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FIRST FUNDS
TENNESSEE TAX-FREE PORTFOLIO
SUPPLEMENT DATED MARCH 2, 1998, TO
THE PROSPECTUS DATED OCTOBER 24, 1997
At a meeting on February 27, 1998, shareholders of the Tennessee
Tax-Free Portfolio (the Portfolio) of First Funds approved a Sub-Advisory
Agreement between First Tennessee Bank National Association (First
Tennessee), the Portfolio's investment adviser, and its affiliated company,
Martin & Company, Inc. (Martin), acting as sub-adviser. The new sub-advisory
arrangement became effective March 2,1998. Accordingly, the following changes
are made to the Prospectus:
All references that appear under the following headings in the
Prospectus to First Tennessee acting in its capacity as the day-to-day
manager of the Portfolio's investments are changed to refer instead to
Martin: "Is the Portfolio a Suitable Investment?; Investment Risks," "What
are the Portfolio's Investment Policies and Limitations?," "How are
Investments, Exchanges and Redemptions Made?" and "Investment Instruments,
Transactions, Strategies and Risks."
The following is added as the last paragraph under the heading "What
Advisory and Other Fees Does the Portfolio Pay? -- Investment Advisory and
Management and Sub-Advisory Agreements":
"Martin became Sub-Adviser to the Portfolio in March 1998 with
shareholder approval. Martin serves as Sub-Adviser subject to the
supervision of First Tennessee and pursuant to the authority granted to it
under its Sub-Advisory Agreement with First Tennessee. In January 1998,
Martin became an investment advisory subsidiary of First Tennessee National
Corporation, which also owns First Tennessee. Martin and its predecessors
have been in the investment advisory business for over 8 years and have
considerable experience in securities selection, including expertise in the
selection of fixed-income securities. Martin has not previously advised or
sub-advised a registered investment company such as First Funds, although
Martin is subject to the supervision of First Tennessee, which has a
history of investment management since 1929 and has served as the
investment adviser to First Funds since its inception in 1992. First
Tennessee is obligated to pay Martin a monthly sub-advisory fee at the
annual rate of 0.30% of the Portfolio's average net assets. The Portfolio
is not responsible for paying any portion of Martin's sub-advisory fee.
Martin has agreed to voluntarily waive its sub-advisory fee, although this
waiver could be discontinued in whole or in part at any time. Martin's
principal office is located at Two Centre Square, Suite 200, 625 South Gay
Street, Knoxville, TN 37902."
The paragraph under the heading "How is the Portfolio Organized?
- --Portfolio Management" is deleted in its entirety and the following two
paragraphs substituted in its place:
"Ralph W. Herbert, Vice President and Portfolio Manager with Martin,
is a co-manager for the Tennessee Tax-Free Portfolio. Mr. Herbert has over
19 years of experience in the financial services industry and specializes
in fixed-income securities. Mr. Herbert is a 1977 graduate of The
University of Tennessee.
"Ted L. Flickinger, Jr., Vice President and Fixed Income Portfolio
Manager with Martin, co-manages the Tennessee Tax-Free Portfolio with
Mr. Herbert. Mr. Flickinger is a Chartered Financial Analyst and has
over 14 years of experience in the investment management industry, at
least 7 of which have been with Martin concentrating on fixed-income
securities. Mr. Flickinger is a 1977 graduate of The University of
Tennessee."
The information about the Portfolio's average maturity under the heading
"What is the Investment Objective of the Portfolio?" is supplemented with the
following:
"The dollar-weighted average maturity of the Portfolio since
inception has been between 5 and 15 years. At the beginning of March,
1998, assets were transferred in-kind into the Portfolio, which
shortened the dollar-weighted average maturity of the Portfolio from
approximately 9.4 years to approximately 6.6 years. In addition,
Martin became Sub-Adviser to the Portfolio effective that date. As a
fixed-income
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securities adviser, Martin has historically favored securities with a
maturity range between 3 and 10 years. Consequently, the Portfolio's
average maturity may decrease further over time."
The first sentence under the heading "What is the Effect of Income Tax
on This Investment? - Federal Taxes" is deleted in its entirety and the
following substituted in its place:
"Distributions of gains from the sale of assets held by the Portfolio
for more than one year generally are taxable to shareholders at the
applicable mid-term or long-term capital gains rate, regardless of how long
they have owned their Portfolio shares. Distributions from other sources
generally are taxed as ordinary income."
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FIRST FUNDS
TENNESSEE TAX-FREE PORTFOLIO
STATEMENT OF ADDITIONAL INFORMATION FOR CLASS I, CLASS II, AND CLASS III
OCTOBER 24, 1997
AS AMENDED MARCH 2, 1998
This Statement is not a prospectus but should be read in conjunction with the
current Prospectus for each Class of Tennessee Tax-Free Portfolio dated
October 24, 1997, as it may be amended or supplemented from time to time.
Please retain this Statement for future reference. The Portfolio's financial
statements and financial highlights, included in the Annual Report for the
fiscal year ended June 30, 1997, are incorporated herein by reference. To
obtain additional free copies of this Statement, the Annual Report or the
Prospectus, please call the Distributor at 1-800-442-1941, option 1 or write
to the Distributor at 370 17th Street, Suite 3100, Denver CO 80202.
<TABLE>
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TABLE OF CONTENTS PAGE
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Investment Restrictions and Limitations 2
Investment Instruments 3
Special Considerations Affecting Tennessee 6
Portfolio Transactions 6
Valuation of Portfolio Securities 7
Performance 7
Additional Purchase and Redemption Information 10
Distributions and Taxes 10
Trustees and Officers 11
Investment Advisory Agreement 12
Administration Agreement and Other Contracts 13
Description of the Trust 15
Financial Statements 16
Appendix 16
</TABLE>
INVESTMENT ADVISER
First Tennessee Bank National Association (First Tennessee or the Investment
Adviser)
ADMINISTRATOR AND DISTRIBUTOR
ALPS Mutual Funds Services, Inc. (ALPS or the Administrator and Distributor)
SUB-ADVISER
Martin & Company, Inc. (Martin or the Sub-Adviser)
CO-ADMINISTRATOR
First Tennessee Bank National Association (First Tennessee or the
Co-Administrator)
TRANSFER AGENT & SHAREHOLDER SERVICING AGENT
Chase Global Funds Services Company (CGFSC or the Transfer Agent)
CUSTODIAN
Chase Manhattan Bank, N.A. (Chase or the Custodian)
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INVESTMENT RESTRICTIONS AND LIMITATIONS
The following policies and limitations supplement those set forth in the
Prospectus. Unless otherwise noted, whenever an investment policy or
limitation states a maximum percentage of the Portfolio's assets that may be
invested in any security or other asset, or sets forth a policy regarding
quality standards, such standard or percentage limitation will be determined
immediately after and as a result of the Portfolio's acquisition of such
security or other asset. Accordingly, any subsequent change in values, net
assets, or other circumstances will not be considered when determining
whether the investment complies with the Portfolio's investment policies and
limitations.
Fundamental policies and investment limitations cannot be changed without
approval by a "majority of the outstanding voting securities" (as defined in
the Investment Company Act of 1940) of the Portfolio. However, except for
the fundamental investment limitations set forth below, the investment
policies and limitations described in this Statement of Additional
Information are not fundamental and may be changed without shareholder
approval.
INVESTMENT LIMITATIONS OF TENNESSEE TAX-FREE PORTFOLIO
THE FOLLOWING ARE TENNESSEE TAX-FREE PORTFOLIO'S FUNDAMENTAL LIMITATIONS SET
FORTH IN THEIR ENTIRETY. THE PORTFOLIO MAY NOT:
(1) issue senior securities, except as permitted under the Investment Company
Act of 1940;
(2) borrow money, except that the Portfolio may borrow money for temporary or
emergency purposes (not for leveraging or investment) in an amount
not exceeding 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings). Any borrowings that come to
exceed this amount will be reduced within three days (not including
Sundays and holidays) to the extent necessary to comply with the 33 1/3%
limitation;
(3) underwrite securities issued by others, except to the extent that the
Portfolio may be considered an underwriter within the meaning of the
Securities Act of 1933 in the disposition of restricted securities;
(4) purchase the securities of any issuer (other than securities issued or
guaranteed by the U.S. government or any of its agencies or
instrumentalities, or tax-exempt obligations issued or guaranteed by a
U.S. territory or possession or the state of Tennessee or any county,
municipality, or political subdivision of any of the foregoing, including
any agency, board authority, or commission of the foregoing) if, as a
result, 25% or more of the Portfolio's total assets would be invested in
securities of companies whose principal business activities are in the
same industry;
(5) purchase or sell real estate, unless acquired as a result of ownership of
securities or other instruments (but this shall not prevent the
Portfolio from investing in securities or other instruments backed by
real estate or securities of companies engaged in the real estate
business);
(6) purchase or sell physical commodities unless acquired as a result of
ownership of securities or other instruments (but this shall not
prevent the Portfolio from purchasing or selling options and futures
contracts or from investing in securities or other instruments backed by
physical commodities); or
(7) lend any security or make any other loan if, as a result, more than
33 1/3% of its total assets would be lent to other parties, but this
limit does not apply to purchases of debt securities or to repurchase
agreements.
(8) The Portfolio may, notwithstanding any other fundamental investment
policy or limitation, invest all of its assets in the securities of a
single open-end management investment company with substantially the same
fundamental investment objectives, policies, and limitations as the
Portfolio.
THE FOLLOWING LIMITATIONS OF TENNESSEE TAX-FREE PORTFOLIO ARE NOT FUNDAMENTAL
AND MAY BE CHANGED WITHOUT SHAREHOLDER APPROVAL:
(i) To meet federal tax requirements for qualification as a "regulated
investment company," the Portfolio limits its investments so that at
the close of each quarter of its taxable year: (a) with regard to at
least 50% of total assets, no more than 5% of total assets are invested
in the securities of a single issuer, and (b) no more than 25% of total
assets are invested in the securities of a single issuer. Limitations
(a) and (b) do not apply to "government securities" as defined for
federal tax purposes.
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(ii) The Portfolio does not currently intend during the coming year to
purchase securities on margin, except that the Portfolio may
obtain such short-term credits as are necessary for the clearance of
transactions, and provided that margin payments in connection with
futures contracts and options on futures contracts shall not constitute
purchasing securities on margin.
(iii) The Portfolio may borrow money only (a) from a bank, or (b) by engaging
in reverse repurchase agreements with any party (reverse repurchase
agreements are treated as borrowings for purposes of fundamental
investment limitation 2). The Portfolio will not purchase any security
while borrowings representing more than 5% of its total assets are
outstanding.
(iv) The Portfolio does not currently intend during the coming year to
purchase any security, if, as a result, more than 15% of its net
assets would be invested in securities that are deemed to be illiquid
because they are subject to legal or contractual restrictions on resale
or because they cannot be sold or disposed of in the ordinary course of
business at approximately the prices at which they are valued.
(v) The Portfolio does not currently intend during the coming year to
engage in repurchase agreements or make loans, but this
limitation does not apply to purchases of debt securities.
INVESTMENT INSTRUMENTS
DELAYED DELIVERY TRANSACTIONS. The Portfolio may buy and sell securities on
a delayed delivery or when-issued basis. These transactions involve a
commitment by the Portfolio to purchase or sell specific securities at a
predetermined price and/or yield, with payment and delivery taking place
after the customary settlement period for that type of security (and more
than seven days in the future). Typically, no interest accrues to the
purchaser until the security is delivered. The Portfolio may receive fees
for entering into delayed delivery transactions.
When purchasing securities on a delayed delivery basis, the Portfolio assumes
the rights and risks of ownership, including the risk of price and yield
fluctuations. Because the Portfolio is not required to pay for securities
until the delivery date, these risks are in addition to the risks associated
with the Portfolio's other investments. If the Portfolio remains
substantially fully invested at a time when delayed delivery purchases are
outstanding, the delayed delivery purchases may result in a form of leverage.
When delayed delivery purchases are outstanding, the Portfolio will set
aside appropriate liquid assets in a segregated custodial account to cover
its purchase obligations. When the Portfolio has sold a security on a delayed
delivery basis, the Portfolio does not participate in further gains or losses
with respect to the security. If the other party to a delayed delivery
transaction fails to deliver or pay for the securities, the Portfolio could
miss a favorable price or yield opportunity, or could suffer a loss.
The Portfolio may renegotiate delayed delivery transactions after they are
entered into, and may sell underlying securities before they are delivered,
which may result in capital gains or losses.
FEDERALLY-TAXABLE OBLIGATIONS. Tennessee Tax-Free Portfolio does not intend
to invest in securities whose interest is federally taxable; however, from
time to time, the Portfolio may invest a portion of its assets on a temporary
basis in fixed-income obligations whose interest is subject to federal income
tax. As an operating policy, the Portfolio intends to invest its assets to
achieve as fully as possible tax exempt income for both Tennessee state and
federal purposes. For example, the Portfolio may invest in obligations whose
interest is federally taxable pending the investment or reinvestment in
municipal securities of proceeds from the sale of its shares or sales of
portfolio securities.
Should the Portfolio invest in taxable obligations, it would purchase
securities which in the judgment of First Tennessee are of high quality.
These would include obligations issued or guaranteed by the U.S. government,
its agencies or instrumentalities, obligations of domestic banks, and
repurchase agreements. The Portfolio's standards for high-quality taxable
obligations are essentially the same as those described by Moody's Investors
Service, Inc. (Moody's) in rating corporate obligations within its two
highest ratings of Aaa and Aa, and those described by Standard and Poor's
Corporation (S&P) in rating corporate obligations within its two highest
ratings of AAA and AA.
Proposals to restrict or eliminate the federal income tax exemption for
interest on municipal obligations are introduced before Congress from time to
time. Proposals also may be introduced before the Tennessee General Assembly
that would affect the state tax treatment of the Portfolio's distributions.
If such proposals were enacted, the availability of municipal obligations and
the value of the Portfolio's holdings would be affected and the Board of
Trustees (the Trustees) would reevaluate the Portfolio's investment objective
and policies.
Tennessee Tax-Free Portfolio anticipates being as fully invested as
practicable in municipal securities; however, there may be occasions when as
a result of maturities of portfolio securities, or sales of Portfolio shares,
or in order to meet redemption requests, the Portfolio
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may hold cash that is not earning income. In addition, there may be
occasions when, in order to raise cash to meet redemptions, the Portfolio may
be required to sell securities at a loss.
ILLIQUID INVESTMENTS are investments that cannot be sold or disposed of in
the ordinary course of business at approximately the prices at which they are
valued. Under guidelines established by the Trustees, the Sub-Adviser
determines the liquidity of Tennessee Tax-Free Portfolio's investments and,
through reports from the Sub-Adviser, the Trustees monitor investments in
illiquid instruments. In determining the liquidity of the Portfolio's
investments, the Sub-Adviser may consider various factors including (1) the
frequency of trades and quotations, (2) the number of dealers and prospective
purchasers in the marketplace, (3) dealer undertakings to make a market, (4)
the nature of the security (including any demand or tender features) and (5)
the nature of the marketplace for trades (including the ability to assign or
offset the Portfolio's rights and obligations relating to the investment).
Investments currently considered by the Portfolio to be illiquid include
repurchase agreements not entitling the holder to payment of principal and
interest within seven days, and some restricted securities determined by the
Sub-Adviser to be illiquid. In the absence of market quotations, illiquid
investments are valued at fair value as determined in good faith by the
Trustees. If through a change in values, net assets or other circumstances,
the Portfolio were in a position where more than 15% of its net assets were
invested in illiquid securities, the Trustees would seek to take appropriate
steps to protect liquidity.
MUNICIPAL LEASE OBLIGATIONS. The Portfolio may invest a portion of its
assets in municipal leases and participation interests therein. These
obligations, which may take the form of a lease, an installment purchase, or
a conditional sale contract, are issued by state and local governments and
authorities to acquire land and a wide variety of equipment and facilities.
Generally, the Portfolio will not hold such obligations directly as a lessor
of the property, but will purchase a participation interest in a municipal
obligation from a bank or other third party. A participation interest gives
a Portfolio a specified, undivided interest in the obligation in proportion
to its purchased interest in the total amount of the obligation.
Municipal leases frequently have risks distinct from those associated with
general obligation or revenue bonds. State constitutions and statutes set
forth requirements that states or municipalities must meet to incur debt.
These may include voter referenda, interest rate limits, or public sale
requirements. Leases, installment purchase, or conditional sale contracts
(which normally provide for title to the leased asset to pass to the
governmental issuer) have evolved as a means for governmental issuers to
acquire property and equipment without meeting their constitutional and
statutory requirements for the issuance of debt. Many leases and contracts
include "non-appropriation clauses" providing that the governmental issuer
has no obligation to make future payments under the lease or contract unless
money is appropriated for such purpose by the appropriate legislative body on
a yearly or other periodic basis. Non-appropriation clauses free the issuer
from debt issuance limitations.
REFUNDING CONTRACTS. Tennessee Tax-Free Portfolio generally will not be
obligated to pay the full purchase price if it fails to perform under a
refunding contract. Instead, refunding contracts generally provide for
payment of liquidated damages to the issuer (currently 15 - 20% of the
purchase price). The Portfolio may secure its obligations under a refunding
contract by depositing collateral or a letter of credit equal to the
liquidated damages provisions of the refunding contract. When required by
Securities and Exchange Commission (SEC) guidelines, the Portfolio will place
liquid assets in a segregated custodial account equal in amount to its
obligations under refunding contracts.
REPURCHASE AGREEMENTS are transactions in which the Portfolio purchases a
security and simultaneously commits to resell that security at an agreed upon
price and date within a number of days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security.
A repurchase agreement involves the obligation of the seller to pay the
agreed upon price. This obligation is in effect secured by the underlying
security having a value at least equal to the amount of the agreed upon
resale price. The Portfolio may enter into a repurchase agreement with
respect to any security in which it is authorized to invest. While it
presently does not appear possible to eliminate all risks from the
transactions (particularly the possibility of a decline in the market value
of the underlying securities, as well as delay and costs to the Portfolio in
connection with bankruptcy proceedings), it is the policy of the Portfolio to
limit repurchase agreements to those parties whose creditworthiness has been
reviewed and found satisfactory by the Sub-Adviser.
REVERSE REPURCHASE AGREEMENTS. In a reverse repurchase agreement, the
Portfolio sells a portfolio security to another party, such as a bank or
broker-dealer, in return for cash and agrees to repurchase the instrument at
a particular price and time. While a reverse repurchase agreement is
outstanding, the Portfolio will maintain appropriate high grade liquid assets
in a segregated custodial account to cover its obligation under the
agreement. The Portfolio will enter into reverse repurchase agreements only
with parties whose creditworthiness has been found satisfactory by the
Sub-Adviser. As a result, such transactions may increase fluctuations in the
market values of the Portfolio's assets and may be viewed as a form of
leverage.
RESTRICTED SECURITIES generally can be sold in privately negotiated
transactions, pursuant to an exemption from registration under the Securities
Act of 1933, or in a registered public offering. Where registration is
required, Tennessee Tax-Free Portfolio may be obligated
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to pay all or part of the registration expense and a considerable period may
elapse between the time each decides to seek registration and the time the
Portfolio may be permitted to sell a security under an effective registration
statement. If, during such a period, adverse market conditions were to
develop, the Portfolio might obtain a less favorable price than prevailed
when it decided to seek registration of the security.
STANDBY COMMITMENTS are puts that entitle holders to same-day settlement at
an exercise price equal to the amortized cost of the underlying security plus
accrued interest, if any, at the time of exercise. Tennessee Tax-Free
Portfolio may acquire standby commitments to enhance the liquidity of
portfolio securities, but only when the issuers of the commitments present
minimal risk of default.
Ordinarily, the Portfolio will not transfer a standby commitment to a third
party, although it could sell the underlying municipal security to a third
party at any time. The Portfolio may purchase standby commitments separate
from or in conjunction with the purchase of securities subject to such
commitments. In the latter case, the Portfolio would pay a higher price for
the securities acquired, thus reducing their yield to maturity.
Standby commitments are subject to certain risks, including the ability of
issuers to pay for securities at the time the commitments are exercised; the
fact that standby commitments are not marketable by the Portfolio; and that
the maturities of the underlying securities may be different from those of
the commitments.
TENDER OPTION BONDS are created by coupling an intermediate or long-term
fixed-rate tax-exempt bond (generally held pursuant to a custodial
arrangement) with a tender agreement that gives the holder the option to
tender the bond at its face value. As consideration for providing the tender
option, the sponsor (usually a bank, broker-dealer, or other financial
institution) receives periodic fees equal to the difference between the
bond's fixed coupon rate and the rate (determined by a remarketing or similar
agent) that would cause the bond, coupled with the tender option, to trade at
par on the date of such determination. After payment of the tender option
fee, Tennessee Tax-Free Portfolio effectively holds a demand obligation that
bears interest at the prevailing short-term tax-exempt rate. In selecting
tender option bonds for the Portfolio, the Sub-Adviser will consider the
creditworthiness of the issuer of the underlying bond, the custodian, and the
third party provider of the tender option. In certain instances, a sponsor
may terminate a tender option if, for example, the issuer of the underlying
bond defaults on interest payments.
VARIABLE AND FLOATING RATE DEMAND OBLIGATIONS (VRDOS/FRDOS) are obligations
that bear variable or floating interest rates and carry rights that permit
holders to demand payment of the unpaid principal balance plus accrued
interest from the issuers or certain financial intermediaries. Floating rate
instruments have interest rates that change whenever there is a change in a
designated base rate while variable rate obligations provide for a specified
periodic adjustment in the interest rate. These formulas are designed to
result in a market value for the VRDO or FRDO that approximates its par
value.
Tennessee Tax-Free Portfolio may invest in fixed-rate bonds that are subject
to third party puts and in participation interests in such bonds held by a
bank in trust or otherwise. These bonds and participation interests have
tender options or demand features that permit the Portfolio to tender (or
put) their bonds to an institution at periodic intervals and to receive the
principal amount thereof. The Portfolio considers variable rate instruments
structured in this way (Participating VRDOs) to be essentially equivalent to
other VRDOs they purchase.
ZERO COUPON BONDS do not make regular interest payments; instead they are
sold at a deep discount from their face value and are redeemed at face value
when they mature. Because zero coupon bonds do not pay current income, their
prices can be very volatile when interest rates change. In calculating its
daily dividend, the Portfolio takes into account as income a portion of the
difference between a zero coupon bond's purchase price and its face value.
A broker-dealer creates a DERIVATIVE ZERO by separating the interest and
principal components of a U.S. Treasury security and selling them as two
individual securities. CATS (Certificates of Accrual on Treasury
Securities), TIGRs (Treasury Investment Growth Receipts), and TRs (Treasury
Receipts) are examples of derivative zeros.
The Federal Reserve Bank creates STRIPS (Separate Trading of Registered
Interest and Principal of Securities) by separating the interest and
principal components of an outstanding U.S. Treasury bond and selling them as
individual securities. Bonds issued by the Resolution Funding Corporation
(REFCORP) and the Financing Corporation (FICO) can also be separated in this
fashion. ORIGINAL ISSUE ZEROS are zero coupon securities originally issued
by the U.S. government, a government agency, or a corporation in zero coupon
form.
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SPECIAL CONSIDERATIONS AFFECTING TENNESSEE
TENNESSEE OBLIGATIONS. The following information as to certain Tennessee
considerations is given to investors in view of the Portfolio's policy of
concentrating its investments in Tennessee issuers. Such information is
derived from sources that are generally available to investors and is
believed to be accurate. Such information constitutes only a brief summary,
does not purport to be a complete description and is based on information
from official statements relating to securities offerings of Tennessee
issuers. Neither the Trust or the Portfolio has independently verified this
information.
In 1978, the voters of the State of Tennessee approved an amendment to the
State Constitution requiring that (1) the total expenditures of the State for
any fiscal year shall not exceed the State's revenues and reserves, including
the proceeds of debt obligations issued to finance capital expenditures and
(2) in no year shall the rate of growth of appropriations from State tax
revenues exceed the estimated rate of growth of the State's economy. In the
past the Governor and the General Assembly have had to restrict expenditures
to comply with the State Constitution.
While the financial operations of the State were negatively impacted by the
national economic downturn, the State's finances have stabilized in recent
years. The General Fund balance was reduced to $7.3 million in 1991;
however, operating surpluses for 1992 built up the balance to $150.1 million
for 1993. In fiscal 1996 the General Fund was $128.6 million.
Several new programs could have a negative impact on the financial operations
of the State. A half percent increase in the sales tax rate, imposed in
fiscal 1993, was dedicated to a new Basic Education Program. This increase
has since been made permanent. Tennessee will provide health care to the
entire Medicaid population as well as the uninsured population in the State.
A service tax that was implemented to help fund this program was repealed in
connection with the implementation of the expanded health care program
although recently, the costs of this healthcare plan have stabilized.
The Tennessee economy is largely based on manufacturing and services, which
accounted for approximately 42% of the gross State product in 1995. The
location of General Motors' Saturn project in Tennessee is believed to
demonstrate the continuing viability of manufacturing in the State. Other
important segments of the State economy include the wholesale and retail
trade, transportation, and the government sector. The State unemployment
rate for August 1997 increased to 5.1% from 4.4% for August 1996, which is
slightly higher than the national average which was 4.9% for August 1997.
There can be no assurance that Tennessee's relatively favorable economic
performance will continue.
As of the date of this Statement of Additional Information, general
obligations of the State of Tennessee are rated "AA+," "Aaa" and "AAA" by
S&P, Moody's and Fitch. There can be no assurance that the economic
conditions on which these ratings are based will continue or that particular
bond issues may not be adversely affected by changes in economic, political
or other conditions.
PORTFOLIO TRANSACTIONS
All orders for the purchase or sale of securities are placed on behalf of the
Portfolio by the Sub-Adviser pursuant to authority contained in the
Sub-Advisory Agreement for the Portfolio. The Sub-Adviser is also
responsible for the placement of transaction orders for other accounts for
which it or its affiliates act as investment adviser. In selecting
broker-dealers, subject to applicable limitations of the federal securities
laws, the Sub-Adviser considers various relevant factors, including, but not
limited to, the actual handling of the order by the broker, the ability of
the broker to settle the trade, the financial standing of the broker and the
broker's execution abilities.
The Portfolio may execute portfolio transactions with broker-dealers who
provide research and execution services to the Portfolio or other accounts
over which the Sub-Adviser or its affiliates exercise investment discretion.
Such services may include furnishing analyses and reports concerning issuers,
industries, and economic factors and trends.
The receipt of research from broker-dealers that execute transactions on
behalf of the Portfolio may be useful to the Sub-Adviser or its affiliates in
rendering investment management services to the Portfolio and/or its other
clients, and conversely, such information provided by broker-dealers who have
executed transaction orders on behalf of other clients may be useful to the
Sub-Adviser in carrying out its obligations to the Portfolio. The receipt of
such research has not reduced the Sub-Adviser's normal independent research
activities; however, it enables the Sub-Adviser to avoid the additional
expenses that could be incurred if it tried to develop comparable information
through its own efforts.
Subject to applicable limitations of the federal securities laws,
broker-dealers may receive commissions for agency transactions that are
higher than the commission of another broker-dealer who might have charged
for their research and execution services. In order to cause the Portfolio
to pay such higher commissions, the Sub-Adviser must determine in good faith
that such commissions are reasonable in
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relation to the value of the brokerage and research services provided by such
executing broker-dealers viewed in terms of a particular transaction or the
Sub-Adviser's overall responsibilities to the Portfolio and its other
clients. In reaching this determination, the Sub-Adviser will not attempt to
place a specific dollar value on the brokerage and research services provided
or to determine what portion of the compensation should be related to those
services.
The Sub-Adviser is authorized to use research services provided by and to
place portfolio transactions to the extent permitted by law, with brokerage
firms that have provided assistance in the distribution of shares of the
Portfolio.
The Trustees periodically review the Sub-Adviser's performance of its
responsibilities in connection with the placement of portfolio transactions
on behalf of the Portfolio and review the commissions paid by the Portfolio
over representative periods of time to determine if they are reasonable in
relation to the benefits to the Portfolio.
For the fiscal periods ended June 30, 1997 and 1996, the portfolio turnover
rate was 122% and 8%, respectively. The increase in portfolio turnover rate
is due primarily to the fact that the 1996 rate reflects only the first six
months of the Portfolio's operations. No brokerage commissions were paid by
the Portfolio during the fiscal periods ended June 30, 1997 and 1996.
From time to time the Trustees will review whether the recapture for the
benefit of the Portfolio of some portion of the brokerage commissions or
similar fees paid by the Portfolio on portfolio transactions is legally
permissible and advisable. The Portfolio seeks to recapture soliciting
broker-dealer fees on the tender of portfolio securities, but at present no
other recapture arrangements are in effect. The Trustees intend to continue
to review whether recapture opportunities are available and are legally
permissible and, if so, to determine, in the exercise of their business
judgment, whether it would be advisable for the Portfolio to seek such
recapture.
When two or more Portfolios are simultaneously engaged in the purchase or
sale of the same security, the prices and amounts are allocated in accordance
with a formula considered by the Trustees and the Sub-Adviser to be equitable
to each Portfolio. In some cases this system could have a detrimental effect
on the price or value of the security as far as the Portfolio is concerned.
In other cases, however, the ability of the Portfolio to participate in
volume transactions will produce better executions for the Portfolio. It is
the current opinion of the Trustees that the desirability of retaining the
Sub-Adviser as sub-adviser to the Portfolio outweighs any disadvantages that
may be said to exist from exposure to simultaneous transactions.
VALUATION OF PORTFOLIO SECURITIES
Valuations of securities furnished by the pricing service employed by the
Portfolio are based upon a computerized matrix system and/or appraisals by
the independent pricing service, in each case in reliance upon information
concerning market transactions and quotations from recognized securities
dealers. The methods used by the pricing service and the quality of
valuations so established are reviewed by officers of the Portfolio and the
Portfolio's pricing agent under general supervision of the Trustees.
Use of pricing services has been approved by the Board of Trustees.
Securities and other assets for which there is no readily available market
are valued in good faith by a committee appointed by the Board of Trustees.
The procedures set forth above need not be used to determine the value of the
securities owned by the fund if, in the opinion of a committee appointed by
the Board of Trustees, some other method (e.g., closing over-the-counter- bid
prices in the case of debt instruments traded on an exchange) would more
accurately reflect the fair market value of such securities.
PERFORMANCE
For each class of the Portfolio, yields used in advertising are computed by
dividing interest income for a given 30-day or one-month period, net of
expenses, by the average number of shares entitled to receive dividends
during the period, dividing this figure by the net asset value per share
(NAV) at the end of the period and annualizing the result (assuming
compounding of income) in order to arrive at an annual percentage rate.
Income is calculated for purposes of yield quotations in accordance with
standardized methods applicable to all bond funds. In general, interest
income is reduced with respect to bonds trading at a premium over their par
value by subtracting a portion of the premium from income on a daily basis,
and is increased with respect to bonds trading at a discount by adding a
portion of the discount to daily income. Capital gains and losses generally
are excluded from the calculation.
Income calculated for the purposes of determining yields differs from income
as determined for other accounting purposes. Because of the different
accounting methods used, and because of the compounding of income assumed in
yield calculations, yield may not equal its distribution rate, the income
paid to an account, or income reported in financial statements.
7
<PAGE>
Yield information may be useful in reviewing performance and in providing a
basis for comparison with other investment alternatives. Yield will
fluctuate, unlike investments that pay a fixed interest rate over a stated
period of time. Investors should give consideration to the quality and
maturity of portfolio securities of the respective investment companies when
comparing investments.
Investors should recognize that in periods of declining interest rates, yield
will tend to be somewhat higher than prevailing market rates, and in periods
of rising interest rates yield will tend to be somewhat lower. Also, when
interest rates are falling, the inflow of net new money from the continuous
sale of its shares will likely be invested in instruments producing lower
yields than the balance of the holdings, thereby reducing the current yield.
In periods of rising interest rates, the opposite can be expected to occur.
As of June 30, 1997, the 30-day yield was 4.96%, 4.77 % and 4.74% for Class
I, II and III, respectively.
Tennessee Tax-Free Portfolio also may quote the TAX-EQUIVALENT YIELD for each
class, which shows the taxable yield an investor would have to earn, before
taxes, to equal the tax-free yield. Tax-equivalent yield is the current
yield that would have to be earned, in the investor's tax bracket, to match
the tax-free yields shown below after taking federal income taxes into
account. Tax-equivalent yields are calculated by dividing current yield by
the result of one minus a stated federal or combined federal and state tax
rate. It gives the approximate yield a taxable security must provide at
various income brackets to produce after-tax yields equivalent to those of
tax-exempt obligations yielding from 2.0% to 8.0%. Of course, no assurance
can be given that each class will achieve any specific tax-exempt yield.
While the Portfolio invests principally in municipal obligations whose
interest is not includable in gross income for purposes of calculating
federal income tax, other income received by the Portfolio may be taxable.
The following table shows the effect of a shareholder's tax status on effective
yield under the federal income tax laws for 1997:
1997 TAX RATES AND TAX-EQUIVALENT YIELDS
<TABLE>
<CAPTION>
Taxable Federal
Income * Tax If individual tax-exempt yield is:
Bracket ** 2.00% 3.00% 4.00%
single return joint return Then taxable equivalent yield is:
<S> <C> <C> <C> <C> <C>
$0 - $24,650 $0 - $41,200 15% 2.35% 3.53% 4.71%
$24,651 - $59,750 $41,201 - $99,600 28% 2.78% 4.17% 5.56%
$59,751 - $124,650 $99,601 - $151,750 31% 2.90% 4.35% 5.80%
$124,651 - $271,050 $151,751 - $271,050 36% 3.13% 4.69% 6.25%
$271,051 - above $271,051 - above 39.6% 3.31% 4.97% 6.62%
</TABLE>
* Taxable income (gross income after all exemptions, adjustments, and
deductions) based on 1997 tax rates.
**Excludes the impact of the phaseout of personal exemptions, limitation on
itemized deductions, and other credits, exclusions, and adjustments which may
raise a taxpayer's marginal tax rate. An increase in a shareholder's marginal
tax rate would increase that shareholder's tax-equivalent yield.
Tennessee individual income tax is levied at a flat rate of 6%. The tax is
levied on dividend and interest income.
If your effective combined federal and Tennessee state tax rate in 1997 is:
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C>
20.10% 32.32% 35.14% 39.84% 43.22%
</TABLE>
Then your tax-equivalent yield is:
<TABLE>
<CAPTION>
TAX-EQUIVALENT YIELD*
<S> <C> <C> <C> <C> <C>
2.0% 2.50% 2.96% 3.08% 3.32% 3.52%
3.0% 3.75% 4.43% 4.63% 4.99% 5.28%
4.0% 5.01% 5.91% 6.17% 6.65% 7.04%
5.0% 6.26% 7.39% 7.71% 8.31% 8.81%
6.0% 7.51% 8.87% 9.25% 9.97% 10.57%
7.0% 8.76% 10.34% 10.79% 11.64% 12.33%
8.0% 10.01% 11.82% 12.33% 13.30% 14.09%
</TABLE>
*The Portfolio may invest a portion of its assets in obligations that are
subject to state or federal income tax. When the Portfolio invests in these
obligations, its tax-equivalent yield will be lower. In the table above,
tax-equivalent yields are calculated assuming investments are 100% federally
and state tax-free.
8
<PAGE>
TOTAL RETURNS for each Class of the Portfolio quoted in advertising reflect
all aspects of return, including the effect of reinvesting dividends and
capital gain distributions (if any), and any change in NAV over the period.
AVERAGE ANNUAL TOTAL RETURNS are calculated by determining the growth or
decline in value of a hypothetical historical investment over a stated
period, and then calculating the annually compounded percentage rate that
would have produced the same result if the rate of growth or decline in value
had been constant over the period. For example, a cumulative total return of
100% over ten years would produce an average annual total return of 7.18%,
which is the steady annual rate of return that would equal 100% growth on a
compounded basis in ten years. While average annual total returns are a
convenient means of comparing investment alternatives, investors should
realize that performance is not constant over time, but changes from year to
year, and that average annual total returns represent averaged figures as
opposed to the actual year-to-year performance. Average annual returns
covering periods of less than one year are calculated by determining total
return for the period, extending that return for a full year (assuming that
performance remains constant over the year), and quoting the result as an
annual return. The following table shows total returns as of June 30, 1997
for each Class of the Portfolio:
<TABLE>
<CAPTION>
CLASS I AVERAGE CLASS II AVERAGE CLASS III AVERAGE
ANNUAL TOTAL RETURN ANNUAL TOTAL RETURN ANNUAL TOTAL RETURN
------------------- ------------------- -------------------
ONE SINCE ONE SINCE ONE SINCE
YEAR INCEPTION YEAR INCEPTION YEAR INCEPTION
---- --------- ---- --------- ---- ---------
<S> <C> <C> <C> <C> <C> <C>
Tennessee Tax-Free 8.26% 4.84% 4.29% 2.28% 8.20% 4.64%
</TABLE>
CUMULATIVE TOTAL RETURNS reflect the simple change in value of an investment
over a stated period. Average annual and cumulative total returns may be
quoted as a percentage or as a dollar amount, and may be calculated for a
single investment, a series of investments, or a series of redemptions, over
any time period. Total returns may be broken down into their components of
income and capital (including capital gains and changes in share price) in
order to illustrate the relationship of these factors and their contributions
to total return. Total returns, yields, and other performance information
may be quoted numerically or in a table, graph, or similar illustration.
Where applicable, sales loads may or may not be included.
The Portfolio may compare the performance of its Classes or the performance
of securities in which it or its Classes may invest to other mutual funds,
especially to those with similar investment objectives. These comparisons
may be based on data published by IBC/Donoghue's Money Fund Report of
Ashland, MA 01721, or by Lipper Analytical Services, Inc. (Lipper, sometimes
referred to as Lipper Analytical Services), an independent service located in
Summit, New Jersey that monitors the performance of mutual funds. Lipper
generally ranks funds on the basis of total return, assuming reinvestment of
distributions, but does not take sales charges or redemption fees into
consideration, and is prepared without regard to tax consequences. Lipper
may also rank funds based on yield. In addition to the mutual fund rankings,
the Portfolio's performance may be compared to mutual fund performance
indices prepared by Lipper. The BOND FUND REPORT AVERAGES' which is reported
in the BOND FUND REPORT, covers taxable bond funds. Investors should give
consideration to the quality and maturity of the portfolio securities of the
respective investment companies when comparing investment alternatives.
From time to time, the Portfolio's performance may also be compared to other
mutual funds tracked by financial or business publications and periodicals.
For example, the Portfolio may quote Morningstar, Inc. in its advertising
materials. Morningstar, Inc. is a mutual fund rating service that rates
mutual funds on the basis of risk-adjusted performance.
The Portfolio may be compared in advertising to certificates of deposits
(CDs) or other investments issued by banks. Mutual funds differ from bank
investments in several respects. For example, the Portfolio may offer
greater liquidity or higher potential returns than CDs, and the Portfolio
does not guarantee your principal or your return.
Ibbotson Associates of Chicago, Illinois (Ibbotson) provides historical
returns of the capital markets in the United States, including common stocks,
small capitalization stocks, long-term corporate bonds, intermediate-term
government bonds, long-term government bonds, Treasury bills, the U.S. rate
of inflation (based on the Consumer Price Index), and combinations of various
capital markets. The performance of these capital markets is based on the
return of different indices.
The Portfolio may compare its performance to that of the Lehman Brothers
Municipal Bond Index, an index comprised of revenue bonds and state
government obligations. The Portfolio may also compare its performance to
that of the Lehman Brothers General Obligation Bond Index, an index comprised
of all public, fixed-rate, non-convertible investment-grade domestic
corporate debt. The Portfolio may also quote mutual fund rating services in
its advertising materials, including data from a mutual fund rating service
which rates mutual funds on the basis of risk adjusted performance. Because
the fees for Class II and Class III are higher than the fees for Class I,
yields and returns for those classes will be lower than for Class I.
9
<PAGE>
The Portfolio may advertise examples of the effects of periodic investment
plans, including the principle of dollar cost averaging. In such a program,
the investor invests a fixed dollar amount at periodic intervals, thereby
purchasing fewer shares when prices are high and more shares when prices are
low. While such a strategy does not assure a profit nor guard against loss
in a declining market, the investor's average cost per share can be lower
than if fixed numbers of shares had been purchased at those intervals. In
evaluating such a plan, investors should consider their ability to continue
purchasing shares through periods of low price levels.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The following holiday closings have been scheduled: Veterans' Day,
Thanksgiving Day, Christmas Day, New Year's Day, Dr. Martin Luther King Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
and Columbus Day. Although First Tennessee expects the same holiday schedule
to be observed in the future, the New York Stock Exchange (NYSE) and the
Federal Reserve Bank of New York (New York Federal Reserve) may modify their
holiday schedules at any time.
If the Trustees determine that existing conditions make cash payment
undesirable, redemption payments may be made in whole or in part in
securities or other property, valued for this purpose as they are valued in
computing the Portfolio's NAV. Shareholders receiving securities or other
property on redemption may realize a gain or loss for tax purposes and will
incur any costs of sale, as well as the associated inconveniences.
Pursuant to Rule 11a-3 under the 1940 Act, the Portfolio is required to give
shareholders at least 60 days' notice prior to terminating or modifying the
Portfolio's exchange privilege. Under Rule 11a-3, the 60 day notification
requirement may be waived if (i) the only effect of a modification would be
to reduce or eliminate an administrative fee, redemption fee or deferred
sales charge ordinarily payable at the time of exchange, or (ii) under
extraordinary circumstances, a Portfolio temporarily suspends the offering of
shares as permitted under the 1940 Act or by the SEC or because it is unable
to invest amounts effectively in accordance with its investment objective and
policies. This exchange limit may be modified for accounts in certain
institutional retirement plans to conform to plan exchange limits and
Department of Labor Regulations.
ADDITIONAL CLASS II AND CLASS III INFORMATION
SYSTEMATIC INVESTING PROGRAM. Investors can make regular investments in
Class II and Class III with Systematic Investing by completing the
appropriate section on the account application and attaching a voided
personal check. If the bank account is jointly owned, make sure that all
owners sign. Investments may be made monthly by automatically deducting $25
or more from your checking account. This monthly purchase amount may be
changed at any time. There is a $50 minimum initial investment requirement
for this option. For employees of First Tennessee Bank National Association
or any of its affiliates who participate in the Systematic Investing Program,
the minimum initial investment requirement is $50. Accounts will be drafted
on or about the first business day of every month. Systematic Investing may
be canceled at any time without payment of a cancellation fee. Investors
will receive a confirmation from their securities broker or financial
institution (Investment Professional), or from the Transfer Agent for every
transaction, and a debit entry will appear on your bank statement.
SYSTEMATIC WITHDRAWAL PLAN. Investors can have monthly, quarterly or
semi-annual checks sent from their account to you, to a person named by them,
or to their bank checking account. The Systematic Withdrawal Plan payments
are drawn from share redemptions and must be in the amount of $100 or more
per Portfolio per month. If Systematic Withdrawal Plan redemptions exceed
income dividends earned on shares, an account eventually may be exhausted.
Contact the Investment Professional for more information.
DISTRIBUTIONS AND TAXES
DIVIDENDS. To the extent that the Portfolio's income is derived from
federally tax-exempt interest, the daily dividends declared by the Portfolio
are also federally tax-exempt. The Portfolio will send each shareholder a
notice in January describing the tax status of dividends and capital gain
distributions, if any, for the prior year. Dividends derived from Tennessee
Tax-Free Portfolio's tax-exempt income are not subject to federal income tax,
but must be reported to the IRS by shareholders. Exempt-interest dividends
are included in income for purposes of computing the portion of social
security and railroad retirement benefits that may be subject to federal tax.
If the Portfolio earns taxable income or capital gains from its investments,
these amounts will be designated as taxable distributions. Dividends derived
from taxable investment income and short-term capital gains are taxable as
ordinary income. The Portfolio will send a tax statement showing the amount
of tax-exempt distributions for the past calendar year, and will send an IRS
Form 1099-DIV by January 31 if the Portfolio makes any taxable distributions.
The Portfolio purchases municipal obligations based on opinions of bond
counsel regarding the federal income tax status of the obligations. These
opinions generally will be based upon covenants by the issuers regarding
continuing compliance with federal tax
10
<PAGE>
requirements. If the issuer of an obligation fails to comply with its
covenants at any time, interest on the obligation could become federally
taxable retroactive to the date the obligation was issued.
As a result of the Tax Reform Act of 1986, interest on certain "private
activity" securities (referred to in the Internal Revenue Code as "qualified
bonds") is subject to the federal alternative minimum tax (AMT), although the
interest continues to be excludable from gross income for other purposes.
Interest from private activity securities will be considered tax-exempt for
purposes of the Portfolio's policies of investing so that at least 80% of its
income is free from federal income tax. Interest from private activity
securities is a tax preference item for the purpose of determining whether a
taxpayer is subject to the AMT and the amount of AMT to be paid, if any.
Private activity securities issued after August 7, 1986 to benefit a private
or industrial user or to finance a private facility are affected by this rule.
STATE TAXES. In the opinion of fund counsel, Baker, Donelson, Bearman &
Caldwell, investments in Tennessee Tax-Free Portfolio will not be subject to
Tennessee personal income taxes on distributions received from the Portfolio
to the extent such distributions are attributable to interest on bonds or
securities of the U.S. government or any of its agencies or
instrumentalities, or in bonds or other securities of the State of Tennessee
or any county, municipality or political subdivision, including any agency,
board, authority or commission. Other distributions from the Portfolio,
including dividends attributable to obligations of issuers in other states,
and all long-term and short-term capital gains, will not be exempt from
personal income taxes in Tennessee. The Portfolio will report annually the
percentage and source, on a state-by-state basis, of interest income received
by the Portfolio on municipal bonds during the preceding year.
CAPITAL GAIN DISTRIBUTIONS. Distributions of gains from the sale of assets
held by the Portfolio for more than one year generally are taxable to
shareholders of the Portfolio at the applicable mid-term or long-term capital
gains rate, as designated by the Portfolio, regardless of how long the
shareholders have owned their Portfolio shares. There is presently no
guidance concerning the treatment of any loss on the sale of Portfolio shares
held less than six months.
A portion of the gain on bonds purchased at a discount after April 30, 1993
and short-term capital gains distributed by the Portfolio are taxable to
shareholders as dividends, not as capital gains. Distributions from
short-term capital gains do not qualify for the dividends received deduction.
Dividend distributions resulting from a re-characterization of gain from the
sale of bonds purchased at a discount after April 30, 1993 are not considered
income for the purposes of the Portfolio's policy of investing so that at
least 80% of its income is free from federal income tax.
TAX STATUS OF THE TRUST. The Portfolio intends to qualify as a "regulated
investment company" under the Internal Revenue Code of 1986, as amended, (the
Code), so that the Portfolio will not be liable for federal income or excise
taxes on net investment income or capital gains to the extent that these are
distributed to shareholders in accordance with applicable provisions of the
Code. In order to qualify as a regulated investment company and avoid being
subject to federal income or excise taxes, the Portfolio intends to
distribute substantially all of its net investment income and net realized
capital gains within each calendar year as well as on a fiscal year basis.
The Portfolio also intends to comply with other tax rules applicable to
regulated investment companies.
OTHER TAX INFORMATION. The information above is only a summary of some of
the tax consequences generally affecting the Portfolio and its shareholders,
and no attempt has been made to discuss individual tax consequences. In
addition to federal income taxes, shareholders of the Portfolio may be
subject to state and local taxes on distributions received from the
Portfolio. Investors should consult their tax advisors to determine whether
the Portfolio is suitable to their particular tax situation.
Effective January 1, 1993, federal income tax will be withheld at a 20% rate
on any eligible rollover distributions that are not transferred directly to
another qualified plan or IRA. Actual income tax may be higher or lower and
will be due when tax forms for the year are filed. Taxes will not be
withheld in cases of direct rollover into an IRA or another qualified plan.
TRUSTEES AND OFFICERS
The Trustees and executive officers of the Trust are listed below. Each
Trustee or officer that is an "interested person" (as defined in the 1940
Act) by virtue of his affiliation with First Tennessee or ALPS is indicated
by an asterisk (*).
THOMAS M. BATCHELOR, age 76, Trustee, 4325 Woodcrest Drive, Memphis, TN, who
presently operates a management consultant business on a limited basis,
retired after owning and operating two General Insurance Companies agencies
for over thirty years. He was one of the founders and served as a director
of First American State Bank in Memphis, TN (now part of United American Bank
of Memphis). He currently serves as Chairman, Memphis Union Mission, TN, as
well as a charity and a non-profit foundation.
11
<PAGE>
JOHN A. DECELL, age 62, Trustee, 5178 Wheelis Dr., Suite 2, Memphis, TN is
Proprietor, DeCell & Company (real estate and business consulting), and
President of Capital Advisers, Inc. (real estate consulting and asset
management).
*L. R. JALENAK, JR., age 67, Trustee, 6094 Apple Tree Drive, Suite 11,
Memphis, TN was Chairman of the Board (1990 - 1993 (retired)), Cleo Inc.
(manufacturer of gift-related products), a Gibson Greetings Company. Mr.
Jalenak is also a Director of Perrigo Company (1988 - present), Lufkin
Industries (1990 -present), Dyersburg Corporation (1990 - present), was
President and CEO (until 1990) of Cleo Inc., and was a Director of Gibson
Greetings, Inc. from 1983 to 1991.
LARRY W. PAPASAN, age 57, Trustee, 5114 Winton Place, Memphis, TN is
President of Smith & Nephew, Inc. (orthopedic implants). Mr. Papasan is a
former Director of First American National Bank of Memphis and The West
Tennessee Board of First American National Bank (1988 - 1991) and was
President of Memphis Light Gas and Water Division of the City of Memphis
(1984 - 1991). Mr. Papasan is also a member of the Board of the Plough
Foundation, a non-profit trust.
*RICHARD C. RANTZOW, age 59, President and Trustee, 5790 Shelby Avenue,
Memphis, TN is Vice President/Director, Ron Miller Associates, Inc.
(manufacturer). Mr. Rantzow was Managing Partner (until 1990) of the Memphis
office of Ernst & Young.
*JEREMY O. MAY, age 27, Treasurer, is a Fund Controller at ALPS Mutual Funds
Services, Inc. (ALPS), the Administrator and Distributor. Prior to joining
ALPS, Mr. May was an auditor with Deloitte & Touche LLP in their Denver
office.
*JAMES V. HYATT, age 47, Secretary, is General Counsel of ALPS . Prior to
joining ALPS, Mr. Hyatt served as Senior Legal Counsel for Fidelity
Investments and Clerk for Fidelity Management Trust Company.
The Trustees of the Trust each receive from the Trust an annual fee of $4,000
and a fee in the amount of $1,250 for attending each regularly scheduled
quarterly meeting of the Trustees and $500 for each unscheduled meeting. The
Trustees were compensated as follows for their services provided during the
Trust's fiscal year ended June 30, 1997:
<TABLE>
<CAPTION>
AGGREGATE PENSION OR RETIREMENT ESTIMATED ANNUAL AGGREGATE
COMPENSATION FROM THE BENEFITS ACCRUED AS BENEFITS UPON COMPENSATION FROM
TRUST PART OF FUND EXPENSES RETIREMENT THE TRUST AND FUND
COMPLEX PAID TO
TRUSTEES
--------------------- --------------------- ---------------- ------------------
<S> <C> <C> <C> <C>
Thomas M. Batchelor $10,000 $0 $0 $10,000
Trustee
John A. DeCell $10,000 $0 $0 $10,000
Trustee
L.R. Jalenak, Jr. $10,000 $0 $0 $10,000
Trustee
Larry W. Papasan $ 8,750 $0 $0 $ 8,750
Trustee
Richard C. Rantzow $10,000 $0 $0 $10,000
Trustee
</TABLE>
As of September 30, 1997, the officers and Trustees of the Trust owned less
than 1% of the outstanding shares of any Portfolio.
INVESTMENT ADVISORY AGREEMENT
The Portfolio employs First Tennessee Bank National Association (First
Tennessee or the Investment Adviser), Memphis, Tennessee, to furnish
investment advisory and other services to the Portfolio. Under the
Investment Advisory and Management Agreement with the Portfolio, First
Tennessee is authorized to appoint one or more sub-advisers at First
Tennessee's expense. Martin, Memphis, Tennessee, acts as Sub-Adviser to the
Portfolio. Subject to the direction of the Trustees and of First Tennessee,
the Sub-Adviser directs the investments of the Portfolio in accordance with
its investment objective, policies and limitations.
12
<PAGE>
In addition to First Tennessee's fee payable to First Tennessee and the fees
payable to the Transfer Agent and Pricing and Accounting Agent, and to the
Administrator, the Portfolio pays for all its expenses, without limitation,
that are not assumed by these parties. The Portfolio pays for typesetting,
printing and mailing of proxy material to existing shareholders, legal
expenses, and the fees of the custodian, auditor and Trustees. Other
expenses paid by the Portfolio include: interest, taxes, brokerage
commissions, the Portfolio's proportionate share of insurance premiums and
Investment Company Institute dues, and costs of registering shares under
federal and state securities laws. The Portfolio also is liable for such
nonrecurring expenses as may arise, including costs of litigation to which
the Portfolio is a party, and its obligation under the Declaration of Trust
to indemnify its officers and Trustees with respect to such litigation.
For managing its investment and business affairs, Tennessee Tax-Free
Portfolio pays First Tennessee a monthly management fee at the annual rate of
.50% of average net assets. First Tennessee has voluntarily agreed to waive
its entire fee for the Portfolio. This fee waiver may be discontinued at any
time. For the fiscal years ended June 30, 1997 and 1996, First Tennessee
earned $65,349 and $12,692, respectively, before waiving its entire fee.
Under its Investment Advisory and Management Agreement with the Portfolio,
First Tennessee is authorized, at its own expense, to hire a sub-adviser to
provide investment advice to the Portfolio. As Sub-Adviser, Martin is
entitled to receive from First Tennessee a monthly sub-advisory fee at the
annual rate of .30% of the Portfolio's average net assets. Under the terms
of the Sub-Advisory Agreement with First Tennessee, the Sub-Adviser, subject
to the supervision of First Tennessee, supervises the day-to-day operations
of the Portfolio and provides investment research and credit analysis
concerning the Portfolio's investments, conducts a continual program of
investment of the Portfolio's assets and maintains the books and records
required in connection with its duties under the Sub-Advisory Agreement. In
addition, the Sub-Adviser keeps First Tennessee informed of the developments
materially affecting the Portfolio. The Sub-Adviser is currently waiving some
or all of the fees it is entitled to receive from First Tennessee.
ADMINISTRATION AGREEMENT AND OTHER CONTRACTS
ADMINISTRATOR AND DISTRIBUTOR. ALPS Mutual Funds Services, Inc. (ALPS, the
Administrator and Distributor), is the Administrator and Distributor to the
Portfolio under an Administration and General Distribution Agreement. ALPS,
a Colorado corporation, is a broker-dealer registered under the Securities
Exchange Act of 1934 and a member of the National Association of Securities
Dealers, Inc.
As the Administrator, ALPS assists in the Portfolio's administration and
operation, including, but not limited to, providing office space and various
legal and accounting services in connection with the regulatory requirements
applicable to the Portfolio. ALPS is entitled to and receives from the
Portfolio a monthly fee at the annual rate of .15% of average net assets.
From January 1, 1996 through July 28, 1996, ALPS voluntarily agreed to waive
its administration fee and reimburse the Portfolio for fund
accounting/transfer agent fees as well as custody out-of-pocket fees. From
July 29, 1996 through March 31, 1997, ALPS voluntarily agreed to waive its
administration fee and assume all expenses of the Portfolio in order to
maintain an expense ratio of 0.00% for all classes of the Portfolio, after
taking into consideration waivers by First Tennessee. Effective April 1,
1997, ALPS began to phase out the assumption of Portfolio expenses while
continuing to waive its administration fee. The reimbursement of non-12b-1
expenses for each Class of the Portfolio was reduced by 0.15% as of April 1,
1997, and was further reduced 0.10% on the first business day of each month
thereafter until July 1, 1997 when all remaining reimbursements of non-12b-1
expenses by ALPS were discontinued. For Class III of the Portfolio, the
reimbursement of 12b-1 fees by ALPS decreased by 0.125% on April 1, 1997, by
0.05% on the first business day of May and June and by 0.025% on July 1,
1997. Thereafter, ALPS has voluntarily agreed to waive one half of the 0.50%
12b-1 fee applicable to Class III of the Portfolio or 0.25% of that Class'
average net assets. ALPS reserves the right to modify or terminate this
waiver of 12b-1 expense at any time.
First Tennessee serves as the Co-Administrator for the Portfolio. As the
Co-Administrator, First Tennessee assists in the Portfolio's operation,
including, but not limited to, providing non-investment related research and
statistical data and various operational and administrative services. First
Tennessee is entitled to and receives from the Portfolio a monthly fee at the
annual rate of .05% of average net assets.
As the Distributor, ALPS sells shares of Class I as agent on behalf of the
Trust at no additional cost to the Trust. Class III is obligated to pay ALPS
monthly a 12b-1 fee at the annual rate of up to .75% of the average net
assets of Class III, all or a portion of which may be paid out to
broker-dealers or others involved in the distribution of Class III shares.
See "Administration Agreements and Other Contracts - Distribution Plan."
Class II and III pay shareholder servicing fees to Investment Professionals
at an annual rate of up to .25% of average net assets as more fully described
under the section "Administration Agreement and Other Contracts - Shareholder
Services Plans". First Tennessee and its affiliates neither participate in
nor are responsible for the underwriting of Portfolio shares. Consistent with
applicable law, affiliates of First Tennessee may receive commissions or
asset-based fees.
TRANSFER AGENT, FUND ACCOUNTING AND CUSTODIAN. Chase Global Funds Services
Company (CGFSC or the Transfer Agent), provides transfer agent and
shareholder services for the Portfolio, and calculates the NAV and dividends
of each Class and maintains the portfolio
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<PAGE>
and general accounting records. For such services, CGFSG is entitled to
receive from each Class fees at the annual rate of 0.07% of average net
assets through $50 million and 0.05% over $50 million plus out-of-pocket
expenses. Chase Manhattan Bank is Custodian of the assets of the Portfolio.
The Custodian is responsible for the safekeeping of the Portfolio's assets
and the appointment of sub-custodian banks and clearing agencies. For such
services, Chase is entitled to receive from each Portfolio fees at the annual
rate of 0.018% of average net assets plus out-of-pocket expenses. The
Custodian takes no part in determining the investment policies of the
Portfolio or in deciding which securities are purchased or sold by the
Portfolio. The Portfolio, however, may invest in obligations of the
Custodian and may purchase securities from or sell securities to the
Custodian.
DISTRIBUTION PLAN. The Trustees of the Trust have adopted a Distribution
Plan on behalf of Class III of the Portfolio (the Class III Plan) pursuant to
Rule 12b-1 (the Rule) under the 1940 Act. The Rule provides in substance
that a mutual fund may not engage directly or indirectly in financing any
activity that is intended primarily to result in the sale of shares of the
fund except pursuant to a plan adopted by the fund under the Rule. The
Trustees have adopted the Plan to allow Class III and ALPS to incur
distribution expenses. The Class III Plan provides for payment of a
distribution fee (12b-1 fee) to ALPS of up to 0.75% of the average net assets
of Class III of the Portfolio. (These fees are in addition to the fees paid
to ALPS under the Administration Agreement.) The Trustees have limited the
12b-1 fee to 0.50% of Class III's average net assets. ALPS has agreed to
voluntarily waive one half of the 0.50% 12b-1 fee applicable to Class III of
the Portfolio or 0.25% of that Class' average net assets. The Trust or ALPS,
on behalf of Class III of the Portfolio, may enter into servicing agreements
(Service Agreements) with banks, broker-dealers or other institutions (Agency
Institutions). The Class III Plan provides that ALPS may use its fees and
other resources to make payments to Agency Institutions for performance of
distribution-related services, including those enumerated above. The Service
Agreements further provide for compensation to broker-dealers for their
efforts to sell Class III shares. The distribution-related services include,
but are not limited to, the following: formulation and implementation of
marketing and promotional activities, such as mail promotions and television,
radio, newspaper, magazine and other mass media advertising; preparation,
printing and distribution of sales literature; preparation, printing and
distribution of prospectuses of the Portfolio and reports to recipients other
than existing shareholders of the Portfolio; obtaining such information,
analyses and reports with respect to marketing and promotional activities as
ALPS may from time to time, deem advisable; making payments to securities
dealers and others engaged in the sales of Class III Shares; and providing
training, marketing and support to such dealers and others with respect to
the sale of Class III Shares. The Class III Plan recognizes ALPS may use its
fees and other resources to pay expenses associated with the promotion and
administration of activities primarily intended to result in the sale of
shares.
The Plan has been approved by the Trustees, including the majority of
disinterested Trustees. As required by the Rule, the Trustees carefully
considered all pertinent factors relating to the implementation of the Plans
prior to its approval, and have determined that there is a reasonable
likelihood that the Plan will benefit the Portfolio and its shareholders. To
the extent that the Class III Plans give ALPS greater flexibility in
connection with the distribution of shares of the class, additional sales of
shares may result.
The Class III Plans could be construed as compensation plans because ALPS is
paid a fixed fee and is given discretion concerning what expenses are payable
under the Plans. ALPS may spend more for marketing and distribution than it
receives in fees and reimbursements from the Portfolio. However, to the
extent fees received exceed expenses, including indirect expenses such as
overhead, ALPS could be said to have received a profit. For example, if ALPS
pays $1 for Class III distribution-related expenses and receives $2 under a
Class III Plan, the $1 difference could be said to be a profit for ALPS.
(Because ALPS is reimbursed for its out-of-pocket direct promotional
expenses, a Class III Plan also could be construed as a reimbursement plan.
Until the issue is resolved by the SEC, unreimbursed expenses incurred in one
year will not be carried over to a subsequent year.) If after payments by
ALPS for marketing and distribution there are any remaining fees attributable
to a Class III Plan, these may be used as ALPS may elect. Since the amount
payable under a Class III Plan will be commingled with ALPS's general funds,
including the revenues it receives in the conduct of its business, it is
possible that certain of ALPS's overhead expenses will be paid out of Plan
fees and that these expenses may include items such as the costs of leases,
depreciation, communications, salaries, training and supplies. The Portfolio
believes that such expenses, if paid, will be paid only indirectly out of the
fees being paid under the Plan. For the fiscal year ended June 30, 1997, the
Portfolio paid distribution fees in the amount of $18,797, a portion of which
was reimbursed by ALPS pursuant to the voluntary waiver and reimbursement of
portfolio expenses discussed under "Administration Agreement and Other
Contracts - Administrator and Distributor." All of these fees were paid as
compensation to dealers.
SHAREHOLDER SERVICES PLANS. In addition to the Rule 12b-1 Distribution Plans
described above, Class II and Class III have adopted Shareholder Services
Plans to compensate Agency Institutions for individual shareholder services
and account maintenance. These functions include: maintaining account
records for each shareholder who beneficially owns Class III Shares;
answering questions and handling correspondence from shareholders about their
accounts; handling the transmission of funds representing the purchase price
or redemption proceeds; issuing confirmations for transactions in Class III
Shares by shareholders; assisting customers in completing application forms;
communicating with the transfer agent; and providing account maintenance and
account level support for all transactions. For these services the
participating Agency Institutions are paid a service fee at the annual rate
of up to .25% of average net assets of Class II and Class III. Shareholder
Servicing Fees for Class II or Class III have not currently been authorized
by the Board
14
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of Trustees although such fees may become effective at a future time. For the
fiscal year ended June 30, 1997, the Portfolio did not pay any shareholder
servicing fees.
Banking laws and regulations, including the Glass-Steagall Act as currently
interpreted by the Board of Governors of the Federal Reserve System, prohibit
a bank holding company registered under the Bank Holding Company Act of 1956
or any affiliate thereof from sponsoring, organizing, controlling, or
distributing the shares of a registered, open-end investment company
continuously engaged in the issuance of its shares and prohibit banks
generally from issuing, underwriting, selling or distributing securities.
The same laws and regulations generally permit a bank or bank affiliate to
act as an investment adviser and co-administrator and to purchase shares of
the investment company as agent for and upon the order of a customer. In the
Trust's and Investment Adviser's opinion, banks and their affiliates may be
paid for investment advisory, shareholder servicing, recordkeeping and
co-administration functions. Changes in federal or state statutes and
regulations pertaining to the permissible activities of banks and their
affiliates or subsidiaries, as well as further judicial or administrative
decisions or interpretations, could prevent a bank from continuing to perform
all or a part of the contemplated services. If a bank or its affiliates were
prohibited from so acting, the Trustees would consider what actions, if any,
would be necessary to continue to provide efficient and effective shareholder
services. In such event, changes in the operation of the Portfolio might
occur, including possible termination of any automatic investment or
redemption or other services then being provided by any bank. It is not
expected that shareholders would suffer any adverse financial consequences as
a result of any of these occurrences. The Portfolio may execute portfolio
transactions with and purchase securities issued by depository institutions
that receive payments under the Plans. No preference will be shown in the
selection of investments for the instruments of such depository institutions.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein, and banks and other
financial institutions may be required to register as dealers pursuant to
state law.
DESCRIPTION OF THE TRUST
TRUST ORGANIZATION. Tennessee Tax Free Portfolio is a portfolio of First
Funds (formerly The Masters Group of Mutual Funds), an open-end management
investment company organized as a Massachusetts business trust by a
Declaration of Trust dated March 6, 1992, as amended and restated on
September 4, 1992. The Declaration of Trust permits the Trustees to create
additional portfolios and classes. There are nine portfolios of the Trust,
each with three Classes.
The assets of the Trust received for the issue or sale of shares of the
Portfolio and all income, earnings, profits, and proceeds thereof, subject
only to the rights of creditors, are specially allocated to such Portfolio,
and constitute the underlying assets of such Portfolio. The underlying
assets of the Portfolio are segregated on the books of account, and are to be
charged with the liabilities with respect to such Portfolio and with a share
of the general expenses of the Trust. Expenses with respect to the Trust are
to be allocated in proportion to the asset value of the respective Portfolios
except where allocations of direct expense can otherwise be fairly made. The
officers of the Trust, subject to the general supervision of the Trustees,
have the power to determine which expenses are allocable to a given
Portfolio, or which are general or allocable to all of the Portfolios. In
the event of the dissolution or liquidation of the Trust, shareholders of a
Portfolio are entitled to receive as a class the underlying assets of such
Portfolio available for distribution.
SHAREHOLDER AND TRUSTEE LIABILITY. The Trust is an entity of the type
commonly known as a "Massachusetts business trust." Under Massachusetts law,
shareholders of such a trust may, under certain circumstances, be held
personally liable for the obligations of the trust. The Declaration of Trust
provides that the Trust shall not have any claim against shareholders except
for the payment of the purchase price of shares and requires that each
agreement, obligation, or instrument entered into or executed by the Trust or
the Trustees shall include a provision limiting the obligations created
thereby to the Trust and its assets. The Declaration of Trust provides for
indemnification out of the Portfolio's property of any shareholders held
personally liable for the obligations of the Portfolio. The Declaration of
Trust also provides that the Portfolio shall, upon request, assume the
defense of any claim made against any shareholder for any act or obligation
of a Portfolio and satisfy any judgment thereon. Thus, the risk of a
shareholder incurring financial loss on account of shareholder liability is
limited to circumstances in which the Portfolio itself would be unable to
meet its obligations. The Trustees believe that, in view of the above, the
risk of personal liability to shareholders is remote.
The Declaration of Trust further provides that the Trustees, if they have
exercised reasonable care, will not be liable for any neglect or wrongdoing,
but nothing in the Declaration of Trust protects a Trustee against any
liability to which he would otherwise be subject by reason of willful
misfeasance, bad faith, gross negligence, or reckless disregard of the duties
involved in the conduct of his office.
As of September 30, 1997, the following shareholders owned more than 5% of
the outstanding shares of the indicated Class of the Portfolio:
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<TABLE>
<CAPTION>
NAME AND ADDRESS CLASS % OF CLASS HELD
<S> <C> <C>
Tennessee Mex. Inc, Agency I 6%
Knoxville, TN
Emmett N. Kennon II 9%
Rose S. Kennon, JTWROS
1603 Tyne Blvd.
Nashville, TN 37215
Gerald E. Stuart III 11%
P.O. Box 10288
Knoxville, TN 37939
NFSC FBO III 7%
H. Barrett Heywood III
Joan Talley Heywood
1506 Lexington Rd.
Chattanooga, TN 37405
S.T. Canale III 5%
1594 Peabody
Memphis, TN 38104
</TABLE>
VOTING RIGHTS. The Portfolio's capital consists of shares of beneficial
interest. The shares have no preemptive or conversion rights; the voting and
dividend rights, the right of redemption, and the privilege of exchange are
described in the Prospectus. Shares are fully paid and nonassessable, except
as set forth under the heading "Shareholder and Trustee Liability" above.
Shareholders representing 10% or more of the Trust or a Portfolio may, as set
forth in the Declaration of Trust, call meetings of the Trust or a Portfolio
for any purpose related to the Trust or Portfolio, as the case may be,
including, in the case of a meeting of the entire Trust, the purpose of
voting on removal of one or more Trustees. The Trust or any Portfolio may be
terminated upon the sale of its assets to another open-end management
investment company, or upon liquidation and distribution of its assets, if
approved by vote of the holders of a majority of the outstanding shares of
the Trust or that Portfolio. If not so terminated, the Trust and the
Portfolio will continue indefinitely.
CLASSES. Pursuant to the Declaration of Trust, the Trustees have authorized
additional classes of shares for the Portfolio of the Trust. Although the
investment objective for each separate class of a particular Portfolio is the
same, fee structures are different such that one class may have a higher
yield than another class of the same Portfolio at any particular time.
Shareholders of the Trust will vote together in the aggregate and not
separately by Portfolio, or by class thereof, except as otherwise required by
law or when the Trustees determine that the matter to be voted upon affects
only the interests of the shareholders of a particular Portfolio or a class
thereof. Pursuant to a vote by the Board of Trustees, the Trust has adopted
Rule 18f-3 under the Act and has issued multiple classes of shares with
respect to each of its Portfolios. Accordingly, the rights, privileges and
obligations of each such class will be determined in accordance with such
rule.
INDEPENDENT ACCOUNTANTS. Price Waterhouse LLP, 160 Federal Street, Boston,
Massachusetts, serves as the Trust's independent accountant. The independent
accountant examines the annual financial statements for the Trust and
provides other audit, tax, and related services.
FINANCIAL STATEMENTS
The Portfolio's financial statements and financial highlights for the fiscal
year ended June 30, 1997 are included in the Portfolio's Annual Report which
is a separate report supplied independent of this Statement of Additional
Information. The Portfolio's financial statements and financial highlights
are incorporated herein by reference.
APPENDIX
Dollar-Weighted Average Maturity for the Portfolio is derived by multiplying
the value of each investment by the number of days remaining to its maturity,
adding these calculations, and then dividing the total by the value of the
fund's Portfolio. An obligation's maturity is typically determined on a
stated final maturity basis, although there are some exceptions to this rule.
16
<PAGE>
For example, if it is probable that the issuer of an instrument will take
advantage of a maturity-shortening device, such as a call, refunding, or
redemption provision, the date on which the instrument will probably be
called, refunded, or redeemed may be considered to be its maturity date.
When a municipal bond issuer has committed to call an issue of bonds and has
established an independent escrow account that is sufficient to, and is
pledged to, refund that issue, the number of days to maturity for the
pre-refunded bond is considered to be the number of days to the announced
call date of the bonds.
The descriptions that follow are examples of eligible ratings for the
Portfolio. The Portfolio may, however, consider the ratings for other types
of investments and the ratings assigned by other rating organizations when
determining the eligibility of a particular investment.
DESCRIPTION OF MOODY'S INVESTORS SERVICE, INC.'S RATINGS OF STATE AND
MUNICIPAL NOTES: Moody's ratings for state and municipal and other short-term
obligations will be designated Moody's Investment Grade (MIG or VMIG for
variable rate obligations). This distinction is in recognition of the
difference between short-term credit risk and long-term credit risk. Factors
affecting the liquidity of the borrower and short-term cyclical elements are
critical in short-term ratings, while other factors of major importance in
bond risk, long-term secular trends for example, may be less important over
the short run. Symbols used will be as follows:
MIG-1/VMIG-1 - This designation denotes best quality. There is present
strong protection by established cash flows, superior liquidity support or
demonstrated broad-based access to the market for refinancing.
MIG-2/VMIG-2 - This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
MIG-3/VMIG-3 - This designation denotes favorable quality, with all security
elements accounted for but there is lacking the undeniable strength of the
preceding grades. Liquidity and cash flow protection may be narrow and
market access for refinancing is likely to be less well established.
MIG-4/VMIG-4 - This designation denotes adequate quality protection commonly
regarded as required of an investment security is present and although not
distinctly or predominantly speculative, there is specific risk.
DESCRIPTION OF STANDARD & POOR'S CORPORATION'S RATINGS OF STATE AND MUNICIPAL
NOTES:
SP-1 - Very strong or strong capacity to pay principal and interest. Those
issues determined to possess overwhelming safety characteristics will be
given a plus (+) designation.
SP-2 - Satisfactory capacity to pay principal and interest.
SP-3 - Speculative capacity to pay principal and interest.
Description of Moody's Investors Service, Inc.'s municipal bond ratings:
Aaa - Bonds rated Aaa are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edge." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
Aa - Bonds rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high
grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other
elements present which make the long-term risks appear somewhat larger than
Aaa securities.
A - Bonds rated A possess many favorable investment attributes and are to be
considered as upper medium grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present
which suggest a susceptibility to impairment sometime in the future.
DESCRIPTION OF STANDARD & POOR'S CORPORATION'S MUNICIPAL BOND RATINGS:
AAA - Debt rated AAA has the highest rating assigned by S&P to a debt
obligation. Capacity to pay interest and repay principal is extremely strong.
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<PAGE>
AA - Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest rated debt issues only in small degree.
A - Debt rated A has a strong capacity to pay interest and repay principal,
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions.
The ratings may be modified by the addition of a plus or minus to show
relative standing within the major rating categories.
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<PAGE>
FIRST FUNDS
GROWTH & INCOME PORTFOLIO
CAPITAL APPRECIATION PORTFOLIO
BOND PORTFOLIO
INTERMEDIATE BOND PORTFOLIO
STATEMENT OF ADDITIONAL INFORMATION FOR CLASS I, CLASS II, AND CLASS III
OCTOBER 24, 1997
AS AMENDED FEBRUARY 27, 1998 AND MARCH 2, 1998
This Statement is not a prospectus but should be read in conjunction with the
current Prospectus for each Class of First Funds: Growth & Income, Capital
Appreciation, Bond and Intermediate Bond Portfolios dated October 24, 1997, as
it may be amended or supplemented from time to time. Please retain this
Statement for future reference. The financial statements and financial
highlights of the Growth & Income and Bond Portfolios are included in the Annual
Report for the fiscal year ended June 30, 1997 and the Semi-Annual Report for
the period ended December 31, 1997, and are incorporated herein by reference.
The financial statements and financial highlights of the Capital Appreciation
Portfolio are included in the Semi-Annual Report for the period ended December
31, 1997, and are incorporated herein by reference. The Intermediate Bond
Portfolio had not commenced operations as of December 31, 1997 and therefore is
not included in the Annual or Semi-Annual Reports. To obtain additional free
copies of this Statement, the Annual or Semi-Annual Reports or the Prospectuses
for each Portfolio, please call the Distributor at 1-800-442-1941, option 1 or
write to the Distributor at 370 17th Street, Suite 3100, Denver CO 80202.
TABLE OF CONTENTS PAGE
Investment Restrictions and Limitations 2
Investment Instruments 3
Portfolio Transactions 8
Valuation of Portfolio Securities 9
Performance 9
Additional Purchase and Redemption Information 11
Distributions and Taxes 12
Trustees and Officers 13
Investment Advisory Agreements 14
Administration Agreements and Other Contracts 14
Description of the Trust 16
Financial Statements 18
Appendix 18
INVESTMENT ADVISER (GROWTH & INCOME, BOND AND INTERMEDIATE BOND PORTFOLIOS)
First Tennessee Bank National Association (First Tennessee)
SUB-ADVISER (GROWTH & INCOME AND BOND PORTFOLIOS)
Highland Capital Management Corp. (Highland or a Sub-Adviser)
SUB-ADVISER (INTERMEDIATE BOND PORTFOLIO)
Martin & Company, Inc.(Martin or a Sub-Adviser)
CO-INVESTMENT ADVISERS (CAPITAL APPRECIATION PORTFOLIO)
First Tennessee Bank National Association (First Tennessee)
Investment Advisers, Inc. (IAI)
ADMINISTRATOR AND DISTRIBUTOR
ALPS Mutual Funds Services, Inc. (ALPS or the Administrator and Distributor)
CO-ADMINISTRATOR
First Tennessee Bank National Association (First Tennessee or the
Co-Administrator)
TRANSFER AGENT & SHAREHOLDER SERVICING AGENT
Chase Global Funds Services Company (CGFSC or the Transfer Agent)
CUSTODIAN
Chase Manhattan Bank, N.A. (Chase or the Custodian)
1
<PAGE>
INVESTMENT RESTRICTIONS AND LIMITATIONS
The following policies and limitations supplement those set forth in the
Portfolios' Prospectuses. Unless otherwise noted, whenever an investment policy
or limitation states a maximum percentage of a Portfolio's assets that may be
invested in any security or other asset, or sets forth a policy regarding
quality standards, such standard or percentage limitation will be determined
immediately after and as a result of a Portfolio's acquisition of such security
or other asset. Accordingly, any subsequent change in values, net assets, or
other circumstances will not be considered when determining whether the
investment complies with a Portfolio's investment policies and limitations. With
respect to illiquid securities, any investment in such securities that exceeds
15% of a Portfolio's net assets will be reduced promptly to meet such
limitation.
Fundamental policies and investment limitations cannot be changed without
approval by a "majority of the outstanding voting securities" (as defined in the
Investment Company Act of 1940) of that Portfolio. However, except for the
fundamental investment limitations set forth below, the investment policies and
limitations described in this Statement of Additional Information are not
fundamental and may be changed without shareholder approval.
INVESTMENT LIMITATIONS OF THE GROWTH & INCOME, CAPITAL APPRECIATION, BOND AND
INTERMEDIATE BOND PORTFOLIOS
THE FOLLOWING ARE THE FUNDAMENTAL LIMITATIONS FOR EACH PORTFOLIO, SET FORTH IN
THEIR ENTIRETY. EACH PORTFOLIO MAY NOT:
(1) with respect to 75% of a Portfolio's total assets, purchase the
securities of any issuer (other than securities issued or guaranteed
by the U.S. government or any of its agencies or instrumentalities)
if, as a result, (a) more than 5% of a Portfolio's total assets would
be invested in the securities of that issuer; or (b) such a Portfolio
would hold more than 10% of the outstanding voting securities of that
issuer;
(2) issue senior securities, except as permitted under the Investment
Company Act of 1940;
(3) borrow money, except that each Portfolio may borrow money for
temporary or emergency purposes (not for leveraging or investment) in
an amount not exceeding 33 1/3% of its total assets (including the
amount borrowed) less liabilities (other than borrowings). Any
borrowings that come to exceed this amount will be reduced within
three days (not including Sundays and holidays) to the extent
necessary to comply with the 33 1/3% limitation;
(4) underwrite securities issued by others, except to the extent that each
Portfolio may be considered an underwriter within the meaning of the
Securities Act of 1933 in the disposition of restricted securities;
(5) purchase the securities of any issuer (other than securities issued or
guaranteed by the U.S. government or any of its agencies or
instrumentalities) if, as a result, 25% or more of such a Portfolio's
total assets would be invested in the securities of companies whose
principal business activities are in the same industry;
(6) purchase or sell real estate unless acquired as a result of ownership
of securities or other instruments (but this shall not prevent a
Portfolio from investing in securities or other instruments backed by
real estate or securities of companies engaged in the real estate
business);
(7) purchase or sell physical commodities unless acquired as a result of
ownership of securities or other instruments (but this shall not
prevent a Portfolio from purchasing or selling options and futures
contracts or from investing in securities or other instruments backed
by physical commodities); or
(8) lend any security or make any other loan if, as a result, more than 33
1/3% of its total assets would be lent to other parties, but this
limit does not apply to purchases of debt securities or to repurchase
agreements.
(9) Each Portfolio may, notwithstanding any other fundamental investment
policy or limitation, invest all of its assets in the securities of a
single open-end or closed-end management investment company with
substantially the same fundamental investment objectives, policies,
and limitations as the Portfolio.
THE FOLLOWING LIMITATIONS OF EACH PORTFOLIO ARE NOT FUNDAMENTAL AND MAY BE
CHANGED WITHOUT SHAREHOLDER APPROVAL.
(i) Each Portfolio does not currently intend during the coming year to
purchase securities on margin, except that each Portfolio may obtain
such short-term credits as are necessary for the clearance of
transactions, and provided that margin payments in connection with
futures contracts and options on futures contracts shall not
constitute purchasing securities on margin.
2
<PAGE>
(ii) Each Portfolio may borrow money only (a) from a bank or (b) by
engaging in reverse repurchase agreements with any party (reverse
repurchase agreements are treated as borrowings for purposes of
fundamental investment limitation 3). The Portfolio will not purchase
any security while borrowings representing more than 5% of its total
assets are outstanding.
(iii) Each Portfolio does not currently intend during the coming year to
purchase any security, if, as a result, more than 15% of its net
assets would be invested in securities that are deemed to be illiquid
because they are subject to legal or contractual restrictions on
resale or because they cannot be sold or disposed of in the ordinary
course of business at approximately the prices at which they are
valued.
(iv) Each Portfolio does not currently intend during the coming year to
purchase or sell futures contracts. This limitation does not apply to
securities that incorporate features similar to futures contracts.
(v) Each Portfolio does not currently intend during the coming year to
make loans, but this limitation does not apply to purchases of debt
securities.
(vi) Each Portfolio does not currently intend during the coming year to
invest all of its assets in the securities of a single open-end
management investment company with substantially the same fundamental
investment objectives, policies, and limitations as the Portfolio.
INVESTMENT INSTRUMENTS
First Tennessee Bank National Association (First Tennessee), serves as
Investment Adviser to the Growth & Income, Bond and Intermediate Bond
Portfolios and, with the prior approval of the Board of Trustees (the
Trustees), has engaged Highland Capital Management Corp. (Highland or a
Sub-Adviser) to act as Sub-Adviser to the Growth & Income and Bond
Portfolios, and has engaged Martin & Company, Inc. (Martin or a Sub-Adviser)
as Sub-Adviser to the Intermediate Bond Portfolio. First Tennessee and
Investment Advisers, Inc. (IAI) act as Co-Advisers to the Capital
Appreciation Portfolio. The activities of the Sub-Advisers and IAI include
providing investment research and credit analysis concerning Portfolio
investments and conducting a continuous program of investment of Portfolio
assets in accordance with the investment policies and objectives of each
Portfolio.
DELAYED-DELIVERY TRANSACTIONS. Each Portfolio may buy and sell securities on
a delayed-delivery or when-issued basis. These transactions involve a
commitment by each Portfolio to purchase or sell specific securities at a
predetermined price and/or yield, with payment and delivery taking place
after the customary settlement period for that type of security (and more
than seven days in the future). Typically, no interest accrues to the
purchaser until the security is delivered. Each Portfolio may receive fees
for entering into delayed delivery transactions.
When purchasing securities on a delayed-delivery basis, each Portfolio
assumes the rights and risks of ownership, including the risk of price and
yield fluctuations. Because a Portfolio is not required to pay for
securities until the delivery date, these risks are in addition to the risks
associated with such Portfolio's other investments. If a Portfolio remains
substantially fully invested at a time when delayed-delivery purchases are
outstanding, the delayed-delivery purchases may result in a form of leverage.
When delayed-delivery purchases are outstanding, a Portfolio will set aside
appropriate liquid assets in a segregated custodial account to cover its
purchase obligations. When a Portfolio has sold a security on a
delayed-delivery basis, a Portfolio does not participate in further gains or
losses with respect to the security. If the other party to a
delayed-delivery transaction fails to deliver or pay for the securities, such
Portfolio could miss a favorable price or yield opportunity, or could suffer
a loss.
Each Portfolio may renegotiate delayed-delivery transactions after they are
entered into, and may sell underlying securities before they are delivered,
which may result in capital gains or losses.
FOREIGN INVESTMENTS. Foreign investments purchased by each Portfolio can
involve significant risks in addition to the risks inherent in U.S.
investments. The value of securities denominated in or indexed to foreign
currencies, and of dividends and interest from such securities, can change
significantly when foreign currencies strengthen or weaken to the U.S.
dollar. Foreign securities markets generally have less trading volume and
less liquidity than U.S. markets, and prices on some foreign markets can be
highly volatile. Many foreign countries lack uniform accounting and
disclosure standards comparable to those applicable to U.S. companies, and it
may be more difficult to obtain reliable information regarding an issuer's
financial condition and operations. In addition, the costs of foreign
investing, including withholding taxes, brokerage commissions, and custodial
costs, are generally higher than for U.S. investments.
Foreign markets may offer less protection to investors than U.S. markets.
Foreign issuers, brokers, and securities markets may be subject to less
government supervision. Foreign security trading practices, including those
involving the release of assets in advance of payment, may involve increased
risks in the event of a failed trade or the insolvency of a broker-dealer,
and may involve substantial delays. It may also be difficult to enforce
legal rights in foreign countries.
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Investing abroad also involves different political and economic risks. Foreign
investments may be affected by actions of foreign governments adverse to the
interests of U.S. investors, including the possibility of expropriation or
nationalization of assets, confiscatory taxation, restriction on U.S. investment
or on the ability to repatriate assets or convert currency into U.S. dollars, or
other government intervention. There may be a greater possibility of default by
foreign governments or foreign government-sponsored enterprises. Investments in
foreign countries also involve a risk of local political, economic, or social
instability, military action or unrest, or adverse diplomatic developments.
There is no assurance that a Portfolio's investment adviser will be able to
anticipate or counter these potential events.
The considerations noted above generally are intensified for investments in
developing countries. Developing countries may have relatively unstable
governments, economies based on only a few industries, and securities markets
that trade a small number of securities.
Each Portfolio may invest in foreign securities that impose restrictions on
transfer within the U.S. or to U.S. persons. Although securities subject to
transfer restrictions may be marketable abroad, they may be less liquid than
foreign securities of the same class that are not subject to such restrictions.
American Depository Receipts and European Depository Receipts (ADRs and EDRs)
are certificates evidencing ownership of shares of a foreign-based corporation
held in trust by a bank or similar financial institution. Designed for use in
U.S. and European securities markets, respectively, ADRs and EDRs are
alternatives to the purchase of the underlying securities in their national
markets and currencies.
FOREIGN CURRENCY TRANSACTIONS. The Portfolios may conduct foreign currency
transactions on a spot (i.e., cash) basis or by entering into forward contracts
to purchase or sell foreign currencies at a future date and price. The
Portfolios will convert currency on a spot basis from time to time, and
investors should be aware of the costs of currency conversion. Although foreign
exchange dealers generally do not charge a fee for conversion, they do realize a
profit based on the difference between the prices at which they are buying and
selling various currencies. Thus, a dealer may offer to sell a foreign currency
to the fund at one rate, while offering a lesser rate of exchange should the
portfolio desire to resell that currency to the dealer. Forward contracts are
generally traded in an interbank market conducted directly between currency
traders (usually large commercial banks) and their customers. The parties to a
forward contract may agree to offset or terminate the contract before its
maturity, or may hold the contract to maturity and complete the contemplated
currency exchange.
Each Portfolio may use currency forward contracts for any purpose consistent
with its investment objective. The following discussion summarizes the
principal currency management strategies involving forward contracts that could
be used by the Portfolio. The Portfolios may also use swap agreements, indexed
securities, and options and futures contracts relating to foreign currencies for
the same purposes.
When a Portfolio agrees to buy or sell a security denominated in a foreign
currency, it may desire to "lock in" the U.S. dollar price of the security. By
entering into a forward contract for the purchase or sale, for a fixed amount of
U.S. dollars, of the amount of foreign currency involved in the underlying
security transaction, the Portfolio will be able to protect itself against an
adverse change in foreign currency values between the date the security is
purchased or sold and the date on which payment is made or received. This
technique is sometimes referred to as a "settlement hedge" or "transaction
hedge." The Portfolio may also enter into forward contracts to purchase or sell
a foreign currency in anticipation of future purchases or sales of securities
denominated in foreign currency, even if the specific investments have not yet
been selected by the Portfolio's investment adviser.
A Portfolio may also use forward contracts to hedge against a decline in the
value of existing investments denominated in foreign currency. For example, if
a Portfolio owned securities denominated in pounds sterling, it could enter into
a forward contract to sell pounds sterling in return for U.S. dollars to hedge
against possible declines in the pound's value. Such a hedge, sometimes
referred to as a "position hedge," would tend to offset both positive and
negative currency fluctuations, but would not offset changes in security values
caused by other factors. A Portfolio could also hedge the position by selling
another currency expected to perform similarly to the pound sterling - for
example, by entering into a forward contract to sell Deutsche marks or European
Currency Units in return for U.S. dollars. This type of hedge, sometimes
referred to as a "proxy hedge," could offer advantages in terms of cost, yield,
or efficiency, but generally would not hedge currency exposure as effectively as
a simple hedge into U.S. dollars. Proxy hedges may result in losses if the
currency used to hedge does not perform similarly to the currency in which the
hedged securities are denominated.
A Portfolio may enter into forward contracts to shift its investment exposure
from one currency into another. This may include shifting exposure from U.S.
dollars to a foreign currency, or from one foreign currency to another foreign
currency. For example, if a Portfolio held investments denominated in Deutsche
marks, such Portfolio could enter into forward contracts to sell Deutsche marks
and purchase Swiss Francs. This type of strategy, sometimes known as a "cross
hedge," will tend to reduce or eliminate exposure to the currency that is sold,
and increase exposure to the currency that is purchased, much as if the
Portfolio had sold a security denominated in one currency and purchased an
equivalent security denominated in another. Cross-hedges protect against losses
resulting from a decline in the hedged currency, but will cause the Portfolio to
assume the risk of fluctuations in the value of the currency it purchases.
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Under certain conditions, Securities and Exchange Commission (SEC) guidelines
require mutual funds to set aside cash or other appropriate liquid assets in
a segregated custodial account to cover currency forward contracts. As
required by SEC guidelines, the Portfolios will segregate assets to cover
currency forward contracts, if any, whose purpose is essentially speculative.
The Portfolios will not segregate assets to cover forward contracts entered
into for hedging purposes, including settlement hedges, position hedges, and
proxy hedges.
Successful use of forward currency contracts will depend on an investment
adviser's skill in analyzing and predicting currency values. Forward
contracts may substantially change a Portfolio's investment exposure to
changes in currency exchange rates, and could result in losses to a Portfolio
if currencies do not perform as the investment adviser anticipates. For
example, if a currency's value rose at a time when the investment adviser had
hedged a Portfolio by selling that currency in exchange for dollars, a
Portfolio would be unable to participate in the currency's appreciation. If
the investment adviser hedges currency exposure through proxy hedges, a
Portfolio could realize currency losses from the hedge and the security
position at the same time if the two currencies do not move in tandem.
Similarly, if the investment adviser increases a Portfolio's exposure to a
foreign currency, and that currency's value declines, the Portfolio will
realize a loss. There is no assurance that an investment adviser's use of
forward currency contracts will be advantageous to a Portfolio or that it
will hedge at an appropriate time. The policies described in this section
are non-fundamental policies of each Portfolio.
ILLIQUID INVESTMENTS are investments that cannot be sold or disposed of in
the ordinary course of business at approximately the prices at which they are
valued. Under guidelines established by the Trustees, the appropriate
Sub-Adviser, under the supervision of First Tennessee, and IAI determines the
liquidity of each respective Portfolio's investments and, through reports
from the Sub-Adviser and IAI, the Trustees monitor investments in illiquid
instruments. In determining the liquidity of each Portfolio's investments, a
Sub-Adviser and IAI may considers various factors including (1) the frequency
of trades and quotations, (2) the number of dealers and prospective
purchasers in the marketplace, (3) dealer undertakings to make a market, (4)
the nature of the security (including any demand or tender features) and (5)
the nature of the marketplace for trades (including the ability to assign or
offset each Portfolio's rights and obligations relating to the investment).
Investments currently considered by each Portfolio to be illiquid include
repurchase agreements not entitling the holder to payment of principal and
interest within seven days, over-the-counter options, and some restricted
securities determined by the appropriate Sub-Adviser or IAI to be illiquid.
However, with respect to over-the-counter options that each Portfolio writes,
all or a portion of the value of the underlying instrument may be illiquid
depending on the assets held to cover the option and the nature and terms of
any agreement each Portfolio may have to close out the option before
expiration. In the absence of market quotations, illiquid investments are
priced at fair value as determined in good faith by the Trustees. If through
a change in values, net assets or other circumstances, each Portfolio was in
a position where more than 15% of its net assets were invested in illiquid
securities, the Trustees would seek to take appropriate steps to protect
liquidity.
REAL ESTATE INVESTMENT TRUSTS. The Growth & Income and Capital Appreciation
Portfolio (Equity Portfolios) may purchase interests in real estate
investment trusts. Real estate industry companies include, among others,
equity real estate investment trusts, which own properties, and mortgage real
estate investment trusts, which make construction, development, and long-term
mortgage loans. Equity real estate investment trusts may be affected by
changes in the value of the underlying property owned by the trusts, while
mortgage real estate investment trusts may be affected by the quality of
credit extended. Equity and mortgage real estate investment trusts are
dependent upon management skill, are not diversified, and are subject to the
risks of financing projects. Such trusts are also subject to heavy cash flow
dependency, defaults by borrowers, self liquidation, and the possibilities of
failing to qualify for tax-free pass-through of income under the Internal
Revenue Code and failing to maintain exemption from the Investment Company
Act of 1940 (the 1940 Act).
REPURCHASE AGREEMENTS are transactions in which a Portfolio purchases a
security and simultaneously commits to resell that security at an agreed upon
price and date within a number of days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security.
A repurchase agreement involves the obligation of the seller to pay the
agreed upon price. This obligation is in effect secured by the underlying
security having a value at least equal to the amount of the agreed upon
resale price. Each Portfolio may enter into a repurchase agreement with
respect to any security in which it is authorized to invest. While it
presently does not appear possible to eliminate all risks from the
transactions (particularly the possibility of a decline in the market value
of the underlying securities, as well as delay and costs to each Portfolio in
connection with bankruptcy proceedings), it is the policy of each Portfolio
to limit repurchase agreements to those parties whose creditworthiness has
been reviewed and found satisfactory by the appropriate Sub-Adviser or IAI,
as the case may be.
REVERSE REPURCHASE AGREEMENTS. In a reverse repurchase agreement, a
Portfolio sells a portfolio security to another party, such as a bank or
broker-dealer, in return for cash and agrees to repurchase the instrument at
a particular price and time. While a reverse repurchase agreement is
outstanding, each Portfolio will maintain appropriate high grade liquid
assets in a segregated custodial account to cover its obligation under the
agreement. Each Portfolio will enter into reverse repurchase agreements only
with parties whose creditworthiness has been found satisfactory by the
appropriate Sub-Adviser or IAI, as the case may be. Such transactions may
increase fluctuations in the market values of each Portfolio's assets and may
be viewed as a form of leverage.
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RESTRICTED SECURITIES generally can be sold in privately negotiated
transactions, pursuant to an exemption from registration under the Securities
Act of 1933, or in a registered public offering. Where registration is
required, each Portfolio may be obligated to pay all or part of the
registration expense and a considerable period may elapse between the time it
decides to seek registration and the time each Portfolio may be permitted to
sell a security under an effective registration statement. If, during such a
period, adverse market conditions were to develop, each Portfolio might
obtain a less favorable price than prevailed when it decided to seek
registration of the security.
SECURITIES LENDING. Each Portfolio may lend securities to parties such as
broker-dealers or institutional investors. Securities lending allows the
Portfolios to retain ownership of the securities loaned and, at the same
time, to earn additional income. Since there may be delays in the recovery
of loaned securities, or even a loss of rights in collateral supplied should
the borrower fail financially, loans will be made only to parties deemed by
the appropriate Sub-Adviser or IAI to be of good standing. Furthermore, they
will only be made if, in the appropriate Sub-Adviser's or IAI's judgment, the
consideration to be earned from such loans would justify the risk.
First Tennessee, Highland, Martin and IAI understand that it is the current
view of the SEC that each Portfolio may engage in loan transactions only
under the following conditions: (1) each Portfolio must receive 100%
collateral in the form of cash or cash equivalents (e.g., U.S. Treasury bills
or notes) from the borrower; (2) the borrower must increase the collateral
whenever the market value of the securities loaned (determined on a daily
basis) rises above the value of the collateral; (3) after giving notice, each
Portfolio must be able to terminate the loan at any time; (4) each Portfolio
must receive reasonable interest on the loan or a flat fee from the borrower,
as well as amounts equivalent to any dividends, interest, or other
distributions on the securities loaned and to any increase in market value;
(5) each Portfolio may pay only reasonable custodian fees in connection with
the loan; and (6) the Trustees must be able to vote proxies on the securities
loaned, either by terminating the loan or by entering into an alternative
arrangement with the borrower.
Cash received through loan transactions may be invested in any security in
which the Portfolios are authorized to invest. Investing this cash subjects
that investment, as well as the security loaned, to market forces (i.e.,
capital appreciation or depreciation).
VARIABLE AND FLOATING RATE DEMAND OBLIGATIONS (VRDOS/FRDOS) are obligations
that bear variable or floating interest rates and carry rights that permit
holders to demand payment of the unpaid principal balance plus accrued
interest from the issuers or certain financial intermediaries. Floating rate
instruments have interest rates that change whenever there is a change in a
designated base rate while variable rate obligations provide for a specified
periodic adjustment in the interest rate. These formulas are designed to
result in a market value for the VRDO or FRDO that approximates its par
value.
The Bond and Intermediate Bond Portfolios (the Bond Portfolios) may invest in
fixed-rate bonds that are subject to third party puts and in participation
interests in such bonds held by a bank in trust or otherwise. These bonds
and participation interests have tender options or demand features that
permit these Portfolios to tender (or put) their bonds to an institution at
periodic intervals and to receive the principal amount thereof. These
Portfolios consider variable rate instruments structured in this way
(Participating VRDOs) to be essentially equivalent to other VRDOs they
purchase.
WARRANTS. The Equity Portfolios may invest in warrants which entitle the
holder to buy equity securities at a specific price during a specific period
of time. Warrants may be considered more speculative than certain other types
of investments in that they do not entitle a holder to dividends or voting
rights with respect to the securities which may be purchased, nor do they
represent any rights in the assets of the issuing company. The value of a
warrant may be more volatile than the value of the securities underlying the
warrants. Also, the value of the warrant does not necessarily change with
the value of the underlying securities and a warrant ceases to have value if
it is not exercised prior to the expiration date. Warrants may be allowed to
expire if the appropriate Sub-Adviser or IAI deems it undesirable to exercise
or sell.
LIMITATIONS ON OPTIONS TRANSACTIONS. Each Portfolio will not: (a) purchase
put options or write call options if, as a result, more than 25% of a
Portfolio's total assets would be hedged with options under normal
conditions; (b) write put options if, as a result, a Portfolio's total
obligations upon settlement or exercise of written put options would exceed
25% each of their total assets; or (c) purchase call options if, as a result,
the current value of option premiums for call options purchased by each
Portfolio would exceed 5% of total assets. These limitations do not apply to
options attached to or acquired or traded together with their underlying
securities, and do not apply to securities that incorporate features similar
to options.
PURCHASING PUT AND CALL OPTIONS. By purchasing a put option, a Portfolio
obtains the right (but not the obligation) to sell the option's underlying
instrument at a fixed strike price. In return for this right, a Portfolio
pays the current market price for the option (known as the option premium).
Options have various types of underlying instruments, including specific
securities and indexes of securities prices. A Portfolio may terminate its
position in a put option it has purchased by allowing them to expire or by
exercising the option. If the option is allowed to expire, a Portfolio will
lose the entire premium it paid. If a Portfolio exercises the option, it
completes the sale of the underlying instrument at the strike price. A
Portfolio may also terminate a put option position by closing it out in the
secondary market at its current price, if a liquid secondary market exists.
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The buyer of a typical put option can expect to realize a gain if security
prices fall substantially. However, if the underlying instrument's price
does not fall enough to offset the cost of purchasing the option, a put buyer
can expect to suffer a loss (limited to the amount of the premium paid, plus
related transaction costs).
The features of call options are essentially the same as those of put
options, except that the purchaser of a call option obtains the right to
purchase, rather than sell, the underlying instrument at the option's strike
price. A call buyer typically attempts to participate in potential price
increases of the underlying instrument with risk limited to the cost of the
option if security prices fall. At the same time, the buyer can expect to
suffer a loss if security prices do not rise sufficiently to offset the cost
of the option.
WRITING PUT AND CALL OPTIONS. When a Portfolio writes a put option, it takes
the opposite side of the transaction from the option's purchaser. In return
for receipt of the premium, the Portfolio assumes the obligation to pay the
strike price for the option's underlying instrument if the other party to the
option chooses to exercise it. The Portfolios may seek to terminate their
positions in put options they write before exercise by closing out the
options in the secondary market at their current price. If the secondary
market is not liquid for a put option a Portfolio has written, however, the
Portfolio must continue to be prepared to pay the strike price while the
option is outstanding, regardless of price changes, and must continue to set
aside assets to cover its position.
If security prices rise, a put writer would generally expect to profit,
although its gain would be limited to the amount of the premium it received.
If security prices remain the same over time, it is likely that the writer
will also profit, because it should be able to close out the option at a
lower price. If security prices fall, the put writer would expect to suffer
a loss. This loss should be less than the loss from purchasing the
underlying instrument directly, however, because the premium received for
writing the option should mitigate the effects of the decline.
Writing a call option obligates each Portfolio to sell or deliver the
option's underlying instrument, in return for the strike price, upon exercise
of the option. The characteristics of writing call options are similar to
those of writing put options, except that writing calls generally is a
profitable strategy if prices remain the same or fall. Through receipt of
the option premium, a call writer mitigates the effects of a price decline.
At the same time, because a call writer must be prepared to deliver the
underlying instrument in return for the strike price, even if its current
value is greater, a call writer gives up some ability to participate in
security price increases.
COMBINED POSITIONS. Each Portfolio may purchase and write options in
combination with each other, or in combination with forward contracts, to
adjust the risk and return characteristics of the overall position. For
example, the Portfolios may purchase a put option and write a call option on
the same underlying instrument, in order to construct a combined position
whose risk and return characteristics are similar to selling a futures
contract. Another possible combined position would involve writing a call
option at one strike price and buying a call option at a lower price, in
order to reduce the risk of the written call option in the event of a
substantial price increase. Because combined options positions involve
multiple trades, they result in higher transaction costs and may be more
difficult to open and close out.
CORRELATION OF PRICE CHANGES. Because there are a limited number of types of
exchange-traded options contracts, it is likely that the standardized
contracts available will not match the Portfolios' current or anticipated
investments exactly. Each Portfolio may invest in options contracts based on
securities with different issuers, maturities, or other characteristics from
the securities in which each typically invests.
Options prices can also diverge from the prices of their underlying
instruments, even if the underlying instruments match the Portfolios'
investments well. Options prices are affected by such factors as current and
anticipated short-term interest rates, changes in volatility of the
underlying instrument, and the time remaining until expiration of the
contract, which may not affect security prices the same way. Imperfect
correlation may also result from differing levels of demand in the options
markets and the securities markets, from structural differences in how
options and securities are traded, or from imposition of daily price
fluctuation limits or trading halts. The Portfolios may purchase or sell
options contracts with a greater or lesser value than the securities it
wishes to hedge or intends to purchase in order to attempt to compensate for
differences in volatility between the contract and the securities, although
this may not be successful in all cases. If price changes in the Portfolios'
options positions are poorly correlated with its other investments, the
positions may fail to produce anticipated gains or result in losses that are
not offset by gains in other investments.
LIQUIDITY OF OPTIONS. There is no assurance a liquid secondary market will
exist for any particular options contract at any particular time. Options may
have relatively low trading volume and liquidity if their strike prices are
not close to the underlying instrument's current price. On volatile trading
days when the price fluctuation limit is reached or a trading halt is
imposed, it may be impossible for the Portfolios to enter into new positions
or close out existing positions. If the secondary market for a contract is
not liquid because of price fluctuation limits or otherwise, it could prevent
prompt liquidation of unfavorable positions, and potentially could require
the Portfolios to continue to hold a position until delivery or expiration
regardless of changes in its value. As a result, the Portfolios' access to
other assets held to cover its options or futures positions could also be
impaired.
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OTC OPTIONS. Unlike exchange-traded options, which are standardized with
respect to the underlying instrument, expiration date, contract size, and
strike price, the terms of over-the-counter options (options not traded on
exchanges) generally are established through negotiation with the other party
to the option contract. While this type of arrangement allows the Portfolios
greater flexibility to tailor an option to its needs, OTC options generally
involve greater credit risk than exchange-traded options, which are
guaranteed by the clearing organization of the exchanges where they are
traded.
ASSET COVERAGE FOR OPTIONS POSITIONS. The Portfolios will comply with
guidelines established by the SEC with respect to coverage of options
strategies by mutual funds and, if the guidelines so require, will set aside
appropriate liquid assets in a segregated custodial account in the amount
prescribed. Securities held in a segregated account cannot be sold while the
option strategy is outstanding, unless they are replaced with other suitable
assets. As a result, there is a possibility that segregation of a large
percentage of the Portfolios' assets could impede portfolio management or the
Portfolios' ability to meet redemption requests or other current obligations.
PORTFOLIO TRANSACTIONS
All orders for the purchase or sale of securities are placed on behalf of the
respective Portfolios by First Tennessee, Highland, Martin and IAI
(collectively, the Advisers) pursuant to authority contained in each
Portfolio's Investment Advisory Agreement, Sub-Advisory Agreement or
Co-Advisory Agreement, as the case may be. The Advisers are also responsible
for the placement of transaction orders for other investment companies and
accounts for which they or their affiliates act as investment adviser. In
selecting broker-dealers, subject to applicable limitations of the federal
securities laws, the Advisers consider various relevant factors, including,
but not limited to, the broker's execution capability; the broker's perceived
financial stability; the broker's responsiveness to the Advisers' transaction
requests; and the broker's clearance and settlement capability. Commissions
for foreign investments traded on foreign exchanges will generally be higher
than for U.S. investments and may not be subject to negotiation.
Each Portfolio may execute portfolio transactions with broker-dealers who
provide research and execution services to the Portfolios or other accounts
over which the Advisers or their affiliates exercise investment discretion.
Such services may include research-related computer hardware and software;
and furnishing analyses and reports concerning issuers, industries, and
economic factors and trends.
The receipt of research from broker-dealers that execute transactions on
behalf of each Portfolio may be useful to the Advisers in rendering
investment management services to each Portfolio and/or its other clients,
and conversely, such information provided by broker-dealers who have executed
transaction orders on behalf of other clients may be useful to the Advisers
in carrying out its obligations to each Portfolio. The receipt of such
research has not reduced the Advisers' normal independent research
activities; however, it enables the Advisers to avoid the additional expenses
that could be incurred if they tried to develop comparable information
through their own efforts.
Subject to applicable limitations of the federal securities laws,
broker-dealers may receive commissions for agency transactions that are
higher than the commission of other broker-dealers in recognition of their
research and execution services. In order to cause each Portfolio to pay
such higher commissions, the Advisers must determine in good faith that such
commissions are reasonable in relation to the value of the brokerage and
research services provided by such executing broker-dealers viewed in terms
of a particular transaction or the Advisers' overall responsibilities to each
Portfolio and its other clients. In reaching this determination, the
Advisers will not attempt to place a specific dollar value on the brokerage
and research services provided or to determine what portion of the
compensation should be related to those services.
The Advisers are authorized to use research services provided by and to place
portfolio transactions, to the extent permitted by law, with brokerage firms
that have provided assistance in the distribution of shares of each
Portfolio.
The Trustees periodically review the Advisers' performance of its
responsibilities in connection with the placement of portfolio transactions
on behalf of each Portfolio and review the commissions paid by each Portfolio
over representative periods of time to determine if they are reasonable in
relation to the benefits to each Portfolio.
For the fiscal years ended June 30, 1997 and 1996, the portfolio turnover
rates were 25% and 41% for the Growth & Income Portfolio, and 56% and 56% for
the Bond Portfolio. The Growth & Income Portfolio paid brokerage commissions
in the amounts of $147,563, $276,190 and $146,176 during the fiscal years
ended June 30, 1997, 1996 and 1995, respectively. During the fiscal years
ended June 30, 1997, 1996 and 1995, no brokerage commissions were paid by the
Growth & Income Portfolio to an affiliated broker of the Trust. No brokerage
commissions were paid by the Bond Portfolio during the last three fiscal
years. The Capital Appreciation and Intermediate Bond Portfolios had not
commenced operations as of June 30, 1997.
From time to time the Trustees will review whether the recapture for the
benefit of each Portfolio of some portion of the brokerage commissions or
similar fees paid by each Portfolio on portfolio transactions is legally
permissible and advisable. Each Portfolio seeks to recapture soliciting
broker-dealer fees on the tender of portfolio securities, but at present no
other recapture arrangements are in effect.
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The Trustees intend to continue to review whether recapture opportunities are
available and are legally permissible and, if so, to determine, in the
exercise of their business judgment, whether it would be advisable for each
Portfolio to seek such recapture.
When two or more Portfolios are simultaneously engaged in the purchase or
sale of the same security, the prices and amounts are allocated in accordance
with a formula considered by the Trustees and each Portfolio's respective
investment adviser to be equitable to each Portfolio. In some cases this
system could have a detrimental effect on the price or value of the security
as far as each Portfolio is concerned. In other cases, however, the ability
of each Portfolio to participate in volume transactions will produce better
executions for each Portfolio. It is the current opinion of the Trustees that
the desirability of retaining the Portfolios' investment advisers outweighs
any disadvantages to the Portfolios that may be said to exist from exposure
to simultaneous transactions.
VALUATION OF PORTFOLIO SECURITIES
Securities owned by each Portfolio are appraised by various methods depending
on the market or exchange on which they trade. Securities traded on the New
York Stock Exchange (NYSE) or the American Stock Exchange are appraised at
the last sale price, or if no sale has occurred, at the closing bid price.
Securities traded on other exchanges are appraised as nearly as possible in
the same manner. Securities and other assets for which exchange quotations
are not readily available are valued on the basis of closing over-the-counter
bid prices, if available, or at their fair value as determined in good faith
under consistently applied procedures under the general supervision of the
Trustees. Short-term securities maturing in 60 days are valued either at
amortized cost or at original cost plus accrued interest, both of which
approximate current value. Convertible securities and fixed-income securities
are valued primarily by a pricing service that uses a vendor security
valuation matrix which incorporates both dealer-supplied valuations and
electronic data processing techniques. This two-fold approach is believed to
more accurately reflect fair value because it takes into account appropriate
factors such as institutional trading in similar groups of securities, yield,
quality, coupon rate, maturity, type of issue, trading characteristics, and
other market data, without exclusive reliance upon quoted, exchange, or
over-the-counter prices.
Use of pricing services has been approved by the Trustees. Securities and
other assets for which there is no readily available market are valued in
good faith by a committee appointed by the Trustees. The procedures set
forth above need not be used to determine the value of the securities owned
by a Portfolio if, in the opinion of a committee appointed by the Trustees,
some other method (e.g., closing over-the-counter bid prices in the case of
debt instruments traded on an exchange) would more accurately reflect the
fair market value of such securities.
Generally, the valuation of foreign and domestic equity securities, as well
as corporate bonds, U.S. government securities, money market instruments, and
repurchase agreements, is substantially completed each day at the close of
the NYSE. The values of any such securities held by the Portfolios are
determined as of such time for the purpose of computing the Portfolios' net
asset values per share (NAV). Foreign security prices are furnished by
independent brokers or quotation services which express the value of
securities in their local currency. Chase Global Funds Services Company, the
Transfer Agent, gathers all exchange rates daily at the close of the NYSE
using the last quoted price on the local currency and then translates the
value of foreign securities from their local currency into U.S. dollars. Any
changes in the value of forward contracts due to exchange rate fluctuations
and days to maturity are included in the calculation of the net asset value.
If an extraordinary event that is expected to materially affect the value of
a portfolio security occurs after the close of an exchange on which that
security is traded, then the security will be valued as determined in good
faith.
PERFORMANCE
For each Class of the Portfolios, yields used in advertising are computed by
dividing interest income for a given 30-day or one-month period, net of
expenses, by the average number of shares entitled to receive dividends
during the period, dividing this figure by the NAV at the end of the period
and annualizing the result (assuming compounding of income) in order to
arrive at an annual percentage rate. Income is calculated for purposes of
yield quotations in accordance with standardized methods applicable to all
bond funds. In general, interest income is reduced with respect to bonds
trading at a premium over their par value by subtracting a portion of the
premium from income on a daily basis, and is increased with respect to bonds
trading at a discount by adding a portion of the discount to daily income.
Capital gains and losses generally are excluded from the calculation.
Income calculated for the purposes of determining yields differs from income
as determined for other accounting purposes. Because of the different
accounting methods used, and because of the compounding of income assumed in
yield calculations, yield may not equal its distribution rate, the income
paid to an account, or income reported in financial statements.
Yield information may be useful in reviewing performance and in providing a
basis for comparison with other investment alternatives. Yield will
fluctuate, unlike investments that pay a fixed interest rate over a stated
period of time. Investors should give consideration to the quality and
maturity of portfolio securities of the respective investment companies when
comparing investments.
Investors should recognize that in periods of declining interest rates, yield
will tend to be somewhat higher than prevailing market rates, and in periods
of rising interest rates, yield will tend to be somewhat lower. Also, when
interest rates are falling, the inflow of net new
9
<PAGE>
money from the continuous sale of its shares will likely be invested in
instruments producing lower yields than the balance of the holdings, thereby
reducing the current yield. In periods of rising interest rates, the
opposite can be expected to occur. As of December 31, 1997, the 30-day
yields for Class I, II and III of the Bond Portfolio were 5.96%, 5.47% and
4.79%, respectively. The Intermediate Bond Portfolio had not commenced
operations as of December 31, 1997.
TOTAL RETURNS for each Class of each Portfolio quoted in advertising reflect
all aspects of return, including the effect of reinvesting dividends and
capital gain distributions (if any), and any change in NAV over the period.
AVERAGE ANNUAL TOTAL RETURNS are calculated by determining the growth or
decline in value of a hypothetical historical investment over a stated
period, and then calculating the annually compounded percentage rate that
would have produced the same result if the rate of growth or decline in value
had been constant over the period. For example, a cumulative total return of
100% over ten years would produce an average annual total return of 7.18%,
which is the steady annual rate of return that would equal 100% growth on a
compounded basis in ten years. While average annual total returns are a
convenient means of comparing investment alternatives, investors should
realize that performance is not constant over time, but changes from year to
year, and that average annual total returns represent averaged figures as
opposed to the actual year-to-year performance. Average annual returns
covering periods of less than one year are calculated by determining total
return for the period, extending that return for a full year (assuming that
performance remains constant over the year), and quoting the result as an
annual return. The following table shows total returns as of December 31,
1997 for each Class of the Growth & Income, Capital Appreciation and Bond
Portfolios (the Intermediate Bond Portfolio had not commenced operations as
of December 31, 1997):
<TABLE>
<CAPTION>
CLASS I AVERAGE CLASS II AVERAGE CLASS III AVERAGE
ANNUAL TOTAL RETURN ANNUAL TOTAL RETURN ANNUAL TOTAL RETURN
------------------- ------------------- -------------------
ONE SINCE ONE SINCE ONE SINCE
YEAR INCEPTION YEAR INCEPTION YEAR INCEPTION
------ --------- ----- --------- ----- ----------
<S> <C> <C> <C> <C> <C> <C>
Growth & Income Portfolio 36.16% 23.06% 28.05% 21.28% 34.68% 21.74%
Bond Portfolio 9.28% 6.42% 5.01% 5.29% 8.02% 5.17%
Capital Appreciation N/A (1.00)% N/A (6.88)% N/A (1.40)%
</TABLE>
CUMULATIVE TOTAL RETURNS reflect the simple change in value of an investment
over a stated period. Average annual and cumulative total returns may be
quoted as a percentage or as a dollar amount, and may be calculated for a
single investment, a series of investments, or a series of redemptions, over
any time period. Total returns may be broken down into their components of
income and capital (including capital gains and changes in share price) in
order to illustrate the relationship of these factors and their contributions
to total return. Total returns, yields, and other performance information
may be quoted numerically or in a table, graph, or similar illustration.
Where applicable, sales loads may or may not be included.
Each Portfolio may compare the performance of each of its Classes or the
performance of securities in which it or each of its Classes may invest to
other mutual funds, especially to those with similar investment objectives.
These comparisons may be based on data published by IBC USA (Publications),
Inc. of Ashland, MA or by Lipper Analytical Services, Inc. (Lipper, sometimes
referred to as Lipper Analytical Services), an independent service located in
Summit, New Jersey that monitors the performance of mutual funds. Lipper
generally ranks funds on the basis of total return, assuming reinvestment of
distributions, but does not take sales charges or redemption fees into
consideration, and is prepared without regard to tax consequences. Lipper
may also rank funds based on yield. In addition to the mutual fund rankings,
the Portfolio's performance may be compared to mutual fund performance
indices prepared by Lipper. The BOND FUND REPORT AVERAGES' which is reported
in the BOND FUND REPORT, covers taxable bond funds. When evaluating
comparisons to money market funds, investors should consider the relevant
differences in investment objectives and policies. Specifically, money market
funds invest in short-term, high-quality instruments and seek to maintain a
stable $1.00 share price. The Bond Portfolios, however, invest in longer-term
instruments and their share price changes daily in response to a variety of
factors. Investors should give consideration to the quality and maturity of
the portfolio securities of the respective investment companies when
comparing investment alternatives.
MOVING AVERAGES. The Portfolios may illustrate performance using moving
averages. A long-term moving average is the average of each week's adjusted
closing NAV for a specified period. A short-term moving average is the
average of each day's adjusted closing NAV for a specified period. Moving
Average Activity Indicators combine adjusted closing NAVs from the last
business day of each week with moving averages for a specified period to
produce indicators showing when an NAV has crossed, stayed above, or stayed
below its moving average.
NET ASSET VALUE. Charts and graphs using the Portfolios' net asset values,
adjusted net asset values, and benchmark indices may be used to exhibit
performance. An adjusted NAV includes any distributions paid by the
Portfolio and reflects all elements of its return. Unless otherwise
indicated, the Portfolio's adjusted NAVs are not adjusted for sales charges,
if any.
10
<PAGE>
From time to time, each Portfolio's performance may also be compared to other
mutual funds tracked by financial or business publications and periodicals.
For example, the Portfolios may quote Morningstar, Inc. in its advertising
materials. Morningstar, Inc. is a mutual fund rating service that rates
mutual funds on the basis of risk-adjusted performance.
Each Portfolio may be compared in advertising to certificates of deposits
(CDs) or other investments issued by banks. Mutual funds differ from bank
investments in several respects. For example, the Portfolios may offer
greater liquidity or higher potential returns than CDs, and the Portfolio
does not guarantee your principal or your return.
Ibbotson Associates of Chicago, Illinois (Ibbotson) provides historical
returns of the capital markets in the United States, including common stocks,
small capitalization stocks, long-term corporate bonds, intermediate-term
government bonds, long-term government bonds, Treasury bills, the U.S. rate
of inflation (based on the Consumer Price Index), and combinations of various
capital markets. The performance of these capital markets is based on the
return of different indices.
Growth & Income Portfolio may compare its performance to that of the Standard
& Poor's Composite Index of 500 stocks (S&P 500), a widely recognized,
unmanaged index of the combined performance of the stocks of 500 American
companies. The Capital Appreciation Portfolio may compare its performance to
that of the S&P 500, the Standard & Poor's 400 Midcap Index, the Russell 2000
Index or the Russell 2500 Growth Index. The Bond Portfolio may compare its
performance to that of the Lehman Brothers Government Bond Index, an index
comprised of all public obligations of the U.S. Treasury, U.S. government
agencies, quasi-federal corporations, and corporate debt guaranteed by the
U.S. government, and the Lehman Brothers Corporate Bond Index, an index
comprised of all public, fixed-rate, non-convertible investment-grade
domestic corporate debt. Issues included in this index are rated at least
Baa by Moody's or BBB by S&P, or in the case of non-rated bonds, BBB by Fitch
Investors Service. The Government Bond Index and the Corporate Bond Index
are combined to form the Government/Corporate Bond Index. The Intermediate
Bond Portfolio may compare its performance to that of the Lehman Brothers
Government/Corporate Intermediate Bond Index, which consists of the
Government/Corporate Bond Index securities with maturities less than ten
years. Each Portfolio may also quote mutual fund rating services in its
advertising materials, including data from a mutual fund rating service which
rates mutual funds on the basis of risk adjusted performance. Because the
fees for Class II and Class III are higher than the fees for Class I, yields
and returns for those classes will be lower than for Class I.
Each Portfolio may advertise examples of the effects of periodic investment
plans, including the principle of dollar cost averaging. In such a program,
the investor invests a fixed dollar amount at periodic intervals, thereby
purchasing fewer shares when prices are high and more shares when prices are
low. While such a strategy does not assure a profit nor guard against loss
in a declining market, the investor's average cost per share can be lower
than if fixed numbers of shares had been purchased at those intervals. In
evaluating such a plan, investors should consider their ability to continue
purchasing shares through periods of low price levels.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The following holiday closings have been scheduled: Veterans' Day,
Thanksgiving Day, Christmas Day, New Year's Day, Dr. Martin Luther King Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
and Columbus Day. Although First Tennessee expects the same holiday schedule
to be observed in the future, the New York Stock Exchange and the Federal
Reserve Bank of New York (New York Federal Reserve) may modify their holiday
schedules at any time.
If the Trustees determine that existing conditions make cash payment
undesirable, redemption payments may be made in whole or in part in
securities or other property, valued for this purpose as they are valued in
computing each Portfolio's NAV. Shareholders receiving securities or other
property on redemption may realize a gain or loss for tax purposes and will
incur any costs of sale, as well as the associated inconveniences.
Pursuant to Rule 11a-3 under the 1940 Act, each Portfolio is required to give
shareholders at least 60 days' notice prior to terminating or modifying each
Portfolio's exchange privilege. Under Rule 11a-3, the 60-day notification
requirement may be waived if (i) the only effect of a modification would be
to reduce or eliminate an administrative fee, redemption fee or deferred
sales charge ordinarily payable at the time of exchange, or (ii) under
extraordinary circumstances, a Portfolio temporarily suspends the offering of
shares as permitted under the 1940 Act or by the SEC or because it is unable
to invest amounts effectively in accordance with its investment objective and
policies. This exchange limit may be modified for accounts in certain
institutional retirement plans to conform to plan exchange limits and
Department of Labor Regulations.
ADDITIONAL CLASS II AND CLASS III INFORMATION
SYSTEMATIC INVESTING PROGRAM. Investors can make regular investments in
Class II and Class III with Systematic Investing by completing the
appropriate section on the account application and attaching a voided
personal check. If the bank account is jointly owned, make sure that all
owners sign. Investments may be made monthly by automatically deducting $25
or more from your checking account. This monthly purchase amount may be
changed at any time. There is a $250 minimum initial investment requirement
for this option. For employees of First Tennessee Bank National Association
or any of its affiliates, who participate in the Systematic Investing
Program, the
11
<PAGE>
minimum initial investment requirement is $50. Accounts will be drafted on
or about the first business day of every month. Systematic Investing may be
canceled at any time without payment of a cancellation fee. Investors will
receive a confirmation from their securities broker or financial institution
(Investment Professional), or from the Transfer Agent for every transaction,
and a debit entry will appear on your bank statement.
SYSTEMATIC WITHDRAWAL PLAN. Investors can have monthly, quarterly or
semi-annual checks sent from their account to you, to a person named by them,
or to their bank checking account. The Systematic Withdrawal Plan payments
are drawn from share redemptions and must be in the amount of $100 or more
per Portfolio per transaction. If Systematic Withdrawal Plan redemptions
exceed income dividends earned on shares, an account eventually may be
exhausted. Contact the Investment Professional for more information.
DISTRIBUTIONS AND TAXES
DIVIDENDS. A portion of the income distributed by the Equity Portfolios may
qualify for the dividends-received deduction available to corporate
shareholders to the extent that the Portfolios' income is derived from
qualifying dividends. Because the Portfolios may also earn other types of
income, such as interest, income from securities loans, non-qualifying
dividends and short-term capital gains, the percentage of dividends from each
Portfolio that qualifies for the deduction will generally be less than 100%.
Each Portfolio will notify corporate shareholders annually of the percentage
of portfolio dividends which qualify for the dividends received deduction.
Because the income earned by the Bond Portfolios is primarily derived from
interest, dividends from each such Portfolio generally will not qualify for
the dividends-received deduction available to corporations. A portion of
each Portfolio's dividends derived from certain U.S. government obligations
may be exempt from state and local taxation. Gains (losses) attributable to
foreign currency fluctuations are generally taxable as ordinary income and
therefore increase (decrease) dividend distributions. Each Portfolio will
send each shareholder a notice in January describing the tax status of
dividends and capital gain distributions for the prior year.
CAPITAL GAIN DISTRIBUTIONS. Distributions of gains from the sale of assets
held by a Portfolio for more than one year generally are taxable to
shareholders of that Portfolio at the applicable mid-term or long-term
capital gains rate, as designated by the Portfolio, regardless of how long
the shareholders have owned their Portfolio shares. There is presently no
guidance concerning the treatment of any loss on the sale of Portfolio shares
held less than six months.
Short-term capital gains distributed by a Portfolio, if any, are taxable to
shareholders as dividends, not as capital gains. Distributions from
short-term capital gains do not qualify for the dividends received deduction.
FOREIGN TAXES. Foreign governments may withhold taxes on dividends and
interest paid with respect to foreign securities. Because each Portfolio
does not currently anticipate that securities of foreign corporations will
constitute more than 50% of each Portfolio's total assets at the end of its
fiscal year, shareholders should not expect to claim a foreign tax credit or
deduction on their federal income tax returns with respect to foreign taxes
withheld.
TAX STATUS OF THE TRUST. Each Portfolio has qualified and intends to qualify
as a "regulated investment company" under Subchapter M of the Internal
Revenue Code of 1986, as amended (the Code), so that each Portfolio will not
be liable for federal income or excise taxes on net investment income or
capital gains to the extent that these are distributed to shareholders in
accordance with applicable provisions of the Code. In order to qualify as a
regulated investment company and avoid being subject to federal income or
excise taxes, each Portfolio intends to distribute substantially all of its
net investment income and net realized capital gains within each calendar
year as well as on a fiscal year basis. Each Portfolio also intends to
comply with other tax rules applicable to regulated investment companies.
Gains from some forward currency contracts and options are included in this
30% calculation, which may limit each Portfolio's investments in such
instruments. If the Portfolios purchase shares in certain foreign investment
entities, called passive foreign investment companies (PFICs), they may be
subject to U.S. federal income tax on a portion of any excess distribution or
gain from the disposition of such shares. Interest charges may also be
imposed on the Portfolios with respect to deferred taxes arising from such
distributions or gains.
OTHER TAX INFORMATION. The information above is only a summary of some of
the tax consequences generally affecting each Portfolio and its shareholders,
and no attempt has been made to discuss individual tax consequences. In
addition to federal income taxes, shareholders may be subject to state and
local taxes on distributions received from each Portfolio. Investors should
consult their tax advisors to determine whether each Portfolio is suitable to
their particular tax situation.
Federal income tax will be withheld at a 20% rate on any eligible rollover
distributions that are not transferred directly to another qualified plan or
IRA. Actual income tax may be higher or lower and will be due when tax forms
for the year are filed. Taxes will not be withheld in cases of direct
rollover into an IRA or another qualified plan.
12
<PAGE>
TRUSTEES AND OFFICERS
The Trustees and executive officers of the Trust are listed below. Each
Trustee or officer that is an "interested person" (as defined in the 1940
Act) by virtue of his affiliation with First Tennessee or ALPS, is indicated
by an asterisk (*).
THOMAS M. BATCHELOR, age 76, Trustee, 4325 Woodcrest Drive, Memphis, TN, who
presently operates a management consultant business on a limited basis,
retired after owning and operating two General Insurance Companies agencies
for over thirty years. He was one of the founders and served as a director
of First American State Bank in Memphis, TN (now part of United American Bank
of Memphis). He currently serves as Chairman, Memphis Union Mission, TN, as
well as a charity and a non-profit foundation.
JOHN A. DECELL, age 62, Trustee, 5178 Wheelis Dr., Suite 2, Memphis, TN is
Proprietor, DeCell & Company (real estate and business consulting), and
President of Capital Advisers, Inc. (real estate consulting and asset
management).
*L. R. JALENAK, JR., age 67, Trustee, 6094 Apple Tree Drive, Suite 11,
Memphis, TN was Chairman of the Board (1990 - 1993 (retired)), Cleo Inc.
(manufacturer of gift-related products), a Gibson Greetings Company. Mr.
Jalenak is also a Director of Perrigo Company (1988 - present), Lufkin
Industries (1990 -present), Dyersburg Corporation (1990 - present), was
President and CEO (until 1990) of Cleo Inc., and was a Director of Gibson
Greetings, Inc. from 1983 to 1991.
LARRY W. PAPASAN, age 57, Trustee, 5114 Winton Place, Memphis, TN is
President of Smith & Nephew, Inc. (orthopedic implants). Mr. Papasan is a
former Director of First American National Bank of Memphis and The West
Tennessee Board of First American National Bank (1988 - 1991) and was
President of Memphis Light Gas and Water Division of the City of Memphis
(1984 - 1991). Mr. Papasan is also a member of the Board of the Plough
Foundation, a non-profit trust.
*RICHARD C. RANTZOW, age 59, President and Trustee, 5790 Shelby Avenue,
Memphis, TN is Vice President/Director, Ron Miller Associates, Inc.
(manufacturer). Mr. Rantzow was Managing Partner (until 1990) of the Memphis
office of Ernst & Young.
*JEREMY O. MAY, age 27, Treasurer, is a Fund Controller at ALPS Mutual Funds
Services, Inc. (ALPS), the Administrator and Distributor. Prior to joining
ALPS, Mr. May was an auditor with Deloitte & Touche LLP in their Denver
office.
*JAMES V. HYATT, age 47, Secretary, is General Counsel of ALPS. Prior to
joining ALPS, Mr. Hyatt served as Senior Legal Counsel for Fidelity
Investments and Clerk for Fidelity Management Trust Company.
The Trustees of the Trust each receive from the Trust an annual fee of $4,000
and a fee in the amount of $1,250 for attending each regularly scheduled
quarterly meeting of the Trustees and $500 for each unscheduled meeting. The
Trustees were compensated as follows for their services provided during the
Trust's fiscal year ended June 30, 1997:
<TABLE>
<CAPTION>
Aggregate Pension or Retirement Estimated Annual Aggregate
Compensation from Benefits Accrued As Benefits Upon Compensation From
the Trust Part of Fund Expenses Retirement the Trust and Fund
Complex Paid
to Trustees
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Thomas M. Batchelor $10,000 $0 $0 $10,000
Trustee
- --------------------------------------------------------------------------------------------------------
John A. DeCell $10,000 $0 $0 $10,000
Trustee
- --------------------------------------------------------------------------------------------------------
L.R. Jalenak, Jr. $10,000 $0 $0 $10,000
Trustee
- --------------------------------------------------------------------------------------------------------
Larry W. Papasan $ 8,750 $0 $0 $ 8,750
Trustee
- --------------------------------------------------------------------------------------------------------
Richard C. Rantzow $10,000 $0 $0 $10,000
Trustee
- --------------------------------------------------------------------------------------------------------
</TABLE>
As of September 30, 1997, the officers and Trustees of the Trust owned less
than 1% of the outstanding shares of any Portfolio.
13
<PAGE>
INVESTMENT ADVISORY AGREEMENTS
The Growth & Income, Bond and Intermediate Bond Portfolios employ First
Tennessee Bank National Association, Memphis, Tennessee, to furnish
investment advisory and other services to each such Portfolio. Under the
Investment Advisory and Management Agreement with each such Portfolio, First
Tennessee is authorized to appoint one or more sub-advisers at First
Tennessee's expense. Highland Capital Management Corp., Memphis, Tennessee,
acts as Sub-Adviser to the Growth & Income and Bond Portfolios. Martin &
Company, Inc., Memphis, Tennessee, acts as Sub-Adviser to the Intermediate
Bond Portfolio. Subject to the direction of the Trustees and of First
Tennessee, the Sub-Advisers will direct the investments of these Portfolios
in accordance with their respective investment objective, policies and
limitations.
First Tennessee and Investment Advisers, Inc., Minneapolis, Minnesota, act as
Co-Advisers to the Capital Appreciation Portfolio. Subject to the direction
of the Trustees and monitoring by First Tennessee, IAI directs the
investments of this Portfolio in accordance with the Portfolio's investment
objective, policies and limitations.
In addition to First Tennessee's and IAI's fees and the fees payable to the
Transfer Agent, Pricing and Accounting Agent, and to the Administrator, each
Portfolio pays for all its expenses, without limitation, that are not assumed
by these parties. Each Portfolio pays for typesetting, printing and mailing
of proxy material to existing shareholders, legal expenses, and the fees of
the custodian, auditor and Trustees. Other expenses paid by each Portfolio
include: interest, taxes, brokerage commissions, the Portfolio's
proportionate share of insurance premiums and Investment Company Institute
dues, and costs of registering shares under federal and state securities
laws. Each Portfolio also is liable for such nonrecurring expenses as may
arise, including costs of litigation to which each Portfolio is a party, and
its obligation under the Declaration of Trust to indemnify its officers and
Trustees with respect to such litigation.
For managing the investment and business affairs of the Growth & Income,
Capital Appreciation, Bond and Intermediate Bond Portfolios, First Tennessee
is entitled to receive a monthly management fee at the annual rate of .65%,
.15%, .55% and .50% of each Portfolio's average net assets, respectively. For
the fiscal years ended June 30, 1997, 1996 and 1995, First Tennessee earned
$1,520,039, $1,076,198 and $686,850 from the Growth & Income Portfolio,
respectively, before waiving $350,778, $358,250 and $532,648 of its fees,
respectively. First Tennessee has voluntarily agreed to waive its fee to
.50%, .00%, .15% and .00% of the average net assets of the Growth & Income,
Capital Appreciation, Bond and Intermediate Bond Portfolios, respectively.
The fee waivers may be discontinued at any time. For the fiscal years ended
June 30, 1997, 1996 and 1995, First Tennessee earned $658,049, $563,748 and
$447,309 from the Bond Portfolio, respectively, before waiving $478,581,
$482,559 and $447,309 of its fees, respectively. The Capital Appreciation and
Intermediate Bond Portfolios had not commenced operations as of June 30, 1997.
Under its Investment Advisory and Management Agreement with each of the
Growth & Income, Bond and Intermediate Bond Portfolios, First Tennessee is
authorized, at its own expense, to hire sub-advisers to provide investment
advice to each such Portfolio. As Sub-Adviser, Highland is entitled to
receive from First Tennessee a monthly sub-advisory fee at the annual rate of
.38% of Growth & Income Portfolio's average net assets and .33% of Bond
Portfolio's average net assets. As Sub-Adviser, Martin is entitled to receive
from First Tennessee a monthly sub-advisory fee at the annual rate of .30% of
Intermediate Bond Portfolio's average net assets. As Co-Adviser to the
Capital Appreciation Portfolio, IAI is entitled to receive .70% of that
Portfolio's average net assets up to $50 million and .65% thereafter. Under
the terms of each sub-advisory agreement with First Tennessee and IAI's
Investment Advisory and Management Agreement with the Trust, the
Sub-Advisers, subject to the supervision of First Tennessee, and IAI
supervise the day-to-day operations of their respective Portfolios and
provide investment research and credit analysis concerning their respective
Portfolios' investments, conduct a continual program of investment of their
respective Portfolios' assets and maintain the books and records required in
connection with their duties under their advisory agreements. In addition,
the Sub-Advisers and IAI keep First Tennessee informed of the developments
materially affecting each Portfolio. The Sub-Advisers are currently waiving
some or all of the fees they are entitled to receive from First Tennessee.
ADMINISTRATION AGREEMENT AND OTHER CONTRACTS
ADMINISTRATOR AND DISTRIBUTOR. ALPS Mutual Funds Services, Inc. (ALPS, the
Administrator and Distributor), is the Administrator and Distributor to each
Portfolio. ALPS, a Colorado corporation, is a broker-dealer registered under
the Securities Exchange Act of 1934 and a member of the National Association
of Securities Dealers, Inc.
As the Administrator, ALPS assists in each Portfolio's administration and
operation, including, but not limited to, providing office space and various
legal and accounting services in connection with the regulatory requirements
applicable to each Portfolio. ALPS is entitled to and receives from each
Portfolio a monthly fee at the annual rate of .15% of average net assets.
For the fiscal years ended June 30, 1997 and 1996, ALPS earned administration
fees in the amount of $350,778 and $248,353 from the Growth & Income
Portfolio. For the fiscal years ended June 30, 1997 and 1996, ALPS earned
administration fees in the amount of $179,468 and $153,749 from the Bond
Portfolio, respectively. The Capital Appreciation and Intermediate Bond
Portfolios had not commenced operations as of June 30, 1997. For the fiscal
year ended June 30, 1995, National Financial Services Corporation (NFSC)
14
<PAGE>
served as the Administrator and Distributor for the Growth & Income and Bond
Portfolios. As Administrator, NFSC earned fees from each Portfolio computed
daily and payable monthly at an annual rate of .20% of average net assets
through $100 million, .15% above $100 million and through $200 million, and
.10% over $200 million. For the fiscal year ended June 30, 1995, NFSC earned
administration fees in the amount of $208,504 and $162,658 from the Growth &
Income Portfolio and the Bond Portfolio, respectively.
First Tennessee serves as the Co-Administrator for each Portfolio. As the
Co-Administrator, First Tennessee assists in each Portfolio's operation,
including, but not limited to, providing non-investment related research and
statistical data and various operational and administrative services. First
Tennessee is entitled to receive from each Portfolio a monthly fee at the
annual rate of .05% of average net assets. For the fiscal years ended June
30, 1997 and 1996, First Tennessee earned co-administration fees in the
amount of $116,926 and $82,965 from the Growth & Income Portfolio,
respectively before waiving $0 and $34,639 of its fees, respectively. For
the fiscal years ended June 30, 1997 and 1996, First Tennessee earned
co-administration fees in the amount of $59,823 and $51,198 from the Bond
Portfolio, respectively, before waiving $0 and $23,882, respectively.
As the Distributor, ALPS sells shares of Class I as agent on behalf of the
Trust at no additional cost to the Trust. Class III is obligated to pay ALPS
monthly a 12b-1 fee at the annual rate of .75% of average net assets, all or
a portion of which may be paid out to broker-dealers or others involved in
the distribution of Class III shares. See "Administration Agreements and
contracts -Distribution Plan." Classes II and III pay shareholder servicing
fees to Investment Professionals at an annual rate of .25% of average net
assets as more fully described under the section "Administration Agreements
and Other Contracts - Shareholder Services Plans". First Tennessee and its
affiliates neither participate in nor are responsible for the underwriting of
Portfolio shares. Consistent with applicable law, affiliates of First
Tennessee may receive commissions or asset-based fees.
TRANSFER AGENT, FUND ACCOUNTING AND CUSTODIAN. Chase Global Funds Services
Company (CGFSC or the Transfer Agent), provides transfer agent and
shareholder services for each Portfolio, and calculates the NAV and dividends
of each Class of each Portfolio and maintains the portfolio and general
accounting records. For such services, CGFSC is entitled to receive from each
Class of each Portfolio, fees at the annual rate of .07% of each Class'
average net assets through $50 million and .05% over $50 million plus
out-of-pocket expenses. Chase Manhattan Bank (Chase or the Custodian) is
Custodian of the assets of the Portfolios. The Custodian is responsible for
the safekeeping of the Portfolio's assets and the appointment of
sub-custodian banks and clearing agencies. For such services, Chase is
entitled to receive from each Portfolio fees at the annual rate of .018% of
average net assets plus out-of-pocket expenses. The Custodian takes no part
in determining the investment policies of the Portfolios or in deciding which
securities are purchased or sold by the Portfolios. The Portfolios, however,
may invest in obligations of the Custodian and may purchase securities from
or sell securities to the Custodian.
DISTRIBUTION PLAN. The Trustees of the Trust have adopted a Distribution
Plan on behalf of Class III of each Portfolio (each Class III Plan) pursuant
to Rule 12b-1 (the Rule) under the 1940 Act. The Rule provides in substance
that a mutual fund may not engage directly or indirectly in financing any
activity that is intended primarily to result in the sale of shares of the
fund except pursuant to a plan adopted by the fund under the Rule. The
Trustees have adopted the Plans to allow each class and ALPS to incur
distribution expenses. ALPS receives a Distribution and Service fee (12b-1
fee) of up to 0.75% of the average net assets of Class III of each Portfolio.
(These fees are in addition to the fees paid to ALPS under the
Administration Agreement.) The Trust or ALPS, on behalf of Class III of each
Portfolio, may enter into servicing agreements (Service Agreements) with
banks, broker-dealers or other institutions (Agency Institutions). Each
Class III Plan provides that ALPS may use its fees and other resources to
make payments to Agency Institutions for performance of distribution-related
services, including those enumerated above. The Service Agreements further
provide for compensation to broker-dealers for their efforts to sell Class
III shares. The distribution-related services include, but are not limited
to, the following: formulation and implementation of marketing and
promotional activities, such as mail promotions and television, radio,
newspaper, magazine and other mass media advertising; preparation, printing
and distribution of sales literature; preparation, printing and distribution
of prospectuses of each Portfolio and reports to recipients other than
existing shareholders of each Portfolio; obtaining such information, analyzes
and reports with respect to marketing and promotional activities as ALPS may
from time to time, deem advisable; making payments to securities dealers and
others engaged in the sales of Class III Shares; and providing training,
marketing and support to such dealers and others with respect to the sale of
Class III Shares. Each Class III Plan recognizes ALPS may use its fees and
other resources to pay expenses associated with the promotion and
administration of activities primarily intended to result in the sale of
shares.
Each Plan has been approved by the Trustees, including the majority of
disinterested Trustees. As required by the Rule, the Trustees carefully
considered all pertinent factors relating to the implementation of the Plans
prior to its approval, and have determined that there is a reasonable
likelihood that each Plan will benefit each Portfolio and its shareholders.
To the extent that the Class III Plans give ALPS greater flexibility in
connection with the distribution of shares of the class, additional sales of
shares may result.
The Class III Plans could be construed as compensation plans because ALPS is
paid a fixed fee and is given discretion concerning what expenses are payable
under the Plans. ALPS may spend more for marketing and distribution than it
receives in fees and reimbursements from each Portfolio. However, to the
extent fees received exceed expenses, including indirect expenses such as
overhead, ALPS could be said to have received a profit. For example, if ALPS
pays $1 for Class III distribution-related expenses and receives $2 under a
Class III Plan, the $1 difference could be said to be a profit for ALPS.
(Because ALPS is reimbursed for its out-of-pocket direct promotional
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<PAGE>
expenses, a Class III Plan also could be construed as a reimbursement plan.
Until the issue is resolved by the SEC, unreimbursed expenses incurred in one
year will not be carried over to a subsequent year.) If after payments by
ALPS for marketing and distribution there are any remaining fees attributable
to a Class III Plan, these may be used as ALPS may elect. Since the amount
payable under a Class III Plan will be commingled with ALPS's general funds,
including the revenues it receives in the conduct of its business, it is
possible that certain of ALPS's overhead expenses will be paid out of Plan
fees and that these expenses may include items such as the costs of leases,
depreciation, communications, salaries, training and supplies. Each
Portfolio believes that such expenses, if paid, will be paid only indirectly
out of the fees being paid under the Plan.
For the fiscal year ended June 30, 1997, Class III of the Growth & Income
Portfolio and the Bond Portfolio paid distribution fees in the amounts of
$314,518 and $21,842, respectively. All of these fees were paid as
compensation to dealers. The Capital Appreciation and Bond Portfolios had
not commenced operations as of June 30, 1997.
SHAREHOLDER SERVICES PLANS. In addition to the Rule 12b-1 Distribution Plans
described above, Class II and Class III have adopted Shareholder Services
Plans to compensate Agency Institutions for individual shareholder services
and account maintenance. These functions include: maintaining account
records for each shareholder who beneficially owns Class II or Class III
Shares; answering questions and handling correspondence from shareholders
about their accounts; handling the transmission of funds representing the
purchase price or redemption proceeds; issuing confirmations for transactions
in Class II or Class III Shares by shareholders; assisting customers in
completing application forms; communicating with the transfer agent; and
providing account maintenance and account level support for all transactions.
For these services the participating Agency Institutions are paid a service
fee at the annual rate of up to .25% of average net assets of Class II and
Class III.
For the fiscal year ended June 30, 1997, the Growth & Income Portfolio and
the Bond Portfolio paid shareholder servicing fees in the following amounts
(the Capital Appreciation and Intermediate Bond Portfolios had not commenced
operations as of June 30, 1997):
<TABLE>
<CAPTION>
GROWTH & INCOME BOND
PORTFOLIO PORTFOLIO
--------------- ---------
<S> <C> <C>
Class II $ 17,386 $1,260
Class III $104,839 $7,281
</TABLE>
Banking laws and regulations, including the Glass-Steagall Act as currently
interpreted by the Board of Governors of the Federal Reserve System, prohibit
a bank holding company registered under the Bank Holding Company Act of 1956
or any affiliate thereof from sponsoring, organizing, controlling, or
distributing the shares of a registered, open-end investment company
continuously engaged in the issuance of its shares and prohibit banks
generally from issuing, underwriting, selling or distributing securities.
The same laws and regulations generally permit a bank or bank affiliate to
act as an investment adviser and co-administrator and to purchase shares of
the investment company as agent for and upon the order of a customer. In the
Trust's and Investment Adviser's opinion, banks and their affiliates may be
paid for investment advisory, shareholder servicing, recordkeeping and
co-administration functions. Changes in federal or state statutes and
regulations pertaining to the permissible activities of banks and their
affiliates or subsidiaries, as well as further judicial or administrative
decisions or interpretations, could prevent a bank from continuing to perform
all or a part of the contemplated services. If a bank or its affiliates were
prohibited from so acting, the Trustees would consider what actions, if any,
would be necessary to continue to provide efficient and effective shareholder
services. In such event, changes in the operation of the Portfolios might
occur, including possible termination of any automatic investment or
redemption or other services then being provided by any bank. It is not
expected that shareholders would suffer any adverse financial consequences as
a result of any of these occurrences. The Portfolios may execute portfolio
transactions with and purchase securities issued by depository institutions
that receive payments under the Plans. No preference will be shown in the
selection of investments for the instruments of such depository institutions.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein, and banks and other
financial institutions may be required to register as dealers pursuant to
state law.
DESCRIPTION OF THE TRUST
TRUST ORGANIZATION. Growth & Income Portfolio and Bond Portfolio are
Portfolios of First Funds (formerly The Masters Group of Mutual Funds), an
open-end management investment company organized as a Massachusetts business
trust by a Declaration of Trust dated March 6, 1992, as amended and restated
on September 4, 1992. The Declaration of Trust permits the Trustees to
create additional Portfolios and Classes. There are nine Portfolios of the
Trust, each with three Classes.
The assets of the Trust received for the issue or sale of shares of each
Portfolio and all income, earnings, profits, and proceeds thereof, subject
only to the rights of creditors, are specially allocated to such Portfolio,
and constitute the underlying assets of such Portfolio. The underlying assets
of each Portfolio are segregated on the books of account, and are to be
charged with the liabilities with respect to such Portfolio and with a share
of the general expenses of the Trust. Expenses with respect to the Trust are
to be allocated in proportion to the asset value of the respective Portfolios
except where allocations of direct expense can otherwise be fairly made. The
officers of the
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Trust, subject to the general supervision of the Trustees, have the power to
determine which expenses are allocable to a given Portfolio, or which are
general or allocable to all of the Portfolios. In the event of the
dissolution or liquidation of the Trust, shareholders of a Portfolio are
entitled to receive as a class the underlying assets of such Portfolio
available for distribution.
SHAREHOLDER AND TRUSTEE LIABILITY. The Trust is an entity of the type
commonly known as a "Massachusetts business trust." Under Massachusetts law,
shareholders of such a trust may, under certain circumstances, be held
personally liable for the obligations of the trust. The Declaration of Trust
provides that the Trust shall not have any claim against shareholders except
for the payment of the purchase price of shares and requires that each
agreement, obligation, or instrument entered into or executed by the Trust or
the Trustees shall include a provision limiting the obligations created
thereby to the Trust and its assets. The Declaration of Trust provides for
indemnification out of each Portfolio's property of any shareholders held
personally liable for the obligations of each Portfolio. The Declaration of
Trust also provides that each Portfolio shall, upon request, assume the
defense of any claim made against any shareholder for any act or obligation
of a Portfolio and satisfy any judgment thereon. Thus, the risk of a
shareholder incurring financial loss on account of shareholder liability is
limited to circumstances in which the Portfolio itself would be unable to
meet its obligations. The Trustees believe that, in view of the above, the
risk of personal liability to shareholders is remote.
The Declaration of Trust further provides that the Trustees, if they have
exercised reasonable care, will not be liable for any neglect or wrongdoing,
but nothing in the Declaration of Trust protects a Trustee against any
liability to which he would otherwise be subject by reason of willful
misfeasance, bad faith, gross negligence, or reckless disregard of the duties
involved in the conduct of his office.
As of September 30, 1997, the following shareholders owned more than 5% of
the outstanding shares of the indicated Class of the Portfolios:
<TABLE>
<CAPTION>
NAME AND ADDRESS PORTFOLIO CLASS % OF CLASS HELD
- ---------------- --------- ----- ---------------
<S> <C> <C> <C>
First Tennessee National Corp. Growth & Income I 47%
D/B Pension Plan Bond I 57%
Memphis, TN Capital Appreciation I 92%
First Tennessee National Corp. Growth & Income I 10%
401K Savings - Fund A Bond I 6%
Memphis, TN Capital Appreciation I 6%
Memphis Commerce Square Growth & Income II 13%
FBO National Bank of Commerce
Memphis, TN
Giobbi Turner Trust #1 Bond II 26%
1277 East Massey
Memphis, TN 38120
Janet Forbes Misner Trust Bond II 20%
76 Walnut Grove Circle
Memphis, TN 38117
Harvey B. Jackson, IRT Bond II 16%
4274 Fox Race Cv.
Memphis, TN 38141
Bank of Bolivar County PS Fixed Bond II 12%
P.O. Box 88
Shelby, MS 38774
James G. Wills Rollover IRA Bond II 11%
241 Sea Marsh Drive
Kiawah Island, SC 29455
Charles S. Hughs Rollover IRT Bond II 10%
P.O. Box 771596
Memphis, TN 38177
The Smith Trust Bond II 6%
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
NAME AND ADDRESS PORTFOLIO CLASS % OF CLASS HELD
- ---------------- --------- ----- ---------------
<S> <C> <C> <C>
Joe G. Bagwell, Trustee
8560 Kingston Pike Ste C-202
Knoxville, TN 38919
Effie W. Porter and Bond II 5%
Leslie F. Heun, JT TEN
6920 Amberly Rd.
Memphis, TN 38119
</TABLE>
VOTING RIGHTS. Each Portfolio's capital consists of shares of beneficial
interest. The shares have no preemptive or conversion rights; the voting and
dividend rights, the right of redemption, and the privilege of exchange are
described in the Prospectus. Shares are fully paid and nonassessable, except
as set forth under the heading "Shareholder and Trustee Liability" above.
Shareholders representing 10% or more of the Trust or a Portfolio may, as set
forth in the Declaration of Trust, call meetings of the Trust or a Portfolio
for any purpose related to the Trust or Portfolio, as the case may be,
including, in the case of a meeting of the entire Trust, the purpose of
voting on removal of one or more Trustees. The Trust or any Portfolio may be
terminated upon the sale of its assets to another open-end management
investment company, or upon liquidation and distribution of its assets, if
approved by vote of the holders of a majority of the outstanding shares of
the Trust or that Portfolio. If not so terminated, the Trust and each
Portfolio will continue indefinitely.
CLASSES. Pursuant to the Declaration of Trust, the Trustees have authorized
additional Classes of shares for each Portfolio of the Trust. Although the
investment objective for each separate Class of a particular Portfolio is the
same, fee structures are different such that one Class may have a higher
yield than another Class of the same Portfolio at any particular time.
Shareholders of the Trust will vote together in the aggregate and not
separately by Portfolio, or by Class thereof, except as otherwise required by
law or when the Trustees determine that the matter to be voted upon affects
only the interests of the shareholders of a particular Portfolio or a Class
thereof. Pursuant to a vote by the Board of Trustees, the Trust has adopted
Rule 18f-3 under the Act and has issued multiple Classes of shares with
respect to each of its Portfolios. Accordingly, the rights, privileges and
obligations of each such Class will be determined in accordance with such
rule.
INDEPENDENT ACCOUNTANTS. Price Waterhouse LLP, 160 Federal Street, Boston,
Massachusetts, serves as the Trust's independent accountant. The independent
accountant examines the annual financial statements for the Trust and
provides other audit, tax, and related services.
FINANCIAL STATEMENTS
The Growth & Income and Bond Portfolios' financial statements and financial
highlights for the fiscal year ended June 30, 1997 and the six months ended
December 31, 1997 are included in the Trust's Annual and Semi-Annual Reports,
respectively, which are separate reports supplied independently of this
Statement of Additional Information. The Capital Appreciation Portfolio's
unaudited financial statements and financial highlights for the six months
ended December 31, 1997 are included in the Trusts's Semi-Annual Report. The
Intermediate Bond Portfolio had not commenced operations as of December 31,
1997. The Growth & Income, Capital Appreciation and Bond Portfolios'
financial statements and financial highlights are incorporated herein by
reference.
APPENDIX
DOLLAR-WEIGHTED AVERAGE MATURITY for Bond Portfolio is derived by multiplying
the value of each investment by the number of days remaining to its maturity,
adding these calculations, and then dividing the total by the value of the
Portfolio. An obligation's maturity is typically determined on a stated
final maturity basis, although there are some exceptions to this rule.
For example, if it is probable that the issuer of an instrument will take
advantage of a maturity-shortening device, such as a call, refunding, or
redemption provision, the date on which the instrument will probably be
called, refunded, or redeemed may be considered to be its maturity date.
Also, the maturities of mortgage-backed securities and some asset-backed
securities, such as collateralized mortgage obligations, are determined on a
weighted average life basis, which is the average time for principal to be
repaid. For a mortgage security, this average time is calculated by assuming
a constant prepayment rate for the life of the mortgage. The weighted
average life of these securities is likely to be substantially shorter than
their stated final maturity.
DESCRIPTION OF MOODY'S INVESTORS SERVICE, INC.'S CORPORATE BOND RATINGS:
AAA - Bonds rated Aaa are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edge." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements
are likely to change, such changes as can be visualized are most unlikely to
impair the fundamentally strong position of such issues.
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<PAGE>
Aa - Bonds rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as
high-grade bonds. They are rated lower than the best bonds because margins of
protections may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other
elements present which make the long-term risks appear somewhat larger than
Aaa securities.
A - Bonds rated A possess many favorable investment attributes and are to be
considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present
which suggest a susceptibility to impairment sometime in the future.
Baa - Bonds rated Baa are considered as medium-grade obligations, i.e., they
are neither highly protected nor poorly secured. Interest payments and
principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any
great length of time. Such bonds lack outstanding investment characteristics
and in fact have speculative characteristics as well.
Moody's applies numerical modifiers, 1, 2, and 3, in each generic rating
classification from Aa through Baa in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates that the issue ranks in the lower end of its generic
rating category.
DESCRIPTION OF STANDARD & POOR'S CORPORATION'S CORPORATE BOND RATINGS:
AAA - Debt rated AAA has the highest rating assigned by Standard & Poor's to
a debt obligation. Capacity to pay interest and repay principal is extremely
strong.
AA - Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest-rated debt issues only in small degree.
A - Debt rated A has a strong capacity to pay interest and repay principal,
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB - Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate
protection parameters, adverse economic conditions or changing circumstances
are more likely to lead to a weakened capacity to pay interest and repay
principal for debt in this category than in highest-rated categories.
The ratings from AA to BBB may be modified by the addition of a plus or minus
to show relative standing within the major rating categories.
19
