INVESTMENT ADVISER:
R-SQUARED CAPITAL MANAGEMENT L.P.
This Statement of Additional Information ("SAI") is not a prospectus. This SAI
is intended to provide additional information regarding the activities and
operations of The Advisors' Inner Circle Fund II (the "Trust") and the RSQ
International Equity Fund (the "Fund"). This SAI is incorporated by reference
into and should be read in conjunction with the Fund's prospectus dated [ ],
2013. Capitalized terms not defined herein are defined in the prospectus.
Shareholders may obtain copies of the Fund's prospectus or Annual Report, when
available, free of charge by writing to the Trust at RSQ International Equity
Fund, P.O. Box 219009, Kansas City, MO 64121-9009 (Express Mail Address: RSQ
International Equity Fund, c/o DST Systems, Inc., 430 West 7th Street, Kansas
City, MO 64105) or calling the Fund at [ ].
i
TABLE OF CONTENTS
THE TRUST ................................................................ S-1
DESCRIPTION OF PERMITTED INVESTMENTS ..................................... S-1
INVESTMENT LIMITATIONS ................................................... S-31
THE ADVISER .............................................................. S-33
THE PORTFOLIO MANAGERS ................................................... S-34
THE ADMINISTRATOR ........................................................ S-34
THE DISTRIBUTOR .......................................................... S-35
PAYMENTS TO FINANCIAL INTERMEDIARIES ..................................... S-36
THE TRANSFER AGENT ....................................................... S-37
THE CUSTODIAN ............................................................ S-37
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ............................ S-37
LEGAL COUNSEL ............................................................ S-37
TRUSTEES AND OFFICERS OF THE TRUST ....................................... S-37
PURCHASING AND REDEEMING SHARES .......................................... S-47
DETERMINATION OF NET ASSET VALUE ......................................... S-47
TAXES .................................................................... S-48
FUND TRANSACTIONS ........................................................ S-54
PORTFOLIO HOLDINGS ....................................................... S-56
DESCRIPTION OF SHARES .................................................... S-57
SHAREHOLDER LIABILITY .................................................... S-57
LIMITATION OF TRUSTEES' LIABILITY ........................................ S-57
PROXY VOTING ............................................................. S-57
CODES OF ETHICS .......................................................... S-58
5% AND 25% SHAREHOLDERS .................................................. S58
APPENDIX A -- DESCRIPTION OF RATINGS ..................................... A-1
APPENDIX B -- PROXY VOTING POLICIES AND PROCEDURES ....................... B-1
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[ ], 2013 [INVENTORY CODE]
ii
THE TRUST
GENERAL. The Fund is a separate series of the Trust, an open-end investment
management company established under Massachusetts law as a Massachusetts
voluntary association (commonly known as a business trust) under a Declaration
of Trust dated July 24, 1992, as amended and restated February 18, 2004 and
August 10, 2004 and amended May 15, 2012. The Declaration of Trust permits the
Trust to offer separate series ("funds") of shares of beneficial interest
("shares"). The Trust reserves the right to create and issue shares of
additional funds. Each fund is a separate mutual fund, and each share of each
fund represents an equal proportionate interest in that fund. All consideration
received by the Trust for shares of any fund, and all assets of such fund,
belong solely to that fund and would be subject to any liabilities related
thereto. Each fund of the Trust pays its (i) operating expenses, including fees
of its service providers, expenses of preparing prospectuses, proxy
solicitation material and reports to shareholders, costs of custodial services
and registering its shares under federal and state securities laws, pricing and
insurance expenses, brokerage costs, interest charges, taxes and organization
expenses and (ii) pro rata share of the fund's other expenses, including audit
and legal expenses. Expenses attributable to a specific fund shall be payable
solely out of the assets of that fund. Expenses not attributable to a specific
fund are allocated across all of the funds on the basis of relative net assets.
The other funds of the Trust are described in one or more separate Statements
of Additional Information.
DESCRIPTION OF MULTIPLE CLASSES OF SHARES. The Trust is authorized to offer
shares of the Fund in Institutional Class Shares and Investor Class Shares. The
different classes provide for variations in certain distribution expenses and
minimum initial investment requirements. Minimum investment requirements and
investor eligibility are described in the prospectus. The Trust reserves the
right to create and issue additional classes of shares. For more information on
distribution expenses, see "The Distributor" section in this SAI.
VOTING RIGHTS. Each shareholder of record is entitled to one vote for each
share held on the record date for the meeting. The Fund will vote separately on
matters relating solely to it. As a Massachusetts voluntary association, the
Trust is not required, and does not intend, to hold annual meetings of
shareholders. Approval of shareholders will be sought, however, for certain
changes in the operation of the Trust and for the election of Trustees under
certain circumstances. Under the Declaration of Trust, the Trustees have the
power to liquidate the Fund without shareholder approval. While the Trustees
have no present intention of exercising this power, they may do so if the Fund
fails to reach a viable size within a reasonable amount of time or for such
other reasons as may be determined by the Board of Trustees (each, a "Trustee"
and collectively, the "Board").
In addition, a Trustee may be removed by the remaining Trustees or by
shareholders at a special meeting called upon written request of shareholders
owning at least 10% of the outstanding shares of the Trust. In the event that
such a meeting is requested, the Trust will provide appropriate assistance and
information to the shareholders requesting the meeting.
Any series of the Trust created on or after February 18, 2004 may reorganize or
merge with one or more other series of the Trust or of another investment
company. Any such reorganization or merger shall be pursuant to the terms and
conditions specified in an agreement and plan of reorganization authorized and
approved by the Trustees and entered into by the relevant series in connection
therewith. In addition, such reorganization or merger may be authorized by vote
of a majority of the Trustees then in office and, to the extent permitted by
applicable law and the Declaration of Trust, without the approval of
shareholders of any series.
DESCRIPTION OF PERMITTED INVESTMENTS
The Fund's investment objective and principal investment strategies are
described in the prospectus. The Fund is classified as a "diversified"
investment company under the Investment Company Act of 1940, as amended (the
"1940 Act"). The following information supplements, and should be read in
conjunction with, the prospectus. The following
S-1
are descriptions of the permitted investments and investment practices of the
Fund and the associated risk factors. The Fund may invest in any of the
following instruments or engage in any of the following investment practices
unless such investment or activity is inconsistent with or is not permitted by
the Fund's stated investment policies, including those stated below.
EQUITY SECURITIES. Equity securities represent ownership interests in a company
or partnership and consist of common stocks, preferred stocks, warrants to
acquire common stock, securities convertible into common stock, and investments
in master limited partnerships. Investments in equity securities in general are
subject to market risks that may cause their prices to fluctuate over time.
Fluctuations in the value of equity securities in which the Fund invests will
cause the net asset value of the Fund to fluctuate. The Fund purchases equity
securities traded in the United States on registered exchanges or the
over-the-counter market. Equity securities are described in more detail below:
o COMMON STOCK. Common stock represents an equity or ownership interest in
an issuer. In the event an issuer is liquidated or declares bankruptcy, the
claims of owners of bonds and preferred stock take precedence over the
claims of those who own common stock.
o PREFERRED STOCK. Preferred stock represents an equity or ownership
interest in an issuer that pays dividends at a specified rate and that has
precedence over common stock in the payment of dividends. In the event an
issuer is liquidated or declares bankruptcy, the claims of owners of bonds
take precedence over the claims of those who own preferred and common
stock.
o EXCHANGE-TRADED FUNDS. An ETF is a fund whose shares are bought and sold
on a securities exchange as if it were a single security. An ETF holds a
portfolio of securities designed to track a particular market segment or
index. Some examples of ETFs are SPDRs([R]), DIAMONDS(SM), NASDAQ 100 Index
Tracking Stock(SM) ("QQQs(SM)"), and iShares([R]). The Fund could purchase
an ETF to temporarily gain exposure to a portion of the U. S. or foreign
market while awaiting an opportunity to purchase securities directly. The
risks of owning an ETF generally reflect the risks of owning the underlying
securities they are designed to track, although lack of liquidity in an ETF
could result in it being more volatile than the underlying portfolio of
securities and ETFs have management fees that increase their costs versus
the costs of owning the underlying securities directly. See "Securities of
Other Investment Companies" below.
o EXCHANGE-TRADED NOTES. An ETN is a type of unsecured, unsubordinated debt
security that differs from other types of bonds and notes because ETN
returns are based upon the performance of a market index minus applicable
fees. No period coupon payments are distributed, and no principal
protection exists. ETNs were designed to create a type of security that
combines both the aspects of bonds and ETFs. Similar to ETFs, ETNs are
traded on a major exchange, such as the NYSE during normal trading hours.
However, investors can also hold the debt security until maturity. At that
time the issuer will give the investor a cash amount that would be equal to
principal amount.
One factor that affects the ETN's value is the credit rating of the issuer.
The value of the ETN may drop despite no change in the underlying index.
This might occur, for instance, due to a downgrade in the issuer's credit
rating.
o WARRANTS. Warrants are instruments that entitle the holder to buy an
equity security at a specific price for a specific period of time. Changes
in the value of a warrant do not necessarily correspond to changes in the
value of its underlying security. The price of a warrant may be more
volatile than the price of its underlying security, and a warrant may offer
greater potential for capital appreciation as well as capital loss.
Warrants do not entitle a holder to dividends or voting rights with respect
to the underlying security and do not represent any rights in the assets of
the issuing company. A warrant ceases to have value if it is not exercised
prior to its expiration date. These factors can make warrants more
speculative than other types of investments.
o CONVERTIBLE SECURITIES. Convertible securities are bonds, debentures,
notes, preferred stocks or other securities
S-2
that may be converted or exchanged (by the holder or by the issuer) into
shares of the underlying common stock (or cash or securities of equivalent
value) at a stated exchange ratio. A convertible security may also be
called for redemption or conversion by the issuer after a particular date
and under certain circumstances (including a specified price) established
upon issue. If a convertible security held by the Fund is called for
redemption or conversion, the Fund could be required to tender it for
redemption, convert it into the underlying common stock, or sell it to a
third party.
Convertible securities generally have less potential for gain or loss than
common stocks. Convertible securities generally provide yields higher than
the underlying common stocks, but generally lower than comparable non-
convertible securities. Because of this higher yield, convertible
securities generally sell at a price above their "conversion value," which
is the current market value of the stock to be received upon conversion.
The difference between this conversion value and the price of convertible
securities will vary over time depending on changes in the value of the
underlying common stocks and interest rates. When the underlying common
stocks decline in value, convertible securities will tend not to decline to
the same extent because of the interest or dividend payments and the
repayment of principal at maturity for certain types of convertible
securities. However, securities that are convertible other than at the
option of the holder generally do not limit the potential for loss to the
same extent as securities convertible at the option of the holder. When the
underlying common stocks rise in value, the value of convertible securities
may also be expected to increase. At the same time, however, the difference
between the market value of convertible securities and their conversion
value will narrow, which means that the value of convertible securities
will generally not increase to the same extent as the value of the
underlying common stocks. Because convertible securities may also be
interest-rate sensitive, their value may increase as interest rates fall
and decrease as interest rates rise. Convertible securities are also
subject to credit risk, and are often lower-quality securities.
The Fund may also invest in zero coupon convertible securities. Zero coupon
convertible securities are debt securities which are issued at a discount
to their face amount and do not entitle the holder to any periodic payments
of interest prior to maturity. Rather, interest earned on zero coupon
convertible securities accretes at a stated yield until the security
reaches its face amount at maturity. Zero coupon convertible securities are
convertible into a specific number of shares of the issuer's common stock.
In addition, zero coupon convertible securities usually have put features
that provide the holder with the opportunity to sell the securities back to
the issuer at a stated price before maturity. Generally, the prices of zero
coupon convertible securities may be more sensitive to market interest rate
fluctuations then conventional convertible securities.
o MICRO, SMALL AND MEDIUM CAPITALIZATION ISSUERS. Investing in equity
securities of micro, small and medium capitalization companies often
involves greater risk than is customarily associated with investments in
larger capitalization companies. This increased risk may be due to the
greater business risks of smaller size, limited markets and financial
resources, narrow product lines and frequent lack of depth of management.
The securities of micro and smaller companies are often traded in the
over-the-counter market and even if listed on a national securities
exchange may not be traded in volumes typical for that exchange.
Consequently, the securities of micro and smaller companies are less likely
to be liquid, may have limited market stability, and may be subject to more
abrupt or erratic market movements than securities of larger, more
established growth companies or the market averages in general.
MASTER LIMITED PARTNERSHIPS. MLPs are limited partnerships or limited liability
companies, whose partnership units or limited liability interests are listed
and traded on a U.S. securities exchange, and are treated as publicly traded
partnerships for federal income tax purposes. To qualify to be treated as a
partnership for tax purposes, an MLP must receive at least 90% of its income
from qualifying sources as set forth in Section 7704(d) of the Internal Revenue
Code of 1986, as amended (the "Code"). These qualifying sources include
activities such as the exploration, development, mining, production,
processing, refining, transportation, storage and marketing of mineral or
natural resources. MLPs generally have two classes of owners, the general
partner and limited partners. MLPs that are formed as limited liability
S-3
companies generally have two analogous classes of owners, the managing member
and the members. For purposes of this section, references to general partners
also apply to managing members and references to limited partners also apply to
members. The general partner is typically owned by a major energy company, an
investment fund, the direct management of the MLP or is an entity owned by one
or more of such parties. The general partner may be structured as a private or
publicly traded corporation or other entity. The general partner typically
controls the operations and management of the MLP through an equity interest of
as much as 2% in the MLP plus, in many cases, ownership of common units and
subordinated units. Limited partners own the remainder of the MLP through
ownership of common units and have a limited role in the MLP's operations and
management.
MLPs are typically structured such that common units and general partner
interests have first priority to receive quarterly cash distributions up to an
established minimum amount ("minimum quarterly distributions" or "MQD"). Common
and general partner interests also accrue arrearages in distributions to the
extent the MQD is not paid. Once common and general partner interests have been
paid, subordinated units receive distributions of up to the MQD; however,
subordinated units do not accrue arrearages. Distributable cash in excess of
the MQD paid to both common and subordinated units is distributed to both
common and subordinated units generally on a pro rata basis. The general
partner is also eligible to receive incentive distributions if the general
partner operates the business in a manner which results in distributions paid
per common unit surpassing specified target levels. As the general partner
increases cash distributions to the limited partners, the general partner
receives an increasingly higher percentage of the incremental cash
distributions. A common arrangement provides that the general partner can reach
a tier where it receives 50% of every incremental dollar paid to common and
subordinated unit holders. These incentive distributions encourage the general
partner to streamline costs, increase capital expenditures and acquire assets
in order to increase the partnership's cash flow and raise the quarterly cash
distribution in order to reach higher tiers. Such results benefit all security
holders of the MLP.
General partner interests of MLPs are typically retained by an MLP's original
sponsors, such as its founders, corporate partners, entities that sell assets
to the MLP and investors such as us. A holder of general partner interests can
be liable under certain circumstances for amounts greater than the amount of
the holder's investment in the general partner interest. General partner
interests often confer direct board participation rights and in many cases,
operating control, over the MLP. These interests themselves are not publicly
traded, although they may be owned by publicly traded entities. General partner
interests receive cash distributions, typically 2% of the MLP's aggregate cash
distributions, which are contractually defined in the partnership agreement. In
addition, holders of general partner interests typically hold incentive
distribution rights ("IDRs"), which provide them with a larger share of the
aggregate MLP cash distributions as the distributions to limited partner unit
holders are increased to prescribed levels. General partner interests generally
cannot be converted into common units. The general partner interest can be
redeemed by the MLP if the MLP unitholders choose to remove the general
partner, typically with a supermajority vote by limited partner unitholders.
DEBT SECURITIES. Corporations and governments use debt securities to borrow
money from investors. Most debt securities promise a variable or fixed rate of
return and repayment of the amount borrowed at maturity. Some debt securities,
such as zero-coupon bonds, do not pay current interest and are purchased at a
discount from their face value.
TYPES OF DEBT SECURITIES:
o CORPORATE BONDS - Corporations issue bonds and notes to raise money for
working capital or for capital expenditures such as plant construction,
equipment purchases and expansion. In return for the money loaned to the
corporation by investors, the corporation promises to pay investors
interest, and repay the principal amount of the bond or note.
o MORTGAGE-BACKED SECURITIES - Mortgage-backed securities are interests in
pools of mortgage loans that various governmental, government-related and
private organizations assemble as securities for sale to investors. Unlike
S-4
most debt securities, which pay interest periodically and repay principal
at maturity or on specified call dates, mortgage-backed securities make
monthly payments that consist of both interest and principal payments. In
effect, these payments are a "pass-through" of the monthly payments made by
the individual borrowers on their mortgage loans, net of any fees paid to
the issuer or guarantor of such securities. Since homeowners usually have
the option of paying either part or all of the loan balance before
maturity, the effective maturity of a mortgage-backed security is often
shorter than is stated.
Governmental entities, private insurers and the mortgage poolers may insure
or guarantee the timely payment of interest and principal of these pools
through various forms of insurance or guarantees, including individual
loan, title, pool and hazard insurance and letters of credit. The Fund's
adviser (the "Adviser") will consider such insurance and guarantees and the
creditworthiness of the issuers thereof in determining whether a
mortgage-related security meets its investment quality standards. It is
possible that the private insurers or guarantors will not meet their
obligations under the insurance policies or guarantee arrangements.
Although the market for such securities is becoming increasingly liquid,
securities issued by certain private organizations may not be readily
marketable.
COMMERCIAL BANKS, SAVINGS AND LOAN INSTITUTIONS, PRIVATE MORTGAGE INSURANCE
COMPANIES, MORTGAGE BANKERS AND OTHER SECONDARY MARKET ISSUERS - Commercial
banks, savings and loan institutions, private mortgage insurance companies,
mortgage bankers and other secondary market issuers also create pass-through
pools of conventional mortgage loans. In addition to guaranteeing the
mortgage-related security, such issuers may service and/or have originated the
underlying mortgage loans. Pools created by these issuers generally offer a
higher rate of interest than pools created by GNMA, FNMA & Freddie Mac because
they are not guaranteed by a government agency.
RISKS OF MORTGAGE-BACKED SECURITIES - Yield characteristics of mortgage-backed
securities differ from those of traditional debt securities in a variety of
ways. The most significant differences of mortgage-backed securities are: 1)
payments of interest and principal are more frequent (usually monthly) and 2)
falling interest rates generally cause individual borrowers to pay off their
mortgage earlier than expected, which results in prepayments of principal on
the securities, thus forcing the Fund to reinvest the money at a lower interest
rate. In addition to risks associated with changes in interest rates described
in "Factors Affecting the Value of Debt Securities," a variety of economic,
geographic, social and other factors, such as the sale of the underlying
property, refinancing or foreclosure, can cause investors to repay the loans
underlying a mortgage-backed security sooner than expected. When prepayment
occurs, the Fund may have to reinvest its principal at a rate of interest that
is lower than the rate on existing mortgage-backed securities.
OTHER ASSET-BACKED SECURITIES - These securities are interests in pools of a
broad range of assets other than mortgages, such as automobile loans, computer
leases and credit card receivables. Like mortgage-backed securities, these
securities are pass-through. In general, the collateral supporting these
securities is of shorter maturity than mortgage loans and is less likely to
experience substantial prepayments with interest rate fluctuations, but may
still be subject to pre-payment risk.
Asset-backed securities present certain risks that are not presented by
mortgage-backed securities. Primarily, these securities may not have the
benefit of any security interest in the related assets, which raises the
possibility that recoveries on repossessed collateral may not be available to
support payments on these securities. For example, 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 allow debtors to
reduce their balances by offsetting certain amounts owed on the credit cards.
Most issuers of asset-backed securities backed by automobile receivables permit
the servicers of such receivables 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 asset-backed securities. Due to the quantity of
vehicles involved and requirements under state laws, asset-backed securities
S-5
backed by automobile receivables may not have a proper security interest in all
of the obligations backing such receivables.
To lessen the effect of failures by obligors on underlying assets to make
payments, the entity administering the pool of assets may agree to ensure the
receipt of payments on the underlying pool occurs in a timely fashion
("liquidity protection"). In addition, asset-backed securities may obtain
insurance, such as guarantees, policies or letters of credit obtained by the
issuer or sponsor from third parties, for some or all of the assets in the pool
("credit support"). Delinquency or loss more than that anticipated or failure
of the credit support could adversely affect the return on an investment in
such a security.
The Fund may also invest in residual interests in asset-backed securities,
which consist of the excess cash flow remaining after making required payments
on the securities and paying related administrative expenses. The amount of
residual cash flow resulting from a particular issue of asset-backed securities
depends in part on the characteristics of the underlying assets, the coupon
rates on the securities, prevailing interest rates, the amount of
administrative expenses and the actual prepayment experience on the underlying
assets.
INFLATION PROTECTED SECURITIES -- The Fund may invest in inflation protected
securities, which are fixed income securities whose value is periodically
adjusted according to the rate of inflation. These securities may be issued by
U.S. and foreign governments and corporations. Two structures are common. The
U.S. Treasury and some other issuers utilize a structure that accrues inflation
into the principal value of the bond. Most other issuers pay out the Consumer
Price Index ("CPI") accruals as part of a semiannual coupon. Inflation
protected securities issued by the U.S. Treasury have maturities of
approximately five, ten or thirty years, although it is possible that
securities with other maturities will be issued in the future. The U.S.
Treasury securities pay interest on a semi-annual basis equal to a fixed
percentage of the inflation adjusted principal amount. If the periodic
adjustment rate measuring inflation falls, the principal value of inflation
protected bonds will be adjusted downward, and consequently the interest
payable on these securities (calculated with respect to a smaller principal
amount) will be reduced. Repayment of the original bond principal upon maturity
(as adjusted for inflation) is guaranteed by the U.S. Treasury in the case of
U.S. Treasury inflation indexed bonds, even during a period of deflation.
However, the current market value of the bonds is not guaranteed and will
fluctuate. The Fund may also invest in other U.S. and foreign inflation related
bonds that may or may not provide a similar guarantee. If a guarantee of
principal is not provided, the adjusted principal value of the bond to be
repaid at maturity may be less than the original principal amount and,
therefore, is subject to credit risk. The value of inflation protected bonds is
expected to change in response to changes in real interest rates. Real interest
rates in turn are tied to the relationship between nominal interest rates and
the rate of inflation. Therefore, if the rate of inflation rises at a faster
rate than nominal interest rates, real interest rates might decline, leading to
an increase in value of inflation protected bonds. In contrast, if nominal
interest rates increase at a faster rate than inflation, real interest rates
might rise, leading to a decrease in value of inflation protected bonds. While
these securities are expected to be protected from long-term inflationary
trends, short-term increases in inflation may lead to a decline in value. If
interest rates rise due to reasons other than inflation (for example, due to
changes in currency exchange rates), investors in these securities may not be
protected to the extent that the increase is not reflected in the bond's
inflation measure. The periodic adjustment of U.S. inflation protected bonds is
tied to the non-seasonally adjusted U.S. City Average All Items Consumer Price
Index for All Urban Consumers ("CPI-U"), published monthly by the U.S. Bureau
of Labor Statistics. The CPI-U is a measurement of changes in the cost of
living, made up of components such as housing, food, transportation and energy.
Inflation indexed bonds issued by a foreign government are generally adjusted
to reflect a comparable inflation index calculated by that government. There
can be no assurance that the CPI-U or any foreign inflation index will
accurately measure the real rate of inflation in the prices of goods and
services. Moreover, there can be no assurance that the rate of inflation in a
foreign country will be correlated to the rate of inflation in the United
States. Any increase in principal for an inflation protected security resulting
from inflation adjustments is considered by the IRS to be taxable income in the
year it occurs. The Fund's distributions to shareholders include interest
income and the income attributable to principal adjustments, both of which will
be taxable to shareholders. The tax treatment of the
S-6
income attributable to principal adjustments may result in the situation where
the Fund needs to make its required annual distributions to shareholders in
amounts that exceed the cash received. As a result, the Fund may need to
liquidate certain investments when it is not advantageous to do so. Also, if
the principal value of an inflation protected security is adjusted downward due
to deflation, amounts previously distributed in the taxable year may be
characterized in some circumstances as a return of capital.
SHORT-TERM INVESTMENTS - To earn a return on uninvested assets, meet
anticipated redemptions, or for temporary defensive purposes, the Fund may
invest a portion of its assets in the short-term securities listed below, U.S.
Government securities and investment-grade corporate debt securities. Unless
otherwise specified, a short-term debt security has a maturity of one year or
less.
BANK OBLIGATIONS - The Fund will only invest in a security issued by a
commercial bank if the bank:
o Has total assets of at least $1 billion, or the equivalent in other
currencies (based on the most recent publicly available information about
the bank);
o Is a U.S. bank and a member of the Federal Deposit Insurance Corporation;
and
o Is a foreign branch of a U.S. bank and the Adviser believes the security
is of an investment quality comparable with other debt securities that the
Fund may purchase.
TIME DEPOSITS - Time deposits are non-negotiable deposits, such as savings
accounts or certificates of deposit, held by a financial institution for a
fixed term with the understanding that the depositor can withdraw its money
only by giving notice to the institution. However, there may be early
withdrawal penalties depending upon market conditions and the remaining
maturity of the obligation.
CERTIFICATES OF DEPOSIT - Certificates of deposit are negotiable certificates
issued against funds deposited in a commercial bank or savings and loan
association for a definite period of time and earning a specified return.
BANKERS' ACCEPTANCE - A bankers' acceptance is a time draft drawn on a
commercial bank by a borrower, usually in connection with an international
commercial transaction (to finance the import, export, transfer or storage of
goods).
COMMERCIAL PAPER - Commercial paper is a short-term obligation with a maturity
ranging from 1 to 270 days issued by banks, corporations and other borrowers.
Such investments are unsecured and usually discounted. The Fund may invest in
commercial paper rated A-1 or A-2 by Standard and Poor's Ratings Services
("S&P") or Prime-1 or Prime-2 by Moody's Investors Service, Inc. ("Moody's"),
or, if not rated, issued by a corporation having an outstanding unsecured debt
issue rated A or better by Moody's or by S&P. See "Appendix A - Ratings" for a
description of commercial paper ratings.
STRIPPED MORTGAGE-BACKED SECURITIES - Stripped mortgage-backed securities are
derivative multiple-class mortgage-backed securities. Stripped mortgage-backed
securities usually have two classes that receive different proportions of
interest and principal distributions on a pool of mortgage assets. Typically,
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 remaining principal.
In extreme cases, one class will receive all of the interest ("interest only"
or "IO" class) while the other class will receive the entire principal
("principal only" or "PO" class). The cash flow and yields on IOs and POs are
extremely sensitive to the rate of principal payments (including prepayments)
on the underlying mortgage loans or mortgage-backed securities. A rapid rate of
principal payments may adversely affect the yield to maturity of IOs and could
cause the total loss of investment. Slower than anticipated prepayments of
principal may adversely affect the yield to maturity of a PO. The yields and
market risk of interest only and principal only stripped mortgage-backed
securities, respectively, may be more volatile than those of other fixed income
securities, including traditional mortgage-backed securities.
S-7
U.S. SMALL BUSINESS ADMINISTRATION ("SBA") STRIPPED SECURITIES - The Fund may
purchase Treasury receipts and other "stripped" securities that evidence
ownership in either the future interest payments or the future principal
payments on U.S. Government and other obligations. These participations, issued
by the U.S. Small Business Administration, are issued at a discount to their
"face value." Stripped securities may exhibit greater price volatility than
ordinary debt securities because of the manner in which their principal and
interest are returned to investors, and they are often illiquid. The Fund
accrues income on these securities prior to the receipt of cash payments. The
Fund intends to distribute substantially all of its income to its shareholders
to qualify for pass-through treatment under the tax laws and may, therefore,
need to use its cash reserves to satisfy distribution requirements.
YANKEE BONDS - Yankee bonds are dollar-denominated bonds issued inside the U.S.
by foreign entities. Investment in these securities involves certain risks
which are not typically associated with investing in domestic securities. See
"Foreign Securities."
ZERO COUPON BONDS - These securities make no periodic payments of interest, but
instead are sold at a discount from their face value. When held to maturity,
their entire income, which consists of accretion of discount, comes from the
difference between the issue price and their value at maturity. The amount of
the discount rate varies depending on factors including the time remaining
until maturity, prevailing interest rates, the security's liquidity and the
issuer's credit quality. The market value of zero coupon securities may exhibit
greater price volatility than ordinary debt securities because a stripped
security will have a longer duration than an ordinary debt security with the
same maturity. The Fund's investments in pay-in-kind, delayed and zero coupon
bonds may require it to sell certain of its portfolio securities to generate
sufficient cash to satisfy certain income distribution requirements.
These securities may include treasury securities that have had their interest
payments ("coupons") separated from the underlying principal ("corpus") by
their holder, typically a custodian bank or investment brokerage firm. Once the
holder of the security has stripped or separated corpus and coupons, it may
sell each component separately. The principal or corpus is then 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. Typically, the coupons are sold separately or grouped with
other coupons with like maturity dates and sold bundled in such form. The
underlying treasury security is held in book-entry form at the Federal Reserve
Bank or, in the case of bearer securities (i.e., unregistered securities which
are owned ostensibly by the bearer or holder thereof), in trust on behalf of
the owners thereof. Purchasers of stripped obligations acquire, in effect,
discount obligations that are economically identical to the zero coupon
securities that the U.S. Treasury sells itself.
The U.S. Treasury has facilitated transfers of ownership of zero coupon
securities by accounting separately for the beneficial ownership of particular
interest coupon and corpus payments on Treasury securities through the Federal
Reserve book-entry record keeping system. Under a Federal Reserve program known
as "STRIPS" or "Separate Trading of Registered Interest and Principal of
Securities," the Fund may record its beneficial ownership of the coupon or
corpus.
TERMS TO UNDERSTAND:
MATURITY - Every debt security has a stated maturity date when the issuer must
repay the amount it borrowed (principal) from investors. Some debt securities,
however, are callable, meaning the issuer can repay the principal earlier, on
or after specified dates (call dates). Debt securities are most likely to be
called when interest rates are falling because the issuer can refinance at a
lower rate, similar to a homeowner refinancing a mortgage. The effective
maturity of a debt security is usually its nearest call date.
Mutual funds that invest in debt securities have no real maturity. Instead,
they calculate their weighted average maturity. This number is an average of
the effective or anticipated maturity of each debt security held by the mutual
fund, with the maturity of each security weighted by the percentage of the
assets of the mutual fund it represents.
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DURATION - Duration is a calculation that seeks to measure the price
sensitivity of a debt security, or of a mutual fund that invests in debt
securities, to changes in interest rates. It measures sensitivity more
accurately than maturity because it takes into account the time value of cash
flows generated over the life of a debt security. Future interest payments and
principal payments are discounted to reflect their present value and then are
multiplied by the number of years they will be received to produce a value
expressed in years -- the duration. Effective duration takes into account call
features and sinking fund prepayments that may shorten the life of a debt
security.
An effective duration of four years, for example, would suggest that for each
1% reduction in interest rates at all maturity levels, the price of a security
is estimated to increase by 4%. An increase in rates by the same magnitude is
estimated to reduce the price of the security by 4%. By knowing the yield and
the effective duration of a debt security, one can estimate total return based
on an expectation of how much interest rates, in general, will change. While
serving as a good estimator of prospective returns, effective duration is an
imperfect measure.
FACTORS AFFECTING THE VALUE OF DEBT SECURITIES - The total return of a debt
instrument is composed of two elements: the percentage change in the security's
price and interest income earned. The yield to maturity of a debt security
estimates its total return only if the price of the debt security remains
unchanged during the holding period and coupon interest is reinvested at the
same yield to maturity. The total return of a debt instrument, therefore, will
be determined not only by how much interest is earned, but also by how much the
price of the security and interest rates change.
INTEREST RATES
The price of a debt security generally moves in the opposite direction from
interest rates (i.e., if interest rates go up, the value of the bond will go
down, and vice versa).
o PREPAYMENT RISK
This risk affects mainly mortgage-backed securities. Unlike other debt
securities, falling interest rates can adversely affect the value of
mortgage-backed securities, which may cause your share price to fall. Lower
rates motivate borrowers to pay off the instruments underlying mortgage-backed
and asset-backed securities earlier than expected, resulting in prepayments on
the securities. The Fund may then have to reinvest the proceeds from such
prepayments at lower interest rates, which can reduce its yield. The unexpected
timing of mortgage and asset-backed prepayments caused by the variations in
interest rates may also shorten or lengthen the average maturity of the Fund.
If left unattended, drifts in the average maturity of the Fund can have the
unintended effect of increasing or reducing the effective duration of the Fund,
which may adversely affect the expected performance of the Fund.
o EXTENSION RISK
The other side of prepayment risk occurs when interest rates are rising. Rising
interest rates can cause the Fund's average maturity to lengthen unexpectedly
due to a drop in mortgage prepayments. This would increase the sensitivity of
the Fund to rising rates and its potential for price declines. Extending the
average life of a mortgage-backed security increases the risk of depreciation
due to future increases in market interest rates. For these reasons,
mortgage-backed securities may be less effective than other types of U.S.
Government securities as a means of "locking in" interest rates.
o CREDIT RATING
Coupon interest is offered to investors of debt securities as compensation for
assuming risk, although short-term Treasury securities, such as three-month
treasury bills, are considered "risk-free." Corporate securities offer higher
yields than Treasury securities because their payment of interest and complete
repayment of principal is less certain. The credit rating or financial
condition of an issuer may affect the value of a debt security. Generally, the
lower the quality rating of a security, the greater the risks that the issuer
will fail to pay interest and return principal. To
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compensate investors for taking on increased risk, issuers with lower credit
ratings usually offer their investors a higher "risk premium" in the form of
higher interest rates than those available from comparable Treasury
securities.
Changes in investor confidence regarding the certainty of interest and
principal payments of a corporate debt security will result in an adjustment to
this "risk premium." Since an issuer's outstanding debt carries a fixed coupon,
adjustments to the risk premium must occur in the price, which affects the
yield to maturity of the bond. If an issuer defaults or becomes unable to honor
its financial obligations, the bond may lose some or all of its value.
A security rated within the four highest rating categories by a rating agency
is called investment-grade because its issuer is more likely to pay interest
and repay principal than an issuer of a lower rated bond. Adverse economic
conditions or changing circumstances, however, may weaken the capacity of the
issuer to pay interest and repay principal. If a security is not rated or is
rated under a different system, the Adviser may determine that it is of
investment-grade. The Adviser may retain securities that are downgraded, if it
believes that keeping those securities is warranted. Securities rated BBB,
while investment-grade, still possess speculative characteristics.
Debt securities rated below investment-grade ("junk bonds") are highly
speculative securities that are usually issued by smaller, less credit worthy
and/or highly leveraged (indebted) companies. A corporation may issue a junk
bond because of a corporate restructuring or other similar event. Compared with
investment-grade bonds, junk bonds carry a greater degree of risk and are less
likely to make payments of interest and principal. Market developments and the
financial and business condition of the corporation issuing these securities
influence their price and liquidity more than changes in interest rates, when
compared to investment-grade debt securities. Insufficient liquidity in the
junk bond market may make it more difficult to dispose of junk bonds and may
cause the Fund to experience sudden and substantial price declines. A lack of
reliable, objective data or market quotations may make it more difficult to
value junk bonds accurately.
Rating agencies are organizations that assign ratings to securities based
primarily on the rating agency's assessment of the issuer's financial strength.
The Fund currently uses ratings compiled by Moody's, S&P, and Fitch. Credit
ratings are only an agency's opinion, not an absolute standard of quality, and
they do not reflect an evaluation of market risk. The section "Appendix A --
Description of Ratings" contains further information concerning the ratings of
certain rating agencies and their significance.
The Adviser may use ratings produced by rating agencies as guidelines to
determine the rating of a security at the time the Fund buys it. A rating
agency may change its credit ratings at any time. The Adviser monitors the
rating of the security and will take appropriate actions if a rating agency
reduces the security's rating. The Fund is not obligated to dispose of
securities whose issuers subsequently are in default or which are downgraded.
The Fund may invest in securities of any rating.
FOREIGN SECURITIES. Foreign securities are debt and equity securities that are
traded in markets outside of the U.S. The markets in which these securities are
located can be developed or emerging. The Fund can invest in foreign securities
in a number of ways:
o The Fund can invest directly in foreign securities denominated in a
foreign currency.
o The Fund can invest in American Depositary Receipts, Global
Depositary Receipts, European Depositary Receipts and other similar
global instruments.
o The Fund can invest in investment funds.
AMERICAN DEPOSITARY RECEIPTS ("ADRS") -- ADRs as well as other "hybrid" forms
of ADRs, including European Depositary Receipts ("EDRs") and Global Depositary
Receipts ("GDRs"), are certificates evidencing ownership of shares of a foreign
issuer. These certificates are issued by depository banks and generally trade
on an established market
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in the United States or elsewhere. A custodian bank or similar financial
institution in the issuer's home country holds the underlying shares in trust.
The depository bank may not have physical custody of the underlying securities
at all times and may charge fees for various services, including forwarding
dividends and interest and corporate actions. ADRs are alternatives to directly
purchasing the underlying foreign securities in their national markets and
currencies. ADRs are subject to many of the risks associated with investing
directly in foreign securities. European Depositary Receipts are similar to
ADRs, except that they are typically issued by European banks or trust
companies.
Investments in the securities of foreign issuers may subject the Fund to
investment risks that differ in some respects from those related to investments
in securities of U.S. issuers. Such risks include future adverse political and
economic developments, possible imposition of withholding taxes on income,
possible seizure, nationalization or expropriation of foreign deposits,
possible establishment of exchange controls or taxation at the source or
greater fluctuation in value due to changes in exchange rates. Foreign issuers
of securities often engage in business practices different from those of
domestic issuers of similar securities, and there may be less information
publicly available about foreign issuers. In addition, foreign issuers are,
generally speaking, subject to less government supervision and regulation and
different accounting treatment than are those in the United States.
ADRs can be sponsored or unsponsored. While these types are similar, there are
differences regarding a holder's rights and obligations and the practices of
market participants. A depository may establish an unsponsored facility without
participation by (or acquiescence of) the underlying issuer; typically,
however, the depository requests a letter of non-objection from the underlying
issuer prior to establishing the facility. Holders of unsponsored depositary
receipts generally bear all the costs of the facility. The depository usually
charges fees upon the deposit and withdrawal of the underlying securities, the
conversion of dividends into U.S. dollars or other currency, the disposition of
non-cash distributions, and the performance of other services. Sponsored
depositary receipt facilities are created in generally the same manner as
unsponsored facilities, except that sponsored depositary receipts are
established jointly by a depository and the underlying issuer through a deposit
agreement. The deposit agreement sets out the rights and responsibilities of
the underlying issuer, the depository, and the depositary receipt holders. With
sponsored facilities, the underlying issuer typically bears some of the costs
of the depositary receipts (such as dividend payment fees of the depository),
although most sponsored depositary receipts holders may bear costs such as
deposit and withdrawal fees. Depositories of most sponsored depositary receipts
agree to distribute notices of shareholder meetings, voting instructions, and
other shareholder communications and information to the depositary receipt
holders at the underlying issuer's request. The depositary of an unsponsored
facility frequently is under no obligation to distribute shareholder
communications received from the issuer of the deposited security or to pass
through, to the holders of the receipts, voting rights with respect to the
deposited securities.
EMERGING MARKETS - An "emerging country" is generally a country that the
International Bank for Reconstruction and Development (World Bank) and the
International Finance Corporation would consider to be an emerging or
developing country. Typically, emerging markets are in countries that are in
the process of industrialization, with lower gross national products (GNP) than
more developed countries. There are currently over 130 countries that the
international financial community generally considers to be emerging or
developing countries, approximately 40 of which currently have stock markets.
These countries generally include every nation in the world except the United
States, Canada, Japan, Australia, New Zealand and most nations located in
Western Europe.
INVESTMENT FUNDS - Some emerging countries currently prohibit direct foreign
investment in the securities of their companies. Certain emerging countries,
however, permit indirect foreign investment in the securities of companies
listed and traded on their stock exchanges through investment funds that they
have specifically authorized. Investments in these investment funds may be
subject to the provisions of the 1940 Act. If the Fund invests in such
investment funds, shareholders will bear not only their proportionate share of
the expenses of the Fund (including operating expenses and the fees of the
Adviser), but also will indirectly bear similar expenses of the underlying
investment funds. In addition, these investment funds may trade at a premium
over their net asset value.
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RISKS OF FOREIGN SECURITIES:
Foreign securities, foreign currencies, and securities issued by U.S. entities
with substantial foreign operations may involve significant risks in addition
to the risks inherent in U.S. investments.
POLITICAL AND ECONOMIC FACTORS - Local political, economic, regulatory, or
social instability, military action or unrest, or adverse diplomatic
developments may affect the value of foreign investments. Listed below are some
of the more important political and economic factors that could negatively
affect an investment in foreign securities:
o The economies of foreign countries may differ from the economy of the
United States in such areas as growth of gross national product, rate of
inflation, capital reinvestment, resource self-sufficiency, budget deficits
and national debt;
o Foreign governments sometimes participate to a significant degree, through
ownership interests or regulation, in their respective economies. Actions
by these governments could significantly influence the market prices of
securities and payment of dividends;
o The economies of many foreign countries are dependent on international
trade and their trading partners and they could be severely affected if
their trading partners were to enact protective trade barriers and economic
conditions;
o The internal policies of a particular foreign country may be less stable
than in the United States. Other countries face significant external
political risks, such as possible claims of sovereignty by other countries
or tense and sometimes hostile border clashes; and
o A foreign government may act adversely to the interests of U. S.
investors, including expropriation or nationalization of assets,
confiscatory taxation and other restrictions on U. S. investment. A country
may restrict control foreign investments in its securities markets. These
restrictions could limit the Fund's ability to invest in a particular
country or make it very expensive for the Fund to invest in that country.
Some countries require prior governmental approval, limit the types or
amount of securities or companies in which a foreigner can invest. Other
countries may restrict the ability of foreign investors to repatriate their
investment income and capital gains.
INFORMATION AND SUPERVISION - There is generally less publicly available
information about foreign companies than companies based in the United States.
For example, there are often no reports and ratings published about foreign
companies comparable to the ones written about U.S. companies. Foreign
companies are typically not subject to uniform accounting, auditing and
financial reporting standards, practices and requirements comparable to those
applicable to U.S. companies. The lack of comparable information makes
investment decisions concerning foreign companies more difficult and less
reliable than domestic companies.
STOCK EXCHANGE AND MARKET RISK - The Adviser anticipates that in most cases an
exchange or over-the-counter ("OTC") market located outside of the United
States will be the best available market for foreign securities. Foreign stock
markets, while growing in volume and sophistication, are generally not as
developed as the markets in the United States. Foreign stock markets tend to
differ from those in the United States in a number of ways.
Foreign stock markets:
o are generally more volatile than, and not as developed or efficient as,
those in the United States;
o have substantially less volume;
o trade securities that tend to be less liquid and experience rapid and
erratic price movements;
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o have generally higher commissions and are subject to set minimum rates, as
opposed to negotiated rates;
o employ trading, settlement and custodial practices less developed than
those in U.S. markets; and
o may have different settlement practices, which may cause delays and
increase the potential for failed settlements.
Foreign markets may offer less protection to shareholders than U.S. markets
because:
o foreign accounting, auditing, and financial reporting requirements may
render a foreign corporate balance sheet more difficult to understand and
interpret than one subject to U.S. law and standards;
o adequate public information on foreign issuers may not be available, and
it may be difficult to secure dividends and information regarding corporate
actions on a timely basis;
o in general, there is less overall governmental supervision and regulation
of securities exchanges, brokers, and listed companies than in the United
States;
o OTC markets tend to be less regulated than stock exchange markets and, in
certain countries, may be totally unregulated;
o economic or political concerns may influence regulatory enforcement and
may make it difficult for shareholders to enforce their legal rights; and
o restrictions on transferring securities within the United States or to
U.S. persons may make a particular security less liquid than foreign
securities of the same class that are not subject to such restrictions.
FOREIGN CURRENCY RISK - While the Fund denominates its net asset value in U.S.
dollars, the securities of foreign companies are frequently denominated in
foreign currencies. Thus, a change in the value of a foreign currency against
the U.S. dollar will result in a corresponding change in value of securities
denominated in that currency. Some of the factors that may impair the
investments denominated in a foreign currency are:
o It may be expensive to convert foreign currencies into U.S. dollars
and vice versa;
o Complex political and economic factors may significantly affect the
values of various currencies, including U. S. dollars, and their
exchange rates;
o Government intervention may increase risks involved in purchasing or
selling foreign currency options, forward contracts and futures
contracts, since exchange rates may not be free to fluctuate in
response to other market forces;
o There may be no systematic reporting of last sale information for
foreign currencies or regulatory requirement that quotations available
through dealers or other market sources be firm or revised on a timely
basis;
o Available quotation information is generally representative of very
large round-lot transactions in the inter-bank market and thus may not
reflect exchange rates for smaller odd-lot transactions (less than $1
million) where rates may be less favorable; and
o The inter-bank market in foreign currencies is a global,
around-the-clock market. To the extent that a market is closed while
the markets for the underlying currencies remain open, certain markets
may not always reflect significant price and rate movements.
TAXES - Certain foreign governments levy withholding taxes on dividend and
interest income. Although in some countries it is possible for the Fund to
recover a portion of these taxes, the portion that cannot be recovered will
reduce the income the Fund receives from its investments. The Fund does not
expect such foreign withholding taxes to have a significant impact on
performance.
EMERGING MARKETS - Investing in emerging markets may magnify the risks of
foreign investing. Security prices in emerging markets can be significantly
more volatile than those in more developed markets, reflecting the greater
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uncertainties of investing in less established markets and economies. In
particular, countries with emerging markets may:
o Have relatively unstable governments;
o Present greater risks of nationalization of businesses, restrictions
on foreign ownership and prohibitions on the repatriation of assets;
o Offer less protection of property rights than more developed
countries; and
o Have economies that are based on only a few industries, may be
highlyvulnerable to changes in local or global trade conditions, and
may suffer from extreme and volatile debt burdens or inflation rates.
Local securities markets may trade a small number of securities and may be
unable to respond effectively to increases in trading volume, potentially
making prompt liquidation of holdings difficult or impossible at times.
MONEY MARKET SECURITIES. Money market securities include short-term U.S.
government securities; custodial receipts evidencing separately traded interest
and principal components of securities issued by the U.S. Treasury; commercial
paper rated in the highest short-term rating category by a nationally
recognized statistical ratings organization ("NRSRO"), such as Standard &
Poor's Rating Services ("S&P") or Moody's Investor Services, Inc. ("Moody's"),
or determined by the Adviser to be of comparable quality at the time of
purchase; short-term bank obligations (certificates of deposit, time deposits
and bankers' acceptances) of U.S. commercial banks with assets of at least $1
billion as of the end of their most recent fiscal year; and repurchase
agreements involving such securities. Each of these money market securities are
described below. For a description of ratings, see "Appendix A -- Description
of Ratings" to this SAI.
STRUCTURED NOTES. The Fund may invest in a broad category of instruments known
as "structured notes." These instruments are debt obligations issued by
industrial corporations, financial institutions or governmental or
international agencies. Traditional debt obligations typically obligate the
issuer to repay the principal plus a specified rate of interest. Structured
notes, by contrast, obligate the issuer to pay amounts of principal or interest
that are determined by reference to changes in some external factor or factors,
or the principal and interest rate may vary from the stated rate because of
changes in these factors. For example, the issuer's obligations could be
determined by reference to changes in the value of a commodity (such as gold or
oil) or commodity index, a foreign currency, an index of securities (such as
the S&P 500 Index) or an interest rate (such as the U.S. Treasury bill rate).
In some cases, the issuer's obligations are determined by reference to changes
over time in the difference (or "spread") between two or more external factors
(such as the U.S. prime lending rate and the total return of the stock market
in a particular country, as measured by a stock index). In some cases, the
issuer's obligations may fluctuate inversely with changes in an external factor
or factors (for example, if the U.S. prime lending rate goes up, the issuer's
interest payment obligations are reduced). In some cases, the issuer's
obligations may be determined by some multiple of the change in an external
factor or factors (for example, three times the change in the U.S. Treasury
bill rate). In some cases, the issuer's obligations remain fixed (as with a
traditional debt instrument) so long as an external factor or factors do not
change by more than the specified amount (for example, if the value of a stock
index does not exceed some specified maximum), but if the external factor or
factors change by more than the specified amount, the issuer's obligations may
be sharply reduced.
Structured notes can serve many different purposes in the management of the
Fund. For example, they can be used to increase the Fund's exposure to changes
in the value of assets that the Fund would not ordinarily purchase directly
(such as currencies traded in a market that is not open to U.S. investors).
They can also be used to hedge the risks associated with other investments the
Fund holds. For example, if a structured note has an interest rate that
fluctuates inversely with general changes in a country's stock market index,
the value of the structured note would generally move in the opposite direction
to the value of holdings of stocks in that market, thus moderating the effect
of stock market movements on the value of the Fund's portfolio as a whole.
RISKS. Structured notes involve special risks. As with any debt obligation,
structured notes involve the risk
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that the issuer will become insolvent or otherwise default on its payment
obligations. This risk is in addition to the risk that the issuer's
obligations (and thus the value of the Fund's investment) will be reduced
because of adverse changes in the external factor or factors to which the
obligations are linked. The value of structured notes will in many cases be
more volatile (that is, will change more rapidly or severely) than the
value of traditional debt instruments. Volatility will be especially high
if the issuer's obligations are determined by reference to some multiple of
the change in the external factor or factors. Many structured notes have
limited or no liquidity, so that the Fund would be unable to dispose of the
investment prior to maturity. As with all investments, successful use of
structured notes depends in significant part on the accuracy of the
Investment Adviser's analysis of the issuer's creditworthiness and
financial prospects, and of the Investment Adviser's forecast as to changes
in relevant economic and financial market conditions and factors. In
instances where the issuer of a structured note is a foreign entity, the
usual risks associated with investments in foreign securities (described
below) apply. Structured notes may be considered derivative securities.
REAL ESTATE INVESTMENT TRUSTS. A real estate investment trust ("REIT") is a
corporation or business trust (that would otherwise be taxed as a corporation)
which meets the definitional requirements of the Code. The Code permits a
qualifying REIT to deduct from taxable income the dividends paid, thereby
effectively eliminating corporate level federal income tax and making the REIT
a pass-through vehicle for federal income tax purposes. To meet the
definitional requirements of the Code, a REIT must, among other things: invest
substantially all of its assets in interests in real estate (including
mortgages and other REITs), cash and government securities; derive most of its
income from rents from real property or interest on loans secured by mortgages
on real property; and distribute annually 95% or more of its otherwise taxable
income to shareholders.
REITs are sometimes informally characterized as Equity REITs and Mortgage
REITs. An Equity REIT invests primarily in the fee ownership or leasehold
ownership of land and buildings; a Mortgage REIT invests primarily in mortgages
on real property, which may secure construction, development or long-term
loans.
REITs in which the Fund invests may be affected by changes in underlying real
estate values, which may have an exaggerated effect to the extent that REITs in
which the Fund invests may concentrate investments in particular geographic
regions or property types. Additionally, rising interest rates may cause
investors in REITs to demand a higher annual yield from future distributions,
which may in turn decrease market prices for equity securities issued by REITs.
Rising interest rates also generally increase the costs of obtaining financing,
which could cause the value of the Fund's investments to decline. During
periods of declining interest rates, certain Mortgage REITs may hold mortgages
that the mortgagors elect to prepay, which prepayment may diminish the yield on
securities issued by such Mortgage REITs. In addition, Mortgage REITs may be
affected by the ability of borrowers to repay when due the debt extended by the
REIT and Equity REITs may be affected by the ability of tenants to pay rent.
Certain REITs have relatively small market capitalization, which may tend to
increase the volatility of the market price of securities issued by such REITs.
Furthermore, REITs are dependent upon specialized management skills, have
limited diversification and are, therefore, subject to risks inherent in
operating and financing a limited number of projects. By investing in REITs
indirectly through the Fund, a shareholder will bear not only his proportionate
share of the expenses of the Fund, but also, indirectly, similar expenses of
the REITs. REITs depend generally on their ability to generate cash flow to
make distributions to shareholders.
In addition to these risks, Equity REITs may be affected by changes in the
value of the underlying property owned by the trusts, while Mortgage REITs may
be affected by the quality of any credit extended. Further, Equity and Mortgage
REITs are dependent upon management skills and generally may not be
diversified. Equity and Mortgage REITs are also subject to heavy cash flow
dependency defaults by borrowers and self-liquidation. In addition, Equity and
Mortgage REITs could possibly fail to qualify for tax free pass-through of
income under the Code or to maintain their exemptions from registration under
the 1940 Act. The above factors may also adversely affect a borrower's or a
lessee's ability to meet its obligations to the REIT. In the event of default
by a borrower or lessee, the REIT may
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experience delays in enforcing its rights as a mortgagee or lessor and may
incur substantial costs associated with protecting its investments.
U.S. GOVERNMENT SECURITIES. The Fund may invest in U.S. government securities.
Securities issued or guaranteed by the U.S. government or its agencies or
instrumentalities include U.S. Treasury securities, which are backed by the
full faith and credit of the U.S. Treasury and which differ only in their
interest rates, maturities, and times of issuance. U.S. Treasury bills have
initial maturities of one-year or less; U.S. Treasury notes have initial
maturities of one to ten years; and U.S. Treasury bonds generally have initial
maturities of greater than ten years. Certain U.S. government securities are
issued or guaranteed by agencies or instrumentalities of the U.S. government
including, but not limited to, obligations of U.S. government agencies or
instrumentalities such as the Federal National Mortgage Association ("Fannie
Mae"), the Government National Mortgage Association ("Ginnie Mae"), the Small
Business Administration, the Federal Farm Credit Administration, the Federal
Home Loan Banks, Banks for Cooperatives (including the Central Bank for
Cooperatives), the Federal Land Banks, the Federal Intermediate Credit Banks,
the Tennessee Valley Authority, the Export-Import Bank of the United States,
the Commodity Credit Corporation, the Federal Financing Bank, the National
Credit Union Administration and the Federal Agricultural Mortgage Corporation
("Farmer Mac").
Some obligations issued or guaranteed by U.S. government agencies and
instrumentalities, including, for example, Ginnie Mae pass-through
certificates, are supported by the full faith and credit of the U.S. Treasury.
Other obligations issued by or guaranteed by federal agencies, such as those
securities issued by Fannie Mae, are supported by the discretionary authority
of the U.S. government to purchase certain obligations of the federal agency,
while other obligations issued by or guaranteed by federal agencies, such as
those of the Federal Home Loan Banks, are supported by the right of the issuer
to borrow from the U.S. Treasury, while the U.S. government provides financial
support to such U.S. government-sponsored federal agencies, no assurance can be
given that the U.S. government will always do so, since the U.S. government is
not so obligated by law. U.S. Treasury notes and bonds typically pay coupon
interest semi-annually and repay the principal at maturity.
On September 7, 2008, the U.S. Treasury announced a federal takeover of Fannie
Mae and the Federal Home Loan Mortgage Association ("Freddie Mac"), placing the
two federal instrumentalities in conservatorship. Under the takeover, the U.S.
Treasury agreed to acquire $1 billion of senior preferred stock of each
instrumentality and obtained warrants for the purchase of common stock of each
instrumentality (the "Senior Preferred Stock Purchase Agreement" or
"Agreement"). Under the Agreement, the U.S. Treasury pledged to provide up to
$200 billion per instrumentality as needed, including the contribution of cash
capital to the instrumentalities in the event their liabilities exceed their
assets. This was intended to ensure that the instrumentalities maintain a
positive net worth and meet their financial obligations, preventing mandatory
triggering of receivership. On December 24, 2009, the U.S. Treasury announced
that it was amending the Agreement to allow the $200 billion cap on the U.S.
Treasury's funding commitment to increase as necessary to accommodate any
cumulative reduction in net worth through the end of 2012. The unlimited
support the U.S. Treasury extended to the two companies expired at the
beginning of 2013 -- Fannie Mae's support is now capped at $125 billion and
Freddie Mac has a limit of $149 billion.
On August 17, 2012, the U.S. Treasury announced that it was again amending the
Agreement to terminate the requirement that Fannie Mae and Freddie Mac each pay
a 10% annual dividend. Instead, the companies will transfer to the U.S.
Treasury on a quarterly basis all profits earned during a quarter that exceed a
capital reserve amount of $3 billion. It is believed that the new amendment
puts Fannie Mae and Freddie Mac in a better position to service their debt
because the companies no longer have to borrow from the U.S. Treasury to make
fixed dividend payments. As part of the new terms, Fannie Mae and Freddie Mac
also will be required to reduce their investment portfolios at an annual rate
of 15 percent instead of the previous 10 percent, which puts each of them on
track to cut their portfolios to a targeted $250 billion in 2018.
Fannie Mae and Freddie Mac are the subject of several continuing class action
lawsuits and investigations by
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federal regulators over certain accounting, disclosure or corporate governance
matters, which (along with any resulting financial restatements) may adversely
affect the guaranteeing entities. Importantly, the future of the entities is in
serious question as the U.S. Government reportedly is considering multiple
options, ranging from nationalization, privatization, consolidation, or
abolishment of the entities.
o U. S. TREASURY OBLIGATIONS. U. S. Treasury obligations consist of bills,
notes and bonds issued by the U. S. Treasury and separately traded interest
and principal component parts of such obligations that are transferable
through the federal book-entry system known as Separately Traded Registered
Interest and Principal Securities ("STRIPS") and Treasury Receipts ("TRs").
o RECEIPTS. Interests in separately traded interest and principal component
parts of U. S. government obligations that are issued by banks or brokerage
firms and are created by depositing U. S. government obligations into a
special account at a custodian bank. The custodian holds the interest and
principal payments for the benefit of the registered owners of the
certificates or receipts. The custodian arranges for the issuance of the
certificates or receipts evidencing ownership and maintains the register.
TRs and STRIPS are interests in accounts sponsored by the U. S. Treasury.
Receipts are sold as zero coupon securities.
o U. S. GOVERNMENT ZERO COUPON SECURITIES. STRIPS and receipts are sold as
zero coupon securities, that is, fixed income securities that have been
stripped of their unmatured interest coupons. Zero coupon securities are
sold at a (usually substantial) discount and redeemed at face value at
their maturity date without interim cash payments of interest or principal.
The amount of this discount is accreted over the life of the security, and
the accretion constitutes the income earned on the security for both
accounting and tax purposes. Because of these features, the market prices
of zero coupon securities are generally more volatile than the market
prices of securities that have similar maturity but that pay interest
periodically. Zero coupon securities are likely to respond to a greater
degree to interest rate changes than are non-zero coupon securities with
similar maturity and credit qualities.
o U. S. GOVERNMENT AGENCIES. Some obligations issued or guaranteed by
agencies of the U. S. government are supported by the full faith and credit
of the U. S. Treasury, others are supported by the right of the issuer to
borrow from the U. S. Treasury, while still others are supported only by
the credit of the instrumentality. Guarantees of principal by agencies or
instrumentalities of the U. S. government may be a guarantee of payment at
the maturity of the obligation so that in the event of a default prior to
maturity there might not be a market and thus no means of realizing on the
obligation prior to maturity. Guarantees as to the timely payment of
principal and interest do not extend to the value or yield of these
securities nor to the value of the Fund's shares.
COMMERCIAL PAPER. Commercial paper is the term used to designate unsecured
short-term promissory notes issued by corporations and other entities.
Maturities on these issues vary from a few to 270 days.
OBLIGATIONS OF DOMESTIC BANKS, FOREIGN BANKS AND FOREIGN BRANCHES OF U.S.
BANKS. The Fund may invest in obligations issued by banks and other savings
institutions. Investments in bank obligations include obligations of domestic
branches of foreign banks and foreign branches of domestic banks. Such
investments in domestic branches of foreign banks and foreign branches of
domestic banks may involve risks that are different from investments in
securities of domestic branches of U.S. banks. These risks may include future
unfavorable political and economic developments, possible withholding taxes on
interest income, seizure or nationalization of foreign deposits, currency
controls, interest limitations, or other governmental restrictions which might
affect the payment of principal or interest on the securities held by the Fund.
Additionally, these institutions may be subject to less stringent reserve
requirements and to different accounting, auditing, reporting and recordkeeping
requirements than those applicable to domestic branches of U.S. banks. Bank
obligations include the following:
o BANKERS' ACCEPTANCES. Bankers' acceptances are bills of exchange or time
drafts drawn on and accepted by a commercial bank. Corporations use
bankers' acceptances to finance the shipment and storage of goods and to
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furnish dollar exchange. Maturities are generally six months or less.
o CERTIFICATES OF DEPOSIT. Certificates of deposit are interest-bearing
instruments with a specific maturity. They are issued by banks and savings
and loan institutions in exchange for the deposit of funds and normally can
be traded in the secondary market prior to maturity. Certificates of
deposit with penalties for early withdrawal will be considered illiquid.
o TIME DEPOSITS. Time deposits are non-negotiable receipts issued by a bank
in exchange for the deposit of funds. Like a certificate of deposit, it
earns a specified rate of interest over a definite period of time; however,
it cannot be traded in the secondary market. Time deposits with a
withdrawal penalty or that mature in more than seven days are considered to
be illiquid securities.
REPURCHASE AGREEMENTS. The Fund may enter into repurchase agreements with
financial institutions. A repurchase agreement is an agreement under which a
fund acquires a fixed income security (generally a security issued by the U.S.
government or an agency thereof, a banker's acceptance, or a certificate of
deposit) from a commercial bank, broker, or dealer, and simultaneously agrees
to resell such security to the seller at an agreed upon price and date
(normally, the next business day). Because the security purchased constitutes
collateral for the repurchase obligation, a repurchase agreement may be
considered a loan that is collateralized by the security purchased. The
acquisition of a repurchase agreement may be deemed to be an acquisition of the
underlying securities as long as the obligation of the seller to repurchase the
securities is collateralized fully. The Fund follows certain procedures
designed to minimize the risks inherent in such agreements. These procedures
include effecting repurchase transactions only with creditworthy financial
institutions whose condition will be continually monitored by the Adviser. The
repurchase agreements entered into by the Fund will provide that the underlying
collateral at all times shall have a value at least equal to 102% of the resale
price stated in the agreement and consist only of securities permissible under
Section 101(47)(A)(i) of the Bankruptcy Code (the Adviser monitors compliance
with this requirement). Under all repurchase agreements entered into by the
Fund, the custodian or its agent must take possession of the underlying
collateral. In the event of a default or bankruptcy by a selling financial
institution, the Fund will seek to liquidate such collateral. However, the
exercising of the Fund's right to liquidate such collateral could involve
certain costs or delays and, to the extent that proceeds from any sale upon a
default of the obligation to repurchase were less than the repurchase price,
the Fund could suffer a loss. It is the current policy of the Fund not to
invest in repurchase agreements that do not mature within seven days if any
such investment, together with any other illiquid assets held by that Fund,
amounts to more than 15% of the Fund's total assets. The investments of the
Fund in repurchase agreements, at times, may be substantial when, in the view
of the Adviser, liquidity or other considerations so warrant.
REVERSE REPURCHASE AGREEMENTS. Reverse repurchase agreements are transactions
in which the Fund sells portfolio securities to financial institutions, such as
banks and broker-dealers, and agrees to repurchase them at a mutually
agreed-upon date and price that is higher than the original sale price. Reverse
repurchase agreements are similar to a fully collateralized borrowing by the
Fund. At the time the Fund enters into a reverse repurchase agreement, it will
earmark on the books of the Fund or place in a segregated account cash or
liquid securities having a value equal to the repurchase price (including
accrued interest) and will subsequently monitor the account to ensure that such
equivalent value is maintained.
Reverse repurchase agreements involve risks. Reverse repurchase agreements are
a form of leverage, and the use of reverse repurchase agreements by the Fund
may increase the Fund's volatility. Reverse repurchase agreements are also
subject to the risk that the other party to the reverse repurchase agreement
will be unable or unwilling to complete the transaction as scheduled, which may
result in losses to the Fund. Reverse repurchase agreements also involve the
risk that the market value of the securities sold by the Fund may decline below
the price at which it is obligated to repurchase the securities. In addition,
when the Fund invests the proceeds it receives in a reverse repurchase
transaction, there is a risk that those investments may decline in value. In
this circumstance, the Fund could be required to sell other investments in
order to meet its obligations to repurchase the securities.
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SECURITIES LENDING. The Fund may lend portfolio securities to brokers, dealers
and other financial organizations that meet capital and other credit
requirements or other criteria established by the Trust's Board of Trustees.
These loans, if and when made, may not exceed 33 1/3% of the total asset value
of the Fund (including the loan collateral). The Fund will not lend portfolio
securities to its Adviser or their affiliates unless permissible under the 1940
Act and the rules and promulgations thereunder. Loans of portfolio securities
will be fully collateralized by cash, letters of credit or U.S. government
securities, and the collateral will be maintained in an amount equal to at
least 100% of the current market value of the loaned securities by marking to
market daily. Any gain or loss in the market price of the securities loaned
that might occur during the term of the loan would be for the account of the
Fund.
The Fund may pay a part of the interest earned from the investment of
collateral, or other fee, to an unaffiliated third party for acting as the
Fund's securities lending agent, but will bear all of any losses from the
investment of collateral.
By lending its securities, the Fund may increase its income by receiving
payments from the borrower that reflect the amount of any interest or any
dividends payable on the loaned securities as well as by either investing cash
collateral received from the borrower in short-term instruments or obtaining a
fee from the borrower when U.S. government securities or letters of credit are
used as collateral. The Fund will adhere to the following conditions whenever
its portfolio securities are loaned: (i) the Fund must receive at least 100%
cash collateral or equivalent securities of the type discussed in the preceding
paragraph from the borrower; (ii) the borrower must increase such collateral
whenever the market value of the securities rises above the level of such
collateral; (iii) the Fund must be able to terminate the loan on demand; (iv)
the Fund must receive reasonable interest on the loan, as well as any
dividends, interest or other distributions on the loaned securities and any
increase in market value; (v) the Fund may pay only reasonable fees in
connection with the loan (which fees may include fees payable to the lending
agent, the borrower, the Fund's administrator and the custodian); and (vi)
voting rights on the loaned securities may pass to the borrower, provided,
however, that if a material event adversely affecting the investment occurs,
the Fund must terminate the loan and regain the right to vote the securities.
The Board has adopted procedures reasonably designed to ensure that the
foregoing criteria will be met. Loan agreements involve certain risks in the
event of default or insolvency of the borrower, including possible delays or
restrictions upon the Fund's ability to recover the loaned securities or
dispose of the collateral for the loan, which could give rise to loss because
of adverse market action, expenses and/or delays in connection with the
disposition of the underlying securities.
SECURITIES OF OTHER INVESTMENT COMPANIES. The Fund may invest in shares of
other affiliated and unaffiliated investment companies, to the extent permitted
by applicable law and subject to certain restrictions. These investment
companies typically incur fees that are separate from those fees incurred
directly by the Fund. The Fund's purchase of such investment company securities
results in the layering of expenses, such that shareholders would indirectly
bear a proportionate share of the operating expenses of such investment
companies, including advisory fees, in addition to paying the Fund's expenses.
Unless an exception is available, Section 12(d)(1)(A) of the 1940 Act prohibits
a fund from (i) acquiring more than 3% of the voting shares of any one
investment company, (ii) investing more than 5% of its total assets in any one
investment company, and (iii) investing more than 10% of its total assets in
all investment companies combined, including its ETF investments.
For hedging or other purposes, the Fund may invest in investment companies that
seek to track the composition and/or performance of specific indexes or
portions of specific indexes. Certain of these investment companies, known as
exchange-traded funds, are traded on a securities exchange. (See "Exchange
Traded Funds" above). The market prices of index-based investments will
fluctuate in accordance with changes in the underlying portfolio securities of
the investment company and also due to supply and demand of the investment
company's shares on the exchange upon which the shares are traded. Index-based
investments may not replicate or otherwise match the composition or performance
of their specified index due to transaction costs, among other things.
Certain affiliated and unaffiliated investment companies, including certain
iShares, Market Vectors, Vanguard,
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ProShares, PowerShares, Guggenheim (formerly, Claymore),Direxion, Wisdom Tree,
Rydex, First Trust and SPDR exchange-traded funds have been issued orders by
the SEC pursuant to which the Fund may invest in such investment companies in
excess of the 3% limit described above, provided that the Fund complies with
the conditions of the SEC order as it may be amended, procedures approved by
the Board, and any other applicable investment limitations. Neither the
investment companies issued such SEC orders nor their investment advisers make
any representations regarding the advisability of investing in the investment
companies.
WHEN ISSUED, DELAYED--DELIVERY AND FORWARD TRANSACTIONS. A when-issued security
is one whose terms are available and for which a market exists, but which have
not been issued. In a forward delivery transaction, the Fund contracts to
purchase securities for a fixed price at a future date beyond customary
settlement time. "Delayed delivery" refers to securities transactions on the
secondary market where settlement occurs in the future. In each of these
transactions, the parties fix the payment obligation and the interest rate that
they will receive on the securities at the time the parties enter the
commitment; however, they do not pay money or deliver securities until a later
date. Typically, no income accrues on securities the Fund has committed to
purchase before the securities are delivered, although the Fund may earn income
on securities it has in a segregated account to cover its position. The Fund
will only enter into these types of transactions with the intention of actually
acquiring the securities, but may sell them before the settlement date.
The Fund uses when-issued, delayed-delivery and forward delivery transactions
to secure what it considers an advantageous price and yield at the time of
purchase. When the Fund engages in when-issued, delayed-delivery or forward
delivery transactions, it relies on the other party to consummate the sale. If
the other party fails to complete the sale, the Fund may miss the opportunity
to obtain the security at a favorable price or yield.
When purchasing a security on a when-issued, delayed delivery, or forward
delivery basis, the Fund assumes the rights and risks of ownership of the
security, including the risk of price and yield changes. At the time of
settlement, the market value of the security may be more or less than the
purchase price. The yield available in the market when the delivery takes place
also may be higher than those obtained in the transaction itself. Because the
Fund does not pay for the security until the delivery date, these risks are in
addition to the risks associated with its other investments.
The Fund will segregate cash or liquid securities equal in value to commitments
for the when-issued, delayed delivery or forward delivery transactions. The
Fund will segregate additional liquid assets daily so that the value of such
assets is equal to the amount of the commitments, such Fund's liquidity and the
ability of the Adviser to manage it might be affected in the event its
commitments to purchase "when-issued" securities ever exceed 25% of the value
of its total assets. Under normal market conditions, however, the Fund's
commitment to purchase "when-issued" or "delayed-delivery" securities will not
exceed 25% of the value of its total assets.
DERIVATIVES
Derivatives are financial instruments whose value is based on an underlying
asset, such as a stock or a bond, or an underlying economic factor, such as an
interest rate or a market benchmark. Unless otherwise stated in the Fund's
prospectuses, the Fund may use derivatives for risk management purposes,
including to gain exposure to various markets in a cost efficient manner, to
reduce transaction costs or to remain fully invested. The Fund may also invest
in derivatives to protect it from broad fluctuations in market prices, interest
rates or foreign currency exchange rates (a practice known as "hedging"). When
hedging is successful, the Fund will have offset any depreciation in the value
of its portfolio securities by the appreciation in the value of the derivative
position. Although techniques other than the sale and purchase of derivatives
could be used to control the exposure of the Fund to market fluctuations, the
use of derivatives may be a more effective means of hedging this exposure.
Because many derivatives have a leverage or borrowing component, adverse
changes in the value or level of the underlying asset, reference rate, or index
can result in a loss substantially greater than the amount invested in the
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derivative itself. Certain derivatives have the potential for unlimited loss,
regardless of the size of the initial investment. Accordingly, certain
derivative transactions may be considered to constitute borrowing transactions
for purposes of the 1940 Act. Such a derivative transaction will not be
considered to constitute the issuance of a "senior security" by the Fund, and
therefore such transaction will not be subject to the 300% asset coverage
requirement otherwise applicable to borrowings by the Fund, if the Fund covers
the transaction or segregates sufficient liquid assets in accordance with the
requirements and interpretations of the SEC and its staff.
As a result of recent amendments to rules under the Commodity Exchange Act
("CEA") by the Commodity Futures Trading Commission ("CFTC"), the Fund must
either operate within certain guidelines and restrictions with respect to the
Fund's use of futures, options on such futures, commodity options and certain
swaps, or the Adviser will be subject to registration with the CFTC as a
"commodity pool operator" ("CPO").
Consistent with the CFTC's new regulations, the Trust, on behalf of the Fund,
has claimed an exclusion from the definition of the term CPO under the CEA and,
therefore, the Fund is not subject to registration or regulation as a CPO under
the CEA. As a result, the Fund will operate within certain guidelines and
restrictions with respect to its use of futures, options on such futures,
commodity options and certain swaps.
TYPES OF DERIVATIVES:
FUTURES - A futures contract is an agreement between two parties whereby one
party sells and the other party agrees to buy a specified amount of a financial
instrument at an agreed upon price and time. The financial instrument
underlying the contract may be a stock, stock index, bond, bond index, interest
rate, foreign exchange rate or other similar instrument. Agreeing to buy the
underlying financial information is called buying a futures contract or taking
a long position in the contract. Likewise, agreeing to sell the underlying
financial instrument is called selling a futures contract or taking a short
position in the contract.
Futures contracts are traded in the United States on commodity exchanges or
boards of trade - known as "contract markets" - approved for such trading and
regulated by the Commodity Futures Trading Commission ("CFTC"). These contract
markets standardize the terms, including the maturity date and underlying
financial instrument, of all futures contracts.
Unlike other securities, the parties to a futures contract do not have to pay
for or deliver the underlying financial instrument until some future date (the
delivery date). Contract markets require both the purchaser and seller to
deposit "initial margin" with a futures broker, known as a futures commission
merchant or custodian bank, when they enter into the contract. Initial margin
deposits are typically equal to a percentage of the contract's value. After
they open a futures contract, the parties to the transaction must compare the
purchase price of the contract to its daily market value. If the value of the
futures contract changes in such a way that a party's position declines, that
party must make additional "variation margin" payments so that the margin
payment is adequate. On the other hand, the value of the contract may change in
such a way that there is excess margin on deposit, possibly entitling the party
that has a gain to receive all or a portion of this amount. This process is
known as "marking to the market."
Although the actual terms of a futures contract call for the actual delivery of
and payment for the underlying security, in many cases the parties may close
the contract early by taking an opposite position in an identical contract. If
the sale price upon closing out the contract is less than the original purchase
price, the person closing out the contract will realize a loss. If the sale
price upon closing out the contract is more than the original purchase price,
the person closing out the contract will realize a gain. If the purchase price
upon closing out the contract is more than the original sale price, the person
closing out the contract will realize a loss. If the purchase price upon
closing out the contract is less than the original sale price, the person
closing out the contract will realize a gain.
The Fund may incur commission expenses when it opens or closes a futures
position.
S-21
OPTIONS - An option is a contract between two parties for the purchase and sale
of a financial instrument for a specified price (known as the "strike price" or
"exercise price") at any time during the option period. Unlike a futures
contract, an option grants a right (not an obligation) to buy or sell a
financial instrument. Generally, a seller of an option can grant a buyer two
kinds of rights: a "call" (the right to buy the security) or a "put" (the right
to sell the security). Options have various types of underlying instruments,
including specific securities, indices of securities prices, foreign
currencies, interest rates and futures contracts. Options may be traded on an
exchange (exchange-traded-options) or may be customized agreements between the
parties (over-the-counter or "OTC" options). Like futures, a financial
intermediary, known as a clearing corporation, financially backs
exchange-traded options. However, OTC options have no such intermediary and are
subject to the risk that the counter-party will not fulfill its obligations
under the contract.
o PURCHASING PUT AND CALL OPTIONS
When the Fund purchases a put option, it buys the right to sell the instrument
underlying the option at a fixed strike price. In return for this right, the
Fund pays the current market price for the option (known as the "option
premium"). The Fund may purchase put options to offset or hedge against a
decline in the market value of its securities ("protective puts") or to benefit
from a decline in the price of securities that it does not own. The Fund would
ordinarily realize a gain if, during the option period, the value of the
underlying securities decreased below the exercise price sufficiently to cover
the premium and transaction costs. However, if the price of the underlying
instrument does not fall enough to offset the cost of purchasing the option, a
put buyer would lose the premium and related transaction costs.
Call options are similar to put options, except that the Fund obtains the right
to purchase, rather than sell, the underlying instrument at the option's strike
price. The Fund would normally purchase call options in anticipation of an
increase in the market value of securities it owns or wants to buy. The Fund
would ordinarily realize a gain if, during the option period, the value of the
underlying instrument exceeded the exercise price plus the premium paid and
related transaction costs. Otherwise, the Fund would realize either no gain or
a loss on the purchase of the call option.
The purchaser of an option may terminate its position by:
o Allowing it to expire and losing its entire premium;
o Exercising the option and either selling (in the case of a put
option) or buying (in the case of a call option) the underlying
instrument at the strike price; or
o Closing it out in the secondary market at its current price.
o SELLING (WRITING) PUT AND CALL OPTIONS
When the Fund writes a call option it assumes an obligation to sell specified
securities to the holder of the option at a specified price if the option is
exercised at any time before the expiration date. Similarly, when the Fund
writes a put option it assumes an obligation to purchase specified securities
from the option holder at a specified price if the option is exercised at any
time before the expiration date. The Fund may terminate its position in an
exchange-traded put option before exercise by buying an option identical to the
one it has written. Similarly, it may cancel an OTC option by entering into an
offsetting transaction with the counter-party to the option.
The Fund could try to hedge against an increase in the value of securities it
would like to acquire by writing a put option on those securities. If security
prices rise, the Fund would expect the put option to expire and the premium it
received to offset the increase in the security's value. If security prices
remain the same over time, the Fund would hope to profit by closing out the put
option at a lower price. If security prices fall, the Fund may lose an amount
of money equal to the difference between the value of the security and the
premium it received. Writing covered put
S-22
options may deprive the Fund of the opportunity to profit from a decrease in
the market price of the securities it would like to acquire.
The characteristics of writing call options are similar to those of writing put
options, except that call writers expect to profit if prices remain the same or
fall. The Fund could try to hedge against a decline in the value of securities
it already owns by writing a call option. If the price of that security falls
as expected, the Fund would expect the option to expire and the premium it
received to offset the decline of the security's value. However, the Fund must
be prepared to deliver the underlying instrument in return for the strike
price, which may deprive it of the opportunity to profit from an increase in
the market price of the securities it holds.
The Fund is permitted only to write covered options. At the time of selling the
call option, the Fund may cover the option by owning, among other things:
o The underlying security (or securities convertible into the underlying
security without additional consideration), index, interest rate, foreign
currency or futures contract;
o A call option on the same security or index with the same or lesser
exercise price;
o A call option on the same security or index with a greater exercise price
and segregating cash or liquid securities in an amount equal to the
difference between the exercise prices;
o Cash or liquid securities equal to at least the market value of the
optioned securities, interest rate, foreign currency or futures contract;
or
o In the case of an index, the portfolio of securities that corresponds to
the index.
At the time of selling a put option, the Fund may cover the put option by,
among other things:
o Entering into a short position in the underlying security;
o Purchasing a put option on the same security, index, interest rate,
foreign currencyor futures contract with the same or greater exercise
price;
o Purchasing a put option on the same security, index, interest rate,
foreign currency or futures contract with a lesser exercise price and
segregating cash or liquid securities in an amount equal to the difference
between the exercise prices; or
o Maintaining the entire exercise price in liquid securities.
o OPTIONS ON SECURITIES INDICES
Options on securities indices are similar to options on securities, except that
the exercise of securities index options requires cash settlement payments and
does not involve the actual purchase or sale of securities. In addition,
securities index options are designed to reflect price fluctuations in a group
of securities or segment of the securities market rather than price
fluctuations in a single security.
o OPTIONS ON FUTURES
An option on a futures contract provides the holder with the right to buy a
futures contract (in the case of a call option) or sell a futures contract (in
the case of a put option) at a fixed time and price. Upon exercise of the
option by the holder, the contract market clearing house establishes a
corresponding short position for the writer of the option (in the
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case of a call option) or a corresponding long position (in the case of a put
option). If the option is exercised, the parties will be subject to the futures
contracts. In addition, the writer of an option on a futures contract is
subject to initial and variation margin requirements on the option position.
Options on futures contracts are traded on the same contract market as the
underlying futures contract.
The buyer or seller of an option on a futures contract may terminate the option
early by purchasing or selling an option of the same series (i.e., the same
exercise price and expiration date) as the option previously purchased or sold.
The difference between the premiums paid and received represents the trader's
profit or loss on the transaction.
The Fund may purchase put and call options on futures contracts instead of
selling or buying futures contracts. The Fund may buy a put option on a futures
contract for the same reasons it would sell a futures contract. It also may
purchase such put options in order to hedge a long position in the underlying
futures contract. The Fund may buy call options on futures contracts for the
same purpose as the actual purchase of the futures contracts, such as in
anticipation of favorable market conditions.
The Fund may write a call option on a futures contract to hedge against a
decline in the prices of the instrument underlying the futures contracts. If
the price of the futures contract at expiration were below the exercise price,
the Fund would retain the option premium, which would offset, in part, any
decline in the value of its portfolio securities.
The writing of a put option on a futures contract is similar to the purchase of
the futures contracts, except that, if the market price declines, the Fund
would pay more than the market price for the underlying instrument. The premium
received on the sale of the put option, less any transaction costs, would
reduce the net cost to the Fund.
o COMBINED POSITIONS
The Fund may purchase and write options in combination with each other, or in
combination with futures or forward contracts, to adjust the risk and return
characteristics of the overall position. For example, the Fund could construct
a combined position whose risk and return characteristics are similar to
selling a futures contract by purchasing a put option and writing a call option
on the same underlying instrument. Alternatively, the Fund could write a call
option at one strike price and buy a call option at a lower price to reduce the
risk of the written call option in the event of a substantial price increase.
Because combined options positions involve multiple trades, they result in
higher transaction costs and may be more difficult to open and close out.
o FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
A forward foreign currency contract involves an obligation to purchase or sell a
specific amount of currencyat a future date or date range at a specific price.
In the case of a cancelable forward contract, the holder has the unilateral
right to cancel the contract at maturity by paying a specified fee. Forward
foreign currency exchange contracts differ from foreign currency futures
contracts in certain respects. Unlike futures contracts, forward contracts:
o Do not have standard maturity dates or amounts (i.e., the parties to
the contract may fix the maturity date and the amount);
o Are traded in the inter-bank markets conducted directly between
currency traders (usually large commercial banks) and their customers,
as opposed to futures contracts which are traded only on exchanges
regulated by the CFTC;
o Do not require an initial margin deposit; and
o May be closed by entering into a closing transaction with the
currency trader who is a party to the original forward contract, as
opposed to a commodities exchange.
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FOREIGN CURRENCY HEDGING STRATEGIES - A "settlement hedge" or "transaction
hedge" is designed to protect the Fund against an adverse change in foreign
currency values between the date a security is purchased or sold and the date
on which payment is made or received. Entering into a forward contract for the
purchase or sale of the amount of foreign currency involved in an underlying
security transaction for a fixed amount of U.S. dollars "locks in" the U.S.
dollar price of the security. The Fund may also use forward contracts to
purchase or sell a foreign currency when it anticipates purchasing or selling
securities denominated in foreign currency, even if it has not yet selected the
specific investments.
The Fund may use forward contracts to hedge against a decline in the value of
existing investments denominated in foreign currency. Such a hedge, sometimes
referred to as a "position hedge," would tend to offset both positive and
negative currency fluctuations, but would not offset changes in security values
caused by other factors. The Fund could also hedge the position by selling
another currency expected to perform similarly to the currency in which the
Fund's investment is denominated. This type of hedge, sometimes referred to as
a "proxy hedge," could offer advantages in terms of cost, yield, or efficiency,
but generally would not hedge currency exposure as effectively as a direct
hedge into U.S. dollars. Proxy hedges may result in losses if the currency used
to hedge does not perform similarly to the currency in which the hedged
securities are denominated.
Transaction and position hedging do not eliminate fluctuations in the
underlying prices of the securities that the Fund owns or intends to purchase
or sell. They simply establish a rate of exchange that one can achieve at some
future point in time. Additionally, these techniques tend to minimize the risk
of loss due to a decline in the value of the hedged currency and to limit any
potential gain that might result from the increase in value of such currency.
The Fund may enter into forward contracts to shift its investment exposure from
one currency into another. Such transactions may call for the delivery of one
foreign currency in exchange for another foreign currency, including currencies
in which its securities are not then denominated. This may include shifting
exposure from U.S. dollars to a foreign currency, or from one foreign currency
to another foreign currency. This type of strategy, sometimes known as a
"cross-hedge," will tend to reduce or eliminate exposure to the currency that
is sold, and increase exposure to the currency that is purchased. Cross-hedges
may protect against losses resulting from a decline in the hedged currency, but
will cause the Fund to assume the risk of fluctuations in the value of the
currency it purchases. Cross-hedging transactions also involve the risk of
imperfect correlation between changes in the values of the currencies
involved.
It is difficult to forecast with precision the market value of portfolio
securities at the expiration or maturity of a forward or futures contract.
Accordingly, the Fund may have to purchase additional foreign currency on the
spot market if the market value of a security it is hedging is less than the
amount of foreign currency it is obligated to deliver. Conversely, the Fund may
have to sell on the spot market some of the foreign currency it received upon
the sale of a security if the market value of such security exceeds the amount
of foreign currency it is obligated to deliver.
EQUITY-LINKED SECURITIES - The Fund may invest in privately issued securities
whose investment results are designed to correspond generally to the
performance of a specified stock index or "basket" of securities, or sometimes
a single stock (referred to as "equity-linked securities"). These securities
are used for many of the same purposes as derivative instruments and share many
of the same risks. Equity-linked securities may be considered illiquid and thus
subject to the Fund's restrictions on investments in illiquid securities.
SWAPS, CAPS, COLLARS AND FLOORS
SWAP AGREEMENTS - A swap is a financial instrument that typically involves the
exchange of cash flows between two parties on specified dates (settlement
dates), where the cash flows are based on agreed-upon prices, rates, indices,
etc. The nominal amount on which the cash flows are calculated is called the
notional amount. Swaps are individually negotiated and structured to include
exposure to a variety of different types of investments or market factors, such
as interest rates, foreign currency rates, mortgage securities, corporate
borrowing rates, security prices or inflation rates.
S-25
Swap agreements may increase or decrease the overall volatility of the
investments of the Fund and its share price. The performance of swap agreements
may be affected by a change in the specific interest rate, currency, or other
factors that determine the amounts of payments due to and from the Fund. If a
swap agreement calls for payments by the Fund, the Fund must be prepared to
make such payments when due. In addition, if the counter-party's
creditworthiness declined, the value of a swap agreement would be likely to
decline, potentially resulting in losses.
Generally, swap agreements have a fixed maturity date that will be agreed upon
by the parties. The agreement can be terminated before the maturity date under
certain circumstances, such as default by one of the parties or insolvency,
among others, and can be transferred by a party only with the prior written
consent of the other party. The Fund may be able to eliminate its exposure
under a swap agreement either by assignment or by other disposition, or by
entering into an offsetting swap agreement with the same party or a similarly
creditworthy party. If the counter-party is unable to meet its obligations
under the contract, declares bankruptcy, defaults or becomes insolvent, the
Fund may not be able to recover the money it expected to receive under the
contract. The Fund will not enter into any swap agreement unless the Adviser
believes that the other party to the transaction is creditworthy.
A swap agreement can be a form of leverage, which can magnify the Fund's gains
or losses. In order to reduce the risk associated with leveraging, the Fund may
cover its current obligations under swap agreements according to guidelines
established by the Securities and Exchange Commission (the "SEC"). If the Fund
enters into a swap agreement on a net basis, it will segregate assets with a
daily value at least equal to the excess, if any, of the Fund's accrued
obligations under the swap agreement over the accrued amount the Fund is
entitled to receive under the agreement. If the Fund enters into a swap
agreement on other than a net basis, it will segregate assets with a value
equal to the full amount of the Fund's accrued obligations under the
agreement.
o EQUITY SWAPS
In a typical equity swap, one party agrees to pay another party the return on a
stock, stock index or basket of stocks in return for a specified interest rate.
By entering into an equity index swap, for example, the index receiver can gain
exposure to stocks making up the index of securities without actually
purchasing those stocks. Equity index swaps involve not only the risk
associated with investment in the securities represented in the index, but also
the risk that the performance of such securities, including dividends, will not
exceed the return on the interest rate that the Fund will be committed to pay.
o TOTAL RETURN SWAPS
Total return swaps are contracts in which one party agrees to make payments of
the total return from a reference instrument -- which may be a single asset, a
pool of assets or an index of assets -- during a specified period, in return
for payments equal to a fixed or floating rate of interest or the total return
from another underlying reference instrument. The total return includes
appreciation or depreciation on the underlying asset, plus any interest or
dividend payments. Payments under the swap are based upon an agreed upon
principal amount but, since the principal amount is not exchanged, it
represents neither an asset nor a liability to either counterparty, and is
referred to as notional. Total return swaps are marked to market daily using
different sources, including quotations from counterparties, pricing services,
brokers or market makers. The unrealized appreciation (depreciation) related to
the change in the valuation of the notional amount of the swap is combined with
the amount due to the Fund at termination or settlement. The primary risks
associated with total return swaps are credit risks (if the counterparty fails
to meet its obligations) and market risk (if there is no liquid market for the
agreement or unfavorable changes occur to the underlying reference
instrument).
o INTEREST RATE SWAPS
Interest rate swaps are financial instruments that involve the exchange of one
type of interest rate for another type of interest rate cash flow on specified
dates in the future. Some of the different types of interest rate swaps are
"fixed-for
S-26
floating rate swaps," "termed basis swaps" and "index amortizing swaps."
Fixed-for floating rate swaps involve the exchange of fixed interest rate cash
flows for floating rate cash flows. Termed basis swaps entail cash flows to
both parties based on floating interest rates, where the interest rate indices
are different. Index amortizing swaps are typically fixed-for floating swaps
where the notional amount changes if certain conditions are met.
Like a traditional investment in a debt security, the Fund could lose money by
investing in an interest rate swap if interest rates change adversely. For
example, if the Fund enters into a swap where it agrees to exchange a floating
rate of interest for a fixed rate of interest, the Fund may have to pay more
money than it receives. Similarly, if the Fund enters into a swap where it
agrees to exchange a fixed rate of interest for a floating rate of interest,
the Fund may receive less money than it has agreed to pay.
o CURRENCY SWAPS
A currency swap is an agreement between two parties in which one party agrees to
make interest rate payments in one currency and the other promises to make
interest rate payments in another currency. The Fund may enter into a currency
swap when it has one currency and desires a different currency. Typically, the
interest rates that determine the currency swap payments are fixed, although
occasionally one or both parties may pay a floating rate of interest. Unlike an
interest rate swap, however, the principal amounts are exchanged at the
beginning of the contract and returned at the end of the contract. Changes in
foreign exchange rates and changes in interest rates, as described above may
negatively affect currency swaps.
o INFLATION SWAPS
Inflation swaps are fixed-maturity, over-the-counter derivatives where one
party pays a fixed rate in exchange for payments tied to an inflation index,
such as the Consumer Price Index ("CPI"). The fixed rate, which is set by the
parties at the initiation of the swap, is often referred to as the "breakeven
inflation" rate and generally represents the current difference between
treasury yields and TIPS yields of similar maturities at the initiation of the
swap agreement. Inflation swaps are typically designated as "zero coupon,"
where all cash flows are exchanged at maturity. The value of an inflation swap
is expected to fluctuate in response to changes in the relationship between
nominal interest rates and the rate of inflation. An inflation swap can lose
value if the realized rate of inflation over the life of the swap is less than
the fixed market implied inflation rate (the breakeven inflation rate) the
investor agreed to pay at the initiation of the swap.
CAPS, COLLARS AND FLOORS - Caps and floors have an effect similar to buying or
writing options. In a typical cap or floor agreement, one party agrees to make
payments only under specified circumstances, usually in return for payment of a
fee by the other party. For example, the buyer of an interest rate cap obtains
the right to receive payments to the extent that a specified interest rate
exceeds an agreed-upon level. The seller of an interest rate floor is obligated
to make payments to the extent that a specified interest rate falls below an
agreed-upon level. An interest rate collar combines elements of buying a cap
and selling a floor.
RISKS OF DERIVATIVES:
While transactions in derivatives may reduce certain risks, these transactions
themselves entail certain other risks. For example, unanticipated changes in
interest rates, securities prices or currency exchange rates may result in a
poorer overall performance of the Fund than if it had not entered into any
derivatives transactions. Derivatives may magnify the Fund's gains or losses,
causing it to make or lose substantially more than it invested.
When used for hedging purposes, increases in the value of the securities the
Fund holds or intends to acquire should offset any losses incurred with a
derivative. Purchasing derivatives for purposes other than hedging could expose
the Fund to greater risks.
S-27
CORRELATION OF PRICES - The Fund's ability to hedge its securities through
derivatives depends on the degree to which price movements in the underlying
index or instrument correlate with price movements in the relevant securities.
In the case of poor correlation, the price of the securities the Fund is
hedging may not move in the same amount, or even in the same direction as the
hedging instrument. The Adviser will try to minimize this risk by investing
only in those contracts whose behavior it expects to resemble with the
portfolio securities it is trying to hedge. However, if the Fund's prediction
of interest and currency rates, market value, volatility or other economic
factors is incorrect, the Fund may lose money, or may not make as much money as
it expected.
Derivative prices can diverge from the prices of their underlying instruments,
even if the characteristics of the underlying instruments are very similar to
the derivative. Listed below are some of the factors that may cause such a
divergence:
o current and anticipated short-term interest rates, changes in volatility
of the underlying instrument, and the time remaining until expiration of
the contract;
o a difference between the derivatives and securities markets, including
different levels of demand, how the instruments are traded, the imposition
of daily price fluctuation limits or trading of an instrument stops; and
o differences between the derivatives, such as different margin
requirements, different liquidity of such markets and the participation of
speculators in such markets.
Derivatives based upon a narrower index of securities, such as those of a
particular industry group, may present greater risk than derivatives based on a
broad market index. Since narrower indices are made up of a smaller number of
securities, they are more susceptible to rapid and extreme price fluctuations
because of changes in the value of those securities.
While currency futures and options values are expected to correlate with
exchange rates, they may not reflect other factors that affect the value of the
investments of the Fund. A currency hedge, for example, should protect a
yen-denominated security from a decline in the yen, but will not protect the
Fund against a price decline resulting from deterioration in the issuer's
creditworthiness. Because the value of the Fund's foreign-denominated
investments changes in response to many factors other than exchange rates, it
may not be possible to match the amount of currency options and futures to the
value of the Fund's investments precisely over time.
LACK OF LIQUIDITY - Before a futures contract or option is exercised or
expires, the Fund can terminate it only by entering into a closing purchase or
sale transaction. Moreover, the Fund may close out a futures contract only on
the exchange the contract was initially traded. Although the Fund intends to
purchase options and futures only where there appears to be an active market,
there is no guarantee that such a liquid market will exist. If there is no
secondary market for the contract, or the market is illiquid, the Fund may not
be able to close out its position. In an illiquid market, the Fund may:
o have to sell securities to meet its daily margin requirements at a time
when it is disadvantageous to do so;
o have to purchase or sell the instrument underlying the contract;
o not be able to hedge its investments; and/or
o not be able to realize profits or limit its losses.
Derivatives may become illiquid (i.e., difficult to sell at a desired time and
price) under a variety of market conditions.
For example:
S-28
o an exchange may suspend or limit trading in a particular derivative
instrument, an entire category of derivatives or all derivatives, which
sometimes occurs because of increased market volatility;
o unusual or unforeseen circumstances may interrupt normal operations of an
exchange;
o the facilities of the exchange may not be adequate to handle current
trading volume;
o equipment failures, government intervention, insolvency of a brokerage
firm or clearing house or other occurrences may disrupt normal trading
activity; or
o investors may lose interest in a particular derivative or category of
derivatives.
MANAGEMENT RISK - If the Adviser incorrectly predicts stock market and interest
rate trends, the Fund may lose money by investing in derivatives. For example,
if the Fund were to write a call option based on the Adviser's expectation that
the price of the underlying security would fall, but the price were to rise
instead, the Fund could be required to sell the security upon exercise at a
price below the current market price. Similarly, if the Fund were to write a
put option based on the Adviser's expectation that the price of the underlying
security would rise, but the price were to fall instead, the Fund could be
required to purchase the security upon exercise at a price higher than the
current market price.
PRICING RISK - At times, market conditions might make it hard to value some
investments. For example, if the Fund has valued its securities too high, you
may end up paying too much for Fund shares when you buy into the Fund. If the
Fund underestimates its price, you may not receive the full market value for
your Fund shares when you sell.
MARGIN - Because of the low margin deposits required upon the opening of a
derivative position, such transactions involve an extremely high degree of
leverage. Consequently, a relatively small price movement in a derivative may
result in an immediate and substantial loss (as well as gain) to the Fund and
it may lose more than it originally invested in the derivative.
If the price of a futures contract changes adversely, the Fund may have to sell
securities at a time when it is disadvantageous to do so to meet its minimum
daily margin requirement. The Fund may lose its margin deposits if a
broker-dealer with whom it has an open futures contract or related option
becomes insolvent or declares bankruptcy.
VOLATILITY AND LEVERAGE - The prices of derivatives are volatile (i.e., they
may change rapidly, substantially and unpredictably) and are influenced by a
variety of factors, including:
o actual and anticipated changes in interest rates;
o fiscal and monetary policies; and
o national and international political events.
Most exchanges limit the amount by which the price of a derivative can change
during a single trading day. Daily trading limits establish the maximum amount
that the price of a derivative may vary from the settlement price of that
derivative at the end of trading on the previous day. Once the price of a
derivative reaches this value, the Fund may not trade that derivative at a
price beyond that limit. The daily limit governs only price movements during a
given day and does not limit potential gains or losses. Derivative prices have
occasionally moved to the daily limit for several consecutive trading days,
preventing prompt liquidation of the derivative.
Because many derivatives have a leverage or borrowing component, adverse
changes in the value or level of the underlying asset, reference rate, or index
can result in a loss substantially greater than the amount invested in the
derivative itself. Certain derivatives have the potential for unlimited loss,
regardless of the size of the initial investment.
S-29
Accordingly, certain derivative transactions may be considered to constitute
borrowing transactions for purposes of the 1940 Act. Such a derivative
transaction will not be considered to constitute the issuance of a "senior
security" by the Fund, and therefore such a transaction will not be subject to
the 300% asset coverage requirement otherwise applicable to borrowings by the
Fund, if the Fund covers the transaction or segregates sufficient liquid assets
in accordance with these requirements, and subject to certain risks.
RESTRICTED AND ILLIQUID SECURITIES. The Fund may purchase illiquid securities,
including securities that are not readily marketable and securities that are
not registered ("restricted securities") under the Securities Act of 1933, as
amended (the "1933 Act"), but which can be offered and sold to "qualified
institutional buyers" under Rule 144A under the 1933 Act. Illiquid securities
are securities that cannot be sold or disposed of in the ordinary course of
business within seven business days at approximately the value at which they
are being carried on the Fund's books. Because of their illiquid nature,
illiquid securities must be priced at fair value as determined in good faith
pursuant to procedures approved by the Trust's Board. Despite such good faith
efforts to determine fair value prices, the Fund's illiquid securities are
subject to the risk that the security's fair value price may differ from the
actual price which the Fund may ultimately realize upon their sale or
disposition. Difficulty in selling illiquid securities may result in a loss or
may be costly to the Fund. The Fund will not hold more than 15% of its net
assets in illiquid securities. If the percentage of the Fund's net assets held
in illiquid securities exceeds 15% due to market activity, the Fund will take
steps to bring the aggregate amount of illiquid securities back within the
limitation as soon as reasonably practicable. Illiquid securities may include a
wide variety of investments, such as repurchase agreements maturing in more
than seven days, OTC options contracts and certain other derivatives (including
certain swap agreements), fixed time deposits that are not subject to
prepayment or do not provide for withdrawal penalties upon prepayment (other
than overnight deposits), participation interests in loans, commercial paper
issued pursuant to Section 4(2) of the 1933 Act, and restricted, privately
placed securities that, under the federal securities laws, generally may be
resold only to qualified institutional buyers. If a substantial market develops
for a restricted security (or other illiquid investment) held by the Fund, it
may be treated as a liquid security, in accordance with procedures and
guidelines approved by the Board. Under the supervision of the Trust's Board,
the Adviser determines the liquidity of the Fund's investments. In determining
the liquidity of the Fund's investments, the Adviser may consider various
factors, including (1) the frequency and volume of trades and quotations, (2)
the number of dealers and prospective purchasers in the marketplace, (3) dealer
undertakings to make a market, and (4) the nature of the security and the
market in which it trades (including any demand, put or tender features, the
mechanics and other requirements for transfer, any letters of credit or other
credit enhancement features, any ratings, the number of holders, the method of
soliciting offers, the time required to dispose of the security, and the
ability to assign or offset the rights and obligations of the security).
SHORT SALES. As consistent with the Fund's investment objectives, the Fund may
engage in short sales that are either "uncovered" or "against the box." A short
sale is "against the box" if at all times during which the short position is
open, the Fund owns at least an equal amount of the securities or securities
convertible into, or exchangeable without further consideration for, securities
of the same issue as the securities that are sold short. A short sale against
the box is a taxable transaction to the Fund with respect to the securities
that are sold short.
Uncovered short sales are transactions under which the Fund sells a security it
does not own. To complete such a transaction, the Fund must borrow the security
to make delivery to the buyer. The Fund then is obligated to replace the
security borrowed by purchasing the security at the market price at the time of
the replacement. The price at such time may be more or less than the price at
which the security was sold by the Fund. Until the security is replaced, the
Fund is required to pay the lender amounts equal to any dividends or interest
that accrue during the period of the loan. To borrow the security, the Fund
also may be required to pay a premium, which would increase the cost of the
security sold. The proceeds of the short sale will be retained by the broker,
to the extent necessary to meet margin requirements, until the short position
is closed out.
Until the Fund closes its short position or replaces the borrowed security, the
Fund may: (a) segregate cash or liquid securities at such a level that the
amount segregated plus the amount deposited with the broker as collateral
S-30
will equal the current value of the security sold short or (b) otherwise cover
the Fund's short position.
INVESTMENT LIMITATIONS
FUNDAMENTAL POLICIES
In addition to the Fund's investment objective, the following investment
limitations are fundamental, which means that the Fund cannot change them
without approval by the vote of a majority of the outstanding shares of the
Fund. The phrase "majority of the outstanding shares" means the vote of (i) 67%
or more of the Fund's shares present at a meeting, if more than 50% of the
outstanding shares of the Fund are present or represented by proxy, or (ii)
more than 50% of the Fund's outstanding shares, whichever is less.
The Fund may not:
1. Purchase securities of an issuer that would cause the Fund to fail to
satisfy the diversification requirement for a diversified management
company under the 1940 Act, the rules or regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended
or interpreted from time to time.
2. Concentrate investments in a particular industry or group of industries,
as concentration is defined under the 1940 Act, the rules and regulations
thereunder or any exemption therefrom, as such statute, rules or
regulations may be amended or interpreted from time to time.
3. Borrow money or issue senior securities (as defined under the 1940 Act),
except to the extent permitted under the 1940 Act, the rules and
regulations thereunder or any exemption therefrom, as such statute, rules
or regulations may be amended or interpreted from time to time.
4. Make loans, except to the extent permitted under the 1940 Act, the rules
and regulations thereunder or any exemption therefrom, as such statute,
rules or regulations may be amended or interpreted from time to time.
5. Purchase or sell commodities or real estate, except to the extent
permitted under the 1940 Act, the rules and regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended
or interpreted from time to time.
6. Underwrite securities issued by other persons, except to the extent
permitted under the 1940 Act, the rules and regulations thereunder or any
exemption therefrom, as such statute, rules or regulations may be amended
or interpreted from time to time.
NON-FUNDAMENTAL POLICIES
The following limitations are non-fundamental and may be changed by the Trust's
Board without shareholder approval.
These non-fundamental policies are based upon the regulations currently set
forth in the 1940 Act.
1. Purchase an investment if, as a result, more than 15% of the value of the
Fund's net assets would be invested in illiquid securities.
2. The Fund may not pledge, mortgage or hypothecate any assets owned by the
Fund in excess of 33 1/3% of the Fund's total assets at the time of such
pledging, mortgaging or hypothecating.
3. The Fund may not borrow money in an amount exceeding 33 1/3% of the value
of its total assets, provided that investment strategies which either
obligate the Fund to purchase securities or require the Fund to cover a
S-31
position by segregating assets or entering into an offsetting position
shall not be subject to this limitation. To the extent that its borrowings
exceed 5% of its assets, the Fund will not make any further investments.
4. The Fund may not make loans if, as a result, more than 33 1/3% of its
total assets would be lent to other parties, except that the Fund may: (i)
purchase or hold debt instruments in accordance with its investment
objective and policies; (ii) enter into repurchase agreements; and (iii)
engage in securities lending as described in its SAI.
5. The Fund will not purchase or sell real estate, except that the Fund may
purchase: marketable securities issued by companies which own or invest in
real estate (including REITs).
6. The Fund will not purchase or sell physical commodities or commodities
contracts based on physical commodities, except that the Fund may purchase
marketable securities issued by companies which own or invest in physical
commodities or commodities contracts based on physical commodities.
7. Under normal circumstances, the Fund invests at least 80% of its net
assets, plus any borrowings for investment purposes, in equity securities
of companies organized or located throughout the world, including the
United States. This non-fundamental policy may be changed by the Board upon
at least 60 days' written notice to Fund shareholders.
Except with respect to Fund policies concerning borrowing and illiquid
securities, if a percentage restriction is adhered to at the time of an
investment, a later increase or decrease in percentage resulting from changes
in values or assets will not constitute a violation of such restriction. With
respect to the limitation on illiquid securities, in the event that a
subsequent change in net assets or other circumstances causes the Fund to
exceed its limitation, the Fund will take steps to bring the aggregate amount
of illiquid instruments back within the limitations as soon as reasonably
practicable. With respect to the limitation on borrowing, in the event that a
subsequent change in net assets or other circumstances cause the Fund to exceed
its limitation, the Fund will take steps to bring the aggregate amount of
borrowing back within the limitations within three days thereafter (not
including Sundays and holidays).
The following descriptions of certain provisions of the 1940 Act may assist
investors in understanding the above policies and restrictions:
DIVERSIFICATION. Under the 1940 Act, a diversified investment management
company, as to 75% of its total assets, may not purchase securities of any
issuer (other than securities issued or guaranteed by the U.S. Government, its
agents or instrumentalities or securities of other investment companies) if, as
a result, more than 5% of its total assets would be invested in the securities
of such issuer, or more than 10% of the issuer's outstanding voting securities
would be held by the fund.
CONCENTRATION. The SEC has defined concentration as investing 25% or more of an
investment company's net assets in an industry or group of industries, with
certain exceptions.
BORROWING. The 1940 Act presently allows a fund to borrow from any bank in an
amount up to 33 1/3% of its total assets (including the amount borrowed) and to
borrow for temporary purposes in an amount not exceeding 5% of the value of its
total assets.
SENIOR SECURITIES. Senior securities may include any obligation or instrument
issued by a fund evidencing indebtedness. The 1940 Act generally prohibits
funds from issuing senior securities, although it does not treat certain
transactions as senior securities, such as certain borrowings, short sales,
reverse repurchase agreements, firm commitment agreements and standby
commitments, with appropriate earmarking or segregation of assets to cover such
obligation.
S-32
LENDING. Under the 1940 Act, an investment company may only make loans if
expressly permitted by its investment policies.
REAL ESTATE AND COMMODITIES. The 1940 Act does not directly restrict an
investment company's ability to invest in real estate or commodities, but does
require that every investment company have a fundamental investment policy
governing such investments.
UNDERWRITING. Under the 1940 Act, underwriting securities involves a fund
purchasing securities directly from an issuer for the purpose of selling
(distributing) them or participating in any such activity either directly or
indirectly. Under the 1940 Act, a diversified fund may not make any commitment
as underwriter, if immediately thereafter the amount of its outstanding
underwriting commitments, plus the value of its investments in securities of
issuers (other than investment companies) of which it owns more than 10% of the
outstanding voting securities, exceeds 25% of the value of its total assets.
THE ADVISER
GENERAL. R-Squared Capital Management L.P. (the "Adviser"), located at 299 Park
Avenue, 6th Floor, New York, NY 10171 is a professional investment management
firm registered with the SEC under the Investment Advisers Act of 1940. The
Adviser is a Delaware limited partnership founded in 2013 that is 100% employee
owned. As of [ ], 2013, the Adviser had approximately $[ ] in assets under
management.
ADVISORY AGREEMENT WITH THE TRUST. The Trust and the Adviser have entered into
an investment advisory agreement dated [ ] (the "Advisory Agreement"). Under
the Advisory Agreement, the Adviser serves as the investment adviser and makes
investment decisions for the Fund and continuously reviews, supervises and
administers the investment program of the Fund, subject to the supervision of,
and policies established by, the Trustees of the Trust.
After the initial two-year term, the continuance of the Advisory Agreement must
be specifically approved at least annually: (i) by the vote of the Trustees or
by a vote of the shareholders of the Fund; and (ii) by the vote of a majority
of the Trustees who are not parties to the Advisory Agreement or "interested
persons" of any party thereto, cast in person at a meeting called for the
purpose of voting on such approval. The Advisory Agreement will terminate
automatically in the event of its assignment, and is terminable at any time
without penalty by the Trustees of the Trust or, with respect to the Fund, by a
majority of the outstanding shares of the Fund, on not less than 30 days' nor
more than 60 days' written notice to the Adviser, or by the Adviser on 90 days'
written notice to the Trust. As used in the Advisory Agreement, the terms
"majority of the outstanding voting securities," "interested persons" and
"assignment" have the same meaning as such terms in the 1940 Act.
ADVISORY FEES PAID TO THE ADVISER. For its services to the Fund, the Adviser is
entitled to a fee, which is calculated daily and paid monthly, at an annual
rate of 0.80% of the average daily net assets of the Fund. The Adviser has
contractually agreed to reduce fees and/or reimburse expenses to the extent
necessary to keep total annual Fund operating expenses (excluding interest,
taxes, brokerage commissions, acquired fund fees and expenses, and
extraordinary expenses (collectively, "excluded expenses")) from exceeding
1.10% and 1.35% of the Fund's Institutional Class and Investor Class Shares'
average daily net assets, respectively, until February 28, 2015. In addition,
if at any point total annual Fund operating expenses (not including excluded
expenses) are below the expense cap, the Adviser may receive from the Fund the
difference between total annual Fund operating expenses (not including excluded
expenses) and the expense cap to recover all or a portion of its prior fee
reductions or expense reimbursements made during the preceding three-year
period during which this agreement was in place. This agreement may be
terminated: (i) by the Board of Trustees of the Trust, for any reason at any
time, or (ii) by the Adviser, upon ninety (90) days' prior written notice to
the Trust, effective as of the close of business on February 28, 2015.
S-33
THE PORTFOLIO MANAGERS
This section includes information about the Fund's portfolio managers,
including information about other accounts they manage, the dollar range of
Fund shares they own and how they are compensated.
COMPENSATION. The portfolio managers are majority owners of the Adviser. The
portfolio managers' compensation is based on their share, as owners, of the
Adviser's net income from all sources, including management fees that the
Adviser receives from the Fund. In addition, Mr. Testorf receives an annual
salary and each portfolio manager receives an annual bonus based on the
profitability of the Adviser, which vests over a three year period.
FUND SHARES OWNED BY PORTFOLIO MANAGERS. The Fund is required to show the
dollar amount range of each portfolio manager's "beneficial ownership" of
shares of the Fund as of the end of the most recently completed fiscal year.
Dollar amount ranges disclosed are established by the SEC. "Beneficial
ownership" is determined in accordance with Rule 16a-1(a)(2) under the
Securities Exchange Act of 1934, as amended (the "1934 Act"). Because the Fund
is new, as of the date of this SAI, the portfolio managers did not beneficially
own shares of the Fund.
OTHER ACCOUNTS. In addition to the Fund, the portfolio managers are responsible
for the day-to-day management of certain other accounts, as listed below. [None
of the accounts listed below are subject to a performance-based advisory fee.]
The information below is provided as of [ ], 2013.
--------------------------------------------------------------------------------------------
REGISTERED INVESTMENT OTHER POOLED INVESTMENT
COMPANIES VEHICLES OTHER ACCOUNTS
--------------------------------------------------------------------------------------------
NUMBER OF TOTAL ASSETS NUMBER OF TOTAL ASSETS NUMBER OF TOTAL ASSETS
NAME ACCOUNTS (IN MILLIONS) ACCOUNTS (IN MILLIONS) ACCOUNTS (IN MILLIONS)
--------------------------------------------------------------------------------------------
Rudolph-Riad
Younes [ ] $[ ] [ ] $[ ] [ ] $[ ]
--------------------------------------------------------------------------------------------
Richard Pell [ ] $[ ] [ ] $[ ] [ ] $[ ]
--------------------------------------------------------------------------------------------
Michael Testorf [ ] $[ ] [ ] $[ ] [ ] $[ ]
--------------------------------------------------------------------------------------------
|
CONFLICTS OF INTEREST. The portfolio managers' management of "other accounts"
may give rise to potential conflicts of interest in connection with their
management of the Fund's investments, on the one hand, and the investments of
the other accounts, on the other. The other accounts may have the same
investment objective as the Fund. Therefore, a potential conflict of interest
may arise as a result of the identical investment objectives, whereby the
portfolio managers could favor one account over another. Another potential
conflict could include the portfolio managers' knowledge about the size, timing
and possible market impact of the Fund's trades, whereby a portfolio manager
could use this information to the advantage of other accounts and to the
disadvantage of the Fund. However, the Adviser has established policies and
procedures to ensure that the purchase and sale of securities among all
accounts it manages are fairly and equitably allocated.
THE ADMINISTRATOR
GENERAL. SEI Investments Global Funds Services (the "Administrator"), a
Delaware statutory trust, has its principal business offices at One Freedom
Valley Drive, Oaks, Pennsylvania 19456. SEI Investments Management Corporation
("SIMC"), a wholly-owned subsidiary of SEI Investments Company ("SEI
Investments"), is the owner of all beneficial interest in the Administrator.
SEI Investments and its subsidiaries and affiliates, including the
Administrator, are leading providers of funds evaluation services, trust
accounting systems, and brokerage and information services to financial
institutions, institutional investors, and money managers. The Administrator
and its affiliates also serve as administrator or sub-administrator to other
mutual funds.
ADMINISTRATION AGREEMENT WITH THE TRUST. The Trust and the Administrator have
entered into an administration
S-34
agreement dated January 28, 1993, as amended and restated November 12, 2002
(the "Administration Agreement"). Under the Administration Agreement, the
Administrator provides the Trust with administrative services, including
regulatory reporting and all necessary office space, equipment, personnel and
facilities. Pursuant to a schedule to the Administration Agreement, the
Administrator also serves as the shareholder servicing agent for the Fund
whereby the Administrator provides certain shareholder services to the Fund.
The Administration Agreement provides that the Administrator shall not be
liable for any error of judgment or mistake of law or for any loss suffered by
the Trust in connection with the matters to which the Administration Agreement
relates, except a loss resulting from willful misfeasance, bad faith or gross
negligence on the part of the Administrator in the performance of its duties or
from reckless disregard by it of its duties and obligations thereunder.
ADMINISTRATION FEES PAID TO THE ADMINISTRATOR. For its services under the
Administration Agreement, the Administrator is entitled to a fee, which is
calculated daily and paid monthly, at an annual rate that is detailed below in
the following schedule:
--------------------------------------------------------------------------------
FEE (AS A PERCENTAGE OF AGGREGATE FUND'S AVERAGE
AVERAGE ANNUAL ASSETS) DAILY NET ASSETS
--------------------------------------------------------------------------------
[X.XX]% First $[XX] million
--------------------------------------------------------------------------------
[X.XX]% $[XX] million to $[XX] million
--------------------------------------------------------------------------------
[X.XX]% Over $[XX] million
--------------------------------------------------------------------------------
|
THE DISTRIBUTOR
GENERAL. The Trust and SEI Investments Distribution Co. (the "Distributor"), a
wholly-owned subsidiary of SEI Investments, and an affiliate of the
Administrator, are parties to a distribution agreement dated January 28, 1993,
as amended and restated as of November 14, 2005 ("Distribution Agreement"). The
principal business address of the Distributor is One Freedom Valley Drive,
Oaks, Pennsylvania 19456.
The continuance of the Distribution Agreement must be specifically approved at
least annually (i) by the vote of the Trustees or by a vote of the shareholders
of the Fund and (ii) by the vote of a majority of the Trustees who are not
"interested persons" of the Trust and have no direct or indirect financial
interest in the operations of the Distribution Agreement or any related
agreement, cast in person at a meeting called for the purpose of voting on such
approval. The Distribution Agreement will terminate automatically in the event
of its assignment (as such term is defined in the 1940 Act), and is terminable
at any time without penalty by the Board or, with respect to the Fund, by a
majority of the outstanding shares of the Fund, upon not more than 60 days'
written notice by either party. The Distribution Agreement provides that the
Distributor shall not be protected against any liability to the Trust or its
shareholders by reason of willful misfeasance, bad faith or gross negligence on
its part in the performance of its duties or from reckless disregard of its
obligations or duties thereunder.
DISTRIBUTION PLAN. The Trust has adopted a Distribution Plan (the "Plan") in
accordance with the provisions of Rule 12b-1 under the 1940 Act, which
regulates circumstances under which an investment company may directly or
indirectly bear expenses relating to the distribution of its shares.
Continuance of the Plan must be approved annually by a majority of the Trustees
of the Trust and by a majority of the Trustees who are not interested persons
(as defined in the 1940 Act) of the Trust and have no direct or indirect
financial interest in the Plan or in any agreements related to the Plan
("Qualified Trustees"). The Plan requires that quarterly written reports of
amounts spent under the Plan and the purposes of such expenditures be furnished
to and reviewed by the Trustees. The Plan may not be amended to increase
materially the amount that may be spent thereunder without approval by a
majority of the outstanding shares of the Trust. All material amendments of the
Plan will require approval by a majority of the Trustees of the Trust and of
the Qualified Trustees.
S-35
o INVESTOR CLASS SHARES. Under the Plan, the Distributor, or third parties
that enter into agreements with the Distributor ("Service Providers"), may
receive up to 0.25% of the assets of the Fund attributable to Investor
Class Shares as compensation for distribution and shareholder services
pursuant to Rule 12b-1 of the 1940 Act. The Plan is characterized as a
compensation plan since the distribution fee will be paid to the
Distributor without regard to the distribution or shareholder service
expenses incurred by the Distributor or the amount of payments made to
other financial institutions and intermediaries. Investors should
understand that some Service Providers may charge their clients fees in
connection with purchases of shares or the provision of shareholder
services with respect to shares. The Trust intends to operate the Plan in
accordance with its terms and with the Financial Industry Regulatory
Authority ("FINRA") rules concerning sales charges.
o DESCRIPTION OF DISTRIBUTION SERVICES. Distribution services may include:
(i) services in connection with distribution assistance; or (ii) payments
to financial institutions and other financial intermediaries, such as
banks, savings and loan associations, insurance companies, investment
counselors, broker-dealers, mutual fund "supermarkets" and the
Distributor's affiliates and subsidiaries, as compensation for services,
reimbursement of expenses incurred in connection with distribution
assistance or provision of shareholder services. The Distributor may, at
its discretion, retain a portion of such payments to compensate itself for
distribution services and distribution related expenses such as the costs
of preparation, printing, mailing or otherwise disseminating sales
literature, advertising, and prospectuses (other than those furnished to
current shareholders of the Fund), promotional and incentive programs, and
such other marketing expenses that the Distributor may incur.
PAYMENTS TO FINANCIAL INTERMEDIARIES
The Adviser and/or its affiliates, at their discretion, may make payments from
their own resources and not from Fund assets to affiliated or unaffiliated
brokers, dealers, banks (including bank trust departments), trust companies,
registered investment advisers, financial planners, retirement plan
administrators, insurance companies, and any other institution having a
service, administration, or any similar arrangement with the Fund, their
service providers or their respective affiliates, as incentives to help market
and promote the Fund and/or in recognition of their distribution, marketing,
administrative services, and/or processing support.
These additional payments may be made to financial intermediaries that sell
Fund shares or provide services to the Fund, the Distributor or shareholders of
the Fund through the financial intermediary's retail distribution channel
and/or fund supermarkets. Payments may also be made through the financial
intermediary's retirement, qualified tuition, fee-based advisory, wrap fee bank
trust, or insurance (e.g., individual or group annuity) programs. These
payments may include, but are not limited to, placing the Fund in a financial
intermediary's retail distribution channel or on a preferred or recommended
fund list; providing business or shareholder financial planning assistance;
educating financial intermediary personnel about the Fund; providing access to
sales and management representatives of the financial intermediary; promoting
sales of Fund shares; providing marketing and educational support; maintaining
share balances and/or for sub-accounting, administrative or shareholder
transaction processing services. A financial intermediary may perform the
services itself or may arrange with a third party to perform the services.
The Adviser and/or its affiliates may also make payments from their own
resources to financial intermediaries for costs associated with the purchase of
products or services used in connection with sales and marketing, participation
in and/or presentation at conferences or seminars, sales or training programs,
client and investor entertainment and other sponsored events. The costs and
expenses associated with these efforts may include travel, lodging, sponsorship
at educational seminars and conferences, entertainment and meals to the extent
permitted by law.
Revenue sharing payments may be negotiated based on a variety of factors,
including the level of sales, the amount of Fund assets attributable to
investments in the Fund by financial intermediaries customers, a flat fee or
other measures as determined from time to time by the Adviser and/or its
affiliates. A significant purpose of these payments is to increase
S-36
the sales of Fund shares, which in turn may benefit the Adviser through
increased fees as Fund assets grow.
THE TRANSFER AGENT
DST Systems, Inc., 333 West 11(th) Street, Kansas City, Missouri 64105 (the
"Transfer Agent"), serves as the Fund's transfer agent.
THE CUSTODIAN
[___] (the "Custodian"), acts as custodian of the Fund. The Custodian holds
cash, securities and other assets of the Fund as required by the 1940 Act.
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
[___], serves as independent registered public accounting firm for the Fund.
LEGAL COUNSEL
Morgan, Lewis & Bockius LLP, 1701 Market Street, Philadelphia, PA 19103-2921,
serves as legal counsel to the Trust.
DETERMINATION OF NET ASSET VALUE
GENERAL POLICY. The Fund adheres to Section 2(a)(41), and Rule 2a-4 thereunder,
of the 1940 Act with respect to the valuation of portfolio securities. In
general, securities for which market quotations are readily available are
valued at current market value, and all other securities are valued at fair
value as determined in good faith by the Board. In complying with the 1940 Act,
the Trust relies on guidance provided by the SEC and by the SEC staff in
various interpretive letters and other guidance.
EQUITY SECURITIES. Securities listed on a securities exchange, market or
automated quotation system for which quotations are readily available (except
for securities traded on NASDAQ), including securities traded over the counter,
are valued at the last quoted sale price on the primary exchange or market
(foreign or domestic) on which they are traded on valuation date (or at
approximately 4:00 p.m., Eastern Time, if a security's primary exchange is
normally open at that time), or, if there is no such reported sale on the
valuation date, at the most recent quoted bid price. For securities traded on
NASDAQ, the NASDAQ Official Closing Price will be used. If such prices are not
available or determined to not represent the fair value of the security as of
the Fund's pricing time, the security will be valued at fair value as
determined in good faith using methods approved by the Board.
MONEY MARKET SECURITIES AND OTHER DEBT SECURITIES. If available, money market
securities and other debt securities are priced based upon valuations provided
by recognized independent, third-party pricing agents. Such values generally
reflect the last reported sales price if the security is actively traded. The
third-party pricing agents may also value debt securities by employing
methodologies that utilize actual market transactions, broker-supplied
valuations, or other methodologies designed to identify the market value for
such securities. Such methodologies generally consider such factors as security
prices, yields, maturities, call features, ratings and developments relating to
specific securities in arriving at valuations. Money market securities and
other debt securities with remaining maturities of sixty days or less may be
valued at their amortized cost, which approximates market value. If such prices
are not available or determined to not represent the fair value of the security
as of the Fund's pricing time, the security will be valued at fair value as
determined in good faith using methods approved by the Board.
S-47
DERIVATIVES AND OTHER COMPLEX SECURITIES. Exchange traded options on securities
and indices purchased by the Fund generally are valued at their last trade
price or, if there is no last trade price, the last bid price. Exchange traded
options on securities and indices written by the Fund generally are valued at
their last trade price or, if there is no last trade price, the last asked
price. In the case of options traded in the over-the-counter ("OTC") market, if
the OTC option is also an exchange traded option, the Fund will follow the
rules regarding the valuation of exchange traded options. If the OTC option is
not also an exchange traded option, the Fund will value the option at fair
value in accordance with procedures adopted by the Board. Futures contracts and
options on futures contracts are valued at the last trade price prior to the
end of the Fund's pricing cycle.
Illiquid securities, securities for which reliable quotations or pricing
services are not readily available, and all other assets will be valued either
at the average of the last bid price of the securities obtained from two or
more dealers or otherwise at their respective fair value as determined in good
faith by, or under procedures established by the Board. The Board has adopted
fair valuation procedures for the Fund and has delegated responsibility for
fair value determinations to the Fair Valuation Committee. The members of the
Fair Valuation Committee report, as necessary, to the Board regarding portfolio
valuation determination. The Board, from time to time, will review these
methods of valuation and will recommend changes which may be necessary to
assure that the investments of the Fund are valued at fair value.
USE OF THIRD-PARTY INDEPENDENT PRICING AGENTS. Pursuant to contracts with the
Trust's Administrator, market prices for most securities held by the Fund are
provided daily by third-party independent pricing agents that are approved by
the Board. The valuations provided by third-party independent pricing agents
are reviewed daily by the Administrator.
TAXES
The following is only a summary of certain additional federal income tax
considerations generally affecting the Fund and its shareholders that is
intended to supplement the discussion contained in the Fund's prospectus. No
attempt is made to present a detailed explanation of the tax treatment of the
Fund or its shareholders, and the discussion here and in the Fund's prospectus
is not intended as a substitute for careful tax planning. Shareholders are
urged to consult their tax advisors with specific reference to their own tax
situations, including their state and local tax liabilities.
This general discussion of certain federal income tax consequences is based on
the Code and the regulations issued thereunder as in effect on the date of this
SAI. New legislation, as well as administrative changes or court decisions, may
significantly change the conclusions expressed herein, and may have a
retroactive effect with respect to the transactions contemplated herein.
QUALIFICATIONS AS A REGULATED INVESTMENT COMPANY ("RIC"). The Fund intends to
qualify and elect to be treated as a RIC under Subchapter M of the Code. By
following such a policy, the Fund expects to eliminate or reduce to a nominal
amount the federal taxes to which they may be subject. The Board reserves the
right not to maintain the qualification of the Fund as a RIC if it determines
such course of action to be beneficial to shareholders.
In order to be taxable as a RIC, the Fund must distribute at least 90% of its
net investment income (which includes dividends taxable interest, and the
excess of net short-term capital gains over net long-term capital losses, less
operating expenses) and at least 90% of its net tax exempt interest income, for
each tax year, if any, to its shareholders and also must meet several
additional requirements. Among these requirements are the following: (i) at
least 90% of the Fund's gross income each taxable year must be derived from
dividends, interest, payments with respect to certain securities loans, and
gains from the sale or other disposition of stock, securities, or foreign
currencies, or certain other income (including, but not limited to, gains from
options, futures or forward contracts) derived with respect to its business of
investing in such stocks, securities, or currencies, and net income derived
from an interest in a qualified publicly traded partnership (the "Qualifying
Income Test"); (ii) at the close of each quarter of the Fund's taxable year, at
least 50% of the value of the Fund's total assets must be represented by cash
and cash items, U.S. government securities, securities
S-48
of other RICs and other securities, with such other securities limited, in
respect to any one issuer, to an amount that does not exceed 5% of the value of
the Fund's assets and that does not represent more than 10% of the outstanding
voting securities of such issuer; and (iii) at the close of each quarter of the
Fund's taxable year, not more than 25% of the value of the Fund's assets may be
invested in securities (other than U.S. government securities or the securities
of other RICs) of any one issuer or the securities (other than the securities
of another RIC) of two or more issuers that the Fund controls and that are
engaged in the same, similar or related trades or business, or the securities
of one or more qualified publicly traded partnerships (the "Diversification
Test"). Although the Fund intends to distribute substantially all of their net
investment income and may distribute their capital gains for any taxable year,
the Fund will be subject to federal income taxation to the extent any such
income or gains are not distributed.
If the Fund fails to satisfy the qualifying income or diversification
requirements in any taxable year, the Fund may be eligible for relief
provisions if the failures are due to reasonable cause and not willful neglect
and if a penalty tax is paid with respect to each failure to satisfy the
applicable requirements. Additionally, relief is provided for certain de
minimis failures of the diversification requirements where the Fund corrects
the failure within a specified period. If the Fund fails to qualify for any
taxable year as a RIC and these relief provisions are not available, all of its
taxable income will be subject to tax at regular corporate income tax rates
without any deduction for distributions to shareholders, and such distributions
generally will be taxable to shareholders as ordinary dividends to the extent
of the Fund's current and accumulated earnings and profits. In this event,
distributions generally will be eligible for the dividend-received deduction
for corporate shareholders and for the lower capital gains rates on qualified
dividend income for individual shareholders to the extent they would qualify if
the Fund was a regular corporation. In addition, the Fund could be required to
recognize unrealized gains, pay substantial taxes and interest, and make
substantial distributions before requalifying as a RIC.
The Fund may elect to treat part or all of any "qualified late year loss" as if
it had been incurred in the succeeding taxable year in determining the Fund's
taxable income, net capital gain, net short-term capital gain, and earnings and
profits. The effect of this election is to treat any such "qualified late year
loss" as if it had been incurred in the succeeding taxable year in
characterizing Fund distributions for any calendar. A "qualified late year
loss" generally includes a net capital loss, net long-term capital loss, or net
short-term capital loss incurred after October 31 of the current taxable year
(commonly referred to as "post-October losses") and certain other late-year
losses.
If the Fund has a "net capital loss" (that is, capital losses in excess of
capital gains), the excess of the Fund's net short-term capital losses over its
net long-term capital gains is treated as a short-term capital loss arising on
the first day of the Fund's next taxable year, and the excess (if any) of the
Fund's net long-term capital losses over its net short-term capital gains is
treated as a long-term capital loss arising on the first day of the Fund's next
taxable year. In addition, the carryover of capital losses may be limited under
the general loss limitation rules if the Fund experiences an ownership change
as defined in the Code.
FEDERAL EXCISE TAX. If the Fund fails to distribute in a calendar year at least
98% of its ordinary income for the year and 98.2% of its capital gain net
income (the excess of short- and long-term capital gains over short- and
long-term capital losses) for the one-year period ending October 31 of that
year (and any retained amount from the prior calendar year on which the Fund
paid no federal income tax), the Fund will be subject to a nondeductible 4%
Federal excise tax on the undistributed amounts. The Fund intends to make
sufficient distributions to avoid imposition of this tax, or to retain, at most
its net capital gains and pay tax thereon.
DISTRIBUTIONS TO SHAREHOLDERS. The Fund may derive capital gains and losses in
connection with sales or other dispositions of its portfolio of securities.
Distributions of net short-term capital gains will be taxable to you as
ordinary income. Distributions of net long-term capital gains will be taxable
to you as long-term capital gain regardless of how long you have held your
shares. Distributions of dividends will be taxed as ordinary income except that
distributions of qualified dividend income will be taxed at the lower capital
gains rates available for individual shareholders.
S-49
Certain distributions by the Fund may be eligible for the reduced maximum tax
rate to individuals of 20% (lower rates apply to individuals in lower tax
brackets) to the extent that the Fund receives qualified dividend income on the
securities it holds and the Fund designates the distributions as qualified
dividend income. A distribution from the Fund generally qualifies as qualified
dividend income to the extent it is designated as such by the Fund and was
distributed from dividends received by the Fund from taxable domestic
corporations and certain qualified foreign corporations, subject to limitations
including holding period limitations, imposed on the Fund and its shareholders.
Distributions the Fund receives from REITs generally will not be treated as
qualified dividend income. Capital gain distributions consisting of the Fund's
net capital gains will be taxable as long-term capital gains at a maximum rate
of 20%.
The Fund will inform you of the amount of your ordinary income dividends,
qualified dividend income and capital gain distributions, if any, at the time
they are paid and will advise you of its tax status for federal income tax
purposes shortly after the close of each calendar year. REITs in which the Fund
may invest often do not provide complete and final tax information until after
the time that the Fund issues the tax reporting statement. As a result, the
Fund may at times find it necessary to reclassify the amount and character of
its distributions to you after it issues your tax reporting statement. When
such reclassification is necessary, the Fund will send you a corrected, final
Form 1099-DIV to reflect the reclassified information. If you receive a
corrected Form 1099-DIV, use the information on this corrected form, and not
the information on the previously issued tax reporting statement, in completing
your tax returns. If you have not held Fund shares for a full year, the Fund
may designate and distribute to you, as ordinary income, qualified dividend
income or capital gain, a percentage of income that is not equal to the actual
amount of such income earned during the period of your investment in the Fund.
If the Fund's distributions exceed its taxable income and capital gains
realized during a taxable year, all or a portion of the distributions made in
the same taxable year may be recharacterized as a return of capital to
shareholders. A return of capital distribution will generally not be taxable,
but will reduce each shareholder's cost basis in the Fund and result in a
higher reported capital gain or lower reported capital loss when those shares
on which the distribution was received are sold. If the net asset value of
shares were reduced below the shareholder's cost by dividends or distributions
representing gains realized on sales of securities, such dividends or
distributions would be a return of investment though taxable to the shareholder
in the same manner as other dividends or distributions.
A dividend or distribution received shortly after the purchase of shares
reduces the net asset value of the shares by the amount of the dividend or
distribution and, although in effect a return of capital, will be taxable to
the shareholder.
Dividends declared to shareholders of record in October, November or December
and actually paid in January of the following year will be treated as having
been received by shareholders on December 31 of the calendar year in which
declared. Under this rule, therefore, a shareholder may be taxed in one year on
dividends or distributions actually received in January of the following year.
In the case of corporate shareholders, Fund distributions (other than capital
gains distributions) generally qualify for the dividend-received deduction to
the extent such distributions are so designated and do not exceed the gross
amount of qualifying dividends received by the Fund for the year. Generally,
and subject to certain limitations (including certain holding period
limitations), a dividend will be treated as a qualifying dividend if it has
been received from a domestic corporation. All such qualifying dividends
(including the deducted portion) must be included in your alternative minimum
taxable income calculation.
SALES OR REDEMPTIONS. Any gain or loss recognized on a sale or redemption of
shares of the Fund by a shareholder who is not a dealer in securities will
generally, for individual shareholders, be treated as a long-term capital gain
or loss if the shares have been held for more than twelve months and otherwise
will be treated as a short-term capital gain or loss. However, if shares on
which a shareholder has received a net capital gain distribution are
subsequently sold or redeemed and such shares have been held for six months or
less, any loss recognized will be treated as a long-term
S-50
capital loss to the extent of the net capital gain distribution. In addition,
the loss realized on a sale or other disposition of shares will be disallowed
to the extent a shareholder repurchases (or enters into a contract to or option
to repurchase) shares within a period of 61 days (beginning 30 days before and
ending 30 days after the disposition of the shares). This loss disallowance
rule will apply to shares received through the reinvestment of dividends during
the 61-day period.
In certain cases, the Fund will be required to withhold at a rate of 28% and
remit to the U.S. Treasury, back up withholding on any distributions paid to a
shareholder who (1) has failed to provide a correct taxpayer identification
number, (2) is subject to backup withholding by the Internal Revenue Service
("IRS"), (3) has not certified to the Fund that such shareholder is not subject
to backup withholding, or (4) has failed to certify that he or she is a U.S.
citizen or U.S. resident alien.
The Fund (or its administrative agent) must report to the IRS and furnish to
Fund shareholders the cost basis information for Fund shares. In addition, the
Fund is also required to report whether these shares had a short-term or
long-term holding period. For each sale of Fund shares the Fund will permit
Fund shareholders to elect from among several IRS-accepted cost basis methods,
including average basis. In the absence of an election, the Fund will use the
average basis method as its default cost basis method. The cost basis method
elected by the Fund shareholder (or the cost basis method applied by default)
for each sale of Fund shares may not be changed after the settlement date of
each such sale of Fund shares. Fund shareholders should consult with their tax
advisors to determine the best IRS-accepted cost basis method for their tax
situation and to obtain more information about how cost basis reporting applies
to them.
Beginning January 1, 2013, U.S. individuals with income exceeding $200,000
($250,000 if married and filing jointly) are subject to a 3.8% Medicare
contribution tax on their "net investment income," including interest,
dividends, and capital gains (including capital gains realized on the sale or
exchange of Fund shares).
The Fund may invest in complex securities. These investments may be subject to
numerous special and complex tax rules. These rules could affect whether gains
and losses recognized by the Fund are treated as ordinary income or capital
gain, accelerate the recognition of income to the Fund and/or defer the Fund's
ability to recognize losses. In turn, those rules may affect the amount, timing
or character of the income distributed to you by the Fund.
With respect to investments in STRIPS, TRs, and other zero coupon securities
which are sold at original issue discount and thus do not make periodic cash
interest payments, the Fund will be required to include as part of its current
income the imputed interest on such obligations even though the Fund has not
received any interest payments on such obligations during that period. Because
the Fund distributes all of its net investment income to its shareholders, the
Fund may have to sell Fund securities to distribute such imputed income which
may occur at a time when the Adviser would not have chosen to sell such
securities and which may result in taxable gain or loss.
The Fund may invest in certain MLPs which may be treated as qualified publicly
traded partnerships. Income from qualified publicly traded partnerships is
qualifying income for purposes of the Qualifying Income Test, but the Fund's
investment in one or more of such qualified publicly traded partnerships is
limited under the Diversification Test to no more than 25% of the value of the
Fund's assets. The Fund will monitor its investment in such qualified publicly
traded partnerships in order to ensure compliance with the Qualifying Income
Test.
The Fund may invest in entities taxable as REITs under the Code. Investments in
REIT equity securities may require the Fund to accrue and distribute income not
yet received. To generate sufficient cash to make the requisite distributions,
the Fund may be required to sell securities in its portfolio (including when it
is not advantageous to do so) that it otherwise would have continued to hold.
The Fund's investments in REIT equity securities may at other times result in
the Fund's receipt of cash in excess of the REIT's earnings if the Fund
distributes these amounts, these distributions could constitute a return of
capital to Fund shareholders for federal income tax purposes. Dividends paid by
a REIT, other than capital gain distributions, will be taxable as ordinary
income up to the amount of the REIT's
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current and accumulated earnings and profits. Capital gain dividends paid by a
REIT to the Fund will be treated as long-term capital gains by the Fund and, in
turn, may be distributed by the Fund to its shareholders as a capital gain
distribution. Dividends received by the Fund from a REIT generally will not
constitute qualified dividend income and will not qualify for the dividends
received deduction. If a REIT is operated in a manner such that it fails to
qualify as a REIT, an investment in the REIT would become subject to double
taxation, meaning the taxable income of the REIT would be subject to federal
income tax at regular corporate rates without any deduction for dividends paid
to shareholders and the dividends would be taxable to shareholders as ordinary
income (or possibly as qualified dividend income) to the extent of the REIT's
current and accumulated earnings and profits.
Certain tax-exempt shareholders, including qualified pension plans, individual
retirement accounts, salary deferral arrangements, 401(k)s, and other
tax-exempt entities, generally are exempt from federal income taxation except
with respect to their unrelated business taxable income ("UBTI"). Under current
law, the Fund generally serves to block UBTI from being realized by its
tax-exempt shareholders. However, notwithstanding the foregoing, the tax-exempt
shareholder could realize UBTI by virtue of an investment in the Fund where,
for example: (i) the Fund invests in residual interests of Real Estate Mortgage
Investment Conduits (REMICs); (ii) the Fund invests in a REIT that is a taxable
mortgage pool (TMP) or that has a subsidiary that is a TMP or that invests in
the residual interest of a REMIC; or (iii) shares in the Fund constitute
debt-financed property in the hands of the tax-exempt shareholder within the
meaning of section 514(b) of the Code. Charitable remainder trusts are subject
to special rules and should consult their tax advisor. The IRS has issued
guidance with respect to these issues and prospective shareholders, especially
charitable remainder trusts, are encouraged to consult with their tax advisors
regarding these issues.
Transactions by the Fund in foreign currencies and forward foreign currency
contracts will be subject to special provisions of the Code that, among other
things, may affect the character of gains and losses realized by the Fund
(i.e., may affect whether gains or losses are ordinary or capital), accelerate
recognition of income to the Fund and defer losses. These rules could therefore
affect the character, amount and timing of distributions to shareholders. These
provisions also may require the Fund to mark-to-market certain types of
positions in its portfolio (i.e., treat them as if they were closed out) which
may cause the Fund to recognize income without receiving cash with which to
make distributions in amounts necessary to satisfy the distribution
requirements for avoiding income and excise taxes. The Fund intends to monitor
its transactions, intends to make the appropriate tax elections, and intends to
make the appropriate entries in its books and records when it acquires any
foreign currency or forward foreign currency contract in order to mitigate the
effect of these rules so as to prevent disqualification of the Fund as a RIC
and minimize the imposition of income and excise taxes.
If the Fund owns shares in certain foreign investment entities, referred to as
"passive foreign investment companies" or "PFIC," the Fund will be subject to
one of the following special tax regimes: (i) the Fund will be liable for
federal income tax, and an additional interest charge, on a portion of any
"excess distribution" from such foreign entity or any gain from the disposition
of such shares, even if the entire distribution or gain is paid out by the Fund
as a dividend to its shareholders; (ii) if the Fund is able and elect to treat
a PFIC as a "qualifying electing fund" or "QEF," the Fund would be required
each year to include in income, and distribute to shareholders in accordance
with the distribution requirements set forth above, the Fund's pro rata share
of the ordinary earnings and net capital gains of the PFIC, whether or not such
earnings or gains are distributed to the Fund; or (iii) annually the Fund may
be entitled to mark-to-market shares of the PFIC, and in such event, would be
required to distribute to shareholders any such mark-to-market gains in
accordance with the distribution requirements set forth above and any
market-to-market losses, as well as loss from an actual disposition of PFIC
stock, would be reported as ordinary loss to the extent of any net
market-to-market gains included in income in prior years.
FOREIGN TAXES. Dividends and interest received by the Fund may be subject to
income, withholding or other taxes imposed by foreign countries and U.S.
possessions that would reduce the yield on the Fund's securities. Tax
conventions between certain countries and the U.S. may reduce or eliminate
these taxes. Foreign countries generally do not impose taxes on capital gains
with respect to investments by foreign investors. If more than 50% of the value
of the
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Fund's total assets at the close of its taxable year consists of stock or
securities of foreign corporations, the Fund will be eligible to, and will,
file an election with the IRS that will enable shareholders, in effect, to
receive the benefit of the foreign tax credit with respect to any foreign and
U.S. possessions income taxes paid by the Fund. Pursuant to the election, the
Fund will treat those taxes as dividends paid to its shareholders. Each
shareholder will be required to include a proportionate share of those taxes in
gross income as income received from a foreign source and must treat the amount
so included as if the shareholder had paid the foreign tax directly. The
shareholder may then either deduct the taxes deemed paid by him or her in
computing his or her taxable income or, alternatively, use the foregoing
information in calculating the foreign tax credit (subject to significant
limitations) against the shareholder's federal income tax. If the Fund makes
the election, it will report annually to its shareholders the respective
amounts per share of the Fund's income from sources within, and taxes paid to,
foreign countries and U.S. possessions. Foreign tax credits, if any, received
by the Fund as a result of an investment in an ETF which is taxable as a RIC
will generally not be passed through to you.
Most foreign exchange gains realized on the sale of debt securities are treated
as ordinary income by the Fund. Similarly, foreign exchange losses realized by
the Fund on the sale of debt securities are generally treated as ordinary
losses by the Fund. These gains when distributed will be taxed to you as
ordinary dividends, and any losses will reduce the Fund's ordinary income
otherwise available for distribution to you. This treatment could increase or
reduce the Fund's ordinary income distributions to you, and may cause some or
all of the Fund's previously distributed income to be classified as a return of
capital.
Foreign shareholders (i.e., nonresident alien individuals and foreign
corporations, partnerships, trusts and estates) are generally subject to U.S.
withholding tax at the rate of 30% (or a lower tax treaty rate) on
distributions derived from net investment income including short-term capital
gains, and dividends; provided, however, that for the Fund's taxable years
beginning on or before December 31, 2013, interest related dividends and
qualified short-term capital gain dividends generally will not be subject to
U.S. withholding taxes. Distributions to foreign shareholders of such
interest-related dividends, and of long-term capital gains and any gains from
the sale or other disposition of shares of a Series generally are not subject
to U.S. taxation, unless the recipient is an individual who either (1) meets
the Code's definition of "resident alien" or (2) is physically present in the
U.S. for 183 days or more per year. Certification of foreign status by such
shareholders also will generally be required to avoid backup withholding on
capital gain distributions and redemption proceeds. Different tax consequences
may result if the foreign shareholder is engaged in a trade or business within
the U.S. In addition, the tax consequences to a foreign shareholder entitled to
claim the benefits of a tax treaty may be different than those described
above.
A U.S. withholding tax at a 30% rate will be imposed on dividends beginning
after June 30, 2014 (and proceeds of sales in respect of Fund shares received
by Fund shareholders beginning after December 31, 2016) for shareholders who
own their shares through foreign accounts or foreign intermediaries if certain
disclosure requirements related to U.S. accounts or ownership are not
satisfied. The Fund will not pay any additional amounts in respect to any
amounts withheld.
Any non-U.S. investors in the Fund may be subject to U.S. withholding and
estate tax and are encouraged to consult their tax advisors prior to investing
in the Fund.
Under U.S. Treasury regulations, generally, if an individual shareholder
recognizes a loss of $2 million or more or a corporate shareholder recognizes a
loss of $10 million or more, the shareholder must file with the IRS a
disclosure statement on Form 8886. Direct shareholders of portfolio securities
are in many cases excepted from this reporting requirement, but under current
guidance, shareholders of a RIC such as the Fund are not excepted. Future
guidance may extend the current exception from this reporting requirement to
shareholders of most or all RICs. The fact that a loss is reportable under
these regulations does not affect the legal determination of whether the
taxpayer's treatment of the loss is proper. Shareholders should consult their
tax advisors to determine the applicability of these regulations in light of
their individual circumstances.
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STATE TAXES. It is expected that the Fund will not be liable for any corporate
excise, income or franchise tax in Massachusetts if it qualifies as a RIC for
federal income tax purposes. Distributions by the Fund to shareholders and the
ownership of shares may be subject to state and local taxes. Rules of state and
local taxation of dividend and capital gains distributions from RICs often
differ from rules for federal income taxation described above. Shareholders are
urged to consult their tax advisors regarding state and local taxes applicable
to an investment in the Fund.
Many states grant tax-free status to dividends paid to you from interest earned
on direct obligations of the U.S. government, subject in some states to minimum
investment requirements that must be met by a fund. Investment in Ginnie Mae or
Fannie Mae securities, banker's acceptances, commercial paper, and repurchase
agreements collateralized by U.S. government securities do not generally
qualify for such tax-free treatment. The rules on exclusion of this income are
different for corporate shareholders.
FUND TRANSACTIONS
BROKERAGE TRANSACTIONS. Generally, equity securities, both listed and
over-the-counter, are bought and sold through brokerage transactions for which
commissions are payable. Purchases from underwriters will include the
underwriting commission or concession, and purchases from dealers serving as
market makers will include a dealer's mark-up or reflect a dealer's mark-down.
Money market securities and other debt securities are usually bought and sold
directly from the issuer or an underwriter or market maker for the securities.
Generally, the Fund will not pay brokerage commissions for such purchases. When
a debt security is bought from an underwriter, the purchase price will usually
include an underwriting commission or concession. The purchase price for
securities bought from dealers serving as market makers will similarly include
the dealer's mark up or reflect a dealer's mark down. When the Fund executes
transactions in the over-the-counter market, it will generally deal with
primary market makers unless prices that are more favorable are otherwise
obtainable.
In addition, the Adviser may place a combined order for two or more accounts it
manages, including the Fund, engaged in the purchase or sale of the same
security if, in its judgment, joint execution is in the best interest of each
participant and will result in best price and execution. Transactions involving
commingled orders are allocated in a manner deemed equitable to each account or
fund. Although it is recognized that, in some cases, the joint execution of
orders could adversely affect the price or volume of the security that a
particular account or the Fund may obtain, it is the opinion of the Adviser
that the advantages of combined orders outweigh the possible disadvantages of
separate transactions. Nonetheless, the Adviser believes that the ability of
the Fund to participate in higher volume transactions will generally be
beneficial to the Fund.
BROKERAGE SELECTION. The Trust does not expect to use one particular broker or
dealer, and when one or more brokers is believed capable of providing the best
combination of price and execution, the Adviser may select a broker based upon
brokerage or research services provided to the Adviser. The Adviser may pay a
higher commission than otherwise obtainable from other brokers in return for
such services only if a good faith determination is made that the commission is
reasonable in relation to the services provided.
Section 28(e) of the 1934 Act permits the Adviser, under certain circumstances,
to cause the Fund to pay a broker or dealer a commission for effecting a
transaction in excess of the amount of commission another broker or dealer
would have charged for effecting the transaction in recognition of the value of
brokerage and research services provided by the broker or dealer. In addition
to agency transactions, the Adviser may receive brokerage and research services
in connection with certain riskless principal transactions, in accordance with
applicable SEC guidance. Brokerage and research services include: (1)
furnishing advice as to the value of securities, the advisability of investing
in, purchasing or selling securities, and the availability of securities or
purchasers or sellers of securities; (2) furnishing analyses and reports
concerning issuers, industries, securities, economic factors and trends,
portfolio strategy, and the performance of accounts; and (3) effecting
securities transactions and performing functions incidental thereto (such as
clearance,
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settlement, and custody). In the case of research services, the Adviser
believes that access to independent investment research is beneficial to its
investment decision-making processes and, therefore, to the Fund.
To the extent research services may be a factor in selecting brokers, such
services may be in written form or through direct contact with individuals and
may include information as to particular companies and securities as well as
market, economic, or institutional areas and information which assists in the
valuation and pricing of investments. Examples of research-oriented services
for which the Adviser might utilize Fund commissions include research reports
and other information on the economy, industries, sectors, groups of
securities, individual companies, statistical information, political
developments, technical market action, pricing and appraisal services, credit
analysis, risk measurement analysis, performance and other analysis. The
Adviser may use research services furnished by brokers in servicing all client
accounts and not all services may necessarily be used by the Adviser in
connection with the Fund or any other specific client accounts that paid
commissions to the broker providing such services. Information so received by
the Adviser will be in addition to and not in lieu of the services required to
be performed by the Fund's Adviser under the Advisory Agreement. Any advisory
or other fees paid to the Adviser are not reduced as a result of the receipt of
research services.
In some cases the Adviser may receive a service from a broker that has both a
"research" and a "non-research" use. When this occurs, the Adviser makes a good
faith allocation, under all the circumstances, between the research and
non-research uses of the service. The percentage of the service that is used
for research purposes may be paid for with client commissions, while the
Adviser will use its own funds to pay for the percentage of the service that is
used for non-research purposes. In making this good faith allocation, the
Adviser faces a potential conflict of interest, but the Adviser believes that
its allocation procedures are reasonably designed to ensure that it
appropriately allocates the anticipated use of such services to their research
and non-research uses.
From time to time, the Fund may purchase new issues of securities for clients
in a fixed price offering. In these situations, the seller may be a member of
the selling group that will, in addition to selling securities, provide the
adviser with research services. The Financial Industry Regulatory Authority
("FINRA") has adopted rules expressly permitting these types of arrangements
under certain circumstances. Generally, the seller will provide research
"credits" in these situations at a rate that is higher than that which is
available for typical secondary market transactions. These arrangements may
not fall within the safe harbor of Section 28(e).
BROKERAGE WITH FUND AFFILIATES. The Fund may execute brokerage or other agency
transactions through registered broker-dealer affiliates of either the Fund,
the Adviser or the Distributor for a commission in conformity with the 1940
Act, the 1934 Act and rules promulgated by the SEC. These rules require that
commissions paid to the affiliate by the Fund for exchange transactions not
exceed "usual and customary" brokerage commissions. The rules define "usual and
customary" commissions to include amounts which are "reasonable and fair
compared to the commission, fee or other remuneration received or to be
received by other brokers in connection with comparable transactions involving
similar securities being purchased or sold on a securities exchange during a
comparable period of time." The Trustees, including those who are not
"interested persons" of the Fund, have adopted procedures for evaluating the
reasonableness of commissions paid to affiliates and review these procedures
periodically.
SECURITIES OF "REGULAR BROKER-DEALERS." The Fund is required to identify any
securities of its "regular brokers and dealers" (as such term is defined in the
1940 Act) that the Fund held during its most recent fiscal year. Because the
Fund is new, as of the date of this SAI, the Fund does not hold any securities
of "regular brokers and dealers."
PORTFOLIO TURNOVER RATES. Portfolio turnover rate is defined under SEC rules as
the greater of the value of the securities purchased or securities sold,
excluding all securities whose maturities at the time of acquisition were
one-year or less, divided by the average monthly value of such securities owned
during the year. Based on this definition, instruments with remaining
maturities of less than one-year are excluded from the calculation of the
portfolio turnover rate. Instruments excluded from the calculation of portfolio
turnover generally would include the futures contracts in
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which the Fund may invest since such contracts generally have remaining
maturities of less than one year. The Fund may at times hold investments in
other short-term instruments, such as repurchase agreements, which are excluded
for purposes of computing portfolio turnover.
PORTFOLIO HOLDINGS
The Board has approved a policy and procedures that govern the timing and
circumstances regarding the disclosure of Fund portfolio holdings information
to shareholders and third parties. These policies and procedures are designed
to ensure that disclosure of information regarding the Fund's portfolio
securities is in the best interests of the Fund's shareholders, and include
procedures to address conflicts between the interests of the Fund's
shareholders, on the one hand, and those of the Fund's Adviser, principal
underwriter, or any affiliated person of the Fund, the Adviser, or the
principal underwriter, on the other. Pursuant to such procedures, the Board has
authorized the Adviser's Chief Compliance Officer ("Adviser CCO") to authorize
the release of the Fund's portfolio holdings, as necessary, in conformity with
the foregoing principles. The Adviser CCO, either directly or through reports
by the Fund's Chief Compliance Officer, reports quarterly to the Board
regarding the operation and administration of such policies and procedures.
Pursuant to applicable law, the Fund is required to disclose its complete
portfolio holdings quarterly, within 60 days of the end of each fiscal quarter
(currently, each January 31, April 30, July 31, and October 31). The Fund will
disclose a complete or summary schedule of investments (which includes each of
the Fund's 50 largest holdings in unaffiliated issuers and each investment in
unaffiliated issuers that exceeds one percent of the Fund's net asset value
("Summary Schedule")) in its Semi-Annual and Annual Reports which are
distributed to the Fund's shareholders. The Fund's complete schedule of
investments following the first and third fiscal quarters will be available in
quarterly holdings reports filed with the SEC on Form N-Q, and the Fund's
complete schedule of investments following the second and fourth fiscal
quarters will be available in shareholder reports filed with the SEC on Form
N-CSR.
Reports filed with the SEC on Form N-Q and Form N-CSR are not distributed to
the Fund's shareholders but are available, free of charge, on the EDGAR
database on the SEC's website at www.sec.gov. Should the Fund include only a
Summary Schedule rather than a complete schedule of investments in its
Semi-Annual and Annual Reports, its Form N-CSR will be available without
charge, upon request, by calling [ ].[INFORMATION REGARDING PORTFOLIO HOLDINGS
DISCLOSURE ON WEBSITE TO BE INSERTED].
In addition to information provided to shareholders and the general public,
portfolio holdings information may be disclosed as frequently as daily to
certain service providers, such as the custodian, administrator or transfer
agent, in connection with their services to the Fund. From time to time rating
and ranking organizations, such as S&P, Lipper and Morningstar, Inc., may
request non-public portfolio holdings information in connection with rating the
Fund. Similarly, institutional investors, financial planners, pension plan
sponsors and/or their consultants or other third-parties may request portfolio
holdings information in order to assess the risks of the Fund's portfolio along
with related performance attribution statistics. The lag time for such
disclosures will vary. The Fund believes that these third parties have
legitimate objectives in requesting such portfolio holdings information.
The Fund's policies and procedures provide that the Adviser's CCO may authorize
disclosure of non-public portfolio holdings information to such parties at
differing times and/or with different lag times. Prior to making any disclosure
to a third party, the Adviser's CCO must determine that such disclosure serves
a reasonable business purpose, is in the best interests of the Fund's
shareholders and that to the extent conflicts between the interests of the
Fund's shareholders and those of the Fund's Adviser, principal underwriter, or
any affiliated person of the Fund exists, such conflicts are addressed.
Portfolio holdings information may be disclosed no more frequently than monthly
to ratings agencies, consultants and other qualified financial professionals or
individuals. The disclosures will not be made sooner than three days after the
date of the information. The Fund's Chief Compliance Officer will regularly
review these arrangements and will make periodic reports to the Board regarding
disclosure pursuant to such arrangements.
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With the exception of disclosures to rating and ranking organizations as
described above, the Fund requires any third party receiving non-public
holdings information to enter into a confidentiality agreement with the
Adviser. The confidentiality agreement provides, among other things, that
non-public portfolio holdings information will be kept confidential and that
the recipient has a duty not to trade on the non-public information and will
use such information solely to analyze and rank the Fund, or to perform due
diligence and asset allocation, depending on the recipient of the information.
The Fund's policies and procedures prohibit any compensation or other
consideration from being paid to or received by any party in connection with
the disclosure of portfolio holdings information, including the Fund, the
Adviser and its affiliates or recipients of the Fund's portfolio holdings
information.
DESCRIPTION OF SHARES
The Declaration of Trust authorizes the issuance of an unlimited number of
funds and shares of each fund, each of which represents an equal proportionate
interest in that fund with each other share. Shares are entitled upon
liquidation to a pro rata share in the net assets of the fund. Shareholders
have no preemptive rights. The Declaration of Trust provides that the Trustees
of the Trust may create additional series or class of shares. All consideration
received by the Trust for shares of any additional funds and all assets in
which such consideration is invested would belong to that fund and would be
subject to the liabilities related thereto. Share certificates representing
shares will not be issued. The Fund's shares, when issued, are fully paid and
non-assessable.
SHAREHOLDER LIABILITY
The Trust is an entity of the type commonly known as a "Massachusetts business
trust." Under Massachusetts law, shareholders of such a trust could, under
certain circumstances, be held personally liable as partners for the
obligations of the Trust. Even if, however, the Trust were held to be a
partnership, the possibility of the shareholders incurring financial loss for
that reason appears remote because the Trust's Declaration of Trust contains an
express disclaimer of shareholder liability for obligations of the Trust and
requires that notice of such disclaimer be given in each agreement, obligation
or instrument entered into or executed by or on behalf of the Trust or the
Trustees, and because the Declaration of Trust provides for indemnification out
of the Trust property for any shareholder held personally liable for the
obligations of the Trust.
LIMITATION OF TRUSTEES' LIABILITY
The Declaration of Trust provides that a Trustee shall be liable only for his
or her own willful defaults and, if reasonable care has been exercised in the
selection of officers, agents, employees or investment advisers, shall not be
liable for any neglect or wrongdoing of any such person. The Declaration of
Trust also provides that the Trust will indemnify its Trustees and officers
against liabilities and expenses incurred in connection with actual or
threatened litigation in which they may be involved because of their offices
with the Trust unless it is determined in the manner provided in the
Declaration of Trust that they have not acted in good faith in the reasonable
belief that their actions were in the best interests of the Trust. However,
nothing in the Declaration of Trust shall protect or indemnify a Trustee
against any liability for his or her willful misfeasance, bad faith, gross
negligence or reckless disregard of his or her duties. Nothing contained in
this section attempts to disclaim a Trustee's individual liability in any
manner inconsistent with the federal securities laws.
PROXY VOTING
The Board has delegated responsibility for decisions regarding proxy voting for
securities held by the Fund to the Adviser. The Adviser will vote such proxies
in accordance with its proxy policies and procedures, which are included in
Appendix B to this SAI.
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The Trust is required to disclose annually the Fund's complete proxy voting
record during the most recent 12-month period ended June 30 on Form N-PX. This
voting record is available: (i) without charge, upon request, by calling
[____]; and (ii) on the SEC's website at http://www.sec.gov.