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PROSPECTUS/DECEMBER 22, 1997
[SMITH BREEDEN LOGO]
SMITH BREEDEN
-----------------------
M U T U A L F U N D S
- Equity Market Plus Fund
- Financial Services Fund
- Short Duration U.S. Government Fund
- Intermediate Duration U.S. Government Fund
"We are pleased to announce the introduction of our newest fund -- the Smith
Breeden Financial Services Fund. This fund, like our others, aims to deliver
professional investment strategies that focus on performance and risk
control."
<TABLE>
<S> <C>
/s/ DOUGLAS T. BREEDEN /s/ MICHAEL J. GIARLA
Douglas T. Breeden Michael J. Giarla
Chairman President
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[INTENTIONAL LEFT BLANK PAGE]
<PAGE>
[SMITH BREEDEN LOGO]
NOT PART OF THE PROSPECTUS
Dear Investor,
Thank you for selecting Smith Breeden No-Load Mutual Funds. Enclosed
is the information you requested.
How Your Fund is Managed -- Please read the enclosed prospectus
booklet carefully to learn about the potential rewards and risks of
each fund before you invest or send money. Please call us at
800-221-3138 if you have questions.
How To Invest -- To invest, simply complete the separate account
application. Please return the application with a check payable to
Smith Breeden Mutual Funds ($1000 initial minimum for each fund,
$250 minimum for Uniform Gifts to Minors and Retirement accounts,
$50 subsequent minimum purchase) using the enclosed postage paid
envelope. Shares may also be purchased by bank wire transfer or
through leading computerized fund trading systems.
We Will Keep You Informed -- You will receive an account statement
each time you buy or sell shares, and whenever your fund pays or
reinvests a dividend. The share prices of most Smith Breeden funds
are published daily in the mutual fund section of major newspapers
or simply call us at 800-221-3138 for prices and dividend
information.
Again, thank you for selecting Smith Breeden Mutual Funds.
Sincerely,
/s/ DOUGLAS T. BREEDEN /s/ MICHAEL J. GIARLA
Douglas T. Breeden Michael J. Giarla
Chairman President
<PAGE>
[SMITH BREEDEN LOGO]
NOT PART OF THE PROSPECTUS
Fund Spotlight:
Short Duration US Govt Fund
Intermediate Duration US Govt Fund
Fund Managers:
[PHOTO OF DANIEL C. DEKTAR] [PHOTO OF TIMOTHY D. ROWE]
Daniel C. Dektar Timothy D. Rowe
Smith Breeden's goal is to design funds that target the risk profile of
specific asset classes and not deviate from those risk targets. Our focus is on
risk target stability, as well as delivering returns that exceed relevant
benchmarks.
The Short Duration Fund is positioned to be a step up from money market
funds. Our goal is to maintain a very low risk profile -- about the same as a
6-month Treasury Bill.
Our Intermediate Duration Fund also has a specific risk target: the Salomon
Brothers Mortgage Index, whose risk should be similar to a 3-5 year maturity
Treasury Note. Of course while Treasury Bills and Notes are U.S. Government
insured and offer a fixed rate of return, the U.S. Government does not
guarantee mutual fund performance. All bond funds experience some fluctuation
in principal and yield.
Smith Breeden's expertise is in finding undervalued securities in the
mortgage-backed securities market. We've been successful in creating total
returns in the mortgage market that are above what you'd expect for the risks
we have taken. We call these "excess returns."
Mortgage-backed securities can be prepaid by homeowners. That possibility
generally results in higher yields but a different risk profile than, say,
non-callable corporate bonds. Our expertise in protecting against mortgage
prepayment risk is a key feature in each of these bond funds.
We are willing to spend part of the higher yield that mortgage securities
provide to pay for the cost of hedging (protecting) our investments from
homeowner prepayment risk. With both of our bond funds, our goal is to mimic
the risk profile of our benchmarks but deliver higher total returns.
Fund Spotlight:
Equity Market Plus Fund
Fund Manager:
[PHOTO OF JOHN B. SPROW]
John B. Sprow
I am often asked about the unique strategy used by the Equity Market Plus
Fund. So I would like to discuss how the Fund works.
The Equity Market Plus Fund, like our bond funds, is designed to match the risk
profile of a specific benchmark. In this case it's the S&P 500 stock index. But
unlike a purely passive index fund, we use a strategy designed to outperform
the S&P 500 without adding additional equity market risk.
The Equity Market Plus Fund can be viewed as comprising income and equity
segments. The income segment invests in a combination of U.S. Government Agency
mortgage securities, hedged to a low level of interest rate risk, a strategy
similar to that of our Short Duration bond fund. The Equity segment invests in
S&P 500 index futures contracts. (S&P 500 index futures contracts only require
the posting of 5% margin, so 95% of the cash in the Fund is available to invest
in the income segment.) When the "excess" returns we generate in the income
segment (using our expertise in the mortgage markets) exceed the funding cost
of the S&P 500 futures contracts plus the operating expenses incurred by the
Fund, the Fund is able to outperform the S&P 500 Index.
While S&P 500 futures contracts are designed to track the S&P 500 index, they
are not stocks and their performance can differ from the actual S&P index.
Smith Breeden was one of the first firms to implement this institutional
strategy in a no-load mutual fund and we've been very pleased with the results.
DFU 7/97
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Past performance is not indicative of future results. Share prices and returns
will fluctuate and when redeemed, shares may be worth more or less than their
original investment. There are special risks associated with investing in
futures and option contracts which may or may not be suitable for all
investors.
<PAGE>
[SMITH BREEDEN LOGO]
NOT PART OF THE PROSPECTUS
Fund Spotlight:
Financial Services Fund
Fund Managers:
[PHOTO OF [PHOTO OF [PHOTO OF
DOUGLAS T. BREEDEN] MICHAEL J. GIARIA] ROBERT B. PERRY]
DOUGLAS T. BREEDEN] Michael J. Giaria Robert B. Perry
Smith Breeden Associates began life in 1982 as a business consultant to
financial services firms. These past 15 years, the firm has had extensive
consulting relationships with over 50 financial firms. Additionally, Smith
Breeden's principals have made substantial investments in financial services
firms. With such depth of specialized experience, managing a financial services
mutual fund is a natural extension of our expertise.
Successful analysis of investments in the financial services sector depends on
understanding the internal workings of the companies themselves, the industry
in which they operate, how that industry is regulated, and how it is impacted
by economic events. Here we are uniquely qualified.
My work teaching graduate level courses in banking as well as serving as Editor
for the Journal of Fixed Income helps enormously in keeping our investment
research techniques at the leading edge of this rapidly changing
industry. Assisting me in managing this portfolio will be Michael J. Giarla,
President of Smith Breeden and Robert B. Perry, a Principal of Smith Breeden,
both of whom have extensive experience in consulting for financial
institutions. Our goal is to invest in firms where the values seem reasonable
in relation to the growth prospects and risks of the firms. Banks, thrifts,
financial and leasing companies, brokerage, investment banking and advisory
firms, these are the primary types of firms we analyze.
Knowing that the fortunes of these firms can be related to changes in the
market and in interest rates, we may also seek to protect investments in this
area through the use of interest rate and equity futures and options,
securities in which we have extensive experience. Although all investments
involve a degree of risk, and we can't guarantee future results, we are
confident that our skills and unique qualifications will provide investors with
the potential to reap the rewards from the dynamic financial services sector.
DFU 12/97
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Past performance is not indicative of future results. Share prices and returns
will fluctuate and when redeemed, shares may be worth more or less than their
original investment. There are special risks associated with investing in
futures and option contracts which may or may not be suitable for all
investors.
<PAGE>
[SMITH BREEDEN LOGO]
NOT PART OF THE PROSPECTUS
Tips for Successful Investing
1. Invest Regularly. Most mutual fund share prices fluctuate, and we
do not believe that anyone can predict future share prices. By
investing at regular intervals you don't have to worry about buying
at the "right" time. With regular periodic investing you are more
likely to buy shares at a variety of prices and achieve an average
purchase price that is satisfactory. Smith Breeden has an automatic
investment plan that makes regular investing easy.1
2. Invest For The Long Term. You should expect daily fluctuations in
the performance of most mutual funds. Short-term fluctuations may
result in gains or losses. But mutual fund performance over longer
(monthly, annual or multi-year) periods tend to be less volatile. By
focusing on the long-term, you are less likely to sell your shares
prematurely due to daily news events.
3. Defer Taxes When Possible. If you can invest through an IRA
(Individual Retirement Account) or other tax-deferred account, you
will benefit from compounded returns on a portion of investment
gains you might otherwise pay in federal or state income taxes. Such
compounded returns can increase your overall investment success.
Please call us at 800-221-3138 if you wish to set up a Smith Breeden
IRA account or have other questions.
1Dollar cost averaging does not guarantee a profit or loss against a
declining market and an investor should consider his or her ability
to continue investing through periods of low price levels.
DFU 7/97
<PAGE>
[SMITH BREEDEN LOGO]
Dear Shareholder:
We are delighted to share with you the addition of The Financial Services Fund
to the Smith Breeden group of mutual funds. The Financial Services Fund seeks
capital appreciation through investment of its assets in U.S. and foreign
financial services companies. The investments include banks, thrifts, finance
and leasing companies, brokerage, investment banking and advisory firms, real
estate related firms and insurance companies.
Since its inception in 1982, Smith Breeden Associates, Inc. has had extensive
consulting relationships with over 50 financial services companies. The
principals of Smith Breeden have made and continue to retain substantial
investments in financial services firms. From this unique depth of specialized
experience and "Hands On" knowledge of the industry, the Smith Breeden
Financial Services Fund has been created and launched. The Fund is comanaged by
three principals of Smith Breeden with combined experience in the financial
services industry of over 30 years. Highlights of their experience and
background are detailed below.
Fund Manager Douglas T. Breeden: Dr. Breeden, the Chairman of the Board of
Smith Breeden Associates, co-founded the firm in 1982. He has served on
business school facilities 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. Dr. Breeden is the Editor of the
Journal of Fixed Income. He has served as Associate Editor for five journals in
financial economics, and was elected to the Board of Directors of the American
Finance Association. He 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.
Fund Manager Michael J. Giarla: Mr. Giarla is Chief Operating Officer,
President and Director of Smith Breeden Associates and has been with the firm
since 1985. 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. 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.
Fund Manager Robert F. Perry: Mr. 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
affects of interest rate and economic changes. 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.
Please read the enclosed prospectus for more detailed and complete information
on the new Financial Services Fund. It also includes complete and updated
information of the Smith Breeden Mutual Funds in which you are already
invested.
Thank you for your continued trust in the Smith Breeden Mutual Funds. Please
visit our website @ www.smithbreeden.com for daily performance and portfolio
manager updates.
Sincerely,
/s/ Marianthe S. Mewkill
Marianthe S. Mewkill
Chief Financial Officer, Smith Breeden Mutual Funds
enclosures
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Past performance is no guarantee of future results. Please read enclosed
prospectus for more complete information including management fees and
expenses. Read it carefully before you invest or send money. Share prices and
returns will fluctuate and when redeemed, shares may be worth more or less than
their original investment. There are special risks associated with investing in
futures and option contracts which may or may not be suitable for all
investors. DISTRIBUTOR; FPS BROKER SERVICES, INC. 800/221-3137 12/97
<PAGE>
[SMITH BREEDEN LOGO]
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.
1
<PAGE>
[SMITH BREEDEN LOGO]
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.........................14
Management of the Funds....................................................18
Pricing of Fund Shares.....................................................22
How to Purchase Shares.....................................................23
How to Exchange Shares.....................................................25
How to Redeem Shares.......................................................25
Dividends and Distributions................................................27
Shareholder Reports and Information........................................28
Retirement Plans...........................................................29
Service and Distribution Plans.............................................28
Taxes......................................................................28
Capital Structure..........................................................30
Transfer, Dividend Disbursing Agent, Custodian and
Independent Accountants...................................................30
Fund Performance...........................................................30
No person has been authorized to give any information or to make any
representations not contained in this Prospectus and, if given or made, such
information or representations must not be relied upon as having been
authorized by the Funds. The Prospectus does not constitute an offering by the
Funds in any jurisdiction in which such offering may not be lawfully made.
2
<PAGE>
[SMITH BREEDEN LOGO]
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.
</TABLE>
<TABLE>
<CAPTION>
Equity
Market Financial
Plus Services Short Intermediate
Fund Fund Fund Fund
<S> <C> <C> <C> <C>
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%
</TABLE>
- -------------------------
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.
3
<PAGE>
[SMITH BREEDEN LOGO]
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
<TABLE>
<CAPTION>
1 Year 3 Years 5 Years 10 Years
------------ --------- --------- ---------
<S> <C> <C> <C>
$ 8 $ 26 $ 45 $ 99
</TABLE>
Intermediate Duration Fund and Equity Market Plus Fund
<TABLE>
<CAPTION>
1 Year 3 Years 5 Years 10 Years
------- --------- --------- ---------
<S> <C> <C> <C>
$ 9 $ 29 $ 50 $ 111
</TABLE>
Financial Services Fund
<TABLE>
<CAPTION>
1 Ye ar 3 Years 5 Years 10 Years
------------ --------- --------- ---------
<S> <C> <C> <C>
$ 16 $ 49 $ 84 $ 184
</TABLE>
These examples are based on the annual operating expenses shown above and
should not be considered a representation of past or future expenses or
performance. Actual expenses may be greater or less than those shown. The
annual rate of return may be more or less than 5%.
The Funds may be recommended to investors by registered investment
advisors. Such advisors customarily impose fees that would be in addition to
any fees and expenses presented in the above table. Certain broker- dealers may
also charge a fee for purchase or redemption of shares through their
network. Neither the Funds, nor the Adviser, exercise any control over such
advisory or broker-dealer fees and may not be informed of the level of such
fees.
4
<PAGE>
[SMITH BREEDEN LOGO]
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.
<TABLE>
<CAPTION>
Six Months
Ended Year Ended Year Ended Year Ended Year Ended Period Ended
September 30, March 31, March 31, March 31, March 31, March 31,
1997 1997 1996 1995 1994 1993
--------------- ------------- ------------ ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Net Asset Value, Beginning of
Period .............................. $12.56 $12.27 $10.84 $ 9.88 $10.85 $10.00
----------- ----------- ---------- ---------- ---------- --------
Income From Investment Operations
- ---------------------------------------
Net investment income .................. 0.250 0.592 0.615 0.568 0.476 0.355
Net realized and unrealized gain (loss)
on Investments ........................ 2.877 1.813 2.768 1.081 ( 0.216) 1.281
----------- ----------- ---------- ---------- ---------- --------
Total from investment operations ...... 3.127 2.405 3.383 1.649 0.260 1.636
----------- ----------- ---------- ---------- ---------- --------
Less Distributions
- -----------------------------------------
Dividends from net investment
income .............................. ( 0.230) ( 0.590) ( 0.583) ( 0.568) ( 0.472) ( 0.311)
Dividends in excess of net investment
income .............................. -- -- -- ( 0.001) -- --
Distributions from net realized gains
on Investments ........................ ( 0.247) ( 1.525) ( 1.370) ( 0.047) ( 0.701) ( 0.420)
Distributions in excess of net realized
gains on Investments .................. -- -- -- ( 0.073) ( 0.057) ( 0.055)
----------- ----------- ---------- ---------- ---------- --------
Total distributions .................. ( 0.477) ( 2.115) ( 1.953) ( 0.689) ( 1.230) ( 0.786)
----------- ----------- ---------- ---------- ---------- --------
Net Asset Value, End of Period ......... $15.21 $12.56 $12.27 $10.84 $ 9.88 $10.85
=========== =========== ========== ========== ========== ========
Total Return ........................... 25.08 % 21.41 % 32.30 % 17.18 % 2.19 % 22.59 %*
Ratios/Supplemental Data
- -----------------------------------------
Net assets, end of period ............ $61,086,390 $13,507,377 $4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to average net assets
Before expense limitation ............ 1.28 %* 2.60 % 4.58 % 7.75 % 7.08 % 28.48 %*
After expense limitation ............ 0.88 %* 0.88 % 0.90 % 0.90 % 0.90 % 0.57 %*
Ratio of net income to average net
assets ..............................
Before expense limitation ............ 4.54 %* 3.58 % 1.85 % 0.59 % 1.84 % (22.63 %)*
After expense limitation ............ 4.95 %* 5.30 % 5.53 % 7.44 % 8.02 % 5.28 %*
Portfolio turnover rate ............... 196% 182% 107% 120% 119% 271%
</TABLE>
* Annualized
Additional performance information is presented in the Fund's Annual Report,
which is available without charge upon request.
5
<PAGE>
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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.
<TABLE>
<CAPTION>
Six Months
Ended Year Ended
September 30, March 31,
1997 1997
--------------- --------------
<S> <C> <C>
Net Asset Value, Beginning of Period..... $9.83 $9.74
------------ ------------
Income From Investment Operations
- -----------------------------------------
Net investment income .................. 0.261 0.476
Net gain (loss) on securities (both
realized and unrealized) ............... 0.059 0.146
------------ ------------
Total from investment operations ......... 0.320 0.622
------------ ------------
Less Distributions
- -------------------------------------------
Dividends from net investment income ... (0.260) (0.476)
Dividends in excess of net investment
income ................................. -- (0.056)
------------ ------------
Total distributions ..................... (0.260) (0.532)
------------ ------------
Net Asset Value, End of Period ......... $9.89 $9.83
============ ============
Total Return ........................... 3.30 % 6.57 %
Ratios/Supplemental Data
- -------------------------------------------
Net assets, end of period ............... $103,238,834 $118,988,609
Ratio of expenses to average net assets
Before expense limitation ............... 1.01 %* 0.93 %
After expense limitation ............... 0.78 %* 0.78 %
Ratio of net income to average net assets
Before expense limitation ............... 5.39 %* 4.90 %
After expense limitation ............... 5.62 %* 5.04 %
Portfolio turnover rate .................. 306% 556%
<CAPTION>
Year Ended Year Ended Year Ended Period Ended
March 31, March 31, March 31, March 31,
1996 1995 1994 1993
-------------- -------------- -------------- -------------
<S> <C> <C> <C> <C>
Net Asset Value, Beginning of Period...... $9.90 $9.90 $10.00 $10.00
------------ ------------ ------------ -----------
Income From Investment Operations
- -----------------------------------------
Net investment income .................. 0.621 0.628 0.432 0.552
Net gain (loss) on securities (both
realized and unrealized) ............... (0.148) -- (0.070) 0.002
------------ ------------ ------------ -----------
Total from investment operations ......... 0.473 0.628 0.362 0.554
------------ ------------ ------------ -----------
Less Distributions
- -------------------------------------------
Dividends from net investment income ... (0.621) (0.628) (0.462) ( 0.554)
Dividends in excess of net investment
income ................................. (0.012) -- -- --
------------ ------------ ------------ -----------
Total distributions ..................... (0.633) (0.628) (0.462) ( 0.554)
------------ ------------ ------------ -----------
Net Asset Value, End of Period ......... $9.74 $9.90 $ 9.90 $10.00
============ ============ ============ ===========
Total Return ........................... 4.95 % 6.58 % 3.67 % 5.67 %
Ratios/Supplemental Data
- -------------------------------------------
Net assets, end of period ............... $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to average net assets
Before expense limitation ............... 0.93 % 0.92 % 1.00 % 2.58 %
After expense limitation ............... 0.78 % 0.78 % 0.78 % 0.78 %
Ratio of net income to average net assets
Before expense limitation ............... 6.13 % 6.18 % 3.95 % 2.73 %
After expense limitation ............... 6.29 % 6.33 % 4.17 % 4.53 %
Portfolio turnover rate .................. 225 % 47 % 112 % 3%
</TABLE>
* Annualized
Additional performance information is presented in the Short Fund's Annual
Report, which is available without charge upon request.
6
<PAGE>
[SMITH BREEDEN LOGO]
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.
<TABLE>
<CAPTION>
Six Months
Ended Year Ended Year Ended Year Ended Year Ended Period Ended
September 30, March 31, March 31, March 31, March 31, March 31,
1997 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 1.05 0.826
Net gain (loss) on securities (both
realized and unrealized) ............ 0.328 (0.024) 2.77 (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) (0664) (1.044) (0826)
Dividends in excess of net investment
income .............................. -- -- -- (0108) -- --
Distributions from net realized gains
on Investments ........................ -- (0.251) (0.101) -- (0015) --
Distributions in excess of net realized
gains on Investments .................. -- -- -- (0.022) -- --
----------- ----------- ----------- ----------- ---------- ----------
Total distributions .................. (0.280) (0.855) (0.757) (0.794) (1.059) (0826)
----------- ----------- ----------- ----------- ---------- ----------
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 ..............................
Before expense limitation ............ 1.04 %* 1.16 % 1.14 % 2.33 % 2.34 % 17.52 %
After expense limitation ............ 0.88 %* 0.88 % 0.90 % 0.90 % 0.90 % 0.82 %
Ratio of net income to average net
assets ..............................
Before expense limitation ............ 5.53 %* 5.92 % 6.26 % 4.77 % 6.30 % ( 8.52 %)
After expense limitation ............ 5.69 %* 6.19 % 6.49 % 6.20 % 7.74 % 8.18 %
Portfolio turnover rate ............... 162 % 409 % 193 % 557 % 84 % 42%
</TABLE>
*Annualized
Additional performance information is presented in the Intermediate Fund's
Annual Report, which is available without charge upon request.
7
<PAGE>
[SMITH BREEDEN LOGO]
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 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
8
<PAGE>
[SMITH BREEDEN LOGO]
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 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.
9
<PAGE>
[SMITH BREEDEN LOGO]
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 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 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
10
<PAGE>
[SMITH BREEDEN LOGO]
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 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
11
<PAGE>
[SMITH BREEDEN LOGO]
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 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 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.
12
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[SMITH BREEDEN LOGO]
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 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 maturity
characteristics corresponding to their underlying assets. Unlike traditional
debt securities, which may pay a fixed rate of interest until maturity
13
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[SMITH BREEDEN LOGO]
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 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.
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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 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 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
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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 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.
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Reverse repurchase agreements and dollar rolls are considered borrowings by a
Fund and require segregation of assets with a Fund's custodian in an amount
equal to the Fund's obligations pending completion of such transactions. Each
Fund may also borrow money from banks in an amount up to 33 1/3% of a Fund's
total assets to realize investment opportunities, for extraordinary or
emergency purposes, or for the clearance of transactions. Borrowing from banks
usually involves certain transaction and ongoing costs and may require a Fund
to maintain minimum bank account balances. Use of these borrowing techniques to
purchase securities is a speculative practice known as "leverage." Depending on
whether the performance of the investments purchased with borrowed funds is
sufficient to meet the costs of borrowing, a Fund's net asset value per share
will increase or decrease, as the case may be, more rapidly than if the Fund
did not employ leverage.
Short Sales. The Funds may make short sales of securities. A short sale is a
transaction in which the Fund sells a security it does not own in anticipation
that the market price of that security will decline. The 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 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
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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 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
* Interested Person
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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.
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.
Stephen M. Schaefer Trustee
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at the London
Business School. Previously on the Faculty of the Graduate School of Business
of Stanford University, he has also taught at the Universities of California
(Berkeley), Chicago, British Columbia and Venice. His research interests focus
on capital markets and financial regulation. He served on the editorial board
of a number of professional journals including, currently, the Journal of Fixed
Income, the Review of Derivative Research, and Ricerche Economiche. He consults
for a number of leading financial institutions and is a former Independent
Board Member of the Securities and Futures Authority of Great Britain.
Myron S. Scholes Trustee
Myron S. Scholes is a Principal in the money management firm Long-Term Capital
Management Co. (since 1993). He is the Frank E. Buck Professor of Finance
Emeritus at the Graduate School of Business at Stanford University (since
1983). He is a member of the Econometric Society. Professor Scholes was also a
Managing Director and co-head of the fixed income derivatives group at Salomon
Brothers between 1991-1993. Prior to coming to Stanford University in 1983,
Professor Scholes was the Edward Eagle Brown Professor of Finance at the
Graduate School of Business, University of Chicago (1974-1983). He served as
the Director of the University of Chicago's Center for Research in Security
Prices from 1974-1980. Prior to coming to the University of Chicago, Professor
Scholes was first an Assistant Professor then an Associate Professor at the
Sloan School of Management at M.I.T. from 1968 to 1973. He received his
Ph.D. in 1969 from the Graduate School of Business, University of Chicago. He
has honorary Doctor of Law degrees from the University of Paris and McMaster
University. He is a past president of the American Finance Association (1990).
Dr. Scholes has published numerous articles in academic journals and in
professional volumes. He is most noted as the 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.
* Interested Person
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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
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. In December
1997, Timothy D. Rowe joined Mr. Dektar as co-Portfolio Manager of the
Intermediate Fund, and shares 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
Timothy D. Rowe is a Principal, Director, and Vice President of Smith Breeden
Associates. Mr. Rowe, in conjunction with Daniel C. Dektar, is 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.
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John B. Sprow Vice President, Smith Breeden Trust
Portfolio Manager, Equity Market Plus Fund
John B. Sprow is a Principal, Director and Executive Vice President of Smith
Breeden Associates. Mr. Sprow has been primarily responsible for the day-to-day
management of the Equity 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 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.
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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, 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.
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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."
<TABLE>
<CAPTION>
Initial Minimum Additional Minimum
Type of Account Investment Investment
<S> <C> <C>
Regular $1000 $50
Automatic Investment Plan None $50
Individual Retirement Account $250 $50
Gift to Minors $250 $50
</TABLE>
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 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
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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 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 safekeeping and delivery of stock
certificates, the Funds do not currently issue certificates.
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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 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
25
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[SMITH BREEDEN LOGO]
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.
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 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.
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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 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
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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 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 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
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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 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.
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The Funds will be required to withhold federal income tax at a rate of 31%
("backup withholding") from distribution payments and redemption and exchange
proceeds if you fail to properly complete the Purchase Application.
The foregoing is only a summary of some of the important federal tax
considerations generally affecting each Fund and its shareholders. See "Taxes"
in the relevant Statement of Additional Information for further
discussion. There may be other federal, state or local tax considerations
applicable to you as an investor. You therefore are urged to consult your tax
adviser regarding any tax-related issues.
CAPITAL STRUCTURE
The Smith Breeden Trust 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.
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
30
<PAGE>
[SMITH BREEDEN LOGO]
return which, if applied to an initial investment at the beginning of a stated
period and compounded over that period, would result in the redeemable value of
the investment at the end of the period assuming reinvestment of all dividends
and distributions and reflecting the effect of all recurring fees. An
investor's principal in each Fund and the Fund's return are not guaranteed and
will fluctuate according to market conditions. When considering "average" total
return figures for periods longer than one year, you should note that a Fund's
annual total return for any one year in the period might have been greater or
less than the average for the entire period. Each Fund also may use "aggregate"
total return figures for various periods, representing the cumulative change in
value of an investment in the Fund for a specific period (again reflecting
changes in the Fund's share price and assuming reinvestment of dividends and
distributions).
The Short and Intermediate Funds may also advertise current yield and
distribution rate information. Current yield reflects the income per share
earned by the Short or Intermediate Fund's portfolio investments, and is
calculated by dividing a Fund's net investment income per share during a recent
30-day period by a Fund's net asset value on the last day of that period and
annualizing the result. The current yield (or "SEC Yield"), which is calculated
according to a formula prescribed by the SEC (see the relevant Statement of
Additional Information), is not indicative of the dividends or distributions
which were or will be paid to a Fund's shareholders. SEC regulations require
that net investment income be calculated on a "yield-to-maturity" basis, which
has the effect of amortizing any premiums or discounts in the current market
value of fixed income securities. Dividends or distributions paid to
shareholders are reflected in the current distribution rate which may be quoted
to shareholders, and may not reflect amortization in the same manner.
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.
31
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<PAGE>
Shareholder Services
Account Inquiries, Balance
and Transaction Information
1-800-221-3137
Dealer Services
Current Prospectuses, Sales Literature
Yields, Prices, Fund Information
1-800-221-3138
Distributed by:
FPS Broker Services, Inc.
3200 Horizon Drive
P.0. Box 61503
King of Prussia, PA 19406-0903
[SMITH BREEDEN LOGO]
100 Europa Drive, Suite 200
Chapel Hill, NC 27514-2310
(919) 967-7221
<PAGE>
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
<PAGE>
SMITH BREEDEN MUTUAL FUNDS
ANNUAL REPORTS
Smith Breeden Short Duration U.S. Government Series
Smith Breeden Intermediate Duration U.S. Government Series
Smith Breeden Equity Plus Fund
March 31, 1997
May 8, 1997
Dear Fellow Shareholder:
Enclosed please find the annual report for the Smith Breeden
Mutual Funds for
the fiscal year ended March 31, 1997.
We are pleased to report that all three Smith Breeden Mutual Funds
continue to
maintain either four or five star ratings from Morningstar,
indicative of
strong risk-adjusted performance relative to their peers. As your
funds
celebrate their five-year anniversaries during 1997 (March 31 for
the Short and
Intermediate Series and June 30 for the Equity Plus Fund), you may
have noticed
an increase in their visibility in the financial press. The
Funds' philosophy,
management style and performance have been the subject of a number
of articles,
including a recent story in the May issue of Money magazine.
In an effort to make information more easily accessible to you, we
have
directed additional resources to our toll-free phone lines and
introduced
a Smith Breeden website. We hope you have a chance to visit the
website at
www.smithbreeden.com. The NAVs for all three funds are now listed
daily in
major newspapers such as The Wall Street Journal and The New York
Times.
The recent stock and bond market volatility has caused many people
to reassess
their investment strategies. At the Smith Breeden Mutual Funds we
endeavor to
make investing simple by offering a small number of funds --each
representing
a distinct domestic asset class and risk level -- stocks, bonds,
and cash.
Whatever your risk tolerance or target asset allocation, Smith
Breeden Mutual
Funds offers sound investment alternatives to help achieve your
goals.
The annual report begins with a discussion of each fund's
performance. Please
do not hesitate to call us if you have any questions about the
information
presented or if you have suggestions about how we might better
serve you. We
would like to thank the many shareholders who have paid us a
compliment by
either recommending Smith Breeden Mutual Funds to others or by
entrusting us to
manage a greater proportion of their investment dollars.
Thank you for your continued trust in the Smith Breeden Mutual
Funds.
Sincerely,
Douglas T. Breeden Michael J. Giarla
Chairman President
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 EQUITY PLUS FUND
STATEMENT OF ASSETS AND LIABILITIES
31-Mar-97
ASSETS:
Investments at market value (identified cost $16,394,418)
(Note 1) $16,422,411
Cash........................................................
62,780
Receivables:
Subscriptions............................................
180,877
Interest.................................................
53,648
Maturities...............................................
2,590
Securities sold.........................................
2,925,313
Deferred organization expenses (Note 1)...................
6,796
TOTAL ASSETS..........................................
19,654,415
LIABILITIES:
Variation margin on futures contracts (Note 2)..............
192,294
Payables:
Redemptions ..............................................
50,041
Securities purchased......................................
5,876,144
Due to adviser (Note 3).....................................
8,343
Accrued expenses.............................................
20,216
TOTAL LIABILITIES.........................................
6,147,038
NET ASSETS:
(Applicable to outstanding shares of 1,075,509; unlimited
number of shares
of beneficial interest authorized; no stated par).......
$13,507,377
Net asset value, offering price and redemption
price per share ($13,507,377/ 1,075,509)................
$12.56
SOURCE OF NET ASSETS:
Paid in capital.............................................
$13,094,357
Undistributed net investment income..........................
36,234
Accumulated net realized gain on investments.................
865,097
Net unrealized depreciation of investments...................
(488,311)
NET ASSETS............................................
$13,507,377
The accompanying notes are an integral part of these financial
statements.
35
SMITH BREEDEN EQUITY PLUS FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1997
INVESTMENT INCOME:
Interest and discount earned, net of premium amortization
(Note 1)...... $473,488
EXPENSES:
Advisory fees (Note
3)........................................... 53,341
Accounting and pricing services
fees........................... 25,141
Custodian
fees................................................. 13,067
Audit and tax preparation
fees.................................... 10,250
Legal
fees.......................................................
2,799
Amortization of organization expenses (Note 1)..........
27,791
Transfer agent
fees.............................................. 29,506
Registration
fees............................................... 27,132
Trustees fees and expenses...................................
3,751
Insurance expense....................................
6,549
Other.............................................................
. 40
TOTAL EXPENSES BEFORE REIMBURSEMENT............
199,367
Expenses reimbursed by Adviser (Note
3)....................... (131,965)
NET
EXPENSES................................................
67,402
NET INVESTMENT
INCOME....................................... 406,086
REALIZED AND UNREALIZED GAIN ON INVESTMENTS:
Net realized gain on
investments............................... 1,374,343
Change in unrealized appreciation (depreciation) of
investments (526,585)
Net realized and unrealized gain on
investments................ 847,758
Net increase in net assets resulting from operations.........
$1,253,844
The accompanying notes are an integral part of these financial
statements.
36
SMITH BREEDEN EQUITY PLUS FUND
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1997 March 31, 1996
OPERATIONS:
Net investment income....................... $406,086
$171,628
Net realized gain on investments............... 1,374,343
709,594
Change in unrealized appreciation (depreciation)
of investments..... (526,585)
(66,654)
Net increase in net assets resulting from
operations.................. 1,253,844
814,568
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment income.......... (382,446)
(159,034)
Distributions from net realized gains on
investments............ (808,371)
(371,974)
Total distributions........................ (1,190,817)
(531,008)
CAPITAL SHARE TRANSACTIONS:
Shares sold................................ 8,844,701
2,256,010
Shares issued on reinvestment of distributions 1,125,870
502,798
Shares redeemed.......................... (1,292,755)
(383,180)
Increase in net assets resulting from capital
share transactions (a) 8,677,816
2,375,628
TOTAL INCREASE IN NET ASSETS..... 8,740,843
2,659,188
NET ASSETS:
Beginning of year.......................... 4,766,534
2,107,346
End of year................................. $13,507,377
$4,766,534
(a) Transactions in capital shares were as follows:
Shares sold........................... 695,525
183,531
Shares issued on reinvestment of distributions 93,492
42,520
Shares redeemed........................ (102,037)
(32,004)
Net increase........................... 686,980
194,047
Beginning balance ..................... 388,529
194,482
Ending balance........................ 1,075,509
388,529
The accompanying notes are an integral part of these financial
statements.
37
SMITH BREEDEN EQUITY PLUS FUND
FINANCIAL HIGHLIGHTS
<TABLE>
The following average per share data, ratios and supplemental
information has been derived from information provided in the
financial statements.
<CAPTION>
Year Year Year Year Period
Ended Ended Ended Ended Ended
31-Mar-97 31-Mar-96 31-Mar-95 31-Mar-94 31-Mar-93*
<S>
<C> <C> <C> <C> <C>
Net Asset Value, Beginning of
Period...........................$12.27 $10.84
$9.88 $10.85 $10.00
Income From Investment Operations
Net investment income.........................................
0.592 0.615 0.568 0.476 0.355
Net realized and unrealized gain (loss) on
investments.........1.813 2.768 1.081 (0.216)
1.281
Total from investment operations..........................
2.405 3.383 1.649 0.26 1.636
Less Distributions
Dividends from net investment income..........................
(0.59) (0.583) (0.568) (0.472) (0.311)
Dividends in excess of net investment income..................
- - - 0.001 - -
Distributions from net realized gains on investments.........
(1.525) (1.37) (0.047) (0.701) (0.42)
Distributions in excess of net realized gains on investments.
- - - (0.073) (0.057) (0.055)
Total
distributions........................................(2.115)
(1.953) (0.689) (1.23) (0.786)
Net Asset Value, End of Period..............................
$12.56 $12.27 $10.84 $9.88 $10.85
Total Return....................................................
21.41% 32.30% 17.18% 2.19% 22.59%**
Ratios/Supplemental Data
Net assets, end of period................................
$13,507,377 $4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to average net assets <F1>.................
0.88% 0.90% 0.90% 0.90% 0.57%**
Ratio of net investment income to average net assets
<F2>.......5.30% 5.53% 7.44% 8.02%
5.28%**
Portfolio turnover
rate.........................................182% 107%
120% 119% 271%
<FN>
<F1>
The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 2.60%, 4.58%,
7.75%, 7.08%, and 28.48% 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>
<FN>
<F2> The annualized ratio of net investment income to average net
assets prior to reimbursement of expenses by the Adviser was
3.58%, 1.85%, 0.59%, 1.84%, and (22.63%) 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>
* Commenced operations June 30, 1992.
** Annualized
The accompanying notes are an integral part of these financial
statements.
38
SMITH BREEDEN EQUITY PLUS FUND
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Equity Plus Fund (the "Fund") is a series of the
Smith Breeden Trust (the "Trust"), an open-end, diversified
management investment company registered under the Investment
Company Act of 1940, as amended. The following is a summary of
significant accounting policies consistently followed by the 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 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 net capital loss carryforward.
C. Repurchase Agreements: The 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 Fund's custodian maintains control or custody of these
securities which collateralize 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 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.
39
NOTES TO FINANCIAL STATEMENTS (cont.)
E. 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.
F. Deferred Organization Expenses: Deferred organization
expenses are being amortized on a straight-line basis over five
years.
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
A. Derivative Financial Instruments Held or Issued for
Purposes other than Trading: The Fund uses interest rate futures
contracts for risk management purposes in order to manage the
Fund's
interest-rate risk relative to its benchmark. 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.
Futures contracts 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.
40
NOTES TO FINANCIAL STATEMENTS (cont.)
The Fund had the following open futures contracts as of March 31,
1997:
Type Notional Position Expiration
Unrealized
Amount Month
Gain/(Loss)
3 Month Eurodollar $18,000,000 Long June, 1997
$(6,781)
3 Month Eurodollar 9,000,000 Short March, 1998
8,297
3 Month Eurodollar 9,000,000 Short September, 1998
2,210
3 Month Eurodollar 13,000,000 Short March, 1999
9,692
3 Month Eurodollar 9,000,000 Short September, 1999
584
3 Month Eurodollar 12,000,000 Short March, 2000
8,322
3 Month Eurodollar 1,000,000 Short June, 2000
1,845
3 Month Eurodollar 10,000,000 Short September, 2000
10,705
3 Month Eurodollar 13,000,000 Short March, 2001
10,016
10 Year Treasury 400,000 Short June, 1997
5,982
Total
$50,872
B. Derivative Financial Instruments Held or Issued for
Trading Purposes:
The Fund invests in futures contracts on the S&P 500 Index and New
York Stock Exchange Index whose returns are expected to track
movements in the S&P 500 Index and New York Stock Exchange
Index.
The Fund had the following open futures contracts on the S&P 500
and New York Stock Exchange Indices as of March 31, 1997:
Type Notional Position Expiration Unrealized
Amount Month Gain/Loss
S&P 500 $10,599,680 Long June, 1997 $(423,940)
S&P 500 2,271,360 Long September, 1997 (134,280)
NYSE 199,275 Long June, 1997 (8,956)
Total $(567,176)
The aggregate market value of investments pledged to cover margin
requirements for the open positions at March 31, 1997 was
$691,539.
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 Fund pays the
41
NOTES TO FINANCIAL STATEMENTS (cont.)
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
the
expenses of the Fund 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 March 31,
1997. For the year ended March 31, 1997, the Adviser received
fees
of $53,341 and reimbursed the Fund $131,965.
Effective August 1, 1994, the Fund adopted a Distribution and
Services Plan (the "Plan") pursuant to Rule 12b-1 under the
Investment Company Act of 1940. 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
paid to it by the Fund, to dealers and other persons at the annual
rate
of up to 0.25% of the Fund's average net assets subject
to the authority 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.
4. INVESTMENT TRANSACTIONS
During the year-ended March 31, 1997, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$19,129,765 and $11,798,195, respectively. The cost of securities
for
federal income tax purposes is $16,394,418. Net unrealized
depreciation of investments and futures contracts consists of:
Gross unrealized appreciation $ 81,061
Gross unrealized depreciation (569,372)
Net unrealized depreciation $ (488,311)
42
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Equity Plus Fund of the Smith Breeden Series Trust:
We have audited the accompanying statement of assets and
liabilities,
including the schedule of investments, of the Smith Breeden Equity
Plus Fund of the Smith Breeden Series Trust 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 June
30,
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 Equity Plus Fund of the Smith Breeden Series
Trust
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
43
BOARD OF TRUSTEES
Douglas T. Breeden
Michael J. Giarla
Stephen M. Schaefer
Myron S. Scholes
William E. Sharpe
OFFICERS
PRESIDENT
Michael J. Giarla
VICE PRESIDENTS
Daniel C. Dektar (Smith Breeden Series Fund)
John B. Sprow (Smith Breeden Trust)
TREASURER AND SECRETARY
Marianthe S. Mewkill
INVESTMENT ADVISER
Smith Breeden Associates, Inc.
100 Europa Drive
Suite 200
Chapel Hill NC
27514
TRANSFER AGENT AND DIVIDEND PAYING AGENT
FPS Services, Inc.
3200 Horizon Drive
PO Box 61503
King of Prussia PA 19406-0903
DISTRIBUTOR
FPS Broker Services, INc.
3200 Horizon Drive
PO Box 61503
King of Prussia, PA
19406-0903
CUSTODIAN
Bank of New York
48 Wall Street
New York, New York
10286
INDEPENDENT AUDITORS
Deloitte and Touche LLP
117 Campus Drive
Princeton, New Jersey
08540
For information about:
Establishing an account
Account Procedures
Exchanges
Call 1-800-221-3137
For all other information about the Funds:
Call 1-800-221-3138
