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NICHOLAS-APPLEGATE-Registered Trademark- MUTUAL FUNDS
CLASS Q (ADVISORY FUND) SHARES
600 West Broadway, 30th Floor
San Diego, California 92101
(800) 551-8643
STATEMENT OF ADDITIONAL INFORMATION
July 24, 1998
Nicholas-Applegate Mutual Funds (the "Trust") is an open-end management
investment company currently offering a number of separate diversified funds.
This Statement of Additional Information contains information regarding the
Class Q shares of these funds and the Class I shares of the Mini Cap Growth Fund
(defined below) (each a "Fund" and collectively the "Funds"):
Nicholas-Applegate International Core Growth Fund (the "International Core
Growth Fund"); Nicholas-Applegate Worldwide Growth Fund (the "Worldwide Growth
Fund"); Nicholas-Applegate International Small Cap Growth Fund (the
"International Small Cap Growth Fund"); Nicholas-Applegate Emerging Countries
Fund (the "Emerging Countries Fund"); Nicholas-Applegate Large Cap Growth Fund
(the "Large Cap Fund"); Nicholas-Applegate Mid Cap Growth Fund (the "Mid Cap
Growth Fund"); Nicholas-Applegate Value Fund (the "Value Fund");
Nicholas-Applegate Small Cap Growth Fund (the "Small Cap Growth Fund");
Nicholas-Applegate Mini Cap Growth Fund (the "Mini Cap Growth Fund");
Nicholas-Applegate Convertible Fund (the "Convertible Fund"); Nicholas-Applegate
Balanced Growth Fund (the "Balanced Fund"); Nicholas-Applegate High Quality Bond
Fund (the "High Quality Bond Fund"); and Nicholas-Applegate High Yield Bond Fund
(the "High Yield Bond Fund").
The Class Q shares of the various Funds of the Trust and the Class I shares
of the Mini Cap Growth Fund may from time to time be collectively referred to as
the "Nicholas-Applegate Advisory Shares."
This Statement of Additional Information is not a prospectus, but contains
information in addition to and more detailed than that set forth in the Funds'
Prospectus and should be read in conjunction with such Prospectus. The
Prospectus may be obtained without charge by calling or writing the Trust at the
address and phone number written above.
TABLE OF CONTENTS
Page
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General Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . B-2
Investment Objectives, Policies and Risks. . . . . . . . . . . . . . . . . B-2
Investment Restrictions. . . . . . . . . . . . . . . . . . . . . . . . . .B-27
Principal Holders of Securities. . . . . . . . . . . . . . . . . . . . . .B-29
Trustees and Principal Officers. . . . . . . . . . . . . . . . . . . . . .B-30
Investment Adviser . . . . . . . . . . . . . . . . . . . . . . . . . . . .B-32
Administrator. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .B-34
Distributor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .B-35
Portfolio Transactions and Brokerage . . . . . . . . . . . . . . . . . . .B-36
Purchase and Redemption of Fund Shares . . . . . . . . . . . . . . . . . .B-38
Shareholder Services . . . . . . . . . . . . . . . . . . . . . . . . . . .B-38
Net Asset Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .B-40
Dividends, Distributions and Taxes . . . . . . . . . . . . . . . . . . . .B-41
Performance Information. . . . . . . . . . . . . . . . . . . . . . . . . .B-45
Custodian, Transfer and Dividend Disbursing Agent,
Independent Auditors and Legal Counsel . . . . . . . . . . . . . . . . .B-50
Miscellaneous. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .B-51
Appendix A - Description of Securities Ratings . . . . . . . . . . . . . . A-1
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GENERAL INFORMATION
The Trust was organized in December 1992 as a business trust under the laws
of Delaware. Information regarding 13 Funds of the Trust is included in this
Statement of Additional Information. Each of the Funds consists of more one or
more classes of shares, including Class Q shares which are the subject of this
Statement of Additional Information.
Prior to a reorganization of the Trust which became effective on
July 24, 1998 (the "Reorganization"), the Trust offered shares in a number of
separate diversified portfolios each of which invested all of its assets in a
corresponding master fund of Nicholas-Applegate Investment Trust (the "Master
Trust"). The Reorganization eliminated this two-tiered "master-feeder"
structure.
INVESTMENT OBJECTIVES, POLICIES AND RISKS
The following discussion describes the various investment policies and
techniques employed by the Funds. There can be no assurance that any of the
Funds will achieve their investment objectives.
EQUITY SECURITIES OF GROWTH COMPANIES
Each Fund may invest in equity securities of domestic and foreign
companies, the earnings and stock prices of which are expected by the Investment
Adviser to grow at an above-average rate. Such investments will be diversified
over a cross-section of industries and individual companies. Examples of
possible investments include emerging growth companies employing new technology,
cyclical companies, initial public offerings of companies offering high growth
potential, or other corporations offering good potential for high growth in
market value. The securities of such companies may be subject to more abrupt or
erratic market movements than larger, more established companies both because
the securities typically are traded in lower volume and because the issuers
typically are subject to a greater degree to changes in earnings and prospects.
PREFERRED STOCK
Each Fund may invest in preferred stock. Preferred stock, unlike common
stock, offers a stated dividend rate payable from a corporation's earnings.
Such preferred stock dividends may be cumulative or non-cumulative,
participating, or auction rate. If interest rates rise, the fixed dividend on
preferred stocks may be less attractive, causing the price of preferred stocks
to decline. Preferred stock may have mandatory sinking fund provisions, as well
as call/redemption provisions prior to maturity, a negative feature when
interest rates decline. Dividends on some preferred stock may be "cumulative,"
requiring all or a portion of prior unpaid dividends to be paid before dividends
are paid on the issuer's common stock. Preferred stock also generally has a
preference over common stock on the distribution of a corporation's assets in
the event of liquidation of the corporation, and may be "participating," which
means that it may be entitled to a dividend exceeding the stated dividend in
certain cases. The rights of preferred stocks on the distribution of a
corporation's assets in the event of a liquidation are generally subordinate to
the rights associated with a corporation's debt securities.
CONVERTIBLE SECURITIES AND WARRANTS
Each Fund may invest in convertible securities and warrants. The value of
a convertible security is a function of its "investment value" (determined by
its yield in comparison with the yields of other securities of comparable
maturity and quality that do not have a conversion privilege) and its
"conversion value" (the security's worth, at market value, if converted into the
underlying common stock). The credit standing of the issuer and other factors
may also affect the investment value of a convertible security. The conversion
value of a convertible security is determined by the market price of the
underlying common stock. If the conversion value is low relative to the
investment value, the price of the convertible security is governed principally
by its investment value. To the extent the
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market price of the underlying common stock approaches or exceeds the conversion
price, the price of the convertible security will be increasingly influenced by
its conversion value.
The market value of convertible debt securities tends to vary inversely
with the level of interest rates. The value of the security declines as
interest rates increase and increases as interest rates decline. Although under
normal market conditions longer term debt securities have greater yields than do
shorter term debt securities of similar quality, they are subject to greater
price fluctuations. A convertible security may be subject to redemption at the
option of the issuer at a price established in the instrument governing the
convertible security. If a convertible security held by a Fund is called for
redemption, the Fund must permit the issuer to redeem the security, convert it
into the underlying common stock or sell it to a third party. Rating
requirements do not apply to convertible debt securities purchased by the Funds
because the Funds purchase such securities for their equity characteristics.
As a matter of operating policy, no Fund will invest more than 5% of its
net assets in warrants. A warrant gives the holder a right to purchase at any
time during a specified period a predetermined number of shares of common stock
at a fixed price. Unlike convertible debt securities or preferred stock,
warrants do not pay a fixed dividend. Investments in warrants involve certain
risks, including the possible lack of a liquid market for resale of the
warrants, potential price fluctuations as a result of speculation or other
factors, and failure of the price of the underlying security to reach or have
reasonable prospects of reaching a level at which the warrant can be prudently
exercised (in which event the warrant may expire without being exercised,
resulting in a loss of the Fund's entire investment therein).
SYNTHETIC CONVERTIBLE SECURITIES
Each Fund may invest in "synthetic" convertible securities, which are
derivative positions composed of two or more different securities whose
investment characteristics, taken together, resemble those of convertible
securities. For example, a Fund may purchase a non-convertible debt security
and a warrant or option, which enables the Fund to have a convertible-like
position with respect to a company, group of companies or stock index.
Synthetic convertible securities are typically offered by financial institutions
and investment banks in private placement transactions. Upon conversion, a Fund
generally receives an amount in cash equal to the difference between the
conversion price and the then current value of the underlying security. Unlike
a true convertible security, a synthetic convertible comprises two or more
separate securities, each with its own market value. Therefore, the market
value of a synthetic convertible is the sum of the values of its fixed-income
component and its convertible component. For this reason, the values of a
synthetic convertible and a true convertible security may respond differently to
market fluctuations. A Fund only invests in synthetic convertibles with respect
to companies whose corporate debt securities are rated "A" or higher by Moody's
or "A" or higher by S&P and will not invest more than 15% of its net assets in
such synthetic securities and other illiquid securities.
EURODOLLAR CONVERTIBLE SECURITIES
Each Fund may invest in Eurodollar convertible securities, which are
fixed-income securities of a U.S. issuer or a foreign issuer that are issued
outside the United States and are convertible into equity securities of the same
or a different issuer. Interest and dividends on Eurodollar securities are
payable in U.S. dollars outside of the United States. Each Fund may invest
without limitation in Eurodollar convertible securities that are convertible
into foreign equity securities listed, or represented by ADRs listed, on the New
York Stock Exchange or the American Stock Exchange or convertible into publicly
traded common stock of U.S. companies. Each Fund may also invest up to 15% of
its total assets invested in convertible securities, taken at market value, in
Eurodollar convertible securities that are convertible into foreign equity
securities which are not listed, or represented by ADRs listed, on such
exchanges.
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EURODOLLAR AND YANKEE DOLLAR INSTRUMENTS
Each Fund may invest in Eurodollar and Yankee Dollar instruments.
Eurodollar instruments are bonds that pay interest and principal in U.S. dollars
held in banks outside the United States, primarily in Europe. Eurodollar
instruments are usually issued on behalf of multinational companies and foreign
governments by large underwriting groups composed of banks and issuing houses
from many countries. Yankee Dollar instruments are U.S. Dollar denominated
bonds issued in the U.S. by foreign banks and corporations. These investments
involve risks that are different from investments in securities issued by U.S.
issuers. See "Foreign Investment Considerations."
RISKS OF INVESTING IN DEBT SECURITIES
There are a number of risks generally associated with an investment in debt
securities (including convertible securities). Yields on short, intermediate,
and long-term securities depend on a variety of factors, including the general
condition of the money and bond markets, the size of a particular offering, the
maturity of the obligation, and the rating of the issue. Debt securities with
longer maturities tend to produce higher yields and are generally subject to
potentially greater capital appreciation and depreciation than obligations with
short maturities and lower yields.
Securities with ratings below "Baa" and/or "BBB" are commonly referred to
as "junk bonds." Such bonds are subject to greater market fluctuations and risk
of loss of income and principal than higher rated bonds for a variety of
reasons, including the following:
SENSITIVITY TO INTEREST RATE AND ECONOMIC CHANGES. The economy and
interest rates affect high yield securities differently from other securities.
For example, the prices of high yield bonds have been found to be less sensitive
to interest rate changes than higher-rated investments, but more sensitive to
adverse economic changes or individual corporate developments. Also, during an
economic downturn or substantial period of rising interest rates, highly
leveraged issuers may experience financial stress which would adversely affect
their ability to service their principal and interest obligations, to meet
projected business goals, and to obtain additional financing. If the issuer of
a bond defaults, a Fund may incur additional expenses to seek recovery. In
addition, periods of economic uncertainty and changes can be expected to result
in increased volatility of market prices of high yield bonds and each Fund's
asset values.
PAYMENT EXPECTATIONS. High yield bonds present certain risks based on
payment expectations. For example, high yield bonds may contain redemption and
call provisions. If an issuer exercises these provisions in a declining interest
rate market, a Fund would have to replace the security with a lower yielding
security, resulting in a decreased return for investors. Conversely, a high
yield bond's value will decrease in a rising interest rate market, as will the
value of the Fund's assets. If a Fund experiences unexpected net redemptions,
it may be forced to sell its high yield bonds without regard to their investment
merits, thereby decreasing the asset base upon which the Fund's expenses can be
spread and possibly reducing the Fund's rate of return.
LIQUIDITY AND VALUATION. To the extent that there is no established retail
secondary market, there may be thin trading of high yield bonds. This may
impact an Investment Adviser's ability to accurately value high yield bonds and
the Funds' assets and hinder the Funds' ability to dispose of the bonds.
Adverse publicity and investor perceptions, whether or not based on fundamental
analysis, may decrease the values and liquidity of high yield bonds, especially
in a thinly traded market.
CREDIT RATINGS. Credit ratings evaluate the safety of principal and
interest payments, not the market value risk of high yield bonds. The rating of
an issuer is also heavily weighted by past developments and does not necessarily
reflect probable future conditions. There is frequently a lag between the time
a rating is assigned and the time it is updated. Also, since credit rating
agencies may fail to timely change the credit ratings to reflect subsequent
events, the Investment Adviser must monitor the issuers of high yield bonds in
the Funds' portfolios to determine if the issuers will have
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sufficient cash flow and profits to meet required principal and interest
payments, and to assure the bonds' liquidity so the Funds can meet redemption
requests.
SHORT-TERM INVESTMENTS
Each Fund may invest in any of the following securities and instruments:
BANK CERTIFICATES OF DEPOSIT, BANKERS' ACCEPTANCES AND TIME DEPOSITS. The
Funds may acquire certificates of deposit, bankers' acceptances and time
deposits. Certificates of deposit are negotiable certificates issued against
funds deposited in a commercial bank for a definite period of time and earning a
specified return. Bankers' acceptances are negotiable drafts or bills of
exchange, normally drawn by an importer or exporter to pay for specific
merchandise, which are "accepted" by a bank, meaning in effect that the bank
unconditionally agrees to pay the face value of the instrument on maturity.
Certificates of deposit and bankers' acceptances acquired by the Funds will be
dollar-denominated obligations of domestic or foreign banks or financial
institutions which at the time of purchase have capital, surplus and undivided
profits in excess of $100 million (including assets of both domestic and foreign
branches), based on latest published reports, or less than $100 million if the
principal amount of such bank obligations are fully insured by the U.S.
Government.
A Fund holding instruments of foreign banks or financial institutions may
be subject to additional investment risks that are different in some respects
from those incurred by a fund which invests only in debt obligations of U.S.
domestic issuers. See "Foreign Investments" below. Domestic banks and foreign
banks are subject to different governmental regulations with respect to the
amount and types of loans which may be made and interest rates which may be
charged. In addition, the profitability of the banking industry depends largely
upon the availability and cost of funds for the purpose of financing lending
operations under prevailing money market conditions. General economic conditions
as well as exposure to credit losses arising from possible financial
difficulties of borrowers play an important part in the operations of the
banking industry. Federal and state laws and regulations require domestic banks
to maintain specified levels of reserves, limited in the amount which they can
loan to a single borrower, and subject to other regulations designed to promote
financial soundness. However, such laws and regulations do not necessarily
apply to foreign bank obligations that a Fund may acquire.
In addition to purchasing certificates of deposit and bankers' acceptances,
to the extent permitted under their respective investment objectives and
policies stated above and in their Prospectuses, the Funds may make
interest-bearing time or other interest-bearing deposits in commercial or
savings banks. Time deposits are non-negotiable deposits maintained at a
banking institution for a specified period of time at a specified interest rate.
SAVINGS ASSOCIATION OBLIGATIONS. The Funds may invest in certificates of
deposit (interest-bearing time deposits) issued by savings banks or savings and
loan associations that have capital, surplus and undivided profits in excess of
$100 million, based on latest published reports, or less than $100 million if
the principal amount of such obligations is fully insured by the U.S.
Government.
COMMERCIAL PAPER, SHORT-TERM NOTES AND OTHER CORPORATE OBLIGATIONS. The
Funds may invest a portion of their assets in commercial paper and short-term
notes. Commercial paper consists of unsecured promissory notes issued by
corporations. Issues of commercial paper and short-term notes will normally
have maturities of less than nine months and fixed rates of return, although
such instruments may have maturities of up to one year.
Commercial paper and short-term notes will consist of issues rated at the
time of purchase "A-2" or higher by S&P, "Prime-l" or "Prime-2" by Moody's, or
similarly rated by another nationally recognized statistical rating organization
or, if unrated, will be determined by the Investment Adviser to be of comparable
quality. These rating symbols are described in Appendix A.
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Corporate obligations include bonds and notes issued by corporations to
finance longer-term credit needs than supported by commercial paper. While such
obligations generally have maturities of ten years or more, the Funds may
purchase corporate obligations which have remaining maturities of one year or
less from the date of purchase and which are rated "AA" or higher by S&P or "Aa"
or higher by Moody's.
GOVERNMENT OBLIGATIONS
Each Fund may make short-term investments in U.S. Government obligations.
Such obligations include Treasury bills, certificates of indebtedness, notes and
bonds, and issues of such entities as the Government National Mortgage
Association ("GNMA"), Export-Import Bank of the United States, Tennessee Valley
Authority, Resolution Funding Corporation, Farmers Home Administration, Federal
Home Loan Banks, Federal Intermediate Credit Banks, Federal Farm Credit Banks,
Federal Land Banks, Federal Housing Administration, Federal National Mortgage
Association ("FNMA"), Federal Home Loan Mortgage Corporation, and the Student
Loan Marketing Association. No assurance can be given that the U.S. Government
would provide financial support to U.S. Government-sponsored instrumentalities
if it is not obligated to do so by law.
Each Fund may invest in sovereign debt obligations of foreign countries. A
number of factors affect a sovereign debtor's willingness or ability to repay
principal and interest in a timely manner, including its cash flow situation,
the extent of its foreign reserves, the availability of sufficient foreign
exchange on the date a payment is due, the relative size of the debt service
burden to the economy as a whole, the sovereign debtor's policy toward principal
international lenders and the political constraints to which it may be subject.
Emerging market governments could default on their sovereign debt. Such
sovereign debtors also may be dependent on expected disbursements from foreign
governments, multilateral agencies and other entities abroad to reduce principal
and interest arrearages on their debt. The commitments on the part of these
governments, agencies and others to make such disbursements may be conditioned
on a sovereign debtor's implementation of economic reforms and/or economic
performance and the timely service of such debtor's obligations. Failure to
meet such conditions could result in the cancellation of such third parties'
commitments to lend funds to the sovereign debtor, which may further impair such
debtor's ability or willingness to service its debt in a timely manner.
MUNICIPAL SECURITIES
Each Fund may invest in debt obligations issued by state and local
governments, territories and possessions of the U.S., regional government
authorities, and their agencies and instrumentalities ("municipal securities").
Municipal securities include both notes (which have maturities of less than one
year) and bonds (which have maturities of one year or more) that bear fixed or
variable rates of interest.
In general, "municipal securities" debt obligations are issued to obtain
funds for a variety of public purposes, such as the construction, repair, or
improvement of public facilities including airports, bridges, housing,
hospitals, mass transportation, schools, streets, water and sewer works.
Municipal securities may be issued to refinance outstanding obligations as well
as to raise funds for general operating expenses and lending to other public
institutions and facilities.
The two principal classifications of municipal securities are "general
obligation" securities and "revenue" securities. General obligation securities
are secured by the issuer's pledge of its full faith, credit, and taxing power
for the payment of principal and interest. Characteristics and methods of
enforcement of general obligation bonds vary according to the law applicable to
a particular issuer, and the taxes that can be levied for the payment of debt
service may be limited or unlimited as to rates or amounts of special
assessments. Revenue securities are payable only from the revenues derived from
a particular facility, a class of facilities or, in some cases, from the
proceeds of a special excise tax. Revenue bonds are issued to finance a wide
variety of capital projects including: electric, gas, water and sewer systems;
highways, bridges, and tunnels; port and airport facilities; colleges and
universities; and hospitals. Although the principal security behind these bonds
may vary, many provide additional
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security in the form of a debt service reserve fund the assets of which may be
used to make principal and interest payments on the issuer's obligations.
Housing finance authorities have a wide range of security, including partially
or fully insured mortgages, rent subsidized and collateralized mortgages, and
the net revenues from housing or other public projects. Some authorities are
provided further security in the form of a state's assistance (although without
obligation) to make up deficiencies in the debt service reserve fund.
Each Fund may purchase insured municipal debt in which scheduled payments
of interest and principal are guaranteed by a private, non-governmental or
governmental insurance company. The insurance does not guarantee the market
value of the municipal debt or the value of the shares of a Fund.
Securities of issuers of municipal obligations are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the Bankruptcy Reform Act of 1978. In addition,
the obligations of such issuers may become subject to laws enacted in the future
by Congress, state legislatures or referenda extending the time for payment of
principal or interest, or imposing other constraints upon enforcement of such
obligations or upon the ability of municipalities to levy taxes. Furthermore,
as a result of legislation or other conditions, the power or ability of any
issuer to pay, when due, the principal of and interest on its municipal
obligations may be materially affected.
MORAL OBLIGATION SECURITIES. Municipal securities may include "moral
obligation" securities which are usually issued by special purpose public
authorities. If the issuer of moral obligation bonds cannot fulfill its
financial responsibilities from current revenues, it may draw upon a reserve
fund, the restoration of which is moral commitment but not a legal obligation of
the state or municipality which created the issuer.
INDUSTRIAL DEVELOPMENT AND POLLUTION CONTROL BONDS. Each Fund may invest
in tax-exempt industrial development bonds and pollution control bonds which, in
most cases, are revenue bonds and generally are not payable from the
unrestricted revenues of an issuer. They are issued by or on behalf of public
authorities to raise money to finance privately operated facilities for
business, manufacturing, housing, sport complexes, and pollution control.
Consequently, the credit quality of these securities is dependent upon the
ability of the user of the facilities financed by the bonds and any guarantor to
meet its financial obligations.
MUNICIPAL LEASE OBLIGATIONS. Each Fund may invest in lease obligations or
installment purchase contract obligations of municipal authorities or entities
("municipal lease obligations"). Although lease obligations do not constitute
general obligations of the municipality for which its taxing power is pledged, a
lease obligation is ordinarily backed by the municipality's covenant to budget
for, appropriate and make the payment due under the lease obligation. A Fund
may also purchase "certificates of participation," which are securities issued
by a particular municipality or municipal authority to evidence a proportionate
interest in base rental or lease payments relating to a specific project to be
made by the municipality, agency or authority. However, certain lease
obligations contain "non-appropriation" clauses which provide that the
municipality has no obligation to make lease or installment purchase payments in
any year unless money is appropriated for such purpose for such year. Although
"non-appropriation" lease obligations are secured by the leased property,
disposition of the property in the event of default and foreclosure might prove
difficult. In addition, these securities represent a relatively new type of
financing, and certain lease obligations may therefore be considered to be
illiquid securities.
Each Fund will attempt to minimize the special risks inherent in municipal
lease obligations and certificates of participation by purchasing only lease
obligations which meet the following criteria: (1) rated A or better by at
least one nationally recognized securities rating organization; (2) secured by
payments from a governmental lessee which has actively traded debt obligations;
(3) determined by the Investment Adviser to be critical to the lessee's ability
to deliver essential services; and (4) contain legal features which the
Investment Adviser deems appropriate, such as covenants to make lease
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payments without the right of offset or counterclaim, requirements for insurance
policies, and adequate debt service reserve funds.
SHORT-TERM OBLIGATIONS. Each Fund may invest in short-term municipal
obligations These securities include the following:
TAX ANTICIPATION NOTES are used to finance working capital needs of
municipalities and are issued in anticipation of various seasonal tax revenues,
to be payable from these specific future taxes. They are usually general
obligations of the issuer, secured by the taxing power of the municipality for
the payment of principal and interest when due.
REVENUE ANTICIPATION NOTES are issued in expectation of receipt of other
kinds of revenue, such as federal revenues available under the Federal Revenue
Sharing Program. They also are usually general obligations of the issuer.
BOND ANTICIPATION NOTES normally are issued to provide interim financing
until long-term financing can be arranged. The long-term bonds then provide the
money for the repayment of the notes.
CONSTRUCTION LOAN NOTES are sold to provide construction financing for
specific projects. After successful completion and acceptance, many projects
receive permanent financing through the Federal National Mortgage Association or
the Government National Mortgage Association.
SHORT-TERM DISCOUNT NOTES (tax-exempt commercial paper) are short-term (365
days or less) promissory notes issued by municipalities to supplement their cash
flow.
ZERO COUPON SECURITIES
Each Fund may each invest up to 35% of its net assets in zero coupon
securities issued or guaranteed by the U.S. Government and its agencies and
instrumentalities. Zero coupon securities may be issued by the U.S. Treasury or
by a U.S. Government agency, authority or instrumentality (such as the Student
Loan Marketing Association or the Resolution Funding Corporation). Zero coupon
securities are sold at a substantial discount from face value and redeemed at
face value at their maturity date without interim cash payments of interest and
principal. This discount is amortized over the life of the security and such
amortization will constitute the income earned on the security for both
accounting and tax purposes. Because of these features, such securities may be
subject to greater volatility as a result of changes in prevailing interest
rates than interest paying investments in which the Funds may invest. Because
income on such securities is accrued on a current basis, even though the Funds
do not receive the income currently in cash, the Funds may have to sell other
portfolio investments to obtain cash needed by the Funds to make income
distributions.
PARTICIPATION INTERESTS
Each Fund may invest in participation interests, subject to the limitation
on investments by the Funds in illiquid investments. No Fund currently intends
to invest more than 5% of its net assets in such interests. Participation
interests represent an undivided interest in or assignment of a loan made by an
issuing financial institution. No more than 5% of the Fund's net assets can be
invested in participation interests of the same issuing borrower. Participation
interests are primarily dependent upon the financial strength of the borrowing
corporation, which is obligated to make payments of principal and interest on
the loan, and there is a risk that such borrowers may have difficulty making
payments. In the event the borrower fails to pay scheduled interest or
principal payments, Fund could experience a reduction in its income and might
experience a decline in the net asset value of its shares. In the event of a
failure by the financial institution to perform its obligation in connection
with the participation, a Fund might incur certain costs and delays in realizing
payment or may suffer a loss of principal and/or interest. The Investment
Adviser has set certain creditworthiness standards for issuers of loan
participations and monitors their creditworthiness.
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VARIABLE AND FLOATING RATE INSTRUMENTS
Each Fund may acquire variable and floating rate instruments. Credit
rating agencies frequently do not rate such instruments; however, the Investment
Adviser under guidelines established by the Trust's Board of Trustees will
determine what unrated and variable and floating rate instruments are of
comparable quality at the time of the purchase to rated instruments eligible for
purchase by the Fund. In making such determinations, the Investment Adviser
considers the earning power, cash flow and other liquidity ratios of the issuers
of such instruments (such issuers include financial, merchandising, bank holding
and other companies) and will monitor their financial condition. An active
secondary market may not exist with respect to particular variable or floating
rate instruments purchased by a Fund. The absence of such an active secondary
market could make it difficult for the Fund to dispose of the variable or
floating rate instrument involved in the event of the issuer of the instrument
defaulting on its payment obligation or during periods in which the Fund is not
entitled to exercise its demand rights, and the Fund could, for these or other
reasons, suffer a loss to the extent of the default. Variable and floating rate
instruments may be secured by bank letters of credit.
INDEX AND CURRENCY-LINKED SECURITIES
Each Fund may invest in "index-linked" or "commodity-linked" notes, which
are debt securities of companies that call for interest payments and/or payment
at maturity in different terms than the typical note where the borrower agrees
to make fixed interest payments and to pay a fixed sum at maturity. Principal
and/or interest payments on an index-linked note depend on the performance of
one or more market indices, such as the S&P 500 Index or a weighted index of
commodity futures such as crude oil, gasoline and natural gas. Each Fund may
also invest in "equity linked" and "currency-linked" debt securities. At
maturity, the principal amount of an equity-linked debt security is exchanged
for common stock of the issuer or is payable in an amount based on the issuer's
common stock price at the time of maturity. Currency-linked debt securities are
short-term or intermediate term instruments having a value at maturity, and/or
an interest rate, determined by reference to one or more foreign currencies.
Payment of principal or periodic interest may be calculated as a multiple of the
movement of one currency against another currency, or against an index.
Index and currency-linked securities are derivative instruments which may
entail substantial risks. Such instruments may be subject to significant price
volatility. The company issuing the instrument may fail to pay the amount due
on maturity. The underlying investment or security may not perform as expected
by the Investment Adviser. Markets, underlying securities and indexes may move
in a direction that was not anticipated by the Investment Adviser. Performance
of the derivatives may be influenced by interest rate and other market changes
in the U.S. and abroad. Certain derivative instruments may be illiquid. See
"Illiquid Securities" below.
MORTGAGE-RELATED SECURITIES
Each Fund may invest in mortgage-related securities. Mortgage-related
securities are derivative interests in pools of mortgage loans made to U.S.
residential home buyers, including mortgage loans made by savings and loan
institutions, mortgage bankers, commercial banks and others. Pools of mortgage
loans are assembled as securities for sale to investors by various governmental,
government-related and private organizations. The High Quality Bond Fund may
also invest in debt securities which are secured with collateral consisting of
U.S. mortgage-related securities, and in other types of U.S. mortgage-related
securities.
U.S. MORTGAGE PASS-THROUGH SECURITIES. Interests in pools of
mortgage-related securities differ from other forms of debt securities, which
normally provide for periodic payment of interest in fixed amounts with
principal payments at maturity or specified call dates. Instead, these
securities provide a monthly payment which consists of both interest and
principal payments. In effect, these payments are a "pass-through" of the
monthly payments made by the individual borrowers on their residential mortgage
loans, net of any fees paid to the issuer or guarantor of such securities.
Additional payments are caused by repayments of principal resulting from the
sale of the underlying residential
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property, refinancing or foreclosure, net of fees or costs which may be
incurred. Some mortgage-related securities (such as securities issued by the
Government National Mortgage Association) are described as "modified
pass-throughs." These securities entitle the holder to receive all interest and
principal payments owed on the mortgage pool, net of certain fees, at the
scheduled payment dates regardless of whether or not the mortgagor actually
makes the payment.
The principal governmental guarantor of U.S. mortgage-related securities is
the Government National Mortgage Association ("GNMA"). GNMA is a wholly owned
United States Government corporation within the Department of Housing and Urban
Development. GNMA is authorized to guarantee, with the full faith and credit of
the United States Government, the timely payment of principal and interest on
securities issued by institutions approved by GNMA (such as savings and loan
institutions, commercial banks and mortgage bankers) and backed by pools of
mortgages insured by the Federal Housing Agency or guaranteed by the Veterans
Administration.
Government-related guarantors include the Federal National Mortgage
Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
FNMA is a government-sponsored corporation owned entirely by private
stockholders and subject to general regulation by the Secretary of Housing and
Urban Development. FNMA purchases conventional residential mortgages not
insured or guaranteed by any government agency from a list of approved
seller/services which include state and federally chartered savings and loan
associations, mutual savings banks, commercial banks and credit unions and
mortgage bankers. FHLMC is a government-sponsored corporation created to
increase availability of mortgage credit for residential housing and owned
entirely by private stockholders. FHLMC issues participation certificates which
represent interests in conventional mortgages from FHLMC's national portfolio.
Pass-through securities issued by FNMA and participation certificates issued by
FHLMC are guaranteed as to timely payment of principal and interest by FNMA and
FHLMC, respectively, but are not backed by the full faith and credit of the
United States Government.
Although the underlying mortgage loans in a pool may have maturities of up
to 30 years, the actual average life of the pool certificates typically will be
substantially less because the mortgages will be subject to normal principal
amortization and may be prepaid prior to maturity. Prepayment rates vary widely
and may be affected by changes in market interest rates. In periods of falling
interest rates, the rate of prepayment tends to increase, thereby shortening the
actual average life of the pool certificates. Conversely, when interest rates
are rising, the rate of prepayments tends to decrease, thereby lengthening the
actual average life of the certificates. Accordingly, it is not possible to
predict accurately the average life of a particular pool.
COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOs"). A domestic or foreign CMO is
a hybrid between a mortgage-backed bond and a mortgage pass-through security.
Like a bond, interest is paid, in most cases, semiannually. CMOs may be
collateralized by whole mortgage loans, but are more typically collateralized by
portfolios of mortgage pass-through securities guaranteed by GNMA, FHLMC, FNMA
or equivalent foreign entities.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life depend upon the prepayment
experience of the collateral. CMOs provide for a modified form of call
protection through a de facto breakdown of the underlying pool of mortgages
according to how quickly the loans are repaid. Monthly payment of principal and
interest received from the pool of underlying mortgages, including prepayments,
is first returned to the class having the earliest maturity date or highest
maturity. Classes that have longer maturity dates and lower seniority will
receive principal only after the higher class has been retired.
FOREIGN MORTGAGE-RELATED SECURITIES. Foreign mortgage-related securities
are interests in pools of mortgage loans made to residential home buyers
domiciled in a foreign country. These include mortgage loans made by trust and
mortgage loan companies, credit unions, chartered banks, and others. Pools of
mortgage loans are assembled as securities for sale to investors by various
governmental, government-related and private organizations (E.G., Canada
Mortgage and Housing Corporation and First Australian National Mortgage
Acceptance Corporation Limited). The mechanics
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of these mortgage-related securities are generally the same as those issued in
the United States. However, foreign mortgage markets may differ materially from
the U.S. mortgage market with respect to matters such as the sizes of loan
pools, pre-payment experience, and maturities of loans.
"ROLL" TRANSACTIONS
Each Fund may enter into "roll" transactions, which are the sale of GNMA
certificates and other securities together with a commitment to purchase
similar, but not identical, securities at a later date from the same party.
During the roll period, a Fund forgoes principal and interest paid on the
securities. The Fund is compensated by the difference between the current sales
price and the forward price for the future purchase, as well as by the interest
earned on the cash proceeds of the initial sale. Like when-issued securities or
firm commitment agreements, roll transactions involve the risk that the market
value of the securities sold by the Fund may decline below the price at which
the Fund is committed to purchase similar securities. Additionally, in the
event the buyer of securities under a roll transaction files for bankruptcy or
becomes insolvent, the Fund's use of the proceeds of the transactions may be
restricted pending a determination by the other party, or its trustee or
receiver, whether to enforce the Fund's obligation to repurchase the securities.
A Fund will engage in roll transactions for the purpose of acquiring
securities for its portfolio consistent with its investment objective and
policies and not for investment leverage. Nonetheless, roll transactions are
speculative techniques and are considered to be the economic equivalent of
borrowings by the Fund. To avoid leverage, the Fund will establish a segregated
account with its Custodian in which it will maintain liquid assets in an amount
sufficient to meet its payment obligations with respect to these transactions.
A Fund will not enter into roll transactions if, as a result, more than 15% of
the Fund's net assets would be segregated to cover such contracts.
FOREIGN INVESTMENTS
Each Fund may invest in securities of foreign issuers that are not publicly
traded in the United States. Each Fund may also invest in depository receipts.
The United States Government from time to time has imposed restrictions,
through taxation or otherwise, on foreign investments by U.S. entities such as
the Funds. If such restrictions should be reinstituted, it might become
necessary for such Funds to invest substantially all of their assets in United
States securities. In such event, the Board of Trustees of the Trust would
consider alternative arrangements, including reevaluation of the Funds'
investment objectives and policies or investment of all of the Funds' assets in
another investment company with different investment objectives and policies
than the Funds. However, a Fund would adopt any revised investment objective
and fundamental policies only after approval by the shareholders holding a
majority (as defined in the Investment Company Act) of the shares of the Fund.
DEPOSITORY RECEIPTS. Each of the Funds may invest in American Depository
Receipts ("ADRs"), which are receipts issued by an American bank or trust
company evidencing ownership of underlying securities issued by a foreign
issuers. ADRs, in registered form, are designed for use in U.S. securities
markets. Such depository receipts may be sponsored by the foreign issuer or may
be unsponsored. The Funds may also invest in European and Global Depository
Receipts ("EDRs" and "GDRs"), which, in bearer form, are designed for use in
European securities markets, and in other instruments representing securities of
foreign companies. Such depository receipts may be sponsored by the foreign
issuer or may be unsponsored. Unsponsored depository receipts are organized
independently and without the cooperation of the foreign issuer of the
underlying securities; as a result, available information regarding the issuer
may not be as current as for sponsored depository receipts, and the prices of
unsponsored depository receipts may be more volatile than if they were sponsored
by the issuer of the underlying securities. ADRs may be listed on a national
securities exchange or may trade in the over-the-counter market. ADR prices are
denominated in United States dollars; the underlying security may be denominated
in a foreign currency, although the underlying security may be subject to
foreign government taxes which would reduce the yield on such securities.
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RISKS OF INVESTING IN FOREIGN SECURITIES. Investments in foreign securities
involve certain inherent risks, including the following:
MARKET CHARACTERISTICS. Settlement practices for transactions in foreign
markets may include delays beyond periods customary in the United States.
Foreign security trading practices, including those involving securities
settlement where Fund assets may be released prior to receipt of payment or
securities, may expose the Funds to increased risk in the event of a failed
trade or the insolvency of a foreign broker-dealer.
Transactions in options on securities, futures contracts, futures options
and currency contracts may not be regulated as effectively on foreign exchanges
as similar transactions in the United States, and may not involve clearing
mechanisms and related guarantees. The value of such positions also could be
adversely affected by the imposition of different exercise terms and procedures
and margin requirements than in the United States. The value of a Fund's
positions may also be adversely impacted by delays in its ability to act upon
economic events occurring in foreign markets during non-business hours in the
United States.
LEGAL AND REGULATORY MATTERS. In addition to nationalization, foreign
governments may take other actions that could have a significant effect on
market prices of securities and payment of interest, including restrictions on
foreign investment, expropriation of goods and imposition of taxes, currency
restrictions and exchange control regulations.
TAXES. The interest payable on certain of the Funds' foreign portfolio
securities may be subject to foreign withholding taxes, thus reducing the net
amount of income available for distribution to the Funds' shareholders. A
shareholder otherwise subject to United States federal income taxes may, subject
to certain limitations, be entitled to claim a credit or deduction of U.S.
federal income tax purposes for his proportionate share of such foreign taxes
paid by the Funds.
COSTS. The expense ratios of the Funds are likely to be higher than those
of investment companies investing in domestic securities, since the cost of
maintaining the custody of foreign securities is higher.
In considering whether to invest in the securities of a foreign company,
the Investment Adviser considers such factors as the characteristics of the
particular company, differences between economic trends and the performance of
securities markets within the U.S. and those within other countries, and also
factors relating to the general economic, governmental and social conditions of
the country or countries where the company is located. The extent to which a
Fund will be invested in foreign companies and countries and depository receipts
will fluctuate from time to time within the limitations described in the
Prospectus, depending on the Investment Adviser's assessment of prevailing
market, economic and other conditions.
SECURITIES SWAPS
Each Fund may enter into securities swaps, a technique primarily used to
indirectly participate in the securities market of a country from which a Fund
would otherwise be precluded for lack of an established securities custody and
safekeeping system. The Fund deposits an amount of cash with its custodian (or
the broker, if legally permitted) in an amount equal to the selling price of the
underlying security. Thereafter, the Fund pays or receives cash from the broker
equal to the change in the value of the underlying security.
OPTIONS ON SECURITIES AND SECURITIES INDICES
PURCHASING PUT AND CALL OPTIONS. Each Fund is authorized to purchase put
and call options with respect to securities which are otherwise eligible for
purchase by the Fund and with respect to various stock indices subject to
certain restrictions. Put and call options are derivative securities traded on
United States and foreign exchanges, including the American Stock Exchange,
Chicago Board
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Options Exchange, Philadelphia Stock Exchange, Pacific Stock Exchange and New
York Stock Exchange. Except as indicated in "Non-Hedging Strategic
Transactions", the Funds will engage in trading of such derivative securities
exclusively for hedging purposes.
If a Fund purchases a put option, the Fund acquires the right to sell the
underlying security at a specified price at any time during the term of the
option (for "American-style" options) or on the option expiration date (for
"European-style" options). Purchasing put options may be used as a portfolio
investment strategy when the Investment Adviser perceives significant short-term
risk but substantial long-term appreciation for the underlying security. The
put option acts as an insurance policy, as it protects against significant
downward price movement while it allows full participation in any upward
movement. If the Fund holds a stock which the Investment Adviser believes has
strong fundamentals, but for some reason may be weak in the near term, the Fund
may purchase a put option on such security, thereby giving itself the right to
sell such security at a certain strike price throughout the term of the option.
Consequently, the Fund will exercise the put only if the price of such security
falls below the strike price of the put. The difference between the put's
strike price and the market price of the underlying security on the date the
Fund exercises the put, less transaction costs, is the amount by which the Fund
hedges against a decline in the underlying security. If during the period of
the option the market price for the underlying security remains at or above the
put's strike price, the put will expire worthless, representing a loss of the
price the Fund paid for the put, plus transaction costs. If the price of the
underlying security increases, the premium paid for the put option less any
amount for which the put may be sold reduces the profit the Fund realizes on the
sale of the securities.
If a Fund purchases a call option, it acquires the right to purchase the
underlying security at a specified price at any time during the term of the
option. The purchase of a call option is a type of insurance policy to hedge
against losses that could occur if the Fund has a short position in the
underlying security and the security thereafter increases in price. The Fund
will exercise a call option only if the price of the underlying security is
above the strike price at the time of exercise. If during the option period the
market price for the underlying security remains at or below the strike price of
the call option, the option will expire worthless, representing a loss of the
price paid for the option, plus transaction costs. If a Fund purchases the call
option to hedge a short position in the underlying security and the price of the
underlying security thereafter falls, the premium paid for the call option less
any amount for which such option may be sold reduces the profit the Fund
realizes on the cover of the short position in the security.
Prior to exercise or expiration, an option may be sold when it has
remaining value by a purchaser through a "closing sale transaction," which is
accomplished by selling an option of the same series as the option previously
purchased. The Funds generally will purchase only those options for which the
Investment Adviser believes there is an active secondary market to facilitate
closing transactions.
WRITING CALL OPTIONS. Each Fund may write covered call options. A call
option is "covered" if a Fund owns the security underlying the call or has an
absolute right to acquire the security without additional cash consideration
(or, if additional cash consideration is required, cash or cash equivalents in
such amount as are held in a segregated account by the Custodian). The writer
of a call option receives a premium and gives the purchaser the right to buy the
security underlying the option at the exercise price. The writer has the
obligation upon exercise of the option to deliver the underlying security
against payment of the exercise price during the option period. If the writer
of an exchange-traded option wishes to terminate his obligation, he may effect a
"closing purchase transaction." This is accomplished by buying an option of the
same series as the option previously written. A writer may not effect a closing
purchase transaction after it has been notified of the exercise of an option.
Effecting a closing transaction in the case of a written call option will
permit a Fund to write another call option on the underlying security with
either a different exercise price, expiration date or both. Also, effecting a
closing transaction allows the cash or proceeds from the concurrent sale of any
securities subject to the option to be used for other investments of the Fund.
If the Fund desires to sell
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a particular security from its portfolio on which it has written a call option,
it will effect a closing transaction prior to or concurrent with the sale of the
security.
A Fund realizes a gain from a closing transaction if the cost of the
closing transaction is less than the premium received from writing the option or
if the proceeds from the closing transaction are more than the premium paid to
purchase the option. A Fund realizes a loss from a closing transaction if the
cost of the closing transaction is more than the premium received from writing
the option or if the proceeds from the closing transaction are less than the
premium paid to purchase the option. However, because increases in the market
price of a call option generally reflect increases in the market price of the
underlying security, appreciation of the underlying security owned by the Fund
generally offsets, in whole or in part, any loss to the Fund resulting from the
repurchase of a call option.
STOCK INDEX OPTIONS. Each Fund may also purchase put and call options with
respect to the S&P 500 and other stock indices. The Funds may purchase such
options as a hedge against changes in the values of portfolio securities or
securities which it intends to purchase or sell, or to reduce risks inherent in
the ongoing management of the Fund.
The distinctive characteristics of options on stock indices create certain
risks not found in stock options generally. Because the value of an index
option depends upon movements in the level of the index rather than the price of
a particular stock, whether the Fund will realize a gain or loss on the purchase
or sale of an option on an index depends upon movements in the level of stock
prices in the stock market generally rather than movements in the price of a
particular stock. Accordingly, successful use by a Fund of options on a stock
index depends on the Investment Adviser's ability to predict correctly movements
in the direction of the stock market generally. This requires different skills
and techniques than predicting changes in the price of individual stocks.
Index prices may be distorted if circumstances disrupt trading of certain
stocks included in the index, such as if trading were halted in a substantial
number of stocks included in the index. If this happens, the Fund could not
close out options which it had purchased, and if restrictions on exercise were
imposed, the Fund might be unable to exercise an option it holds, which could
result in substantial losses to the Fund. The Funds purchase put or call
options only with respect to an index which the Investment Adviser believes
includes a sufficient number of stocks to minimize the likelihood of a trading
halt in the index.
RISKS OF INVESTING IN OPTIONS. There are several risks associated with
transactions in options on securities and indices. Options may be more volatile
than the underlying instruments and, therefore, on a percentage basis, an
investment in options may be subject to greater fluctuation than an investment
in the underlying instruments themselves. There are also significant
differences between the securities and options markets that could result in an
imperfect correlation between these markets, causing a given transaction not to
achieve its objective. In addition, a liquid secondary market for particular
options may be absent for reasons which include the following: there may be
insufficient trading interest in certain options; restrictions may be imposed by
an exchange on opening transactions or closing transactions or both; trading
halts, suspensions or other restrictions may be imposed with respect to
particular classes or series of option of underlying securities; unusual or
unforeseen circumstances may interrupt normal operations on an exchange; the
facilities of an exchange or clearing corporation may not at all times be
adequate to handle current trading volume; or one or more exchanges could, for
economic or other reasons, decide or be compelled at some future date to
discontinue the trading of options (or a particular class or series of options),
in which event the secondary market on that exchange (or in that class or series
of options) would cease to exist, although outstanding options that had been
issued by a clearing corporation as a result of trades on that exchange would
continue to be exercisable in accordance with their terms.
A decision as to whether, when and how to use options involves the exercise
of skill and judgment, and even a well-conceived transaction may be unsuccessful
to some degree because of market behavior or unexpected events. The extent to
which a Fund may enter into options transactions
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may be limited by the Internal Revenue Code requirements for qualification of
the Fund as a regulated investment company. See "Dividends, Distributions and
Taxes."
In addition, foreign options exchanges do not afford to participants many
of the protections available in United States option exchanges. For example,
there may be no daily price fluctuation limits in such exchanges or markets, and
adverse market movements could therefore continue to an unlimited extent over a
period of time. Although the purchaser of an option cannot lose more than the
amount of the premium plus related transaction costs, this entire amount could
be lost. Moreover, a Fund as an option writer could lose amounts substantially
in excess of its initial investment, due to the margin and collateral
requirements typically associated with such option writing. See "Dealer
Options" below.
DEALER OPTIONS. Each Fund may engage in transactions involving dealer
options as well as exchange-traded options. Certain risks are specific to
dealer options. While the Funds might look to a clearing corporation to
exercise exchange-traded options, if a Fund purchases a dealer option it must
rely on the selling dealer to perform if the Fund exercises the option. Failure
by the dealer to do so would result in the loss of the premium paid by the Fund
as well as loss of the expected benefit of the transaction.
Exchange-traded options generally have a continuous liquid market while
dealer options may not. Consequently, a Fund can realize the value of a dealer
option it has purchased only by exercising or reselling the option to the
issuing dealer. Similarly, when a Fund writes a dealer option, the Fund can
close out the option prior to its expiration only by entering into a closing
purchase transaction with the dealer. While the Fund seeks to enter into dealer
options only with dealers who will agree to and can enter into closing
transactions with the Fund, no assurance exists that the Fund will at any time
be able to liquidate a dealer option at a favorable price at any time prior to
expiration. Unless the Fund, as a covered dealer call option writer, can effect
a closing purchase transaction, it will not be able to liquidate securities (or
other assets) used as cover until the option expires or is exercised. In the
event of insolvency of the other party, the Fund may be unable to liquidate a
dealer option. With respect to options written by the Fund, the inability to
enter into a closing transaction may result in material losses to the Fund. For
example, because a Fund must maintain a secured position with respect to any
call option on a security it writes, the Fund may not sell the assets which it
has segregated to secure the position while it is obligated under the option.
This requirement may impair the Fund's ability to sell portfolio securities at a
time when such sale might be advantageous.
The Staff of the Securities and Exchange Commission (the "Commission")
takes the position that purchased dealer options are illiquid securities. A
Fund may treat the cover used for written dealer options as liquid if the dealer
agrees that the Fund may repurchase the dealer option it has written for a
maximum price to be calculated by a predetermined formula. In such cases, the
dealer option would be considered illiquid only to the extent the maximum
purchase price under the formula exceeds the intrinsic value of the option.
With that exception, however, the Fund will treat dealer options as subject to
the Fund's limitation on illiquid securities. If the Commission changes its
position on the liquidity of dealer options, the Fund will change its treatment
of such instruments accordingly.
FOREIGN CURRENCY OPTIONS
Each Fund may buy or sell put and call options on foreign currencies. A
put or call option on a foreign currency gives the purchaser of the option the
right to sell or purchase a foreign currency at the exercise price until the
option expires. The Funds use foreign currency options separately or in
combination to control currency volatility. Among the strategies employed to
control currency volatility is an option collar. An option collar involves the
purchase of a put option and the simultaneous sale of call option on the same
currency with the same expiration date but with different exercise (or "strike")
prices. Generally, the put option will have an out-of-the-money strike price,
while the call option will have either an at-the-money strike price or an
in-the-money strike price. Foreign currency options are derivative securities.
Currency options traded on U.S. or other
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exchanges may be subject to position limits which may limit the ability of the
Funds to reduce foreign currency risk using such options.
As with other kinds of option transactions, writing options on foreign
currency constitutes only a partial hedge, up to the amount of the premium
received. The Funds could be required to purchase or sell foreign currencies at
disadvantageous exchange rates, thereby incurring losses. The purchase of an
option on foreign currency may constitute an effective hedge against exchange
rate fluctuations; however, in the event of exchange rate movements adverse to a
Fund's position, the Fund may forfeit the entire amount of the premium plus
related transaction costs.
FORWARD CURRENCY CONTRACTS
Each Fund may enter into forward currency contracts in anticipation of
changes in currency exchange rates. A forward currency contract is an
obligation to purchase or sell a specific currency at a future date, which may
be any fix number of days from the date of the contract agreed upon by the
parties, at a price set at the time of the contract. For example, a Fund might
purchase a particular currency or enter into a forward currency contract to
preserve the U.S. dollar price of securities it intends to or has contracted to
purchase. Alternatively, it might sell a particular currency on either a spot
or forward basis to hedge against an anticipated decline in the dollar value of
securities it intends to or has contracted to sell. Although this strategy
could minimize the risk of loss due to a decline in the value of the hedged
currency, it could also limit any potential gain from an increase in the value
of the currency.
FUTURES CONTRACTS AND RELATED OPTIONS
Each Fund may invest in futures contracts and options on futures contracts
as a hedge against changes in market conditions or interest rates. The Funds
trade in such derivative securities for bona fide hedging purposes and otherwise
in accordance with the rules of the Commodity Futures Trading Commission
("CFTC"). Each Fund segregates liquid assets in a separate account with its
Custodian when required to do so by CFTC guidelines in order to cover its
obligation in connection with futures and options transactions.
A Fund does not pay or receive funds upon the purchase or sale of a futures
contract. When it enters into a domestic futures contract, the Fund deposits in
a segregated account with its Custodian liquid assets equal to approximately 5%
of the contract amount. This amount is known as initial margin. The margin
requirements for foreign futures contracts may be different.
The nature of initial margin in futures transactions differs from that of
margin in securities transactions. Futures contract margin does not involve the
borrowing of funds by the customer to finance the transactions. Rather, the
initial margin is in the nature of a performance bond or good faith deposit on
the contract which is returned to the Fund upon termination of the futures
contract, assuming it satisfies all contractual obligations. Subsequent
payments (called variation margin) to and from the broker will be made on a
daily basis as the price of the underlying stock index fluctuates, to reflect
movements in the price of the contract making the long and short positions in
the futures contract more or less valuable. For example, when a Fund purchases
a stock index futures contract and the price of the underlying stock index
rises, that position will have increased in value and the Fund will receive from
the broker a variation margin payment equal to that increase in value.
Conversely, when a Fund purchases a stock index futures contract and the price
of the underlying stock index declines, the position will be less valuable
requiring the Fund to make a variation margin payment to the broker.
At any time prior to expiration of a futures contract, the Fund may elect
to close the position by taking an opposite position, which will operate to
terminate the Fund's position in the futures contract. A final determination of
variation margin is made on closing the position. The Fund either pays or
receives cash, thus realizing a loss or a gain.
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STOCK INDEX FUTURES CONTRACTS. Each Fund may invest in futures contracts
on stock indices. A stock index futures contracts is a bilateral agreement
pursuant to which the parties agree to take or make delivery of an amount of
cash equal to a specified dollar amount times the difference between the index
value at the close of the last trading day of the contract and the price at
which the contract is originally struck. No physical delivery of the underlying
stocks in the index is made. Currently, stock index futures contracts can be
purchased or sold with respect to the S&P 500 Stock Price Index on the Chicago
Mercantile Exchange, the Major Market Index on the Chicago Board of Trade, the
New York Stock Exchange Composite Index on the New York Futures Exchange and the
Value Line Stock Index on the Kansas City Board of Trade. Foreign financial and
stock index futures are traded on foreign exchanges including the London
International Financial Futures Exchange, the Singapore International Monetary
Exchange, the Sydney Futures Exchange Limited and the Tokyo Stock Exchange.
INTEREST RATE OR FINANCIAL FUTURES CONTRACTS. Each Fund may invest in
interest rate or financial futures contracts. Bond prices are established in
both the cash market and the futures market. In the cash market, bonds are
purchased and sold with payment for the full purchase price of the bond being
made in cash, generally within five business days after the trade. In the
futures market, a contract is made to purchase or sell a bond in the future for
a set price on a certain date. Historically, the prices for bonds established
in the futures markets have generally tended to move in the aggregate in concert
with cash market prices, and the prices have maintained fairly predictable
relationships.
The sale of an interest rate or financial futures sale by a Fund obligates
the Fund, as seller, to deliver the specific type of financial instrument called
for in the contract at a specific future time for a specified price. A futures
contract purchased by a Fund obligates the Fund, as purchaser, to take delivery
of the specific type of financial instrument at a specific future time at a
specific price. The specific securities delivered or taken, respectively, at
settlement date, would not be determined until at or near that date. The
determination would be in accordance with the rules of the exchange on which the
futures contract sale or purchase was made.
Although interest rate or financial futures contracts by their terms call
for actual delivery or acceptance of securities, in most cases the contracts are
closed out before the settlement date without delivery of securities. A Fund
closes out a futures contract sale by entering into a futures contract purchase
for the same aggregate amount of the specific type of financial instrument and
the same delivery date. If the price in the sale exceeds the price in the
offsetting purchase, the Fund receives the difference and thus realizes a gain.
If the offsetting purchase price exceeds the sale price, the Fund pays the
difference and realizes a loss. Similarly, the Fund closes out a futures
contract purchase by entering into a futures contract sale. If the offsetting
sale price exceeds the purchase price, the Fund realizes a gain, and if the
purchase price exceeds the offsetting sale price, the Fund realizes a loss.
The Funds deal only in standardized contracts on recognized exchanges.
Each exchange guarantees performance under contract provisions through a
clearing corporation, a nonprofit organization managed by the exchange
membership. Domestic interest rate futures contracts are traded in an auction
environment on the floors of several exchanges - principally, the Chicago Board
of Trade and the Chicago Mercantile Exchange. A public market now exists in
domestic futures contracts covering various financial instruments including
long-term United States Treasury bonds and notes; Government National Mortgage
Association (GNMA) modified pass-through mortgage-backed securities; three-month
United States Treasury bills; and 90-day commercial paper. A Fund may trade in
any futures contract for which there exists a public market, including, without
limitation, the foregoing instruments. International interest rate futures
contracts are traded on the London International Financial Futures Exchange, the
Singapore International Monetary Exchange, the Sydney Futures Exchange Limited
and the Tokyo Stock Exchange.
FOREIGN CURRENCY FUTURES CONTRACTS. Each Fund may use foreign currency
future contracts for hedging purposes. A foreign currency futures contract
provides for the future sale by one party and purchase by another party of a
specified quantity of a foreign currency at a specified price and time. A
public market exists in futures contracts covering several foreign currencies,
including the Australian dollar, the Canadian dollar, the British pound, the
German mark, the Japanese yen, the Swiss franc,
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and certain multinational currencies such as the European Currency Unit ("ECU").
Other foreign currency futures contracts are likely to be developed and traded
in the future. The Funds will only enter into futures contracts and futures
options which are standardized and traded on a U.S. or foreign exchange, board
of trade, or similar entity, or quoted on an automated quotation system.
RISKS OF TRANSACTIONS IN FUTURES CONTRACTS. There are several risks
related to the use of futures as a hedging device. One risk arises because of
the imperfect correlation between movements in the price of the futures contract
and movements in the price of the securities which are the subject of the hedge.
The price of the future may move more or less than the price of the securities
being hedged. If the price of the future moves less than the price of the
securities which are the subject of the hedge, the hedge will not be fully
effective, but if the price of the securities being hedged has moved in an
unfavorable direction, a Fund would be in a better position than if it had not
hedged at all. If the price of the securities being hedged has moved in a
favorable direction, this advantage will be partially offset by the loss on the
future. If the price of the future moves more than the price of the hedged
securities, the Fund will experience either a loss or a gain on the future which
will not be completely offset by movements in the price of the securities which
are subject to the hedge.
To compensate for the imperfect correlation of movements in the price of
securities being hedged and movements in the price of the futures contract, a
Fund may buy or sell futures contracts in a greater dollar amount than the
dollar amount of securities being hedged if the historical volatility of the
prices of such securities has been greater than the historical volatility over
such time period of the future. Conversely, the Fund may buy or sell fewer
futures contracts if the historical volatility of the price of the securities
being hedged is less than the historical volatility of the futures contract
being used. It is possible that, when the Fund has sold futures to hedge its
portfolio against a decline in the market, the market may advance while the
value of securities held in the Fund's portfolio may decline. If this occurs,
the Fund will lose money on the future and also experience a decline in value in
its portfolio securities. However, the Investment Adviser believes that over
time the value of a diversified portfolio will tend to move in the same
direction as the market indices upon which the futures are based.
When futures are purchased to hedge against a possible increase in the
price of securities before a Fund is able to invest its cash (or cash
equivalents) in securities (or options) in an orderly fashion, it is possible
that the market may decline instead. If the Fund then decides not to invest in
securities or options at that time because of concern as to possible further
market decline or for other reasons, it will realize a loss on the futures
contract that is not offset by a reduction in the price of securities purchased.
In addition to the possibility that there may be an imperfect correlation,
or no correlation at all, between movements in the futures and the securities
being hedged, the price of futures may not correlate perfectly with movement in
the stock index or cash market due to certain market distortions. All
participants in the futures market are subject to margin deposit and maintenance
requirements. Rather than meeting additional margin deposit requirements,
investors may close futures contracts through offsetting transactions, which
could distort the normal relationship between the index or cash market and
futures markets. In addition, the deposit requirements in the futures market
are less onerous than margin requirements in the securities market. Therefore,
increased participation by speculators in the futures market may also cause
temporary price distortions. As a result of price distortions in the futures
market and the imperfect correlation between movements in the cash market and
the price of securities and movements in the price of futures, a correct
forecast of general trends by the Investment Adviser may still not result in a
successful hedging transaction over a very short time frame.
Positions in futures may be closed out only on an exchange or board of
trade which provides a secondary market for such futures. Although the Funds
intend to purchase or sell futures only on exchanges or boards of trade where
there appears to be an active secondary market, there is no assurance that a
liquid secondary market on an exchange or board of trade will exist for any
particular contract or at any particular time. In such event, it may not be
possible to close a futures position, and
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in the event of adverse price movements, the Funds would continue to be required
to make daily cash payments of variation margin. When futures contracts have
been used to hedge portfolio securities, such securities will not be sold until
the futures contract can be terminated. In such circumstances, an increase in
the price of the securities, if any, may partially or completely offset losses
on the futures contract. However, as described above, there is no guarantee
that the price of the securities will in fact correlate with the price movements
in the futures contract and thus provide an offset to losses on a futures
contract.
Most United States futures exchanges limit the amount of fluctuation
permitted in futures contract prices during a single trading day. The daily
limit establishes the maximum amount that the price of a futures contract may
vary either up or down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
futures contract, no trades may be made on that day at a price beyond that
limit. The daily limit governs only price movement during a particular trading
day and therefore does not limit potential losses, because the limit may prevent
the liquidation of unfavorable positions. Futures contract prices have
occasionally moved to the daily limit for several consecutive trading days with
little or no trading, thereby preventing prompt liquidation of futures positions
and subjecting some futures traders to substantial losses.
Successful use of futures by a Fund depends on the Investment Adviser's
ability to predict correctly movements in the direction of the market. For
example, if the Fund hedges against the possibility of a decline in the market
adversely affecting stocks held in its portfolio and stock prices increase
instead, the Fund will lose part or all of the benefit of the increased value of
the stocks which it has hedged because it will have offsetting losses in its
futures positions. In addition, in such situations, if the Fund has
insufficient cash, it may have to sell securities to meet daily variation margin
requirements. Such sales of securities may be, but will not necessarily be, at
increased prices which reflect the rising market. The Fund may have to sell
securities at a time when it may be disadvantageous to do so.
In the event of the bankruptcy of a broker through which a Fund engages in
transactions in futures contracts or options, the Fund could experience delays
and losses in liquidating open positions purchased or sold through the broker,
and incur a loss of all or part of its margin deposits with the broker.
OPTIONS ON FUTURES CONTRACTS. The Funds may purchase options on the
futures contracts they can purchase or sell, as described above. A futures
option gives the holder, in return for the premium paid, the right to buy (call)
from or sell (put) to the writer of the option a futures contract at a specified
price at any time during the period of the option. Upon exercise, the writer of
the option is obligated to pay the difference between the cash value of the
futures contract and the exercise price. Like the buyer or seller of a futures
contract, the holder or writer of an option has the right to terminate its
position prior to the scheduled expiration of the option by selling, or
purchasing an option of the same series, at which time the person entering into
the closing transaction will realize a gain or loss. There is no guarantee that
such closing transactions can be effected.
Investments in futures options involve some of the same considerations as
investments in futures contracts (for example, the existence of a liquid
secondary market). In addition, the purchase of an option also entails the risk
that changes in the value of the underlying futures contract will not be fully
reflected in the value of the option. Depending on the pricing of the option
compared to either the futures contract upon which it is based, or upon the
price of the securities being hedged, an option may or may not be less risky
than ownership of the futures contract or such securities. In general, the
market prices of options are more volatile than the market prices on the
underlying futures contracts. Compared to the purchase or sale of futures
contracts, however, the purchase of call or put options on futures contracts may
frequently involve less potential risk to the Funds because the maximum amount
at risk is limited to the premium paid for the options (plus transaction costs).
RESTRICTIONS ON THE USE OF FUTURES CONTRACTS AND RELATED OPTIONS. Except
as described below under "Non-Hedging Strategic Transactions," a Fund will not
engage in transactions in futures
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contracts or related options for speculation, but only as a hedge against
changes resulting from market conditions in the values of securities held in the
Fund's portfolio or which it intends to purchase and where the transactions are
economically appropriate to the reduction of risks inherent in the ongoing
management of the Fund. A Fund also may not purchase or sell futures or
purchase related options if, immediately thereafter, the sum of the amount of
margin deposits on the Fund's existing futures positions and premiums paid for
such options would exceed 5% of the market value of the Fund's net assets.
Upon the purchase of futures contracts, a Fund will deposit an amount of
cash or liquid debt or equity securities, equal to the market value of the
futures contracts, in a segregated account with the Custodian or in a margin
account with a broker to collateralize the position and thereby insure that the
use of such futures is unleveraged.
These restrictions, which are derived from current federal and state
regulations regarding the use of options and futures by mutual funds, are not
"fundamental restrictions" and the Trustees of the Trust may change them if
applicable law permits such a change and the change is consistent with the
overall investment objective and policies of a Fund.
The extent to which a Fund may enter into futures and options transactions
may be limited by the Internal Revenue Code requirements for qualification of
the Fund as a regulated investment company. See "Taxes."
INTEREST RATE AND CURRENCY SWAPS
For hedging purposes, each Fund may enter into interest rate swap
transactions and purchase or sell interest rate caps and floors, and may enter
into currency swap cap transactions. An interest rate or currency swap involves
an agreement between the Fund and another party to exchange payments calculated
as if they were interest on a specified ("notional") principal amount (e.g., an
exchange of floating rate payments by one party for fixed rate payments by the
other). An interest rate cap or floor entitles the purchaser, in exchange for a
premium, to receive payments of interest on a notional principal amount from the
seller of the cap or floor, to the extent that a specified reference rate
exceeds or falls below a predetermined level.
A Fund usually enters into such transactions on a "net" basis, with the
Fund receiving or paying, as the case may be, only the net amount of the two
payment streams. The net amount of the excess, if any, of a Fund's obligations
over its entitlements with respect to each swap is accrued on a daily basis, and
an amount of cash or high-quality liquid securities having an aggregate net
asset value at least equal to the accrued excess is maintained in a segregated
account by the Trust's custodian. If a Fund enters into a swap on other than a
net basis, or sells caps or floors, the Fund maintains a segregated account in
the full amount accrued on a daily basis of the Fund's obligations with respect
to the transaction. Such segregated accounts are maintained in accordance with
applicable regulations of the Commission.
A Fund will not enter into any of these derivative transactions unless the
unsecured senior debt or the claims paying ability of the other party to the
transaction is rated at least "high quality" at the time of purchase by at least
one of the established rating agencies (e.g., AAA or AA by S&P). The swap
market has grown substantially in recent years, with a large number of banks and
investment banking firms acting both as principals and agents utilizing standard
swap documentation, and the Investment Adviser has determined that the swap
market has become relatively liquid. Swap transactions do not involve the
delivery of securities or other underlying assets or principal, and the risk of
loss with respect to such transactions is limited to the net amount of payments
that the Fund is contractually obligated to make or receive. Caps and floors
are more recent innovations for which standardized documentation has not yet
been developed; accordingly, they are less liquid than swaps, and caps and
floors purchased by the Fund are considered to be illiquid assets.
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INTEREST RATE SWAPS. As indicated above, an interest rate swap is a
contract between two entities ("counterparties") to exchange interest payments
(of the same currency) between the parties. In the most common interest rate
swap structure, one counterparty agrees to make floating rate payments to the
other counterparty, which in turn makes fixed rate payments to the first
counterparty. Interest payments are determined by applying the respective
interest rates to an agreed upon amount, referred to as the "notional principal
amount." In most such transactions, the floating rate payments are tied to the
London Interbank Offered Rate, which is the offered rate for short-term
Eurodollar deposits between major international banks. As there is no exchange
of principal amounts, an interest rate swap is not an investment or a borrowing.
CROSS-CURRENCY SWAPS. A cross-currency swap is a contract between two
counterparties to exchange interest and principal payments in different
currencies. A cross-currency swap normally has an exchange of principal at
maturity (the final exchange); an exchange of principal at the start of the swap
(the initial exchange) is optional. An initial exchange of notional principal
amounts at the spot exchange rate serves the same function as a spot transaction
in the foreign exchange market (for an immediate exchange of foreign exchange
risk). An exchange at maturity of notional principal amounts at the spot
exchange rate serves the same function as a forward transaction in the foreign
exchange market (for a future rate for the exchange risk). The currency swap
market convention is to use the spot rate rather than the forward rate for the
exchange at maturity. The economic difference is realized through the coupon
exchanges over the life of the swap. In contrast to single currency interest
rate swaps, cross-currency swaps involve both interest rate risk and foreign
exchange risk.
SWAP OPTIONS. Each Fund may invest in swap options. A swap option is a
contract that gives a counterpart the right (but not the obligation) to enter
into a new swap agreement or to shorten, extend, cancel or otherwise change an
existing swap agreement, at some designated future time on specified terms. It
is different from a forward swap, which is a commitment to enter into a swap
that starts at some future date with specified rates. A swap option may be
structured European-style (exercisable on the pre-specified date) or
American-style ( exercisable during a designated period). The right pursuant to
a swap option must be exercised by the right holder. The buyer of the right to
receive fixed pursuant to a swap option is said to own a call.
CAPS AND FLOORS. Each Fund may invest in interest rate caps and floors and
currency swap cap transactions. An interest rate cap is a right to receive
periodic cash payments over the life of the cap equal to the difference between
any higher actual level of interest rates in the future and a specified strike
(or "cap") level. The cap buyer purchases protection for a floating rate move
above the strike. An interest rate floor is the right to receive periodic cash
payments over the life of the floor equal to the difference between any lower
actual level of interest rates in the future and a specified strike (or "floor")
level. The floor buyer purchases protection for a floating rate move below the
strike. The strikes are typically based on the three-month LIBOR (although
other indices are available) and are measured quarterly. Rights arising
pursuant to both caps and floors are exercised automatically if the strike is in
the money. Caps and floors eliminate the risk that the buyer fails to exercise
an-in-the-money option.
RISKS ASSOCIATED WITH SWAPS. The risks associated with interest rate and
currency swaps and interest rate caps and floors are similar to those described
above with respect to dealer options. In connection with such transactions, a
Fund relies on the other party to the transaction to perform its obligations
pursuant to the underlying agreement. If there were a default by the other
party to the transaction, the Fund would have contractual remedies pursuant to
the agreement, but could incur delays in obtaining the expected benefit of the
transaction or loss of such benefit. In the event of insolvency of the other
party, the Fund might be unable to obtain its expected benefit. In addition,
while each Fund will seek to enter into such transaction only with parties which
are capable of entering into closing transactions with the Fund, there can be no
assurance that a Fund will be able to close out such a transaction with the
other party, or obtain an offsetting position with any other party, at any time
prior to the end of the term of the underlying agreement. This may impair a
Fund's ability to enter into other transactions at a time when doing so might be
advantageous.
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NON-HEDGING STRATEGIC TRANSACTIONS
Each Fund's options, futures and swap transactions will generally be
entered into for hedging purposes to protect against possible changes in the
market values of securities held in or to be purchased for the Fund's portfolio
resulting from securities markets, currency or interest rate fluctuations, to
protect the Fund's unrealized gains in the value of its portfolio securities, to
facilitate the sale of such securities for investment purposes, to manage the
effective maturity or duration of the Fund's portfolio, or to establish a
position in the derivatives markets as a temporary substitute for purchase or
sale of particular securities. However, in addition to the hedging transactions
referred to above, the High Quality Bond Fund may enter into options, futures
and swap transactions to enhance potential gain in circumstances where hedging
is not involved. The Fund's net loss exposure resulting from transactions
entered into for such purposes will not exceed 5% of the Fund's net assets at
any one time and, to the extent necessary, the Fund will close out transactions
in order to comply with this limitation. Such transactions are subject to the
limitations described above under "Options," "Futures Contracts," and "Interest
Rate and Currency Swaps."
REPURCHASE AGREEMENTS
Each Fund may enter into repurchase agreements with respect to its
portfolio securities. Pursuant to such agreements, the Fund acquires securities
from financial institutions such as banks and broker-dealers as are deemed to be
creditworthy by the Investment Adviser, subject to the seller's agreement to
repurchase and the Fund's agreement to resell such securities at a mutually
agreed upon date and price. The repurchase price generally equals the price
paid by the Fund plus interest negotiated on the basis of current short-term
rates (which may be more or less than the rate on the underlying portfolio
security). Securities subject to repurchase agreements will be held by the
Custodian or in the Federal Reserve/Treasury Book-Entry System or an equivalent
foreign system. The seller under a repurchase agreement will be required to
maintain the value of the underlying securities at not less than 102% of the
repurchase price under the agreement. If the seller defaults on its repurchase
obligation, the Fund holding the repurchase agreement will suffer a loss to the
extent that the proceeds from a sale of the underlying securities is less than
the repurchase price under the agreement. Bankruptcy or insolvency of such a
defaulting seller may cause the Fund's rights with respect to such securities to
be delayed or limited. Repurchase agreements are considered to be loans under
the Investment Company Act.
REVERSE REPURCHASE AGREEMENTS
Each Fund may enter into reverse repurchase agreements, which involve the
sale of a security by the Fund and its agreement to repurchase the security (or,
in the case of mortgage-backed securities, substantially similar but not
identical securities) at a specified time and price. The Fund will maintain in
a segregated account with the Custodian cash, U.S. Government securities or
other appropriate liquid securities in an amount sufficient to cover its
obligations under these agreements with broker-dealers (no such collateral is
required on such agreements with banks). Under the 1940 Act, these agreements
are considered borrowings by the Fund, and are subject to the percentage
limitations on borrowings described below. The agreements are subject to the
same types of risks as borrowings.
WHEN-ISSUED SECURITIES, FORWARD COMMITMENTS AND DELAYED SETTLEMENTS
Each Fund may purchase securities on a "when-issued," forward commitment or
delayed settlement basis. In this event, the Custodian will set aside cash or
liquid portfolio securities equal to the amount of the commitment in a separate
account. Normally, the Custodian will set aside portfolio securities to satisfy
a purchase commitment. In such a case, a Fund may be required subsequently to
place additional assets in the separate account in order to assure that the
value of the account remains equal to the amount of the Fund's commitment. It
may be expected that a Fund's net assets will fluctuate to a greater degree when
it sets aside portfolio securities to cover such purchase commitments than when
it sets aside cash.
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The Funds do not intend to engage in these transactions for speculative
purposes but only in furtherance of their investment objectives. Because a Fund
will set aside cash or liquid Fund securities to satisfy its purchase
commitments in the manner described, the Fund's liquidity and the ability of the
Investment Adviser to manage it may be affected in the event the Fund's forward
commitments, commitments to purchase when-issued securities and delayed
settlements ever exceeded 15% of the value of its net assets.
A Fund will purchase securities on a when-issued, forward commitment or
delayed settlement basis only with the intention of completing the transaction.
If deemed advisable as a matter of investment strategy, however, a Fund may
dispose of or renegotiate a commitment after it is entered into, and may sell
securities it has committed to purchase before those securities are delivered to
the Fund on the settlement date. In these cases the Fund may realize a taxable
capital gain or loss. When a Fund engages in when-issued, forward commitment
and delayed settlement transactions, it relies on the other party to consummate
the trade. Failure of such party to do so may result in a Fund's incurring a
loss or missing an opportunity to obtain a price credited to be advantageous.
The market value of the securities underlying a when-issued purchase,
forward commitment to purchase securities, or a delayed settlement and any
subsequent fluctuations in their market value is taken into account when
determining the market value of a Fund starting on the day the Fund agrees to
purchase the securities. A Fund does not earn interest on the securities it has
committed to purchase until they are paid for and delivered on the settlement
date.
BORROWING
Short sales "not against the box" and roll transactions are considered
borrowings for purposes of the percentage limitations applicable to borrowings.
The use of borrowing by a Fund involves special risk considerations that
may not be associated with other funds having similar objectives and policies.
Since substantially all of a Fund's assets fluctuate in value, whereas the
interest obligation resulting from a borrowing remain fixed by the terms of the
Fund's agreement with its lender, the asset value per share of the Fund tends to
increase more when its portfolio securities increase in value and to decrease
more when its portfolio assets decrease in value than would otherwise be the
case if the Fund did not borrow funds. In addition, interest costs on
borrowings may fluctuate with changing market rates of interest and may
partially offset or exceed the return earned on borrowed funds. Under adverse
market conditions, the Fund might have to sell portfolio securities to meet
interest or principal payments at a time when fundamental investment
considerations would not favor such sales.
The Trust has entered into a Credit Agreement on behalf of its various
series, including the Funds, with several banks and The Chase Manhattan Bank, as
administrative agent for the lenders, to borrow up to $75,000,000 from time to
time to satisfy shareholder redemption requests without the necessity of
requiring the Funds to sell portfolio securities, at times when the Investment
Adviser believes such sales are not in the best interests of the shareholders of
the Funds or other series of the Trust, in order to provide the Funds or such
other series with cash to meet such redemption requests. The Credit Agreement
expires on April 7, 1999, unless renewed by the parties.
Under the Credit Agreement, each Fund may borrow, repay and reborrow
amounts (collectively, the "Revolving Credit Loans") in increments of $50,000,
provided the Revolving Credit Loans outstanding at any time aggregate at least
$350,000 (the "Credit Facility"). The Trust will pay a commitment fee at the
rate of 0.10% per annum of the average daily unused portion of the Credit
Facility, and may at any time terminate the Credit Agreement or reduce the
lenders' commitment thereunder in increments of $2,500,000.
While outstanding, the Revolving Credit Loans bear interest, fluctuating
daily and payable monthly, at either of the following rates or a combination
thereof, at the Trust's option: (i) at the weighted average of the rates on
overnight federal funds transactions with members of the Federal
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Reserve System arranged by federal funds brokers, plus 0.625% per annum; or (ii)
the prime rate of interest of The Chase Manhattan Bank. If, as a result of
changes in applicable laws, regulations or guidelines with respect to the
capital adequacy of any lender, the return on such lender's capital is reduced,
the Trust may be required to adjust the rate of interest to compensate such
lender for such reduction. Each Revolving Credit Loan is payable in thirty
days, and may be prepaid at any time in increments of $100,000 without premium
or penalty. No Fund is liable for repayment of a Revolving Credit Loan to any
other Fund.
The Credit Agreement contains, among other things, covenants that require
each Fund to maintain certain minimum ratios of debt to net worth; limit the
ability of the Trust to incur other indebtedness and create liens on its assets
or guarantee obligations of others; merge or consolidate with, or sell its
assets to, others; make material changes in its method of conducting business;
make distributions to shareholders in excess of the requirements of Subchapter M
of the Internal Revenue Code in the event of a default under the Credit
Agreement; or make changes in fundamental investment policies. The Credit
Agreement also contains other terms and conditions customary in such agreements,
including various events of default.
LENDING PORTFOLIO SECURITIES
Under the present regulatory requirements which govern loans of portfolio
securities, the loan collateral must, on each business day, at least equal the
value of the loaned securities and must consist of cash, letters of credit of
domestic banks or domestic branches of foreign banks, or securities of the U.S.
Government or its agencies. To be acceptable as collateral, letters of credit
must obligate a bank to pay amounts demanded by the Fund if the demand meets the
terms of the letter. Such terms and the issuing bank must satisfy the Fund.
Any loan might be secured by any one or more of the three types of collateral.
The terms of the Fund's loans must permit the Fund to reacquire loaned
securities on five days' notice or in time to vote on any serious matter and
must meet certain tests under the Internal Revenue Code.
SHORT SALES
Certain Funds may make short sales of securities they own or have the right
to acquire at no added cost through conversion or exchange of other securities
they own (referred to as short sales "against the box") and short sales of
securities which they do not own or have the right to acquire.
In a short sale that is not "against the box," a Fund sells a security
which it does not own, in anticipation of a decline in the market value of the
security. To complete the sale, the Fund must borrow the security generally
from the broker through which the short sale is made) in order to make delivery
to the buyer. The Fund must replace the security borrowed by purchasing it at
the market price at the time of replacement. The Fund is said to have a "short
position" in the securities sold until it delivers them to the broker. The
period during which the Fund has a short position can range from one day to more
than a year. Until the Fund replaces the security, the proceeds of the short
sale are retained by the broker, and the Fund must pay to the broker a
negotiated portion of any dividends or interest which accrue during the period
of the loan. To meet current margin requirements, the Fund must deposit with
the broker additional cash or securities so that it maintains with the broker a
total deposit equal to 150% of the current market value of the securities sold
short (100% of the current market value if a security is held in the account
that is convertible or exchangeable into the security sold short within 90 days
without restriction other than the payment of money).
Short sales by a Fund that are not made "against the box" create
opportunities to increase the Fund's return but, at the same time, involve
specific risk considerations and may be considered a speculative technique.
Since the Fund in effect profits from a decline in the price of the securities
sold short without the need to invest the full purchase price of the securities
on the date of the short sale, the Fund's net asset value per share tends to
increase more when the securities it has sold short decrease in value, and to
decrease more when the securities it has sold short increase in value, than
would otherwise be the case if it had not engaged in such short sales. The
amount of any gain will be
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decreased, and the amount of any loss increased, by the amount of any premium,
dividends or interest the Fund may be required to pay in connection with the
short sale. Short sales theoretically involve unlimited loss potential, as the
market price of securities sold short may continually increase, although a Fund
may mitigate such losses by replacing the securities sold short before the
market price has increased significantly. Under adverse market conditions the
Fund might have difficulty purchasing securities to meet its short sale delivery
obligations, and might have to sell portfolio securities to raise the capital
necessary to meet its short sale obligations at a time when fundamental
investment considerations would not favor such sales.
If a Fund makes a short sale "against the box," the Fund would not
immediately deliver the securities sold and would not receive the proceeds from
the sale. The seller is said to have a short position in the securities sold
until it delivers the securities sold, at which time it receives the proceeds of
the sale. To secure its obligation to deliver securities sold short, a Fund
will deposit in escrow in a separate account with the Custodian an equal amount
of the securities sold short or securities convertible into or exchangeable for
such securities. The Fund can close out its short position by purchasing and
delivering an equal amount of the securities sold short, rather than by
delivering securities already held by the Fund, because the Fund might want to
continue to receive interest and dividend payments on securities in its
portfolio that are convertible into the securities sold short.
A Fund's decision to make a short sale "against the box" may be a technique
to hedge against market risks when the Investment Adviser believes that the
price of a security may decline, causing a decline in the value of a security
owned by the Fund or a security convertible into or exchangeable for such
security. In such case, any future losses in the Fund's long position would be
reduced by a gain in the short position. The extent to which such gains or
losses in the long position are reduced will depend upon the amount of
securities sold short relative to the amount of the securities the Fund owns,
either directly or indirectly, and, in the case where the Fund owns convertible
securities, changes in the investment values or conversion premiums of such
securities.
In the view of the Commission, a short sale involves the creation of a
"senior security" as such term is defined in the Investment Company Act, unless
the sale is "against the box" and the securities sold short are placed in a
segregated account (not with the broker), or unless the Fund's obligation to
deliver the securities sold short is "covered" by placing in a segregated
account (not with the broker) cash, U.S. Government securities or other liquid
debt or equity securities in an amount equal to the difference between the
market value of the securities sold short at the time of the short sale and any
such collateral required to be deposited with a broker in connection with the
sale (not including the proceeds from the short sale), which difference is
adjusted daily for changes in the value of the securities sold short. The total
value of the cash, U.S. Government securities or other liquid debt or equity
securities deposited with the broker and otherwise segregated may not at any
time be less than the market value of the securities sold short at the time of
the short sale. Each Fund will comply with these requirements. In addition, as
a matter of policy, the Trust's Board of Trustees has determined that no Fund
will make short sales of securities or maintain a short position if to do so
could create liabilities or require collateral deposits and segregation of
assets aggregating more than 25% of the Fund's total assets, taken at market
value.
The extent to which a Fund may enter into short sales transactions may be
limited by the Internal Revenue Code requirements for qualification of the Fund
as a regulated investment company. See "Dividends, Distributions and Taxes."
ILLIQUID SECURITIES
Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act of 1933, as amended (the "Securities Act"),
securities which are otherwise not readily marketable and repurchase agreements
having a maturity of longer than seven days. Securities which have not been
registered under the Securities Act are referred to as private placement or
restricted securities and are purchased directly from the issuer or in the
secondary market. Mutual funds do not typically hold a significant
B-25
<PAGE>
amount of these restricted or other illiquid securities because of the potential
for delays on resale and uncertainty in valuation. Limitations on resale may
have an adverse effect on the marketability of portfolio securities and the Fund
might be unable to dispose of restricted or other illiquid securities promptly
or at reasonable prices and might thereby experience difficulty satisfying
redemption within seven days. The Fund might also have to register such
restricted securities in order to dispose of them, resulting in additional
expense and delay. Adverse market conditions could impede such a public offering
of securities.
In recent years, however, a large institutional market has developed for
certain securities that are not registered under the Securities Act, including
repurchase agreements, commercial paper, foreign securities, municipal
securities and corporate bonds and notes. Institutional investors depend on an
efficient institutional market in which the unregistered security can be readily
resold or on an issuer's ability to honor a demand for repayment. The fact that
there are contractual or legal restrictions on resale to the general public or
to certain institutions may not be indicative of the liquidity of such
investments. If such securities are subject to purchase by institutional buyers
in accordance with Rule 144A promulgated by the Commission under the Securities
Act, the Trust's Board of Trustees has determined that such securities are not
illiquid securities notwithstanding their legal or contractual restrictions on
resale. In all other cases, however, securities subject to restrictions on
resale will be deemed illiquid. Investing in restricted securities eligible for
resale under Rule 144A could have the effect of increasing the level of
illiquidity in the Funds to the extent that qualified institutional buyers
become uninterested in purchasing such securities.
The Emerging Countries Fund may invest in foreign securities that are
restricted against transfer within the United States or to United States
persons. Although securities subject to such 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. Unless these securities are
acquired directly from the issuer or its underwriter, the Fund treats foreign
securities whose principal market is abroad as not subject to the investment
limitation on securities subject to legal or contractual restrictions on resale.
INVESTMENT TECHNIQUES AND PROCESSES
The Investment Adviser's investment techniques and processes, which it has
used in managing institutional portfolio for many years, are described generally
in the Funds' prospectus. In making decisions with respect to equity securities
for the Funds, GROWTH OVER TIME-Registered Trademark- is the Investment
Adviser's underlying goal, and the Investment Adviser emphasizes growth over
time through investment in securities of companies with earnings growth
potential. Its investment techniques focus on discovering positive developments
when they first show up in an issuer's earnings, but before they are fully
reflected in the price of the issuer's securities.
As indicated in the Funds' prospectus, the Investment Adviser's techniques
and processes include relationships with an extensive network of brokerage
research firms located throughout the world. These analysts are often located
in the same geographic regions as the companies they follow, have followed those
companies for a number of years, and have developed excellent sources of
information about them. The Investment Adviser does not employ in-house
analysts other than the personnel actually engaged in managing investments for
the Funds and the Investment Adviser's other clients. However, information
obtained from a brokerage research firm is confirmed with other research sources
or the Investment Adviser's computer-assisted quantitative analysis (including
"real time" pricing data) of a substantial universe of potential investments.
DIVERSIFICATION
Each Fund is "diversified" within the meaning of the Investment Company
Act. In order to qualify as diversified, a Fund must diversify its holdings so
that at all times at least 75% of the value of its total assets is represented
by cash and cash items (including receivables), securities issued or guaranteed
as to principal or interest by the United States or its agencies or
instrumentalities, securities of other investment companies, and other
securities (for this purpose other securities of any one issuer
B-26
<PAGE>
are limited to an amount not greater than 5% of the value of the total assets of
the Fund and to not more than 10% of the outstanding voting securities of the
issuer).
The equity securities of each issuer that are included in the investment
portfolio of a Fund are purchased by the Investment Adviser in approximately
equal amounts, and the Investment Adviser attempts to stay fully invested within
the applicable percentage limitations set forth in the Prospectus. In addition,
for each issuer whose securities are added to an investment portfolio, the
Investment Adviser sells the securities of one of the issuers currently included
in the portfolio.
INVESTMENT RESTRICTIONS
The Trust, on behalf of the Funds, has adopted the following fundamental
policies that cannot be changed without the affirmative vote of a majority of
the outstanding shares of the appropriate Fund (as defined in the Investment
Company Act).
All percentage limitations set forth below apply immediately after a
purchase or initial investment, and any subsequent change in any applicable
percentage resulting from market fluctuations will not require elimination of
any security from the relevant portfolio.
The investment objective of each Fund is a fundamental policy. In
addition, no Fund:
1. May invest in securities of any one issuer if more than 5% of the
market value of its total assets would be invested in the securities of such
issuer, except that up to 25% of a Fund's total assets may be invested without
regard to this restriction and a Fund will be permitted to invest all or a
portion of its assets in another diversified, open-end management investment
company with substantially the same investment objective, policies and
restrictions as the Fund. This restriction also does not apply to investments
by a Fund in securities of the U.S. Government or any of its agencies and
instrumentalities.
2. May purchase more than 10% of the outstanding voting securities, or of
any class of securities, of any one issuer, or purchase the securities of any
issuer for the purpose of exercising control or management, except that a Fund
will be permitted to invest all or a portion of its assets in another
diversified, open-end management investment company with substantially the same
investment objective, policies and restrictions as the Fund.
3. May invest 25% or more of the market value of its total assets in the
securities of issuers in any one particular industry, except that a Fund will be
permitted to invest all or a portion of its assets in another diversified,
open-end management investment company with substantially the same investment
objective, policies and restrictions as the Fund. This restriction does not
apply to investments by a Fund in securities of the U.S. Government or its
agencies and instrumentalities.
4. May purchase or sell real estate. However, a Fund may invest in
securities secured by, or issued by companies that invest in, real estate or
interests in real estate.
5. May make loans of money, except that a Fund may purchase publicly
distributed debt instruments and certificates of deposit and enter into
repurchase agreements. Each Fund reserves the authority to make loans of its
portfolio securities in an aggregate amount not exceeding 30% of the value of
its total assets.
6. May borrow money on a secured or unsecured basis, except for
temporary, extraordinary or emergency purposes or for the clearance of
transactions in amounts not exceeding 20% of the value of its total assets at
the time of the borrowing, provided that, pursuant to the Investment Company
Act, borrowings will only be made from banks and will be made only to the extent
that the value of the Fund's total assets, less its liabilities other than
borrowings, is equal to at least 300% of all borrowings
B-27
<PAGE>
(including the proposed borrowing). If such asset coverage of 300% is not
maintained, the Fund will take prompt action to reduce its borrowings as
required by applicable law.
7. May pledge or in any way transfer as security for indebtedness any
securities owned or held by it, except to secure indebtedness permitted by
restriction 6 above. This restriction shall not prohibit the Funds from
engaging in options, futures and foreign currency transactions.
8. May underwrite securities of other issuers, except insofar as it may
be deemed an underwriter under the Securities Act in selling portfolio
securities.
9. May invest more than 15% of the value of its net assets in securities
that at the time of purchase have legal or contractual restrictions on resale or
are otherwise illiquid.
10. May purchase securities on margin, except for initial and variation
margin on options and futures contracts, and except that a Fund may obtain such
short-term credit as may be necessary for the clearance of purchases and sales
of securities.
11. May engage in short sales (other than the Mid Cap Growth, Mini Cap
Growth, Small Cap Growth, International Core Growth, Worldwide Growth, High
Yield Bond and the International Small Cap Growth Funds), except that a Fund may
use such short-term credits as are necessary for the clearance of transactions.
12. May invest in securities of other investment companies, except (a)
that a Fund will be permitted to invest all or a portion of its assets in
another diversified, open-end management investment company with substantially
the same investment objective, policies and restrictions as the Fund; (b) in
compliance with the Investment Company Act and applicable state securities laws;
or (c) as part of a merger, consolidation, acquisition or reorganization
involving the Fund.
13. May issue senior securities, except that a Fund may borrow money as
permitted by restrictions 6 and 7 above. This restriction shall not prohibit
the Funds from engaging in short sales, options, futures and foreign currency
transactions.
14. May enter into transactions for the purpose of arbitrage, or invest in
commodities and commodities contracts, except that a Fund may invest in stock
index, currency and financial futures contracts and related options in
accordance with any rules of the Commodity Futures Trading Commission.
15. May purchase or write options on securities, except for hedging
purposes (except in the case of the High Quality Bond Fund, which may do so for
non-hedging purposes) and then only if (i) aggregate premiums on call options
purchased by a Fund do not exceed 5% of its net assets, (ii) aggregate premiums
on put options purchased by a Fund do not exceed 5% of its net assets, (iii) not
more than 25% of a Fund's net assets would be hedged, and (iv) not more than 25%
of a Fund's net assets are used as cover for options written by the Fund.
OPERATING RESTRICTIONS
As a matter of operating (not fundamental) policy adopted by the Board of
Trustees of the Trust, no Fund:
1. May invest in interests in oil, gas or other mineral exploration or
development programs or leases, or real estate limited partnerships, although a
Fund may invest in the securities of companies which invest in or sponsor such
programs.
2. May lend any securities from its portfolio unless the value of the
collateral received therefor is continuously maintained in an amount not less
than 100% of the value of the loaned securities by marking to market daily.
B-28
<PAGE>
PRINCIPAL HOLDERS OF SECURITIES
As of June 30, 1998, the following persons held of record more than 5% of
the outstanding shares of the Funds:
LARGE CAP GROWTH QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (85.45%).
SMALL CAP GROWTH QUALIFIED PORTFOLIO: Suntrust Bank, Cust. FBO The Ackerman
Senterfitt Edison PA Cash or Deferred PSP TR A/C 56800103, Attn: 3144, P.O. Box
105870, Atlanta, Georgia 30348-5870 (25.65%); Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (23.74%); Suntrust Bank Central Fl. NA TTEE, FBO Hubbard Construction
Co. Emp. PSP and 401K Plan, c/o FAS Corp. Record Keeper, 8515 Orchard Road,
Englewood, CO 80111-5002 (13.29%); Suntrust Bank Central Fl. NA TTEE, FBO
Akerman Senterfitt & Edison P Cash or Deferred PS PL & Trust, c/o FAS Corp.
Record Keeper, 8515 E. Orchard Road, Suite 212, Englewood, Colorado 80111-5002
(7.11%).
MID CAP GROWTH QUALIFIED PORTFOLIO: Clark & Co., FBO Swedish American
Hosp., 403B Aggr, P.O. Box 39, Westerville, Ohio 43086-0039 (39.18%); Clark &
Co., FBO Swedish American Hosp., 401K Aggr. Growth, P.O. Box 39, Westerville,
Ohio 43086-0039 (23.91%); Charles Schwab & Co., Inc., Attn: Mutual Funds, 101
Montgomery Street, 11th Floor, San Francisco, California 94104-4122 (9.42%).
CONVERTIBLE QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn: Mutual
Funds, 101 Montgomery Street, 11th Floor, San Francisco, California 94104-4122
(96.37%).
BALANCED GROWTH QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (96.48%).
GOVERNMENT INCOME QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (99.51%).
INTERNATIONAL CORE GROWTH QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc.,
Attn: Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (65.61%).
WORLDWIDE GROWTH QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (38.04%); PaineWebber for the benefit of PaineWebber CDN., FBO,
Rosemary S. Garbett IRA RLVR, P.O. Box 3321, Weehawken NJ 07087-8154 (15.35%).
INTERNATIONAL SMALL CAP GROWTH QUALIFIED PORTFOLIO: Charles Schwab & Co.,
Inc., Attn: Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco,
California 94104-4122 (88.77%).
EMERGING COUNTRIES QUALIFIED PORTFOLIO: Charles Schwab & Co., Inc., Attn:
Mutual Funds, 101 Montgomery Street, 11th Floor, San Francisco, California
94104-4122 (41.75%).
HIGH YIELD BOND FUND - CLASS Q: Charles Schwab & Co., Inc., Attn: Mutual
Funds, 101 Montgomery Street, 11th Floor, San Francisco, California 94104-4122
(69.14%); Donaldson Lufkin Jenrette Securities Corporation, Inc., P.O. Box 2052,
Jersey City, New Jersey 07303-2052 (10.92%); Donaldson Lufkin Jenrette
Securities Corporation, Inc., P.O. Box 2052, Jersey City, New Jersey 07303-2052
(5.83%).
As of such date, the Trustees and officers of the Trust, as a group, owned
beneficially and of record less than 1% of the outstanding shares of each of the
Funds, except for the shares indicated above that are held by Nicholas-Applegate
Capital Management.
B-29
<PAGE>
TRUSTEES AND PRINCIPAL OFFICERS
TRUST
The names, ages and addresses of the Trustees and principal officers of the
Trust, including their positions and principal occupations during the past five
years, are shown below. Trustees whose names are followed by an asterisk are
"interested persons" of the Trust (as defined by the Investment Company Act).
Unless otherwise indicated, the address of each Trustee and officer is 600 West
Broadway, 30th Floor, San Diego, California 92101.
FRED C. APPLEGATE (52), TRUSTEE AND CHAIRMAN OF THE BOARD OF TRUSTEES.
885 La Jolla Corona Court, La Jolla, California. Private investor. Formerly
President, Nicholas-Applegate Capital Management (from August 1984 to December
1991). Director of Nicholas-Applegate Fund, Inc. (since 1987). Mr. Applegate's
interests in Nicholas-Applegate Capital Management, Inc., the general partner of
the Investment Adviser, were acquired by Mr. Nicholas in 1991 and 1992.
DANN V. ANGELOFF (62), TRUSTEE. 727 West Seventh Street, Los Angeles,
California. President, The Angeloff Company, corporate financial advisers
(since 1976); Director, Nicholas-Applegate Fund, Inc. (since 1987); Trustee
(1979 to 1987) and University Counselor to the President (since 1987),
University of Southern California (since 1987); Director, Public Storage, Inc.,
a real estate investment trust (since 1980). Formerly Trustee,
Nicholas-Applegate Investment Trust (until 1998).
WALTER E. AUCH (76), TRUSTEE. 6001 North 62nd Place, Paradise Valley,
Arizona. Director, Geotech Communications, Inc., a mobile radio communications
company (since 1987); Fort Dearborn Fund (since 1987); Brinson Funds (since
1994), Smith Barney Trak Fund (since 1992), registered investment companies;
Pimco Advisors L.P., an investment manager (since 1994); and Banyan Realty Fund
(since 1987), Banyan Strategic Land Fund (since 1987), Banyan Strategic Land
Fund II (since 1988), and Banyan Mortgage Fund (since 1988), real estate
investment trusts. Formerly Chairman and Chief Executive Officer, Chicago Board
Options Exchange (1979 to 1986); Senior Executive Vice President, Director and
Member of the Executive Committee, PaineWebber, Inc. (until 1979). Formerly,
Trustee, Nicholas-Applegate Investment Trust (until 1998). Mr. Auch is
considered to be an "interested person" of the Trust under the 1940 Act because
he is on the board of a company a subsidiary of which is a broker-dealer.
THEODORE J. COBURN (44), TRUSTEE. 17 Cotswold Road, Brookline,
Massachusetts. Partner, Brown Coburn & Co. an investment banking firm (since
1991), and research associate, Harvard Graduate School of Education (since
1996). Director, Nicholas-Applegate Fund, Inc. (since 1987), Emerging Germany
Fund (since 1991), Moovies, Inc. (since 1995). Formerly Managing Director of
Global Equity Transactions Group and member of Board of Directors, Prudential
Securities (from 1986 to June 1991). Formerly, Trustee, Nicholas-Applegate
Investment Trust (until 1998).
DARLENE DEREMER (42), TRUSTEE. 155 South Street, Wrentham, Massachusetts.
President and Founder, DeRemer Associates, a marketing consultant for the
financial services industry (since 1987); Vice President, PBNG Funds, Inc.
(since 1995); formerly Vice President and Director, Asset Management Division,
State Street Bank and Trust Company (from 1982 to 1987), and Vice President, T.
Rowe Price & Associates (1979 to 1982); Director, Jurika & Voyles Fund Group
(since 1994), Nicholas-Applegate Strategic Opportunities Ltd. (since 1994),
Nicholas-Applegate Securities International (since 1994), and King's Wood
Montessori School (since 1995); Member of Advisory Board, Financial Women's
Association (since 1995). Formerly Trustee, Nicholas-Applegate Investment Trust
(until 1998).
GEORGE F. KEANE (68), TRUSTEE. 450 Post Road East, Westport, Connecticut.
President Emeritus and Senior Investment Adviser, The Common Fund, a non-profit
investment management organization representing educational institutions (since
1993), after serving as its President (from 1971 to 1992); Member of Investment
Advisory Committee, New York State Common Retirement Fund
B-30
<PAGE>
(since 1982); Director and Chairman of the Investment Committee, United Negro
College Fund (since 1987); Director, United Educators Risk Retention Group
(since 1989); Director, RCB Trust Company (since 1991); Director, School,
College and University Underwriters Ltd. (since 1986); Trustee, Fairfield
University (since 1993); Director, The Bramwell Funds, Inc. (since 1994);
Chairman of the Board, Trigen Energy Corporation (since 1994); Director
Universal Stainless & Alloy Products Inc. (since 1994). Formerly President,
Endowment Advisers, Inc. (from August 1987 to December 1992). Formerly,
Trustee, Nicholas-Applegate Investment Trust (until 1998).
ARTHUR B. LAFFER (57), TRUSTEE.*/ 5405 Morehouse Drive, Suite 340, San
Diego, California. Chairman, A.B. Laffer & Associates, an economic consulting
firm (since 1979); Chairman, Laffer Advisors Incorporated, economic consultants
(since 1981); Director, Nicholas-Applegate Fund, Inc. (since 1987); Director,
U.S. Filter Corporation (since March 1991) and MasTec, Inc. (construction)
(since 1994), and Coinmach Laundry Corporation (since 1996); Chairman, Calport
Asset Management, Inc. (since 1992); formerly Distinguished University Professor
and Director, Pepperdine University (from Sept. 1985 to May 1988) and Professor
of Business Economics, University of Southern California (1976 to 1984). Mr.
Laffer is considered to be an "interested person" of the Trust because A.B.
Laffer & Associates received material compensation from the Investment Adviser
for consulting services provided from time to time to the Investment Adviser,
and because during the last two fiscal years his son was an employee of the
Investment Adviser.
CHARLES E. YOUNG (66), TRUSTEE. UCLA, 2224 Murphy Hall, Los Angeles,
California. Chancellor, UCLA (1968-1997); Director, Nicholas-Applegate Fund,
Inc. (since 1992); Director, Intel Corp. (since 1974), Academy of Television
Arts and Sciences Foundation (since October 1988), Los Angeles World Affairs
Council (since 1977) and Town Hall of California (since 1982).
ARTHUR E. NICHOLAS (51), PRESIDENT*/. Managing Partner and Chief
Investment Officer, Nicholas-Applegate Capital Management (since 1984), and
Chairman / President Nicholas-Applegate Securities. Director and Chairman of
the Board of Directors of Nicholas-Applegate Fund, Inc., a registered open-end
investment company, since 1987. Formerly Trustee, Nicholas-Applegate Investment
Trust (until 1998).
E. BLAKE MOORE, JR. (39), CHIEF FINANCIAL OFFICER AND SECRETARY. Chief
Financial Officer, Nicholas-Applegate Capital Management and Nicholas-Applegate
Securities (since 1998), and General Counsel and Secretary, Nicholas-Applegate
Capital Management and Nicholas-Applegate Securities (since 1993); formerly
Attorney, Luce, Forward, Hamilton & Scripps (from 1989 to 1993).
PETER J. JOHNSON (42), VICE PRESIDENT. Partner and Director - Client
Services/Marketing, Nicholas-Applegate Capital Management (since January 1992)
and Vice President, Nicholas-Applegate Securities (since December 1995);
formerly, Marketing Director, Pacific Financial Asset Management Company, an
investment management firm (from July 1989 to December 1991), and Senior
Marketing Representative, Fidelity Investments Institutional Services (from
August 1987 to July 1989).
Each Trustee of the Trust who is not an officer or affiliate of the Trust,
the Investment Adviser or the Distributor receives an aggregate annual fee of
$14,000 for services rendered as a Trustee of the Trust, and $1,000 for each
meeting attended ($2,000 per Committee meeting for Committee chairmen). Each
Trustee is also reimbursed for out-of-pocket expenses incurred as a Trustee.
The following table sets forth the aggregate compensation paid by the Trust
for the fiscal year ended March 31, 1998, to the Trustees who are not affiliated
with the Investment Adviser and the aggregate compensation paid to such Trustees
for service on the Trust's board and that of all other funds in the "Trust
complex" (as defined in Schedule 14A under the Securities Exchange Act of 1934):
B-31
<PAGE>
<TABLE>
<CAPTION>
Aggregate Pension or Estimated Annual Total Compensation
Compensation Retirement Benefits Benefits Upon from Trust and
Name from Trust Accrued as Part of Retirement Trust Complex Paid
Trust Expenses to Trustee
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Fred C. Applegate $23,000 None N/A $37,000 (63*)
Arthur B. Laffer $18,000 None N/A $32,000 (63*)
Charles E. Young $19,000 None N/A $34,000 (63*)
Dann V. Angeloff $22,000 None N/A $39,000 (18*)
Walter E. Auch $20,000 None N/A $20,000 (17*)
Theodore J. Coburn $20,000 None N/A $36,000 (18*)
Darlene Deremer $18,000 None N/A $18,000 (17*)
George F. Keane $20,000 None N/A $20,000 (17*)
</TABLE>
* Indicates number of funds in Trust complex, including the Funds.
INVESTMENT ADVISER
The Investment Adviser to the Trust is Nicholas-Applegate Capital
Management, a California limited partnership, with offices at 600 West Broadway,
30th Floor, San Diego, California 92101.
The Investment Adviser was organized in 1984 to manage discretionary
accounts investing in publicly traded securities for a variety of investors.
Its general partner is Nicholas-Applegate Capital Management Holdings, L.P., a
California limited partnership the general partner of which is
Nicholas-Applegate Capital Management Holdings, Inc., a California corporation
owned by Mr. Nicholas.
Personnel of the Investment Adviser may invest in securities for their own
accounts pursuant to a Code of Ethics that sets forth all partners' and
employees' fiduciary responsibilities regarding the Funds, establishes
procedures for personal investing, and restricts certain transactions. For
example, all personal trades in most securities require pre-clearance, and
participation in initial public offerings is prohibited. In addition,
restrictions on the timing of personal investing in relation to trades by the
Funds and on short-term trading have been adopted.
THE INVESTMENT ADVISORY AGREEMENT
Under the Investment Advisory Agreement between the Trust and the
Investment Adviser with respect to the Funds, the Trust retains the Investment
Adviser to manage the Funds' investment portfolio, subject to the direction of
the Trust's Board of Trustees. The Investment Adviser is authorized to
determine which securities are to be bought or sold by the Funds and in what
amounts.
The Investment Advisory Agreement provides that the Investment Adviser will
not be liable for any error of judgment or for any loss suffered by a Fund or
the Trust in connection with the matters to which the Investment Advisory
Agreement relates, except for liability resulting from willful misfeasance, bad
faith or gross negligence in the performance of its duties or by reason of the
Investment Adviser's reckless disregard of its duties and obligations under the
Investment Advisory Agreement. The Trust has agreed to indemnify the Investment
Adviser against liabilities, costs and expenses that the Investment Adviser may
incur in connection with any action, suit, investigation or other proceeding
arising out of or otherwise based on any action actually or allegedly taken or
omitted to be taken by the Investment Adviser in connection with the performance
of its duties or obligations under the Investment Advisory Agreement or
otherwise as an investment adviser of the Trust. The Investment Adviser is not
entitled to
B-32
<PAGE>
indemnification with respect to any liability to the Trust or its shareholders
by reason of willful misfeasance, bad faith or gross negligence in the
performance of its duties, or of its reckless disregard of its duties and
obligations under the Investment Advisory Agreement.
Prior to the Reorganization of the Trust and the elimination of its
master-feeder structure, the Trust had not engaged the services of an investment
adviser for the Trust's Qualified Portfolios because these Portfolios invested
all of their assets in master funds of the Master Trust. Consequently, the
amounts of the advisory fees earned by the Investment Adviser and reported below
were for services provided to the Master Funds of the Master Trust. The amounts
of the advisory fees earned by the Investment Adviser for the fiscal year ended
March 31, 1998, and the amounts of the reductions in fees and reimbursement of
expenses by the Investment Adviser (or recoupment of fees previously deferred
and expenses previously reimbursed) as a result of the expense limitations and
fee waivers described below under "Expense Limitation" were as follows:
<TABLE>
<CAPTION>
Fee Reductions and
Expense Reimbursements
Fund Advisory Fees (or Recoupments)
- ---------------------------------------------------------------------------
<S> <C> <C>
International Core Growth Fund $308,562 $30,669
Worldwide Growth Fund 1,251,181 111,071
International Small Cap Growth Fund 658,893 79,886
Emerging Countries Fund 2,790,216 84,868
Large Cap Fund 32,530 53,872
Mid Cap Growth Fund 3,422,148 9,400
Value Fund 52,328 60,348
Small Cap Growth Fund 6,613,874 0
Mini Cap Growth Fund 866,987 (5,098)
Convertible Fund 1,427,198 0
Balanced Growth Fund 220,025 48,936
High Quality Bond Fund(1)/ 94,359 193,047
High Yield Bond Fund 36,505 111,479
</TABLE>
(1)/ Includes the advisory fees, fee reductions and expense reimbursements of
the Government Income Fund, the assets and liabilities of which were assigned to
and assumed by the High Quality Bond Fund pursuant to the Reorganization.
The Investment Advisory Agreement provides that it will terminate in the
event of its assignment (as defined in the Investment Company Act). The
Investment Advisory Agreement may be terminated with respect to any Fund by the
Trust (by the Board of Trustees of the Trust or vote of a majority of the
outstanding voting securities of the Fund, as defined in the Investment Company
Act) or the Investment Adviser upon not more than 60 days' written notice,
without payment of any penalty. The Investment Advisory Agreement provides that
it will continue in effect with respect to each Fund for a period of more than
two years from its execution only so long as such continuance is specifically
approved at least annually in conformity with the Investment Company Act.
EXPENSE LIMITATION
Under the Investment Advisory Agreement, the Investment Adviser has agreed
to defer its fees, and to absorb other expenses of each Fund (including
administrative fees and distribution expenses for the Fund, but excluding
interest, taxes, brokerage commissions and other costs incurred in connection
with portfolio securities transactions, organizational expenses and other
capitalized expenditures and extraordinary expenses), subject to possible
reimbursement during a five year period, to ensure that the operating expenses
for the Funds do not exceed the amounts specified in the Funds' prospectus.
B-33
<PAGE>
ADMINISTRATOR
The principal administrator of the Trust is Investment Company
Administration Corporation ("ICAC"), 4455 East Camelback Road, Suite 261-E,
Phoenix, Arizona 85018.
Pursuant to an Administration Agreement with the Trust, ICAC is responsible
for performing all administrative services required for the daily business
operations of the Trust, subject to the supervision of the Board of Trustees of
the Trust. ICAC has no supervisory responsibility over the investment
operations of the Funds. The management or administrative services of ICAC for
the Trust are not exclusive under the terms of the Administration Agreement and
ICAC is free to, and does, render management and administrative services to
others.
For its services, ICAC receives under the Administration Agreement annual
fees from each Fund equal to the Fund's pro rata portion (based on its net
assets compared to the Trust's total net assets) of a fee equal to 0.05% of the
first $100 million of the Trust's average net assets, 0.04% of the next $150
million, 0.03% of the next $300 million, 0.02% of the next $300 million and
0.01% thereafter, subject to a $40,000 annual minimum. As a result, for the
fiscal year ended March 31, 1998, ICAC received aggregate compensation of
$848,799 for all of the series of the Trust. Such fees will be allocated among
the series in each grouping based on relative net asset values.
In connection with its management of the corporate affairs of the Trust,
the Administrator pays the salaries and expenses of all its personnel and pays
all expenses incurred in connection with managing the ordinary course of the
business of the Trust, other than expenses assumed by the Trust as described
below.
Under the terms of the Administration Agreement, the Trust is responsible
for the payment of the following expenses: (a) the fees and expenses incurred
by the Trust in connection with the management of the investment and
reinvestment of their assets, (b) the fees and expenses of Trustees and officers
of the Trust who are not affiliated with ICAC or the Investment Adviser, (c)
out-of-pocket travel expenses for the officers and Trustees of the Trust and
other expenses of Board of Trustees' meetings, (d) the fees and certain expenses
of the Custodian, (e) the fees and expenses of the Transfer and Dividend
Disbursing Agent that relate to the maintenance of each shareholder account, (f)
the charges and expenses of the Trust's legal counsel and independent
accountants, (g) brokerage commissions and any issue or transfer taxes
chargeable to Trustees and officers of the Trust in connection with securities
transactions, (h) all taxes and corporate fees payable by the Trust to federal,
state and other governmental agencies, (i) the fees of any trade association of
which the Trust may be a member, (j) the cost of maintaining the Trust's
existence, taxes and interest, (k) the cost of fidelity and liability insurance,
(l) the fees and expenses involved in registering and maintaining the
registration of the Trust and of its shares with the Commission and registering
the Trust as a broker or dealer and qualifying their shares under state
securities laws, including the preparation and printing of the Trust's
registration statement, prospectuses and statements of additional information,
(m) allocable communication expenses with respect to investor services and all
expenses of shareholders' and Board of Trustees' meetings and of preparing,
printing and mailing prospectuses and reports to shareholders, (n) litigation
and indemnification expenses and other extraordinary expenses not incurred in
the ordinary course of the business of the Trust, and (o) expenses assumed by
the Trust pursuant to any plan of distribution adopted in conformity with Rule
12b-1 under the Investment Company Act.
The Administration Agreement provides that ICAC will not be liable for any
error of judgment or for any loss suffered by the Trust in connection with the
matters to which the Administration Agreement relates, except a loss resulting
from ICAC's willful misfeasance, bad faith, gross negligence or reckless
disregard of its duties. The Administration Agreement will terminate
automatically if assigned, and may be terminated without penalty by either ICAC
or the Trust (by the Board of Trustees of the Trust or vote of a majority of the
outstanding voting securities of the Trust, as defined in the Investment Company
Act), upon 60 days' written notice. The Administration Agreement will continue
in effect only so long as such continuance is specifically approved at least
annually in conformity with the Investment Company Act.
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<PAGE>
Pursuant to an Administrative Services Agreement with the Trust, the
Investment Adviser is responsible for providing all administrative services
which are not provided by ICAC or by the Trust's Distributor, transfer agents,
accounting agents, independent accountants and legal counsel. These services
are comprised principally of assistance in coordinating with the Trust's various
service providers, providing certain officers of the Trust, responding to
inquiries from shareholders which are directed to the Trust rather than other
service providers, calculating performance data, providing various reports to
the Board of Trustees, and assistance in preparing reports, prospectuses, proxy
statements and other shareholder communications. The Agreement contains
provisions regarding liability and termination similar to those of the
Administration Agreement.
DISTRIBUTOR
Nicholas-Applegate Securities (the "Distributor"), 600 West Broadway, 30th
Floor, San Diego, California 92101, is the principal underwriter and distributor
for the Trust and, in such capacity, is responsible for distributing shares of
the Funds. The Distributor is a California limited partnership organized in
1992 to distribute shares of registered investment companies. Its general
partner is Nicholas-Applegate Capital Management Holdings, L.P., the general
partner of the Investment Adviser.
DISTRIBUTION AGREEMENT
Pursuant to its Distribution Agreement with the Trust, the Distributor has
agreed to use its best efforts to effect sales of shares of the Funds, but is
not obligated to sell any specified number of shares. The Distribution
Agreement contains provisions with respect to renewal and termination similar to
those in the Investment Advisory Agreement discussed above. The minimum assets
for investors in Class Q shares of the Funds may be waived from time to time.
Pursuant to the Distribution Agreement, the Trust has agreed to indemnify the
Distributor to the extent permitted by applicable law against certain
liabilities under the Securities Act.
SHAREHOLDER SERVICE PLAN
The Trust has also adopted a Shareholder Service Plan with respect to the
Funds. Under the Shareholder Service Plan, the Distributor is compensated at
the annual rate of 0.25% of the average daily net assets of each Fund
attributable to the Class Q shares of such Fund, for certain shareholder service
expenses provided by the Distributor and fees paid to plan sponsors and others
for the provision of support services to their clients who are beneficial owners
of shares of the Funds.
Support services include, among other things, establishing and maintaining
accounts and records relating to their clients that invest in Fund shares;
processing dividend and distribution payments from the Funds on behalf of
clients; preparing tax reports; arranging for bank wires; responding to client
inquiries concerning their investments in Fund shares; providing the information
to the Funds necessary for accounting and subaccounting; preparing tax reports,
forms and related documents; forwarding shareholder communications from the
Trust (such as proxies, shareholder reports, annual and semi-annual financial
statements and dividend, distribution and tax notices) to clients; assisting in
processing exchange and redemption requests from clients; assisting clients in
changing dividend options, account designations and addresses; and providing
such other similar services.
The Shareholder Service Plan continues in effect from year to year,
provided that each such continuance is approved at least annually by a vote of
the Board of Trustees of the Trust, including a majority of the Trustees who
have no direct or indirect financial interest in the operation of the
Shareholder Service Plan or in any agreement related to the Shareholder Service
Plan (the "Independent Trustees"), cast in person at a meeting called for the
purpose of voting on such continuance. The Shareholder Service Plan may be
amended at any time by the Board, provided that any material amendments of the
terms of the Plan will become effective only upon the approval by a majority of
the Board and a majority of the Independent Trustees pursuant to a vote cast in
person at a meeting called for
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<PAGE>
the purpose of voting on the Plan. The Shareholder Service Plan may be
terminated with respect to any Fund or class at any time, without penalty, by
the Board.
Under the Shareholder Service Plan, the Distributor pays plan sponsors and
others an account servicing fee of up to 0.25% annually of the average daily net
assets of each Fund attributable to the Class Q shares of such Fund in the
accounts of their customers, as compensation for providing certain
shareholder-related services.
MISCELLANEOUS
Pursuant to the Shareholder Service Plan, the Board of Trustees reviews at
least quarterly a written report of the service expenses incurred on behalf of
shares of the Funds by the Distributor. The report includes an itemization of
the service expenses and the purposes of such expenditures. Because the Trust
offers shares of numerous Funds (other than those to which this Statement of
Additional Information applies) which are subject to Rule 12b-1 under the
Investment Company Act, the selection and nomination of Trustees who are not
interested persons of the Trust is committed to the Trustees who are not
interested persons of the Trust.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to policies established by the Trust's Board of Trustees, the
Investment Adviser executes the Funds' portfolio transactions and allocates the
brokerage business. In executing such transactions, the Investment Adviser
seeks to obtain the best price and execution for the Funds, taking into account
such factors as price, size of order, difficulty and risk of execution and
operational facilities of the firm involved. Securities in which the Funds
invest may be traded in the over-the-counter markets, and the Funds deal
directly with the dealers who make markets in such securities except in those
circumstances where better prices and execution are available elsewhere. The
Investment Adviser negotiates commission rates with brokers or dealers based on
the quality or quantity of services provided in light of generally prevailing
rates, and while the Investment Adviser generally seeks reasonably competitive
commission rates, the Funds do not necessarily pay the lowest commissions
available. The Board of Trustees of the Trust periodically reviews the
commission rates and allocation of orders.
The Funds have no obligation to deal with any broker or group of brokers in
executing transactions in portfolio securities. Subject to obtaining the best
price and execution, brokers who sell shares of the Funds or provide
supplemental research, market and statistical information and other research
services and products to the Investment Adviser may receive orders for
transactions by the Funds. Such information, services and products are those
which brokerage houses customarily provide to institutional investors, and
include items such as statistical and economic data, research reports on
particular companies and industries, and computer software used for research
with respect to investment decisions. Information, services and products so
received are in addition to and not in lieu of the services required to be
performed by the Investment Adviser under the Investment Advisory Agreement, and
the expenses of the Investment Adviser are not necessarily reduced as a result
of the receipt of such supplemental information, services and products. Such
information, services and products may be useful to the Investment Adviser in
providing services to clients other than the Trust, and not all such
information, services and products are used by the Investment Adviser in
connection with the Funds. Similarly, such information, services and products
provided to the Investment Adviser by brokers and dealers through whom other
clients of the Investment Adviser effect securities transactions may be useful
to the Investment Adviser in providing services to the Funds. The Investment
Adviser may pay higher commissions on brokerage transactions for the Funds to
brokers in order to secure the information, services and products described
above, subject to review by the Trust's Board of Trustees from time to time as
to the extent and continuation of this practice.
Although the Investment Adviser makes investment decisions for the Trust
independently from those of its other accounts, investments of the kind made by
the Funds may often also be made by such other accounts. When the Investment
Adviser buys or sells the same security at substantially the same
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<PAGE>
time on behalf of the Funds and one or more other accounts managed by the
Investment Adviser, the Investment Adviser allocates available investments by
such means as, in its judgment, result in fair treatment. The Investment
Adviser aggregates orders for purchases and sales of securities of the same
issuer on the same day among the Funds and its other managed accounts, and the
price paid to or received by the Funds and those accounts is the average
obtained in those orders. In some cases, such aggregation and allocation
procedures may affect adversely the price paid or received by the Funds or the
size of the position purchased or sold by the Funds.
Securities trade in the over-the-counter market on a "net" basis with
dealers acting as principal for their own accounts without a stated commission,
although the price of the security usually includes a profit to the dealer. In
underwritten offerings, securities are purchased at a fixed price which includes
an amount of compensation to the underwriter, generally referred to as the
underwriter's commission or discount. On occasion, certain money market
instruments and agency securities may be purchased directly from the issuer, in
which case no commissions or discounts are paid.
During the fiscal year ended March 31, 1998, the following master funds of
the Master Trust (which were predecessors to the corresponding Funds) acquired
securities of their regular brokers or dealers (as defined in Rule 10b-1 under
the Investment Company Act) or their parents: Worldwide Growth Fund -- Merrill
Lynch & Co.; International Small Cap Growth Fund -- Merrill Lynch & Co.;
Emerging Countries Fund -- Merrill Lynch & Co.; Large Cap Growth Fund -- Merrill
Lynch & Co., J. P. Morgan & Co.; Mid Cap Growth Fund -- Merrill Lynch & Co., J.
P. Morgan & Co.; Small Cap Growth Fund -- Merrill Lynch & Co.; Mini Cap Growth
Fund -- Merrill Lynch & Co.; Convertible Fund -- Salomon Smith Barney, Merrill
Lynch & Co., J. P. Morgan & Co.; Balanced Growth Fund -- Bear Stearns Co.,
Morgan Stanley Dean Witter Discover & Co.; High Yield Bond Fund -- Merrill Lynch
& Co., J. P. Morgan & Co. The holdings of securities of such brokers and
dealers were as follows as of March 31, 1998: Worldwide Growth Fund -- Merrill
Lynch & Co. ($456,500); Large Cap Growth Fund -- Merrill Lynch & Co. ($116,200);
Mid Cap Growth Fund -- Merrill Lynch & Co. ($3,925,900); Convertible Fund --
Salomon Smith Barney ($2,619,937); Balanced Growth Fund -- Bear Stearns Co.
($103,778), Morgan Stanley Dean Witter Discover & Co. ($131,175); High Yield
Bond Fund -- Merrill Lynch & Co. ($1,205,000).
The aggregate dollar amount of brokerage commissions paid by the master
funds predecessors to the corresponding Funds during the last three fiscal years
of the Trust were as follows:
<TABLE>
<CAPTION>
Year Ended
------------------------------------------------
March 31, 1998 March 31, 1997 March 31, 1996
------------------------------------------------
<S> <C> <C> <C>
International Core Growth Fund $464,615 $24,643 N/A
Worldwide Growth Fund 1,065,153 970,564 $484,310
International Small Cap Growth Fund 745,259 692,326 116,735
Emerging Countries Fund 3,634,338 1,427,861 169,728
Large Cap Growth Fund 30,907 4,620 0
Mid Cap Growth Fund 1,809,755 1,139,938 862,396
Value Fund 14,316 8,996 N/A
Small Cap Growth Fund 1,002,867 987,245 1,038,140
Mini Cap Growth Fund 202,223 90,844 40,185
Convertible Fund 130,017 114,243 83,459
Balanced Growth Fund 43,966 35,105 51,038
High Quality Bond Fund(1)/ 100 0 0
High Yield Bond Fund 1,896 200 N/A
</TABLE>
(1)/ The Government Income Fund, the assets and liabilities of which were
assigned to and assumed by the High Quality Bond Fund paid no brokerage fees in
the fiscal year ended March 31, 1998.
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<PAGE>
PURCHASE AND REDEMPTION OF FUND SHARES
Class Q shares of the Funds may be purchased and redeemed at their net
asset value without any initial or deferred sales charge.
The price paid for purchases and redemptions of shares of the Funds is
based on the net asset value per share, which is calculated once daily at the
close of trading (normally 4:00 P.M. New York time) each day the New York Stock
Exchange is open. The New York Stock Exchange is currently closed on weekends
and on the following holidays: New Year's Day, Martin Luther King's Birthday,
Washington's Birthday, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving and Christmas Day. The offering price is effective for orders
received by the Transfer Agent or any sub-transfer agent prior to the time of
determination of net asset value. Dealers are responsible for promptly
transmitting purchase orders to the Transfer Agent or a sub-transfer agent. The
Trust reserves the right in its sole discretion to suspend the continued
offering of the Funds' shares and to reject purchase orders in whole or in part
when such rejection is in the best interests of the Trust and the affected
Funds. Payment for shares redeemed will be made not more than seven days after
receipt of a written or telephone request in appropriate form, except as
permitted by the Investment Company Act and the rules thereunder. Such payment
may be postponed or the right of redemption suspended at times when the New York
Stock Exchange is closed for other than customary weekends and holidays, when
trading on such Exchange is restricted, when an emergency exists as a result of
which disposal by a Portfolio of securities owned by it is not reasonably
practicable or it is not reasonably practicable for the Portfolio fairly to
determine the value of its net assets, or during any other period when the
Securities and Exchange Commission, by order, so permits.
SHAREHOLDER SERVICES
The services offered by the Trust to shareholders of the Class Q shares can
vary, depending on the needs of the retirement plan, and should be arranged by
contacting the Trust, the Distributor, the Administrator or the Transfer Agent.
SHAREHOLDER INVESTMENT ACCOUNT
Upon the initial purchase of shares of a Fund, a Shareholder Investment
Account is established for each investor under which the shares are held for the
investor by the Transfer Agent. No certificates will be issued for shares of
the Class Q shares of a Fund.
AUTOMATIC REINVESTMENT OF DIVIDENDS AND/OR DISTRIBUTIONS
For the convenience of investors, all dividends and distributions are
automatically reinvested in full and fractional shares of the applicable Class Q
shares of a Fund at net asset value. An investor may direct the Transfer Agent
in writing not less than five full business days prior to the record date to
have subsequent dividends and/or distributions sent in cash rather than
reinvested. In the case of recently purchased shares for which registration
instructions have not been received on the record date, cash payment will be
made directly to the dealer. Any shareholder who receives a cash payment
representing a dividend or distribution may reinvest such distribution at net
asset value by returning the check or the proceeds to the Transfer Agent within
30 days after the payment date. Such investment will be made at the net asset
value per share next determined after receipt of the check or proceeds by the
Transfer Agent.
AUTOMATIC INVESTMENT PLAN
Under the Automatic Investment Plan, an investor may arrange to have a
fixed amount automatically invested in shares of a Fund on a monthly or
quarterly basis on any day of the month or quarter by authorizing his or her
bank account to be debited to invest specified dollar amounts in shares of the
Fund. The investor's bank must be a member of the Automatic Clearing House
System. Stock certificates are not issued to participants of the Automatic
Investment Plan. Participation in the Plan will
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<PAGE>
begin within 30 days after receipt of the account application. If the
investor's bank account cannot be charged due to insufficient funds, a
stop-payment order or closing of the account, the investor's Plan may be
terminated and the related investment reversed. The investor may change the
amount of the investment or discontinue the Plan at any time by writing to the
Transfer Agent. Further information about this program and an application form
can be obtained from the Transfer Agent or the Distributor.
CROSS-REINVESTMENT OF DIVIDENDS AND DISTRIBUTIONS
A shareholder of Class Q shares of one Fund may elect to cross-reinvest
dividends or dividends and capital gain distributions paid by that Fund (the
"paying Fund") into Class Q shares of any other Fund (the "receiving Fund")
subject to the following conditions: (i) the aggregate value of the
shareholder's account(s) in the paying Fund(s) must equal or exceed $5,000 (this
condition is waived if the value of the account in the receiving Fund equals or
exceeds that Fund's minimum initial investment requirement), (ii) as long as the
value of the account in the receiving Fund is below that Fund's minimum initial
investment requirement, dividends and capital gain distributions paid by the
receiving Fund must be automatically reinvested in the receiving Fund, and (iii)
if this privilege is discontinued with respect to a particular receiving Fund,
the value of the account in that Fund must equal or exceed the Fund's minimum
initial investment requirement or the Fund will have the right, if the
shareholder fails to increase the value of the account to such minimum within 90
days after being notified of the deficiency, automatically to redeem the account
and send the proceeds to the shareholder. These cross-reinvestments of
dividends and capital gain distributions will be at net asset value (without a
sales charge).
AUTOMATIC WITHDRAWAL
The Transfer Agent arranges for the redemption by the Fund of sufficient
shares, deposited by the shareholder with the Transfer Agent, to provide the
withdrawal payment specified. Withdrawal payments should not be considered as
dividends, yield or income. Automatic investments may not be made into a
shareholder account from which there are automatic withdrawals. Withdrawals of
amounts exceeding reinvested dividends and distributions and increases in share
value will reduce the aggregate value of the shareholder's account.
REDEMPTION IN KIND
The Trust intends to pay in cash for all shares of a Fund redeemed, but
when the Trust makes payment to a Fund in readily marketable investment
securities, the Trust reserves the right to make payment wholly or partly in
shares of such securities. In such cases, a shareholder may incur brokerage
costs in converting such securities to cash. However, the Trust has elected to
be governed by the provisions of Rule 18f-1 under the Investment Company Act,
pursuant to which it is obligated to pay in cash all requests for redemptions by
any shareholder of record, limited in amount with respect to each shareholder
during any 90-day period to the lesser of $250,000 or 1% of the net asset value
of the Trust at the beginning of such period.
EXCHANGE PRIVILEGE
Shares of a Fund may be exchanged into shares of any other Fund or Class A
shares as provided in the Prospectus. The Trust's exchange privilege is not
intended to afford shareholders a way to speculate on short-term market
movements. Accordingly the Trust reserves the right to limit the number of
exchanges an investor or participant may make in any year, to avoid excessive
Fund expenses.
Before effecting an exchange, investors should obtain the currently
effective prospectus of the series into which the exchange is to be made.
Exchange purchases are subject to the minimum investment requirements of the
series being purchased. An exchange will be treated as a redemption and
purchase for tax purposes.
B-39
<PAGE>
TELEPHONE PRIVILEGE
Investors may exchange or redeem shares by telephone if they have elected
the telephone privilege on their account applications as provided in the
Prospectus.
The Trust will employ procedures designed to provide reasonable assurance
that instructions communicated by telephone are genuine and, if it does not do
so, it may be liable for any losses due to unauthorized or fraudulent
instructions. The procedures employed by the Trust include requiring personal
identification by account number and social security number, tape recording of
telephone instructions, and providing written confirmation of transactions. The
Trust reserves the right to refuse a telephone exchange or redemption request if
it believes, for example, that the person making the request is neither the
record owner of the shares being exchanged or redeemed nor otherwise authorized
by the investor to request the exchange or redemption. Investors will be
promptly notified of any refused request for a telephone exchange or redemption.
No Fund or its agents will be liable for any loss, liability or cost which
results from acting upon instructions of a person reasonably believed to be an
investor with respect to the telephone privilege.
REPORTS TO INVESTORS
Each Fund will send its investors annual and semi-annual reports. The
financial statements appearing in annual reports will be audited by independent
accountants. In order to reduce duplicate mailing and printing expenses, the
Funds may provide one annual and semi-annual report and annual prospectus per
household. In addition, quarterly unaudited financial data are available from
the Funds upon request.
NET ASSET VALUE
The net asset value of a share of a Class of a Fund is calculated by
dividing (i) the value of the securities held by the Fund (I.E., the value of
its investments in a Fund), plus any cash or other assets, minus the Class'
proportional interest in the Fund's liabilities (including accrued estimated
expenses on an annual basis) and all liabilities allocable to such Class, by
(ii) the total number of shares of the Class outstanding. The value of the
investments and assets of a Fund is determined each business day. Investment
securities, including ADRs and EDRs, that are traded on a stock exchange or on
the NASDAQ National Market System are valued at the last sale price as of the
close of business on the New York Stock Exchange (normally 4:00 P.M. New York
time) on the day the securities are being valued, or lacking any sales, at the
mean between the closing bid and asked prices. Securities listed or traded on
certain foreign exchanges whose operations are similar to the United States
over-the-counter market are valued at the price within the limits of the latest
available current bid and asked prices deemed by the Investment Adviser best to
reflect fair value. A security which is listed or traded on more than one
exchange is valued at the quotation on the exchange determined to be the primary
market for such security by the Investment Adviser. Listed securities that are
not traded on a particular day and other over-the-counter securities are valued
at the mean between the closing bid and asked prices.
In the event that the New York Stock Exchange or the national securities
exchange on which stock or stock options are traded adopt different trading
hours on either a permanent or temporary basis, the Board of Trustees of the
Trust will reconsider the time at which they compute net asset value. In
addition, the asset value of a Fund may be computed as of any time permitted
pursuant to any exemption, order or statement of the Commission or its staff.
The Funds value long-term debt obligations at the quoted bid prices for
such securities or, if such prices are not available, at prices for securities
of comparable maturity, quality and type; however, the Investment Adviser will
use, when it deems it appropriate, prices obtained for the day of valuation from
a bond pricing service, as discussed below. The Funds value debt securities
with maturities of 60 days or less at amortized cost if their term to maturity
from date of purchase is less than 60 days, or by amortizing, from the
sixty-first day prior to maturity, their value on the sixty-first day prior to
maturity if
B-40
<PAGE>
their term to maturity from date of purchase by the Fund or the Fund is more
than 60 days, unless this is determined by the Board of Trustees of the Trust
not to represent fair value. The Funds value repurchase agreements at cost plus
accrued interest.
The Funds value U.S. Government securities which trade in the
over-the-counter market at the last available bid prices, except that securities
with a demand feature exercisable within one to seven days are valued at par.
Such valuations are based on quotations of one or more dealers that make markets
in the securities as obtained from such dealers, or on the evaluation of a
pricing service.
The Funds value options, futures contracts and options thereon which trade
on exchanges at their last sale or settlement price as of the close of such
exchanges or, if no sales are reported, at the mean between the last reported
bid and asked prices. If an options or futures exchange closes later than 4:00
p.m. New York time, the options or futures traded on it are valued based on the
sale price, or on the mean between the bid and ask prices, as the case may be,
as of 4:00 p.m. New York time.
Trading in securities on foreign securities exchanges and over-the-counter
markets is normally completed well before the close of business day in New York.
In addition, foreign securities trading may not take place on all business days
in New York, and may occur in various foreign markets on days which are not
business days in New York and on which net asset value is not calculated. The
calculation of net asset value may not take place contemporaneously with the
determination of the prices of portfolio securities used in such calculation.
Events affecting the values of portfolio securities that occur between the time
their prices are determined and the close of the New York Stock Exchange will
not be reflected in the calculation of net asset value unless the Board of
Trustees of the Trust deems that the particular event would materially affect
net asset value, in which case an adjustment will be made. Assets or
liabilities initially expressed in terms of foreign currencies are translated
prior to the next determination of the net asset value into U.S. dollars at the
spot exchange rates at 1:00 p.m. New York time or at such other rates as the
Investment Adviser may determine to be appropriate in computing net asset value.
Securities and assets for which market quotations are not readily
available, or for which the Trust's Board of Trustees or persons designated by
the Board determine that the foregoing methods do not accurately reflect current
market value, are valued at fair value as determined in good faith by or under
the direction of the Trust's Board of Trustees. Such valuations and procedures
will be reviewed periodically by the Board of Trustees.
The Trust may use a pricing service approved by its Board of Trustees.
Prices provided by such a service represent evaluations of the mean between
current bid and asked market prices, may be determined without exclusive
reliance on quoted prices, and may reflect appropriate factors such as
institution-size trading in similar groups of securities, yield, quality, coupon
rate, maturity, type of issue, individual trading characteristics, indications
of values from dealers and other market data. Such services may use electronic
data processing techniques and/or a matrix system to determine valuations. The
procedures of such services are reviewed periodically by the officers of the
Trust under the general supervision and responsibility of its Board of Trustees,
which may replace a service at any time if it determines that it is in the best
interests of the Funds to do so.
DIVIDENDS, DISTRIBUTIONS AND TAXES
The Balanced and Convertible Funds declare and pay quarterly dividends of
net investment income. The High Quality Bond Fund declares and pays monthly
dividends of net investment income. All other Funds declare and pay annual
dividends of all investment income. Each Fund makes distributions at least
annually of its net capital gains, if any. In determining amounts of capital
gains to be distributed by a Fund, any capital loss carryovers from prior years
will be offset against its capital gains.
B-41
<PAGE>
REGULATED INVESTMENT COMPANY
The Trust has elected to qualify each Fund as a regulated investment
company under Subchapter M of the Code, and intends that each Fund will remain
so qualified.
As a regulated investment company, a Fund will not be liable for federal
income tax on its income and gains provided it distributes all of its income and
gains currently. Qualification as a regulated investment company under the Code
requires, among other things, that each Fund (a) derive at least 90% of its
gross income from dividends, interest, payments with respect to securities
loans, and gains from the sale or other disposition of securities or foreign
currencies, or other income (including, but not limited to, gains from options,
futures or forward contracts) derived with respect to its business of investing
in such securities or currencies; (b) for taxable years beginning on or before
August 5, 1997 derive less than 30% of its gross income from the sale or other
disposition of stock, securities, options, futures, forward contracts, certain
foreign currencies and certain options, futures, and forward contracts on
foreign currencies held less than three months; (c) diversify its holdings so
that, at the end of each fiscal quarter, (i) at least 50% of the market value of
the Fund's assets is represented by cash, U.S. Government securities and
securities of other regulated investment companies, and other securities (for
purposes of this calculation generally limited, in respect of any one issuer, to
an amount not greater than 5% of the market value of the Fund's assets and 10%
of the outstanding voting securities of such issuer) and (ii) not more than 25%
of the value of its assets is invested in the securities of any one issuer
(other than U.S. Government securities or the securities of other regulated
investment companies), or two or more issuers which the Trust controls and which
are determined to be engaged in the same or similar trades or businesses; and
(d) distribute at least 90% of its investment company taxable income (which
includes dividends, interest, and net short-term capital gains in excess of net
long-term capital losses) each taxable year.
A Fund generally will be subject to a nondeductible excise tax of 4% to the
extent that it does not meet certain minimum distribution requirements as of the
end of each calendar year. To avoid the tax, a Fund must distribute during each
calendar year an amount equal to the sum of (1) at least 98% of its ordinary
income and net capital gain (not taking into account any capital gains or losses
as an exception) for the calendar year, (2) at least 98% of its capital gains in
excess of its capital losses (and adjusted for certain ordinary losses) for the
twelve month period ending on October 31 of the calendar year, and (3) all
ordinary income and capital gains for previous years that were not distributed
during such years. A distribution will be treated as paid on December 31 of the
calendar year if it is declared by the Fund in October, November, or December of
that year to shareholders of record on a date in such a month and paid by the
Fund during January of the following year. Such distributions will be taxable
to shareholders (other than those not subject to federal income tax) in the
calendar year in which the distributions are declared, rather than the calendar
year in which the distributions are received. To avoid the excise tax, the
Funds intend to make timely distributions of their income in compliance with
these requirements and anticipate that they will not be subject to the excise
tax.
Dividends paid by a Fund from ordinary income, and distributions of the
Fund's net realized short-term capital gains, are taxable to its shareholders as
ordinary income. Distributions to corporate shareholders will be eligible for
the 70% dividends received deduction to the extent that the income of the Funds
is derived from dividends on common or preferred stock of domestic corporations.
Dividend income earned by a Fund will be eligible for the dividends received
deduction only if the Fund have satisfied a 46-day holding period requirement
(described below) with respect to the underlying portfolio security (91 days in
the case of dividends derived from preferred stock). In addition, a corporate
shareholder must have held its shares in the Fund for not less than 46 days
during the 90-day period that begins 45 days before the stock becomes
ex-dividend with respect to the dividend (91 days during the 180-day period that
begins 90 days before the stock becomes ex-dividend with respect to the dividend
in the case of dividends derived from preferred stock) in order to claim the
dividend received deduction. Not later than 60 days after the end of its
taxable year, the Fund will send to its shareholders a written notice
designating the amount of any distributions made during such year which may be
taken into account by its shareholders for purposes of such deduction provisions
of the Code. Net capital gain distributions are not eligible for the dividends
received deduction.
B-42
<PAGE>
Under the Code, any distributions designated as being made from net capital
gains are taxable to a Fund's shareholders as long-term capital gains,
regardless of the holding period of such shareholders. Such distributions of
net capital gains will be designated by the Fund as a capital gains distribution
in a written notice to its shareholders which accompanies the distribution
payment. Any loss on the sale of shares held for less than six months will be
treated as a long-term capital loss for federal tax purposes to the extent a
shareholder receives net capital gain distributions on such shares. The maximum
federal income tax rate applicable to long-term capital gains is currently 28%
(20% for property sold after July 28, 1997 that was held more than 18 months)
for individual shareholders and 35% for corporate shareholders. Dividends and
distributions are taxable as such whether received in cash or reinvested in
additional shares of a Fund.
Any loss realized on a sale, redemption or exchange of shares of a Fund by
a shareholder will be disallowed to the extent the shares are replaced within a
61-day period (beginning 30 days before the disposition of shares). Shares
purchased pursuant to the reinvestment of a dividend will constitute a
replacement of shares.
A shareholder who acquires shares of a Fund and sells or otherwise disposes
of such shares within 90 days of acquisition may not be allowed to include
certain sales charges incurred in acquiring such shares for purposes of
calculating gain or loss realized upon a sale or exchange of shares of the Fund
if the shareholder acquires shares in a Fund of the Trust pursuant to a
reinvestment right that reduces the sales charges in the subsequent acquisition
of shares.
SPECIAL TAX CONSIDERATIONS
U.S. GOVERNMENT OBLIGATIONS. Income received on direct U.S. Government
obligations is exempt from tax at the state level when received directly and may
be exempt, depending on the state, when received by a shareholder from a Fund
provided that certain conditions are satisfied. Interest received on repurchase
agreements collateralized by U.S. Government obligations normally is not exempt
from state taxation. The Trust will inform shareholders annually of the
percentage of income and distributions derived from direct U.S. Government
obligations. Shareholders should consult their tax advisers to determine
whether any portion of the income dividends received from the Fund is considered
tax exempt in their particular states.
SECTION 1256 CONTRACTS. Many of the futures contracts and forward
contracts used by the Funds are "section 1256 contracts." Any gains or losses
on section 1256 contracts are generally credited 60% long-term and 40%
short-term capital gains or losses ("60/40") although gains and losses from
hedging transactions, certain mixed straddles and certain foreign currency
transactions from such contracts may be treated as ordinary in character. Also,
section 1256 contracts held by the Funds at the end of each taxable year (and,
for purposes of the 4% excise tax, on certain other dates as prescribed under
the Code) are "marked to market" with the result that unrealized gains or losses
are treated as though they were realized and the resulting gain or loss is
treated as ordinary or 60/40 gain or loss, depending on the circumstances.
STRADDLE RULES. Generally, the hedging transactions and certain other
transactions in options, futures and forward contracts undertaken by the Funds
may result in "straddles" for U.S. federal income tax purposes. The straddle
rules may affect the character of gains (or losses) realized by the Funds. In
addition, losses realized by a Fund on positions that are part of a straddle may
be deferred under the straddle rules, rather than being taken into account in
calculating the taxable income for the taxable year in which such losses are
realized. Because only a few regulations implementing the straddle rules have
been promulgated, the tax consequences of transactions in options, futures and
forward contracts to the Funds are not entirely clear. The transactions may
increase the amount of short-term capital gain realized by a Fund which is taxed
as ordinary income when distributed to shareholders.
The Funds may make one or more of the elections available under the Code
which are applicable to straddles. If the Funds make any of the elections, the
amount, character and timing of the recognition of gains or losses from the
affected straddle positions will be determined under rules that vary according
B-43
<PAGE>
to the election(s) made. The rules applicable under certain of the elections
operate to accelerate the recognition of gains or losses from the affected
straddle positions.
Because application of the straddle rules may affect the character of gains
or losses, defer losses and/or accelerate the recognition of gains or losses
from the affected straddle positions, the amount which must be distributed to
the shareholders, and which will be taxed to shareholders as ordinary income or
long-term capital gain, may be increased or decreased substantially as compared
to a fund that did not engage in such hedging transactions.
The qualifying income and diversification requirements applicable to the
Funds' assets may limit the extent to which the Funds will be able to engage in
transactions in options, futures contracts or forward contracts.
SECTION 988 GAINS AND LOSSES. Under the Code, gains or losses attributable
to fluctuations in exchange rates which occur between the time a Fund accrues
interest or other receivables or accrues expenses or other liabilities
denominated in a foreign currency and the time the Fund actually collects such
receivables or pays such liabilities generally are treated as ordinary income or
loss. Similarly, gains or losses on disposition of debt securities denominated
in a foreign currency and on disposition of certain futures attributable to
fluctuations in the value of the foreign currency between the date of
acquisition of the security or contract and the date of disposition also are
treated as ordinary gain or loss. These gains and losses, referred to under the
Code as "section 988" gains or losses, may increase or decrease the amount of
the Fund's investment company taxable income to be distributed to the
shareholders.
FOREIGN TAX. Foreign countries may impose withholding and other taxes on
income received by a Fund from sources within those countries. Tax conventions
between certain countries and the U.S. may reduce or eliminate such taxes. In
addition, the Investment Adviser intends to manage the Funds with the intention
of minimizing foreign taxation in cases where it is deemed prudent to do so. If
more than 50% of the value of a Fund's total assets at the close of its taxable
year consists of securities of foreign corporations, the Fund will be eligible
to elect to "pass-through" to the Fund's shareholders the amount of foreign
income and similar taxes paid by the Fund. Each shareholder will be notified in
writing within 60 days after the close of the Fund's taxable year whether the
foreign taxes paid by the Fund will "pass-through" for that year.
Generally, a credit for foreign taxes is subject to the limitation that it
may not exceed the shareholder's U.S. tax attributable to his or her total
foreign source taxable income. For this purpose, if the Fund elects
pass-through treatment, the source of the Fund's income flows through to
shareholders of the Fund. With respect to such election, the Fund treats gains
from the sale of securities as derived from U.S. sources and certain currency
fluctuation gains, including fluctuation gains from foreign currency denominated
debt securities, receivables and payables as ordinary income derived from U.S.
sources. The limitation on the foreign tax credit applies separately to foreign
source passive income, and to certain other types of income. Shareholders may
be unable to claim a credit for the full amount of their proportion at share of
the foreign taxes paid by the Fund. The foreign tax credit is modified for
purposes of the federal alternative minimum tax and can be used to offset only
90% of the alternative minimum tax imposed on corporations and individuals and
foreign taxes generally are not deductible in computing alternative minimum
taxable income.
SHORT SALES. Generally, capital gain or loss realized by the Fund in a
short sale may be long-term or short term depending on the holding period of the
short position. Under a special rule, however, the capital gain will be
short-term gain if (1) as of the date of the short sale, the Fund owned property
for the short-term holding period that was substantially identical to that which
the Fund used to close the sale or (2) after the short sale and on or before its
closing, the Fund acquired substantially similar property. Similarly, if the
Fund held property substantially identical to that sold short for the long-term
holding period as of the date of the short sale, any loss on closing the short
position will be long-term capital loss. These special rules do not apply to
substantially similar property to the extent such property exceeds the property
used by the Fund to close its short position.
B-44
<PAGE>
ORIGINAL ISSUE DISCOUNT. The Funds may treat some of the debt securities
(with a fixed maturity date of more than one year from the date of issuance)
they may acquire as issued originally at a discount. Generally, the Funds treat
the amount of the original issue discount ("OID") as interest income and include
it in income over the term of the debt security, even though they do not receive
payment of that amount until a later time, usually when the debt security
matures. The Funds treat a portion of the OID includable in income with respect
to certain high-yield corporation debt securities as a dividend for federal
income tax purposes.
The Funds may treat some of the debt securities (with a fixed maturity date
of more than one year from the date of issuance) that they may acquire in the
secondary market as having market discount. Generally, a Fund treats any gain
recognized on the disposition of, and any partial payment of principal on, a
debt security having market discount as ordinary interest income to the extent
the gain, or principal payment, does not exceed the "accrued market discount" on
such debt security. Market discount generally accrues in equal daily
installments. The Funds may make one or more of the elections applicable to
debt securities having market discount, which could affect the character and
timing the recognition of income.
The Funds generally must distribute dividends to shareholders representing
discount on debt securities that is currently includable in income, even though
the Funds have yet to receive cash representing such income. The Funds may
obtain cash to pay such dividends from sales proceeds of securities held by the
Funds.
OTHER TAX INFORMATION
The Funds may be required to withhold for U.S. federal income taxes 31% of
all taxable distributions payable to shareholders who fail to provide the Trust
with their correct taxpayer identification number or to make required
certifications, or who have been notified by the Internal Revenue Service that
they are subject to backup withholding. Corporate shareholders and certain
other shareholders specified in the Code generally are exempt from such backup
withholding. Backup withholding is not an additional tax. Any amounts withheld
may be credited against the shareholder's U.S. federal income tax liability.
The Trust may also be subject to state or local taxes in certain other
states where it is deemed to be doing business. Further, in those states which
have income tax laws, the tax treatment of the Trust and of shareholders of a
Fund with respect to distributions by the Fund may differ from federal tax
treatment. Distributions to shareholders may be subject to additional state and
local taxes. Shareholders should consult their own tax advisers regarding
specific questions as to federal, state or local taxes.
PERFORMANCE INFORMATION
The Trust may from time to time advertise total returns and yields for the
Funds, compare Fund performance to various indices, and publish rankings of the
Funds prepared by various ranking services. Any performance information should
be considered in light of the Fund's investment objectives and policies,
characteristics and quality of its portfolio, and the market conditions during
the given period, and should not be considered to be representative of what may
be achieved in the future. For purposes of calculating the historical
performance of a Fund, the Trust will take into account the historical
performance of the series of the Trust corresponding to the Fund prior to the
Reorganization of the Trust as well as the historical performance of that
series' corresponding master fund of the Master Trust for periods, if any, prior
to the date of inception of the series.
TOTAL RETURN
The total return for a Fund is computed by assuming a hypothetical initial
payment of $1,000. It is assumed that all investments are made at net asset
value (as opposed to market price) and that all of the dividends and
distributions by the Fund over the relevant time periods are invested at net
asset value. It is
B-45
<PAGE>
then assumed that, at the end of each period, the entire amount is redeemed
without regard to any redemption fees or costs. The average annual total return
is then determined by calculating the annual rate required for the initial
payment to grow to the amount which would have been received upon redemption.
Total return does not take into account any federal or state income taxes.
Total return is computed according to the following formula:
n
P(1 + T) = ERV
Where: P = a hypothetical initial payment of $1,000.
T = average annual total return.
n = number of years.
ERV = ending redeemable value at the end of the period (or
fractional portion thereof) of a hypothetical $1,000
payment made at the beginning of the period.
YIELD
The yield for a Fund is calculated based on a 30-day or one-month period,
according to the following formula:
6
Yield = 2[(a - b + 1) -1]
-----
(c x d)
For purposes of this formula, "a" is total dividends and interest earned
during the period; "b" is total expenses accrued for the period (net of
reimbursements); "c" is the average daily number of shares outstanding during
the period that were entitled to receive dividends; and "d" is the maximum
offering price per share on the last day of the period.
Yields for the Portfolios predecessors to the corresponding Class of shares
of the Funds for the 30-day period ended March 31, 1998 were as follows:
Convertible Fund Class Q Shares 1.94%
Balanced Growth Fund Class Q Shares 2.15%
COMPARISON TO INDICES AND RANKINGS
A Fund may compare its performance to various unmanaged indices such as the
Dow Jones Composite Average or its component averages, Standard and Poor's 500
Stock Index or its component indices, Standard and Poor's 100 Stock Index, the
Russell Midcap Growth Index, the Russell 2000 Growth Index, the Russell 1000
Index, the CS First Boston Convertible Index, the Lehman Brothers Government
Bond Index, the Morgan Stanley Capital International World Index, the Morgan
Stanley Capital International Emerging Markets Free Index, the Emerging Markets
Investible Index, the Morgan Stanley Capital International Europe, Australia and
Far East Index, the IFC Emerging Markets Investible Index, The New York Stock
Exchange composite or component indices, the Wilshire 5000 Equity Index, indices
prepared by Lipper Analytical Services and Morningstar, Inc., the CDA Mutual
Fund Report published by CDA Investment Technologies, Inc., performance
statistics reported in financial publications such as The Wall Street Journal,
Business Week, Changing Times, Financial World, Forbes, Fortune and Money
magazines, the Consumer Price Index (or Cost of Living Index) published by the
U.S. Bureau of Labor Statistics, Stocks, Bonds, Bills and Inflation published by
Ibbotson Associates, Savings and Loan Historical Interest Rates published in the
U.S. Savings & Loan League Fact Book, and historical data supplied by the
research departments of First Boston Corporation, The J.P. Morgan companies,
Salomon Brothers, Merrill Lynch, Lehman Brothers, Smith Barney Shearson and
Bloomberg L.P. Unmanaged indices (I.E., other than Lipper) generally do not
reflect deductions for administrative and management costs and expenses.
B-46
<PAGE>
A number of independent mutual fund ranking entities prepare performance
rankings. These entities categorize and rank funds by various criteria,
including fund type, performance over a given period of years, total return,
standardized yield, variations in sales charges and risk\reward considerations.
The following indices are referred to in the Fund's Prospectus in
connection with the Investment Strategy of the Large Cap Growth, Mid Cap Growth,
Value and Small Cap Growth Funds:
The S&P 500 Index is an unmanaged index containing common stocks of 500
industrial, transportation, utility and financial companies, regarded as
generally representative of the U.S. stock market. The Index reflects the
reinvestment of income dividends and capital gain distributions, if any,
but does not reflect fees, brokerage commissions, or other expenses of
investing.
The Russell 1000 Growth Index contains those companies among the Russell
1000 securities with higher than average price-to-book ratios and
forecasted growth. The Russell 1000 Index contains the top 1,000
securities of the Russell 3000 Index, which comprises the 3,000 largest
U.S. securities as determined by total market capitalization. The Russell
1000 Growth Index is considered generally representative of the U.S. market
for large cap stocks. The Index reflects the reinvestment of income
dividends and capital gains distributions, if any, but does not reflect
fees, brokerage commissions, or other expenses of investing.
The Russell 2000 Growth Stock Index contains those securities in the
Russell 2000 Index with a greater-than-average growth orientation.
Companies in the Growth Stock Index generally have higher price-to-book and
price earnings ratios than the average for all companies in the 2000 Index.
The Russell 2000 Index is a widely regarded small-cap index of the 2,000
smallest securities in the Russell 3000 Index, which comprises the 3,000
largest U.S. securities as determined by total market capitalization. The
Index reflects the reinvestment of income dividends and capital gains
distributions, if any, but does not reflect fees, brokerage commissions, or
other expenses of investing.
The Russell Midcap Growth Index measures the performance of those companies
among the 800 smallest companies in the Russell 1000 Index with higher than
average price-to-book ratios and forecasted growth. The Russell 1000 Index
contains the top 1,000 securities of the Russell 3000 Index, which
comprises the 3,000 largest U.S. securities as determined by total market
capitalization. The Russell Midcap Growth Index is considered generally
representative of the U.S. market for midcap stocks. The average market
capitalization is approximately $4 billion, the median market
capitalization is approximately $2.5 billion, and the largest company in
the Index had an approximate market capitalization of $8.7 billion. This
Index reflects the reinvestment of income dividends and capital gains
distributions, if any, but does not reflect fees, brokerage commissions, or
other expenses of investment. The index was not available until 1986.
PRIOR PERFORMANCE OF CERTAIN FUNDS AND THEIR PREDECESSORS
The following tables set forth historical performance information for the
Class Q shares of the Large Cap and Balanced Funds. It includes historical
performance information for the Qualified Portfolios which preceded the Funds
prior to the reorganization of the Trust in March 1998 and the Investment
Adviser's composite performance data relating to the historical performance of
all institutional private accounts managed by the Investment Adviser, since the
dates indicated, that have investment objectives, policies, strategies and risks
substantially similar to those of such Funds. The data is provided to
illustrate the past performance of the Investment Adviser in managing
substantially similar accounts as measured against specified market indices and
does not represent the performance of the Funds. Investors should not consider
this performance data as an indication of future performance of the Funds or of
the Investment Adviser.
B-47
<PAGE>
The Investment Adviser's composite performance data shown below were
calculated in accordance with recommended standards of the Association for
Investment Management and Research ("AIMR"(1)), retroactively applied to all
time periods. All returns presented were calculated on a total return basis and
include all dividends and interest, accrued income and realized and unrealized
gains and loses. All returns reflect the deduction of investment advisory fees,
brokerage commissions and execution costs paid by the Investment Adviser's
institutional private accounts, without provision for federal or state income
taxes. Custodial fees, if any, were not included in the calculation. The
Investment Adviser's composites include all actual, fee-paying, discretionary
institutional private accounts managed by the Investment Adviser that have
investment objectives, policies, strategies and risks substantially similar to
those of the Large Cap and Balanced Funds. Securities transactions are
accounted for on the trade date and accrual accounting is utilized. Cash and
equivalents are included in performance returns. The monthly returns of the
Investment Adviser's composites combine the individual accounts' returns
(calculated on a time-weighted rate of return that is revalued whenever cash
flows exceed $500) by asset-weighing each individual account's asset value as of
the beginning of the month. Quarterly and yearly returns are calculated by
geometrically linking the monthly and quarterly returns, respectively. The
yearly returns are computed by geometrically linking the returns of each quarter
within the calendar year. Investors should be aware that the SEC uses a
methodology different from that used below to calculate performance which, as
with the use of any methodology different from that below, could result in
different performance data.
The institutional private accounts that are included in the Investment
Adviser's composite are not subject to the same types of expenses to which the Q
Class of shares of the Large Cap, Value and Balanced Funds are subject nor to
the diversification requirements, specific tax restrictions and investment
limitations imposed on the Funds by the Investment Company Act or Subchapter M
of the Internal Revenue Code. Consequently, the performance results for the
Investment Adviser's composites could have been adversely affected if the
institutional private accounts included in the composites had been subject to
the same expenses as the funds or had been regulated as investment companies
under the federal securities laws.
The investment results of the Investment Adviser's composites presented
below are unaudited and are not intended to predict or suggest the returns that
might be experienced by the Large Cap, Value or Balanced Funds or an individual
investor investing in any Class of shares of such Funds.
- --------------------
(1)/ AIMR is a non-profit membership and education organization with more than
60,000 members worldwide that, among other things, has formulated a set of
performance presentation standards for investment advisers. These AIMR
performance presentation standards are intended to (i) promote full and fair
presentations by investment advisers of their performance results, and
(ii) ensure uniformity in reporting so that performance results of investment
advisers are directly comparable.
B-48
<PAGE>
<TABLE>
<CAPTION>
Class Q Shares of the Fund
60% S&P 500
Investment Lehman Index 40% Investment
Balanced Adviser's Bros. Lehman Bros. Adviser's
Growth Balanced S&P 500 Gov't./Corp. Lehman Bros. Value S&P 500
Year Fund Composite Index(1) Index(2) Index Value Fund Composite Index(1)
---- ---- --------- -------- -------- ----- ---------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1988(3). . . . . . . 4.98% 10.25% 3.80% 7.67%
1989 . . . . . . . . 17.61 31.61 14.23 24.59
1990 . . . . . . . . 5.69 (3.04) 8.29 1.59
1991 . . . . . . . . 32.73 30.46 16.13 24.81
1992 . . . . . . . . 9.40 7.62 7.57 7.67
1993(4). . . . . . . 13.60% 20.14 (10.07) 11.06 10.52
1994(4). . . . . . . (5.99) (5.37) 1.32 (3.51) (0.57) 3.79% 1.32%
1995 . . . . . . . . 23.87% 29.23 37.60 19.24 30.02 30.79 37.60
1996 . . . . . . . . 16.86 11.88 22.96 2.89 14.65 32.01 22.96
1997 . . . . . . . . 21.49 17.70 33.31 9.75 23.63 40.55 33.31
1998(5). . . . . . . 10.19 13.95 1.52 8.90 14.54 13.95
Last Year(5) . . . . 40.21 36.38 47.97 12.39 32.91 57.78 47.97
Last 5 years(5). . . N/A 14.87 22.39 6.95 16.11 N/A N/A
Since inception(5) . 15.72 14.98 18.93 8.92 14.98 30.33 28.27
</TABLE>
- --------------------
(1) The S&P 500 Index is an unmanaged index containing common stocks of 500
industrial, transportation, utility and financial companies, regarding as
generally representative of the U.S. stock market. The Index reflects the
reinvestment of income dividends and capital gain distributions, if any,
but does not reflect fees, brokerage commissions, or other expenses of
investing.
(2) The Lehman Brothers Government/Corporate Bond Index is an unmanaged
market-weighted index consisting of all public obligations of the U.S.
Government, its agencies and instrumentalities, and all corporate issuers
of fixed rate, non-convertible, investment grade U.S. dollar denominated
bonds having maturities of greater than one year. It is generally regarded
as representative of the market for domestic bonds. The Index reflects the
reinvestment of income dividends and capital gains distributions, if any,
but does not reflect fees, brokerage commissions or markups, or other
expenses of investing.
(3) Commencement of investment operations is April 1, 1988.
(4) Inception dates are as follows: Balanced Growth Composite - April 1, 1988;
Balanced Growth Qualified Portfolio (predecessor to the Class Q shares of
the Balanced Fund) - August 31, 1995; Value Composite - April 1, 1994;
Value Fund Class Q Shares - August 1, 1998.
(5) Through March 31, 1998.
B-49
<PAGE>
<TABLE>
<CAPTION>
Class Q Shares of the Fund
-----------------------------------------------
INVESTMENT
RUSSELL ADVISER'S
LARGE CAP 1,000 S&P 500 LARGE CAP
GROWTH GROWTH
Year FUND INDEX(2) INDEX(1),(3)COMPOSITE(1)
---- --------- -------- ---------- ------------
<S> <C> <C> <C> <C>
1995(4) . . . . . . . . . 25.26% 25.37% 35.38%
1996(5) . . . . . . . . . (1.18)% (1.53) (1.98) 26.63
1997. . . . . . . . . . . 45.45 30.48 33.31 33.06
1998(6) . . . . . . . . . 17.40 15.15 13.95 16.17
LAST YEAR(6). . . . . . . 62.47 49.45 47.97 57.24
Since inception.. . . . . 51.59 32.33 32.79 38.38
</TABLE>
- --------------------
(1) Annualized.
(2) The Russell 1000 Growth Index contains those companies among the Russell
1000 Securities with higher than average price-to-book ratios and
forecasted growth. The Russell 1000 Index contains the top 1,000
securities of the Russell 3000 Index, which comprises the 3,000 largest
U.S. securities as determined by total market capitalization. The Russell
1000 Growth Index is considered generally representative of the U.S. market
for large cap stocks. The Index reflects the reinvestment of income
dividends and capital gains distributions, if any, but does not reflect
fees, brokerage commissions, or other expenses of investing.
(3) The S&P 500 Index is an unmanaged index containing common stocks of 500
industrial, transportation, utility and financial companies, regarding as
generally representative of the U.S. stock market. The Index reflects the
reinvestment of income dividends and capital gain distributions, if any,
but does not reflect fees, brokerage commissions, or other expenses of
investing.
(4) Commencement of investment operations was April 1, 1995.
(5) Inception dates are as follows: Large Cap Growth Composite - April 1,
1995; Large Cap Qualified Portfolio (predecessor to the Class Q shares of
the Large Cap Fund) - December 27, 1996.
(6) Through March 31, 1998.
CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT,
INDEPENDENT AUDITORS AND LEGAL COUNSEL
PNC Bank, Airport Business Center, International Court 2, 200 Stevens
Drive, Lester, Pennsylvania 19113, serves as Custodian for the portfolio
securities and cash of the Funds and in that capacity maintains certain
financial and accounting books and records pursuant to agreements with the
Trust. PFPC Inc., 103 Bellevue Parkway, Wilmington, Delaware, an affiliate of
the Custodian, provides additional accounting services to the Funds.
State Street Bank and Trust Company, 2 Heritage Drive, 7th Floor, North
Quincy, Massachusetts, 02171, serves as the Dividend Disbursing Agent and as the
Transfer Agent for the Funds. The Transfer Agent provides customary transfer
agency services to the Trust, including the handling of shareholder
communications, the processing of shareholder transactions, the maintenance of
shareholder account records, and related functions. The Dividend Disbursing
Agent provides customary dividend disbursing services to the Trust, including
payment of dividends and distributions and related functions.
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The Charles Schwab Trust Company, 101 Montgomery Street, San Francisco,
California 94104, serves as co-transfer agent for shares of the Funds. The
following act as sub-transfer agents for the Funds: Financial Data Services,
Inc., 4800 Deer Lake Drive, 2nd Floor, Jacksonville, Florida 32246; William M.
Mercer Plan Participant Services, Inc., 1417 Lake Cook Road, Deerfield, Illinois
60015; and Schwab Retirement Plan Services, Inc., 101 Montgomery Street, San
Francisco, California 94104.
Ernst & Young, L.L.P., 515 South Flower Street, Los Angeles, California
90071, serves as the independent auditors for the Trust, and in that capacity
examines the annual financial statements of the Trust.
Paul, Hastings, Janofsky & Walker LLP, 555 South Flower Street, Los
Angeles, California 90071, is legal counsel for the Trust. It also acts as
legal counsel for the Investment Adviser and Distributor.
MISCELLANEOUS
SHARES OF BENEFICIAL INTEREST
The Trust is currently comprised of 23 series, each consisting of one or
more classes of shares -- A, B, C, Q or I.
On any matter submitted to a vote of shareholders of the Trust, all shares
then entitled to vote will be voted by the affected Fund(s) unless otherwise
required by the Investment Company Act, in which case all shares of the Trust
will be voted in the aggregate or by Classes, as the case may be. For example, a
change in a Fund's fundamental investment policies would be voted upon only by
shareholders of all Classes of that Fund, as would the approval of any advisory
or distribution contract for the Fund. However, all shares of the Trust may
vote together in the election or selection of Trustees, principal underwriters
and accountants for the Trust.
Rule 18f-2 under the Investment Company Act provides that any matter
required to be submitted to the holders of the outstanding voting securities of
an investment company such as the Trust shall not be deemed to have been
effectively acted upon unless approved by a majority of the outstanding shares
of the series of the Trust affected by the matter. Under Rule 18f-2, a series
is presumed to be affected by a matter, unless the interests of each series in
the matter are identical or the matter does not affect any interest of such
series. Under Rule 18f-2 the approval of an investment advisory agreement or
any change in a fundamental investment policy would be effectively acted upon
with respect to a Fund only if approved by a majority of its outstanding shares.
However, the rule also provides that the ratification of independent public
accountants, the approval of principal underwriting contracts and the election
of directors may be effectively acted upon by the shareholders of the Trust
voting without regard to Fund.
As used in the Funds' prospectus and in this Statement of Additional
Information, the term "majority," when referring to approvals to be obtained
from shareholders of a Fund, means the vote of the lesser of (i) 67% of the
shares of the Fund represented at a meeting if the holders of more than 50% of
the outstanding shares of the Fund are present in person or by proxy, or (ii)
more than 50% of the outstanding shares of the Fund. The term "majority," when
referring to the approvals to be obtained from shareholders of the Trust, means
the vote of the lesser of (i) 67% of the Trust's shares represented at a meeting
if the holders of more than 50% of the Trust's outstanding shares are present in
person or by proxy, or (ii) more than 50% of the Trust's outstanding shares.
Shareholders are entitled to one vote for each full share held and fractional
votes for fractional shares held. Unless otherwise provided by law (for
example, by Rule 18f-2 discussed above) or by the Trust's Declaration of Trust
or Bylaws, the Trust may take or authorize any action upon the favorable vote of
the holders of more than 50% of the outstanding shares of the Trust.
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The Trust will dispense with annual meetings of shareholders in any year in
which it is not required to elect Trustees under the Investment Company Act.
However, the Trust undertakes to hold a special meeting of its shareholders for
the purpose of voting on the question of removal of a Trustee or Trustees if
requested in writing by the holders of at least 10% of the Trust's outstanding
voting securities, and to assist in communicating with other shareholders as
required by Section 16(c) of the Investment Company Act.
Each share of each class of a Fund represents an equal proportional
interest in the Fund with each other share of the same Class and is entitled to
such dividends and distributions out of the income earned on the assets
allocable to the Class as are declared in the discretion of the Trustees. In
the event of the liquidation or dissolution of the Trust, shareholders of a Fund
are entitled to receive the assets attributable to the Fund that are available
for distribution, and a distribution of any general assets not attributable to a
particular Fund that are available for distribution in such manner and on such
basis as the Trustees in their sole discretion may determine.
Shareholders are not entitled to any preemptive rights. All shares, when
issued, will be fully paid and nonassessable by the Trust.
DECLARATION OF TRUST
The Declaration of Trust of the Trust provides that obligations of the
Trust are not binding upon its Trustees, officers, employees and agents
individually and that the Trustees, officers, employees and agents will not be
liable to the trust or its investors for any action or failure to act, but
nothing in the Declaration of Trust protects a Trustee, officer, employee or
agent against any liability to the trusts or their respective investors to which
the Trustee, officer, employee or agent would otherwise be subject by reason of
willful misfeasance, bad faith, gross negligence, or reckless disregard of his
or her duties. The Declaration of Trust also provides that the debts,
liabilities, obligations and expenses incurred, contracted for or existing with
respect to a designated Fund shall be enforceable against the assets and
property of such Fund only, and not against the assets or property of any other
Fund or the investors therein.
FINANCIAL STATEMENTS
The Trust's 1998 Annual Report to Shareholders of the Portfolios
(predecessors to the Class Q shares of the Fund) accompanies this Statement of
Additional Information. The financial statements in such Annual Report are
incorporated in this Statement of Additional Information by reference. Such
financial statements for the fiscal years ended March 31, 1996, 1997 and 1998
have been audited by the Funds' independent auditors, Ernst & Young L.L.P.,
whose report thereon appears in such Annual Report. Such financial statements
have been incorporated herein in reliance upon such report given upon their
authority as experts in accounting and auditing. Additional copies of the
Trust's 1998 Annual Report to Shareholders may be obtained at no charge by
writing or telephoning the Trust at the address or number on the front page of
this Statement of Additional Information.
REGISTRATION STATEMENT
The Registration Statement of the Trust, including the Funds' Prospectuses,
the Statements of Additional Information and the exhibits filed therewith, may
be examined at the office of the Commission in Washington, D.C. Statements
contained in the Funds' Prospectuses or the Statements of Additional Information
as to the contents of any contract or other document referred to herein or in
the Prospectus are not necessarily complete, and, in each instance, reference is
made to the copy of such contract or other document filed as an exhibit to these
Registration Statements, each such statement being qualified in all respects by
such reference.
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APPENDIX A
DESCRIPTION OF SECURITIES RATINGS
The following paragraphs summarize the descriptions for the rating symbols
of securities.
COMMERCIAL PAPER
The following paragraphs summarize the description for the rating symbols
of commercial paper.
MOODY'S INVESTORS SERVICE, INC.
Moody's short-term debt ratings, which are also applicable to commercial
paper investments permitted to be made by the Master Trust, are opinions of the
ability of issuers to repay punctually their senior debt obligations which have
an original maturity not exceeding one year. Moody's employs the following
designations, all judged to be investment grade, to indicate the relative
repayment capacity of rated issuers:
PRIME 1: Issuers (or related supporting institutions) rated PRIME-1 have a
superior ability for repayment of short-term promissory obligations. PRIME-1
repayment ability will often be evidenced by the following characteristics: (A)
leading market positions in well-established industries; (B) high rates of
return on funds employed; (C) conservative capitalization structures with
moderate reliance on debt and ample asset protection; (D) broad margins in
earnings coverage of fixed financial charges and high internal cash generation;
and (E) well-established access to a range of financial markets and assured
sources of alternate liquidity.
PRIME-2: Issuers rated PRIME-2 (or related supporting institutions) have a
strong ability for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above in the PRIME-1
category but to a lesser degree. Earning trends and coverage ratios, while
sound, will be more subject to variation. Capitalization characteristics, while
still appropriate, may be more affected by external conditions. Ample alternate
liquidity is maintained.
PRIME 3: Issuers rated PRIME-3 (or related supporting institutions) have
an acceptable ability for repayment of short-term debt obligations. The effect
of industry characteristics and market composition may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt protection measurements and may require relatively high financial leverage.
Adequate alternate liquidity is maintained.
STANDARD & POOR'S CORPORATION
Standard & Poor's ratings are a current assessment of the likelihood of
timely payment of debt having an original maturity of no more than 365 days.
The ratings are based on current information furnished to Standard & Poor's by
the issuer and obtained by Standard & Poor's from other sources it considers
reliable. Ratings are graded into four categories, ranging from "A" for the
highest quality obligations to "D" for the lowest. Issues within the "A"
category are delineated with the numbers 1, 2, and 3 to indicate the relative
degree of safety, as follows:
A-1: This designation indicates the degree of safety regarding timely
payment is overwhelming or very strong. Those issuers determined to possess
overwhelming safety characteristics are denoted with a "PLUS" (+) designation.
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A-2: Capacity for timely payment on issues with this designation is
strong. However, the relative degree of safety is not as overwhelming as for
issues designated A-1.
A-3: Issues carrying this designation have a satisfactory capacity for
timely payment. They are, however, more vulnerable to the adverse effects of
changes in circumstances than obligations carrying the higher designations.
B: Issues rated "B" are regarded as having only an adequate capacity for
timely payment. However, such capacity may be damaged by changing conditions or
short-term adversities.
C: Issues rated "C" are regarded as having a doubtful capacity for
payment.
FITCH INVESTORS SERVICE, INC.
F-1+: Exceptionally strong credit quality. Commercial paper assigned this
rating is regarded as having the strongest degree of assurance for timely
payment.
F-1: Very strong credit quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues rated F-1+.
F-2: Good credit quality. Commercial paper assigned this rating has a
satisfactory degree of assurance for timely payment but the margin of safety is
not as great as for issuers assigned F-1+ and F-1 ratings.
F-3: Fair credit quality. Issues assigned this rating have
characteristics suggesting that the degree of assurance for timely payment is
adequate, however, near term adverse changes could cause these securities to be
rated below investment grade.
DUFF & PHELPS
The three rating categories of Duff & Phelps for investment grade
commercial paper are "Duff 1," "Duff 2" and "Duff 3." Duff & Phelps employs
three designations, "Duff 1+," Duff 1" and "Duff 1-," within the highest rating
category. The following summarizes the rating categories used by Duff & Phelps
for commercial paper:
DUFF 1+ - Debt possesses highest certainty of timely payment. Short-term
liquidity, including internal operating factors and/or access to alternative
sources of funds, is outstanding, and safety is just below risk-free U.S.
Treasury short-term obligations.
DUFF 1 - Debt possesses very high certainty of timely payment. Liquidity
factors are excellent and supported by good fundamental protection factors. Risk
factors are minor.
DUFF 1- - Debt possesses high certainty of timely payment. Liquidity
factors are strong and supported by good fundamental protection factors. Risk
factors are very small.
DUFF 2 - Debt possesses good certainty of timely payment. Liquidity
factors and company fundamentals are sound. Although ongoing funding needs may
enlarge total financing requirements, access to capital markets is good. Risk
factors are small.
DUFF 3 - Debt possesses satisfactory liquidity, and other protection
factors qualify issue as investment grade. Risk factors are larger and subject
to more variation. Nevertheless, timely payment is expected.
DUFF 4 - Debt possesses speculative investment characteristics.
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DUFF 5 - Issuer has failed to meet scheduled principal and/or interest
payments.
THOMSON BANKWATCH
Thomson BankWatch commercial paper ratings assess the likelihood of an
untimely payment of principal or interest of debt having a maturity of one year
or less which is issued by United States commercial banks, thrifts and non-bank
banks; non-United States banks; and broker-dealers. The following summarizes
the ratings used by Thomson BankWatch:
TBW-1 - This designation represents Thomson BankWatch's highest rating
category and indicates a very high degree of likelihood that principal and
interest will be paid on a timely basis.
TBW-2 - This designation indicates that while the degree of safety
regarding timely payment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated "TBW-1."
TBW-3 - This designation represents the lowest investment grade category
and indicates that while the debt is more susceptible to adverse developments
(both internal and external) than obligations with higher ratings, capacity to
service principal and interest in a timely fashion is considered adequate.
IBCA
IBCA assesses the investment quality of unsecured debt with an original
maturity of less than one year which is issued by bank holding companies and
their principal bank subsidiaries. The following summarizes the rating
categories used by IBCA for short-term debt ratings:
A1+ - Obligations are supported by the highest capacity for timely
repayment.
A1 - Obligations are supported by a strong capacity for timely repayment.
A2 - Obligations are supported by a satisfactory capacity for timely
repayment, although such capacity may be susceptible to adverse changes in
business, economic, or financial conditions.
A3 - Obligations are supported by an adequate capacity for timely
repayment. Such capacity is more susceptible to adverse changes in business,
economic, or financial conditions than for obligations in higher categories.
CORPORATE BONDS
MOODY'S
Moody's corporate bond ratings are opinions of the relative investment
qualities of bonds. Moody's employs nine designations to indicate such relative
qualities, ranging from "Aaa" for the highest quality obligations to "C" for the
lowest. Issues are further refined with the designation 1,2, and 3 to indicate
the relative ranking within designations. Bonds with the following Moody's
ratings have the following investment qualities:
Aaa: Bonds in this category are judged to be of the highest 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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Aa: Bonds in this category are judged to be of high quality by all
standards. Together with the AAA group, they comprise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins
of protection may not be as large as in AAA securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risks appear somewhat larger than in AAA
securities.
A: Bonds in this category possess many favorable investment attributes
and are considered to be 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 in this category are considered 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.
Ba: Bonds in this category are judged to have speculative elements; their
future cannot be considered as well-assured. Often the protection of interest
and principal payments may be very moderate, and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B: Bonds in this category generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
Caa: Bonds in this category are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
Ca: Bonds in this category represent obligations which are speculative in
a high degree. Such issues are often in default or have other marked
shortcoming.
C: Bonds in this category are the lowest rated class of bonds, and issues
so rated can be regarded as having extremely poor prospects of ever attaining
any real investment standing.
STANDARD & POOR'S
A Standard & Poor's corporate debt rating is a current assessment of the
creditworthiness of an obligor with respect to a specific obligation. Ratings
are graded into ten categories, ranging from "AAA" for the highest quality
obligation to "D" for debt in default. Issues are further refined with a "PLUS"
or "MINUS" sign to show relative standing within the categories. Bonds with the
following Standard & Poor's ratings have the following investment qualities:
AAA: Bonds in this category have the highest rating assigned by Standard
& Poor's. Capacity to pay interest and repay principal is extremely strong.
AA: Bonds in this category have a very strong capacity to pay interest and
repay principal and differ from the higher rated issues only in small degree.
A: Bonds in this category have a strong capacity to pay interest and repay
principal although they are somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher rated
categories.
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BBB: Bonds in this category have an adequate capacity to pay interest and
repay principal. Whereas such issues normally exhibit 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 higher-rated categories.
BB: Bonds in this category have less near-term vulnerability to default
than other speculative issues. However, they face major ongoing uncertainties
or exposure to adverse business, financial or economic conditions which could
lead to inadequate capacity to meet timely interest and principal payments. The
"BB" rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied "BBB-"rating.
B: Bonds in this category have a greater vulnerability to default but
currently have the capacity to meet interest payments and principal repayments.
Adverse business, financial, or economic conditions will likely impair capacity
or willingness to pay interest and repay principal. The "B" rating is also used
for debt subordinated to senior debt that is assigned an actual or implied "BB"
or "BB-" rating.
CCC: Bonds in this category have currently identifiable vulnerability to
default, and are dependent upon favorable business, financial and economic
conditions to meet timely payment of interest and repayment of principal. In
the event of adverse business, financial, or economic conditions, they are not
likely to have the capacity to pay interest and repay principal. The "CCC"
rating category is also used for debt subordinated to senior debt that is
assigned an actual or implied "B" or "B-" rating.
C: This rating is typically applied to debt subordinated to senior debt
which is assigned an actual or implied "CCC-" debt rating. The "C" rating may
be used to cover a situation where a bankruptcy petition has been filed, but
debt service payments are continued.
DUFF & PHELPS
The following summarizes the ratings used by Duff & Phelps for corporate
and municipal long-term debt:
AAA - Debt is considered to be of the highest credit quality. The risk
factors are negligible, being only slightly more than for risk-free U.S.
Treasury debt.
AA - Debt is considered of high credit quality. Protection factors are
strong. Risk is modest but may vary slightly from time to time because of
economic conditions.
A - Debt possesses protection factors which are average but adequate.
However, risk factors are more variable and greater in periods of economic
stress.
BBB - Debt possesses below average protection factors but such protection
factors are still considered sufficient for prudent investment. Considerable
variability in risk is present during economic cycles.
BB, B, CCC, DD AND DP - Debt that possesses one of these ratings is
considered to be below investment grade. Although below investment grade, debt
rated "BB" is deemed likely to meet obligations when due. Debt rated "B"
possesses the risk that obligations will not be met when due. Debt rated "CCC"
is well below investment grade and has considerable uncertainty as to timely
payment of principal, interest or preferred dividends. Debt rated "DD" is a
defaulted debt obligation, and the rating "DP" represents preferred stock with
dividend arrearages.
To provide more detailed indications of credit quality, the "AA," "A,"
"BBB," "BB" and "B" ratings may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within these major categories.
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FITCH INVESTORS SERVICE, INC.
The following summarizes the highest four ratings used by Fitch for
corporate and municipal bonds:
AAA - Bonds considered to be investment grade and of the highest credit
quality. The obligor has an exceptionally strong ability to pay interest and
repay principal, which is unlikely to be affected by reasonably foreseeable
events.
AA - Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong, although not quite as strong as bonds rated "AAA." Because bonds rated
in the "AAA" and "AA" categories are not significantly vulnerable to foreseeable
future developments, short-term debt of these issuers is generally rated "F-1+."
A - Bonds considered to be investment grade and of high credit quality.
The obligor's ability to pay interest and repay principal is considered to be
strong, but may be more vulnerable to adverse changes in economic conditions and
circumstances than bonds with higher ratings.
BBB - Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have an adverse impact on these
bonds, and therefore, impair timely payment. The likelihood that the ratings of
these bonds will fall below investment grade is higher than for bonds with
higher ratings.
BB, B, CCC, CC, C, DDD, DD, AND D - Bonds that possess one of these ratings
are considered by Fitch to be speculative investments. The ratings "BB" to "C"
represent Fitch's assessment of the likelihood of timely payment of principal
and interest in accordance with the terms of obligation for bond issues not in
default. For defaulted bonds, the rating "DDD" to "D" is an assessment of the
ultimate recovery value through reorganization or liquidation.
To provide more detailed indications of credit quality, the Fitch ratings
from and including "AA" to "C" may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within these major rating categories.
IBCA
IBCA assesses the investment quality of unsecured debt with an original
maturity of more than one year which is issued by bank holding companies and
their principal bank subsidiaries. The following summarizes the rating
categories used by IBCA for long-term debt ratings:
AAA - Obligations for which there is the lowest expectation of investment
risk. Capacity for timely repayment of principal and interest is substantial
such that adverse changes in business, economic or financial conditions are
unlikely to increase investment risk significantly.
AA - Obligations for which there is a very low expectation of investment
risk. Capacity for timely repayment of principal and interest is substantial.
Adverse changes in business, economic or financial conditions may increase
investment risk albeit not very significantly.
A - Obligations for which there is a low expectation of investment risk.
Capacity for timely repayment of principal and interest is strong, although
adverse changes in business, economic or financial conditions may lead to
increased investment risk.
BBB - Obligations for which there is currently a low expectation of
investment risk. Capacity for timely repayment of principal and interest is
adequate, although adverse changes in business, economic or
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financial conditions are more likely to lead to increased investment risk than
for obligations in higher categories.
BB, B, CCC, CC, AND C - Obligations are assigned one of these ratings where
it is considered that speculative characteristics are present. "BB" represents
the lowest degree of speculation and indicates a possibility of investment risk
developing. "C" represents the highest degree of speculation and indicates that
the obligations are currently in default.
IBCA may append a rating of plus (+) or minus (-) to a rating to denote
relative status within major rating categories.
THOMSON BANKWATCH
Thomson BankWatch assesses the likelihood of an untimely repayment of
principal or interest over the term to maturity of long term debt and preferred
stock which are issued by United States commercial banks, thrifts and non-bank
banks; non-United States banks; and broker-dealers. The following summarizes
the rating categories used by Thomson BankWatch for long-term debt ratings:
AAA - This designation represents the highest category assigned by Thomson
BankWatch to long-term debt and indicates that the ability to repay principal
and interest on a timely basis is very high.
AA - This designation indicates a superior ability to repay principal and
interest on a timely basis with limited incremental risk versus issues rated in
the highest category.
A - This designation indicates that the ability to repay principal and
interest is strong. Issues rated "A" could be more vulnerable to adverse
developments (both internal and external) than obligations with higher ratings.
BBB - This designation represents Thomson BankWatch's lowest investment
grade category and indicates an acceptable capacity to repay principal and
interest. Issues rated "BBB" are, however, more vulnerable to adverse
developments (both internal and external) than obligations with higher ratings.
BB, B, CCC, AND CC, - These designations are assigned by Thomson BankWatch
to non-investment grade long-term debt. Such issues are regarded as having
speculative characteristics regarding the likelihood of timely payment of
principal and interest. "BB" indicates the lowest degree of speculation and
"CC" the highest degree of speculation.
D - This designation indicates that the long-term debt is in default.
PLUS (+) OR MINUS (-) - The ratings from "AAA" through "CC" may include a
plus or minus sign designation which indicates where within the respective
category the issue is placed.
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