SMITH BREEDEN MUTUAL FUNDS
Smith Breeden Short Duration U.S. Government Series
Smith Breeden Intermediate Duration U.S. Government Series
Smith Breeden Equity Plus Fund
Supplement dated August 1, 1996
to Prospectus dated August 1, 1996
Effective August 31, 1996, as described in the accompanying prospectus,
the investment objective of the Smith Breeden Equity Plus Fund (formerly
the Smith Breeden Market Tracking Fund) will be changed to the following:
"to provide a total return exceeding the Standard & Poor's 500 Composite
Stock Price Index ("S&P 500 Index") without additional equity market risk."
Prior to that date, the Fund's objective will continue to be "to provide
a total return approximating the S&P 500 Index." The change in objective
will not affect how the Fund is currently managed, and is meant merely to
clarify the Fund's investment goals.
AUGUST 1, 1996
SMITH BREEDEN MUTUAL FUNDS
PROSPECTUS
The Smith Breeden Mutual Funds consist of three no-load, registered
investment companies (the "Funds" or a "Fund"). Smith Breeden
Associates, Inc. (the "Adviser") serves as the investment adviser to the Funds.
Smith Breeden Equity Plus Fund (the "Equity Plus Fund") seeks to provide
a total return exceeding the Standard & Poor's 500 Composite Stock Price
Index without additional equity market risk. The previous name of the
Equity Plus Fund was the Smith Breeden Market Tracking Fund.
Smith Breeden Short Duration U.S. Government Series (the "Short Series")
seeks a high level of current income, consistent with low volatility of
net asset value. The Short Series seeks to match the interest-rate risk
of a portfolio that invests exclusively in six month U.S. Treasury
securities on a constant maturity basis. The dollar weighted average
maturity of the Fund's securities may significantly exceed six months
at times.
Smith Breeden Intermediate Duration U.S. Government Series (the
"Intermediate Series") seeks a total return in excess of the total return
of the major market indices for mortgage-backed securities. The major market
indices for mortgage-backed securities include, but are not limited to, the
Salomon Brothers Mortgage Index and the Lehman Brothers Mortgage Index.
These indices include all outstanding government sponsored fixed-rate
mortgage-backed securities, weighted in proportion to their current market
capitalization. The duration, or interest-rate risk, of these indices is
similar to that of intermediate-term U.S. Treasury Notes, and typically
will range between three and five years. The Intermediate Series
consistently seeks to achieve a volatility of net asset value similar to
that of a portfolio that invests exclusively in mortgage-backed securities,
as weighted in the major mortgage market indices.
An investment in any of the Funds is neither insured nor guaranteed by the
U.S. Government. There can be no assurance that any of the Funds will meet
their investment objectives. This Prospectus sets forth concisely the
information about the Funds that you should know before investing. You are
advised to read this Prospectus carefully and keep it for future reference.
A Statement of Additional Information, dated August 1, 1996 which is
incorporated herein by reference, has been filed with the Securities and
Exchange Commission with respect to each Fund. The Statements of Additional
Information, which may be revised from time to time, contain further
information about the Funds, and are available without charge by writing to
the Funds at 100 Europa Drive, Chapel Hill, North Carolina 27514 or by
calling 1-800-221-3138.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY
THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR
HAS THE SECURITIES
AND EXCHANGE COMMISSION PASSED UPON THE ACCURACY OR
ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
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TABLE OF CONTENTS
Expense Table. . . . . . . . . . . . . . . . . . . . . . . . .3
Financial Highlights--Equity Plus Fund . . . . . . . . . . . .5
Financial Highlights--Short Series . . . . . . . . . . . . . .6
Financial Highlights--Intermediate Series. . . . . . . . . . .7
Smith Breeden Mutual Funds. . . . . . . . . . . . . . . . .8
Investment Objectives, Policies and Risk
Considerations . . . . . . . . . . . . . . . . . . . . . . . .8
Other Investment Practices and Risk Considerations . . . . . 20
Management of the Funds . . . . . . . . . . . . . . . . . . . 22
Pricing of Fund Shares . . . . . . . . . . . . . . . . . . . 26
How to Purchase Shares . . . . . . . . . . . . . . . . . . . 27
How to Exchange Shares . . . . . . . . . . . . . . . . . . . 29
How to Redeem Shares . . . . . . . . . . . . . . . . . . . . 30
Dividends and Distributions. . . . . . . . . . . . . . . . . 33
Shareholder Reports and Information. . . . . . . . . . . . . 34
Retirement Plans . . . . . . . . . . . . . . . . . . . . . . 34
Service and Distribution Plans . . . . . . . . . . . . . . . 35
Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Capital Structure. . . . . . . . . . . . . . . . . . . . . . 36
Transfer, Dividend Disbursing Agent, Custodian and
Independent Auditors. . . . . . . . . . . . . . . . . . . 37
Fund Performance . . . . . . . . . . . . . . . . . . . . . . 37
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.
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EXPENSE TABLE
The following table is designed to assist you in
understanding the expenses you will bear as a
shareholder in the Funds. Shareholder Transaction
Expenses are charges that you pay when buying or
selling shares of a Fund. Annual Fund Operating
Expenses are paid out of a Fund's assets and include
fees for portfolio management, maintenance of
shareholder accounts, shareholder servicing,
accounting and other services. The expenses shown
below are based on each Fund's expenses for the past
fiscal year.
Short Intermediate Equity Plus
Series Series Fund
Shareholder
Transaction Expenses
Maximum Sales Load
Imposed on Purchases None None None
Maximum Sales Load
Imposed on Reinvested
Dividends None None None
Deferred Sales Load
Imposed on Redemptions None None None
Redemption Fees1 None None None
Exchange Fees None None None
Annual Fund Operating
Expenses
(as a percentage of
average net assets)
Management Fees2 0.70% 0.70% 0.70%
Other Expenses (net
of reimbursement) 0.18% 0.08% 0.18%
Total Fund Operating
Expenses (net of
reimbursement)3 0.88% 0.78% 0.88%
_____________________________
1 A transaction cost of $9 may be imposed on redemptions by wire transfer.
2 Pursuant to a distribution and services plan in respect of each
Fund, the Adviser may pay annual distribution and servicing fees of
up to 0.25% of each of the Funds' net assets out of its management
fee. See "Service and Distribution Plans."
3 The Other Expenses in the table and Total Fund Operating Expenses
reflect undertakings by the Adviser to bear expenses of each of the
Funds and/or waive its fees to the extent necessary to limit Total
Fund Operating Expenses to 0.78% for the Short Series and 0.88% for
each of the Equity Plus Fund and Intermediate Series through March
31, 1997 and are estimates which are based upon Total Fund Operating
Expenses for the fiscal year ended March 31, 1996. Absent the
expense limitation, Other Expenses and Total Fund Operating Expenses
would be 0.23% and 0.93% for the Short Series, 0.44% and 1.14% for
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the Intermediate Series, and 3.88% and 4.58% for the Equity Plus
Fund. Actual Total Fund Operating Expenses for the fiscal year
ended March 31, 1996 were 0.78% for the Short Series and 0.90% for
each of the Equity Plus Fund and Intermediate Series.
The following examples illustrate the expenses that
apply to a $500 investment in each Fund over various
time periods assuming (1) a 5% annual rate of return
and (2) redemption or no redemption at the end of each
time period. Except as noted in the table above, the
Funds charge no redemption fees.
Short Duration Series
1 Year 3 Years 5 Years 10 Years
$ 4 $ 13 $ 22 $ 48
Intermediate Duration Series and Equity Plus Fund
1 Year 3 Years 5 Years 10 Years
$ 5 $ 15 $ 24 $ 53
These examples are based on the annual operating
expenses shown above and should not be considered a
representation of past or future expenses or
performance. Actual expenses may be greater or less
than those shown. The annual rate of return may be
more or less than 5%.
The Funds may be recommended to investors by
registered investment advisors. Such advisors
customarily impose fees which would be in addition to
any fees and expenses presented in the above table.
According to recent financial articles, such fees may
be as high as 2% of assets per year. Neither the
Funds, nor the Adviser, exercise any control over such
advisory fees and may not be informed of the level of
such fees.
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EQUITY PLUS FUND
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods from
June 30, 1992, the date the Fund commenced operations, through March 31, 1996
and are a part of the Fund's financial statements which have been audited by
Deloitte & Touche LLP,independent auditors. This data should be read in
conjunction with the Fund's most recent annual audited financial statements
and the report of Deloitte & Touch LLP thereon which appear in the Fund's
Statement of Additional Information. (The Equity Plus Fund was previously
named The Market Tracking Fund.)
Year Ended Year Ended Year Ended Period Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31, 1993
Net Asset Value,
Beginning of Period... $10.84 $9.88 $10.85 $10.00
Income From Investment
Operations
Net investment income. 0.615 0.568 0.476 0.355
Net realized and
unrealized gain (loss)
on investments........ 2.768 1.081 (0.216) 1.281
Total from investment
operations............ 3.383 1.649 0.260 1.636
Less Distributions
Dividends from net
investment income..... (0.583) (0.568) (0.472) (0.311)
Dividends in excess of
net investment income. -- (0.001) -- --
Distributions from net
realized gains on
investments........... (1.370) (0.047) (0.701) (0.420)
Distributions in excess
of net realized gains
on investments........ -- (0.073) (0.057) (0.055)
Total distributions... (1.953) (0.689) (1.230) (0.786)
Net Asset Value,
End of Period......... $12.27 $10.84 $9.88 $10.85
Total Return.......... 32.30% 17.18% 2.19% 22.59%*
Ratios/Supplemental Data
Net assets, end of
period................$4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses to
average net assets
Before expense
limitation.......... 4.58% 7.75% 7.08% 28.48%*
After expense
limitation.......... 0.90% 0.90% 0.90% 0.57%*
Ratio of net income to
average net assets
Before expense
limitation.......... 1.85% 0.59% 1.84% (22.63%)*
After expense
limitation.......... 5.53% 7.44% 8.02% 5.28%*
Portfolio turnover rate 107% 120% 119% 271%
* Annualized
Additional performance information is presented in the Fund's Annual Report,
which is available without charge upon request.
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SHORT DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods from
March 31, 1992, the date the Fund commenced operations, through March 31, 1996
and are a part of the Short Series' financial statements which have been
audited by Deloitte & Touche LLP, independent auditors. This data should be
read in conjunction with the Short Series' most recent annual audited
financial statements and the report of Deloitte & Touche LLP thereon which
appear in the Fund's Statement of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31,1996 March 31, 1995 March 31,1994 March 31,1993
Net Asset Value,
Beginning of Period.... $9.90 $9.90 $10.00 $10.00
Income From Investment
Operations
Net investment income.. 0.621 0.628 0.432 0.552
Net gain (loss) on
securities (both realized
and unrealized)........ (0.148) -- (0.070) 0.002
Total from investment
operations............. 0.473 0.628 0.362 0.554
Less Distributions
Dividends from net
investment income...... (0.621) (0.628) (0.462) (0.554)
Dividends in excess of
investment income...... (0.012) -- -- --
Total distributions.... (0.633) (0.628) (0.462) (0.554)
Net Asset Value, End of
Period................. $9.74 $9.90 $9.90 $10.00
Total Return........... 4.95% 6.58% 3.67% 5.67%
Ratios/Supplemental Data
Net assets, end of
period................. $221,825,136 $218,431,665 $218,167,491 $48,531,206
Ratio of expenses to
average net assets
Before expense
limitation........... 0.93% 0.92% 1.00% 2.58%
After expense
limitation........... 0.78% 0.78% 0.78% 0.78%
Ratio of net income to
average net assets
Before expense
limitation........... 6.13% 6.18% 3.95% 2.73%
After expense
limitation........... 6.29% 6.33% 4.17% 4.53%
Portfolio turnover rate 225% 47% 112% 3%
Additional performance information is presented in the Short Series' Annual
Report, which is available without charge upon request.
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INTERMEDIATE DURATION SERIES
FINANCIAL HIGHLIGHTS
FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
The following selected per share data and ratios cover the fiscal periods from
March 31, 1992, the date the Fund commenced operations, through March 31, 1996
and are a part of the Intermediate Series' financial statements which have
been audited by Deloitte & Touche LLP, independent auditors. This data should
be read in conjunction with the Intermediate Series' most recent annual
audited financial statements and the report of Deloitte & Touche LLP thereon
which appear in the Fund's Statement of Additional Information.
Year Ended Year Ended Year Ended Year Ended
March 31,1996 March 31,1995 March 31,1994 March 31,1993
Net Asset Value,
Beginning of Period.... $9.83 $10.01 $10.62 $10.00
Income From Investment
Operations
Net investment income.. 0.660 0.664 1.05 0.826
Net gain (loss) on
securities (both
realized and unrealized) 0.277 (0.049) (0.601) 0.621
Total from investment
operations............. 0.937 0.615 0.449 1.447
Less Distributions
Dividends from net
investment income...... (0.656) (0.664) (1.044) (0.826)
Dividends in excess of
net investment income.. -- (0.108) -- --
Distributions from net
realized gains on
investments.......... (0.101) -- (0.015) --
Distributions in excess
of net realized gains on
investments............ -- (0.022) -- --
Total distributions.... (0.757) (0.794) (1.059) (0.826)
Net asset value, end
of period.............. $10.01 $9.83 $10.01 $10.62
Total Return........... 9.69% 6.10% 4.11% 14.93%
Ratios/Supplemental Data
Net assets, end of
period................. $36,446,940 $34,797,496 $6,779,666 $2,923,913
Ratio of expenses to
average net assets
Before expense
limitation.......... 1.14% 2.33% 2.34% 17.52%
After expense
limitation.......... 0.90% 0.90% 0.90% 0.82%
Ratio of net income to
average net assets
Before expense
limitation.......... 6.26% 4.77% 6.30% (8.52)%
After expense
limitation.......... 6.49% 6.20% 7.74% 8.18%
Portfolio turnover rate 193% 557% 84% 42%
Additional performance information is presented in the Intermediate Series'
Annual Report, which is available without charge upon request.
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SMITH BREEDEN MUTUAL FUNDS
The Short and Intermediate Series are series of the Smith Breeden Series Fund
(the "Series Fund"), an open-end diversified management investment company,
registered under the Investment Company Act of 1940 (the "1940 Act"). The
Series Fund currently issues shares in two series, which are the Short and
Intermediate Series. The Equity Plus Fund is currently the only series of the
Smith Breeden Trust (the "Trust"), also an open-end diversified management
investment company registered under the 1940 Act.
Smith Breeden Associates, Inc. ("Smith Breeden" or the "Adviser") acts as
investment adviser to the Funds. Smith Breeden is a money management and
consulting firm founded in 1982 whose clients include pension funds,
financial institutions, corporations, government entities and charitable
foundations. The firm specializes in mortgage securities, interest-rate risk
management, and the application of option pricing to investments and banking.
Smith Breeden currently advises, or manages on a discretionary basis, assets
totalling over $20 billion.
INVESTMENT OBJECTIVES, POLICIES, AND RISK CONSIDERATIONS
Each of the Funds has a different investment objective and a different
investment policy since each Fund is designed to meet different investment
needs.
The investment objectives and certain investment policies of the Short and
Intermediate Series are fundamental and may not be changed without a vote of
shareholders of the relevant Fund. The investment objective of the Equity
Plus Fund is not fundamental, and may be changed without a vote of the
majority of the shareholders of the Equity Plus Fund. Shareholders of the
Equity Plus Fund will receive a written notification at least thirty days
prior to any change in the Equity Plus Fund's investment objective. If such
a change in the investment objective of the Equity Plus Fund occurs, such
changes may result in the Fund having an investment objective different from
the objective which the shareholders considered appropriate at the time of
their investment in the Equity Plus Fund.
Because shares of each Fund represent an investment in securities with
fluctuating market prices, you should understand that the net asset value per
share of each Fund will vary as the aggregate value of a Fund's portfolio
securities increases or decreases. Because of the risks inherent in all
investments, there can be no assurance that the objectives of the Funds will
be met. The descriptions that follow are designed to help you choose the
Fund or combination of Funds that best fits your investment objectives.
Short Series
The Short Series' investment objective is to provide investors with a high
level of current income, consistent with a volatility of net asset value
similar to that of a portfolio which invests exclusively in six-month U.S.
Treasury securities on a constant maturity basis. There is no assurance
that the Short Series will be able to maintain a low volatility of net asset
value.
Under normal circumstances the Short Series will seek to achieve an
interest-rate risk or option-adjusted duration similar to that of a six-month
U.S. Treasury security on a constant maturity basis. Option-adjusted duration
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is a measure of the price sensitivity (in percentage) of a portfolio to
changes in interest rates, taking into account the changing nature of
expected cash flows, as influenced by mortgage prepayments and other factors.
The Short Series expects that, under normal circumstances, the
dollar-weighted average life (or period until the next reset date) of its
portfolio securities will be longer than six months, sometimes significantly.
The maturity of a security measures only the time until final payment is due,
whereas option-adjusted duration takes into account the pattern of all
payments of interest and principal on a security over time, including how
these payments are affected by prepayments and by changes in interest rates.
In computing the duration of the Short Series' portfolio, the Adviser will
estimate the duration of obligations that are subject to prepayment, or
redemption by the issuer, taking into account the influence of changes in
interest rates on prepayments and coupon flows. The Adviser will use certain
hedging techniques (discussed in more detail in Appendix A and in "Investment
Policies of the Short and Intermediate Series and Fixed Income Segment of the
Equity Plus Fund") to lengthen or shorten the option-adjusted duration of the
Short Series' portfolio so that it targets the interest-rate risk of a six-
month U.S. Treasury security.
The Adviser believes that by investing in mortgage securities from a variety
of market sectors on a selective basis and adjusting the overall
option-adjusted duration of the portfolio to approximate that of a six-month
U.S. Treasury security, the Short Series will achieve a more consistent and
less volatile net asset value than is characteristic of mutual funds that
invest primarily in mortgage securities paying a fixed rate of interest or
those that invest exclusively in adjustable-rate mortgage securities. The
securities in which the Short Series may invest may not yield as high a level
of income as other securities in which other funds may invest. However,
such higher yielding securities may be more volatile and may be issued by
less creditworthy entities.
Intermediate Series
The Intermediate Series' investment objective is to provide investors with a
total return in excess of the total return of the major market indices for
mortgage-backed securities. The major market indices for mortgage-backed
securities include, but are not limited to, the Salomon Brothers Mortgage
Index and the Lehman Brothers Mortgage Index. These indices include all
outstanding government sponsored fixed-rate mortgage-backed securities,
weighted in proportion to their current market capitalization. Total return
is the change in value of the investment assuming reinvestment of all
distributions. Under normal circumstances, the Intermediate Series will seek
to achieve an interest-rate risk or option-adjusted duration similar to that
of a portfolio that invests exclusively in mortgage-backed securities, as
weighted in the major market indices. The duration, or interest-rate risk, of
these indices is similar to the that of intermediate-term U.S. Treasury
Notes, and typically will range between three and five years. When market
interest rates decline, the value of a portfolio invested in
intermediate-term fixed-rate obligations can be expected to rise.
Conversely, when market interest rates rise, the value of a portfolio
invested in intermediate-term fixed-rate obligations can be expected to fall.
Option-adjusted duration is a measure of the price sensitivity (in
percentage) of a portfolio to changes in interest rates, taking into account
the changing nature of expected cash flows, as influenced by mortgage
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prepayments and other factors. The maturity of a security measures only the
time until final payment is due, whereas option-adjusted duration takes into
account the pattern of all payments of interest and principal on a security
over time, including how these payments are affected by prepayments and by
changes in interest rates. In computing the duration of the Intermediate
Series' portfolio, the Adviser will estimate the duration of obligations that
are subject to prepayment, or redemption by the issuer, taking into account
the influence of changes in interest rates on prepayments and coupon flows.
The Adviser may use certain hedging techniques (as described in more detail
in Appendix A and in "Investment Policies of the Short and Intermediate
Series and Fixed Income Segment of the Equity Plus Fund") to lengthen or
shorten the option-adjusted duration of the Intermediate Series so that it
targets the interest-rate risk of a portfolio that invests exclusively in
mortgage-backed securities, as weighted in the major mortgage indices.
There is no assurance that the Intermediate Series will be able to maintain
a total return in excess of the total return of major market indices for
mortgage-backed securities or that it will match the interest-rate risk of a
portfolio investing exclusively in these securities.
Equity Plus Fund
The Equity Plus Fund seeks to provide a total return exceeding the Standard
& Poor's Composite Stock Price Index (the "S&P 500 Index") without additional
equity market risk. (The former name of the Equity Plus Fund was the Smith
Breeden Market Tracking Fund.) Total return is a measure of investment
performance which includes all of the interest, dividends and other income,
net of expenses, paid on the Fund's investments, as well as all realized and
unrealized capital gains and losses. The S&P 500 Index is composed of 500
common stocks, most of which are listed on the New York Stock Exchange.
Standard & Poor's, which is not a sponsor of or in any other way affiliated
with the Fund, chooses the 500 stocks included in the S&P 500 Index on the
basis of market value and industry diversification. The S&P 500 Index
assigns relative values to the stocks included in the index, weighted
according to each stock's total market value relative to the total market
value of the other stocks included in the index.
The Equity Plus Fund seeks to achieve its objective by dividing its portfolio
into two separate segments, an "Equity Simulation Segment" and a "Fixed
Income Segment." The Equity Plus Fund's Equity Simulation Segment will
invest in a combination of Equity Swap Contracts (described more fully
below), futures contracts on the S&P 500 Index and on other stock indices,
including, but not limited to the New York Stock Exchange Composite Index
("S&P 500 and Other Stock Index Futures"), and a combination of common stocks
whose return (before deducting allocated costs) is expected to track
movements in the S&P 500 Index. In the Equity Simulation Segment, the Equity
Plus Fund expects its use of stock index futures other than S&P 500 Stock
Index Futures to be minimal.
The Equity Plus Fund's Fixed Income Segment will seek a total return greater
than the expenses of the Fund (including the expenses associated with the
Equity Simulation Segment such as those relating to the Equity Swap Contracts
and S&P 500 and Other Stock Index Futures) by investing in fixed-income
securities and futures, options, floors, caps and swaps related thereto.
Through these investments, the Fixed Income Segment seeks to generate income
(consisting primarily of interest income) and gains which exceed the expenses
of operating the entire Equity Plus Fund. Thus, whether the Fund outperforms
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or underperforms the S&P 500 Index will depend on whether the total return on
the Fixed Income Segment is greater or less than the Fund's total operating
expenses (including transaction costs and the costs of the equity derivative
instruments held in the Equity Simulation Segment), respectively.
Investment Policies of the Equity Simulation Segment of the Equity Plus Fund
As stated above, the Equity Plus Fund's Equity Simulation Segment will invest
in a combination of Equity Swap Contracts, S&P 500 and other Stock Index
Futures, and a combination of common stocks whose return is expected to track
movements in the S&P 500 Index. By employing such a strategy, the Equity
Plus Fund seeks to achieve the same opportunity and risk profile for the
Equity Simulation Segment as that of a hypothetical portfolio, equal in size
to the Fund, invested in the common stocks comprising the S&P 500 Index (in
proportion to their respective weight in the S&P 500 Index.)
Set forth below is an example of a hypothetical portfolio allocation for the
Fund, assuming total assets of $100 million. The Fund might:
1. Enter into an Equity Swap Contract with a notional amount of $50 million;
2. Purchase S&P 500 Index Futures contracts with a total value of $45
million; and
3. Purchase $5 million worth of common stocks comprising the S&P 500 Index
in proportion to their respective weightings in the S&P 500 Index.
The Fixed Income Segment would invest $100 million in various fixed income
assets with appropriate hedging strategies. If, during the course of the
year, the stocks comprising the S&P 500 Index appreciate 10% on average and
pay a 4% dividend, and if the interest on the Equity Swap Contract's notional
amount is 6%, at the end of the year the following would occur:
1. The counterparty to the equity swap contract will be required to pay
the Fund $4 million ($7 million appreciation and dividends minus $3
million interest);
2. The S&P 500 Index Futures contract would be closed out at a gain of $3.6
million ($6.3 million S&P 500 Index appreciation less $2.7 million for
the S&P 500 Futures implicit cost of carry);
3. Dividend income and gain on the common stocks would total $0.7 million
and in sum;
4. The Fund's return, before Fund operating expenses, would total $8.3
million dollars or 8.3%.
The Fund's total operating expenses (other than brokerage expenses and the
interest on the notional amount of the Equity Swap contract as described
above) are 0.88% of total net assets or $0.88 million dollars. After
consideration of these expenses, the Fund's return would total 7.42%.
Therefore, the Fund will achieve a total return equal to the S&P 500 Index
only if the Fixed Income Segment has a total return equal to 6.58% per annum.
If the Fixed Income Segment achieves this result, then the Fund's total net
assets will be $114 million - an increase of 14% and a total return equal to
the S&P 500 Index. If the Fixed Income Segment's total return is greater or
less than 6.58% per annum, the Fund's total return will, in turn, be greater
or less than the S&P 500 Index.
The Equity Simulation Segment's actual opportunities for gain and loss will
tend to be greater than a hypothetical portfolio invested in the stocks
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comprising the S&P 500 Index if the Fund's exposure to the S&P 500 Index is
higher or lower than the Fund's total assets. For example, the total
notional amount of the Fund's Equity Swap Contracts (less the notional
amount of any Reverse Equity Swap Contracts) plus the face amount of the
Fund's S&P 500 or Other Stock Index Futures plus the market value of common
stocks owned by the Fund may exceed the Fund's total net assets from time to
time, due to purchases and redemptions which will frequently affect the
Fund's total assets and because S&P 500 Index Futures can only be purchased
in multiples of 500 times the S&P 500 Index. Under normal market conditions,
the Fund expects that such variations in exposure to the S&P 500 Index will
generally be up to 5% greater or less than the Fund's total net assets.
Also, the ability of the Equity Simulation Segment of the Fund's portfolio to
replicate the opportunity and risk profile of a hypothetical stock portfolio
may be diminished by imperfect correlations between price movements of the
S&P 500 Index itself with price movements of S&P 500 and Other Stock Index
Futures and/or the common stocks purchased by the Fund. In addition, the
purchase and sale of common stocks and S&P 500 and Other Stock Index Futures
involve transaction costs and Equity Swap Contracts require the Fund to pay
interest on the notional amount of the contract. Therefore, if the aggregate
face amount of the Fund's S&P 500 and Other Stock Index Futures, the
notional amount of the Fund's Equity Swap Contracts (less the notional amount
of any Reverse Equity Swap Contracts) and the value of the Fund's common
stocks is equal to the Fund's total net assets, and if there is exact price
movement correlation between the Fund's common stocks and/or S&P 500 Index
and Other Stock Index Futures and the S&P 500 Index, the Fund will outperform
the S&P 500 Index only if the total net return on the Fixed Income Segment of
the Fund's portfolio exceeds the sum of (1) the Fund's transaction costs on
S&P 500 and Other Stock Index Futures and common stock transactions, (2) the
interest payments under the Fund's Equity Swap Contracts and (3) all the
Fund's operating expenses as described more fully under "Management of the
Fund."
The Equity Plus Fund will not enter into any Equity Swap Contract or Reverse
Equity Swap Contract unless, at the time of entering into such transaction,
the unsecured senior debt of the counterparty is rated at least A by Moody's
Investors Service, Inc. ("Moody's") or Standard & Poor's ("S&P"). In
addition, the staff of the SEC considers Equity Swap Contracts and Reverse
Equity Swap Contracts to be illiquid securities. Consequently, while the
staff maintains this position, the Fund will not invest in Equity Swap
Contracts or Reverse Equity Swap Contracts if, as a result of the investment,
the total value of such investments together with that of all other illiquid
securities which the Fund owns would exceed 15% of the Fund's total assets.
The Adviser and the Equity Plus Fund do not believe that the Fund's
obligations under Equity Swap Contracts or Reverse Equity Swap Contracts are
senior securities, so long as a segregated account is maintained, and,
accordingly, the Fund will not treat them as being subject to its borrowing
restrictions. The net amount of the excess, if any, of the Fund's
obligations over its entitlements with respect to each Equity Swap Contract
and each Reverse Equity Swap Contract will be accrued on a daily basis and an
amount of cash, U.S. Government Securities or other liquid high quality debt
securities having an aggregate market value at least equal to the accrued
excess will be maintained in a segregated account by the Fund's custodian.
The Equity Plus Fund will not purchase S&P 500 or Other Stock Index Futures,
except for bona fide hedging purposes, if as a result the Fund's aggregate
initial margin deposits and premiums would be greater than 5% of the Fund's
-12-
total assets. In addition to margin deposits, when the Fund purchases an S&P
500 or Other Stock Index Futures Contract, it is required to maintain at all
times while the contract is held by the Fund, cash, U.S. government
securities or other liquid high quality debt obligations in a segregated
account with its Custodian, in an amount which, together with the initial
margin deposit on the futures contract, is equal to the current delivery or
cash settlement value of the futures contract.
The Fund will not use Equity Swap Contracts, or S&P 500 or Other Stock Index
Futures for leverage.
Characteristics of the Securities in which the Equity Segment of the Equity
Plus Fund may invest.
Equity Swap Contracts. The Equity Simulation Segment will use equity swap
contracts whose return (before deducting interest costs) is expected to track
closely the return of the S&P 500 Index ("Equity Swap Contracts"). The
counterparty to an Equity Swap Contract will typically be a bank, investment
banking firm or broker/dealer. The counterparty generally agrees to pay the
Fund the amount, if any, by which the notional amount of the Equity Swap
Contract would have increased in value had it been invested in the stocks
comprising the S&P 500 Index in proportion to the composition of the Index,
plus the dividends that would have been received on those stocks. The Fund
agrees to pay to the counterparty a floating rate of interest (typically the
London Inter Bank Offered Rate) on the notional amount of the Equity Swap
Contract plus the amount, if any, by which that notional amount would have
decreased in value had it been invested in such stocks. Therefore, the
return to the Fund on any Equity Swap Contract should be the gain or loss on
the notional amount plus dividends on the stocks comprising the S&P 500 Index
(as if the Fund had invested the notional amount in stocks comprising the S&P
500 Index) less the interest paid by the Fund on the notional amount. The
Fund will enter into Equity Swap Contracts only on a net basis, i.e., where
the two parties' obligations are netted out, with the Fund paying or
receiving, as the case may be, only the net amount of any payments.
Payments under an Equity Swap Contract may be made at the conclusion of the
contract or periodically during its term. If there is a default by the
counterparty to an Equity Swap Contract, the Fund will be limited to
contractual remedies pursuant to the agreements related to the transaction.
There is no assurance that Equity Swap Contract counterparties will be able
to meet their obligations pursuant to Equity Swap Contracts or that, in the
event of default, the Fund will succeed in pursuing contractual remedies.
The Fund thus assumes the risk that it may be delayed in or prevented from
obtaining payments owed to it pursuant to Equity Swap Contracts. The Fund
will closely monitor the credit of Equity Swap Contract counterparties in
order to minimize this risk.
The Fund may from time to time enter into the opposite side of Equity Swap
Contracts (i.e., where the Fund is obligated to pay the increase (net of
interest) or receive the decrease (plus interest) on the S&P 500 Index) to
reduce the amount of the Fund's equity market exposure consistent with the
Fund's objective. These positions are sometimes referred to as "Reverse
Equity Swap Contracts".
S&P 500 Index and Other Stock Index Futures. The Equity Simulation Segment
of the Fund may also invest in S&P 500 and Other Stock Index Futures to track
the return of the S&P 500 Index.
-13-
S&P 500 and Other Stock Index Futures represent contracts to buy a number of
units of the S&P 500 Index or some other stock index at a specified future
date at a price agreed upon when the contract is made. Upon entering into a
contract, the Fund will be required to deposit with its custodian in a
segregated account in the name of the futures broker a specified amount of
cash or securities, generally not exceeding 5% of the face amount of the
contract. This amount is known as "initial margin" and is in the nature of
a performance bond or good faith deposit on the contract which is returned to
the Fund upon termination of the futures contract, assuming all contractual
obligations have been satisfied. Subsequent payments, called "variation
margin" to and from the broker will be made on a daily basis as the price of
the S&P 500 or Other Stock Index Future fluctuates.
Long positions in S&P 500 or Other Stock Index Futures may be closed out only
by entering into a futures contract sale with the same terms as the contract
to be closed out on the futures exchange on which the futures are traded.
The liquidity of the market in S&P 500 or Other Stock Index Futures could be
adversely affected by "daily price fluctuation limits" established by an
exchange which limit the amount of fluctuation in the price of an S&P 500 or
Other Stock Index Futures contract during a single trading day. In such
case, it may not be possible for the Fund to close out its futures contract
position, and, in the event of adverse price movements, the Fund would
continue to be required to make daily cash payments of variation margin.
Common Stocks. When S&P 500 or Other Stock Index Futures and/or Equity Swap
Contracts are, in the judgement of the Adviser, overpriced relative to the
common stocks underlying the S&P 500 Index, the Fund may also invest directly
in the common stocks represented by the S&P 500 Index. The Fund will
generally not own all 500 issues, but will attempt to purchase a basket of
common stocks which the Adviser expects will, on average, match movements in
the S&P 500 Index. Subject to limits on the Fund's investments in other
investment companies, the Fund may also invest in these stocks indirectly by
purchasing interests in asset pools investing in such stocks. To the extent
that the Fund purchases interests in other investment companies, shareholders
of the Fund may be subject to a layering of expenses because they may
indirectly bear a proportionate share of the expenses of such investment
companies (including advisory fees) in addition to bearing the direct
expenses of the Fund.
Investment Policies of the Short and Intermediate Series and the Fixed Income
Segment of the Equity Plus Fund
The Short and Intermediate Series each seek to achieve their investment
objective by investing, under normal circumstances, at least 70% of their
total assets in fixed-income U.S. Government securities. The Fixed Income
Segment of the Equity Plus Fund will also invest substantially in U.S.
Government securities." U.S. Government Securities" include U.S. Treasury
Bills, Notes, Bonds, discount notes and other debt securities issued by the
U.S. Treasury, and obligations issued or guaranteed by the U.S. Government,
its agencies and instrumentalities, including, but not limited to Government
National Mortgage Association ("GNMA"), Federal National Mortgage Association
("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") securities.
(Other U.S. Government agencies or instrumentalities include Federal Home
Loan Banks, Bank for Cooperatives, Farm Credit Banks, Tennessee Valley
Authority, Federal Financing Bank, Small Business Administration, and Federal
Agricultural Mortgage Corporation.) It is anticipated that the Funds will
invest substantially in FNMA, FHLMC, and GNMA mortgage-backed certificates
-14-
and other U.S. Government Securities representing ownership interests in
mortgage pools.
With respect to their remaining assets, the Short and Intermediate Series may
invest in fixed-rate and adjustable-rate mortgage-backed securities issued by
private originators of, or investors in, mortgage loans issued by private
entities that are rated AAA by Standard & Poor's ("S&P") or Aaa by Moody's
Investors Service ("Moody's") or, if unrated, determined by the Adviser to be
of comparable quality. The two Series may also invest in money market
instruments of a comparable short-term rating or credit quality, as well as
in time and savings deposits (including fixed-rate or adjustable-rate
certificates of deposit) in commercial banks or in institutions whose
accounts are insured by the FDIC, BIF or SAIF. The Short and Intermediate
Series will not pay any additional fees for credit support and will not
invest in private mortgage pass-through securities unless they are rated AAA
by S&P or Aaa by Moody's, or are unrated but deemed to be of comparable
credit quality by the Adviser. In addition, the Short and Intermediate
Series will only purchase mortgage-backed securities which constitute
"Mortgage Related Securities" for purposes of the Secondary Mortgage Market
Enhancement Act of 1984.
With respect to the remaining assets of the Equity Plus Fund, its Fixed
Income Segment may invest a portion of its assets in bank certificates of
deposit, corporate debt obligations, and mortgage-backed and other asset-
backed securities of non-governmental issuers. At the time of purchase, with
the exception of mortgage-backed and asset-backed securities, the Fund's
Fixed Income Segment's investments will be either of investment grade (as
rated by S&P or Moody's), or, if unrated, determined by the Adviser to be of
comparable quality. Its investment in mortgage-backed and other asset-backed
securities will be rated at least A by Moody's and S&P. The lowest quality
investment grade fixed income securities are rated BBB by Moody's or Baa by
S&P, have certain speculative characteristics, and are more susceptible to
adverse changes in circumstances and economic conditions than higher rated
fixed income securities. The Adviser will monitor the Equity Plus Fund's
investments in fixed income securities and will cause the Equity Plus Fund to
dispose of any such security whose rating is reduced to below investment
grade.
While certain U.S. Government securities such as U.S. Treasury obligations
and GNMAs are backed by the full faith and credit of the U.S. Government,
other securities in which the Funds may invest are subject to varying degrees
of risk of default. These risk factors include the creditworthiness of the
issuer and, in the case of mortgage-backed and asset-backed securities, the
ability of the mortgagor or other borrower to meet its obligations. The
Short and Intermediate Series will seek to minimize this credit risk by
investing in securities of the highest credit quality instruments, while the
Equity Plus Fund will seek to minimize this risk of default by investing in
securities of investment grade. The individual securities continue to be
subject to the risk that their prices can fluctuate, in some cases
significantly, due to changes in prevailing interest rates.
The Short and Intermediate Series may employ certain active management
techniques both to hedge the interest rate risks associated with portfolio
securities and to seek to minimize fluctuation in net asset values in
accordance with their investment objectives and targeted option-adjusted
durations. In addition, the Fixed Income Segment of the Equity Plus Fund
will engage in various hedging strategies so that its volatility will be
-15-
similar to that of a one-year Treasury Bill. Such investment techniques and
hedging strategies include mortgage and interest rate swaps, interest rate
futures and options on such futures, short sales and interest rate caps,
floors and collars. In addition, the Short and Intermediate Series may use
stripped mortgage-backed securities to reduce the option-adjusted duration.
Appendix A provides information about these hedging techniques.
There can be no assurance that the hedging techniques employed by the Short
and Intermediate Series and the Fixed Income Segment of the Equity Plus Fund
will be successful. As a result, the Funds may not achieve, and may at times
exceed, their targeted option-adjusted duration. The Funds' hedging
techniques may not be successful because the Adviser's computation of
option-adjusted duration is based on estimates of expected prepayment rates,
valuation of homeowners' prepayment options, and the correlation of changes
in the market prices of the securities and the hedge instruments owned by the
Funds (as described in Appendix A).
Both of the Series, as well as the Fixed Income Segment of the Equity Plus
Fund, may also engage in loans of portfolio securities, dollar rolls and
reverse repurchase agreements as investment techniques. These techniques
will be undertaken to enhance income and total return.
Characteristics of the Securities in which the Short and Intermediate Series
and Fixed Income Segment of the Equity Plus Fund Invest.
Mortgage-Backed and Other Asset-Backed Securities. Mortgage-backed
securities are securities that directly or indirectly represent a
participation in, or are collateralized by and payable from, mortgage loans
secured by real property. The term "mortgage-backed securities", as used
herein, includes adjustable-rate mortgage securities, fixed-rate mortgage
securities, and derivative mortgage products such as collateralized mortgage
obligations, stripped mortgage-backed securities and other instruments
described below.
There are currently three basic types of mortgage-backed securities: (i)
those issued or guaranteed by the U.S. Government or one of its agencies or
instrumentalities, such as GNMA, FNMA and FHLMC; (ii) those issued by private
issuers that represent an interest in or are collateralized by
mortgage-backed securities issued or guaranteed by the U.S. Government or one
of its agencies or instrumentalities; and (iii) those issued by private
issuers that represent an interest in or are collateralized by whole mortgage
loans or mortgage-backed securities without a government guarantee but
usually having some form of private credit enhancement.
The Equity Plus Fund may invest in other mortgage-backed and asset-backed
securities. Asset-backed securities are structured like mortgage-backed
securities, but instead of mortgage loans or interests in mortgage loans, the
underlying assets may include, but are not limited to, pools of automobile
loans, educational loans and credit card receivables.
Mortgage-backed and asset-backed securities have yield and maturity
characteristics corresponding to their underlying assets. Unlike traditional
debt securities, which may pay a fixed rate of interest until maturity when
the entire principal amount comes due, payments on certain mortgage-backed
and asset-backed securities include both interest and a partial payment of
principal. This partial payment of principal may be comprised of a scheduled
principal payment as well as an unscheduled payment from the voluntary
-16-
prepayment, refinancing, or foreclosure of the underlying loans. As a result
of these unscheduled payments of principal, or prepayments on the underlying
securities, the price and yield of mortgage-backed securities can be
adversely affected. For example, during periods of declining interest rates,
prepayments can be expected to accelerate, and the Funds would be required to
reinvest the proceeds at the lower interest rates then available.
Prepayments of mortgages which underlie securities purchased at a premium
could result in capital losses because the premium may not have been fully
amortized at the time the obligation is prepaid. In addition, like other
interest-bearing securities, the values of mortgage-backed securities
generally fall when interest rates rise, but when interest rates fall, their
potential for capital appreciation is limited due to the existence of the
prepayment feature. In order to hedge against possible prepayment, the Funds
may purchase certain options and options on futures contracts as described
more fully in Appendix A.
Adjustable-Rate Securities. Adjustable-rate securities are securities that
have interest rates that are reset at periodic intervals, usually by
reference to some interest rate index or market interest rate. Some
adjustable-rate securities are backed by pools of mortgage loans. The Short
and Intermediate Series will only invest in adjustable-rate securities backed
by pools of mortgage loans ("ARMs"). The Fixed Income Segment of the Equity
Plus Fund may invest in adjustable-rate securities backed by assets other
than mortgage pools.
Although the rate adjustment feature may act as a buffer to reduce large
changes in the value of adjustable-rate securities, these securities are
still subject to changes in value based on changes in market interest rates
or changes in the issuer's creditworthiness. Because the interest rate is
reset only periodically, changes in the interest rates on adjustable-rate
securities may lag changes in prevailing market interest rates. Also, some
adjustable-rate securities (or the underlying mortgages or other underlying
loans or receivables) are subject to caps or floors that limit the maximum
change in interest rate during a specified period or over the life of the
security. Because of the resetting of interest rates, adjustable-rate
securities are less likely than non-adjustable-rate securities of comparable
quality and maturity to increase significantly in value when market interest
rates fall. Adjustable-rate securities are also subject to the prepayment
risks associated with mortgage-backed securities generally.
Collateralized Mortgage Obligations ("CMOs") A CMO is a security backed by
a portfolio of mortgages or mortgage-backed securities held under an
indenture. The issuer's obligation to make interest and principal payments
is secured by the underlying portfolio of mortgages or mortgage-backed
securities. CMOs are issued with a number of classes or series which have
different maturities representing interests in some or all of the interest or
principal on the underlying collateral or a combination thereof. Payments of
interest or principal on some classes or series of CMOs may be subject to
contingencies, or some classes or series may bear some or all of the risk of
default on the underlying mortgages. CMOs of different classes are generally
retired in sequence as the underlying mortgage loans in the mortgage pools
are repaid. In the event of sufficient early prepayments on such mortgages,
the class or series of CMO first to mature generally will be retired prior to
its stated maturity. Thus, the early retirement of a particular class or
series of a CMO held by the Funds would have the same effect as the
prepayment of mortgages underlying a mortgage-backed pass-through security.
Another type of CMO is a real estate mortgage investment conduit ("REMIC")
-17-
which qualifies for special tax treatment under the Internal Revenue Code and
invests in certain mortgages principally secured by interests in real
property and other permitted investments.
CMOs also include securities representing the interest in any excess cash
flow and/or the value of any collateral remaining after the issuer has
applied cash flow from the underlying mortgages or mortgage-backed securities
to the payment of principal of and interest on all other CMOs and the
administrative expenses of the issuer ("Residuals"). Residuals have value
only to the extent that income from such underlying mortgages or
mortgage-backed securities exceeds the amounts necessary to satisfy the
issuer's debt obligations represented by all other outstanding classes or
series of the CMOs. In addition, if a CMO bears interest at an adjustable-
rate, the cash flows on the related Residual will also be extremely sensitive
to the level of the index upon which the rate adjustments are based. As a
non-fundamental policy (meaning it can be changed without the vote of the
shareholders), the Short and Intermediate Series will not invest in
Residuals.
In reliance on an interpretation by the Securities and Exchange Commission
("SEC"), the Funds' investments in certain qualifying CMOs and REMICs are not
subject to the 1940 Act's limitations on acquiring interests in other
investment companies. See "Investment Restrictions" in the Statement of
Additional Information with respect to each Fund. CMOs and REMICs issued by
an agency or instrumentality of the U.S. Government are considered U.S.
Government securities for the purposes of this Prospectus.
Stripped Securities ("STRIPS"). The Funds may invest in STRIPS. The Short
and Intermediate Series may invest only in stripped mortgage-backed
securities ("SMBS") which are STRIPS represented by derivative multi-class
mortgage securities. In addition to SMBS issued by the U.S. Government, its
agencies or instrumentalities, the Short and Intermediate Series may purchase
SMBS issued by private originators of, or investors in, mortgage loans,
including depository institutions, mortgage banks, investment banks and
special purpose subsidiaries of these entities. However, the Short and
Intermediate Series will purchase only SMBS that are collateralized by
mortgage-backed securities that are issued or guaranteed by the U.S.
Government or its agencies or instrumentalities. The Equity Plus Fund may
invest in STRIPS collateralized by other fixed income securities, including
other types of asset-backed securities.
STRIPS are usually structured with two classes that receive different
proportions of the interest and principal distributions from a pool of
underlying assets. A common type of STRIP will have one class receiving all
of the interest from the underlying assets ("interest-only" or "IO" class),
while the other class will receive all of the principal ("principal-only" or
"PO" class). However, in some instances, one class will receive some of the
interest and most of the principal while the other class will receive most of
the interest and the remainder of the principal. STRIPS are unusually
volatile in response to changes in interest rates. The yield to maturity on
an IO class of STRIPS is extremely sensitive not only to changes in
prevailing interest rates but also to the rate of principal payments
(including prepayments) on the underlying assets. A rapid rate of principal
prepayments may have a measurably adverse effect on a Fund's yield to
maturity to the extent it invests in IOs. Conversely, POs tend to increase
in value if prepayments are greater than anticipated and decline if
prepayments are slower than anticipated. Thus, if the underlying assets
-18-
experience greater than anticipated prepayments of principal, a Fund may fail
to fully recover its initial investment in these securities, even if the
STRIPS were rated of the highest credit quality by S&P or Moody's,
respectively. The Adviser will seek to manage these risks (and potential
benefits) by investing in a variety of such securities and by using certain
hedging techniques, as described below in "Hedging Instruments" and in
Appendix A. In addition, the secondary market for STRIPS may be less liquid
than that for other mortgage-backed or asset-backed securities, potentially
limiting a Fund's ability to buy or sell those securities at any particular
time.
The Adviser expects that IO SMBS will be purchased by the Short and
Intermediate Series for their hedging characteristics. Such SMBS will reduce
the variance of the Funds' respective net asset values from their targeted
option-adjusted durations. Under no circumstances will the Short or
Intermediate Series purchase SMBS if such purchase would cause SMBS to exceed
5% of the assets of a Fund.
New instruments and variations of existing mortgage-backed securities
continue to be developed. The Funds may invest in any such instruments or
variations to the extent consistent with their investment objectives and
policies and applicable regulatory requirements.
Zero Coupon Securities. The Funds may also invest in "zero coupon"
securities (which are issued at a significant discount from face value and
pay interest only at maturity rather than at intervals during the life of the
security). Zero coupon securities tend to be more volatile than other
securities with similar stated maturities, but which make regular payments of
either principal or interest.
The Funds are required to accrue and distribute income from zero coupon
securities on a current basis, even though a Fund does not receive the income
currently. Thus, a Fund may have to sell other investments to obtain cash
needed to make income distributions, which may reduce a Fund's assets and may
thereby increase its expense ratio and decrease its rate of return.
Hedging Instruments. The Funds may employ certain active management
techniques to achieve their duration objectives and to hedge the interest-
rate risks associated with their fixed-income securities in accordance with
such objectives. Since some of the securities may have longer or shorter
durations than a Fund's specified duration objectives, hedging may be
required either to lengthen or to shorten the duration of a Fund's portfolio.
The Funds will seek continually to manage duration within a narrow range.
The Funds intend to use hedging transactions primarily to protect against
interest-rate fluctuations and not as speculative transactions. The Funds
may also use hedging transactions as a temporary substitute for purchasing
particular securities. Each Fund may enter into mortgage and interest-rate
swaps, purchase or sell interest-rate floors, caps or collars, enter into
interest-rate futures contracts and related options, and engage in short
sales to hedge against interest rate fluctuations. In addition, the Funds
may use SMBS to better maintain their respective targeted option-adjusted
durations.
Any or all of these techniques may be used at one time. Use of any
particular transaction is a function of market conditions. The hedging
transactions that the Funds currently contemplate using are described in
detail in Appendix A, including a discussion of their respective risks.
-19-
As a matter of fundamental policy, the Short and Intermediate Series will
limit purchases to the following classes of assets:
1. Securities issued directly or guaranteed by the U.S. Government or its
agencies or instrumentalities;
2. Mortgage-Backed Securities rated AAA by S&P or Aaa by Moody's or unrated
but deemed of equivalent quality by the Adviser;
3. Assets fully collateralized by assets in either of the above classes;
4. Assets which would qualify as liquidity items under federal regulations
if held by a commercial bank or savings institution; and
5. Hedge instruments, which may only be used for risk management purposes.
Any securities described in the "Hedging" section and any stripped
Mortgage-Backed Securities may only be used for risk management
purposes.
OTHER INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Funds may also engage in the following investment practices, each of
which may involve certain special risks. The Statement of Additional
Information for each Fund contains more detailed information about these
practices, including limitations designed to reduce these risks.
Securities Loans, Repurchase Agreements and Forward Commitments. The Funds
may lend portfolio securities to broker-dealers and may enter into repurchase
agreements. These transactions must be fully collateralized at all times but
involve some risk to the Funds if the other party should default on its
obligations and a Fund is delayed or prevented from recovering the
collateral. None of the Funds will lend portfolio securities if, as a
result, the aggregate of such loans exceeds 33 1/3% of the total asset value
(including such loans.) The Funds will only enter into repurchase agreements
with or lend securities to (i) member banks of the Federal Reserve System
having total assets in excess of $500 million and (ii) securities dealers,
provided such banks or dealers meet the creditworthiness standards
established by the Board of Trustees ("Qualified Institutions"). The Adviser
will monitor the continued creditworthiness of Qualified Institutions,
subject to the oversight of the Board of Trustees.
The Funds may also purchase securities for future delivery, which may
increase overall investment exposure and involves a risk of loss if the value
of the securities declines prior to the settlement date. At the time a Fund
enters into a transaction on a when-issued or forward commitment basis, a
segregated account consisting of cash, U.S. Government securities or other
liquid high grade debt securities equal to at least 100% of the value of the
when-issued or forward commitment securities will be established and
maintained with the Funds' custodian. Subject to this requirement, the Funds
may purchase securities on such basis without limit. Settlements in the
ordinary course, which may be substantially more than three business days for
mortgage-backed securities, are not treated as when-issued or forward
commitment transactions, and are not subject to the foregoing limitations,
although some of the risks described above may exist.
Reverse Repurchase Agreements, Dollar Roll Agreements and Borrowing. In
order to increase income, the Funds may enter into reverse repurchase
agreements or dollar roll agreements with commercial banks and registered
broker-dealers in amounts up to 33 1/3% of their assets. The Short and
Intermediate Series may only enter into these transactions with commercial
banks and registered broker-dealers which are also Qualified Institutions.
-20-
The Statement of Additional Information for each Fund contains a more
detailed explanation of these practices. Reverse repurchase agreements and
dollar rolls are considered borrowings by a Fund and require segregation of
assets with a Fund's custodian in an amount equal to the Fund's obligations
pending completion of such transactions. Each Fund may also borrow money
from banks in an amount up to 33 1/3% of a Fund's total assets to realize
investment opportunities, for extraordinary or emergency purposes, or for the
clearance of transactions. Borrowing from banks usually involves certain
transaction and ongoing costs and may require a Fund to maintain minimum bank
account balances. Use of these borrowing techniques to purchase securities
is a speculative practice known as "leverage." Depending on whether the
performance of the investments purchased with borrowed funds is sufficient to
meet the costs of borrowing, a Fund's net asset value per share will increase
or decrease, as the case may be, more rapidly than if the Fund did not employ
leverage.
Short Sales. The Funds may make short sales of securities. A short sale is
a transaction in which the Fund sells a security it does not own in
anticipation that the market price of that security will decline. The Funds
expect to engage in short sales as a form of hedging to shorten the overall
duration of the portfolio and in order to maintain portfolio flexibility.
When a Fund makes a short sale, it must borrow the security sold short and
deliver it to the broker-dealer through which it made the short sale as
collateral for its obligation to deliver the security upon completion of the
transaction. A Fund may have to pay a fee to borrow particular securities
and is often obligated to relinquish any payments received on such borrowed
securities.
Until a Fund replaces a borrowed security, it will maintain daily a
segregated account with its custodian containing cash, U.S. Government
securities, or other liquid high-grade debt obligations, such that the amount
deposited in the account plus any amount deposited with the broker as
collateral will equal the current value of the security sold short.
Depending on arrangements made with the broker, a Fund may not receive any
payments (including interest) on collateral deposited with the broker. If the
price of the security sold short increases between the time of the short sale
and the time a Fund replaces the borrowed security, the Fund will incur a
loss; conversely, if the price declines, the Fund will realize a gain.
Although a Fund's gain is limited to the amount at which it sold the security
short, its potential loss is limited only by the maximum attainable price of
the security less the price at which the security was sold.
A Fund will not make a short sale if, after giving effect to such sale, the
market value of all securities sold exceeds 25% of the value of the Fund's
total net assets. A Fund may also effect short sales where the Fund owns or
has the right to acquire at no additional cost the identical security (a
technique known as a short sale "against the box").
Illiquid Securities. A Fund may invest up to 15% of its net assets in
securities for which there are legal or contractual restrictions on resale or
for which there is no readily available market or other illiquid securities,
including non-terminable repurchase agreements having maturities of more than
seven days. See "Investment Restrictions" in the Statement of Additional
Information for each Fund. The Adviser will monitor a Fund's investments in
illiquid securities under the supervision of the Trustees. The determination
of whether certain IO/PO Strips issued by the U.S. Government and backed by
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fixed-rate mortgages or any other securities in which a Fund desires to
invest are liquid shall be made by the Trustees or the Adviser under
guidelines established by the Trustees in accordance with applicable
pronouncements of the SEC. At present, all other IO/PO Strips, other
residual interests of CMOs and OTC options are treated as illiquid
securities. The SEC staff also currently takes the position that the
interest rate swaps, caps and floors discussed in Appendix A, as well as
Equity Swap Contracts and Reverse Equity Swap Contracts, are illiquid.
Portfolio Turnover. The Adviser buys and sells securities for a Fund
whenever it believes it is appropriate to do so. Portfolio turnover
generally involves some expense to a Fund, including brokerage commissions or
dealer mark-ups and other transaction costs on the sale of securities and
reinvestment in other securities. Such transactions may result in
realization of taxable capital gains. The portfolio turnover rate for each
Fund's previous fiscal periods is shown in the table under the heading
"Financial Highlights".
While the Funds will pay commissions in connection with options and future
transactions and, for the Equity Plus Fund only, possibly in relation to any
purchase of common stocks, most of the securities in which the Funds invest
are generally traded on a "net" basis with dealers acting as principals for
their own account without a stated commission. Nevertheless, high portfolio
turnover may involve correspondingly greater brokerage commissions and other
transaction costs which will be borne directly by a Fund.
Another potential consequence of high portfolio turnover is that if 30% or
more of a Fund's gross income for a taxable year is derived from gains from
the sale of securities held for less than three months, the Fund would not
qualify as a regulated investment company and, therefore, would be subject
to corporate income tax during that taxable year. The Adviser endeavors to
manage the investment composition of the Funds and to adjust the portfolio
turnover, if necessary, to ensure that each Fund will be eligible for
treatment as a regulated investment company.
MANAGEMENT OF THE FUNDS
The business affairs of the Funds are managed by its Board of Trustees. Each
of the Funds has entered into an investment advisory agreement with Smith
Breeden Associates, Inc., 100 Europa Drive, Chapel Hill, North Carolina,
27514 ( the "Investment Advisory Agreements"). Pursuant to such investment
advisory agreements, the Adviser furnishes continuous investment advisory
services to each of the Funds.
Trustees and Officers
The following is a listing of the Trustees and officers of the Series Fund
and Trust, the legal entities that have issued shares in the Funds. Unless
otherwise indicated, all of the named individuals serve in their capacities
for both the Series Fund and Trust.
Douglas T. Breeden* Trustee and Chairman
Dr. Breeden, the Chairman of the Board of Smith Breeden Associates,
co-founded the firm in 1982. Dr. Breeden has served on business school
faculties at Duke University, Stanford University and the University of
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Chicago, and as a visiting professor at Yale University and at the
Massachusetts Institute of Technology. He is the Editor of the Journal of
Fixed Income. Dr. Breeden has served as Associate Editor for five journals
in financial economics, and was elected to the Board of Directors of the
American Finance Association. He has published several well-cited articles
in finance and economics journals. He holds a Ph.D. in Finance from the
Stanford University Graduate School of Business, and a B.S. in Management
Science from the Massachusetts Institute of Technology. He is a Director of
Roosevelt Bank of St. Louis, the nation's tenth largest thrift, and served
as Chairman in 1995-96. He also is a principal investor and strategist for
Community First Financial Group, a commercial bank holding company with three
small banks located in Indiana and California. He serves as Chairman of
Harrington Financial Group, the holding company for Harrington Bank, F.S.B.,
of Richmond, Indiana.
Michael J. Giarla* Trustee and President
Mr. Giarla, is an Executive Vice President, a Director and the Chief
Operating Officer of Smith Breeden Associates. He also serves as a Director
of Harrington Financial Group, the holding company for Harrington Bank,
F.S.B., of Richmond, Indiana. Formerly Smith Breeden's Director of Research,
he was involved in research and programming, particularly in the development
and implementation of models to evaluate and hedge mortgage securities. He
also consults with institutional clients and conducts special projects.
Before joining Smith Breeden Associates, Mr. Giarla was a Summer Associate in
Goldman Sachs & Company's Equity Strategy Group in New York. Mr. Giarla has
published a number of articles and book chapters regarding MBS investment,
risk management and hedging. He served as an Associate Editor of The Journal
of Fixed Income from 1991-1993. Mr. Giarla holds a Master of Business
Administration with Concentration in Finance from the Stanford University
Graduate School of Business, where he was an Arjay Miller Scholar. He earned
a Bachelor of Arts in Statistics, summa cum laude, from Harvard University,
where he was elected to Phi Beta Kappa and was a Harvard Club of Boston
Scholar. Mr. Giarla is a Trustee of the Roxbury Latin School, West Roxbury,
Massachusetts.
Stephen M. Schaefer Trustee
Stephen M. Schaefer is Esmee Fairbairn Professor of Finance at the London
Business School. Previously on the Faculty of the Graduate School of
Business of Stanford University, he has also taught at the Universities of
California (Berkeley), Chicago, British Columbia and Venice. His research
interests focus on capital markets and financial regulation. He has served
on the editorial board of a number of professional journals including,
currently, the Journal of Fixed Income, the Review of Derivative Research,
and Ricerche Economiche. He consults for a number of leading financial
institutions and is an Independent Board Member of the Securities and Futures
Authority of Great Britain.
Myron S. Scholes Trustee
Myron S. Scholes is the Frank E. Buck Professor of Finance at the Graduate
School of Business at Stanford University (since 1983); a Senior Research
Fellow at the Hoover Institution (since 1987); and is currently on leave as
a Professor of Law, Stanford Law School. He is a Principal in the money
management firm Long-Term Capital Management Co. (since 1993). He is a
Research Associate of the National Bureau of Economic Research and is a
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member of the Econometric Society. Professor Scholes was also a Managing
Director and co-head of the fixed income derivatives group at Salomon
Brothers between 1991-1993. Prior to coming to Stanford University,
Professor Scholes was the Edward Eagle Brown Professor of Finance at the
Graduate School of Business, University of Chicago (1974-1983). He served as
the Director of the University of Chicago's Center for Research in Security
Prices from 1974-1980. Prior to coming to the University of Chicago,
Professor Scholes was first an Assistant Professor then an Associate
Professor at the Sloan School of Management at M.I.T. from 1968 to 1973. He
received his Ph.D. in 1969 from the Graduate School of Business, University
of Chicago. He has honorary Doctor of Law degrees from the University of
Paris and McMaster University. He is a past president of the American
Finance Association (1990).
Dr. Scholes has published numerous articles in academic journals and in
professional volumes. He is most noted as the co-originator of the
Black-Scholes Options Pricing Model as described in the paper, "The Pricing
of Options and Corporate Liabilities," published in the Journal of Political
Economy (May 1973) (with Fischer Black). His other papers include such
topics as risk-return relationships, the effects of dividend policy on stock
prices, and the effects of taxes and tax policy on corporate decision making.
His book with Mark Wolfson (Stanford University) Taxes and Business Strategy:
A Planning Approach was published by Prentice Hall in 1991.
William F. Sharpe Trustee
William F. Sharpe is the STANCO 25 Professor of Finance at Stanford
University's Graduate School of Business. He is best known as one of the
developers of the Capital Asset Pricing Model, including the beta and alpha
concepts used in risk analysis and performance measurement. He developed
the widely-used binomial method for the valuation of options and other
contingent claims. He also developed the computer algorithm used in many
asset allocation procedures, and a procedure for estimating the style of an
investment manager from its historic returns. Dr. Sharpe has published
articles in a number of professional journals. He has also written six
books, including Portfolio Theory and Capital Markets, (McGraw-Hill, 1970),
Asset Allocation Tools, (Scientific Press, 1987), Fundamentals of Investments
(with Gordon J. Alexander and Jeffery Bailey, Prentice-Hall, 1993) and
Investments (with Gordon J. Alexander and Jeffrey Bailey, Prentice-Hall,
1990). Dr. Sharpe is a past President of the American Finance Association.
He has also served as consultant to a number of corporations and investment
organizations. He is also a member of the Board of Trustees of Rosenberg
Series Trust, an investment company, and a director at CATS Software and
Stanford Management Company. He received the Nobel Prize in Economic
Sciences in 1990.
Daniel C. Dektar Vice President, Smith Breeden Series Fund
Portfolio Manager, Short and Intermediate
Series
Principal, Executive Vice President, Director of Portfolio Management, and
Director of Smith Breeden Associates. Mr. Dektar has been primarily
responsible for the day-to-day management of the Short and Intermediate
Series from their commencement of their operations in 1992. As head of Smith
Breeden Associates' portfolio management group, Mr. Dektar is constantly in
touch with developments on Wall Street. He serves as a liaison among the
portfolio management, client service, and research groups to ensure accurate
-24-
analysis and timely execution of portfolio management opportunities. Mr.
Dektar consults with institutional clients in the areas of investments and
risk management. He has made several presentations on mortgage investments
and risk management at seminars for institutional investors. Mr. Dektar was
an Associate in the Mergers and Acquisitions Group of Montgomery Securities
in San Francisco, California and a Financial Analyst in the Investment
Banking Division of Morgan Stanley & Co., Incorporated, New York before
joining Smith Breeden Associates. He holds a Master of Business
Administration with Concentration in Finance from Stanford University
Graduate School of Business, where he was an Arjay Miller Scholar. Mr.
Dektar received a Bachelor of Science in Business Administration, summa cum
laude, from the University of California at Berkeley, where he was University
of California Regent's Scholar, was elected to Phi Beta Kappa and Phi Eta
Sigma, and won the White Award as the top student in finance.
John B. Sprow Vice President, Smith Breeden Trust
Portfolio Manager, Equity Plus Fund
Principal and Vice President, Smith Breeden Associates. Mr. Sprow has been
primarily responsible for the day-to-day management of the Equity Plus Fund
from the commencement of its operations in 1992. Mr. Sprow is a senior
portfolio manager who works primarily with discretionary pension accounts.
In addition to traditional mortgage accounts, he manages S&P 500 indexed
accounts. Prior to directly managing discretionary accounts, Mr. Sprow's
research and programming efforts assisted in the development of the Adviser's
models for pricing and hedging mortgage-related securities, risky commercial
debt, and forecasting mortgage prepayment behavior. Mr. Sprow came to Smith
Breeden Associates from the Fuqua School of Business, Duke University, where
he was Research Assistant. Previously, Mr. Sprow was a Research Assistant to
the Department Head of the Materials Science Department, Cornell University.
He received a Master of Business Administration with Emphasis in Finance from
the Fuqua School of Business, Duke University. Mr. Sprow holds a Bachelor of
Science in Materials Science and Engineering from Cornell University, where
he was awarded the Carpenter Technology Scholarship three successive years.
Marianthe S. Mewkill Vice President, Secretary, Treasurer, and
Chief Accounting Officer
Principal, Vice President and Chief Financial Officer, Smith Breeden
Associates. Ms. Mewkill handles financial reporting, budgeting, tax research
and planning for the Smith Breeden Family of Funds and for Smith Breeden
Associates, Inc.. She ensures compliance with agency regulations and
administers the company's internal trading and other policies. She was
previously employed as a Controller for the Hunt Alternatives Fund, as an
Associate at Goldman Sachs & Co., and as a Senior Auditor at Arthur Andersen
& Co. She earned a Master of Business Administration with Concentrations in
Finance and Accounting from New York University and graduated from Wellesley
College, magna cum laude with a Bachelor of Arts degree in History and French
and a Minor in Economics.
* Interested Party
Investment Adviser
Smith Breeden Associates, Inc., a registered investment adviser, acts as
investment adviser to the Funds. Approximately 71% of the Adviser's voting
stock is owned by Douglas T. Breeden, its Chairman and President. Under its
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Investment Advisory Agreement with each Fund, the Adviser, subject to the
general supervision of the Board of Trustees, manages the Funds' portfolios
and provides for the administration of all of the Funds' other affairs. For
these services, the Adviser receives a fee, computed daily, and payable
monthly, at the annual rate of 0.70% of the Funds' average daily net assets.
Until March 31, 1997, the Adviser has voluntarily agreed to reduce its
compensation, and to the extent necessary absorb other expenses of the Funds,
such that the total expenses (exclusive of ordinary brokerage commissions,
investment transaction taxes and extraordinary expenses) do not exceed 0.88%
of the average net assets for each of the Equity Plus Fund and the
Intermediate Series, and 0.78% of the average net assets of the Short Series.
The Adviser places all orders for purchases and sales of the Funds'
securities. Subject to seeking the most favorable price and execution
available, the Adviser may consider sales of shares of the Funds as a factor
in the selection of broker-dealers.
Distribution
Fund/Plan Broker Services, Inc. ( the "Principal Underwriter") acts as
distributor for the Funds for which the Adviser pays the Principal
Underwriter a fee of $25,000. Shares also may be sold by authorized dealers
who have entered into dealer agreements with the Principal Underwriter or the
Adviser.
Expenses
The Funds pay all of their own expenses, including without limitation, the
cost of preparing and printing their registration statements required under
the Securities Act of 1933 and the 1940 Act and any amendments thereto, the
expense of registering their shares with the Securities and Exchange
Commission and the various states, the printing and distribution costs of
prospectuses mailed to existing investors, reports to investors, reports to
government authorities and proxy statements, fees paid to directors who are
not interested persons of the Adviser, interest charges, taxes, legal
expenses, association membership dues, auditing services, insurance premiums,
brokerage commissions and expenses in connection with portfolio transactions,
fees and expenses of the custodian of their assets, printing and mailing
expenses and charges and expenses of dividend disbursing agents, accounting
services agents, registrars and stock transfer agents.
PRICING OF FUND SHARES
The price you pay when buying a Fund's shares, and the price you receive when
selling (redeeming) a Fund's shares, is the net asset value of the shares
next determined after receipt of a purchase or redemption request in proper
form. No front end sales charge or commission of any kind is added by the
Fund upon a purchase and no charge is deducted upon a redemption. The Funds
currently charge a $9 fee for each redemption made by wire. See "How to
Redeem Shares."
The per share net asset value of a Fund is determined by dividing the total
value of its assets, less its liabilities, by the total number of its shares
outstanding at that time. The net asset value is determined as of the close
of regular trading (currently 4:00 p.m. Eastern time) each day that the
Adviser and Transfer Agent are open for business and on which there is a
sufficient degree of trading in a Fund's securities such that the net asset
value of a Fund's shares might be affected. Accordingly, Purchase
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Applications accepted or redemption requests received in proper form by the
Transfer Agent, or other agent designated by the Funds, prior to 4:00 p.m.
Eastern time, each day that the Adviser and Transfer Agent are open for
business, will be confirmed at that day's net asset value. Purchase
Applications accepted or redemption requests received in proper form after 4
p.m Eastern Time by the Transfer Agent, or other agent designated by the
Funds, will be confirmed at the net asset value of the following business
day.
Current holiday schedules indicate that the Funds' net asset values will not
be calculated on New Year's Day, President's Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, the day following
Thanksgiving, Christmas Eve and Christmas Day. In addition, the Short and
Intermediate Series will not be priced on Martin Luther King Day, Columbus
Day and Veterans' Day.
Under procedures approved by the Board of Trustees, a Fund's securities for
which market quotations are readily available are valued at current market
value provided by a pricing service, bank or broker/dealer experienced in
such matters. Short-term investments that will mature in 60 days or less may
be valued at amortized cost, which approximates market value. All other
securities and assets are valued at fair market value as determined following
procedures approved by the Board of Trustees.
HOW TO PURCHASE SHARES
All of the Funds are no-load, so you may purchase, redeem or exchange shares
directly at net asset value without paying a sales charge. Because the Funds'
net asset value changes daily, your purchase price will be the next net asset
value determined after the Funds' Transfer Agent, or other agent designated
by the Funds, receives and accepts your purchase order. See "Pricing of Fund
Shares."
Initial Minimum Additional Minimum
Type of Account Investment Investment
Regular $500 $50
Automatic Investment Plan $50 $50
Individual Retirement Account $500 $50
Gift to Minors $500 $50
Each Fund reserves the right to reject any order for the purchase of its
shares or to limit or suspend, without prior notice, the offering of its
shares. The required minimum investments may be waived in the case of
qualified retirement plans.
How to Open Your Account by Mail. Please complete the Purchase Application.
You can obtain additional copies of the Purchase Application and a copy of
the IRA Purchase Application from the Funds by calling 1-800-221-3138.
(Please note that you must use a different application than the one provided
in the prospectus for an IRA.)
Your completed Purchase Application should be mailed directly to:
Smith Breeden Mutual Funds
2 West Elm Street
P.O. Box 874
Conshohocken, PA 19428
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All applications must be accompanied by payment in the form of a check or
money order made payable to "Smith Breeden Mutual Funds." All purchases
must be made in U.S. dollars and checks must be drawn on U.S. banks. No cash,
credit cards or third party checks will be accepted. When a purchase is made
by check and a redemption is made shortly thereafter, the Funds will delay
the mailing of a redemption check until the purchase check has cleared your
bank, which may take up to 10 calendar days from the purchase date. If you
contemplate needing access to your investment shortly after purchase, you
should purchase the shares by wire as discussed below.
How to Open Your Account by Wire. You may make purchases by direct wire
transfers. To ensure proper credit to your account, please call the Funds at
1-800-221-3137 for instructions prior to wiring funds. Funds should be wired
through the Federal Reserve System as follows:
United Missouri Bank
A.B.A. Number 10-10-00695
For the account of Fund/Plan 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, 2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428.
Shares will not be redeemed until the Funds receive a properly completed and
executed Purchase Application.
Telephone Transactions. The privilege to initiate redemption or exchange
transactions by telephone will be made available to shareholders when opening
an account, if they check the appropriate boxes on the Purchase Application.
Each Fund will employ reasonable procedures to ensure that instructions
communicated by telephone are genuine. If reasonable procedures are not
implemented, the Funds may be liable for any loss due to unauthorized or
fraudulent transactions. In all other cases, you are liable for any loss for
unauthorized transactions. The Funds reserve the right to refuse a telephone
transaction if they believe it advisable to do so.
If you have any questions, please call the Funds at 1-800-221-3137.
How to Add to Your Account. You may make additional investments by mail or by
wire in an amount equal to or greater than $50. When adding to an account by
mail, you should send the Funds your check, together with the additional
investment form from a recent statement. If this form is unavailable, you
should send a signed note giving the full name of the account and the account
number. For additional investments made by wire transfer, you should use the
wiring instructions listed above. Be sure to include your account number.
Automatic Investment Plan. You may make purchases of shares of each Fund
automatically on a regular basis ($50 minimum per transaction). You must meet
the Automatic Investment Plan's ("the Plan") minimum initial investment of
$50 before the Plan may be established. Under the Plan, your designated bank
or other financial institution debits a preauthorized amount from your
account each month and applies the amount to the purchase of Fund shares. The
Plan can be implemented with any financial institution that is a member of
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the Automated Clearing House. No service fee is currently charged by the
Funds for participation in the Plan. A $20 fee will be imposed by the Funds
if sufficient funds are not available in your account or if your account has
been closed at the time of the automatic transaction. You may adopt the Plan
at the time an account is opened by completing the appropriate section of the
Purchase Application. You may obtain an application to establish the
Automatic Investment Plan after an account is opened by calling the Funds at
1-800-221-3138. In the event you discontinue participation in the Plan, the
Funds reserve the right to redeem your Fund account involuntarily, upon sixty
days' written notice, if the account's net asset value is $500 or less.
Purchasing Shares Through Other Institutions. If you purchase shares through
a program of services offered or administered by a broker-dealer, financial
institution, or other service provider, you should read the program
materials, including information relating to fees, in addition to this
Prospectus. Certain services of a Fund may not be available or may be
modified in connection with the program of services provided, and service
providers may establish higher minimum investment amounts. The Funds may only
accept requests to purchase additional shares into a broker-dealer street
name account from the broker-dealer.
Certain broker-dealers, financial institutions, or other service providers
that have entered into an agreement with the Adviser or Principal Underwriter
may enter purchase orders on behalf of their customers by phone, with payment
to follow within several days as specified in the agreement. The Funds may
effect such purchase orders at the net asset value next determined after
receipt of the telephone purchase order. It is the responsibility of the
broker-dealer, financial institution, or other service provider to place the
order with the Funds on a timely basis. If payment is not received within the
time specified in the agreement, the broker-dealer, financial institution, or
other service provider could be held liable for any resulting fees or losses.
Miscellaneous. The Funds will charge a $20 service fee against your account
for any check or electronic funds transfer that is returned unpaid. You will
also be responsible for any losses suffered by the Funds as a result. In
order to relieve you of responsibility for the safekeeping and delivery of
stock certificates, the Funds do not currently issue certificates.
HOW TO EXCHANGE SHARES
Shares of any Fund may be exchanged for shares of another Fund at any time.
This exchange offer is available only in states where shares of such other
Fund may be legally sold. You may open a new account, or purchase additional
shares in an existing account, by making an exchange from an identically
registered Smith Breeden Fund account. A new account will have the same
registration as the existing account from which the exchange was made, and is
subject to the same initial investment minimum ($500).
Exchanges may be made either in writing or by telephone. Written
instructions should be mailed to 2 West Elm Street, Conshohocken, PA 19428
and must be signed by all account owners, and accompanied by any properly
endorsed outstanding share certificates, if applicable. The telephone
exchange privilege can be adopted by checking the appropriate box on the
Purchase Application. The telephone exchange privilege is available only for
uncertificated shares. During periods of drastic economic or market changes,
it is possible that exchanges by telephone may be difficult to implement. In
this event, shareholders should follow the written exchange procedures. The
-29-
telephone exchange privilege may be modified or discontinued by the Funds at
any time upon 60 days' notice to the shareholders. To exchange by telephone,
you must follow the instructions below under "How to Redeem by Telephone."
The Funds will accept exchange orders by telephone or other means of
electronic transmission from broker-dealers, financial institutions or other
service providers who execute an agreement with the Adviser or Principal
Underwriter. It is the responsibility of the broker-dealer, financial
institution or other service provider to place the exchange order on a timely
basis.
Exchanges are made on the basis of the Funds' relative net asset values.
Because the exchange is considered a redemption and purchase of shares, the
shareholder may recognize a gain or loss for federal income tax purposes.
Backup withholding and information reporting may also apply. Additional
information regarding the possible tax consequences of such an exchange is
included under the caption "Additional Information on Distributions and
Taxation" in the Funds' Statements of Additional Information.
There are differences among the Funds. Before making an exchange, a
shareholder should obtain and review the current prospectus of the Fund into
which the shareholder wishes to transfer. When exchanging shares,
shareholders should be aware that the Funds may have different dividend
payment dates. The dividend payment schedules should be checked before
exchanging shares. The amount of any accumulated, but unpaid, dividend is
included in the net asset value per share.
If you buy shares by check, you may not exchange those shares for up to 10
calendar days to ensure your check has cleared. If you intend to exchange
shares soon after their purchase, you should purchase the shares by wire or
contact the Funds at 1-800-221-3137 for further information.
The Funds reserve the right to temporarily or permanently terminate, with or
without advance notice, the exchange privilege of any investor who makes
excessive use of the exchange privilege (e.g., more than five exchanges per
calendar year).
Additional documentation may be required for exchange requests if shares are
registered in the name of a corporation, partnership or fiduciary. Please
contact the Funds for additional information concerning the exchange
privilege.
HOW TO REDEEM SHARES
You may redeem shares of the Funds at any time. The price at which the shares
will be redeemed is the net asset value per share next determined after
proper redemption instructions are received by the Transfer Agent or other
agent designated by the Funds. See "Pricing of Fund Shares." There are no
charges for the redemption of shares except that a fee of $9 is charged for
each wire redemption. Depending upon the redemption price you receive, you
may realize a capital gain or loss for federal income tax purposes.
How to Redeem by Mail to Receive Proceeds by Check. To redeem shares by mail,
simply send an unconditional written request to the Funds specifying the
number of shares or dollar amount to be redeemed, the name of the Fund, the
name(s) on the account registration and the account number. A request for
redemption must be signed exactly as the shares are registered. If the amount
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requested is greater than $25,000, or the proceeds are to be sent to a person
other than the recordholder or to a location other than the address of
record, each signature must be guaranteed by a commercial bank or trust
company in the United States, a member firm of the National Association of
Securities Dealers, Inc. or other eligible guarantor institution. A notary
public is not an acceptable guarantor. Guarantees must be signed by an
authorized signatory of the bank, trust company, or member firm and
"Signature Guaranteed" must appear with the signature. Additional
documentation may be required for the redemption of shares held in corporate,
partnership or fiduciary accounts. In case of any questions, please contact
the Funds in advance.
A Fund will mail payment for redemption within seven days after receiving
proper instructions for redemption. However, the Funds will delay payment for
10 calendar days on redemptions of recent purchases made by check. This
allows the Funds to verify that the check used to purchase Fund shares will
not be returned due to insufficient funds and is intended to protect the
remaining investors from loss.
How to Redeem by Telephone. To redeem shares by telephone, you must have
selected this option on the Purchase Application. Once this feature has been
requested, shares may be redeemed by calling the Funds at 1-800-221-3137.
Proceeds redeemed by telephone will be mailed to your address, or wired or
credited to your preauthorized bank account. To establish wire redemption
privileges, you must select the appropriate box on the Purchase Application
and enclose a voided check.
In order to arrange for telephone redemptions after your account has been
opened or to change the bank account or address designated to receive
redemption proceeds, you must send a written request to your Fund. The
request must be signed by each registered holder of the account with the
signatures guaranteed by a commercial bank or trust company in the United
States, a member firm of the National Association of Securities Dealers, Inc.
or other eligible guarantor institution. A notary public is not an acceptable
guarantor. Further documentation as provided above may be requested from
corporations, executors, administrators, trustees and guardians.
Payment of the redemption proceeds for Fund shares redeemed by telephone
where you request wire payment will normally be made in federal funds on the
next business day. The Funds reserve the right to delay payment for a period
of up to seven days after receipt of the redemption request. There is
currently a $9 fee for each wire redemption. It will be deducted from your
account.
The Funds reserve the right to refuse a telephone redemption or exchange
transaction if it believes it is advisable to do so. Procedures for redeeming
or exchanging shares of the Funds by telephone may be modified or terminated
by the Funds at any time. In an effort to prevent unauthorized or fraudulent
redemption or exchange requests by telephone, the Funds have implemented
procedures designed to reasonably assure that telephone instructions are
genuine. These procedures include: requesting verification of certain
personal information; recording telephone transactions; confirming
transactions in writing; and restricting transmittal of redemption proceeds
only to preauthorized designations. Other procedures may be implemented from
time to time. If reasonable procedures are not implemented, the Funds may be
liable for any loss due to unauthorized or fraudulent transactions. In all
other cases, you are liable for any loss for unauthorized transactions.
-31-
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,
2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428.
The Funds reserve the right to suspend or postpone redemptions during any
period when trading on the New York Stock Exchange ("Exchange") is
restricted, as determined by the Securities and Exchange Commission ("SEC"),
or the Exchange is closed for other than customary weekend and holiday
closing; the SEC has by order permitted such suspension; or an emergency, as
determined by the SEC, exists, making disposal of portfolio securities or
valuation of net assets of a Fund not reasonably practicable.
Due to the relatively high cost of maintaining small accounts, if your
account balance falls below the $500 minimum as a result of a redemption or
exchange or if you discontinue the Automatic Investment Plan before your
account balance reaches the required minimum, you will be given a 60-day
notice to reestablish the minimum balance or activate an Automatic Investment
Plan. If this requirement is not met, your account may be closed and the
proceeds sent to you.
Check Writing. In addition to telephone and written redemption requests, the
Short Series offers redemption through check writing. Shareholders electing
this option will receive checks that may be used like personal or business
checks. There is no limit on the number of checks you may write. Checks
must be at least $100 and may not exceed $25,000. There is a $30 fee for
returned checks. Because dividends declared on shares held in a
shareholder's account, prior redemptions, and possible changes in net asset
value may cause the value of the account to change, shareholders should not
write a check for the entire value of the account or close the account by
writing a check.
In using the check writing privilege, shareholders bear the responsibility of
ensuring that the check amount does not exceed the value of their account on
the day the check is presented to the Transfer Agent for payment. The day
the check is presented for payment is the day the redemption of Fund shares
takes place. If insufficient shares are in the account, the check will be
returned and no shares will be redeemed. The clearing agent for the check
writing facility is United Missouri Bank. Shareholders utilizing check
writing are subject to United Missouri Bank's rules governing checking
accounts. However, this check writing facility is purely a means to redeem
Fund shares. No facilities characteristic of bank accounts, such as deposit
insurance, are being provided along with the check writing option.
If you would like to initiate check writing, please call Shareholder Services
at 1-800-221-3137 or check the appropriate box on the Purchase Application.
Systematic Withdrawal Plan. A shareholder may establish a Systematic
Withdrawal Plan and receive regular periodic payments from the account. An
initial balance of $10,000 is required to establish a Systematic Withdrawal
Plan. There are no service charges for establishing or maintaining a
Systematic Withdrawal Plan. The minimum amount which the shareholder may
withdraw periodically is $100. Capital gain distributions and income
dividends to the shareholder's account are received in additional shares at
net asset value. Payments are then made from the liquidation of shares at
net asset value to meet the specified withdrawals. Liquidation of shares may
-32-
reduce or possibly exhaust the shares in the shareholder's account, to the
extent withdrawals exceed shares earned through dividends and distributions,
particularly in the event of a market decline. No payment pursuant to a
Systematic Withdrawal Plan will be made if there are insufficient shares on
deposit on the date of the scheduled distribution. A subsequent deposit of
shares will not result in a payment under the plan retroactive to the
distribution date. As with other redemptions, a liquidation to make a
withdrawal payment is a sale for federal income tax purposes. The entire
Systematic Withdrawal Plan payment cannot be considered as actual yield or
income since part of the Plan's payment may be a return of capital.
A Systematic Withdrawal Plan may be terminated upon written notice by the
shareholder, or by a Fund on 30 days written notice, and it will terminate
automatically if all shares are liquidated or withdrawn from the account or
upon the Fund's receipt of notification of the death or incapacity of the
shareholder. Shareholders may change the amount (but not below the specified
minimums), and schedule of withdrawal payments, or suspend such payments, by
giving written notice to the Transfer Agent at least five business days prior
to the next scheduled payment. Share certificates may not be issued while a
Systematic Withdrawal Plan is in effect.
DIVIDENDS AND DISTRIBUTIONS
The Short and Intermediate Series intend to make monthly distributions to
their shareholders of net investment income. The Equity Plus Fund intends to
make quarterly distributions of net investment income. All Funds will
distribute net realized gains at least annually. Each Fund may make
additional distributions if necessary to avoid imposition of a 4% excise tax
or other tax on undistributed income and gains.
The monthly distributions for the Short Series' shares are quoted ex-dividend
on the business day after record date (the "ex-date"). Record date is
usually the first or second business day of the month. If a shareholder
elects to reinvest dividends, the date the dividends are reinvested is also
the ex-date. Dividends are paid in cash by the Short Series generally one
week after the ex-date.
The Intermediate Series will declare daily dividends for shareholders of
record. The Intermediate Series' dividend payable date, and the day that
dividends are reinvested for shareholders who have made this election is the
last business day of the month. Shares begin accruing dividends on the
business day after federal funds (funds credited to a member bank's account
at the Federal Reserve Bank) are available from the purchase payment for such
shares and continue to accrue dividends through, and including, the day the
redemption order for the shares is executed. If an investor closes his
account, any accrued dividends, through and including the day of redemption,
will be paid as part of the redemption proceeds.
Dividends and capital gains distributions may be declared more or less
frequently at the direction of the Trustees. In order to be entitled to a
dividend or a distribution, an investor must acquire a Fund's shares on or
before the record date. Caution should be exercised, however, before
purchasing shares immediately prior to a distribution record date. Because
the value of a Fund's shares is based directly on the amount of its net
assets, rather than on the principle of supply and demand, any distribution
of income or capital gain will result in a decrease in the value of its
shares equal to the amount of the distribution. While a dividend or capital
-33-
gain distribution received shortly after purchasing shares represents, in
effect, a return of the shareholder's investment, it may be taxable as
dividend income or capital gain. You may separately elect to reinvest
income dividends and capital gains distributions in shares of a Fund or
receive cash as designated on the Purchase Application. You may change your
election at any time by sending written notification to your Fund. The
election is effective for distributions with a dividend record date on or
after the date that the Funds receive notice of the election. If you do not
specify an election, all income dividends and capital gains distributions
will automatically be reinvested in full and fractional shares of a Fund.
Reinvested dividends and distributions receive the same tax treatment as
those paid in cash.
SHAREHOLDER REPORTS AND INFORMATION
The Funds will provide the following statements and reports:
Confirmation and Account Statements. After each transaction that affects
the account balance or account registration, including the payment of
dividends, you will receive a confirmation statement.
Form 1099. By January 31 of each year, all shareholders will receive Form
1099 which will report the amount and tax status of distributions paid to you
by the Funds for the preceding calendar year.
Financial Reports. Financial reports are provided to shareholders
semiannually. Annual reports will include audited financial statements. To
reduce the Funds' expenses, one copy of each report will be mailed to each
Taxpayer Identification Number even though the investor may have more than
one account in a Fund.
Reports to Depository Institutions. Shareholders of the Short or
Intermediate Series who are financial institutions may request receipt of
monthly or quarterly reports which provide information about the Short or
Intermediate Series' investments considering regulatory risk-based asset
categories.
If you need additional copies of previous statements, you may order
statements for the current and preceding year at no charge. Call
1-800-221-3137 to order past statements. If you need information on your
account with the Funds or if you wish to submit any applications, redemption
requests, inquiries or notifications, please contact: Smith Breeden Family of
Funds Inc.,#2 West Elm Street, P.O. Box 874, Conshohocken, PA 19428 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 $500. There is a $12 annual maintenance fee charged to
process an account. You may obtain additional information regarding
establishing such an account by calling the Funds at 1-800-221-3138.
-34-
The Funds may be used as investment vehicles for established defined
contribution plans, including simplified employee (including SAR-SEPs),
401(k), profit-sharing and money purchase pension plans ("Retirement Plans").
For details concerning Retirement Plans, please call 1-800-221-3138.
SERVICE AND DISTRIBUTION PLANS
Each Fund has adopted a Distribution and Services Plan (the "Plans") pursuant
to Rule 12b-1 under the 1940 Act. The purpose of the Plans is to permit the
Adviser to compensate investment dealers and other persons involved in
servicing shareholder accounts for services provided and expenses incurred in
promoting the sale of shares of the Funds, reducing redemptions, or otherwise
maintaining or improving services provided to shareholders by such dealers or
other persons. The Plans provide for payments by the Adviser out of its
advisory fee to dealers and other persons at an annual rate of up to 0.25% of
a Fund's average net assets, subject to the authority of the Trustees to
reduce the amount of payments permitted under the Plan or to suspend the Plan
for such periods as they may determine. Subject to these limitations, the
amount of such payments and the purposes for which they are made shall be
determined by the Adviser.
Any distribution and servicing related payments made by the Adviser to
investment dealers or other persons are subject to the continuation of the
Plans, the terms of any related service agreements, and any applicable limits
imposed by the National Association of Securities Dealers, Inc.
TAXES
Each Fund intends to qualify as a regulated investment company under the
Internal Revenue Code. In each taxable year that a Fund so qualifies, such
Fund (but not its shareholders) will be relieved of federal income tax on the
part of its net investment income and net capital gain that is distributed to
shareholders. Each Fund will distribute annually substantially all of its
net investment income and net capital gains on a current basis.
All Fund distributions from net investment income (whether paid in cash or
reinvested in additional shares) will be taxable to its shareholders as
ordinary income, except that any distributions of a Fund's net long-term
capital gain will be taxable to its shareholders as long-term capital gain,
regardless of how long they have held their Fund shares. Each Fund provides
federal tax information to its shareholders annually about distributions paid
during the preceding year.
It is not anticipated that any of the Funds' distributions will qualify for
either the corporate dividends-received deduction or tax-exempt interest
income. Distributions will also probably be subject to state and local taxes
depending on each shareholder's tax situation. While many states grant tax-
free status to mutual fund distributions paid from interest income earned
from direct obligations of the U.S. Government, none of the Short or
Intermediate Series' distributions are expected to qualify for such tax-free
treatment, and only an insignificant amount of the Equity Plus Fund's
distributions are expected to so qualify.
The Funds will be required to withhold federal income tax at a rate of 31%
("backup withholding") from distribution payments and redemption and exchange
proceeds if you fail to properly complete the Purchase Application.
-35-
The foregoing is only a summary of some of the important federal tax
considerations generally affecting each Fund and its shareholders. See
"Taxes" in the relevant Statement of Additional Information for further
discussion. There may be other federal, state or local tax considerations
applicable to you as an investor. You therefore are urged to consult your
tax adviser regarding any tax-related issues.
CAPITAL STRUCTURE
The Smith Breeden Trust, which issues shares in the Equity Plus Fund, and the
Smith Breeden Series Fund, which issues shares in the Short and Intermediate
Series, are both Massachusetts business trusts. The Trust was organized
under an Agreement and Declaration of Trust, dated December 18, 1991. The
Series Fund was organized under an Agreement and Declaration of Trust dated
October 3, 1991. Copies of both Agreements, which are governed by
Massachusetts law, are on file with the Secretary of State of the
Commonwealth of Massachusetts. The Trust and the Series Fund have the same
Trustees.
The Trustees have the authority to issue shares in an unlimited number of
series of either the Series Fund or Trust. Each such series of shares may be
further divided into classes. The assets and liabilities of each such series
will be separate and distinct. All shares when issued are fully paid, non
assessable, and redeemable and have equal voting, dividend and liquidation
rights.
Shareholders of the separate series of the Series Fund or Trust will vote
together in electing trustees and in certain other matters. Shareholders in
each series of the Series Fund should be aware that the outcome of the
election of trustees and of certain other matters could be controlled by the
shareholders of the other series. The shares have noncumulative voting
rights, which means that holders of more than 50% of the shares voting for
the election of the trustees can elect 100% of the trustees if they choose to
do so.
Although neither the Series Fund nor the Trust is required to hold annual
meetings of its shareholders, shareholders have the right to call a meeting
to elect or remove trustees, or to take other actions as provided in the
respective Declaration of Trust. Upon written request by the holders of at
least 1% of the outstanding shares stating that such shareholders wish to
communicate with the other shareholders for the purpose of obtaining the
signatures necessary to demand a meeting to consider the removal of a
trustee, both the Series Fund and Trust have undertaken to provide a list of
shareholders or to disseminate appropriate materials (at the expense of the
requesting shareholders).
Under Massachusetts law, shareholders of a business trust may, under certain
circumstances, be held personally liable as partners for its obligations.
However, the risk of a shareholder incurring financial loss on account of
shareholder liability is limited to circumstances in which both (i) any
liability was greater than a Fund's insurance coverage and (ii) a Fund itself
was unable to meet its obligations.
-36-
TRANSFER AND DIVIDEND DISBURSING
AGENT, CUSTODIAN AND
INDEPENDENT ACCOUNTANTS
Fund/Plan Services, Inc. ("Fund/Plan Services" or the "Transfer Agent"), 2
West Elm Street, Conshohocken, PA 19428, acts as each Fund's Transfer and
Dividend Disbursing Agent. See "Management of the Funds." The Bank of New
York acts as the custodian of each Fund's assets. The Bank of New York's
address is 48 Wall Street, New York, New York 10286. Neither the Transfer and
Dividend Disbursing Agent nor the Custodian has any part in deciding the
Funds' investment policies or which securities are to be purchased or sold
for the Funds' portfolios. Deloitte & Touche, LLP, has been selected to serve
as independent auditors of the Company for the fiscal year ending March 31,
1997.
FUND PERFORMANCE
Each Fund may quote the Fund's average annual total and/or aggregate total
return for various time periods in advertisements or communications to
shareholders. An average annual total return refers to the rate of return
which, if applied to an initial investment at the beginning of a stated
period and compounded over that period, would result in the redeemable value
of the investment at the end of the period assuming reinvestment of all
dividends and distributions and reflecting the effect of all recurring fees.
An investor's principal in each Fund and the Fund's return are not guaranteed
and will fluctuate according to market conditions. When considering "average"
total return figures for periods longer than one year, you should note that
a Fund's annual total return for any one year in the period might have been
greater or less than the average for the entire period. Each Fund also may
use "aggregate" total return figures for various periods, representing the
cumulative change in value of an investment in the Fund for a specific period
(again reflecting changes in the Fund's share price and assuming reinvestment
of dividends and distributions).
The Short and Intermediate Series may also advertise current yield and
distribution rate information. Current yield reflects the income per share
earned by the Short or Intermediate Series' portfolio investments, and is
calculated by dividing a Fund's net investment income per share during a
recent 30-day period by a Fund's net asset value on the last day of that
period and annualizing the result. The current yield (or "SEC Yield"), which
is calculated according to a formula prescribed by the SEC (see the relevant
Statement of Additional Information), is not indicative of the dividends or
distributions which were or will be paid to a Series' shareholders. SEC
regulations require that net investment income be calculated on a "yield-to-
maturity" basis, which has the effect of amortizing any premiums or discounts
in the current market value of fixed income securities. Dividends or
distributions paid to shareholders are reflected in the current distribution
rate which may be quoted to shareholders, and may not reflect amortization in
the same manner.
The Fund may also compare its performance to that of other mutual funds and
to stock and other relevant indices or to rankings prepared by independent
services or industry publications. For example, a Fund's total return may be
compared to data prepared by Lipper Analytical Services, Inc., Morningstar,
Inc., Value Line Mutual Fund Survey and CDA Investment Technologies, Inc.
Total return data as reported in such national financial publications as The
Wall Street Journal, The New York Times, Investor's Business Daily, USA
Today, Barron's, Money and Forbes as well as in publications of a local or
-37-
regional nature, may be used in comparing Fund performance.
The Equity Plus Fund's total return may also be compared to the returns of
such indices as the Dow Jones Industrial Average, Standard & Poor's 500
Composite Stock Price Index, Nasdaq Composite OTC Index or Nasdaq Industrials
Index, Consumer Price Index and Russell 2000 Index. The Short Series' total
return may also be compared that of taxable money funds as quoted in
Donaghue's Money Fund Report and to total returns for the six month U.S.
Treasury as published by Merrill Lynch or other suppliers. The Intermediate
Series' return will most likely be compared to the total return of the
Salomon Brothers Mortgage Index, or the total return of intermediate U.S.
Treasury Notes as published by various brokerage firms and others. Further
information on performance measurement may be found in the relevant Statement
of Additional Information.
Performance quotations of a Fund represent the Fund's past performance and
should not be considered representative of future results. The investment
return and principal value of an investment in a Fund will fluctuate so that
an investor's shares, when redeemed, may be worth more or less than their
original cost. The methods used to compute a Fund's total return and yield
are described in more detail in the relevant Statement of Additional
Information.
-38-
APPENDIX A
Hedging Instruments and Transactions (Short and Intermediate Series and
Equity Plus Fund's Fixed Income Segment)
Hedging and risk management techniques require different skills from those
involved in the selection of portfolio securities. One such skill is the
ability to predict the correlation of interest rate changes between markets.
The Adviser has been engaged in hedging target duration portfolios for more
than ten years. There can be no assurance that the Adviser will accurately
predict market movements which accompany interest rate changes, in which
event a Fund's overall performance may be less than if the Fund had not
entered into hedging transactions.
Interest Rate and Mortgage Swaps, Caps, Floors and Collars. Interest rate
swaps involve the exchange by a Fund with another party of their respective
commitments to pay or receive interest, for example, an exchange of floating-
rate payments for fixed-rate payments. Mortgage swaps are similar to
interest rate swaps in that they represent commitments to pay and receive
interest. The notional principal amount, however, is tied to a reference
pool or pools of mortgages.
The Short or Intermediate Series will enter into interest rate swaps only on
a net basis, i.e., where the two payment streams are netted out, with a Fund
receiving or paying, as the case may be, only the net amount of the two
payments. The Fixed Income Segment of the Equity Plus Fund may enter into
interest rate swaps on other than a net basis.
The purchase of an interest rate cap entitles the purchaser, to the extent
that a specified index exceeds a predetermined interest rate, to receive
payments of interest on a notional principal amount from the party selling
such interest rate cap. The purchase of an interest rate floor entitles the
purchaser, to the extent that a specified index falls below a predetermined
interest rate, to receive payments of interest on a notional principal amount
from the party selling such interest rate floor. An interest rate collar
combines the elements of purchasing a cap and selling a floor. The collar
protects against an interest rate rise above the maximum amount but gives up
the benefits of an interest rate decline below the minimum amount. There can
be no assurance that the Funds will be able to enter into interest rate
swaps, caps, floors or collars on favorable terms. Furthermore, there can be
no assurance that any of the Funds will be able to terminate an interest rate
swap or sell or offset interest rate caps, floors or collars notwithstanding
any terms in the agreements providing for such termination.
Inasmuch as these hedging transactions are entered into for hedging purposes,
the Adviser and the Funds believe swaps, caps, floors and collars do not
constitute senior securities and, accordingly, will not treat them as being
subject to its borrowing restrictions. The net amount of the excess, if any,
of a Fund's obligations over its entitlement with respect to each interest
rate swap will be accrued on a daily basis and an amount of cash or liquid
securities having an aggregate net asset value at least equal to the accrued
excess will be maintained in a segregated account by a custodian that
satisfies the requirements of the 1940 Act. To the extent that the Fixed
Income Segment of the Equity Plus Fund enters into interest rate swaps on
other than a net basis, the amount maintained in its segregated account will
be the full amount of the Fund's obligations, if any, with respect to such
interest rate swaps, accrued on a daily basis.
-39-
The Short and Intermediate Series will not write interest rate caps, floors
and collars and will not enter into any interest rate swap, cap, floor or
collar transaction unless the unsecured commercial paper, unsecured senior
debt or the claims-paying ability of the other party is rated either AA or
A-1 or better by Standard & Poor's or Aa or P-1 or better by Moody's
Investors Service, Inc., at the time of entering into such transaction. The
Fixed Income Segment of the Equity Plus Fund may enter into such transactions
with counterparties who are rated at least A by Moody's and S&P at the time
of entering into the contract. The Funds and the Adviser will closely
monitor, subject to the oversight of the Board of Trustees, the
creditworthiness of the contract counterparties in order to minimize risk.
If there is a default by the other party to such a transaction, the Funds
will have contractual remedies pursuant to the agreements related to the
transaction. There is no assurance that interest-rate swap, cap, floor or
collar counterparties will be able to meet their obligations pursuant to
their contracts, or that, in the event of default, a Fund will succeed in
pursuing contractual remedies. The Funds thus assume the risk that one of
them may be delayed in or prevented from obtaining payments owed to it
pursuant to interest rate swaps, caps, floors or collars.
The swap, cap, floor and collar market has grown substantially in recent
years with a large number of banks and investment banking firms acting both
as principals and as agents utilizing standardized documentation. As a
result, this market has become relatively liquid, although the Funds will
still treat these instruments as illiquid investments subject to the
limitation on such investments described in the Prospectus at "Illiquid
Securities".
Calls and Puts on Securities. In order to reduce fluctuations in net asset
value and portfolio holdings relative to their targeted option-adjusted
duration, a Fund may purchase call or put options or sell options where it
owns the security which is the subject of the option (a "covered option") on
United States Treasury securities, mortgage-backed securities and Eurodollar
instruments that are traded on United States and foreign-securities exchanges
and in over-the-counter markets ("OTC Options"). A Fund will not sell
options which are not covered. The premiums paid on call options purchased
and any related transaction costs will increase the cost of securities
acquired upon exercise of the option, and unless the price of the underlying
security rises sufficiently, the options may expire worthless to the Funds.
The Short and Intermediate Series will not purchase a put or call option on
U.S. Government securities or mortgage-backed securities if, as a result of
such purchase, more than 10% of its total assets would be invested in such
options. A Fund's ability to purchase put and call options may be limited by
Internal Revenue Code requirements.
The Adviser monitors the creditworthiness of dealers with whom a Fund would
enter into OTC option transactions under the general supervision of the
Board of Trustees. The Funds will engage in OTC option transactions only
with primary United States government securities dealers recognized by the
Federal Reserve Bank of New York.
Futures and Related Options. In order to reduce fluctuations in net asset
value of portfolio holdings relative to their targeted option-adjusted
durations or to employ temporary substitutes for anticipated future
transactions, the Funds may buy or sell financial futures contracts, purchase
-40-
call or put options, or sell covered call options on such futures. There is
no overall limitation on the percentage of a Fund's assets which may be
subject to a hedge position.
Options and futures transactions involve costs and may result in losses. The
effective use of options and futures strategies depends on a Fund's ability
to terminate options and futures positions at times when the Adviser deems it
desirable to do so. This ability to terminate positions when the Adviser
deems it desirable to do so may be hindered by the lack of existence of a
liquid secondary market. Although a Fund will take an options or futures
contract position only if the Adviser believes there is a liquid secondary
market for the option or futures contract, there is no assurance that a Fund
will be able to effect closing transactions at any particular time or at an
acceptable price.
The use of options and futures strategies also involves the risk of imperfect
correlation between movements in the values of the securities underlying the
futures and options purchased and sold by a Fund, of the option and futures
contract itself, and of the securities which are the subject of a hedge. A
Fund, therefore, bears the risk that prices of hedged securities will not
move to the same degree as the hedging instrument or that price movements in
the hedging instrument will not accurately reflect price movements in the
security underlying the hedging instrument. It is also possible for a Fund
to incur a loss on both the hedged securities and the hedging instrument.
At times, a Fund may sell interest rate futures in a different dollar amount
than the dollar amount of securities being hedged, depending on the expected
relationship between the volatility of the prices of such securities and the
volatility of the futures contracts, based on duration calculations by the
Adviser. If the actual price movements of the securities and futures are
inconsistent with their durations as so calculated, the hedge may not be
fully effective.
A Fund will not maintain open short positions in interest rate futures
contracts if, in the aggregate, the value of the open positions (marked to
market) exceeds the current market value of its securities portfolio plus or
minus the unrealized gain or loss on these open positions, adjusted for the
expected volatility relationship between the portfolio and the futures
contracts based on duration calculations. If this limitation should be
exceeded at any time, a Fund will take prompt action to close out the
appropriate number of open contracts to bring its open futures position into
compliance with this limitation.
The Funds' ability to engage in options and futures transactions and to sell
related securities may be limited by tax considerations and by certain
regulatory requirements. See "Additional Information Regarding Taxation" in
the relevant Statement of Additional Information.
Other Portfolio Strategies (Equity Plus Fund's Equity Simulation Segment)
Any investment in warrants, valued at the lower of cost or market, may not
exceed 5% of the value of the Equity Plus Fund's net assets. Included within
that amount, but not to exceed 2% of the value of the Equity Plus Fund's net
assets, may be warrants which are not listed on the New York or American
Stock Exchange. Warrants acquired by the Equity Plus Fund in units or
attached to securities may be deemed to be without value.
-41-
SMITH BREEDEN TRUST
SMITH BREEDEN EQUITY PLUS FUND
STATEMENT OF ADDITIONAL INFORMATION
August 1, 1996
100 Europa Drive, Suite 200
Chapel Hill, North Carolina 27514-2310
(919) 967-7221
This Statement of Additional Information contains
information pertaining to Smith Breeden Equity Plus
Fund which may be useful to investors and is not
included in the Prospectus of the Smith Breeden Mutual Funds.
The former name of the Equity Plus Fund was the Smith Breeden
Market Tracking Fund. This Statement is not a Prospectus and is
only authorized for distribution when accompanied or
preceded by the Prospectus of the Smith Breeden Mutual Funds
dated August 1, 1996, as may be amended from time to time. The
Statement should be read together with the Prospectus.
Contents Page
DEFINITIONS. . . . . . . . . . . . . . . . . . . . . . . . . .1
INVESTMENT RESTRICTIONS OF THE FUND. . . . . . . . . . . . . .1
MISCELLANEOUS INVESTMENT PRACTICES AND RISK
CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . .4
TAXES. . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
FUND CHARGES AND EXPENSES. . . . . . . . . . . . . . . . . . .8
MANAGEMENT OF THE FUND . . . . . . . . . . . . . . . . . . . .9
THE INVESTMENT ADVISORY AGREEMENT AND OTHER SERVICES . . . . 10
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING
PERSONS. . . . . . . . . . . . . . . . . . . . . . . . . . . 15
DETERMINATION OF NET ASSET VALUE . . . . . . . . . . . . . . 15
ADDITIONAL INFORMATION REGARDING PURCHASES
AND REDEMPTIONS OF FUND SHARES . . . . . . . . . . . . 16
SHAREHOLDER INFORMATION. . . . . . . . . . . . . . . . . . . 18
SUSPENSION OF REDEMPTIONS. . . . . . . . . . . . . . . . . . 18
SHAREHOLDER LIABILITY. . . . . . . . . . . . . . . . . . . . 18
STANDARD PERFORMANCE MEASURES. . . . . . . . . . . . . . . . 19
INDEPENDENT AUDITORS . . . . . . . . . . . . . . . . . . . . 21
EXPERTS. . . . . . . . . . . . . . . . . . . . . . . . . . . 21
REPORT OF INDEPENDENT AUDITORS AND FINANCIAL
STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . 22
SMITH BREEDEN TRUST,
SMITH BREEDEN EQUITY PLUS FUND
Statement of Additional Information
DEFINITIONS
The "Trust" -- Smith Breeden Trust
The "Fund" -- Smith Breeden Equity Plus Fund, a
series of the Trust offering its
shares to the public.
The "Adviser" -- Smith Breeden Associates, Inc.,
the Fund's investment adviser.
The "Custodian"-- The Bank of New York, the Fund's
custodian.
"Fund/Plan
Services" -- Fund/Plan Services, Inc., the Fund's
investor servicing agent.
INVESTMENT RESTRICTIONS OF THE FUND
Subject to the Fund's ability to invest all or
substantially all of its assets in another investment
company with substantially the same investment
objective, as fundamental investment restrictions,
which may not be changed without a vote of a majority
of the outstanding voting securities, the Fund may not
and will not:
1. Issue senior securities, borrow money or pledge
its assets, except that the Fund may borrow from
banks or through reverse repurchase agreements or
dollar rolls up to 33 1/3% of the value of its
respective total assets (calculated when the loan
is made) for temporary, extraordinary or
emergency purposes and to take advantage of
investment opportunities and may pledge up to 33
1/3% of the value of its total assets to secure
such borrowings. For purposes of this
restriction, the purchase or sale of securities
on a "when-issued" or delayed delivery basis, the
purchase and sale of futures contracts, the entry
into forward contracts, reverse repurchase
agreements and dollar roll transactions, short
sales, interest rate caps, floors and swaps,
mortgage swaps, and collateral arrangements with
respect thereto and such other practices as may
be determined by counsel to the Fund (consistent
with pronouncements of the Securities and
Exchange Commission) are not deemed to be a
pledge of assets and none of such transactions or
-1-
arrangements nor obligations of the Fund 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 25% or more of
the 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 any security, other than mortgage-backed
securities, obligations of the U.S. Government,
its agencies or instrumentalities or
collateralized mortgage obligations, if as a
result the 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.
5. Acquire, sell, lease or hold real estate or real
estate limited partnerships, except that it may
invest in securities of companies which deal in
real estate and in securities collateralized by
real estate or interests therein and it may
acquire, sell, lease or hold real estate in
connection with protecting its rights as a
creditor.
6. Purchase or sell commodities or commodity
contracts, except that the Fund may purchase and
sell financial futures contracts and options
thereon. (Does not include caps, floors, collars
or swaps.)
7. Invest in interests in oil, gas, mineral leases
or other mineral exploration or development
program.
8. Invest in companies for the purpose of exercising
control or management.
9. Purchase securities of other investment
companies, except to the extent permitted by the
Investment Company Act.
10. 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 Fund may invest
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consistently with its investment objectives and
policies and investment limitations or the
investment in repurchase agreements with
qualified institutions. The Fund will not lend
portfolio securities if, as a result, the
aggregate of such loans exceeds 33 1/3% of the
value of the Fund's total assets (including such
loans).
11. Purchase securities on margin (but the Fund may
obtain such short-term credits as may be
necessary for the clearance of transactions);
provided that the deposit or payment by the Fund
of initial or variation margin in connection with
options or futures contracts is not considered
the purchase of a security on margin.
12. Make short sales of securities or maintain a
short position if, when added together, more than
25% of the value of the 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.
It is contrary to the Fund's present policy, which may
be changed without shareholder approval, to:
(a) sell over-the-counter options which it does
not own; or
(b) sell options on futures contracts which
options it does not own.
As noted in the Prospectus, the Fund may invest up to
15% of its total net assets in illiquid securities.
In order to comply with certain "blue sky"
restrictions, the Fund will not, as a matter of
operating policy, invest in securities of any issuer
if, to the knowledge of the Fund, any officer or
Trustee of the Fund or the Fund's Adviser owns more
than one half of 1% of the outstanding securities of
such issuer, and such officers and Trustees who own
more than one half of 1% own in the aggregate more
than 5% of the outstanding securities of such issuer.
All percentage limitations on investments will apply
at the time of the making of an investment and shall
not be considered violated unless an excess or
deficiency occurs or exists immediately after and as
a result of such investment.
The Investment Company Act of 1940 provides that a
"vote of a majority of the outstanding voting
-3-
securities" of the Fund means the affirmative of the
lesser of (1) more than 50% of the outstanding shares
of the Fund, or (2) 67% or more of the shares present
at a meeting if more than 50% of the outstanding
shares are represented at the meeting in person or by
proxy.
MISCELLANEOUS INVESTMENT PRACTICES AND RISK CONSIDERATIONS
The Fund's Prospectus states that the Fund may engage
in each of the following investment practices.
However, the fact that the Fund may engage in a
particular practice does not necessarily mean that it
will actually do so.
Repurchase Agreements. The Fixed Income Segment may
invest in repurchase agreements. A repurchase
agreement is a contract under which the 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 Fund's 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 Fund which are collateralized by the securities
subject to repurchase. The Adviser will monitor such
transactions to determine that the value of the
underlying securities is at least equal at all times
to the total amount of the repurchase obligation,
including the interest factor. If the seller
defaults, the Fund could realize a loss on the sale of
the underlying security to the extent that the
proceeds of sale including accrued interest are less
than the resale price provided in the agreement
including interest. In addition, if the seller should
be involved in bankruptcy or insolvency proceedings,
the 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. The Fixed Income Segment may
enter into contracts to purchase securities for a
fixed price at a future date beyond customary
settlement time ("forward commitments" and "when
issued" and "delayed delivery" securities) if the 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 the 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
-4-
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, the
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
the Fund will generally enter into forward commitments
with the intention of acquiring securities for its
portfolio or for delivery pursuant to options
contracts it has entered into, the Fund may dispose of
a commitment prior to settlement if the Adviser deems
it appropriate to do so. The Fund may realize
short-term profits or losses upon the sale of forward
commitments.
Securities Loans. The Fund may make secured loans of
Fixed Income Segment securities amounting to not more
than 33 1/3% of the Fund's 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. The Fixed Income Segment 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 the Fund's
total assets (computed at the time the loan is made)
to take advantage of investment opportunities and for
extraordinary or emergency purposes, or for the
clearance of transactions. The Fund may pledge up to
33 1/3% of its total assets to secure these
borrowings. If the 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. The Fund will incur borrowing costs when it
-5-
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
the 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. The Fixed Income Segment 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 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. During the reverse
repurchase agreement period, the 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 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 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
-6-
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 to enforce the Fund's obligation to
repurchase the securities. Reverse repurchase
agreements and dollar rolls are considered borrowings
by the Fund.
TAXES
Taxation of the Fund. The Fund intends to qualify
each year as a regulated investment company under
Subchapter M of the Internal Revenue Code of 1986, as
amended (the "Code"). In order so to qualify and to
qualify for the special tax treatment accorded
regulated investment companies and their shareholders,
the Fund must, among other things:
(a) Derive at least 90% of its gross income from
dividends, interest, payments with respect
to certain securities loans, and gains from
the sale of stock, securities and foreign
currencies, or other income (including but
not limited to gains from options, futures,
or forward contracts) derived with respect
to its business of investing in such stock,
securities, or currencies;
(b) derive less than 30% of its gross income
from gains from the sale or other
disposition of certain assets (including
securities) held for less than three months;
(c) distribute with respect to each taxable year
at least 90% of its taxable and tax-exempt
income for such year; and
(d) diversify its holdings so that, at the end
of each fiscal quarter (i) at least 50% of
the market value of the Fund's assets is
represented by cash and cash items, U.S.
Government securities, securities of other
regulated investment companies, and other
securities limited in respect of any one
issuer to a value not greater than 5% of the
value of the Fund's total assets and 10% of
the outstanding voting securities of such
issuer, and (ii) not more than 25% of the
value of its assets is invested in the
securities (other than those of the U.S.
Government or other regulated investment
companies) of any one issuer or of two or
-7-
more issuers which the Fund controls and
which are engaged in the same, similar, or
related trades or businesses.
Qualification as a regulated investment company
exempts the Fund from federal income tax on income
paid to its shareholders in the form of dividends
(including capital gain dividends). A dividend paid
to shareholders by the Fund in January of a year
generally is deemed to have been paid by the Fund on
December 31 of the preceding year, if the dividend was
declared and payable to shareholders of record on a
date in October, November or December of that
preceding year.
If the Fund failed to qualify as a regulated
investment company accorded special tax treatment in
any taxable year, the Fund would be subject to tax on
its taxable income at corporate rates, and could be
required to recognize unrealized gains, pay
substantial taxes and interest and make substantial
distributions before requalifying as a regulated
investment company that is accorded special tax
treatment.
If the Fund fails to distribute in a calendar year
substantially all of its ordinary income for such year
and substantially all of its net capital gain for the
year ending October 31 (or later if the Fund is
permitted so to elect and so elects), plus any
retained amount from the prior year, the Fund will be
subject to a 4% excise tax on the undistributed
amounts. The Fund intends generally to make
distributions sufficient to avoid imposition of the 4%
excise tax. In calculating its income, the Fund must
include dividends in income not when received but on
the date when the stock in question is acquired or
becomes ex-dividend, whichever is later. Also, a
portion of the yield on certain high yield securities
(including certain payment-in-kind bonds) issued after
July 10, 1989 may be treated as dividends.
Return of capital distributions. If the Fund makes
a distribution to you in excess of its current and
accumulated "earnings and profits" in any taxable
year, the excess distribution will be treated as a
return of capital to the extent of your tax basis in your
shares, and thereafter as capital gain. A return of
capital is not taxable, but it reduces your tax basis
in your shares.
FUND CHARGES AND EXPENSES
Management Fees. The Fund pays a monthly fee to the
Adviser based on the average net assets of the Fund,
as determined at the close of each business day during
the month, at an annual rate of 0.70%. Advisory fees
-8-
paid for the fiscal year ended March 31, 1996 were
$21,727. Advisory fees for each of the last three
fiscal years ended March 31 were $5,931, $11,056 and
$21,727, respectively. The amounts paid in prior
fiscal years from June 30, 1992 through August 1, 1994
reflect a previous advisory contract rate of 0.35% of
average net assets. For each of the last three fiscal
years ended March 31, the Adviser reimbursed the Fund
$104,828, $128,959 and $114,100, respectively, under
expense limitation provisions.
Other Expenses. The Fund 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 Fund/Plan Services
which serves as the Fund's shareholder servicing and
accounting agent are determined by contract as
approved by the Board of Trustees.
MANAGEMENT OF THE FUND
The Board of Trustees has the responsibility for the
overall management of the Fund, including general
supervision and review of its investment activities.
The Trustees, in turn, elect the officers of the Fund
who are responsible for administering the day-to-day
operations of the Fund. Trustees and officers of the
Fund are identified in the Prospectus.
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 Fund. The table below shows the fees paid to
each independent Director for the fiscal year ended
March 31, 1996:
Director Aggregate Compensation
William F. Sharpe $ 4,250
Myron S. Scholes $ 0
Stephen M. Schaefer $ 0
The Agreement and Declaration of Trust of the Fund
provides that the Fund will indemnify its Trustees and
officers against liabilities and expenses incurred in
connection with litigation in which they may be
involved because of their offices with the Fund,
except if it is determined in the manner specified in
the Agreement and Declaration of Trust that they have
not acted in good faith in the reasonable belief that
their actions were in the best interests of the Fund
or that such indemnification would relieve any officer
or Trustee of any liability to the Fund or its
shareholders by reason of willful misfeasance, bad
faith, gross negligence or reckless disregard of his
-9-
or her duties.
Trustees and officers of the Fund who are also
officers or shareholders of the Adviser will benefit
from the advisory fees paid by the Fund.
Potential Conflicts of Interest. Principals of the
Adviser as individuals own approximately 67% of the
common stock of Harrington Financial Group, the
holding company for Harrington Bank, FSB of Richmond,
Indiana (the "Association"). As of May 31, 1996, the
Association had total assets of $356 million. The
Association invests in assets of the same types as
those to be held by the Fund
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 Investment Advisory
services. The Fund will transact no business directly
or indirectly with either CFFG or the banks and
thrifts which it owns. CFFG and its subsidiaries
invest in assets of the same types as those to be held
by the Fund.
The Adviser may also manage advisory accounts with
investment objectives similar to or the same as those
of the Fund, or different from the Fund but trading in
the same type of securities and instruments as the
Fund. Portfolio decisions and results of the Fund's
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 Fund.
THE INVESTMENT ADVISORY AGREEMENT AND OTHER SERVICES
The investment manager of the Fund is Smith Breeden
Associates, Inc. (the "Adviser"). The table in the
Prospectus indicates which officers and trustees are
affiliated persons of the Adviser.
Under the Investment Advisory Agreement between the
Fund and the Adviser, subject to such policies as the
Trustees may determine, the Adviser, at its expense,
furnishes continuously an investment program for the
Fund and makes investment decisions on behalf of the
Fund. Subject to the control of the Trustees, the
Adviser also manages, supervises and conducts the
other affairs and business of the Fund, furnishes
office space and equipment, provides bookkeeping and
-10-
clerical services and places all orders for the
purchase and sale of the Fund's portfolio securities.
For details of the Adviser's compensation under the
Investment Advisory Agreement, see "Fund Charges and
Expenses" in this Statement. The Adviser's
compensation under the Investment Advisory Agreement
may be reduced in any year if the Fund's expenses
exceed the limits on investment company expenses
imposed by any statute or regulatory authority of any
jurisdiction in which shares of the Fund are qualified
for offer or sale. The term "expenses" is defined in
the statutes or regulations of such jurisdictions,
and, generally speaking, excludes brokerage
commissions, taxes, interest and extraordinary
expenses. The only such limitation as of the date of
this Statement (imposed by the State of California)
was 2.5% of the first $30 million of average net
assets, 2% of the next $70 million and 1.5% of any
excess over $100 million.
Under the Investment Advisory Agreement, the Adviser
may reduce its compensation to the extent that the
Fund's expenses exceed such lower expense limitation
as the Adviser may, by notice to the Fund, voluntarily
declare to be effective. The expenses subject to this
limitation are exclusive of brokerage commissions,
interest, taxes, and extraordinary expenses. The
terms of the expense limitation currently in effect
are described in the Prospectus and on the following
page. The Fund pays all expenses not assumed by the
Adviser including, without limitation, auditing,
legal, tax preparation and consulting, custodial,
investor servicing and shareholder reporting expenses.
The Investment Advisory Agreement provides that the
Adviser shall not be subject to any liability to the
Fund or to any shareholder of the Fund for any act or
omission in the course of or connected with rendering
services to the Fund in the absence of willful
misfeasance, bad faith, gross negligence or reckless
disregard of its duties on the part of the Adviser.
The Investment Advisory Agreement may be terminated
without penalty by vote of the Trustees or the
shareholders of the Fund, or by the Adviser, on 60
days written notice. It may be amended only by a vote
of the shareholders of the Fund. The Investment
Advisory Agreement also terminates without payment of
any penalty in the event of its assignment as defined
in the Investment Company Act. The Investment
Advisory Agreement provides that it will continue in
effect after its initial term of two years only so
long as such continuance is approved at least annually
by vote of either the Trustees or the shareholders,
and, in either case, by a majority of the Trustees who
are not "interested persons" of the Adviser or the
-11-
Fund. In each of the foregoing cases, the vote of the
shareholders is the affirmative vote of a "majority of
the outstanding voting securities".
Under the terms of the Investment Advisory Agreement,
the Adviser performs certain administrative services
as follows: (1) coordinates with the Fund's custodian
and transfer agent and monitors the services they
provide to the Fund; (2) coordinates with and monitors
other third parties furnishing services to the Fund;
(3) provides the Fund with necessary office space,
telephones and other communications facilities and
personnel competent to perform administrative and
clerical functions for the Fund; (4) supervises the
preparation by third parties of all Federal, state and
local tax returns and reports of the Fund required by
applicable law; (5) prepares and, after approval by
the Fund, files and arranges for the distribution of
proxy materials and periodic reports to shareholders
of the Fund as required by applicable law; (6)
prepares and, after approval by the Fund, arranges for
the filing of such registration statements and other
documents with the Securities and Exchange Commission
and other Federal and state regulatory authorities as
may be required by applicable law; (7) reviews and
submits to the officers of the Fund for their approval
invoices or other requests for payment of Fund
expenses; and (8) takes such other actions with
respect to the Fund as may be necessary in the opinion
of the Advisor to perform its duties under the
agreement.
The Adviser has voluntarily agreed to bear normal
operating expenses (excluding litigation,
indemnification and other extraordinary expenses) of
the Fund, and, if necessary, to waive its advisory
fee, for the period ending March 31, 1997 such that
total operating expenses would not exceed 0.88% of the
average net assets of the Fund. Such expense
limitations, if any, are calculated daily based on
average net assets and may be continued or modified by
the Adviser at any time in its sole discretion.
Portfolio Transactions
Investment decisions. Investment decisions for the
Fund and for the other investment advisory clients of
the Adviser are made with a view to achieving their
respective investment objectives. Investment
decisions are the product of many factors in addition
to basic suitability for the particular client
involved. Thus, a particular security may be bought
or sold for certain clients even though it could have
been bought or sold for other clients at the same
time. Likewise, a particular security may be bought
for one or more clients when one or more other clients
are selling the security. In some instances, one
-12-
client may sell a particular security to another
client. It also sometimes happens that two or more
clients simultaneously purchase or sell the same
security, in which event each day's transactions in
such security are, insofar as possible, averaged as to
price and allocated between such clients in a manner
which in the Adviser's opinion is equitable to each
and in accordance with the amount being purchased or
sold by each. There may be circumstances when
purchases or sales of portfolio securities for one or
more clients will have an adverse effect on other
clients.
Brokerage and research services. Transactions on U.S.
stock exchanges, commodities markets and futures
markets and other agency transactions involve the
payment by the Fund of negotiated brokerage
commissions. Such commissions vary among different
brokers. In addition, a particular broker may charge
different commissions according to such factors as the
difficulty and size of the transaction. There is
generally no stated commission in the case of
securities traded in the over-the-counter markets, but
the price paid by the Fund usually includes an
undisclosed dealer commission or mark-up. In
underwritten offerings, the price paid by the Fund
includes a disclosed, fixed commission or discount
retained by the underwriter or dealer. The Fund paid
approximately $1000 in brokerage commissions on
futures and options transactions for each of its three
fiscal years ended March 31.
The Adviser places all orders for the purchase and
sale of portfolio investments for the Fund and may buy
and sell investments for the Fund through a
substantial number of brokers and dealers. In so
doing, the Adviser uses its best efforts to obtain for
the Fund the most favorable price and execution
available. In seeking the most favorable price and
execution, the Adviser, having in mind the Fund's best
interests, considers all factors it deems relevant,
including, by way of illustration, price, the size of
the transaction, the nature of the market for the
security or other investment, the amount of the
commission, the timing of the transaction taking into
account market prices and trends, the reputation,
experience and financial stability of the
broker-dealer involved and the quality of service
rendered by the broker-dealer in other transactions.
When it is determined that several brokers or dealers
are equally able to provide the best net price and
execution, the Adviser may execute transactions
through brokers or dealers who provide quotations and
other services to its advisory clients, including the
quotations necessary to determine these clients' net
assets, in such amount of total brokerage as may
-13-
reasonably be required in light of such services, and
through brokers and dealers who supply statistical and other
data to the Adviser and its clients in such amount of total
brokerage as may reasonably be required.
Consistent with the Rules of Fair Practice of the
National Association of Securities Dealers, Inc. and
subject to seeking the most favorable price and
execution available and such other policies as the
Trustees may determine, the Adviser may consider sales
of shares of the Fund (and, if permitted by law, of
the other funds managed by the Adviser) as a factor in
the selection of broker-dealers to execute portfolio
transactions for the Fund.
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.
Investor Servicing Agent and Underwriter
Fund/Plan Services is the Fund's investor servicing
agent (transfer, plan and dividend disbursing agent),
for which it receives fees which are paid monthly by
the Fund as an expense of all its shareholders. See
"Fund Charges and Expenses" in this Statement for
information on fees and reimbursements received by
Fund/Plan Services. Fund/Plan Services is also
investor servicing agent for the other funds managed
by the Adviser and receives fees from each of those
funds for its services.
Custodian
The Bank of New York ("Custodian") acts as custodian
of the Fund's assets. In carrying out its duties
under its custodian contract, the Custodian may employ
one or more subcustodians whose responsibilities will
include safeguarding and controlling the Fund's cash
and securities, handling the receipt and delivery of
securities and collecting interest and dividends on
the Fund's investments. The Fund pays the Custodian
an annual fee based on the assets of the Fund and the
Fund's securities transactions. The Fund also pays
the Custodian an annual fee based on the Fund's
securities holdings for the year and reimburses the
-14-
Custodian for certain out-of-pocket expenses incurred
by it or any subcustodian employed by it in performing
custodial services. The Custodian pays the fees and
other charges of any subcustodian employed by it.
PRINCIPAL HOLDERS OF SECURITIES AND CONTROLLING PERSONS
Listed below are the names and addresses of those
shareholders who, as of June 30, 1996, owned 5% or
more of the shares of the Fund.
Shareholder Percentage
Owned
Charles Schwab & Company 16.73%
Attn: Mutual Funds
101 Montgomery Street
San Francisco, CA 94104
Sammie C. Bledsoe 13.01%
Sammie C. Bledsoe Trust
1737 East 30th Place
Tulsa, OK 74114
Shepard Barbash and Vicki Ragan 9.30%
1732 Meadowdale Avenue
Atlanta, GA 30306-3114
Payne & Jones Profit Sharing Plan 6.62%
Jodde Lanning & Thomas Jones, Trustees
P.O. Box 25625
Overland Park, KS 66225
A Fund Trustee owns less than 1% of the shares of the
Fund as of June 30, 1996.
DETERMINATION OF NET ASSET VALUE
The Fund determines net asset value as of the close of
regular trading on the New York Stock Exchange at 4
p.m.
If any securities held by the Fund are restricted as
to resale, the Adviser determines their fair value
following
procedures approved by the Trustees. The Trustees
periodically review such valuation procedures. The
fair value of such securities is generally determined
as the amount which the Fund could reasonably expect
to realize from an orderly disposition of such
securities over a reasonable period of time. The
valuation procedures applied in any specific instance
are likely to vary from case to case. However,
consideration is generally given to the financial
position of the issuer and other fundamental
analytical data relating to the investment and to the
nature of the restrictions on disposition of the
-15-
securities (including any registration expenses that
might be borne by the Fund in connection with such
disposition). In addition, specific factors are also
generally considered, such as the cost of the
investment, the market value of any unrestricted
securities of the same class (both at the time of
purchase and at the time of valuation), the size of
the holding, the prices of any recent transactions or
offers with respect to such securities and any
available analysts' reports regarding the issuer.
Generally, trading in certain securities is
substantially completed each day at various times
prior to the close of regular trading on the Exchange.
The values of these securities used in determining the
net asset value of the Fund's shares are computed as
of such times. Also, because of the amount of time
required to collect and process trading information as
to large numbers of securities issues, the values of
certain securities (such as convertible bonds and U.S.
Government securities) are determined based on market
quotations collected earlier in the day at the latest
practicable time prior to the close of the Exchange.
Occasionally, events affecting the value of such
securities may occur between such times and the close
of the Exchange which will not be reflected in the
computation of the Fund's net asset value. If events
materially affecting the value of such securities
occur during such period, then these securities will
be valued at their fair market value following
procedures approved by the Trustees.
ADDITIONAL INFORMATION REGARDING PURCHASES AND
REDEMPTIONS OF FUND SHARES
All checks, drafts, wires and other payment mediums
used for purchasing or redeeming shares of the Fund
must be denominated in U.S. Dollars. The Fund
reserves the right, in its sole discretion, to either
(a) reject any order for the purchase or sale of
shares denominated in any other currency, or (b) to
honor the transaction or make adjustments to
shareholder's account for the transaction as of a date
and with a foreign currency exchange factor determined
by the drawee bank.
Dividend checks which are returned to the Fund marked
"unable to forward" by the postal service will be
deemed to be a request to change the dividend option
and the proceeds will be reinvested in additional
shares at the current net asset value until new
instructions are received.
Redemptions in Kind. The Fund has committed itself to
pay in cash all requests for redemption by any
shareholder of record, limited in amount, however,
-16-
during any 90-day period to the lesser of $250,000 or
1% of the value of the 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 the Fund
in case of any emergency, or if the payment of such
redemption in cash would be detrimental to the
existing shareholders of the Fund. In such
circumstances, the securities distributed would be
valued at the price used to compute the Fund's net
assets. Should the Fund do so, a shareholder may
incur brokerage fees or other transaction costs in
converting the securities to cash.
Principal Underwriter. Fund/Plan Broker Services,
Inc. (the "Principal Underwriter"), #2 West Elm
Street, P.O. Box 874, Conshohocken, Pennsylvania
19428-0874, is the principal underwriter for the Fund
and is acting on a best efforts basis. The Principal
Underwriter is registered as a broker-dealer under the
Securities Exchange Act of 1934 and is a member of the
National Association of Securities Dealers, Inc. The
offering of the Fund's shares is continuous.
The Fund's underwriting agreement with the Principal
Underwriter provides that the Fund will pay all fees
and expenses in connection with: registering and
qualifying its shares under the various state "blue
sky" laws; preparing, setting in type, printing, and
mailing its prospectuses and reports to shareholders;
and issuing its shares, including expenses of
confirming purchase orders.
The Principal Underwriter acts as the agent of the
Fund in connection with the sale of its 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 Fund
shares at the offering price. For these services, the
Adviser pays the Principal Underwriter approximately
$8000. The Principal Underwriter may enter into
agreements with other broker-dealers for the sale of
Fund shares by them.
Reinvestment Date. The dividend reinvestment date is
the date on which the additional shares are purchased
for the investor who has its dividends reinvested.
This date will vary and is not necessarily the same
date as the record date or the payable date for cash
dividends.
Special Services. The Fund may pay certain financial
institutions which maintain omnibus accounts with the
-17-
Fund on behalf of numerous beneficial owners for
recordkeeping operations performed with respect to
such beneficial owners. Such financial institutions may
also charge a fee for their services directly to their
clients.
SHAREHOLDER INFORMATION
Each time shareholders buy, redeem or exchange shares
or receive a distribution, they will receive a
statement confirming the transaction and listing their
current share balance. The Fund also sends annual and
semiannual reports that keep shareholders informed
about its portfolio and performance, and year-end tax
information to simplify their recordkeeping.
Shareholders may call Fund/Plan Services toll-free at
1-800-221-3137 between 9:00 a.m. and 7:00 p.m.
(Eastern Time) for more information, including account
balances.
SUSPENSION OF REDEMPTIONS
The Fund may not suspend shareholders' right of
redemption, or postpone payment for more than seven
days, unless the New York Stock Exchange (the
"Exchange") is closed for other than customary
weekends or holidays, or if permitted by the rules of
the Securities and Exchange Commission during periods
when trading on the Exchange is restricted or during
any emergency which makes it impracticable for the
Fund to dispose of its securities or to determine
fairly the value of its net assets, or during any
other period permitted by order of the Commission for
protection of investors.
SHAREHOLDER LIABILITY
Under Massachusetts law, shareholders could, under
certain circumstances, be held personally liable for
the obligations of the Fund. However, the Agreement
and Declaration of Trust disclaims shareholder
liability for acts or obligations of the Fund and
requires that notice of such disclaimer be given in
each agreement, obligation, or instrument entered into
or executed by the Fund or the Trustees. The
Agreement and Declaration of Trust provides for
indemnification out of Fund property for all loss and
expense of any shareholder held personally liable for
the obligations of the Fund. Thus, the risk of a
shareholder incurring financial loss on account of
shareholder liability is limited to circumstances in
which the Fund would be unable to meet its obligations.
The likelihood of such circumstances is remote.
-18-
STANDARD PERFORMANCE MEASURES
Total return data for the Fund may from time to time
be presented in this Statement and in advertisements.
Total return for the one-year period and for the life
of the Fund is determined by calculating the actual
dollar amount of investment return on a $500
investment in the Fund made at the net asset value at
the beginning of the period, and then calculating the
annual compounded rate of return which would produce
that amount. Total return for a period of one year is
equal to the actual return of the Fund during that period.
Total return calculations assume reinvestment of all Fund
distributions at net asset value on their respective
reinvestment dates. As of March 31, 1996, the average
annual total return for the Fund since inception is
17.74% and the average annual total return for the one year
period ended March 31, 1996 is 32.30%.
At times, the Adviser may reduce its compensation or
assume expenses of the Fund in order to reduce the
Fund's expenses. The per share amount of any such fee
reduction or assumption of expenses for the life of
the Fund, will be reflected in the Prospectus as
updated. Any such fee reduction or assumption of
expenses would increase the Fund's total return during
the period of the fee reduction or assumption of
expenses.
Independent statistical agencies measure the Fund's
investment performance and publish comparative
information showing how the Fund, and similar
investment companies, performed in specified time
periods. The agencies whose reports are commonly used
for Morningstar comparisons are Lipper Analytical
Services and Wiesenberger Investment Companies
Service. From time to time, the Fund may distribute
these comparisons to its shareholders or to potential
investors.
The Fund's performance may also from time to time be
compared to Standard & Poor's 500 Composite Stock
Price Index (the "S&P 500 Index"). The S&P 500 Index
is an unmanaged list of common stocks frequently used
as a general measure of stock market performance.
Standard & Poor's performance figures reflect changes
of market prices and reinvestment of all regular cash
dividends and are not adjusted for commissions or
other costs. Because the Fund is a managed portfolio
investing in a variety of securities and derivative
instruments, the securities it owns will not match
those in the Index.
Other publications, indices, and averages which may be
used are as follows:
-19-
a) 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.
b) Mutual Fund Source book, published by
Morningstar, Inc. - analyzes price, yield, risk
and total return for equity and fixed income
funds.
c) Financial publications: Barron's, Business Week,
Changing Times, Financial World, Forbes, Fortune,
and Money magazines - rate fund performance over
specified time periods.
d) 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.
e) Stocks, Bonds, Bills, and Inflation, published by
Ibbotson Associates - historical measure of
yield, price and total return for common and
small company stock, long-term government bonds,
treasury bills, and inflation.
f) Savings and Loan Historical Interest Rates - as
published in the U.S. Savings & Loan League Fact
Book.
g) Salomon Brothers Broad Bond Index or its
component indices - The Broad Index measures
yield, price and total return for Treasury,
Agency, Corporate, and Mortgage bonds.
h) Salomon Brothers Composite High Yield Index or
its component indices - The High Yield Index
measures yield, price and total return for
Long-Term High-Yield Index, Intermediate-Term
High-Yield Index and Long-Term Utility High-Yield
Index.
i) Lehman Brothers Aggregate Bond Index or its
component indices - The Aggregate Bond Index
measures yield, price and total return for
Treasury, Agency, Corporate, Mortgage, and Yankee
bonds.
j) Lehman Brothers Government/Corporate Bond Index.
k) 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.
-20-
l) 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.
m) Donoghues's Money Fund Report - industry averages
for seven-day annualized and compounded yields of
taxable, tax-free and government money funds.
n) Total returns and yields for Treasury Securities
and fixed income indices as published by Ryan
Laboratories or other suppliers.
Volatility. Occasionally statistics may be used to
specify Fund 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 the portfolio to the
expected excess return on the market index is called
beta. Equity funds commonly use the S&P 500 as their
market index. A beta of more than 1.00 indicates
volatility greater than the market, and a beta of less
than 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 the
portfolio's excess return (relative to T-Bills)
divided by the standard deviation of its returns.
All data are based on past performance and do not
predict future results.
INDEPENDENT AUDITORS
Deloitte & Touche LLP, 117 Campus Drive, Princeton,
New Jersey 08540, are the Fund's independent auditors,
providing audit services, tax return review and
preparation services and assistance and consultation
in connection with the review of various Securities
and Exchange Commission filings.
EXPERTS
The financial statements of the Fund and related notes
thereto included in this Statement of Additional
Information have been so included in reliance upon the
report of Deloitte & Touche LLP, independent auditors,
given on the authority of said firm as experts in
auditing and accounting.
-21-
REPORT OF INDEPENDENT AUDITORS AND FINANCIAL STATEMENTS
See attached report.
-22-
SMITH BREEDEN MARKET TRACKING FUND
ANNUAL REPORT
PERFORMANCE REVIEW
The Smith Breeden Market Tracking Fund provided at total return
of 32.30% for the year ended March 31, 1996, while the S&P 500
index return was 32.10%. The annualized total return of the
Market Tracking Fund from its inception on June 30, 1992 through
March 31, 1996 was 17.74%, while the annualized return of the
S&P 500 index was 16.10% over the same period.
The S&P 500 index, with dividends reinvested, has posted
positive returns every month from December 1994 through March
1996, with the one exception of a -0.36% return in October of
1995. This excellent performance was supported by strong
corporate earnings combined with low inflation and generally
falling long term interest rates. Long term interest rates, as
measured by the yield on the benchmark thirty year U.S. Treasury
Bond, fell from 7.43% in March 1995 to 5.96% in December 1995.
Falling long term interest rates benefit stocks in two ways.
Firstly, as bond yields fall, the price of bond investments
increases, and stocks become more attractive as an alternative
to bonds. Secondly, lower interest rates directly help raise
corporate earnings by lowering interest expense, which in turn
supports higher stock prices.
IN ACCORDANCE WITH REG. 232.304 OF REGULATION S-T, THE
FOLLOWING
IS A DESCRIPTION OF THE GRAPH PRESENTED HERE IN THE TEXT IN
COMPLIANCE WITH ITEM 5a. OF FORM N-1A:
THE GRAPH DEPICTS THE CHANGE IN VALUE OF A $10,000 INVESTMENT IN
THE MARKET TRACKING FUND VERSUS THAT OF ITS BENCHMARK, THE
S&P
500 INDEX. FROM INCEPTION OF JUNE 30, 1992 THROUGH MARCH 31,
1996, AN INVESTMENT OF $10,000 IN THE MARKET TRACKING FUND
WOULD
HAVE GROWN TO $18,459, VERSUS $17,514, IF INVESTED IN THE S&P
500 INDEX. THE AVERAGE ANNUAL TOTAL RETURN IN THE MARKET
TRACKING FUND WAS 32.30% FOR THE ONE YEAR PERIOD, 16.57% FOR
THE
THREE YEAR PERIOD, AND 17.74% FOR THE PERIOD SINCE INCEPTION.
In the first quarter of 1996, the stock market rally continued
unabated, with the S&P 500 index returning 5.37%, and the Market
Tracking Fund returning 5.90%. Interest rates however began
climbing during the first quarter fueled by investors' fears of
higher inflation in the future. The thirty year benchmark U.S.
Treasury yield rose from 5.96% in December 1995 to 6.66% on
March 31, 1996. Despite the climb in interest rates, investors
continued to expect strong earnings growth and accordingly were
willing to buy stocks at higher prices over the quarter.
The Market Tracking 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, along with U.S. Treasury Bills,
while the equity segment invests in S&P 500 index futures
contracts with a notional value approximately the same as the
Fund's net assets. When the return on the income segment of the
portfolio exceeds the funding cost implicit in the price 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.
This strategy was successful in the year to March 31, 1996, with
the Fund providing a total return 0.20% in excess of the total
return of the S&P 500 index.
Mortgage securities held in the income segment of the portfolio
varied from 95% of net assets in March 1995 to a low of 80% in
November 1995, and stood at 89% in March 1996. The balance of
the income segment was invested in U.S. Treasury Bills. During
the year, the Fund's holdings of 9.5% to 13.5% coupon FNMA and
FHLMC fixed-rate mortgages were reduced, dropping from 38% of
net assets in March 1995 to 10% in March 1996. In their place
GNMA and FNMA adjustable-rate mortgage securities were
purchased, and holdings of these securities rose from 52% of net
assets to 78% of assets over the year. The change in portfolio
composition resulted from opportunities to sell securities at a
relatively low risk-adjusted yield and to purchase securities at
a higher risk-adjusted yield. Portfolio turnover, which is
calculated by dividing the lesser of purchases and sales by
average assets, was 107% for the year.
SMITH BREEDEN MARKET TRACKING FUND
SCHEDULE OF INVESTMENTS MARCH 31, 1996
Market
Face Amount Security Value
U.S. GOVERNMENT & AGENCY OBLIGATIONS - 99.61%
FEDERAL HOME LOAN MORTGAGE CORPORATION - 4.49% *
FHLMC:
$146,653 9.50%, due 7/1/02 ....................... $153,163
53,465 12.50%, due 2/1/14 ...................... 60,699
TOTAL FEDERAL HOME LOAN MORTGAGE CORPORATION
(Cost $212,374)......................... 213,862
FEDERAL NATIONAL MORTGAGE ASSOCIATION - 30.92% *
FNMA:
139,126 12.50%, due 9/1/12 ...................... 159,548
109,513 13.50%, due 11/1/14 to 1/1/15 ........... 125,483
FNMA ARM:
342,269 5.98%, due 9/1/25 ....................... 350,845
758,504 7.687%, due 9/1/18 ...................... 780,943
54,881 7.839%, due 12/1/26 ..................... 56,916
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION
(Cost $1,460,675)....................... 1,473,735
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION - 53.22% *
GNMA ARM:
1,010,000 5.50%, due 3/20/26 ...................... 998,082
325,955 6.75%, due 2/20/16 ...................... 330,601
136,926 7.00%, due 5/20/25 ...................... 139,611
1,047,808 7.375%, due 4/20/16 to 6/20/21 .......... 1,068,366
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION
(Cost $2,536,598)....................... 2,536,660
U.S. GOVERNMENT OBLIGATIONS - 10.98%
U.S. TREASURY BILL **
300,000 5.00%, due 6/27/96 ...................... 296,375
230,000 5.02%, due 6/27/96 ...................... 227,221
TOTAL U.S. GOVERNMENT OBLIGATIONS
(Cost $523,585) ........................ 523,596
TOTAL U.S. GOVERNMENT & AGENCY OBLIGATIONS
(Cost $4,733,232)....................... 4,747,853
THREE MONTH EURODOLLAR FUTURES PUT OPTIONS - 0.01%
Contracts
20 Expires 6/96, Strike Price $93.75 ....... 500
TOTAL EURODOLLAR PUT OPTIONS (Cost $1,590) 500
TOTAL INVESTMENTS (Cost $4,734,822) -
99.62% ................................. 4,748,353
CASH AND OTHER ASSETS LESS LIABILITIES -
0.38% .................................. 18,181
NET ASSETS - 100.00% .................... $4,766,534
* 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 is the rate in effect at March 31, 1996. ARMs have
coupon rates which adjust periodically. The adjusted rate is
determined by adding a spread to a specified index.
** The interest rate shown is the discount rate paid at the time
of purchase by the Fund.
Portfolio Abbreviations:
ARM - Adjustable-Rate Mortgage
FHLMC - Federal Home Loan Mortgage Corporation
FNMA - Federal National Mortgage Association
GNMA - Government National Mortgage Association
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1996
ASSETS:
Investments at market value
(identified cost $4,734,822)(Note 1).............. $4,748,353
Cash................................................. 35,919
Receivables:
Interest.......................................... 26,778
Maturities........................................ 4,329
Subscriptions..................................... 4,760
Other............................................. 848
Prepaid expenses..................................... 27
Deferred organization expenses (Note 1).............. 34,587
TOTAL ASSETS.................................... 4,855,601
LIABILITIES:
Variation margin on futures contracts................ 48,342
Due to adviser (Note 3).............................. 29,004
Accrued expenses..................................... 11,721
TOTAL LIABILITIES............................... 89,067
NET ASSETS:
(Applicable to outstanding shares of 388,529;
unlimited number of shares of beneficial
interest authorized; no stated par)................. $4,766,534
Net asset value, offering price and redemption
price per share ($4,766,534 / 388,529)............ $12.27
SOURCE OF NET ASSETS:
Paid in capital...................................... $4,416,541
Undistributed net investment income.................. 12,594
Accumulated net realized gain on investments......... 299,125
Net unrealized appreciation of investments........... 38,274
NET ASSETS...................................... $4,766,534
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 31, 1996
INVESTMENT INCOME:
Interest and discount earned, net of
premium amortization (Note 1).................. $199,564
EXPENSES:
Advisory fees (Note 3)......................... 21,727
Accounting and pricing services fees........... 25,000
Custodian fees................................. 8,455
Audit and tax preparation fees................. 4,800
Legal fees..................................... 2,250
Amortization of organization expenses (Note 1). 27,943
Transfer agent fees............................ 25,284
Registration fees.............................. 20,004
Trustees fees and expenses..................... 3,630
Insurance expense.............................. 2,793
Other.......................................... 150
TOTAL EXPENSES BEFORE REIMBURSEMENT........ 142,036
Expenses reimbursed by Adviser (Note 3).... (114,100)
NET EXPENSES............................... 27,936
NET INVESTMENT INCOME...................... 171,628
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on investments............... 709,594
Change in unrealized appreciation of
investments.................................... (66,654)
Net realized and unrealized gain on
investments.................................... 642,940
Net increase in net assets resulting
from operations................................ $814,568
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED MARCH 31, 1996 AND 1995
Year Ended Year Ended
March 31, 1996 March 31, 1995
OPERATIONS:
Net investment income............ $171,628 $140,115
Net realized gain (loss) on
investments...................... 709,594 (64,050)
Change in unrealized appreciation
(depreciation) of investments.... (66,654) 229,458
Net increase in net assets
resulting from operations........ 814,568 305,523
DISTRIBUTIONS TO SHAREHOLDERS:
Dividends from net investment
income........................... (159,034) (104,085)
Dividends in excess of net
investment income................ - (251)
Distributions from net realized
gains on investments............. (371,974) (9,133)
Distributions in excess of
net realized gains on investments - (13,962)
Total distributions.............. (531,008) (127,431)
CAPITAL SHARE TRANSACTIONS:
Shares sold...................... 2,256,010 200,709
Shares issued on reinvestment of
distributions.................... 502,798 120,434
Shares redeemed.................. (383,180) (152,408)
Increase in net assets resulting
from capital share transactions
(a).............................. 2,375,628 168,735
TOTAL INCREASE IN NET ASSETS. 2,659,188 346,827
NET ASSETS:
Beginning of year................ 2,107,346 1,760,519
End of year...................... $4,766,534 $2,107,346
(a) Transactions in capital shares
were as follows:
Shares sold................. 183,531 19,300
Shares issued on reinvestment
of distributions............ 42,520 11,593
Shares redeemed............. (32,004) (14,689)
Net increase................ 194,047 16,204
Beginning balance .......... 194,482 178,278
Ending balance.............. 388,529 194,482
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED MARCH 31, 1996
Year Ended
March 31, 1996
Cash Flows from Operating Activities:
Net increase in net assets resulting
from operations................................ $814,568
Net realized and unrealized gain on investments (642,940)
Net investment income........................ 171,628
Adjustments to reconcile net investment income
to net cash provided by operating activities:
Net paydown gains and losses................... 16,109
Increase in interest receivable................ (11,919)
Decrease in other assets....................... 31,562
Decrease in other liabilities.................. (19,935)
Net cash provided by operating activities.... 187,445
Cash Flows from Investing Activities:
Settlement payment on S&P 500 equity
swap contract.................................. 168,247
Proceeds from futures variations............... 554,718
Proceeds from sales of long-term investments... 2,826,874
Proceeds from maturities of short-term
investments.................................... 2,365,000
Proceeds from sales of short-term investments.. 2,627,509
Proceeds from paydowns of long-term investments 449,569
Purchases of long-term investments............. (5,625,270)
Purchases of short-term investments............ (5,439,093)
Net cash used in investing activities........ (2,072,446)
Cash Flows from Financing Activities:
Purchase of shares tendered.................... 1,868,070
Dividends from net investment income and
realized gains................................. (28,210)
Net cash provided by financing activities.... 1,839,860
Net decrease in cash......................... (45,141)
Cash at beginning of year......................... 81,060
Cash at end of year............................... $35,919
Noncash Financing Activities:
Market value of shares issued to stockholders
through reinvestment of dividends............ $502,798
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
FINANCIAL HIGHLIGHTS
The following average per share data, ratios and supplemental information
has been derived from information provided in the financial statements.
Year Year Year Period
Ended Ended Ended Ended
March 31, 1996 March 31, 1995 March 31, 1994 March 31,1993*
Net Asset Value,
Beginning of Period $10.84 $9.88 $10.85 $10.00
Income From Investment
Operations
Net investment
income.......... 0.615 0.568 0.476 0.355
Net realized and
unrealized gain
(loss) on
investments..... 2.768 1.081 (0.216) 1.281
Total from
investment
operations.. 3.383 1.649 0.260 1.636
Less Distributions
Dividends from
net investment
income.......... (0.583) (0.568) (0.472) (0.311)
Dividends in excess
of net investment
income.......... - (0.001) - -
Distributions from
net realized gains
on investments.. (1.370) (0.047) (0.701) (0.420)
Distributions in
excess of net
realized gains on
investments..... - (0.073) (0.057) (0.055)
Total
distributions (1.953) (0.689) (1.230) (0.786)
Net Asset Value,
End of Period.... $12.27 $10.84 $9.88 $10.85
Total Return..... 32.30% 17.18% 2.19% 22.59%**
Ratios/Supplemental Data
Net assets, end
of period....... $4,766,534 $2,107,346 $1,760,519 $903,846
Ratio of expenses
to average net
assets (1)...... 0.90% 0.90% 0.90% 0.57%**
Ratio of net
investment income
to average net
assets (2)...... 5.53% 7.44% 8.02% 5.28%**
Portfolio
turnover rate... 107% 120% 119% 271%
______________________
(1) The annualized ratio of expenses to average net assets prior to
reimbursement of expenses by the Adviser was 4.58%, 7.75%, 7.08%,
and 28.48% for the years ended March 31, 1996, March 31,1995, March
31, 1994, and the period ended March 31, 1993, respectively.
(2) The annualized ratio of net investment income to average net assets
prior to reimbursement of expenses by the Adviser was 1.85%, 0.59%,
1.84%, and (22.63%) for the years ended March 31, 1996, March 31, 1995,
March 31, 1994, and the period ended March 31, 1993, respectively.
* The Smith Breeden Market Tracking Fund commenced operations June 30,1992.
** Annualized
The accompanying notes are an integral part of these financial statements.
SMITH BREEDEN MARKET TRACKING FUND
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
The Smith Breeden Market Tracking 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: 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, 1996, 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.
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. 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.
The Fund had the following open futures contracts, held for
purposes other than trading, as of March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain/(Loss)
Eurodollar $3,000,000 Short June, 1996 $ (88)
Eurodollar 5,000,000 Short September, 1996 (1,473)
Eurodollar 6,000,000 Short September, 1997 3,973
Eurodollar 6,000,000 Short September, 1998 (601)
Eurodollar 4,000,000 Short September, 1999 (418)
$ 1,393
The aggregate market value of investments pledged to cover
margin requirements for the open positions at March 31, 1996 was
$227,221.
B. Derivative Financial Instruments Held or Issued for Trading
Purposes: The Fund invests in Futures Contracts on the S&P 500
Index whose return is expected to track movements in the S&P 500
Index.
The Fund had fifteen open futures contracts on the S&P 500 Index
as of March 31, 1996:
Notional Expiration Unrealized
Type Amount Position Month Gain
S&P 500 $4,841,250 Long June, 1996 $23,350
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
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 limit the expenses of the
Fund to 0.90% 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 0.90% through March 31,
1996. For the year ended March 31, 1996, the Adviser received
fees of $21,727 and reimbursed the Fund $114,100.
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 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, 1996, purchases and proceeds
from sales of securities, other than short-term investments,
aggregated $5,597,637 and $2,831,265, respectively. The cost of
securities for federal income tax purposes is $4,734,822. Net
unrealized appreciation of investments and futures contracts
consists of:
Gross unrealized appreciation....... $47,183
Gross unrealized depreciation....... (8,909)
Net unrealized appreciation......... $38,274
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders,
Smith Breeden Market Tracking Fund of the Smith Breeden Trust:
We have audited the accompanying statement of assets and
liabilities, including the schedule of investments, of the Smith
Breeden Market Tracking Fund of the Smith Breeden Trust as of
March 31, 1996, and the related statements of operations and
cash flows for the year then ended, the statements of changes in
net assets for each of the years in the two-year period then
ended and the financial highlights for each of the years in the
three year period then ended and the period 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, 1996 by correspondence with the
custodian. 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 Market
Tracking Fund of the Smith Breeden Trust as of March 31, 1996,
the results of its operations and its cash flows, the changes in
its net assets, and the financial highlights for the respective
stated periods in conformity with generally accepted accounting
principles.
Deloitte & Touche LLP
Princeton, New Jersey
May 10, 1996
