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PROSPECTUS AND APPENDIX
This document is incorporated by reference to Post-Effective Amendment No. 3,
Registration Number 33-71158 filed on Form N-1A on April 30, 1995.
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STATEMENT OF ADDITIONAL INFORMATION
LINCOLN NATIONAL EQUITY-INCOME FUND, INC.
This Statement of Additional Information should be read in conjunction with the
Prospectus of Lincoln National Equity-Income Fund, Inc. (the Fund) dated April
29, 1995. You may obtain a copy of the Fund's Prospectus on request and without
charge. Please write Kim Oakman, The Lincoln National Life Insurance Company,
P.O. Box 2340, Fort Wayne, Indiana 46801 or call 1-800-348-1212, Extension 4912.
THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A PROSPECTUS.
The date of this Statement of Additional Information is April 29, 1995.
TABLE OF CONTENTS
Page
Investment Objective 2
Investment Policies and Limitations (Restrictions) 2
Investment Techniques 3
Portfolio Transactions and Brokerage 12
Determination of Net Asset Value 13
Appendix
Investment Advisor and Sub-Advisor A-1
Directors and Officers A-2
Investment Policies and Techniques (continued) A-2
Options, Futures, Securities Lending, Repurchase and
Reverse Repurchase Agreements
Custodian A-6
Independent Auditors A-7
Financial Statements A-7
Bond Ratings A-7
Commercial Paper Ratings A-8
U.S. Government Obligations A-8
Taxes A-8
State Requirements A-9
Derivative Transactions-Definitions A-9
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INVESTMENT OBJECTIVE
The Fund's investment objective is to obtain reasonable income by investing
primarily in income-producing equity securities. The Fund's investment
objective and certain investment policies are fundamental and cannot be changed
without the affirmative vote of a majority of the outstanding voting securities
of the Fund. See "General Information" in the Appendix to the Prospectus.
There can be no assurance that the objective of the Fund will be achieved.
The Fund seeks to achieve its objective by actively managing income-producing
common and preferred stock and debt convertible into common stock. In choosing
securities, the Fund will also consider the potential for capital appreciation.
The Fund's goal is to achieve a yield which exceeds the composite yield on the
securities comprising the Standard & Poor's 500 Composite Stock Price Index.
INVESTMENT POLICIES AND LIMITATIONS (RESTRICTIONS)
The following policies and limitations supplement those set forth in the
Prospectus. Unless otherwise noted, whenever an investment policy or limitation
states a maximum percentage of the Fund's assets that may be invested in any
security or other asset, or sets forth a policy regarding quality standards,
such standard or percentage limitation will be determined immediately after and
as a result of the Fund's acquisition of such security or other asset.
Accordingly, any subsequent change in values, net assets, or other circumstances
will not be considered when
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determining whether the investment complies with the Fund's investment policies
and limitations.
The Fund's fundamental investment policies and limitations cannot be changed
without approval by a "majority of the outstanding voting securities" of the
Fund. However, except for the fundamental investment limitations set forth
below, the investment policies and limitations described in this Statement of
Additional Information are not fundamental and may be changed without
shareholder approval.
The following are the Fund's fundamental investment limitations. The Fund may
not:
(1) with respect to 75% of the Fund's total assets, purchase the securities of
any issuer (other than securities issued or guaranteed by the U.S.
Government or any of its agencies or instrumentalities) if, as a result, (a)
more than 5% of the Fund's total assets would be invested in the securities
of that issuer, or (b) the Fund would hold more than 10% of the outstanding
voting securities of that issuer;
(2) issue senior securities, except as permitted under the Investment Company
Act of 1940, as amended (the "1940 Act");
(3) borrow money, except that the Fund (i) may borrow money for temporary or
emergency purposes (not for leveraging or investment or (ii) engage in
reverse repurchase agreements, provided that (i) and (ii) in combination
(borrowings) do not exceed 33 1/3% of its total assets (including the amount
borrowed) less liabilities (other than borrowings). Any borrowings that come
to exceed 33 1/3% of the value of the Fund's total assets by reason of a
decline in net assets will be reduced within three days (exclusive of
Sundays and holidays) to the extent necessary to comply with the 33 1/3%
limitation;
(4) underwrite securities issued by others, except to the extent that the Fund
may be considered an underwriter within the meaning of the Securities Act of
1933 in the disposition of restricted securities;
(5) purchase the securities of any issuer (other than securities issued or
guaranteed by the U.S. Government or any of its agencies or
instrumentalities) if, as a result, more than 25% of its total assets would
be invested in the securities of companies whose principal business
activities are in the same industry;
(6) purchase or sell real estate unless acquired as a result of ownership of
securities or other instruments (but this shall not prevent the Fund from
investing in securities or other instruments backed by real estate or
securities of companies engaged in the real estate business);
(7) purchase or sell physical commodities unless acquired as a result of
ownership of securities or other instruments (but this shall not prevent the
Fund from purchasing or selling options and futures contracts for from
investing in securities or other instruments backed by physical
commodities); or
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(8) lend any security or make any other loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, but this limitation does
not apply to purchases of debt securities or to repurchase agreements.
The following investment limitations for the Fund are not fundamental and
may be changed without shareholder notification:
(i) The Fund does not currently intend to sell securities short, unless
it owns or has the right to obtain securities equivalent in kind and
amount to the securities sold short, and provided that transactions
in futures contracts and options are not deemed to constitute selling
securities short.
(ii) The Fund does not currently intend to purchase securities on margin,
except that the Fund may obtain such short-term credits as are
necessary for the clearance of transactions, and provided that margin
payments in connection with futures contracts and options on futures
contracts shall not constitute purchasing securities on margin.
(iii) The Fund may borrow money only (a) from a bank or (b) by engaging in
reverse repurchase agreements with any party (reverse repurchase
agreements are treated as borrowings for purposes of fundamental
investment limitation (3)). The Fund will not borrow money in excess
of 25% of net assets so long as this limitation is required for
certification by certain state insurance departments. Any borrowings
that come to exceed this amount will be reduced within seven days
(not including Sundays and holidays) to the extent necessary to
comply with the 25% limitation. The Fund will not purchase any
security while borrowings representing more than 5% of its total
assets are outstanding.
(iv) The Fund does not currently intend to purchase any security if, as a
result, more than 10% of the Fund's net assets would be invested in
securities that are deemed to be illiquid because they are subject to
legal or contractual restrictions on resale or because they cannot be
sold or disposed of in the ordinary course of business at
approximately the prices at which they are valued.
(v) The Fund does not currently intend to lend assets other than
securities to other parties, except by acquiring loans, loan
participants, or other forms of direct debt instruments and, in
connection therewith, assuming any associated unfunded commitments of
the sellers. (This limitation does not apply to purchases of debt
securities or to repurchase agreements.)
(vi) The Fund does not currently intend to (a) purchase securities of
other investment companies, except in the open market where no
commission except the ordinary broker's commission is paid, or (b)
purchase or retain securities issued by other open-end investment
companies. Limitations (a) and (b) do not apply to securities
received
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as dividends, through offers of exchange, or as a result of a
reorganization, consolidation, or merger. (Due to certain state
insurance regulations, the Fund does not currently intend to purchase
the securities of other investment companies.)
(vii) The Fund does not currently intend to invest in oil, gas, or other
mineral exploration or development programs or leases.
For the Fund's limitations on futures and options transactions, see
"Limitations on Futures and Options Transactions" below. For the Fund's
limitations on short sales, see "Short Sales" below.
In accordance with the Fund's fundamental investment policies, there are no
limitations on the percentage of the Fund's assets which may be invested in
any one type of instrument. Nor are there limitations (except those imposed
by certain state insurance regulations) on the percentage of the Fund's
assets which may be invested in any foreign country. However, in order to
comply with diversification requirements under Section 817(h) of the
Internal Revenue Code of 1986, as amended, in connection with Fidelity
Management Trust Company serving as sub-adviser, the Fund has agreed to
certain non-fundamental limitations. Please refer to the prospectus for the
Variable Annuity Account for more information.
INVESTMENT TECHNIQUES
The following paragraphs provide a brief description of securities in which
the Fund may invest and transactions it may make. The Fund is not limited by
this discussion, however, and may purchase other types of securities and
enter into other types of transactions if they are consistent with the
Fund's investment objectives and policies.
Fund management expects securities selection for the Fund to closely
parallel that for an existing Fidelity retail fund, the Fidelity Equity-
Income Fund, which has a similar investment objective. However, there cannot
be a precise correlation, and performance of the Fund is not expect to be
the same as the performance of the corresponding retail fund. Selection
criteria for portfolio securities and the relative weightings of the
selections can differ based on asset size, timing, cash flow, expenses and
other factors. Portfolio selections will be made by Fund's Sub-Advisor,
Fidelity Management Trust Company (the "Sub-Advisor"), which is an affiliate
of Fidelity Management & Research Company ("Fidelity"), which manages the
Fidelity Equity-Income Fund.
AFFILIATED BANK TRANSACTIONS. Pursuant to exemptive orders issued by the
Securities and Exchange Commission (SEC), the Fund may engage in
transactions with banks that are, or may be considered to be, "affiliated
persons" of the Fund under the 1940 Act. Such transactions may be entered
into only pursuant to procedures established and periodically reviewed by
the Board of
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Directors. These transactions may include repurchase agreements with
custodian banks; purchases, as principal, of short-term obligations of, and
repurchase agreements with, the 50 largest U.S. banks (measured by
deposits); transactions in municipal securities; and transactions in U.S.
Government securities with affiliated banks that are primary dealers in
these securities.
FUND'S RIGHTS AS A SHAREHOLDER. The Fund does not intend to direct or
administer the day-to-day operations of any company. The fund, however, may
exercise its rights as a shareholder and may communicate its views on
important matters of policy to management, the Board of Directors, and
shareholders of a company when the Sub-Adviser determines that such matters
could have a significant effect on the value of the Fund's investment in
the company. The activities that the Fund may engage in, either
individually or in conjunction with others, may include, among others,
supporting or opposing proposed changes in a company's corporate structure
or business activities; seeking changes in a company's directors or
management; seeking changes in a company's direction or policies; seeking
the sale or reorganization of the company or a portion of its assets; or
supporting or opposing third party takeover efforts. This area of corporate
activity is increasingly prone to litigation and it is possible that the
Fund could be involved in lawsuits related to such activities. The Sub-
Adviser will monitor such activities with a view to mitigating, to the
extent possible, the risk of litigation against the Fund and the risk of
actual liability if the Fund is involved in litigation. No guarantee can be
made, however, that litigation against the Fund will not be undertaken or
liabilities incurred.
PERMITTED INSTRUMENTS:
Money Market refers to the marketplace where short-term, high grade debt
securities are traded, and includes U.S. Government obligations, commercial
paper, certificates of deposit and bankers' acceptances, time deposits and
short-term corporate obligations. Money market instruments may carry fixed
rates of return or have variable or floating interest rates.
Commercial Paper represents short-term obligations issued by banks, broker-
dealers, corporations and other entities for purposes such as financing
their current operations.
Certificates of Deposit represent a commercial bank's obligations to repay
funds deposited with it earning specified rates of interest over given
periods.
Banker's Acceptances are obligations of a bank to pay a draft which has
been drawn on it by a customer. These obligations are backed by large banks
and usually backed by goods in international trade.
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Time Deposits are non-negotiable deposits in a banking institution earning
a specified interest rate over a given period of time.
U.S. Government Obligations are debt securities issued or guaranteed as to
principal and interest by the U.S. Treasury or by an agency or
instrumentality of the U.S. Government. Not all U.S. Government obligations
are backed by the full faith and credit of the United States. For example,
securities issued by the Federal Farm Credit Bank or by the Federal
National Mortgage Association are supported by the agency's right to borrow
money from the U.S. Treasury under certain circumstances. Securities issued
by the Federal Home Loan Bank are supported only by the credit of the
agency. There is no guarantee that the government will support these types
of securities, and therefore they involve more risk than other government
obligations.
Variable or Floating Rate Instruments (including notes purchased directly
from issuers) bear variable or floating interest rates and may carry rights
that permit holders to demand full payment from the issuers or certain
financial intermediaries. Floating rate securities have interest rates that
change whenever there is a change in a designated market-based interest
rate, while variable rate instruments provide for a specified periodic
adjustment in the interest rate. These formulas are designed to result in a
market value for the instrument that approximates its par value.
Credit Enhancement Agreements may be purchased simultaneously with a money
market instrument for guaranteeing and/or interest and may e considered
with the instrument for purposes of determining the quality of the
instruments. The irrevocable note repurchase agreements or letters of
credit issued by banks and guarantees provided by creditworthy
institutions. The Fund will purchase these agreements to enhance the
creditworthiness of instruments when the Sub-Adviser (through yield and
credit analysis) feels it is in the Fund's best interest.
Corporate Obligations are bonds and notes issued by corporations and other
business organizations in order to finance their long-term credit needs.
Loans and Other Direct Debt Instruments are interests in amounts owed by a
corporate, governmental or other borrower to another party. They may
represent amounts owed to lenders or lending syndicates (loans and loan
participations), to suppliers of goods or services (trade claims or other
receivables), or to other parties. Direct debt instruments purchased by the
Fund may have a maturity of any number of days or years, may be secured or
unsecured, and may be of any credit quality. Direct debt instruments
involve the risk of loss in case of default or insolvency of the borrower.
Direct debt instruments may offer less legal protection to the Fund in the
event of fraud or misrepresentation. In addition, loan participations
involve a
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risk of insolvency of the lending bank or other financial intermediary.
Direct debt instruments also may include standby financing commitments that
obligate the Fund to supply additional cash to the borrower on demand at a
time when the Fund would not have otherwise done so, even if the borrower's
condition makes it unlikely that the amount ever will be repaid.
Mortgage-Backed Securities. Mortgage-backed securities are securities
issued by government and non-government entities such as banks, mortgage
lenders, or other financial institutions. A mortgage-backed security may be
an obligation of the issuer backed by a mortgage or pool of mortgages or a
direct interest in an underlying pool of mortgages. Some mortgage-backed
securities, such as collateralized mortgage obligations or CMOs, make
payments of both principal and interest at a variety of intervals; others
make semiannual interest payments at a predetermined rate and repay
principal at maturity (like a typical bond). Mortgage-backed securities are
based on different types of mortgages, including those on commercial real
estate or residential properties. Other types of mortgage-backed securities
will likely be developed in the future, and the Fund may invest in them if
the Sub-Adviser determines they are consistent with the Fund's investment
objective and policies.
The value of mortgage-backed securities may change due to shifts in the
market's perception of issuers. In addition, regulatory or tax changes may
adversely affect the mortgage securities market as a whole. Non-government
mortgage-backed securities may offer higher yields than those issued by
government entities, but also may be subject to greater price changes than
government issues. Mortgage-backed securities are subject to prepayment
risk. Prepayment, which occurs when unscheduled or early payments are made
on the underlying mortgages, may shorten the effective maturities of these
securities and may lower their total returns.
Stripped Mortgage-Backed Securities are created when a U.S. Government
agency or a financial institution separates the interest and principal
components of a mortgage-backed security and sells them as individual
securities. The holder of the "principal-only" security (PO) receives the
principal payments made by the underlying mortgage-backed security, while
the holder of the "interest-only" security (IO) receives interest payments
from the same underlying security.
The prices of stripped mortgage-backed securities may be particularly
affected by changes in interest rates. As interest rates fall, prepayment
rates tend to increase, which tends to reduce prices of IOs and increase
prices of POs. Rising interest rates can have the opposite effect.
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Asset-Backed Securities consist of undivided fractional interests in pools
of consumer loans (unrealted to mortgage loans) held in a trust. Payments
of principal and interest are passed through to certificate holders and are
typically suppported by some form of credit enhancement, such as a letter
of credit, surety bond, limited guaranty, or senior/subordination. The
degree of credit enhancement varies, but generallly amounts to only a
fraction of the asset-backed security's par value until exhausted. Asset-
backed securities are ultimately dependent upon payment of consumer loans
by individuals, and the certificate holder generally has no recourse to the
entity that originated the loans. The underlying loans are subject to
prepayments which shorten the securities' weighted average life and may
lower their return. (as prepayments flow through at par, total returns
would be affecteed by the prepayments; if a security were trading at a
premium, its total return would be lowered by prepayments, and if a
security were trading at a discount, its total return would be increased by
prepayments.) If the credit enhancement is exchausted, certificate holders
may experience losses or delays in payment if the required payments of
principal and interest are not made to the trust with respect to the
underlying loans. The value of these securities also may change because of
changes in the market's perception of the creditworthiness of the servicing
agent for the loan pool, the originator of the loans, or the financial
institution providing the credit enhancement.
The Sub-Advisor believes that CMOs, asset-backed securities and mortgage-
backed securities are readily marketable based on the size of the market
and the number of trades transacted each day.
Zero Coupon Bonds do not make interest payments; instead, they are sold at
a deep discount from their face value and are redeemed at face value when
they mature. Because zero coupon bonds do not pay current income, their
prices can be very volatile when interest rates change. In calculating its
daily dividend, the Fund takes into account as income a portion of the
difference between a zero coupon bond's purchase price and its face value.
A broker-dealer creates a derivative zero by separating the interest and
principal components of a U.S. Treasury security and selling them as two
individual securities. CATS (Certificates of Accrual on Treasury
Securities), TIGRs (Treasury Investment Growth Receipts), and TRs (Treasury
Receipts) are examples of derivative zeros.
The Federal Reserve Bank creates STRIPS (Separate Trading of Registered
Interest and Principal of Securities) by separating the interest and
principal componenets of an outstanding U.S. Treasury bond and selling them
as individual securities. Bonds issued by the Resolution Funding
Corporation (REFCORP) and the Financing Corporation (FICO) can also be
separated in this fashion. Original issue zeros are zero coupon securities
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originally issued by the U.S. Government, a government agency, or a
corporation in zero coupon form.
REPURCHASE AGREEMENTS. The Fund may also make short-term investments in
repurchase agreements. A repurchase agreement typically involves the
purchase by the Fund of securities (U.S. Government or other money market
securities) from a financial institution such as a bank, broker or savings
and loan association, coupled with an agreement by the seller to repurchase
the same securities form the Fund at the specified price and at a fixed
time in the future, usually not more than seven days from the date of
purchase. The difference between the purchase price to the Fund and the
resale price to the seller represents the interest earned by the Fund which
is unrelated to the coupon rate or maturity of the purchased security. If
the seller defaults, the Fund may incur a loss if the value of the
collateral securing the repurchase agreement declines, or the Fund may
incur disposition costs in connection with liquidating the collateral. If
bankruptcy proceedings are commenced with respect to the seller,
realization upon the collateral by the Fund may be delayed or limited and a
loss may be incurred if the collateral securing the repurchase agreement
declines in value during the bankruptcy proceedings. However, repurchase
agreements will be made only with brokers or dealers deemed by the Board of
Directors to be creditworthy; they will be fully collateralized; and the
collateral for each transaction will be in the actual or constructive
possession of the Fund during the term of the transaction, as provided in
the agreement. Repurchase agreements with a duration of more than seven
days are considered illiquid securities and are subject to the limit stated
above.In a repurchase agreement, the Fund purchases a security and
simultaneously commits to resell that security to the seller at an agreed
upon price on an agreed upon date within a number of days (usually not more
than seven) from the date of purchase. The resale price reflects the
purchase price plus an agreed upon incremental amount that is unrelated to
the coupon rate or maturity of the purchased security. A repurchase
agreement involves the obligation of the seller to pay the agreed upon
price, which obligation is in effect secured by the value (at least equal
to the amount of the agreed upon resale price and marked-to-market daily)
of the underlying security. The Fund may engage in a repurchase agreement
with respect to any security in which it is authorized to invest. While it
does not presently appear possible to eliminate all risks from these
transactions (particularly the possibility of a decline in the market value
of the underlying securities, as well as delays and costs to the Fund in
the event of bankruptcy of the seller), it is the policy of the Fund to
limit repurchase agreements to those parties whose creditworthiness has
been reviewed and found satisfactory by the Adviser or Sub-Adviser. In
addition, the Fund currently intends to invest only in repurchase
agreements collateralized by U.S. Government securities.
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Pursuant to an Exemptive Order issued by the SEC, the Fund, along with
other registered investment companies having management contracts with the
Sub-Adviser or an affiliate thereof, may invest in a pool of one or more
large overnight repurchase agreements. The repurchase agreements'
underlying securities are U.S. Government securities in which the Fund is
permitted to invest.
REVERSE REPURCHASE AGREEMENTS. Reverse repurchase agreements are
transactions when the Fund temporarily transfers possession of a portfolio
instrument to another party, such as a bank or broker-dealer, in return for
cash. At the same time, the Fund agrees to repurchase the instrument in an
agreed-upon price and time. The Fund expects that it will engage in reverse
repurchase agreements for temporary purposes such as to fund redemptions or
when it is able to invest the cash so acquired at a rate higher than the
cost of the agreement, which would increase the income earned by the Fund.
Reverse repurchase agreements may increase the risk of fluctuation in the
market value of assets or in its yield.In a reverse repurchase agreement,
the Fund sells a fund instrument to another party, such as a bank or
broker-dealer, in return for cash and agrees to repurchase the instrument
at a particular price and time. While a reverse repurchase agreement is
outstanding, the Fund will maintain appropriate liquid assets in a
segregated custodial account to cover its obligation under the agreement.
The Fund will enter into reverse repurchase agreements only with parties
whose creditworthiness has been reviewed and found satisfactory by the
Board of Directors. Such transactions may increase fluctuations in the
market value of the Fund's assets and may be viewed as a form of leverage.
SECURITIES LENDING. The Fund may from time to time lend securities from its
portfolio to brokers, dealers and financial institutions and receive
collateral from the borrower, in the form of cash (which may be invested in
short-term securities), U.S. Government obligations or certificates of
deposit. Such collateral will be maintained at all times in an amount equal
to at least 100% of the current market value of the loaned securities, and
will be in the actual or constructive possession of the Fund during the
term of the loan. The Fund will retain the incidents of ownership of the
loaned securities and will be entitled to the interest or dividends payable
on the loaned securities. In addition, the Fund will receive interest on
the amount of the loan. The loans will be terminable by the Fund at any
time and will not be made to any affiliates of the Fund or the Adviser or
Sub-Adviser. The Fund may pay reasonable finder's fees to persons
unaffiliated with it in connection with the arrangement of the loans.
As with any extensions of credit, there are risks of delay in recovery and,
in some cases, even loss of rights in the collateral or the loaned
securities should the borrower of securities fail financially. However,
loans of portfolio securities will be made only to firms deemed by the
Board of
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Directors to be creditworthy. As a fundamental policy, the Fund will not lend
securities, if, as a result, more than 25% of its total assets would be lent to
other parties.
ILLIQUID INVESTMENTS, in which the Fund may invest up to 10% of its total
assets, are investments that cannot be sold or disposed of in the ordinary
course of business at approximately the prices at which they are valued. Under
the supervision of the Board of Directors, the Sub-Adviser determines the
liquidity of the Fund's investments and, through reports from the Sub-Adviser
may consider various factors, including (1) the frequency of trades and
quotations, (2) the number of dealers and prospective purchasers in the
marketplace, (3) dealer undertakings to make a market, (4) the nature of the
security (including any demand or tender features), and (5) the nature of the
marketplace for trades (including the ability to assign or offset the Fund's
rights and obligations relating to the investment).
Investments currently considered by the Fund to be illiquid include repurchase
agreements not entitling the holder to payment of principal and interest within
seven days, loans and other direct debt instruments, over-the-counter options,
non-government stripped fixed-rate mortgage-backed securities, and restricted
securities, government-stripped fixed-rate mortgage-backed securities, and sway
agreements determined by the Sub-Adviser to be illiquid. However, with respect
to over-the-counter options the Fund writes, all or a portion of the value of
the underlying instrument may be illiquid depending on the assets held to cover
the option and the nature and terms of any agreement the Fund may have to close
out the option before expiration.
In the absence of market quotations, illiquid investments are valued at fair
value as determined in good faith by a committee appointed by the Board of
Directors of the Fund. If through a change in values, net assets, or other
circumstances, the Fund were in a position where more than 10% of net assets
were invested in illiquid securities, it would seek to take appropriate steps to
protect liquidity.
RESTRICTED SECURITIES generally can be sold in privately negotiated
transactions, pursuant to an exemption from registration under the Securities
Act of 1933, or in a registered public offering. Where registration is
required, the Fund may be obligated to pay all or part of the registration
expense and a considerable period may elapse between the time it decides to seek
registration and the time the Fund may be permitted to sell a security under an
effective registration statement. If, during such a period, adverse market
conditions were to develop, the Fund might obtain a less favorable price than
prevailed when it decided to seek registration of the security.
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SWAP AGREEMENTS. As one way of managing its exposure to different types of
investments, the Fund may enter into interest rate swaps, currency swaps, and
other types of swap agreements such as caps, collars, and floors. In a typical
interest rate swap, one party agrees to make regular payments equal to a
floating interest rate multiplied by a "notional principal amount," in return
for payments equal to a fixed rate multiplied by the same amount, for a
specified period of time. If a swap agreement provides for payments in
different currencies, the parties might agree to exchange the notional principal
amount as well. Swaps may also depend on other prices or rates, such as the
value of an index or mortgage prepayment rates.
In a typical cap or floor agreement, one party agrees to make payments only
under specified circumstances, usually in return for payment of a fee by the
other party. For example, the buyer of an interest rate cap obtains the right
to receive payments to the extent that a specified interest rate exceeds an
agreed-upon level, while the seller of an interest rate floor is obligated to
make payments to the extent that a specified interest rate falls below an
agreed-upon level. An interest rate collar combines elements of buying a cap
and selling a floor.
Swap agreements will tend to shift the Fund's investment exposure from one type
of investment to another. For example, if the Fund agreed to exchange payments
in dollars for payments in foreign currency, the swap agreement would tend to
decrease the Fund's exposure to U.S. interest rates and increase its exposure to
foreign currency and interest rates. Caps and floors have an effect similar to
buying or writing options. Depending on how they are used, swap agreements may
increase or decrease the overall volatility of the Fund's investments and its
share price and yield.
Swap agreements are sophisticated hedging instruments that typically involve a
small investment of cash relative to the magnitude of risks assumed. As a
result, swaps can be highly volatile and may have a considerable impact on the
Fund's performance. Swap agreements are subject to risks related to the
counterparty's ability to perform, and may decline in value if the
counterparty's creditworthiness deteriorates. The Fund may also suffer losses
if it is unable to terminate outstanding swap agreements or reduce its exposure
through offsetting transactions.
Swap agreements can be individually negotiated and structured to include
exposure to a variety of different types of investments or market factors.
Depending on their structure, swap agreements may increase or decrease the
Fund's exposure to long or short-term interest rates (in the U.S. or abroad),
foreign currency values, mortgage securities, corporate borrowing rates, or
other factors such as security prices or inflation rates. Swap agreements can
take many different forms and are known by a variety of names. The Fund is not
limited to any particular form
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of swap agreement if the Sub-Adviser determines it is consistent with the Fund's
investment objective and policies.
The most significant factor in the performance of swap agreements is the change
in the specific interest rate, currency, or other factors that determine the
amounts of payments due to and from the Fund. If a swap agreement calls for
payments by the Fund, it must be prepared to make such payments when due. In
addition, if the counterparty's creditworthiness declined, the value of a swap
agreement would be likely to decline, potentially resulting in losses. The Fund
expects to be able to eliminate its exposure under swap agreements either by
assignment or other disposition, or by entering into an offsetting swap
agreement with the same party or a similarly creditworthy party.
The Fund will maintain appropriate liquid assets in a segregated custodial
account to cover its current obligations under swap agreements. If the Fund
enters into a swap agreement on a net basis, it will segregate assets with a
daily value at least equal to the excess, if any, of its accrued obligations
under the swap agreement over the accrued amount it is entitled to receive under
the agreement. If the Fund enters into a swap agreement on other than a net
basis, it will segregate assets with a value equal to the full amount of its
accrued obligations under the agreement.
INDEXED SECURITIES. The fund may purchase securities whose prices are indexed
to the prices of other securities, securities indices, currencies, precious
metals or other commodities, or other financial indicators. Indexed securities
typically, but not always, are debt securities or deposits whose value at
maturity or coupon rate is determined by reference to a specific instrument or
statistic. Gold-indexed securities, for example, typically provide for a
maturity value that depends on the price of gold, resulting in a security whose
price tends to rise and fall together with gold prices. Currency-indexed
securities typically are short-term to intermediate-term debt securities whose
maturity values or interest rates are determined by reference to the values of
one or more specified foreign currencies, and may offer higher yields than U.S.
dollar-denominated securities of equivalent issuers. Currency-indexed
securities may be positively or negatively indexed; that is, their maturity
value may increase when the specified currency value increases, resulting in a
security that performs similarly to a foreign-denominated instrument, or their
maturity value may decline when foreign currencies increase, resulting in a
security whose price characteristics are similar to a put on the underlying
currency. Currency-indexed securities may also have prices that depend on the
values of a number of different foreign currencies relative to each other.
The performance of indexed securities depends to a great extent on the
performance of the security, currency, or other instrument
<PAGE>
to which they are indexed, and may also be influenced by interest rate changes
in the U.S. and abroad. At the same time, indexed securities are subject to
the credit risks associated with the issuer of the security, and their values
may decline substantially if the issuer's creditworthiness deteriorates. Recent
issuers of indexed securities have included banks, corporations, and certain
U.S. Government agencies.
WARRANTS. Warrants are securities that give the Fund the right to purchase
equity securities from the issuer at a specific price (the strike price) for a
limited period of time. The strike price of warrants typically is much lower
than the current market price of the underlying securities, yet they are subject
to similar price fluctuations. As a result, warrants may be more volatile
investments than the underlying securities and may offer greater potential for
capital appreciation as well as capital loss.
Warrants do not entitle a holder to dividends or voting rights with respect to
the underlying securities and do not represent any rights in the assets of the
issuing company. Also, the value of the warrant does not necessarily change
with the value of the underlying securities and a warrant ceases to have value
if it is not exercised prior to the expiration date. These factors can make
warrants more speculative than other types of investments.
LOANS AND OTHER DIRECT DEBT INSTRUMENTS. Direct debt instruments are interests
in amounts owed by a corporate, governmental, or other borrower to lenders or
lending syndicates (loans and loan participations), to suppliers of goods or
services (trade claims or other receivables), or to other parties. Direct debt
instruments are subject to the Fund's policies regarding the quality of debt
securities.
Purchasers of loans and other forms of direct indebtedness depend primarily upon
the creditworthiness of the borrower for payment of principal and interest.
Direct debt instruments may not be rated by any nationally recognized rating
service. If the Fund does not receive scheduled interest or principal payments
on such indebtedness, the Fund's share price and yield could be adversely
affected. Loans that are fully secured offer the Fund more protections than an
unsecured loan in the event of non-payment of scheduled interest or principal.
However, there is no assurance that the liquidation of collateral from a secured
loan would satisfy the borrower's obligation, or that the collateral can be
liquidated. Indebtedness of borrowers whose creditworthiness is poor involves
substantially greater risks, and may be highly speculative. Borrowers that are
in bankruptcy or restructuring may never pay off their indebtedness, or may pay
only a small fraction of the amount owed. Direct indebtedness of developing
countries will also involve a risk that the governmental entities responsible
for the repayment of the debt may be unable, or unwilling, to pay interest and
repay principal when due.
<PAGE>
Investments in loans through direct assignment of a financial institution's
interests with respect to a loan may involve additional risks to the Fund.
For example, if a loan is foreclosed, the Fund could become part owner of
any collateral, and would bear the costs and liabilities associated with
owning and disposing of the collateral. In addition, it is conceivable
that under emerging legal theories of lender liability, the Fund could be
held liable as a co-lender. Direct debt instruments may also involve a
risk of insolvency of the lending bank or other intermediary. Direct debt
instruments that are not in the form of securities may offer less legal
protection to the Fund in the event of fraud or misrepresentation. In the
absence of definitive regulatory guidance, the Fund relies on the Sub-
Adviser's research in an attempt to avoid situations where fraud or
misrepresentation could adversely affect the Fund.
A loan is often administered by a bank or other financial institution that
acts as agent for all holders. The agent administers the terms of the
loan, as specified in the loan agreement. Unless, under the terms of the
loan or other indebtedness, the Fund has direct recourse against the
borrower, it may have to rely on the agent to apply appropriate credit
remedies against a borrower. If assets held by the agent for the benefit
of the Fund were determined to be subject to the claims of the agent's
general creditors, the Fund might incur certain costs and delays in
realizing payment on the loan or loan participation and could suffer a loss
of principal or interest.
Direct indebtedness purchased by the Fund may include letters of credit,
revolving credit facilities, or other standby financing commitments
obligating the Fund to pay additional cash on demand. These commitments may
have the effect of requiring the Fund to increase its investment in a
borrower at a time when it would not otherwise have done so, even if the
company's condition makes it unlikely that the amount will ever be repaid.
The Fund will set aside appropriate liquid assets in a segregated custodial
account to cover its potential obligations under standby financing
commitments.
The Fund limits the amount of total assets that it will invest in any one
issuer or in issuers within the same industry (see limitations (1) and (5)
for the Fund). For purposes of these limitations, the Fund generally will
treat the borrower as the "issuer" of indebtedness held by the Fund. In
the case of loan participants where a bank or other lending institution
serves as financial intermediary between the Fund and the borrower, if the
participation does not shift to the Fund the direct debtor-creditor
relationship with the borrower, SEC interpretations require the Fund, in
appropriate circumstances, to treat both the lending bank or other lending
institution and the borrower as "issuers" for the purposes of determining
whether the Fund has invested more than 5% of its total assets in a single
issuer.
<PAGE>
Treating a financial intermediary as an issuer of indebtedness may restrict
the Fund's ability to invest in indebtedness related to a single financial
intermediary, or a group of intermediaries engaged in the same industry,
even if the underlying borrowers represent many different companies and
industries.
FOREIGN INVESTMENTS. Foreign investments can involve significant risks in
addition to the risks inherent in U.S. investments. The value of
securities denominated in or indexed to foreign currencies, and of
dividends and interest from such securities, can change significantly when
foreign currencies strengthen or weaken relative to the U.S. dollar.
Foreign securities markets generally have less trading volume and less
liquidity than U.S. markets, and prices on some foreign markets can be
highly volatile. Many foreign countries lack uniform accounting and
disclosure standards comparable to those applicable to U.S. companies, and
it may be more difficult to obtain reliable information regarding an
issuer's financial condition and operations. In addition, the costs of
foreign investing, including withholding taxes, brokerage commissions, and
custodial costs, are generally higher than for U.S. investments.
Foreign markets may offer less protection to investors than U.S. markets.
Foreign issuers, brokers, and securities markets may be subject to less
government supervision. Foreign security trading practices, including
those involving the release of assets in advance of payment, may involve
increased risks in the event of a failed trade or the insolvency of a
broker-dealer, and may involve substantial delays. It may also be
difficult to enforce legal rights in foreign countries.
Investing abroad also involves different political and economic risks.
Foreign investments may be affected by actions of foreign governments
adverse to the interests of U. S. investors, including the possibility of
expropriation or nationalization of assets, confiscatory taxation,
restrictions on U.S. investment or on the ability to repatriate assets or
convert currency into U.S. dollars, or other government intervention.
There may be a greater possibility of default by foreign governments or
foreign government-sponsored enterprises. Investments in foreign countries
also involve a risk of local political, economic, or social instability,
military action or unrest, or adverse diplomatic developments. There is no
assurance that the Sub-Adviser will be able to anticipate these potential
events or counter their effects.
The considerations noted above generally are intensified for investments in
developing countries. Developing countries may have relatively unstable
governments, economies based on only a few industries, and securities
markets that trade a small number of securities.
The Fund may invest a portion of its assets in developing countries, or in
countries with new or developing capital
<PAGE>
markets; for example, nations in Eastern Europe. The considerations noted
above are generally intensified for these investments. These countries may
have relatively unstable governments, econimies based on only a few
industries, and securities markets that trade a small number of securities.
Securities of issuers located int hse countries tend to have volatile
prices and mayoffer significant potential for loss as well as gain.
American Depositary Receipts and European Depositary Receipts (ADRs and
EDRs) are certificates evidencing ownership of shares of a foreign-based
issuer held in trust by a bank or similar financial institution. Designed
for use in U.S. and European securities markets, respectively, ADRs and
EDRs are alternatives to the purchase of the underlying securities in their
national markets and currencies.
FOREIGN CURRENCY TRANSACTIONS. The Fund may conduct foreign currency
transactions on a spot (i.e., cash) basis or by entering into forward
contracts to purchase or sell foreign currencies at a future date and
price. The Fund will convert currency on a spot basis from time to time,
and investors should be aware of the costs of currency conversion.
Although foreign exchange dealers generally do not charge a fee for
conversion, they do realize a profit based on the difference between the
prices at which they are buying and selling various currencies. Thus, a
dealer may offer to sell a foreign currency to the Fund at one rate, while
offering a lesser rate of exchange should the Fund desire to resell that
currency to the dealer. Forward contracts are generally traded in an
interbank market conducted directly between currency traders (usually large
commercial banks) and their customers. The parties to a forward contract
may agree to offset or terminate the contract before its maturity, or may
hold the contract to maturity and complete the contemplated currency
exchange.
The Fund may use currency forward contracts for any purpose consistent with
its investment objective. The following discussion summarizes some, but
not all, of the possible currency management strategies involving forward
contracts that could be used by the Fund. The Fund may also use options
and futures contracts relating to foreign currencies for the same purposes.
When the Fund agrees to buy or sell a security denominated in a foreign
currency, it may desire to "lock in" the U.S. dollar price of the security.
By entering into a forward contract for the purchase or sale, for a fixed
amount of U.S. dollars, of the amount of foreign currency involved in the
underlying security transaction, the Fund will be able to protect itself
against an adverse change in foreign currency values between the date the
security is purchased or sold and the date on which payment is made or
received. This technique is sometimes referred to as a
<PAGE>
"settlement hedge" or "transaction hedge." The Fund may also enter into
forward contracts to purchase or sell a foreign currency in anticipation of
future purchases or sales of securities denominated in foreign currency,
even if the specific investments have not yet been selected by the Sub-
Adviser.
The Fund may also use forward contracts to hedge against a decline in the
value of existing investments denominated in foreign currency. For
example, if the Fund owned securities denominated in pounds sterling, the
Fund could enter into a forward contract to sell pounds sterling in return
for U.S. dollars to hedge against possible declines in the pound's value.
Such a hedge, sometimes referred to as a "position hedge," would tend to
offset both positive and negative currency fluctuations, but would not
offset changes in security values caused by other factors. The Fund could
also hedge the position by selling another currency expected to perform
similarly to the pound sterling--for example, by entering into a forward
contract to sell Deutschemarks or European Currency Units in return for
U.S. dollars. They type of hedge, sometimes referred to as a "proxy
hedge," could offer advantages in terms of cost, yield or efficiency, but
generally will not hedge currency exposure as effectively as a simple hedge
into U.S. dollars. Proxy hedges may result in losses if the currency used
to hedge does not perform similarly to the currency in which the hedged
securities are denominated.
The Fund may enter into forward contracts to shift its investment exposure
from one currency into another currency that is expected to perform better
relative to the U.S. dollar. For example, if the Fund held investments
denominated in Deutschemarks, the Fund could enter into forward contracts
to sell Deutschemarks and purchase Swiss Francs. This type of strategy,
sometimes known as a "cross-hedge," will tend to reduce or eliminate
exposure to the currency that is sold, and increase exposure to the
currency that is purchased, much as if the Fund had sold a security
denominated in one currency and purchased an equivalent security
denominated in another. Cross-hedges protect against losses resulting from
a decline in the hedged currency, but will cause the Fund to assume the
risk of fluctuations in the value of the currency it purchases.
Under certain conditions, SEC guidelines require mutual funds to set aside
appropriate liquid assets in a segregated custodial account to cover
currency forward contracts. As required by SEC guidelines, the Fund will
segregate assets to cover currency forward contracts, if any, whose purpose
is essentially speculative. The Fund will not segregate assets to cover
forward contracts entered into for hedging purposes, including settlement
hedges, position hedges, and proxy hedges.
Successful use of currency forward contracts will depend on the Sub-
Adviser's skill in analyzing and predicting currency values. Forward
contracts may substantially change the Fund's investment
<PAGE>
exposure to changes in currency exchange rates, and could result in losses
to the Fund if currencies do not perform as the Sub-Adviser anticipates.
For example, if a currency's value rose at a time when the Sub-Adviser had
hedge the Fund by selling that currency in exchange for dollars, the Fund
would be unable to participate in the currency's appreciation. If the Sub-
Adviser hedges currency exposure through proxy hedges, the Fund could
realize currency losses from the hedge and the security position at the
same time if the two currencies do not move in tandem. Similarly, if the
Sub-Adviser increases the Fund's exposure to a foreign currency, and that
currency's value declines, the Fund will realize a loss. There is no
assurance that the Sub-Adviser's use of currency forward contracts will be
advantageous to the Fund or that they will hedge at an appropriate time.
The policies described in this section are non-fundamental policies of the
Fund.
Options and Futures Contracts are a way for the Fund to manage its exposure
to changing interest rates, security prices, and currency exchange rates.
Some options and futures strategies, including selling futures, buying
puts, and writing calls, tend to hedge the Fund's investments against price
fluctuations. Other strategies, including buying futures, writing puts, and
buying calls, tend to increase market exposure. Options and futures may be
combined with each other or with forward contracts in order to adjust the
risk and return characteristics of the overall strategy. The Fund may
invest in options and futures based on any type of security, index, or
currency, including options and futures traded on foreign exchanges and
options not traded on exchanges.
Options and futures can be volatile investments, and involve certain risks.
If the Sub-Adviser applies a nedge at an inappropriate time or judges
market conditions incorrectly, options and futures strategies may lower the
Fund's return. The Fund could also experience losses if the prices of its
options and futures positions were poorly correlated with its other
investments, or if it could not close out its positions because of an
illiquid secondary market.
The Fund will not hedge more than 25% of its total assets by selling
futures, buying puts, and writing calls under normal conditions. In
addition, the Fund will not buy futures or write puts whose underlying
value exceeds 25% of its total assets, and the Fund will not buy calls with
a value exceeding 5% of its total assets.
LIMITATIONS ON FUTURES AND OPTIONS TRANSACTIONS. The Fund has filed a
notice of eligibility for exclusion from the definition of the term
"commodity pool operator" with the Commodity Futures Trading Commission
(CFTC) and the National Futures Association, which regulate trading in the
futures markets. The Fund intends
<PAGE>
to comply with Section 4.5 of the regulations under the Commodity Exchange
Act, which limits the extent to which the Fund can commit assets to initial
margin deposits and option premiums.
(a) The Fund will use futures contracts and related options solely for
bona fide hedging purposes within the meaning of CFTC regulations,
provided that the Fund may hold long positions in futures contracts
and related options that do not fall within the definition of bona
fide hedging transactions if the positions are used as part of a Fund
management strategy and are incidental to the Fund's activities in
the cash market, and the underlying commodity value of the positions
at all times will not exceed the sum of (i) cash or money market
instruments set aside in an identifiable manner, plus margin
deposits, (ii) cash proceeds from existing investments due in 30
days, and (iii) accrued profits on the positions held by a futures
commission merchant; and
(b) The Fund will not enter into any futures contract or option on a
futures contract if, as a result, the sum of initial margin deposits
on futures contracts and related options and premiums paid for
options on futures contracts the Fund has purchased, after taking
into account unrealized profits and losses on such contracts, would
exceed 5% of the Fund's total assets.
In addition, the Fund will not: (a) sell futures contracts, purchase put
options, or write call options if, as a result, more than 25% of the Fund's
total assets would be hedged with futures and options under normal
conditions; (b) purchase futures contracts or write put options if, as a
result, the Fund's total obligations upon settlement or exercise of
purchased futures contracts and written put options would exceed 25% of its
total assets; or (c) purchase call options if, as a result, the current
value of option premiums for call options purchased by the Fund would
exceed 5% of the Fund's total assets. These limitations do not apply to
options attached to or acquired or traded together with their underlying
securities, and do not apply to securities that incorporate features
similar to options.
FUTURES CONTRACTS. When the Fund purchases a futures contract, it agrees to
purchase a specified underlying instrument at a specified future date. When
the Fund sells a futures contract, it agrees to sell the underlying
instrument at a specified future date. The price at which the purchase and
sale will take place is fixed when the Fund enters into the contract. Some
currently available futures contracts are based on specific securities,
such as U.S. Treasury bonds or notes, and some are based on indices of
securities prices, such as the Standard & Poor's 500 Composite Stock Price
Index (S&P 500)and the Bond Buyer Index of municipal bonds. Futures can be
held until their delivery dates, or can be closed out before then if a
liquid secondary market is available.
<PAGE>
The value of a futures contract tends to increase and decrease in tandem
with the value of its underlying instrument. Therefore, purchasing futures
contracts will tend to increase the Fund's exposure to positive and
negative price fluctuations in the underlying instrument, much as if it had
purchased the underlying instrument directly. When the Fund sells a futures
contract, by contrast, the value of its futures position will tend to move
in a direction contrary to the market. Selling futures contracts,
therefore, will tend to offset both positive and negative market price
changes, much as if the underlying instrument had been sold.
FUTURES MARGIN PAYMENTS. The purchaser or seller of a futures contract is
not required to deliver of pay for the underlying instrument unless the
contract is held until the delivery date. However, both the purchaser and
seller are required to deposit "initial margin" with a futures broker,
known as a futures commission merchant (FCM), when the contract is entered
into. Initial margin deposits are typically equal to a percentage of the
contract's value. If the value of either party's position declines, that
party will be required to make additional "variation margin" payments to
settle the change in value on a daily basis. The party that has a gain may
be entitled to receive all or a portion of this amount. Initial and
variation margin payments do not constitute purchasing securities on margin
for purposes of the Fund's investment limitations. In the event of the
bankruptcy of an FCM that holds margin on behalf of the Fund, the Fund may
be entitled to return of margin owed to it only in proportion to the amount
received by the FCM's other customers, potentially resulting in losses to
the Fund.
PURCHASING PUT AND CALL OPTIONS. By purchasing a put option, the Fund
obtains the right (but not the obligation) to sell the option's underlying
instrument at a fixed strike price. In return for this right, the Fund pays
the current market price for the option (known as the option premium).
Options have various types of underlying instruments, including specific
securities, indices of securities prices, and futures contracts. The Fund
may terminate its position in a put option it has purchased by allowing it
to expire or by exercising the option. If the option is allowed to expire,
the Fund will lose the entire premium it paid. If the Fund exercises the
option, it completes the sale of the underlying instrument at the strike
price. The Fund may also terminate a put option position by closing it out
in the secondary market at its current price, if a liquid secondary market
exists.
The buyer of a typical put option can expect to realize a gain if security
prices fall substantially. However, if the underlying instrument's price
does not fall enough to offset the cost of purchasing the option, a put
buyer can expect to suffer a loss
<PAGE>
(limited to the amount of the premium paid, plus related transaction
costs).
The features of call options are essentially the same as those of put
options, except that the purchaser of a call option obtains the right to
purchase, rather than sell, the underlying instrument at the option's stake
price. A call buyer typically attempts to participate in potential price
increases of the underlying instrument with risk limited to the cost of the
option if security prices fall. At the same time, the buyer can expect to
suffer a loss if security prices do not rise sufficiently to offset the
cost of the option.
WRITING PUT AND CALL OPTIONS. When the Fund writes a put option, it takes
the opposite side of the transaction from the option's purchaser. In return
for receipt of the premium, the Fund assumes the obligation to pay the
strike price for the option's underlying instrument if the other party to
the option chooses to exercise it. When writing an option on a futures
contract the Fund will be required to make margin payments to an FCM as
described above for futures contracts. The Fund may seek to terminate its
position in a put option it writes before exercise by closing out the
option in the secondary market at its current price. If the secondary
market is not liquid for a put option the Fund has written, however, the
Fund must continue to be prepared to pay the strike price while the option
is outstanding, regardless of price changes, and must continue to set aside
assets to cover its position.
If security prices rise, a put writer would generally expect to profit,
although its gain would be limited to the amount of the premium it
received. If security prices remain the same over time, it is likely that
the writer will also profit, because it should be able to close out the
option at a lower price. If security prices fall, the put writer would
expect to suffer a loss. This loss should be less than the loss from
purchasing the underlying instrument directly, however, because the premium
received for writing the option should mitigate the effects of the decline.
Writing a call option obligates the Fund to sell or deliver the option's
underlying instrument, in return for the strike price, upon exercise of the
option. The characteristics of writing call options are similar to those of
writing put options, except that writing calls generally is a profitable
strategy if prices remain the same to fall. Through receipt of the option
premium, a call writer mitigates the effects of a price decline. At the
same time, because a call writer must be prepared to deliver the underlying
instrument in return for the strike price, even if its current value is
greater, a call writer gives up some ability to participate in security
price increases.
COMBINED POSITIONS. The Fund may purchase and write options in combination
with each other, or in combination with futures or
<PAGE>
forward contracts, to adjust the risk and return characteristics of the
overall position. For example, the Fund may purchase a put option and write
a call option on the same underlying instrument, in order to construct a
combined position whose risk and return characteristics are similar to
selling a futures contract. Another possible combined position would
involve writing a call option at one strike price and buying a call option
at a lower price, in order to reduce the risk of the written call option in
the event of a substantial price increase. Because combined options
positions involve multiple trades, they result in higher transaction costs
and may be more difficult to open and close out.
CORRELATION OF PRICE CHANGES. Because there are a limited number of types
of exchange-traded options and futures contracts, it is likely that the
standardized contracts available will not match the Fund's current or
anticipated investments exactly. The Fund may invest in options and futures
contracts based on securities with different issuers, maturities, or other
characteristics from the securities in which it typically invests, which
involves a risk that the options or futures position will not track the
performance of the Fund's other investments.
Options and futures prices can also diverge from the prices of their
underlying instruments, even if the underlying instruments match the Fund's
investments well. Options and futures prices are affected by such factors
as current and anticipated short-term interest rates, changes in the
volatility of the underlying instrument, and the time remaining until
expiration of the contract, which may not affect security prices the same
way. Imperfect correlation may also result from differing levels of demand
in the options and futures markets and the securities markets, from
structural differences in how options and futures and securities are
traded, or from imposition of daily price fluctuation limits or trading
halts. The Fund may purchase or sell options and futures contracts with a
greater or lesser value than the securities it wishes to hedge or intends
to purchase in order to attempt to compensate for differences in volatility
between the contract and the securities, although this may not be
successful in all cases. If price changes in the Fund's options or futures
positions are poorly correlated with its other investments, the positions
may fail to produce anticipated gains or result in losses that are not
offset by gains in other investments.
LIQUIDITY OF OPTIONS AND FUTURES CONTRACTS. There is no assurance that a
liquid secondary market will exist for any particular options or futures
contract at any particular time. Options may have relatively low trading
volume and liquidity if their strike prices are not close to the underlying
instrument's current price. In addition, exchanges may establish daily
price fluctuation limits for options and futures contracts, and may
<PAGE>
halt trading if a contract's price moves upward or downward more than the
limit in a given day. On volatile trading days when the price fluctuation
limit is reached or a trading half is imposed, it may be impossible for the
Fund to enter into new positions or close out existing positions. If the
secondary market for a contract is not liquid because of price fluctuation
limits or otherwise, it could prevent prompt liquidation of unfavorable
positions, and potentially could require the Fund to continue to hold a
position until delivery or expiration regardless of changes in its value.
As a result, the Fund's access to other assets held to cover its options or
futures positions could also be impaired.
OTC OPTIONS. Unlike exchange-traded options, which are standardized with
respect to the underlying instrument, expiration date, contract size, and
strike price, the terms of over-the-counter options (options not traded on
exchanges) generally are established through negotiation with the other
party to the option contract. While this type of arrangement allows the
Fund greater flexibility tailor an option to its needs, OTC options
generally involve greater credit risk than exchange-traded options, which
are guaranteed by the clearing organization of the exchanges where they are
traded.
OPTIONS AND FUTURES RELATING TO FOREIGN CURRENCIES. Currency futures
contracts are similar to forward currency exchange contracts, except that
they are traded on exchanges (and have margin requirements) and are
standardized as to contract size and deliver date. Most currency futures
contracts call for payment or delivery in U.S. dollars. The underlying
instrument of a currency option may be a foreign currency, which generally
is purchased or delivered in exchange for U.S. dollars, or may be a futures
contract. The purchaser of a currency call obtains the right to purchase
the underlying currency, and the purchaser of a currency put obtains the
right to sell the underlying currency.
The uses and risks of currency options and futures are similar to options
and futures relating to securities or indices, as discussed above. The
Fund may purchase and sell currency futures and may purchase and write
currency options to increase or decrease its exposure to different foreign
currencies. The Fund may also purchase and write currency options in
conjunction with each other or with currency futures or forward contracts.
Currency futures and options values can be expected to correlate with
exchange rates, but may not reflect other factors that affect the value of
the Fund's investments. A currency hedge, for example, should protect a
Yen-denominated creditworthiness. Because the value of the Fund's foreign-
denominated investments changes in response to many factors other than
exchange rates, it may not be possible to match the amount of currency
options and futures to the value of the Fund's investments exactly over
time.
ASSET COVERAGE FOR FUTURES AND OPTIONS POSITIONS. The Fund will comply
with guidelines established by the Securities and Exchange
<PAGE>
Commission with respect to coverage of options and futures strategies by
mutual funds, and if the guidelines so require will set aside appropriate
liquid assets in a segregated custodial account in the amount prescribed.
Securities held in a segregated account cannot be sold while the futures or
option strategy is outstanding, unless they are replaced with other
suitable assets. As a result, there is a possibility that segregation of a
large percentage of the Fund's assets could impede portfolio management or
the Fund's ability to meet redemption requests or other current
obligations.
SHORT SALES. The Fund may enter into short sales with respect to stocks
underlying its convertible security holdings. For example, if the Sub-
Adviser anticipates a decline in the price of the stock underlying a
convertible security the Fund holds, it may sell the stock short. If the
stock price subsequently declines, the proceeds of the short sale could be
expected to offset all or a portion of the effect of the stock's decline on
the value of the convertible security. If it does not, the Fund could
suffer a loss. The Fund currently intends to hedge no more than 15% of its
total assets with short sales on equity securities underlying its
convertible security holdings under normal circumstances.
When the Fund enters into a short sale, it will be required to set aside
securities equivalent in kind and amount to those sold short (or securities
convertible or exchangeable into such securities) and will be required to
continue to hold them while the short sale is outstanding. The Fund will
incur transaction costs, including interest expense, in connection with
opening, maintaining, and closing short sales.
LOWER-RATED DEBT INSTRUMENTS
Lower-rated debt securities are usually defined as securities rated Ba or
lower by Moody's or BB or lower by S&P. Lower-rated debt securities are
considered speculative and involve greater risk of loss than higher-rated
debt securities, and are more sensitive to changes in the issuer's capacity
to pay. This is an aggressive approach to income investing.
The 1980s saw a dramatic increase in the use of lower-rated debt securities
to finance highly leveraged acquisitions and restructurings. Past
experience may not provide an accurate indication of the future performance
of lower-rated debt securities, especially during periods of economic
recession. In fact, from 1989 to 1991, the percentage of lower-rated debt
securities that defaulted rose significantly above prior levels.
Lower-rated debt securities may be thinly traded, which can adversely
affect the prices at which these securities can be sold and can result in
high transaction costs. If market quotations
<PAGE>
are not available, lower-rated debt securities will be valued in accordance
with standards set by the Board of Directors, including the use of outside
pricing services. Judgment plays a greater role in valuing lower-rated
debt securities than securities for which more extensive quotations and
last sale information are available. Adverse publicity and changing
investor perceptions may affect the ability of outside pricing services to
value lower-rated debt securities, and the Fund's ability to dispose of
these securities.
The market prices of lower-rated debt securities may decline significantly
in periods of general economic difficulty which may follow periods of
rising interest rates. During an economic downturn or a prolonged period
of rising interest rates, the ability of issuers of lower-rated debt to
service their payment obligations, meet projected goals, or obtain
additional financing may be impaired.
The Fund may choose, at its expense or in conjunction with others, to
pursue litigation or otherwise to exercise its rights as a security holder
to seek to protect the interests of security holders if it determines this
to be in the interest of the Fund's shareholders.
The considerations discussed above for lower-rated debt securities also
apply to lower-quality, unrated debt instruments of all types, including
loans and other direct indebtedness of businesses with poor credit
standing. Unrated debt instruments are not necessarily of lower quality
than rated instruments, but they may not be attractive to as many buyers.
The Fund relies more on the Sub-Adviser's credit analysis when investing in
debt instruments that are unrated.
Please refer to the Appendix for a discussion of Moody's and S&P ratings.
PORTFOLIO TRANSACTIONS AND BROKERAGE
All orders for the purchase or sale of Fund securities are placed on behalf
of the Fund by the Sub-Adviser (either directly or through affiliated
advisers or sub-advisers) pursuant to authority contained in the Fund's
Sub-Advisory Agreement. The Sub-Adviser may also be responsible for the
placement of transaction orders for other investment companies and accounts
for which it or its affiliates act as investment adviser or sub-adviser.
Money market securities purchased and sold by the Fund generally will be
traded on a net basis (i.e., without commission). In selecting broker-
dealers, subject to applicable limitations of the federal securities laws,
the Sub-Adviser will consider various relevant factors, including, but not
limited to, the size and type of the transaction; the nature and character
of the markets for the security to be purchased or sold; the execution
efficiency, settlement capability and financial condition of the broker-
dealer firm; the broker-dealer's
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execution services rendered on a continuing basis; and the reasonableness
of any commissions. Commissions for foreign investments traded on foreign
exchanges will generally be higher than for U.S. investments and may not be
subject to negotiation.
The Fund may execute portfolio transactions with broker-dealers who provide
research and execution services to the Fund and/or other accounts over
which the Sub-Adviser or its affiliates exercise investment discretion.
Such services may include advice concerning the value of securities; the
advisability of investing in, purchasing or selling securities; the
availability of securities or the purchasers or sellers of securities;
furnishing analyses and reports concerning issuers, industries, securities,
economic factors and trends, fund strategy and performance of accounts; and
effecting securities transactions and performing functions incidental
thereto (such as clearance and settlement). The Sub-Adviser maintains a
listing of broker-dealers who provide such services on a regular basis.
However, as many transactions on behalf of the Fund's money market
securities are placed with dealers (including broker-dealers on the list)
without regard to the furnishing of such services, it is not possible to
estimate the proportion of such transactions directed to such dealers
solely because such services were provided. The selection of such broker-
dealers is generally made by the Sub-Adviser (to the extent possible
consistent with execution considerations) in accordance with a ranking of
broker-dealers determined periodically by the Sub-Adviser's investment
staff based upon the quality of research and execution services provided.
The receipt of research from broker-dealers that execute transactions on
behalf of the Fund may be useful to the Sub-Adviser in rendering investment
management services to the Fund and/or other clients, and conversely, such
information provided by broker-dealers who have executed transaction orders
on behalf of other Sub-Adviser clients may be useful to the Sub-Adviser in
carrying out its obligations to the Fund. The receipt of such research has
not reduced the Sub-Adviser's normal independent research activities;
however, it enables the Sub-Adviser to avoid additional expenses that could
be incurred if the Sub-Adviser tried to develop comparable information
through its own efforts.
Subject to applicable limitations of the federal securities laws, broker
dealers may receive commissions for agency transactions that are in excess
of the amount of commissions charged by other broker dealers in recognition
of their research and/or execution services. In order to cause the Fund to
pay such higher commissions, the Sub-Adviser must determine in good faith
that such commissions are reasonable in relation to the value of the
brokerage and research services provided by such executing broker-dealers
viewed in terms of a particular transaction or the Sub-Adviser's overall
responsibilities to the Fund and its other clients. In reaching this
determination, the Sub-Adviser will
<PAGE>
not attempt to place a specific dollar value on the brokerage and research
services provided or to determine what portion of the compensation should
be related to those services.
The Sub-Adviser is authorized to use research services provided by and to
place portfolio transactions with brokerage firms that have provided
assistance in the distribution of shares of the Fund or shares of other
Fidelity funds to the extent permitted by law. The Sub-Adviser may use
research services provided by and place agency transactions with Fidelity
Brokerage Services, Inc. (FBSI) and Fidelity Brokerage Services, Ltd.
(FBSL), subsidiaries of FMR Corp., if the commissions are fair, reasonable,
and comparable to commissions charged by non-affiliated, qualified
brokerage firms for similar services. Prior to September 4, 1992, FBSL
operated under the name Fidelity Portfolio Services, Ltd. (FPSL) as a
wholly owned subsidiary of Fidelity International Limited (FIL). Edward C.
Johnson 3d is Chairman of FIL. Mr. Johnson 3d, together with various
trusts for the benefit of Johnson family members, owns directly or
indirectly more than 25% of the voting common stock of FIL.
The Fund's Board of Directors periodically reviews the Sub-Adviser's
performance of its responsibilities in connection with the placement of
fund transactions on behalf of the Fund and reviews the commissions, if
any, paid by the Fund over representative periods of time to determine if
they are reasonable in relation to the benefits to the Fund.
BROKERAGE COMMISSIONS. Of the commissions paid to brokerage firms which
provided research services, the providing of such services is not
necessarily a factor in the placement of all business with such firms. The
Fund pays both commissions and spreads in connection with the placement of
fund transactions.
From time to time the Fund's Directors will review whether the recapture
for the benefit of the Fund of some portion of the brokerage commissions or
similar fees paid by the Fund on fund transactions is legally permissible
and advisable. The Fund seeks to recapture soliciting broker-dealer fees
paid by the Fund on fund transactions is legally permissible and advisable.
The Fund seeks to recapture soliciting broker-dealer fees on the tender of
portfolio securities, but at present no other recapture arrangements are in
effect. The Directors intend to continue to review whether recapture
opportunities are available and are legally permissible and, if so, to
determine in the exercise of their business judgment whether it would be
advisable for the Fund to seek such recapture.
Although the Sub-Adviser or its affiliates also manage other funds,
investment decisions for the Fund are made independently from those of
other funds managed by Sub-Adviser or accounts managed by affiliates of the
Sub-Adviser. It sometimes happens that the same security is held in the
portfolio of more than one of these funds or accounts. Simultaneous
transactions are
<PAGE>
inevitable when several funds are managed by the same investment advisor,
particularly when the same security is suitable for the investment
objective of more than one fund.
When two or more funds, or portfolios, are simultaneously engaged in the
purchase or sale of the same security, the prices and amounts are allocated
in accordance with a formula considered by the officers of the funds or
portfolios involved to be equitable to each fund or portfolio. In some
cases this system could have a detrimental effect on the price or volume of
the security as far as the Fund is concerned. In other cases, however, the
ability of the fund or portfolio to participate in volume transactions will
produce better executions and prices for the Fund. It is the current
opinion of the Board of Directors that the desirability of retaining the
Sub-Adviser as sub-investment adviser to the Fund outweighs any
disadvantages that may be said to exist from exposure to simultaneous
transactions.
DETERMINATION OF NET ASSET VALUE
The Fund's securities are appraised by various methods depending on the
market or exchange on which they trade. Securities traded on the New York
Stock Exchange (NYSE) or the American Stock Exchange are appraised at the
last sale price, or if no sale has occurred, at the closing bid price.
Securities traded on other exchanges are appraised, to the extent possible,
in the same manner. Securities and other assets for which exchange
quotations are not readily available are valued using closing over-the-
counter bid prices, if available, or at their fair value as determined in
good faith under consistently applied procedures generally supervised by
the Board of Directors. Short-term securities are valued either at
amortized cost or at original cost plus accrued interest, both of which
approximate their current value. Securities pricing services may be
utilized by the Fund.
The Fund is open for business and it NAV is calculated each day the NYSE is
open for trading. The NYSE has designated the following holiday closings
for 1995: President's Day, February 20; Good Friday, April 14; Memorial
Day, May 29; Independence Day, July 4; Labor Day, September 4; Thanksgiving
Day, November 23; and Christmas Day, December 25. It may also be closed on
other days. Although the Directors expect the same holiday schedule to be
observed in the future, the NYSE may modify its holiday schedule at any
time. On any day that the NYSE closes early, the right is reserved to
advance the time on that day by which purchase and redemption orders must
be received. To the extent that the Fund's securities are traded in other
markets on days when the NYSE is closed, the Fund's NAV may be affected on
days when investors do not have access to the Fund to purchase or redeem
shares.
<PAGE>
If, in the opinion of the Directors, conditions exist that make cash
payment undesirable, redemption payments may be made in whole or in part in
securities or other property, valued for this purpose as they are valued in
computing the NAV of the Fund. Shareholders receiving any such securities
or other property on redemption will incur any costs of selling a domestic
or foreign security as well as the associated inconveniences.
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION APPENDIX
This document is incorporated by reference to Post-Effective Amendment No. 3,
Registration Number 33-71158 filed on Form N-1A on April 30, 1995.
