<PAGE>
Montgomery Variable Series:
International Small Cap Fund
Annual Report
December 31, 1997
[OWL ARTWORK APPEARS HERE]
Invest wisely.(R)
THE MONTGOMERY FUNDS
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Highlights
December 31, 1997
- -------------------------------------------------------------------------------
Investment Review
Q: HOW DID THE MONTGOMERY VARIABLE SERIES: INTERNATIONAL SMALL CAP FUND
PERFORM OVER THE LATTER HALF OF 1997?
A: It outperformed its benchmark, the unmanaged Salomon Smith Barney World
Extended (ex-U.S.) Market Index, though both posted a loss. The Fund
also outperformed the index over the full-year period, by a margin of
over four percentage points.
Q: WHAT FACTORS DROVE THAT PERFORMANCE?
A: The Asian crisis wreaked havoc on world markets in the late summer and
fall, putting international small-cap shares under some pressure.
Japanese equities fell steeper into their decline. We have kept the
portfolio very light on Japan for several years, but the Fund still had
about 18% of its assets there in mid-1997. That exposure worked against
us. The Fund also had roughly 6% of its assets in China/Hong Kong,
another volatile market during the second half.
These Asian holdings were offset by some of the funds European stocks.
One of its largest holdings at year-end, a U.K. transportation company
called National Express Group PLC, performed well in the second half.
This company has benefited from the United Kingdom's moves to deregulate
its transportation system. That trend is occurring in other sectors and
countries such as Germany, where another of our large holdings, Vossloh
AG, is based. We have a very positive outlook for this firm, which
manufactures rail equipment and electrical components; it may profit
from deregulation and increased demand for cross-border transportation
with the advent of the European Economic & Monetary Union (EMU).
Q: THERE'S BEEN A LOT OF TALK ABOUT THE "FLIGHT TO QUALITY" IN THE U.S.
MARKET DURING THE SECOND HALF. DID THE SAME THING HAPPEN OVERSEAS?
A: Yes, but it might be more aptly called a "flight to blue chips." In
Europe, investors favored export-oriented companies and financial
services firms over cyclicals, and large-cap stocks over small. We do
think investors were somewhat justified in being wary of cyclicals, as
Asia's slowdown is likely to reduce demand for basic materials and other
cycle-sensitive goods. We think investors were misguided in applying the
same rationale to international small-caps, however (with the exception
of those in Japan). Most European small companies have little or no
exposure to Asia, but are instead much more domestically driven. As a
result, they may benefit from potentially more-robust economic activity
in many European countries this year, despite Asia's slowdown.
Portfolio Management
John D. Boich, CFA
...................Senior Portfolio Manager
Fund Performance
Average annual total returns for the period
ended 12/31/97
MONTGOMERY VARIABLE SERIES:
INTERNATIONAL SMALL CAP FUND
Since inception (9/30/96) ........... 1.41%
One Year............................. -5.10%
SALOMON SMITH BARNEY WORLD
EXTENDED EX-U.S. MARKET INDEX
Since 9/30/96........................ -8.05%
One Year............................. -9.40%
Past performance is no guarantee of future
results. Net asset value, investment return
and principal value will fluctuate so that
shares, when redeemed, may be worth more or
less than their original cost.
[PERFORMANCE CHART APPEARS HERE]
1 The Salomon Smith Barney World Equity Index is a comprehensive float-weighted
equity index consisting of every company with an investable market
capitalization of over $100 million in 21 countries. Within this index, the
Extended ex-U.S. Market Index defines the small capitalization stock universe.
2 The Lipper International Small Cap Funds Average universe consists of 26
funds.
1
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Highlights (continued)
December 31, 1997
- --------------------------------------------------------------------------------
In our view it's also mistaken to assume that a "flight to quality"
necessarily means a flight from small-caps. We apply the same strategy
to finding investments for this Fund as we use for the larger-cap
international growth mutual fund we manage. Our strategy entails looking
for companies that exhibit strength and stability through a clean
balance sheet, a leading competitive position and capable management,
among other qualities. In other words, we don't have to lower our
standards to find attractive small-cap investments. Whatever the market
segment, one of our goals is to find companies that we think will be
able to thrive in a variety of economic environments.
Q: DID THE SECOND HALF'S VOLATILITY PROMPT YOU TO USE ANY SPECIAL
INVESTMENT TACTICS?
A: No, but we did accelerate our research itinerary to better understand
the risks and opportunities that the volatility might be creating. Our
analysts traveled extensively in Asia and Europe during the Autumn. We
also took advantage of market volatility to build positions in companies
whose shares we thought had been oversold. With investors favoring
large-caps over small-caps in the second half, there seemed to be a
great deal of buying opportunities in the international small-cap
universe. We put emphasis on companies that we think may be able to
deliver consistent earnings-sometimes called "earnings visibility"-even
in a less robust global economic environment.
Q: WHAT DO YOU THINK 1998 MIGHT HOLD FOR INTERNATIONAL SMALL-CAP INVESTORS?
A: We think that global markets may remain volatile as investors and
economists factor the potential impact of Asia's slowdown into their
expectations for 1998. Prior to the crisis, we calculated that major
economists were forecasting global economic growth of 2.93% in 1998. As
of early 1998, our calculations showed that these economists had lowered
their forecast to 2.66%. This largely reflects lower expectations for
Japan and the emerging markets, but we think economists will also have
to lower their forecasts for the United States and Europe in the coming
months. Investors, in turn, may be disappointed by lower-than-expected
corporate earnings once Asia's slowdown is fully factored into the
equation. That said, "lower than expected" may not necessarily mean
weak; it could simply mean moderate.
We think that stock selection will be paramount in this climate. When
the outlook is uncertain, investors often turn to companies that they
believe will be able to achieve consistent earnings growth. That's a
quality we've sought in our holdings since the Fund's inception. We seek
out firms that we believe have strong, consistent earnings and cash-flow
growth, top management teams, commanding market positions and attractive
valuations. These companies may become market leaders in the coming
years, and, as such, could provide excellent long-term growth potential.
2
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Highlights (continued)
December 31, 1997
TOP FIVE COUNTRIES
(AS A PERCENTAGE OF TOTAL NET ASSETS):
Japan.................................. 18.3%
Great Britain.......................... 15.2
Germany................................ 8.4
Sweden................................. 8.3
Italy.................................. 8.1
TOP TEN INDUSTRIES
(AS A PERCENTAGE OF TOTAL NET ASSETS):
Retail Trade........................... 15.1%
Software Systems....................... 10.6
Heavy Construction..................... 7.3
Food and Beverage...................... 6.7
Diversified Financial Services......... 4.5
Computers and Office Equipment......... 4.3
Electronics............................ 3.9
Transport Services..................... 3.5
Insurance.............................. 3.2
Telephone/Wireless..................... 3.2
TOP TEN HOLDINGS
(AS A PERCENTAGE OF TOTAL NET ASSETS):
National Express Group PLC............. 3.5%
Assurances Banque Populaire............ 3.2
CN Selmer A.S.......................... 3.1
Azkoyen S.A............................ 3.0
Nissin Company Ltd..................... 3.0
Vossloh AG............................. 2.9
Otsuka Kagu Ltd........................ 2.9
Hemkopskedjan AB....................... 2.9
Choice Hotels Scandinavia ASA.......... 2.6
Eidos PLC.............................. 2.5
3
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Investments (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Common Stocks-91.9% VALUE
Shares (NOTE 1)
AUSTRIA-2.0%
460 Voest Alpine Eisenbahnsystem (Heavy Construction) $40,423
-------
BELGIUM-0.6%
600 Virgin Express Holdings PLC, Sponsored ADR+ (Airlines) 12,300
-------
CANADA-2.3%
1,900 Cognos, Inc.+ (Software Systems) 43,819
5,000 InMedia Presentations, Inc. + (Software Systems) 4,461
-------
48,280
-------
CHINA/HONG KONG-6.6%
94,000 Esprit Holdings Ltd. (Retail Trade) 30,630
83,000 Four Seas Mercantile Holdings Ltd. (Food and Beverage) 40,166
104,000 Goldlion Holdings, Ltd., ORD (Apparel and Textiles) 34,559
16,500 Smartone Telecommunications (Telephone/Wireless) 31,833
-------
137,188
-------
FRANCE-4.8%
600 Assurances Banque Populaire (Insurance) 65,781
1,100 Dassault Systemes S.A., ADR (Software Systems) 34,169
-------
99,950
-------
GERMANY-8.4%
2,188 Eurobike AG+ (Retail Trade) 39,041
3,100 Rofin-Sinar Technologies Inc.+ (Machinery and Tools) 37,588
1,700 Turbon International AG (Computers and Office
Equipment) 36,759
1,080 Vossloh AG (Building Materials) 60,334
173,722
-------
GREAT BRITAIN-15.2%
12,235 Avis Europe PLC (Retail Trade) 34,763
1,300 Dr. Solomon's Group PLC, ADR + (Software Systems) 41,600
4,740 Eidos PLC+ (Computers and Office Equipment) 52,158
87,200 Freepages Group PLC+ (Broadcasting/Advertising) 46,902
5,379 Henlys Group PLC (Auto/Auto Parts) 36,618
5,220 London Forfaiting Company PLC+ (Diversified
Financial Services) 30,434
6,388 National Express Group PLC (Transport Services) 71,918
-------
314,393
ISRAEL-0.8%
500 Tecnomatix Technologies Ltd.+ (Software Systems) 16,688
-------
ITALY-8.1%
6,900 Editoriale L'Expresso SpA (Newspapers/Publishing) 33,154
1,200 Gucci Group (Retail Trade) 50,250
1,800 Industrie Natuzzi SpA, Sponsored ADR (Retail Trade) 37,125
12,700 Manuli Rubber Industries SpA+ (Rubber) 47,239
-------
167,768
-------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
4
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Investments (continued)
December 31, 1997
COMMON STOCKS (CONTINUED) VALUE
SHARES (NOTE 1)
JAPAN-18.3%
1,300 Fast Retailing Company Ltd. (Retail Trade) $ 20,812
7,000 Fuso Lexel Inc. (Real Estate) 39,946
3,000 Justsystem Corporation+ (Software Systems) 37,917
5,000 Laox (Retail Trade) 40,214
3,750 Mirai Industry Company, Ltd. (Electronics) 41,651
3,000 Nissin Company Ltd. (Diversified Financial Services) 62,045
1,600 Otsuka Kagu Ltd. (Retail Trade) 59,441
7,100 Sawako Corporation (Heavy Construction) 46,771
4,000 Sugimoto & Company (Machinery and Tools) 28,035
---------
376,832
---------
NORWAY-5.8%
16,000 Choice Hotels Scandinavia ASA+ (Lodging) 54,237
6,700 CN Selmer A.S. (Heavy Construction). 64,502
118,739
---------
POLAND-1.9%
3,500 Prokom ADR**+ (Software Systems) 39,288
---------
PORTUGAL-1.7%
32 Telecel-Comunicacoes Pessoais, S.A.+
(Telephone/Wireless) 34,095
---------
SPAIN-4.9%
592 Azkoyen S.A. (Consumer Services) 62,561
2,075 Baron de Ley, S.A.+ (Food and Beverage) 39,226
---------
101,787
---------
SWEDEN-8.3%
2,900 Allgon AB, Series B (Electronics) 39,081
4,800 Hemkopskedjan AB+ (Food and Beverage) 59,245
2,850 Munters AB+ (Environmental Services) 24,588
3,650 Nobel Biocare AB+ (Medical Products) 47,809
---------
170,723
---------
SWITZERLAND-2.2%
200 Fotolabo S.A. (Film Processing) 44,470
---------
TOTAL COMMON STOCKS (COST $2,269,054) 1,896,646
---------
RIGHTS-0.0%# (COST $612)
FRANCE-0.0%#
113 Assurances Banque Populaire, Expires 01/09/98+
(Insurance) 639
---------
TOTAL SECURITIES (COST $2,269,666) 1,897,285
---------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
5
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Portfolio Investments (continued)
December 31, 1997
<TABLE>
<CAPTION>
REPURCHASE AGREEMENT-8.1% (COST $167,000) VALUE
PRINCIPAL AMOUNT (NOTE 1)
<C> <S> <C>
$167,000 Agreement with Bear Stearns, Tri-Party, 6.850%
dated 12/31/97, to be repurchased at $167,064,
on 01/02/98, collateralized by $173,956 market
value of U.S. government securities, having
various maturities and various interest
rates $ 167,000
----------
TOTAL INVESTMENTS (COST $2,436,666*) 100.0 % 2,064,285
OTHER ASSETS AND LIABILITIES (NET) (0.0)# (853)
----- ----------
NET ASSETS 100.0 % $2,063,432
===== ==========
</TABLE>
- ----------
* Aggregate cost for federal tax purposes was $2,442,384.
** Illiquid Security or Special Situation Security (See Note 6 to Financial
Statements).
+ Non-income-producing security.
# Amount represents less than 0.1%.
ABBREVIATIONS:
ADR American Depositary Receipts
ORD Ordinary
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
6
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Statement of Assets and Liabilities
December 31, 1997
<TABLE>
<CAPTION>
ASSETS:
<S> <C>
Investments in securities, at value
(Identified cost $2,436,666)(Note 1)
Securities................................................ $1,897,285
Repurchase agreements..................................... 167,000
----------
Total investments......................................... 2,064,285
Cash.............................................................. 11,283
Forward foreign currency exchange contracts:
Net unrealized appreciation of forward foreign currency
contracts (Note 3)....................................... 148
Receivables:
Investment securities sold................................ 31,083
Expenses absorbed by Manager (Note 2)..................... 4,982
Dividends................................................. 2,726
Interest.................................................. 32
Other Assets:
Organization costs (Note 1)............................... 1,341
----------
Total Assets...................................................... 2,115,880
LIABILITIES:
Payables:
Legal and audit fees......................... $32,632
Investment securities purchased.............. 5,284
Organization cost............................ 4,247
Shares of beneficial interest redeemed....... 3,975
Custodian fees............................... 2,791
Trustees' fees and expenses (Note 2)......... 1,369
Other accrued liabilities and expenses....... 2,150
-------
Total Liabilities................................................. 52,448
----------
NET ASSETS........................................................ $2,063,432
==========
NET ASSETS consist of:
Distribution in excess of net investment income........... $ (2,945)
Distributions in excess of realized gain on securities
sold, forward foreign currency contracts and foreign
currency transactions.................................... (222,961)
Net unrealized depreciation of investments, forward
foreign currency exchange contracts and foreign currency
transactions............................................. (372,491)
Shares of beneficial interest............................. 2,489
Additional paid-in capital................................ 2,660,340
----------
NET ASSETS........................................................ $2,063,432
----------
Net Asset Value, offering and redemption price per share
($2,063,432 248,947 shares of beneficial interest outstanding)... $ 8.29
----------
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
7
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Statement of Operations
For the Year Ended December 31, 1997
<TABLE>
<S> <C> <C>
INVESTMENT INCOME:
Dividends (net of foreign withholding taxes of $3,729)................. $ 37,460
Interest............................................................... 21,557
Total Investment Income................................................ 59,017
EXPENSES:
Legal and audit fees................................................... $ 35,440
Management fee (Note 2)................................................ 34,368
Custodian fees......................................................... 13,777
Trustees' fees and expenses (Note 2)................................... 4,828
Amortization of organization expenses (Note 1)......................... 746
Other.................................................................. 7,168
--------
TOTAL EXPENSES......................................................... 96,327
Fees deferred and expenses absorbed by Manager (Note 2)................ (96,327)
---------
NET EXPENSES........................................................... 0
---------
NET INVESTMENT INCOME.................................................. 59,017
---------
NET REALIZED AND UNREALIZED GAIN/(LOSS) ON INVESTMENTS (NOTES 1 AND 3):
Net realized gain/(loss) on:
Security transactions.......................................... 84,683
Forward foreign currency exchange contracts.................... (17,010)
Foreign currency transactions.................................. (6,015)
---------
Net realized gain on investments during the year....................... 61,658
---------
Change in unrealized appreciation/(depreciation) of:
Securities transactions........................................ (421,837)
Forward foreign currency exchange contracts.................... 148
Foreign currency transactions and net other assets............. (284)
---------
Net unrealized depreciation of investments during the year............. (421,973)
---------
NET REALIZED AND UNREALIZED LOSS ON INVESTMENTS........................ (360,315)
---------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS................... $(301,298)
---------
</TABLE>
Statement of Changes in Net Assets
<TABLE>
<CAPTION>
For the Year Ended For the Period Ended
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS:.................. 12/31/97 12/31/96*
------------------ --------------------
<S>.................................................................... <C> <C>
Net investment income.................................................. $ 59,017 $ 5,449
Net realized gain on securities, forward foreign currency exchange
contracts and foreign currency transactions during the period......... 61,658 17,392
Net unrealized appreciation/(depreciation) of securities transactions,
forward foreign currency exchange contracts, foreign currency
transactions and net other assets during the period................... (421,973) 49,482
---------- ----------
Net increase/(decrease) in net assets resulting from operations........ (301,298) 72,323
DISTRIBUTIONS TO SHAREHOLDERS:
Distributions from net investment income............................... (40,393) (4,977)
Distributions from net realized gain................................... (325,197) (526)
BENEFICIAL INTEREST TRANSACTIONS:
Net increase from beneficial interest transactions (Note 4)............ 1,623,638 39,862
---------- ----------
Net increase in net assets............................................. 956,750 106,682
NET ASSETS:
Beginning of period.................................................... 1,106,682 1,000,000
---------- ----------
End of period.......................................................... $2,063,432 $1,106,682
========== ==========
Undistributed/(Distribution in excess of) net investment income........ $ (3,945) $ 472
========== ==========
</TABLE>
- --------
* Montgomery Variable Series: International Small Cap Fund commenced operations
on September 30, 1996.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
8
<PAGE>
Montgomery Variable Series: International Small Cap Fund
Financial Highlights
Selected Per Share Data for the Year or Period Ended:
<TABLE>
<CAPTION>
12/31/97 12/31/96*
-------- --------
<S> <C> <C>
Net asset value-beginning of period........................................................ $ 10.67 $ 10.00
-------- --------
Net investment income...................................................................... 0.22 0.05
Net realized and unrealized gain/(loss) on investments..................................... (0.78) 0.68
-------- --------
Net increase/(decrease) in net assets resulting from investment operations................. (0.56) 0.73
-------- --------
Distributions to shareholders:
Distributions from net investment income........................................... (0.20) (0.05)
Distributions from net realized gains on investments............................... (1.62) (0.01)
-------- --------
Total distributions................................................................ (1.82) (0.06)
-------- --------
Net asset value-end of period.............................................................. $ 8.29 $ 10.67
-------- --------
Total return**............................................................................. (5.10)% 7.23%
======== ========
RATIOS TO AVERAGE NET ASSETS/SUPPLEMENTAL DATA:
Net assets, end of period (in 000's)....................................................... $ 2,063 $ 1,107
Ratio of net investment income to average net assets....................................... 2.15% 2.03%+
Ratio of operating expenses to average net assets.......................................... 0.00% 0.00%+
Portfolio turnover rate.................................................................... 176% 12%
Average commission rate paid (a)........................................................... $ 0.0139 $ 0.0059
Net investment loss before deferral of fees and absorption of
expenses by Manager....................................................................... $ (0.17) $ (0.11)
Operating expense ratio before deferral of fees and absorption of
expenses by Manager....................................................................... 3.50% 6.30%+
</TABLE>
- ------------
* Montgomery Variable Series: International Small Cap Fund commenced
operations on September 30, 1996.
** Total return represents aggregate total return for the periods indicated.
+ Annualized.
(a) Average commission rate paid per share of securities purchased and sold by
the Fund.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PAT OF THESE FINANCIAL STATEMENTS.
9
<PAGE>
The Montgomery Funds III
Notes to Financial Statements
The Montgomery Funds III (the Trust) is registered under the Investment
Company Act of 1940, as amended (the 1940 Act), as a diversified, open-
end management investment company, and was organized as a Delaware
business trust on August 24, 1994. As of December 31, 1997, the Trust
had four series, the Montgomery Variable Series: Growth Fund, the
Montgomery Variable Series: Emerging Markets Fund, the Montgomery
Variable Series: International Small Cap Fund and the Montgomery
Variable Series: Small Cap Opportunities Fund. The Montgomery Variable
Series: Small Cap Opportunities Fund had not commenced operations as of
December 31, 1997. Prior to the public offerings of shares of the Funds,
a limited number of shares were sold to Montgomery Asset Management, LLC
(or its predecessor). and/or affiliated persons of Montgomery Asset
Management in private placement offerings. Otherwise, the Funds had no
significant operations prior to February 2, 1996, the date on which the
Montgomery Variable Series: Emerging Markets Fund commenced operations
(i.e., commenced selling shares to the public). Information presented in
these financial statements pertains to the Montgomery Variable Series:
International Small Cap Fund (the Fund). The Montgomery Variable Series:
Emerging Markets Fund and the Montgomery Variable Series: Growth Fund
are presented under separate covers.
1. SIGNIFICANT ACCOUNTING POLICIES:
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts and disclosures in the
financial statements. Actual results could differ from those estimates.
The following is a summary of significant accounting policies.
a. PORTFOLIO VALUATION
The Fund's securities are valued using current market
valuations: either the last reported sales price or, lacking any
reported sales, and in the case of fixed income securities, the
mean between the closing bid and asked prices. The value of
securities denominated in foreign currencies and traded on
foreign exchanges or in foreign markets are translated into U.S.
dollars at the last price of their respective currency
denomination against U.S. dollars quoted by a major bank or, if
no such quotation is available, at the rate of exchange
determined in accordance with policies established in good faith
by the Board of Trustees. Securities for which market quotations
are not readily available (including restricted securities which
are subject to limitations as to their sale) are valued at fair
value by management as determined in good faith by or under the
supervision of the Trust in accordance with methods which are
authorized by the Trust's Board of Trustees.
Short term debt obligations with remaining maturities in excess
of 60 days are valued at current market prices, as discussed
above. Short-term securities with maturities of 60 days or less
are carried at amortized cost, which approximates market value.
b. DIVIDENDS AND DISTRIBUTIONS
Dividends, if any, from net investment income of the Fund are
declared and paid at least annually. Distributions of net
realized capital gains (including net short-term capital gains)
are distributed no less frequently than annually. Additional
distributions of net investment income and capital gains for the
Fund may be made in order to avoid the application of a 4% non-
deductible excise tax on certain undistributed amounts of
ordinary income and capital gains. Income distributions and
capital gain distributions are determined in accordance with
income tax regulations which may differ from generally accepted
accounting principles. These differences are primarily due to
differing treatments of income and gains on various investment
securities held by the Fund, timing differences and differing
characterizations of distributions made by the Fund. Permanent
differences incurred during the year ended December 31, 1997,
resulting from differences in book and tax accounting have been
reclassified at year end to reflect a decrease to undistributed
investment income of $23,041, a decrease to paid-in capital of
$671 and an increase to accumulated realized loss of $23,712.
c. FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
The Fund may engage in forward foreign currency exchange
contracts with off balance sheet risk in the normal course of
investing activities in order to manage exposure to market
risks. Forward foreign currency exchange contracts are valued at
the forward rate and are marked-to-market daily. The change in
market value is recorded by the Fund as an unrealized gain or
loss.
When the contract is closed, the Fund records a realized gain or
loss equal to the difference between the value of the contract
at the time it was opened and the value at the time it was
closed. Forward foreign currency exchange contracts are used
solely to establish a rate of exchange for settlement of
transactions. Although forward foreign currency exchange
contracts limit the risk of loss due to a decline in the value
of the hedged currency, they also limit any potential gain that
might result should the value of the currency increase. In
addition, the Fund could be exposed to risks if the
counterparties to the contracts are unable to meet the terms of
their contracts.
10
<PAGE>
The Montgomery Funds III
Notes to Financial Statements
(continued)
d. FOREIGN CURRENCY
Foreign currencies, investments and other assets and liabilities
are translated into U.S. dollars at the exchange rates
prevailing at the end of the period, and purchases and sales of
investment securities and income and expenses are translated on
the respective dates of such transactions. Unrealized gains and
losses which result from changes in foreign currency exchange
rates on investments have been included in the unrealized
appreciation/(depreciation) of securities. Net realized foreign
currency gains and losses resulting from movement in exchange
rates include foreign currency gains and losses between trade
date and settlement date on investment securities transactions
foreign currency transactions and the difference between the
amounts of interest and dividends recorded on the books of the
Fund and the amount actually received and the portion of foreign
currency gains and losses related to fluctuations in exchange
rates between the initial purchase trade date and subsequent
sale trade date.
e. REPURCHASE AGREEMENTS
The Fund may engage in repurchase agreement transactions
individually or jointly through a joint repurchase account with
other series of the Trust and affiliated registered investment
companies pursuant to a joint repurchase agreement. Under the
terms of a typical repurchase agreement, the Fund takes
possession of a government debt obligation as collateral. The
Fund also agrees with the counterparty to allow the counterparty
to repurchase, and the Fund to resell the obligation at a
specified date and price, thereby determining the yield during
the Fund's holding period. This arrangement results in a fixed
rate of return that is not subject to market fluctuations during
the Fund's holding period. The value of the collateral is at
least equal at all times to the total amount of the repurchase
obligations, including interest. In the event of counterparty
default, the Fund has the right to use the collateral to offset
losses incurred. There could be potential loss to the Fund in
the event the Fund is delayed or prevented from exercising its
rights to dispose of the collateral securities, including the
risk of a possible decline in the value of the underlying
securities during the period while the Fund seeks to assert its
rights. The Fund's investment manager, acting under the
supervision of the Board of Trustees, reviews the value of the
collateral and the creditworthiness of those banks and dealers
with which the Fund enters into repurchase agreements to
evaluate potential risks. The Fund may also participate on an
individual or joint basis in tri-party repurchase agreements
which involve a counterparty and a custodian bank.
f. SECURITIES TRANSACTIONS aND INVESTMENT INCOME SECURITIES
transactions are recorded on a trade-date basis. Realized gain
and loss from securities transactions are computed on the
specific identified cost basis of the securities sold. Dividend
income is recognized on the ex-dividend date and interest
income, including, amortization of discount on short-term
investments, is recognized on an accrual basis. Dividend income
on foreign securities is recognized as soon as the Fund is
informed of the ex-dividend date.
g. FEDERAL INCOME TAXES
The Fund has elected and qualified and it is the intention of
the Fund to continue to qualify as a regulated investment
company under Subchapter M of the Internal Revenue Code of 1986,
as amended (the Code), by complying with the applicable requi
rements of the Code, and by making distributions of taxable
income to shareholders sufficient to relieve the Fund from all
or substantially all federal income taxes. Accordingly, no
provision for federal income taxes is required.
h. ORGANIZATION COSTS
Expenses incurred in connection with the organization of the
Fund amounted to $4,247 and are amortized on a straight-line
basis over a period of sixty months from commencement of
operations.
i. EXPENSES
General expenses of the Trust are allocated to the Fund based
upon relative net assets. Operating expenses directly
attributable to the Fund are charged to the Fund's operations.
2. MANAGEMENT FEES AND OTHER TRANSACTIONS WITH AFFILIATES:
a. Montgomery Asset Management, LLC is the Fund's Manager (the
Manager). The Manager, a Delaware limited liability company, is
an investment adviser registered with the Securities and
Exchange Commission under the Investment Advisers Act of 1940,
as amended (the Advisers Act). The Manager is a subsidiary of
Commerzbank AG, one of the largest publicly held commercial
banks in Germany.
<PAGE>
The Montgomery Funds III
Notes to Financial Statements
(continued)
Pursuant to the investment management agreement (Investment
Management Agreement), the Manager provides the Fund with advice
on buying and selling securities, manages the investments of the
Fund including the placement of orders for portfolio
transactions, furnishes the Fund with office space and certain
administrative services, and provides the personnel needed by
the Trust with respect to the Manager's responsibilities under
such Agreement. As compensation, the Fund pays the Manager a
monthly management fee (accrued daily) at the following annual
rates based upon the average daily net assets of the Fund:
First $250 Million Over $250 Million
------------------ -----------------
1.25% 1.00%
The Manager has voluntarily agreed to reduce some or all of its
management fee or absorb the Fund expenses if necessary to keep
the Fund's annual operating expenses, exclusive of interest or
taxes, at or below 1.50% of the average daily net assets of the
Fund. Any reductions or absorptions made for the Fund by the
Manager of its fees are subject to recovery within the following
three years provided the Fund is able to affect such
reimbursement and remain in compliance with applicable expense
limitations. Any of the Manager's voluntary absorptions are also
subject to recovery.
For the year ended December 31, 1997, the Manager has deferred
fees of $34,368 and absorbed expenses of $61,959.
As of December 31, 1997, deferred management fees and absorbed
expenses subject to recoupment are $113,258.
b. Certain officers and Trustees of the Trust are, with respect to
the Trust's Managers, affiliated persons as defined in the 1940
Act. Each Trustee who is not an affiliated person receives an
annual retainer and quarterly meeting fees totalling $35,000 per
annum, as well as reimbursement for expenses, for services as
Trustee of all three Trusts advised by the Manager ($5,000 of
which will be allocated to the Montgomery Funds III).
MAM Securities LLC ("MAM Securities") serves as the Fund's
transfer agent.
3. SECURITIES TRANSACTIONS:
a. The aggregate amount of purchases and sales of investment
securities, other than short-term securities, for the year ended
December 31, 1997, were $5,303,258 and $4,130,748, respectively.
b. At December 31, 1997, aggregate gross unrealized appreciation
for all securities in which there was an excess of value over
tax cost and aggregate gross unrealized depreciation for all
securities in which there was an excess of tax cost over value
for federal income tax purposes were $79,460 and $457,559,
respectively.
c. The schedule of forward foreign currency exchange contracts at
December 31, 1997 was as follows:
<TABLE>
<CAPTION>
NET UNREALIZED
APPRECIATION/
CONTRACT VALUE VALUE (DEPRECIATION)
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS TO BUY: DATE (NOTE 1) OF CONTRACTS
(Contract Cost $1,345)
<C> <S> <C> <C> <C>
10,430 Swedish Krona 01/02/98 $1,314 $ (31)
====== ======
<CAPTION>
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS TO SELL:
(Contract Cost $13,924)
<C> <S> <C> <C> <C>
24,727 German Mark 01/02/98 $13,745 $ 179
====== ======
</TABLE>
4. TRANSACTIONS IN SHARES OF BENEFICIAL INTEREST:
The Trust has authorized an unlimited number of shares of beneficial
interest which have a par value of $0.01. Transactions in shares of
beneficial interest for the periods indicated below were:
<TABLE>
<CAPTION>
YEAR ENDED PERIOD ENDED
DECEMBER 31, 1997 DECEMBER 31, 1996*
SHARES AMOUNT SHARES AMOUNT
<S> <C> <C> <C> <C>
Shares Sold 456,763 $ 5,184,384 3,261 $35,367
Issued as Reinvestment of Dividends 44,584 365,590 514 5,504
Shares Redeemed (356,080) (3,926,336) (95) (1,009)
-------- ----------- ----- -------
Net Increase 145,267 $1,623,638 3,680 $39,862
======== =========== ===== =======
</TABLE>
- ---------
* Montgomery Variable Series: International Small Cap Fund commenced operations
on September 30, 1996, with initial funding of $1,000,000 and 100,000 shares.
12
<PAGE>
The Montgomery Funds III
Notes to Financial Statements
(continued)
5. FOREIGN SECURITIES
The Fund purchases securities in foreign countries. Securities of
foreign companies and foreign governments involve special risks and
considerations not typically associated with investing in U.S. companies
and the U.S. government. These risks include revaluation of currencies,
less reliable information about issuers, differences in the clearance
and settlement of securities transactions practices, and future adverse
political and economic developments. Moreover, securities of many
foreign companies and foreign governments and their markets may be less
liquid and their prices more volatile than those securities of
comparable U.S. companies and the U.S. government.
6. SPECIAL SITUATION SECURITIES:
The Fund may not invest more than 15% of its net assets in illiquid
securities. The security shown in the table below has been determined by
the Manager to be illiquid because it is restricted or because there is
an exceptionally low trading volume in the primary trading market for
this security at December 31, 1997. This security is valued at market
price:
<TABLE>
<CAPTION>
ACQUISITION 12/31/97 VALUE % OF TOTAL
SECURITY DATE SHARES MARKET VALUE PER SHARE COST NET ASSETS
<S> <C> <C> <C> <C> <C> <C>
Prokom ADR 11/25/97 3,500 $39,288 $11.23 $37,135 1.90%
</TABLE>
7. CHANGE OF CONTROL OF MANAGER:
On March 25, 1997, Montgomery Securities, the Manager and CAM
Acquisition LLC (CAM), a newly organized subsidiary of Commerzbank
Aktiengesellschaft, entered into an agreement providing for the transfer of
substantially all the assets comprising the Manager's business to CAM. On June
23, 1997, the shareholders of the Fund approved a new Investment Management
Agreement with CAM (renamed Montgomery Asset Management, LLC) that became
effective upon the closing of the Manager's transaction with CAM. Such
transaction was closed July 31, 1997.
8. POST-OCTOBER LOSS
Under current tax law, net capital and currency losses realized after
October 31 may be deferred and treated as occurring on the first day of
the following fiscal year. In the fiscal year ended December 31, 1997,
the following Fund elected to defer losses occurring, between November
1, 1997 and December 31, 1997 under these rules as follows:
Montgomery Variable Series: International Small Cap....... $221,009
Such deferred losses will be treated as arising on the first day of the
fiscal year ending December 31, 1998.
13
<PAGE>
Report of Independent Accountants
To the Trustees and Shareholders of the Montgomery Variable Series:
International Small Cap Fund
In our opinion, the accompanying statement of assets and liabilities, including
the portfolio investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of Montgomery Variable Series:
International Small Cap (one of the portfolios constituting The Montgomery Funds
III, and hereafter referred to as the "Fund") at December 31, 1997, and the
results of its operations, the changes in its net assets and the financial
highlights for the year then ended, in conformity with generally accepted
accounting principles. These financial statements and financial highlights
(hereafter referred to as "financial statements") are the responsibility of the
Fund's management; our responsibility is to express an opinion on these
financial statements based on our audit. We conducted our audit of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audit, which included
confirmation of investments at December 31, 1997 by correspondence with the
custodian and brokers, and the application of alternative auditing procedures
where confirmations from brokers were not received, provides a reasonable basis
for the opinion expressed above.
The financial statements of Montgomery Variable Series: International Small Cap
Fund for the period from September 30, 1996 (commencement of operations) through
December 31, 1996 were audited by other independent accountants whose report
dated January 31, 1997 expressed an unqualified opinion on those statements.
PRICE WATERHOUSE LLP
SAN FRANCISCO, CA
FEBRUARY 11, 1998
14
<PAGE>
The Montgomery Funds III
NOTE: RESULTS OF VOTING AT SPECIAL SHAREHOLDERS' MEETING (UNAUDITED)
A special meeting of the Fund's shareholders was held on June 23, 1997.
The results of votes taken among shareholders on proposals before them
are listed below (may not total 100% because of rounding):
PROPOSAL 1
For the approval of the new Investment Management Agreement
between the Fund and CAM Acquisition, LLC ("New Montgomery")
pursuant to which New Montgomery will act as adviser with
respect to the assets of the Fund, to become effective upon the
closing of the transaction by which substantially all the assets
of Montgomery Asset Management, L.P. will be acquired by New
Montgomery, as subsidiary of Commerzbank AG.
VOTING RESULT # OF SHARES VOTED % OF SHARES VOTED
For 205,518.100 98.968%
Against 2,143.270 1.032
Abstained 0.000 0.000
TOTAL 207,661.370 100.000%
PROPOSAL 2
For the approval of authority for the Board of Trustees to
approve any future conversion of each Fund to a feeder fund in a
master/feeder fund structure.
VOTING RESULT # OF SHARES VOTED % OF SHARES VOTED
For 206,589.740 99.484%
Against 1,071.630 0.516
Abstained 0.000 0.000
TOTAL 207,661.370 100.000%
PROPOSAL 3
For the approval of certain changes to the fundamental
investment restrictions of certain Funds, as described in the
proxy statement.
VOTING RESULT # OF SHARES VOTED % OF SHARES VOTED
For 187,300.360 90.195%
Against 20,361.010 9.805
Abstained 0.000 0.000
TOTAL 207,661.370 100.000%
15
