basis, which has the effect of amortizing any
premiums or discounts in the current market value of fixed
income securities. Dividends or distributions paid to
shareholders are reflected in the current distribution rate
which may be quoted to shareholders, and may not reflect
<PAGE>
43
amortization in the same manner.
A 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 Market Plus Fund's total return may also be
compared to the return of the Standard & Poor's 500
Composite Stock Price Index. For purposes of showing the
returns of large company stocks versus small company stocks,
or to compare returns versus inflation, the Equity Market
Plus Fund's total return may also be compared to the total
return of the Nasdaq Composite OTC Index, Nasdaq Industrials
Index, Russell 2000 Index, or the Consumer Price Index. The
Short Fund's total return may also be compared to that of
taxable money funds as quoted in Donaghue's Money Fund
Report and other suppliers, and to total returns for the six
month U.S. Treasury as published by Merrill Lynch or others.
The Intermediate Fund's return will most likely be compared
to the total return of the Salomon Brothers Mortgage Index,
or the total return of intermediate U.S. Treasury Notes as
published by various brokerage firms and others. The
Financial Services Fund's return may be compared to the S&P
500 Index return, an investment of 80% in the S&P Financial
Composite Index and 20% in money market funds, the Keefe,
Bruyette & Woods Index, or the average of the mutual funds
in the Morningstar Specialty Financial Category. 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>
44
Part B: Information Required in
Statement of Additional Information
N-1A
Item No. Item Location in the
Registration
Statement
10. Cover Page Cover Page
11. Table of Contents Table of Contents
12. General Information
and History See Part A Item 4.
13. Investment Objective Miscellaneous
and Policies Investment Practices and
Risk Considerations
14. Management of the Trustees and
Registrant Officers
15. Control Persons and Principal Holders of
Principal Holders of Securities and
Securities Controlling Persons
16. Investment Advisory Investment Advisory
and Other Services and Other Services
17. Brokerage Allocation Investment Advisory
and Other Services
18. Capital Stock and Additional Information
Other Securities Regarding Purchases and
Redemptions of Fund Shares
19. Purchase, Redemption Additional Information
and Pricing of Regarding Purchases and
Securities Being Redemptions of Fund
Offered Shares
20. Tax Status Taxes
21. Underwriters Additional Information
Regarding Purchases and
Redemptions of Fund
Shares
22. Calculation of
Performance Data Standard Performance
Measures
23. Financial Statements Experts; Financial
Statements
SMITH BREEDEN SERIES FUND
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
STATEMENT OF ADDITIONAL INFORMATION
DECEMBER 22, 1997
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
This Statement of Additional Information contains information
pertaining to the Smith Breeden Series Fund (the "Series Fund"),
a no load open-end management investment company offering
redeemable shares of beneficial interest in two separate series,
the Smith Breeden Short Duration U.S. Government Fund (the "Short
Fund") and the Smith Breeden Intermediate Duration U.S.
Government Fund (the "Intermediate Fund"). This Statement of
Additional Information contains information which may be useful
to investors and which is not included in the Prospectus of the
Smith Breeden Mutual Funds. This Statement of Additional
Information is not a prospectus and is only authorized for
distribution when accompanied or preceded by the Prospectus of
the Smith Breeden Mutual Funds dated December 22, 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. 11
TRUSTEES AND OFFICERS 14
INVESTMENT ADVISORY AND OTHER SERVICES 14
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS 16
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS 17
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES. 19
TAXES 21
STANDARD PERFORMANCE MEASURES 24
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS 29
EXPERTS 29
FINANCIAL STATEMENTS 29
APPENDIX 30
<PAGE>
1
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS
Investment Policies
The following supplements the information contained in the
Prospectus about the investment policies of the Short and
Intermediate Funds (the "Funds"). Terms used herein have the
same meanings as in the Prospectus. The Funds' Prospectus states
that the Funds may engage in each of the following investment
practices. However, the fact that the Funds may engage in a
particular practice does not necessarily mean that they will
actually do so.
Repurchase Agreements. A Fund may invest in repurchase
agreements. A repurchase agreement is a contract under which a
Fund acquires a security for a relatively short period (usually
not more than one week) subject to the obligation of the seller
to repurchase and the Fund to resell such security at a fixed
time and price (representing the Fund's cost plus interest). It
is the Funds' present intention to enter into repurchase
agreements only with commercial banks and registered broker-
dealers, and only with respect to obligations of the U.S.
Government or its agencies or instrumentalities. Repurchase
agreements may also be viewed as loans made by the Funds which
are collateralized by the securities subject to repurchase. The
Adviser will monitor such transactions to determine that the
value of the underlying securities is at least equal at all times
to the total amount of the repurchase obligation, including the
interest factor. If the seller defaults, a Fund could realize a
loss on the sale of the underlying security to the extent that
the proceeds of the sale including accrued interest are less than
the resale price provided in the agreement including interest.
In addition, if the seller should be involved in bankruptcy or
insolvency proceedings, a Fund may incur delay and costs in
selling the underlying security or may suffer a loss of principal
and interest if the Fund is treated as an unsecured creditor and
required to return the underlying collateral to the seller's
estate.
Forward Commitments. A Fund may enter into contracts to purchase
securities for a fixed price at a future date beyond customary
settlement time ("forward commitments," "when issued" and
"delayed delivery" securities) if a Fund holds until the
settlement date, in a segregated account, cash or high-grade debt
obligations in an amount sufficient to meet the purchase price,
or if a Fund enters into offsetting contracts for the forward
sale of other securities it owns. Forward commitments may be
considered securities in themselves, and involve a risk of loss
if the value of the security to be purchased declines prior to
the settlement date. Where such purchases are made through
dealers, a Fund relies on the dealer to consummate the sale. The
dealer's failure to do so may result in the loss to the Fund of
an advantageous return or price. Although a Fund will generally
enter into a forward commitment with the intention of acquiring
securities for its portfolio or for delivery pursuant to options
contracts it has entered into, the Fund may dispose of a
commitment prior to settlement if the Adviser deems it
appropriate to do so. A Fund may realize short-term profits or
losses upon the sale of forward commitments.
<PAGE>
2
Securities Loans. A Fund may make secured loans of its
securities amounting to not more than 33 1/3% of its total
assets, thereby realizing additional income. The risks in
lending portfolio securities, as with other extensions of credit,
consist of possible delay in recovery of the securities or
possible loss of rights in the collateral should the borrower
fail financially. As a matter of policy, securities loans are
made to broker-dealers pursuant to agreement requiring that loans
be continuously secured by collateral in cash or short-term debt
obligations at least equal at all times to the value of the
securities on loan. The borrower pays to the Fund an amount equal
to any dividends or interest received on securities lent.
The Fund retains all or a portion of the interest received on
investment of the cash collateral, or receives a fee from the
borrower. Although voting rights, or rights to consent, with
respect to the loaned securities pass to the borrower, the Fund
retains the right to call the loans at any time on reasonable
notice, and it will do so in order that the securities may be
voted by the Fund if the holders of such securities are asked to
vote upon or consent to matters materially affecting the
investment. The Fund may also call such loans in order to sell
the securities involved.
Borrowing. A Fund may borrow from banks and enter into reverse
repurchase agreements or dollar rolls (as described in Appendix A
of the Prospectus) up to 33 1/3% of the value of a Fund's total
assets (computed at the time the loan is made) in order to take
advantage of investment opportunities, for extraordinary or
emergency purposes, or for the clearance of transactions. A Fund
may pledge up to 33 1/3% of its total assets to secure these
borrowings. If a Fund's asset coverage for borrowings falls
below 300%, the Fund will take prompt action to reduce its
borrowings even though it may be disadvantageous at that time
from an investment point of view. A Fund will incur borrowing
costs when it leverages, including payment of interest and any
fee necessary to maintain a line of credit, and may be required
to maintain a minimum average balance. If the income and
appreciation on assets acquired with borrowed funds exceed their
borrowing cost, the Fund's investment performance will increase,
whereas if the income and appreciation on assets acquired with
borrowed funds are less than their borrowing costs, investment
performance will decrease. In addition, if a Fund borrows to
invest in securities, any investment gains made on the securities
in excess of the costs of the borrowing, and any gain or loss on
hedging, will cause the net asset value of the shares to rise
faster than would otherwise be the case. On the other hand, if
the investment performance of the additional securities
purchased fails to cover their cost (including any interest paid
on the money borrowed) to the Fund, the net asset value of the
Fund's shares will decrease faster than would otherwise be the
case. This speculative characteristic is known as "leverage."
Reverse Repurchase Agreements and Dollar Roll Agreements. A Fund
may enter into reverse repurchase agreements and dollar roll
agreements with commercial banks and registered broker-dealers to
seek to enhance returns. Reverse repurchase agreements involve
sales by a Fund of portfolio assets concurrently with an
agreement by the Fund to repurchase the same assets at a later
<PAGE>
3
date at a fixed price. During the reverse repurchase agreement
period, a Fund continues to receive principal and interest
payments on these securities and also has the opportunity to earn
a return on the collateral furnished by the counterparty to
secure its obligation to redeliver the securities. Dollar rolls
are transactions in which a Fund sells securities for delivery in
the current month and simultaneously contracts to repurchase
substantially similar (same type and coupon) securities on a
specified future date. During the roll period, the Fund forgoes
principal and interest paid on the securities. The Fund is
compensated by the difference between the current sales price and
the forward price for the future purchase (often referred to as
the "drop") as well as by the interest earned on the cash
proceeds of the initial sale. The Fund will establish a
segregated account with its custodian in which it will maintain
cash, U.S. Government securities or other liquid high grade debt
obligations equal in value to its obligations in respect of
reverse repurchase agreements and dollar rolls. Reverse
repurchase agreements and dollar rolls involve the risk that the
market value of the securities retained by the Fund may decline
below the price of the securities the Fund has sold but is
obligated to repurchase under the agreement. In the event the
buyer of securities under a reverse repurchase agreement or
dollar roll files for bankruptcy or becomes insolvent, the Fund's
use of the proceeds of the agreement may be restricted pending a
determination by the other party, or its trustee or receiver,
whether or not to enforce the Fund's obligation to repurchase the
securities. Reverse repurchase agreements and dollar rolls are
considered borrowings by a Fund.
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
<PAGE>
4
principal of and interest on all other CMOs and the
administrative expenses of the issuer ("Residuals"). Residuals
have value only to the extent that income from such underlying
mortgages or mortgage-backed securities exceeds the amounts
necessary to satisfy the issuer's debt obligations represented by
all other outstanding classes or series of the CMOs. In
addition, if a CMO bears interest at an adjustable-rate, the cash
flows on the related Residual will also be extremely sensitive to
the level of the index upon which the rate adjustments are based.
As a non-fundamental policy (meaning it can be changed without
the vote of the shareholders), the Short and Intermediate Fund
will not invest in Residuals.
In reliance on an interpretation by the Securities and
Exchange Commission ("SEC"), the Fund's investments in certain
qualifying CMOs and REMICs are not subject to the 1940 Act's
limitations on acquiring interests in other investment companies.
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"). 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 the 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, the 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
in "Other Investment Practices and Risk Considerations" in the
Prospectus. In addition, the secondary market for STRIPS may be
less liquid than that for other mortgage-backed or asset-backed
securities, potentially limiting the Fund's ability to buy or
sell those securities at any particular time.
The Adviser expects that interest-only STRIPS will be
purchased for their hedging characteristics. Because of their
structure, interest-only STRIPS will most likely move differently
than typical fixed income securities in relation to changes in
interest rates. For example, with increases in interest rates,
these securities will typically increase rather than decrease in
<PAGE>
5
value. As a result, since they move differently to changes in
interest rates than the typical investments held by a Fund,
interest-only STRIPS can be used as hedging instruments to reduce
the variance of a Fund's net asset value from its targeted
option-adjusted duration. There can be no assurance that the use
of interest-only STRIPS will be effective as a hedging technique,
in which event, a Fund's overall performance may be less than if
the Fund had not purchased the STRIPS. STRIPS will not
constitute more than 5% of a Fund's net assets.
The determination of whether certain IO and PO STRIPS issued
by the U.S. Government and backed by fixed-rate mortgages are
liquid shall be made by the Trustees in accordance with
applicable pronouncements of the SEC. At present all other IO
and PO STRIPS are treated as illiquid securities for the purposes
of the 15% limitation on illiquid securities as a percentage of a
Fund's net assets.
In addition to STRIPS issued by the U.S. Government, its
agencies or instrumentalities, the Short and Intermediate Funds
may purchase STRIPS issued by private originators of, or
investors in, mortgage loans, including depository institutions,
mortgage banks, investment banks and special purpose subsidiaries
of these entities. However, the Short and Intermediate Funds will
purchase only STRIPS that are collateralized by mortgage-backed
securities that are issued or guaranteed by the U.S. Government
or its agencies or instrumentalities.
The Short and Intermediate Funds may invest only in stripped
mortgage-backed securities ("SMBS") which are STRIPS represented
by derivative multi-class mortgage securities. Under no
circumstances will the Short or Intermediate Funds purchase SMBS
if such purchase would cause SMBS to exceed 5% of the assets of a
Fund.
Zero Coupon Securities. The Funds may 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.
A Fund is required to accrue and distribute income from zero
coupon securities on a current basis, even though it 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.
General Characteristics and Risks of Options, Futures, Swaps, and
Caps and Floors
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
<PAGE>
6
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 a potential purchaser might have less of a loss. An option
purchaser does not have the choice of "waiting out" an unexpected
decrease or increase in the underlying instrument's price beyond
the expiration date of the option. The more that an option is
out-of-the-money and the shorter its remaining term to
expiration, the greater the risk that a purchaser of the option
will lose all or part of his investment. Further, except where
the value of the remaining life of an option may be realized in
the secondary market, for an option purchase to be profitable the
market price of the underlying interest must exceed or, as
applicable, be below the exercise price by more than the premium
and transaction costs paid in connection with the purchase of the
option and its sale or exercise.
A Fund's ability to close out its position as a purchaser of an
exchange-listed option is dependent upon the existence of a
liquid secondary market on option exchanges. Among the possible
reasons for the absence of a liquid secondary market on an
exchange are (i) insufficient trading interest in certain
options; (ii) restrictions on transactions imposed by an
exchange; (iii) trading halts, suspensions or other restrictions
imposed with respect to particular classes or series of options
or underlying securities; (iv) interruption of the normal
operations on an exchange; (v) inadequacy of the facilities of an
exchange or the OCC to handle current trading volume; or (vi) a
decision by one or more exchanges to discontinue the trading of
options (or a particular class or series of options), in which
event the secondary market on that exchange (or in that class or
series of options) would cease to exist, although outstanding
options on that exchange that had been listed by the OCC as a
result of trades on that exchange would generally continue to be
exercisable in accordance with their terms. OTC Options are
purchased from or sold to dealers or financial institutions which
have entered into direct agreement with a Fund. With OTC
Options, such variables as expiration date, exercise price and
premium will be agreed upon between the Fund and the transacting
dealer, without the intermediation of a third party such as the
OCC. If the transacting dealer fails to make or take delivery of
the securities underlying an option it has written, in accordance
with the terms of that option as written, the Fund would lose
the premium paid for the option as well as any anticipated
benefit of the transaction. OTC Options and their underlying
securities are considered illiquid. The Funds will engage in
OTC Option transactions only with primary United States
<PAGE>
7
Government securities dealers recognized by the Federal Reserve
Bank of New York. The Adviser monitors the creditworthiness of
dealers with whom a Fund enters into OTC options transactions
under the general supervision of the Fund's Board of Trustees.
The hours of trading for options on debt securities may not
conform to the hours during which the underlying securities are
traded. To the extent that the option markets close before the
markets for the underlying securities, significant price and rate
movements can take place in the underlying markets that cannot be
reflected in the option markets.
Futures Contracts and Related Options. As a purchaser of an
interest rate futures contract, a Fund incurs an obligation to
take delivery of a specified amount of the obligation underlying
the futures contract at a specified time in the future for a
specified price or, in "cash settlement" futures contracts, to
pay to (or receive from) the seller in cash the difference
between the original price in the futures contract and the market
price of the instrument on the specified date, if the market
price is lower (or higher, as the case may be). A futures
contract sale creates an obligation by a Fund, as seller, to
deliver the specified type of financial instrument called for in
the contract at a specified future time for a specified price or,
in "cash settlement" futures contracts, to pay to (or receive
from) the buyer in cash the difference between the original price
in the futures contract and the market price of the instrument on
the specified date, if the market price is higher (or lower, as
the case may be). Options on futures contracts are similar to
options on securities except that an option on a futures contract
gives the purchaser the right in return for the premium paid to
assume a position in a futures contract (a long position if the
option is a call and short position if the option is a put).
Although most futures contracts call for actual delivery or
acceptance of securities, the contracts usually are closed out
before the settlement date without the making or taking of
delivery. A futures contract sale is closed out by effecting a
futures contract purchase for the same aggregate amount of the
specific type of security and the same delivery date. If the sale
price exceeds the offsetting purchase price, the seller would be
paid the difference and would realize a gain. If the offsetting
purchase price exceeds the sale price, the seller would pay the
difference and would realize a loss. Similarly, a futures
contract purchase is closed out by effecting a futures contract
sale for the same aggregate amount of the specific type of
security and the same delivery date. If the offsetting sale price
exceeds the purchase price, the purchaser would realize a gain,
whereas if the purchase price exceeds the offsetting sale price,
the purchaser would realize a loss. There is no assurance that
the Short or Intermediate Fund will be able to enter into a
closing transaction.
Initial margin in futures transactions is different from margin
in securities transactions in that initial margin does not
involve the borrowing of funds by a broker's client, but rather,
a good faith deposit on the futures contract which will be
returned to the Short or Intermediate Fund upon the proper
termination of the futures contract. The margin deposits made
<PAGE>
8
are marked to market daily and the Funds may be required to make
subsequent deposits into the segregated account, maintained at
its Custodian for that purpose, or cash, U.S. Government
securities or other liquid highgrade debt securities, called
"variation margin", in the name of the broker, which are
reflective of price fluctuations in the futures contract.
Currently, interest rate futures contracts can be purchased on
debt securities such as U.S. Treasury Bills and Bonds, Eurodollar
instruments, U.S. Treasury Notes and GNMA Certificates.
Exchanges limit the amount by which the price of a futures
contract may move on any day. If the price moves equal the daily
limit on successive days, then it may prove impossible to
liquidate a futures position until the daily limit moves have
ceased. In the event of adverse price movements, the Funds would
continue to be required to make daily cash payments of variation
margin on open futures positions. In such situations, if the
Funds have insufficient cash, it may be disadvantageous to do so.
In addition, the Funds may be required to take or make delivery
of the instruments underlying interest rate futures contracts it
holds at a time when it is disadvantageous to do so. An
inability to close out options and futures positions could also
have an adverse impact on a Fund's ability to effectively hedge
its portfolio.
In the event of the bankruptcy of a broker through which the
Short or Intermediate Fund engages in transactions in futures or
options, either Fund could experience delays and/or losses in
liquidating open positions purchased or sold through the broker
and/or incur a loss of all or part of its margin deposits with
the broker. Transactions are entered into by the Funds only with
broker or financial institutions deemed creditworthy by the
Adviser.
The variable degree of correlation between price movements of
futures contracts and price movements in the position being
hedged creates the possibility that losses on the hedge may be
greater than gains in the value of a Fund's position. In
addition, futures and futures option markets may not be liquid in
all circumstances. As a result, in volatile markets, a Fund may
not be able to close out a transaction without incurring losses
substantially greater than the initial deposit. Although the
contemplated use of these contracts should tend to minimize the
risk of loss due to a decline in the value of the hedged
position, at the same time they tend to limit any potential gain
which might result from an increase in the value of such
position. The ability of the Short or Intermediate Fund to
hedge successfully will depend on the Adviser's ability to
forecast pertinent market movements, which cannot be assured.
In order to achieve its investment objective, a Fund may sell
interest rate futures in a different dollar amount than the
dollar amount of securities being hedged depending on the
expected relationship between the volatility of the prices of
such securities and the volatility of the futures contracts,
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.
<PAGE>
9
A Fund will not maintain open short positions in interest rate
futures contracts if, in the aggregate, the value of the open
positions (marked to market) exceeds the current market value of
its securities portfolio plus or minus the unrealized gain or
loss on those open positions, adjusted for the expected
volatility relationship between the Fund and the futures
contracts based on duration calculations. If this limitation
should be exceeded at any time, the Short or Intermediate Fund
will take prompt action to close out the appropriate number of
open contracts to bring its open futures position into compliance
with this limitation.
Finally, the daily deposit requirements in futures contracts
create a greater ongoing potential financial risk than do options
transactions, where the exposure is limited to the cost of the
initial premium. Losses due to hedging transactions may reduce
net asset value. Income earned by the Short or Intermediate Fund
from its hedging activities generally will be treated as capital
gains.
In accordance with regulations established by the Commodity
Futures Trading Commission, each Fund's aggregate initial margin
and premiums on all futures and options contract positions not
held for bona fide hedging purposes, will not exceed 5% of a
Fund's net assets, after taking into account unrealized profits
and losses on such contracts.
Interest Rate and Mortgage Swaps, Caps, Floors and Collars.
Interest rate swaps involve the exchange by a Fund with another
party of their respective commitments to pay or receive interest,
for example, an exchange of floating-rate payments for fixed-rate
payments. Mortgage swaps are similar to interest rate swaps in
that they represent commitments to pay and receive interest. The
notional principal amount, however, is tied to a reference pool
or pools of mortgages.
The Short or Intermediate Funds will enter into interest rate
swaps only on a net basis, i.e., where the two payment streams
are netted out, with a Fund receiving or paying, as the case may
be, only the net amount of the two payments.
The 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.
<PAGE>
10
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.
The Short and Intermediate Funds will not write interest rate
caps, floors and collars, and will not enter into any interest
rate swap, cap, floor or collar transaction unless the unsecured
commercial paper, unsecured senior debt or the 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.
If there is 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 under "Illiquid Securities" in the
Prospectus.
INVESTMENT RESTRICTIONS
The following restrictions (except as noted) have been adopted as
fundamental policies for the Funds, which means that they may not
be changed without the approval of a majority of the outstanding
shares of each of the Funds, as the case may be (as defined in
the Investment Company Act). A Fund may not (except that none of
the following investment restrictions shall prevent a Fund from
investing all of its assets (other than assets which are not
"investment securities" as defined in the Investment Company Act)
in an open-end investment company with substantially the same
investment objectives):
1. Issue senior securities, borrow money or pledge its assets,
except that the Short or Intermediate Fund may borrow from banks
or through reverse repurchase agreements or dollar rolls up to 33
1/3% of the value of its respective total assets (calculated when
the loan is made) for temporary, extraordinary or emergency
purposes and to take advantage of investment opportunities, and
<PAGE>
11
may pledge up to 33 1/3% of the value of its total assets to
secure such borrowings. For purposes of this restriction, the
purchase or sale of securities on a "when issued" or "delayed
delivery" basis, the purchase and sale of futures contracts, the
entry into reverse repurchase agreements and dollar roll
transactions, short sales, interest rate swaps, mortgage swaps,
over-the-counter options, and collateral arrangements with
respect thereto are not deemed to be a pledge of assets and none
of such transactions or arrangements nor obligations of the
Funds to Trustees pursuant to deferred compensation arrangements
are deemed to be the issuance of a senior security.
2. Act as underwriter except to the extent that, in connection
with the disposition of portfolio securities, it may be deemed to
be an underwriter under certain federal securities laws.
3. Purchase any security (other than obligations of the U.S.
Government, its agencies and instrumentalities) if as a result:
(i) with respect to 75% of its total assets more than 5% of the
Short or Intermediate Fund's total assets (determined at the time
of investment) would then be invested in securities of a single
issuer, or (ii) 25% or more of a Fund's total assets (determined
at the time of investment) would be invested in one or more
issuers having their principal business activities in the same
industry.
4. Purchase the securities of any issuer which would result in
owning more than 10% of any class of the outstanding voting
securities of such issuer.
5. Purchase any security, other than Mortgage-Backed
Securities, or obligations of the U.S. Government, its
agencies or instrumentalities, if as a result the Short or
Intermediate Fund would have invested more than 5% of its
respective total assets in securities of issuers (including
predecessors) having a record of less than three years of
continuous operation; except for investments in regulated
investment companies with the same objective.
6. Acquire, lease or hold real estate. (Does not preclude
investments in securities collateralized by real estate or
interests therein.)
7. Purchase or sell commodities or commodity contracts except
for hedging purposes.
8. Invest in interests in oil, gas or other mineral exploration
or development program.
9. Invest in companies for the purpose of exercising control or
management.
10. Purchase securities of other investment companies, except to
the extent permitted by the Investment Company Act.
11. Make loans of money or property to any person, except
through loans of portfolio securities to Qualified Institutions,
the purchase of debt obligations in which the Short or
Intermediate Fund may invest consistently with its investment
<PAGE>
12
objectives and policies and investment limitations or the
investment in repurchase agreements with Qualified Institutions.
The Short or Intermediate Fund will not lend portfolio securities
if, as a result, the aggregate of such loans exceeds 33 1/3% of
the value of a Fund's respective total assets (including such
loans).
12. Purchase securities on margin (though the Short or
Intermediate Fund may obtain such short-term credits as may be
necessary for the clearance of transactions); provided that the
deposit or payment by a Fund of initial or variation margin in
connection with options or futures contracts is not considered
the purchase of a security on margin.
13. Make short sales of securities or maintain a short position
if, when added together, more than 25% of the value of the Short
or Intermediate Fund's net assets would be (i) deposited as
collateral for the obligation to replace securities borrowed to
effect short sales, and (ii) allocated to segregated accounts in
connection with short sales. Short sales "against-the box" are
not subject to this limitation.
Whenever any fundamental investment policy or investment
restriction states a maximum percentage of assets, it is intended
that if the percentage limitation is met at the time the
investment is made, a later change in percentage resulting from
changing total or net asset values will not be considered a
violation of such policy. However, in the event that the asset
coverage for borrowings falls below 300%, the Funds will take
prompt action to reduce its borrowings as required by applicable
laws.
In order to change any of the foregoing restrictions, which are
fundamental policies, approval must be obtained by shareholders
of the Short or Intermediate Fund, as the case may be. Such
approval requires the affirmative vote of the lesser of (i) 67%
or more of the voting securities present at a meeting if the
holders of more than 50% of voting securities are represented at
that meeting or (ii) more than 50% of the outstanding voting
securities of either the Short or Intermediate Fund.
In addition, as non-fundamental policies, a Fund may not:
(a) sell over-the-counter options which it does not own;
(b) sell options on futures contracts which options it does not
own; or
(c) invest in residual interests in a REMIC or a CMO.
Other Policies
There are no restrictions or limitations on investments in
obligations of the United States, or of corporations chartered by
Congress as federal government instrumentalities. The underlying
assets of the Short or Intermediate Fund may be retained in cash,
including cash equivalents which are Treasury bills, short-term
bank obligations such as certificates of deposit, bankers'
acceptances and repurchase agreements. However, it is intended
<PAGE>
13
that only so much of the underlying assets of the Short or
Intermediate Fund be retained in cash as is deemed desirable or
expedient under then-existing market conditions. As noted in the
Prospectus, a Fund may invest up to 15% of its respective total
net assets in illiquid securities.
TRUSTEES AND OFFICERS
The Board of Trustees has the responsibility for the overall
management of the Series Fund and each of the Funds, including
general supervision and review of the Funds' investment
activities. The Trustees, in turn, elect the officers who are
responsible for administering the day-to-day operations of the
Funds. Trustees and officers of the Series Fund are identified in
the Prospectus.
All of the Trustees are Trustees of all the other Funds
managed by the Adviser and each independent Trustee receives fees
for his or her services. The Trustees do not receive pension or
retirement benefits from the Funds. The table below shows the
fees paid by each of the Funds of the Smith Breeden Series Fund
separately to each independent Director for the fiscal year ended
March 31, 1997, and the total fees paid by the entire Fund
complex for the fiscal year ended March 31, 1997. There are two
other Funds in the complex besides the Short Duration U.S.
Government Fund and the Intermediate Duration U.S. Government
Fund.
Director Total Total Total
Compensation Compensation Compensation
Paid by Paid by Paid by
Short Fund Intermediate Fund Smith Breeden
Fund Complex
Stephen M. Schaefer $31,250 $4,127 $38,750
Myron S. Scholes $33,750 $5,000 $38,750
William F. Sharpe $32,350 $5,000 $38,750
The Series Fund's Declaration of Trust provides that it will
indemnify its Trustees and officers against liabilities and
expenses incurred in connection with litigation in which they may
be involved because of their offices with the Series Fund, unless
it is determined that they had acted with willful misfeasance,
bad faith, gross negligence or reckless disregard of the duties
involved in their offices, or had not acted in good faith in the
reasonable belief that their actions were in the best interests
of the Series Fund or the Funds.
INVESTMENT ADVISORY AND OTHER SERVICES
The investment manager of each of the Funds is Smith Breeden
Associates, Inc. (the "Adviser"). The table in the Prospectus
indicates which officers and Trustees are affiliated persons of
the Adviser.
Pursuant to an Investment Advisory Agreement with each of the
Funds (the "Advisory Agreement"), the Adviser provides investment
<PAGE>
14
research and portfolio management services, including the
selection of securities to purchase, hold or sell, and the
selection of brokers and dealers through whom portfolio
transactions are executed. The Adviser's activities are subject
to the review and supervision of the Board of Trustees to whom
the Adviser renders periodic reports of both Funds' investment
activities. The Adviser, at its own expense, furnishes the Funds
with office space and office furnishings, facilities and
equipment required for managing the business affairs of the
Funds; maintains all internal bookkeeping, clerical, secretarial
and administrative personnel and services; carries fidelity
insurance on its own officers and directors for the protection of
the Funds; and provides certain telephone and other mechanical
services. Except for the expense limitation in place through
August 1, 1998, each of the Funds bears all expenses related to
its operation not borne by the Adviser, as discussed in the
Prospectus.
Each Advisory Agreement is in effect until August 1, 1998.
Thereafter, it may continue in effect for successive periods not
exceeding one year, providing such continuance is specifically
approved at least annually by a vote of the Funds' Board of
Trustees or by a vote of the holders of a majority of each of the
Funds' outstanding voting securities, and in either event by a
majority of the Fund's Trustees who are not parties to the
Agreement or interested persons of any such party (other than as
Trustees of the Fund), cast in person at a meeting called for
that purpose. Each Advisory Agreement may be terminated without
penalty at any time by each Fund, or by the Adviser on sixty
days' written notice and will automatically terminate in the
event of its assignment as defined in the Investment Company Act.
The Advisory Agreement provides that the Adviser will not be
liable for any error of judgment or for any loss suffered by
either Fund in connection with matters to which the Advisory
Agreement relates, except a loss resulting from willful
misfeasance, bad faith gross negligence or reckless disregard of
duty.
As compensation for the services rendered to each of the Funds by
the Adviser under the terms of the Advisory Agreement, and the
assumption by the Adviser of the related expenses, each Fund pays
the Adviser a fee, computed daily and payable monthly, at an
annual rate equal to 0.70% of the respective Fund's average daily
net asset value. For the last three fiscal years ended March 31,
the Adviser received no fees from the Short Fund for the year
ended March 31, 1995, and received $1,717,748, and $1,417,921 for
the fiscal years ended March 31, 1996 and March 31, 1997,
respectively. The Short Fund, prior to April 1, 1995, indirectly
bore investment advisory fees through its investment in the Smith
Breeden Institutional Short Duration U.S. Government Fund. On
March 31, 1995, this two-tier structure was consolidated, which
resulted in the Short Fund becoming a stand-alone fund. The
Adviser received $132,174 from the Intermediate Fund for the
fiscal year ended March 31, 1995, $256,075 for the fiscal year
ended March 31, 1996, and $259,767 for the fiscal year ended
March 31, 1997. Prior to August 1, 1994, the Intermediate Fund
indirectly bore investment advisory fees through its investment
in the Smith Breeden Institutional Intermediate Duration U.S.
Government Fund. On August 1, 1994, this two-tier structure was
<PAGE>
15
eliminated, which resulted in the Intermediate Fund becoming a
stand-alone fund. During the three year period ended March 31,
the Adviser reimbursed the Short Fund $146,256, $364,865, and
$301,998 for the periods ended 1995, 1996, and 1997,
respectively, under expense limitation provisions. The
Intermediate Fund was reimbursed $123,390, $85,364, and $101,379
for the same periods under expense limitation provisions.
Under the terms of its Advisory agreement with each of the Funds,
the Adviser also provides certain administrative services. FPS
Services, Inc. is the shareholder servicing, accounting, transfer
and dividend paying agent. Each of the Funds pays its own
expenses, including, but not limited to auditing, legal, tax
preparation and consulting, insurance, custodial, accounting,
shareholder servicing and shareholder report expenses. Fees paid
to FPS Services are determined by contract as approved by the
Trustees.
Bank of New York, 48 Wall Street, New York, NY, 10286 acts as
custodian of the securities and other assets of each of the
Funds. A custodian's responsibilities include generally
safeguarding and controlling a Fund's cash and securities,
handling the receipt and delivery of securities, and collecting
interest and dividends on a Fund's investments. The custodian
does not participate in decisions relating to the purchase and
sale of portfolio securities.
Deloitte & Touche, 117 Campus Drive, Princeton, New Jersey 08540,
are the Funds' independent auditors, providing audit services,
tax return preparation and other tax consulting services, and
assistance and consultation in connection with the review of
various Securities and Exchange Commission filings. Ropes &
Gray, One International Place, Boston, Massachusetts, 02110-2624,
are legal counsel to the Series Fund and each of the Funds.
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those shareholders
who, to the Short Fund's best knowledge, as of November 30, 1997,
owned 5% or more of the shares of the Fund.
Dell USA L.P.
2112 Kramer Lane
Austin, TX 78758 20.49%
Monterey Bank
36 Brennan Street
Watsonville, CA 95076 13.20%
Webster Financial
PO Box 191
Waterbury, CT 0672010.50%
Sun World Savings Bank
PO Box 20222
El Paso, TX 79998 5.49%
<PAGE>
16
The Officers and Trustees of the Short Fund together as a group
owned less than 1.00% of the shares of the Short Duration Fund as
of November 30, 1997.
Listed below are the names and addresses of those
shareholders, who as of November 30, 1997, to the best knowledge
of the Intermediate Fund, owned 5% or more of shares of the Fund.
Public School Retirement System
1 Mercantile Center
St. Louis, MO 6310132.20%
Acceptance Insurance Company
222 S. 15th Street, Suite 600
Omaha, NE 68102 5.65%
The Officers and Trustees of the Intermediate Fund together as a
group owned less than 1.00% of the shares of the Fund as of
November 30, 1997.
Potential Conflicts of Interest
Principals of the Adviser as individuals own approximately 70%
of the common stock of Harrington Financial Group, the holding
company for Harrington Bank, FSB (the "Bank"). As of October 31,
1997, the Bank had total assets of $505 million. The Bank invests
in assets of the same types as those to be held by the Funds.
Douglas T. Breeden, in combination with immediate family
members, controls over 75% of the common stock of Community First
Financial Group, Inc. ("CFFG"), the holding company for certain
banks and thrifts to which the Adviser renders certain Investment
Advisory Services. CFFG and its subsidiaries invest in assets of
the same types as those to be held by the Funds.
The Adviser may also manage advisory accounts with investment
objectives similar to or the same as those of the Short or
Intermediate Fund, or different from both Funds, but trading in
the same type of securities and instruments. Portfolio decisions
and results of both Funds' investments may differ from those of
such accounts managed by the Adviser. When two or more accounts
managed by the Adviser seek to purchase or sell the same assets,
the assets actually purchased or sold may be allocated among the
accounts on a basis determined by the Adviser in its good faith
discretion to be equitable. In some cases, this system may
adversely affect the size or the price of the position obtainable
for the Short or Intermediate Fund.
POLICIES REGARDING BROKERS USED IN PORTFOLIO TRANSACTIONS
Under the Advisory Agreement, the selection of brokers and
dealers to execute transactions on behalf of a Fund is made by
the Adviser in accordance with criteria set forth in the Advisory
Agreement and any directions which the Board of Trustees may
give. However, each of the Funds does not anticipate that it will
incur a significant amount of brokerage expense because brokerage
commissions are not normally incurred on investments in Mortgage
<PAGE>
17
Securities, which are generally traded on a "net" basis; that is,
in principal amounts without the addition or deduction of
brokerage commissions. The Short and Intermediate Funds paid
$51,367 and $4,203 respectively in brokerage commissions on
futures and options trades in the year ended March 31, 1997. In
the year ended March 31, 1996, the Short and Intermediate Funds
paid $46,156 and $3,483, respectively, in brokerage commissions
on futures and options. In the year end March 31, 1995, the
Short and Intermediate Funds paid $0 and $3,483, respectively in
brokerage commissions. Neither Fund paid any brokerage
commissions for the year ended March 31, 1994. Prior to March 31,
1995, the Short Fund paid brokerage commissions indirectly by
virtue of its investment in the Smith Breeden Short Duration U.S.
Government Fund. Prior to August 1, 1994, the Intermediate Fund
paid brokerage commissions indirectly by virtue of its investment
in the Smith Breeden Institutional Intermediate U.S. Government
Fund. (See "Investment Advisory and Other Services").
When placing a portfolio transaction, the Adviser attempts to
obtain the best net price and execution of the transaction. On
portfolio transactions that are done on a securities exchange,
the amount of commission paid by the Short or Intermediate Fund
is negotiated between the Adviser and the broker executing the
transaction. The Adviser seeks to obtain the lowest commission
rate available from brokers that are felt to be capable of
efficient execution of the transactions. The determination and
evaluation of the reasonableness of the brokerage commissions
paid in connection with portfolio transactions are based to a
large degree on the professional opinions of the persons
responsible for the placement and review of such transactions.
These opinions are formed on the basis of, among other things,
the experience of these individuals in the securities industry
and information available to them concerning the level of
commissions being paid by other institutional investors of
comparable size.
Securities may be purchased directly from issuers or from
underwriters. Where possible, purchase and sale transactions will
be effected through dealers (including banks) which specialize in
the types of securities which the Funds will be holding, unless
better executions are available elsewhere. Dealers and
underwriters usually act as principals for their own account.
Purchases from underwriters will include a concession paid by the
issuer to the underwriter, and purchases from dealers will
include the spread between the bid and the asked price. No broker
or dealer affiliated with the Funds or with the Adviser may
purchase securities from, or sell securities to, the Funds.
When it is felt that several brokers or dealers are equally able
to provide the best net price and execution, the Adviser may
decide to execute transactions through brokers or dealers who
provide quotations and other services to the Short or
Intermediate Fund, specifically including the quotations
necessary to determine each of the Fund's net assets, in such
amount of total brokerage as may reasonably be required in light
of such services, and through brokers and dealers who supply
statistical and other data to both Funds in such amount of total
brokerage as may reasonably be required.
<PAGE>
18
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 of the Funds must be
denominated in U.S. Dollars. Each Fund reserves the right, in
its sole discretion, to either (a) reject any order for the
purchase or sale of shares denominated in any other currency, or
(b) to honor the transaction or make adjustments to shareholder's
account for the transaction as of a date and with a foreign
currency exchange factor determined by the drawee bank. Dividend
checks which are returned to a Fund marked "unable to forward" by
the postal service will be deemed to be a request to change the
dividend option and the proceeds will be reinvested in additional
shares at the current net asset value until new instructions are
received.
Redemptions in Kind
The Funds have committed themselves to pay in cash all requests
for redemption by any shareholder of record, limited in amount,
however, during any 90-day period to the lesser of $250,000 or 1%
of the value of either Fund's net assets at the beginning of such
period. Such commitment is irrevocable without the prior approval
of the Securities and Exchange Commission. In the case of
requests for redemption in excess of such amounts, the Trustees
reserve the right to make payments in whole or in part in
securities or other assets of either of the Funds in case of an
emergency, or if the payment of such redemption in cash would be
detrimental to the existing shareholders of either of the Funds.
In such circumstances, the securities distributed would be valued
at the price used to compute the Short or Intermediate Fund's net
assets. Should the Short or Intermediate Fund do so, a
shareholder may incur brokerage fees or other transaction costs
in converting the securities to cash.
Principal Underwriter
FPS Broker Services, Inc. (the "Principal Underwriter"), 3200
Horizon Drive, P.O. Box 61503, King of Prussia, PA 19406 0903, is
the principal underwriter for the Funds, and is acting on a best
efforts basis. The Principal Underwriter is registered as a
broker dealer under the Securities Exchange Act of 1934 and is a
member of the National Association of Securities Dealers, Inc.
The offering of the Funds' shares is continuous.
<PAGE>
19
The underwriting agreement with the Principal Underwriter
provides that each Fund will pay all fees and expenses in
connection with: registering and qualifying its shares under the
various state "blue sky" laws; preparing, setting in type,
printing, and mailing its prospectuses and reports to
shareholders; and issuing its shares, including expenses of
confirming purchase orders. (See the description of the
Distribution Plan in the Prospectus). The Principal Underwriter
acts as the agent of both the Funds in connection with the sale
of their shares in all states in which the shares are qualified
and in which the Principal Underwriter is qualified as a broker-
dealer. Under the underwriting agreement, the Principal
Underwriter may accept orders for either Fund's shares at the
offering price. The Principal Underwriter may enter into
agreements with other broker-dealers for the sale of Short or
Intermediate Fund shares by them.
The Principal Underwriter is paid approximately $15,000 in
total by the Adviser for its services to the two Funds. In
addition, for the year March 31, 1997, the Principal Underwriter
received no sales charges or commissions.
Calculation of Net Asset Value
As noted in the Prospectus, the Funds will generally calculate
their net asset value as of the close of trading each Monday
through Friday that the Adviser and Transfer Agent are open for
business and sufficient trading takes place to impact the value
of the Short or Intermediate Fund assets. As of the date of this
Statement, current holiday schedules indicate that the net asset
value will not be calculated on: New Year's Day, Presidents' Day,
Dr. Martin Luther King Day Jr. Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Columbus Day, Veteran's Day,
Thanksgiving Day, the day following Thanksgiving, Christmas Eve,
and Christmas Day.
Reinvestment Date
The dividend reinvestment date is the date on which the
additional shares are purchased for the investor who has his
dividends reinvested. This date will vary from month to month
and is not necessarily the same date as the record date or the
payable date for cash dividends.
Ownership and Authority Disputes
In the event of disputes involving multiple claims of ownership
or authority to control a shareholder's account, each Fund has
the right (but no obligation) to (a) require the written
agreement of all persons deemed by the Fund to have a potential
property interest in the account, prior to executing instructions
regarding the account; (b) interplead disputed funds or account
with a court of competent jurisdiction, or (c) surrender
ownership of all or a portion of the account to the Internal
Revenue Service in response to a Notice of Levy.
<PAGE>
20
TAXES
Taxation of the Funds
For federal income tax purposes, each of the Funds will be
treated as a separate corporation. Each of the Funds intends to
qualify each year and elects to be treated as regulated
investment companies ("RICs") for federal income tax purposes. To
so qualify, the Funds must, among other things: (i) derive at
least 90% of their gross income for each taxable year from
dividends, interest, payments with respect to loans of securities
and gains from the sale or other disposition of securities or
certain other related income; (ii) only until March 31, 1998,
generally derive less than 30% of their gross income for each
taxable year from gains from the sale or other disposition of
securities and certain other investments held for less than three
months; and (iii) diversify their holdings so that at the end of
each quarter of the taxable year (A) at least 50% of the value of
each of the Fund's assets would be represented by cash, U.S.
Government securities, securities of other RICs, and other
securities which, with respect to any one issuer, do not
represent more than 5% of the value of each of the Fund's assets
nor more than 10% of the voting securities of such issuer and (B)
not more than 25% of the value of each of the Fund's assets are
invested in the securities of any one issuer (other than U.S.
Government securities or the securities of other RICs).
The requirement (only until March 31, 1998) that each of the
Funds derive less than 30% of its gross income from gains from
the sale or other disposition of securities and certain other
investments held for less than three months (the "Short-Short
Rule") may cause the Short or Intermediate Fund to (i) hold
certain investments that it otherwise would have sold or (ii)
sell certain investments that it otherwise would have held. In
addition, if the Short or Intermediate Fund were to experience a
large quantity of share redemptions during a taxable year, either
Fund may have difficulty satisfying the Short-Short Rule during
that year. If the Short or Intermediate Fund fails to satisfy
the Short-Short Rule in a taxable year, it would lose its RIC
status for that year. Each of the Funds, however, will endeavor
to select investments for sale during a taxable year in such a
way that it will satisfy the Short-Short Rule.
If the Funds qualify as RICs and distribute to their
shareholders at least 90% of their net investment income
(including tax-exempt interest and net short-term capital gain
but not net capital gain, which is the excess of net long-term
capital gains over net short term capital losses), then the Funds
will not be subject to federal income tax on the income so
distributed. However, the Funds will be subject to corporate
income tax on any undistributed income. In addition, either of
the Funds would be subject to a nondeductible 4% excise tax on
the amount by which the income it distributed in any calendar
year would be less than a minimum distribution amount. The
minimum distribution amount required to avoid the excise tax for
a calendar year equals the sum of (i) 98% of a Fund's ordinary
income (excluding tax-exempt interest income) for such calendar
year; (ii) 98% of the excess of capital gains over capital losses
for the one year period ending on October 31 of each year; and
<PAGE>
21
(iii) 100% of the undistributed ordinary income and gains from
prior years. For purposes of the excise tax, any income or
capital gains retained by, and taxed in the hands of, either of
the Funds will be treated as having been distributed.
Both Funds intend to distribute sufficient income so as to avoid
corporate income tax and excise tax. The Short Fund may be
subject to a 4% excise tax to the extent that the amount of
ordinary income distributed during the calendar year is less than
98% of the ordinary income (excluding tax-exempt interest income)
for the year. The Short Fund will endeavor to pay dividends in
such a manner that an excise tax will not be incurred. The Short
Fund also may elect to retain all or a portion of its net capital
gain, as described under "Taxation of Shareholders Distributions"
below.
Any capital losses resulting from the disposition of securities
can be used only to offset capital gains and cannot be used to
reduce a Fund's ordinary income. Such capital losses may be
carried forward for eight years. If any capital losses have not
been utilized at the time a Fund terminates, such capital losses
will become unusable.
Taxation of Shareholders
Distributions. In general, all distributions to shareholders
attributable to the Short or Intermediate Fund's net investment
income (including any tax-exempt interest income distributed)
will be taxable as ordinary dividend income whether paid in cash
or in additional shares.
To the extent either of the Funds does realize net capital gains,
it intends to distribute such gains at least annually and
designate them as capital gain dividends. Capital gain dividends
are taxable as capital gains, whether paid in cash or in
additional shares, regardless of how long the shares have been
held. The Short or Intermediate Fund may elect to retain net
capital gains and pay corporate income tax thereon. In such
event, the Short or Intermediate Fund would most likely make an
election that would require each shareholder of record on the
last day of the Fund's taxable year to include in income for tax
purposes his proportionate share of the Fund's undistributed net
capital gain. If such an election is made, each shareholder would
be entitled to credit his proportionate share of the tax paid by
the Fund against his federal income tax liabilities and to claim
refunds to the extent that the credit exceeds such liabilities.
In addition, the shareholder would be entitled to increase the
basis of his shares for federal tax purposes by an amount equal
to 66% of his proportionate share of the undistributed net
capital gain.
Shareholders receiving distributions in the form of additional
shares will be treated for federal income tax purposes as
receiving an equivalent amount of cash. In general, the basis of
such shares will equal the amount of cash that the shareholder
would have received if he had elected to receive distributions in
cash.
Liquidating distributions which, in the aggregate, exceed a
<PAGE>
22
shareholder's basis in shares will be treated as gain from the
sale of shares. If a shareholder receives, in the aggregate,
liquidating distributions which are less than such basis, such
shareholder will recognize a loss to that extent. Dividends and
other distributions by either the Short or Intermediate Fund are
generally taxable to the shareholders at the time the dividend or
distribution is made.
If a shareholder purchases shares at a cost that reflects an
anticipated dividend, such dividend will be taxable even though
it represents economically a return of part of the purchase
price. Investors should consider the tax implications of buying
shares shortly prior to a distribution.
Sale or Redemption of Shares. The sale, exchange, or
redemption of Fund shares may give rise to a gain or loss. In
general, any gain realized upon a taxable disposition of shares
will be treated as mid-term gain if the shares have been held for
more than 12 months, but not more than 18 months, and as adjusted
net long-term capital gains if the shares have been held for more
than 18 months. Otherwise the gain on the sale, exchange or
redemption of Fund shares will be treated as short-term capital
gain or loss. In addition, any loss (not already disallowed as
provided in the next sentence) realized upon a taxable
disposition of shares held for six months or less will be treated
as long-term, rather than short-term, to the extent of any long-
term capital gain distributions received by the shareholder with
respect to the shares. All or a portion of any loss realized
upon a taxable disposition of Fund shares will be disallowed if
other Fund shares are purchased within 30 days before or after
the disposition. In such a case, the basis of the newly
purchased shares will be adjusted to reflect the disallowed
loss.
Tax-Exempt Investors. If a shareholder that is a benefit plan
investor (e.g., an individual retirement account, pension plan
401(k) plan, or Keogh plan) or charitable organization (a "Tax
Exempt Investor") incurs debt to finance the acquisition of its
shares, a portion of the income received by the Tax-Exempt
Investor with respect to its shares would constitute unrelated
business taxable income ("UBTI"). In that case, the UBTI portion
of the Tax Exempt Investor's income from its investment in the
Short or Intermediate Fund for the year would equal the total
income recognized by the Tax-Exempt Investor in that year
multiplied by the ratio of the Tax-Exempt Investor's average
acquisition debt balance to the average tax basis of its shares
for the year. A Tax Exempt Investor is generally subject to
federal income tax to the extent that its UBTI for a taxable year
exceeds its annual $1,000 exclusion.
Consequences of Certain Fund Investments
Hedging Transactions. Each of the Funds intends to engage in
various hedging transactions. Under various provisions of the
Code, the result of such investments and transactions may be to
change the character of recognized gains and losses, accelerate
the recognition of certain gains and losses, and defer the
recognition of certain losses. For example, the tax treatment of
futures contracts entered into by a Fund as well as listed
<PAGE>
23
nonequity options written or purchased by a Fund on U.S.
exchanges (including options on debt securities and options on
futures contracts) will be governed by section 1256 of the Code.
Absent a tax election for "mixed straddles" (described below),
each such position held by a Fund on the last business day of
each taxable year will be marked to market (i.e., treated as if
it were closed out), and all resulting gain or loss will be
treated as 60% long term capital gain or loss and 40% short-term
capital gain or loss, with subsequent adjustments made to any
gain or loss realized upon an actual disposition of such
positions (currently, the 60% long-term portion will be treated
as if held for more than 18 months). When a Fund holds an option
or contract governed by section 1256 which substantially
diminishes the Fund's risk of loss with respect to another
position of its Portfolio not governed by section 1256 (as might
occur in some hedging transactions), that combination of
positions generally will be a "mixed straddle" that is subject to
the straddles rules of section 1092 of the Code. The application
of Section 1092 might result in deferral of losses, adjustments
in the holding periods of a Fund's securities and conversion of
short term capital losses into long-term capital losses. Either
Fund may make certain tax elections for its "mixed straddles"
that could alter certain effects of section 1256 or section
1092.
Tax Implications of Certain Investments. Certain of a Fund's
investments, including investments in stripped securities, will
create taxable income in excess of the cash they generate. In
such cases, a Fund may be required to sell assets (including when
it is not advantageous to do so) to generate the cash necessary
to distribute to its shareholders all of its income and gains and
therefore to eliminate any tax liability at the Fund level.
The character of the Short or Intermediate Fund's taxable income
will, in most cases, be determined on the basis of reports made
to the Funds by the issuers of the securities in which they
invest. The tax treatment of certain securities in which a Fund
may invest is not free from doubt and it is possible that an IRS
examination of the issuers of such securities could result in
adjustments to the income of a Fund. The foregoing discussion is
a general summary of certain of the current federal income tax
laws regarding both Funds and investors in the shares.
The discussion does not purport to deal with all of the federal
income tax consequences applicable to the Funds or to all
categories of investors, some of which maybe subject to special
rules. Investors should consult their own tax advisers regarding
the tax consequences to them of investments in shares.
STANDARD PERFORMANCE MEASURES
Performance
As noted in the Prospectus, a Fund may from time to time quote
various performance figures to illustrate its past performance.
It may occasionally cite statistics to reflect its volatility or
risk.
<PAGE>
24
Performance quotations by investment companies are subject to
rules adopted by the Securities and Exchange Commission ("SEC").
These rules require the use of standardized performance
quotations, or alternatively, that every non-standardized
performance quotation furnished by a Fund be accompanied by
certain standardized performance information computed as required
by the SEC. Current yield and average annual compounded total
return quotations used by a Fund are based on the standardized
methods of computing performance mandated by the SEC. An
explanation of those and other methods used by a Fund to compute
or express performance follows.
Total Return
The average annual total return is determined by finding the
average annual compounded rates of return over one, five, and ten
year periods (or for the life of a Fund, if shorter) that would
equate an initial hypothetical $1000 investment to its ending
redeemable value. The calculation assumes no sales charge is
deducted from the initial $1000 purchase order, capital gains and
all income dividends are reinvested at net asset value on the
reinvestment dates during the period. The quotation assumes the
account was completely redeemed at the end of each one, five and
ten year period and the deduction of all applicable charges and
fees.
A Fund's average annual compounded rate of return is determined
by reference to a hypothetical $1000 investment, according to the
following formula:
P(1+T)n = ERV
where:
P = a hypothetical initial payment of $1000
T = average annual total return
n = number of years
ERV = ending redeemable value of a
hypothetical $1000 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, a Fund may quote total rates of
return in addition to its average annual total return. Such
quotations are computed in the same manner as a Fund's average
annual compounded rate, except that such quotations will be based
on a Fund's actual aggregate return for a specified period as
opposed to its average return over certain periods.
Yield
Current yield reflects the income per share earned by a Fund's
portfolio investments. Current yield is determined by dividing
the net investment income per share earned during a 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
<PAGE>
25
where:
a = dividends and interest earned during the
period.
b = expenses accrued for the period (net of
reimbursements).
c = the average daily number of shares
outstanding during the period that
were entitled to receive dividends.
d = the maximum offering price or net asset
value per share, as the case may be,
on the last day of the period.
The following table shows the average annual total return for
the periods stated, and yield for the Funds for the 30 day period
ended September 30, 1997.
AVERAGE ANNUAL TOTAL RETURN
ONE YEAR FIVE YEARS INCEPTION 30DAY
YIELD
SHORT FUND 6.62% 5.42% 5.59% 5.79%
INTERMEDIATE
FUND 9.44% 7.44% 8.52% 5.70%
The investment results of the Funds, like all others, fluctuate
over time. Thus, performance figures should not be considered to
represent what an investment may earn in the future or what the
Short or Intermediate Fund's yield or total return may be for any
future period.
Current Distribution Rate
Yield, which is calculated according to a formula prescribed by
the SEC, is not indicative of the amounts which will be paid to a
Fund's shareholders. Amounts paid to shareholders are reflected
in the quoted "current distribution rate." The current
distribution rate is computed by dividing the total amount of
dividends, excluding long-term capital gains, per share paid by a
Fund during the past twelve months by its current net asset
value. Under certain circumstances, such as when there has been a
change in the amount of dividend payout, or a fundamental change
in investment policies, it might be appropriate to annualize the
dividends paid over the period such policies were in effect,
rather than using the dividends during the past twelve months.
The current distribution rate differs from the current yield
computation because it may include distributions to shareholders
from sources other than dividends and interest, such as 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 Fund's
volatility or risk. Measures of volatility or risk are generally
used to compare fund net asset value or performance relative to a
market index. One measure of volatility is beta. The ratio of
the expected excess return on a Fund to the expected excess
return on the market index is called beta. Equity funds commonly
<PAGE>
26
use the S&P 500 as their market index. A beta of more than 1.00
indicates volatility greater than the market, and a beta of less
that 1.00 indicates volatility less than the market. Another
measure of volatility or risk is standard deviation. Standard
deviation is used to measure variability of net asset value or
total return around an average, over a specified period of time.
The premise is that greater volatility connotes greater risk
undertaken in achieving performance.
A statistic often used by sophisticated institutional investors
when comparing the relative performance of portfolios is the
Sharpe Ratio. This statistic is a Fund's excess return (relative
to T-Bills) divided by the standard deviation of its returns.
Comparisons and Advertisements
To help investors better evaluate how an investment in a Fund
might satisfy their objective, advertisements regarding either of
the Funds may discuss various measures of a Fund's performance as
reported by various financial publications. Advertisements may
also compare performance (as calculated above) to performance as
reported by other investments, indices, and averages. The
following publications, indices, and averages may be used:
a) Lipper-Mutual Fund Performance Analysis, Lipper-Fixed Income
Analysis, and Lipper-Mutual Fund Indices - measures total return
and average current yield for the mutual fund industry and rank
individual mutual fund performance over specified time periods
assuming reinvestment of all distributions, exclusive of sales
charges.
b) CDA Mutual Fund Report, published by CDA Investment
Technologies, Inc. - analyzes price, current yield, risk, total
return, and average rate of return (average annual compounded
growth rate) over specified time periods for the mutual fund
industry.
c) Mutual Fund Source book, published by Morningstar, Inc. -
analyzes price, yield, risk, and total return for equity and
fixed income funds.
d) Financial publications: Barron's, Business Week, Changing
Times, Financial World, Forbes, Fortune, and Money magazines -
rate fund performance over specified time periods.
e) Consumer Price Index (or Cost Of Living Index), published by
the U.S. Bureau of Labor Statistics - a statistical measure of
change, over time, in the price of goods and services, in major
expenditure groups.
f) Stocks, Bonds, Bills, and Inflation, published by Ibbotson
Associates - a historical measure of yield, price, and total
return for common and small company stock, long-term government
bonds, treasury bills, and inflation.
g) Savings and Loan Historical Interest Rates - as published in
the U.S. Savings & Loan League Fact Book.
<PAGE>
27
h) Salomon Brothers Broad Bond Index - measures yield, price,
and total return for Treasury, Agency, Corporate, and
Mortgage bonds. All issues mature in one year or more and
have at least $50 million outstanding, with the exception of
mortgages. The entry criteria for mortgage issues is $200
million for each coupon.
i) Salomon Brothers Mortgage Index - measures only the mortgage
component of the Salomon Brothers Broad Bond Index.
j) Salomon Brothers Composite High Yield Index or its component
indices - measures yield, price and total return for Long-
Term High Yield Index, Intermediate Term High Yield Index,
and Long-Term Utility High Yield Index.
k) Lehman Brothers Aggregate Bond Index or its component
indices - measures yield, price and total return for Treasury,
Agency, Corporate, Mortgage, and Yankee bonds.
l) Lehman Brothers Government/Corporate Bond Index.
m) Standard & Poor's Bond Indices - measure yield and price of
Corporate, Municipal, and Government bonds.
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, taxfree and
government money funds.
q) Total returns and yields for Treasury Securities and fixed
income indices as published by Ryan Laboratories or other
suppliers.
In assessing such comparisons of performance, an investor should
keep in mind that the composition of the investments in the
reported indices and averages is not identical, and in some cases
is very different, to a Fund's portfolio, that the averages are
generally unmanaged and that the items included in the
calculations of such averages may not be identical to the formula
used by a Fund to calculate its figures. In addition, there can
be no assurance that a Fund will continue its performance as
compared to such other averages.
Shareholders should note that the investment results of the Short
or Intermediate Fund will fluctuate over time, and any
presentation of a Fund's current yield or total return for any
period should not be considered as a representation of what an
investment may earn or what a shareholder's yield or total return
may be in any future period.
<PAGE>
28
Shareholders should also note that although the Funds believe
that there are substantial benefits to be realized by investing
in its shares, such investments also involve certain risks. (See
"Investment Objectives and Policies of the Fund Risks of Mortgage
Securities" in the Funds' Prospectus).
ADDITIONAL INFORMATION FOR INSTITUTIONAL INVESTORS
As the investments permitted to the Funds are primarily in
mortgage securities issued or guaranteed by the U.S. Government
or its agencies and instrumentalities, the shares of either the
Short or Intermediate Fund may be eligible for investment by
federally chartered credit unions, federally chartered thrifts,
and national banks. Either of the Funds may be a permissible
investment for certain state chartered institutions as well,
including state and local government authorities and agencies.
Any financial institution or agency considering an investment in
either of the Funds should refer to the applicable laws and
regulations governing its operations in order to determine if a
Fund is a permissible investment.
EXPERTS
The annual financial statements of both the Short and
Intermediate Funds and related notes thereto attached to this
Statement of Additional Information have been so attached in
reliance upon the report of Deloitte & Touche LLP, independent
auditors, given in authority of said firm as experts in auditing
and accounting. The semi-annual financial statements and related
notes thereto attached to this Statement of Additional
Information have not been audited by Deloitte & Touche LLP.
FINANCIAL STATEMENTS
The audited annual and unaudited semi-annual financial
statements of the Funds are attached and follow the Appendix.
<PAGE>
29
APPENDIX
Description of Moody's Investors Service, Inc.'s corporate bond
ratings:
Aaa - Bonds which are rated Aaa are judged to be of the best
quality. They carry the smallest degree of investment
risk and are generally referred to as "gilt edged."
Interest payments are protected by a large or
exceptionally stable margin and principal is secure.
While the various protective elements are likely to
change, such changes as can be visualized are most
unlikely to impair the fundamentally strong position of
such issues.
Aa - Bonds which are rated Aa are judged to be of high
quality by all standards. Together with the Aaa group
they comprise what are generally known as high grade
bonds. They are rated lower than the best bonds because
margins of protection may not be as large as in Aaa
securities, or fluctuation of protective elements may
be of greater amplitude,or there may be other elements
present which make the long-term risks appear somewhat
larger than in Aaa securities.
A - Bonds which are rated A possess many favorable
investment attributes and are to be considered as upper
medium grade obligations. Factors giving security to
principal and interest are considered adequate but
elements may be present which suggest a susceptibility
to impairment sometime in the future.
Baa - Bonds which are rated Baa are considered as medium
grade obligations, i.e., they are neither highly
protected nor poorly secured. Interest payments and
principal security appear adequate for the present, but
certain protective elements may be lacking or may be
characteristically unreliable over any great length of
time. Such bonds lack outstanding investment
characteristics and have speculative characteristics as
well.
Ba - Bonds which are rated Ba are judged to have
predominantly speculative elements; their future cannot
be considered as well assured. Often the protection of
interest and principal payments may be very moderate
and thereby not well safeguarded during both good and
bad times over the future. Uncertainty of position
characterizes bonds in this class.
B - Bonds which are rated B generally lack characteristics of
the 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.
<PAGE>
31
Ca - Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in
default or have other marked shortcomings.
Description of Standard & Poor's Corporation's corporate bond
ratings:
AAA - Bonds rated AAA are given the highest rating assigned by
Standard & Poor's to a debt obligation,
which indicates an extremely strong capacity to pay
principal and interest.
AA - Bonds rated AA also qualify as high-quality debt
obligations. Capacity to pay principal and interest is
very strong, and in the majority of instances they
differ from AAA issues only in small degree.
A - Bonds rated A have a strong capacity to pay principal
and interest, although they are somewhat more
susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB - Bonds rated BBB are regarded as having an adequate
capacity to pay principal and interest. Whereas they
normally exhibit protection parameters, adverse
economic conditions or changing circumstances are more
likely to lead to a weakened capacity to 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.
<PAGE>
32
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
SCHEDULE OF INVESTMENTS (UNAUDITED)
SEPTEMBER 30, 1997
- ------------------------------------------------------------
- --------------------
<TABLE>
<CAPTION>
MARKET
FACE AMOUNT
SECURITY VALUE
- --------------- --
- ------ ----------
- --
<C> <S>
<C>
U.S. GOVERNMENT & AGENCY OBLIGATIONS --
97.93%
FEDERAL HOME LOAN MORTGAGE CORP. -- 25.05%
*
FHLMC GOLD:
$16,750,000 7.50%, due date to be
announced...................................................
....... $ 17,096,992
180,622 8.00%, due
5/01/25.....................................................
.................. 186,940
8,194,327 8.50%, due 5/01/25 to
12/01/25....................................................
....... 8,585,978
- ------------
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(COST
$25,585,820)................................................
..................... 25,869,910
- ------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION --
0.43% *
FNMA INTEREST ONLY **:
1,495,854 9.00%, due
7/25/21.....................................................
.................. 439,099
- ------------
TOTAL FEDERAL NATIONAL MORTGAGE
ASSOCIATION
(COST
$165,646)...................................................
..................... 439,099
- ------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION -
- - 72.08% *.....................................
GNMA ARM:
25,596,477 5.00%, due 1/20/27 to
9/20/27.....................................................
....... 25,431,180
42,885,307 5.50%, 2/20/27 to
9/20/27.....................................................
........... 42,824,134
645,226 7.00%, due
3/20/21.....................................................
.................. 666,012
2,633,367 7.125%, due 7/20/17 to
9/20/22.....................................................
...... 2,717,311
1,461,889 7.375%, due 5/20/22 to
4/01/24.....................................................
...... 1,506,257
GNMA:
1,169,913 9.50%, due 7/15/09 to
4/15/25.....................................................
....... 1,265,674
- ------------
TOTAL GOVERNMENT NATIONAL MORTGAGE
ASSOCIATION
(COST
$73,747,542)................................................
..................... 74,410,568
- ------------
U.S. GOVERNMENT OBLIGATIONS -- 0.37%
U.S. TREASURY BILL ***
400,000 5.51%, due
5/29/97.....................................................
.................. 386,430
- ------------
TOTAL U.S. GOVERNMENT OBLIGATIONS (COST
$385,355)........................................
386,430
- ------------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(COST
$99,884,363)................................................
..................... 101,106,007
- ------------
<CAPTION>
NOTIONAL AMOUNT THREE-MONTH LIBOR INTEREST RATE SWAP
CONTRACTS -- (0.13)%
- ---------------
<C> <S>
<C>
$20,000,000 Contract dated 6/22/93 with Prudential
Global Funding,
Expires 6/22/98, pay rate
5.458%......................................................
... 78,261
20,000,000 Contract dated 8/31/93 with Salomon
Swapco,
Expires 8/30/00, pay rate
5.34%.......................................................
... 431,295
20,000,000 Contract dated 5/15/95 with Salomon
Swapco,
Expires 5/15/05, pay rate
6.951%......................................................
... (646,767)
- ------------
TOTAL THREE-MO. LIBOR INTEREST RATE SWAP
CONTRACTS.......................................
(137,211)
- ------------
THREE-MONTH LIBOR INTEREST RATE CAP
CONTRACTS -- 0.58%
50,000,000 Contract with Salomon Swapco, expires
4/23/03,
Strike rate
7.50%.......................................................
................. 597,000
- ------------
TOTAL THREE-MO. LIBOR INTEREST RATE CAP
CONTRACTS
(COST
$1,565,832).................................................
..................... 597,000
- ------------
</TABLE>
2
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
SCHEDULE OF INVESTMENTS (CONTINUED) (UNAUDITED)
SEPTEMBER 30, 1997
- ------------------------------------------------------------
- --------------------
<TABLE>
<CAPTION>
MARKET
CONTRACTS
SECURITY VALUE
- --------------- --
- ------ ----------
- --
<C> <S>
<C>
OPTION CONTRACTS -- 0.05%
60 Call on 10 Year US Treasury Note futures,
expires 12/97, strike price $110............... $
26,250
72 Call on 10 Year US Treasury Note futures,
expires 12/97, strike price $112...............
13,500
40 Put on 10 Year US Treasury Note futures,
expires 12/97, strike price $106................
1,250
80 Put on 10 Year US Treasury Note futures,
expires 12/97, strike price $107................
6,250
- ------------
TOTAL OPTION CONTRACTS (COST
$84,885)....................................................
47,250
- ------------
TOTAL INVESTMENTS -- 98.43% (COST
$101,535,080)..........................................
101,613,046
- ------------
<CAPTION>
FACE AMOUNT REPURCHASE AGREEMENTS -- 5.81%:
- ---------------
<C> <S>
<C>
$ 6,000,000 Morgan Stanley 5.58 due 10/01/97 dated
9/24/97...........................................
6,000,000
- ------------
TOTAL REPURCHASE AGREEMENTS (COST
$6,000,000)............................................
6,000,000
- ------------
SHORT SALES -- (9.47%)
10,000,000 GNMA 6.5% due date to be
announced...................................................
.... (9,778,125)
- ------------
TOTAL SHORT SALES (PROCEEDS
$9,196,318).................................................
. (9,778,125)
- ------------
CASH AND OTHER ASSETS LESS LIABILITIES --
5.23%..........................................
5,403,913
- ------------
NET ASSETS --
100.00%.....................................................
............... $103,238,834
- ------------
- ------------
</TABLE>
- ---------------
* 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 September 30,
1997. ARMs have coupon rates which adjust periodically.
The adjusted rate is
determined by adding a spread to a specified index.
** Represents an interest only stripped mortgage-backed
security.
*** Security is segregated as collateral.
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.
3
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENT OF ASSETS AND LIABILITIES
AS OF SEPTEMBER 30, 1997 (UNAUDITED)
- ------------------------------------------------------------
- --------------------
<TABLE>
<S>
<C>
ASSETS:
Investments at market value (identified cost $101,535,080)
(Note 1).......................................
$101,613,046
Cash........................................................
..............................................
85,631
Repurchase agreement (cost $6,000,000) (Note
1)..........................................................
. 6,000,000
Receivables:
Subscriptions...............................................
........................................... 61,658
Interest....................................................
........................................... 548,555
Securities
sold........................................................
................................ 29,311,385
Other
assets......................................................
........................................ 55,856
- ------------
TOTAL
ASSETS......................................................
..................................... 137,676,131
- ------------
LIABILITIES:
Short sales at market value (Proceeds
$9,196,318).................................................
........ 9,778,125
Payables:
Variation margin on futures contracts (Note
2).........................................................
38,062
Redemptions.................................................
........................................... 98,561
Securities
purchased...................................................
................................ 24,348,250
Swap
interest....................................................
...................................... 26,913
Due to adviser (Note
3)..........................................................
...................... 59,188
Accrued
expenses....................................................
................................... 88,198
- ------------
TOTAL
LIABILITIES.................................................
..................................... 34,437,297
- ------------
NET ASSETS:
(Applicable to outstanding shares of 10,442,306 unlimited
number of shares of beneficial interest
authorized; no stated
par)........................................................
..................... $103,238,834
- ------------
- ------------
Net asset value, offering price and redemption price per
share ($103,238,834410,442,306).................. $
9.89
- ------------
- ------------
SOURCE OF NET ASSETS:
Paid in
capital.....................................................
...................................... $108,038,150
Overdistributed net investment
income......................................................
............... (573,182)
Accumulated net realized loss on
investments.................................................
............. (3,991,764)
Net unrealized depreciation of investments, interest rate
swaps, short sales and futures contracts........
(234,370)
- ------------
NET
ASSETS......................................................
....................................... $103,238,834
- ------------
- ------------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
4
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED SEPTEMBER 30, 1997 (UNAUDITED)
- ------------------------------------------------------------
- --------------------
<TABLE>
<S>
<C>
INVESTMENT INCOME:
Interest and discount earned, net of premium amortization
and interest expense (Note 1)..................... $
3,500,534
EXPENSES:
Advisory fees (Note
3)..........................................................
............................ 388,801
Accounting and pricing services
fees........................................................
................ 25,261
Custodian
fees........................................................
...................................... 17,785
Audit and tax preparation
fees........................................................
...................... 14,400
Legal
fees........................................................
.......................................... 22,895
Transfer agent
fees........................................................
................................. 13,989
Registration
fees........................................................
................................... 10,437
Trustees fees and
expenses....................................................
.............................. 34,400
Insurance...................................................
................................................
8,614
Other.......................................................
................................................
19,257
- -----------
TOTAL EXPENSES BEFORE
REIMBURSEMENT...............................................
....................... 555,839
EXPENSES REIMBURSED BY ADVISER (NOTE
3)..........................................................
........ (122,584)
- -----------
NET
EXPENSES....................................................
......................................... 433,255
- -----------
NET INVESTMENT
INCOME......................................................
.............................. 3,067,279
- -----------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on
investments.................................................
........................... 1,597,495
Change in unrealized appreciation (depreciation) of
investments, interest rate swaps, caps, and futures
contracts...................................................
............................................. (1,054,272)
- -----------
Net realized and unrealized gain on
investments.................................................
............ 543,223
- -----------
Net increase in net assets resulting from
operations..................................................
...... $ 3,610,502
- -----------
- -----------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
5
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENTS OF CHANGES IN NET ASSETS
- ------------------------------------------------------------
- --------------------
<TABLE>
<CAPTION>
SIX MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 1997 MARCH 31, 1997
(UNAUDITED) (AUDITED)
- ------------------ --------------
<S>
<C> <C>
OPERATIONS:
Net investment
income......................................................
......... $ 3,067,279 $ 10,225,930
Net realized gain on
investments.................................................
... 1,597,495 846,686
Change in unrealized appreciation (depreciation) of
investments, interest rate
swaps, caps and futures
contracts................................................
(1,054,272) 1,887,652
- ------------------ --------------
Net increase in net assets resulting from
operations................................ 3,610,502
12,960,268
- ------------------ --------------
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income................................................
(2,963,547) (10,225,930)
Dividends in excess of net investment
income........................................
- -- (929,596)
- ------------------ --------------
Total
distributions...............................................
.................. (2,963,547) (11,155,526)
- ------------------ --------------
CAPITAL SHARE TRANSACTIONS:
Shares
sold........................................................
................. 18,539,448 59,328,830
Shares issued on reinvestment of
distributions......................................
1,415,524 2,816,807
Shares
redeemed....................................................
................. (36,351,702) (166,786,906)
- ------------------ --------------
Decrease in net assets resulting from capital
share transactions
(a).........................................................
.. (16,396,730) (104,641,269)
- ------------------ --------------
TOTAL DECREASE IN NET
ASSETS.....................................................
(15,749,775) (102,836,527)
NET ASSETS:
Beginning of
period......................................................
........... 118,988,609 221,825,136
- ------------------ --------------
End of
period......................................................
................. $103,238,834 $ 118,988,609
- ------------------ --------------
- ------------------ --------------
(a) Transactions in capital shares were as follows:
Shares
sold........................................................
.............. 1,882,124 6,065,723
Shares issued on reinvestment of
distributions...................................
144,195 289,222
Shares
redeemed....................................................
.............. (3,690,432) (17,017,982)
- ------------------ --------------
Net
decrease....................................................
................. (1,664,113) (10,663,037)
Beginning
balance.....................................................
........... 12,106,419 22,769,456
- ------------------ --------------
Ending
balance.....................................................
.............. 10,442,306 12,106,419
- ------------------ --------------
- ------------------ --------------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
6
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
FINANCIAL HIGHLIGHTS
- ------------------------------------------------------------
- --------------------
The following average per share data, ratios and
supplemental information have
been derived from information provided in the financial
statements.
<TABLE>
<CAPTION>
FOR THE
PERIOD
SIX MONTHS
MARCH 31,
ENDED YEAR
YEAR YEAR YEAR 1992 (1)
SEPTEMBER 30, ENDED
ENDED ENDED ENDED TO
1997 MARCH 31,
MARCH 31, MARCH 31, MARCH 31, MARCH 31,
(UNAUDITED) 1997
1996 1995 1994 1993
------------- ------------
- ------------ ------------ ------------ ------------
- -
<S> <C> <C>
<C> <C> <C> <C>
NET ASSET VALUE, BEGINNING
OF PERIOD................ $ 9.83 $ 9.74
$ 9.90 $ 9.90 $ 10.00 $
10.00
------------- ------------
- ------------ ------------ ------------ ------------
- -
INCOME FROM INVESTMENT
OPERATIONS
Net investment income.... 0.261 0.476
0.621 0.628 0.432 0.552
Net realized and
unrealized gain (loss)
on investments......... 0.059 0.146
(0.148) -- (0.070) 0.002
------------- ------------
- ------------ ------------ ------------ ------------
- -
Total from investment
operations........... 0.320 0.622
0.473 0.628 0.362 0.554
------------- ------------
- ------------ ------------ ------------ ------------
- -
LESS DISTRIBUTIONS
Dividends from net
investment income...... (0.260 ) (0.476)
(0.621) (0.628) (0.462) (0.554)
Dividends in excess of
investment income...... -- (0.056)
(0.012) -- -- --
------------- ------------
- ------------ ------------ ------------ ------------
- -
Total distributions.... (0.260 ) (0.532)
(0.633) (0.628) (0.462) (0.554)
------------- ------------
- ------------ ------------ ------------ ------------
- -
NET ASSET VALUE, END OF
PERIOD................... $ 9.89 $ 9.83
$ 9.74 $ 9.90 $ 9.90 $
10.00
------------- ------------
- ------------ ------------ ------------ ------------
- -
TOTAL RETURN............... 3.30% 6.57%
4.95% 6.58% 3.67% 5.67%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of
period................. $103,238,834 $118,988,609
$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% 0.78% 0.78%
Ratio of net investment
income to average net
assets................. 5.62%* 5.04%
6.29% 6.33% 4.17% 4.53%
Portfolio turnover
rate................... 306% 556%
225% 47% 112% 3%
Ratio of expenses to
average net assets
before reimbursement of
expenses by the Adviser
(2).................... 1.01%* 0.93%
0.93% 0.92% 1.00% 2.58%
Ratio of net investment
income to average net
assets before
reimbursement of
expenses by the
Adviser................ 5.39%* 4.90%
6.13% 6.18% 3.95% 2.73%
</TABLE>
- ---------------
(1) Commencement of operations.
(2) Through March 31, 1995, expense ratios include both the
direct expenses of
the Short Duration U.S. Government Fund, and the
indirect expenses incurred
through the Fund's investment in the Institutional Short
Duration U.S.
Government Fund (Note 1).
* Annualized
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
7
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (UNAUDITED)
- ------------------------------------------------------------
- --------------------
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Trust") 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 Fund (the "Short Fund" or "Fund")
and the Smith Breeden
Intermediate Duration U.S. Government Fund. Prior to April
1, 1995, the Short
Fund sought to achieve its investment objective by investing
all of its assets
in the Smith Breeden Institutional Short Duration U.S.
Government Fund (the
"Institutional Fund"), an open-end, diversified management
investment company
having the same investment objective as the Fund. 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 Institutional Short
Fund, and approved by
the Board of Trustees of the Short Fund, the Short Fund
redeemed in-kind its
shares of the Institutional Fund. The assets of the
Institutional Fund were
transferred in proportion to the Short Fund's ownership of
the Institutional
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 Fund's 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
Fund 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: Dividends to shareholders are
recorded on the
ex-dividend date. The Short Fund 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 Fund of Federal
income taxes. To so qualify, the Fund intends to distribute
substantially all of
its net investment income and net realized capital gains, if
any, less any
available capital loss carryforward. As of March 31, 1997,
the Fund had a net
capital loss carryforward of $3,170,133 with $589 expiring
on March 31, 2001,
$75,461 expiring on March 31, 2002, $905,312 expiring on
March 31, 2003,
$1,359,214 expiring on March 31, 2004, and $829,557 expiring
on March 31, 2005.
F. DETERMINATION OF GAINS OR LOSSES ON SALES OF SECURITIES:
Gains or losses on
the sale of securities are calculated for accounting and tax
purposes on the
identified cost basis.
8
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED)
- ------------------------------------------------------------
- --------------------
1. SIGNIFICANT ACCOUNTING POLICIES -- CONTINUED
G. SECURITIES TRANSACTIONS AND INVESTMENT INCOME: Interest
income is accrued
daily on both long-term bonds and short-term investments.
Interest income also
includes net amortization from the purchase of fixed-income
securities.
Discounts and premiums on securities purchased are amortized
over the life of
the respective securities. Transactions are recorded on the
first business day
following the trade date. Realized gains and losses from
security transactions
are determined and accounted for on the basis of identified
cost.
2. FINANCIAL INSTRUMENTS
DERIVATIVE FINANCIAL INSTRUMENTS HELD OR ISSUED FOR PURPOSES
OTHER THAN TRADING:
Interest rate futures, swap, cap and option contracts are
used for risk
management purposes in order to reduce fluctuations in net
asset value relative
to the Fund's 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 Fund had the following open futures contracts as
of September 30, 1997
<TABLE>
<CAPTION>
NOTIONAL EXPIRATION UNREALIZED
TYPE
AMOUNT POSITION MONTH GAIN/(LOSS)
----- ----
- -------- --------- --------------- -----------
<S> <C>
<C> <C> <C>
5 Year Treasury...................................... $
(3,400,000) Short December, 1997 $
(23,059)
10 Year Treasury.....................................
20,500,000 Long December, 1997 225,170
3 Month Eurodollar...................................
115,000,000 Long December, 1997
48,645
3 Month Eurodollar...................................
(70,000,000) Short March, 1998
(89,565)
3 Month Eurodollar...................................
(60,000,000) Short March, 1999
(91,270)
3 Month Eurodollar...................................
50,000,000 Long March, 2000 99,775
3 Month Eurodollar...................................
50,000,000 Long March, 2001 99,775
- -----------
Total $ 269,471
- -----------
- -----------
</TABLE>
Futures transactions involve costs and may result in losses.
The effective use
of strategies using futures depends on the Fund's ability to
terminate futures
positions at times when the Fund's 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 Fund, of the futures contract itself, and of the
securities which
are the subject of a hedge.
The aggregate market value of investments to cover margin
requirements for the
open positions was $386,430.
B. INTEREST RATE SWAP CONTRACTS: The Fund may enter into
over-the-counter
transactions swapping interest rates. Interest rate swaps
represent an agreement
between counterparties to exchange cash flows based on the
difference between
two interest rates, applied to a notional principal amount
for a specified
period. The most common type of interest rate swap involves
the exchange of
fixed-rate cash flows for variable-rate cash flows. Interest
rate swaps do not
involve the exchange of principal between the parties. The
Fund's interest rate
swap contracts have been entered into on a net basis, i.e.,
the two payment
streams are netted out, with the Short Fund receiving or
paying, as the case may
be, only the net amount of the two payments. As of September
30, 1997, the Short
Fund had three open interest rate swap contracts. In each of
the contracts, the
Short Fund has agreed to pay a fixed rate and receive a
floating rate. The
floating rate on the contracts resets quarterly and is the
three month London
Interbank Offered Rate ("LIBOR"). Interest rate swap
contracts will not be
entered into unless the unsecured commercial paper,
unsecured senior debt or the
claims-paying ability of the other party thereto is rated
either AA or A-1 or
better by Standard & Poor's Corporation or Aa or P-1 or
better by Moody's
Investors Service,
9
<PAGE>
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED)
- ------------------------------------------------------------
- --------------------
2. FINANCIAL INSTRUMENTS -- CONTINUED
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 Fund 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 Fund
will succeed in pursuing contractual remedies. The Short
Fund 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 Fund's interest payable on the interest rate swap
contracts as of
September 30, 1997 was $26,913, and swap contract interest
receivable was
$10,384. 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
Fund had one interest
rate cap contract open at September 30, 1997.
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser,
provides the Short Fund with investment management services.
As compensation for
these services, the Short Fund pays the Adviser a fee
computed daily and payable
monthly at an annual rate equal to 0.70% of the Fund's
average daily net asset
value.
The Adviser has voluntarily agreed to reimburse normal
business expenses of the
Short Fund through August 1, 1998 so that total direct and
indirect operating
expenses do not exceed 0.78% of its average net assets. This
voluntary agreement
may be terminated at any time by the Adviser in its sole
discretion except that
the Adviser has agreed to limit expenses of the Fund to
0.78% through August 1,
1998. For the six-months ended September 30, 1997, the
Adviser received $388,801
in fees and reimbursed the Short Fund $122,584.
Pursuant to Rule 12b-1 under the Investment Company Act of
1940 ("1940 Act"),
the Fund 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 Fund, reducing redemptions, or otherwise
maintaining or improving
services provided to shareholders by such dealers or other
persons. The Plan
provides for payments by the Adviser, out of the advisory
fee paid to it by the
Short Fund, to dealers and other persons at the annual rate
of up to 0.25% of
the Short Fund's average net assets, subject to the
authority of the Trustees of
the Short Fund, to reduce the amount of payments permitted
under the Plan or to
suspend the Plan for such periods as they may determine.
Subject to these
limitations, the amount of such payments and the purposes
for which they are
made shall be determined by the Adviser.
Certain officers and trustees of the Fund are also officers
and directors of the
Adviser.
4. INVESTMENT TRANSACTIONS
During the six-months ended September 30, 1997, purchases
and proceeds from
sales of securities, other than short-term investments,
aggregated $341,692,189
and $339,717,944 respectively for the Fund. The cost of the
Short Fund's
securities for federal income tax purposes at September 30,
1997, is
$101,535,080. Net unrealized depreciation of investments,
short sales and
futures contracts consists of:
<TABLE>
<S>
<C>
Gross unrealized
appreciation................................. $ 2,254,120
Gross unrealized
depreciation................................. (2,488,490)
- -----------
Net unrealized
depreciation................................... $
(234,370)
- -----------
- -----------
</TABLE>
10
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
SCHEDULE OF INVESTMENTS (UNAUDITED)
SEPTEMBER 30, 1997
- ------------------------------------------------------------
- --------------------
<TABLE>
<CAPTION>
MARKET
FACE AMOUNT
SECURITY
VALUE
- ----------- ----
- ---- ----------
- -
<C> <S>
<C>
U.S. GOVERNMENT & AGENCY OBLIGATIONS -- 90.42%
FEDERAL HOME LOAN MORTGAGE CORP. -- 32.77%*
FHLMC GOLD:
$ 2,000,000 7.50%, due date to be
announced...................................................
........... $ 2,045,000
10,972,600 7.50%, due 7/01/27 to
9/01/27.....................................................
........... 11,173,938
1,500,000 7.50%, due date to be
announced...................................................
........... 1,537,969
595,203 8.00%, due
10/19/24....................................................
...................... 616,978
- -----------
TOTAL FEDERAL HOME LOAN MORTGAGE CORP. (COST
$15,167,806)....................................
15,373,885
- -----------
FEDERAL NATIONAL MORTGAGE ASSOC. -- 24.57%*
FNMA:
3,600,000 7.00%, due date to be
announced...................................................
........... 3,581,577
3,123,347 7.00%, due 8/1/23 to
6/01/24.....................................................
............ 3,130,833
3,500,000 7.50%, due date to be
announced...................................................
........... 3,552,500
1,169,792 9.50%, due 7/01/16 to
5/01/22.....................................................
........... 1,260,569
- -----------
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC. (COST
$11,205,712)....................................
11,525,479
- -----------
GOVERNMENT NATIONAL MORTGAGE ASSOC. -- 32.94%*
GNMA:
57,779 7.00%, due
3/15/26.....................................................
...................... 57,862
1,354,463 8.00%, due 11/15/06 to
12/15/26....................................................
.......... 1,413,339
GNMA ARM:
8,783,602 5.50%, due 11/1/26 to
9/20/27.....................................................
........... 8,807,538
1,837,315 6.00%, due
1/20/27.....................................................
...................... 1,866,191
561,519 6.875%, due 11/20/17 to
12/20/17....................................................
......... 579,436
1,018,469 7.125%, due 8/20/17 to
8/20/18.....................................................
.......... 1,051,893
1,623,045 7.375%, due 6/20/16 to
4/20/22.....................................................
.......... 1,675,711
- -----------
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(COST $15,197,385).................................
15,451,970
- -----------
UNITED STATES TREASURY BILLS -- 0.14%**
70,000 5.51%, due
5/28/98***..................................................
...................... 67,625
- -----------
TOTAL UNITED STATES TREASURY BILLS (COST
$67,437)............................................
67,625
- -----------
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(COST $41,638,340)................................
42,418,959
- -----------
TOTAL INVESTMENTS (COST $41,638,340) --
90.42%...............................................
42,418,959
- -----------
<CAPTION>
REPURCHASE AGREEMENTS -- 16.41%:
<C> <S>
<C>
7,700,000 Morgan Stanley, 5.58%, due 10/1/97 dated
9/24/97.............................................
7,700,000
- -----------
TOTAL REPURCHASE AGREEMENTS (COST
$7,700,000)................................................
7,700,000
- -----------
SHORT SALES -- (3.28%)
1,500,000 FHLMC GOLD 8.00%, due date to be
announced...................................................
(1,537,969)
- -----------
TOTAL SHORT SALES (PROCEEDS
$1,537,969).................................................
..... (1,537,969)
- -----------
CASH AND OTHER ASSETS LESS LIABILITIES --
(3.55%)............................................
(1,666,976)
- -----------
NET ASSETS --
100.00%.....................................................
................... $46,914,014
- -----------
- -----------
</TABLE>
- ---------------
* 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 September 30,
1997. ARMs have coupon rates which adjust periodically.
The adjusted rate is
determined by adding a spread to a specified index.
** The interest rate shown is the discount rate paid at the
time of purchase by
the Fund.
*** Security is segregated as collateral.
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.
11
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 30, 1997 (UNAUDITED)
- ------------------------------------------------------------
- --------------------
<TABLE>
<S>
<C>
ASSETS:
Investments at market value (identified cost $41,638,340)
(Note 1)..........................................
$42,418,959
Repurchase agreement (cost $7,700,000) (Note
1)..........................................................
... 7,700,000
Cash........................................................
................................................
1,115,801
Receivables:
Subscriptions...............................................
............................................. 99,338
Interest....................................................
............................................. 254,582
Securities
sold........................................................
.................................. 7,742,344
Other
assets......................................................
.......................................... 18,907
- -----------
TOTAL
ASSETS......................................................
....................................... 59,349,931
- -----------
LIABILITIES:
Short sales at market value (Proceeds
$1,537,969).................................................
.......... 1,537,969
Payables:
Variation margin on futures contracts (Note
2)..........................................................
. 18,017
Securities
purchased...................................................
.................................. 10,707,900
Redemptions.................................................
............................................. 1,025
Distributions...............................................
............................................. 129,867
Due to advisor (Note
3)..........................................................
........................ 26,514
Accrued
expenses....................................................
........................................ 14,625
- -----------
TOTAL
LIABILITIES.................................................
....................................... 12,435,917
- -----------
NET ASSETS:
(Applicable to outstanding shares of 4,662,311; unlimited
number of shares of beneficial interest
authorized; no stated
par)........................................................
....................... $46,914,014
- -----------
- -----------
Net asset value, offering price and redemption price per
share ($46,914,01444,662,311)...................... $
10.06
- -----------
- -----------
SOURCE OF NET ASSETS:
Paid in
capital.....................................................
........................................ $46,377,488
Overdistributed net investment
income......................................................
................. (130,006)
Accumulated net realized loss on
investments.................................................
............... (171,473)
Net unrealized appreciation of
investments.................................................
................. 838,005
- -----------
NET
ASSETS......................................................
......................................... $46,914,014
- -----------
- -----------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
12
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED SEPTEMBER 30, 1997 (UNAUDITED)
- ------------------------------------------------------------
- --------------------
<TABLE>
<S>
<C>
INVESTMENT INCOME:
Interest and discount earned, net of premium amortization
(Note 1)...........................................
$1,350,905
EXPENSES:
Advisory fees (Note
3)..........................................................
............................. 145,889
Accounting and pricing services
fees........................................................
................. 16,913
Custodian
fees........................................................
....................................... 6,276
Audit & tax preparation
fees........................................................
......................... 3,270
Transfer agent
fees........................................................
.................................. 12,447
Registration
fees........................................................
.................................... 8,333
Trustees fees and
expenses....................................................
............................... 8,158
Insurance...................................................
.................................................
4,355
Other.......................................................
.................................................
9,478
- ----------
TOTAL EXPENSES BEFORE
REIMBURSEMENT...............................................
........................ 215,119
EXPENSES REIMBURSED BY ADVISER (NOTE
3)..........................................................
......... (31,716)
- ----------
NET
EXPENSES....................................................
.......................................... 183,403
- ----------
NET INVESTMENT
INCOME......................................................
............................... 1,167,502
- ----------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on
investments.................................................
............................ 659,229
Change in unrealized appreciation of
investments.................................................
............ 701,559
- ----------
Net realized and unrealized gain on
investments.................................................
............. 1,360,788
- ----------
Net increase in net assets resulting from
operations..................................................
....... $2,528,290
- ----------
- ----------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
13
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
STATEMENTS OF CHANGES IN NET ASSETS
- ------------------------------------------------------------
- --------------------
<TABLE>
<CAPTION>
SIX MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 1997 MARCH 31, 1997
(UNAUDITED) (AUDITED)
- ------------------ --------------
<S>
<C> <C>
OPERATIONS:
Net investment
income......................................................
.......... $ 1,167,502 $ 2,303,301
Net realized (loss) gain on
investments..............................................
659,229 (82,705)
Change in unrealized appreciation (depreciation) of
investments...................... 701,559
(93,993)
- ------------------ --------------
Net increase in net assets resulting from
operations.................................
2,528,290 2,126,603
- ------------------ --------------
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income.................................................
(1,167,502) (2,260,030)
Dividends in excess of net investment
income.........................................
(5,696) --
Distributions from net realized gains on
investments.................................
- -- (943,662)
- ------------------ --------------
Total
distributions...............................................
................... (1,173,198) (3,203,692)
- ------------------ --------------
CAPITAL SHARE TRANSACTIONS:
Shares
sold........................................................
.................. 8,159,400 1,730,791
Shares issued on reinvestment of
distributions.......................................
419,570 935,335
Shares
redeemed....................................................
.................. (755,573) (300,452)
- ------------------ --------------
Increase in net assets resulting from capital share
transactions (a)................. 7,823,397
2,365,674
- ------------------ --------------
TOTAL INCREASE IN NET
ASSETS......................................................
9,178,489 1,288,585
NET ASSETS:
Beginning of
period......................................................
............ 37,735,525 36,446,940
- ------------------ --------------
End of
period......................................................
.................. $ 46,914,014 $ 37,735,525
- ------------------ --------------
- ------------------ --------------
(a) Transactions in capital shares were as follows:
Shares
sold........................................................
............... 817,963 174,344
Shares issued on reinvestment of
distributions....................................
42,086 94,439
Shares
redeemed....................................................
............... (75,748) (30,101)
- ------------------ --------------
Net
increase....................................................
.................. 784,301 238,682
Beginning
balance.....................................................
............ 3,878,010 3,639,328
- ------------------ --------------
Ending
balance.....................................................
............... 4,662,311 3,878,010
- ------------------ --------------
- ------------------ --------------
</TABLE>
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
14
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
FINANCIAL HIGHLIGHTS
- ------------------------------------------------------------
- --------------------
The following average per share data, ratios and
supplemental information
have been derived from information provided in the financial
statements.
<TABLE>
<CAPTION>
SIX MONTHS
FOR THE PERIOD
ENDED YEAR
YEAR YEAR YEAR MARCH 31,
SEPTEMBER 30, ENDED
ENDED ENDED ENDED 1992 (1)
1997 MARCH
31, MARCH 31, MARCH 31, MARCH 31, TO
MARCH 31,
(UNAUDITED) 1997
1996 1995 1994 1993
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
<S> <C> <C>
<C> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF
PERIOD........................ $ 9.73 $
10.01 $ 9.83 $ 10.01 $ 10.62 $
10.00
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
INCOME FROM INVESTMENT
OPERATIONS
Net investment income......... 0.284
0.599 0.660 0.664 1.050
0.826
Net realized and unrealized
(loss) gain on investments.. 0.328
(0.024) 0.277 (0.049) (0.601)
0.621
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
Total from investment
operations................ 0.612
0.575 0.937 0.615 0.449
1.447
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
LESS DISTRIBUTIONS
Dividends from net investment
income...................... (0.280)
(0.604) (0.656) (0.664) (1.044)
(0.826)
Dividends in excess of net
investment income........... --
- -- -- (0.108) --
- --
Distributions from net
realized gains on
investments................. --
0.000 (0.101) -- (0.015)
- --
Distributions in excess of net
realized gains on
investments................. --
- -- -- (0.022) --
- --
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
Total distributions......... (0.280)
(0.604) (0.757) (0.794) (1.059)
(0.826)
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
NET ASSET VALUE, END OF
PERIOD........................ $ 10.06 $
9.73 $ 10.01 $ 9.83 $ 10.01 $
10.62
------------- --------
- --- ----------- ----------- ---------- ---------
- -----
TOTAL RETURN.................... 6.33%
5.92% 9.69% 6.10% 4.11%
14.93%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period..... $ 46,914,014
$37,735,525 $36,446,940 $34,797,496 $6,779,666
$ 2,923,913
Ratio of expenses to average
net assets (2).............. 0.88%*
0.88% 0.90% 0.90% 0.90%
0.82%
Ratio of net investment income
to average net assets....... 5.69%*
6.19% 6.49% 6.20% 7.74%
8.18%
Portfolio turnover rate....... 162%
409% 193% 557% 84%
42%
Ratio of expenses to average
net assets before
reimbursement of expenses by
the Adviser................. 1.04%*
1.16% 1.14% 2.33% 2.34%
17.52%
Ratio of net investment income
to average net assets before
reimbursement of expenses by
the Adviser................. 5.53%*
5.92% 6.26% 4.77% 6.30%
(8.52%)
</TABLE>
- ---------------
(1) Commencement of operations.
(2) Through August 1, 1994, expense ratios include both the
direct expenses of
the Intermediate Duration U.S. Government Fund, and the
indirect expenses
incurred through the Fund's investment in the
Institutional Intermediate
Duration U.S. Government Fund (Note 5).
* Annualized
- ------------------------------------------------------------
- --------------------
The accompanying notes are an integral part of these
financial statements.
15
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (UNAUDITED)
- ------------------------------------------------------------
- --------------------
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Trust") 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 Fund and the Smith Breeden
Intermediate Duration U.S.
Government Fund ("Intermediate Fund" or "Fund"). The
following is a summary of
significant accounting policies consistently followed by the
Intermediate Fund.
A. SECURITY VALUATION: Portfolio securities are valued at
current market value
provided by a pricing service or by a bank or broker/dealer
experienced in such
matters, when over-the-counter market quotations are readily
available.
Securities and other assets for which market prices are not
readily available
are valued at fair market value as determined in accordance
with procedures
approved by the Board of Trustees.
B. DISTRIBUTIONS AND TAXES: Dividends to shareholders are
recorded on the
ex-dividend date. The Intermediate Fund 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 Fund of Federal
income taxes. To so qualify, the Fund intends to distribute
substantially all of
its net investment income and net realized capital gains, if
any, less any
available capital loss carryforward. As of March 31, 1997,
the Fund had no
capital loss carryforward.
C. REPURCHASE AGREEMENTS: The Intermediate Fund 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 Fund's Board of
Trustees. In a
repurchase agreement, the Fund 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 Fund's 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
Fund in the event of
the seller's default. However, in the event of default or
bankruptcy of the
seller, the Fund's right to the collateral may be subject to
legal proceedings.
D. REVERSE REPURCHASE AGREEMENTS: A reverse repurchase
agreement involves the
sale by the Intermediate Fund of portfolio assets
concurrently with an agreement
by the Fund to repurchase the same assets at a later date at
a fixed price. The
Fund 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 Fund's use
of the proceeds of the agreement may be restricted pending a
determination by
the other party, or its trustee or receiver, whether to
enforce the Fund's
obligation to repurchase the securities.
E. DOLLAR ROLL AGREEMENTS: The Intermediate Fund may enter
into dollar rolls in
which the Fund sells securities for delivery in the current
month and
simultaneously contracts to repurchase substantially similar
(same type and
coupon) securities on a specified future date. During the
roll period, the Fund
foregoes principal and interest paid on these securities.
The Fund is
compensated by the difference between the current sales
price and the forward
price for the future purchase (often referred to as the
"drop") as well as by
the interest earned on the cash proceeds of the initial
sale.
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. SECURITIES TRANSACTIONS AND INVESTMENT INCOME: Interest
income is accrued
daily on both long-term bonds and short-term investments.
Interest income also
includes net amortization from the purchase of fixed-income
securities.
Discounts and premiums on securities purchased are amortized
over the life of
the respective securities. Transactions are recorded on the
first business day
following the trade date. Realized gains and losses from
security transactions
are determined and accounted for on the basis of identified
cost.
16
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED)
- ------------------------------------------------------------
- --------------------
2. FINANCIAL INSTRUMENTS
A. DERIVATIVE FINANCIAL INSTRUMENTS HELD OR ISSUED FOR
PURPOSES OTHER THAN
TRADING: The Intermediate Fund uses interest rate futures
contracts for risk
management purposes in order to reduce fluctuation of the
Fund's net asset value
relative to its targeted option-adjusted duration. Upon
entering into a futures
contract, the Fund 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 Fund
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 Fund
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 Fund had the following open futures
contracts as of September
30, 1997:
<TABLE>
<CAPTION>
NOTIONAL EXPIRATION UNREALIZED
TYPE
AMOUNT POSITION MONTH GAIN/(LOSS)
----- --
- -------- --------- --------------- -----------
<S>
<C> <C> <C> <C>
5 Year Treasury........................................ $
(300,000) Short December, 1997 $(2,920)
10 Year Treasury.......................................
4,800,000 Long December, 1997 52,846
10 Year Treasury.......................................
900,000 Long March, 1998 7,460
- -----------
Total $57,386
- -----------
- -----------
</TABLE>
Futures transactions involve costs and may result in losses.
The effective use
of futures strategies depends on the Fund's ability to
terminate futures
positions at times when the Fund's 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 Fund, 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 September 30, 1997 was $67,625.
3. INVESTMENT ADVISORY FEES AND OTHER TRANSACTIONS WITH
AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment adviser,
provides the Fund with investment management services. As
compensation for these
services, the Intermediate Fund pays the Adviser a fee
computed daily and
payable monthly, at an annual rate equal to 0.70% of the
Fund's average daily
net asset value.
The Adviser has voluntarily agreed to reduce or otherwise
limit other expenses
of the Intermediate Fund (excluding advisory fees and
litigation,
indemnification and other extraordinary expenses) to 0.88%
of the Fund's average
daily net assets. This voluntary agreement may be terminated
or modified at any
time by the Adviser in its sole discretion except that the
Adviser has agreed to
limit expenses of the Fund to 0.88% through August 1, 1998.
For the six-months
ended September 30, 1997, the Adviser received fees of
$145,889 and reimbursed
the Fund $31,716.
Effective August 1, 1994, the Fund 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 Fund, 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 Fund's average net assets subject to the
authority of the
Trustees of the Fund to reduce the amount of payments
permitted under the Plan
or to suspend the Plan for such periods as they may
determine. Subject to these
limitations, the amount of such payments and the purposes
for which they are
made shall be determined by the Adviser.
Certain officers and trustees of the Fund are also officers
and directors of the
Adviser.
17
<PAGE>
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT FUND
NOTES TO FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED)
- ------------------------------------------------------------
- --------------------
4. INVESTMENT TRANSACTIONS
During the six-months ended September 30, 1997, purchases
and proceeds from
sales of securities, other than short-term investments,
aggregated $66,560,069
and $65,365,098, respectively. The purchases and proceeds
shown above do not
include dollar roll agreements which are considered
borrowings by the
Intermediate Fund. The cost of securities for federal income
tax purposes is
$41,638,340. Net unrealized appreciation of investments,
short sales and futures
contracts consist of:
<TABLE>
<S>
<C>
Gross unrealized
appreciation.................................... $840,396
Gross unrealized
depreciation.................................... (2,391)
- --------
Net unrealized
appreciation......................................
$838,005
- --------
- --------
</TABLE>
18
ANNUAL REPORTS
Smith Breeden Short Duration U.S. Government Series
Smith Breeden Intermediate Duration U.S. Government Series
March 31, 1997
1
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
ANNUAL REPORT AND PERFORMANCE REVIEW
Performance Review
The Smith Breeden Short Duration U.S. Government Series provided a
total
return of 6.57% in the year ended March 31, 1997. The Series'
return
exceeded its benchmark, the six-month U.S. Treasury Bill, by a
significant
margin, 1.16%. Since the Series' inception, its return has
exceeded that of
its benchmark by 4.48%, and on an annualized basis by 0.74%. The
graph below
plots the Series' return versus both its benchmarks and the
average return of
Morningstar, Inc.'s Ultrashort Bond Fund category.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE SHORT SERIES'
INDEX ACCORDING
TO ITEM 5a. OF FORM N1-A IS LOCATED HERE IN THE TEXT AND IS
DESCRIBED BELOW IN
ACCORDANCE WITH REG. 232.304 OF REGULATION S-T:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000 INVESTMENT IN
THE SHORT
SERIES VERSUS THAT OF TWO BENCHMARKS, THE SIX MONTH US TREASURY
BILL AND
MORNINGSTAR INC.'S ULTRASHORT BOND FUND CATEGORY. FROM INCEPTION
OF MARCH 31,
1992 THROUGH MARCH 31, 1997, AN INVESTMENT OF $10,000 IN THE SHORT
SERIES WOULD
HAVE GROWN TO $13,959, VERSUS $12,623 IN THE AVERAGE OF THE FUNDS
IN THE
ULTRASHORT CATEGORY AND VERSUS $12,610 IN THE SIX MONTH US
TREASURY BILL.
SHORT SERIES AND MORNINGSTAR RETURNS ARE NET OF FEES AND SALES
CHARGES; THE
RETURN OF THE SIX MONTH US TREASURY DOES NOT REFLECT FEES OR
TRANSACTION COSTS.
THE ANNUALIZED ONE YEAR RETURN FOR THE SHORT SERIES IS 6.57%,
ANNUALIZED THREE
RETURN IS 6.03%, ANNUALIZED FIVE YEAR RETURN IS 5.48% AND
ANNUALIZED RETURN
FROM INCEPTION IS 5.48%. THE ANNUALIZED RETURNS FOR THE AVERAGE OF
THE FUNDS
IN MORNINGSTAR'S ULTRASHORT BOND FUND CATEGORY ARE AS FOLLOWS: ONE
YEAR 5.62%,
THREE YEAR 5.17%, FIVE YEAR 4.77%, AND INCEPTION 4.77%. THE
ANNUALIZED RETURNS
FOR THE SIX MONTH US TREASURY ARE AS FOLLOWS: ONE YEAR 5.41%,
THREE YEAR 5.46%
FIVE YEAR 4.74%, AND INCEPTION 4.74%.
The Series' outstanding performance for the fiscal year owes
mostly to
declines in interest rate volatility, both on a realized and an
expected basis.
Most of the Series' holdings are mortgage-backed securities (MBS),
which
perform better when volatility is low because investors have
greater certainty
about the timing of their cashflows. MBS cashflows are inherently
uncertain,
because homeowners change their refinancing behavior in response
to changes
in interest rates. When rates fall, refinancing activity rises;
when rates
rise, refinancing activity falls. Investors in MBS require a
substantial yield
premium over US Treasury securities, most of which is to
compensate them for
the uncertainty of MBS cashflows (in contrast, Treasury cashflows
are fixed).
When interest rate volatility is low, investors require less of a
yield premium
and MBS perform well relative to Treasury securities, as they have
over the
past year.
2
The excellent return of the Series reflects more than just
the good
overall performance of the MBS market, however. We were able to
add value
in other ways as well, using three general techniques:
(1) we raised and lowered the overall mortgage weight in
response
to short-term changes in the relative attractiveness of the MBS
market;
(2) we changed portfolio sector weights frequently as
relative value
changed, for example selling fixed-rate MBS to purchase adjustable-
rate MBS;
and
(3) we took advantage of opportunities to move within MBS
sectors, for example selling low-coupon fixed-rate MBS to purchase
middle-
coupon MBS. Smith Breeden's extensive coverage of the MBS market
and
our proprietary valuation models enabled us to make these
portfolio
adjustments in a timely and profitable fashion.
Since the Series' holdings are very liquid, we are able to
reposition
the portfolio frequently to produce excess return. The
transaction costs are
small in relation to the advantage gained through the
repositioning. This high-
liquidity, actively-managed style does result in relatively high
portfolio
turnover, which totaled 556% for the year. Much of the turnover
resulted
from transactions among very similar securities, however. Selling
a GNMA
7% passthrough to purchase a GNMA 8% passthrough creates
"turnover," but
the change in the portfolio's characteristics is much smaller
than, for example,
if a stock fund were to sell Ford stock to purchase Intel.
The Series' strong risk management discipline stood it in good
stead during the
fiscal year and will continue to do so in the months to come,
which many
expect to be fairly unpredictable, in both the fixed income and
stock markets.
As the Series' performance demonstrated not only over the past
year but over
its five-year history, our attention to risk management, combined
with our
skills in mortgage investing, have enabled the Series to provide
steady,
superior returns in rising and falling interest rate environments.
3
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS 31-Mar-97
Market
Face Amount Security
Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS -
123.30 %
FEDERAL HOME LOAN MORTGAGE CORP. -
34.22% *
FHLMC GOLD:
$23,728,869 7.50%, due 7/01/24 to 6/01/27 ...............$
23,273,767
944,252 8.00%, due 9/01/24 to 5/01/25...........
952,924
16,057,726 8.50%, due 11/01/24 to 8/01/26 ...........
16,493,947
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $40,870,754 )
40,720,638
FEDERAL NATIONAL MORTGAGE ASSOCIATION -
0.46% *
FNMA INTEREST ONLY **:
1,649,849 9.00%, due 7/25/21
............................... 543,088
TOTAL FEDERAL NATIONAL MORTGAGE
ASSOCIATION
(Cost $227,375)
543,088
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
- - 88.11% *
GNMA ARM:
19,286,497 5.00%, due 1/20/27 to 2/20/27 ..........
.......18,658,334
20,600,000 5.50%, due (a) ..........................
.....20,128,625
2,985,894 5.50%, 12/20/26...........................
2,948,412
12,901,392 6.00%, due 2/20/27***......................
12,850,847
4,500,000 6.00%, due (a)
..................................4,462,031
3,652,376 6.50%, due 3/20/21 to 9/20/26 .............
3,705,068
3,779,910 7.125%, due 7/20/17 to 4/01/24
.............. 3,869,279
GNMA:
36,563,907 8.00%, due 6/1/26 to 1/1/27.................
36,769,416
1,349,922 9.50%, due 7/15/09 to 4/15/25......... .....
1,450,502
TOTAL GOVERNMENT NATIONAL MORTGAGE
ASSOCIATION
(Cost $105,238,843)
104,842,514
U.S. GOVERNMENT OBLIGATIONS - 0.51%
U.S. TREASURY BILL ****
610,000 5.39% and 5.02%, due 5/29/97
................. ... 604,890
TOTAL U.S. GOVERNMENT OBLIGATIONS
(Cost $604,767)...........
604,890
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $146,941,739) .
146,711,130
Notional Amount INTEREST RATE SWAP CONTRACTS - 1.81%
$20,000,000 Contract dated 6/22/93 with Prudential Global
Funding,
Expires 6/22/98, pay rate 5.458% ..
.............. 212,603
20,000,000 Contract dated 8/31/93 with Salomon Swapco,
Expires 8/30/00, pay rate 5.34% ..
............... 884,505
20,000,000 Contract dated 12/2/93 with Morgan Guaranty
Trust Company,
Expires 12/2/00, pay rate 5.69%
................. 677,160
40,000,000 Contract dated 5/15/95 with Salomon Swapco,
Expires 5/15/05, pay rate 6.951%
................ 381,282
TOTAL INTEREST RATE SWAP CONTRACTS
.............. 2,155,550
Notional
Market
Amount Security
Value
THREE MONTH LIBOR INTEREST RATE CAP
CONTRACTS - 1.17%
$50,000,000 Contract with Salomon Swapco, expires 4/23/03,
Strike rate
7.50%................................ $1,393,000
TOTAL THREE-MO. LIBOR INTEREST RATE CAP
CONTRACTS
(Cost $1,585,644) ..
1,393,000
Contracts OPTION CONTRACTS - 0.27%
130 Call on 10 Year US Treasury Note futures,
expires 5/97,
strike price $109 ..
8,125
50 Call on 10 Year US Treasury Note futures,
expires 5/97,
strike price $111
781
100 Call on 10 Year US Treasury Note futures,
expires 5/97,
strike price $112
1,563
130 Put on 10 Year US Treasury Note futures,
expires 5/97,
strike price $105 .
95,469
100 Put on 10 Year US Treasury Note futures,
expires 5/97,
strike price $106 .
120,313
50 Put on 10 Year US Treasury Note futures,
expires 5/97,
strike price $107 .
92,187
TOTAL OPTION CONTRACTS (Cost $243,144)
............... 318,438
TOTAL INVESTMENTS- 126.55% (Cost
$148,770,527) .....150,578,118
Face Amount REPURCHASE AGREEMENTS - 18.49%:
$22,000,000 Morgan Stanley, 5.55% and 5.63%, due 4/01/97 and
4/3/97
dated 3/25/97 and 3/27/97
$22,000,000
TOTAL REPURCHASE AGREEMENTS (Cost
$22,000,000)... 22,000,000
REVERSE REPURCHASE AGREEMENTS - (10.08%):
12,000,000 FHLMC, 6.60%, due 4/01/97 dated 3/31/97.........
(12,000,000)
TOTAL REVERSE REPURCHASE AGREEMENTS
......... (12,000,000)
SHORT SALES - (17.06%)
21,106,250 GNMA 6.5% due (a)................................
(20,301,875)
TOTAL SHORT SALES (Proceeds
$20,350,000)........... (20,301,875)
OTHER LIABILITIES LESS CASH AND OTHER
ASSETS - (17.90%).
(21,287,634)
NET ASSETS - 100.00%
$118,988,609
* Mortgage-backed obligations are subject to principal
paydowns as a
result of prepayments or refinancings of the underlying
mortgage
instruments. As a result, the average life may be
substantially less
than the original maturity. The interest rate shown is the
rate in
effect at March 31, 1997. ARMs have coupon rates which
adjust
periodically. The adjusted rate is determined by adding a
spread to a
specified index.
** Represents an interest only stripped mortgage-backed
security.
*** This security is held as collateral under a reverse
repurchase agreement.
**** Security is segregated as collateral.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial
statements.
5
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
31-Mar-97
ASSETS:
Investments at market value (identified cost $148,770,527)
(Note 1)..
$150,578,118
Cash..............................................................
676,200
Repurchase agreement (cost $22,000,000) (Note 1)............
22,000,000
Receivables:
Subscriptions............................................
1,152,765
Interest.................................................
762,909
Securities sold.........................................
80,444,418
TOTAL ASSETS..........................................
255,614,410
LIABILITIES:
Reverse repurchase agreement (Note 1).......................
12,000,000
Short sales at market value (Proceeds $20,350,000).........
20,301,875
Payables:
Variation margin on futures contracts (Note 2)............
9,191
Redemptions.................................
.................. 20,470
Distribution.................................
................. 676,913
Securities purchased....................................
103,345,618
Swap interest...............................
................ 72,393
Due to adviser (Note 3)..................... ..........
80,755
Accrued expenses.......................................
118,586
TOTAL LIABILITIES.......................................
136,625,801
NET ASSETS:
(Applicable to outstanding shares of 12,106,419
unlimited number of shares of beneficial
interest authorized; no stated par).....................
$118,988,609
Net asset value, offering price and redemption
price per share ($118,988,609/12,106,419)..
................. $9.83
SOURCE OF NET ASSETS:
Paid in
capital...............................................$124,434,880
Overdistributed net investment
income........................... (676,914)
Accumulated net realized loss on investments.................
(5,589,259)
Net unrealized appreciation of investments, interest rate
swaps,
short sales and futures contracts.............
............... 819,902
NET ASSETS.............................................
$118,988,609
The accompanying notes are an integral part of these financial
statements.
6
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1997
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization and interest
expense (Note 1) ................................. $11,805,901
EXPENSES:
Advisory fees (Note 3).............................. 1,417,921
Accounting and pricing services fees....................69,655
Custodian fees..........................................74,731
Audit and tax preparation fees..........................57,500
Legal fees..............................................65,580
Amortization of organization expenses (Note 1).......... 9,548
Transfer agent fees.....................................32,778
Registration fees.......................................18,228
Trustees fees and expenses.............................102,499
Insurance...............................................22,309
Other...................................................11,220
TOTAL EXPENSES BEFORE REIMBURSEMENT..............1,881,969
Expenses reimbursed by Adviser (Note 3)...........(301,998)
NET EXPENSES.....................................1,579,971
NET INVESTMENT INCOME ......................... 10,225,930
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments........................846,686
Change in unrealized appreciation (depreciation)
of investments, interest rate swaps,
caps, and futures
contracts............................1,887,652
Net realized and unrealized gain on
investments........2,734,338
Net increase in net assets resulting from
operations.$12,960,268
The accompanying notes are an integral part of these financial
statements.
7
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended
Year Ended
31-Mar-
97 31-Mar-96
OPERATIONS:
Net investment income.............................$10,225,930
$15,412,781
Net realized gain on investments.................... 846,686
4,639,312
Change in unrealized appreciation
(depreciation) of investments,
interest rate swaps, caps and futures contracts......1,887,652
(8,342,309)
Net increase in net assets resulting from
operations..........................................12,960,268
11,709,784
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income...............(10,225,930)
(15,412,781)
Dividends in excess of net investment income..........(929,596)
(269,331)
Total distributions......................... ......(11,155,526)
(15,682,112)
CAPITAL SHARE TRANSACTIONS:
Shares sold........................................ 59,328,830
93,214,276
Shares issued on reinvestment of distributions.......2,816,807
3,773,450
Shares redeemed...................................(166,786,906)
(89,621,927)
(Decrease) increase in net assets
resulting from capital
share transactions (a)..........................(104,641,269)
7,365,799
TOTAL INCREASE (DECREASE) IN NET ASSETS......(102,836,527)
3,393,471
NET ASSETS:
Beginning of year.................................221,825,136
218,431,665
End of year......................................$118,988,609
$221,825,136
(a) Transactions in capital shares were as follows:
Shares sold.....................................6,065,723
9,500,348
Shares issued on reinvestment of distributions....289,222
386,101
Shares redeemed...............................(17,017,982)
(9,167,732)
Net (decrease) increase ......................(10,663,037)
718,717
Beginning balance .............................22,769,456
22,050,739
Ending balance.................................12,106,419
22,769,456
The accompanying notes are an integral part of these financial
statements.
8
SMITH BREEDEN SHORT DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1997
Year Ended
31-Mar-97
Cash flows from operating activities:
Net increase in net assets resulting from
operations.......$12,960,268
Net realized and unrealized gain on investments.........
(2,734,338)
Net investment
income.....................................10,225,930
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Interest rate cap and interest-only strip amortization......
225,006
Net paydown gains and losses...................................
34,366
Decrease in interest receivable. ...............
793,222
Increase in other assets............. ......................
(9,643)
Decrease in other liabilities......... ...........
(72,793)
Net cash provided by operating activities................
11,196,088
Cash flows from investing activities:
Payments for futures variations.... .............
(265,747)
Proceeds from sales of long-term investments.. ..........
462,741,835
Proceeds from sales of short-term investments.. .........
508,493
Proceeds from sales of options.....................
833,807
Proceeds from maturities of short-term investments.....
2,076,065,225
Proceeds from paydowns of long-term investments.........
12,247,008
Purchases of long-term
investments........................(352,732,116)
Purchases of short-term
investments.....................(2,099,153,718)
Purchases of options......................................
(2,768,588)
Net cash provided by investing
activities................(97,476,199)
Cash flows from financing activities:
Increase in collateralized
borrowings......................11,000,000
Proceeds from shares tendered........... ...........
55,359,258
Payments for shares redeemed...........................
(166,766,436)
Dividends from net investment income..... .........
(7,661,806)
Net cash used in financing activities...............
(108,068,984)
Net increase in cash................... .......
(603,303)
Cash at beginning of year..... ..........................
72,897
Cash at end of year.................. .................
$676,200
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of dividends.......................
$2,816,807
Supplemental disclosure:
Interest
paid.................................................$61,491
The accompanying notes are an integral part of these financial
statements.
9
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
<TABLE>
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental
information
have been derived from information provided in the financial
statements.
<CAPTION>
Year Year Year Year
Year
Ended Ended
Ended Ended 3/31/92 <F1>
3/31/97 3/31/96
3/31/95 3/31/94 to 3/31/93
<S> <C> <C> <C>
<C> <C>
Net Asset Value, Beginning of Period $9.74 $9.90
$9.90 $10.00 $10.00
Income From Investment Operations
Net investment income.............. 0.476 0.621
0.628 0.432 0.552
Net realized and unrealized
gain (loss) on investments......... 0.146 (0.148)
- - (0.07) 0.002
Total from investment operations. 0.622 0.473
0.628 0.362 0.554
Less Distributions
Dividends from net
investment income................... (0.476) (0.621)
(0.628) (0.462) (0.554)
Dividends in excess of
investment income.................... (0.056) (0.012)
- - - -
Total distributions............ (0.532) (0.633)
(0.628) (0.462) (0.554)
Net Asset Value, End of Period....... $9.83 $9.74
$9.90 $9.90 $10.00
Total Return .......................... 6.57% 4.95%
6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of period....... $118,988,609 $221,825,136
$218,431,665 $218,167,491 $48,531,206
Ratio of expenses to average net assets <F2> 0.78% 0.78%
0.78% 0.78% 0.78%
Ratio of net investment income to
average net assets <F3>... 5.04% 6.29%
6.33% 4.17% 4.53%
<FN>
<F1>
Commencement of operations.
</FN>
<FN>
<F2>
The annualized operating expense ratios prior to reimbursement of
expenses by the Adviser were 0.93%, 0.93%, 0.92%, 1.00%, and
2.58% for the Short Duration U.S. Government Series for the years
ended March 31, 1997, March 31, 1996, March 31, 1995, March 31,
1994, and the period ended 1993, respectively. Through March 31,
1995, expense ratios include both the direct expenses of the Short
Duration U.S. Government Series, and the indirect expenses
incurred through the Series' investment in the Short Duration U.S.
Government Fund (Note 1).
</FN>
<FN>
<F3>
The annualized net investment income ratios prior to reimbursement
of both direct and indirect expenses by the Adviser were 4.90%,
6.13%, 6.18%, 3.95% and 2.73% for the Short Duration U.S.
Government Series for the years ended March 31, 1997, March 31,
1996,
March 31, 1995, March 31, 1994, and the period ended March 31,
1993, respectively.
</FN>
</TABLE>
The accompanying notes are an integral part of these financial
statements.
10
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified
management investment company registered under the Investment
Company
Act of 1940, as amended. The Fund offers shares in two series:
the Smith
Breeden Short Duration U.S. Government Series (the "Short Series"
or
"Series") and the Smith Breeden Intermediate Duration U.S.
Government
Series ("Intermediate Duration Series"). Prior to April 1, 1995,
the Short
Series sought to achieve its investment objective by investing all
of its
assets in the Smith Breeden Short Duration U.S. Government Fund
(the "Short
Fund"), an open-end, diversified management investment company
having
the same investment objective as the Series. However, at the
close of
business on March 31, 1995, pursuant to a plan of liquidation
adopted
March 1, 1995 by the Board of Trustees of the Short Fund,
and approved by the Board of Trustees of the Short Series, the
Short Series
redeemed in-kind its shares of the Short Fund. The assets of the
Short Fund
were transferred in proportion to the Short Series' ownership of
the Short
Fund in cancellation of its shares.
A. Security Valuation: Securities are valued at current market
value
provided by a pricing service or by a bank or broker/dealer
experienced in
such matters, when over-the-counter market quotations are readily
available.
Securities and other assets for which market prices are not
readily available
are valued at fair market value as determined in accordance with
the
procedures approved by the Board of Trustees.
B. Repurchase Agreements: Repurchase agreements may be entered
into with member banks of the Federal Reserve System having total
assets in
excess of $500 million and securities dealers, provided that such
banks or
dealers meet the credit guidelines of the Funds' Board of
Trustees. In a
repurchase agreement, securities are acquired from a third party
with the
commitment that they will be repurchased by the seller at a fixed
price on an
agreed upon date. The custodian maintains control or custody of
securities
collateralizing repurchase agreements until maturity of the
repurchase
agreements. The value of the collateral will be monitored daily,
and if
necessary, additional collateral is received to ensure that the
market value of the underlying assets remains sufficient to
protect the Series
in the event of the seller's default. However, in the event of
default or
bankruptcy of the seller, the right to the collateral may be
subject to legal
proceedings.
C. Reverse Repurchase Agreements: A reverse repurchase
agreement
involves the sale of portfolio assets concurrently with an
agreement to
repurchase the same assets at a later date at a fixed price.
Assets will be
maintained in a segregated account with the custodian, which will
be marked
to market daily, consisting of cash, U.S. Government securities
or other
liquid high-grade debt obligations equal in value to the
obligations under the
reverse repurchase agreements. In the event the buyer of
securities under a
reverse repurchase agreement files for bankruptcy or becomes
insolvent, the
use of the proceeds under the agreement may be restricted pending
a
determination by the other party, or its trustee or receiver,
whether to
enforce the obligation to repurchase the securities.
11
NOTES TO FINANCIAL STATEMENTS (cont.)
D. Dollar Roll Agreements: A dollar roll is an agreement to
sell
securities for delivery in the current month and simultaneously
contract to
repurchase substantially similar (same type and coupon)
securities on a
specified future date. During the roll period, principal and
interest paid on
these securities are not received. Compensation under the dollar
roll
agreement is represented by the difference between the current
sales price
and the forward price for the future purchase (often referred to
as the
"drop") as well as by the interest earned on the cash proceeds of
the initial
sale.
E. Distributions and Taxes: Dividends to shareholders are
recorded on
the ex-dividend date. The Short Series intends to continue to
qualify for and
elect the special tax treatment afforded regulated investment
companies
under Subchapter M of the Internal Revenue Code, thereby
relieving the
Series of Federal income taxes. To so qualify, the Series
intends to
distribute substantially all of its net investment income and net
realized
capital gains, if any, less any available capital loss
carryforward. As of
March 31, 1997, the Series had a net capital loss carryforward of
$3,170,133 with $589 expiring on March 31, 2001, $75,461
expiring on March 31, 2002, $905,312 expiring on March 31, 2003,
$1,359,214 expiring on March 31, 2004, and $829,557 expiring on
March
31, 2005.
F. Determination of Gains or Losses on Sales of Securities:
Gains or
losses on the sale of securities are calculated for accounting and
tax purposes
on the identified cost basis.
G. Deferred Organization Expenses: Deferred organization
expenses are
being amortized on a straight-line basis over five years.
H. Securities Transactions and Investment Income: Interest
income is
accrued daily on both long-term bonds and short-term investments.
Interest
income also includes net amortization from the purchase of fixed-
income
securities. Discounts and premiums on securities purchased are
amortized
over the life of the respective securities. Transactions are
recorded on the
first business day following the trade date. Realized gains and
losses from
security transactions are determined and accounted for on the
basis of
identified cost.
2. FINANCIAL INSTRUMENTS
Derivative Financial Instruments Held or Issued for Purposes other
than
Trading: Interest rate futures, swap, cap and option contracts are
used for
risk management purposes in order to reduce fluctuations in net
asset value
relative to the Series' targeted option-adjusted duration.
A. Futures Contracts: Upon entering into a futures contract,
either cash
or securities in an amount (initial margin) equal to a certain
percentage of
the contract value is required to be deposited in a segregated
account.
Subsequent payments (variation margin) are made or received each
day.
The variation margin payments are equal to the daily changes in
the contract
value and are recorded as unrealized gains or losses. A realized
gain or loss
is recognized when the contract is closed or expires equal to the
difference
between the value of the contract at the time it was opened and
the value at
the time it was closed.
12
NOTES TO FINANCIAL STATEMENTS (cont.)
The Short Series had the following open futures contracts as of
March 31,
1997:
Type Notional Expiration
Unrealized
Amount Position Month
Gain/(Loss)
5 Year Treasury $ 22,400,000 Long June,
1997 $(432,132)
10 Year Treasury 16,700,000 Long June,
1997 (405,658)
3 Month Eurodollar 98,000,000 Long
September, 1997 ( 41,779)
3 Month Eurodollar 150,000,000 Long June,
1997 (133,425)
3 Month Eurodollar 154,000,000 Long March,
1998 (25,443)
3 Month Eurodollar 40,000,000 Short March,
1999 820
3 Month Eurodollar 38,000,000 Short March,
2000 779
3 Month Eurodollar 30,000,000 Short March,
2001 615
3 Month Eurodollar 20,000,000 Short March,
2002 410
Total
$(1,035,813)
Futures transactions involve costs and may result in losses. The
effective use
of strategies using futures depends on the Series' ability to
terminate
futures positions at times when the Series' investment adviser
deems it
desirable to do so. The use of futures also involves the risk of
imperfect
correlation among movements in the values of the securities
underlying the
futures purchased and sold by the Series, of the futures contract
itself,
and of the securities which are the subject of a hedge.
The aggregate market value of investments to cover margin
requirements for
the open positions was $604,890.
B. Interest Rate Swap Contracts: The Fund may enter into over-
the-
counter transactions swapping interest rates. Interest rate swaps
represent an
agreement between counterparties to exchange cash flows based on
the
difference between two interest rates, applied to a notional
principal amount
for a specified period. The most common type of interest rate
swap involves
the exchange of fixed-rate cash flows for variable-rate cash
flows. Interest
rate swaps do not involve the exchange of principal between the
parties.
The Series' interest rate swap contracts have been entered into
on a net
basis, i.e., the two payment streams are netted out, with the
Short Series
receiving or paying, as the case may be, only the net amount of
the two
payments. As of March 31, 1997, the Short Series had four open
interest
rate swap contracts. In each of the contracts, the Short Series
has agreed to
pay a fixed rate and receive a floating rate. The floating rate
on the
contracts resets quarterly and is the three month London Interbank
Offered
Rate ("LIBOR"). Interest rate swap contracts will not be entered
into unless
the unsecured commercial paper, unsecured senior debt or the
claims-paying
ability of the other party thereto is rated either AA or A-1 or
better by
Standard & Poor's Corporation or Aa or P-1 or better by Moody's
Investors
Service, Inc. (or is otherwise acceptable to either agency) at
the time of
entering into such transaction. If there is a default by the
other party to the
swap transaction, the Short Series will be limited to contractual
remedies
pursuant to the agreements related to the transaction. There is
no assurance
that interest rate swap contract counterparties will be able to
meet their
obligations pursuant to the swap contracts or that, in the event
of default,
the Short Series will succeed in pursuing contractual remedies.
The Short
Series thus assumes the risk that it may be delayed in, or
prevented from,
obtaining payments owed to it pursuant to the swap contracts.
13
NOTES TO FINANCIAL STATEMENTS (cont.)
The Short Series' interest payable on the interest rate swap
contracts as of
March 31, 1997 was $72,393, and swap contract interest receivable
was
$2,935. No collateral is required to be maintained on these
contracts.
C. Interest Rate Cap Contracts: The purchase of an interest
rate cap
entitles the purchaser, to the extent that a specified index
exceeds a
predetermined interest rate, to receive payments of interest on a
notional
principal amount from the party selling such interest rate caps.
The Short
Series had one interest rate cap contract open at March 31, 1997.
3. TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment
adviser, provides the Short Series with investment management
services.
The Adviser has voluntarily agreed to reimburse normal business
expenses of
the Short Series through March 31, 1998 so that total direct and
indirect
operating expenses do not exceed 0.78% of its average net assets.
This
voluntary agreement may be terminated at any time by the Adviser
in its sole
discretion after March 31, 1998. The Adviser has also agreed to
reduce its
fees payable (to the extent of such fees) by the amount the
Series' direct and
indirect expenses would, absent the fee reduction, exceed the
applicable
expense limitations imposed by state securities administrators.
For the year
ended March 31, 1997, the Adviser received $1,417,921 in fees and
reimbursed the Short Series $301,998.
Certain officers and trustees of the Fund are also officers and
directors of the
Adviser.
Pursuant to Rule 12b-1 under the Investment Company Act of 1940
("1940
Act"), the Series adopted, effective August 1, 1994, a
Distribution and
Services Plan (the "Plan"). The purpose of the Plan is to
permit the Adviser
to compensate investment dealers and other persons involved in
servicing
shareholder accounts for services provided and expenses incurred
in
promoting the sale of shares of the Short Series, reducing
redemptions, or
otherwise maintaining or improving services provided to
shareholders by
such dealers or other persons. The Plan provides for payments by
the
Adviser, out of the advisory fee paid to it by the Short Series,
to dealers and
other persons at the annual rate of up to 0.25% of the Short
Series' average
net assets, subject to the authority of the Trustees of the Short
Series, to
reduce the amount of payments permitted under the Plan or to
suspend the
Plan for such periods as they may determine. Subject to these
limitations,
the amount of such payments and the purposes for which they are
made shall
be determined by the Adviser.
14
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1997, purchases and proceeds from
sales of
securities, other than short-term investments, aggregated
$1,226,155,709 and
$1,357,342,232 respectively for the Series. The cost of the Short
Series'
securities for federal income tax purposes at March 31, 1997, is
$148,770,527. Net unrealized appreciation of investments, short
sales and
futures contracts consists of:
Gross unrealized appreciation $ 3,190,281
Gross unrealized depreciation (2,370,379)
Net unrealized appreciation $ 819,902
15
INDEPENDENT AUDITORS REPORT
The Board of Trustees and Shareholders,
Smith Breeden Short Duration U.S. Government Series of the Smith
Breeden Series Fund:
We have audited the accompanying statement of assets and
liabilities,
including the schedule of investments, of the Smith Breeden Short
Duration U.S. Government Series of the Smith Breeden Series Fund
as
of March 31, 1997, and the related statements of operations and
cash
flows for the year then ended, the statements of changes in net
assets for
each of the years in the two-year period then ended and the
financial
highlights for each of the years in the four-year period then
ended and
the period March 31, 1992 (commencement of operations) to March
31,
1993. These financial statements and the financial highlights are
the
responsibility of the Fund's management. Our responsibility is to
express an opinion on these financial statements and the financial
highlights based on our audits.
We conducted our audits in accordance with generally accepted
auditing
standards. Those standards require that we plan and perform the
audit
to obtain reasonable assurance about whether the financial
statements
and the financial highlights are free of material misstatement.
An audit
includes examining, on a test basis, evidence supporting the
amounts and
disclosures in the financial statements. Our procedures included
confirmation of securities owned at March 31, 1997 by
correspondence
with the custodian and brokers. An audit also includes assessing
the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable
basis for
our opinion.
In our opinion, the financial statements and financial highlights
referred
to above present fairly, in all material respects, the financial
position of
the Smith Breeden Short Duration U.S. Government Series of the
Smith
Breeden Series Fund as of March 31, 1997, the results of its
operations
and its cash flows, the changes in its net assets, and the
financial
highlights for the respective stated periods in conformity with
generally
accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1997
16
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
ANNUAL REPORT AND PERFORMANCE REVIEW
Performance Review
The Smith Breeden Intermediate Duration U.S. Government
Series
provided a total return of 5.92% in the year ending March 31,
1997. The
Series' return exceeded that of its benchmark, the Salomon
Brothers
Mortgage Index by 0.03%. Since the Series' inception, its return
has
exceeded that of its benchmark by 2.60%, and on an annualized
basis by
0.39%. The graph below plots the Series' return versus its
benchmark,
which as noted in the graph, changed effective January 1, 1994.
The graph
also shows the Series' return versus the average return of the
Morningstar,
Inc.'s Government Bond Mortgage fund category, of which the
Intermediate Series was the number one performing fund over the
five-year
period ended March 31, 1997.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE INTERMEDIATE
SERIES' INDEX
ACCORDING TO ITEM 5a. OF FORM N1-A IS LOCATED HERE IN THE TEXT AND
IS
DESCRIBED BELOW IN ACCORDANCE WITH REG 232.304 OF REGULATION S-T:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000 INVESTMENT IN
THE INTERMEDIATE SERIES VERSUS ITS STATED BENCHMARK AND VERSUS THE
AVERAGE OF
THE FUNDS IN MORNINGSTAR'S GOVERNMENT BOND MORTGAGE CATEGORY. FOR
THE PERIOD
FROM THE SERIES' INCEPTION MARCH 31, 1992 THROUGH DECEMBER 31,
1993, THE SERIES
STATED BENCHMARK WAS THE FIVE YEAR US TREASURY AS TRACKED BY
SALOMON BROTHERS,
INC. AFTER DECEMBER 31, 1993, UPON APPROVAL OF A MAJORITY OF THE
SHAREHOLDERS,
THE SERIES' BENCHMARK WAS CHANGED TO THE SALOMON BROTHERS MORTGAGE
INDEX.
THE SERIES' AVERAGE ANNUAL RETURN WAS 5.92% FOR THE ONE YEAR
PERIOD, 7.21% FOR
THE THREE YEAR PERIOD, 8.08% FOR THE FIVE YEAR PERIOD, AND 8.08%
FOR THE PERIOD
SINCE INCEPTION. THE AVERAGE ANNUAL RETURN OF THE STATED BENCHMARK
WAS 5.89%
FOR THE ONE YEAR PERIOD, 7.45% FOR THE THREE YEAR PERIOD, 7.69%
FOR THE FIVE
YEAR PERIOD, AND 7.69% FOR THE PERIOD FROM INCEPTION. THE AVERAGE
ANNUAL
RETURN OF THE AVERAGE OF THE FUNDS IN MORNINGSTAR'S GOVERNMENT
BOND MORTGAGE
CATEGORY WAS 4.78% FOR THE ONE YEAR PERIOD, 5.99% FOR THE THREE
YEAR PERIOD,
AND 6.01% FOR THE FIVE YEAR AND SINCE INCEPTION RETURNS.
FROM INCEPTION THROUGH MARCH 31, 1997, AN INVESTMENT
OF $10,000 IN THE INTERMEDIATE SERIES WOULD HAVE GROWN TO $14,748,
VERSUS
$14,486 IN ITS BENCHMARK, AND $13,389 IN THE AVERAGE OF THE FUNDS
IN
MORNINGSTAR'S GOVERNMENT BOND MORTGAGE CATEGORY.
The Salomon Brothers Mortgage Index, and the Intermediate
Series, performed outstandingly well over the last twelve months.
For the
year, the Series' performance exceeded that of the five-year U.S.
Treasury
Note by 2.77% and the three-year Note by 1.22%. Compared to the
Lehman
Intermediate Aggregate Bond Index, the Series' performance was
0.69%
ahead.
17
The reason for the outstanding performance of mortgages
relates
mostly to declines in interest rate volatility, both on a realized
and an
expected basis. Mortgage-backed securities (MBS) perform better
when
volatility is low because investors have greater certainty about
the timing of
their cashflows. MBS cashflows are inherently uncertain, because
homeowners change their refinancing behavior in response to
changes in
interest rates. When rates fall, refinancing activity rises; when
rates rise,
refinancing activity falls. Investors in MBS require a
substantial yield
premium over US Treasury securities, most of which is to
compensate for
the uncertainty of MBS cashflows (in contrast, Treasury cashflows
are
fixed). When interest rate volatility is low, investors require
less of a yield
premium and MBS perform well relative to Treasury securities, as
they
have over the past year.
While the benchmark of the Intermediate Series is the Salomon
Brothers Mortgage Index ("SBMI"), the Series will invest in
mortgages
not included in the SBMI. In so doing, the Series seeks to
generate excess
returns, on a risk-adjusted basis, which after fund expenses, will
contribute
to the fund's incremental performance. As the Intermediate
Series' moves
in and out of different mortgage sectors, this can drive up the
fund's
portfolio turnover rate. The portfolio turnover rate for the
fiscal year 1996
was 409%. However, since the Intermediate Series limits its
investment in
these sectors to those that are the most liquid and of AAA credit
quality,
transaction costs related to this portfolio turnover are
relatively small.
18
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
SCHEDULE OF INVESTMENTS 31-Mar-97
Market
Face Amount Security
Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS -
113.17%
FEDERAL HOME LOAN MORTGAGE CORP. -
43.24 % *
FHLMC GOLD:
$14,500,000 7.50%, due (a) ...................
$14,198,906
2,089,955 8.00%, due 9/01/24 to 10/19/24
.......2,116,804
TOTAL FEDERAL HOME LOAN MORTGAGE CORP.
(Cost $16,381,165)
16,315,710
FEDERAL NATIONAL MORTGAGE ASSOC. -
11.82% *
FNMA:
3,199,150 7.00%, due 8/1/23 to 6/01/24 .........
3,078,697
1,282,714 9.50%, due 7/01/16 to 5/01/22........
1,381,554
TOTAL FEDERAL NATIONAL MORTGAGE ASSOC.
(Cost $4,282,274)
4,460,251
GOVERNMENT NATIONAL MORTGAGE ASSOC. -
57.69% *
GNMA:
59,603 7.00%, due 3/15/26 .....................
56,926
9,241,972 8.00%, due 11/15/06 to 12/15/26 ....
9,320,120
GNMA ARM:
990,000 5.00%, due 3/20/27 ............. .......
957,230
3,942,410 5.50%, due 11/20/26 ...........
3,889,964
2,858,832 6.00%, due 11/20/26 to 1/20/27...
2,848,303
293,950 6.88%, due 11/20/17
....................300,234
1,823,924 6.50%, due 2/20/23 ...................
1,857,098
2,479,666 7.125%, due 8/20/17 to
4/20/22.........2,540,041
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOC.
(Cost $21,663,823)
21,769,916
UNITED STATES TREASURY BILLS - 0.42% **
160,000 5.39%, due 5/29/97 ***................
158,660
TOTAL UNITED STATES TREASURY BILLS
(Cost $158,612)
158,660
TOTAL U.S. GOVERNMENT & AGENCY
OBLIGATIONS
(Cost $42,485,874)
42,704,537
Contracts OPTION CONTRACTS - 0.02%
10 Call on 10 Year US Treasury Note
futures, expires 5/97,
strike price $109
625
10 Call on 10 Year US Treasury Note
futures, expires 5/97,
strike price $105
7,343
TOTAL OPTION CONTRACTS (Cost $9,778)
.... 7,968
TOTAL INVESTMENTS
(Cost $42,495,652) - 113.19% ..
42,712,505
Face Amount REPURCHASE AGREEMENTS - 18.55%:
$7,000,000 Morgan Stanley, 5.63%, due 4/3/97
dated 3/27/97 . ....
7,000,000
TOTAL REPURCHASE AGREEMENTS
(Cost $7,000,000). ..
7,000,000
SHORT SALES - (7.36%)
3,000,000 GNMA 6.50%, due
(a)....................(2,777,813)
TOTAL SHORT SALES
(Proceeds $2,836,992).. .......
(2,777,813)
CASH AND OTHER ASSETS LESS LIABILITIES - (24.38%)
(9,199,167)
NET ASSETS - 100.00% ............................
$37,735,525
19
* Mortgage-backed obligations are subject to principal paydowns
as a result
of prepayments or refinancings of the underlying mortgage
instruments.
As a result, the average life may be substantially less than
the original
maturity. The interest rate shown is the rate in effect at
March 31, 1997.
ARMs have coupon rates which adjust periodically. The
adjusted rate is
determined by adding a spread to a specified index.
** The interest rate shown is the discount rate paid at the time
of purchase
by the Fund.
*** Security is segregated as collateral.
(a) To be announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial
statements.
20
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF ASSETS AND LIABILITIES
31-Mar-97
ASSETS:
Investments at market value (identified cost $42,495,652)
(Note 1)
$42,712,505
Repurchase agreement (cost $7,000,000) (Note 1).............
7,000,000
Cash..........
............................................... 2,270,462
Receivables:
Subscriptions. .
........................................... 8,800
Interest.........
........................................ 206,189
Securities sold......... ..........................
12,215,707
Deferred organization expenses (Note 1).
.................. 757
TOTAL ASSETS............................................
64,414,420
LIABILITIES:
Short sales at market value (Proceeds $2,836,992)...........
2,777,813
Payables:
Variation margin on futures contracts (Note 2).
............... 2,469
Securities purchased........................................
23,738,701
Distributions.....................................
......... 124,309
Due to advisor (Note 3).................................
...... 14,992
Accrued expenses..............................................
20,611
TOTAL LIABILITIES........................................
26,678,895
NET ASSETS:
(Applicable to outstanding shares of 3,878,010;
unlimited number of shares of beneficial
interest authorized; no stated par)........................
$37,735,525
Net asset value, offering price and redemption
price per share ($37,735,525/3,878,010)
$9.73
SOURCE OF NET ASSETS:
Paid in capital..............................................
$38,554,091
Overdistributed net investment income........................
(124,309)
Accumulated net realized loss on
investments...................... (830,703)
Net unrealized appreciation of investments...
................... 136,446
NET ASSETS.............................................
$37,735,525
The accompanying notes are an integral part of these financial
statements.
21
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1997
INVESTMENT INCOME:
Interest and discount earned, net of premium amortization and
interest
expense (Note 1) .............................................
$2,632,266
EXPENSES:
Advisory fees (Note 3) ......................
.................. 259,767
Accounting and pricing services fees
........................... 39,224
Custodian fees
................................................. 21,512
Audit & tax preparation fees ................. .........
14,500
Legal fees
..................................................... 10,251
Amortization of organization expenses (Note 1)
................. 9,402
Transfer agent fees ................................
.......... 29,735
Registration fees
.............................................. 20,200
Trustees fees and expenses .........................
........... 13,324
Insurance
...................................................... 10,541
Other
..........................................................
1,888
TOTAL EXPENSES BEFORE REIMBURSEMENT ................
430,344
Expenses reimbursed by Adviser (Note 3) ..................
(101,379)
NET EXPENSES .............................
................. 328,965
NET INVESTMENT INCOME ..............................
2,303,301
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized loss on investments . ............... ...........
(82,705)
Change in unrealized appreciation of
investments................ (93,993)
Net realized and unrealized loss on investments ...............
(176,698)
Net increase in net assets resulting from operations ........
$2,126,603
The accompanying notes are an integral part of these financial
statements.
22
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1997 March 31, 1996
OPERATIONS:
Net investment income......................... $2,303,301
$2,369,671
Net realized (loss) gain on investments....... (82,705)
1,227,064
Change in unrealized appreciation (depreciation)
of investments.............
(93,993) (257,447)
Net increase in net assets resulting from
operations............
2,126,603 3,339,288
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income........ (2,260,030)
(2,358,436)
Distributions from net realized gains on
investments... ...
(943,662) (367,107)
Total distributions...................... (3,203,692)
(2,725,543)
CAPITAL SHARE TRANSACTIONS:
Shares sold.... ............................ 1,730,791
1,030,079
Shares issued on reinvestment of distributions 935,335
702,855
Shares redeemed. ........................... (300,452)
(697,235)
Increase in net assets resulting from capital
share transactions(a). ....
2,365,674 1,035,699
TOTAL INCREASE IN NET ASSETS........... 1,288,585
1,649,444
NET ASSETS:
Beginning of year... ...................... 36,446,940
34,797,496
End of year........... .................... $37,735,525
$36,446,940
(a) Transactions in capital shares were as follows:
Shares sold........ ................... 174,344
100,992
Shares issued on reinvestment of
distributions.............. ...
94,439 69,235
Shares redeemed..................... . (30,101)
(69,182)
Net increase......................... . 238,682
101,045
Beginning balance ................... . 3,639,328
3,538,283
Ending balance ........................ 3,878,010
3,639,328
The accompanying notes are an integral part of these financial
statements.
23
SMITH BREEDEN INTERMEDIATE DURATION US GOVERNMENT SERIES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1997
Year Ended
31-Mar-97
Cash flows from operating activities:
Net increase in net assets resulting from operations.......
$2,126,603
Net realized and unrealized loss on investments............
176,698
Net investment income....................................
2,303,301
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and
losses........................................(37,392)
Decrease in interest
receivable.................................... 53,993
Decrease in other
assets........................................... 18,904
Decrease in other
liabilities...................................... (14,677)
Net cash provided by operating activities... ............
2,324,129
Cash flows from investing activities:
Payments for futures variations.
.......................... (60,974)
Proceeds from sales of long-term investments.......
56,055,128
Proceeds from sales of short-term
investments..................... 159,527
Proceeds from sales of options................
.................... 5,223
Proceeds from maturities of short-term
investments..............232,680,862
Proceeds from paydowns of long-term investments...............
3,435,588
Purchases of long-term investments........................
(51,848,780)
Purchases of short-term investments........................
(239,832,318)
Purchases of options.......................................
(102,279)
Net cash provided by investing activities................
491,977
Cash flows from financing activities:
Proceeds from shares
tendered.....................................1,721,991
Payments for shares
redeemed.......................................(300,452)
Dividends from net investment income and
realized gains on
investments.....................................(2,279,430)
Net cash used in financing
activities...........................(857,891)
Net increase in cash....................................
1,958,215
Cash at beginning of
year............................................. 312,247
Cash at end of year..............................................
$2,270,462
Noncash financing activities:
Market value of shares issued to stockholders
through reinvestment of
dividends............................... $935,335
Supplemental disclosure:
Interest paid..................................................
$ 3,079
The accompanying notes are an integral part of these financial
statements.
24
SMITH BREEDEN INTERMEDIATE DURATION U.S. GOVERNMENT SERIES
FINANCIAL HIGHLIGHTS
<TABLE>
The following average per share data, ratios and supplemental
information have
been derived from information provided in the financial
statements.
<CAPTION>
Year Year Year Year Period
Ended Ended Ended Ended 3/31/92 <F3>
3/31/97 3/31/96 3/31/95 3/31/94 to 3/31/93
<S>
<C> <C> <C> <C> <C>
Net Asset Value,
Beginning of Period
$10.01 $9.83 $10.01 $10.62 $10.00
Income From Investment Operations
Net investment
income............................................0.599 0.66
0.664 1.05 0.826
Net realized and unrealized (loss) gain on
investments..........(0.024) 0.277 (0.049)
(0.601) 0.621
Total from investment
operations.............................0.575 0.937 0.615
0.449 1.447
Less Distributions
Dividends from net investment
income............................(0.604) (0.656) (0.664)
(1.044) (0.826)
Dividends in excess of net investment
income......................- - (0.108) -
- -
Distributions from net realized gains on
investments............(0.251) (0.101) - (0.015)
- -
Distributions in excess of net realized gains on
investments......- - (0.022) - -
Total distributions........................................
(0.855) (0.757) (0.794) (1.059) (0.826)
Net Asset Value, End of
Period....................................$9.73 $10.01
$9.83 $10.01 $10.62
Total
Return.......................................................5.92%
9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of
period......................................$37,735,525
$36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to average net assets
<F1>.......................0.88% 0.90% 0.90%
0.90% 0.82%
Ratio of net investment income to average net assets
<F2>..........6.19% 6.49% 6.20% 7.74%
8.18%
Portfolio turnover
rate.......................................... 409% 193%
557% 84% 42%
<FN>
<F1>
(1)The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 1.16%, 1.14%,
2.33%, 2.34%, and 17.52% for the years ended March 31, 1997, March
31, 1996, March 31, 1995 and March 31, 1994 and for the
period ended March 31, 1993, respectively. Through August 1,
1994, expense ratios include both
the direct expenses of the Intermediate Duration U.S. Government
Series, and the indirect expenses
incurred through the Series' investment in the Institutional
Intermediate Duration U.S. Government Fund (Note 5).
</FN>
<FN>
<F2>
(2) The annualized ratio of net investment income to average net
assets prior to reimbursement of both direct and indirect expenses
by the Advisor was 6.26%, 4.77%, 6.30% and (8.52)% for the years
ended March 31, 1997, March 31, 1996, March 31, 1995 and March 31,
1994, and for the period March 31, 1993, respectively.
</FN>
<FN>
<F3>
(3) Commencement of operations.
</FN>
</TABLE>
The accompanying notes are an integral part of these financial
statements.
25
SMITH BREEDEN INTERMEDIATE DURATION U.S.
GOVERNMENT SERIES
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Series Fund (the "Fund") is an open-end,
diversified
management investment company registered under the Investment
Company
Act of 1940, as amended. The Fund offers shares in two series:
the Smith
Breeden Short Duration U.S. Government Series and the Smith
Breeden
Intermediate Duration U.S. Government Series ("Intermediate
Series" or
"Series"). The following is a summary of significant accounting
policies
consistently followed by the Intermediate Series.
A. Security Valuation: Portfolio securities are valued at
current market
value provided by a pricing service or by a bank or broker/dealer
experienced
in such matters, when over-the-counter market quotations are
readily available.
Securities and other assets for which market prices are not
readily available
are valued at fair market value as determined in accordance with
procedures
approved by the Board of Trustees.
B. Distributions and Taxes: Dividends to shareholders are
recorded on
the ex-dividend date. The Intermediate Series intends to continue
to qualify
for and elect the special tax treatment afforded regulated
investment companies
under Subchapter M of the Internal Revenue Code, thereby relieving
the Series
of Federal income taxes. To so qualify, the Series intends to
distribute
substantially all of its net investment income and net realized
capital gains,
if any, less any available capital loss carryforward. As of March
31, 1997,
the Series had no capital loss carryforward.
C. Repurchase Agreements: The Intermediate Series may enter into
repurchase agreements with member banks of the Federal Reserve
System
having total assets in excess of $500 million and securities
dealers, provided
that such banks or dealers meet the credit guidelines of the
Series' Board of
Trustees. In a repurchase agreement, the Series acquires
securities from a third
party with the commitment that they will be repurchased by the
seller at a fixed
price on an agreed upon date. The Intermediate Series' custodian
maintains
control or custody of these securities collateralizing the
repurchase agreements
until maturity of the repurchase agreements. The value of the
collateral is
monitored daily, and if necessary, additional collateral is
received to ensure
that the market value of the underlying assets remains sufficient
to protect the
Series in the event of the seller's default. However, in the
event of default
or bankruptcy of the seller, the Series' right to the collateral
may be subject
to legal proceedings.
D. Reverse Repurchase Agreements: A reverse repurchase
agreement
involves the sale by the Intermediate Series of portfolio assets
concurrently
with an agreement by the Series to repurchase the same assets at a
later date at
a fixed price. The Series will maintain a segregated account with
its custodian
which will be marked to market daily, consisting of cash, U.S.
Government
securities or other liquid high-grade debt obligations equal in
value to its
obligations under reverse repurchase agreements. In the event the
buyer of
securities under a reverse repurchase agreement files for
bankruptcy or
becomes insolvent, the Series' use of the proceeds of
26
NOTES TO FINANCIAL STATEMENTS (cont.)
the agreement may be restricted pending a determination by the
other party, or
its trustee or receiver, whether to enforce the Series' obligation
to repurchase
the securities.
E. Dollar Roll Agreements: The Intermediate Series may enter
into
dollar rolls in which the Series sells securities for delivery in
the current
month and simultaneously contracts to repurchase substantially
similar (same
type and coupon) securities on a specified future date. During
the roll
period, the Series foregoes principal and interest paid on these
securities.
The Series is compensated by the difference between the current
sales price
and the forward price for the future purchase (often referred to
as the
"drop") as well as by the interest earned on the cash proceeds of
the initial
sale.
F. Determination Of Gains Or Losses On Sales Of Securities:
Gains
or losses on the sale of securities are calculated for accounting
and tax
purposes on the identified cost basis.
G. Deferred Organizational Expenses: Deferred organizational
expenses are being amortized on a straight-line basis over five
periods.
H. Securities Transactions and Investment Income: Interest
income is
accrued daily on both long-term bonds and short-term investments.
Interest
income also includes net amortization from the purchase of fixed-
income
securities. Discounts and premiums on securities purchased are
amortized over
the life of the respective securities. Transactions are recorded
on the first
business day following the trade date. Realized gains and losses
from security
transactions are determined and accounted for on the basis of
identified cost.
2. FINANCIAL INSTRUMENTS
A. Derivative Financial Instruments Held or Issued for Purposes
other than Trading:
The Intermediate Series uses interest rate futures contracts for
risk
management purposes in order to reduce fluctuation of the Series'
net asset
value relative to its targeted option-adjusted duration. Upon
entering into a
futures contract, the Series is required to deposit either cash or
securities in
an amount (initial margin) equal to a certain percentage of the
contract value.
Subsequent payments (variation margin) are made or received by the
Series
each day. The variation margin payments are equal to the daily
changes in the
contract value and are recorded as unrealized gains or losses.
The Series
recognizes a realized gain or loss when the contract is closed or
expires equal
to the difference between the value of the contract at the time it
was opened
and the value at the time it was closed.
27
NOTES TO FINANCIAL STATEMENTS (cont.)
The Intermediate Series had the following open futures contracts
as of
March31, 1997:
Type Notionanal Position Expiration
Unrealized
Amount Month
Gain/ (Loss)
5 Year Treasury $1,500,000 Long June, 1997 $
32,817
10 Year Treasury 3,200,000 Long June, 1997
(106,769)
Total
$ (139,586)
Futures transactions involve costs and may result in losses. The
effective use
of futures strategies depends on the Series' ability to terminate
futures
positions at times when the Series' investment adviser deems it
desirable to do
so. The use of futures also involves the risk of imperfect
correlation among
movements in the values of the securities underlying the futures
purchased and
sold by the Series, of the futures contract itself, and of the
securities
which are the subject of a hedge.
The aggregate market value of investments pledged to cover margin
requirements for the open positions at March 31, 1997 was
$158,660.
3. INVESTMENT ADVISORY FEES AND OTHER
TRANSACTIONS WITH AFFILIATES
Smith Breeden Associates, Inc. (the "Adviser"), a registered
investment
adviser, provides the Series with investment management services.
As
compensation for these services, the Intermediate Series pays the
Adviser a fee
computed daily and payable monthly, at an annual rate equal to
0.70% of the
Series' average daily net asset value.
The Adviser has voluntarily agreed to reduce or otherwise limit
other expenses
of the Intermediate Series (excluding advisory fees and
litigation,
indemnification and other extraordinary expenses) to 0.88% of the
Series'
average daily net assets. This voluntary agreement may be
terminated or
modified at any time by the Adviser in its sole discretion. The
Adviser has
agreed to reduce the fees payable (to the extent of such fees) by
the amount
the Series' expenses would, absent the fee reduction, exceed the
applicable
expense limitations imposed by state securities administrators.
For the year
ended March 31, 1997, the Adviser received fees of $259,767 and
reimbursed
the Series $101,379.
28
NOTES TO FINANCIAL STATEMENTS (cont.)
Effective August 1, 1994, the Series adopted a Distribution and
Services Plan
(the "Plan") pursuant to Rule 12b-1 under the 1940 Act. The
purpose of the
Plan is to permit the Adviser to compensate investment dealers and
other
persons involved in servicing shareholder accounts for services
provided and
expenses incurred in promoting the sale of shares of the Series,
reducing
redemptions, or otherwise maintaining or improving services
provided to
shareholders by such dealers or other persons.
The Plan provides for payments by the Adviser, out of its advisory
fee, to
dealers and other persons at the annual rate of up to 0.25% of the
Intermediate
Series' average net assets subject to the authority of the
Trustees of the
Series to reduce the amount of payments permitted under the Plan
or to suspend
the Plan for such periods as they may determine. Subject to these
limitations,
the amount of such payments and the purposes for which they are
made shall be
determined by the Adviser.
Certain officers and trustees of the Series are also officers and
directors of
the Adviser.
4. INVESTMENT TRANSACTIONS
During the year ended March 31, 1997, purchases and proceeds from
sales of
securities, other than short-term investments, aggregated
$174,835,826 and
$180,397,654, respectively. The purchases and proceeds shown
above do not
include dollar roll agreements which are considered borrowings by
the
Intermediate Series. The cost of securities for federal income
tax purposes is
$42,495,652. Net unrealized appreciation of investments, short
sales and
futures contracts consists of:
Gross unrealized appreciation $ 431,474
Gross unrealized depreciation (295,028)
Net unrealized appreciation $ 136,446
29
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Intermediate Duration U.S. Government Series of the
Smith Breeden Series Fund:
We have audited the accompanying statement of assets and
liabilities,
including the schedule of investments, of the Smith Breeden
Intermediate
Duration U.S. Government Series of the Smith Breeden Series Fund
as of
March 31, 1997, and the related statements of operations and cash
flows
for the year then ended, the statements of changes in net assets
for each of
the years in the two-year period then ended and the financial
highlights for
each of the years in the four-year period then ended and the
period March
31, 1992 (commencement of operations) to March 31, 1993. These
financial statements and the financial highlights are the
responsibility of the
Fund's management. Our responsibility is to express an opinion on
these
financial statements and the financial highlights based on our
audits.
We conducted our audits in accordance with generally accepted
auditing
standards. Those standards require that we plan and perform the
audit to
obtain reasonable assurance about whether the financial statements
and
the financial highlights are free of material misstatement. An
audit
includes examining, on a test basis, evidence supporting the
amounts and
disclosures in the financial statements. Our procedures included
confirmation of securities owned at March 31, 1997 by
correspondence
with the custodian and brokers. An audit also includes assessing
the
accounting principles used and significant estimates made by
management,
as well as evaluating the overall financial statement
presentation. We
believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements and financial highlights
referred to
above present fairly, in all material respects, the financial
position of the
Smith Breeden Intermediate Duration U.S. Government Series of the
Smith Breeden Series Fund as of March 31, 1997, the results of its
operations and its cash flows, the changes in its net assets, and
the
financial highlights for the respective stated periods in
conformity with
generally accepted accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1997
30
Smith Breeden Equity Plus Fund Annual Report and Performance
Review
Performance Review
The Smith Breeden Equity Plus Fund provided a total return of
21.41% in the year ending March 31, 1997. The Fund's return
exceeded
the 19.84% return of its benchmark, the S&P 500 Index, by 1.57%.
Since
the Fund's inception on June 30, 1992, its return has exceeded
that of its
benchmark by 14.22%, and on an annualized basis by 1.62%. The
graph
below plots the Fund's return versus its benchmark and versus the
average
return of Morningstar Inc.'s Growth and Income fund category.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE EQUITY PLUS' 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 VERSUS THE S&P 500 AND VERSUS THE AVERAGE OF
THE FUNDS IN MORNINGSTAR'S GROWTH AND INCOME CATEGORY.
THE EQUITY PLUS' AVERAGE ANNUAL RETURN WAS 21.41% FOR THE ONE YEAR
PERIOD,
23.47% THE THREE YEAR PERIOD, 18.50% FOR THE PERIOD
SINCE INCEPTION. THE AVERAGE ANNUAL RETURN OF THE S&P 500 WAS
19.84%
FOR THE ONE YEAR PERIOD, 22.31% FOR THE THREE YEAR PERIOD, 16.88%
FOR THE
PERIOD FROM INCEPTION. THE AVERAGE ANNUAL
RETURN OF THE AVERAGE OF THE FUNDS IN MORNINGSTAR'S GROWTH AND
INCOME
CATEGORY WAS 16.10% FOR THE ONE YEAR PERIOD, 18.35% FOR THE THREE
YEAR PERIOD,
AND 14.87% FOR THE FIVE YEAR AND SINCE INCEPTION RETURNS.
FROM INCEPTION THROUGH MARCH 31, 1997, AN INVESTMENT
OF $10,000 IN THE EQUITY PLUS WOULD HAVE GROWN TO $22,411, VERSUS
$20,988 IN ITS BENCHMARK, AND $19,320 OF THE AVERAGE OF THE FUNDS
IN
MORNINGSTAR'S GROWTH AND INCOME CATEGORY.
The S&P 500 index return was produced by strong corporate
earnings rather than by falling interest rates in the year ending
March 31,
1997. Corporate earnings were approximately 15% higher in the
year
ending December 1996 over a year earlier. First quarter 1997
earnings
were also generally strong, in many cases exceeding analysts'
expectations.
The growth in corporate earnings, combined with low unemployment
rates, caused some concern that the U.S. economy is growing too
fast and
this led to moderately rising interest rates due to increased
fears of
inflation. The thirty-year U.S. Treasury bond yield rose from
6.66% in
March 1996 to 7.09% in March 1997. Rising interest rates in turn
produced several small sell-offs in the stock market, resulting in
declines in
the S&P 500 Index in three out of the last twelve months. It is
by no
means clear that inflation is on the rise however, and much of the
gain in
corporate earnings can be explained by the high levels of
productive
investment made by corporations during this economic expansion.
31
The strategy employed by the Equity Plus Fund to achieve its
goal
of providing a return in excess of the S&P 500 index has two
components.
The Fund uses equity index futures contracts to track the S&P 500
index,
and it uses a hedged bond portfolio to provide income to cover the
operating costs of the fund as well as the financing costs of the
equity index
futures contracts. Equity index futures contracts are available
with
different maturity dates. Because the fund controls when it sells
one equity
futures contract and buys a new one, it can take advantage of
times when
one futures contract is cheap relative to another. Approximately
0.30% of
the Fund's return in excess of its benchmark for the year ending
March
1997 was due to purchasing equity index futures at favorable
prices relative
to the price of the contracts sold.
U.S. Government agency mortgage securities produced excellent
hedged returns in the year ended March 31, 1997, and the Equity
Plus
Fund was able to take advantage of this performance to generate
the rest of
the Fund's excess return over the S&P 500 index. One factor
explaining
the superior performance by mortgages was a decline in interest
rate
volatility. Mortgage buyers demand a yield premium when they
purchase
mortgage bonds against the risk that interest rates will move in
an
unfavorable direction. Because interest rate volatility measures
the
likelihood of changes in the level of interest rates, when
volatility falls
mortgage buyers demand a smaller premium and consequently the
yield on
mortgages falls relative to the yield on U.S. Treasury securities.
The
Equity Plus Fund held approximately 60% of its assets in
adjustable-rate
mortgages during the year ended on March 31, 1997, and about 20%
in
fixed-rate mortgages. The remaining assets were invested in U.S.
Treasury
Bills.
32
SMITH BREEDEN EQUITY PLUS FUND
SCHEDULE OF INVESTMENTS MARCH 31, 1997
Market
Face Amount Security
Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 121.45%
FEDERAL HOME LOAN MORTGAGE CORPORATION - 7.92% *
FHLMC:
$983,120 7.50%, due (a) ...................................
$963,150
103,239 9.50%, due 7/1/02 ................................
106,178
TOTAL FEDERAL HOME LOAN MORTGAGE CORPORATION
(Cost $1,090,669) 1,069,328
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 6.94% *
FNMA:
110,165 12.50%, due 9/1/12 ..............................
126,541
104,722 13.50%, due 11/1/14 to 1/1/15 ..................
120,635
FNMA ARM:
660,968 7.753%, due 9/1/18..............................
689,968
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $916,731) 937,144
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 66.09% *
GNMA ARM:
2,020,000 5.00%, due 3/20/27 ...........................
1,953,136
1,990,000 5.50%, due (a) ...............................
1,944,294
2,632,161 6.50%, due 2/20/16 to 10/20/26 ...............
2,676,380
2,295,509 7.125%, due 4/20/16 to 9/20/22 ...............
2,353,002
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $8,904,340) 8,926,812
U.S. GOVERNMENT OBLIGATIONS - 40.50%
U.S. TREASURY BILL **
20,000 5.38%, due 5/29/97 .............................
19,832
1,000,000 5.05%, due 5/29/97 .............................
991,622
600,000 4.94%, due 5/29/97*** ..........................
594,973
2,000,000 5.12%, due 5/29/97 .............................
1,983,244
600,000 5.08%, due 5/29/97 .............................
594,973
700,000 5.06%, due 5/29/97 .............................
694,136
500,000 5.02%, due 5/29/97 .............................
495,812
100,000 5.21%, due 11/13/97*** .........................
96,566
TOTAL U.S. GOVERNMENT OBLIGATIONS (Cost $5,472,482)
5,471,158
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $16,384,222) 16,404,442
Contracts OPTION CONTRACTS - 0.13%
3 Call on 5 Year US Treasury Note futures, expires 5/97,
strike price $110 47
37 Put on 5 Year US Treasury Note futures, expires 5/97,
strike price $104 17,922
TOTAL OPTION CONTRACTS (Cost $10,196) ................
17,969
TOTAL INVESTMENTS (Cost $16,394,418) - 121.58% ....
16,422,411
CASH AND OTHER ASSETS LESS LIABILITIES - (21.58%)
(2,915,034)
NET ASSETS - 100.00% ........................
$13,507,377
33
* Mortgage-backed obligations are subject to principal
paydowns as a result
of prepayments or refinancings of the underlying mortgage
loans. As a
result, the average life may be substantially less than the
original
maturity. The interest rate shown in the rate in effect at
March 31,
1997. ARMs have coupon rates which adjust periodically.
The adjusted
rate is determined by adding a spread to a specified index.
** The interest rate shown is the discount rate paid at the
time of purchase
by the Fund.
*** Security is segregated as collateral.
(a) To be Announced
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial
statements.
34
SMITH BREEDEN SERIES FUND
FORM N-1A
PART C. OTHER INFORMATION
Item 24. Financial Statements and Exhibits.
(a) Financial Statement filed with Part B
(b) Exhibits:
(1) Declaration of Trust: Incorporated by Reference
(2) By-Laws: Incorporated by Reference
(3) Voting Trust Agreement: Not Applicable
(4) Specimen Share Certificate: Incorporated by
Reference
(5)(a) Form of Investment Advisory Agreement
for Smith Breeden Intermediate Duration
Fund: Incorporated by Reference
(5)(b) Form of Investment Advisory Agreement
for Smith Breeden Short Duration Fund:
Incorporated by Reference
(6) Form of Underwriting or Distribution
Agreement
(7) Bonus, Profit Sharing, Pension and Other
Similar Arrangements: Not Applicable
(8) Custodian Agreement: Incorporated by Reference
(9)(a) Shareholder Services Agreement: Incorporated by
Reference
(9)(b) Accounting Services Agreement: Incorporated by
Reference
(9)(c) Sub-Administration Agreement: Not Applicable
(10) Opinion and Consent of Counsel
(a) Incorporated by Reference to Pre-Effective
Amendment No. 1 filed on November 26, 1991.
(11) Independent Auditors' Consent
(12) Financial Statements Omitted from Item 23:
Not Applicable
(13) Letter of Understanding relating to
initial capital--Incorporated by Reference
(14) Model Retirement Plan -- Not Applicable
(15)(a) Form of Rule 12b-1 Plan for Smith
Breeden Intermediate Duration Fund:Incorporated by
Reference
(15)(b) Form of Rule 12b-1 Plan for Smith
Breeden Short Duration Fund: Incorporated by
Reference
(16) Performance Calculation --
Not Applicable
(17) Financial Data Schedule
(18) 18f-3 Multi-Class Plan: Not Applicable
<PAGE>
Item 25. Persons Controlled by or under Common Control with
Registrant.
There were no persons controlled by or under Common
Control with the Smith Breeden Short Duration U.S. Government
Fund as of 11/30/97. The Public Retirement System of
St. Louis, Missouri may be deemed to control the Smith Breeden
Intermediate Duration U.S. Government Fund by virtue of owning
32.20% of the outstanding shares of the Fund as of November
30, 1997.
Item 26. Number of Holders of Securities.
NUMBER OF RECORD HOLDERS
TITLE OF CLASS AS OF NOVEMBER 30, 1997
Smith Breeden Short Duration
U.S. Government Fund 399
Shares of Beneficial Interest
Smith Breeden Intermediate
Duration U.S. Government Fund 287
Shares of Beneficial Interest
Item 27. Indemnification.
Reference is made to Article IV, Sections 4.2 and 4.3 of
Registrant's Declaration of Trust (Exhibit 1(a)) with respect to
indemnification of the Trustees and officers of Registrant
against liabilities which may be incurred by them in such
capacities.
Insofar as indemnification for liability arising under the
Securities Act of 1933, as amended (the "Act"), may be permitted
to directors, officers and controlling persons of the Registrant
pursuant to the foregoing provisions, or otherwise, the
Registrant has been advised that, in the opinion of the
Securities and Exchange Commission ("SEC"), such indemnification
is against public policy as expressed in the Act, and is,
therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment
by the Registrant of expenses incurred or paid by a trustee, an
officer or a controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted
by such trustee, officer or controlling person in connection with
the securities being registered, the Registrant will, unless in
the opinion of its counsel the matter has been settled by
controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Act and will be
governed by the final adjudication of such issue.
Each disinterested Trustee has entered into an indemnity
agreement with the Adviser whereby the Adviser indemnifies each
disinterested Trustee against defense costs in connection with a
civil claim which involves the Trustee by virtue of his position
with the Fund.
<PAGE>
Item 28. Business and Other Connections of Adviser.
Smith Breeden Associates, Inc. (the "Adviser") acts as investment adviser to
financial institution, insurance, pension, charitable foundation clients and
other registered investment companies. For a description of the officers and
directors of the Adviser and their business affiliations, see "Management of
the Fund" in the Prospectus contained within this Registration Statement.
Item 29. Principal Underwriters
(a)FPS Broker Services, Inc. ("FPSB"), the principal underwriter
for the Registrant's securities, currently acts as principal
underwriter for the following entities:
The Govett Funds, Inc.
Bjurman Funds
Farrell Alpha Strategies
Focus Trust, Inc.
IAA Trust Growth Fund
IAA Trust Asset Allocation Fund, Inc.
IAA Trust Tax Exempt Bond Fund, Inc.
IAA Trust Taxable Fixed Income Series Fund, Inc.
Matthews International Funds
McM Funds
Metropolitan West Funds
Polynous Trust
Smith Breeden Series Fund
Smith Breeden Trust
Sage/Tso Trust
The Stratton Funds, Inc.
Stratton Growth Fund,Inc.
Stratton Monthly Dividend Shares, Inc.
Trainer Wortham First Mutual Funds.
(b) The table below sets forth certain information as to the
Underwriter's Directors, Officers and Control Persons:
NAME AND PRINCIPAL POSITION AND OFFICES POSITION AND
BUSINESS ADDRESS WITH UNDERWRITER OFFICES WITH
REGISTRANT
Kenneth J. Kempf Director and None
3200 Horizon Drive President
King of Prussia, PA
19406-0903
Lynne Cannon Vice President and None
3200 Horizon Drive Principal
King of Prussia, PA
19406-0903
Rocco J. Cavalieri Director and None
3200 Horizon Drive Vice President
King of Prussia, PA
19406-0903
Gerald J. Holland Director, None
3200 Horizon Drive Vice President and
King of Prussia, PA Principal
19406-0903
Joseph M. O'Donnell Director and None
3200 Horizon Drive Vice President
King of Prussia, PA
19406-0903
Sandra L. Adams Assistant Vice President None
3200 Horizon Drive and Principal
King of Prussia, PA
19406-0903
John H. Leven Treasurer None
3200 Horizon Drive
King of Prussia, PA
19406-0903
Mary P. Efstration Secretary None
3200 Horizon Drive
King of Prussia, PA
19406-0903
Bruno DiStefano Principal None
3200 Horizon Drive
King of Prussia, PA
19406-0903
James W. Stratton may be considered a control person of the Underwriter due to
his direct or indirect ownership of FPS Services, Inc., the parent of the
Underwriter.
(c) Not Applicable.
Item 30. Locations of Accounts and Records.
The accounts, books or other documents required to be maintained by
Section 31(a) of the Investment Company Act of 1940 and the Rules
thereunder will be kept by the Registrant at the following offices.
(1) FPS Broker Services, Inc., 3200 Horizon Drive,
P. O. Box 61503, King of Prussia, Pennsylvania 19406-0903
(2) Smith Breeden Associates, Inc., 100 Europa Drive, Suite 200,
Chapel Hill, NC 27514
Item 31. Management Services.
There are no management-related service contracts not discussed in
Part A or Part B.
Item 32. Undertakings.
(a) The Registrant previously has undertaken to promptly call a
meeting of shareholders for the purpose of voting upon the question of
removal of any trustee or trustees when requested in writing to do so by
the record holders of not less than 10 percent of the Registrant's
outstanding shares and to assist its shareholders in accordance with the
requirements of Section 16(c) of the Investment Company Act of 1940
relating to shareholder communications.
(b) The registrant hereby undertakes to furnish to each person to
whom a prospectus is delivered a copy of the Registrant's latest annual
report to shareholders upon request and without charge.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as
amended, and the Investment Company Act of 1940, as amended, the
Registrant certifies that it meets all of the requirements for
effectiveness of this Registration Statement pursuant to Rule 485 (b)
under the Securities Act of 1933 and has duly caused this Amendment
to the Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Chapel Hill,
and the State of North Carolina, on the 16th day of December, 1997.
SMITH BREEDEN SERIES FUND
By
Michael J. Giarla
President
Pursuant to the requirements of the Securities Act of 1933, this
Amendment to the Registration Statement has been signed below by the
following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
Michael J. Giarla President, Principal December 16, 1997
Executive Officer, and Trustee
Douglas T. Breeden* Trustee December 16, 1997
Stephen M. Schaefer* Trustee December 16, 1997
Myron S. Scholes* Trustee December 16, 1997
William F. Sharpe* Trustee December 16, 1997
Marianthe S. Mewkill Principal Financial and December 16, 1997
Accounting Officer
* By Marianthe S. Mewkill
*Attorney-in-Fact pursuant to power-of-attorney filed previously.
CONSENT OF INDEPENDENT AUDITORS
Smith Breeden Series Fund:
We consent to the use in Post-Effective Amendment No. 15 to
Registration Statement
No. 33-43089 of our reports dated May 12, 1997 relating to the
Smith Breeden Short Duration U.S. Government Series and Smith
Breeden Intermediate Duration U.S. Government Series of the Smith
Breeden Series Fund incorporated by reference in the Statement of
Additional Information, which is a part of such Registration
Statement, and to the references to us under the captions
"Experts" appearing in the Statement of Additional Information
and "Financial Highlights" appearing in the Prospectus, which
also is a part of such Registration Statement.
DELOITTE & TOUCHE LLP
Princeton, New Jersey
December 8, 1997
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<NAME> SMITH BREEDEN INT. DURATION US GOVT FUND
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Underwriting Agreement between Smith Breeden Series Fund, Smith
Breeden Associates, Inc. and FPS Broker Services, Inc.
Underwriting Agreement
This Agreement, dated as of the 1st day of August, 1997,
made by and between Smith Breeden Series Fund a Massachusetts
business trust (the "Trust") operating as an open-end management
investment company registered under the Investment Company Act of
1940, as amended (the "Act"); Smith Breeden Associates, Inc.
(Smith Breeden), a registered investment advisor duly organized
and existing as a corporation under the laws of the state of
Kansas; and FPS Broker Services, Inc. ("FPSB"), a corporation
duly organized and existing under the laws of the State of
Delaware (collectively, the "Parties").
Witnesseth That:
WHEREAS, the Trust is authorized by its Declaration of Trust
to issue separate series of shares representing interests in
separate investment portfolios (the "Series"), which Series are
identified on Schedule "C" attached hereto, and which Schedule
"C" may be amended from time to time by mutual agreement among
the Parties; and
WHEREAS, Smith Breeden has been appointed investment adviser
to the Trust; and
WHEREAS, FPSB is a broker-dealer registered with the U.S.
Securities and Exchange Commission and a member in good standing
of the National Association of Securities Dealers, Inc. (the
"NASD"); and
WHEREAS, the Parties are desirous of entering into an
agreement providing for the distribution by FPSB of the shares of
the Trust (the "Shares").
NOW, THEREFORE, in consideration of the premises and mutual
covenants contained herein, and in exchange of good and valuable
consideration, the sufficiency and receipt of which is hereby
acknowledged, the Parties hereto, intending to be legally bound,
do hereby agree as follows:
1. Appointment.
The Trust hereby appoints FPSB as its principal agent for
the distribution of the Shares in the fifty United States of
America, the District of Columbia and Commonwealth of Puerto
Rico, and FPS hereby accepts such appointment under the
terms of this Agreement. The Trust agrees that it will not
sell any shares to any person except to fill orders for the
shares received through FPSB; provided, however, that the
foregoing exclusive right shall not apply: (a) to shares
issued or sold in connection with the merger or
consolidation of any other investment company with the Trust
or the acquisition by purchase or otherwise of all or
substantially all of the assets of any investment company or
substantially all of the outstanding shares of any such
company by the Trust; (b) to shares which may be offered by
the Trust to its stockholders for reinvestment of cash
distributed from capital gains or net investment income of
the Trust; or (c) to shares which may be issued to
shareholders of other funds who exercise any exchange
<PAGE>
1
privilege set forth in the Trust=s Prospectus.
Notwithstanding any other provision hereof, the Trust may
terminate, suspend, or withdraw the offering of the Shares
whenever, in their sole discretion, they deem such action to
be desirable.
2. Sale and Repurchase of Shares.
(a) FPSB is hereby granted the right, as agent for the
Trust, to sell Shares to the public against orders
received at the public offering price as defined in the
Trust=s Prospectus and Statement of Additional
Information.
(b) FPSB will also have the right to take, as agent
for the Trust, all actions which, in FPSB's
judgement, and subject to the Trust's reasonable
approval, are necessary to carry into effect the
distribution of the Shares.
(c) FPSB will act as agent for the Trust in connection with
the repurchase of Shares by the Trust upon the terms
set forth in the Trust=s Prospectus and Statement of
Additional Information.
(d) The net asset value of the Shares shall be
determined in the manner provided in the then
current Prospectus and Statement of Additional
Information relating to the Shares, and when
determined shall be applicable to all transactions
as provided in the Prospectus. The net asset
value of the Shares shall be calculated by the
Trust or by another entity on behalf of the Trust.
FPSB shall have no duty to inquire into, or
liability for, the accuracy of the net asset value
per Share as calculated.
(e) On every sale, FPSB shall promptly pay to the
Trust the applicable net asset value of the
Shares.
(f) Upon receipt of purchase instructions, FPSB will
transmit such instructions to the Trust or its
transfer agent for registration of the Shares
purchased.
(g) Nothing in this Agreement shall prevent FPSB or any
affiliated person (as defined in the Act) of FPSB from acting as
underwriter for any other person, firm or corporation (including
other investment companies), or in any way limit or restrict FPSB
or such affiliated person from buying, selling or trading any
securities for its or their own account or for the accounts of
others for whom it or they may be acting; provided, however, that
FPSB expressly agrees that it will not for its own account
purchase any Shares of the Trust except for investment purposes,
and that it will not for its own account dispose of any such
Shares except by redemption of such Shares with the Trust, and
that it will not undertake in any activities which, in its
judgement, will adversely affect the performance of its
obligations to the Trust under this Agreement.
3. Rules of Sale of Shares.
FPSB does not agree to sell any specific number of Shares
and serves only in the capacity of Statutory Underwriter.
The Trust reserves the right to terminate, suspend or
withdraw the sale of its Shares for any reason deemed
adequate by it, and the Trust reserves the right to refuse
at any time or times to sell any of its Shares to any person
<PAGE>
2
for any reason deemed adequate by it.
4. Rules of NASD, etc.
(a) FPSB will conform to the Conduct Rules of the NASD and
the securities laws of any jurisdiction in which it
directly or indirectly sells any Shares.
(b) FPSB will require each dealer with whom FPSB has a selling
agreement to conform to the applicable provisions of the
Prospectus, with respect to the public offering price of the
Shares, and FPSB shall not cause the Trust to withhold the
placing of purchase orders so as to make a profit thereby.
(c) The Trust and Smith Breeden agree to furnish to FPSB
sufficient copies of any and all: agreements, plans,
communications with the public or other materials which the Trust
or Smith Breeden intend to use in connection with any sales of
Shares, in adequate time for FPSB to file and clear such
materials with the proper authorities before they are put in use.
FPSB and the Trust or Smith Breeden may agree that any such
material does not need to be filed subsequent to distribution.
In addition, the Trust and Smith Breeden agree not to use any
such materials until so filed and cleared for use, if required,
by appropriate authorities as well as by FPSB.
(d) FPSB, at its own expense, will qualify as a dealer or
broker, or otherwise, under all applicable state or
federal laws required in order that the Shares may be
sold in such states as may be mutually agreed upon by
the Parties.
(e) FPSB shall remain registered with the U.S. Securities
and Exchange Commission and a member of the National
Association of Securities Dealers for the term of this
Agreement.
(f) FPSB shall not, in connection with any sale or
solicitation of a sale of the Shares, make or authorize
any representative, service organization, broker or
dealer to make any representations concerning the
Shares, except those contained in the Prospectus
offering the Shares and in communications with the
public or sales materials approved by FPSB as
information supplemental to such Prospectus. Copies of
the Prospectus will be supplied by the Trust or Smith
Breeden to FPSB in reasonable quantities upon request.
(g) FPSB shall only be authorized to make representations in
respect of the Trust consistent with the then current Prospectus,
Statement of Additional Information, and other written
information provided by the Trust or its agents to be used
explicitly with respect to the sale of Shares.
5. Records to be Supplied by the Trust.
The Trust shall furnish to FPSB copies of all information,
financial statements and other papers which FPSB may
reasonably request for use in connection with the
underwriting of the Shares including, but not limited to,
one certified copy of all financial statements prepared for
the Trust by its independent public accountants.
6. Expenses.
(a) The Trust will bear the following expenses:
(i) preparation, setting in type, and printing of
sufficient copies of the Prospectus and Statement
<PAGE>
3
of Additional Information for distribution to
shareholders, and the cost of distribution of
same to the shareholders;
(ii) preparation, printing and distribution of reports
and other communications to shareholders;
(iii)registration of the Shares under the federal
securities laws;
(iv) qualification of the Shares for sale in the
jurisdictions as directed by the Trust;
(v) maintaining facilities for the issue and transfer
of the Shares;
(vi) supplying information, prices and other data to
be furnished by the Trust under this Agreement;
and
(vii)any original issue taxes or transfer taxes
applicable to the sale or delivery of the Shares
or certificates therefor.
(b) Smith Breeden will pay all other expenses incident to
the sale and distribution of the Shares sold hereunder.
(d) FPSB agrees to pay all of its own expenses in performing its
obligations hereunder.
7. Term and Compensation.
(a) The term of this Agreement shall commence on the date
on hereinabove first written (the "Effective Date").
(b) This Agreement shall remain in effect for one (1) year
from the Effective Date. This Agreement shall continue
thereafter for periods not exceeding one (1) year, if
approved at least annually (i) by a vote of a majority
of the outstanding voting securities of each Series; or
(ii) by a vote of a majority of the Trustees of the
Trust who are not parties to this Agreement (other than
as Trustees of the Trust) or interested persons of any
such party, cast in person at a meeting called for the
purpose of voting on such approval.
(c) Fees payable to FPSB shall be paid by Smith Breeden as
set forth in Schedule "B" attached and shall be fixed
for the one (1) year period commencing on the Effective
Date of this Agreement. Thereafter, the fee schedule
will be subject to annual review and adjustment.
(d) This Agreement (i) may be terminated at any time
without the payment of any penalty, either by a vote of
the Trustees of the Trust or by a vote of a majority of
the outstanding voting securities of each Series with
respect to such Series, on sixty (60) days' written
notice to FPSB; and (ii) may be terminated by FPSB on
sixty (60) days' written notice to the Trust with
respect to any Series.
(e) This Agreement shall automatically terminate in the event of
its assignment, as defined in the Investment Company Act of 1940.
8. Indemnification of FPSB by Smith Breeden and the Trust.
FPSB is responsible for its own conduct and the employment,
control, and conduct of its agents and employees and for
injury to such agents or employees or to others caused by
it, its agents or employees. Notwithstanding the above.
Smith Breeden and the Trust will indemnify and hold FPSB
harmless for the actions of Smith Breeden's employees
registered with the NASD as registered representatives of
<PAGE>
4
FPSB, and Smith Breeden hereby undertakes to maintain
compliance with all NASD and U.S. Securities and Exchange
Commission rules and regulations concerning any activities
of such employees.
9. Liability of FPSB.
(a) FPSB, its directors, officers, employees, shareholders
and agents shall not be liable for any error of
judgement or mistake of law or for any loss suffered by
the Trust in connection with the performance of this
Agreement, except a loss resulting from a breach of
FPSB's obligations pursuant to Section 4 of this
Agreement (Rules of NASD), a breach of fiduciary duty
with respect to the receipt of compensation for
services or a loss resulting from willful misfeasance,
bad faith or gross negligence on the part of FPSB in
the performance of its obligations and duties or by
reason of its reckless disregard of its obligations and
duties under this Agreement. FPSB agrees to indemnify
and hold harmless the Trust and each person who has
been, is, or may hereafter be a Trustee, officer, or
employee of the Trust against expenses reasonably
incurred by any of them in connection with any claim or
in connection with any action, suit, or proceeding to
which any of them may be a party, which arises out of
or is alleged to arise out of any misrepresentation or
omission to state a material fact, or out of any
alleged misrepresentation or omission to state a
material fact, on the part of FPSB or any agent or
employee of FPSB or any other person for whose acts
FPSB is responsible or is alleged to be responsible
unless such misrepresentation or omission was made in
reliance upon written information furnished to FPSB by
the Trust. FPSB also agrees to indemnify and hold
harmless the Trust and each such person in connection
with any claim or in connection with any action, suit,
or proceeding which arises out of or is alleged to
arise out of FPSB=s failure to exercise reasonable care
and diligence with respect to its services rendered in
connection with the purchase and sale of Shares. The
foregoing rights of indemnification shall be in
addition to any other rights to which the Trust or any
such person shall be entitled to as a matter of law.
(b) The Trust agrees to indemnify and hold harmless FPSB
against any and all liability, loss, damages, costs or
expenses (including reasonable counsel fees) which FPSB
may incur or be required to pay hereafter, in
connection with any action, suit or other proceeding,
whether civil or criminal, before any court or
administrative or legislative body, in which FPSB may
be involved as a party or otherwise or with which FPSB
may be threatened, by reason of the offer or sale of
the Trust=s Shares by persons other than FPSB or its
representatives, prior to the execution of this
Agreement. If a claim is made against FPSB as to which
FPSB may seek indemnity under this Section, FPSB shall
notify the Trust promptly after any written assertion
of such claim threatening to institute an action or
proceeding with respect thereto and shall notify the
<PAGE>
5
Trust promptly of any action commenced against FPSB
within 10 days time after FPSB shall have been served
with a summons or other legal process, giving
information as to the nature and basis of the claim.
Failure to notify the Trust shall not, however, relieve
the Trust from any liability which it may have on
account of the indemnity under this Section 9(b) if the
Trust has not been prejudiced in any material respect
by such failure. The Trust shall have the sole right
to control the settlement of any such action, suit or
proceeding subject to FPSB's approval, which shall not
be unreasonably withheld. FPSB shall have the right to
participate in the defense of an action or proceeding
and to retain its own counsel, and the reasonable fees
and expenses of such counsel shall be borne by the
Trust (which shall pay such fees, costs and expenses at
least quarterly) if:
(i) FPSB has received an opinion of counsel
stating that the use of counsel chosen by the
Trust to represent FPSB would present such
counsel with a conflict of interest;
(ii) the defendants in, or targets of, any
such action or proceeding include both FPSB
and the Trust, and legal counsel to FPSB
shall have reasonably concluded that there
are legal defenses available to it which are
different from or additional to those
available to the Trust or which may be
adverse to or inconsistent with defenses
available to the Trust (in which case the
Trust shall not have the right to direct the
defense of such action on behalf of FPSB); or
(iii) the Trust shall authorize FPSB to employ
separate counsel at the expense of the Trust.
(c) Any person, even though also a director, officer,
employee, shareholder or agent of FPSB, who may be or
become an officer, director, Trustee, employee or agent
of the Trust, shall be deemed, when rendering services
to the Trust or acting on any business of the Trust
(other than services or business in connection with
FPSB's duties hereunder), to be rendering such services
to or acting solely for the Trust and not as a
director, officer, employee, shareholder or agent, or
one under the control or direction of FPSB even though
receiving a salary from FPSB.
(d) The Trust agrees to indemnify and hold harmless FPSB,
and each person who controls FPSB within the meaning of
Section 15 of the Securities Act of 1933, as amended
(the "Securities Act"), or Section 20 of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"),
against any and all losses, claims, damages and
liabilities, joint or several (including any reasonable
investigative, legal and other expenses incurred in
connection therewith) to which they, or any of them,
may become subject under the Act, the Securities Act,
the Exchange Act or other federal or state law or
regulation, at common law or otherwise insofar as such
losses, claims, damages or liabilities (or actions,
suits or proceedings in respect thereof) arise out of
<PAGE>
6
or are based upon any untrue statement or alleged
untrue statement of a material fact contained in a
Prospectus, Statement of Additional Information,
supplement thereto, sales literature (or other written
information) prepared by the Trust and furnished by the
Trust to FPSB for FPSB's use hereunder, disseminated by
the Trust or which arise out of or are based upon any
omission or alleged omission to state therein a
material fact required to be stated therein or
necessary to make the statements therein not
misleading.
Such indemnity shall not, however, inure to the benefit
of FPSB (or any person controlling FPSB) on account of
any losses, claims, damages or liabilities (or actions,
suits or proceedings in respect thereof) arising from
the sale of the Shares of the Trust to any person by
FPSB (i) if such untrue statement or omission or
alleged untrue statement or omission was made in the
Prospectus, Statement of Additional Information, or
supplement, sales or other literature, in reliance upon
and in conformity with information furnished in writing
to the Trust by FPSB specifically for use therein or
(ii) if such losses, claims, damages or liabilities
arise out of or are based upon an untrue statement or
omission or alleged untrue statement or omission found
in any Prospectus, Statement of Additional Information,
supplement, sales or other literature, subsequently
corrected, but negligently distributed by FPSB and a
copy of the corrected Prospectus was not delivered to
such person at or before the confirmation of the sale
to such person.
(e) FPSB shall not be responsible for any damages,
consequential or otherwise, which Smith Breeden or the
Trust may experience, due to the disruption of the
distribution of Shares caused by any action or inaction
of any registered representative or affiliate of FPSB
or of FPSB itself.
10. Amendments.
No provision of this Agreement may be amended or modified in
any manner whatsoever, except by a written agreement
properly authorized and executed by the Parties.
11. Section Headings.
Section and paragraph headings are for convenience only and
shall not be construed as part of this Agreement.
12. Reports.
FPSB shall prepare reports for the Board of Trustees of the
Trust, on a quarterly basis, showing such information as,
from time to time, shall be reasonably requested by the
Board.
13. Severability.
If any part, term or provision of this Agreement is held by
any court to be illegal, in conflict with any law or
otherwise invalid, the remaining portion or portions shall
be considered severable and not affected, and the rights and
obligations of the Parties shall be construed and enforced
<PAGE>
7
as if the Agreement did not contain the particular part,
term or provision held to be illegal or invalid provided
that the basic agreement is not thereby substantially
impaired.
14. Governing Law.
This Agreement shall be governed by the laws of the
Commonwealth of Pennsylvania and the exclusive venue of any
action arising under this Agreement shall be Montgomery
County, Commonwealth of Pennsylvania.
15. Authority to Execute
The Parties represent and warrant to each other that the
execution and delivery of this Agreement by the undersigned
officer of each Party has been duly and validly authorized;
and, when duly executed, this Agreement will constitute a
valid and legally binding and enforceable obligation of each
Party.
IN WITNESS WHEREOF, the Parties hereto have caused this Agreement
consisting of ten type written pages, together with Schedule "A",
Schedule "B", and Schedule "C", to be signed by their duly
authorized officers, as of the day and year first above written.
Smith Breeden Associates, Inc. FPS Broker Services,
Inc.
By: Marianthe S. Mewkill By: Kenneth J. Kempf
Chief Financial Officer President
Smith Breeden Series Fund
By: Marianthe S. Mewkill
Vice President
<PAGE>
8
Schedule "A"
Underwriter/Sponsor Services
for
Smith Breeden Series Fund
I. Underwriter/Sponsor services include:
A) Preparation and execution of Underwriter and 12b-1 Plan
Agreements
! Monitoring accruals
! Monitoring expenses
! Disbursements for expenses and trail commissions
B) Quarterly 12b-1 Reports to Board of Trustees
C) Literature review, recommendations and submission to
the NASD
D) Initial NASD Licensing and Transfers of Registered
Representatives
! U-4 Form and Fingerprint Submission to NASD
! Supplying Series 6 and 63 written study material
! Registration for Exam Preparation classes
! Renewals and Terminations of Representatives
E) Written supervisory procedures and manuals for
Registered Representatives
F) Ongoing compliance updates for Representatives
regarding sales practices, written correspondence and
other communications with the public.
G)NASD Continuing Education Requirement
<PAGE>
9
Schedule "B"
Statutory Underwriter Schedule
for
Smith Breeden Series fund
This Fee Schedule is fixed for a period of one (1) year from the
Effective Date as that term is defined in the Agreement.
I. Statutory Underwriter Services
A) The Trust agrees to pay FPS Broker Services, Inc. (FPSB)
$15,000 for the services performed under this Agreement.
B) FPSB agrees register certain employees of Smith Breeden
Associates, Inc., as its representatives follows:
Up to 10 States: $2,000 per Representative per Year
All 50 States: $4,000 per Representative per Year
Schedule "C"
Identification of Series
Below are listed the Series and Classes of Shares to which
services under this Agreement are to be performed as of the
Effective Date of this Agreement:
ASmith Breeden Series Fund@
1. Smith Breeden Short Duration U.S. Government Fund
2. Smith Breeden Intermediate Duration U.S. Government Fund
This Schedule "C" may be amended from time to time by agreement
of the Parties.
<PAGE>
10
