(LOGO)
SUPPLEMENT
DATED MAY 15, 2000
TO THE PROSPECTUS DATED DECEMBER 29, 1999
INTERNATIONAL FIXED INCOME FUND. Effective June 30, 2000 the name of the
International Fixed Income Fund will be changed to the "Global Fixed Income
Fund." In connection with this change, the following will replace the first
sentence of the first paragraph under "Principal Investment Strategies and Risks
- - Investment Strategies" on page 20:
In seeking to maximize total return, the Fund will invest, under normal market
conditions, at least 65% of its total assets in bonds and other fixed income
securities of issuers located in at least three different countries. From time
to time, U.S. companies may dominate the Fund's portfolio.
INCOME EQUITY FUND. Effective June 30, 2000 the Income Equity Fund may invest
all or any portion of its assets in convertible securities that are below
investment grade.
TAX-EXEMPT MONEY MARKET FUND, MUNICIPAL MONEY MARKET FUND, CALIFORNIA MUNICIPAL
MONEY MARKET FUND, INTERMEDIATE TAX-EXEMPT FUND, CALIFORNIA INTERMEDIATE TAX-
EXEMPT FUND, FLORIDA INTERMEDIATE TAX-EXEMPT FUND, TAX-EXEMPT FUND, ARIZONA TAX-
EXEMPT FUND, CALIFORNIA TAX-EXEMPT FUND AND HIGH YIELD MUNICIPAL FUND.
Currently, the principal investment strategies for each of these Funds provide
that under normal market conditions, at least 80% of a Fund's annual gross
income will be derived from municipal instruments. This strategy has been
changed to provide that under normal market conditions, at least 80% of a Fund's
net assets will be invested in municipal instruments.
SMALL CAP FUND. The name of the Small Cap Fund has been changed to the "Small
Cap Value Fund" in order to better reflect the investment strategy of the Fund.
For details on the Fund's investment strategy, refer to your
current prospectus.
OTHER CHANGES. Northern Trust Quantitative Advisors, Inc. has changed its name
to "Northern Trust Investments, Inc."
The following replaces the paragraph under "Borrowings and Reverse Repurchase
Agreements - Investment Strategy" on page 87:
INVESTMENT STRATEGY. Each Fund may borrow and enter into reverse repurchase
agreements in amounts not exceeding one-third of its total assets (including the
amount borrowed). Each Fund may also borrow up to an additional 5% of its total
assets for temporary purposes. The Funds may enter into reverse repurchase
agreements when the investment management team expects that the interest income
to be earned from the investment of the transaction proceeds will be greater
than the related interest expense.
The following replaces the paragraph under "Investment Companies - Investment
Strategy" on page 90:
Investment Strategy. Investments by a Fund in other investment companies will be
subject to the limitations of the 1940 Act. Although the Funds do not expect to
do so in the foreseeable future, each Fund is authorized to invest substantially
all of its assets in a single open-end investment company or series thereof that
has substantially the same investment objective, policies and fundamental
restrictions as the Fund.
xxxxxxx
(LOGO)
SUPPLEMENT
DATED MAY 15, 2000
TO THE MONEY MARKET FUNDS PROSPECTUS
DATED DECEMBER 29, 1999
TAX-EXEMPT MONEY MARKET FUND, MUNICIPAL MONEY MARKET FUND AND CALIFORNIA
MUNICIPAL MONEY MARKET FUND. Currently, the principal investment strategies for
each of these Funds provide that under normal market conditions, at least 80% of
a Fund's annual gross income will be derived from municipal instruments. This
strategy has been changed to provide that under normal market conditions, at
least 80% of a Fund's net assets will be invested in municipal instruments.
OTHER CHANGES. The following replaces the paragraph under "Borrowings and
Reverse Repurchase Agreements - Investment Strategy" on page 41:
INVESTMENT STRATEGY. Each Fund may borrow and enter into reverse repurchase
agreements in amounts not exceeding one-third of its total assets (including the
amount borrowed). Each Fund may also borrow up to an additional 5% of its total
assets for temporary purposes. The Funds may enter into reverse repurchase
agreements when the investment management team expects that the interest income
to be earned from the investment of the transaction proceeds will be greater
than the related interest expense.
The following replaces the paragraph under "Investment Companies - Investment
Strategy" on page 43:
Investment Strategy. Investments by a Fund in other investment companies will be
subject to the limitations of the 1940 Act. Although the Funds do not expect to
do so in the foreseeable future, each Fund is authorized to invest substantially
all of its assets in a single open-end investment company or series thereof that
has substantially the same investment objective, policies and fundamental
restrictions as the Fund.
33-73404
811-8236
PART B
STATEMENT OF ADDITIONAL INFORMATION
MONEY MARKET FUND
U.S. GOVERNMENT MONEY MARKET FUND
U.S. GOVERNMENT SELECT MONEY MARKET FUND
TAX-EXEMPT MONEY MARKET FUND
MUNICIPAL MONEY MARKET FUND
CALIFORNIA MUNICIPAL MONEY MARKET FUND
U.S. GOVERNMENT FUND
SHORT-INTERMEDIATE U.S. GOVERNMENT FUND
INTERMEDIATE TAX-EXEMPT FUND
CALIFORNIA INTERMEDIATE TAX-EXEMPT FUND
FLORIDA INTERMEDIATE TAX-EXEMPT FUND
FIXED INCOME FUND
TAX-EXEMPT FUND
ARIZONA TAX-EXEMPT FUND
CALIFORNIA TAX-EXEMPT FUND
INTERNATIONAL FIXED INCOME FUND<F1>
HIGH YIELD MUNICIPAL FUND
HIGH YIELD FIXED INCOME FUND
INCOME EQUITY FUND
STOCK INDEX FUND
GROWTH EQUITY FUND
SELECT EQUITY FUND
MARKETCOMMAND FUND
MID CAP GROWTH FUND
SMALL CAP INDEX FUND
SMALL CAP FUND<F1>
SMALL CAP GROWTH FUND
INTERNATIONAL GROWTH EQUITY FUND
INTERNATIONAL SELECT EQUITY FUND
TECHNOLOGY FUND
NORTHERN FUNDS
(THE "TRUST")
This Statement of Additional Information dated December 29, 1999, and
revised as of May 15, 2000 (the "Additional Statement"), is not a prospectus.
This Additional Statement should be read in conjunction with the Prospectus
dated December 29, 1999, as amended or supplemented from time to time, for the
Money Market Fund, U.S. Government Money Market Fund, U.S. Government Select
Money Market Fund, Tax-Exempt Money Market Fund, Municipal Money Market Fund,
California Municipal Money Market Fund (collectively, the "Money Market Funds"),
U.S. Government Fund, Short-Intermediate U.S. Government Fund, Intermediate Tax-
Exempt Fund, California Intermediate Tax-Exempt Fund, Florida Intermediate Tax-
Exempt Fund, Fixed Income Fund, Tax-Exempt Fund, Arizona Tax-Exempt Fund,
California Tax-Exempt Fund, High Yield Municipal Fund, High Yield Fixed Income
Fund, International Fixed Income Fund, Income Equity Fund, Stock Index Fund,
Growth Equity Fund, Select Equity Fund, MarketCommand Fund, Mid Cap Growth Fund,
Small Cap Index Fund, Small Cap Fund, Small Cap Growth Fund, International
Growth Equity Fund, International Select Equity Fund and Technology Fund
(collectively, the "Non-Money Market Funds," and together with the Money Market
Funds, the "Funds") of Northern Funds (the "Prospectus"). Copies of the
Prospectus may be obtained without charge from the Transfer Agent by writing to
the Northern Funds Center, P.O. Box 75986, Chicago, Illinois 60675-5986 or by
calling 1-800-595-9111. Capitalized terms not otherwise defined have the same
meaning as in the Prospectus.
The unaudited financial statements contained in the semi-annual report to
the Funds' shareholders for the period ended September 30, 1999 and audited
financial statements and related report of Arthur Andersen LLP, independent
accountants, contained in the annual report to shareholders for the fiscal year
ended March 31, 1999 are incorporated herein by reference in the section
entitled "Financial Statements." No other part of the semi-annual report or
annual report is incorporated by reference herein. Copies of the semi-annual
report or annual report may be obtained, upon request and without charge by
calling The Northern Trust Company at 1-800-595-9111.
--------------
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THIS ADDITIONAL STATEMENT OR IN THE PROSPECTUS
IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS AND, IF GIVEN OR MADE,
SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED BY NORTHERN FUNDS OR ITS DISTRIBUTOR. THE PROSPECTUS DOES NOT
CONSTITUTE AN OFFERING BY NORTHERN FUNDS OR BY THE DISTRIBUTOR IN ANY
JURISDICTION IN WHICH SUCH OFFERING MAY NOT LAWFULLY BE MADE.
An investment in a Fund is not a deposit of any bank and is not insured or
guaranteed by the Federal Deposit Insurance Corporation or any government
agency. An investment in a Fund involves investment risks, including possible
loss of principal. Although each of the Money Market Funds seeks to preserve
the value of your investment at $1.00 per share, it is possible to lose money by
investing in the Funds.
- ---------------------------------------
<F1> The Small Cap Fund has been renamed the Small Cap Value Fund. Effective
June 30, 2000, the International Fixed Income Fund will be renamed the Global
Fixed Income Fund.
INDEX
Page
----
ADDITIONAL INVESTMENT INFORMATION...........................................4
Investment Objectives and Policies..........................................4
Special Risk Factors and Considerations Relating to California Municipal
Instruments, Florida Municipal Instruments and Arizona Municipal
Instruments...........................................................35
California Municipal Instruments...........................................35
Florida Municipal Instruments..............................................47
Arizona Municipal Instruments..............................................51
Investment Restrictions....................................................54
ADDITIONAL TRUST INFORMATION...............................................58
Classification and History.................................................58
Trustees and Officers......................................................58
Investment Adviser, Transfer Agent and Custodian...........................67
Co-Administrators and Distributor..........................................80
Service Organizations......................................................84
Counsel and Auditors.......................................................86
In-Kind Purchases and Redemptions..........................................86
Automatic Investing Plan...................................................86
Directed Reinvestments.....................................................87
Redemptions And Exchanges..................................................87
Retirement Plans...........................................................87
Expenses...................................................................88
PERFORMANCE INFORMATION....................................................88
Money Market Funds.........................................................88
Non-Money Market Funds.....................................................90
General Information........................................................95
NET ASSET VALUE............................................................97
TAXES .....................................................................99
Federal - General Information..............................................99
Federal - Tax-Exempt Information..........................................101
Taxation Of Certain Financial Instruments.................................102
Special State Tax Considerations Pertaining To The California Funds.......102
Special State Tax Considerations Pertaining To The Florida Intermediate
Tax-Exempt Fund......................................................104
Special State Tax Considerations Pertaining To The Arizona
Tax-Exempt Fund......................................................105
DESCRIPTION OF SHARES.....................................................105
FINANCIAL STATEMENTS......................................................109
OTHER INFORMATION.........................................................110
APPENDIX A................................................................A-1
APPENDIX B................................................................B-1
ADDITIONAL INVESTMENT INFORMATION
INVESTMENT OBJECTIVES AND POLICIES
The following supplements the investment objectives, strategies and risks
of the Funds as set forth in the Prospectus. The investment objective of each
Fund may be changed without the vote of the majority of the Fund's outstanding
shares. Except as expressly noted below, each Fund's investment policies may be
changed without shareholder approval. In addition to the instruments discussed
below and in the Prospectus, each Fund may purchase other types of financial
instruments, however designated, whose investment and credit quality
characteristics are determined by the Investment Advisers to be substantially
similar to those of any other investment otherwise permitted by the Funds'
investment policies.
MONEY MARKET FUNDS
Money Market Fund seeks to maximize current income to the extent
consistent with the preservation of capital and maintenance of
liquidity by investing only in high-quality money market
instruments.
U.S. Government Money Market Fund has the same objective as the
Money Market Fund but invests primarily in securities issued or
guaranteed by the U.S. government, its agencies or
instrumentalities and related repurchase agreements.
U.S. Government Select Money Market Fund seeks to maximize
current income to the extent consistent with the preservation of
capital and maintenance of liquidity by investing exclusively in
high quality money market instruments.
Tax-Exempt Money Market Fund seeks to provide a high level of
income exempt from regular Federal income tax, to the extent
consistent with the preservation of capital, by investing
primarily in municipal instruments.
Municipal Money Market Fund seeks high current income exempt from
regular federal tax to the extent consistent with preserving
capital by investing mainly in short-term municipal instruments.
California Municipal Money Market Fund seeks to provide its
shareholders to the extent consistent with the preservation of
capital and prescribed portfolio standards, a high level of
income exempt from regular federal income tax and California
state personal income tax.
FIXED INCOME FUNDS
U.S. Government Fund seeks high current income from U.S.
Government securities. The Fund's dollar-weighted average
maturity is anticipated to range between one and ten years. It
is designed for investors who seek greater principal stability
than is generally available from higher yielding corporate bonds.
Short-Intermediate U.S. Government Fund seeks high current income
from a broad range of U.S. Government securities. The Fund's
dollar-weighted average maturity is anticipated to range between
two and five years. It is designed for investors who seek
greater principal stability than is generally available from
higher yielding corporate bonds.
Fixed Income Fund seeks high current income from a broad range of
bonds and other fixed income securities. The Fund's average
maturity is anticipated to range between seven and twelve years.
This Fund generally presents greater risk and reward potential
than the U.S. Government Fund and the Short-Intermediate U.S.
Government Fund.
International Fixed Income Fund seeks to maximize total return
consistent with reasonable risk while investing in foreign
securities markets. Total return is comprised of current income
and value fluctuations from investing in bonds and other fixed
income securities of foreign issuers. (Effective June 30, 2000,
the Fund will seek to maximize total return consistent with
reasonable risk while investing in securities of issuers located
in at least three different countries, one of which may be the
U.S.)
High Yield Municipal Fund seeks a high level of current income
exempt from regular federal income tax.
High Yield Fixed Income Fund seeks a high level of current
income. In seeking current income, the Fund may also consider
the potential for capital appreciation. In pursuing its
investment objective, the Fund invests in high yield fixed income
instruments.
TAX-EXEMPT FIXED INCOME FUNDS
Intermediate Tax-Exempt Fund seeks high current income exempt
from regular federal income tax by investing in a broad range of
municipal instruments with an expected average maturity of three
to ten years.
California Intermediate Tax-Exempt Fund seeks high current income
exempt from regular federal income tax and California state
personal income tax by investing in municipal instruments with an
expected average maturity of three to ten years.
Florida Intermediate Tax-Exempt Fund seeks high current income
exempt from regular federal income tax by investing in municipal
instruments with an expected average maturity of three to ten
years. The Fund intends, but cannot guarantee, that its shares
will qualify for exemption from the Florida intangibles tax.
Tax-Exempt Fund seeks high current income exempt from regular
federal income tax by investing in municipal instruments with an
expected average maturity of ten to thirty years.
Arizona Tax-Exempt Fund seeks high current income exempt from
regular federal income tax and Arizona state personal income tax
by investing in municipal instruments with an expected average
maturity of ten to thirty years.
California Tax-Exempt Fund seeks high current income exempt from
regular federal income tax and California state personal income
tax by investing in municipal instruments with an expected
average maturity of ten and thirty years.
EQUITY FUNDS
Income Equity Fund seeks to achieve high current income and, as a
secondary objective, longer-term capital appreciation. The Fund
invests in convertible and other equity securities. Because it
emphasizes high current income, this Fund is likely to have the
least price fluctuation of Northern Funds' equity funds.
Stock Index Fund seeks to provide investment results
approximating the aggregate price and dividend performance of the
securities included in the S&P 500 Index.
Growth Equity Fund seeks long-term capital appreciation by
investing mainly in the equity securities of growth companies.
It is designed for investors willing to accept above-average
price volatility in search of long-term reward.
Select Equity Fund is also for the more aggressive investor,
seeking long-term capital appreciation by investing principally
in common stocks of companies the adviser believes to have
superior growth characteristics. Any income is incidental to
this objective.
MarketCommand Fund seeks to provide long-term capital
appreciation by investing primarily in the equity securities of a
concentrated group of companies believed to have significant
"market power." Any income received is incidental to this
objective.
Mid Cap Growth Fund seeks long-term capital appreciation by
investing primarily in equity securities of companies with market
capitalizations that are within the capitalization range of the
Standard & Poor's MidCap 400 Stock Index at the time of
investment.
Small Cap Index Fund seeks to provide investment results
approximating the aggregate price and dividend performance of the
securities included in the Russell 2000 Index.
Small Cap Fund seeks long-term capital appreciation; any income
is incidental to this objective. Because it invests principally
in the equity securities of smaller companies, this Fund is
likely to have more price volatility than the Growth Equity and
Select Equity Funds.
Small Cap Growth Fund seeks long-term capital appreciation by
investing primarily in equity securities of companies with market
capitalizations that are within the capitalization range of the
Russell 2000 Small Stock Index.
International Growth Equity Fund offers the potential benefits of
international diversification to investors willing to accept
above-average price volatility while seeking long-term capital
appreciation. While subject to additional risks such as currency
fluctuations and the higher volatility of foreign securities,
this Fund uses diversification, in an effort to control risk.
International Select Equity Fund seeks long-term growth by
investing principally in common stock of foreign issuers that the
adviser believes are growing faster than their markets. Because
fewer countries and securities are generally represented in this
Fund than in the International Growth Equity Fund, it is likely
to experience more price volatility.
Technology Fund seeks long-term capital appreciation by investing
principally in equity securities and securities convertible into
common stock of companies that develop, produce or distribute
products and services related to advances in technology. The
Fund will, under normal market conditions, invest at least 65% of
the value of its total assets in securities of companies
principally engaged in technology business activities. An issuer
is considered principally engaged in technology business
activities if such issuer is listed on the Morgan Stanley High-
Technology 35 Index (the "Morgan Stanley Index"), the Hambrecht
and Quist Technology Index (the "H&Q Index"), the SoundView
Technology Index, the technology grouping of the S&P 500 Index or
any other comparable index. Companies engaged in businesses
related to the following products and services are also
considered by Northern Trust to be engaged in technology business
activities whether or not they are listed in a technology index:
industrial and business machines; communications; computers,
software and peripheral products; electronics, electronic media;
internet; television and video equipment and services; and
satellite technology and equipment.
The Morgan Stanley Index is an equal dollar weighted index of 35
stocks drawn from nine technology subsectors: computer services,
design software, server software, PC software and new media,
networking and telecom equipment, server hardware, PC hardware
and peripherals, specialized systems and semi-conductors. The
SoundView Technology Index is an equal dollar weighted index
designed to measure the performance of the technology industry.
It is comprised of 100 major technology companies chosen by
SoundView Financial Group. The H&Q Index is comprised of
publicly traded stocks of approximately 250 technology companies.
The H&Q Index includes companies in the electronics, services and
related technologies industries and is a market capitalization
weighted index. Changes in the indices may occur when Morgan
Stanley, SoundView or H&Q choose to modify their indices or as
mergers, acquisitions and failures dictate. Such changes may
happen with fair regularity owing to the fast-changing nature of
the technology industries.
COMMERCIAL PAPER, BANKERS' ACCEPTANCES, CERTIFICATES OF DEPOSIT, TIME
DEPOSITS AND BANK NOTES. Commercial paper represents short-term unsecured
promissory notes issued in bearer form by banks or bank holding companies,
corporations and finance companies. 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. Fixed time deposits are bank obligations payable
at a stated maturity date and bearing interest at a fixed rate. Fixed time
deposits may be withdrawn on demand by the investor, but may be subject to early
withdrawal penalties that vary depending upon market conditions and the
remaining maturity of the obligation. There are no contractual restrictions on
the right to transfer a beneficial interest in a fixed time deposit to a third
party. Bank notes and bankers' acceptances rank junior to deposit liabilities
of the bank and pari passu with other senior, unsecured obligations of the bank.
Bank notes are classified as "other borrowings" on a bank's balance sheet, while
deposit notes and certificates of deposit are classified as deposits. Bank notes
are not insured by the Federal Deposit Insurance Corporation or any other
insurer. Deposit notes are insured by the Federal Deposit Insurance Corporation
only to the extent of $100,000 per depositor per bank.
A Fund may invest a portion of its net assets in the obligations of foreign
banks and foreign branches of domestic banks. Such obligations include
Eurodollar Certificates of Deposit ("ECDs"), which are U.S. dollar-denominated
certificates of deposit issued by offices of foreign and domestic banks located
outside the United States; Eurodollar Time Deposits ("ETDs"), which are U.S.
dollar-denominated deposits in a foreign branch of a U.S. bank or a foreign
bank; Canadian Time Deposits ("CTDs"), which are essentially the same as ETDs
except they are issued by Canadian offices of major Canadian banks; Schedule Bs,
which are obligations issued by Canadian branches of foreign or domestic banks;
Yankee Certificates of Deposit ("Yankee Cds"), which are U.S. dollar-denominated
certificates of deposit issued by a U.S. branch of a foreign bank and held in
the United States; and Yankee Bankers' Acceptances ("Yankee Bas"), which are
U.S. dollar-denominated bankers' acceptances issued by a U.S. branch of a
foreign bank and held in the United States.
INSURANCE FUNDING AGREEMENTS. An insurance funding agreement ("IFA") is
normally a general obligation of the issuing insurance company and not a
separate account. The purchase price paid for an IFA becomes part of the
general assets of the insurance company, and the contract is paid from the
company's general assets. The Money Market Fund and Fixed Income Fund will only
purchase highly rated IFAs. The High Yield Fixed Income Fund is not subject to
any minimum rating criteria. Generally, IFAs are not assignable or transferable
without the permission of the issuing insurance companies, and an active
secondary market in IFAs may not exist. Therefore, IFAs will be subject to a
Fund's limitation on illiquid investments when the Fund may not demand payment
of the principal amount within seven days and a reliable trading market is
absent.
ZERO COUPON, PAY-IN-KIND AND CAPITAL APPRECIATION BONDS. To the extent
consistent with their respective investment objectives, each Fund may invest in
zero coupon bonds, capital appreciation bonds and pay-in-kind ("PIK")
securities. Zero coupon and capital appreciation bonds are debt securities
issued or sold at a discount from their face value and which do not entitle the
holder to any periodic payment of interest prior to maturity or a specified
date. The original issue discount varies depending on the time remaining until
maturity or cash payment date, prevailing interest rates, the liquidity of the
security and the perceived credit quality of the issuer. These securities also
may take the form of debt securities that have been stripped of their unmatured
interest coupons, the coupons themselves or receipts or certificates
representing interests in such stripped debt obligations or coupons. The market
prices of zero coupon bonds, capital appreciation bonds and PIK securities
generally are more volatile than the market prices of interest bearing
securities and are likely to respond to a greater degree to changes in interest
rates than interest bearing securities having similar maturities and credit
quality.
PIK securities may be debt obligations or preferred shares that provide
the issuer with the option of paying interest or dividends on such obligations
in cash or in the form of additional securities rather than cash. Similar to
zero coupon bonds, PIK securities are designed to give an issuer flexibility in
managing cash flow. PIK securities that are debt securities can either be senior
or subordinated debt and generally trade flat (i.e., without accrued interest).
The trading price of PIK debt securities generally reflects the market value of
the underlying debt plus an amount representing accrued interest since the last
interest payment.
Zero coupon bonds, capital appreciation bonds and PIK securities involve
the additional risk that, unlike securities that periodically pay interest to
maturity, a Fund will realize no cash until a specified future payment date
unless a portion of such securities is sold and, if the issuer of such
securities defaults, a Fund may obtain no return at all on its investment. In
addition, even though such securities do not provide for the payment of current
interest in cash, the Funds are nonetheless required to accrue income on such
investments for each taxable year and generally are required to distribute such
accrued amounts (net of deductible expenses, if any) to avoid being subject to
tax. Because no cash is generally received at the time of the accrual, a Fund
may be required to liquidate other portfolio securities to obtain sufficient
cash to satisfy federal tax distribution requirements applicable to the Fund.
LOAN PARTICIPATIONS. The High Yield Fixed Income Fund may invest in
loan participations. Such loans must be to issuers in whose obligations the
High Yield Fixed Income Fund may invest. A loan participation is an interest in
a loan to a U.S. or foreign company or other borrower which is administered and
sold by a financial intermediary. In a typical corporate loan syndication, a
number of lenders, usually banks (co-lenders), lend a corporate borrower a
specified sum pursuant to the terms and conditions of a loan agreement. One of
the co-lenders usually agrees to act as the agent bank with respect to the loan.
Participation interests acquired by the High Yield Fixed Income Fund may
take the form of a direct or co-lending relationship with the corporate
borrower, an assignment of an interest in the loan by a co-lender or another
participant, or a participation in the seller's share of the loan. When the
High Yield Fixed Income Fund acts as co-lender in connection with a
participation interest or when the High Yield Fixed Income Fund acquires certain
participation interests, the High Yield Fixed Income Fund will have direct
recourse against the borrower if the borrower fails to pay scheduled principal
and interest. In cases where the High Yield Fixed Income Fund lacks direct
recourse, it will look to the agent bank to enforce appropriate credit remedies
against the borrower. In these cases, the High Yield Fixed Income Fund may be
subject to delays, expenses and risks that are greater than those that would
have been involved if the Fund had purchased a direct obligation (such as
commercial paper) of such borrower. For example, in the event of the bankruptcy
or insolvency of the corporate borrower, a loan participation may be subject to
certain defenses by the borrower as a result of improper conduct by the agent
bank. Moreover, under the terms of the loan participation, the High Yield Fixed
Income Fund may be regarded as a creditor of the agent bank (rather than of the
underlying corporate borrower), so that the High Yield Fixed Income Fund may
also be subject to the risk that the agent bank may become insolvent. The
secondary market, if any, for these loan participations is limited and any loan
participations purchased by the High Yield Fixed Income Fund will be regarded as
illiquid.
For purposes of certain investment limitations pertaining to
diversification of the High Yield Fixed Income Fund's portfolio investments, the
issuer of a loan participation will be the underlying borrower. However, in
cases where the High Yield Fixed Income Fund does not have recourse directly
against the borrower, both the borrower and each agent bank and co-lender
interposed between the High Yield Fixed Income Fund and the borrower will be
deemed issuers of a loan participation.
REPURCHASE AGREEMENTS. Each Fund may agree to purchase portfolio
securities from financial institutions subject to the seller's agreement to
repurchase them at a mutually agreed upon date and price ("repurchase
agreements"). Repurchase agreements are considered to be loans under the
Investment Company Act of 1940 (the "1940 Act"). Although the securities
subject to a repurchase agreement may bear maturities exceeding one year,
settlement for the repurchase agreement will never be more than one year after a
Fund's acquisition of the securities and normally will be within a shorter
period of time. Securities subject to repurchase agreements are held either by
Northern Funds' custodian or subcustodian (if any), or in the Federal
Reserve/Treasury Book-Entry System. The seller under a repurchase agreement
will be required to maintain the value of the securities subject to the
agreement in an amount exceeding the repurchase price (including accrued
interest). Default by the seller would, however, expose a Fund to possible loss
because of adverse market action or delay in connection with the disposition of
the underlying obligations.
REVERSE REPURCHASE AGREEMENTS. A Fund may borrow funds by selling
portfolio securities to financial institutions such as banks and broker/dealers
and agreeing to repurchase them at a mutually specified date and price ("reverse
repurchase agreements"). The Funds may use the proceeds of reverse repurchase
agreements to purchase other securities either maturing, or under an agreement
to resell, on a date simultaneous with or prior to the expiration of the reverse
repurchase agreement. Reverse repurchase agreements are considered to be
borrowings under the 1940 Act. Reverse repurchase agreements involve the risk
that the market value of the securities sold by a Fund may decline below the
repurchase price. A Fund will pay interest on amounts obtained pursuant to a
reverse repurchase agreement. While reverse repurchase agreements are
outstanding, a Fund will segregate liquid assets in an amount at least equal to
the market value of the securities, plus accrued interest, subject to the
agreement.
VARIABLE AND FLOATING RATE INSTRUMENTS. With respect to the variable and
floating rate instruments that may be acquired by the Funds as described in the
Prospectus, the Investment Advisers will consider the earning power, cash flows
and other liquidity ratios of the issuers and guarantors of such instruments
and, if the instruments are subject to demand features, will monitor their
financial status and ability to meet payment on demand. In determining weighted
average portfolio maturity, an instrument may, subject to applicable Securities
and Exchange Commission ("SEC") regulations, be deemed to have a maturity
shorter than its nominal maturity based on the period remaining until the next
interest rate adjustment or the time a Fund can recover payment of principal as
specified in the instrument. Where necessary to ensure that a variable or
floating rate instrument is of the minimum required credit quality for a Fund,
the issuer's obligation to pay the principal of the instrument will be backed by
an unconditional bank letter or line of credit, guarantee or commitment to lend.
Variable and floating rate instruments eligible for purchase by the Funds
include variable amount master demand notes, which permit the indebtedness
thereunder to vary in addition to providing for periodic adjustments in the
interest rate, and (except for the Money Market Funds) leveraged inverse
floating rate debt instruments ("inverse floaters"). The interest rate on an
inverse floater resets in the opposite direction from the market rate of
interest to which the inverse floater is indexed. An inverse floater may be
considered to be leveraged to the extent that its interest rate varies by a
magnitude that exceeds the magnitude of the change in the index rate of
interest. The higher degree of leverage interest in inverse floaters is
associated with greater volatility in their market values. Accordingly, the
duration of an inverse floater may exceed its stated final maturity. The Funds
may deem the maturity of variable and floating rate instruments to be less than
their stated maturities based on their variable and floating rate features
and/or their put features. Unrated variable and floating rate instruments will
be determined by the Investment Advisers to be of comparable quality at the time
of purchase to rated instruments which may be purchased by the Funds.
Variable and floating rate instruments including inverse floaters held by a
Fund will be subject to the Fund's limitation on illiquid investments when the
Fund may not demand payment of the principal amount within seven days absent a
reliable trading market.
FORWARD COMMITMENTS, WHEN-ISSUED SECURITIES AND DELAYED-DELIVERY
TRANSACTIONS. Each Fund may purchase securities on a when-issued basis or
purchase or sell securities on a forward commitment (sometimes called delayed
delivery) basis. These transactions involve a commitment by the Fund to
purchase or sell securities at a future date. The price of the underlying
securities (usually expressed in terms of yield) and the date when the
securities will be delivered and paid for (the settlement date) are fixed at the
time the transaction is negotiated. When-issued purchases and forward
commitment transactions are normally negotiated directly with the other party.
A Fund will purchase securities on a when-issued basis or purchase or sell
securities on a forward commitment basis only with the intention of completing
the transaction and actually purchasing or selling the securities. If deemed
advisable as a matter of investment strategy, however, a Fund may dispose of or
negotiate a commitment after entering into it. A Fund also may sell securities
it has committed to purchase before those securities are delivered to the Fund
on the settlement date.
When a Fund purchases securities on a when-issued, delayed-delivery or
forward commitment basis, the Fund will segregate liquid assets having a value
(determined daily) at least equal to the amount of the Fund's purchase
commitments until three days prior to the settlement date, or will otherwise
cover its position. These procedures are designed to ensure that the Fund will
maintain sufficient assets at all times to cover its obligations under when-
issued purchases, forward commitments and delayed-delivery transactions. For
purposes of determining a Fund's average dollar-weighted maturity, the maturity
of when-issued, delayed-delivery or forward commitment securities will be
calculated from the commitment date.
UNITED STATES GOVERNMENT OBLIGATIONS. Examples of the types of U.S.
Government obligations that may be acquired by the Funds include U.S. Treasury
Bills, Treasury Notes and Treasury Bonds and the obligations of Federal Home
Loan Banks, Federal Farm Credit Banks, Federal Land Banks, the Federal Housing
Administration, Farmers Home Administration, Export-Import Bank of the United
States, Small Business Administration, Federal National Mortgage Association
("FNMA"), Government National Mortgage Association ("GNMA"), General Services
Administration, Central Bank for Cooperatives, Federal Home Loan Mortgage
Corporation ("FHLMC"), Federal Intermediate Credit Banks and Maritime
Administration.
SUPRANATIONAL BANK OBLIGATIONS. A Fund may invest in obligations of
supranational banks. Supranational banks are international banking institutions
designed or supported by national governments to promote economic
reconstruction, development or trade among nations (e.g., the International Bank
for Reconstruction and Development). Obligations of supranational banks may be
supported by appropriated but unpaid commitments of their member countries and
there is no assurance that these commitments will be undertaken or met in the
future.
STRIPPED OBLIGATIONS. The Treasury Department has facilitated transfers of
ownership of zero coupon securities by accounting separately for the beneficial
ownership of particular interest coupon and principal payments on Treasury
securities through the Federal Reserve book-entry record-keeping system. The
Federal Reserve program as established by the Treasury Department is known as
"STRIPS" or "Separate Trading of Registered Interest and Principal of
Securities." The Funds may purchase securities registered in the STRIPS
program. Under the STRIPS program, the Funds are able to have their beneficial
ownership of zero coupon securities recorded directly in the book-entry record-
keeping system in lieu of having to hold certificates or other evidences of
ownership of the underlying U.S. Treasury securities.
In addition, the Funds, other than the U.S. Government Select Money Market
Fund, may acquire U.S. Government obligations and their unmatured interest
coupons that have been separated ("stripped") by their holder, typically a
custodian bank or investment brokerage firm. Having separated the interest
coupons from the underlying principal of the U.S. Government obligations, the
holder will resell the stripped securities in custodial receipt programs with a
number of different names, including "Treasury Income Growth Receipts" ("TIGRs")
and "Certificate of Accrual on Treasury Securities" ("CATS"). The stripped
coupons are sold separately from the underlying principal, which is usually sold
at a deep discount because the buyer receives only the right to receive a future
fixed payment on the security and does not receive any rights to periodic
interest (cash) payments. The underlying U.S. Treasury bonds and notes
themselves are held in book-entry form at the Federal Reserve Bank or, in the
case of bearer securities (i.e., unregistered securities which are ostensibly
owned by the bearer or holder), in trust on behalf of the owners. Counsel to
the underwriters of these certificates or other evidences of ownership of U.S.
Treasury securities have stated that, in their opinion, purchasers of the
stripped securities most likely will be deemed the beneficial holders of the
underlying U.S. Government obligations for federal tax purposes. Northern Funds
is unaware of any binding legislative, judicial or administrative authority on
this issue.
The Prospectus discusses other types of stripped securities that may be
purchased by the Funds, including stripped mortgage-backed securities ("SMBS").
SMBS are usually structured with two or more classes that receive different
proportions of the interest and principal distributions from a pool of mortgage-
backed obligations. A common type of SMBS will have one class receiving all of
the interest, while the other class receives all of the principal. However, in
some instances, one class will receive some of the interest and most of the
principal while the other class will receive most of the interest and the
remainder of the principal. If the underlying obligations experience greater
than anticipated prepayments of principal, a Fund may fail to fully recoup its
initial investment in these securities. The market value of the class consisting
entirely of principal payments generally is extremely volatile in response to
changes in interest rates. The yields on a class of SMBS that receives all or
most of the interest are generally higher than prevailing market yields on other
mortgage-backed obligations because their cash flow patterns are also volatile
and there is a risk that the initial investment will not be fully recouped. SMBS
issued by the U.S. Government (or a U.S. Government agency or instrumentality)
may be considered liquid under guidelines established by the Trust's Board of
Trustees if they can be disposed of promptly in the ordinary course of business
at a value reasonably close to that used in the calculation of the net asset
value per share.
ASSET-BACKED SECURITIES. To the extent described in the Prospectus, the
Funds may purchase asset-backed securities, which are securities backed by
mortgages, installment contracts, credit card receivables or other financial
assets. Asset-backed securities represent interests in "pools" of assets in
which payments of both interest and principal on the securities are made
periodically, thus in effect "passing through" such payments made by the
individual borrowers on the assets that underlie the securities, net of any fees
paid to the issuer or guarantor of the securities. The average life of asset-
backed securities varies with the maturities of the underlying instruments, and
the average life of a mortgage-backed instrument, in particular, is likely to be
substantially less than the original maturity of the mortgage pools underlying
the securities as a result of mortgage prepayments. For this and other reasons,
an asset-backed security's stated maturity may be shortened, and the security's
total return may be difficult to predict precisely.
If an asset-backed security is purchased at a premium, a prepayment rate
that is faster than expected will reduce yield to maturity, while a prepayment
rate that is slower than expected will have the opposite effect of increasing
yield to maturity. Conversely, if an asset-backed security is purchased at a
discount, faster than expected prepayments will increase, while slower than
expected prepayments will decrease, yield to maturity. In calculating a Fund's
average weighted maturity, the maturity of asset-backed securities will be based
on estimates of average life.
Prepayments on asset-backed securities generally increase with falling
interest rates and decrease with rising interest rates; furthermore, prepayment
rates are influenced by a variety of economic and social factors. In general,
the collateral supporting non-mortgage asset-backed securities is of shorter
maturity than mortgage loans and is less likely to experience substantial
prepayments.
Asset-backed securities acquired by the Funds may include collateralized
mortgage obligations ("CMOs") issued by private companies. CMOs provide the
holder with a specified interest in the cash flow of a pool of underlying
mortgages or other mortgage-backed securities. Issuers of CMOs ordinarily elect
to be taxed as pass-through entities known as real estate mortgage investment
conduits ("REMICs"). CMOs are issued in multiple classes, each with a specified
fixed or floating interest rate and a final distribution date. The relative
payment rights of the various CMO classes may be structured in a variety of
ways. The Funds will not purchase "residual" CMO interests, which normally
exhibit greater price volatility.
There are a number of important differences among the agencies and
instrumentalities of the U.S. Government that issue mortgage-related securities
and among the securities that they issue. Mortgage-related securities guaranteed
by GNMA include GNMA Mortgage Pass-Through Certificates (also known as "Ginnie
Maes"), which are guaranteed as to the timely payment of principal and interest
by GNMA and backed by the full faith and credit of the United States. GNMA is a
wholly-owned U.S. Government corporation within the Department of Housing and
Urban Development. GNMA certificates also are supported by the authority of
GNMA to borrow funds from the U.S. Treasury to make payments under its
guarantee. Mortgage-backed securities issued by FNMA include FNMA Guaranteed
Mortgage Pass-Through Certificates (also known as "Fannie Maes"), which are
solely the obligations of FNMA and are not backed by or entitled to the full
faith and credit of the United States, but are supported by the right of the
issuer to borrow from the Treasury. FNMA is a government-sponsored organization
owned entirely by private stockholders. Fannie Maes are guaranteed as to timely
payment of the principal and interest by FNMA. Mortgage-related securities
issued by the Federal Home Loan Mortgage Corporation ("FHLMC") include FHLMC
Mortgage Participation Certificates (also known as "Freddie Macs" or "PCs").
FHLMC is a corporate instrumentality of the United States, created pursuant to
an Act of Congress, which is owned entirely by Federal Home Loan Banks. Freddie
Macs are not guaranteed and do not constitute a debt or obligation of the United
States or of any Federal Home Loan Bank. Freddie Macs entitle the holder to
timely payment of interest, which is guaranteed by FHLMC. FHLMC guarantees
either ultimate collection or timely payment of all principal payments on the
underlying mortgage loans. When FHLMC does not guarantee timely payment of
principal, FHLMC may remit the amount due on account of its guarantee of
ultimate payment of principal at any time after default on an underlying
mortgage, but in no event later than one year after it becomes payable.
Non-mortgage asset-backed securities involve certain risks that are not
presented by mortgage-backed securities. Primarily, these securities do not
have the benefit of the same security interest in the underlying collateral.
Credit card receivables are generally unsecured and the debtors are entitled to
the protection of a number of state and federal consumer credit laws, many of
which have given debtors the right to set off certain amounts owed on the credit
cards, thereby reducing the balance due. Most issuers of automobile receivables
permit the servicers to retain possession of the underlying obligations. If the
servicer were to sell these obligations to another party, there is a risk that
the purchaser would acquire an interest superior to that of the holders of the
related automobile receivables. In addition, because of the large number of
vehicles involved in a typical issuance and technical requirements under state
laws, the trustee for the holders of the automobile receivables may not have an
effective security interest in all of the obligations backing such receivables.
Therefore, there is a possibility that recoveries on repossessed collateral may
not, in some cases, be able to support payments on these securities.
MUNICIPAL INSTRUMENTS. Municipal instruments are generally issued to
finance public works, such as airports, bridges, highways, housing, health-
related entities, transportation-related projects, educational programs, water
and pollution control and sewer works. They are also issued to repay
outstanding obligations, to raise funds for general operating expenses and to
make loans to other public institutions and for other facilities. Municipal
instruments include private activity bonds issued by or on behalf of public
authorities. Private activity bonds are or have been issued to obtain funds to
provide, among other things, privately operated housing facilities, pollution
control facilities, convention or trade show facilities, mass transit, airport,
port or parking facilities and certain local facilities for water supply, gas,
electricity or sewage or solid waste disposal. Private activity bonds are also
issued to privately held or publicly owned corporations in the financing of
commercial or industrial facilities. State and local governments are authorized
in most states to issue private activity bonds for such purposes in order to
encourage corporations to locate within their communities. The principal and
interest on these obligations may be payable from the general revenues of the
users of such facilities.
Municipal instruments include both "general" and "revenue" obligations.
General obligations are secured by the issuer's pledge of its full faith, credit
and taxing power for the payment of principal and interest. Revenue obligations
are payable only from the revenues derived from a particular facility or class
of facilities or, in some cases, from the proceeds of a special excise tax or
other specific revenue source such as lease revenue payments from the user of
the facility being financed. Private activity bonds are in most cases revenue
securities and are not payable from the unrestricted revenues of the issuer.
Consequently, the credit quality of a private activity bond is usually directly
related to the credit standing of the private user of the facility involved.
The Tax-Exempt Money Market Fund, Intermediate Tax-Exempt Fund, California
Intermediate Tax-Exempt Fund, Florida Intermediate Tax-Exempt Fund, Tax-Exempt
Fund, Arizona Tax-Exempt Fund and California Tax-Exempt Fund (the "Tax-Exempt
Funds") and the Municipal Money Market Fund, California Municipal Money Market
Fund and High Yield Municipal Fund (the "Municipal Funds") may also invest in
"moral obligation" bonds, which are normally issued by special purpose public
authorities. If the issuer of a moral obligation bond is unable to meet its
debt service obligations from current revenues, it may draw on a reserve fund
(if such a fund has been established), the restoration of which is a moral
commitment but not a legal obligation of the state or municipality which created
the issuer.
The Tax-Exempt Money Market, Municipal Money Market and California
Municipal Money Market Funds may invest in fixed and variable rate notes and
similar debt instruments rated MIG-2, VMIG-2 or Prime-2 or higher by Moody's,
SP-2 or A-2 or higher by S&P, D-2 or higher by D&P or F-2 or higher by Fitch
IBCA and tax-exempt commercial paper and similar debt instruments rated Prime-2
or higher by Moody's, A-2 or higher by S&P, D-2 or higher by D&P or F-2 or
higher by Fitch IBCA. The Tax-Exempt Money Market, Municipal Money Market and
California Municipal Money Market Funds may also invest in rated and unrated
municipal bonds, notes, paper or other instruments that are of comparable
quality to the tax-exempt commercial paper permitted to be purchased by the
Funds.
Within the principal classifications of municipal instruments described
above there are a variety of categories, including municipal bonds, municipal
notes, municipal leases, custodial receipts and participation certificates.
Municipal notes include tax, revenue and bond anticipation notes of short
maturity, generally less than three years, which are issued to obtain temporary
funds for various public purposes. Municipal leases and participation
certificates are obligations issued by state or local governments or authorities
to finance the acquisition of equipment and facilities. Participation
certificates may represent participations in a lease, an installment purchase
contract, or a conditional sales contract. Certain municipal lease obligations
(and related participation certificates) may include "non-appropriation" clauses
which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. Custodial receipts are underwritten by
securities dealers or banks and evidence ownership of future interest payments,
principal payments or both on certain municipal securities. Municipal leases
(and participations in such leases) present the risk that a municipality will
not appropriate funds for the lease payments. Northern Trust, under the
supervision of Northern Funds' Board of Trustees, will determine the credit
quality of any unrated municipal leases on an ongoing basis, including an
assessment of the likelihood that the leases will not be cancelled.
There are, of course, variations in the quality of municipal instruments,
both within a particular category and between categories, and the yields on
municipal instruments depend upon a variety of factors, including general market
conditions, the financial condition of the issuer, general conditions of the
municipal bond market, the size of a particular offering, the maturity of the
obligation, and the rating of the issue. The ratings of an NRSRO, such as
Moody's, S&P and Fitch IBCA described in Appendix A hereto, represent such
NRSRO's opinion as to the quality of municipal instruments. It should be
emphasized that these ratings are general and are not absolute standards of
quality. Municipal instruments with the same maturity, interest rate and rating
may have different yields. Municipal instruments of the same maturity and
interest rate with different ratings may have the same yield.
An issuer's obligations under its municipal instruments are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the Federal Bankruptcy Code, and laws, if any,
which may be enacted by federal or state legislatures extending the time for
payment of principal or interest, or both, or imposing other constraints upon
enforcement of such obligations or upon the ability of municipalities to levy
taxes. The power or ability of an issuer to meet its obligations for the
payment of interest on and principal of its municipal instruments may be
materially adversely affected by litigation or other conditions.
From time to time proposals have been introduced before Congress for the
purpose of restricting or eliminating the federal income tax exemption for
interest on municipal instruments. For example, under the Tax Reform Act of 1986
interest on certain private activity bonds must be included in an investor's
federal alternative minimum taxable income, and corporate investors must include
all tax-exempt interest in their federal alternative minimum taxable income.
Northern Funds cannot predict what legislation, if any, may be proposed in the
future in Congress as regards the federal income tax status of interest on
municipal instruments or which proposals, if any, might be enacted. Such
proposals, if enacted, might materially and adversely affect the availability of
municipal instruments for investment by the Tax-Exempt and Municipal Funds and
the Funds' liquidity and value. In such an event the Board of Trustees would
reevaluate the Funds' investment objectives and policies and consider changes in
their structure or possible dissolution.
Certain of the municipal instruments held by a Fund may be insured as to
the timely payment of principal and interest. The insurance policies will
usually be obtained by the issuer of the municipal instrument at the time of its
original issuance. In the event that the issuer defaults on an interest or
principal payment, the insurer will be notified and will be required to make
payment to the bondholders. There is, however, no guarantee that the insurer
will meet its obligations. In addition, such insurance will not protect against
market fluctuations caused by changes in interest rates and other factors. A
Fund may invest more than 25% of its total assets in municipal instruments
covered by insurance policies.
In addition, municipal instruments may be backed by letters of credit or
guarantees issued by domestic or foreign banks or other financial institutions
which are not subject to federal deposit insurance. Adverse developments
affecting the banking industry generally or a particular bank or financial
institution that has provided its credit or guarantee with respect to a
municipal instrument held by a Fund, including a change in the credit quality of
any such bank or financial institution, could result in a loss to the Fund and
adversely affect the value of its shares. As described below under "Foreign
Securities," letters of credit and guarantees issued by foreign banks and
financial institutions involve certain risks in addition to those of similar
instruments issued by domestic banks and financial institutions.
Interest earned by the Tax-Exempt Money Market Fund, Intermediate Tax-
Exempt Fund, California Intermediate Tax-Exempt Fund, Florida Intermediate Tax-
Exempt Fund, Tax-Exempt Fund, Arizona Tax-Exempt Fund or California Tax-Exempt
Fund on private activity bonds (if any) that is treated as a specific tax
preference item under the federal alternative minimum tax will not be deemed to
have been derived from municipal instruments for purposes of determining whether
that Fund meets its fundamental policy that at least 80% of its annual gross
income be derived from municipal instruments.
The Tax-Exempt Funds and the Municipal Funds may invest in municipal
leases, which may be considered liquid under guidelines established by Northern
Funds' Board of Trustees. The guidelines will provide for determination of the
liquidity of a municipal lease obligation based on factors including the
following: (1) the frequency of trades and quotes for the obligation; (2) the
number of dealers willing to purchase or sell the security and the number of
other potential buyers; (3) the willingness of dealers to undertake to make a
market in the security; and (4) the nature of the marketplace trades, including
the time needed to dispose of the security, the method of soliciting offers and
the mechanics of transfer. Northern Trust, under the supervision of Northern
Funds' Board of Trustees, will also consider the continued marketability of a
municipal lease obligation based upon an analysis of the general credit quality
of the municipality issuing the obligation and the essentiality to the
municipality of the property covered by the lease.
Opinions relating to the validity of municipal instruments (including
California, Florida and Arizona municipal instruments) and to federal and state
tax issues relating to these securities are rendered by counsel to the
respective issuing authorities at the time of issuance. Such opinions may
contain various assumptions, qualifications or exceptions that are reasonably
acceptable to Northern Trust. Neither Northern Funds nor Northern Trust will
review the proceedings relating to the issuance of municipal instruments or the
bases for such opinions.
Currently it is not the intention of the Tax-Exempt Funds and the Municipal
Funds to invest more than 25% of the value of their total assets in municipal
instruments whose issuers are in the same state.
STANDBY COMMITMENTS. The Tax-Exempt Funds and Municipal Funds may enter
into standby commitments with respect to municipal instruments held by them.
Under a standby commitment, a dealer agrees to purchase at a Fund's option a
specified municipal instrument. Standby commitments may be exercisable by a Fund
at any time before the maturity of the underlying municipal instruments and may
be sold, transferred or assigned only with the instruments involved.
The Funds expect that standby commitments will generally be available
without the payment of any direct or indirect consideration. However, if
necessary or advisable, the Funds may pay for a standby commitment either
separately in cash or by paying a higher price for municipal instruments which
are acquired subject to the commitment (thus reducing the yield to maturity
otherwise available for the same securities). The total amount paid in either
manner for outstanding standby commitments held by a Fund will not exceed 1/2 of
1% of the value of the Fund's total assets calculated immediately after each
standby commitment is acquired.
The Funds intend to enter into standby commitments only with dealers, banks
and broker-dealers which, in Northern Trust's opinion, present minimal credit
risks. The Funds will acquire standby commitments solely to facilitate
portfolio liquidity and do not intend to exercise their rights thereunder for
trading purposes. The acquisition of a standby commitment will not affect the
valuation of the underlying municipal instrument. The actual standby commitment
will be valued at zero in determining net asset value. Accordingly, where a
Fund pays directly or indirectly for a standby commitment, its cost will be
reflected as an unrealized loss for the period during which the commitment is
held by the Fund and will be reflected in realized gain or loss when the
commitment is exercised or expires.
WARRANTS. The Income Equity, Growth Equity, Select Equity, MarketCommand,
Mid Cap Growth, Small Cap, Small Cap Growth, International Growth Equity,
International Select Equity, Technology and High Yield Fixed Income Funds may
purchase warrants and similar rights, which are privileges issued by
corporations enabling the owners to subscribe to and purchase a specified number
of shares of the corporation at a specified price during a specified period of
time. The prices of warrants do not necessarily correlate with the prices of
the underlying shares. The purchase of warrants involves the risk that a Fund
could lose the purchase value of a warrant if the right to subscribe to
additional shares is not exercised prior to the warrant's expiration. Also, the
purchase of warrants involves the risk that the effective price paid for the
warrant added to the subscription price of the related security may exceed the
value of the subscribed security's market price such as when there is no
movement in the level of the underlying security.
FOREIGN SECURITIES. The International Funds intend to invest primarily in
the securities of foreign issuers. In addition, each Equity Fund, the Fixed
Income Fund and the High Yield Fixed Income Fund may invest a portion of their
assets in such securities, including (except with respect to the Fixed Income
Fund) eurodollar convertible securities, which are fixed income securities that
are issued in U.S. dollars outside the United States and are convertible into or
exchangeable for equity securities of the same or a different issuer. The Money
Market Fund may also invest in dollar-denominated obligations issued or
guaranteed by one or more foreign governments or any of their political
subdivisions, agencies or instrumentalities, as well as other foreign issuers.
These obligations may be issued by supranational entities, including
international organizations (such as the European Coal and Steel Community)
designed or supported by governmental entities to promote economic
reconstruction or development and international banking institutions and related
government agencies.
Investment in foreign securities involves special risks. These include
market risk, interest rate risk and the risks of investing in securities of
foreign issuers and of companies whose securities are principally traded outside
the United States and in investments denominated in foreign currencies. Market
risk involves the possibility that stock prices will decline over short or even
extended periods. The stock markets tend to be cyclical, with periods of
generally rising prices and periods of generally declining prices. These cycles
will affect the value of a Fund that invests in foreign stocks. The holdings of
a Fund that invests in fixed income securities will be sensitive to changes in
interest rates and the interest rate environment. Generally, the prices of
bonds and debt securities fluctuate inversely with interest rate changes. In
addition, the performance of investments in securities denominated in a foreign
currency will depend on the strength of the foreign currency against the U.S.
dollar and the interest rate environment in the country issuing the currency.
Absent other events which could otherwise affect the value of a foreign security
(such as a change in the political climate or an issuer's credit quality),
appreciation in the value of the foreign currency generally can be expected to
increase the value of a foreign currency-denominated security in terms of U.S.
dollars. A rise in foreign interest rates or decline in the value of the
foreign currency relative to the U.S. dollar generally can be expected to
depress the value of a foreign currency-denominated security.
There are other risks and costs involved in investing in foreign securities
which are in addition to the usual risks inherent in domestic investments.
Investment in foreign securities involves higher costs than investment in U.S.
securities, including higher transaction and custody costs as well as the
imposition of additional taxes by foreign governments. Foreign investments also
involve risks associated with the level of currency exchange rates, less
complete financial information about the issuers, less market liquidity, more
market volatility and political instability. Future political and economic
developments, the possible imposition of withholding taxes on dividend income,
the possible seizure or nationalization of foreign holdings, the possible
establishment of exchange controls, or the adoption of other governmental
restrictions might adversely affect an investment in foreign securities.
Additionally, foreign banks and foreign branches of domestic banks are subject
to less stringent reserve requirements, and to different accounting, auditing
and recordkeeping requirements.
The Money Market Fund, the Fixed Income Fund, the High Yield Fixed Income
Fund, each Equity Fund and each International Fund may invest in foreign debt,
including the securities of foreign governments. Several risks exist concerning
such investments, including the risk that foreign governments may default on
their obligations, may not respect the integrity of such debt, may attempt to
renegotiate the debt at a lower rate, and may not honor investments by United
States entities or citizens.
To the extent consistent with their investment objectives, the Funds may
also invest in obligations of the International Bank for Reconstruction and
Development (also known as the World Bank) which are supported by subscribed,
but unpaid, commitments of its member countries. There is no assurance that
these commitments will be undertaken or complied with in the future.
The end of the Cold War, the reunification of Germany, the accession of new
Western European members to the European Economic and Monetary Union and the
aspirations of Eastern European states to join and other political and social
events in Europe have caused considerable economic, social and political
dislocation. In addition, events in the Japanese economy, as well as social and
political developments there have affected Japanese securities and currency
markets, and have disrupted the relationship of the Japanese yen with other
currencies and with the U.S. dollar. Future political, economic and social
developments in Europe, Japan and in the Asia\Pacific regional context can be
expected to produce continuing effects on securities and currency markets.
In addition, the International Funds and High Yield Fixed Income Fund may
invest their assets in countries with emerging economies or securities markets.
These countries are located in the Asia-Pacific region, Eastern Europe, Latin
and South America and Africa. Political and economic structures in many of
these countries may be undergoing significant evolution and rapid development,
and these countries may lack the social, political and economic stability
characteristics of more developed countries. Some of these countries may have
in the past failed to recognize private property rights and may have at times
nationalized or expropriated the assets of private companies. In general, the
securities markets of these countries are less liquid, subject to greater price
volatility, have smaller market capitalizations and have problems with
securities registration and custody. As a result, the risks presented by
investments in these countries are heightened. Additionally, settlement
procedures in emerging countries are frequently less developed and reliable than
those in the United States and may involve a Fund's delivery of securities
before receipt of payment for their sale. Settlement or registration problems
may make it more difficult for a Fund to value its portfolio securities and
could cause the Fund to miss attractive investment opportunities, to have a
portion of its assets uninvested or to incur losses due to the failure of a
counterparty to pay for securities the Fund has delivered or the Fund's
inability to complete its contractual obligations.
Although a Fund (other than the Money Market Fund) may invest in securities
denominated in foreign currencies, its portfolio securities and other assets are
valued in U.S. dollars. Currency exchange rates may fluctuate significantly
over short periods of time causing, together with other factors, a Fund's net
asset value to fluctuate as well. Currency exchange rates can be affected
unpredictably by the intervention or the failure to intervene by U.S. or foreign
governments or central banks, or by currency controls or political developments
in the U.S. or abroad. To the extent that a Fund's total assets, adjusted to
reflect the Fund's net position after giving effect to currency transactions,
are denominated in the currencies of foreign countries, the Fund will be more
susceptible to the risk of adverse economic and political developments within
those countries. In addition, through the use of forward currency exchange
contracts and with other instruments, the respective net currency positions of
the International Funds may expose them to risks independent of their securities
positions. Although the net long and short foreign currency exposure of the
International Funds will not exceed their respective total asset values, to the
extent that a Fund is fully invested in foreign securities while also
maintaining currency positions, it may be exposed to greater risk than it would
have if it did not maintain the currency positions. The Funds are also subject
to the possible imposition of exchange control regulations or freezes on the
convertibility of currency.
Investors should understand that the expense ratios of the International
Funds can be expected to be higher than those of Funds investing primarily in
domestic securities. The costs attributable to investing abroad are usually
higher for several reasons, such as the higher cost of investment research,
higher costs of custody of foreign securities, higher commissions paid on
comparable transactions on foreign markets and additional costs arising from
delays in settlements of transactions involving foreign securities.
Dividends and interest payable on a Fund's foreign portfolio securities may
be subject to foreign withholding taxes. To the extent such taxes are not
offset by credits or deductions allowed to investors under U.S. federal income
tax law, they may reduce the net return to the shareholders. See "Taxes."
AMERICAN DEPOSITORY RECEIPTS. Each Equity Fund and each International Fund
can invest in ADRs. ADRs are receipts typically issued by a United States bank
or trust company evidencing ownership of the underlying foreign securities and
are denominated in U.S. dollars. Some institutions issuing ADRs may not be
sponsored by the issuer.
A non-sponsored depository may not provide the same shareholder information
that a sponsored depository is required to provide under its contractual
arrangement with the issuer.
EUROPEAN DEPOSITORY RECEIPTS. Each Equity Fund and each International Fund
can also invest in EDRs and GDRs. EDRs and GDRs are receipts issued by a non-
U.S. financial institution evidencing ownership of underlying foreign or U.S.
securities and are usually denominated in foreign currencies. EDRs and GDRs may
not be denominated in the same currency as the securities they represent.
Generally, EDRs and GDRs are designed for use in the foreign securities markets.
FOREIGN CURRENCY TRANSACTIONS. In order to protect against a possible loss
on investments resulting from a decline or appreciation in the value of a
particular foreign currency against the U.S. dollar or another foreign currency
or for other reasons, the Fixed Income, International Fixed Income, High Yield
Fixed Income, Income Equity, Growth Equity, Select Equity, MarketCommand, Mid
Cap Growth, Small Cap, Small Cap Growth, International Growth Equity,
International Select Equity and Technology Funds are authorized to enter into
forward currency exchange contracts. These contracts involve an obligation to
purchase or sell a specified currency at a future date at a price set at the
time of the contract. Forward currency contracts do not eliminate fluctuations
in the values of portfolio securities but rather may allow a Fund to establish a
rate of exchange for a future point in time.
When entering into a contract for the purchase or sale of a security, a
Fund may enter into a forward foreign currency exchange contract for the amount
of the purchase or sale price to protect against variations, between the date
the security is purchased or sold and the date on which payment is made or
received, in the value of the foreign currency relative to the U.S. dollar or
other foreign currency.
In addition, when an Investment Adviser anticipates that a particular
foreign currency may decline substantially relative to the U.S. dollar or other
leading currencies, in order to reduce risk, a Fund may enter into a forward
contract to sell, for a fixed amount, the amount of foreign currency
approximating the value of some or all of the Fund's securities denominated in
such foreign currency. Similarly, when the securities held by a Fund create a
short position in a foreign currency, a Fund may enter into a forward contract
to buy, for a fixed amount, an amount of foreign currency approximating the
short position. A Fund's net long and short foreign currency exposure will not
exceed its total asset value. With respect to any forward foreign currency
contract, it will not generally be possible to match precisely the amount
covered by that contract and the value of the securities involved due to the
changes in the values of such securities resulting from market movements between
the date the forward contract is entered into and the date it matures. While
forward contracts may offer protection from losses resulting from declines or
appreciation in the value of a particular foreign currency, they also limit
potential gains which might result from changes in the value of such currency.
A Fund will also incur costs in connection with forward foreign currency
exchange contracts and conversions of foreign currencies and U.S. dollars.
In addition, Northern Trust may purchase or sell forward currency exchange
contracts for the International Fixed Income Fund, International Growth Equity
Fund and International Select Equity Fund (collectively, the "International
Funds") and the High Yield Fixed Income Fund to seek to increase total return
when Northern Trust anticipates that the foreign currency will appreciate or
depreciate in value. The International Funds and the High Yield Fixed Income
Fund may engage in cross-hedging by using forward contracts in one currency to
hedge against fluctuations in the value of securities denominated in a different
currency if Northern Trust believes that there is a pattern of correlation
between the two currencies.
Liquid assets equal to the amount of a Fund's assets that could be required
to consummate forward contracts will be segregated except to the extent the
contracts are otherwise "covered." The segregated assets will be valued at
market or fair value. If the market or fair value of such assets declines,
additional liquid assets will be segregated daily so that the value of the
segregated assets will equal the amount of such commitments by the Fund. A
forward contract to sell a foreign currency is "covered" if a Fund owns the
currency (or securities denominated in the currency) underlying the contract, or
holds a forward contract (or call option) permitting the Fund to buy the same
currency at a price that is (i) no higher than the Fund's price to sell the
currency or (ii) greater than the Fund's price to sell the currency provided the
Fund segregates liquid assets in the amount of the difference. A forward
contract to buy a foreign currency is "covered" if a Fund holds a forward
contract (or put option) permitting the Fund to sell the same currency at a
price that is (i) as high as or higher than the Fund's price to buy the currency
or (ii) lower than the Fund's price to buy the currency provided the Fund
segregates liquid assets in the amount of the difference.
OPTIONS. Each Non-Money Market Fund may buy put options and buy call
options and write covered call and secured put options. Such options may relate
to particular securities, foreign and domestic securities indices, financial
instruments, foreign currencies or (in the case of the International Fixed
Income Fund and the High Yield Fixed Income Fund) the yield differential between
two securities ("yield curve options"), and may or may not be listed on a
domestic or foreign securities exchange and may or may not be issued by the
Options Clearing Corporation. A call option for a particular security gives the
purchaser of the option the right to buy, and a writer the obligation to sell,
the underlying security at the stated exercise price prior to the expiration of
the option, regardless of the market price of the security. The premium paid to
the writer is in consideration for undertaking the obligation under the option
contract. A put option for a particular security gives the purchaser the right
to sell the security at the stated exercise price prior to the expiration date
of the option, regardless of the market price of the security. Options on
indices and yield curve options provide the holder with the right to make or
receive a cash settlement upon exercise of the option. With respect to options
on indices, the amount of the settlement will equal the difference between the
closing price of the index at the time of exercise and the exercise price of the
option expressed in dollars, times a specified multiple. With respect to yield
curve options, the amount of the settlement will equal the difference between
the yields of designated securities.
Options trading is a highly specialized activity which entails greater than
ordinary investment risk. 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.
The Funds will write call options only if they are "covered." In the case
of a call option on a security or currency, the option is "covered" if a Fund
owns the instrument underlying the call or has an absolute and immediate right
to acquire that instrument without additional cash consideration (or, if
additional cash consideration is required, liquid assets in such amount are
segregated) upon conversion or exchange of other securities held by it. For a
call option on an index, the option is covered if a Fund maintains with its
custodian securities comprising the index or liquid assets equal to the contract
value. A call option is also covered if a Fund holds a call on the same
instrument or index as the call written where the exercise price of the call
held is (i) equal to or less than the exercise price of the call written, or
(ii) greater than the exercise price of the call written provided the Fund
segregates liquid assets in the amount of the difference. The Funds will write
put options only if they are "secured" by segregated liquid assets in an amount
not less than the exercise price of the option at all times during the option
period.
With respect to yield curve options, a call (or put) option is covered if
the International Fixed Income Fund or High Yield Fixed Income Fund holds
another call (or put) option on the spread between the same two securities and
maintains in a segregated account liquid assets sufficient to cover the Fund's
net liability under the two options. Therefore, the Fund's liability for such a
covered option is generally limited to the difference between the amount of the
Fund's liability under the option written by the Fund less the value of the
option held by the Fund. Yield curve options may also be covered in such other
manner as may be in accordance with the requirements of the counterparty with
which the option is traded and applicable laws and regulations. Yield curve
options are traded over-the-counter, and because they have been only recently
introduced, established trading markets for these securities have not yet
developed.
A Fund's obligation to sell an instrument subject to a covered call option
written by it, or to purchase an instrument subject to a secured put option
written by it, may be terminated prior to the expiration date of the option by
the Fund's execution of a closing purchase transaction, which is effected by
purchasing on an exchange an option of the same series (i.e., same underlying
instrument, exercise price and expiration date) as the option previously
written. Such a purchase does not result in the ownership of an option. A
closing purchase transaction will ordinarily be effected to realize a profit on
an outstanding option, to prevent an underlying instrument from being called, to
permit the sale of the underlying instrument or to permit the writing of a new
option containing different terms on such underlying instrument. The cost of
such a liquidation purchase plus transaction costs may be greater than the
premium received upon the original option, in which event the Fund will have
incurred a loss in the transaction. There is no assurance that a liquid
secondary market will exist for any particular option. An option writer, unable
to effect a closing purchase transaction, will not be able to sell the
underlying instrument (in the case of a covered call option) or liquidate the
segregated assets (in the case of a secured put option) until the option expires
or the optioned instrument or currency is delivered upon exercise with the
result that the writer in such circumstances will be subject to the risk of
market decline or appreciation in the instrument during such period.
When a Fund purchases an option, the premium paid by it is recorded as an
asset of the Fund. When a Fund writes an option, an amount equal to the net
premium (the premium less the commission) received by a Fund is included in the
liability section of the Fund's statement of assets and liabilities as a
deferred credit. The amount of this asset or deferred credit will be
subsequently marked-to-market to reflect the current value of the option
purchased or written. The current value of the traded option is the last sale
price or, in the absence of a sale, the current bid price. If an option
purchased by a Fund expires unexercised, the Fund realizes a loss equal to the
premium paid. If a Fund enters into a closing sale transaction on an option
purchased by it, the Fund will realize a gain if the premium received by the
Fund on the closing transaction is more than the premium paid to purchase the
option, or a loss if it is less. If an option written by a Fund expires on the
stipulated expiration date or if a Fund enters into a closing purchase
transaction, it will realize a gain (or loss if the cost of a closing purchase
transaction exceeds the net premium received when the option is sold) and the
deferred credit related to such option will be eliminated. If an option written
by a Fund is exercised, the proceeds of the sale will be increased by the net
premium originally received and the Fund will realize a gain or loss.
There are several risks associated with transactions in options. For
example, there are significant differences between the securities, currency and
options markets that could result in an imperfect correlation between these
markets, causing a given transaction not to achieve its objectives. In
addition, a liquid secondary market for particular options, whether traded over-
the-counter or on an exchange 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 options or underlying
securities or currencies; unusual or unforeseen circumstances may interrupt
normal operations on an exchange; the facilities of an exchange or the Options
Clearing Corporation may not at all times be adequate to handle current trading
value; 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 the Options Clearing
Corporation as a result of trades on that exchange would continue to be
exercisable in accordance with their terms.
FUTURES CONTRACTS AND RELATED OPTIONS. The Funds (other than the Money
Market Funds) may purchase and sell futures contracts and may purchase and sell
call and put options on futures contracts for hedging purposes, for speculative
purposes (to seek to increase total return), or for liquidity management
purposes. When used as a hedge, a Fund may sell a futures contract in order to
offset a decrease in the market value of its portfolio securities that might
otherwise result from a market decline or currency exchange fluctuations. A
Fund may do so either to hedge the value of its portfolio of securities as
whole, or to protect against declines, occurring prior to sales of securities,
in the value of the securities to be sold. Conversely, a Fund may purchase a
futures contract as a hedge in anticipation of purchases of securities. In
addition, a Fund may utilize futures contracts in anticipation of changes in the
composition of its portfolio holdings. For a detailed description of futures
contracts and related options, see Appendix B to this Additional Statement.
Participation in foreign futures and foreign options transactions involves
the execution and clearing of trades on or subject to the rules of a foreign
board of trade. Neither the National Futures Association nor any domestic
exchange regulates activities of any foreign boards of trade, including the
execution, delivery and clearing of transactions, or has the power to compel
enforcement of the rules of a foreign board of trade or any applicable foreign
law. This is true even if the exchange is formally linked to a domestic market
so that a position taken on the market may be liquidated by a transaction on
another market. Moreover, such laws or regulations will vary depending on the
foreign country in which the foreign futures or foreign options transaction
occurs. For these reasons, persons who trade foreign futures or foreign options
contracts may not be afforded certain of the protective measures provided by the
Commodity Exchange Act, the Commodity Futures Trading Commission's ("CFTC")
regulations and the rules of the National Futures Association and any domestic
exchange, including the right to use reparations proceedings before the CFTC and
arbitration proceedings provided them by the National Futures Association or any
domestic futures exchange. In particular, a Fund's investments in foreign
futures or foreign options transactions may not be provided the same protections
in respect of transactions on United States futures exchanges. In addition, the
price of any foreign futures or foreign options contract and, therefore, the
potential profit and loss thereon may be affected by any variance in the foreign
exchange rate between the time an order is placed and the time it is liquidated,
offset or exercised. For a detailed description of futures contracts and
related options, see Appendix B to this Additional Statement.
In connection with a Fund's position in a futures contract or related
option, the Fund will segregate liquid assets or will otherwise cover its
position in accordance with applicable SEC requirements.
Northern Funds intends to comply with the regulations of the Commodity
Futures Trading Commission exempting the Funds from registration as a "commodity
pool operator."
REAL ESTATE INVESTMENT TRUSTS. The High Yield Fixed Income Fund, Income
Equity Fund, Small Cap Index Fund, Small Cap Fund and Small Cap Growth Fund may
invest in equity real estate investment trusts ("REITs"). REITs pool investors'
funds for investment primarily in commercial real estate properties.
Investments in REITs may subject the Fund to certain risks. REITs may be
affected by changes in the value of the underlying property owned by the trusts.
REITs are dependent upon specialized management skill, may not be diversified
and are subject to the risks of financing projects. REITs are also subject to
heavy cash flow dependency, defaults by borrowers, self liquidation and the
possibility of failing to qualify for the beneficial tax treatment available to
REITs under the Internal Revenue Code of 1986, as amended, and to maintain
exemption from the 1940 Act. As a shareholder in a REIT, the Fund would bear,
along with other shareholders, its pro rata portion of the REIT's operating
expenses. These expenses would be in addition to the advisory and other
expenses the Fund bears directly in connection with its own operations.
SECURITIES LENDING. Collateral for loans of portfolio securities made by a
Fund may consist of cash, cash equivalents, securities issued or guaranteed by
the U.S. Government or its agencies or (except for the U.S. Government Money
Market Fund, U.S. Government Select Money Market Fund, U.S. Government Fund and
Short-Intermediate U.S. Government Fund) irrevocable bank letters of credit (or
any combination thereof). The borrower of securities will be required to
maintain the market value of the collateral at not less than the market value of
the loaned securities, and such value will be monitored on a daily basis. When
a Fund lends its securities, it continues to receive dividends and interest on
the securities loaned and may simultaneously earn interest on the investment of
the cash collateral. Although voting rights, or rights to consent, attendant to
securities on loan pass to the borrower, such loans will be called so that the
securities may be voted by a Fund if a material event affecting the investment
is to occur.
INTEREST RATE SWAPS, FLOORS AND CAPS AND CURRENCY SWAPS. The U.S.
Government, Short-Intermediate U.S. Government, Intermediate Tax-Exempt,
California Intermediate Tax-Exempt, Florida Intermediate Tax-Exempt, Fixed
Income, Tax-Exempt, Arizona Tax-Exempt, California Tax-Exempt, International
Fixed Income, High Yield Municipal, High Yield Fixed Income and Income Equity
Funds may enter into interest rate swaps for hedging purposes and not for
speculation. The U.S. Government, Short-Intermediate U.S. Government, Fixed
Income, International Fixed Income, High Yield Municipal and High Yield Fixed
Income Funds may also purchase interest rate floors or caps for hedging purposes
and not for speculation. A Fund will typically use interest rate swaps to
preserve a return on a particular investment or portion of its portfolio or to
shorten the effective duration of its portfolio investments. Interest rate
swaps involve the exchange by a Fund with another party of their respective
commitments to pay or receive interest, such as an exchange of fixed rate
payments for floating rate payments. The purchase of an interest rate floor or
cap entitles the purchaser to receive payments of interest on a notional
principal amount from the seller, to the extent the specified index falls below
(floor) or exceeds (cap) a predetermined interest rate. The International Funds
and the High Yield Fixed Income Fund may also enter into currency swaps, which
involve the exchange of the rights of a Fund and another party to make or
receive payments in specific currencies.
A Fund will only enter into interest rate swaps or interest rate floor or
cap transactions on a net basis, i.e. the two payment streams are netted out,
----
with a Fund receiving or paying, as the case may be, only the net amount of the
two payments. In contrast, currency swaps usually involve the delivery of the
entire principal value of one designated currency in exchange for the other
designated currency. Inasmuch as these transactions are entered into for good
faith hedging purposes, the Funds and the Investment Advisers believe that such
obligations do not constitute senior securities as defined in the 1940 Act and,
accordingly, will not treat them as being subject to the Funds' borrowing
restrictions.
The net amount of the excess, if any, of the Funds' obligations over their
entitlements with respect to each interest rate or currency swap will be accrued
on a daily basis, and an amount of liquid assets having an aggregate net asset
value at least equal to such accrued excess, will be segregated by the Funds.
Except for the High Yield Fixed Income Fund (which is not subject to any
minimum rating criteria), a Fund will not enter into a currency or interest rate
swap or interest rate floor or cap transaction unless the unsecured commercial
paper, senior debt or the claims-paying ability of the other party thereto is
rated either A or A-1 or better by S&P, Duff or Fitch IBCA, or A or P-1 or
better by Moody's. If there is a default by the other party to such
transaction, a Fund will have contractual remedies pursuant to the agreements
related to the transaction. The swap market has grown substantially in recent
years with a large number of banks and investment banking firms acting both as
principals and as agents utilizing standardized swap documentation. As a
result, the swap market has become relatively liquid in comparison with markets
for other similar instruments which are traded in the Interbank market.
EQUITY SWAPS. Each Equity Fund may enter into equity swap contracts to
invest in a market without owning or taking physical custody of securities in
circumstances in which direct investment is restricted for legal reasons or is
otherwise impracticable. Equity swaps may also be used for hedging purposes or
to seek to increase total return. The counterparty to an equity swap contract
will typically be a bank, investment banking firm or broker/dealer. Equity swap
contracts may be structured in different ways. For example, a counterparty may
agree to pay the Fund the amount, if any, by which the notional amount of the
equity swap contract would have increased in value had it been invested in
particular stocks (or an index of stocks), plus the dividends that would have
been received on those stocks. In these cases, the Fund may agree to pay to the
counterparty the amount, if any, by which that notional amount would have
decreased in value had it been invested in the stocks. Therefore, the return to
the Fund on any equity swap contract should be the gain or loss on the notional
amount plus dividends on the stocks less the interest paid by the Fund on the
notional amount. In other cases, the counterparty and the Fund may each agree
to pay the other the difference between the relative investment performances
that would have been achieved if the notional amount of the equity swap contract
had been invested in different stocks (or indices of stocks).
A Fund will enter into equity swaps only on a net basis, which means that
the two payment streams are netted out, with the Fund receiving or paying, as
the case may be, only the net amount of the two payments. Payments may be made
at the conclusion of an equity swap contract or periodically during its term.
Equity swaps do not involve the delivery of securities or other underlying
assets. Accordingly, the risk of loss with respect to equity swaps is limited
to the net amount of payments that a Fund is contractually obligated to make.
If the other party to an equity swap defaults, a Fund's risk of loss consists of
the net amount of payments that such Fund is contractually entitled to receive,
if any. Inasmuch as these transactions are entered into for hedging purposes or
are offset by segregated cash or liquid assets to cover the Funds' potential
exposure, the Funds and their Investment Advisers believe that transactions do
not constitute senior securities under the 1940 Act and, accordingly, will not
treat them as being subject to a Fund's borrowing restrictions.
The Funds will not enter into any equity swap transactions unless the
unsecured commercial paper, senior debt or claims-paying ability of the other
party is rated either A, or A-1 or better by Standard & Poor's, Duff & Phelps or
Fitch IBCA, or A or P-1 or better by Moody's Investors Service. If there is a
default by the other party to such a transaction, a Fund will have contractual
remedies pursuant to the agreements related to the transaction.
The use of equity swaps is a highly specialized activity which involves
investment techniques and risks different from those associated with ordinary
portfolio securities transactions. If the Investment Advisers are incorrect in
their forecasts of market values, the investment performance of a Fund would be
less favorable than it would have been if this investment technique were not
used.
CONVERTIBLE SECURITIES. Convertible securities entitle the holder to
receive interest paid or accrued on debt or the dividend paid on preferred stock
until the convertible securities mature or are redeemed, converted or exchanged.
Prior to conversion, convertible securities have characteristics similar to
ordinary debt securities in that they normally provide a stable stream of income
with generally higher yields than those of common stock of the same or similar
issuers. Convertible securities rank senior to common stock in a corporation's
capital structure and therefore generally entail less risk than the
corporation's common stock, although the extent to which such risk is reduced
depends in large measure upon the degree to which the convertible security sells
above its value as a fixed income security.
In selecting convertible securities, the Investment Advisers will consider,
among other factors: an evaluation of the creditworthiness of the issuers of
the securities; the interest or dividend income generated by the securities; the
potential for capital appreciation of the securities and the underlying common
stocks; the prices of the securities relative to other comparable securities and
to the underlying common stocks; whether the securities are entitled to the
benefits of sinking funds or other protective conditions; diversification of a
Fund's portfolio as to issuers; and whether the securities are rated by a rating
agency and, if so, the ratings assigned.
The value of convertible securities is a function of their investment value
(determined by yield in comparison with the yields of other securities of
comparable maturity and quality that do not have a conversion privilege) and
their conversion value (their worth, at market value, if converted into the
underlying common stock). The investment value of convertible securities is
influenced by changes in interest rates, with investment value declining as
interest rates increase and increasing as interest rates decline, and by the
credit standing of the issuer and other factors. The conversion value of
convertible securities 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 securities is governed principally by their
investment value. To the extent the market price of the underlying common stock
approaches or exceeds the conversion price, the price of the convertible
securities will be increasingly influenced by their conversion value. In
addition, convertible securities generally sell at a premium over their
conversion value determined by the extent to which investors place value on the
right to acquire the underlying common stock while holding fixed income
securities.
Capital appreciation for a Fund may result from an improvement in the
credit standing of an issuer whose securities are held in the Fund or from a
general lowering of interest rates, or a combination of both. Conversely, a
reduction in the credit standing of an issuer whose securities are held by a
Fund or a general increase in interest rates may be expected to result in
capital depreciation to the Fund.
In general, investments in lower quality convertible securities are subject
to a significant risk of a change in the credit rating or financial condition of
the issuing entity. Investments in convertible securities of medium or lower
quality are also likely to be subject to greater market fluctuation and to
greater risk of loss of income and principal due to default than investments of
higher quality fixed-income securities. Such lower quality securities generally
tend to reflect short-term corporate and market developments to a greater extent
than higher quality securities, which react more to fluctuations in the general
level of interest rates. A Fund will generally reduce risk to the investor by
diversification, credit analysis and attention to current developments in trends
of both the economy and financial markets. However, while diversification
reduces the effect on a Fund of any single investment, it does not reduce the
overall risk of investing in lower quality securities.
RISKS RELATED TO SMALL COMPANY SECURITIES. While the Investment Advisers
believe that smaller companies can provide greater growth potential than larger,
more mature firms, investing in the securities of such companies also involves
greater risk, portfolio price volatility and cost. Historically, small
capitalization stocks, which will be the Small Cap Index, Small Cap and Small
Cap Growth Funds' primary investments, and stocks of recently organized
companies, in which the Small Cap Index, Small Cap and Small Cap Growth Funds
may also invest, have been more volatile in price than the larger capitalization
stocks included in the S&P 500 Index. Among the reasons for this greater price
volatility are the lower degree of market liquidity (the securities of companies
with small stock market capitalizations may trade less frequently and in limited
volume) and the greater sensitivity of small companies to changing economic
conditions. For example, these companies are associated with higher investment
risk due to the greater business risks of small size and limited product lines,
markets, distribution channels and financial and managerial resources.
The values of small company stocks will frequently fluctuate independently
of the values of larger company stocks. Small company stocks may decline in
price as large company stock prices rise, or rise in price as large company
stock prices decline. You should, therefore, expect that the net asset value of
the Fund's shares will be more volatile than, and may fluctuate independently
of, broad stock market indices such as the S&P 500 Index.
The additional costs associated with the acquisition of small company
stocks include brokerage costs, market impact costs (that is, the increase in
market prices which may result when a Fund purchases thinly traded stock) and
the effect of the "bid-ask" spread in small company stocks. These costs will be
borne by all shareholders and may negatively impact investment performance.
RISKS RELATED TO MEDIUM AND LOWER QUALITY SECURITIES. Investments in
medium and lower quality securities present special risk considerations. Medium
quality securities, although considered investment grade, are also considered to
have speculative characteristics. Lower quality securities are considered
predominately speculative by traditional investment standards. In some cases,
these obligations may be highly speculative and have poor prospects for reaching
investment grade standard. While any investment carries some risk, certain
risks associated with lower quality securities are different from those for
investment-grade securities. The risk of loss through default is greater because
lower quality securities are usually unsecured and are often subordinate to an
issuer's other obligations. Additionally, the issuers of these securities
frequently have high debt levels and are thus more sensitive to difficult
economic conditions, individual corporate developments and rising interest
rates. Consequently, the market price of these securities may be quite volatile
and may result in wider fluctuations of a Fund's net asset value per share.
There remains some uncertainty about the performance level of the market
for lower quality securities under adverse market and economic environments. An
economic downturn or increase in interest rates could have a negative impact on
both the markets for lower quality securities (resulting in a greater number of
bond defaults) and the value of lower quality securities held in a portfolio of
investments.
The economy and interest rates can affect lower quality securities
differently than other securities. For example, the prices of lower quality
securities are more sensitive to adverse economic changes or individual
corporate developments than are the prices of higher quality investments. In
addition, during an economic downturn or period in which interest rates are
rising significantly, highly leveraged issuers may experience financial
difficulties, which, in turn, would adversely affect their ability to service
their principal and interest payment obligations, meet projected business goals
and obtain additional financing.
The market value of lower quality securities tends to reflect individual
corporate developments to a greater extent than that of higher quality
securities which react primarily to fluctuations in the general level of
interest rates. Lower quality securities are often issued in connection with a
corporate reorganization or restructuring or as a part of a merger, acquisition,
takeover or similar event. They are also issued by less established companies
seeking to expand. Such issuers are often highly leveraged, may not have
available to them more traditional methods of financing and are generally less
able than more established or less leveraged entities to make scheduled payments
of principal and interest in the event of adverse economic developments or
business conditions.
A holder's risk of loss from default is significantly greater for lower
quality securities than is the case for holders of other debt securities because
such securities are generally unsecured and are often subordinated to the rights
of other creditors of the issuers of such securities. Investment by a Fund in
defaulted securities poses additional risk of loss should nonpayment of
principal and interest continue in respect of such securities. Even if such
securities are held to maturity, recovery by a Fund of its initial investment
and any anticipated income or appreciation will be uncertain. A Fund may also
incur additional expenses in seeking recovery on defaulted securities. If an
issuer of a security defaults, a Fund may incur additional expenses to seek
recovery. In addition, periods of economic uncertainty would likely result in
increased volatility for the market prices of lower quality securities as well
as a Fund's net asset value. In general, both the prices and yields of lower
quality securities will fluctuate.
The secondary market for lower quality securities is concentrated in
relatively few market makers and is dominated by institutional investors,
including mutual funds, insurance companies and other financial institutions.
Accordingly, the secondary market for such securities is not as liquid as, and
is more volatile than, the secondary market for higher quality securities. In
addition, market trading volume for high yield fixed income securities is
generally lower and the secondary market for such securities could contract
under adverse market or economic conditions, independent of any specific adverse
changes in the condition of a particular issuer. These factors may have an
adverse effect on the market price and a Fund's ability to dispose of particular
portfolio investments. A less developed secondary market may also make it more
difficult for a Fund to obtain precise valuations of the high yield securities
in its portfolio.
Adverse publicity and investor perceptions, whether or not based on
fundamental analysis, may decrease the value and liquidity of lower quality
convertible securities held by a Fund, especially in a thinly traded market.
Illiquid or restricted securities held by a Fund may involve special
registration responsibilities, liabilities and costs, and could involve other
liquidity and valuation difficulties.
The credit ratings assigned by a rating agency evaluate the safety of a
rated security's principal and interest payments, but do not address market
value risk and, therefore, may not fully reflect the true risks of an
investment. Because the ratings of the rating agencies may not always reflect
current conditions and events, in addition to using recognized rating agencies
and other sources, the Investment Adviser performs its own analysis of the
issuers whose lower quality securities a Fund holds. Because of this, a Fund's
performance may depend more on its Investment Adviser's credit analysis than is
the case of mutual funds investing in higher quality securities.
INVESTMENT COMPANIES. With respect to the investments of the Funds in the
securities of other investment companies, such investments will be limited so
that, as determined after a purchase is made, either (a) not more than 3% of the
total outstanding stock of such investment company will be owned by a Fund, the
Trust as a whole and their affiliated persons (as defined in the 1940 Act) or
(b) (i) not more than 5% of the value of the total assets of a Fund will be
invested in the securities of any one investment company; (ii) not more than 10%
of the value of its total assets will be invested in the aggregate in securities
of investment companies as a group; and (iii) not more than 3% of the
outstanding voting stock of any one investment company will be owned by the
Fund.
Certain investment companies whose securities are purchased by the Funds
may not be obligated to redeem such securities in an amount exceeding 1% of the
investment company's total outstanding securities during any period of less than
30 days. Therefore, such securities that exceed this amount may be illiquid.
If required by the 1940 Act, each Fund expects to vote the shares of other
investment companies that are held by it in the same proportion as the vote of
all other holders of such securities.
A Fund may invest substantially all of its assets in a single open-end
investment company or series thereof with substantially the same investment
objective, policy and restrictions as the Fund. However, each Fund currently
intends to limit its investments in securities issued by other investment
companies to the extent described above. A Fund may adhere to more restrictive
limitations with respect to its investments in securities issued by other
investment companies if required by the SEC or deemed to be in the best
interests of the Trust.
YIELDS AND RATINGS. The yields on certain obligations, including the money
market instruments in which the Funds invest, are dependent on a variety of
factors, including general economic conditions, conditions in the particular
market for the obligation, financial condition of the issuer, size of the
offering, maturity of the obligation and ratings of the issue. The ratings of
Standard & Poor's, Moody's, Duff, Fitch IBCA and Thomson BankWatch, Inc.
represent their respective opinions as to the quality of the obligations they
undertake to rate. Ratings, however, are general and are not absolute standards
of quality. Consequently, obligations with the same rating, maturity and
interest rate may have different market prices. For a more complete discussion
of ratings, see Appendix A to this Additional Statement.
Subject to the limitations stated in the Prospectus, if a security held by
a Fund undergoes a rating revision, the Fund may continue to hold the security
if the Investment Advisers determine such retention is warranted.
STOCK INDICES. The Standard & Poor's 500R Composite Stock Price Index (the
"S&P 500 Index") is a market value-weighted index consisting of 500 common
stocks which are traded on the New York Stock Exchange, American Stock Exchange
and the Nasdaq National Market System and selected by Standard & Poor's
Corporation ("Standard & Poor's") through a detailed screening process starting
on a macro-economic level and working toward a micro-economic level dealing with
company-specific information such as market value, industry group
classification, capitalization and trading activity. Standard & Poor's primary
objective for the S&P 500 Index is to be the performance benchmark for the U.S.
equity markets. The companies chosen for inclusion in the S&P 500 Index tend to
be leaders in important industries within the U.S. economy. However, companies
are not selected by Standard & Poor's for inclusion because they are expected to
have superior stock price performance relative to the market in general or other
stocks in particular. Standard & Poor's makes no representation or warranty,
implied or express, to purchasers of Stock Index Fund shares or any member of
the public regarding the advisability of investing in the Fund or the ability of
the S&P 500 Index to track general stock market performance.
The Standard & Poor's MidCap 400 Stock Index ("S&P MidCap 400 Index") is a
market-weighted index composed of 400 common stocks chosen by Standard & Poor's
for market size, liquidity and industry group representation. The purpose of
the S&P MidCap 400 Index is to represent the performance of the medium-
capitalization sector of the U.S. securities market. Medium capitalized stocks
which are included in the S&P 500 Index are excluded from the S&P MidCap 400
Index. Except for a limited number of Canadian securities, the S&P MidCap 400
does not include foreign securities. As of November 30, 1999, the approximate
market capitalization range of the companies included in the S&P MidCap 400
Index was between $195 million and $23.4 billion.
The Russell 2000 Index is a market value-weighted index composed of the
stocks of the smallest 2000 companies in the Russell 3000 Index, which is
composed of the stocks of 3000 large U.S. domiciled companies (based on market
capitalization) that represent approximately 98% of the investable U.S. equity
markets. Because of its emphasis on the smallest 2000 companies, the Russell
2000 Index represents approximately 10% of the total market capitalization of
the Russell 3000 Index. As of November 30, 1999, the average market
capitalization of the companies included in the Russell 2000 Index was
approximately $570 million. The Russell 2000 Index is reconstituted annually to
reflect changes in market capitalization. The primary criteria used by Frank
Russell & Company ("Russell") to determine the initial list of securities
eligible for inclusion in the Russell 3000 Index (and accordingly, the Russell
2000 Index) is total market capitalization adjusted for large private holdings
and cross-ownership. However, companies are not selected by Russell for
inclusion in the Russell 2000 Index because they are expected to have superior
stock price performance relative to the market in general or other stocks in
particular. Russell makes no representation or warranty, implied or express, to
purchasers of Small Cap Index or Small Cap Growth Fund shares or any member of
the public regarding the advisability of investing in the Fund or the ability of
the Russell 2000 Index to track general market performance of small
capitalization stocks.
RELATIVE VALUE APPROACH. In buying and selling securities for the Fixed
Income Funds, the investment management team uses a relative value approach.
This approach involves an analysis of economic and market information, including
economic growth rates, interest and inflation rates, deficit levels, the shape
of the yield curve, sector and quality spreads and risk premiums. It also
involves the use of proprietary valuation models to analyze and compare expected
returns and assumed risks. Under the relative value approach, the investment
management team will emphasize particular securities and particular types of
securities that the team believes will provide a favorable return in light of
these risks.
TRACKING VARIANCE. As discussed in the Prospectus, the Stock Index and
Small Cap Index Funds are subject to the risk of tracking variance. Tracking
variance may result from share purchases and redemptions, transaction costs,
expenses and other factors. Share purchases and redemptions may necessitate the
purchase and sale of securities by a Fund and the resulting transaction costs
which may be substantial because of the number and the characteristics of the
securities held. In addition, transaction costs are incurred because sales of
securities received in connection with spin-offs and other corporate
organizations are made to conform a Fund's holdings with its investment
objective. Tracking variance may also occur due to factors such as the size of
a Fund, the maintenance of a cash reserve pending investment or to meet expected
redemptions, changes made in the Fund's designated Index or the manner in which
the Index is calculated or because the indexing and investment approach of the
Investment Adviser does not produce the intended goal of the Fund. Tracking
variance is monitored by the Investment Adviser at least quarterly. In the
event the performance of a Fund is not comparable to the performance of its
designated Index, the Board of Trustees will evaluate the reasons for the
deviation and the availability of corrective measures. If substantial deviation
in a Fund's performance were to continue for extended periods, it is expected
that the Board of Trustees would consider recommending to shareholders possible
changes to the Fund's investment objective.
CALCULATION OF PORTFOLIO TURNOVER RATE. The portfolio turnover rate for
the Funds is calculated by dividing the lesser of purchases or sales of
portfolio investments for the reporting period by the monthly average value of
the portfolio investments owned during the reporting period. The calculation
excludes all securities, including options, whose maturities or expiration dates
at the time of acquisition are one year or less. Portfolio turnover may vary
greatly from year to year as well as within a particular year, and may be
affected by, changes in the holdings of specific issuers, changes in country and
currency weightings, cash requirements for redemption of shares and by
requirements which enable the Funds to receive favorable tax treatment. For the
fiscal year ended March 31, 1999, the turnover rates with respect to the U.S.
Government, Intermediate Tax-Exempt, Florida Intermediate Tax-Exempt, Fixed
Income, Tax-Exempt, California Tax-Exempt Fund, International Fixed Income, High
Yield Municipal, High Yield Fixed Income, Income Equity, Stock Index, Growth
Equity, Select Equity, Mid Cap Growth, Small Cap, International Growth Equity,
International Select Equity and Technology Funds were 123.75%, 54.03%, 57.98%,
84.85%, 140.39%, 62.55%, 16.49%, 0.00%, 0.00%, 79.95%, 2.46%, 49.67%, 87.73%,
173.39%, 18.74%, 177.89%, 168.19% and 61.01%, respectively. The Tax-Exempt
Money Market Fund, Short-Intermediate U.S. Government Fund, California
Intermediate Tax-Exempt Fund, Arizona Tax-Exempt Fund, MarketCommand Fund, Small
Cap Index Fund and Small Cap Growth Fund had not commenced operations during the
fiscal year ended March 31, 1999. The Funds are not restricted by policy with
regard to portfolio turnover and will make changes in their investment portfolio
from time to time as business and economic conditions as well as market prices
may dictate.
MISCELLANEOUS. Securities may be purchased on margin only to obtain such
short-term credits as are necessary for the clearance of purchases and sales of
securities. The Funds will not engage in selling securities short. The Funds
may, however, make short sales against the box although the Funds have no
current intention to do so in the coming year. "Selling short against the box"
involves selling a security that a Fund owns for delivery at a specified date in
the future.
SPECIAL RISK FACTORS AND CONSIDERATIONS RELATING TO CALIFORNIA MUNICIPAL
INSTRUMENTS, FLORIDA MUNICIPAL INSTRUMENTS AND ARIZONA MUNICIPAL INSTRUMENTS
Some of the risk factors relating to investments by the California, Florida
Intermediate Tax-Exempt and Arizona Tax-Exempt Funds in California, Florida, and
Arizona municipal instruments are summarized below. This summary does not
purport to be a comprehensive description of all relevant factors. Although the
Trust has no reason to believe that the information summarized herein is not
correct in all material respects, this information has not been independently
verified for accuracy or thoroughness by the Trust. Rather, the information
presented herein with respect to California municipal instruments was culled
from official statements and prospectuses issued in connection with various
securities offerings of the State of California and local agencies in California
available as of the date of this Statement of Additional Information and, with
respect to the Florida Intermediate Tax-Exempt and Arizona Tax-Exempt Funds, the
information is derived principally from official statements relating to issues
of Florida and Arizona municipal instruments released prior to the date of this
Additional Statement. Further, any estimates and projections presented herein
should not be construed as statements of fact. They are based upon assumptions
which may be affected by numerous factors and there can be no assurance that
target levels will be achieved.
CALIFORNIA MUNICIPAL INSTRUMENTS
General
The financial condition of the State of California ("California"), its
public authorities and local governments could affect the market values and
marketability of, and therefore the net asset value per unit and the interest
income of, the California Funds, or result in the default of existing
obligations, including obligations which may be held by the California Funds.
It should be noted that the creditworthiness of obligations issued by local
issuers may be unrelated to the creditworthiness of California, and that there
is no obligation on the part of California to make payment on such local
obligations in the event of default in the absence of a specific guarantee or
pledge provided by California.
During the early 1990's, California experienced significant financial
difficulties, which reduced its credit standing, but the State's finances have
improved significantly since 1994, with ratings increases since 1996. The
ratings of certain related debt of other issuers for which California has an
outstanding lease purchase, guarantee or other contractual obligation (such as
for state-insured hospital bonds) are generally linked directly to California's
rating. Should the financial condition of California deteriorate again, its
credit ratings could be reduced, and the market value and marketability of all
outstanding notes and bonds issued by California, its public authorities or
local governments could be adversely affected.
Economic Factors
California's economy is the largest among the 50 states and one of the
largest in the world. The State's population of almost 34 million represents
over 12 percent of the total United States population and grew by 26 percent in
the 1980s, more than double the national rate. Population growth slowed to less
than 1 percent annually in 1994 and 1995, but rose to 1.8 percent in 1996 and
1.6 percent in 1997. During the early 1990's, net population growth in the
State was due to births and foreign immigration, but in recent years, in-
migration from the other states has increased.
Total personal income in the State, at an estimated $902 billion in 1998,
accounts for almost 13 percent of all personal income in the nation. Total
employment is over 15 million, the majority of which is in the service, trade
and manufacturing sectors.
From mid-1990 to late 1993, the State suffered a recession with the worst
economic, fiscal and budget conditions since the 1930s. Construction,
manufacturing (especially aerospace), and financial services, among others, were
all severely affected, particularly in Southern California. Employment levels
stabilized by late 1993 and pre-recession job levels were reached in 1996.
Unemployment, while remaining higher than the national average, has come down
from its 10 percent recession peak to under 6 percent in early 1999. Economic
indicators show a steady and strong recovery underway in California since the
start of 1994 particularly in high technology manufacturing and services,
including computer software, electronic manufacturing and motion
picture/television production, and other services, entertainment and tourism,
and both residential and commercial construction. International economic
problems starting in 1997 had some moderating impact on California's economy,
but negative impacts, such as a sharp drop in exports to Asia which have hurt
the manufacturing and agricultural sectors, have apparently been offset by
increased exports to Latin American and other nations, and a greater strength in
services, computer software and construction. Current forecasts predict
continued strong growth of the State's economy in 1999, with a slowdown in the
rate of growth predicted in 2000 and beyond. Any delay or reversal of the
recovery may create new shortfalls in State revenues.
Constitutional Limitations on Taxes, Other Charges and Appropriations
Limitation on Property Taxes. Certain California municipal instruments may
be obligations of issuers which rely in whole or in part, directly or
indirectly, on ad valorem property taxes as a source of revenue. The taxing
powers of California local governments and districts are limited by
Article XIIIA of the California Constitution, enacted by the voters in 1978 and
commonly known as "Proposition 13." Briefly, Article XIIIA limits to 1 percent
of full cash value of the rate of ad valorem property taxes on real property and
generally restricts the reassessment of property to 2 percent per year, except
under new construction or change of ownership (subject to a number of
exemptions). Taxing entities may, however, raise ad valorem taxes above the 1
percent limit to pay debt service on voter-approved bonded indebtedness.
Under Article XIIIA, the basic 1 percent ad valorem tax levy is applied
against the assessed value of property as of the owner's date of acquisition (or
as of March 1, 1975, if acquired earlier), subject to certain adjustments. This
system has resulted in widely varying amounts of tax on similarly situated
properties. Several lawsuits have been filed challenging the acquisition-based
assessment system of Proposition 13, but it was upheld by the U.S. Supreme Court
in 1992.
Article XIIIA prohibits local governments from raising revenues through ad
valorem taxes above the 1 percent limit; it also requires voters of any
governmental unit to give two-thirds approval to levy any "special tax." Court
decisions, however, allowed a non-voter approved levy of "general taxes" which
were not dedicated to a specific use.
Limitations on Other Taxes, Fees and Charges. On November 5, 1996, the
voters of the State approved Proposition 218, called the "Right to Vote on Taxes
Act." Proposition 218 added Articles XIIIC and XIIID to the State Constitution,
which contain a number of provisions affecting the ability of local agencies to
levy and collect both existing and future taxes, assessments, fees and charges.
Article XIIIC requires that all new or increased local taxes be submitted
to the electorate before they become effective. Taxes for general governmental
purposes require a majority vote and taxes for specific purposes require a two-
thirds vote. Further, any general purpose tax which was imposed, extended or
increased without voter approval after December 31, 1994 must be approved by a
majority vote within two years.
Article XIIID contains several new provisions making it generally more
difficult for local agencies to levy and maintain "assessments" for municipal
services and programs. Article XIIID also contains several new provisions
affecting "fees" and "charges," defined for purposes of Article XIIID to mean
"any levy other than an ad valorem tax, a special tax, or an assessment, imposed
by a [local government] upon a parcel or upon a person as an incident of
property ownership, including a user fee or charge for a property related
service." All new and existing property related fees and charges must conform to
requirements prohibiting, among other things, fees and charges which generate
revenues exceeding the funds required to provide the property related service or
are used for unrelated purposes. There are new notice, hearing and protest
procedures for levying or increasing property related fees and charges, and,
except for fees or charges for sewer, water and refuse collection services (or
fees for electrical and gas service, which are not treated as "property related"
for purposes of Article XIIID), no property related fee or charge may be imposed
or increased without majority approval by the property owners subject to the fee
or charge or, at the option of the local agency, two-thirds voter approval by
the electorate residing in the affected area.
In addition to the provisions described above, Article XIIIC removes
limitations on the initiative power in matters of local taxes, assessments, fees
and charges. Consequently, local voters could, by future initiative, repeal,
reduce or prohibit the future imposition or increase of any local tax,
assessment, fee or charge. It is unclear how this right of local initiative may
be used in cases where taxes or charges have been or will be specifically
pledged to secure debt issues.
The interpretation and application of Proposition 218 will ultimately be
determined by the courts with respect to a number of matters, and it is not
possible at this time to predict with certainty the outcome of such
determinations. Proposition 218 is generally viewed as restricting the fiscal
flexibility of local governments, and for this reason, some ratings of
California cities and counties have been, and others may be, reduced.
Appropriations Limits. The State and its local governments are subject to
an annual "appropriations limit" imposed by Article XIIIB of the California
Constitution, enacted by the voters in 1979 and significantly amended by
Propositions 98 and 111 in 1988 and 1990, respectively. Article XIIIB prohibits
the State or any covered local government from spending "appropriations subject
to limitation" in excess of the appropriations limit imposed. "Appropriations
subject to limitation" are authorizations to spend "proceeds of taxes," which
consist of tax revenues and certain other funds, including proceeds from
regulatory licenses, user charges or other fees, to the extent that such
proceeds exceed the cost of providing the product or service, but "proceeds of
taxes" exclude most State subventions to local governments. No limit is imposed
on appropriations of funds which are not "proceeds of taxes," such as reasonable
user charges or fees, and certain other non-tax funds, including bond proceeds.
Among the expenditures not included in the Article XIIIB appropriations
limit are (1) the debt service cost of bonds issued or authorized prior to
January 1, 1979, or subsequently authorized by the voters, (2) appropriations
arising from certain emergencies declared by the Governor, (3) appropriations
for certain capital outlay projects, (4) appropriations by the State of post-
1989 increases in gasoline taxes and vehicle weight fees, and (5) appropriations
made in certain cases of emergency.
The appropriations limit for each year is adjusted annually to reflect
changes in cost of living and population, and any transfers of service
responsibilities between government units. The definitions for such adjustments
were liberalized in 1990 to follow more closely growth in the State's economy.
"Excess" revenues are measured over a two year cycle. Local governments
must return any excess to taxpayers by rate reductions. The State must refund
50 percent of any excess, with the other 50 percent paid to schools and
community colleges. With more liberal annual adjustment factors since 1988, and
depressed revenues since 1990 because of the recession, few governments are
currently operating near their spending limits, but this condition may change
over time. Local governments may by voter approval exceed their spending limits
for up to four years. During fiscal year 1986-87, State receipts from proceeds
of taxes exceeded its appropriations limit by $1.1 billion, which was returned
to taxpayers. Since that year, appropriations subject to limitation have been
under the State limit. State appropriations were $6.8 billion under the limit
for fiscal year 1998-99.
Because of the complex nature of Articles XIIIA, XIIIB, XIIIC and XIIID of
the California Constitution, the ambiguities and possible inconsistencies in
their terms, and the impossibility of predicting future appropriations or
changes in population and cost of living, and the probability of continuing
legal challenges, it is not currently possible to determine fully the impact of
these Articles on California municipal instruments or on the ability of the
State or local governments to pay debt service on such California municipal
instruments. It is not possible, at the present time, to predict the outcome of
any pending litigation with respect to the ultimate scope, impact or
constitutionality of these Articles or the impact of any such determinations
upon State agencies or local governments, or upon their ability to pay debt
service on their obligations. Further initiatives or legislative changes in laws
or the California Constitution may also affect the ability of the State or local
issuers to repay their obligations.
Obligations of the State of California
Under the California Constitution, debt service on outstanding general
obligation bonds is the second charge to the General Fund after support of the
public school system and public institutions of higher education. As of May 1,
1999, the State had outstanding approximately $19.7 billion of long-term general
obligation bonds, plus $246 million of general obligation commercial paper which
will be refunded by long-term bonds in the future, and $6.6 billion of lease-
purchase debt supported by the State General Fund. The State also had about
$15.3 billion of authorized and unissued long-term general obligation bonds and
lease-purchase debt. In FY 1997-98, debt service on general obligation bonds
and lease purchase debt was approximately 4.4 percent of General Fund revenues.
Recent Financial Results
The principal sources of General Fund revenues in 1997-1998 were the
California personal income tax (51 percent of total revenues), the sales tax (32
percent), bank and corporation taxes (11 percent), and the gross premium tax on
insurance (2 percent). The State maintains a Special Fund for Economic
Uncertainties (the "SFEU"), derived from General Fund revenues, as a reserve to
meet cash needs of the General Fund, but which is required to be replenished as
soon as sufficient revenues are available. Year-end balances in the SFEU are
included for financial reporting purposes in the General Fund balance. Because
of the recession and an accumulated budget deficit, no reserve was budgeted in
the SFEU from 1992-93 to 1995-96.
Throughout the 1980's, State spending increased rapidly as the State
population and economy also grew rapidly, including increased spending for many
assistance programs to local governments, which were constrained by Proposition
13 and other laws. The largest State program is assistance to local public
school districts. In 1988, an initiative (Proposition 98) was enacted which
(subject to suspension by a two-thirds vote of the Legislature and the Governor)
guarantees local school districts and community college districts a minimum
share of State General Fund revenues (currently about 35 percent).
Recent Budgets. As a result of the severe economic recession from
1990-94 and other factors, during this period the State experienced substantial
revenue shortfalls, and greater than anticipated social service costs. The
State accumulated and sustained a budget deficit in the budget reserve, the
SFEU, approaching $2.8 billion at its peak at June 30, 1993. The Legislature
and Governor responded to these deficits by enacting a series of fiscal steps
between FY1991-92 and FY1994-95, including significant cuts in health and
welfare and other program expenditures, tax increases, transfers of program
responsibilities and some funding sources from the State to local governments,
and transfer of about $3.6 billion in annual local property tax revenues
primarily from cities and counties to local school districts, thereby reducing
State funding for schools.
A consequence of the accumulated budget deficits in the early 1990's,
together with other factors such as disbursement of funds to local school
districts "borrowed" from future fiscal years and hence not shown in the annual
budget, was to significantly reduce the State's cash resources available to pay
its ongoing obligations. The State's cash condition became so serious that from
late spring 1992 until 1995, the State had to rely on issuance of short term
notes which matured in a subsequent fiscal year to finance its ongoing deficit,
and pay current obligations. The last of these deficit notes was repaid in
April, 1996.
The State's financial condition improved markedly in the years from FY1995-
96 onward, with a combination of better than expected revenues, slowdown in
growth of social welfare programs, and continued spending restraint based on the
actions taken in earlier years. The State's cash position also improved, and no
external deficit borrowing has occurred over the fiscal year since FY 1994-95.
The economy grew strongly during these fiscal years, and as a result, the
General Fund took in substantially greater tax revenues (around $2.2 billion in
1995-96, $1.6 billion in 1996-97, $2.1 billion in 1997-98, and $1.0 billion in
1998-99) than were initially planned when the budgets were enacted. These
additional funds were largely directed to school spending as mandated by
Proposition 98, and to make up shortfalls from reduced federal health and
welfare aid in 1995-96 and 1996-97. The accumulated budget deficit from the
recession years was finally eliminated. The Department of Finance estimates
that the State's budget reserve (the SFEU) totaled about $1.8 billion at June
30, 1998 and $1.9 billion at June 30, 1999.
The growth in General Fund revenues since the end of the recession resulted
in significant increases in State funding for local school districts under
Proposition 98. From the recession level of about $4,300 per pupil, annual
State funding has increased to over $6,000 per pupil in FY 1999-2000. A
significant amount of the new moneys have been directed to specific educational
reforms, including reduction of class sizes in many grade levels. The improved
budget condition also allowed annual increases in support for higher education
in the State, permitting increased enrollment and reduction of student fees.
Part of the 1997-98 Budget Act was completion of State welfare reform
legislation to implement the new federal law passed in 1996. The new State
program, called "CalWORKs," became effective January 1, 1998, and emphasizes
programs to bring aid recipients into the workforce. As required by federal
law, new time limits are placed on receipt of welfare aid. Generally, health and
welfare costs have been contained even during the recent period of economic
recovery, with the first real increases (after inflation) in welfare support
levels occurring in 1999-2000.
FY 1998-99 Budget. The FY 1998-99 Budget Act was signed on August 21,
1998. After giving effect to line-item vetoes made by the Governor, the Budget
plan resulted in spending of about $57.3 billion for the General Fund and $14.7
billion for Special Funds. The Budget Act assumed General Fund revenues and
transfers in FY 1998-99 of $57.0 billion. After enactment of the Budget Act,
the Legislature passed a number of additional fiscal bills. Taking these into
account, the Administration projected in September, 1998 that the balance in the
SFEU at June 30, 1999 would be about $1.2 billion.
One of the most important elements of the 1998-99 Budget Act was agreement
on substantial tax cuts. The largest of these was a phased-in cut in the
Vehicle License Fee (an annual tax on the value of cars registered in the State,
the "VLF"). Starting on January 1, 1999, the VLF has been reduced by 25
percent. Under pre-existing law, VLF funds are automatically transferred to
cities and counties, so the new legislation provided for the General Fund to
make up the reductions. If State General Fund revenues continue to grow above
certain targeted levels in future years, the cut could reach as much as 67.5
percent by the year 2003. The initial 25 percent VLF cut will be offset by
about $500 million in General Fund money in FY 1998-99, and $1 billion annually
for future years. Other tax cuts in FY 1998-99 included an increase in the
dependent credit exemption for personal income tax filers, restoration of a
renter's tax credit for taxpayers, and a variety of business tax relief
measures. The total cost of these tax cuts was estimated at $1.4 billion for FY
1998-99.
The Administration released new projections for the balance of FY 1998-99
on May 14, 1999 as part of the May Revision of the Governor's Proposed Budget
for 1999-2000 (the "May Revision"). The May Revision revealed that the State's
economy was much stronger in late 1998 and into 1999 than the Administration had
thought when it made its first FY 1999-2000 Budget Proposal in January 1999. As
a result, the May Revision updated 1998-99 General Fund revenues to be $57.9
billion, almost $1 billion above the original FY 1998-99 estimates, and over
$1.6 billion above the Administration's January estimate. Most of the increase
is from personal income taxes, reflecting stronger wage employment than
previously estimated, and extraordinary growth in capital gain realizations
resulting from the stock market's rise. The May Revision projected the SFEU
will have a balance of almost $1.9 billion at June 30, 1999.
Although, as noted, the Administration projected a budget reserve in the
SFEU of about $1.9 billion on June 30, 1999, the General Fund balance on that
date also reflects $1.0 billion of "loans" which the General Fund made to local
schools in the recession years, representing cash outlays above the mandatory
minimum funding level. Settlement of litigation over these transactions in July
1996 calls for repayment of these loans over the period ending in 2001-02, about
equally split between outlays from the General Fund and from schools'
entitlements. The 1998-99 Budget Act contained a $300 million appropriation
from the General Fund toward this settlement.
FY 1999-2000 Budget. The newly elected Governor, Gray Davis, released his
proposed FY 1999-00 Budget in January 1999. It projected somewhat lower General
Fund revenues than in earlier projections, due to slower economic growth which
was expected in late 1998, but totaling an estimated $60.3 billion. The May
Revision has sharply increased the revenue estimates, by over $2.7 billion, to a
total of almost $63.0 billion, which would represent a 9 percent increase above
FY 1998-99. Again, the greatest increase is expected in personal income taxes
(about 10 percent year-over-year increase), with more moderate increases in
sales taxes (6 percent) and corporate taxes (3 percent).
The 1999-00 Budget Act was signed on June 29, 1999, only the second time in
the decade the budget was in place at the start of the fiscal year. After the
Governor used his line-item veto power to reduce expenditures by about $581
million, the final spending plan called for about $63.7 billion of General Fund
expenditures, $16.1 billion of Special Fund expenditures, and $1.5 billion in
bond funded expenditures. The Governor's final budget actions left the SFEU
with an estimated balance of $881 million at June 30, 2000, but the Governor
also reduced spending to set aside $300 million for future appropriation for
either employee pay raises or potential litigation costs. If not fully used,
these "set-aside" funds would increase the SFEU year-end balance.
The final Budget Act generally provided increased funding for a wide range
of programs. Education spending under Proposition 98 received the largest
increase (over $2.3 billion above 1998-99), with other significant increases for
higher education, health and welfare, natural resources and capital outlay. The
budget provides several hundred million dollars in direct new aid to cities and
counties. A proposal is being drafted to place a constitutional amendment on
the ballot in 2000 to provide more extensive, permanent fiscal relief for local
government.
The final spending plan includes several targeted tax cuts for businesses,
totaling under $100 million in 1999-00. The plan also includes a one-time, one-
year additional cut of 10 percent in the Vehicle License Fee for calendar year
2000. This cut will cost the General Fund about $500 million in each of 1999-00
and 2000-01 to make up lost funds for local governments. Under the 1998 law, the
VLF cut to 35 percent would become permanent in the year 2001 if General Fund
revenues reach a certain specified level in 2000-01.
Although the State's strong economy is producing record revenues to the
State government, the State's budget continues to be under stress from mandated
spending on education, a rising prison population, and social needs of a growing
population with many immigrants. These factors which limit State spending
growth also put pressure on local governments. There can be no assurances that,
if economic conditions weaken, or other factors intercede, the State will not
experience budget gaps in the future.
Bond Rating
The ratings on California's long-term general obligation bonds were reduced in
the early 1990's from "AAA" levels which had existed prior to the recession.
After 1996, the three major rating agencies raised their ratings of California's
general obligation bonds, which as of July 1, 1999 were assigned ratings of "A+"
from Standard & Poor's, "Aa3" from Moody's and "AA-" from Fitch IBCA.
There can be no assurance that such ratings will be maintained in the
future. It should be noted that the creditworthiness of obligations issued by
local California issuers may be unrelated to creditworthiness of obligations
issued by the State of California, and that there is no obligation on the part
of the State to make payment on such local obligations in the event of default.
Legal Proceedings
The State is involved in certain legal proceedings (described in the
State's recent financial statements) that, if decided against the State, may
require the State to make significant future expenditures or may substantially
impair revenues. Trial courts have recently entered tentative decisions or
injunctions which would overturn several parts of the State's recent budget
compromises. The matters covered by these lawsuits include reductions in
welfare payments and the use of certain cigarette tax funds for health costs.
All of these cases are subject to further proceedings and appeals, and if
California eventually loses, the final remedies may not have to be implemented
in one year.
Year 2000 Preparations
The State and local governments, along with all other public and private
institutions in the nation, face a major challenge to ensure that their computer
systems, including microchips embedded into existing machinery, will not fail
prior to or at the January 1, 2000 date which may not be recognized properly by
software utilizing only two digits to identify a year. The new State
Administration has placed a very high priority on "Year 2000" remediation and
contingency planning. The State has a Department of Information Technology
("DOIT") which coordinates activities, provides technical assistance to State
agencies and local governments, and reports on the status of remediation efforts
by over 100 State departments and agencies.
DOIT has reported that, as of early 1999, 372 of 564 "mission critical"
systems in State government had been remediated (although final testing was
still going on in some cases). Of the balance, 54 were being retired and 138
were in process. DOIT does not report on all State agencies. In addition to
hardware and software changes, agencies are preparing business contingency plans
in case of computer problems at 1/1/2000, and are actively coordinating with
outside agencies, vendors, contractors and others with whom computer data is
shared. The State Treasurer and State Controller, responsible for State fiscal
controls and debt service payments, have reported they were fully remediated by
December 31, 1998 and are spending the 1999 year in testing and confirmation of
their systems.
The State has expended and plans to spend many hundreds of millions of
dollars on Year 2000 projects of all sorts, and has set aside several tens of
millions of dollars in contingency funds to support late-coming needs. There is
no survey of local government costs, or the overall status of their activities.
It is likely that larger government agencies are better prepared at this time
than smaller ones. Both the State and local governments are preparing emergency
plans for Year 2000 computer difficulties similar to their normal planning for
natural emergencies, such as floods or earthquakes.
Obligations of Other Issuers
Other Issuers of California Municipal Instruments. There are a number of
State agencies, instrumentalities and political subdivisions of the State that
issue municipal instruments, some of which may be conduit revenue obligations
payable from payments from private borrowers. These entities are subject to
various economic risks and uncertainties, and the credit quality of the
securities issued by them may vary considerably from the credit quality of
obligations backed by the full faith and credit of the State.
State Assistance. Property tax revenues received by local governments
declined more than 50 percent following passage of Proposition 13.
Subsequently, the California Legislature enacted measures to provide for the
redistribution of the State's General Fund surplus to local agencies, the
reallocation of certain State revenues to local agencies and the assumption of
certain governmental functions by the State to assist municipal issuers to raise
revenues. Total local assistance from the State's General Fund was budgeted at
approximately 75 percent of General Fund expenditures in recent years, including
the effect of implementing reductions in certain aid programs. To reduce State
General Fund support for school districts, the 1992-93 and 1993-94 Budget Acts
caused local governments to transfer $3.9 billion of property tax revenues to
school districts, representing loss of the post-Proposition 13 "bailout" aid.
Local governments have in return received greater revenues and greater
flexibility to operate health and welfare programs. However, except for
agreement in 1997 on a new program for the State to substantially take over
funding for local trial courts (saving cities and counties some $400 million
annually), there has been no large-scale reversal of the property tax shift to
help local government.
To the extent the State should be constrained by its Article XIIIB
appropriations limit, or its obligation to conform to Proposition 98, or other
fiscal considerations, the absolute level, or the rate of growth, of State
assistance to local governments may continue to be reduced. Any such reductions
in State aid could compound the serious fiscal constraints already experienced
by many local governments, particularly counties. Los Angeles County, the
largest in the State, was forced to make significant cuts in services and
personnel, particularly in the health care system, in order to balance its
budget in FY1995-96 and FY1996-97. Orange County, which emerged from Federal
Bankruptcy Court protection in June 1996, has significantly reduced county
services and personnel, and faces strict financial conditions following large
investment fund losses in 1994 which resulted in bankruptcy.
Counties and cities may face further budgetary pressures as a result of
changes in welfare and public assistance programs, which were enacted in August,
1997 in order to comply with the federal welfare reform law. Generally,
counties play a large role in the new system, and are given substantial
flexibility to develop and administer programs to bring aid recipients into the
workforce. Counties are also given financial incentives if either at the county
or statewide level, the "Welfare-to-Work" programs exceed minimum targets;
counties are also subject to financial penalties for failure to meet such
targets. Counties remain responsible to provide "general assistance" for able-
bodied indigents who are ineligible for other welfare programs. The long-term
financial impact of the new CalWORKs system on local governments is still
unknown.
Assessment Bonds. California municipal instruments which are assessment
bonds may be adversely affected by a general decline in real estate values or a
slowdown in real estate sales activity. In many cases, such bonds are secured
by land which is undeveloped at the time of issuance but anticipated to be
developed within a few years after issuance. In the event of such reduction or
slowdown, such development may not occur or may be delayed, thereby increasing
the risk of a default on the bonds. Because the special assessments or taxes
securing these bonds are not the personal liability of the owners of the
property assessed, the lien on the property is the only security for the bonds.
Moreover, in most cases the issuer of these bonds is not required to make
payments on the bonds in the event of delinquency in the payment of assessments
or taxes, except from amounts, if any, in a reserve fund established for the
bonds.
California Long Term Lease Obligations. Based on a series of court
decisions, certain long-term lease obligations, though typically payable from
the general fund of the State or a municipality, are not considered
"indebtedness" requiring voter approval. Such leases, however, are subject to
"abatement" in the event the facility being leased is unavailable for beneficial
use and occupancy by the municipality during the term of the lease. Abatement
is not a default, and there may be no remedies available to the holders of the
certificates evidencing the lease obligation in the event abatement occurs. The
most common cases of abatement are failure to complete construction of the
facility before the end of the period during which lease payments have been
capitalized and uninsured casualty losses to the facility (e.g., due to
earthquake). In the event abatement occurs with respect to a lease obligation,
lease payments may be interrupted (if all available insurance proceeds and
reserves are exhausted) and the certificates may not be paid when due. Although
litigation is brought from time to time which challenges the constitutionality
of such lease arrangements, the California Supreme Court issued a ruling in
August, 1998 which reconfirmed the legality of these financing methods.
Other Considerations
The repayment of industrial development securities secured by real property
may be affected by California laws limiting foreclosure rights of creditors.
Securities backed by health care and hospital revenues may be affected by
changes in State regulations governing cost reimbursements to health care
providers under Medi-Cal (the State's Medicaid program), including risks related
to the policy of awarding exclusive contracts to certain hospitals.
Limitations on ad valorem property taxes may particularly affect "tax
allocation" bonds issued by California redevelopment agencies. Such bonds are
secured solely by the increase in assessed valuation of a redevelopment project
area after the start of redevelopment activity. In the event that assessed
values in the redevelopment project decline (e.g., because of a major natural
----
disaster such as an earthquake), the tax increment revenue may be insufficient
to make principal and interest payments on these bonds. Both Moody's and S&P
suspended ratings on California tax allocation bonds after the enactment of
Articles XIIIA and XIIIB, and only resumed such ratings on a selective basis.
Proposition 87, approved by California voters in 1988, requires that all
revenues produced by a tax rate increase go directly to the taxing entity which
increased such tax rate to repay that entity's general obligation indebtedness.
As a result, redevelopment agencies (which, typically, are the issuers of tax
allocation securities) no longer receive an increase in tax increment when taxes
on property in the project area are increased to repay voter-approved bonded
indebtedness.
The effect of these various constitutional and statutory changes upon the
ability of California municipal securities issuers to pay interest and principal
on their obligations remains unclear. Furthermore, other measures affecting the
taxing or spending authority of California or its political subdivisions may be
approved or enacted in the future. Legislation has been or may be introduced
which would modify existing taxes or other revenue-raising measures or which
either would further limit or, alternatively, would increase the abilities of
state and local governments to impose new taxes or increase existing taxes. It
is not possible, at present, to predict the extent to which any such legislation
will be enacted. Nor is it possible, at present, to determine the impact of any
such legislation on California municipal instruments in which the Fund may
invest, future allocations of state revenues to local governments or the
abilities of state or local governments to pay the interest on, or repay the
principal of, such California municipal instruments.
Substantially all of California is within an active geologic region subject
to major seismic activity. Northern California in 1989 and Southern California
in 1994 experienced major earthquakes causing billions of dollars in damages.
The federal government provided more than $13 billion in aid for both
earthquakes, and neither event is expected to have any long-term negative
economic impact. Any California Municipal Obligation in the Fund could be
affected by an interruption of revenues because of damaged facilities, or,
consequently, income tax deductions for casualty losses or property tax
assessment reductions. Compensatory financial assistance could be constrained
by the inability of (i) an issuer to have obtained earthquake insurance coverage
rates; (ii) an insurer to perform on its contracts of insurance in the event of
widespread losses; or (iii) the federal or State government to appropriate
sufficient funds within their respective budget limitations.
FLORIDA MUNICIPAL INSTRUMENTS
The financial condition of the State of Florida may be affected by
various financial, social, economic and political factors. Those factors can be
very complex, may vary from fiscal year to fiscal year, and are frequently the
result of actions taken not only by the State and its agencies and
instrumentalities but also by entities that are not under the control of the
State. Adverse developments affecting the State's financing activities, its
agencies or its political subdivisions could adversely affect the State's
financial condition.
The State's revenues increased from $32,957,715,000 during the 1996-97
fiscal year ended June 30, 1997 to $35,849,518,000 during the fiscal year ended
June 30, 1998. The State's operating expenditures increased from
$31,494,591,000 during the 1996-97 fiscal year ended June 30, 1997 to
$33,373,020,000 during the 1997-98 fiscal year ended June 30, 1998. The Office
of Economic and Demographic Research of the Florida Legislature also projected
non-agricultural jobs to grow 3.5% and 3.1% in fiscal years 1998-99 and 1999-
2000, respectively. The revenue growth in the 1998-1999 fiscal year is driven
by the State's sales tax collections. The sales tax accounts for close to 75% of
total revenues through March 31, 1999. A March 31, 1999 estimate shows an
expected year-end surplus of $573.8 million. When this is combined with the
Budget Stabilization Fund balance of $786.9 million, Florida's total reserves
are $1,360.7 million.
The Constitution of the State of Florida limits the right of the State
and its local governments to tax. The Constitution requires the State to have a
balanced budget and to raise revenues to defray its operating expenses. The
State may not borrow for the purpose of maintaining ordinary operating expenses,
but may generally borrow for capital improvements.
An amendment to the Florida Constitution adopted in 1994 requires that
state revenues in excess of an allowed amount plus a growth factor must be
contributed to a Budget Stabilization Fund until this fund reaches a certain
amount at which time the excess state revenues must be distributed to the
taxpayers. The growth factor is the average annual rate of growth in the state
personal income over the most recent 20 quarters times the amount of state
revenue allowed under the Constitution for the prior fiscal year. Included among
the categories of revenues that are exempt from this revenue limitation are
revenues pledged to state bonds and other payments related to debt. A two-thirds
vote of the Florida legislature can raise the amount of the limit on state
revenues. It is difficult to predict the impact of this amendment on Florida
state finances, especially since courts have not interpreted it extensively. To
the extent that local governments traditionally receive revenues from the state
which are subject to or limited by this Constitutional amendment, the further
distribution of such state revenues may be adversely impacted by the amendment.
There are a number of methods by which the State of Florida may incur
debt. The State may issue bonds backed by the State's full faith and credit to
finance or refinance certain capital projects authorized by its voters. The
total outstanding principal of State bonds pledging the full faith and credit of
the State may not exceed 50% of the total tax revenues of the State for the two
preceding fiscal years, excluding any tax revenues held in trust. The State
also may issue certain bonds backed by the State's full faith and credit to
finance or refinance pollution control, solid waste disposal and water
facilities for local governments; county roads; school districts and capital
public education projects without voter authorization. The State may also,
pursuant to specific constitutional authorization, directly guarantee certain
obligations of the State's authorities, agencies and instrumentalities.
Payments of debt service on State bonds backed by the State's full faith and
credit and State-guaranteed bonds and notes are legally enforceable obligations
of the State. Revenue bonds to finance or refinance certain capital projects
also may be issued by the State of Florida without voter authorization.
However, revenue bonds are payable solely from funds derived directly from
sources other than state tax revenues.
The State of Florida currently imposes, among other taxes, an ad
valorem tax on intangible property and a corporate income tax. The Florida
Constitution prohibits the levying of a personal income tax. Certain other
taxes the State of Florida imposes include: an estate or inheritance tax which
is limited by the State's Constitution to an amount not in excess of the amount
allowed to be credited upon or deducted from federal estate taxes or the estate
taxes of another state; and a 6% sales tax on most goods and certain services
with an option for counties to impose up to an additional 1% sales tax on such
goods and services. In addition, counties chartered before June 1, 1976 or
county with a consolidated county/municipal government may assess up to a 1%
discretionary sales surtax within the county for the development, construction,
maintenance and operation of a fixed guideway rapid transit system.
The Constitution reserves the right to charge an ad valorem tax on
real estate and tangible personal property to Florida's local governments. All
other forms of taxation are preempted to the State of Florida except as may be
provided by general law. Motor vehicles, boats, airplanes, trailers, trailer
coaches and mobile homes, as defined by law, may be subject to a license tax for
their operation, but may not be subject to an ad valorem tax.
Under the Constitution, ad valorem taxes may not be levied in excess
of the following millage upon the assessed value of real estate and tangible
personal property: for all county purposes, ten mills; for all municipal
purposes, ten mills; for all school purposes, ten mills; for water management
purposes for the northwest portion of the State, .05 mills; for water management
purposes for the remaining portion of the State, one mill; and for all other
special districts a millage authorized by law and approved by referendum. When
authorized by referendum, the above millage caps may be exceeded for up to two
years. Counties, school districts, municipalities, special districts and local
governmental bodies with taxing powers may issue bonds to finance or refinance
capital projects payable from ad valorem taxes in excess of the above millage
cap when approved by referendum. It should be noted that several municipalities
and counties have charters that further limit either ad valorem taxes or the
millage that may be assessed.
The Florida legislature has passed a number of mandates which limit or
place requirements on local governments without providing the local governments
with compensating changes in their fiscal resources. The Florida legislature
enacted a comprehensive growth management act which forces local governments to
establish and implement comprehensive planning programs to guide and control
future development. This legislation prohibits public or private development
that does not conform with the locality's comprehensive plan. Local governments
may face greater requirements for services and capital expenditures than they
had previously experienced if their locality experiences increased growth or
development. The burden for funding these potential services and capital
expenditures which has been left to the local governments may be quite large.
The Florida Constitution limits the assessed value of homestead real
property for ad valorem tax purposes to the lower of (A) three percent (3%) of
the assessed value for the prior year; or (B) the percentage change in the
Consumer Price Index for the preceding calendar year. In addition, no such
assessed value shall exceed "just value" and such just value shall be reassessed
(notwithstanding the 3% cap) as of January 1 of the year following a change of
ownership of the assessed real property.
Florida has grown dramatically since 1980 and as of April 1, 1997
ranked fourth nationally with an estimated population of 14.7 million. Florida's
substantial population increases over the past few years are expected to
continue. It is anticipated that corresponding increases in State revenues will
be necessary during the next decade to meet increased burdens on the various
public and social services provided by the State. Much of this growth is being
funded by bonded revenues secured by the expanding real property tax base. As of
1997, real property values exceed $724 billion. Residential property values
account for over $400 billion in value while commercial and industrial property
values exceed $100 billion.
Florida's job market continues to reflect strong performance. The
state's March 1999 unemployment rate was 4.1 percent, 0.3 percentage points
lower than the year ago rate of 4.4 percent. Florida's unemployment rate was one
of the lowest since October 1973 when it was 3.4 percent. The U.S. unemployment
rate was 4.2 percent in March 1999, just above Florida's rate. Fueled by low
interest rates, construction had the fastest growth rate at 5.8 percent and
added 20,000 jobs over the year. Similarly, finance, insurance, and real estate
and government also experienced year to year increases of 19,100 jobs and 16,400
jobs, respectively. The apparel and textiles industries lost 1,500 jobs due to
tariffs and foreign competition. The State is gradually becoming less dependent
on employment related to construction, agriculture and manufacturing, and more
dependent on employment related to trade and services. Presently, services
constitute 34.9% and trade 25.6% of the State's total non-farm jobs.
Personal income in the State has been growing strongly the last
several years and has generally outperformed both the nation as a whole and the
Southeast in particular. The reasons for this are strong population growth and
diversification of the economy. From 1992 through 1997, the State's per capita
income rose an average of 5.0% per year, while the national per capita income
increased an average of 4.8%. For 1997, the State's per capita personal income
rose an average of 4.0% while the national per capita personal income rose 4.7%.
In 1997, per capita personal income in Florida was $24,795, while the national
per capita personal income was $25,298. The structure of the State's income
differs from that of the nation and the Southeast. Because the State has a
proportionately greater retirement age population, property income (dividends,
interest and rent) and transfer payments (social security and pension benefits,
among other sources of income) are a relatively more important source of income.
Transfer payments, such as social security, are occasionally subject to
legislative change.
Tourism is one of Florida's most important industries. According to
Visit Florida (formerly the Florida Tourism Commission), about 47 million people
visited the State in 1997. Tourists to Florida effectively represent additional
residents, spending their dollars predominantly at eating and drinking
establishments, hotels and motels, and amusement and recreation parks. Their
expenditures generate additional business activity and State tax revenues. The
State's tourist industry over the years has become more sophisticated,
attracting visitors year-round, thus to a degree, reducing its seasonality.
The State also has a strong construction industry, with single and
multi-family housing starts accounting for approximately 9.2% of total U.S.
housing starts in 1997, while the State's population was only 5.5% of the
nation's total population. The reason for such a dynamic construction industry
was the rapid growth of the State's population. Since 1985, total housing
starts have averaged approximately 148,000 per year. Total housing starts were
132,813 in 1997, and are projected to be 97,600 in 1998-99.
Florida has experienced a diversifying economic base as technology
related industry, healthcare and financial services have grown into leading
elements of Florida's economy, complementing the State's previous reliance
primarily on agriculture and tourism. With the increasing costs and capital
needs related to its growing population, Florida's ability to meet its expenses
will be dependent in part upon the State's continued ability to foster business
and economic growth. Florida has also increased its funding of capital projects
through more frequent debt issuance rather than its historical pay-as-you go
method.
At the regional level, local economies within Florida perform
differently according to their urban or rural qualities and level of economic
diversification. The spectrum of local economies spans dense urban centers such
as Miami and Tampa to rural agricultural regions of citrus, cattle ranching and
sugar cane production. For example, Central Florida is a premier world-class
resort/vacation destination with its economy driven by the presence of Disney
World, studio theme parks and other tourist oriented recreational parks with a
laser/optical research node and motion picture industries helping to diversify
the Central Florida local economy. In contrast to the highly urban areas of
Southeast Florida, North Florida and the Florida Panhandle are rural in many
areas with local economies is dominated by the logging and paper industries,
defense, tourism, state government and retirement.
Florida has a moderate debt burden. As of June 30, 1998 full faith and
credit bonds totaled $8.7 billion and revenue bonds totaled $5 billion for a
total debt of $13.7 billion. Full faith and credit debt per capita was $577. In
the 1998 fiscal year, debt service as a percent of Governmental Fund
expenditures was 2.0%. In recent years debt issuance for the State has been
increasing. The State brought a new indenture to the market in late Fiscal Year
1998, the Florida Lottery Bonds. These bonds will finance capital improvements
for Florida schools.
The payment on most Florida municipal instruments held by the Florida
Intermediate Tax-Exempt Fund will depend upon the issuer's ability to meet its
obligations. If the State or any of its political subdivisions were to suffer
serious financial difficulties jeopardizing their ability to pay their
obligations, the marketability of obligations issued by the State or localities
within the State, and the value of the Florida Intermediate Tax-Exempt Fund's
portfolio, could be adversely affected.
ARIZONA MUNICIPAL INSTRUMENTS
Under its Constitution, the State of Arizona is not permitted to issue
general obligation bonds secured by the State's full faith and credit. However,
agencies and instrumentalities of the State are authorized under specified
circumstances to issue bonds secured by revenues. The State enters into certain
lease transactions that are subject to annual renewal at its option. Local
governmental units in the State are also authorized to incur indebtedness. The
major source of financing for such local government indebtedness is an ad
valorem property tax. In addition, to finance public projects, local
governments may issue revenue bonds to be paid from the revenues of an
enterprise or the proceeds of an excise tax, from assessment bonds payable from
special proceeds of an excise tax, or from assessment bonds payable by special
assessments. Arizona local governments have also financed public projects
through leases that are subject to annual appropriation at the option of the
local government.
There are periodic attempts in the form of voter initiatives and
legislative proposals to further limit the amount of annual increases in taxes
that can be levied by the various taxing jurisdictions without voter approval.
It is possible that if such a proposal were enacted, there would be an adverse
impact on State or local government financing. It is not possible to predict
whether any such proposals will be enacted in the future or what would be their
possible impact on state or local government financing.
The State is required by law to maintain a balanced budget. To achieve
this objective, it has in the past utilized a combination of spending
reductions and tax increases. In recent years, the State's fiscal situation has
improved, even while tax reduction measures have been enacted each year since
1992. In 1992, voters passed a measure that requires a two-thirds vote of the
legislature to increase state taxes.
The State's population, because of continued employment growth, is expected
to record above-average growth rates. After population growth of 3% in 1997 and
2.9% in 1998, 2.8% growth is expected in 1999 and 2.6% in 2000. That translates
into almost 132,000 more people in the state in 1999 and 126,000 in 2000.
The State's diversified economic base is not dependent on any single
industry. Principal economic sectors include services, manufacturing, mining,
tourism, and the military. Agriculture, at one time a major sector, plays a much
smaller role in the economy. For several decades, the population has grown at a
substantially higher rate than the population of the United States.
The economy of the State is growing. Since the current boom peaked in
1994, when employment grew by 6.8%, the rate of growth has slowed, but only
modestly. Through November 1998 (the latest data available), employment was
4.7% higher than the year before.
Different parts of the State have different growth rates and structures.
The Phoenix metropolitan area accounts for 70.6% of all Arizona jobs and almost
80% of the State's employment growth. The Tucson area saw growth accelerate in
1998 by 3%, versus 1.8% in 1997. The balance of the State also grew at more
moderate levels.
On a percentage basis, this expansion has not been as strong as previous
expansions. Yet, in terms of absolute employment growth, this expansion has
created more jobs than any period of economic growth in the State's history.
For example, since the beginning of the current expansion in March 1991, more
than 580,000 jobs have been created. In comparison, 297,200 jobs were created
in the 1975-1980 expansion, and about 450,000 jobs were created in the expansion
that lasted from 1982 to 1990.
According to the national Blue Chip Economic Indicators, after real GDP
growth of 3.9% in 1997 and 3.6% in 1998, growth is expected to moderate to 2.2%
in 1999. Inflation is expected to remain low and interest rates are also likely
to be low and through most of 1999.
As of 1998, 47% of all manufacturing employment in the Phoenix area and 25%
in Pima County is in high technology. The national average is 14.3%. The high-
tech areas include computers, telecommunications, electronic components,
aviation, and instrumentation. In the Phoenix area, the economy is weighted
towards electronic components employment, which accounts for 27% of all
manufacturing jobs. Tucson's high-tech manufacturing employment is more evenly
spread among computers, electronic components, aviation and instrumentation.
It is expected that international trade in the high-tech industry will
continue to grow, which will be a positive for the Arizona economy. But in the
near term, the unbalanced mix of employment could be a problem. Roughly 52% of
Arizona manufacturing exports are of high-tech products; further, nearly 40% of
the state's exports are to Japan, Malaysia, Taiwan, Hong Kong and Singapore, all
of which are experiencing some degree of economic problems.
In 1997, Arizona's total exports as a percent of personal income ranked
fifth in the U.S. at 13.5%, compared to 9.2% for the nation. When analyzing data
using only high-tech exports, Arizona ranked second at 7.1%, versus 2.1%
nationally. Thus, the impact of the reduction in high-tech exports will likely
affect Arizona more than other states. This is expected to result in some
continued layoffs in the manufacturing sector.
The unemployment rate, 4.1% for 1998, is also expected to remain relatively
low, especially in the State's metropolitan areas. However, it is expected to
increase in both 1999 and 2000. The current level of unemployment, the lowest in
nearly three decades, suggests a tight labor market. The modest rise in
unemployment projected for 1999 suggests that labor markets will moderately
soften. After employment growth of 5.6% in 1996, 4.5% in 1997 and an estimated
4.6% in 1998, employment should increase by another 3.5% in 1999 with growth
continuing at about 3% in 2000 and 2001. The Phoenix area's unemployment rate
remains low, at about 2.7%.
The outlook for continued, albeit slower, growth for the U.S. economy acts
as a base for the Arizona economy. The state has been one of the top five
employment-growth states for quite some time, and it is expected to remain in
the top five through 1999. There are other positive factors as well. First, as
of November 1998, manufacturing was 2.3% above the November 1997 rate. Second,
the unemployment rate is low in greater Phoenix and for many other parts of
Arizona. That suggests that job growth will continue. Third, California, the
State's leading domestic trading partner, is expected to enjoy continued, albeit
slower, growth. Fourth, single-family housing markets continue to boom. Although
the absolute level of permits is expected to decline from 1998's record levels,
the outlook is for a relatively strong housing market.
Housing, which is expected to be up by about 15% in 1998, is expected to
decrease by about 10% in 1999. The slowdown is expected to be in single-family
activity. In 1999, even if single-family housing slows, commercial construction
is expected to continue to do well throughout most of the year, despite higher
vacancy rates in the Phoenix-area office and industrial markets. This is
expected to prevent any significant problem in construction employment in 1999,
despite the likelihood of a slowdown.
Another uncertainty is the tourism market. Given the strong economy,
tourist activity is expected to be strong. But declines in the value of the
Canadian dollar, the peso and other currencies versus the U.S. dollar could hurt
winter visitation in Arizona.
Personal income, after growing by 8% in 1996 and 7.3% in 1997, is expected
to grow by another 8% in 1998, 7.8% in 1999, and 7% in 2000.
Overall, General Fund revenues are expected to grow modestly, including 4%
in FY 1999 and 5.7% in FY 2001. However, the FY 1999 rate of growth reflects the
impact of the $120 million tax reduction program passed last year, and the FY
2000 revenue estimate includes an incremental reduction to account for an
additional $60 million of tax reductions already enacted.
The Governor's budget proposals in 1999 sought to limit overall spending,
continue the growth of the State's "rainy day" funds, reflect conservative
revenue forecasts to reflect a slowing economy, and propose for the 8th and 9th
consecutive years tax reductions.
State policy makers have been very successful in recent years in depositing
monies into various accounts that have been established for a "rainy day."
These monies are reserved for a true budget emergency precipitated by an
economic downturn. By the end of FY 2001, the rainy day fund is expected to
reach $425 million, or 7.08% of the General Fund revenues.
OTHER INFORMATION ON CALIFORNIA, FLORIDA AND ARIZONA MUNICIPAL
INSTRUMENTS
Northern Trust believes that it is likely that sufficient California,
Florida and Arizona municipal instruments and certain specified federal
obligations should be available to satisfy the respective investment objectives,
policies and limitations of the California, Florida Intermediate Tax-Exempt and
the Arizona Tax-Exempt Funds. If Northern Funds' Board of Trustees, after
consultation with Northern Trust, should for any reason determine that it is
impracticable to satisfy a Fund's investment objective, policies and limitations
because of the unavailability of suitable investments, the Board would re-
evaluate the particular Fund's investment objective and policies and consider
changes in its structure and name or possible dissolution.
INVESTMENT RESTRICTIONS
The Funds are subject to the fundamental investment restrictions enumerated
below which may be changed with respect to a particular Fund only by a vote of
the holders of a majority of such Fund's outstanding shares.
No Fund may:
(1) Make loans, except through (a) the purchase of debt
obligations in accordance with the Fund's investment objective and
policies, (b) repurchase agreements with banks, brokers, dealers and other
financial institutions, (c) loans of securities, and (d) loans to
affiliates of the Fund to the extent permitted by law.
(2) Purchase or sell real estate or real estate limited
partnerships, but this restriction shall not prevent a Fund from investing
directly or indirectly in portfolio instruments secured by real estate or
interests therein or acquiring securities of real estate investment trusts
or other issuers that deal in real estate.
(3) Invest in commodities or commodity contracts, except
that a Fund may invest in currency and financial instruments and contracts
that are commodities or commodity contracts.
(4) Invest in companies for the purpose of exercising
control.
(5) Act as underwriter of securities, except as a Fund may
be deemed to be an underwriter under the Securities Act of 1933 (the "1933
Act") in connection with the purchase and sale of portfolio instruments in
accordance with its investment objective and portfolio management policies.
(6) Purchase securities (other than obligations issued or
guaranteed by the U.S. Government, its agencies or instrumentalities and
repurchase agreements collateralized by such obligations) if, except for
the Technology Fund, such purchase would cause 25% or more in the aggregate
of the market value of the total assets of the Fund to be invested in the
securities of one or more issuers having their principal business
activities in the same industry, provided that with respect to each Money
Market Fund there is no limitation, and each Money Market Fund reserves
freedom of action, when otherwise consistent with its investment policies,
to concentrate its investments in obligations (other than commercial paper)
issued or guaranteed by U.S. banks (including foreign branches of U.S.
banks) and U.S. branches of foreign banks and repurchase agreements and
securities loans collateralized by such bank obligations. For the purposes
of this restriction, state and municipal governments and their agencies and
authorities are not deemed to be industries; as to utility companies, the
gas, electric, water and telephone businesses are considered separate
industries; personal credit finance companies and business credit finance
companies are deemed to be separate industries; and wholly-owned finance
companies are considered to be in the industries of their parents if their
activities are primarily related to financing the activities of their
parents. The Technology Fund may not, except during temporary defensive
periods, purchase the securities of any issuer, if, as a result of such
purchase, less than 25% of the assets of the Technology Fund would be
invested in the securities of issuers principally engaged in technology
business activities.
(7) Borrow money, except that to the extent permitted by
applicable law (a) a Fund may borrow from banks, other affiliated
investment companies and other persons, and may engage in reverse
repurchase agreements and other transactions which involve borrowings, in
amounts up to 33-1/3% of its total assets (including the amount borrowed)
or such other percentage permitted by law, (b) a Fund may borrow up to an
additional 5% of its total assets for temporary purposes, (c) a Fund may
obtain such short-term credits as may be necessary for the clearance of
purchases and sales of portfolio securities, and (d) a Fund may purchase
securities on margin. If due to market fluctuations or other reasons a
Fund's borrowings exceed the limitations stated above, Northern Funds will
promptly reduce the borrowings of a Fund in accordance with the 1940 Act.
In addition, as a matter of fundamental policy, a Fund will not issue
senior securities to the extent such issuance would violate applicable law.
(8) Make any investment inconsistent with a Fund's
classification as a diversified company under the 1940 Act. This
restriction does not, however, apply to any Fund classified as a non-
diversified company under the 1940 Act.
(9) Notwithstanding any of a Fund's other fundamental investment
restrictions (including, without limitation, those restrictions relating to
issuer diversification, industry concentration and control), a Fund may:
(a) purchase securities of other investment companies to the full extent
permitted under Section 12 or any other provision of the 1940 Act (or any
successor provision thereto) or under any regulation or order of the SEC;
and (b) invest all or substantially all of its assets in a single open-end
investment company or series thereof with substantially the same investment
objective, policies and fundamental restrictions as the Fund.
* * * *
For the purposes of Investment Restrictions (1) and (7) above, the Funds
expect that they would be required to file an exemptive application with the SEC
and receive the SEC's approval of that application prior to entering into
lending or borrowing arrangements with affiliates. As of May 15, 2000, the
Funds had not filed such an exemptive application.
Also, as a matter of fundamental policy, changeable only with the approval
of the holders of a majority of the outstanding shares of the Fund involved, at
least 80% of the net assets of each Tax-Exempt and Municipal Fund will be
invested in debt instruments, the interest on which is, in the opinion of bond
counsel or counsel for issuers, if any, exempt from regular Federal income tax,
except in extraordinary circumstances such as when the Investment Adviser
believes that market conditions indicate that a Fund should adopt a temporary
defensive posture by holding uninvested cash or investing in taxable securities.
Interest earned on "private activity bonds" that is treated as an item of tax
preference under the Federal alternative minimum tax will be deemed by a
Municipal Fund, but will not be deemed by a Tax-Exempt Fund, to be exempt from
regular Federal income tax for purposes of determining whether the Municipal and
Tax-Exempt Funds meet this fundamental policy.
As a non-fundamental investment restriction, the International Fixed
Income, Florida Intermediate Tax-Exempt, California Intermediate Tax-Exempt,
Arizona Tax-Exempt, California Tax-Exempt and MarketCommand Funds may not hold,
at the end of any tax quarter, more than 10% of the outstanding voting
securities of any one issuer, except that up to 50% of the total value of the
assets of each Fund may be invested in any securities without regard to this 10%
limitation so long as no more than 25% of the total value of its assets is
invested in the securities of any one issuer (except the U.S. Government, its
agencies and instrumentalities). Also, as a non-fundamental investment
restriction, these Funds will not hold any securities (except U.S. government
securities) that would cause, at the end of any tax quarter, more than 5% of
their respective total assets to be invested in the securities of any one
issuer, except that up to 50% of the respective Fund's total assets may be
invested without regard to this limitation so long as no more than 25% of the
Fund's total assets are invested in any one issuer (except the U.S. government,
its agencies and instrumentalities).
Except as otherwise provided in Investment Restriction (6), for the purpose
of such restriction in determining industry classification with respect to the
Funds other than the International Funds and the Technology Fund, Northern Funds
intends to use the industry classification titles in the Bloomberg Industry
Group Classification. With respect to the International Funds, Northern Funds
intends to use the Morgan Stanley Capital International industry classification
titles. With respect to the Technology Fund, Northern Funds intends to consider
an issuer to be principally engaged in technology business activities if such
issuer is listed in the Morgan Stanley Index, the H&Q Index, the SoundView
Technology Index, the technology grouping of the S&P 500 Index or any other
comparable index. The freedom of action reserved in Investment Restriction (6)
above with respect to U.S. branches of foreign banks is subject to the
requirement that they are subject to the same regulation as domestic branches of
U.S. banks, and such freedom with respect to foreign branches of U.S. banks is
subject to the requirement that the domestic parent be unconditionally liable in
the event that a foreign branch fails to pay on its instruments for any reason.
Securities held in escrow or separate accounts in connection with the Funds'
investment practices described in this Additional Statement and in the
Prospectus are not deemed to be mortgaged, pledged or hypothecated for purposes
of the foregoing Investment Restrictions.
A security is considered to be issued by the entity, or entities, whose
assets and revenues back the security. A guarantee of a security is not deemed
to be a security issued by the guarantor when the value of all securities issued
and guaranteed by the guarantor, and owned by a Fund, does not exceed 10% of the
value of the Fund's total assets.
The Money Market, U.S. Government Money Market, U.S. Government Select
Money Market, Municipal Money Market, Tax-Exempt Money Market and California
Municipal Money Market Funds intend, as a non-fundamental policy, to diversify
their investments in accordance with current SEC regulations. Investments in the
securities of any single issuer (excluding cash, cash items, certain repurchase
agreements, U.S. Government securities and securities of other investment
companies) will be limited to not more than 5% of the value of a Fund's total
assets at the time of purchase, except that (a) 25% of the total assets of the
California Municipal Money Market Fund may be invested in fewer than five
issuers; and 25% of the value of the total assets of the other Money Market
Funds may be invested in the securities of any one issuer for a period of up to
three Business Days. A security that has an unconditional guarantee meeting
special SEC requirements (a "Guarantee") does not need to satisfy the foregoing
issuer diversification requirements that would otherwise apply, but the
Guarantee is instead subject to the following diversification requirements:
Immediately after the acquisition of the security, a Money Market Fund may not
have invested more than 10% of its total assets in securities issued by or
subject to Guarantees from the same person, except that a Fund, subject to
certain conditions, may invest up to 25% of its total assets in securities
issued or subject to Guarantees of the same persons. This percentage is 100% if
the Guarantee is issued by the U.S. Government or an agency thereof. In
addition, the Municipal Money Market, Tax-Exempt Money Market and California
Municipal Money Market Funds will limit their investments in certain conduit
securities that are not rated in the highest short-term rating category as
determined by two nationally recognized statistical rating organizations (each
an "NRSRO") (or one NRSRO if the security is rated by only one NRSRO) or, if
unrated, are not of comparable quality to First Tier Securities ("Second Tier
Securities") to 5% of their total assets, with investments in any one such
issuer being limited to no more than 1% of a Fund's total assets or $1 million,
whichever is greater, measured at the time of purchase. Conduit securities
subject to this limitation are municipal instruments that are not subject to a
Guarantee and involve an arrangement whereunder a person, other than a municipal
issuer, provides for or secures repayment of the security and are not: (i)
fully and unconditionally guaranteed by a municipal issuer; or (ii) payable from
the general revenues of the municipal issuer or other municipal issuers; or
(iii) related to a project owned and operated by a municipal issuer; or
(iv) related to a facility leased to and under the control of an industrial or
commercial enterprise that is part of a public project which, as a whole, is
owned and under the control of a municipal issuer. The Money Market, U.S.
Government and U.S. Government Select Money Market Funds will limit their
investments in all Second Tier Securities (that are not subject to Guarantees)
in accordance with the foregoing percentage limitations.
In addition to the foregoing, each Money Market Fund is subject to
additional diversification requirements imposed by SEC regulations on the
acquisition of securities subject to other types of demand features and puts
whereunder a Fund has the right to sell the securities to third parties.
Each Investment Restriction which involves a maximum percentage (other than
the restriction set forth above in Investment Restriction (7)) will not be
considered violated unless an excess over the percentage occurs immediately
after, and is caused by, an acquisition or encumbrance of securities or assets
of the Fund. The 1940 Act requires that if the asset coverage for borrowings at
any time falls below the limits described in Investment Restriction (7), the
Fund involved will, within three days thereafter (not including Sundays and
holidays), reduce the amount of its borrowings to an extent that the net asset
coverage of such borrowings shall conform to such limits.
Although the foregoing Investment Restrictions would permit the Money
Market Funds to acquire options, enter into forward currency contracts and
engage in short sales and interest rate and currency swaps, they are not
currently permitted to engage in these transactions under SEC regulations. In
addition, the U.S. Government Select Money Market Fund does not intend to
purchase any bank or corporate obligation during the current fiscal year.
ADDITIONAL TRUST INFORMATION
CLASSIFICATION AND HISTORY
Northern Funds is an open-end, management investment company. Each Fund is
classified as diversified under the 1940 Act, except the California Municipal
Money Market, California Intermediate Tax-Exempt, Florida Intermediate Tax-
Exempt, Arizona Tax-Exempt, California Tax-Exempt, International Fixed Income
and MarketCommand Funds. Each Fund is a series of the Trust which was formed as
a Massachusetts business trust on October 12, 1993 under an Agreement and
Declaration of Trust. At a meeting of shareholders held on March 21, 2000, the
shareholders approved, among other things, an Agreement and Plan of
Reorganization pursuant to which the Trust will be reorganized as a Delaware
business trust. See "Description of Shares."
TRUSTEES AND OFFICERS
The business and affairs of the Trust are managed under the direction of
the Trust's Board of Trustees. Information pertaining to the Trustees and
officers of Northern Funds is set forth below.
- -------------------------------------------------------------------------------
NAME POSITION(S) PRINCIPAL OCCUPATION(S)
AND ADDRESS AGE WITH TRUST DURING PAST 5 YEARS
- -------------------------------------------------------------------------------
Mr. Richard G. Cline 65 Trustee Chairman, Hawthorne
4200 Commerce Court Investors, Inc. (a management
Suite 300 advisory services and private
Lisle, IL 60532 investment company) since
January 1996; Chairman,
Hussman International, Inc.
(a refrigeration company)
since 1998; Chairman and CEO
of NICOR Inc. (a diversified
public utility holding
company) from 1986 to 1995,
and President, 1992 to 1993;
Chairman, Federal Reserve
Bank of Chicago from 1992 to
1995, and Deputy Chairman
from 1995 to 1996. Director:
Whitman Corporation (a
diversified holding company);
Kmart Corporation (a
retailing company); Ryerson
Tull, Inc. (a metals
distribution company);
University of Illinois
Foundation. Trustee:
Northern Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Edward J. Condon, 60 Trustee Chairman of The Paradigm
Jr. Group, Ltd. (a financial
Sears Tower, Suite 9650 advisor) since July 1993;
233 S. Wacker Drive Vice President and Treasurer
Chicago, IL 60606 of Sears, Roebuck and Co. (a
retail corporation) from
February l989 to July 1993;
Member of Advisory Board of
Real-Time USA, Inc. (a
software development
company); Member of the Board
of Managers of The Liberty
Hampshire Company, LLC (a
receivables funding company);
Vice Chairman and Director of
Energenics L.L.C. (a waste to
energy recycling company).
Director: University
Eldercare Inc. (an
Alzheimer's disease research
and treatment company);
Financial Pacific Company (a
small business leasing
company). Trustee: Dominican
University. Trustee:
Northern Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Wesley M. Dixon, Jr.72 Trustee Director of Kinship
400 Skokie Blvd. Corporation (a financial
Suite 300 services company) 1985 to
Northbrook, IL 60062 1996; Vice Chairman and
Director of G.D. Searle & Co.
(manufacture and sale of food
products and pharmaceuticals)
from 1977 to 1985 and
President of G.D. Searle &
Co. prior thereto. Trustee:
Northern Institutional Funds.
- -------------------------------------------------------------------------------
Mr. William J. Dolan, 67 Trustee Partner of Arthur Andersen &
Jr. Co. S.C. (accounting firm)
1534 Basswood Circle from 1966 to 1989. Financial
Glenview, IL 60025 Consultant, Ernst & Young
from 1992 to 1993 and 1997.
Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Mr. John W. English 67 Trustee Private Investor; Vice
50-H New England Ave. President and Chief
P.O. Box 640 Investment Officer of The
Summit, NJ 07902-0640 Ford Foundation (a charitable
trust) from 1981 to 1993.
Director: University of Iowa
Foundation; Blanton-Peale
Institutes of Religion and
Health; Community Foundation
of Sarasota County. Former
Director: Duke Management
Company (manager of the Duke
University endowment fund);
John Ringling Centre
Foundation (a non-profit
historical preservation
organization). Trustee: The
China Fund, Inc.; Select
Sector SPDR Trust; WM Funds;
American Red Cross in Greater
New York; Mote Marine
Laboratory (a non-profit
marine research facility);
and United Board for
Christian Higher Education in
Asia. Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Raymond E. George, 69 Trustee Senior Vice President and
Jr. <F1> Senior Fiduciary Officer of
703 Prospect Avenue The Northern Trust Company
Winnetka, IL 60093 from 1990 to 1993. Trustee:
Northern Institutional Funds.
- -------------------------------------------------------------------------------
Ms. Sandra Polk Guthman 56 Trustee President and CEO of Polk
420 N. Wabash Avenue Bros. Foundation (an Illinois
Suite 204 not-for-profit corporation)
Chicago, IL 60611 from 1993 to present;
Director of Business
Transformation 1992 to 1993,
and Midwestern Director of
Marketing 1988 to 1992, IBM
(a technology company).
Director: MBIA Insurance
Corporation of Illinois (a
municipal bond insurance
company). Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Michael E. Murphy 63 Trustee President of Sara Lee
<F2> Foundation (philanthropic
Suite 2222 organization) since November
20 South Clark Street 1997; Vice Chairman and
Chicago, IL 60603 Chief Administrative Officer
of Sara Lee Corporation (a
consumer product company)
from November 1994 to October
1997; Vice Chairman and
Chief Financial and
Administrative Officer of
Sara Lee Corporation from
July 1993 to November 1994.
Director: Payless Shoe
Source, Inc. (a retail shoe
store business); True North
Communications, Inc. (a
global advertising and
communications holding
company); American General
Corporation (a diversified
financial services company);
GATX Corporation (a railroad
holding company); Bassett
Furniture Industries, Inc. (a
furniture manufacturer).
Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Mary Jacobs Skinner, 42 Trustee Partner in the law firm of
Esq.<F3> Sidley & Austin. Trustee:
One First National Plaza Northern Institutional Funds
Chicago, IL 06063
- -------------------------------------------------------------------------------
Mr. William H. Springer 71 Chairman and Vice Chairman of Ameritech (a
701 Morningside Drive Trustee telecommunications holding
Lake Forest, IL 60045 company) from February 1987
to August 1992; Vice
Chairman, Chief Financial and
Administrative Officer of
Ameritech prior to 1987.
Director: Walgreen Co. (a
retail drug store business);
Baker, Fentress & Co. (a
closed-end, non-diversified
management investment
company). Trustee: Goldman
Sachs Trust; Goldman Sachs
Variable Insurance Trust.
Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Richard P. Strubel 61 Trustee President and Chief Operating
737 N. Michigan Avenue Officer, UNext.com (a
Suite 1405 provider of educational
Chicago, IL 60611 services via the internet)
since 1999; Managing Director
of Tandem Partners, Inc. (a
privately held management
services firm) from 1990 to
1999; President and Chief
Executive Officer, Microdot,
Inc. (a privately held
manufacturing firm) from 1984
to 1994. Director: Gildan
Activewear, Inc. (an athletic
clothing marketing and
manufacturing company);
Children's Memorial Medical
Center. Trustee: University
of Chicago; Goldman Sachs
Trust; Goldman Sachs Variable
Insurance Trust. Trustee:
Northern Institutional Funds.
- -------------------------------------------------------------------------------
Mr. Stephen B. 55 Trustee President of Northern Funds
Timbers<F4> Global Investments, a
50 South LaSalle Street, division of Northern Trust
B-3 Corporation, and Executive
Chicago, IL 60675 Vice President, The Northern
Trust Company since 1998;
President, Chief Executive
Officer and Director of
Zurich Kemper Investments (a
financial services company)
from 1996 to 1998; President,
Chief Operating Officer and
Director of Kemper
Corporation (a financial
services company) from 1992
to 1996; President and
Director of Kemper Funds (a
registered investment
company) from 1990 to 1998.
Director: LTV Corporation (a
steel producer); and Northern
Trust Quantitative Advisors,
Inc. Trustee: Northern
Institutional Funds.
- -------------------------------------------------------------------------------
Ms. Jylanne M. Dunne 40 President Senior Vice President for
4400 Computer Drive Distribution Services at PFPC
Westborough, MA 01581 Inc. ("PFPC") (formerly First
Data Investor Services Group,
Inc. ("FDISG")), since 1988.
- -------------------------------------------------------------------------------
Mr. Archibald E. King 42 Vice President Senior Vice President and
50 South LaSalle Street other positions at The
Chicago, IL 60675 Northern Trust Company since
1979.
- -------------------------------------------------------------------------------
Mr. Lloyd A. Wennlund 42 Vice President Senior Vice President and
50 South LaSalle Street other positions at The
Chicago, IL 60675 Northern Trust Company,
President of Northern Trust
Securities, Inc., and
Managing Executive, Mutual
Funds for Northern Trust
Global Investments since
1989.
- -------------------------------------------------------------------------------
Mr. Brian R. Curran 32 Vice President Director of Fund
4400 Computer Drive and Treasurer Administration at PFPC since
Westborough, MA 01581 1997; Director of Fund
Administration at State
Street Bank and Trust Company
from February 1997 to October
1997; Senior Auditor at Price
Waterhouse L.L.P. (an
accounting firm) from
February 1994 to February
1997.
- -------------------------------------------------------------------------------
Ms. Judith E. Clear 33 Assistant Client Treasury Manager of
4400 Computer Drive Treasurer Mutual Fund Administration at
Westborough, MA 01581 PFPC since 1997; Compliance
Manager at Citizens Trust
from 1994 to 1996.
- -------------------------------------------------------------------------------
Ms. Suzanne E. Anderson 27 Assistant Client Treasury Manager of
4400 Computer Drive Treasurer Mutual Fund Administration at
Westborough, MA 01581 PFPC since August 1998;
Manager of Fund
Administration at State
Street Bank & Trust Company
from October 1996 to August
1998; Fund Administrator at
State Street Bank & Trust
Company from October 1995 to
October 1996; Mutual Fund
Accountant at The Boston
Company prior thereto.
- -------------------------------------------------------------------------------
Jeffrey A. Dalke, Esq. 49 Secretary Partner in the law firm of
One Logan Square Drinker Biddle & Reath LLP.
18th and Cherry Streets
Philadelphia, PA
19103-6996
- -------------------------------------------------------------------------------
Linda J. Hoard, Esq. 52 Assistant Vice President at PFPC since
4400 Computer Drive Secretary 1998; Attorney Consultant for
Westborough, MA 01581 Fidelity Investments & Co. (a
financial service company),
Investors Bank & Trust
Company (a financial service
provider) and PFPC (formerly
FDISG) from September 1994 to
June 1998.
- -------------------------------------------------------------------------------
Ms. Therese Hogan 37 Assistant Director of the State
4400 Computer Drive Secretary Regulation Department at PFPC
Westborough, MA 01581 since 1994.
- -------------------------------------------------------------------------------
<F1> Mr. George is deemed to be an "interested" Trustee because he owns shares
of Northern Trust Corporation.
<F2> Mr. Murphy is deemed to be an "interested" Trustees because he owns shares
of Northern Trust Corporation.
<F3> Ms. Skinner is deemed to be an "interested" Trustee because her law firm
provides legal services to Northern Trust Corporation.
<F4> Mr. Timbers is deemed to be an "interested" Trustee because he is an
officer, director, employee and shareholder of Northern Trust Corporation
and/or Northern and NTQA.
Certain of the Trustees and officers and the organizations with which they
are associated have had in the past, and may have in the future, transactions
with the Investment Advisers, PFPC, Northern Funds Distributors, LLC ("NFD") and
their respective affiliates. The Trust has been advised by such Trustees and
officers that all such transactions have been and are expected to be in the
ordinary course of business and the terms of such transactions, including all
loans and loan commitments by such persons, have been and are expected to be
substantially the same as the prevailing terms for comparable transactions for
other customers. As a result of the responsibilities assumed by Northern Funds'
service providers under Northern Funds' Advisory Agreement, Transfer Agency
Agreement, Custodian Agreement, Foreign Custodian Agreement, Co-Administration
Agreement and Distribution Agreement, Northern Funds itself requires no
employees.
Each officer holds comparable positions with certain other investment
companies for which NFD, PFPC or an affiliate thereof is the investment adviser,
administrator and/or distributor.
Each Trustee, except Mr. Timbers, earns an annual retainer of $30,000 and
the Chairman of the Board earns an annual retainer of $40,000. Each Trustee
earns an additional fee of $1,500, and the Chairman of the Board earns an
additional fee of $3,500, for each meeting attended, plus reimbursement of
expenses incurred as a Trustee.
In addition, the Trustees established an Audit Committee consisting of
three members, including a Chairman of the Committee. The Audit Committee
members are Messrs. Condon, Jr. (chairman), Dolan, Jr. and Strubel. Each member
earns an annual fee of $1,500 and the Chairman earns an annual fee of $3,500.
The Trustees have also established a Nominating Committee consisting of
three members, including a Chairman of the Committee. The Nominating Committee
members are Messrs. Dixon (chairman) and Cline and Ms. Guthman. Each member
earns an annual fee of $1,500 and the chairman earns an annual fee of $3,500.
The Trustees have also established a Valuation Committee consisting of four
members, including a Chairman of the Committee. The Valuation Committee members
are Messrs. George (chairman), English and Murphy and Ms. Skinner. Each member
earns an annual fee of $1,500 and the chairman earns an annual fee of $3,500.
The Trust's officers do not receive fees from the Trust for services in
such capacities. All of the Trust's officers (except Messrs. Dalke, King and
Wennlund) are employees of PFPC, which receives fees from the Trust for
administrative services.
Drinker, Biddle & Reath LLP, of which Mr. Dalke is a partner, receives fees
from the Trust for legal services.
Northern Trust Company, of which Mr. King and Mr. Wennlund are officers,
receives fees from the Trust as investment adviser, custodian, transfer agent
and co-administrator.
For the fiscal year ended March 31, 2000, the Trustees received the
following compensation:
- -------------------------------------------------------------------------------
Pension or
Retirement Total
Aggregate Benefits Accrued Compensation
Compensation as Part of Trust from the Trust
Name of Trustee<F1> from the Trust Expense Complex<F2>
- -------------------------------------------------------------------------------
Wesley M. Dixon, Jr. $31,250 None $33,750
- -------------------------------------------------------------------------------
William J. Dolan, Jr. $32,500 None $35,000
- -------------------------------------------------------------------------------
Raymond E. George, Jr. $31,250 None $33,750
- -------------------------------------------------------------------------------
Michael E. Murphy $30,000 None $30,000
- -------------------------------------------------------------------------------
Mary Jacobs Skinner $32,500 None $35,000
- -------------------------------------------------------------------------------
Richard G. Cline<F3> $1,250 None $45,750
- -------------------------------------------------------------------------------
Edward J. Condon, $1,250 None $50,750
Jr.<F3>
- -------------------------------------------------------------------------------
John W. English<F3> $1,250 None $48,250
- -------------------------------------------------------------------------------
Sandra Polk $1,250 None $45,750
Guthman<F3>
- -------------------------------------------------------------------------------
William H. $1,250 None $59,250
Springer<F3>
- -------------------------------------------------------------------------------
Richard P. Strubel<F3> $1,250 None $56,750
- -------------------------------------------------------------------------------
Stephen B. Timbers<F3> None None None
- -------------------------------------------------------------------------------
<F1> This Table does not include the following amounts paid during the fiscal
year ended March 31, 2000: $17,500 paid to a former Trustee who retired in
September 1999 and $35,000 paid to a former Trustee who retired in March 2000.
<F2> Fund complex includes thirty investment portfolios of the Trust and twenty-
one portfolios of Northern Institutional Funds, a separately registered
investment company.
<F3> Messrs. Cline, Condon, Jr., English, Springer, Strubel and Timbers and Ms.
Guthman joined the Board of Trustees effective as of March 28, 2000.
INVESTMENT ADVISER, TRANSFER AGENT AND CUSTODIAN
Northern Trust is a wholly-owned subsidiary of The Northern Trust
Corporation, a Chicago-based multi-bank holding company with subsidiaries in
Colorado, Illinois, Florida, Michigan, New York, Arizona, Georgia, California
and Texas. Northern Trust has for more than 100 years managed the assets of
individuals, charitable organizations, foundations and large corporate
investors. One of the nation's leading providers of trust and investment
management services, Northern Trust first entered the mutual fund business in
1983 by offering money market funds to institutional clients. As part of its
investment advisory services, Northern Trust offers extensive research services
to its clients. As of the date of this Additional Statement, nearly 300
financial institutions nationwide purchase Northern Trust's economic advisory
services. As of September 30, 1999, Northern Trust Corporation and its
subsidiaries had approximately $33.7 billion in assets and $19.1 billion in
deposits. Northern Trust is one of the strongest banking organizations in the
United States and its clients include public and private retirement funds,
endowments, foundations, trusts, corporations and individuals. Northern Funds
complements the banking and personal trust services available through Northern
Trust by allowing Northern Trust's banking and trust clients to consolidate the
management of their finances and thereby move one step closer to one-stop
financial shopping. Northern Funds utilizes a state-of-the-art investor
services center. Also, trained investment representatives are available at
Northern Trust's offices to assist investors in allocating their investments.
Northern Trust believes it has built its organization by serving clients with
integrity, a commitment to quality, and personal attention. Its stated mission
with respect to all its financial products and services is to achieve unrivaled
client satisfaction. Northern Trust manages the Funds through a team of
professionals, led by portfolio managers who follow a disciplined process to
develop investment strategies. The purpose of this approach is to promote
consistent management. The portfolio managers draw upon the resources of
Northern Trust's research department with specialists in economic analysis,
investment strategy, credit quality and tax law, and which supplies information
on interest rates, GNP growth, corporate profits and other factors. NTQA, also
a wholly-owned subsidiary of Northern Trust Corporation, serves as investment
adviser principally to defined benefit and defined contribution plans and
manages over 60 equity and bond commingled and common trust funds. As of
September 30, 1999, the Investment Advisers and their affiliates administered
approximately $1.38 trillion in assets, including $262.8 billion for which the
Investment Advisers had investment management responsibility, for clients
including public and private retirement funds, endowments, foundations, trusts,
corporations, other investment companies and individuals.
Subject to the general supervision of the Board of Trustees, Northern Trust
makes decisions with respect to and places orders for all purchases and sales of
portfolio securities for the Funds (other than the Stock Index, Small Cap Index
and Small Cap Funds), and also provides certain ancillary services. NTQA
provides similar services to the Stock Index, Small Cap Index and Small Cap
Funds. The Investment Advisers are also responsible for monitoring and
preserving the records required to be maintained under the regulations of the
SEC (with certain exceptions unrelated to its activities for Northern Funds).
In making investment recommendations for the Funds, investment advisory
personnel may not inquire or take into consideration whether issuers of
securities proposed for purchase or sale for the Funds' accounts are customers
of Northern Trust's commercial banking department. These requirements are
designed to prevent investment advisory personnel for the Funds from knowing
which companies have commercial business with Northern Trust and from purchasing
securities where they know the proceeds will be used to repay loans to the bank.
Northern Funds' Investment Advisory and Ancillary Services Agreement with
Northern Trust and NTQA (the "Advisory Agreement") has been approved by the
Board of Trustees, including the "non-interested" Trustees, and the initial
shareholder of Northern Funds. The Advisory Agreement provides that in
executing portfolio transactions and in selecting brokers or dealers (a) with
respect to common and preferred stocks, the Investment Advisers shall use their
best judgment to obtain the best overall terms available, and (b) with respect
to other securities, the Investment Advisers shall attempt to obtain best net
price and execution. Transactions on U.S. stock exchanges involve the payment
of negotiated brokerage commissions. On exchanges on which commissions are
negotiated, the cost of transactions may vary among different brokers.
In assessing the best overall terms available for any transaction, the
Investment Advisers are to consider all factors they deem relevant, including
the breadth of the market in the security, the price of the security, the
financial condition and execution capability of the broker or dealer, and the
reasonableness of the commission, if any, both for the specific transaction and
on a continuing basis. In evaluating the best overall terms available and in
selecting the broker or dealer to execute a particular transaction, the
Investment Advisers may consider the brokerage and research services provided to
the Funds and/or other accounts over which the Investment Advisers or an
affiliate of the Investment Advisers exercise investment discretion. A broker
or dealer providing brokerage and/or research services may receive a higher
commission than another broker or dealer would receive for the same transaction.
These brokerage and research services may include industry and company analyses,
portfolio services, quantitative data, market information systems and economic
and political consulting and analytical services.
Supplemental research information so received is in addition to, and not in
lieu of, services required to be performed by the Investment Advisers and does
not reduce the advisory fees payable to the Investment Advisers by the Funds.
The Trustees will periodically review the commissions paid by the Funds to
consider whether the commissions paid over representative periods of time appear
to be reasonable in relation to the benefits inuring to the Funds. It is
possible that certain of the supplemental research or other services received
will primarily benefit one or more other investment companies or other accounts
for which investment discretion is exercised. Conversely, a Fund may be the
primary beneficiary of the research or services received as a result of
portfolio transactions effected for such other account or investment company.
For the fiscal years or periods indicated, the amount of commissions paid
by each Fund was as follows:
- -------------------------------------------------------------------------------
Fiscal Year Ended Fiscal Year Ended Fiscal Year Ended
March 31, 1999 March 31, 1998 March 31, 1997
- -------------------------------------------------------------------------------
Income Equity Fund $36,166 $91,382 $67,369
- -------------------------------------------------------------------------------
Stock Index Fund $12,651 $32,541 $27,972
- -------------------------------------------------------------------------------
Growth Equity Fund $252,010 $475,781 $364,847
- -------------------------------------------------------------------------------
Select Equity Fund $119,043 $312,832 $96,747
- -------------------------------------------------------------------------------
Mid Cap Growth Fund<F1 $46,823 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund $137,526 $324,908 $170,785
- -------------------------------------------------------------------------------
International Growth $1,717,776 $1,455,258 $2,043,586
Equity Fund
- -------------------------------------------------------------------------------
International Select $1,024,518 $610,796 $634,588
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $84,102 $79,005 $40,228
- -------------------------------------------------------------------------------
<F1> The Mid Cap Growth Fund commenced operations on March 31, 1998.
No commissions were paid by the Funds to any "affiliated" persons (as
defined in the 1940 Act) of the Funds. Transactions on foreign stock exchanges
involve payment for brokerage commissions which are generally fixed. Over-the-
counter issues, including corporate debt and government securities, are normally
traded on a "net" basis (i.e., without commission) through dealers, or otherwise
involve transactions directly with the issuer of an instrument. With respect to
over-the-counter transactions, the Investment Advisers will normally deal
directly with dealers who make a market in the instruments involved except in
those circumstances where more favorable prices and execution are available
elsewhere. The cost of foreign and domestic securities purchased from
underwriters includes an underwriting commission or concession, and the prices
at which securities are purchased from and sold to dealers include a dealer's
mark-up or mark-down.
Northern Funds is required to identify any securities of its "regular
brokers or dealers" or their parents which Northern Funds acquired during its
most recent fiscal year.
During the fiscal year ended March 31, 1999, the Money Market Fund acquired
or sold securities of Bear Stearns & Co., Inc., Morgan (J.P.) & Co., Inc. and
Lehman Brothers, Inc. As of March 31, 1999 the Money Market Fund owned
securities of Bear Stearns & Co., Inc., Morgan (J.P.) & Co. and Lehman
Brothers, Inc. in the amounts of $25,001,000, $55,374,000 and $335,214,000
respectively.
During the fiscal year ended March 31, 1999, the U.S. Government Money
Market Fund acquired or sold securities of ABN-AMRO and Lehman Brothers, Inc.
As of March 31, 1999, the U.S. Government Money Market Fund owned securities of
ABN-AMRO and Lehman Brothers, Inc. in the amounts of $20,000,000 and $28,564,000
respectively.
During the fiscal year ended March 31, 1999, the U.S. Government Select
Money Market Fund did not acquire or sell securities of its regular broker-
dealers.
During the fiscal year ended March 31, 1999, the Municipal Money Market
Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the California Municipal Money
Market Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the U.S. Government Fund did
not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Intermediate Tax-Exempt
Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999; the Florida Intermediate Tax-
Exempt Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Fixed Income Fund did not
acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Tax-Exempt Fund did not
acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the California Tax-Exempt Fund
did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the International Fixed Income
Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the High Yield Municipal Fund
did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the High Yield Fixed Income
Fund did not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Income Equity Fund did not
acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Stock Index Fund acquired
or sold securities of Merrill Lynch & Co., Inc., Morgan Stanley Dean Witter &
Co. and Bear Stearns Co., Inc. As of March 31, 1999, the Stock Index Fund owned
securities of Merrill Lynch & Co., Inc., Morgan Stanley Dean Witter & Co. and
Bear Stearns Co., Inc. in the amount of $478,000, $884,000 and $75,000.
During the fiscal year ended March 31, 1999, the Growth Equity Fund
acquired or sold securities of Merrill Lynch & Co., Inc. and Morgan Stanley Dean
Witter & Co. As of March 31, 1999, the Growth Equity Fund owned securities of
Merrill Lynch & Co., Inc. and Morgan Stanley Dean Witter & Co. in the amount of
$3,997,000 and $3,898,000.
During the fiscal year ended March 31, 1999, the Select Equity Fund
acquired or sold securities of Merrill Lynch & Co. and Morgan Stanley Dean
Witter & Co., Inc. As of March 31, 1999, the Select Equity Fund owned
securities of Merrill Lynch & Co., Inc. and Morgan Stanley Dean Witter & Co. in
the amount of $619,000 and $1,699,000.
During the fiscal year ended March 31, 1999, the Mid Cap Growth Fund did
not acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the Small Cap Fund did not
acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999, the International Growth
Equity Fund acquired or sold securities of Deutsche Bank and Societe Generale
Securities. As of March 31, 1999 the International Growth Equity Fund owned
securities of Deutsche Bank and Societe Generale Securities in the amount of
$2,109,000 and $2,690,000.
During the fiscal year ended March 31, 1999, the International Select
Equity Fund did not acquire or sell securities of its regular broker-dealers
During the fiscal year ended March 31, 1999, the Technology Fund did not
acquire or sell securities of its regular broker-dealers.
During the fiscal year ended March 31, 1999 the Small Cap Index Fund, Small
Cap Growth Fund, Short-Intermediate U.S. Government Fund, California
Intermediate Tax-Exempt Fund, Arizona Tax-Exempt Fund and MarketCommand Fund had
not yet commenced operations.
During the fiscal year ending March 31, 1999, Northern Funds directed
brokerage transactions to brokers because of research services provided. The
amount of such transactions and related commissions were as follows: for the
Income Equity Fund, $65,524,789 in research commission transactions and $30,231
in research commissions; for the Stock Index Fund, $32,559,925 in research
commission transactions and $12,014 in research commissions; for the Growth
Equity Fund, $242,523,742 in research commission transactions and $239,086 in
research commissions; for the Select Equity Fund, $112,947,776 in research
commission transactions and $94,548 in research commissions; for the Mid Cap
Growth Fund, $79,512,853 in research commission transactions and $37,383 in
research commissions; for the Small Cap Fund, $19,684,916 in research commission
transactions and $17,506 in research commissions; for the International Growth
Equity Fund, $405,230,730 in research commission transactions and $1,067,083 in
research commissions; for the International Select Equity Fund, $196,523,961 in
research commission transactions and $573,230 in research commissions; and for
the Technology Fund, $227,815,831 in research commission transactions and
$77,653 in research commissions.
The Funds may participate, if and when practicable, in bidding for the
purchase of portfolio securities directly from an issuer in order to take
advantage of the lower purchase price available to members of a bidding group.
The Funds will engage in this practice, however, only when the Investment
Advisers believe such practice to be in the Funds' interests.
Northern Trust's investment advisory duties for Northern Funds are carried
out through its Trust Department. On occasions when an Investment Adviser deems
the purchase or sale of a security to be in the best interests of a Fund as well
as other fiduciary or agency accounts managed by it (including any other
portfolio, investment company or account for which an Investment Adviser acts as
adviser), the Agreement provides that the Investment Adviser, to the extent
permitted by applicable laws and regulations, may aggregate the securities to be
sold or purchased for such Fund with those to be sold or purchased for such
other accounts in order to obtain the best overall terms available with respect
to common and preferred stocks and the best net price and execution with respect
to other securities. In such event, allocation of the securities so purchased
or sold, as well as the expenses incurred in the transaction, will be made by
the Investment Adviser in the manner it considers to be most equitable and
consistent with its fiduciary obligations to the Fund and other accounts
involved. In some instances, this procedure may adversely affect the size of
the position obtainable for the Fund or the amount of the securities that are
able to be sold for the Fund. To the extent that the execution and price
available from more than one broker or dealer are believed to be comparable, the
Agreement permits each Investment Adviser, at its discretion but subject to
applicable law, to select the executing broker or dealer on the basis of the
Investment Adviser's opinion of the reliability and quality of the broker or
dealer.
The Advisory Agreement provides that the Investment Advisers may render
similar services to others so long as their services under such Agreement are
not impaired thereby. The Advisory Agreement also provides that Northern Funds
will indemnify the Investment Advisers against certain liabilities (including
liabilities under the federal securities laws relating to untrue statements or
omissions of material fact and actions that are in accordance with the terms of
the Agreement) or, in lieu thereof, contribute to resulting losses.
From time to time, the Investment Advisers may voluntarily waive a portion
or all of their fees otherwise payable to it with respect to the Funds.
For the fiscal years or periods indicated, Northern Trust and NTQA received
advisory fees, after fee waivers and reimbursements, as follows:
- -------------------------------------------------------------------------------
Fiscal Year
Ended
Fiscal Year Ended Fiscal Year Ended March 31,
March 31, 1999<F1> March 31, 1998<F2> 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $15,349,562 $9,490,597 $5,197,260
- -------------------------------------------------------------------------------
U.S. Government Money $1,730,444 $1,364,316 $950,352
- -------------------------------------------------------------------------------
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select $1,450,638 $673,956 $297,792
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market $8,162,930 $6,064,365 $4,796,468
Fund
- -------------------------------------------------------------------------------
California Municipal $1,091,368 $719,108 $494,616
Money Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $1,895,842 $1,527,868 $1,199,667
- -------------------------------------------------------------------------------
Intermediate Tax-Exempt $2,242,387 $1,973,661 $1,741,679
Fund
- -------------------------------------------------------------------------------
Florida Intermediate $196,206 $125,977 $0
Tax-Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $1,752,818 $1,105,332 $779,240
- -------------------------------------------------------------------------------
Tax-Exempt Fund $1,365,071 $1,035,810 $874,423
- -------------------------------------------------------------------------------
California Tax-Exempt $404,924 $88,551 N/A
Fund
- -------------------------------------------------------------------------------
International Fixed $118,107 $129,287 $111,384
Income Fund
- -------------------------------------------------------------------------------
High Yield Municipal $0 N/A N/A
Fund
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
Fiscal Year
Ended
Fiscal Year Ended Fiscal Year Ended March 31,
March 31, 1999<F1> March 31, 1998<F2> 1997<F3>
- -------------------------------------------------------------------------------
High Yield Fixed Income $0 N/A N/A
Fund
- -------------------------------------------------------------------------------
Income Equity Fund $978,113 $818,335 $519,235
- -------------------------------------------------------------------------------
Stock Index Fund<F4> $490,454 $226,431 $0
- -------------------------------------------------------------------------------
Growth Equity Fund $4,529,273 $3,339,695 $2,267,044
- -------------------------------------------------------------------------------
Select Equity Fund $1,249,368 $802,297 $369,460
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $216,101 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund<F4> $2,669,690 $2,460,252 $1,468,705
- -------------------------------------------------------------------------------
International Growth $1,946,058 $1,756,185 $1,817,708
Equity Fund
- -------------------------------------------------------------------------------
International Select $1,195,310 $1,138,571 $1,111,449
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $1,757,940 $754,963 $198,909
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal, High Yield Fixed Income, and Mid Cap Growth Funds
commenced operations on December 31, 1998, December 31, 1998, and March 31,
1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996 and the
Technology Fund commenced operations on April 1, 1996.
<F4> NTQA assumed investment advisory responsibilities for these Funds on April
1, 1998.
For the fiscal years or periods indicated, Northern Trust voluntarily
waived and reimbursed advisory fees for each of the Funds as follows:
- -------------------------------------------------------------------------------
Fiscal Year Fiscal Year Fiscal Year
Ended Ended Ended
March 31, March 31, March 31,
1999<F1> 1998<F2> 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $7,674,790 $4,745,304 $2,622,157
- -------------------------------------------------------------------------------
U.S. Government Money Market $865,224 $682,159 $519,441
Fund
- -------------------------------------------------------------------------------
U.S. Government Select Money $725,320 $632,972 $419,570
Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market Fund $4,081,471 $3,032,186 $2,417,444
- -------------------------------------------------------------------------------
California Municipal Money $545,685 $568,061 $497,282
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $0 $0 $31,267
- -------------------------------------------------------------------------------
Intermediate Tax-Exempt Fund $160,168 $140,974 $153,096
- -------------------------------------------------------------------------------
Florida Intermediate Tax- $23,427 $26,197 $53,960
Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $0 $0 $36,750
- -------------------------------------------------------------------------------
Tax-Exempt Fund $97,545 $73,985 $99,421
- -------------------------------------------------------------------------------
California Tax-Exempt Fund $28,923 $53,795 N/A
- -------------------------------------------------------------------------------
International Fixed Income $15,857 $10,037 $34,638
Fund
- -------------------------------------------------------------------------------
High Yield Municipal Fund $10,562 N/A N/A
- -------------------------------------------------------------------------------
High Yield Fixed Income Fund $41,621 N/A N/A
- -------------------------------------------------------------------------------
Income Equity Fund $172,607 $144,411 $138,239
- -------------------------------------------------------------------------------
Stock Index Fund<F4> $245,227 $117,685 $70,191
- -------------------------------------------------------------------------------
Growth Equity Fund $799,277 $589,353 $440,662
- -------------------------------------------------------------------------------
Select Equity Fund $514,443 $330,356 $209,152
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $93,569 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund<F4> $1,099,279 $1,013,041 $639,770
- -------------------------------------------------------------------------------
International Growth Equity $389,208 $351,234 $368,198
Fund
- -------------------------------------------------------------------------------
International Select Equity $239,060 $227,712 $225,196
Fund
- -------------------------------------------------------------------------------
Technology Fund $351,585 $150,991 $89,958
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal, High Yield Fixed Income, and Mid Cap Growth Funds
commenced operations on December 31, 1998, December 31, 1998, and March 31,
1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996 and the
Technology Fund commenced operations on April 1, 1996.
<F4> NTQA assumed investment advisory responsibilities for these Funds on April
1, 1998.
Under its Transfer Agency Agreement with Northern Funds, Northern Trust has
undertaken, among other things, to perform the following services: (1) answer
shareholder inquiries and respond to requests for information regarding Northern
Funds; (2) process purchase and redemption transactions; (3) establish and
maintain shareholder accounts and subaccounts; (4) furnish confirmations in
accordance with applicable law, and provide periodic account statements to each
shareholder; (5) furnish proxy statements and proxies, annual and semi-annual
financial statements, and dividend, distribution and tax notices to
shareholders; (6) act as income disbursing agent; and (7) maintain appropriate
records relating to its services. Northern Trust may appoint one or more sub-
transfer agents in the performance of its services.
As compensation for the services rendered by Northern Trust under the
Transfer Agency Agreement and the assumption by Northern Trust of related
expenses, Northern Trust is entitled to a fee from Northern Funds, payable
monthly, at an annual rate of .10% of the average daily net asset value of each
of the Funds.
For the fiscal years or periods indicated, the amount of transfer agency
fees incurred by each of the Funds was as follows:
- -------------------------------------------------------------------------------
Fiscal Year Ended Fiscal Year Ended Fiscal Year Ended
March 31, 1999<F1> March 31, 1998<F2> March 31, 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $3,837,356 $2,372,628 $1,299,295
- -------------------------------------------------------------------------------
U.S. Government Money $432,607 $341,076 $244,185
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select $362,656 $217,819 $119,115
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market $2,040,714 $1,516,077 $1,199,098
Fund
- -------------------------------------------------------------------------------
California Municipal $272,840 $214,526 $164,871
Money Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $252,777 $203,714 $164,123
- -------------------------------------------------------------------------------
Intermediate Tax-Exemp $320,338 $281,949 $251,858
Fund
- -------------------------------------------------------------------------------
Florida Intermediate $29,284 $20,290 $6,302
Tax-Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $233,707 $147,377 $108,797
- -------------------------------------------------------------------------------
Tax-Exempt Fund $195,008 $147,971 $129,549
- -------------------------------------------------------------------------------
California Tax-Exempt $57,846 $18,926 N/A
Fund
- -------------------------------------------------------------------------------
International Fixed $14,885 $15,480 $16,224
Income Fund
- -------------------------------------------------------------------------------
High Yield Municipal $1,408 N/A N/A
Fund
- -------------------------------------------------------------------------------
High Yield Fixed Incom $5,549 N/A N/A
Fund
- -------------------------------------------------------------------------------
Income Equity Fund $115,071 $96,274 $65,560
- -------------------------------------------------------------------------------
Stock Index Fund $122,613 $57,352 $8,670
- -------------------------------------------------------------------------------
Growth Equity Fund $532,850 $392,901 $270,025
- -------------------------------------------------------------------------------
Select Equity Fund $146,983 $94,387 $48,045
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $30,967 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund $314,078 $289,438 $175,244
- -------------------------------------------------------------------------------
International Growth $194,604 $175,617 $181,765
Equity Fund
- -------------------------------------------------------------------------------
International Select $119,530 $113,856 $111,143
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $175,792 $75,496 $23,916
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal, High Yield Fixed Income, and Mid Cap Growth Funds
commenced operations on December 31, 1998, December 31, 1998, and March 31,
1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996; and the
Technology Fund commenced operations on April 1, 1996.
Northern Trust maintains custody of the assets of the Funds (other than the
International Funds) pursuant to the terms of its Custodian Agreement with
Northern Funds. Northern Trust maintains custody of the assets of the
International Funds pursuant to the terms of its Foreign Custody Agreement with
Northern Funds. Under each of these agreements, Northern Trust (l) holds each
Fund's cash and securities, (2) maintains such cash and securities in separate
accounts in the name of the Fund, (3) makes receipts and disbursements of funds
on behalf of the Fund, (4) receives, delivers and releases securities on behalf
of the Fund, (5) collects and receives all income, principal and other payments
in respect of the Fund's investments held by Northern Trust under the agreement,
and (6) maintains the accounting records of Northern Funds. Northern Trust may
employ one or more subcustodians under the Custody Agreement, provided that
Northern Trust shall, subject to certain monitoring responsibilities, have no
more responsibility or liability to Northern Funds on account of any action or
omission of any subcustodian so employed than such subcustodian has to Northern
Trust and that the responsibility or liability of the subcustodian to Northern
Trust shall conform to the resolution of the Trustees of Northern Funds
authorizing the appointment of the particular subcustodian. Northern Trust may
also appoint an agent to carry out such of the provisions of the Custody
Agreement as Northern Trust may from time to time direct. Under its Foreign
Custody Agreement, Northern Trust has entered into agreements with financial
institutions and depositories located in foreign countries with respect to the
custody of the International Funds' foreign securities.
As compensation for the services rendered to each Fund (other than the
International Funds) under the Custodian Agreement, and the assumption by
Northern Trust of certain related expenses, Northern Trust is entitled to
payment from each of the Funds as follows: (a) a basic custodial fee of (i)
$18,000 annually for each Fund, plus (ii) 1/100th of 1% annually of each Fund's
average daily net assets to the extent they exceed $100 million, plus (b) a
basic accounting fee of (i) $25,000 annually for each Fund, plus (ii) 1/100th of
1% annually of each Fund's average daily net assets to the extent they exceed
$50 million, plus (c) a fixed dollar fee for each trade in portfolio securities,
plus (d) a fixed dollar fee for each time that Northern Trust as Custodian
receives or transmits funds via wire, plus (e) reimbursement of expenses
incurred by Northern Trust as Custodian for telephone, postage, courier fees,
office supplies and duplicating. The fees referred to in clauses (c) and (d)
are subject to annual upward adjustments based on increases in the Consumer
Price Index for All Urban Consumers, provided that Northern Trust may
permanently or temporarily waive all or any portion of any upward adjustment.
As compensation for the services rendered to the International Funds under
the Foreign Custody Agreement, and the assumption by Northern Trust of certain
related expenses, Northern Trust is entitled to payment from each of those Funds
as follows: (i) $35,000 annually for each Fund, plus (ii) 9/100th of 1% annually
of each Fund's average daily net assets, plus (iii) reimbursement for fees
incurred by Northern Trust as foreign Custodian for telephone, postage, courier
fees, office supplies and duplicating. As compensation for basic accounting
services rendered to the International Funds by Northern Trust, Northern Trust
is entitled to receive $25,000 for the first $50 million of each of those Fund's
average daily net assets and 1/100th of 1% of each Fund's average daily net
assets in excess of $50 million.
Northern's fees under the Custodian Agreement and Foreign Custody Agreement
are subject to reduction based on the Funds' daily uninvested cash balances (if
any).
For the fiscal years or periods indicated, the amount of custody and fund
accounting fees incurred by each of the Funds was as follows:
- -------------------------------------------------------------------------------
Fiscal Year Ended Fiscal Year Ended Fiscal Year Ended
March 31, 1999<F1> March 31, 1998<F2> March 31, 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $844,081 $540,182 $319,698
- -------------------------------------------------------------------------------
U.S. Government Money $136,794 $114,701 $90,285
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select $110,597 $79,062 $61,237
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market $478,551 $358,220 $280,150
Fund
- -------------------------------------------------------------------------------
California Municipal $100,159 $86,643 $72,486
Money Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $85,772 $72,223 $65,101
- -------------------------------------------------------------------------------
Intermediate Tax-Exempt $103,042 $91,127 $87,303
Fund
- -------------------------------------------------------------------------------
Florida Intermediate $48,986 $46,979 $31,173
Tax-Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $84,111 $64,094 $57,834
- -------------------------------------------------------------------------------
Tax-Exempt Fund $78,492 $64,384 $60,461
- -------------------------------------------------------------------------------
California Tax-Exempt $50,725 $48,223 N/A
Fund
- -------------------------------------------------------------------------------
International Fixed $77,396 $74,075 $75,592
Income Fund
- -------------------------------------------------------------------------------
High Yield Municipal $14,132 N/A N/A
Fund
- -------------------------------------------------------------------------------
High Yield Fixed Income $14,132 N/A N/A
Fund
- -------------------------------------------------------------------------------
Income Equity Fund $61,425 $56,325 $54,136
- -------------------------------------------------------------------------------
Stock Index Fund $122,803 $133,408 $64,425
- -------------------------------------------------------------------------------
Growth Equity Fund $143,431 $115,833 $92,102
- -------------------------------------------------------------------------------
Select Equity Fund $72,051 $60,090 $51,726
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $44,274 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund $141,187 $136,631 $88,231
- -------------------------------------------------------------------------------
International Growth $257,479 $228,550 $239,257
Equity Fund
- -------------------------------------------------------------------------------
International Select $182,139 $167,301 $168,250
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $78,748 $55,245 $63,987
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal, High Yield Fixed Income, and Mid Cap Growth Funds
commenced operations on December 31, 1998, December 31, 1998, and March 31,
1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996; and the
Technology Fund commenced operations on April 1, 1996.
Unless sooner terminated, Northern Funds' Advisory Agreement, Transfer
Agency Agreement, Custodian Agreement and Foreign Custody Agreement will
continue in effect with respect to a particular Fund until March 31, 2000, and
thereafter for successive 12-month periods, provided that the continuance is
approved at least annually (a) by the vote of a majority of the Trustees who are
not parties to the agreement or "interested persons" (as such term is defined in
the 1940 Act) of any party thereto, cast in person at a meeting called for the
purpose of voting on such approval and (b) by the Trustees or by the vote of a
majority of the outstanding shares of the Fund (as defined under "Description of
Shares"). Each agreement is terminable at any time without penalty by Northern
Funds (by specified Trustee or shareholder action) on 60 days' written notice to
Northern Trust (or NTQA) and by Northern Trust (or NTQA) on 60 days' written
notice to Northern Funds.
Northern Trust is active as an underwriter of municipal instruments. Under
the 1940 Act, the Funds are precluded, subject to certain exceptions, from
purchasing in the primary market those municipal instruments with respect to
which Northern Trust is serving as a principal underwriter. In the opinion of
Northern Trust, this limitation will not significantly affect the ability of the
Funds to pursue their respective investment objectives.
In the Advisory Agreement, Northern Trust agrees that the name "Northern"
may be used in connection with Northern Funds' business on a royalty-free basis.
Northern Trust has reserved to itself the right to grant the non-exclusive right
to use the name "Northern" to any other person. The Advisory Agreement provides
that at such time as the Agreement is no longer in effect, Northern Funds will
cease using the name "Northern."
CO-ADMINISTRATORS AND DISTRIBUTOR
Northern Trust and PFPC, 4400 Computer Drive, Westborough, Massachusetts
01581, act as co-administrators for the Funds under a Co-Administration
Agreement with Northern Funds. Subject to the general supervision of Northern
Funds' Board of Trustees, Northern Trust and PFPC (the "Co-Administrators")
provide supervision of all aspects of Northern Funds' non-investment advisory
operations and perform various corporate secretarial, treasury and blue sky
services, including but not limited to: (a) maintaining office facilities and
furnishing corporate officers for Northern Funds; (b) furnishing data processing
services, clerical services, and executive and administrative services and
standard stationery and office supplies; (c) performing all functions ordinarily
performed by the office of a corporate treasurer, and furnishing the services
and facilities ordinarily incident thereto, such as expense accrual monitoring
and payment of Northern Funds' bills, preparing monthly reconciliation of
Northern Funds' expense records, updating projections of annual expenses,
preparing materials for review by the Board of Trustees and compliance testing;
(d) preparing and submitting reports to Northern Funds' shareholders and the
SEC; (e) preparing and printing financial statements; (f) preparing monthly Fund
profile reports; (g) preparing and filing Northern Funds' federal and state tax
returns (other than those required to be filed by Northern Funds' custodian and
transfer agent) and providing shareholder tax information to Northern Funds'
transfer agent; (h) assisting in marketing strategy and product development; (i)
performing oversight/management responsibilities, such as the supervision and
coordination of certain of Northern Funds' service providers; (j) effecting and
maintaining, as the case may be, the registration of shares of Northern Funds
for sale under the securities laws of various jurisdictions; (k) assisting in
maintaining corporate records and good standing status of Northern Funds in its
state of organization; and (l) monitoring Northern Funds' arrangements with
respect to services provided by Service Organizations to their customers who are
the beneficial owners of shares.
Subject to the limitations described below, as compensation for their
administrative services and the assumption of related expenses, the Co-
Administrators are entitled to a fee from each Fund, computed daily and payable
monthly, at an annual rate of 0.15% of the average daily net assets of each
Fund.
Prior to October 1, 1999, Sunstone Financial Group, Inc., 207 E. Buffalo
Street, Milwaukee, Wisconsin 53202 acted as Northern Funds' administrator
pursuant to an administration agreement substantially similar to the Co-
Administration Agreement currently in effect with Northern Trust and PFPC.
For the fiscal years or periods indicated, Sunstone received, after
waivers, administrative fees as follows:
- -------------------------------------------------------------------------------
Fiscal Year Ended Fiscal Year Ended Fiscal Year Ended
March 31, 1999<F1> March 31, 1998<F2> March 31, 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $2,447,894 $1,186,568 $1,164,584
- -------------------------------------------------------------------------------
U.S. Government Money $294,367 $217,652 $218,281
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Selec $226,085 $124,207 $23,962
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Marke $1,339,727 $929,212 $1,075,662
Fund
- -------------------------------------------------------------------------------
California Municipal $176,849 $131,467 $81,496
Money Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $171,664 $124,997 $195,647
- -------------------------------------------------------------------------------
Intermediate Tax- $215,890 $178,379 $301,417
Exempt Fund
- -------------------------------------------------------------------------------
Florida Intermediate $17,638 $11,284 $7,174
Tax-Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $154,709 $85,293 $129,589
- -------------------------------------------------------------------------------
Tax-Exempt Fund $128,048 $92,041 $154,841
- -------------------------------------------------------------------------------
California Tax-Exempt $35,426 $6,684 N/A
Fund
- -------------------------------------------------------------------------------
International Fixed $10,053 $10,534 $19,435
Income Fund
- -------------------------------------------------------------------------------
High Yield Municipal $708 N/A N/A
Fund
- -------------------------------------------------------------------------------
High Yield Fixed $2,958 N/A N/A
Income Fund
- -------------------------------------------------------------------------------
Income Equity Fund $78,886 $57,142 $77,746
- -------------------------------------------------------------------------------
Stock Index Fund $77,739 $30,318 $9,252
- -------------------------------------------------------------------------------
Growth Equity Fund $349,439 $235,526 $320,662
- -------------------------------------------------------------------------------
Select Equity Fund $94,686 $53,548 $56,368
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $14,391 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund $224,567 $157,708 $208,264
- -------------------------------------------------------------------------------
International Growth $132,079 $115,012 $219,176
Equity Fund
- -------------------------------------------------------------------------------
International Select $82,930 $74,312 $133,479
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $87,044 $41,187 $27,287
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal Fund, High Yield Fixed Income, and Mid Cap Growth
Funds commenced operations on December 31, 1998, December 31, 1998, and
March 31, 1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996; and the
Technology Fund commenced operations on April 1, 1996.
For the fiscal years or periods indicated, Sunstone waived administrative
fees with respect to each Fund as follows:
- -------------------------------------------------------------------------------
Fiscal Year Ended Fiscal Year Ended Fiscal Year Ended
March 31, 1999<F1> March 31, 1998<F2> March 31, 1997<F3>
- -------------------------------------------------------------------------------
Money Market Fund $3,308,194 $2,372,408 $790,270
- -------------------------------------------------------------------------------
U.S. Government Money $354,550 $293,967 $149,167
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select $317,904 $202,525 $155,378
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market $1,721,373 $1,344,926 $727,816
Fund
- -------------------------------------------------------------------------------
California Municipal Mone $232,414 $244,331 $166,479
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Fund $207,505 $180,577 $51,170
- -------------------------------------------------------------------------------
Intermediate Tax-Exempt $264,621 $244,548 $77,538
Fund
- -------------------------------------------------------------------------------
Florida Intermediate Tax- $26,288 $19,151 $2,308
Exempt Fund
- -------------------------------------------------------------------------------
Fixed Income Fund $195,856 $135,774 $34,026
- -------------------------------------------------------------------------------
Tax-Exempt Fund $164,475 $129,918 $39,928
- -------------------------------------------------------------------------------
California Tax-Exempt Fun $51,343 $21,785 N/A
- -------------------------------------------------------------------------------
International Fixed Incom $12,274 $12,687 $4,953
Fund
- -------------------------------------------------------------------------------
High Yield Municipal Fund $1,405 N/A N/A
- -------------------------------------------------------------------------------
High Yield Fixed Income $5,367 N/A N/A
Fund
- -------------------------------------------------------------------------------
Income Equity Fund $93,722 $87,270 $20,875
- -------------------------------------------------------------------------------
Stock Index $106,182 $55,711 $3,836
- -------------------------------------------------------------------------------
Growth Equity Fund $449,843 $353,831 $85,494
- -------------------------------------------------------------------------------
Select Equity Fund $125,790 $88,034 $15,958
- -------------------------------------------------------------------------------
Mid Cap Growth Fund $32,060 N/A N/A
- -------------------------------------------------------------------------------
Small Cap Fund $246,554 $276,453 $55,295
- -------------------------------------------------------------------------------
International Growth $159,830 $148,415 $54,062
Equity Fund
- -------------------------------------------------------------------------------
International Select $96,366 $96,473 $33,602
Equity Fund
- -------------------------------------------------------------------------------
Technology Fund $176,646 $72,057 $8,821
- -------------------------------------------------------------------------------
<F1> The High Yield Municipal Fund, High Yield Fixed Income, and Mid Cap Growth
Funds commenced operations on December 31, 1998, December 31, 1998, and
March 31, 1998, respectively.
<F2> The California Tax-Exempt Fund commenced operations on April 8, 1997.
<F3> The Florida Intermediate Tax-Exempt Fund commenced operations on August 15,
1996; the Stock Index Fund commenced operations on October 7, 1996; and the
Technology Fund commenced operations on April 1, 1996.
Unless sooner terminated, the Co-Administration Agreement will continue in
effect until September 30, 2001, and thereafter for successive one-year terms
with respect to each Fund, provided that the Agreement is approved annually (1)
by the Board of Trustees or (2) by the vote of a majority of the outstanding
shares of such Fund (as defined below under "Description of Shares"), provided
that in either event the continuance is also approved by a majority of the
Trustees who are not parties to the Agreement and who are not interested persons
(as defined in the 1940 Act) of any party thereto, by vote cast in person at a
meeting called for the purpose of voting on such approval. The Co-Administration
Agreement is terminable at any time after September 30, 2001 without penalty by
Northern Funds on at least 60 days written notice to the Co-Administrators.
Each Co-Administrator may terminate the Co-Administration Agreement with respect
to itself at any time after September 30, 2001 without penalty on at least 60
days written notice to Northern Funds and the other Co-Administrator.
Northern Funds may terminate the Co-Administration Agreement prior to
September 30, 2001 in the event that Northern Funds or its shareholders incur
damages in excess of $100,000 as a result of the willful misfeasance, bad faith
or negligence of the Co-Administrators, or the reckless disregard of their
duties under the Agreement. Northern Funds may also terminate the Co-
Administration Agreement prior to September 30, 2001 in the event that the Co-
Administrators fail to meet one of the performance standards set forth in the
Agreement.
Northern Funds has also entered into a Distribution Agreement under which
Northern Funds Distributors, LLC, as agent, sells shares of each Fund on a
continuous basis. Northern Funds Distributors, LLC pays the cost of printing
and distributing prospectuses to persons who are not shareholders of Northern
Funds (excluding preparation and typesetting expenses) and of certain other
distribution efforts. No compensation is payable by Northern Funds to Northern
Funds Distributors, LLC for such distribution services. Northern Funds
Distributors, LLC is a wholly-owned subsidiary of Provident Distributors, Inc.
("PDI"). PDI, based in West Conshohocken, Pennsylvania, is an independently
owned and operated broker-dealer.
The Co-Administration Agreement provides that the Co-Administrators may
render similar services to others so long as their services under such Agreement
are not impaired thereby. The Co-Administration Agreement also provides that
Northern Funds will indemnify each Co-Administrator against all claims except
those resulting from the willful misfeasance, bad faith or negligence of such
Co-Administrator, or the Co-Administrator's breach of confidentiality. The
Distribution Agreement provides that Northern Funds will indemnify Northern
Funds Distributors, LLC against certain liabilities relating to untrue
statements or omissions of material fact except those resulting from the
reliance on information furnished to Northern Funds by Northern Funds
Distributors, LLC, or those resulting from the willful misfeasance, bad faith or
negligence of Northern Funds Distributors, LLC, or Northern Funds Distributors,
LLC's breach of confidentiality.
Under a Service Mark License Agreement with Northern Funds Distributors,
LLC, Northern Trust Corporation agrees that the name "Northern Funds" may be
used in connection with Northern Funds' business on a royalty-free basis.
Northern Trust Corporation has reserved to itself the right to grant the non-
exclusive right to use the name "Northern Funds" to any other person. The
Agreement provides that at such time as the Agreement is no longer in effect,
Northern Funds Distributors, LLC will cease using the name "Northern Funds."
SERVICE ORGANIZATIONS
As stated in the Funds' Prospectus, the Funds may enter into agreements
from time to time with Service Organizations providing for support and/or
distribution services to customers of the Service Organizations who are the
beneficial owners of Fund shares. Under the agreements, the Funds may pay
Service Organizations up to .25% (on an annualized basis) of the average daily
net asset value of the shares beneficially owned by their customers. Support
services provided by Service Organizations under their agreements may include:
(a) processing dividend and distribution payments from a Fund; (b) providing
information periodically to customers showing their share positions; (c)
arranging for bank wires; (d) responding to customer inquiries; (e) providing
subaccounting with respect to shares beneficially owned by customers or the
information necessary for subaccounting; (f) forwarding shareholder
communications; (g) assisting in processing share purchase, exchange and
redemption requests from customers; (h) assisting customers in changing dividend
options, account designations and addresses; and (i) other similar services
requested by the Funds. In addition, Service Organizations may provide
assistance (such as the forwarding of sales literature and advertising to their
customers) in connection with the distribution of Fund shares.
The Funds' arrangements with Service Organizations under the agreements are
governed by two Plans (a Service Plan and a Distribution and Service Plan),
which have been adopted by the Board of Trustees. Because the Distribution and
Service Plan contemplates the provision of services related to the distribution
of Fund shares (in addition to support services), that Plan has been adopted in
accordance with Rule 12b-1 under the 1940 Act. In accordance with the Plans,
the Board of Trustees reviews, at least quarterly, a written report of the
amounts expended in connection with the Funds' arrangements with Service
Organizations and the purposes for which the expenditures were made. In
addition, the Funds' arrangements with Service Organizations must be approved
annually by a majority of the Trustees, including a majority of the Trustees who
are not "interested persons" of the Funds as defined in the 1940 Act and have no
direct or indirect financial interest in such arrangements (the "Disinterested
Trustees").
The Board of Trustees believes that there is a reasonable likelihood that
their arrangements with Service Organizations will benefit each Fund and its
shareholders. Any material amendment to the arrangements with Service
Organizations under the agreements must be approved by a majority of the Board
of Trustees (including a majority of the Disinterested Trustees), and any
amendment to increase materially the costs under the Distribution and Service
Plan with respect to a Fund must be approved by the holders of a majority of the
outstanding shares of the Fund involved. So long as the Distribution and
Service Plan is in effect, the selection and nomination of the members of the
Board of Trustees who are not "interested persons" (as defined in the 1940 Act)
of the Northern Funds will be committed to the discretion of such disinterested
Trustees.
For the fiscal period ended March 31, 1999, the Money Market Fund, U.S.
Government Money Market Fund, Income Equity Fund, Growth Equity Fund, Stock
Index Fund, Select Equity Fund, Small Cap Fund, International Growth Equity
Fund, International Select Equity Fund and Technology Fund paid fees of $25,567,
$29,542, $146, $37, $37, $73, $110, $957, $37 and $2,103, respectively, under
the Service Plan. No other Funds paid fees under either Plan.
For the fiscal period ended March 31, 1998, the Money Market Fund, U.S.
Government Money Market Fund, Income Equity Fund, Growth Equity Fund, Select
Equity Fund, Small Cap Fund, International Select Equity Fund and Technology
Fund paid fees of $107, $40,296, $181, $145, $440, $368, $78 and $449,
respectively, under the Service Plan. No other Funds paid fees under either
Plan.
For the fiscal period ended March 31, 1997, the Municipal Money Market Fund
and the U.S. Government Money Market Fund paid fees of $98 and $59,754,
respectively, under the Service Plan. No other Funds paid fees under either
Plan.
COUNSEL AND AUDITORS
Drinker Biddle & Reath LLP, with offices at One Logan Square, 18th and
Cherry Streets, Philadelphia, Pennsylvania 19103, serve as counsel to Northern
Funds.
Arthur Andersen LLP, independent accountants, 33 West Monroe Street,
Chicago, Illinois 60603-5385 serve as auditors for Northern Funds. The
financial statements dated March 31, 1999, incorporated by reference into this
Additional Statement have been incorporated in reliance on the report of Arthur
Andersen LLP given on the authority of said firm as experts in auditing and
accounting.
IN-KIND PURCHASES AND REDEMPTIONS
Payment for shares of a Fund may, in the discretion of Northern Trust, be
made in the form of securities that are permissible investments for the Fund as
described in the Prospectus. For further information about this form of
payment, contact the Transfer Agent. In connection with an in-kind securities
payment, a Fund will require, among other things, that the securities be valued
on the day of purchase in accordance with the pricing methods used by the Fund
and that the Fund receive satisfactory assurances that it will have good and
marketable title to the securities received by it; that the securities be in
proper form for transfer to the Fund; and that adequate information be provided
concerning the basis and other tax matters relating to the securities.
Although each Fund generally will redeem shares in cash, each Fund reserves
the right to pay redemptions by a distribution in-kind of securities (instead of
cash) from such Fund. The securities distributed in-kind would be readily
marketable and would be valued for this purpose using the same method employed
in calculating the Fund's net asset value per share. If a shareholder receives
redemption proceeds in-kind, the shareholder should expect to incur transaction
costs upon the disposition of the securities received in the redemption.
AUTOMATIC INVESTING PLAN
The Automatic Investing Plan permits an investor to use "Dollar Cost
Averaging" in making investments. Instead of trying to time market performance,
a fixed dollar amount is invested in shares at predetermined intervals. This
may help investors reduce their average cost per share because the agreed upon
fixed investment amount allows more shares to be purchased during periods of
lower share prices and fewer shares during periods of higher share prices. In
order to be effective, Dollar Cost Averaging should usually be followed on a
sustained, consistent basis. Investors should be aware, however, that shares
bought using Dollar Cost Averaging are purchased without regard to their price
on the day of investment or to market trends. Dollar Cost Averaging does not
assure a profit and does not protect against losses in a declining market. In
addition, while investors may find Dollar Cost Averaging to be beneficial, it
will not prevent a loss if an investor ultimately redeems shares at a price
which is lower than their purchase price. An investor may want to consider his
or her financial ability to continue purchases through periods of low price
levels.
DIRECTED REINVESTMENTS
In addition to having your income dividends and/or capital gains
distributions reinvested in shares of the Fund from which such distributions are
paid, you may elect the directed reinvestment option and have dividends and
capital gains distributions automatically invested in another Northern Fund.
Reinvestments can only be directed to an existing Northern Funds account (which
must meet the minimum investment requirement). Directed reinvestments may be
used to invest funds from a regular account to another regular account, from a
qualified plan account to another qualified plan account, or from a qualified
plan account to a regular account. Directed reinvestments from a qualified plan
account to a regular account may have adverse tax consequences including
imposition of a penalty tax and, therefore, you should consult your own tax
adviser before commencing these transactions.
REDEMPTIONS AND EXCHANGES
Exchange requests received on a Business Day prior to the time shares of
the Funds involved in the request are priced will be processed on the date of
receipt. "Processing" a request means that shares in the Fund from which the
shareholder is withdrawing an investment will be redeemed at the net asset value
per share next determined on the date of receipt. Shares of the new Fund into
which the shareholder is investing will also normally be purchased at the net
asset value per share next determined coincident to or after the time of
redemption. Exchange requests received on a Business Day after the time shares
of the Funds involved in the request are priced will be processed on the next
Business Day in the manner described above.
Northern Funds may redeem shares involuntarily to reimburse a Fund for any
loss sustained by reason of the failure of a shareholder to make full payment
for shares purchased by the shareholder or to collect any charge relating to a
transaction effected for the benefit of a shareholder which is applicable to
Fund shares as provided in the Funds' Prospectus from time to time. Northern
Funds reserves the right on 60 days' written notice, to redeem the shares held
in any account if at the time of redemption, the net asset value of the
remaining shares in the account falls below $1,000. Such involuntary
redemptions will not be made if the value of shares in an account falls below
the minimum solely because of a decline in the Fund's net asset value. Northern
Funds may also redeem shares involuntarily if the redemption is appropriate to
carry out Northern Funds' responsibilities under the 1940 Act (see, e.g.,
"Amortized Cost Valuation"). ----
RETIREMENT PLANS
Shares of the Funds may be purchased in connection with certain tax-
sheltered retirement plans, including profit-sharing plans, 401(k) plans, money
purchase pension plans, target benefit plans and individual retirement accounts.
Further information about how to participate in these plans, the fees charged
and the limits on contributions can be obtained from Northern Trust. To invest
through any of the tax-sheltered retirement plans, please call Northern Trust
for information and the required separate application. To determine whether the
benefits of a tax-sheltered retirement plan are available and/or appropriate, a
shareholder should consult with a tax adviser.
EXPENSES
Except as set forth above and in this Additional Statement, each Fund is
responsible for the payment of its expenses. These expenses include, without
limitation, the fees and expenses payable to Northern Trust and PFPC, brokerage
fees and commissions, fees for the registration or qualification of Fund shares
under federal or state securities laws, expenses of the organization of Northern
Funds, taxes, interest, costs of liability insurance, fidelity bonds,
indemnification or contribution, any costs, expenses or losses arising out of
any liability of, or claim for damages or other relief asserted against Northern
Funds for violation of any law, legal, tax and auditing fees and expenses,
expenses of preparing and printing prospectuses, statements of additional
information, proxy materials, reports and notices and the printing and
distributing of the same to the Funds' shareholders and regulatory authorities,
compensation and expenses of its Trustees, payments to Service Organizations,
fees of industry organizations such as the Investment Company Institute, and
miscellaneous and extraordinary expenses incurred by Northern Funds.
Northern Trust and PFPC, intend to voluntarily reimburse a portion of the
Funds' expenses and/or reduce their advisory and co-administrative fees from the
Funds during the current fiscal year. The result of these reimbursements and
fee reductions will be to increase the performance of the Funds during the
periods for which the reductions and reimbursements are made.
PERFORMANCE INFORMATION
MONEY MARKET FUNDS
From time to time Northern Funds may advertise quotations of "yields" and
"effective yields" with respect to each Money Market Fund, and the Municipal
Money Market Fund, Tax-Exempt Money Market Fund and the California Municipal
Money Market Fund may advertise their "tax-equivalent yields" and "tax-
equivalent effective yields." These yield figures will fluctuate, are based on
historical earnings and are not intended to indicate future performance.
"Yield" refers to the net investment income generated by an investment in the
Fund over a seven-day period identified in the advertisement. This net
investment income is then "annualized." That is, the amount of net investment
income generated by the investment during that week is assumed to be generated
each week over a 52-week period and is shown as a percentage of the investment.
In arriving at quotations as to "yield," Northern Funds first determines
the net change during the period in the value of a hypothetical pre-existing
account having a balance of one share at the beginning of the period, then
divides such net change by the value of the account at the beginning of the
period to obtain the base period return, and then multiplies the base period
return by 365/7.
"Effective yield" is calculated similarly but, when annualized, the net
investment income earned by an investment in the Fund is assumed to be
reinvested. The "effective yield" will be slightly higher than the "yield"
because of the compounding effect of this assumed reinvestment. The "effective
yield" with respect to the shares of a Money Market Fund is computed by adding 1
to the base period return (calculated as above), raising the sum to a power
equal to 365 divided by 7, and subtracting 1 from the result.
The "tax-equivalent yield" demonstrates the level of taxable yield
necessary to produce an after-tax yield equivalent to a Fund's tax-free yield.
It is calculated by taking that portion of the seven-day "yield" which is tax-
exempt and adjusting it to reflect the tax savings associated with a stated tax
rate. The "tax-equivalent current yield" will always be higher than the Fund's
yield.
"Tax-equivalent yield" is computed by dividing the tax-exempt portion of
the yield by 1 minus a stated income tax rate and then adding the quotient to
the taxable portion of the yield, if any. There may be more than one tax-
equivalent yield if more than one stated income tax rate is used.
The "tax-equivalent effective yield" demonstrates the level of taxable
yield necessary to produce an after-tax yield equivalent to a Fund's tax-free
effective yield. It is calculated by taking that portion of the seven-day
"effective yield" which is tax-exempt and adjusting it to reflect the tax
savings associated with a stated tax rate. The "tax-equivalent effective yield"
will always be higher than the Fund's effective yield.
"Tax-equivalent effective yield" is computed by dividing the tax-exempt
portion of the effective yield by 1 minus a stated income tax-rate, and then
adding the quotient to the taxable portion of the effective yield, if any.
There may be more than one tax-equivalent effective yield, if more than one
stated income tax rate is used.
The annualized yield of each Money Market Fund for the seven-day period
ended March 31, 1999 was as follows<F1>:
- -------------------------------------------------------------------------------
Effective Tax-Equivalent Tax-Equivalent
Yield Yield Yield Effective Yield
- -------------------------------------------------------------------------------
Money Market Fund 4.97% 5.09% 7.20% 7.38%
- -------------------------------------------------------------------------------
U.S. Government Money 4.82% 4.93% 6.99% 7.14%
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select 4.70% 4.81% 6.81% 6.97%
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market 3.16% 3.21% 4.58% 4.65%
Fund
- -------------------------------------------------------------------------------
California Municipal 2.95% 2.99% 4.28% 4.33%
Money Market Fund
- -------------------------------------------------------------------------------
<F1> An income tax rate of 31% is used in the calculation of tax-equivalent
yield and tax-equivalent effective yield.
The information set forth in the foregoing table reflects certain fee
reductions and expense limitations. See "Additional Trust Information _
Investment Adviser, Transfer Agent and Custodian" and "Co-Administrators and
Distributor." In the absence of such fee reductions and expense limitations,
the annualized yield of each Fund for the same seven-day period would have been
as follows<F1>:
- -------------------------------------------------------------------------------
Effective Tax-Equivalent Tax-Equivalent
Yield Yield Yield Effective Yield
- -------------------------------------------------------------------------------
Money Market Fund 4.77% 4.89% 6.91% 7.09%
- -------------------------------------------------------------------------------
U.S. Government Money 4.62% 4.73% 6.70% 6.86%
Market Fund
- -------------------------------------------------------------------------------
U.S. Government Select 4.50% 4.61% 6.52% 6.68%
Money Market Fund
- -------------------------------------------------------------------------------
Municipal Money Market 2.96% 3.01% 4.29% 4.36%
Fund
- -------------------------------------------------------------------------------
California Municipal 2.75% 2.79% 3.99% 4.04%
Money Market Fund
- -------------------------------------------------------------------------------
<F1> An income tax rate of 31% is used in the calculation of tax-equivalent
yield and tax-equivalent effective yield.
A Money Market Fund may also quote, from time to time, total return
information using the formula described in the following section.
NON-MONEY MARKET FUNDS
The Non-Money Market Funds calculate their total returns separately on an
"average annual total return" basis for various periods. Average annual total
return reflects the average annual percentage change in value of an investment
in the Fund over the measuring period. Total returns for each Non-Money Market
Fund may also be calculated on an "aggregate total return" basis for various
periods. Aggregate total return reflects the total percentage change in value
over the measuring period. Both methods of calculating total return reflect
changes in the price of the shares and assume that any dividends and capital
gain distributions made by a Fund during the period are reinvested in the shares
of the Fund. When considering average total return figures for periods longer
than one year, it is important to note that the annual total return of a Fund
for any one year in the period might have been more or less than the average for
the entire period. The Non-Money Market Funds may also advertise from time to
time the total return on a year-by-year or other basis for various specific
periods by means of quotations, charts, graphs or schedules.
A Non-Money Market Fund calculates its "average annual total return" by
determining the average annual compounded rate of return during specified
periods that equates the initial amount invested to the ending redeemable value
of such investment according to the following formula:
1
n
T = (ERV)-1
------
P
Where: T = average annual total return;
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1, 5 or 10 year
(or other) periods at the end of the applicable period
(or a fractional portion thereof);
P = hypothetical initial payment of $1,000; and
n = period covered by the computation, expressed in years.
A Non-Money Market Fund calculates its "aggregate total return" by
determining the aggregate compounded rates of return during specified periods
that likewise equate the initial amount invested to the ending redeemable value
of such investment. The formula for calculating aggregate total return is as
follows:
Aggregate Total Return = T=[(ERV)]-1
-----
P
The calculations set forth below are made assuming that (a) all dividends
and capital gain distributions are reinvested on the reinvestment dates at the
price per share existing on the reinvestment date, and (b) all recurring fees
charged to all shareholder accounts are included. The ending redeemable value
(variable "ERV" in the formula) is determined by assuming complete redemption of
the hypothetical investment after deduction of all nonrecurring charges at the
end of the measuring period.
<TABLE>
<CAPTION>
FOR PERIODS ENDED MARCH 31, 1999
AVERAGE ANNUAL TOTAL RETURNS (%) AGGREGATE TOTAL RETURNS (%)
SINCE SINCE
1 YEAR 5 YEAR 10 YEAR INCEPTION 1 YEAR 5 YEAR 10 YEAR INCEPTION
------ ------ ------- --------- ------ ------ ------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. GOVERNMENT FUND 6.01% 5.99% N/A 5.99% 6.01% 33.74% N/A 33.74%
(4/1/94 inception)
INTERMEDIATE TAX-EXEMPT FUND 4.88% 5.27% N/A 5.27% 4.88% 29.28% N/A 29.28%
(4/1/94 inception)
FLORIDA INTERMEDIATE TAX- 5.38% N/A N/A 6.28% 5.38% N/A N/A 17.36%
EXEMPT FUND
(8/15/96 inception)
FIXED INCOME FUND 5.18% 7.35% N/A 7.35% 5.18% 42.55% N/A 42.55%
(4/1/94 inception)
TAX-EXEMPT FUND 5.47% 6.73% N/A 6.73% 5.47% 38.50% N/A 38.50%
(4/1/94 inception)
CALIFORNIA TAX-EXEMPT FUND 6.20% N/A N/A 9.09% 6.20% N/A N/A 18.80%
(4/8/97 inception)
INTERNATIONAL FIXED INCOME 9.68% 6.78% N/A 6.78% 9.68% 38.84% N/A 38.84%
FUND
(4/1/94 inception)
INCOME EQUITY FUND 0.67% 13.18% N/A 13.18% 0.67% 85.70% N/A 85.70%
(4/1/94 inception)
STOCK INDEX FUND 17.78% N/A N/A 28.82% 17.78% N/A N/A 87.49%
(10/7/96 inception)
GROWTH EQUITY FUND 24.72% 22.54% N/A 22.54% 24.72% 176.29% N/A 176.29%
(4/1/94 inception)
SELECT EQUITY FUND 28.79% N/A N/A 24.90% 28.79% N/A N/A 203.19%
(4/6/94 inception)
(23.46)% 8.92% N/A 8.92% (23.46)% 53.32% N/A 53.32%
SMALL CAP FUND
(4/1/94 inception)
INTERNATIONAL GROWTH EQUITY 13.04% 8.28% N/A 8.28% 13.04% 48.82% N/A 48.82%
FUND
(4/1/94 inception)
INTERNATIONAL SELECT EQUITY 9.16% N/A N/A 7.44% 9.16% N/A N/A 43.08%
FUND
(4/5/94 inception)
TECHNOLOGY FUND 79.97% N/A N/A 49.16% 79.97% N/A N/A 231.84%
(4/1/96 inception)
The yield of a Non-Money Market Fund is computed based on the Fund's net
income during a specified 30-day (or one month) period. More specifically, the
Fund's yield is computed by dividing the per share net income during the
relevant period by the net asset value per share on the last day of the period
and annualizing the result on a semi-annual basis.
A Non-Money Market Fund calculates its 30-day (or one month) standard yield
in accordance with the method prescribed by the SEC for mutual funds:
a-b 6
Yield = 2[(----- +1)]-1
cd
Where: a = dividends and interest earned during the period;
b = expenses accrued for the period (net of
reimbursements);
c = average daily number of shares outstanding during the
period entitled to receive dividends; and
d = net asset value per share on the last day of the
period.
Based on the foregoing calculations, for the 30-day period ended March 31,
1999, the yields for the U.S. Government, Intermediate Tax-Exempt, Florida
Intermediate Tax-Exempt, Fixed Income, Tax-Exempt, California Tax-Exempt,
International Fixed Income, High Yield Municipal, High Yield Fixed Income and
Income Equity Funds, after fee waivers, were 4.77%, 3.26%, 3.42%, 5.20%, 3.84%,
3.77%, 2.55%, 3.26%, 7.43% and 2.83%, respectively. Also for the 30-day period
ended March 31, 1999, the yields for the U.S. Government, Intermediate Tax-
Exempt, Florida Intermediate Tax-Exempt, Fixed Income, Tax-Exempt, California
Tax-Exempt, International Fixed Income, High Yield Municipal and High Yield
Fixed Income Funds, absent fee waivers, were 4.60%, 3.04%, 3.00%, 4.92%, 3.61%,
3.46%, 1.56%, (0.91)%, 6.24% and 2.45%, respectively.
A Non-Money Market Fund's "tax-equivalent" yield is computed by: (a)
dividing the portion of the Fund's yield (calculated as above) that is exempt
from federal income tax by one minus a stated federal income tax rate; and (b)
adding the quotient to that portion, if any, of the Fund's yield that is not
exempt from federal income tax. For the 30-day period ended March 31, 1999, and
using a federal income tax rate of 31%, the 30-day tax-equivalent yields, after
fee waivers, were 4.72%, 4.96%, 5.57%, 5.46% and 4.72% for the Intermediate Tax-
Exempt, Florida Intermediate Tax-Exempt, Tax-Exempt, California Tax-Exempt and
High Yield Municipal Funds, respectively. Also, for the 30-day period ended
March 31, 1999, and using a federal income tax rate of 31%, the 30-day tax-
equivalent yields, absent fee waivers, were 4.41%, 4.35%, 5.23%, 5.01% and
(0.91)% for the Intermediate Tax-Exempt, Florida Intermediate Tax-Exempt, Tax-
Exempt, California Tax-Exempt and High Yield Municipal Funds, respectively.
GENERAL INFORMATION
The performance information set forth above includes the reinvestment of
dividends and distributions. Certain performance information set forth above
reflects fee waivers in effect; in the absence of fee waivers, these performance
figures would be reduced. Any fees imposed by Northern Trust, NTQA or other
Service Organizations on their customers in connection with investments in the
Funds are not reflected in Northern Funds' calculations of performance for the
Funds.
Each Fund's performance will fluctuate, unlike bank deposits or other
investments which pay a fixed yield for a stated period of time. Past
performance is not necessarily indicative of future return. Actual performance
will depend on such variables as portfolio quality, average portfolio maturity,
the type of portfolio instruments acquired, changes in interest rates, portfolio
expenses and other factors. Performance is one basis investors may use to
analyze a Fund as compared to other funds and other investment vehicles.
However, performance of other funds and other investment vehicles may not be
comparable because of the foregoing variables, and differences in the methods
used in valuing their portfolio instruments, computing net asset value and
determining performance.
The performance of each Fund may be compared to those of other mutual funds
with similar investment objectives and to stock, bond and other relevant indices
or to rankings prepared by independent services or other financial or industry
publications that monitor the performance of mutual funds. For example, the
performance of a Fund may be compared to data prepared by Lipper Analytical
Services, Inc. or to the S&P 500 Index, the S&P MidCap 400 Index, the Russell
2000 or 1000 Small Stock Index, the Consumer Price Index or the Dow Jones
Industrial Average. In addition, performance of the U.S. Government and Fixed
Income Funds may be compared to the Lehman Brothers Government Bond Index (or
its two components, the Treasury Bond Index and Agency Bond Index), the Lehman
Brothers Corporate Bond Index, the Lehman Brothers Intermediate Government Bond
Index and the Lehman Brothers Government/Corporate Bond Index. Performance of
the Intermediate Tax-Exempt and Tax-Exempt Funds may be compared to the Lehman
Brothers Municipal Bond or 5-Year Municipal Bond Indices; performance of the
California Intermediate Tax-Exempt Fund may be compared to the Lehman Brothers
Mutual Fund California Intermediate Index; performance of the Florida
Intermediate Tax-Exempt Fund may be compared to the Lehman Brothers Florida
Intermediate Tax-Exempt Index; performance of the Arizona Tax-Exempt Fund may be
compared to the Lehman Brothers Arizona Municipal Bond Index; performance of the
California Tax-Exempt Fund may be compared to the Lehman Brothers California
Municipal Exempt Index and performance of the California Intermediate Tax-Exempt
Fund, Florida Intermediate Tax-Exempt Fund, Arizona Tax-Exempt Fund and
California Tax-Exempt Fund may be compared to the Lehman Brothers Mutual Fund
Intermediate Municipal Index. Performance of the High Yield Municipal Fund may
be compared to Lehman Brothers Municipal Non-Investment Grade Bond Index.
Performance of the High Yield Fixed Income Fund may be compared to Merrill Lynch
High Yield Master II Index, Lehman Brothers High Yield Corporate Bond Index and
Salomon Brothers Extended High-Yield Market Index. Performance of the Income
Equity Fund may be compared to the Merrill Lynch Investment Grade Convertible
Bond Index. Performance of the International Funds may be compared to the
Morgan Stanley Capital International Europe, Australia and Far East Index
("EAFE"), the Morgan Stanley EAFE blended with Emerging Markets Free Index and
the J.P. Morgan International Government Bond Index. Performance of the
Technology Fund may be compared to the Morgan Stanley Index, the Hambrecht and
Quist Technology Index, the SoundView Technology Index, the technology grouping
of the S&P 500 Index and any other comparable technology index. Performance
data as reported in national financial publications such as Money, Forbes,
Barron's, The Wall Street Journal and The New York Times, or in publications of
a local or regional nature, may also be used in comparing the performance of a
Fund. From time to time, the Funds may also quote the mutual fund ratings of
Morningstar, Inc. and other services in their advertising materials.
Ibbotson Associates of Chicago, Illinois ("Ibbotson") provides historical
returns of the capital markets in the United States, including common stocks,
small capitalization stocks, long-term corporate bonds, intermediate-term
government bonds, long-term government bonds, Treasury bills, the U.S. rate of
inflation (based on the Consumer Price Index), and combinations of various
capital markets. The performance of these capital markets is based on the
returns of different indices. The Funds may use the performance of these
capital markets in order to demonstrate general risk-versus-reward investment
scenarios. Performance comparisons may also include the value of a hypothetical
investment in any of these capital markets. The risks associated with the
security types in any capital market may or may not correspond directly to those
of the Funds. The Funds may also compare performance to that of other
compilations or indices that may be developed and made available in the future.
The Funds may also from time to time include discussions or illustrations
of the effects of compounding in advertisements. "Compounding" refers to the
fact that, if dividends or other distributions on a Fund investment are
reinvested by being paid in additional Fund shares, any future income or capital
appreciation of a Fund would increase the value, not only of the original
investment in the Fund, but also of the additional Fund shares received through
reinvestment.
The Funds may include discussions or illustrations of the potential
investment goals of a prospective investor (including materials that describe
general principles of investing, such as asset allocation, diversification, risk
tolerance, and goal setting, questionnaires designed to help create a personal
financial profile, worksheets used to project savings needs based on assumed
rates of inflation and hypothetical rates of return and action plans offering
investment alternatives), investment management techniques, policies or
investment suitability of a Fund (such as value investing, market timing, dollar
cost averaging, asset allocation, constant ratio transfer, automatic account
rebalancing, the advantages and disadvantages of investing in tax-deferred and
taxable investments), economic and political conditions, the relationship
between sectors of the economy and the economy as a whole, the effects of
inflation and historical performance of various asset classes, including but not
limited to, stocks, bonds and Treasury bills. From time to time advertisements,
sales literature, communications to shareholders or other materials may
summarize the substance of information contained in shareholder reports
(including the investment composition of a Fund), as well as the views of
Northern Trust and NTQA as to current market, economic, trade and interest rate
trends, legislative, regulatory and monetary developments, investment strategies
and related matters believed to be of relevance to a Fund. In addition,
selected indices may be used to illustrate historic performance of selected
asset classes. The Funds may also include in advertisements, sales literature,
communications to shareholders or other materials, charts, graphs or drawings
which illustrate the potential risks and rewards of investment in various
investment vehicles, including but not limited to, stocks, bonds, treasury bills
and shares of a Fund. In addition, advertisements, sales literature,
communications to shareholders or other materials may include a discussion of
certain attributes or benefits to be derived by an investment in a Fund and/or
other mutual funds, shareholder profiles and hypothetical investor scenarios,
timely information on financial management, tax and retirement planning and
investment alternative to certificates of deposit and other financial
instruments. Such sales literature, communications to shareholders or other
materials may include symbols, headlines or other material which highlight or
summarize the information discussed in more detail therein.
Materials may include lists of representative clients of Northern Trust and
NTQA. Materials may refer to the CUSIP numbers of the Funds and may illustrate
how to find the listings of the Funds in newspapers and periodicals. Materials
may also include discussions of other Funds, products, and services.
The Funds may quote various measures of volatility and benchmark
correlation in advertising. In addition, the Funds may compare these measures
to those of other funds. Measures of volatility seek to compare the historical
share price fluctuations or total returns to those of a benchmark. Measures of
benchmark correlation indicate how valid a comparative benchmark may be.
Measures of volatility and correlation may be calculated using averages of
historical data.
The Funds may advertise examples of the effects of periodic investment
plans, including the principle of dollar cost averaging. In such a program, an
investor invests a fixed dollar amount in a Fund at periodic intervals, thereby
purchasing fewer shares when prices are high and more shares when prices are
low. While such a strategy does not assure a profit or guard against loss in a
declining market, the investor's average cost per share can be lower than if
fixed numbers of shares are purchased at the same intervals. In evaluating such
a plan, investors should consider their ability to continue purchasing shares
during periods of low price levels.
A Fund may advertise its current interest rate sensitivity, duration,
weighted average maturity or similar maturity characteristics.
Advertisements and sales materials relating to a Fund may include
information regarding the background and experience of its portfolio managers.
NET ASSET VALUE
As stated in the Prospectus, each Money Market Fund seeks to maintain a net
asset value of $1.00 per share and, in this connection, values its instruments
on the basis of amortized cost pursuant to Rule 2a-7 under the 1940 Act. This
method values a security at its cost on the date of purchase and thereafter
assumes a constant amortization to maturity of any discount or premium,
regardless of the impact of fluctuating interest rates on the market value of
the instrument. While this method provides certainty in valuation, it may
result in periods during which value, as determined by amortized cost, is higher
or lower than the price a Fund would receive if the Fund sold the instrument.
During such periods the yield to investors in the Fund may differ somewhat from
that obtained in a similar entity which uses available indications as to market
value to value its portfolio instruments. For example, if the use of amortized
cost resulted in a lower (higher) aggregate Fund value on a particular day, a
prospective investor in the Fund would be able to obtain a somewhat higher
(lower) yield and ownership interest than would result from investment in such
similar entity and existing investors would receive less (more) investment
income and ownership interest. However, Northern Funds expects that the
procedures and limitations referred to in the following paragraphs of this
section will tend to minimize the differences referred to above.
Under Rule 2a-7, Northern Funds' Board of Trustees, in supervising the
Funds' operations and delegating special responsibilities involving portfolio
management to Northern Trust, has established procedures that are intended,
taking into account current market conditions and the Funds' investment
objectives, to stabilize the net asset value of each Money Market Fund, as
computed for the purposes of purchases and redemptions, at $1.00 per share. The
Trustees' procedures include periodic monitoring of the difference (the "Market
Value Difference") between the amortized cost value per share and the net asset
value per share based upon available indications of market value. Available
indications of market value consist of actual market quotations or appropriate
substitutes which reflect current market conditions and include (a) quotations
or estimates of market value for individual portfolio instruments and/or (b)
values for individual portfolio instruments derived from market quotations
relating to varying maturities of a class of money market instruments. In the
event the Market Value Difference exceeds 1/2 of 1%, the Trustees' procedures
provide that the Trustees will take such steps as they consider appropriate
(e.g., selling portfolio instruments to shorten average portfolio maturity or to
realize capital gains or losses, reducing or suspending shareholder income
accruals, redeeming shares in kind, or utilizing a net asset value per share
based upon available indications of market value which under such circumstances
would vary from $1.00) to eliminate or reduce to the extent reasonably
practicable any material dilution or other unfair results to investors or
existing shareholders which might arise from Market Value Differences. In
particular, if losses were sustained by a Fund, the number of outstanding shares
might be reduced in order to maintain a net asset value per share of $1.00.
Such reduction would be effected by having each shareholder proportionately
contribute to the Fund's capital the necessary shares to restore such net asset
value per share. Each shareholder will be deemed to have agreed to such
contribution in these circumstances by investing in the Fund.
Rule 2a-7 requires that each Money Market Fund limit its investments to
instruments which Northern Trust determines to present minimal credit risks and
which are "Eligible Securities" as defined by the SEC and described in the
Prospectus. The Rule also requires that each Money Market Fund maintain a
dollar-weighted average portfolio maturity (not more than 90 days) appropriate
to its policy of maintaining a stable net asset value per share and precludes
the purchase of any instrument deemed under the Rule to have a remaining
maturity of more than 397 days. Should the disposition of a portfolio security
result in a dollar-weighted average portfolio maturity of more than 90 days, the
Rule requires a Money Market Fund to invest its available cash in such a manner
as to reduce such maturity to the prescribed limit as soon as reasonably
practicable.
Securities held by the other Funds that are listed on a recognized U.S. or
foreign securities exchange are valued at the last quoted sales price on the
securities exchange on which the securities are primarily traded, except that
securities listed on an exchange in the United Kingdom are valued at the average
of the closing bid and ask prices. If securities listed on a U.S. exchange are
not traded on a valuation date, they will be valued at the last quoted bid
price. If securities traded on a foreign securities exchange are not traded on
a valuation date, they will be valued at the most recent quoted sales price.
Securities that are traded in the U.S. over-the-counter markets, absent a last
quoted sales price, are valued at the last quoted bid price. Securities which
are traded in the foreign over-the-counter markets are valued at the last sales
price, except that such securities traded in the United Kingdom are valued at
the average of the closing bid and ask prices. Any securities for which no
current quotations are readily available are valued at fair value as determined
in good faith by Northern Trust under the supervision of the Board of Trustees.
Temporary short-term investments are valued at amortized cost which Northern
Trust has determined, pursuant to Board authorization, approximates market
value. Securities may be valued on the basis of prices provided by independent
pricing services when those prices are believed to reflect the fair market value
of the securities.
Northern Trust is not required to calculate the net asset value of a Fund
on days during which no shares are tendered to a Fund for redemption and no
orders to purchase or sell shares are received by a Fund, or on days on which
there is an insufficient degree of trading in the Fund's portfolio securities
for changes in the value of such securities to affect materially the net asset
value per share.
TAXES
The following summarizes certain additional tax considerations generally
affecting the Funds and their shareholders that are not described in the
Prospectus. No attempt is made to present a detailed explanation of the tax
treatment of the Funds or their shareholders, and the discussions here and in
the Prospectus are not intended as a substitute for careful tax planning.
Potential investors should consult their tax advisers with specific reference to
their own tax situations.
The discussions of federal and state tax consequences in the Prospectus and
this Additional Statement are based on the Code and the laws and regulations
issued thereunder as in effect on the date of this Additional Statement. Future
legislative or administrative changes or court decisions may significantly
change the conclusions expressed herein, and any such changes or decisions may
have a retroactive effect with respect to the transactions contemplated herein.
FEDERAL - GENERAL INFORMATION
Each Fund intends to qualify as a regulated investment company under Part I
of Subchapter M of Subtitle A, Chapter 1 of the Internal Revenue Code of 1986,
as amended (the "Code"). As a regulated investment company, each Fund is
generally exempt from federal income tax on its net investment income and
realized capital gains which it distributes to shareholders, provided that it
distributes an amount equal to at least the sum of 90% of its tax-exempt income
and 90% of its investment company taxable income (net investment income and the
excess of net short-term capital gain over net long-term capital loss), if any,
for the year (the "Distribution Requirement") and satisfies certain other
requirements of the Code that are described below.
In addition to satisfaction of the Distribution Requirement, each Fund must
derive with respect to a taxable year at least 90% of its gross income from
dividends, interest, certain payments with respect to securities loans and gains
from the sale or other disposition of stock or securities or foreign currencies,
or from other income derived with respect to its business of investing in such
stock, securities, or currencies (the "Income Requirement").
In addition to the foregoing requirements, at the close of each quarter of
its taxable year, at least 50% of the value of each Fund's assets must consist
of cash and cash items, U.S. Government securities, securities of other
regulated investment companies, and securities of other issuers (as to which a
Fund has not invested more than 5% of the value of its total assets in
securities of such issuer and as to which a Fund does not hold more than 10% of
the outstanding voting securities of such issuer), and no more than 25% of the
value of each Fund's total assets may be invested in the securities of any one
issuer (other than U.S. Government securities and securities of other regulated
investment companies), or in two or more issuers which such Fund controls and
which are engaged in the same or similar trades or businesses.
Each Fund intends to distribute to shareholders any excess of net long-term
capital gain over net short-term capital loss ("net capital gain") for each
taxable year. Such gain is distributed as a capital gain dividend and is
taxable to shareholders as long-term capital gain, regardless of the length of
time the shareholder has held the shares, whether such gain was recognized by
the Fund prior to the date on which a shareholder acquired shares of the Fund
and whether the distribution was paid in cash or reinvested in shares. In
addition, investors should be aware that any loss realized upon the sale,
exchange or redemption of shares held for six months or less will be treated as
a long-term capital loss to the extent of any capital gain dividends that have
been paid with respect to such shares.
Dividends and distributions from each Fund will generally be taxable to you
in the tax year in which they are paid, with one exception. Dividends and
distributions declared by a Fund in October, November or December and paid in
January are taxed as though they were paid by December 31.
In the case of corporate shareholders, distributions of a Fund for any
taxable year generally qualify for the dividends received deduction to the
extent of the gross amount of "qualifying dividends" from domestic corporations
received by the Fund for the year. A dividend usually will be treated as a
"qualifying dividend" if it has been received from a domestic corporation. A
portion of the dividends paid by the Income Equity Fund, Stock Index Fund,
Growth Equity Fund, Select Equity Fund, MarketCommand Fund, Mid Cap Growth,
Small Cap Index Fund, Small Cap Fund, Small Cap Growth Fund and Technology Fund,
may constitute "qualifying dividends." The other Funds, however, are not
expected to pay qualifying dividends.
If for any taxable year any Fund does not qualify as a regulated investment
company, all of its taxable income will be subject to tax at regular corporate
rates without any deduction for distributions to shareholders. In such event,
all distributions (whether or not derived from exempt-interest income) would be
taxable as ordinary income to the extent of such Fund's current and accumulated
earnings and profits and would be eligible for the dividends received deduction
in the case of corporate shareholders.
The Code imposes a non-deductible 4% excise tax on regulated investment
companies that fail to currently distribute an amount equal to specified
percentages of their ordinary taxable income and capital gain net income (excess
of capital gains over capital losses). Each Fund intends to make sufficient
distributions or deemed distributions of its ordinary taxable income and capital
gain net income each calendar year to avoid liability for this excise tax.
Although each Fund expects to qualify as a "regulated investment company"
and to be relieved of all or substantially all federal income taxes, depending
upon the extent of its activities in states and localities in which its offices
are maintained, in which its agents or independent contractors are located or in
which it is otherwise deemed to be conducting business, each Fund may be subject
to the tax laws of such states or localities.
FEDERAL - TAX-EXEMPT INFORMATION
As described in the Prospectus, the Municipal Money Market, California
Municipal Money Market, Tax-Exempt Money Market, Intermediate Tax-Exempt,
California Intermediate Tax-Exempt, Florida Intermediate Tax-Exempt, Tax-Exempt,
Arizona Tax-Exempt, California Tax-Exempt and High Yield Municipal Funds are
designed to provide investors with federally tax-exempt interest income. The
Funds are not intended to constitute a balanced investment program and are not
designed for investors seeking capital appreciation or maximum tax-exempt income
irrespective of fluctuations in principal. Shares of the Funds would not be
suitable for tax-exempt institutions or for retirement plans qualified under
Section 401 of the Code, H.R. 10 plans and individual retirement accounts
because such plans and accounts are generally tax-exempt and, therefore, would
not gain any additional benefit from the Funds' dividends being tax-exempt. In
addition, the Funds may not be an appropriate investment for persons or entities
that are "substantial users" of facilities financed by private activity bonds or
"related persons" thereof. "Substantial user" is defined under U.S. Treasury
Regulations to include a non-exempt person which regularly uses a part of such
facilities in its trade or business and whose gross revenues derived with
respect to the facilities financed by the issuance of bonds are more than 5% of
the total revenues derived by all users of such facilities, which occupies more
than 5% of the usable area of such facilities or for which such facilities or a
part thereof were specifically constructed, reconstructed or acquired. "Related
persons" include certain related natural persons, affiliated corporations,
partnerships and their partners and S corporations and their shareholders.
In order for the Municipal Money Market, California Municipal Money Market,
Tax-Exempt Money Market, Intermediate Tax-Exempt, California Intermediate Tax-
Exempt, Florida Intermediate Tax-Exempt, Tax-Exempt, Arizona Tax-Exempt,
California Tax-Exempt or High Yield Municipal Funds to pay federal exempt-
interest dividends with respect to any taxable year, at the close of each
taxable quarter at least 50% of the aggregate value of the Fund must consist of
tax-exempt obligations. An exempt-interest dividend is any dividend or part
thereof (other than a capital gain dividend) paid by a Fund and designated as an
exempt-interest dividend in a written notice mailed to shareholders not later
than 60 days after the close of the Fund's taxable year. However, the aggregate
amount of dividends so designated by a Fund cannot exceed the excess of the
amount of interest exempt from tax under Section 103 of the Code received by the
Fund during the taxable year over any amounts disallowed as deductions under
Sections 265 and 171(a)(2) of the Code. The percentage of total dividends paid
by a Fund with respect to any taxable year which qualifies as federal exempt-
interest dividends will be the same for all shareholders receiving dividends
from the Fund with respect to such year.
Interest on indebtedness incurred by a shareholder to purchase or carry
shares of a tax exempt Fund generally is not deductible for federal income tax
purposes to the extent attributable to exempt-interest-dividends. If a
shareholder holds Fund shares for six months or less, any loss on the sale or
exchange of those shares will be disallowed to the extent of the amount of
exempt-interest dividends earned with respect to the shares. The Treasury
Department, however, is authorized to issue regulations reducing the six-month
holding requirement to a period of not less than the greater of 31 days or the
period between regular distributions for investment companies that regularly
distribute at least 90% of its net tax-exempt interest. No such regulations had
been issued as of the date of this Additional Statement.
Corporate taxpayers will be required to take into account all exempt-
interest dividends from the Tax-Exempt Funds and the Municipal Funds in
determining certain adjustments for alternative minimum tax purposes.
The Funds will determine annually the percentages of their respective net
investment income which are exempt from tax, which constitute an item of tax
preference for purposes of the federal alternative minimum tax, and which are
fully taxable, and will apply these percentages uniformly to all dividends
declared from net investment income during that year. These percentages may
differ significantly from the actual percentages for any particular day.
Shareholders will be advised annually as to the federal income tax
consequences of distributions made by the Funds.
TAXATION OF CERTAIN FINANCIAL INSTRUMENTS
The tax principles applicable to transactions in financial instruments and
futures contacts and options that may be engaged in by a Fund, and investments
in passive foreign investment companies ("PFICs"), are complex and, in some
cases, uncertain. Such transactions and investments may cause a Fund to
recognize taxable income prior to the receipt of cash, thereby requiring the
Fund to liquidate other positions, or to borrow money, so as to make sufficient
distributions to shareholders to avoid corporate-level tax. Moreover, some or
all of the taxable income recognized may be ordinary income or short-term
capital gain, so that the distributions may be taxable to shareholders as
ordinary income.
In addition, in the case of any shares of a PFIC in which a Fund invests,
the Fund may be liable for corporate-level tax on any ultimate gain or
distributions on the shares if the Fund fails to make an election to recognize
income annually during the period of its ownership of the shares.
SPECIAL STATE TAX CONSIDERATIONS PERTAINING TO THE CALIFORNIA FUNDS
Assuming each of the California Funds qualifies as a regulated investment
company, it will be relieved of liability for California state franchise and
corporate income tax to the extent its earnings are distributed to its
shareholders. Each of the California Funds may be taxed on its undistributed
taxable income. If for any year one of the California Funds does not qualify as
a regulated investment company, all of that Fund's taxable income (including
interest income on California municipal instruments for franchise tax purposes
only) may be subject to California state franchise or income tax at regular
corporate rates.
If, at the close of each quarter of its taxable year, at least 50% of the
value of the total assets of a regulated investment company, or series thereof,
consists of obligations the interest on which, if held by an individual, is
exempt from taxation by California ("California municipal instruments") then a
regulated investment company, or series thereof, will be qualified to pay
dividends exempt from California state personal income tax to its non-corporate
shareholders (hereinafter referred to as "California exempt-interest
dividends"). "Series" of a regulated investment company is defined as a
segregated portfolio of assets, the beneficial interest in which is defined as a
series of stock of the company. Each of the California Funds intends to qualify
under the above requirements so that it can pay California exempt-interest
dividends. If one of the California Funds fails to so qualify, no part of that
Fund's dividends to shareholders will be exempt from the California state
personal income tax. Each of the California Funds may reject purchase orders
for shares if it appears desirable to avoid failing to so qualify.
Within 60 days after the close of its taxable year, each of the California
Funds will notify each shareholder of the portion of the dividends paid by the
Fund to the shareholder with respect to such taxable year which is exempt from
California state personal income tax. The total amount of California exempt-
interest dividends paid by the Fund with respect to any taxable year cannot
exceed the excess of the amount of interest received by the Fund for such year
on California municipal instruments over any amounts that, if the Fund were
treated as an individual, would be considered expenses related to tax-exempt
income or amortizable bond premium and would thus not be deductible under
federal income or California state personal income tax law. The percentage of
total dividends paid by the Fund with respect to any taxable year which
qualifies as California exempt-interest dividends will be the same for all
shareholders receiving dividends from the Fund with respect to such year.
In cases where shareholders are "substantial users" or "related persons"
with respect to California municipal instruments held by one of the California
Funds, such shareholders should consult their tax advisers to determine whether
California exempt-interest dividends paid by the Fund with respect to such
obligations retain California state personal income tax exclusion. In this
connection, rules similar to those regarding the possible unavailability of
federal exempt-interest dividend treatment to "substantial users" are applicable
for California state tax purposes. See "Federal - Tax-Exempt Information"
above.
To the extent any dividends paid to shareholders are derived from the
excess of net long-term capital gains over net short-term capital losses, such
dividends will not constitute California exempt-interest dividends and will
generally be taxed as long-term capital gains under rules similar to those
regarding the treatment of capital gain dividends for federal income tax
purposes. See "Federal - General Information" above. Moreover, interest on
indebtedness incurred by a shareholder to purchase or carry shares of one of the
California Funds is not deductible for California state personal income tax
purposes if that Fund distributes California exempt-interest dividends during
the shareholder's taxable year.
In addition, any loss realized by a shareholder of the California Funds
upon the sale of shares held for six months or less may be disallowed to the
extent of any exempt-interest dividends received with respect to such shares.
Moreover, any loss realized upon the redemption of shares within six months from
the date of purchase of such shares and following receipt of a long-term capital
gains distribution will be treated as long-term capital loss to the extent of
such long-term capital gains distribution. Finally, any loss realized upon the
redemption of shares within thirty days before or after the acquisition of other
shares of the same Fund may be disallowed under the "wash sale" rules.
California may tax income derived from repurchase agreements involving
federal obligations because such income represents a premium paid at the time
the government obligations are repurchased rather than interest paid by the
issuer of the obligations.
The foregoing is only a summary of some of the important California state
personal income tax considerations generally affecting the California Funds and
their shareholders. No attempt is made to present a detailed explanation of the
California state personal income tax treatment of the California Funds or their
shareholders, and this discussion is not intended as a substitute for careful
planning. Further, it should be noted that the portion of a Fund's dividends
constituting California exempt-interest dividends is excludable from income for
California state personal income tax purposes only. Any dividends paid to
shareholders subject to California state franchise tax or California state
corporate income tax may therefore be taxed as ordinary dividends to such
purchasers notwithstanding that all or a portion of such dividends is exempt
from California state personal income tax. Accordingly, potential investors in
one of the California Funds, including, in particular, corporate investors which
may be subject to either California franchise tax or California corporate income
tax, should consult their tax advisers with respect to the application of such
taxes to the receipt of Fund dividends and as to their own California state tax
situation, in general.
SPECIAL STATE TAX CONSIDERATIONS PERTAINING TO THE FLORIDA INTERMEDIATE TAX-
EXEMPT FUND
The State of Florida does not currently impose an income tax on
individuals. Thus, individual shareholders of the Florida Intermediate Tax-
Exempt Fund will not be subject to any Florida income tax on distributions
received from the Fund. However, Florida does currently impose an income tax on
certain corporations. Consequently, distributions may be taxable to corporate
shareholders.
The State of Florida currently imposes an "intangibles tax" at the annual
rate of 2 mills or 0.20% on certain securities and other intangible assets owned
by Florida residents. Every natural person is entitled to an exemption of the
first $20,000 of the value of taxable property against the first mill of the
annual tax. Spouses filing jointly are entitled to a $40,000 exemption. With
respect to the second mill, natural persons are entitled to an exemption of the
first $100,000 of otherwise taxable property (joint filers are entitled to a
$200,000 exemption). Taxpayers are limited to only one exemption under each
provision. Notes, bonds and other obligations issued by the State of Florida or
its municipalities, counties, and other taxing districts, or by the United
States Government, its agencies and certain U.S. territories and possessions
(such as Guam, Puerto Rico and the Virgin Islands) as well as cash are exempt
from this intangibles tax. If on December 31 of any year at least 90 percent of
the net asset value of the portfolio of the Florida Intermediate Tax-Exempt Fund
consists solely of such exempt assets, then the Fund's shares will be exempt
from the Florida intangibles tax payable in the following year.
In order to take advantage of the exemption from the intangibles tax in any
year, it may be necessary for the Fund to sell some of its non-exempt assets
held in its portfolio during the year and reinvest the proceeds in exempt assets
including cash prior to December 31. Transaction costs involved in
restructuring the portfolio in this fashion would likely reduce the Fund's
investment return and might exceed any increased investment return the Fund
achieved by investing in non-exempt assets during the year.
Outside the State of Florida, income distributions may be taxable to
shareholders under state or local law as dividend income even though all or a
portion of such distributions may be derived from interest on tax-exempt
obligations or U.S. Government obligations which, if realized directly, would be
exempt from such income taxes. Shareholders are advised to consult their tax
advisers concerning the application of state and local taxes.
SPECIAL STATE TAX CONSIDERATIONS PERTAINING TO THE ARIZONA TAX-EXEMPT FUND
Individuals, trusts and estates who are subject to Arizona income tax will
not be subject to such tax on dividends paid by the Arizona Tax-Exempt Fund, to
the extent that such dividends qualify as exempt-interest dividends of a
regulated investment company under Section 852(b)(5) of the Code and are
attributable to either (i) obligations of the State of Arizona or its political
subdivisions thereof or (ii) obligations issued by the governments of Guam,
Puerto Rico, or the Virgin Islands. In addition, dividends paid by the Arizona
Tax-Exempt Fund which are attributable to interest payments on direct
obligations of the United States government will not be subject to Arizona
income tax to the extent the Arizona Tax-Exempt Fund qualifies as a regulated
investment company under Subchapter M of the Code. Other distributions from the
Arizona Tax-Exempt Fund, however, such as distributions of short-term or long-
term capital gains, will generally not be exempt from Arizona income tax.
There are no municipal income taxes in Arizona. Moreover, because shares
of the Arizona Tax-Exempt Fund are intangibles, they are not subject to Arizona
property tax. Shareholders of the Arizona Tax-Exempt Fund should consult their
tax advisors about other state and local tax consequences of their investment in
the Arizona Tax-Exempt Fund.
DESCRIPTION OF SHARES
The Trust Agreement permits Northern Funds' Board of Trustees to issue an
unlimited number of full and fractional shares of beneficial interest of one or
more separate series representing interests in different investment portfolios.
Northern Funds may hereafter create series in addition to Northern Funds'
existing series, which represent interests in thirty portfolios, each of which
is discussed in this Additional Statement. Under the terms of the Trust
Agreement, each share of each Fund has a par value of $.0001, represents a
proportionate interest in the particular Fund with each other share of its class
and is entitled to such dividends and distributions out of the income belonging
to the Fund as are declared by the Trustees. Upon any liquidation of a Fund,
shareholders of each class of a Fund are entitled to share pro rata in the net
assets belonging to that class available for distribution. Shares do not have
any preemptive or conversion rights. The right of redemption is described under
"Redeeming and Exchanging Shares" in the Prospectus. Pursuant to the terms of
the 1940 Act, the right of a shareholder to redeem shares and the date of
payment by a Fund may be suspended for more than seven days (a) for any period
during which the New York Stock Exchange is closed, other than the customary
weekends or holidays, or trading in the markets the Fund normally utilizes is
closed or is restricted as determined by the SEC, (b) during any emergency, as
determined by the SEC, as a result of which it is not reasonably practicable for
the Fund to dispose of instruments owned by it or fairly to determine the value
of its net assets, or (c) for such other period as the SEC may by order permit
for the protection of the shareholders of the Fund. Northern Funds may also
suspend or postpone the recordation of the transfer of its shares upon the
occurrence of any of the foregoing conditions. In addition, Northern Funds
reserves the right to adopt, by action of the Trustees, a policy pursuant to
which it may, without shareholder approval, redeem upon not less than 30 days'
notice all of a Fund's shares if such shares have an aggregate value below a
designated amount and if the Trustees determine that it is not practical,
efficient or advisable to continue the operation of such Fund and that any
applicable requirements of the 1940 Act have been met. Shares when issued as
described in the Prospectus are validly issued, fully paid and nonassessable,
except as stated below. In the interests of economy and convenience,
certificates representing shares of the Funds are not issued.
The proceeds received by each Fund for each issue or sale of its shares,
and all net investment income, realized and unrealized gain and proceeds
thereof, subject only to the rights of creditors, will be specifically allocated
to and constitute the underlying assets of that Fund. The underlying assets of
each Fund will be segregated on the books of account, and will be charged with
the liabilities in respect to that Fund and with a share of the general
liabilities of Northern Funds. Expenses with respect to the portfolios of
Northern Funds are normally allocated in proportion to the net asset value of
the respective portfolios except where allocations of direct expenses can
otherwise be fairly made.
Shareholders are entitled to one vote for each full share held and
proportionate fractional votes for fractional shares held. Each Fund entitled
to vote on a matter will vote in the aggregate and not by Fund, except as
required by law or when the matter to be voted on affects only the interests of
shareholders of a particular Fund.
Rule 18f-2 under the 1940 Act provides that any matter required by the
provisions of the 1940 Act or applicable state law, or otherwise, to be
submitted to the holders of the outstanding voting securities of an investment
company such as Northern Funds shall not be deemed to have been effectively
acted upon unless approved by the holders of a majority of the outstanding
shares of each investment portfolio affected by such matter. Rule 18f-2 further
provides that an investment portfolio shall be deemed to be affected by a matter
unless the interests of each investment portfolio in the matter are
substantially identical or the matter does not affect any interest of the
investment portfolio. Under the Rule, the approval of an investment advisory
agreement, a distribution plan subject to Rule 12b-1 under the 1940 Act or any
change in a fundamental investment policy would be effectively acted upon with
respect to an investment portfolio only if approved by a majority of the
outstanding shares of such investment portfolio. However, the Rule also provides
that the ratification of the appointment of independent accountants, the
approval of principal underwriting contracts and the election of Trustees are
exempt from the separate voting requirements stated above.
The term "majority of the outstanding shares" of either Northern Funds or a
particular Fund or investment portfolio means, with respect to the approval of
an investment advisory agreement, a distribution plan or a change in a
fundamental investment policy, the vote of the lesser of (i) 67% or more of the
shares of Northern Funds or such Fund or portfolio present at a meeting, if the
holders of more than 50% of the outstanding shares of Northern Funds or such
Fund or portfolio are present or represented by proxy, or (ii) more than 50% of
the outstanding shares of Northern Funds or such Fund or portfolio.
As of December 1, 1999 Northern and its affiliates held of record
substantially all of the outstanding shares of the Non-Money Market Funds as
agent, custodian, trustee or investment adviser on behalf of their customers.
At such date, The Northern Trust Company, 50 S. LaSalle Street, Chicago,
Illinois 60675, and its affiliate banks held as beneficial owner five percent or
more of the outstanding shares of the Non-Money Market Funds because they
possessed sole or shared voting or investment power with respect to such shares.
As of December 1, 1999 the names and share ownership of the entities or
individuals which held of record or beneficially more than 5% of the outstanding
shares of any Fund were as follows: Money Market Fund: Northern Trust Bank -
-----------------
Miami on behalf of its customers, 9.6%, Short Term Investment Fund, 18.2%,
Northern Trust Bank Florida - M&I Sweep Account, 5.5%; U.S. Government Money
---------------------
Market Fund: Sahara Enterprises, Inc., 7.1%, Northern Trust - Miami on behalf of
- -----------
its customers, 22.8%, Northern Trust Bank - Miami on behalf of its customers,
9.5%, Northern Trust Bank Florida - M&I Sweep Account, 11.0%; Municipal Money
---------------
Market Fund: Northern Trust Bank - Miami on behalf of its customers, 25.9%; U.S.
- ----------- ----
Government Select Money Market Fund: Northern Trust Bank - Miami on behalf of
- -----------------------------------
its customers, 45.3%, Northern Trust Bank Florida - M&I Sweep Account, 6.6%;
Northern Trust Bank Florida - M&I Sweep Account, 6.6%; Florida Intermediate Tax-
------------------------
Exempt Fund: Abraham General Partnership, 5.0%, Donaldson, Lufkin & Jenrette,
- -----------
8.3% and John C. Schumann, Jr., 6.7%; California Municipal Money Market Fund:
---------------------------------------
Northern Trust Bank - M&I Sweep Account, 12.0%; Fixed Income Fund: Northern
-----------------
Trust Bank Florida, 8.0%; Stock Index Fund: CCT Comb Funds, 8.3%; Select Equity
---------------- -------------
Fund: Donaldson, Lufkin & Jenrette, 11.7%; International Select Equity Fund:
- ---- --------------------------------
James L. Knight 1969 Trust, 5.2%; Williams Trust, 7.0%; California Tax-Exempt
---------------------
Fund: Julius Epstein Residuary T/U/W, 5.5%; Small Cap Index Fund: Dupont JB,
- ---- --------------------
6.7% and CCT Comb Funds, 12.6%; Small Cap Growth Fund: Offield Foundation, 5.1%;
---------------------
High Yield Fixed Income Fund: The Northern Trust Company Pension Plan, 5.0% and
- ----------------------------
William B. Graham, 7.3%; High Yield Municipal Fund: William D. Cox, 5.5%. The
-------------------------
address of all of the above persons is c/o The Northern Trust Bank, 50 S.
LaSalle Street, Chicago, Illinois 60675.
As of December 1, 1999, Northern Trust possessed sole or shared voting or
investment power for its customer accounts with respect to more than 50% of the
outstanding shares of Northern Funds. As of the same date, Northern Fund's
Trustees and officers as a group owned less than 1% of the outstanding shares of
each Fund.
As a general matter, Northern Funds does not hold annual or other meetings
of shareholders. This is because the Trust Agreement provides for shareholder
voting only for the election or removal of one or more Trustees, if a meeting is
called for that purpose, and for certain other designated matters. Each Trustee
serves until the next meeting of shareholders, if any, called for the purpose of
considering the election or reelection of such Trustee or of a successor to such
Trustee, and until the election and qualification of his successor, if any,
elected at such meeting, or until such Trustee sooner dies, resigns, retires or
is removed by the shareholders or two-thirds of the Trustees. In addition, the
Trustees have adopted a by-law (changeable without shareholder approval) that
provides that a Trustee will cease to serve as a Trustee effective as of the
last calendar day in the semi-annual fiscal period of Northern Funds in which
the earlier of the following events occurs: (a) the date such Trustee attains
the age of seventy-three years; and (b) the twelfth anniversary of the date of
such Trustee's written acceptance to serve as a Trustee.
Northern Funds does not presently intend to hold annual meetings of
shareholders except as required by the 1940 Act or other applicable law.
Pursuant to the Trust Agreement, the Trustees will promptly call a meeting of
shareholders to vote upon the removal of any Trustee when so requested in
writing by the record holders of 10% or more of the outstanding shares. To the
extent required by law, Northern Funds will assist in shareholder communications
in connection with the meeting. Shareholders do not have cumulative voting
rights in the election of Trustees and, accordingly, the holders of more than
50% of the aggregate voting power of Northern Funds may elect all of the
Trustees, irrespective of the vote of the other shareholders.
Under Massachusetts law, there is a possibility that shareholders of a
business trust could, under certain circumstances, be held personally liable as
partners for the obligations of the trust. The Trust Agreement contains an
express disclaimer of shareholder (as well as Trustee and officer) liability for
acts or obligations of Northern Funds and requires that notice of such
disclaimer be given in each contract, undertaking or instrument entered into or
executed by Northern Funds or the Trustees. The Trust Agreement provides for
indemnification out of Trust property of any shareholder charged or held
personally liable for the obligations or liabilities of Northern Funds solely by
reason of being or having been a shareholder of Northern Funds and not because
of such shareholder's acts or omissions or for some other reason. The Trust
Agreement also provides that Northern Funds shall, upon proper and timely
request, assume the defense of any charge made against any shareholder as such
for any obligation or liability of Northern Funds and satisfy any judgment
thereon. Thus, the risk of a shareholder incurring financial loss on account of
shareholder liability is limited to circumstances in which Northern Funds itself
would be unable to meet its obligations.
The Trust Agreement provides that each Trustee of Northern Funds will be
liable for his own willful misfeasance, bad faith, gross negligence or reckless
disregard of the duties involved in the conduct of the office of Trustee
("disabling conduct"), and for nothing else, and will not be liable for errors
of judgment or mistakes of fact or law. The Trust Agreement provides further
that Northern Funds will indemnify Trustees and officers of Northern Funds
against liabilities and expenses incurred in connection with litigation and
other proceedings in which they may be involved (or with which they may be
threatened) by reason of their positions with Northern Funds, except that no
Trustee or officer will be indemnified against any liability to Northern Funds
or its shareholders to which he would otherwise be subject by reason of
disabling conduct.
The Trust Agreement provides that each shareholder, by virtue of becoming
such, will be held to have expressly assented and agreed to the terms of the
Trust Agreement and to have become a party thereto.
A meeting of shareholders was held on March 21, 2000 for the purpose, among
other things, of voting on an Agreement and Plan of Reorganization (the "Plan of
Reorganization") pursuant to which the Trust will be reorganized as a Delaware
business trust. The Plan of Reorganization was approved by the shareholders and
the Trust expects that the reorganization will occur during the second or third
quarter of year 2000 or as soon thereafter as possible. The reorganization is
to be accomplished on a tax-free basis, with no change in the dollar value or
number of the Trust's outstanding shares. After the reorganization, the
attributes of the shares of the Trust will be substantially similar to the
attributes of shares described above in this section, except that the Trustees
will be able to determine whether shareholders will vote at shareholder meetings
on the basis of (1) one vote for each share owned; or (2) one vote for each
dollar of net asset value represented by each share owned ("dollar-based
voting").
In addition a shareholder of the reorganized Trust may bring a derivative
action on behalf of the Trust only if the following conditions are met: (a)
shareholders eligible to bring such derivative action under Delaware law who
hold at least 10% of the outstanding shares of the Trust, or 10% of the
outstanding shares of the series or class to which such action relates, must
join in the request for the Trustees to commence such action; and (b) the
Trustees must be afforded a reasonable amount of time to consider such
shareholder request and to investigate the basis of such claim. The Trust
Agreement of the reorganized Trust will also provide that no person, other than
the Trustees, who is not a shareholder of a particular series or class will be
entitled to bring any derivative action, suit or other proceeding on behalf of
or with respect to such series or class. The Trustees will be entitled to
retain counsel or other advisers in considering the merits of the request and
may require an undertaking by the shareholders making such request to reimburse
the Trust for the expense of any such advisers in the event that the Trustees
determine not to bring such action.
After the reorganization, the Trustees may appoint separate Trustees with
respect to one or more series or classes of the Trust's shares (the "Series
Trustees"). To the extent provided by the Trustees in the appointment of Series
Trustees, Series Trustees (a) may, but are not required to, serve as Trustees of
the Trust or any other series or class of the Trust; (b) may have, to the
exclusion of any other Trustee of the Trust, all the powers and authorities of
Trustees under the Trust Agreement with respect to such series or class; and/or
(c) may have no power or authority with respect to any other series or class.
The Trustees are not currently considering the appointment of Series Trustees
for the Trust.
FINANCIAL STATEMENTS
The audited financial statements and related report of the Trust's
independent auditors, contained in the annual report to shareholders for the
fiscal year ended March 31, 1999 (the "Annual Report") are hereby incorporated
herein by reference. In addition, the unaudited financial statements contained
in the Semi-Annual Report for the period ended September 30, 1999 are
incorporated herein by reference. No other part of the Annual Report or the
Semi-Annual Report is incorporated by reference herein. Copies of the Annual
Report and the Semi-Annual Report may be obtained, without charge, from the
Transfer Agent by writing to the Northern Funds Center, P.O. Box 75986, Chicago,
Illinois 60675-5986 or by calling 1-800-595-9111.
OTHER INFORMATION
The Prospectus and this Additional Statement do not contain all the
information included in the Registration Statement filed with the SEC under the
1933 Act with respect to the securities offered by Northern Funds' Prospectus.
Certain portions of the Registration Statement have been omitted from the
Prospectus and this Additional Statement pursuant to the rules and regulations
of the SEC. The Registration Statement, including the exhibits filed therewith,
may be examined at the office of the SEC in Washington, D.C.
Statements contained in the Prospectus or in this Additional Statement as
to the contents of any contract or other documents referred to 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 the Registration Statement of
which the Prospectus and this Additional Statement form a part, each such
statement being qualified in all respects by such reference.
APPENDIX A
COMMERCIAL PAPER RATINGS
- ------------------------
A Standard & Poor's ("S&P") commercial paper rating is a current
assessment of the likelihood of timely payment of debt having an original
maturity of no more than 365 days. The following summarizes the rating
categories used by Standard and Poor's for commercial paper:
"A-1" - Obligations are rated in the highest category indicating that
the obligor's capacity to meet its financial commitment on the obligation is
strong. Within this category, certain obligations are designated with a plus
sign (+). This indicates that the obligor's capacity to meet its financial
commitment on these obligations is extremely strong.
"A-2" - Obligations are somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than obligations in
higher rating categories. However, the obligor's capacity to meet its financial
commitment on the obligation is satisfactory.
"A-3" - Obligations exhibit adequate protection parameters. However,
adverse economic conditions or changing circumstances are more likely to lead to
a weakened capacity of the obligor to meet its financial commitment on the
obligation.
"B" - Obligations are regarded as having significant speculative
characteristics. The obligor currently has the capacity to meet its financial
commitment on the obligation; however, it faces major ongoing uncertainties
which could lead to the obligor's inadequate capacity to meet its financial
commitment on the obligation.
"C" - Obligations are currently vulnerable to nonpayment and are
dependent upon favorable business, financial, and economic conditions for the
obligor to meet its financial commitment on the obligation.
"D" - Obligations are in payment default. The "D" rating category is
used when payments on an obligation are not made on the date due even if the
applicable grace period has not expired, unless S&P believes that such payments
will be made during such grace period. The "D" rating will be used upon the
filing of a bankruptcy petition or the taking of a similar action if payments on
an obligation are jeopardized.
Moody's commercial paper ratings are opinions of the ability of
issuers to repay punctually senior debt obligations not having an original
maturity in excess of one year, unless explicitly noted. The following
summarizes the rating categories used by Moody's for commercial paper:
"Prime-1" - Issuers (or supporting institutions) have a superior
ability for repayment of senior short-term debt obligations. Prime-1 repayment
ability will often be evidenced by many of the following characteristics:
leading market positions in well-established industries; high rates of return on
funds employed; conservative capitalization structure with moderate reliance on
debt and ample asset protection; broad margins in earnings coverage of fixed
financial charges and high internal cash generation; and well-established access
to a range of financial markets and assured sources of alternate liquidity.
"Prime-2" - Issuers (or 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 but to a lesser degree.
Earnings trends and coverage ratios, while sound, may 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 (or supporting institutions) have an acceptable
ability for repayment of senior short-term debt obligations. The effect of
industry characteristics and market compositions 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.
"Not Prime" - Issuers do not fall within any of the Prime rating
categories.
The three rating categories of Duff & Phelps for investment grade
commercial paper and short-term debt are "D-1," "D-2" and "D-3." Duff & Phelps
employs three designations, "D-1+," "D-1" and "D-1-," within the highest rating
category. The following summarizes the rating categories used by Duff & Phelps
for commercial paper:
"D-1+" - Debt possesses the 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.
"D-1" - Debt possesses very high certainty of timely payment.
Liquidity factors are excellent and supported by good fundamental protection
factors. Risk factors are minor.
"D-1-" - Debt possesses high certainty of timely payment. Liquidity
factors are strong and supported by good fundamental protection factors. Risk
factors are very small.
"D-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.
"D-3" - Debt possesses satisfactory liquidity and other protection
factors qualify issues as to investment grade. Risk factors are larger and
subject to more variation. Nevertheless, timely payment is expected.
"D-4" - Debt possesses speculative investment characteristics.
Liquidity is not sufficient to insure against disruption in debt service.
Operating factors and market access may be subject to a high degree of
variation.
"D-5" - Issuer has failed to meet scheduled principal and/or interest
payments.
Fitch IBCA short-term ratings apply to debt obligations that have time
horizons of less than 12 months for most obligations, or up to three years for
U.S. public finance securities. The following summarizes the rating categories
used by Fitch IBCA for short-term obligations:
"F1" - Securities possess the highest credit quality. This
designation indicates the strongest capacity for timely payment of financial
commitments and may have an added "+"to denote any exceptionally strong credit
feature.
"F2" - Securities possess good credit quality. This designation
indicates a satisfactory capacity for timely payment of financial commitments,
but the margin of safety is not as great as in the case of the higher ratings.
"F3" - Securities possess fair credit quality. This designation
indicates that the capacity for timely payment of financial commitments is
adequate; however, near-term adverse changes could result in a reduction to non-
investment grade.
"B" - Securities possess speculative credit quality. This designation
indicates minimal capacity for timely payment of financial commitments, plus
vulnerability to near-term adverse changes in financial and economic conditions.
"C" - Securities possess high default risk. This designation
indicates that default is a real possibility and that the capacity for meeting
financial commitments is solely reliant upon a sustained, favorable business and
economic environment.
"D" - Securities are in actual or imminent payment default.
Thomson BankWatch short-term ratings assess the likelihood of an
untimely payment of principal and interest of debt instruments with original
maturities of one year or less. The following summarizes the ratings used by
Thomson BankWatch:
"TBW-1" - This designation represents Thomson BankWatch's highest
category and indicates a very high likelihood that principal and interest will
be paid on a timely basis.
"TBW-2" - This designation represents Thomson BankWatch's second-
highest category and indicates that while the degree of safety regarding timely
repayment 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 Thomson BankWatch's lowest
investment-grade category and indicates that while the obligation is more
susceptible to adverse developments (both internal and external) than those with
higher ratings, the capacity to service principal and interest in a timely
fashion is considered adequate.
"TBW-4" - This designation represents Thomson BankWatch's lowest
rating category and indicates that the obligation is regarded as non-investment
grade and therefore speculative.
CORPORATE AND MUNICIPAL LONG-TERM DEBT RATINGS
- ----------------------------------------------
The following summarizes the ratings used by Standard & Poor's for
corporate and municipal debt:
"AAA" - An obligation rated "AAA" has the highest rating assigned by
Standard & Poor's. The obligor's capacity to meet its financial commitment on
the obligation is extremely strong.
"AA" - An obligation rated "AA" differs from the highest rated
obligations only in small degree. The obligor's capacity to meet its financial
commitment on the obligation is very strong.
"A" - An obligation rated "A" is somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than
obligations in higher-rated categories. However, the obligor's capacity to meet
its financial commitment on the obligation is still strong.
"BBB" - An obligation rated "BBB" exhibits adequate protection
parameters. However, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity of the obligor to meet its financial
commitment on the obligation.
Obligations rated "BB," "B," "CCC," "CC" and "C" are regarded as
having significant speculative characteristics. "BB" indicates the least degree
of speculation and "C" the highest. While such obligations will likely have
some quality and protective characteristics, these may be outweighed by large
uncertainties or major exposures to adverse conditions.
"BB" - An obligation rated "BB" is less vulnerable to nonpayment than
other speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial or economic conditions which could lead
to the obligor's inadequate capacity to meet its financial commitment on the
obligation.
"B" - An obligation rated "B" is more vulnerable to nonpayment than
obligations rated "BB", but the obligor currently has the capacity to meet its
financial commitment on the obligation. Adverse business, financial or economic
conditions will likely impair the obligor's capacity or willingness to meet its
financial commitment on the obligation.
"CCC" - An obligation rated "CCC" is currently vulnerable to
nonpayment, and is dependent upon favorable business, financial and economic
conditions for the obligor to meet its financial commitment on the obligation.
In the event of adverse business, financial, or economic conditions, the obligor
is not likely to have the capacity to meet its financial commitment on the
obligation.
"CC" - An obligation rated "CC" is currently highly vulnerable to
nonpayment.
"C" - The "C" rating may be used to cover a situation where a
bankruptcy petition has been filed or similar action has been taken, but
payments on this obligation are being continued.
"D" - An obligation rated "D" is in payment default. The "D" rating
category is used when payments on an obligation are not made on the date due
even if the applicable grace period has not expired, unless S&P believes that
such payments will be made during such grace period. The "D" rating also will
be used upon the filing of a bankruptcy petition or the taking of a similar
action if payments on an obligation are jeopardized.
PLUS (+) OR MINUS (-) - The ratings from "AA" through "CCC" may be
modified by the addition of a plus or minus sign to show relative standing
within the major rating categories.
"r" - This symbol is attached to the ratings of instruments with
significant noncredit risks. It highlights risks to principal or volatility of
expected returns which are not addressed in the credit rating. Examples
include: obligations linked or indexed to equities, currencies, or commodities;
obligations exposed to severe prepayment risk _ such as interest-only or
principal-only mortgage securities; and obligations with unusually risky
interest terms, such as inverse floaters.
The following summarizes the ratings used by Moody's for corporate and
municipal long-term debt:
"Aaa" - Bonds are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt
edged." Interest payments are protected by a large or by an exceptionally stable
margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
"Aa" - Bonds 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 risk appear somewhat larger than the "Aaa"
securities.
"A" - Bonds possess many favorable investment attributes and are to be
considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future.
"Baa" - Bonds are considered as medium-grade obligations, (i.e., they
are neither highly protected nor poorly secured). Interest payments and
principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
"Ba," "B," "Caa," "Ca," and "C" - Bonds that possess one of these
ratings provide questionable protection of interest and principal ("Ba"
indicates speculative elements; "B" indicates a general lack of characteristics
of desirable investment; "Caa" are of poor standing; "Ca" represents obligations
which are speculative in a high degree; and "C" represents the lowest rated
class of bonds). "Caa," "Ca" and "C" bonds may be in default.
Con. (---) - Bonds for which the security depends upon the completion
of some act or the fulfillment of some condition are rated conditionally. These
are bonds secured by (a) earnings of projects under construction, (b) earnings
of projects unseasoned in operating experience, (c) rentals which begin when
facilities are completed, or (d) payments to which some other limiting condition
attaches. Parenthetical rating denotes probable credit stature upon completion
of construction or elimination of basis of condition.
Note: Moody's applies numerical modifiers 1, 2, and 3 in each generic
rating classification from "Aa" through "Caa". The modifier 1 indicates that
the obligation ranks in the higher end of its generic rating category; the
modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking
in the lower end of its generic rating category.
The following summarizes the long-term debt 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 to be 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 in periods of greater 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.
The following summarizes the ratings used by Fitch IBCA for corporate
and municipal bonds:
"AAA" - Bonds considered to be investment grade and of the highest
credit quality. These ratings denote the lowest expectation of credit risk and
are assigned only in case of exceptionally strong capacity for timely payment of
financial commitments. This capacity is highly unlikely to be adversely
affected by foreseeable events.
"AA" - Bonds considered to be investment grade and of very high credit
quality. These ratings denote a very low expectation of credit risk and
indicate very strong capacity for timely payment of financial commitments. This
capacity is not significantly vulnerable to foreseeable events.
"A" - Bonds considered to be investment grade and of high credit
quality. These ratings denote a low expectation of credit risk and indicate
strong capacity for timely payment of financial commitments. This capacity may,
nevertheless, be more vulnerable to changes in circumstances or in economic
conditions than is the case for higher ratings.
"BBB" - Bonds considered to be investment grade and of good credit
quality. These ratings denote that there is currently a low expectation of
credit risk. The capacity for timely payment of financial commitments is
considered adequate, but adverse changes in circumstances and in economic
conditions are more likely to impair this capacity.
"BB" - Bonds considered to be speculative. These ratings indicate
that there is a possibility of credit risk developing, particularly as the
result of adverse economic changes over time; however, business or financial
alternatives may be available to allow financial commitments to be met.
Securities rated in this category are not investment grade.
"B" - Bonds are considered highly speculative. These ratings indicate
that significant credit risk is present, but a limited margin of safety remains.
Financial commitments are currently being met; however, capacity for continued
payment is contingent upon a sustained, favorable business and economic
environment.
"CCC," "CC" and "C" - Bonds have high default risk. Default is a real
possibility, and capacity for meeting financial commitments is solely reliant
upon sustained, favorable business or economic developments. "CC" ratings
indicate that default of some kind appears probable, and "C" ratings signal
imminent default.
"DDD," "DD" and "D" - Bonds are in default. Securities are not
meeting obligations and are extremely speculative. "DDD" designates the highest
potential for recovery of amounts outstanding on any securities involved and "D"
represents the lowest potential for recovery.
To provide more detailed indications of credit quality, the Fitch IBCA
ratings from and including "AA" to "B" may be modified by the addition of a plus
(+) or minus (-) sign to show relative standing within these major rating
categories.
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 indicates that the ability to repay principal
and interest on a timely basis is extremely high.
"AA" - This designation indicates a very strong ability to repay
principal and interest on a timely basis, with limited incremental risk compared
to 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 the lowest investment-grade
category and indicates an acceptable capacity to repay principal and interest.
Issues rated "BBB" are 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.
MUNICIPAL NOTE RATINGS
- ----------------------
A Standard and Poor's rating reflects the liquidity concerns and
market access risks unique to notes due in three years or less. The following
summarizes the ratings used by Standard & Poor's Ratings Group for municipal
notes:
"SP-1" - The issuers of these municipal notes exhibit a strong
capacity to pay principal and interest. Those issues determined to possess very
strong characteristics are given a plus (+) designation.
"SP-2" - The issuers of these municipal notes exhibit satisfactory
capacity to pay principal and interest, with some vulnerability to adverse
financial and economic changes over the term of the notes.
"SP-3" - The issuers of these municipal notes exhibit speculative
capacity to pay principal and interest.
Moody's ratings for state and municipal notes and other short-term
loans are designated Moody's Investment Grade ("MIG") and variable rate demand
obligations are designated Variable Moody's Investment Grade ("VMIG"). Such
ratings recognize the differences between short-term credit risk and long-term
risk. The following summarizes the ratings by Moody's Investors Service, Inc.
for short-term notes:
"MIG-1"/"VMIG-1" - This designation denotes best quality. There is
present strong protection by established cash flows, superior liquidity support
or demonstrated broad-based access to the market for refinancing.
"MIG-2"/"VMIG-2" - This designation denotes high quality, with margins
of protection that are ample although not so large as in the preceding group.
"MIG-3"/"VMIG-3" - This designation denotes favorable quality, with
all security elements accounted for but lacking the undeniable strength of the
preceding grades. Liquidity and cash flow protection may be narrow and market
access for refinancing is likely to be less well established.
"MIG-4"/"VMIG-4" - This designation denotes adequate quality.
Protection commonly regarded as required of an investment security is present
and although not distinctly or predominantly speculative, there is specific
risk.
"SG" - This designation denotes speculative quality. Debt instruments
in this category lack of margins of protection.
Fitch IBCA and Duff & Phelps use the short-term ratings described
under Commercial Paper Ratings for municipal notes.
APPENDIX B
As stated in the Prospectus, the Funds (other than the Money Market
Funds) may enter into certain futures transactions. Such transactions are
described in this Appendix.
I. Interest Rate Futures Contracts
-------------------------------
Use of Interest Rate 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, only 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 tended to move generally in the
aggregate in concert with the cash market prices and have maintained fairly
predictable relationships. Accordingly, a Fund may use interest rate futures
contracts as a defense, or hedge, against anticipated interest rate changes. As
described below, this would include the use of futures contract sales to protect
against expected increases in interest rates and futures contract purchases to
offset the impact of interest rate declines.
A Fund presently could accomplish a similar result to that which it
hopes to achieve through the use of futures contracts by selling bonds with long
maturities and investing in bonds with short maturities when interest rates are
expected to increase, or conversely, selling short-term bonds and investing in
long-term bonds when interest rates are expected to decline. However, because
of the liquidity that is often available in the futures market, the protection
is more likely to be achieved, perhaps at a lower cost and without changing the
rate of interest being earned by a Fund, by using futures contracts.
Interest rate future contracts can also be used by a Fund for non-
hedging (speculative) purposes to increase total return.
Description of Interest Rate Futures Contracts. An interest rate
futures contract sale would create an obligation by a 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 purchase would
create an obligation by a 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 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 the making or taking of delivery
of securities. Closing out a futures contract sale is effected by the Fund's
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
of the sale exceeds the price of the offsetting purchase, the Fund is
immediately paid 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 closing out of a futures contract purchase is effected
by the Fund 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.
Interest rate futures contracts are traded in an auction environment
on the floors of several exchanges -- principally, the Chicago Board of Trade,
the Chicago Mercantile Exchange and the New York Futures Exchange. Each
exchange guarantees performance under contract provisions through a clearing
corporation, a nonprofit organization managed by the exchange membership.
A public market now exists in futures contracts covering various
financial instruments including long-term U.S. Treasury Bonds and Notes;
Government National Mortgage Association (GNMA) modified pass-through mortgage
backed securities; three-month U.S. Treasury Bills; and ninety-day commercial
paper. The Funds may trade in any interest rate futures contracts for which
there exists a public market, including, without limitation, the foregoing
instruments.
II. Index Futures Contracts
-----------------------
General. A stock or bond index assigns relative values to the stocks
or bonds included in the index, which fluctuates with changes in the market
values of the stocks or bonds included. Some stock index futures contracts are
based on broad market indexes, such as Standard & Poor's 500 or the New York
Stock Exchange Composite Index. In contrast, certain exchanges offer futures
contracts on narrower market indexes, such as the Standard & Poor's 100 or
indexes based on an industry or market indexes, such as Standard & Poor's 100 or
indexes based on an industry or market segment, such as oil and gas stocks.
Futures contracts are traded on organized exchanges regulated by the Commodity
Futures Trading Commission. Transactions on such exchanges are cleared through
a clearing corporation, which guarantees the performance of the parties to each
contract. To the extent consistent with its investment objective, a Fund may
also engage in transactions, from time to time, in foreign stock index futures
such as the ALL-ORDS (Australia), CAC-40 (France), TOPIX (Japan) and the FTSE-
100 (United Kingdom).
A Fund may sell index futures contracts in order to offset a decrease
in market value of its portfolio securities that might otherwise result from a
market decline. A Fund may do so either to hedge the value of its portfolio as
a whole, or to protect against declines, occurring prior to sales of securities,
in the value of the securities to be sold. Conversely, a Fund will purchase
index futures contracts in anticipation of purchases of securities. A long
futures position may be terminated without a corresponding purchase of
securities.
In addition, a Fund may utilize index futures contracts in
anticipation of changes in the composition of its portfolio holdings. For
example, in the event that a Fund expects to narrow the range of industry groups
represented in its holdings it may, prior to making purchases of the actual
securities, establish a long futures position based on a more restricted index,
such as an index comprised of securities of a particular industry group. A Fund
may also sell futures contracts in connection with this strategy, in order to
protect against the possibility that the value of the securities to be sold as
part of the restructuring of the portfolio will decline prior to the time of
sale.
Index futures contracts may also be used by a Fund for non-hedging
(speculative) purposes to increase total return.
III. Futures Contracts on Foreign Currencies
---------------------------------------
A futures contract on foreign currency creates a binding obligation on
one party to deliver, and a corresponding obligation on another party to accept
delivery of, a stated quantity of foreign currency, for an amount fixed in U.S.
dollars. Foreign currency futures may be used by a Fund to hedge against
exposure to fluctuations in exchange rates between the U.S. dollar and other
currencies arising from multinational transactions.
IV. Margin Payments
---------------
Unlike purchases or sales of portfolio securities, no price is paid
or received by a Fund upon the purchase or sale of a futures contract.
Initially, a Fund will be required to deposit with the broker or in a segregated
account with a custodian or sub-custodian an amount of liquid assets, known as
initial margin, based on the value of the contract. The nature of initial
margin in futures transactions is different from that of margin in security
transactions in that 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 all
contractual obligations have been satisfied. Subsequent payments, called
variation margin, to and from the broker, will be made on a daily basis as the
price of the underlying instruments fluctuates making the long and short
positions in the futures contract more or less valuable, a process known as
"marking-to-market." For example, when a particular Fund has purchased a
futures contract and the price of the contract has risen in response to a rise
in the underlying instruments, that position will have increased in value and
the Fund will be entitled to receive from the broker a variation margin payment
equal to that increase in value. Conversely, where the Fund has purchased a
futures contract and the price of the future contract has declined in response
to a decrease in the underlying instruments, the position would be less valuable
and the Fund would be required to make a variation margin payment to the broker.
Prior to expiration of the futures contract, Northern Trust or NTQA may elect to
close the position by taking an opposite position, subject to the availability
of a secondary market, which will operate to terminate the Fund's position in
the futures contract. A final determination of variation margin is then made,
additional cash is required to be paid by or released to the Fund, and the Fund
realizes a loss or gain.
V. Risks of Transactions in Futures Contracts
------------------------------------------
There are several risks in connection with the use of futures by a
Fund. One risk arises because of the imperfect correlation between movements in
the price of the futures and movements in the price of the instruments which are
the subject of the hedge. The price of the future may move more than or less
than the price of the instruments being hedged. If the price of the futures
moves less than the price of the instruments which are the subject of the hedge,
the hedge will not be fully effective but, if the price of the instruments being
hedged has moved in an unfavorable direction, the Fund would be in a better
position than if it had not hedged at all. If the price of the instruments
being hedged has moved in a favorable direction, this advantage will be
partially offset by the loss on the futures. If the price of the futures moves
more than the price of the hedged instruments, the Fund involved will experience
either a loss or gain on the futures which will not be completely offset by
movements in the price of the instruments which are the subject of the hedge.
To compensate for the imperfect correlation of movements in the price of
instruments being hedged and movements in the price of futures contracts, a Fund
may buy or sell futures contracts in a greater dollar amount than the dollar
amount of instruments being hedged if the volatility over a particular time
period of the prices of such instruments has been greater than the volatility
over such time period of the futures, or if otherwise deemed to be appropriate
by the Investment Advisers. Conversely, a Fund may buy or sell fewer futures
contracts if the volatility over a particular time period of the prices of the
instruments being hedged is less than the volatility over such time period of
the futures contract being used, or if otherwise deemed to be appropriate by the
Investment Advisers. It is also possible that, where a Fund has sold futures to
hedge its portfolio against a decline in the market, the market may advance and
the value of instruments held in the Fund may decline. If this occurred, the
Fund would lose money on the futures and also experience a decline in value in
its portfolio securities.
When futures are purchased to hedge against a possible increase in
the price of securities or a currency before a Fund is able to invest its cash
(or cash equivalents) in an orderly fashion, it is possible that the market may
decline instead; if the Fund then concludes not to invest its cash at that time
because of concern as to possible further market decline or for other reasons,
the Fund will realize a loss on the futures contract that is not offset by a
reduction in the price of the instruments that were to be 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
instruments being hedged, the price of futures may not correlate perfectly with
movement in the cash market due to certain market distortions. Rather than
meeting additional margin deposit requirements, investors may close futures
contracts through off-setting transactions which could distort the normal
relationship between the cash and futures markets. Second, with respect to
financial futures contracts, the liquidity of the futures market depends on
participants entering into off-setting transactions rather than making or taking
delivery. To the extent participants decide to make or take delivery, liquidity
in the futures market could be reduced thus producing distortions. Third, from
the point of view of speculators, 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. Due to the possibility of price distortion in the
futures market, and because of the imperfect correlation between the movements
in the cash market and movements in the price of futures, a correct forecast of
general market trends or interest rate movements by the Investment Adviser may
still not result in a successful hedging transaction over a 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 appear to be active secondary markets, there is no assurance that a liquid
secondary market on any 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 investment position, and in the event of adverse price
movements, a Fund would continue to be required to make daily cash payments of
variation margin. However, in the event 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 on a futures contract.
Further, it should be noted that the liquidity of a secondary market
in a futures contract may be adversely affected by "daily price fluctuation
limits" established by commodity exchanges which limit the amount of fluctuation
in a futures contract price during a single trading day. Once the daily limit
has been reached in the contract, no trades may be entered into at a price
beyond the limit, thus preventing the liquidation of open futures positions.
The trading of futures contracts is also subject to the risk of trading halts,
suspensions, exchange or clearing house equipment failures, government
intervention, insolvency of a brokerage firm or clearing house or other
disruptions of normal trading activity, which could at times make it difficult
or impossible to liquidate existing positions or to recover excess variation
margin payments.
Successful use of futures by a Fund is also subject to the
Investment Advisers' ability to predict correctly movements in the direction of
the market. For example, if a particular Fund has hedged against the
possibility of a decline in the market adversely affecting securities held by it
and securities prices increase instead, the Fund will lose part or all of the
benefit to the increased value of its securities 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. A
Fund may have to sell securities at a time when it may be disadvantageous to do
so.
VI. Options on Futures Contracts
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A Fund may purchase and write options on the futures contracts
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. A Fund will be required to deposit initial margin and variation
margin with respect to put and call options on futures contracts written by it
pursuant to brokers' requirements similar to those described above. Net option
premiums received will be included as initial margin deposits. As an example,
in anticipation of a decline in interest rates, a Fund may purchase call options
on futures contracts as a substitute for the purchase of futures contracts to
hedge against a possible increase in the price of securities which the Fund
intends to purchase. Similarly, if the value of the securities held by a Fund
is expected to decline as a result of an increase in interest rates, the Fund
might purchase put options or sell call options on futures contracts rather than
sell futures contracts.
Investments in futures options involve some of the same
considerations that are involved in connection with investments in futures
contracts (for example, the existence of a liquid secondary market). In
addition, the purchase or sale of an option also entails the risk that changes
in the value of the underlying futures contract will not correspond to changes
in the value of the option purchased. 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 can be expected to be more volatile than the market
prices on the underlying futures contract. 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 Fund because the
maximum amount at risk is the premium paid for the options (plus transaction
costs). The writing of an option on a futures contract involves risks similar
to those risks relating to the sale of futures contracts.
VII. Other Matters
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Accounting for futures contracts will be in accordance with
generally accepted accounting principles.
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