PERFORMANCE REVIEW
The Smith Breeden Short Duration U.S. Government Fund (the "Fund")
provided a total return of 6.75% for the year ended March 31, 1995. The
Fund's return exceeded its benchmark, the six-month U.S. Treasury Bill,
by a significant margin, 1.33%. Since the Fund's inception, its return
has exceeded that of its benchmark by 5.56%. The graph below plots the
Fund's return versus its benchmark.
The year ended March 31, 1995, was a tumultuous one for the fixed
income markets. The Federal Reserve Board raised the discount rate, the
rate at which banks borrow from the Federal Reserve to meet reserve
requirements and temporary liquidity needs, four times. The rate on
March 31, 1994 was 3%, but rose to 5.25% by March 1995. These increases,
and the market's anticipation of the Federal Reserve's actions over the
course of the year, boosted short-term and intermediate-term yields and
increased interest-rate volatility. From March 31, 1994 to March 31, 1995,
short-term U.S. Treasury yields rose over 200 basis points (100 basis points
equals one percent), intermediate-term U.S. Treasury yields rose 85 to 160
basis points, and long-term yields rose less than 50 basis points. Over
the course of the fiscal year, intermediate and long-term interest rates
had actually peaked at much higher levels: for example, in early January
1995, the five-year U.S. Treasury Note yield was 80 basis points over its
closing yield on March 31,1995.
THE LINE GRAPH DETAILING PERFORMANCE VERSUS THE FUND'S 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 Fund versus that of its benchmark, the six month US Treasury Bill.
From inception of February 25, 1992 through March 31, 1995, an investment of
$10,000 would have grown to $11,913, if invested in the Fund and $11,357, if
invested in the six month US Treasury Bill. The return in the Fund is
net of fees and sales charges; the return of the six month US Treasury Bill
does not reflect fees or transaction costs. The annualized one year return
for the Fund is 6.75%, the three year annualized return is 5.67% and since
inception, the annualized return is 5.82%.
As interest rates rose, the effective maturities (durations) of mortgage
securities lengthened. This happened for two predictable reasons. First,
homeowners were less likely to prepay their mortgages (primarily due to
refinancing or moving). This lengthened the expected time to receipt of a
mortgage investor's principal payments and made a mortgage security investment
longer-term in nature. Second, as variable-rate mortgage coupons began to
reset upward (indexed, as they are, to short-term rates), they began to be
subject to caps on their periodic adjustments, and their rates moved closer
to their contractual lifetime maximum rates. This made adjustable-rate
mortgages (ARMs) more fixed-rate and less adjustable-rate in nature,
extending their durations and making them more sensitive to subsequent
changes in interest rates. Although the "extension" of mortgage securities
in 1994's rising rate environment was predictable (and well prepared for by
the Fund, investors in general appeared to be surprised, or at least
disappointed, as many left the market. ARM mutual funds shrank dramatically
during the year as many funds failed to deliver on promises or expectations
of price stability. Government mortgage mutual funds also experienced very
substantial outflows during the year; and banks curtailed their purchases
of ARMs as the market depreciation of their existing holdings was deducted
from their reported capital.
Rising volatility and extending durations hurt mortgage security
returns during the first part of the Fund's fiscal year. Through November
1994, the Fund had outperformed its benchmark by only 35 basis points.
Adjustable-rate mortgages underperformed generic fixed-rate mortgages
during most of 1994, so the Fund took advantage of the opportunity by
increasing its position in ARMs issued by GNMA. In December 1994 and
January 1995, investors realized that ARMs had become considerably
undervalued and bid up the prices of ARMs relative to the mortgage
securities market in general. During this time, fixed-rate mortgages also
performed well. In these two months, the Fund earned 109 basis points
over its six-month U.S. Treasury Bill benchmark.
In February and March 1995 the mortgage markets were "treading water"
as rates declined and spreads held relatively firm. The Fund took advantage
of the strength of the earlier mortgage performance to reduce ARM holdings
in the first months of 1995 and to increase the its cash position for
future opportunities.
The Fund's approach to investment in the mortgage markets is to hold
relatively liquid, easy to price, government mortgage securities in a
portfolio with minimal interest rate risk relative to its benchmark. With
only small exposures to credit risk, interest-rate risk and liquidity risk,
the Fund sought actively to take advantage of changes in relative value
among liquid mortgage securities markets. This portfolio management style
is reflected in the Fund's 438% portfolio turnover for the year ended
March 31, 1995.
At the close of business on March 31, 1995, pursuant to a plan of
liquidation adopted by the Fund's Board of Trustees on March 1, 1995, the
Fund liquidated by distributing its assets to its shareholders in
cancellation of their shares.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1995
INVESTMENT INCOME:
Interest and discount earned, net of premium
amortization...................................... $15,327,100
EXPENSES:
Advisory fees (Note 2)................................ 1,420,528
Registration fees..................................... 350
Custodian fees........................................ 103,428
Accounting and pricing services fees.................. 74,135
S&P rating fees....................................... 17,603
Legal fees............................................ 49,078
Amortization of organization expenses (Note 1)........ 8,997
Transfer agent fees................................... 23,104
Insurance expense..................................... 28,856
Trustees fees and expenses............................ 52,477
Audit and tax preparation fees........................ 66,730
Other................................................. 15,171
TOTAL EXPENSES BEFORE REIMBURSEMENT................ 1,860,457
Expenses reimbursed by adviser (Note 2)............ (200,239)
NET EXPENSES...................................... 1,660,218
NET INVESTMENT INCOME............................. 13,666,882
NET REALIZED AND UNREALIZED GAIN/(LOSS) ON INVESTMENTS:
Net realized loss on investments...................... (6,464,271)
Change in unrealized appreciation(depreciation) on
investments, interest rate swaps, caps and
futures contracts................................. 8,760,104
Net realized and unrealized gain on investments....... 2,295,833
Net increase in net assets resulting from operations.. $15,962,715
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN SHORT DURATION U.S. GOVERNMENT FUND
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended
March 31, 1995 March 31, 1994
OPERATIONS:
Net investment income................. $13,666,882 $6,924,161
Net realized loss on investments.... (6,464,271) (348,058)
Change in unrealized appreciation
(depreciation) of investments,
interest rate swaps and
futures contracts................. 8,760,104 (2,058,637)
Net increase in net assets
resulting from operations......... 15,962,715 4,517,466
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income............................ (13,666,882) (6,186,157)
Dividends in excess of net
investment income................. (1,466,847) -
Distributions from net
realized gains on investments..... (680,487) (795,530)
Distributions in excess of net
realized gains on investments..... (269,036) -
Total distributions................. (16,083,252) (6,981,687)
CAPITAL SHARE TRANSACTIONS:
Shares sold......................... 99,295,926 314,099,209
Shares issued on reinvestment of
distributions..................... 1,345,997 1,606,285
Shares redeemed..................... (142,419,513) (139,146,610)
Shares liquidated................... (221,304,914) -
Increase(decrease) in net assets
resulting from capital share
transactions (a).................. (263,082,504) 176,558,884
TOTAL INCREASE IN NET ASSETS.... (263,203,041) 174,094,663
NET ASSETS:
Beginning of period ................ 263,203,041 89,108,378
End of period....................... $0 $263,203,041
(a) Transactions in capital shares
were as follows:
Shares sold.................... 10,000,237 31,217,127
Shares issued on reinvestment
of distributions.............. 135,812 159,542
Shares redeemed................ (14,353,946) (13,820,630)
Shares liquidated.............. (22,190,031) -
Net increase................... (26,407,928) 17,556,039
Beginning balance ............. 26,407,928 8,851,889
Ending balance................. 0 26,407,928
The accompanying notes are an integral part of these financial statements.
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.
For the Period
Year Ended Year Ended February 25, 1992 (1)
March 31, 1995 March 31, 1994 to March 31, 1993
Net Asset Value,
Beginning of Period.... $9.97 $10.07 $10.00
INCOME FROM INVESTMENT
OPERATIONS
Net investment income.. 0.515 0.421 0.595
Net realized and
unrealized gain/(loss)
on investments....... 0.134 (0.037) 0.130
Total from investment
operations........... 0.649 0.384 0.725
LESS DISTRIBUTIONS
Dividends from net
investment income.... (0.515) (0.425) (0.547)
Dividends in excess of net
investment income.... (0.107) - -
Distributions from net
realized capital gains
on investments....... (0.027) (0.058) (0.108)
Liquidating distribution
in-kind.............. (9.973) - -
Total distributions.... (10.622) (0.483) (0.655)
Net Asset Value,
End of Period.......... $0.00 $9.97 $10.07
Total Return............. 6.75% 3.86% 7.44%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of
period............... $0 $263,203,041 $89,108,378
Ratio of expenses to
average net
assets (2)........... 0.67% 0.49% 0.55%
Ratio of net investment
income to average
net assets (3)....... 5.52% 4.51% 6.79%
Portfolio turnover rate 438% 412% 126%
(1) Commencement of operations.
(2) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 0.75%, 0.55%, and 0.95%
for the years ended March 31, 1995, and March 31, 1994, and period
ended March 31, 1993, respectively.
(3) The annualized ratio of net investment income to average net assets
prior to reimbursement of expenses by the Adviser was 5.44%, 4.45%
and 6.39% for the years ended March 31, 1995, and March 31, 1994,
and period ended March 31, 1993, respectively.
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Short Duration U.S. Government Fund (the "Fund") is
a no-load, open-end, diversified management investment company registered
under the Investment Company Act of 1940, as amended. Pursuant to a plan
of liquidation adopted by the Trustees of the Fund on March 1, 1995, at
the close of business on March 31, 1995, the Fund was liquidated by a
distribution of its assets in kind to its shareholders. The following is
a summary of significant accounting policies consistently followed by the
Fund.
A. Distributions and Taxes: The Fund intends 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 distributed all of its
net investment income and net realized capital gains, if any, less any
available capital loss carry forward. As of March 31, 1995, the Fund had
no capital loss carry forward.
B. 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.
C. Deferred Organizational Expenses: Deferred organizational expenses
were being amortized on a straight-line basis over five years. Pursuant
to the plan of liquidation, the balance of unamortized organizational
expenses as of March 31, 1995 was reimbursed to the Fund by the Adviser.
D. Securities Transactions and Investment Income: Interest income
is accrued daily on both long-term bonds and short-term investments.
Interest income also includes net amortization from the purchase of
fixed-income securities. Transactions are recorded on the first
business day following the trade date. Realized gains and losses
from security transactions are determined and accounted for on the basis
of identified cost.
2. 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 Adviser a fee
computed daily and payable monthly, at an annual rate equal to 0.70%
of the Fund's average daily net assets.
The Adviser has voluntarily agreed to reduce or otherwise limit other
expenses of the Fund (excluding advisory fees and litigation,
indemnification and other extraordinary expenses) to 0.78% annually
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, however the Adviser has agreed to limit expenses to 0.78%
annually through at least March 31, 1995. The Adviser has agreed to
reduce the fees payable (to the extent of such fees) by the amount the
Fund's expenses would, absent the fee reduction, exceed the applicable
expense limitations imposed by state securities administrators. For the
year ended March 31, 1995, the Adviser received fees of $1,420,528 and
reimbursed the Fund $200,239.
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 Fund adopted a distribution plan effective August 1,
1994. The Plan permitted 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 Fund,
reducing redemptions, or otherwise maintaining or improving services
provided to shareholders by such dealers or other persons. The Plan
provided for payments by the Adviser, out of the 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 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 are determined by the Adviser.
3. INVESTMENT TRANSACTIONS
During the year ended March 31, 1995, purchases and proceeds from
sales of securities, other than short-term investments, aggregated
$1,179,282,195 and $1,355,911,248 respectively. The purchases and
proceeds do not include dollar roll agreements which are considered
to be borrowings by the Fund.
4. LIQUIDATION
Pursuant to a plan of liquidation adopted by the Trustees of the Fund on
March 1, 1995, at the close of business on March 31, 1995, the Fund was
liquidated by a distribution of its assets in-kind to its shareholders.
INDEPENDENT AUDITORS' REPORT
The Board of Trustees,
Smith Breeden Short Duration
U.S. Government Fund:
We have audited the Smith Breeden Short Duration U.S. Government Fund's
statements of operations for the year ended March 31, 1995 and changes in
net assets for each of the years in the two-year period then ended, and
financial highlights for each of the years in the two-year period then
ended and the period February 25, 1992 (commencement of operations) to
March 31, 1993. These statements of operations, changes in net assets and
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these statements of operations,
changes in net assets and 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 statements of operations,
changes in net assets and 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. 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, such statements of operations, changes in net assets
and financial highlights present fairly, in all material respects, the
results of its operations, the changes in net assets and financial
highlights of the Smith Breeden Short Duration U.S. Government Fund for
the respective stated periods in conformity with generally accepted
accounting principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 12, 1995
