INVESTMENT OBJECTIVES AND POLICIES
Each Portfolio has a distinct investment objective and policies. There can be no assurance that a Portfolios investment objective
will be achieved. The investment objective and policies of each Portfolio, and the associated risks of each Portfolio are discussed in the Portfolios Prospectus, which should be read carefully
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before an investment is made. All investment objectives and investment policies not specifically designated as fundamental may be changed without shareholder approval. However, to the extent
required by U.S. Securities and Exchange Commission (SEC) regulations including Rule 35d-1 of the Act and the SECs interpretive positions thereunder shareholders will be provided with sixty days notice in the manner prescribed by
the SEC before any change in the Equity Growth Strategy Portfolios policy to invest at least 80% of its net assets plus any borrowings for investment purposes (measured at time of purchase) (Net Assets) in the particular type of
investment suggested by its name.
Each of the Portfolios seeks to achieve its objective by investing in a combination of
underlying funds that currently exist or that may become available for investment in the future for which GSAM or an affiliate now or in the future acts as investment adviser (the Underlying Funds). These Underlying Funds currently
include the: Structured Large Cap Value Fund, Structured Large Cap Growth Fund, Structured Small Cap Equity Fund, Structured International Equity Fund, Emerging Markets Equity Fund, Real Estate Securities Fund, International Real Estate Securities
Fund, Structured Emerging Markets Equity Fund, Structured International Small Cap Fund, International Small Cap Fund, Strategic Growth Fund and Large Cap Value Fund (the Underlying Equity Funds); Short Duration Government Fund, Core
Fixed Income Fund, Global Income Fund, High Yield Fund, Emerging Markets Debt Fund, Local Emerging Markets Debt Fund and High Yield Floating Rate Fund (the Underlying Fixed Income Funds); and the Commodity Strategy and Dynamic Allocation
Funds. The value of the Underlying Funds investments and the net asset value of the shares of both the Underlying Funds and the Portfolios will fluctuate with market, economic and, to the extent applicable, foreign exchange conditions, so that
an investment in any of the Portfolios may be worth more or less when redeemed than when purchased.
For each of the
Portfolios other than the Income Strategies Portfolio and the Satellite Strategies Portfolio, the Investment Advisers Quantitative Investment Strategies Group uses a disciplined, rigorous and quantitative approach, in combination with a
qualitative overlay to global tactical asset allocation. The Global Tactical Asset Allocation (GTAA) strategy attempts to add value by actively managing exposure to global stock, bond and currency markets. In contrast to stock and bond
selection strategies which focus on individual stocks and bonds, GTAA focuses on broad asset classes. The Investment Advisers GTAA models use financial and economic factors that are designed to capture intuitive fundamental relationships
across markets. While the GTAA process is rigorous and quantitative, there is economic reasoning behind each position.
Each
Portfolio starts with a strategic allocation among the various asset classes. The Investment Adviser then tactically deviates from the strategic allocations based on forecasts provided by the models. The tactical process seeks to add value by
overweighting markets that the Investment Adviser believes to be attractive and underweighting markets it considers to be unattractive. Greater deviations from the strategic allocation of a given Portfolio result in higher risk that the tactical
allocation will underperform the strategic allocation. However, the Investment Advisers risk control process balances the amount any asset class can be overweighted in seeking to achieve higher expected returns against the amount of risk
imposed by that deviation from the strategic allocation.
Each Portfolios asset allocation process relies on a
proprietary asset allocation model and a qualitative overlay. As a result of the qualitative overlay, a Portfolios investments may not correspond to those generated by the Investment Advisers asset allocation model. The Portfolios may
invest in, or have exposure to, asset classes other than those generated by the Investment Advisers asset allocation model, at the discretion of the Investment Adviser. In addition, the Investment Adviser may, in its discretion, make changes
to its asset allocation model, or use other asset allocation models based on the Investment Advisers proprietary research.
For the Income Strategies and Satellite Strategies Portfolios, the Investment Adviser believes there are three primary sources of risk that contribute to portfolio returninterest rate risk, equity
market risk and active management risk. The first two risksinterest rate and equity marketconstitute market risk (beta), meaning risk naturally associated with bond or stock market returns. Active management risk, however,
comes from the pursuit of non-market related return (alpha) through active, skilled portfolio management.
Through a Core and
Satellite approach to portfolio construction, investors can separate these three sources of portfolio risk to seek additional return opportunities. Investors achieve their desired exposure to equity and fixed income markets through Core
investmentstypically U.S. large cap equities and fixed income obtained through passive, structured and/or actively-managed strategies. Active and skilled portfolio management can contribute to alpha return of any mutual fund. However,
investors can pursue additional return opportunities through less correlated satellite strategies such as emerging markets, high yield and commodities investments. The Investment Adviser believes the result of Core and Satellite investing is more
efficient portfolio constructionand higher risk-adjusted return potential. Because the risks of satellite investments are typically less correlated with market risk, the Investment Adviser believes they can be added to any portfolio to
increase diversification and return opportunitieswithout greatly impacting a portfolios overall risk.
With
respect to the Satellite Strategies and Income Strategies Portfolios, the Investment Advisers Quantitative Investment Strategies Group uses a disciplined, rigorous and quantitative approach, in combination with a qualitative overlay in
allocating to the satellite asset classes included in the Portfolios. The Portfolios start with a strategic allocation among the various asset classes. For this strategic allocation the Investment Adviser uses a proprietary asset allocation model.
In contrast to traditional equity and fixed income selection strategies which focus on individual stocks and bonds, the model focuses on broad asset classes, such as emerging markets, high yield and commodities. The Investment Advisers model
uses financial and economic factors that are designed to capture the risks and returns of global asset classes across markets. While the asset allocation process is rigorous and quantitative, allocation is driven by intuitive economic reasoning. On
a monthly basis, the Investment Adviser will assess the risk contribution of each asset class and rebalance accordingly. The Investment Adviser employs a proprietary asset allocation technique and other techniques, to what it believes is the best
strategic allocation in the Income Strategies and Satellite Strategies Portfolios.
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From time to time, the Investment Adviser will monitor, and may make changes to, the
selection or weight of Underlying Funds, individual or groups of securities, currencies or markets in a Portfolio. Such changes (which may be the result of changes in the models, the asset allocation techniques, the manner of applying those models
and techniques or the judgment of the Investment Adviser) may include: (i) evolutionary changes to the structure of the models and/or the asset allocation techniques (e.g., the addition of new factors or a new means of weighting the factors,
increasing or decreasing investment in certain Underlying Funds); (ii) changes in trading procedures (e.g., trading frequency); or (iii) changes to the weight of Underlying Funds, individual or groups of securities, currencies or markets
based on the Investment Advisers judgment. Any such changes will preserve a Portfolios basic investment philosophy of combining qualitative and quantitative methods of selecting investments using a disciplined investment process.
Similarly, with respect to those Underlying Funds that are managed pursuant to a quantitative methodology, the Investment Adviser will monitor and may make changes to the selection or weight of individual or groups of securities, currencies, or
markets in those Underlying Funds, including changes resulting from changes in the quantitative methodology, the manner of applying the quantitative methodology, changes in trading procedure, or the judgment of the Investment Adviser. For more
information, please consult the relevant Underlying Funds SAI.
The following description provides additional
information regarding the Underlying Funds and the types of investments that the Underlying Funds may make, and supplements the information in the Portfolios Prospectus.
Description of Underlying Funds
Structured Large Cap Value Fund
Objective
. The Structured Large Cap Value Fund seeks long-term growth of capital and dividend income.
Primary Investment Focus
. The Structured Large Cap Value Fund invests, under normal circumstances, at least
80% of its Net Assets in a diversified portfolio of equity investments in large-cap U.S. issuers, including foreign issuers that are traded in the United States. These issuers have public stock market capitalizations similar to those of companies
constituting the Russell 1000
®
Index at the time of investment, which as of February 1, 2013 was between
$231 million and $311 billion. However, the Underlying Fund may invest in securities outside the Russell 1000
®
capitalization range.
The Underlying Fund uses a structured quantitative style of management, in combination with
a qualitative overlay, that emphasizes fundamentally-based stock selection, careful portfolio construction and efficient implementation. The Underlying Funds investments are selected using fundamental research and a variety of quantitative
techniques based on certain investment themes, including, among others, Valuation, Quality, Management and Momentum. The Valuation theme attempts to capture potential mispricings of securities, typically by comparing a measure of the companys
intrinsic value to its market value. The Quality theme assesses both firm and management quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction to company-specific information and information about
related companies. The underlying investment adviser may, in its discretion, make changes to its quantitative techniques, or use other quantitative techniques that are based on the underlying investment advisers proprietary research.
The Underlying Fund maintains risk, style, and capitalization characteristics similar to the Russell
1000
®
Value Index, which generally consists of companies with above average capitalizations, low earnings growth
expectations and above average dividend yields. The Underlying Fund seeks to maximize expected return while maintaining these and other characteristics similar to the benchmark.
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Other
.
The Underlying Fund may also invest in fixed income securities that are
considered to be cash equivalents.
Structured Large Cap Growth Fund
Objective
. The Structured Large Cap Growth Fund seeks long-term growth of capital, with dividend income as a secondary
consideration.
Primary Investment Focus
. The Structured Large Cap Growth Fund invests, under
normal circumstances, at least 80% of its Net Assets in a broadly diversified portfolio of equity investments in large-cap U.S. issuers, including foreign issuers that are traded in the United States. These issuers have public stock market
capitalizations similar to those of companies constituting the Russell 1000
®
Index, which as of February 1,
2013 was between $231 million and $311 billion. However, the Underlying Fund may invest in securities outside the Russell
1000
®
capitalization range.
The Underlying Fund uses a structured quantitative style of management, in combination with the qualitative overlay, that emphasizes fundamentally-based stock selection, careful portfolio
construction and efficient implementation. The Underlying Funds investments are selected using fundamental research and a variety of quantitative techniques based on certain investment themes, including, among others, Valuation, Quality,
Management and Momentum. The Valuation theme attempts to capture potential mispricings of securities, typically by comparing a measure of the companys intrinsic value to its market value. The Quality theme assesses both firm and management
quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction to company-specific information and information about related companies. The underlying investment adviser may, in its discretion, make changes
to its quantitative techniques, or use other quantitative techniques that are based on the underlying investment advisers proprietary research.
The Underlying Fund maintains risk, style, and capitalization characteristics similar to the Russell 1000
®
Growth Index, which generally consists of companies with above average capitalization and earnings growth expectations and below average dividend yields. The
Underlying Fund seeks to maximize expected return while maintaining these and other characteristics similar to the benchmark.
Other
. The Structured Large Cap Growth Fund may also invest in fixed income securities that are considered to be cash equivalents.
Structured Small Cap Equity Fund
Objective
. The Structured Small Cap Equity Fund seeks long-term growth of capital.
Primary Investment Focus
. The Structured Small Cap Equity Fund invests, under normal circumstances, at least 80% of its Net Assets in a broadly diversified portfolio of equity investments in
small-cap U.S. issuers, including foreign issuers that are traded in the United States. These issuers will have public stock market capitalizations similar to that of the range of the market capitalizations of companies constituting the Russell 2000
®
Index at the time of investment, which as of February 1, 2013 was between $30 million and $5.4 billion.
However, the Underlying Fund may invest in securities outside the Russell 2000
®
capitalization range.
The Underlying Fund uses a structured quantitative style of management, in combination with a qualitative
overlay, that emphasizes fundamentally-based stock selection, careful portfolio construction and efficient implementation. The Underlying Funds investments are selected using fundamental research and a variety of quantitative techniques based
on certain investment themes, including, among others, Valuation, Quality, and Momentum. The Valuation theme attempts to capture potential mispricings of securities, typically by comparing a measure of the companys intrinsic value to its
market value. The Quality theme assesses both
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firm and management quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction to company-specific information and information about related
companies. The Underlying Funds investment adviser may, in its discretion, make changes to its quantitative techniques, or use other quantitative techniques that are based on the underlying funds investment advisers proprietary
research.
The Underlying Fund maintains risk, style, and capitalization characteristics similar to the
Russell 2000
®
Index, which is an index designed to represent an investable universe of small-cap companies. The
Underlying Fund seeks to maximize expected return while maintaining these and other characteristics similar to the benchmark.
Other
. The Structured Small Cap Equity Fund may also invest in fixed income securities that are considered to be cash equivalents.
Structured International Equity Fund
Objective
. The Structured International Equity Fund seeks long-term growth of capital.
Primary Investment Focus
. The Structured International Equity Fund invests, under normal circumstances, at least 80% of its Net Assets in a broadly diversified portfolio of equity investments in
companies that are organized outside the United States or whose securities are principally traded outside the United States.
The portfolio management team uses two distinct strategiesa bottom-up stock selection strategy and a top-down country/currency
selection strategyto manage the Underlying Fund. The Underlying Fund invests in at least three foreign countries and may invest in the securities of issuers in countries with emerging markets or economies (emerging countries).
The Underlying Fund seeks broad representation of large-cap and mid-cap issuers across major countries and sectors of the
international economy, with some exposure to small cap issuers. The Underlying Fund uses a structured quantitative style of management, in combination with a qualitative overlay, that emphasizes fundamentally-based stock and
country/currency selection, careful portfolio construction and efficient implementation. The Underlying Funds investments are selected using fundamental research and a variety of quantitative techniques based on certain investment themes,
including, among others, Valuation, Quality and Momentum. The Valuation theme attempts to capture potential mispricings of securities, typically by comparing a measure of the companys intrinsic value to its market value. The Quality theme
assesses both firm and management quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction to company-specific information and information about related companies. The Underlying Investment Adviser may,
in its discretion, make changes to its quantitative techniques, or use other quantitative techniques that are based on the underlying investment advisers proprietary research.
The Underlying Fund seeks to maximize its expected return, while maintaining risk, style and capitalization
characteristics similar to the MSCI
®
Europe, Australasia, Far East (EAFE
®
) Standard Index (unhedged, with dividends reinvested, net of dividend withholding taxes) (MSCI
®
EAFE
®
(net) Index), adjusted for the Underlying Funds Investment Advisers country views. Additionally, the portfolio management teams views of the
relative attractiveness of countries and currencies are considered in allocating the Underlying Funds assets among countries. The MSCI
®
EAFE (net) Index is designed to measure equity market performance of the large and mid capitalization segments of developed markets, excluding the U.S. and Canada.
Other
. The Structured International Equity Fund may also invest in fixed income securities that are considered to be
cash equivalents.
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Emerging Markets Equity Fund
Objective
. The Emerging Markets Equity Fund seeks long-term capital appreciation.
Primary Investment Focus
. The Emerging Markets Equity Fund invests, under normal circumstances, at least 80% of its Net Assets in a diversified portfolio of equity investments in emerging country
issuers. Such equity investments may include exchange-traded funds (ETFs), futures and other instruments with similar economic exposures. The Underlying Funds Investment Adviser may consider classifications by the World Bank, the
International Finance Corporation, the United Nations (and its agencies) or the Underlying Funds benchmark index provider in determining whether a country is emerging or developed. Emerging countries are generally located in Africa, Asia, the
Middle East, Eastern Europe and Central and South America.
An emerging country issuer is any company that either:
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Has a class of its securities whose principal securities market is in an emerging country;
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Is organized under the laws of, or has a principal office in, an emerging country;
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Derives 50% or more of its total revenue from goods produced, sales made or services provided in one or more emerging countries; or
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Maintains 50% or more of its assets in one or more emerging countries.
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Under normal circumstances, the Underlying Fund maintains investments in at least six emerging countries, and will not invest more than
35% of its Net Assets in securities of issuers in any one emerging country. Allocation of the Underlying Funds investments is determined by the investment advisers assessment of a companys upside potential and downside risk, how
attractive it appears relative to other holdings, and how the addition will impact sector and industry weightings. The largest weightings in the Underlying Funds portfolio relative to the benchmark of the Underlying Fund are given to companies
the Underlying Funds Investment Adviser believes have the most upside return potential relative to their contribution to overall portfolio risk. The Underlying Funds investments are selected using a strong valuation discipline to
purchase what the Underlying Funds investment adviser believes are well-positioned, cash-generating businesses run by shareholder-oriented management teams.
The Underlying Fund may invest in: (i) fixed income securities of private and government emerging country issuers; and (ii) equity and fixed income securities, such as government, corporate and
bank debt obligations, of developed country issuers.
Real Estate Securities Fund
Objective
. The Real Estate Securities Fund seeks total return comprised of long-term growth of capital and dividend income.
Primary Investment Focus
. The Real Estate Securities Fund invests, under normal circumstances, at least 80% of its Net
Assets in a portfolio of equity investments in issuers that are primarily engaged in or related to the real estate industry.
A real estate industry company is a company that derives at least 50% of its gross revenues or net profits from
the ownership, development, construction, financing, management or sale of commercial, industrial or residential real estate or interests therein. Real estate industry companies may include REITs, REIT-like structures, or real estate operating
companies whose businesses and services are related to the real estate industry.
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The Underlying Funds investment strategy is based on the premise that property market
fundamentals are the primary determinant of growth, underlying the success of companies in the real estate industry. The Underlying Funds investment adviser focuses on companies that can achieve sustainable growth in cash flow and dividend
paying capability over time. The investment adviser attempts to purchase securities so that its underlying portfolio will be diversified geographically and by property type. Although the Underlying Fund will invest primarily in publicly traded U.S.
securities, it may invest up to 15% of its total assets (not including securities lending collateral and any investment of that collateral) measured at time of purchase (Total Assets) in foreign securities, including securities quoted in
foreign currencies.
The Underlying Fund concentrates its investments in the real estate industry, which has historically
experienced substantial price volatility. This concentration subjects the Fund to greater risk of loss as a result of adverse economic, business or other developments than if its investments were diversified across different industries. The Fund is
non-diversified, meaning that it is permitted to invest a larger percentage of its assets in fewer issuers than diversified mutual funds. Thus, the Fund may be more susceptible to adverse developments affecting any single issuer held in its
portfolio, and may be more susceptible to greater losses because of these developments.
Risks associated with investments in
the real estate industry include, among others: possible declines in the value of real estate; risks related to general and local economic conditions; possible lack of availability of mortgage financing, variations in rental income, neighborhood
values or the appeal of property to tenants; interest rates; overbuilding; extended vacancies of properties; increases in competition, property taxes and operating expenses; and changes in zoning laws. The real estate industry is particularly
sensitive to economic downturns. The values of securities of companies in the real estate industry may go through cycles of relative underperformance and out-performance in comparison to equity securities markets in general.
REITs whose underlying properties are concentrated in a particular industry or geographic region are subject to risks affecting such
industries and regions. The securities of REITs involve greater risks than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements because of interest rate changes, economic conditions
and other factors. Securities of such issuers may lack sufficient market liquidity to enable the Fund to effect sales at an advantageous time or without a substantial drop in price.
Other
. The Real Estate Securities Fund may invest up to 20% of its Total Assets in fixed income investments, such as government,
corporate and bank debt obligations. The Underlying Fund concentrates its investments in securities of issuers in the real estate industry.
This Underlying Fund is non-diversified under the Act, and may invest a larger percentage of its assets in fewer issuers than diversified mutual funds.
International Real Estate Securities Fund
Objective
. The International Real Estate Securities Fund seeks total return comprised of long-term growth of capital and dividend income.
Primary Investment Focus
. The International Real Estate Securities Fund invests, under normal circumstances, at least 80% of its
Net Assets in a portfolio of equity investments in issuers that are primarily engaged in or related to the real estate industry (real estate industry companies) outside the United States. A real estate industry company is a
company that derives at least 50% of its gross revenues or net profits from the ownership, development, construction, financing, management or sale of commercial, industrial or residential real estate or interests therein. Real estate companies may
include REITs, REIT-like structures, or real estate operating companies whose businesses and services are related to the real estate industry.
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The Underlying Funds investment strategy is based on the premise that property market
fundamentals are the primary determinant of growth, underlying the success of companies in the real estate industry. The Underlying Funds investment adviser focuses on companies that can achieve sustainable growth in cash flow and dividend
paying capability over time. The investment adviser attempts to purchase securities so that its underlying portfolio will be diversified geographically and by property type.
The Underlying Fund invests primarily in real estate industry companies organized outside the United States or whose securities are principally traded outside the United States.
The Underlying Fund expects to invest a substantial portion of its assets in the securities of issuers located in Japan, the United
Kingdom, Australia, Hong Kong, Singapore, Canada and Continental Europe. The Fund may also invest a portion of its assets in securities of issuers located in emerging market countries, such as Central American, South American, African, Middle
Eastern, and certain Asian and Eastern European countries. From time to time, the Underlying Funds investments in a particular country may exceed 25% of its investment portfolio.
Other
. The International Real Estate Securities Fund may invest up to 20% of its Total Assets in REITs or other real estate
companies organized or principally traded in the United States and fixed income investments, such as government, corporate and bank debt obligations. The Fund concentrates its investments in securities of issuers in the real estate industry.
This Underlying Fund is non-diversified under the Act, and may invest a larger percentage of its assets in fewer
issuers than diversified mutual funds.
Structured Emerging Markets Equity Fund
Objective.
The Structured Emerging Markets Equity Fund seeks long-term growth of capital.
Primary Investment Focus.
The Structured Emerging Markets Equity Fund invests, under normal circumstances, at least 80% of its Net
Assets in a diversified portfolio of equity investments in emerging country issuers. Currently, emerging countries include, among others, Central and South American, African, Asian and Eastern European countries. Under normal circumstances, the
Underlying Fund will not invest more than 35% of its Net Assets in securities of issuers in any one emerging country.
The
portfolio management team uses two distinct strategiesa bottom-up stock selection strategy and a top-down country/currency selection strategyto manage the Underlying Fund.
The Underlying Fund uses a structured quantitative style of management, in combination with a qualitative overlay, that
emphasizes fundamentally-based stock and country/currency selection, careful portfolio construction and efficient implementation. The Underlying Funds investments are selected using fundamental research and a variety of quantitative techniques
based on certain investment themes, including, among others, Valuation, Quality and Momentum. The Valuation theme attempts to capture potential mispricings of securities, typically by comparing a measure of the companys intrinsic value to its
market value. The Quality theme assesses both firm and management quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction to company-specific information and information about related companies. The
underlying investment adviser may, in its discretion, make changes to its quantitative techniques, or use other quantitative techniques that are based on the underlying investment advisers proprietary research.
The Underlying Fund seeks to maximize its expected return, while maintaining risk, style and capitalization
characteristics similar to the MSCI
®
Emerging Markets Standard Index (unhedged, with dividends reinvested, net
of dividend withholding taxes) (MSCI
®
Emerging Markets (net) Index), adjusted for the Underlying
Funds Investment Advisers country views. Additionally, the portfolio management teams views
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of the relative attractiveness of emerging countries and currencies are considered in allocating the Underlying Funds assets among emerging countries. The MSCI
®
Emerging Markets (net) Index is designed to measure equity market performance of the large and mid market
capitalization segments of emerging markets.
Other.
The Structured Emerging Markets Equity Fund may invest in fixed
income securities that are considered to be cash equivalents.
Structured International Small Cap Fund
Objective.
The Structured International Small Cap Fund seeks long-term growth of capital.
Primary Investment Focus.
The Underlying Fund invests, under normal circumstances, at least 80% of its Net Assets in a broadly
diversified portfolio of equity investments in small cap non-U.S. issuers.
The Underlying Fund uses a structured
quantitative style of management, in combination with a qualitative overlay, that emphasizes fundamentally-based stock selection, careful portfolio construction and efficient implementation. The Underlying Funds investments are selected using
fundamental research and a variety of quantitative techniques based on certain investment themes, including, among others, Valuation, Quality and Management, Momentum. The Valuation theme attempts to capture potential mispricings of securities,
typically by comparing a measure of the companys intrinsic value to its market value. The Quality theme assesses both firm and management quality. The Momentum theme seeks to predict drifts in stock prices caused by delayed investor reaction
to company-specific information and information about related companies. The underlying investment adviser may, in its discretion, make changes to its quantitative techniques, or use other quantitative techniques that are based on the underlying
investment advisers proprietary research.
The Underlying Fund seeks to maximize its expected
return, while maintaining risk, style, and capitalization characteristics similar to the MSCI
®
Europe,
Australasia, Far East (EAFE
®
) Small Cap Index (unhedged, with dividends reinvested, net of dividend
withholding taxes) (MSCI
®
EAFE
®
Small Cap (net) Index). The
MSCI
®
EAFE
®
Small Cap (net) Index is designed to measure equity market performance of the small capitalization segments of developed markets, excluding the United States and
Canada. The Underlying Fund seeks to maximize its expected return while maintaining these and other characteristics similar to the benchmark.
Other.
The Structured International Small Cap Fund may also invest in the securities of issuers in emerging countries, and fixed income securities that are considered to be cash equivalents.
International Small Cap Fund
Objective
. The International Small Cap Fund seeks long-term capital appreciation.
Primary Investment Objective
. The International Small Cap Fund invests, under normal circumstances, at least 80% of its Net Assets in a diversified portfolio of equity investments in non-U.S.
small-cap companies. Such equity investments may include exchange-traded funds (ETFs), futures and other instruments with similar economic exposures. Non-U.S. small-cap companies are companies:
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With public stock market capitalizations within the range of the market capitalization of companies constituting the S&P Developed Ex-U.S. Small
Cap Index (net) at the time of investment, which as of December 31, 2012 was between $5 million and $12 billion; and
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That are organized outside the United States or whose securities are principally traded outside the United States.
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The Underlying Fund seeks to achieve its investment objective by investing in issuers that
are considered by the Underlying Funds investment adviser to be strategically positioned for long-term growth through its evaluation of factors such as a companys financial position relative to peers, current financial condition,
competitive position in its industry, ability to capitalize on future growth, and equity valuation. The Underlying Funds investments are selected using a strong valuation discipline to purchase what the Underlying Funds investment
adviser believes are well-positioned, cash-generating businesses run by shareholder-oriented management teams.
The Underlying
Funds assets are invested in at least three foreign countries. The Underlying Fund expects to invest a substantial portion of its assets in securities of companies in the developed countries of Western Europe, Japan and Asia, but may also
invest in securities of issuers located in Australia, Canada, New Zealand and in emerging countries. From time to time, the Underlying Funds investments in a particular developed country may exceed 25% of its investment portfolio.
Other
. The International Small Cap Fund may invest in equity investments outside the market capitalization range specified above
and in fixed income securities, such as government, corporate and bank debt obligations.
Strategic Growth Fund
Objective.
The Strategic Growth Fund seeks long-term growth of capital.
Primary Investment Focus.
The Strategic Growth Fund invests, under normal circumstances, at least 90% of its Total Assets in
equity investments. Although the Underlying Fund invests primarily in publicly traded U.S. securities, it may invest up to 25% of its Total Assets in foreign securities, including securities of issuers in emerging countries and securities quoted in
foreign currencies. This Underlying Fund seeks to achieve its investment objective by investing in a diversified portfolio of equity investments that are considered by the Underlying Funds investment adviser to be strategically positioned for
consistent long-term growth. The Underlying Funds fundamental equity growth investment process involves evaluating potential investments based on specific characteristics believed to indicate a high-quality business with sustainable growth,
including strong business franchises, favorable long-term prospects, and excellent management.
The underlying investment
adviser will also consider valuation of companies when determining whether to buy and/or sell securities. The underlying investment adviser may decide to sell a position for various reasons, including when a companys fundamental outlook
deteriorates, because of valuation and price considerations, for risk management purposes, or when a company is deemed to be misallocating capital. In addition, the underlying investment adviser may sell a position in order to meet shareholder
redemptions.
Large Cap Value Fund
Objective.
The Large Cap Value Fund seeks long-term capital appreciation.
Primary Investment Focus.
The Large Cap Value Fund invests, under normal circumstances, at least 80% of its Net Assets in a diversified portfolio of equity investments in large-cap U.S. issuers
with public stock market capitalizations within the range of the market capitalization of companies constituting the Russell
1000
®
Value Index at the time of investment. As of November 30, 2012, the capitalization range of the
Russell 1000
®
Value Index was between $302.4 million and $401.9 billion. Although the Underlying Fund will
invest primarily in publicly traded U.S. securities, it may invest in foreign securities, including securities quoted in foreign currencies. The Underlying Fund seeks its investment objective by investing in value opportunities that the Underlying
Funds investment adviser defines as companies with identifiable competitive advantages whose intrinsic value is not reflected in the stock price. The Underyling Funds equity investment process involves: (1) using multiple
industry-specific valuation metrics to identify real economic value and company potential in
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stocks, screened by valuation, profitability and business characteristics; (2) conducting in-depth company research and assessing overall business quality; and (3) buying those
securities that a sector portfolio manager recommends, taking into account feedback from the rest of the portfolio management team. The underlying investment adviser may decide to sell a position for various reasons, including valuation and price
considerations, readjustment of the underlying investment advisers outlook based on subsequent events, the investment advisers ongoing assessment of the quality and effectiveness of management, if new investment ideas offer the potential
for better risk reward profiles than existing holdings, or for risk management purposes. In addition, the underlying investment adviser may sell a position in order to meet shareholder redemptions.
Other.
The Large Cap Value Fund may invest in fixed income securities, such as government, corporate and bank debt obligations.
Short Duration Government Fund
Objective
. The Short Duration Government Fund seeks a high level of current income and secondarily, in seeking current income, may also consider the potential for capital appreciation.
Primary Investment Focus
. The Short Duration Government Fund invests, under normal circumstances, at least 80% of its Net Assets
in U.S. Government securities and in repurchase agreements collateralized by such securities. Substantially all of Underlying the Funds Net Assets will be invested in U.S. Government securities and instruments based on U.S. Government
securities. The Underlying Fund also intends to invest in derivatives, including (but not limited to) interest rate futures, options and interest rate swaps, which are used primarily to hedge the Funds portfolio risks, manage the Funds
duration and/or gain exposure to certain fixed income securities. 100% of the Underlying Funds portfolio will be invested in U.S. dollar-denominated securities.
The Underlying Funds target duration range under normal interest rate conditions is that of the BofA ML Two-Year U.S. Treasury Note Index, plus or minus 1 year, and over the past ten years ended
June 30, 2012, the duration of this index has been approximately 1.92 years.
Core Fixed Income Fund
Objective
. The Core Fixed Income Fund seeks a total return consisting of capital appreciation and income that exceeds the total
return of the Barclays U.S. Aggregate Bond Index.
Primary Investment Focus
. The Core Fixed Income Fund invests, under
normal circumstances, at least 80% of its Net Assets in fixed income securities, including U.S. Government securities, corporate debt securities, Mortgage-Backed Securities and asset-backed securities. The Underlying Fund may also invest in
custodial receipts, fixed income securities issued by or on behalf of states, territories, and possessions of the United States (including the District of Columbia) (Municipal Securities) and convertible securities. The Underlying Fund
may also engage in forward foreign currency transactions for both speculative and hedging purposes.
The Underlying
Funds investments in non-U.S. dollar denominated obligations (hedged or unhedged against currency risk) will not exceed 25% of its Total Assets, and 10% of the Underlying Funds Total Assets may be invested in obligations of issuers in
emerging countries. Additionally, exposure to non-U.S. currencies (unhedged against currency risk) will not exceed 25% of the Underlying Funds Total Assets. In pursuing its investment objective, the Underlying Fund uses the Index as its
performance benchmark, but the Underlying Fund will not attempt to replicate the Index. The Underlying Fund may, therefore, invest in securities that are not included in the Index.
B-11
The Underlying Fund may invest in fixed income securities rated at least BBB- or Baa3 at the
time of purchase. Securities will either be rated by a NRSRO or, if unrated, determined by the Underlying Funds investment adviser to be of comparable quality. The Underlying Funds target duration range under normal interest rate
conditions is that of the Index plus or minus one year, and over the last ten years ended June 30, 2012, the duration of the Index has ranged between 3.71 and 5.19 years.
Global Income Fund
Objective.
The Global Income Fund seeks a high
total return, emphasizing current income, and, to a lesser extent, providing opportunities for capital appreciation.
Primary Investment Focus.
The Global Income Fund invests, under normal circumstances, at least 80% of its Net Assets in a
portfolio of fixed income securities of U.S. and foreign issuers. Foreign securities include securities of issuers located outside the U.S. or securities quoted or denominated in a currency other than the U.S. dollar. The Underlying Fund also enters
into transactions in foreign currencies, typically through the use of forward contracts and swap contracts.
Under normal
market conditions, the Underlying Fund will:
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Have at least 30% of its Net Assets, after considering the effect of currency positions, denominated in U.S. dollars
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Invest in securities of issuers in at least three countries
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Seek to meet its investment objective by pursuing investment opportunities in foreign and domestic fixed income securities markets and by engaging in
currency transactions to seek to enhance returns and to seek to hedge its portfolio against currency exchange rate fluctuations
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The Underlying Fund may invest more than 25% of its Total Assets in the securities of corporate and governmental issuers located in each of Canada, Germany, Japan and the United Kingdom as well as in the
securities of U.S. issuers. Not more than 25% of the Underlying Funds Total Assets will be invested in securities of issuers in any other single foreign country.
The Underlying Fund may also invest up to 10% of its Total Assets in issuers in emerging countries.
The fixed income securities in which the Fund may invest include:
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U.S. Government securities and custodial receipts therefor
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Securities issued or guaranteed by a foreign government or any of its political subdivisions, authorities, agencies, instrumentalities or by
supranational entities
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Corporate debt securities
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Certificates of deposit and bankers acceptances issued or guaranteed by, or time deposits maintained at, U.S. or foreign banks (and their
branches wherever located) having total assets of more than $1 billion
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Mortgage-Backed Securities and asset-backed securities.
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B-12
The Underlying Fund may invest in fixed income securities rated at least BBB-or Baa3 at the
time of purchase, and at least 25% of the Underlying Funds Total Assets will be invested in fixed income securities rated at least AAA or Aaa at the time of purchase. Securities will either be rated by a NRSRO or, if unrated, determined by the
Underlying Funds Investment Adviser to be of comparable quality. The Underlying Funds target duration range under normal interest rate conditions is that of the Barclays Global Aggregate Index (USD Hedged), plus or minus 2.5 years, and
over the last ten years ended June 30, 2012, the duration of the index has ranged between 3.6 and 7 years. Subject to the above, there are no limits on the length of remaining maturities of securities held by the Underlying Fund. The
approximate interest rate sensitivity of the Underlying Fund is comparable to that of a 6 year bond.
Other.
The
Underlying Fund is non-diversified under the Investment Company Act of 1940, as amended (the Investment Company Act), and may invest more of its assets in fewer issuers than diversified mutual funds.
High Yield Fund
Objective.
The Goldman Sachs High Yield Fund seeks a high level of current income.
Primary Investment Focus.
The Underlying Fund invests, under normal circumstances, at least 80% of its Net Assets in domestic or foreign floating rate loans and other floating or variable rate
obligations rated below investment grade. Non-investment grade obligations are those rated BB+, Ba1 or below by a NRSRO, or, if unrated, determined by the Underlying Funds Investment Adviser to be of comparable quality, and are commonly
referred to as junk bonds.
The Underlying Funds investments in floating and variable rate obligations may
include, without limitation, senior secured loans (including assignments and participations), second lien loans, senior unsecured and subordinated loans, senior and subordinated corporate debt obligations (such as bonds, debentures, notes and
commercial paper), debt issued by governments, their agencies and instrumentalities, and debt issued by central banks. The Underlying Fund may invest indirectly in loans by purchasing participations or sub-participations from financial institutions.
Participations and sub-participations represent the right to receive a portion of the principal of, and all of the interest relating to such portion of, the applicable loan. The Underlying Fund expects to invest principally in the U.S. loan market
and, to a lesser extent, in the European loan market. The Underlying Fund may also invest in other loan markets, although it does not currently intend to do so.
Under normal market conditions, the Underlying Fund may invest up to 20% of its Net Assets in fixed income instruments, regardless of rating, including fixed rate corporate bonds, government bonds,
convertible debt obligations, and mezzanine fixed income instruments. The Fund may also invest in floating or variable rate instruments that are rated investment grade and in preferred stock, repurchase agreements and cash securities.
The Underlying Fund may also invest in derivative instruments. Derivatives are instruments that have a value based on another instrument,
exchange rate or index. The Underlying Funds investments in derivatives may include credit default swaps on credit and loan indices and forward contracts, among others. The Underlying Fund may use currency management techniques, such as
forward foreign currency contracts, for investment or hedging purposes. Derivatives that provide exposure to floating or variable rate loans or obligations rated below investment grade are counted towards the Underlying Funds 80% policy.
The Underlying Funds target duration under normal interest rate conditions is less than 0.5 years. The Underlying
Funds investments in floating rate obligations will generally have short to intermediate maturities (approximately 4-7 years).
The Underlying Funds investments are selected using a bottom-up analysis that incorporates fundamental research, a focus on market conditions and pricing trends, quantitative research, and news or
B-13
market events. The selection of individual investments is based on the overall risk and return profile of the investment taking into account liquidity, structural complexity, cash flow
uncertainty and downside potential. Research analysts and portfolio managers systematically assess portfolio positions, taking into consideration, among other factors, broader macroeconomic conditions and industry and company-specific financial
performance and outlook. Based upon this analysis, the Investment Adviser will sell positions determined to be overvalued and reposition the portfolio in more attractive investment opportunities on a relative basis given the current climate.
Emerging Markets Debt Fund
Objective
. The Goldman Sachs Emerging Markets Debt Fund seeks a high level of total return consisting of income and capital appreciation.
Primary Investment Focus.
The Goldman Sachs Emerging Markets Debt Fund invests, under normal circumstances, at least 80% of its
Net Assets in sovereign and corporate debt securities and other instruments of issuers in emerging market countries. Such instruments may include credit linked notes and other investments with similar economic exposures. Emerging market countries
include but are not limited to those considered to be developing by the World Bank.
Generally, the underlying investment
adviser has broad discretion to identify other countries that it considers to qualify as emerging markets countries. The majority of these countries are likely to be located in Asia, South and Central America, the Middle East, Central and Eastern
Europe, and Africa. Sovereign debt issuers include governments or any of their agencies, political subdivisions or instrumentalities. In determining whether an issuer of corporate debt is in an emerging market country, the underlying investment
adviser will ordinarily do so by identifying the issuers country of risk. The issuers country of risk is defined by Bloomberg and is based on a number of criteria, including its country of domicile, the primary
stock exchange on which it trades, the location from which the majority of its revenue comes, and its reporting currency. However, the underlying investment adviser may also (but is not required to) deem other issuers to be in an emerging market
country if they are otherwise tied economically to an emerging market country.
The Underlying Funds investment adviser
currently intends that the Funds investment focus will be in the following emerging countries: Argentina, Brazil, Colombia, Ecuador, Egypt, Malaysia, Mexico, Peru, The Philippines, Poland, Russia, South Africa, Turkey, Ukraine and Venezuela,
as well as other emerging countries to the extent that foreign investors are permitted by applicable law to make such investments. The Underlying Fund may invest in all types of foreign and emerging country fixed income securities. Foreign
securities include securities of issuers located outside the U.S. or securities quoted or denominated in a currency other than the U.S. Dollar.
The countries in which the Underlying Fund invests may have sovereign ratings that are below investment grade or are unrated. Moreover, to the extent the Underlying Fund invests in corporate or other
privately issued debt obligations, many of the issuers of such obligations will be smaller companies with stock market capitalizations of $1 billion or less at the time of investment. Securities of these issuers may be rated below investment grade
or unrated. Although a majority of the Underlying Funds assets may be denominated in U.S. Dollars, the Underlying Fund may invest in securities denominated in any currency and may be subject to the risk of adverse currency fluctuations.
Additionally, the Underlying Fund intends to use structured securities or derivatives, including but not limited to credit linked notes, financial future contracts, forward contracts and swap contracts to gain exposure to certain countries or
currencies.
The Underlying Fund may invest in securities without regard to credit rating. The Underlying Funds target
duration range under normal interest rate conditions is that of the J.P. Morgan EMBI Global Diversified Index, plus or minus 2 years, and over the last ten years ended June 30, 2012, the duration of this Index has ranged between 5.2 and 7.5
years.
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The Underlying Funds portfolio managers seek to build a portfolio consisting of their
best ideas across the emerging markets debt market consistent with the Underlying Funds overall risk budget and the views of the investment advisers Global Fixed Income top-down teams. As market conditions change, the
volatility and attractiveness of sectors, securities and strategies can change as well. To optimize the Underlying Funds risk/return potential within its long term risk budget, the portfolio managers may dynamically adjust the mix of top-down
and bottom-up strategies in the Underlying Funds portfolio.
Other.
The Underlying Fund is non-diversified under
the Investment Company Act of 1940, as amended (the Investment Company Act), and may invest more of its assets in fewer issuers than diversified mutual funds.
Local Emerging Markets Debt Fund
Objective
. The Goldman Sachs Local
Emerging Markets Debt Fund seeks a high level of total return consisting of income and capital appreciation.
Primary
Investment Focus.
The Local Emerging Markets Debt Funds invests, under normal circumstances, at least 80% of its Net Assets in (i) sovereign and corporate debt securities and other instruments of issuers in emerging market countries,
denominated in the local currency of such emerging market countries, and/or (ii) currencies of such emerging market countries, which may be represented by forwards or other derivatives that may have interest rate exposure. Such instruments
referred to in (i) above may include credit linked notes and other investments with similar economic exposures. Emerging market countries include but are not limited to those considered to be developing by the World Bank. Generally, the
underlying investment adviser has broad discretion to identify other countries that it considers to qualify as emerging markets countries. The majority of these countries are likely to be located in Asia, South and Central America, the Middle East,
Central and Eastern Europe, and Africa. Sovereign debt consists of debt securities issued by governments or any of their agencies, political subdivisions or instrumentalities, denominated in the currency of that country, and may also include nominal
and real inflation-linked securities. In determining whether an issuer of corporate debt is in an emerging market country, the underlying investment adviser will ordinarily do so by identifying the issuers country of risk. The
issuers country of risk is defined by Bloomberg and is based on a number of criteria, including its country of domicile, the primary stock exchange on which it trades, the location from which the majority of its revenue comes, and
its reporting currency. However, the underlying investment adviser may also (but is not required to) deem other issuers to be in an emerging market country if they are otherwise tied economically to an emerging market country. Currency investments,
particularly longer-dated forward contracts, provide the Underlying Fund with economic exposure similar to investments in sovereign and corporate debt with respect to currency and interest rate exposure.
The investment adviser currently intends that the Funds investment focus will be in the following emerging countries: Argentina,
Botswana, Brazil, Chile, China, Colombia, Czech Republic, Dominican Republic, Egypt, Estonia, Ghana, Hong Kong, Hungary, India, Indonesia, Kazakstan, Kenya, Latvia, Lithuania, Malawi, Malaysia, Mauritius, Mexico, Nigeria, Peru, The Philippines,
Poland, Romania, Russia, Serbia, Slovakia, Slovenia, South Africa, South Korea, Sri Lanka, Taiwan, Tanzania, Thailand, Turkey, Uganda, Ukraine, United Arab Emirates, Uruguay, Venezuela, Vietnam and Zambia, as well as other emerging countries to the
extent that foreign investors are permitted by applicable law to make such investments. The Underlying Fund may invest in all types of foreign and emerging country fixed income securities. Foreign securities include securities of issuers located
outside the U.S. or securities quoted or denominated in a currency other than the U.S. Dollar.
The countries in which the
Underlying Fund invests may have sovereign ratings that are below investment grade or are unrated. Moreover, to the extent the Underlying Fund invests in corporate or other privately issued debt obligations, many of the issuers of such obligations
will be smaller companies with stock market capitalizations of $1 billion or less at the time of investment. Securities of these issuers may be rated below investment grade or unrated. Although a majority of the Underlying Funds assets will be
denominated in non-U.S. Dollars, the Underlying Fund may invest in securities denominated in the U.S. Dollar.
B-15
Currently, the Underlying Funds investment advisers emerging markets debt
strategy invests significantly in emerging market sovereign issues. As such, country selection is believed to be the most important factor in the portfolio construction process. The Underlying Funds investment adviser evaluates macro
developments and assesses the net flows within countries. The next most important factor is security selection. Analysis of emerging market debt involves an understanding of the finances, political events, and macroeconomic condition of a country.
The Underlying Funds investment advisers research analysts analyze the balance sheets of the countries they follow.
The Underlying Funds investment adviser intends to use structured securities and derivative instruments to attempt to improve the performance of the Underlying Fund or to gain exposure to certain
countries or currencies in the Underlying Funds investment portfolio in accordance with its investment objective, and the Underlying Funds investments in these instruments may be significant. These transactions may result in substantial
realized and unrealized capital gains and losses relative to the gains and losses from the Underlying Funds investments in bonds and other securities. Short-term and long-term realized capital gains distributions paid by the Underlying Fund
are taxable to its shareholders.
The Underlying Fund may invest in the aggregate up to 20% of its Net Assets in investments
other than emerging country fixed income securities, currency investments and related derivatives, including (without limitation) equity securities and fixed income securities, such as government, corporate and bank debt obligations, of developed
country issuers.
The Underlying Fund may invest in securities without regard to credit rating. The Underlying Funds
target duration range under normal interest rate conditions is that of the J.P. Morgan Government Bond IndexEmerging Markets Global Diversified Index plus or minus 2 years, and since the Indexs inception on December 31, 2002, the
duration of this Index has ranged between 3.8 and 4.7 years. The Underlying Funds portfolio managers seek to build a portfolio consisting of their best ideas across the emerging markets debt market consistent with the Underlying
Funds overall risk budget and the views of the investment advisers Global Fixed Income top-down teams. As market conditions change, the volatility and attractiveness of sectors, securities and strategies can change as well. To optimize
the Underlying Funds risk/return potential within its long term risk budget, the portfolio managers may dynamically adjust the mix of top-down and bottom-up strategies in the Underlying Funds portfolio.
Other.
The Underlying Fund is non-diversified under the Investment Company Act, as amended (the Investment
Company Act), and may invest more of its assets in fewer issuers than diversified mutual funds.
High Yield Floating Rate Fund
Objective
. The High Yield Floating Rate Fund seeks a high level of current income.
Primary Investment Focus.
The High Yield Floating Rate Fund invests, under normal circumstances, at least 80% of its Net Assets in
domestic or foreign floating rate loans and other floating or variable rate obligations rated below investment grade. Non-investment grade obligations are those rated BB+, Ba1 or below by a NRSRO, or, if unrated, determined by the Investment Adviser
to be of comparable quality, and are commonly referred to as junk bonds.
The Underlying Funds investments
in floating and variable rate obligations may include, without limitation, senior secured loans (including assignments and participations), second lien loans, senior unsecured and subordinated loans, senior and subordinated corporate debt
obligations (such as bonds, debentures, notes and commercial paper), debt issued by governments, their agencies and instrumentalities, and debt issued by
B-16
central banks. The Underlying Fund may invest indirectly in loans by purchasing participations or sub-participations from financial institutions. Participations and sub-participations represent
the right to receive a portion of the principal of, and all of the interest relating to such portion of, the applicable loan. The Underlying Fund expects to invest principally in the U.S. loan market and, to a lesser extent, in the European loan
market. The Underlying Fund may also invest in other loan markets, although it does not currently intend to do so.
Under
normal conditions, the Underlying Fund may invest up to 20% of its Net Assets in fixed income instruments, regardless of rating, including fixed rate corporate bonds, government bonds, convertible debt obligations, and mezzanine fixed income
instruments. The Underlying Fund may also invest in floating or variable rate instruments that are rated investment grade and in preferred stock, repurchase agreements and cash securities.
The Underlying Fund may also invest in derivative instruments. Derivatives are instruments that have a value based on another instrument,
exchange rate or index. The Underlying Funds investments in derivatives may include credit default swaps on credit and loan indices and forward contracts, among others. The Underlying Fund may use currency management techniques, such as
forward foreign currency contracts, for investment or hedging purposes. Derivatives that provide exposure to floating or variable rate loans or obligations rated below investment grade are counted towards the Underlying Funds 80% policy.
The Underlying Funds target duration under normal interest rate conditions is less than 0.5 years (the Underlying
Funds duration approximates its price sensitivity to changes in interest rates). The Underlying Funds investments in floating rate obligations will generally have short to intermediate maturities (approximately 4-7 years). The Underlying
Funds investments are selected using a bottom-up analysis that incorporates fundamental research, a focus on market conditions and pricing trends, quantitative research, and news or market events. The selection of individual investments is
based on the overall risk and return profile of the investment taking into account liquidity, structural complexity, cash flow uncertainty and downside potential. Research analysts and portfolio managers systematically assess portfolio positions,
taking into consideration, among other factors, broader macroeconomic conditions and industry and company specific financial performance and outlook. Based upon this analysis, the Investment Adviser will sell positions determined to be overvalued
and reposition the portfolio in more attractive investment opportunities on a relative basis given the current climate.
Commodity Strategy
Fund
Objective.
The Commodity Strategy Fund seeks long-term total return.
Primary Investment Focus
. The Commodity Strategy Fund seeks to maintain substantial economic exposure to the performance of the
commodities markets. The Underlying Fund primarily gains exposure to the commodities markets by investing in a wholly-owned subsidiary of the Fund organized as a company under the laws of the Cayman Islands (the Subsidiary). The
Subsidiary is advised by the Underlying Funds investment adviser, and has the same investment objective as the Underlying Fund.
The Underlying Fund seeks to provide exposure to the commodities markets and returns that correspond to the performance of the S&P GSCI
®
Total Return Index, formerly the Goldman Sachs Commodity Index (S&P GSCI), or other similar indices by investing, through the Subsidiary, in
commodity-linked investments. The Underlying Fund will also seek to add incremental returns through the use of roll-timing or similar strategies as described further below. The S&P GSCI is a composite index of commodity sector
returns, representing an unleveraged, long-only investment in commodity futures that is diversified across the spectrum of commodities. Individual components qualify for inclusion in the S&P GSCI on the basis of liquidity and are weighted by
their respective world production quantities. In pursuing its objective, the Underlying Fund attempts to provide exposure to the returns of real assets that trade in the commodity markets without direct investment in physical commodities. The
Underlying Fund uses the S&P GSCI as its performance benchmark, but the Underlying Fund will not attempt to replicate the index.
B-17
Investment in the Subsidiary.
The Underlying Fund may invest up to 25% of its Total
Assets in the Subsidiary. The Subsidiary primarily obtains its commodity exposure by investing in commodity-linked derivative instruments (which may include total return swaps). Commodity-linked swaps are derivative instruments whereby the cash
flows agreed upon between counterparties are dependent upon the price of the underlying commodity or commodity index over the life of the swap. The value of the swap will rise and fall in response to changes in the underlying commodity or commodity
index. Commodity-linked swaps expose the Subsidiary and the Underlying Fund economically to movements in commodity prices. Neither the Underlying Fund nor the Subsidiary invests directly in commodities. The Subsidiary will also invest in other
instruments, including fixed income securities, either as investments or to serve as margin or collateral for its swap positions.
The Underlying Fund employs commodity roll-timing strategies. Rolling futures exposure is the process by which the holder of a particular futures contract or other instrument providing futures
exposure (
e.g.
swaps) will sell such contract or instrument on or before the expiration date and simultaneously purchase a new contract or instrument with identical terms except for a later expiration date. This process allows a holder of the
instrument to extend its current position through the original instruments expiration without delivering the underlying asset. The Underlying Funds rolling may differ from that of the S&P GSCI. The Underlying Funds
roll-timing strategies may include, for example, rolling the Funds commodity exposure earlier or later versus the S&P GSCI, or holding and rolling positions with longer or different expiration dates than the S&P GSCI.
Fixed Income Investments.
As a result of the Underlying Funds use of derivatives, the Underlying Fund may hold
significant amounts of U.S. Treasury or short-term investments, including money market funds. The Underlying Fund also attempts to enhance returns by investing in investment grade fixed income securities, and may invest up to 10% of its assets in
non-investment grade fixed income securities. The Underlying Fund may invest in corporate securities, U.S. Government securities (including agency debentures), Mortgage-Backed Securities, asset-backed securities, and municipal securities. The
average duration will vary. The Underlying Funds investment adviser uses derivatives, including futures and swaps, to manage the duration of the Underlying Funds investment portfolio.
Other
. The Underlying Fund may also invest in forwards, futures, and swaps. The Underlying Fund invests in forwards, futures and
interest rate swaps to seek to increase total return and/or for hedging purposes. The Underlying Fund may invest up to 35% of its Net Assets in foreign securities.
This Underlying Fund is non-diversified under the Act, and may invest a larger percentage of its assets in fewer issuers than diversified mutual funds.
Dynamic Allocation Fund
Objective. The Dynamic Allocation Fund seeks long-term capital appreciation.
Primary Investment Focus.
The Dynamic Allocation Fund is intended for investors who seek capital appreciation but also seek asset
class and risk diversification. The Underlying Fund seeks to achieve its investment objective by investing primarily in ETFs, futures, swaps, structured notes and other derivatives that provide exposure to a broad spectrum of asset classes,
including but not limited to equities (both in US and non-US companies), fixed income (US and non-US, investment grade and high yield) and commodities. The Underlying Funds investment adviser manages the Underlying Fund dynamically by changing
the Underlying Funds allocations to these asset classes based on the investment advisers tactical views and in response to changing market conditions.
B-18
The investment advisers Quantitative Investment Strategies Group uses a disciplined,
rigorous and quantitative approach in allocating to the asset classes in which the Underlying Fund invests.
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The Underlying Funds tactical allocation models use financial and economic factors that seek to capture the expected return and expected
volatility of global asset classes across markets. In allocating to each of the Underlying Funds asset classesincluding, but not limited to, equities, fixed income and commoditiesthe Underlying Funds investment adviser may
consider the expected volatility of the Underlying Funds overall portfolio and the risk contribution of each asset class. The asset classes used by the Underlying Funds tactical allocation models may vary. Moreover, not all of the
Underlying Funds asset classes may contribute to expected portfolio volatility at a given time, due to market opportunities, compliance with regulatory constraints, changes in the Underlying Funds investment process, or other factors.
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Within a given asset class, the Quantitative Investment Strategies Group will consider a number of factors in selecting individual securities
and investment types, including: cost, trading volume and efficiency and regulatory considerations.
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Additionally, as a measure against inflation, the Underlying Fund will typically allocate some portion of its assets to commodity linked
instruments and Treasury Inflation Protected Securities (TIPS), asset classes that are intended to (and have historically) provide higher returns during inflationary periods.
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As a result of the Underlying Funds use of derivatives, the Underlying Fund may also hold significant amounts of U.S. Treasury or
short-term investments, including money market funds.
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On a regular basis (typically monthly), the investment adviser will assess the risk contribution of each asset class and rebalance accordingly.
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The investment adviser will tactically shift the Underlying Funds portfolio weightings among the
different asset classes both to take advantage of changing market opportunities for greater capital appreciation and in response to changing market risk conditions. At any given time, the Underlying Fund will establish overweight positions in those
asset classes that the investment adviser believes will outperform relative to other asset classes and hold underweight positions in those asset classes that the investment adviser believes will underperform on a relative basis. Additionally, the
investment adviser may adjust the Underlying Funds asset class allocation based on the information provided by its Market Sentiment Indicator (the Indicator). The Indicator is a proprietary composite of various measures of
financial disruption, such as the volatility of the S&P 500 Index and credit spreads. Credit spreads measure the difference in the yield of higher yielding bond sectors relative to Treasury bonds. When those spreads widen, this can indicate
higher levels of uncertainty or distress in financial markets. When the Indicator signals high market distress, the investment adviser may allocate more of the Underlying Funds assets to cash or other less risky assets. There is no guarantee
that the investment advisers asset allocation model or Market Sentiment Indicator will be successful predictors of future market activity.
The investment adviser may also establish a short position for the Underlying Fund with respect to an asset class that the investment adviser believes will underperform over a particular time period. The
Underlying Fund may also use leverage (
e.g.
by borrowing or through derivatives).
The investment adviser may, in its
discretion, make changes to its tactical allocation and other models, including the Indicator, or use other models that are based on the investment advisers proprietary research.
This Underlying Fund is non-diversified under the Act, and may invest a larger percentage of its assets in fewer issuers than
diversified mutual funds.
B-19
DESCRIPTION OF INVESTMENT SECURITIES AND PRACTICES
The Short Duration Government Fund and Financial Square Prime Obligations Fund invest in U.S. Government securities and
related repurchase agreements, and none of these Underlying Funds make foreign investments. The investments of the Financial Square Prime Obligations Fund are limited by SEC regulations applicable to money market funds as described in its
prospectus, and do not include many of the types of investments discussed below that are permitted for the other Underlying Funds. With these exceptions, and the further exceptions noted below, the following description applies generally to the
Underlying Funds.
An Underlying Fixed Income Funds investment adviser uses derivative instruments to manage the
duration of an Underlying Fixed Income Funds investment portfolio in accordance with its respective target duration. These derivative instruments include financial futures contracts and swap transactions, as well as other types of derivatives.
The Underlying Funds investments in derivative instruments, including financial futures contracts and swaps, can be significant. These transactions can result in sizeable realized and unrealized capital gains and losses relative to the gains
and losses from the Underlying Funds investments in bonds and other securities. Short-term and long-term realized capital gains distributions paid by the Underlying Funds are taxable to their shareholders. Financial futures contracts used by
an Underlying Fixed Income Fund include interest rate futures contracts including, among others, Eurodollar futures contracts. Eurodollar futures contracts are U.S. dollar-denominated futures contracts that are based on the implied forward London
Interbank Offered Rate (LIBOR) of a three-month deposit. Further information is included below regarding futures contracts, swaps and other derivative instruments used by an Underlying Fixed Income Fund, including information on the risks presented
by these instruments and other purposes for which they may be used by an Underlying Fixed Income Fund.
Interest rates, fixed
income securities prices, the prices of futures and other derivatives, and currency exchange rates can be volatile, and a variance in the degree of volatility or in the direction of the market from the Investment Advisers expectations may
produce significant losses in an Underlying Fixed Income Funds investments in derivatives. In addition, a perfect correlation between a derivatives position and a fixed income security position is generally impossible to achieve. As a result,
the Investment Advisers use of derivatives may not be effective in fulfilling the Investment Advisers investment strategies and may contribute to losses that would not have been incurred otherwise.
As stated in the Prospectus, the Portfolios may also invest a portion of their assets in high quality, short-term debt obligations and
engage in certain other investment practices. Further information about the Underlying Funds and their respective investment objectives and policies is included in their respective prospectuses and Statements of Additional Information. There is no
assurance that any Portfolio or Underlying Fund will achieve its objective.
Commodity-Linked Securities
The Commodity Strategy Fund and Dynamic Allocation Fund may seek to provide exposure to the investment returns of real assets that trade
in the commodity markets through investments in commodity-linked derivative securities, which are designed to provide this exposure without direct investment in physical commodities or commodities futures contracts. The Commodity Strategy Fund may
also seek to provide exposure to the investment returns of real assets that trade in the commodity markets through investments in the Subsidiary. Real assets are assets such as oil, gas, industrial and precious metals, livestock, and agricultural or
meat products, or other items that have tangible properties, as compared to stocks or bonds, which are financial instruments. In choosing investments, an Underlying Funds investment adviser seeks to provide exposure to various commodities and
commodity sectors. The value of commodity-linked derivative securities held by an Underlying Fund and/or the Subsidiary may be affected by a variety of factors, including, but not limited to, overall market movements and other factors affecting the
value of particular industries or commodities, such as weather, disease, embargoes, acts of war or terrorism, or political and regulatory developments.
B-20
The prices of commodity-linked derivative securities may move in different directions than
investments in traditional equity and debt securities when the value of those traditional securities is declining due to adverse economic conditions. As an example, during periods of rising inflation, debt securities have historically tended to
decline in value due to the general increase in prevailing interest rates. Conversely, during those same periods of rising inflation, the prices of certain commodities, such as oil and metals, have historically tended to increase. Of course, there
cannot be any guarantee that these investments will perform in that manner in the future, and at certain times the price movements of commodity-linked instruments have been parallel to those of debt and equity securities. Commodities have
historically tended to increase and decrease in value during different parts of the business cycle than financial assets. Nevertheless, at various times, commodities prices may move in tandem with the prices of financial assets and thus may not
provide overall portfolio diversification benefits. Under favorable economic conditions, an Underlying Funds investments may be expected to underperform an investment in traditional securities. Over the long term, the returns on an Underlying
Funds investments are expected to exhibit low or negative correlation with stocks and bonds.
With respect to the
Commodity Strategy Fund, its investment adviser generally intends to invest in commodity-linked investments whose returns are linked to the S&P GSCI. However, the Commodity Strategy Fund is not an index fund and its investment adviser may make
allocations that differ from the weightings in the S&P GSCI.
Investments in the Wholly-Owned Subsidiary
The Commodity Strategy Fund may invest in its wholly-owned Subsidiary. Investments in the Subsidiary are expected to provide the
Underlying Fund with exposure to the commodity markets within the limitations of Subchapter M of the Code and recent IRS revenue rulings, as discussed in more detail in the Commodity Strategy Funds SAI. The Subsidiary is a company organized
under the laws of the Cayman Islands, and is overseen by its own board of directors. The Commodity Strategy Fund is currently the sole shareholder of the Subsidiary; however, shares of the Subsidiary may be sold or offered to other investors in the
future. The Subsidiary may invest without limitation in commodity index-linked securities (including leveraged and unleveraged structured notes) and other commodity-linked securities and derivative instruments that provide exposure to the
performance of the commodity markets. Although the Commodity Strategy Fund may invest in commodity-linked derivative instruments directly, the Commodity Strategy Fund may gain exposure to these derivative instruments indirectly by investing in the
Subsidiary. The Subsidiary also invests in fixed income securities, which are intended to serve as margin or collateral for the Subsidiarys derivatives positions. To the extent that the Commodity Strategy Fund invests in the Subsidiary, it may
be subject to the risks associated with those derivative instruments and other securities, which are discussed elsewhere in the Commodity Strategy Funds Prospectus and SAI.
The Subsidiary is not an investment company registered under the Act and is not subject to all of the investor protections of the Act and
other U.S. regulations. Changes in the laws of the United States and/or the Cayman Islands could result in the inability of the Commodity Strategy Fund and/or the Subsidiary to operate as described in the Commodity Strategy Funds Prospectus
and SAI and could negatively affect the Commodity Strategy Fund and its shareholders.
Collateralized Debt Obligations
Certain of the Underlying Funds may invest in collateralized debt obligations (CDOs), which include collateralized loan
obligations (CLOs), collateralized bond obligations (CBOs), and other similarly structured securities. A CLO is a trust typically collateralized by a pool of loans, which may include, among others, domestic and foreign senior
secured loans, senior unsecured loans, and subordinate corporate loans, including loans that may be rated below investment grade or equivalent unrated loans. CDOs may charge management and other administrative fees.
B-21
The cash flows from the trust are split into two or more portions, called tranches, varying
in risk and yield. The riskiest portion is the equity tranche which bears the bulk of defaults from the bonds or loans in the trust and serves to protect the other, more senior tranches from default in all but the most severe
circumstances. Because it is partially protected from defaults, a senior tranche from a CLO trust typically has higher ratings and lower yields than its underlying securities, and can be rated investment grade. Despite the protection from the equity
tranche, CLO tranches can experience substantial losses due to actual defaults, increased sensitivity to defaults due to collateral default and disappearance of protecting tranches, market anticipation of defaults, as well as aversion to CLO
securities as a class.
The risks of an investment in a CDO depend largely on the type of the collateral securities and the
class of the CDO in which the Underlying Fund invests. Normally, CLOs and other CDOs are privately offered and sold, and thus, are not registered under the securities laws. As a result, investments in CDOs may be characterized by the Underlying Fund
as illiquid securities, however an active dealer market may exist for CDOs that qualify under the Rule 144A safe harbor from the registration requirements of the Securities Act for resales of certain securities to qualified institutional
buyers, and such CDOs may be characterized by the Fund as liquid securities. In addition to the normal risks associated with fixed income securities discussed elsewhere in this SAI and the Underlying Funds Prospectuses (e.g., interest rate
risk and default risk), CDOs carry additional risks including, but are not limited to, the risk that: (i) distributions from collateral securities may not be adequate to make interest or other payments; (ii) the quality of the collateral
may decline in value or default; (iii) the Underlying Fund may invest in CDOs that are subordinate to other classes; and (iv) the complex structure of the security may not be fully understood at the time of investment and may produce
disputes with the issuer or unexpected investment results.
Structured Notes
The Commodity Strategy Fund and Dynamic Allocation Fund may invest in structured notes. In one type of structured note in which an
Underlying Fund may invest, the issuer of the note will be a highly creditworthy party. The terms of such notes will be in accordance with applicable IRS guidelines. The note will be issued at par value. The amount payable at maturity, early
redemption or knockout (as defined below) of the note will depend directly on the performance of the S&P GSCI Index. As described more precisely below, the amount payable at maturity will be computed using a formula under which the
issue price paid for the note is adjusted to reflect the percentage appreciation or depreciation of the index over the term of the note in excess of a specified interest factor, and an agreed-upon multiple (the leverage factor) of three.
The note will also bear interest at a floating rate that is pegged to LIBOR. The interest rate will be based generally on the issuers funding spread and prevailing interest rates. The interest will be payable at maturity. The issuer of the
note will be entitled to an annual fee for issuing the note, which will be payable at maturity, and which may be netted against payments otherwise due under the note. The amount payable at maturity, early redemption or knockout of each note will be
calculated by starting with an amount equal to the face amount of the note plus any remaining unpaid interest on the note and minus any accumulated fee amount, and then adding (or subtracting, in the case of a negative number) the amount equal to
the product of (i) the percentage increase (or decrease) of the S&P GSCI Index over the applicable period, less a specified interest percentage, multiplied by (ii) the face amount of the note, and by (iii) the leverage factor of
three. The holder of the note will have a right to put the note to the issuer for redemption at any time before maturity. The note will become automatically payable (
i.e
., will knockout) if the relevant index declines by 15%. In
the event that the index has declined to the knockout level (or below) during any day, the redemption price of the note will be based on the closing index value of the next day. The issuer of the note will receive payment in full of the purchase
price of the note substantially contemporaneously with the delivery of the note. An Underlying Fund, while holding the note, will not be required to make any payment to the issuer of the note in addition to the purchase price paid for the note,
whether as margin, settlement payment, or otherwise, during the life of the note or at maturity. The issuer of the note will not be subject by the terms of the instrument to mark-to-market margining requirements of the Commodity Exchange Act, as
amended (the CEA). The note will not be marketed as a contract of sale of a commodity for future delivery (or option on such a contract) subject to the CEA.
B-22
With respect to a second type of structured note in which certain Underlying Funds intend to
invest, the issuer of the note will be a highly creditworthy party. The term of the note will be for six months. The note will be issued at par value. The amount payable at maturity or early redemption of the note will depend directly on the
performance of a specified basket of 6-month futures contracts with respect to all of the commodities in the S&P GSCI Index, with weightings of the different commodities similar to the weightings in the S&P GSCI Index. As described more
precisely below, the amount payable at maturity will be computed using a formula under which the issue price paid for the note is adjusted to reflect the percentage appreciation or depreciation of the value of the specified basket of commodities
futures over the term of the note in excess of a specified interest factor, and the leverage factor of three, but in no event will the amount payable at maturity be less than 51% of the issue price of the note. The note will also bear interest at a
floating rate that is pegged to LIBOR. The interest rate will be based generally on the issuers funding spread and prevailing interest rates. The interest will be payable at maturity. The issuer of the note will be entitled to a fee for
issuing the note, which will be payable at maturity, and which may be netted against payments otherwise due under the note. The amount payable at maturity or early redemption of each note will be the greater of (i) 51% of the issue price of the
note and (ii) the amount calculated by starting with an amount equal to the face amount of the note plus any remaining unpaid interest on the note and minus any accumulated fee amount, and then adding (or subtracting, in the case of a negative
number) the amount equal to the product of (A) the percentage increase (or decrease) of the specified basket of commodities futures over the applicable period, less a specified interest percentage, multiplied by (B) the face amount of the
note, and by (C) the leverage factor of three. The holder of the note will have a right to put the note to the issuer for redemption at any time before maturity. The issuer of the note will receive payment in full of the purchase price of the
note substantially contemporaneously with the delivery of the note. An Underlying Fund, while holding the note, will not be required to make any payment to the issuer of the note in addition to the purchase price paid for the note, whether as
margin, settlement payment, or otherwise, during the life of the note or at maturity. The issuer of the note will not be subject by the terms of the instrument to mark-to-market margining requirements of the CEA. The note will not be marketed as a
contract of sale of a commodity for future delivery (or option on such a contract) subject to the CEA.
Corporate Debt Obligations
Each Underlying Fund (other than the Short Duration Government Fund and Financial Square Prime Obligations Fund) may,
under normal market conditions, invest in corporate debt obligations, including obligations of industrial, utility and financial issuers. Corporate debt obligations include bonds, notes, debentures and other obligations of corporations to pay
interest and repay principal. Structured Large Cap Value Fund, Structured Large Cap Growth Fund, Structured Small Cap Equity Fund, Structured International Equity Fund, Structured Emerging Markets Equity Fund, Structured International Small Cap Fund
may only invest in debt securities that are cash equivalents. Corporate debt obligations are subject to the risk of an issuers inability to meet principal and interest payments on the obligations and may also be subject to price volatility due
to such factors as market interest rates, market perception of the creditworthiness of the issuer and general market liquidity.
Corporate debt obligations rated BBB or Baa are considered medium-grade obligations with speculative characteristics, and adverse
economic conditions or changing circumstances may weaken their issuers capacity to pay interest and repay principal. Medium to lower rated and comparable non-rated securities tend to offer higher yields than higher rated securities with the
same maturities because the historical financial condition of the issuers of such securities may not have been as strong as that of other issuers. The price of corporate debt obligations will generally fluctuate in response to fluctuations in supply
and demand for similarly rated securities. In addition, the price of corporate debt obligations will generally fluctuate in response to interest rate levels. Fluctuations in the prices of portfolio securities subsequent to their acquisition will not
affect cash income from such securities but will be reflected in a Underlying Funds net asset value (NAV).
B-23
Because medium to lower rated securities generally involve greater risks of loss of income
and principal than higher rated securities, investors should consider carefully the relative risks associated with investment in securities which carry medium to lower ratings and in comparable unrated securities. In addition to the risk of default,
there are the related costs of recovery on defaulted issues. The investment advisers of the Underlying Funds will attempt to reduce these risks through portfolio diversification and by analysis of each issuer and its ability to make timely payments
of income and principal, as well as broad economic trends and corporate developments.
The investment adviser for an
Underlying Fund employs its own credit research and analysis, which includes a study of existing debt, capital structure, ability to service debt and pay dividends, sensitivity to economic conditions, operating history and current earnings trend.
The investment adviser continually monitors the investments in the Underlying Funds portfolio and evaluates whether to dispose of or to retain corporate debt obligations whose credit ratings or credit quality may have changed. If after its
purchase, a portfolio security is assigned a lower rating or ceases to be rated, an Underlying Fund may continue to hold the security if the Underlying Funds investment adviser believes it is in the best interest of the Underlying Fund and its
shareholders.
Commercial Paper and Other Short-Term Corporate Obligations
. Certain of the Underlying Funds may
invest in commercial paper and other short-term obligations payable in U.S. dollars and issued or guaranteed by U.S. corporations, non-U.S. corporations or other entities. Commercial paper represents short-term unsecured promissory notes issued in
bearer form by banks or bank holding companies, corporations and finance companies.
Preferred Securities
.
Certain of the Underlying Funds may invest in trust preferred securities. A trust preferred or capital security is a long dated bond (for example 30 years) with preferred features. The preferred features are that payment of interest can be deferred
for a specified period without initiating a default event. From a bondholders viewpoint, the securities are senior in claim to standard preferred but are junior to other bondholders. From the issuers viewpoint, the securities are
attractive because their interest is deductible for tax purposes like other types of debt instruments.
High Yield
Securities
. Certain of the Underlying Funds may invest in bonds rated BB or below by Standard & Poors or Ba or below by Moodys (or comparable rated and unrated securities). The other funds in this SAI may not invest directly
in high yield securities, but may hold securities that are subsequently downgraded to below investment grade. These bonds are commonly referred to as junk bonds and are considered speculative. Each of the international equity funds may
invest up to 20% of its net assets in non-investment grade securities, and the Balance Fund may invest up to 10% of its Total Assets in non-investment grade securities. The ability of issuers of non-investment grade securities to make principal and
interest by payments may be questionable because such issuers are often less creditworthy or are highly leveraged. High yield securities are also issued by governmental issuers that may have difficulty in making all scheduled interest and principal
payments. In some cases, such bonds may be highly speculative, have poor prospects for reaching investment grade standing and be in default. As a result, investment in such bonds will entail greater risks than those associated with investment grade
bonds (
i.e.
, bonds rated AAA, AA, A or BBB by Standard & Poors or Aaa, Aa, A or Baa by Moodys). Analysis of the creditworthiness of issuers of high yield securities may be more complex than for issuers of higher quality
debt securities, and the ability of an Underlying Fund to achieve its investment objective may, to the extent of its investments in high yield securities, be more dependent upon such creditworthiness analysis than would be the case if the Underlying
Fund were investing in higher quality securities. See Appendix A for a description of the corporate bond and preferred stock ratings by Standard & Poors, Moodys, Fitch, Inc. (Fitch) and Dominion Bond Rating Service
Limited (DBRS).
B-24
Risks associated with acquiring the securities of such issuers generally are greater than is
the case with higher rated securities because such issuers are often less creditworthy companies or are highly leveraged and generally less able than more established or less leveraged entities to make scheduled payments of principal and interest.
High yield securities are also issued by governmental issuers that may have difficulty in making all scheduled interest and principal payments.
The market values of high yield, fixed income securities tend to reflect individual corporate or municipal developments to a greater extent than do those of higher rated securities, which react primarily
to fluctuations in the general level of interest rates. Issuers of such high yield securities are often highly leveraged, and may not be able to make use of more traditional methods of financing. Their ability to service debt obligations may be more
adversely affected than issuers of higher rated securities by economic downturns, specific corporate or governmental developments or the issuers inability to meet specific projected business forecasts. High yield securities also tend to be
more sensitive to economic conditions than higher-rated securities. In the lower quality segments of the fixed income securities market, changes in perceptions of issuers creditworthiness tend to occur more frequently and in a more pronounced
manner than do changes in higher quality segments of the fixed income securities market, resulting in greater yield and price volatility. Another factor which causes fluctuations in the prices of high yield, fixed income securities is the supply and
demand for similarly rated securities. In addition, the prices of investments fluctuate in response to the general level of interest rates. Fluctuations in the prices of portfolio securities subsequent to their acquisition will not affect cash
income from such securities but will be reflected in an Underlying Funds net asset value.
The risk of loss from default
for the holders of high yield, fixed income securities is significantly greater than is the case for holders of other debt securities because such high yield, fixed income securities are generally unsecured and are often subordinated to the rights
of other creditors of the issuers of such securities. Investment by an Underlying Fund in already defaulted securities poses an additional risk of loss should nonpayment of principal and interest continue in respect of such securities. Even if such
securities are held to maturity, recovery by an Underlying Fund of its initial investment and any anticipated income or appreciation is uncertain. In addition, an Underlying Fund may incur additional expenses to the extent that it is required to
seek recovery relating to the default in the payment of principal or interest on such securities or otherwise protect its interests. An Underlying Fund may be required to liquidate other portfolio securities to satisfy the Underlying Funds
annual distribution obligations in respect of accrued interest income on securities which are subsequently written off, even though the Underlying Fund has not received any cash payments of such interest.
The secondary market for high yield, fixed income securities is concentrated in relatively few markets and is dominated by institutional
investors, including mutual funds, insurance companies and other financial institutions. Accordingly, the secondary market for such securities may not be as liquid as and may be more volatile than the secondary market for higher-rated securities. In
addition, the trading volume for high-yield, fixed income securities is generally lower than that of higher rated securities and the secondary market for high yield, fixed income securities could contract under adverse market or economic conditions
independent of any specific adverse changes in the condition of a particular issuer. These factors may have an adverse effect on the ability of an Underlying Fund to dispose of particular portfolio investments when needed to meet their redemption
requests or other liquidity needs. The investment adviser could find it difficult to sell these investments or may be able to sell the investments only at prices lower than if such investments were widely traded. Prices realized upon the sale of
such lower rated or unrated securities, under these circumstances, may be less than the prices used in calculating an Underlying Funds net asset value. A less liquid secondary market also may make it more difficult for an Underlying Fund to
obtain precise valuations of the high yield securities in its portfolio.
The adoption of new legislation could adversely
affect the secondary market for high yield securities and the financial condition of issuers of these securities. The form of any future legislation, and the probability of such legislation being enacted, is uncertain.
B-25
Non-investment grade or high-yield, fixed income securities also present risks based on
payment expectations. High yield, fixed income securities frequently contain call or buy-back features which permit the issuer to call or repurchase the security from its holder. If an issuer exercises such a call option and
redeems the security, an Underlying Fund may have to replace such security with a lower-yielding security, resulting in a decreased return for investors. In addition, if an Underlying Fund experiences unexpected net redemptions of its shares, it may
be forced to sell its higher-rated securities, resulting in a decline in the overall credit quality of the Underlying Funds portfolio and increasing the exposure of the Underlying Fund to the risks of high-yield securities.
Credit ratings issued by credit rating agencies are designed to evaluate the safety of principal and interest payments of rated
securities. They do not, however, evaluate the market value risk of non-investment grade securities and, therefore, may not fully reflect the true risks of an investment. In addition, credit rating agencies may or may not make timely changes in a
rating to reflect changes in the economy or in the conditions of the issuer that affect the market value of the security. Consequently, credit ratings are used only as a preliminary indicator of investment quality. Investments in non-investment
grade and comparable unrated obligations will be more dependent on the credit analysis of an Underlying Funds investment adviser than would be the case with investments in investment-grade debt obligations. An Underlying Funds investment
adviser employs its own credit research and analysis, which includes a study of an issuers existing debt, capital structure, ability to service debt and to pay dividends, sensitivity to economic conditions, operating history and current trend
of earnings. The Underlying Funds investment adviser monitors the investments in an Underlying Funds portfolio and evaluates whether to dispose of or to retain non-investment grade and comparable unrated securities whose credit ratings
or credit quality may have changed. If after its purchase, a portfolio security is assigned a lower rating or ceases to be rated, an Underlying Fund may continue to hold the security of the investment adviser believes it is in the best interest of
the Underlying Fund and its shareholders.
An economic downtown could severely affect the ability of highly leveraged issuers
of junk bond investments to service their debt obligations upon maturity. Factors having an adverse impact on the market value of junk bonds will have an adverse effect on a Funds net asset value to the extent it invests in such investments.
In addition, the Fund may incur additional expenses to the extent it is required to seek recovery upon a default in paying of principal or interest on its portfolio holdings.
Loan Participations
Certain of the Underlying Funds may invest in loan
participations. A loan participation is an interest in a loan to a U.S. or foreign company or other borrower which is administered and sold by a financial intermediary. In a typical corporate loan syndication, a number of lenders, usually banks
(co-lenders), lend a corporate borrower a specified sum pursuant to the terms and conditions of a loan agreement. One of the co-lenders usually agrees to act as the agent bank with respect to the loan.
Participation interests acquired by an Underlying Fund may take the form of a direct or co-lending relationship with the corporate
borrower, an assignment of an interest in the loan by a co-lender or another participant, or a participation in the sellers share of the loan. When an Underlying Fund acts as co-lender in connection with a participation interest or when an
Underlying Fund acquires certain participation interests, an Underlying Fund will have direct recourse against the borrower if the borrower fails to pay scheduled principal and interest. In cases where an Underlying Fund lacks direct recourse, it
will look to the agent bank to enforce appropriate credit remedies against the borrower. In these cases, an Underlying Fund may be subject to delays, expenses and risks that are greater than those that would have been involved if an Underlying Fund
had purchased a direct obligation (such as commercial paper) of such borrower. For example, in the event of the bankruptcy or insolvency of the corporate borrower, a loan participation may be subject to certain defenses by the borrower as a result
of improper conduct by the agent bank. Moreover, under the terms of the loan participation, an Underlying Fund may be regarded as a creditor of the agent bank (rather than of the underlying corporate borrower), so that an Underlying Fund may also be
subject to the risk that the agent bank may become insolvent. The secondary market, if any, for these loan participations is limited and any loan participations purchased by an Underlying Fund will normally be regarded as illiquid.
B-26
An Underlying Fund limits the amount of Total Assets that it will invest in any one issuer
or in issuers within the same industry (see the Underlying Funds investment restrictions). For purposes of these limitations, an Underlying Fund generally will treat the borrower as the issuer of indebtedness held by the Underlying
Fund. In the case of participation interests where a bank or other lending institution serves as intermediate participant between the Underlying Fund and the borrower, if the participation interest does not shift to the Underlying Fund the direct
debtor-creditor relationship with the borrower, SEC interpretations require the Underlying Fund, in appropriate circumstances, to treat both the lending bank or other lending institution and the borrower as issuers for these purposes.
Treating an intermediate participant as an issuer of indebtedness may restrict the Underlying Funds ability to invest in indebtedness related to a single intermediate participant, or a group of intermediate participants engaged in the same
industry, even if the underlying borrowers represent many different companies and industries.
Floating Rate Loans and Other Floating Rate
Debt Securities
Floating rate loans consist generally of obligations of companies or other entities (e.g., a U.S. or
foreign bank, insurance company or finance company) (collectively, borrowers) incurred for a variety of purposes. Floating rate loans may be acquired by direct investment as a lender, as a participation interest (which represents a
fractional interest in a floating rate loan) issued by a lender or other financial institution, or as an assignment of the portion of a floating rate loan previously attributable to a different lender.
Floating rate loans may be obligations of borrowers who are highly leveraged. Floating rate loans may be structured to include both term
loans, which are generally fully funded at the time of the making of the loan, and revolving credit facilities, which would require additional investments upon the borrowers demand. A revolving credit facility may require a purchaser to
increase its investment in a floating rate loan at a time when it would not otherwise have done so, even if the borrowers condition makes it unlikely that the amount will ever be repaid.
A floating rate loan offered as part of the original lending syndicate typically is purchased at par value. As part of the original
lending syndicate, a purchaser generally earns a yield equal to the stated interest rate. In addition, members of the original syndicate typically are paid a commitment fee. In secondary market trading, floating rate loans may be purchased or sold
above, at, or below par, which can result in a yield that is below, equal to, or above the stated interest rate, respectively. At certain times when reduced opportunities exist for investing in new syndicated floating rate loans, floating rate loans
may be available only through the secondary market. There can be no assurance that an adequate supply of floating rate loans will be available for purchase.
Historically, floating rate loans have not been registered with the SEC or any state securities commission or listed on any securities exchange. As a result, the amount of public information available
about a specific floating rate loan historically has been less extensive than if the floating rate loan were registered or exchange-traded. As a result, no active market may exist for some floating rate loans.
Purchasers of floating rate loans and other forms of debt obligations depend primarily upon the creditworthiness of the borrower for
payment of interest and repayment of principal. If scheduled interest or principal payments are not made, the value of the obligation may be adversely affected. Floating rate loans and other debt obligations that are fully secured provide more
protections than unsecured obligations in the event of failure to make scheduled interest or principal payments. Indebtedness of borrowers whose creditworthiness is poor involves substantially greater risks and may be highly speculative. Borrowers
that are in bankruptcy or restructuring may never pay off their indebtedness, or may pay only a small fraction of the amount owed. Some floating rate loans and other debt obligations are not rated by any nationally recognized statistical rating
organization. In connection with the restructuring of a floating rate loan or other debt obligation outside of bankruptcy court in a negotiated work-out or in the context of bankruptcy proceedings, equity securities or junior debt obligations may be
received in exchange for all or a portion of an interest in the obligation.
B-27
From time to time, Goldman Sachs and its affiliates may borrow money from various banks in
connection with their business activities. These banks also may sell floating rate loans to an Underlying Fund or acquire floating rate loans from the Underlying Fund, or may be intermediate participants with respect to floating rate loans owned by
the Underlying Fund. These banks also may act as agents for floating rate loans that an Underlying Fund owns.
Agents
.
Floating rate loans typically are originated, negotiated, and structured by a bank, insurance company, finance company, or other financial institution (the agent) for a lending syndicate of financial institutions. The borrower and the
lender or lending syndicate enter into a loan agreement. In addition, an institution (typically, but not always, the agent) holds any collateral on behalf of the lenders.
In a typical floating rate loan, the agent administers the terms of the loan agreement and is responsible for the collection of principal and interest and fee payments from the borrower and the
apportionment of these payments to all lenders that are parties to the loan agreement. Purchasers will rely on the agent to use appropriate creditor remedies against the borrower. Typically, under loan agreements, the agent is given broad discretion
in monitoring the borrowers performance and is obligated to use the same care it would use in the management of its own property. Upon an event of default, the agent typically will enforce the loan agreement after instruction from the lenders.
The borrower compensates the agent for these services. This compensation may include special fees paid on structuring and funding the floating rate loan and other fees paid on a continuing basis. The typical practice of an agent or a lender in
relying exclusively or primarily on reports from the borrower may involve a risk of fraud by the borrower.
If an agent
becomes insolvent, or has a receiver, conservator, or similar official appointed for it by the appropriate bank or other regulatory authority, or becomes a debtor in a bankruptcy proceeding, the agents appointment may be terminated, and a
successor agent would be appointed. If an appropriate regulator or court determines that assets held by the agent for the benefit of the purchasers of floating rate loans are subject to the claims of the agents general or secured creditors,
the purchasers might incur certain costs and delays in realizing payment on a floating rate loan or suffer a loss of principal and/or interest. Furthermore, in the event of the borrowers bankruptcy or insolvency, the borrowers obligation
to repay a floating rate loan may be subject to certain defenses that the borrower can assert as a result of improper conduct by the agent.
Assignments
. An Underlying Fund may purchase an assignment of a portion of a floating rate loan from an agent or from another group of investors. The purchase of an assignment typically succeeds to
all the rights and obligations under the original loan agreement; however, assignments may also be arranged through private negotiations between potential assignees and potential assignors, and the rights and obligations acquired by the purchaser of
an assignment may differ from, and be more limited than, those held by the assigning agent or investor.
Loan Participation
Interests
. Purchasers of participation interests do not have any direct contractual relationship with the borrower. Purchasers rely on the lender who sold the participation interest not only for the enforcement of the purchasers rights
against the borrower but also for the receipt and processing of payments due under the floating rate loan. For additional information, see the section Loan Participations below.
Liquidity
. Floating rate loans may be transferable among financial institutions, but may not have the liquidity of conventional
debt securities and are often subject to legal or contractual restrictions on resale. Floating rate loans are not currently listed on any securities exchange or automatic quotation system. As a result, no active market may exist for some floating
rate loans. To the extent a secondary market exists for other floating rate loans, such market may be subject to irregular trading activity, wide bid/ask spreads, and extended trade settlement periods. The lack of a highly liquid secondary market
for floating rate loans may have an adverse affect on the value of such loans and may make it more difficult to value the loans for purposes of calculating their respective net asset value.
Collateral
. Most floating rate loans are secured by specific collateral of the borrower and are senior to most other securities or
obligations of the borrower. The collateral typically has a market value, at the time the
B-28
floating rate loan is made, that equals or exceeds the principal amount of the floating rate
loan. The value of the collateral may decline, be insufficient to meet the obligations of the borrower, or be difficult to liquidate. As a result, a floating rate loan may not be fully collateralized and can decline significantly in value.
Floating rate loan collateral may consist of various types of assets or interests, including working capital assets, such as
accounts receivable or inventory; tangible or intangible assets; or assets or other types of guarantees of affiliates of the borrower.
Generally, floating rate loans are secured unless (i) the purchasers security interest in the collateral is invalidated for any reason by a court, or (ii) the collateral is fully released
with the consent of the agent bank and lenders or under the terms of a loan agreement as the creditworthiness of the borrower improves. Collateral impairment is the risk that the value of the collateral for a floating rate loan will be insufficient
in the event that a borrower defaults. Although the terms of a floating rate loan generally require that the collateral at issuance have a value at least equal to 100% of the amount of such floating rate loan, the value of the collateral may decline
subsequent to the purchase of a floating rate loan. In most loan agreements there is no formal requirement to pledge additional collateral. There is no guarantee that the sale of collateral would allow a borrower to meet its obligations should the
borrower be unable to repay principal or pay interest or that the collateral could be sold quickly or easily.
In addition,
most borrowers pay their debts from the cash flow they generate. If the borrowers cash flow is insufficient to pay its debts as they come due, the borrower may seek to restructure its debts rather than sell collateral. Borrowers may try to
restructure their debts by filing for protection under the federal bankruptcy laws or negotiating a work-out. If a borrower becomes involved in bankruptcy proceedings, access to the collateral may be limited by bankruptcy and other laws. In the
event that a court decides that access to the collateral is limited or void, it is unlikely that purchasers could recover the full amount of the principal and interest due.
There may be temporary periods when the principal asset held by a borrower is the stock of a related company, which may not legally be pledged to secure a floating rate loan. On occasions when such stock
cannot be pledged, the floating rate loan will be temporarily unsecured until the stock can be pledged or is exchanged for, or replaced by, other assets.
Some floating rate loans are unsecured. The claims of holders under unsecured loans are subordinated to claims of creditors holding secured indebtedness and possibly also to claims of other creditors
holding unsecured debt. Unsecured loans have a greater risk of default than secured loans, particularly during periods of deteriorating economic conditions. If the borrower defaults on an unsecured floating rate loan, there is no specific collateral
on which the purchaser can foreclose.
Floating Interest Rates
. The rate of interest payable on floating rate loans and
other floating or variable rate obligations is the sum of a base lending rate plus a specified spread. Base lending rates are generally the London Interbank Offered Rate (LIBOR), the Prime Rate of a designated U.S. bank, the Federal
Funds Rate, or another base lending rate used by commercial lenders.
A borrower usually has the right to select the base
lending rate and to change the base lending rate at specified intervals. The applicable spread may be fixed at time of issuance or may adjust upward or downward to reflect changes in credit quality of the borrower.
The interest rate on LIBOR-based floating rate loans/obligations is reset periodically at intervals ranging from 30 to 180 days, while
the interest rate on Prime Rate- or Federal Funds Rate-based floating rate loans/obligations floats daily as those rates change. Investment in floating rate loans/obligations with longer interest rate reset periods can increase fluctuations in the
floating rate loans values when interest rates change.
The yield on a floating rate loan/obligation will primarily
depend on the terms of the underlying floating rate loan/obligation and the base lending rate chosen by the borrower. The relationship between LIBOR, the Prime Rate, and the Federal Funds Rate will vary as market conditions change.
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Maturity
. Floating rate loans typically will have a stated term of five to nine
years. However, because floating rate loans are frequently prepaid, their average maturity is expected to be two to three years. The degree to which borrowers prepay floating rate loans, whether as a contractual requirement or at their election, may
be affected by general business conditions, the borrowers financial condition, and competitive conditions among lenders. Prepayments cannot be predicted with accuracy. Prepayments of principal to the purchaser of a floating rate loan may
result in the principals being reinvested in floating rate loans with lower yields.
Supply of Floating Rate
Loans
. The legislation of state or federal regulators that regulate certain financial institutions may impose additional requirements or restrictions on the ability of such institutions to make loans, particularly with respect to highly
leveraged transactions. The supply of floating rate loans may be limited from time to time due to a lack of sellers in the market for existing floating rate loans or the number of new floating rate loans currently being issued. As a result, the
floating rate loans available for purchase may be lower quality or higher priced.
Restrictive Covenants
. A borrower
must comply with various restrictive covenants contained in the loan agreement. In addition to requiring the scheduled payment of interest and principal, these covenants may include restrictions on dividend payments and other distributions to
stockholders, provisions requiring the borrower to maintain specific financial ratios, and limits on total debt. The loan agreement may also contain a covenant requiring the borrower to prepay the floating rate loan with any free cash flow. A breach
of a covenant that is not waived by the agent (or by the lenders directly) is normally an event of default, which provides the agent or the lenders the right to call the outstanding floating rate loan.
Fees
. Purchasers of floating rate loans may receive and/or pay certain fees. These fees are in addition to interest payments
received and may include facility fees, commitment fees, commissions, and prepayment penalty fees. When a purchaser buys a floating rate loan, it may receive a facility fee; and when it sells a floating rate loan, it may pay a facility fee. A
purchaser may receive a commitment fee based on the undrawn portion of the underlying line of credit portion of a floating rate loan or a prepayment penalty fee on the prepayment of a floating rate loan. A purchaser may also receive other fees,
including covenant waiver fees and covenant modification fees.
Other Types of Floating Rate Debt
Obligations
. Floating rate debt obligations include other forms of indebtedness of borrowers such as notes and bonds, obligations with fixed rate interest payments in conjunction with a right to receive floating rate interest payments,
and shares of other investment companies. These instruments are generally subject to the same risks as floating rate loans but are often more widely issued and traded
Distressed Debt
Certain Underlying Funds may invest in the securities and
other obligations of financially troubled companies, including stressed, distressed and bankrupt issuers and debt obligations that are in covenant or payment default. Such investments generally trade significantly below par and are considered
speculative. The repayment of defaulted obligations is subject to significant uncertainties. Defaulted obligations might be repaid only after lengthy workout or bankruptcy proceedings, during which the issuer might not make any interest or other
payments. Typically such workout or bankruptcy proceedings result in only partial recovery of cash payments or an exchange of the defaulted obligation for other debt or equity securities of the issuer or its affiliates, which may in turn be illiquid
or speculative.
In any investment involving stressed and distressed debt obligations, there exists the risk that the
transaction involving such debt obligations will be unsuccessful, take considerable time or will result in a distribution of cash or a new security or obligation in exchange for the stressed and distressed debt obligations, the value of which may be
less than the Underlying Funds purchase price of such debt obligations. Furthermore, if an anticipated transaction does not occur, the Underlying Fund may be required to sell its investment at a loss. There are a number of significant risks
inherent in the bankruptcy process. Many events in a bankruptcy are the
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product of contested matters and adversary proceedings and are beyond the control of the creditors. A bankruptcy filing by an issuer may adversely and permanently affect the issuer, and if the
proceeding is converted to a liquidation, the value of the issuer may not equal the liquidation value that was believed to exist at the time of the investment. The duration of a bankruptcy proceeding is difficult to predict, and a creditors
return on investment can be adversely affected by delays until the plan of reorganization ultimately becomes effective. The administrative costs in connection with a bankruptcy proceeding are frequently high and would be paid out of the
debtors estate prior to any return to creditors. Because the standards for classification of claims under bankruptcy law are vague, there exists the risk that the Underlying Funds influence with respect to the class of securities or
other obligations it owns can be lost by increases in the number and amount of claims in the same class or by different classification and treatment. In the early stages of the bankruptcy process it is often difficult to estimate the extent of, or
even to identify, any contingent claims that might be made. In addition, certain claims that have priority by law (for example, claims for taxes) may be substantial.
Senior Loans
Certain Underlying Funds may invest in Senior Loans. Senior
Loans hold the most senior position in the capital structure of a business entity (the Borrower), are typically secured with specific collateral and have a claim on the assets and/or stock of the Borrower that is senior to that held by
subordinated debt holders and stockholders of the Borrower. The proceeds of Senior Loans primarily are used to finance leveraged buyouts, recapitalizations, mergers, acquisitions, stock repurchases, refinancings and to finance internal growth and
for other corporate purposes. Senior Loans typically have rates of interest which are redetermined daily, monthly, quarterly or semi-annually by reference to a base lending rate, plus a premium or credit spread. These base lending rates are
primarily the London-Interbank Offered Rate and secondarily the prime rate offered by one or more major U.S. banks and the certificate of deposit rate or other base lending rates used by commercial lenders.
Senior Loans typically have a stated term of between five and nine years, and have rates of interest which typically are redetermined
daily, monthly, quarterly or semi-annually. Longer interest rate reset periods generally increase fluctuations in an Underlying Funds net asset value as a result of changes in market interest rates. The Underlying Funds that may invest in
Senior Loans are not subject to any restrictions with respect to the maturity of Senior Loans held in its portfolio. As a result, as short-term interest rates increase, interest payable to the Underlying Fund from its investments in Senior Loans
should increase, and as short-term interest rates decrease, interest payable to the Underlying Fund from its investments in Senior Loans should decrease. Because of prepayments, it is expected that the average life of the Senior Loans in which an
Underlying Fund invests to be shorter than the stated maturity.
Senior Loans are subject to the risk of non-payment of
scheduled interest or principal. Such non-payment would result in a reduction of income to an Underlying Fund, a reduction in the value of the investment and a potential decrease in the net asset value of the Underlying Fund. There can be no
assurance that the liquidation of any collateral securing a Senior Loan would satisfy the Borrowers obligation in the event of non-payment of scheduled interest or principal payments, or that such collateral could be readily liquidated. In the
event of bankruptcy of a Borrower, an Underlying Fund could experience delays or limitations with respect to its ability to realize the benefits of the collateral securing a Senior Loan. The collateral securing a Senior Loan may lose all or
substantially all of its value in the event of the bankruptcy of a Borrower. Some Senior Loans are subject to the risk that a court, pursuant to fraudulent conveyance or other similar laws, could subordinate such Senior Loans to presently existing
or future indebtedness of the Borrower or take other action detrimental to the holders of Senior Loans including, in certain circumstances, invalidating such Senior Loans or causing interest previously paid to be refunded to the Borrower. If
interest were required to be refunded, it could negatively affect the Underlying Funds performance.
Many Senior Loans
in which an Underlying Fund will invest may not be rated by a rating agency, will not be registered with the Securities and Exchange Commission, or any state securities commission, and will not be
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listed on any national securities exchange. The amount of public information available with respect to Senior Loans will generally be less extensive than that available for registered or
exchange-listed securities. In evaluating the creditworthiness of Borrowers, the Underlying Funds investment adviser will consider, and may rely in part, on analyses performed by others. Borrowers may have outstanding debt obligations that are
rated below investment grade by a rating agency. Many of the Senior Loans in which an Underlying Fund will invest will have been assigned below investment grade ratings by independent rating agencies. In the event Senior Loans are not rated, they
are likely to be the equivalent of below investment grade quality. Because of the protective features of Senior Loans, the Underlying Funds investment adviser(s) believes that Senior Loans tend to have more favorable loss recovery rates as
compared to more junior types of below investment grade debt obligations. The Underlying Funds investment adviser(s) do not view ratings as the determinative factor in their investment decisions and rely more upon their credit analysis
abilities than upon ratings.
No active trading market may exist for some Senior Loans, and some loans may be subject to
restrictions on resale. A secondary market may be subject to irregular trading activity, wide bid/ask spreads and extended trade settlement periods, which may impair the ability to realize full value and thus cause a material decline in an
Underlying Funds net asset value. In addition, an Underlying Fund may not be able to readily dispose of its Senior Loans at prices that approximate those at which the Underlying Fund could sell such loans if they were more widely-traded and,
as a result of such illiquidity, the Underlying Fund may have to sell other investments or engage in borrowing transactions if necessary to raise cash to meet its obligations. During periods of limited supply and liquidity of Senior Loans, an
Underlying Funds yield may be lower.
When interest rates decline, the value of an Underlying Fund invested in fixed
rate obligations can be expected to rise. Conversely, when interest rates rise, the value of an Underlying Fund invested in fixed rate obligations can be expected to decline. Although changes in prevailing interest rates can be expected to cause
some fluctuations in the value of Senior Loans (due to the fact that floating rates on Senior Loans only reset periodically), the value of Senior Loans is substantially less sensitive to changes in market interest rates than fixed rate instruments.
As a result, to the extent an Underlying Fund invests in floating-rate Senior Loans, the Underlying Funds portfolio may be less volatile and less sensitive to changes in market interest rates than if the Underlying Fund invested in fixed rate
obligations. Similarly, a sudden and significant increase in market interest rates may cause a decline in the value of these investments and in the Underlying Funds net asset value. Other factors (including, but not limited to, rating
downgrades, credit deterioration, a large downward movement in stock prices, a disparity in supply and demand of certain securities or market conditions that reduce liquidity) can reduce the value of Senior Loans and other debt obligations,
impairing the Underlying Funds net asset value.
An Underlying Fund may purchase and retain in its portfolio a Senior
Loan where the Borrower has experienced, or may be perceived to be likely to experience, credit problems, including involvement in or recent emergence from bankruptcy reorganization proceedings or other forms of debt restructuring. Such investments
may provide opportunities for enhanced income as well as capital appreciation, although they also will be subject to greater risk of loss. At times, in connection with the restructuring of a Senior Loan either outside of bankruptcy court or in the
context of bankruptcy court proceedings, the Underlying Fund may determine or be required to accept equity securities or junior credit securities in exchange for all or a portion of a Senior Loan.
An Underlying Fund may purchase Senior Loans on a direct assignment basis. If an Underlying Fund purchases a Senior Loan on direct
assignment, it typically succeeds to all the rights and obligations under the loan agreement of the assigning lender and becomes a lender under the loan agreement with the same rights and obligations as the assigning lender. Investments in Senior
Loans on a direct assignment basis may involve additional risks to the Underlying Fund. For example, if such loan is foreclosed, the Underlying Fund could become part owner of any collateral, and would bear the costs and liabilities associated with
owning and disposing of the collateral.
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An Underlying Fund may also purchase, without limitation, participations in Senior Loans.
The participation by the Underlying Fund in a lenders portion of a Senior Loan typically will result in the Underlying Fund having a contractual relationship only with such lender, not with the Borrower. As a result, the Underlying Fund may
have the right to receive payments of principal, interest and any fees to which it is entitled only from the lender selling the participation and only upon receipt by such lender of payments from the Borrower. Such indebtedness may be secured or
unsecured. Loan participations typically represent direct participations in a loan to a Borrower, and generally are offered by banks or other financial institutions or lending syndicates. An Underlying Fund may participate in such syndications, or
can buy part of a loan, becoming a part lender. When purchasing loan participations, the Underlying Fund assumes the credit risk associated with the Borrower and may assume the credit risk associated with an interposed bank or other financial
intermediary. The participation interests in which the Underlying Funds intend to invest may not be rated by any nationally recognized rating service.
Loans and other types of direct indebtedness may not be readily marketable and may be subject to restrictions on resale. In some cases, negotiations involved in disposing of indebtedness may require weeks
to complete. Consequently, some indebtedness may be difficult or impossible to dispose of readily at what the Underlying Funds investment adviser believes to be a fair price. In addition, valuation of illiquid indebtedness involves a greater
degree of judgment in determining the Underlying Funds net asset value than if that valuation were based on available market quotations, and could result in significant variations in the Underlying Funds daily share price. At the same
time, some loan interests are traded among certain financial institutions and accordingly may be deemed liquid. As the market for different types of indebtedness develops, the liquidity of these instruments is expected to improve. The Underlying
Funds currently intend to treat loan indebtedness as liquid when, in the view of the Underlying Funds investment adviser and pursuant to procedures adopted by the Underlying Funds Board, there is a readily available market at the time of
the investment. To the extent a readily available market ceases to exist for a particular investment, such investment would be treated as illiquid for purposes of the Underlying Funds limitations on illiquid investments. Investments in loans
and loan participations are considered to be debt obligations for purposes of the Underlying Funds investment restriction relating to the lending of funds or assets by the Underlying Fund.
Second Lien Loans
Certain Underlying Funds may invest in Second Lien Loans, which have the same characteristics as Senior Loans except that such loans are
second in lien property rather than first. Second Lien Loans typically have adjustable floating rate interest payments. Accordingly, the risks associated with Second Lien Loans are higher than the risk of loans with first priority over the
collateral. In the event of default on a Second Lien Loan, the first priority lien holder has first claim to the underlying collateral of the loan. It is possible that no collateral value would remain for the second priority lien holder and
therefore result in a loss of investment to the Underlying Fund.
This risk is generally higher for subordinated unsecured
loans or debt, which are not backed by a security interest in any specific collateral. Second Lien Loans generally have greater price volatility than Senior Loans and may be less liquid. There is also a possibility that originators will not be able
to sell participations in Second Lien Loans, which would create greater credit risk exposure for the holders of such loans. Second Lien Loans share the same risks as other below investment grade securities.
U.S. Government Securities
Each Underlying Fund may invest in U.S. Government securities which are obligations issued or guaranteed by the U.S. Government and its agencies, instrumentalities or sponsored enterprises (U.S.
Government securities). Some U.S. Government securities (such as Treasury bills, notes and bonds, which differ only in their interest rates, maturities and times of issuance) are supported by the full faith and credit of
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the United States. Others, such as obligations issued or guaranteed by U.S. Government agencies, instrumentalities or sponsored enterprises, are supported either by (i) the right of the
issuer to borrow from the U.S. Treasury, (ii) the discretionary authority of the U.S. Government to purchase certain obligations of the issuer or (iii) only the credit of the issuer. The U.S. Government is under no legal obligation, in
general, to purchase the obligations of its agencies, instrumentalities or sponsored enterprises. No assurance can be given that the U.S. Government will provide financial support to U.S. Government agencies, instrumentalities or sponsored
enterprises in the future.
U.S. Government securities include (to the extent consistent with the Act) securities for which
the payment of principal and interest is backed by an irrevocable letter of credit issued by the U.S. Government, or its agencies, instrumentalities or sponsored enterprises. U.S. Government securities may also include (to the extent consistent with
the Act) participations in loans made to foreign governments or their agencies that are guaranteed as to principal and interest by the U.S. Government or its agencies, instrumentalities or sponsored enterprises. The secondary market for certain of
these participations is extremely limited. In the absence of a suitable secondary market, such participations are regarded as illiquid.
Certain of the Underlying Funds may also purchase U.S. Government securities in private placements, subject to the Underlying Funds limitation on investment in illiquid securities. The Underlying
Funds may also invest in separately traded principal and interest components of securities guaranteed or issued by the U.S. Treasury that are traded independently under the separate trading of registered interest and principal of securities program
(STRIPS).
Treasury Inflation-Protected Securities
. Certain of the Underlying Funds may invest in U.S.
Government securities, called Treasury inflation-protected securities or TIPS, which are fixed income securities whose principal value is periodically adjusted according to the rate of inflation. The interest rate on TIPS is
fixed at issuance, but over the life of the bond this interest may be paid on an increasing or decreasing principal value that has been adjusted for inflation. Although repayment of the original bond principal upon maturity is guaranteed, the market
value of TIPS is not guaranteed, and will fluctuate.
The values of TIPS generally fluctuate in response to changes in real
interest rates, which are in turn tied to the relationship between nominal interest rates and the rate of inflation. If inflation were to rise at a faster rate than nominal interest rates, real interest rates might decline, leading to an increase in
the value of TIPS. In contrast, if nominal interest rates were to increase at a faster rate than inflation, real interest rates might rise, leading to a decrease in the value of TIPS. If inflation is lower than expected during the period an
Underlying Fund holds TIPS, an Underlying Fund may earn less on the TIPS than on a conventional bond. If interest rates rise due to reasons other than inflation (for example, due to changes in the currency exchange rates), investors in TIPS may not
be protected to the extent that the increase is not reflected in the bonds inflation measure. There can be no assurance that the inflation index for TIPS will accurately measure the real rate of inflation in the prices of goods and services.
Any increase in principal value of TIPS caused by an increase in the consumer price index is taxable in the year the increase
occurs, even though an Underlying Fund holding TIPS will not receive cash representing the increase at that time. As a result, an Underlying Fund could be required at times to liquidate other investments, including when it is not advantageous to do
so, in order to satisfy its distribution requirements as a regulated investment company.
If an Underlying Fund invests in
Treasury-inflation protected securities (TIPS), it will be required to treat as original issue discount any increase in the principal amount of the securities that occurs during the course of its taxable year. If an Underlying Fund
purchases such inflation protected securities that are issued in stripped from either as stripped bonds or coupons, it will be treated as if it had purchased a newly issued debt instrument having original issue discount.
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Because an Underlying Fund is required to distribute substantially all of its net investment
income (including accrued original issue discount), an Underlying Funds investment in either zero coupon bonds or TIPS may require an Underlying Fund to distribute to shareholders an amount greater than the total cash income it actually
receives. Accordingly, in order to make the required distributions, an Underlying Fund may be required to borrow or liquidate securities.
Bank Obligations
Certain of the Underlying Funds may invest in debt obligations issued or guaranteed by U.S. or foreign banks. Bank obligations, including
without limitation, time deposits, bankers acceptances and certificates of deposit, may be general obligations of the parent bank or may be limited to the issuing branch by the terms of the specific obligations or government regulation.
Banks are subject to extensive but different governmental regulations which may limit both the amount and types of loans
which may be made and interest rates which may be charged. In addition, the profitability of the banking industry is largely dependent upon the availability and cost of funds for the purpose of financing lending operations under prevailing money
market conditions. General economic conditions as well as exposure to credit losses arising from possible financial difficulties of borrowers play an important part in the operations of this industry.
Certificates of deposit are certificates evidencing the obligation of a bank to repay funds deposited with it for a specified period of
time at a specified rate. Certificates of deposit are negotiable instruments and are similar to saving deposits but have a definite maturity and are evidenced by a certificate instead of a passbook entry. Banks are required to keep reserves against
all certificates of deposit. Fixed time deposits are bank obligations payable at a stated maturity date and bearing interest at a fixed rate. Fixed time deposits may be withdrawn on demand by the investor, but may be subject to early withdrawal
penalties which vary depending upon market conditions and the remaining maturity of the obligation.
Deferred Interest, Pay-in-Kind and
Capital Appreciation Bonds
Certain of the Underlying Funds may invest in deferred interest and capital appreciation bonds
and pay-in-kind (PIK) securities. Deferred interest and capital appreciation bonds are debt securities issued or sold at a discount from their face value and which do not entitle the holder to any periodic payment of interest prior to
maturity or a specified date. The original issue discount varies depending on the time remaining until maturity or cash payment date, prevailing interest rates, the liquidity of the security and the perceived credit quality of the issuer. These
securities also may take the form of debt securities that have been stripped of their unmatured interest coupons, the coupons themselves or receipts or certificates representing interests in such stripped debt obligations or coupons. The market
prices of deferred interest, capital appreciation bonds and PIK securities generally are more volatile than the market prices of interest bearing securities and are likely to respond to a greater degree to changes in interest rates than interest
bearing securities having similar maturities and credit quality.
PIK securities may be debt obligations or preferred shares
that provide the issuer with the option of paying interest or dividends on such obligations in cash or in the form of additional securities rather than cash. Similar to zero coupon bonds and deferred interest bonds, PIK securities are designed to
give an issuer flexibility in managing cash flow. PIK securities that are debt securities can either be senior or subordinated debt and generally trade flat (
i.e.
, without accrued interest). The trading price of PIK debt securities generally
reflects the market value of the underlying debt plus an amount representing accrued interest since the last interest payment.
Deferred interest, capital appreciation and PIK securities involve the additional risk that, unlike securities that periodically pay
interest to maturity, an Underlying Fund will realize no cash until a specified
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future payment date unless a portion of such securities is sold and, if the issuer of such securities defaults, an Underlying Fund may obtain no return at all on its investment. In addition, even
though such securities do not provide for the payment of current interest in cash, an Underlying Fund is nonetheless required to accrue income on such investments for each taxable year and generally are required to distribute such accrued amounts
(net of deductible expenses, if any) to avoid being subject to tax. Because no cash is generally received at the time of the accrual, an Underlying Fund may be required to liquidate other portfolio securities to obtain sufficient cash to satisfy
federal tax distribution requirements applicable to an Underlying Fund. A portion of the discount with respect to stripped tax-exempt securities or their coupons may be taxable.
Zero Coupon Bonds
Each Underlying Funds investment in fixed income
securities may include zero coupon bonds. Zero coupon bonds are debt obligations issued or purchased at a discount from face value. The discount approximates the total amount of interest the bonds would have accrued and compounded over the period
until maturity. A zero coupon bond pays no interest to its holder during its life and its value consists of the difference between its face value at maturity and its cost. Such investments benefit the issuer by mitigating its need for cash to meet
debt service but also require a higher rate of return to attract investors who are willing to defer receipt of such cash. Such investments may experience greater volatility in market value than debt obligations which provide for regular payments of
interest. In addition, if an issuer of zero coupon bonds held by an Underlying Fund defaults, the Underlying Fund may obtain no return at all on its investment. An Underlying Fund will accrue income on such investments for each taxable year which
(net of deductible expenses, if any) is distributable to shareholders and which, because no cash is generally received at the time of accrual, may require the liquidation of other portfolio securities to obtain sufficient cash to satisfy the
Underlying Funds distribution obligations.
Variable and Floating Rate Securities
The interest rates payable on certain securities in which a Fund may invest are not fixed and may fluctuate based upon changes in market
rates. Variable and floating rate obligations are debt instruments issued by companies or other entities with interest rates that reset periodically (typically, daily, monthly, quarterly, or semi-annually) in response to changes in the market rate
of interest on which the interest rate is based. Moreover, such obligations may fluctuate in value in response to interest rate changes if there is a delay between changes in market interest rates and the interest resent date for the obligation. The
value of these obligations is generally more stable than that of a fixed rate obligation in response to changes in interest rate levels, but they may decline in value if their interest rates do not rise as much, or as quickly, as interest rates in
general. Conversely, floating rate securities will not generally increase in value if interest rates decline.
Certain of the
Underlying Funds may invest in leveraged inverse floating rate debt instruments (inverse floaters), including leveraged inverse floaters. The interest rate on inverse floaters resets in the opposite direction from
the market rate of interest to which the inverse floater is indexed. An inverse floater may be considered to be leveraged to the extent that its interest rate varies by a magnitude that exceeds the magnitude of the change in the index rate of
interest. The higher the degree of leverage inherent in inverse floaters is associated with greater volatility in their market values. Accordingly, the duration of an inverse floater may exceed its stated final maturity. Certain inverse floaters may
be deemed to be illiquid securities for purposes of each Underlying Funds limitation on illiquid investments.
Custodial Receipts and
Trust Certificates
Each Underlying Fund may invest in custodial receipts and trust certificates (which may be underwritten
by securities dealers or banks), representing interests in securities held by a custodian or trustee. The securities so held may include U.S. Government securities, Municipal Securities or other types of securities in which an Underlying Fund may
invest. The custodial receipts or trust certificates are underwritten by securities dealers or banks and may
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evidence ownership of future interest payments, principal payments or both on the underlying securities, or, in some cases, the payment obligation of a third party that has entered into an
interest rate swap or other arrangement with the custodian or trustee. For certain securities law purposes, custodial receipts and trust certificates may not be considered obligations of the U.S. Government or other issuer of the securities held by
the custodian or trustee. As a holder of custodial receipts and trust certificates, an Underlying Fund will bear its proportionate share of the fees and expenses charged to the custodial account or trust. The Underlying Funds may also invest in
separately issued interests in custodial receipts and trust certificates.
Although under the terms of a custodial receipt or
trust certificate an Underlying Fund would typically be authorized to assert its rights directly against the issuer of the underlying obligation, the Underlying Fund could be required to assert through the custodian bank or trustee those rights as
may exist against the underlying issuers. Thus, in the event an underlying issuer fails to pay principal and/or interest when due, an Underlying Fund may be subject to delays, expenses and risks that are greater than those that would have been
involved if the Underlying Fund had purchased a direct obligation of the issuer. In addition, in the event that the trust or custodial account in which the underlying securities have been deposited is determined to be an association taxable as a
corporation, instead of a non-taxable entity, the yield on the underlying securities would be reduced in recognition of any taxes paid.
Certain custodial receipts and trust certificates may be synthetic or derivative instruments that have interest rates that reset inversely to changing short-term rates and/or have embedded interest rate
floors and caps that require the issuer to pay an adjusted interest rate if market rates fall below or rise above a specified rate. Because some of these instruments represent relatively recent innovations, and the trading market for these
instruments is less developed than the markets for traditional types of instruments, it is uncertain how these instruments will perform under different economic and interest-rate scenarios. Also, because these instruments may be leveraged, their
market values may be more volatile than other types of fixed income instruments and may present greater potential for capital gain or loss. The possibility of default by an issuer or the issuers credit provider may be greater for these
derivative instruments than for other types of instruments. In some cases, it may be difficult to determine the fair value of a derivative instrument because of a lack of reliable objective information and an established secondary market for some
instruments may not exist. In many cases, the Internal Revenue Service has not ruled on the tax treatment of the interest or payments received on the derivative instruments and, accordingly, purchases of such instruments are based on the opinion of
counsel to the sponsors of the instruments.
Municipal Securities
Certain of the Underlying Funds may invest in bonds, notes and other instruments issued by or on behalf of states, territories and
possessions of the United States (including the District of Columbia) and their political subdivisions, agencies or instrumentalities (Municipal Securities). Dividends paid by the Underlying Funds that are derived from interest paid on
both tax-exempt and taxable Municipal Securities will be taxable to the Underlying Funds shareholders.
Municipal
Securities are often issued to obtain funds for various public purposes including refunding outstanding obligations, obtaining funds for general operating expenses, and obtaining funds to lend to other public institutions and facilities. Municipal
Securities also include certain private activity bonds or industrial development bonds, which are issued by or on behalf of public authorities to provide financing aid to acquire sites or construct or equip facilities within a
municipality for privately or publicly owned corporations.
Investments in municipal securities are subject to the risk that
the issuer could default on its obligations. Such a default could result from the inadequacy of the sources or revenues from which interest and principal payments are to be made or the assets collateralizing such obligations. Revenue bonds (as
described further below), including private activity bonds, are backed only by specific assets or revenue sources and not by the full faith and credit of the governmental issuer.
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The two principal classifications of Municipal Securities are general
obligations and revenue obligations. General obligations are secured by the issuers pledge of its full faith and credit for the payment of principal and interest, although the characteristics and enforcement of general
obligations may vary according to the law applicable to the particular issuer. Revenue obligations, which include, but are not limited to, private activity bonds, resource recovery bonds, certificates of participation and certain municipal notes,
are not backed by the credit and taxing authority of the issuer, and are payable solely from the revenues derived from a particular facility or class of facilities or, in some cases, from the proceeds of a special excise or other specific revenue
source. Nevertheless, the obligations of the issuer of a revenue obligation may be backed by a letter of credit, guarantee or insurance. General obligations and revenue obligations may be issued in a variety of forms, including commercial paper,
fixed, variable and floating rate securities, tender option bonds, auction rate bonds, zero coupon bonds, deferred interest bonds and capital appreciation bonds.
In addition to general obligations and revenue obligations, there are a variety of hybrid and special types of Municipal Securities. There are also numerous differences in the security of Municipal
Securities both within and between these two principal classifications.
An entire issue of Municipal Securities may be
purchased by one or a small number of institutional investors, including one or more Underlying Funds. Thus, the issue may not be said to be publicly offered. Unlike some securities that are not publicly offered, a secondary market exists for many
Municipal Securities that were not publicly offered initially and such securities may be readily marketable.
The credit
rating assigned to Municipal Securities may reflect the existence of guarantees, letters of credit or other credit enhancement features available to the issuers or holders of such Municipal Securities.
The obligations of the issuer to pay the principal of and interest on a Municipal Security are subject to the provisions of bankruptcy,
insolvency and other laws affecting the rights and remedies of creditors, such as the Federal Bankruptcy Code, and laws, if any, that may be enacted by Congress or state legislatures extending the time for payment of principal or interest or
imposing other constraints upon the enforcement of such obligations. There is also the possibility that, as a result of litigation or other conditions, the power or ability of the issuer to pay when due principal of or interest on a Municipal
Security may be materially affected.
From time to time, proposals have been introduced before Congress for the purpose of
restricting or eliminating the federal income tax exemption for interest on Municipal Securities. For example, under the Tax Reform Act of 1986, interest on certain private activity bonds must be included in an investors federal alternative
minimum taxable income, and corporate investors must include all tax-exempt interest in their federal alternative minimum taxable income. The Trust cannot predict what legislation, if any, may be proposed in the future in Congress as regards the
federal income tax status of interest on Municipal Securities or which proposals, if any, might be enacted. Such proposals, if enacted, might materially and adversely affect the liquidity and value of the Municipal Securities in an Underlying
Funds portfolio.
Municipal Leases, Certificates of Participation and Other Participation Interests
. Municipal
Securities include leases, certificates of participation and other participation interests. A municipal lease is an obligation in the form of a lease or installment purchase which is issued by a state or local government to acquire equipment and
facilities. Income from such obligations is generally exempt from state and local taxes in the state of issuance. Municipal leases frequently involve special risks not normally associated with general obligations or revenue bonds. Leases and
installment purchase or conditional sale contracts (which normally provide for title to the leased asset to pass eventually to the governmental issuer) have evolved as a means for governmental issuers to acquire property and equipment without
meeting the constitutional and statutory requirements for the issuance of debt. The debt issuance limitations are deemed to be inapplicable because of the inclusion in many leases or contracts of non-appropriation clauses that relieve
the governmental issuer of any obligation to make future payments under the lease or contract unless money is appropriated for such purpose by the appropriate legislative body on a yearly or other periodic basis. In addition, such leases or
contracts may be subject to the
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temporary abatement of payments in the event the issuer is prevented from maintaining occupancy of the leased premises or utilizing the leased equipment. Although the obligations may be secured
by the leased equipment or facilities, the disposition of the property in the event of non-appropriation or foreclosure might prove difficult, time consuming and costly, and result in a delay in recovering or the failure to fully recover an
Underlying Funds original investment. To the extent that an Underlying Fund invests in unrated municipal leases or participates in such leases, the credit quality rating and risk of cancellation of such unrated leases will be monitored on an
ongoing basis.
Certificates of participation represent undivided interests in municipal leases, installment purchase
agreements or other instruments. The certificates are typically issued by a trust or other entity which has received an assignment of the payments to be made by the state or political subdivision under such leases or installment purchase agreements.
Certain municipal lease obligations and certificates of participation may be deemed to be illiquid for the purpose of an
Underlying Funds limitation on investments in illiquid securities. Other municipal lease obligations and certificates of participation acquired by an Underlying Fund may be determined by its investment adviser, pursuant to guidelines adopted
by the Trustees of the Trust, to be liquid securities for the purpose of such limitation. In determining the liquidity of municipal lease obligations and certificates of participation, the investment adviser will consider a variety of factors
including: (i) the willingness of dealers to bid for the security; (ii) the number of dealers willing to purchase or sell the obligation and the number of other potential buyers; (iii) the frequency of trades or quotes for the
obligation; and (iv) the nature of the marketplace trades. In addition, the investment adviser will consider factors unique to particular lease obligations and certificates of participation affecting the marketability thereof. These include the
general creditworthiness of the issuer, the importance to the issuer of the property covered by the lease and the likelihood that the marketability of the obligation will be maintained throughout the time the obligation is held by an Underlying
Fund.
Certain of the Underlying Funds may purchase participations in Municipal Securities held by a commercial bank or other
financial institution. Such participations provide an Underlying Fund with the right to a pro rata undivided interest in the underlying Municipal Securities. In addition, such participations generally provide an Underlying Fund with the right to
demand payment, on not more than seven days notice, of all or any part of such Underlying Funds participation interest in the underlying Municipal Securities, plus accrued interest. An Underlying Fund will only invest in such
participations if, in the opinion of bond counsel, counsel for the issuers of such participations or counsel selected by the investment advisors, the interest from such participation is exempt from regular federal income tax.
Auction Rate Securities
. Municipal Securities also include auction rate Municipal Securities and auction rate preferred securities
issued by closed-end investment companies that invest primarily in Municipal Securities (collectively, auction rate securities). Provided that the auction mechanism is successful, auction rate securities usually permit the holder to sell
the securities in an auction at par value at specified intervals. The dividend is reset by Dutch auction in which bids are made by broker-dealers and other institutions for a certain amount of securities at a specified minimum yield. The
dividend rate set by the auction is the lowest interest or dividend rate that covers all securities offered for sale. While this process is designed to permit auction rate securities to be traded at par value, there is some risk that an auction will
fail due to insufficient demand for the securities. In certain recent market environments, auction failures have been more prevalent, which may adversely affect the liquidity and price of auction rate securities. Moreover, between auctions, there
may be no secondary market for these securities, and sales conducted on a secondary market may not be on terms favorable to the seller. Thus, with respect to liquidity and price stability, auction rate securities may differ substantially from cash
equivalents, notwithstanding the frequency of auctions and the credit quality of the security.
An Underlying Funds
investments in auction rate securities of closed-end funds are subject to the limitations prescribed by the Act. An Underlying Fund will indirectly bear its proportionate share of any management and other fees paid by such closed-end funds in
addition to the advisory fees payable directly by the Underlying Funds.
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Other Types of Municipal Securities
. Other types of Municipal Securities in which
certain of the Underlying Funds may invest include municipal notes, tax-exempt commercial paper, pre-refunded municipal bonds, industrial development bonds, tender option bonds and insured municipal obligations.
Call Risk and Reinvestment Risk
. Municipal Securities may include call provisions which permit the issuers of such
securities, at any time or after a specified period, to redeem the securities prior to their stated maturity. In the event that Municipal Securities held in an Underlying Funds portfolio are called prior to the maturity, the Underlying Fund
will be required to reinvest the proceeds on such securities at an earlier date and may be able to do so only at lower yields, thereby reducing the Underlying Funds return on its portfolio securities.
Mortgage Loans and Mortgage-Backed Securities
Certain of the Underlying Funds may invest in mortgage loans and mortgage pass-through securities and other securities representing an interest in or collateralized by adjustable and fixed rate mortgage
loans (Mortgage-Backed Securities).
Mortgage-Backed Securities are subject to both call risk and extension risk.
Because of these risks, these securities can have significantly greater price and yield volatility than traditional fixed income securities.
General Characteristics of Mortgage Backed Securities
.
In general, each
mortgage pool underlying Mortgage-Backed Securities consists of mortgage loans evidenced by promissory notes secured by first mortgages or first deeds of trust or other similar security instruments creating a first lien on owner occupied and
non-owner occupied one-unit to four-unit residential properties, multi-family (i.e., five-units or more) properties, agricultural properties, commercial properties and mixed use properties (the Mortgaged Properties). The Mortgaged
Properties may consist of detached individual dwelling units, multi-family dwelling units, individual condominiums, townhouses, duplexes, triplexes, fourplexes, row houses, individual units in planned unit developments, other attached dwelling units
(Residential Mortgaged Properties) or commercial properties, such as office properties, retail properties, hospitality properties, industrial properties, healthcare related properties or other types of income producing real property
(Commercial Mortgaged Properties). Residential Mortgaged Properties may also include residential investment properties and second homes. In addition, the Mortgage-Backed Securities which are residential mortgage-backed securities may
also consist of mortgage loans evidenced by promissory notes secured entirely or in part by second priority mortgage liens on Residential Mortgaged Properties.
The investment characteristics of adjustable and fixed rate Mortgage-Backed Securities differ from those of traditional fixed income securities. The major differences include the payment of interest and
principal on Mortgage-Backed Securities on a more frequent (usually monthly) schedule, and the possibility that principal may be prepaid at any time due to prepayments on the underlying mortgage loans or other assets. These differences can result in
significantly greater price and yield volatility than is the case with traditional fixed income securities. As a result, if an Underlying Fund purchases Mortgage-Backed Securities at a premium, a faster than expected prepayment rate will reduce both
the market value and the yield to maturity from their anticipated levels. A prepayment rate that is slower than expected will have the opposite effect, increasing yield to maturity and market value. Conversely, if an Underlying Fund purchases
Mortgage-Backed Securities at a discount, faster than expected prepayments will increase, while slower than expected prepayments will reduce yield to maturity and market value. To the extent that an Underlying Fund invests in Mortgage-Backed
Securities, its investment adviser may seek to manage these potential risks by investing in a variety of Mortgage-Backed Securities and by using certain hedging techniques.
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Prepayments on a pool of mortgage loans are influenced by changes in current interest rates
and a variety of economic, geographic, social and other factors (such as changes in mortgagor housing needs, job transfers, unemployment, mortgagor equity in the mortgage properties and servicing decisions). The timing and level of prepayments
cannot be predicted. A predominant factor affecting the prepayment rate on a pool of mortgage loans is the difference between the interest rates on outstanding mortgage loans and prevailing mortgage loan interest rates (giving consideration to the
cost of any refinancing). Generally, prepayments on mortgage loans will increase during a period of falling mortgage interest rates and decrease during a period of rising mortgage interest rates. Accordingly, the amounts of prepayments available for
reinvestment by an Underlying Fund are likely to be greater during a period of declining mortgage interest rates. If general interest rates decline, such prepayments are likely to be reinvested at lower interest rates than an Underlying Fund was
earning on the Mortgage-Backed Securities that were prepaid. Due to these factors, Mortgage-Backed Securities may be less effective than U.S. Treasury and other types of debt securities of similar maturity at maintaining yields during periods of
declining interest rates. Because an Underlying Funds investments in Mortgage-Backed Securities are interest-rate sensitive, an Underlying Funds performance will depend in part upon the ability of the Underlying Fund to anticipate and
respond to fluctuations in market interest rates and to utilize appropriate strategies to maximize returns to the Underlying Fund, while attempting to minimize the associated risks to its investment capital. Prepayments may have a disproportionate
effect on certain Mortgage-Backed Securities and other multiple class pass-through securities, which are discussed below.
The
rate of interest paid on Mortgage-Backed Securities is normally lower than the rate of interest paid on the mortgages included in the underlying pool due to (among other things) the fees paid to any servicer, special servicer and trustee for the
trust fund which holds the mortgage pool, other costs and expenses of such trust fund, fees paid to any guarantor, such as Ginnie Mae (as defined below) or to any credit enhancers, mortgage pool insurers, bond insurers and/or hedge providers, and
due to any yield retained by the issuer. Actual yield to the holder may vary from the coupon rate, even if adjustable, if the Mortgage-Backed Securities are purchased or traded in the secondary market at a premium or discount. In addition, there is
normally some delay between the time the issuer receives mortgage payments from the servicer and the time the issuer (or the trustee of the trust fund which holds the mortgage pool) makes the payments on the Mortgage-Backed Securities, and this
delay reduces the effective yield to the holder of such securities.
The issuers of certain mortgage-backed obligations may
elect to have the pool of mortgage loans (or indirect interests in mortgage loans) underlying the securities treated as a REMIC, which is subject to special federal income tax rules. A description of the types of mortgage loans and mortgage-backed
securities in which certain of the Underlying Funds may invest is provided below. The descriptions are general and summary in nature, and do not detail every possible variation of the types of securities that are permissible investments for these
Underlying Funds.
Certain General Characteristics of Mortgage Loans
Adjustable Rate Mortgage Loans (ARMs)
. Certain of the Underlying Funds may invest in ARMs. ARMs generally provide for
a fixed initial mortgage interest rate for a specified period of time. Thereafter, the interest rates (the Mortgage Interest Rates) may be subject to periodic adjustment based on changes in the applicable index rate (the Index
Rate). The adjusted rate would be equal to the Index Rate plus a fixed percentage spread over the Index Rate established for each ARM at the time of its origination. ARMs allow an Underlying Fund to participate in increases in interest rates
through periodic increases in the securities coupon rates. During periods of declining interest rates, coupon rates may readjust downward resulting in lower yields to an Underlying Fund.
Adjustable interest rates can cause payment increases that some mortgagors may find difficult to make. However, certain ARMs may provide
that the Mortgage Interest Rate may not be adjusted to a rate above an applicable lifetime maximum rate or below an applicable lifetime minimum rate for such ARM. Certain ARMs
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may also be subject to limitations on the maximum amount by which the Mortgage Interest Rate may adjust for any single adjustment period (the Maximum Adjustment). Other ARMs
(Negatively Amortizing ARMs) may provide instead or as well for limitations on changes in the monthly payment on such ARMs. Limitations on monthly payments can result in monthly payments which are greater or less than the amount
necessary to amortize a Negatively Amortizing ARM by its maturity at the Mortgage Interest Rate in effect in any particular month. In the event that a monthly payment is not sufficient to pay the interest accruing on a Negatively Amortizing ARM, any
such excess interest is added to the principal balance of the loan, causing negative amortization, and will be repaid through future monthly payments. It may take borrowers under Negatively Amortizing ARMs longer periods of time to build up equity
and may increase the likelihood of default by such borrowers. In the event that a monthly payment exceeds the sum of the interest accrued at the applicable Mortgage Interest Rate and the principal payment which would have been necessary to amortize
the outstanding principal balance over the remaining term of the loan, the excess (or accelerated amortization) further reduces the principal balance of the ARM. Negatively Amortizing ARMs do not provide for the extension of their
original maturity to accommodate changes in their Mortgage Interest Rate. As a result, unless there is a periodic recalculation of the payment amount (which there generally is), the final payment may be substantially larger than the other payments.
After the expiration of the initial fixed rate period and upon the periodic recalculation of the payment to cause timely amortization of the related mortgage loan, the monthly payment on such mortgage loan may increase substantially which may, in
turn, increase the risk of the borrower defaulting in respect of such mortgage loan. These limitations on periodic increases in interest rates and on changes in monthly payments protect borrowers from unlimited interest rate and payment increases,
but may result in increased credit exposure and prepayment risks for lenders. When interest due on a mortgage loan is added to the principal balance of such mortgage loan, the related mortgaged property provides proportionately less security for the
repayment of such mortgage loan. Therefore, if the related borrower defaults on such mortgage loan, there is a greater likelihood that a loss will be incurred upon any liquidation of the mortgaged property which secures such mortgage loan.
ARMs also have the risk of prepayment. The rate of principal prepayments with respect to ARMs has fluctuated in recent years.
The value of Mortgage-Backed Securities collateralized by ARMs is less likely to rise during periods of declining interest rates than the value of fixed-rate securities during such periods. Accordingly, ARMs may be subject to a greater rate of
principal repayments in a declining interest rate environment resulting in lower yields to an Underlying Fund. For example, if prevailing interest rates fall significantly, ARMs could be subject to higher prepayment rates (than if prevailing
interest rates remain constant or increase) because the availability of low fixed-rate mortgages may encourage mortgagors to refinance their ARMs to lock-in a fixed-rate mortgage. On the other hand, during periods of rising interest
rates, the value of ARMs will lag behind changes in the market rate. ARMs are also typically subject to maximum increases and decreases in the interest rate adjustment which can be made on any one adjustment date, in any one year, or during the life
of the security. In the event of dramatic increases or decreases in prevailing market interest rates, the value of an Underlying Funds investment in ARMs may fluctuate more substantially because these limits may prevent the security from fully
adjusting its interest rate to the prevailing market rates. As with fixed-rate mortgages, ARM prepayment rates vary in both stable and changing interest rate environments.
There are two main categories of indices which provide the basis for rate adjustments on ARMs: those based on U.S. Treasury securities and those derived from a calculated measure, such as a cost of funds
index or a moving average of mortgage rates. Indices commonly used for this purpose include the one-year, three-year and five-year constant maturity Treasury rates, the three-month Treasury bill rate, the 180-day Treasury bill rate, rates on
longer-term Treasury securities, the 11th District Federal Home Loan Bank Cost of Funds, the National Median Cost of Funds, the one-month, three-month, six-month or one-year London Interbank Offered Rate (LIBOR), the prime rate of a
specific bank, or commercial paper rates. Some indices, such as the one-year constant maturity Treasury rate, closely mirror changes in market interest rate levels. Others, such as the 11th District Federal Home Loan Bank Cost of Funds index, tend
to lag behind changes in market rate levels and tend
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to be somewhat less volatile. The degree of volatility in the market value of ARMs in an Underlying Funds portfolio and, therefore, in the net asset value of the Underlying Funds
shares, will be a function of the length of the interest rate reset periods and the degree of volatility in the applicable indices.
Fixed-Rate Mortgage Loans
. Generally, fixed-rate mortgage loans included in mortgage pools (the Fixed-Rate Mortgage Loans) will bear simple interest at fixed annual rates and have
original terms to maturity ranging from 5 to 40 years. Fixed-Rate Mortgage Loans generally provide for monthly payments of principal and interest in substantially equal installments for the term of the mortgage note in sufficient amounts to fully
amortize principal by maturity, although certain Fixed-Rate Mortgage Loans provide for a large final balloon payment upon maturity.
Certain Legal Considerations of Mortgage Loans
. The following is a discussion of certain legal and regulatory aspects of the mortgage loans in which an Underlying Fund may invest. This discussion
is not exhaustive, and does not address all of the legal or regulatory aspects affecting mortgage loans. These regulations may impair the ability of a mortgage lender to enforce its rights under the mortgage documents. These regulations may also
adversely affect an Underlying Funds investments in Mortgage-Backed Securities (including those issued or guaranteed by the U.S. Government, its agencies or instrumentalities) by delaying the Underlying Funds receipt of payments derived
from principal or interest on mortgage loans affected by such regulations.
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Foreclosure
. A foreclosure of a defaulted mortgage loan may be delayed due to compliance with statutory notice or service of process provisions, difficulties in
locating necessary parties or legal challenges to the mortgagees right to foreclose. Depending upon market conditions, the ultimate proceeds of the sale of foreclosed property may not equal the amounts owed on the Mortgage-Backed Securities.
Furthermore, courts in some cases have imposed general equitable principles upon foreclosure generally designed to relieve the borrower from the legal effect of default and have required lenders to undertake affirmative and expensive actions to
determine the causes for the default and the likelihood of loan reinstatement.
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Rights of Redemption
. In some states, after foreclosure of a mortgage loan, the borrower and foreclosed junior lienors are given a statutory period in which to
redeem the property, which right may diminish the mortgagees ability to sell the property.
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Legislative Limitations
. In addition to anti-deficiency and related legislation, numerous other federal and state statutory provisions, including the federal
bankruptcy laws and state laws affording relief to debtors, may interfere with or affect the ability of a secured mortgage lender to enforce its security interest. For example, a bankruptcy court may grant the debtor a reasonable time to cure a
default on a mortgage loan, including a payment default. The court in certain instances may also reduce the monthly payments due under such mortgage loan, change the rate of interest, reduce the principal balance of the loan to the then-current
appraised value of the related mortgaged property, alter the mortgage loan repayment schedule and grant priority of certain liens over the lien of the mortgage loan. If a court relieves a borrowers obligation to repay amounts otherwise due on
a mortgage loan, the mortgage loan servicer will not be required to advance such amounts, and any loss may be borne by the holders of securities backed by such loans. In addition, numerous federal and state consumer protection laws impose penalties
for failure to comply with specific requirements in connection with origination and servicing of mortgage loans.
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Due-on-Sale Provisions
. Fixed-rate mortgage loans may contain a so-called due-on-sale clause permitting acceleration of the maturity of
the mortgage loan if the borrower transfers the property. The Garn-St. Germain Depository Institutions Act of 1982 sets forth nine specific instances in which no mortgage lender covered by that Act may exercise a due-on-sale clause upon
a transfer of property. The inability to enforce a due-on-sale clause or the lack of such a clause in mortgage loan documents may result in a mortgage loan being assumed by a purchaser of the property that bears an interest rate below
the current market rate.
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Usury Laws
. Some states prohibit charging interest on mortgage loans in excess of statutory limits. If such limits are exceeded, substantial penalties may be
incurred and, in some cases, enforceability of the obligation to pay principal and interest may be affected.
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Recent Governmental Action, Legislation and Regulation
. The rise in the rate of foreclosures of properties in certain states or localities has resulted in
legislative, regulatory and enforcement action in such states or localities seeking to prevent or restrict foreclosures, particularly in respect of residential mortgage loans. Actions have also been brought against issuers and underwriters of
residential mortgage-backed securities collateralized by such residential mortgage loans and investors in such residential mortgage-backed securities. Legislative or regulatory initiatives by federal, state or local legislative bodies or
administrative agencies, if enacted or adopted, could delay foreclosure or the exercise of other remedies, provide new defenses to foreclosure, or otherwise impair the ability of the loan servicer to foreclose or realize on a defaulted residential
mortgage loan included in a pool of residential mortgage loans backing such residential mortgage-backed securities. While the nature or extent of limitations on foreclosure or exercise of other remedies that may be enacted cannot be predicted, any
such governmental actions that interfere with the foreclosure process could increase the costs of such foreclosures or exercise of other remedies in respect of residential mortgage loans which collateralize Mortgage-Backed Securities held by an
Underlying Fund, delay the timing or reduce the amount of recoveries on defaulted residential mortgage loans which collateralize Mortgage-Backed Securities held by an Underlying Fund, and consequently, could adversely impact the yields and
distributions an Underlying Fund may receive in respect of its ownership of Mortgage-Backed Securities collateralized by residential mortgage loans. For example, the Helping Families Save Their Homes Act of 2009 authorized bankruptcy courts to
assist bankrupt borrowers by restructuring residential mortgage loans secured by a lien on the borrowers primary residence. Bankruptcy judges are permitted to reduce the interest rate of the bankrupt borrowers residential mortgage loan,
extend its term to maturity to up to 40 years or take other actions to reduce the borrowers monthly payment. As a result, the value of, and the cash flows in respect of, the Mortgage-Backed Securities collateralized by these residential
mortgage loans may be adversely impacted, and, as a consequence, an Underlying Funds investment in such Mortgage-Backed Securities could be adversely impacted. Other federal legislation, including the Home Affordability Modification Program
(
HAMP
), encourages servicers to modify residential mortgage loans that are either already in default or are at risk of imminent default. Furthermore, HAMP provides incentives for servicers to modify residential mortgage loans that
are contractually current. This program, as well other legislation and/or governmental intervention designed to protect consumers, may have an adverse impact on servicers of residential mortgage loans by increasing costs and expenses of these
servicers while at the same time decreasing servicing cash flows. Such increased financial pressures may have a negative effect on the ability of servicers to pursue collection on residential mortgage loans that are experiencing increased
delinquencies and defaults and to maximize recoveries on the sale of underlying residential mortgaged properties following foreclosure. Other legislative or regulatory actions include insulation of servicers from liability for modification of
residential mortgage loans without regard to the terms of the applicable servicing agreements. The foregoing legislation and current and future governmental regulation activities may have the effect of reducing returns to an Underlying Fund to the
extent it has invested in Mortgage-Backed Securities collateralized by these residential mortgage loans.
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Government Guaranteed Mortgage-Backed Securities
. There are several types of government guaranteed Mortgage-Backed Securities
currently available, including guaranteed mortgage pass-through certificates and multiple class securities, which include guaranteed Real Estate Mortgage Investment Conduit Certificates (REMIC Certificates), other collateralized mortgage
obligations and stripped Mortgage-Backed Securities. An Underlying Fund is permitted to invest in other types of Mortgage-Backed Securities that may be available in the future to the extent consistent with its investment policies and objective.
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An Underlying Funds investments in Mortgage-Backed Securities may include securities
issued or guaranteed by the U.S. Government or one of its agencies, authorities, instrumentalities or sponsored enterprises, such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae securities are backed by the full faith and credit of the U.S. Government, which means that the U.S. Government guarantees that the
interest and principal will be paid when due. Fannie Mae and Freddie Mac securities are not backed by the full faith and credit of the U.S. Government. Fannie Mae and Freddie Mac have the ability to borrow from the U.S. Treasury, and as a result,
they are generally viewed by the market as high quality securities with low credit risks. From time to time, proposals have been introduced before Congress for the purpose of restricting or eliminating federal sponsorship of Fannie Mae and Freddie
Mac. The Trust cannot predict what legislation, if any, may be proposed in the future in Congress as regards such sponsorship or which proposals, if any, might be enacted. Such proposals, if enacted, might materially and adversely affect the
availability of government guaranteed Mortgage-Backed Securities and the liquidity and value of an Underlying Funds portfolio.
There is risk that the U.S. Government will not provide financial support to its agencies, authorities, instrumentalities or sponsored enterprises. An Underlying Fund may purchase U.S. Government
securities that are not backed by the full faith and credit of the U.S. Government, such as those issued by Fannie Mae and Freddie Mac. The maximum potential liability of the issuers of some U.S. Government securities held by an Underlying Fund may
greatly exceed such issuers current resources, including such issuers legal right to support from the U.S. Treasury. It is possible that these issuers will not have the funds to meet their payment obligations in the future.
Below is a general discussion of certain types of guaranteed Mortgage-Backed Securities in which certain of the Underlying Funds may
invest.
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Ginnie Mae Certificates
. Ginnie Mae is a wholly-owned corporate instrumentality of the United States. Ginnie Mae is authorized to guarantee the
timely payment of the principal of and interest on certificates that are based on and backed by a pool of mortgage loans insured by the Federal Housing Administration (FHA), or guaranteed by the Veterans Administration (VA),
or by pools of other eligible mortgage loans. In order to meet its obligations under any guaranty, Ginnie Mae is authorized to borrow from the United States Treasury in an unlimited amount. The National Housing Act provides that the full faith and
credit of the U.S. Government is pledged to the timely payment of principal and interest by Ginnie Mae of amounts due on Ginnie Mae certificates.
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Fannie Mae Certificates
. Fannie Mae is a stockholder-owned corporation chartered under an act of the United States Congress. Generally, Fannie
Mae Certificates are issued and guaranteed by Fannie Mae and represent an undivided interest in a pool of mortgage loans (a Pool) formed by Fannie Mae. A Pool consists of residential mortgage loans either previously owned by Fannie Mae
or purchased by it in connection with the formation of the Pool. The mortgage loans may be either conventional mortgage loans (i.e., not insured or guaranteed by any U.S. Government agency) or mortgage loans that are either insured by the FHA or
guaranteed by the VA. However, the mortgage loans in Fannie Mae Pools are primarily conventional mortgage loans. The lenders originating and servicing the mortgage loans are subject to certain eligibility requirements established by Fannie Mae.
Fannie Mae has certain contractual
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responsibilities. With respect to each Pool, Fannie Mae is obligated to distribute scheduled installments of principal and interest after Fannie Maes servicing and guaranty fee, whether or
not received, to Certificate holders. Fannie Mae also is obligated to distribute to holders of Certificates an amount equal to the full principal balance of any foreclosed mortgage loan, whether or not such principal balance is actually recovered.
The obligations of Fannie Mae under its guaranty of the Fannie Mae Certificates are obligations solely of Fannie Mae. See Certain Additional Information with Respect to Freddie Mac and Fannie Mae below.
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Freddie Mac Certificates
. Freddie Mac is a publicly held U.S. Government sponsored enterprise. A principal activity of Freddie Mac currently is
the purchase of first lien, conventional, residential and multifamily mortgage loans and participation interests in such mortgage loans and their resale in the form of mortgage securities, primarily Freddie Mac Certificates. A Freddie Mac
Certificate represents a pro rata interest in a group of mortgage loans or participations in mortgage loans (a Freddie Mac Certificate group) purchased by Freddie Mac. Freddie Mac guarantees to each registered holder of a Freddie Mac
Certificate the timely payment of interest at the rate provided for by such Freddie Mac Certificate (whether or not received on the underlying loans). Freddie Mac also guarantees to each registered Certificate holder ultimate collection of all
principal of the related mortgage loans, without any offset or deduction, but does not, generally, guarantee the timely payment of scheduled principal. The obligations of Freddie Mac under its guaranty of Freddie Mac Certificates are obligations
solely of Freddie Mac. See Certain Additional Information with Respect to Freddie Mac and Fannie Mae below.
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Conventional Mortgage Loans
. The conventional mortgage loans underlying the Freddie Mac and Fannie Mae Certificates consist of adjustable rate or fixed-rate mortgage loans normally with original
terms to maturity of between five and thirty years. Substantially all of these mortgage loans are secured by first liens on one- to four-family residential properties or multi-family projects. Each mortgage loan must meet the applicable standards
set forth in the law creating Freddie Mac or Fannie Mae. A Freddie Mac Certificate group may include whole loans, participation interests in whole loans, undivided interests in whole loans and participations comprising another Freddie Mac
Certificate group.
Certain Additional Information with Respect to Freddie Mac and Fannie Mae
. The volatility and
disruption that impacted the capital and credit markets during late 2008 and into 2009 have led to increased market concerns about Freddie Macs and Fannie Maes ability to withstand future credit losses associated with securities held in
their investment portfolios, and on which they provide guarantees, without the direct support of the federal government. On September 6, 2008, both Freddie Mac and Fannie Mae were placed under the conservatorship of the Federal Housing Finance
Agency (FHFA). Under the plan of conservatorship, the FHFA has assumed control of, and generally has the power to direct, the operations of Freddie Mac and Fannie Mae, and is empowered to exercise all powers collectively held by their
respective shareholders, directors and officers, including the power to (1) take over the assets of and operate Freddie Mac and Fannie Mae with all the powers of the shareholders, the directors, and the officers of Freddie Mac and Fannie Mae and
conduct all business of Freddie Mac and Fannie Mae; (2) collect all obligations and money due to Freddie Mac and Fannie Mae; (3) perform all functions of Freddie Mac and Fannie Mae which are consistent with the conservators appointment; (4)
preserve and conserve the assets and property of Freddie Mac and Fannie Mae; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator. In addition, in connection with the actions taken by the FHFA, the
U.S. Treasury Department (the Treasury) entered into certain preferred stock purchase agreements with each of Freddie Mac and Fannie Mae which established the Treasury as the holder of a new class of senior preferred stock in each of
Freddie Mac and Fannie Mae, which stock was issued in connection with financial contributions from the Treasury to Freddie Mac and Fannie Mae.
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The conditions attached to the financial contribution made by the Treasury to Freddie Mac and Fannie Mae and the issuance of this senior preferred stock placed significant restrictions on the
activities of Freddie Mac and Fannie Mae. Freddie Mac and Fannie Mae must obtain the consent of the Treasury to, among other things, (i) make any payment to purchase or redeem its capital stock or pay any dividend other than in respect of the
senior preferred stock to the Treasury, (ii) issue capital stock of any kind, (iii) terminate the conservatorship of the FHFA except in connection with a receivership, or (iv) increase its debt beyond certain specified levels. In
addition, significant restrictions were placed on the maximum size of each of Freddie Macs and Fannie Maes respective portfolios of mortgages and Mortgage-Backed Securities, and the purchase agreements entered into by Freddie Mac and
Fannie Mae provide that the maximum size of their portfolios of these assets must decrease by a specified percentage each year. On June 16, 2010, FHFA ordered Fannie Mae and Freddie Macs stock de-listed from the New York Stock Exchange
(NYSE) after the price of common stock in Fannie Mae fell below the NYSE minimum average closing price of $1 for more than 30 days.
The future status and role of Freddie Mac and Fannie Mae could be impacted by (among other things) the actions taken and restrictions placed on Freddie Mac and Fannie Mae by the FHFA in its role as
conservator, the restrictions placed on Freddie Macs and Fannie Maes operations and activities as a result of the senior preferred stock investment made by the Treasury, market responses to developments at Freddie Mac and Fannie Mae, and
future legislative and regulatory action that alters the operations, ownership, structure and/or mission of these institutions, each of which may, in turn, impact the value of, and cash flows on, any Mortgage-Backed Securities guaranteed by Freddie
Mac and Fannie Mae, including any such Mortgage-Backed Securities held by an Underlying Fund.
Privately Issued
Mortgage-Backed Securities
. Certain of the Underlying Funds may invest in privately issued Mortgage-Backed Securities. Privately issued Mortgage-Backed Securities are generally backed by pools of conventional (i.e., non-government guaranteed or
insured) mortgage loans. The seller or servicer of the underlying mortgage obligations will generally make representations and warranties to certificate-holders as to certain characteristics of the mortgage loans and as to the accuracy of certain
information furnished to the trustee in respect of each such mortgage loan. Upon a breach of any representation or warranty that materially and adversely affects the interests of the related certificate-holders in a mortgage loan, the seller or
servicer generally will be obligated either to cure the breach in all material respects, to repurchase the mortgage loan or, if the related agreement so provides, to substitute in its place a mortgage loan pursuant to the conditions set forth
therein. Such a repurchase or substitution obligation may constitute the sole remedy available to the related certificate-holders or the trustee for the material breach of any such representation or warranty by the seller or servicer.
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Mortgage Pass-Through Securities
Certain Underlying Funds may invest in both government guaranteed and privately issued mortgage pass-through securities (Mortgage
Pass-Throughs) that are fixed or adjustable rate Mortgage-Backed Securities which provide for monthly payments that are a pass-through of the monthly interest and principal payments (including any prepayments) made by the
individual borrowers on the pooled mortgage loans, net of any fees or other amounts paid to any guarantor, administrator and/or servicer of the underlying mortgage loans. The seller or servicer of the underlying mortgage obligations will generally
make representations and warranties to certificate-holders as to certain characteristics of the mortgage loans and as to the accuracy of certain information furnished to the trustee in respect of each such mortgage loan. Upon a breach of any
representation or warranty that materially and adversely affects the interests of the related certificate-holders in a mortgage loan, the seller or servicer may be obligated either to cure the breach in all material respects, to repurchase the
mortgage loan or, if the related agreement so provides, to substitute in its place a mortgage loan pursuant to the conditions set forth therein. Such a repurchase or substitution obligation may constitute the sole remedy available to the related
certificate-holders or the trustee for the material breach of any such representation or warranty by the seller or servicer.
The following discussion describes certain aspects of only a few of the wide variety of structures of Mortgage Pass-Throughs that are
available or may be issued.
General Description of Certificates.
Mortgage Pass-Throughs may be issued in one or more
classes of senior certificates and one or more classes of subordinate certificates. Each such class may bear a different pass-through rate. Generally, each certificate will evidence the specified interest of the holder thereof in the payments of
principal or interest or both in respect of the mortgage pool comprising part of the trust fund for such certificates.
Any
class of certificates may also be divided into subclasses entitled to varying amounts of principal and interest. If a REMIC election has been made, certificates of such subclasses may be entitled to payments on the basis of a stated principal
balance and stated interest rate, and payments among different subclasses may be made on a sequential, concurrent, pro rata or disproportionate basis, or any combination thereof. The stated interest rate on any such subclass of certificates may be a
fixed rate or one which varies in direct or inverse relationship to an objective interest index.
Generally, each registered
holder of a certificate will be entitled to receive its pro rata share of monthly distributions of all or a portion of principal of the underlying mortgage loans or of interest on the principal balances thereof, which accrues at the applicable
mortgage pass-through rate, or both. The difference between the mortgage interest rate and the related mortgage pass-through rate (less the amount, if any, of retained yield) with respect to each mortgage loan will generally be paid to the servicer
as a servicing fee. Because certain adjustable rate mortgage loans included in a mortgage pool may provide for deferred interest (i.e., negative amortization), the amount of interest actually paid by a mortgagor in any month may be less than the
amount of interest accrued on the outstanding principal balance of the related mortgage loan during the relevant period at the applicable mortgage interest rate. In such event, the amount of interest that is treated as deferred interest will
generally be added to the principal balance of the related mortgage loan and will be distributed pro rata to certificate-holders as principal of such mortgage loan when paid by the mortgagor in subsequent monthly payments or at maturity.
Ratings
. The ratings assigned by a rating organization to Mortgage Pass-Throughs generally address the likelihood of the receipt
of distributions on the underlying mortgage loans by the related certificate-holders under the agreements pursuant to which such certificates are issued. A rating organizations ratings normally take into consideration the credit quality of the
related mortgage pool, including any credit support providers, structural and legal aspects associated with such certificates, and the extent to which the payment stream on such mortgage pool is adequate to make payments required by such
certificates. A rating organizations ratings on such certificates do not, however, constitute a statement regarding frequency of prepayments on the related
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mortgage loans. In addition, the rating assigned by a rating organization to a certificate may not address the possibility that, in the event of the insolvency of the issuer of certificates where
a subordinated interest was retained, the issuance and sale of the senior certificates may be recharacterized as a financing and, as a result of such recharacterization, payments on such certificates may be affected. A rating organization may
downgrade or withdraw a rating assigned by it to any Mortgage Pass-Through at any time, and no assurance can be made that any ratings on any Mortgage Pass-Throughs included in an Underlying Fund will be maintained, or that if such ratings are
assigned, they will not be downgraded or withdrawn by the assigning rating organization.
Recently, rating agencies have
placed on credit watch or downgraded the ratings previously assigned to a large number of mortgage-backed securities (which may include certain of the Mortgage-Backed Securities in which certain of the Underlying Funds may have invested or may in
the future be invested), and may continue to do so in the future. In the event that any Mortgage-Backed Security held by an Underlying Fund is placed on credit watch or downgraded, the value of such Mortgage-Backed Security may decline and the
Underlying Fund may consequently experience losses in respect of such Mortgage-Backed Security.
Credit Enhancement
.
Mortgage pools created by non-governmental issuers generally offer a higher yield than government and government-related pools because of the absence of direct or indirect government or agency payment guarantees. To lessen the effect of failures by
obligors on underlying assets to make payments, Mortgage Pass-Throughs may contain elements of credit support. Credit support falls generally into two categories: (i) liquidity protection and (ii) protection against losses resulting from
default by an obligor on the underlying assets. Liquidity protection refers to the provision of advances, generally by the entity administering the pools of mortgages, the provision of a reserve fund, or a combination thereof, to ensure, subject to
certain limitations, that scheduled payments on the underlying pool are made in a timely fashion. Protection against losses resulting from default ensures ultimate payment of the obligations on at least a portion of the assets in the pool. Such
credit support can be provided by, among other things, payment guarantees, letters of credit, pool insurance, subordination, or any combination thereof.
Subordination; Shifting of Interest; Reserve Fund
. In order to achieve ratings on one or more classes of Mortgage Pass-Throughs, one or more classes of certificates may be subordinate certificates
which provide that the rights of the subordinate certificate-holders to receive any or a specified portion of distributions with respect to the underlying mortgage loans may be subordinated to the rights of the senior certificate holders. If so
structured, the subordination feature may be enhanced by distributing to the senior certificate-holders on certain distribution dates, as payment of principal, a specified percentage (which generally declines over time) of all principal payments
received during the preceding prepayment period (shifting interest credit enhancement). This will have the effect of accelerating the amortization of the senior certificates while increasing the interest in the trust fund evidenced by
the subordinate certificates. Increasing the interest of the subordinate certificates relative to that of the senior certificates is intended to preserve the availability of the subordination provided by the subordinate certificates. In addition,
because the senior certificate-holders in a shifting interest credit enhancement structure are entitled to receive a percentage of principal prepayments which is greater than their proportionate interest in the trust fund, the rate of principal
prepayments on the mortgage loans may have an even greater effect on the rate of principal payments and the amount of interest payments on, and the yield to maturity of, the senior certificates.
In addition to providing for a preferential right of the senior certificate-holders to receive current distributions from the mortgage
pool, a reserve fund may be established relating to such certificates (the Reserve Fund). The Reserve Fund may be created with an initial cash deposit by the originator or servicer and augmented by the retention of distributions
otherwise available to the subordinate certificate-holders or by excess servicing fees until the Reserve Fund reaches a specified amount.
The subordination feature, and any Reserve Fund, are intended to enhance the likelihood of timely receipt by senior certificate-holders of the full amount of scheduled monthly payments of principal and
interest
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due to them and will protect the senior certificate-holders against certain losses; however, in certain circumstances the Reserve Fund could be depleted and temporary shortfalls could result. In
the event that the Reserve Fund is depleted before the subordinated amount is reduced to zero, senior certificate-holders will nevertheless have a preferential right to receive current distributions from the mortgage pool to the extent of the then
outstanding subordinated amount. Unless otherwise specified, until the subordinated amount is reduced to zero, on any distribution date any amount otherwise distributable to the subordinate certificates or, to the extent specified, in the Reserve
Fund will generally be used to offset the amount of any losses realized with respect to the mortgage loans (Realized Losses). Realized Losses remaining after application of such amounts will generally be applied to reduce the ownership
interest of the subordinate certificates in the mortgage pool. If the subordinated amount has been reduced to zero, Realized Losses generally will be allocated pro rata among all certificate-holders in proportion to their respective outstanding
interests in the mortgage pool.
Alternative Credit Enhancement
. As an alternative, or in addition to the credit
enhancement afforded by subordination, credit enhancement for Mortgage Pass-Throughs may be provided through bond insurers, or at the mortgage loan-level through mortgage insurance, hazard insurance, or through the deposit of cash, certificates of
deposit, letters of credit, a limited guaranty or by such other methods as are acceptable to a rating agency. In certain circumstances, such as where credit enhancement is provided by bond insurers, guarantees or letters of credit, the security is
subject to credit risk because of its exposure to the credit risk of an external credit enhancement provider.
Voluntary
Advances
. Generally, in the event of delinquencies in payments on the mortgage loans underlying the Mortgage Pass-Throughs, the servicer may agree to make advances of cash for the benefit of certificate-holders, but generally will do so only to
the extent that it determines such voluntary advances will be recoverable from future payments and collections on the mortgage loans or otherwise.
Optional Termination
. Generally, the servicer may, at its option with respect to any certificates, repurchase all of the underlying mortgage loans remaining outstanding at such time the aggregate
outstanding principal balance of such mortgage loans is less than a specified percentage (generally 5-10%) of the aggregate outstanding principal balance of the mortgage loans as of the cut-off date specified with respect to such series.
Multiple Class Mortgage-Backed Securities and Collateralized Mortgage Obligations
. Certain of the Underlying Funds may invest in
multiple class securities including collateralized mortgage obligations (CMOs) and REMIC Certificates. These securities may be issued by U.S. Government agencies, instrumentalities or sponsored enterprises such as Fannie Mae or Freddie
Mac or by trusts formed by private originators of, or investors in, mortgage loans, including savings and loan associations, mortgage bankers, commercial banks, insurance companies, investment banks and special purpose subsidiaries of the foregoing.
In general, CMOs are debt obligations of a legal entity that are collateralized by, and multiple class Mortgage-Backed Securities represent direct ownership interests in, a pool of mortgage loans or Mortgage-Backed Securities the payments on which
are used to make payments on the CMOs or multiple class Mortgage-Backed Securities.
Fannie Mae REMIC Certificates are issued
and guaranteed as to timely distribution of principal and interest by Fannie Mae. In addition, Fannie Mae will be obligated to distribute the principal balance of each class of REMIC Certificates in full, whether or not sufficient funds are
otherwise available.
Freddie Mac guarantees the timely payment of interest on Freddie Mac REMIC Certificates and also
guarantees the payment of principal as payments are required to be made on the underlying mortgage participation certificates (PCs). PCs represent undivided interests in specified level payment, residential mortgages or participations
therein purchased by Freddie Mac and placed in a PC pool. With respect to principal payments on PCs, Freddie Mac generally guarantees ultimate collection of all principal of the related mortgage loans without offset or deduction but the receipt of
the required payments may be delayed. Freddie Mac also guarantees timely payment of principal of certain PCs.
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CMOs and guaranteed REMIC Certificates issued by Fannie Mae and Freddie Mac are types of
multiple class Mortgage-Backed Securities. The REMIC Certificates represent beneficial ownership interests in a REMIC trust, generally consisting of mortgage loans or Fannie Mae, Freddie Mac or Ginnie Mae guaranteed Mortgage-Backed Securities (the
Mortgage Assets). The obligations of Fannie Mae or Freddie Mac under their respective guaranty of the REMIC Certificates are obligations solely of Fannie Mae or Freddie Mac, respectively. See Certain Additional Information with
Respect to Freddie Mac and Fannie Mae.
CMOs and REMIC Certificates are issued in multiple classes. Each class of CMOs
or REMIC Certificates, often referred to as a tranche, is issued at a specific adjustable or fixed interest rate and must be fully retired no later than its final distribution date. Principal prepayments on the mortgage loans or the
Mortgage Assets underlying the CMOs or REMIC Certificates may cause some or all of the classes of CMOs or REMIC Certificates to be retired substantially earlier than their final distribution dates. Generally, interest is paid or accrues on all
classes of CMOs or REMIC Certificates on a monthly basis.
The principal of and interest on the Mortgage Assets may be
allocated among the several classes of CMOs or REMIC Certificates in various ways. In certain structures (known as sequential pay CMOs or REMIC Certificates), payments of principal, including any principal prepayments, on the Mortgage
Assets generally are applied to the classes of CMOs or REMIC Certificates in the order of their respective final distribution dates. Thus, no payment of principal will be made on any class of sequential pay CMOs or REMIC Certificates until all other
classes having an earlier final distribution date have been paid in full.
Additional structures of CMOs and REMIC
Certificates include, among others, parallel pay CMOs and REMIC Certificates. Parallel pay CMOs or REMIC Certificates are those which are structured to apply principal payments and prepayments of the Mortgage Assets to two or more
classes concurrently on a proportionate or disproportionate basis. These simultaneous payments are taken into account in calculating the final distribution date of each class.
A wide variety of REMIC Certificates may be issued in parallel pay or sequential pay structures. These securities include accrual certificates (also known as Z-Bonds), which only accrue
interest at a specified rate until all other certificates having an earlier final distribution date have been retired and are converted thereafter to an interest-paying security, and planned amortization class (PAC) certificates, which
are parallel pay REMIC Certificates that generally require that specified amounts of principal be applied on each payment date to one or more classes or REMIC Certificates (the PAC Certificates), even though all other principal payments
and prepayments of the Mortgage Assets are then required to be applied to one or more other classes of the PAC Certificates. The scheduled principal payments for the PAC Certificates generally have the highest priority on each payment date after
interest due has been paid to all classes entitled to receive interest currently. Shortfalls, if any, are added to the amount payable on the next payment date. The PAC Certificate payment schedule is taken into account in calculating the final
distribution date of each class of PAC. In order to create PAC tranches, one or more tranches generally must be created that absorb most of the volatility in the underlying mortgage assets. These tranches tend to have market prices and yields that
are much more volatile than other PAC classes.
Commercial Mortgage-Backed Securities
. Commercial mortgage-backed
securities (CMBS). are a type of Mortgage Pass-Through that are primarily backed by a pool of commercial mortgage loans. The commercial mortgage loans are, in turn, generally secured by commercial mortgaged properties (such as office
properties, retail properties, hospitality properties, industrial properties, healthcare related properties or other types of income producing real property). CMBS generally entitle the holders thereof to receive payments that depend primarily on
the cash flow from a specified pool of commercial or multifamily mortgage loans. CMBS will be affected by payments, defaults, delinquencies and losses on the underlying mortgage loans. The underlying mortgage loans generally are secured by income
producing properties such as office properties, retail properties, multifamily properties, manufactured housing, hospitality properties, industrial properties and self
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storage properties. Because issuers of CMBS have no significant assets other than the underlying commercial real estate loans and because of the significant credit risks inherent in the
underlying collateral, credit risk is a correspondingly important consideration with respect to the related CMBS Securities. Certain of the mortgage loans underlying CMBS Securities constituting part of the collateral interests may be delinquent, in
default or in foreclosure.
Commercial real estate lending may expose a lender (and the related Mortgage-Backed Security) to a
greater risk of loss than certain other forms of lending because it typically involves making larger loans to single borrowers or groups of related borrowers. In addition, in the case of certain commercial mortgage loans, repayment of loans secured
by commercial and multifamily properties depends upon the ability of the related real estate project to generate income sufficient to pay debt service, operating expenses and leasing commissions and to make necessary repairs, tenant improvements and
capital improvements, and in the case of loans that do not fully amortize over their terms, to retain sufficient value to permit the borrower to pay off the loan at maturity through a sale or refinancing of the mortgaged property. The net operating
income from and value of any commercial property is subject to various risks, including changes in general or local economic conditions and/or specific industry segments; declines in real estate values; declines in rental or occupancy rates;
increases in interest rates, real estate tax rates and other operating expenses; changes in governmental rules, regulations and fiscal policies; acts of God; terrorist threats and attacks and social unrest and civil disturbances. In addition,
certain of the mortgaged properties securing the pools of commercial mortgage loans underlying CMBS may have a higher degree of geographic concentration in a few states or regions. Any deterioration in the real estate market or economy or adverse
events in such states or regions, may increase the rate of delinquency and default experience (and as a consequence, losses) with respect to mortgage loans related to properties in such state or region. Pools of mortgaged properties securing the
commercial mortgage loans underlying CMBS may also have a higher degree of concentration in certain types of commercial properties. Accordingly, such pools of mortgage loans represent higher exposure to risks particular to those types of commercial
properties. Certain pools of commercial mortgage loans underlying CMBS consist of a fewer number of mortgage loans with outstanding balances that are larger than average. If a mortgage pool includes mortgage loans with larger than average balances,
any realized losses on such mortgage loans could be more severe, relative to the size of the pool, than would be the case if the aggregate balance of the pool were distributed among a larger number of mortgage loans. Certain borrowers or affiliates
thereof relating to certain of the commercial mortgage loans underlying CMBS may have had a history of bankruptcy. Certain mortgaged properties securing the commercial mortgage loans underlying CMBS may have been exposed to environmental conditions
or circumstances. The ratings in respect of certain of the CMBS comprising the Mortgage-Backed Securities may have been withdrawn, reduced or placed on credit watch since issuance. In addition, losses and/or appraisal reductions may be allocated to
certain of such CMBS and certain of the collateral or the assets underlying such collateral may be delinquent and/or may default from time to time.
CMBS held by an Underlying Fund may be subordinated to one or more other classes of securities of the same series for purposes of, among other things, establishing payment priorities and offsetting losses
and other shortfalls with respect to the related underlying mortgage loans. Realized losses in respect of the mortgage loans included in the CMBS pool and trust expenses generally will be allocated to the most subordinated class of securities of the
related series. Accordingly, to the extent any CMBS is or becomes the most subordinated class of securities of the related series, any delinquency or default on any underlying mortgage loan may result in shortfalls, realized loss allocations or
extensions of its weighted average life and will have a more immediate and disproportionate effect on the related CMBS than on a related more senior class of CMBS of the same series. Further, even if a class is not the most subordinate class of
securities, there can be no assurance that the subordination offered to such class will be sufficient on any date to offset all losses or expenses incurred by the underlying trust. CMBS are typically not guaranteed or insured, and distributions on
such CMBS generally will depend solely upon the amount and timing of payments and other collections on the related underlying commercial mortgage loans.
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Stripped Mortgage-Backed Securities
. Certain of the Underlying Funds may invest in
stripped mortgage-backed securities (SMBS), which are derivative multiclass mortgage securities, issued or guaranteed by the U.S. Government, its agencies or instrumentalities or non-governmental originators. SMBS are usually structured
with two different classes: one that receives substantially all of the interest payments (the interest-only, or IO and/or the high coupon rate with relatively low principal amount, or IOette), and the other that receives
substantially all of the principal payments (the principal-only, or PO), from a pool of mortgage loans.
Certain
SMBS may not be readily marketable and will be considered illiquid for purposes of an Underlying Funds limitation on investments in illiquid securities. The Investment Adviser may determine that SMBS which are U.S. Government securities are
liquid for purposes of an Underlying Funds limitation on investments in illiquid securities. The market value of POs generally is unusually volatile in response to changes in interest rates. The yields on IOs and IOettes are generally higher
than prevailing market yields on other Mortgage-Backed Securities because their cash flow patterns are more volatile and there is a greater risk that the initial investment will not be fully recouped. An Underlying Funds investment in SMBS may
require the Underlying Fund to sell certain of its portfolio securities to generate sufficient cash to satisfy certain income distribution requirements.
Asset-Backed Securities
Asset-backed securities represent participations
in, or are secured by and payable from, assets such as motor vehicle installment sales, installment loan contracts, leases of various types of real and personal property, receivables from revolving credit (credit card) agreements and other
categories of receivables. Such assets are securitized through the use of trusts and special purpose corporations. Payments or distributions of principal and interest may be guaranteed up to certain amounts and for a certain time period by a letter
of credit or a pool insurance policy issued by a financial institution unaffiliated with the trust or corporation, or other credit enhancements may be present.
Certain of the Underlying Funds may invest in asset-backed securities. Such securities are often subject to more rapid repayment than their stated maturity date would indicate as a result of the
pass-through of prepayments of principal on the underlying loans. During periods of declining interest rates, prepayment of loans underlying asset-backed securities can be expected to accelerate. Accordingly, the Underlying Funds ability to
maintain positions in such securities will be affected by reductions in the principal amount of such securities resulting from prepayments, and its ability to reinvest the returns of principal at comparable yields is subject to generally prevailing
interest rates at that time. To the extent that the Underlying Fund invests in asset-backed securities, the values of the Underlying Funds portfolio securities will vary with changes in market interest rates generally and the differentials in
yields among various kinds of asset-backed securities.
Asset-backed securities present certain additional risks because
asset-backed securities generally do not have the benefit of a security interest in collateral that is comparable to mortgage assets. Credit card receivables are generally unsecured and the debtors on such receivables are entitled to the protection
of a number of state and federal consumer credit laws, many of which give such debtors the right to set-off certain amounts owed on the credit cards, thereby reducing the balance due. Automobile receivables generally are secured, but by automobiles
rather than residential real property. Most issuers of automobile receivables permit the loan servicers to retain possession of the underlying obligations. If the servicer were to sell these obligations to another party, there is a risk that the
purchaser would acquire an interest superior to that of the holders of the asset-backed securities. In addition, because of the large number of vehicles involved in a typical issuance and technical requirements under state laws, the trustee for the
holders of the automobile receivables may not have a proper security interest in the underlying automobiles. Therefore, if the issuer of an asset-backed security defaults on its payment obligations, there is the possibility that, in some cases, the
Underlying Fund will be unable to possess and sell the underlying collateral and that the Underlying Funds recoveries on repossessed collateral may not be available to support payments on these securities.
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Recent Events Relating to the Mortgage- and Asset-Backed Securities Markets and the Overall Economy
The unprecedented disruption in the residential mortgage-backed securities market (and in particular, the
subprime residential mortgage market), the broader mortgage-backed securities market and the asset-backed securities market in 2008-2009 has resulted (and continues to result) in downward price pressures and increasing foreclosures and
defaults in residential and commercial real estate. Concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the mortgage market and a depressed real estate market have contributed to increased volatility and
diminished expectations for the economy and markets going forward, and have contributed to dramatic declines in the housing market, with falling home prices and increasing foreclosures and unemployment, and significant asset write-downs by financial
institutions. These conditions have prompted a number of financial institutions to seek additional capital, to merge with other institutions and, in some cases, to fail or seek bankruptcy protection. Between 2008-2009, the market for Mortgage-Backed
Securities (as well as other asset-backed securities) was particularly adversely impacted by, among other factors, the failure and subsequent sale of Bear, Stearns & Co. Inc. to J.P. Morgan Chase, the merger of Bank of America Corporation
and Merrill Lynch & Co., the insolvency of Washington Mutual Inc., the failure and subsequent bankruptcy of Lehman Brothers Holdings, Inc., the extension of approximately $152 billion in emergency credit by the U.S. Department of the
Treasury to American International Group Inc., and, as described above, the conservatorship and the control by the U.S. Government of Freddie Mac and Fannie Mae. Recently, the global markets have seen an increase in volatility due to uncertainty
surrounding the level and sustainability of sovereign debt of certain countries that are part of the European Union, including Greece, Spain, Portugal, Ireland and Italy, as well as the sustainability of the European Union itself. Recent concerns
over the level and sustainability of the sovereign debt of the United States have aggravated this volatility. No assurance can be made that this uncertainty will not lead to further disruption of the credit markets in the United States or around the
globe. These events, coupled with the general global economic downturn, have resulted in a substantial level of uncertainty in the financial markets, particularly with respect to mortgage-related investments.
The continuation or worsening of this general economic downturn may lead to further declines in income from, or the value of, real
estate, including the real estate which secures the Mortgage-Backed Securities held by certain of the Underlying Funds. Additionally, a lack of credit liquidity, adjustments of mortgages to higher rates and decreases in the value of real property
have occurred and may continue to occur or worsen, and potentially prevent borrowers from refinancing their mortgages, which may increase the likelihood of default on their mortgage loans. These economic conditions, coupled with high levels of real
estate inventory and elevated incidence of underwater mortgages, may also adversely affect the amount of proceeds the holder of a mortgage loan or mortgage-backed securities (including the Mortgaged-Backed Securities in which certain Underlying
Funds may invest) would realize in the event of a foreclosure or other exercise of remedies. Moreover, even if such Mortgage-Backed Securities are performing as anticipated, the value of such securities in the secondary market may nevertheless fall
or continue to fall as a result of deterioration in general market conditions for such Mortgage-Backed Securities or other asset-backed or structured products. Trading activity associated with market indices may also drive spreads on those indices
wider than spreads on Mortgage-Backed Securities, thereby resulting in a decrease in value of such Mortgage-Backed Securities, including the Mortgage-Backed Securities owned by the Underlying Fund.
The U.S. Government, the Federal Reserve, the Treasury, the SEC, the Federal Deposit Insurance Corporation (the FDIC) and
other governmental and regulatory bodies have recently taken or are considering taking actions to address the financial crisis. These actions include, but are not limited to, the enactment by the U.S. Congress of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd Frank Act), which was signed into law on July 21, 2010 and imposes a new regulatory framework over the U.S. financial services
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industry and the consumer credit markets in general, and proposed regulations by the SEC, which, if enacted, would significantly alter the manner in which asset-backed securities, including
Mortgage-Backed Securities, are issued. Given the broad scope, sweeping nature, and relatively recent enactment of some of these regulatory measures, the potential impact they could have on any of the asset-backed or Mortgage-Backed Securities held
by the Underlying Funds is unknown. There can be no assurance that these measures will not have an adverse effect on the value or marketability of any asset-backed or Mortgage-Backed Securities held by the Underlying Funds. Furthermore, no assurance
can be made that the U.S. Government or any U.S. regulatory body (or other authority or regulatory body) will not continue to take further legislative or regulatory action in response to the economic crisis or otherwise, and the effect of such
actions, if taken, cannot be known.
Among its other provisions, the Dodd-Frank Act creates a liquidation framework under
which the FDIC, may be appointed as receiver following a systemic risk determination by the Secretary of Treasury (in consultation with the President) for the resolution of certain nonbank financial companies and other entities, defined
as covered financial companies, and commonly referred to as systemically important entities, in the event such a company is in default or in danger of default and the resolution of such a company under other applicable law
would have serious adverse effects on financial stability in the United States, and also for the resolution of certain of their subsidiaries. No assurances can be given that this new liquidation framework would not apply to the originators of
asset-backed securities, including Mortgage-Backed Securities, or their respective subsidiaries, including the issuers and depositors of such securities, although the expectation embedded in the Dodd-Frank Act is that the framework will be invoked
only very rarely. Recent guidance from the FDIC indicates that such new framework will largely be exercised in a manner consistent with the existing bankruptcy laws, which is the insolvency regime that would otherwise apply to the sponsors,
depositors and issuing entities with respect to asset-backed securities, including Mortgage-Backed Securities. The application of such liquidation framework to such entities could result in decreases or delays in amounts paid on, and hence the
market value of, the Mortgage-Backed or asset-backed securities that are owned by an Underlying Fund.
Recently,
delinquencies, defaults and losses on residential mortgage loans have increased substantially and may continue to increase, which may affect the performance of the Mortgage-Backed Securities in which certain of the Underlying Funds may invest.
Mortgage loans backing non-agency Mortgage-Backed Securities are more sensitive to economic factors that could affect the ability of borrowers to pay their obligations under the mortgage loans backing these securities. In addition, housing prices
and appraisal values in many states and localities have declined or stopped appreciating. A continued decline or an extended flattening of those values may result in additional increases in delinquencies and losses on Mortgage-Backed Securities
generally (including the Mortgaged-Backed Securities that the Underlying Funds may invest in as described above).
The
foregoing adverse changes in market conditions and regulatory climate may reduce the cash flow which an Underlying Fund, to the extent it invests in Mortgage-Backed Securities or other asset-backed securities, receives from such securities and
increase the incidence and severity of credit events and losses in respect of such securities. In addition, interest rate spreads for Mortgage-Backed Securities have widened and are more volatile when compared to the recent past due to these adverse
changes in market conditions. In the event that interest rate spreads for Mortgage-Backed Securities and other asset-backed securities widen following the purchase of such assets by an Underlying Fund, the market value of such securities is likely
to decline and, in the case of a substantial spread widening, could decline by a substantial amount. Furthermore, these adverse changes in market conditions have resulted in reduced liquidity in the market for Mortgage-Backed Securities and other
asset-backed securities (including the Mortgaged-Backed Securities and other asset-backed securities in which certain of the Underlying Funds may invest) and increasing unwillingness by banks, financial institutions and investors to extend credit to
servicers, originators and other participants in the market for Mortgage-Backed and other asset-backed securities. As a result, the liquidity and/or the market value of any Mortgage-Backed or asset-backed securities that are owned by an Underlying
Fund may experience further declines after they are purchased by the Underlying Fund.
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Futures Contracts and Options on Futures Contracts
Each Underlying Fund (other than the Financial Square Prime Obligations Fund) may purchase and sell futures contracts and may also
purchase and write options on futures contracts. The Structured Large Cap Value, Structured Large Cap Growth, Structured Small Cap Equity, Structured Emerging Markets Equity and Structured International Small Cap Funds may only enter into such
transactions with respect to a representative index. The other Underlying Funds (other than the Short Duration Government Fund) may purchase and sell futures contracts based on various securities, securities indices, foreign currencies and other
financial instruments and indices. An Underlying Fund will engage in futures and related options transactions, in order to seek to increase total return or to hedge against changes in interest rates, securities prices or, to the extent an Underlying
Fund invests in foreign securities, currency exchange rates, or to otherwise manage its term structure, sector selection and duration in accordance with its investment objective and policies. Each applicable Underlying Fund may also enter into
closing purchase and sale transactions with respect to such contracts and options. The investment adviser of the Underlying Fixed Income Funds will also use futures contracts and options on futures contracts to manage the Underlying Funds
target duration in accordance with their benchmark or benchmarks.
Futures contracts entered into by an Underlying Fund have
historically been traded on U.S. exchanges or boards of trade that are licensed and regulated by the CFTC or, with respect to certain Underlying Funds, on foreign exchanges. More recently, certain futures may also be traded over-the-counter or on
trading facilities such as derivatives transaction execution facilities, exempt boards of trade or electronic trading facilities that are licensed and/or regulated to varying degrees by the CFTC. Also, certain single stock futures and narrow based
security index futures may be traded over-the-counter or on trading facilities such as contract markets, derivatives transaction execution facilities and electronic trading facilities that are licensed and/or regulated to varying degrees by both the
CFTC and the SEC or on foreign exchanges.
Neither the CFTC, National Futures Association (NFA), SEC nor any
domestic exchange regulates activities of any foreign exchange or boards of trade, including the execution, delivery and clearing of transactions, or has the power to compel enforcement of the rules of a foreign exchange or board of trade or any
applicable foreign law. This is true even if the exchange is formally linked to a domestic market so that a position taken on the market may be liquidated by a transaction on another market. Moreover, such laws or regulations will vary depending on
the foreign country in which the foreign futures or foreign options transaction occurs. For these reasons, an Underlying Funds investments in foreign futures or foreign options transactions may not be provided the same protections in respect
of transactions on United States exchanges. In particular, persons who trade foreign futures or foreign options contracts may not be afforded certain of the protective measures provided by the Commodity Exchange Act (CEA), the
CFTCs regulations and the rules of the NFA and any domestic exchange, including the right to use reparations proceedings before the CFTC and arbitration proceedings provided by the NFA or any domestic futures exchange. Similarly, these persons
may not have the protection of the U.S. securities laws.
Futures Contracts
. A futures contract may generally be
described as an agreement between two parties to buy and sell particular financial instruments or currencies for an agreed price during a designated month (or to deliver the final cash settlement price, in the case of a contract relating to an index
or otherwise not calling for physical delivery at the end of trading in the contract).
When interest rates are rising or
securities prices are falling, an Underlying Fund can seek to offset a decline in the value of its current portfolio securities through the sale of futures contracts. When interest rates are falling or securities prices are rising, an Underlying
Fund, through the purchase of futures contracts, can attempt to secure better rates or prices than might later be available in the market when it effects anticipated purchases. Similarly, certain Underlying Funds may purchase and sell futures
contracts on a specified currency in order to seek to increase total return or to protect against changes in currency exchange rates. For example, certain Underlying Funds may purchase futures contracts on foreign currency to establish the price in
U.S.
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dollars of a security quoted or denominated in such currency that such Underlying Fund has acquired or expects to acquire. In addition, certain Underlying Funds may enter into futures
transactions to seek a closer correlation between the Underlying Funds overall currency exposures and the currency exposures of the Underlying Funds performance benchmark.
Positions taken in the futures markets are not normally held to maturity, but are instead liquidated through offsetting transactions
which may result in a profit or a loss. While an Underlying Fund will usually liquidate futures contracts on securities or currency in this manner, an Underlying Fund may instead make or take delivery of the underlying securities or currency
whenever it appears economically advantageous for the Underlying Fund to do so. A clearing corporation associated with the exchange on which futures on securities or currency are traded guarantees that, if still open, the sale or purchase will be
performed on the settlement date.
Hedging Strategies Using Futures Contracts
. When an Underlying Fund uses futures for
hedging purposes, the Fund often seeks to establish with more certainty than would otherwise be possible the effective price or rate of return on portfolio securities (or securities that an Underlying Fund proposes to acquire) or the exchange rate
of currencies in which portfolio securities are quoted or denominated. An Underlying Fund may, for example, take a short position in the futures market by selling futures contracts to seek to hedge against an anticipated rise in interest
rates or a decline in market prices or foreign currency rates that would adversely affect the U.S. dollar value of the Underlying Funds portfolio securities. Such futures contracts may include contracts for the future delivery of securities
held by an Underlying Fund or securities with characteristics similar to those of an Underlying Funds portfolio securities. Similarly, certain Underlying Funds may sell futures contracts on any currency in which its portfolio securities are
quoted or denominated or sell futures contracts on one currency to seek to hedge against fluctuations in the value of securities quoted or denominated in a different currency if there is an established historical pattern of correlation between the
two currencies. If, in the opinion of an Underlying Funds investment adviser, there is a sufficient degree of correlation between price trends for an Underlying Funds portfolio securities and futures contracts based on other financial
instruments, securities indices or other indices, the Underlying Fund may also enter into such futures contracts as part of its hedging strategy. Although under some circumstances prices of securities in an Underlying Funds portfolio may be
more or less volatile than prices of such futures contracts, its investment adviser will attempt to estimate the extent of this volatility difference based on historical patterns and compensate for any such differential by having the Underlying Fund
enter into a greater or lesser number of futures contracts or by attempting to achieve only a partial hedge against price changes affecting the Underlying Funds portfolio securities. When hedging of this character is successful, any
depreciation in the value of portfolio securities will be substantially offset by appreciation in the value of the futures position. On the other hand, any unanticipated appreciation in the value of an Underlying Funds portfolio securities
would be substantially offset by a decline in the value of the futures position.
On other occasions, an Underlying Fund may
take a long position by purchasing such futures contracts. This would be done, for example, when an Underlying Fund anticipates the subsequent purchase of particular securities when it has the necessary cash, but expects the prices or
currency exchange rates then available in the applicable market to be less favorable than prices or rates that are currently available.
Options on Futures Contracts
. The acquisition of put and call options on futures contracts will give an Underlying Fund the right (but not the obligation), for a specified price, to sell or to
purchase, respectively, the underlying futures contract at any time during the option period. As the purchaser of an option on a futures contract, an Underlying Fund obtains the benefit of the futures position if prices move in a favorable direction
but limits its risk of loss in the event of an unfavorable price movement to the loss of the premium and transaction costs.
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The writing of a call option on a futures contract generates a premium which may partially
offset a decline in the value of an Underlying Funds assets. By writing a call option, an Underlying Fund becomes obligated, in exchange for the premium, to sell a futures contract if the option is exercised, which may have a value higher than
the exercise price. The writing of a put option on a futures contract generates a premium, which may partially offset an increase in the price of securities that an Underlying Fund intends to purchase. However, an Underlying Fund becomes obligated
(upon exercise of the option) to purchase a futures contract if the option is exercised, which may have a value lower than the exercise price. Thus, the loss incurred by an Underlying Fund in writing options on futures is potentially unlimited and
may exceed the amount of the premium received. An Underlying Fund will incur transaction costs in connection with the writing of options on futures.
The holder or writer of an option on a futures contract may terminate its position by selling or purchasing an offsetting option on the same financial instrument. There is no guarantee that such closing
transactions can be effected. An Underlying Funds ability to establish and close out positions on such options will be subject to the development and maintenance of a liquid market.
Other Considerations
. An Underlying Fund will engage in transactions in futures contracts and related options from transactions
only to the extent such transactions are consistent with the requirements of the Internal Revenue Code of 1986, as amended (the Code) for maintaining its qualification as a regulated investment company for federal income tax purposes.
Transactions in futures contracts and options on futures involve brokerage costs, require margin deposits and, in certain cases, require an Underlying Fund to identify on its books cash or liquid assets in an amount equal to the underlying value of
such contracts and options. An Underlying Fund may cover its transactions in futures contracts and related options by identifying on its books cash or liquid assets or by other means, in any manner permitted by applicable law.
While transactions in futures contracts and options on futures may reduce certain risks, such transactions themselves entail certain
other risks. Thus, unanticipated changes in interest rates, securities prices or currency exchange rates may result in a poorer overall performance for an Underlying Fund than if it had not entered into any futures contracts or options transactions.
When futures contracts and options are used for hedging purposes, perfect correlation between an Underlying Funds futures positions and portfolio positions may be impossible to achieve, particularly where futures contracts based on individual
equity or corporate fixed income securities are currently not available. In the event of imperfect correlation between a futures position and a portfolio position which is intended to be protected, the desired protection may not be obtained and an
Underlying Fund may be exposed to risk of loss.
In addition, it is not possible for an Underlying Fund to hedge fully or
perfectly against currency fluctuations affecting the value of securities quoted or denominated in foreign currencies because the value of such securities is likely to fluctuate as a result of independent factors unrelated to currency fluctuations.
The profitability of an Underlying Funds trading in futures depends upon the ability of its investment adviser to analyze correctly the futures markets.
Options on Securities, Securities Indices and Foreign Currencies
Writing Covered Options
. Certain of the Underlying Funds may write (sell) covered call and put options on any securities in which
it may invest or any securities index consisting of securities in which it may invest. An Underlying Fund may write such options on securities that are listed on national domestic securities exchanges or foreign securities exchanges or traded in the
over-the-counter market. A call option written by an Underlying Fund obligates that Underlying Fund to sell specified securities to the holder of the option at a specified price if the option is exercised at any time on or before the expiration
date. Depending upon the type of call option, the purchaser of a call option either (i) has the right to any appreciation in the value of the security over a fixed price (the exercise price) on a certain date in the future (the
expiration date) or (ii) has the right to any appreciation in the value of the security over the exercise price at any time prior to the expiration
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of the option. If the purchaser does not exercise the option, an Underlying Fund pays the purchaser the difference between the price of the security and the exercise price of the option. The
premium, the exercise price and the market value of the security determine the gain or loss realized by an Underlying Fund as the seller of the call option. An Underlying Fund can also repurchase the call option prior to the expiration date, ending
its obligation. In this case, the cost of entering into closing purchase transactions will determine the gain or loss realized by the Underlying Fund. All call options written by an Underlying Fund are covered, which means that such Underlying Fund
will own the securities subject to the option as long as the option is outstanding or such Underlying Fund will use the other methods described below. An Underlying Funds purpose in writing covered call options is to realize greater income
than would be realized on portfolio securities transactions alone. However, an Underlying Fund may forego the opportunity to profit from an increase in the market price of the underlying security.
A put option written by an Underlying Fund would obligate such Underlying Fund to purchase specified securities from the option holder at
a specified price if, depending upon the type of put option, either (i) the option is exercised on or before the expiration date or (ii) the option is exercised on the expiration date. All put options written by an Underlying Fund would be
covered, which means that such Underlying Fund will identify on its books cash or liquid assets with a value at least equal to the exercise price of the put option (less any margin on deposit) or will use the other methods described below. The
purpose of writing such options is to generate additional income for the Underlying Fund. However, in return for the option premium, an Underlying Fund accepts the risk that it may be required to purchase the underlying securities at a price in
excess of the securities market value at the time of purchase.
In the case of a call option, the option is
covered if an Underlying Fund owns the instrument underlying the call or has an absolute and immediate right to acquire that instrument without additional cash consideration (or, if additional cash consideration is required, liquid
assets in such amount are identified on the Underlying Funds books) upon conversion or exchange of other instruments held by it. A call option is also covered if an Underlying Fund holds a call on the same instrument as the option written
where the exercise price of the option held is (i) equal to or less than the exercise price of the option written, or (ii) greater than the exercise price of the option written provided the Underlying Fund identifies liquid assets in the
amount of the difference. An Underlying Fund may also cover call options on securities by identifying cash or liquid assets, as permitted by applicable law, with a value, when added to any margin on deposit that is equal to the market value of the
securities in the case of a call option. A put option is also covered if an Underlying Fund holds a put on the same instrument as the option written where the exercise price of the option held is (i) equal to or higher than the exercise price
of the option written, or (ii) less than the exercise price of the option written provided the Underlying Fund identifies on its books liquid assets in the amount of the difference. Identified cash or liquid assets may be quoted or denominated
in any currency.
Each Underlying Fund may also write (sell) covered call and put options on any securities index comprised of
securities in which it may invest. Options on securities indices are similar to options on securities, except that the exercise of securities index options requires cash 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.
An Underlying Fund may cover call options on a securities index by owning securities whose price changes are expected to be similar to
those of the underlying index, or by having an absolute and immediate right to acquire such securities without additional cash consideration (or for additional consideration which has been identified by the Underlying Fund on its books) upon
conversion or exchange of other securities held by it. An Underlying Fund may cover call and put options on a securities index by identifying cash or liquid assets, as permitted by applicable law, with a value when added to any margin on deposit
that is equal to the market value of the underlying securities in the case of a call option or the exercise price in the case of a put option or by owning offsetting options as described above.
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An Underlying Fund may terminate its obligations under an exchange-traded call or put option
by purchasing an option identical to the one it has written. Obligations under over-the-counter options may be terminated only by entering into an offsetting transaction with the counterparty to such option. Such purchases are referred to as
closing purchase transactions.
Purchasing Options
. Each Underlying Fund (other than Financial Square Prime
Obligations Fund) may purchase put and call options on any securities in which it may invest or any securities index comprised of securities in which it may invest. An Underlying Fund may also enter into closing sale transactions in order to realize
gains or minimize losses on options it had purchased.
An Underlying Fund may purchase call options in anticipation of an
increase, or put options in anticipation of a decrease (protective puts), in the market value of securities or other instruments of the type in which it may invest. The purchase of a call option would entitle an Underlying Fund, in
return for the premium paid, to purchase specified securities at a specified price during the option period. An Underlying Fund would ordinarily realize a gain on the purchase of a call option if, during the option period, the value of such
securities exceeded the sum of the exercise price, the premium paid and transaction costs; otherwise the Underlying Fund would realize either no gain or a loss on the purchase of the call option.
The purchase of a put option would entitle an Underlying Fund, in exchange for the premium paid, to sell specified securities at a
specified price during the option period. The purchase of protective puts is designed to offset or hedge against a decline in the market value of an Underlying Funds securities. Put options may also be purchased by an Underlying Fund for the
purpose of affirmatively benefiting from a decline in the price of securities which it does not own. An Underlying Fund would ordinarily realize a gain on the purchase of a call option if, during the option period, the value of the underlying
securities decreased below the exercise price sufficiently to cover the premium and transaction costs; otherwise the Underlying Fund would realize either no gain or a loss on the purchase of the put option. Gains and losses on the purchase of put
options may be offset by countervailing changes in the value of the underlying portfolio securities.
An Underlying Fund would
purchase put and call options on securities indices for the same purposes as it would purchase options on individual securities. For a description of options on securities indices, see Writing Options above.
Yield Curve Options
. Each Underlying Fixed Income Fund, the Real Estate Securities Fund, International Real Estate Securities
Fund, and Commodity Strategy Fund may enter into options on the yield spread or differential between two securities. Such transactions are referred to as yield curve options. In contrast to other types of options, a yield
curve option is based on the difference between the yields of designated securities, rather than the prices of the individual securities, and is settled through cash payments. Accordingly, a yield curve option is profitable to the holder if this
differential widens (in the case of a call) or narrows (in the case of a put), regardless of whether the yields of the underlying securities increase or decrease.
An Underlying Fund may purchase or write yield curve options for the same purposes as other options on securities. For example, an Underlying Fund may purchase a call option on the yield spread between
two securities if the Underlying Fund owns one of the securities and anticipates purchasing the other security and wants to hedge against an adverse change in the yield spread between the two securities. An Underlying Fund may also purchase or write
yield curve options in an effort to increase current income if, in the judgment of its investment adviser, the Underlying Fund will be able to profit from movements in the spread between the yields of the underlying securities. The trading of yield
curve options is subject to all of the risks associated with the trading of other types of options. In addition, however, such options present risk of loss even if the yield of one of the underlying securities remains constant, or if the spread
moves in a direction or to an extent which was not anticipated.
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Yield curve options written by an Underlying Fund will be covered. A call (or
put) option is covered if an Underlying Fund holds another call (or put) option on the spread between the same two securities and identifies on its books cash or liquid assets sufficient to cover the Underlying Funds net liability under the
two options. Therefore, an Underlying Funds liability for such a covered option is generally limited to the difference between the amount of the Underlying Funds liability under the option written by the Underlying Fund less the value of
the option held by the Underlying Fund. Yield curve options may also be covered in such other manner as may be in accordance with the requirements of the counterparty with which the option is traded and applicable laws and regulations. Yield curve
options are traded over-the-counter, and established trading markets for these options may not exist.
Risks Associated
with Options Transactions
. There is no assurance that a liquid secondary market on a domestic or foreign options exchange will exist for any particular exchange-traded option or at any particular time. If an Underlying Fund is unable to effect a
closing purchase transaction with respect to covered options it has written, the Underlying Fund will not be able to sell the underlying securities or dispose of the assets identified on its books to cover the position until the options expire or
are exercised. Similarly, if an Underlying Fund is unable to effect a closing sale transaction with respect to options it has purchased, it will have to exercise the options in order to realize any profit and will incur transaction costs upon the
purchase or sale of underlying securities.
Reasons for the absence of a liquid secondary market on an exchange include the
following: (i) there may be insufficient trading interest in certain options; (ii) restrictions may be imposed by an exchange on opening or closing transactions or both; (iii) trading halts, suspensions or other restrictions may be
imposed with respect to particular classes or series of options; (iv) unusual or unforeseen circumstances may interrupt normal operations on an exchange; (v) the facilities of an exchange or the Options Clearing Corporation may not at all
times be adequate to handle current trading volume; or (vi) one or more exchanges could, for economic or other reasons, decide or be compelled at some future date to discontinue the trading of options (or a particular class or series of
options), in which event the secondary market on that exchange (or in that class or series of options) would cease to exist, although outstanding options on that exchange that had been issued by the Options Clearing Corporation as a result of trades
on that exchange would continue to be exercisable in accordance with their terms.
There can be no assurance that higher
trading activity, order flow or other unforeseen events will not, at times, render certain of the facilities of the Options Clearing Corporation or various exchanges inadequate. Such events have, in the past, resulted in the institution by an
exchange of special procedures, such as trading rotations, restrictions on certain types of order or trading halts or suspensions with respect to one or more options. These special procedures may limit liquidity.
An Underlying Fund may purchase and sell both options that are traded on U.S. and foreign exchanges and options traded over-the-counter
with broker-dealers who make markets in these options. The ability to terminate over-the-counter options is more limited than with exchange-traded options and may involve the risk that broker-dealers participating in such transactions will not
fulfill their obligations.
Transactions by an Underlying Fund in options will be subject to limitations established by each
of the exchanges, boards of trade or other trading facilities on which such options are traded governing the maximum number of options in each class which may be written or purchased by a single investor or group of investors acting in concert
regardless of whether the options are written or purchased on the same or different exchanges, boards of trade or other trading facilities or are held in one or more accounts or through one or more brokers. Thus, the number of options which an
Underlying Fund may write or purchase may be affected by options written or purchased by other investment advisory clients of the Underlying Funds investment advisers. An exchange, board of trade or other trading facility may order the
liquidation of positions found to be in excess of these limits, and it may impose certain other sanctions.
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The writing and purchase of options is a highly specialized activity which involves
investment techniques and risks different from those associated with ordinary portfolio securities transactions. The use of options to seek to increase total return involves the risk of loss if an investment adviser is incorrect in its expectation
of fluctuations in securities prices or interest rates. The successful use of options for hedging purposes also depends in part on the ability of an investment adviser to manage future price fluctuations and the degree of correlation between the
options and securities markets. If an investment adviser is incorrect in its expectation of changes in securities prices or determination of the correlation between the securities indices on which options are written and purchased and the securities
in an Underlying Funds investment portfolio, the Underlying Fund may incur losses that it would not otherwise incur. The writing of options could increase an Underlying Funds portfolio turnover rate and, therefore, associated brokerage
commissions or spreads.
Preferred Stock, Warrants and Stock Purchase Rights
Certain of the Underlying Funds may invest in preferred stock and in warrants and rights (in addition to those acquired in units or
attached to other securities). Preferred stocks are securities that represent an ownership interest providing the holder with claims on the issuers earnings and assets before common stock owners but after bond owners. Unlike debt securities,
the obligations of an issuer of preferred stock, including dividend and other payment obligations, may not typically be accelerated by the holders of such preferred stock on the occurrence of an event of default (such as a covenant default or filing
of a bankruptcy petition) or other non-compliance by the issuer with the terms of the preferred stock. Often, however, on the occurrence of any such event of default or non-compliance by the issuer, preferred stockholders will be entitled to gain
representation on the issuers board of directors or increase their existing board representation. In addition, preferred stockholders may be granted voting rights with respect to certain issues on the occurrence of any event of default.
Warrants and other rights are options that entitle the holder to buy equity securities at a specific price for a specific
period of time. A Fund will invest in warrants and rights only if such equity securities are deemed appropriate by the Investment Adviser for investment by the Fund. Warrants and rights have no voting rights, receive no dividends and have no rights
with respect to the assets of the issuer.
Foreign Securities
The Emerging Markets Equity, Structured Emerging Markets Equity, Structured International Equity, Structured International Small Cap and International Small Cap Funds invest primarily in foreign
securities under normal circumstances. The Commodity Strategy Fund, Real Estate Securities Fund and International Real Estate Securities Fund may invest in the aggregate up to 35%, 15% and 100%, respectively, of their Total Assets in foreign
securities, including securities of issuers in emerging countries. The Large Cap Value Fund may invest up to 25% of its Net Assets in foreign securities, including emerging country securities. The Strategic Growth Fund may invest up to 25% of its
Total Assets in foreign securities, including securities of issuers in emerging countries and securities quoted in foreign currencies. The Core Fixed Income Fund, Global Income Fund, High Yield Fund, Local Emerging Markets Debt Fund, Emerging
Markets Debt Fund and the Dynamic Allocation Fund may invest in foreign issuers, including in fixed income securities quoted or denominated in a currency other than U.S. dollars. Investments in foreign securities may offer potential benefits not
available from investments solely in U.S. dollar-denominated or quoted securities of domestic issuers. Such benefits may include the opportunity to invest in foreign issuers that appear, in the opinion of an Underlying Funds investment
adviser, to offer the potential for better long-term growth of capital and income than investments in U.S. securities, the opportunity to invest in foreign countries with economic policies or business cycles different from those of the United States
and the opportunity to reduce fluctuations in portfolio value by taking advantage of foreign securities markets that do not necessarily move in a manner parallel to U.S. markets.
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Investments in foreign securities may offer potential benefits not available from
investments solely in U.S. dollar-denominated or quoted securities of domestic issuers. Such benefits may include the opportunity to invest in foreign issuers that appear, in the opinion of the Investment Adviser, to offer the potential for better
long term growth of capital and income than investments in U.S. securities, the opportunity to invest in foreign countries with economic policies or business cycles different from those of the United States and the opportunity to reduce fluctuations
in portfolio value by taking advantage of foreign securities markets that do not necessarily move in a manner parallel to U.S. markets. Investing in the securities of foreign issuers also involves, however, certain special risks, including those
discussed in the Funds Prospectuses and those set forth below, which are not typically associated with investing in U.S. dollar-denominated securities or quoted securities of U.S. issuers. Many of these risks are more pronounced for
investments in emerging countries.
With respect to investments in certain foreign countries, there exist certain economic,
political and social risks, including the risk of adverse political developments, nationalization, military unrest, social instability, war and terrorism, confiscation without fair compensation, expropriation or confiscatory taxation, limitations on
the movement of funds and other assets between different countries, or diplomatic developments, any of which could adversely affect a Underlying Funds investments in those countries. Governments in certain foreign countries continue to
participate to a significant degree, through ownership interest or regulation, in their respective economies. Action by these governments could have a significant effect on market prices of securities and dividend payments.
Many countries throughout the world are dependent on a healthy U.S. economy and are adversely affected when the U.S. economy weakens or
its markets decline. Additionally, many foreign country economies are heavily dependent on international trade and are adversely affected by protective trade barriers and economic conditions of their trading partners. Protectionist trade legislation
enacted by those trading partners could have a significant adverse affect on the securities markets of those countries. Individual foreign economies may differ favorably or unfavorably from the U.S. economy in such respects as growth of gross
national product, rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments position.
Investments in foreign securities often involve currencies of foreign countries. Accordingly, a Underlying Fund may be affected favorably
or unfavorably by changes in currency rates and in exchange control regulations and may incur costs in connection with conversions between various currencies. Certain of the Underlying Funds may be subject to currency exposure independent of their
securities positions. To the extent that an Underlying Fund is fully invested in foreign securities while also maintaining net currency positions, it may be exposed to greater combined risk.
Currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by the forces of supply and
demand in the foreign exchange markets and the relative merits of investments in different countries, actual or anticipated changes in interest rates and other complex factors, as seen from an international perspective. Currency exchange rates also
can be affected unpredictably by intervention (or failure to intervene) by U.S. or foreign governments or central banks or by currency controls or political developments in the United States or abroad. To the extent that a portion of an Underlying
Funds total assets, adjusted to reflect the Underlying Funds net position after giving effect to currency transactions, is denominated or quoted in the currencies of foreign countries, the Underlying Fund will be more susceptible to the
risk of adverse economic and political developments within those countries. An Underlying Funds net currency positions may expose it to risks independent of its securities positions.
Because foreign issuers generally are not subject to uniform accounting, auditing and financial reporting standards, practices and
requirements comparable to those applicable to U.S. companies, there may be less publicly available information about a foreign company than about a U.S. company. Volume and liquidity in most foreign securities markets are less than in the United
States and securities of many foreign companies are less liquid and more volatile than securities of comparable U.S. companies. The securities of foreign issuers may
B-63
be listed on foreign securities exchanges or traded in foreign over-the-counter markets. Fixed commissions on foreign securities exchanges are generally higher than negotiated commissions on U.S.
exchanges, although certain Underlying Funds endeavor to achieve the most favorable net results on its portfolio transactions. There is generally less government supervision and regulation of foreign securities exchanges, brokers, dealers and listed
and unlisted companies than in the United States, and the legal remedies for investors may be more limited than the remedies available in the United States. For example, there may be no comparable provisions under certain foreign laws to insider
trading and similar investor protections that apply with respect to securities transactions consummated in the United States. Mail service between the United States and foreign countries may be slower or less reliable than within the United States,
thus increasing the risk of delayed settlement of portfolio transactions or loss of certificates for portfolio securities.
Foreign markets also have different clearance and settlement procedures, and in certain markets there have been times when settlements
have been unable to keep pace with the volume of securities transactions, making it difficult to conduct such transactions. Such delays in settlement could result in temporary periods when some of an Underlying Funds assets are uninvested and
no return is earned on such assets. The inability of an Underlying Fund to make intended security purchases due to settlement problems could cause the Underlying Fund to miss attractive investment opportunities. Inability to dispose of portfolio
securities due to settlement problems could result either in losses to the Underlying Fund due to subsequent declines in value of the portfolio securities or, if the Underlying Fund has entered into a contract to sell the securities, in possible
liability to the purchaser.
Custodial and/or settlement systems in emerging markets countries may not be fully developed. To
the extent an Underlying Fund invests in emerging markets, an Underlying Funds assets that are traded in such markets and which have been entrusted to such sub-custodians in those markets may be exposed to risks for which the sub-custodian
will have no liability.
Certain of the Underlying Funds may invest in foreign securities which take the form of sponsored and
unsponsored American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs) and certain of the Underlying Funds may also invest in European Depositary Receipts (EDRs) (and the China Equity Fund may also
invest in Taiwan Depositary Receipts (TDRs)) or other similar instruments representing securities of foreign issuers (together, Depositary Receipts). ADRs represent the right to receive securities of foreign issuers deposited
in a domestic bank or a correspondent bank. ADRs are traded on domestic exchanges or in the U.S. over-the-counter market and, generally, are in registered form. EDRs, GDRs and TDRs are receipts evidencing an arrangement with a non-U.S. bank similar
to that for ADRs and are designed for use in the non-U.S. securities markets. EDRs, GDRs and TDRs are not necessarily quoted in the same currency as the underlying security.
To the extent an Underlying Fund acquires Depositary Receipts through banks which do not have a contractual relationship with the foreign issuer of the security underlying the Depositary Receipts to issue
and service such unsponsored Depositary Receipts, there is an increased possibility that the Underlying Fund will not become aware of and be able to respond to corporate actions such as stock splits or rights offerings involving the foreign issuer
in a timely manner. In addition, the lack of information may result in inefficiencies in the valuation of such instruments. Investment in Depositary Receipts does not eliminate all the risks inherent in investing in securities of non-U.S. issuers.
The market value of Depositary Receipts is dependent upon the market value of the underlying securities and fluctuations in the relative value of the currencies in which the Depositary Receipts and the underlying securities are quoted. However, by
investing in Depositary Receipts, such as ADRs, which are quoted in U.S. dollars, an Underlying Fund may avoid currency risks during the settlement period for purchases and sales.
As described more fully below, certain of the Underlying Funds may invest in countries with emerging economies or securities markets.
Political and economic structures in many of such countries may be
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undergoing significant evolution and rapid development, and such countries may lack the social, political and economic stability characteristic of more developed countries. Certain of such
countries have in the past failed to recognize private property rights and have at times nationalized or expropriated the assets of private companies. As a result, the risks described above, including the risks of nationalization or expropriation of
assets, may be heightened. See Investing in Emerging Countries below.
Investing in Europe.
Certain of the
Underlying Funds may operate in euros and/ or may hold euros and/or euro-denominated bonds and other obligations. The euro requires participation of multiple sovereign states forming the Euro zone and is therefore sensitive to the credit, general
economic and political position of each such state, including each states actual and intended ongoing engagement with and/or support for the other sovereign states then forming the European Union, in particular those within the Euro zone.
Changes in these factors might materially adversely impact the value of securities that an Underlying Fund has invested in.
European countries can be significantly affected by the tight fiscal and monetary controls that the European Economic and Monetary Union
(EMU) imposes for membership. Europes economies are diverse, its governments are decentralized, and its cultures vary widely. Several EU countries, including Greece, Ireland, Italy, Spain and Portugal have faced budget issues, some
of which may have negative long-term effects for the economies of those countries and other EU countries. There is continued concern about national-level support for the euro and the accompanying coordination of fiscal and wage policy among EMU
member countries. Member countries are required to maintain tight control over inflation, public debt, and budget deficit to qualify for membership in the EMU. These requirements can severely limit the ability of EMU member countries to implement
monetary policy to address regional economic conditions.
Foreign Government Obligations.
Foreign government
obligations include securities, instruments and obligations issued or guaranteed by a foreign government, its agencies, instrumentalities or sponsored enterprises. Investment in foreign government obligations can involve a high degree of risk. The
governmental entity that controls the repayment of foreign government obligations may not be able or willing to repay the principal and/or interest when due in accordance with the terms of such debt. A governmental entitys willingness or
ability to repay principal and interest due in a timely manner may be affected by, among other factors, its cash flow situation, the extent of its foreign reserves, the availability of sufficient foreign exchange on the date a payment is due, the
relative size of the debt service burden to the economy as a whole, the governmental entitys policy towards the International Monetary Fund and the political constraints to which a governmental entity may be subject. Governmental entities may
also be dependent on expected disbursements from foreign governments, multilateral agencies and others abroad to reduce principal and interest on their debt. The commitment on the part of these governments, agencies and others to make such
disbursements may be conditioned on a governmental entitys implementation of economic reforms and/or economic performance and the timely service of such debtors obligations. Failure to implement such reforms, achieve such levels of
economic performance or repay principal or interest when due may result in the cancellation of such third parties commitments to lend funds to the governmental entity, which may further impair such debtors ability or willingness to
services its debts in a timely manner. Consequently, governmental entities may default on their debt. Holders of foreign government obligations (including certain of the Underlying Funds) may be requested to participate in the rescheduling of such
debt and to extend further loans to governmental agencies.
Investing in Emerging Countries
. The Structured
International Equity, International Real Estate Securities, Emerging Markets Equity, Structured Emerging Markets Equity, Structured International Small Cap, and International Small Cap Funds are intended for long-term investors who can accept the
risks associated with investing primarily in equity and equity-related securities of foreign issuers, including emerging country issuers, as well as the risks associated with investments quoted or denominated in foreign currencies. Certain of the
Underlying Funds may also invest in equity and equity-related securities of foreign issuers, including emerging country issuers, and in debt securities of foreign issuers, including emerging country issuers, and in fixed income securities quoted or
denominated in a currency other than U.S. dollars. The Core Fixed Income Funds,
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Global Income Funds and the High Yield Funds investments in emerging markets are limited to 10%, 10%, 25% and 10%, respectively, of their Total Assets. Neither the Emerging Markets
Debt Fund nor the Local Emerging Markets Debt Fund is limited in its investments in emerging markets.
The securities markets
of emerging countries are less liquid and subject to greater price volatility, and have a smaller market capitalization, than the U.S. securities markets. In certain countries, there may be fewer publicly traded securities, and the market may be
dominated by a few issuers or sectors. Issuers and securities markets in such countries are not subject to as extensive and frequent accounting, financial and other reporting requirements or as comprehensive government regulations as are issuers and
securities markets in the U.S. In particular, the assets and profits appearing on the financial statements of emerging country issuers may not reflect their financial position or results of operations in the same manner as financial statements for
U.S. issuers. Substantially less information may be publicly available about emerging country issuers than is available about issuers in the United States.
Emerging country securities markets are typically marked by a high concentration of market capitalization and trading volume in a small number of issuers representing a limited number of industries, as
well as a high concentration of ownership of such securities by a limited number of investors. The markets for securities in certain emerging countries are in the earliest stages of their development. An Underlying Funds investments in
emerging countries are subject to the risk that the liquidity of particular instruments, or instruments generally in such countries, will shrink or disappear suddenly and without warning as a result of adverse economic, market or political
conditions, or adverse investor perceptions, whether or not accurate. Even the markets for relatively widely traded securities in emerging countries may not be able to absorb, without price disruptions, a significant increase in trading volume or
trades of a size customarily undertaken by institutional investors in the securities markets of developed countries. The limited size of many of the securities markets can cause prices to be erratic for reasons apart from factors that affect the
soundness and competitiveness of the securities issuers. For example, prices may be unduly influenced by traders who control large positions in these markets. Additionally, market making and arbitrage activities are generally less extensive in such
markets, which may contribute to increased volatility and reduced liquidity of such markets. The limited liquidity of emerging country securities may also affect an Underlying Funds ability to accurately value its portfolio securities or to
acquire or dispose of such securities at the price and times it wishes to do so. The risks associated with reduced liquidity may be particularly acute to the extent that an Underlying Fund needs cash to meet redemption requests, to pay dividends and
other distributions or to pay its expenses.
Transaction costs, including brokerage commissions or dealer mark-ups, in
emerging countries may be higher than in the United States and other developed securities markets. In addition, existing laws and regulations are often inconsistently applied. As legal systems in emerging countries develop, foreign investors may be
adversely affected by new or amended laws and regulations. In circumstances where adequate laws exist, it may not be possible to obtain swift and equitable enforcement of the law.
Custodial and/or settlement systems in emerging markets countries may not be fully developed. To the extent a Fund invests in emerging
markets, Fund assets that are traded in such markets and will have been entrusted to such sub-custodians in those markets may be exposed to risks for which the sub-custodian will have no liability.
With respect to investments in certain emerging market countries, antiquated legal systems may have an adverse impact on the
Underlying Funds. For example, while the potential liability of a shareholder of a U.S. corporation with respect to acts of the corporation is generally limited to the amount of the shareholders investment, the notion of limited liability is
less clear in certain emerging market countries. Similarly, the rights of investors in emerging market companies may be more limited than those of shareholders of U.S. corporations.
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Foreign investment in the securities markets of certain emerging countries is restricted or
controlled to varying degrees. These restrictions may limit an Underlying Funds investment in certain emerging countries and may increase the expenses of the Underlying Fund. Certain emerging countries require government approval prior to
investments by foreign persons or limit investment by foreign persons to only a specified percentage of an issuers outstanding securities or a specific class of securities which may have less advantageous terms (including price) than
securities of the company available for purchase by nationals. In addition, the repatriation of both investment income and capital from emerging countries may be subject to restrictions which require governmental consents or prohibit repatriation
entirely for a period of time. Even where there is no outright restriction on repatriation of capital, the mechanics of repatriation may affect certain aspects of the operation of an Underlying Fund. An Underlying Fund may be required to establish
special custodial or other arrangements before investing in certain emerging countries.
Emerging countries may be subject to
a substantially greater degree of economic, political and social instability and disruption than is the case in the United States, Japan and most Western European countries. This instability may result from, among other things, the following:
(i) authoritarian governments or military involvement in political and economic decision making, including changes or attempted changes in governments through extra-constitutional means; (ii) popular unrest associated with demands for
improved political, economic or social conditions; (iii) internal insurgencies; (iv) hostile relations with neighboring countries; (v) ethnic, religious and racial disaffection or conflict; and (vi) the absence of developed legal
structures governing foreign private investments and private property. Such economic, political and social instability could disrupt the principal financial markets in which the Underlying Funds may invest and adversely affect the value of the
Underlying Funds assets. An Underlying Funds investments can also be adversely affected by any increase in taxes or by political, economic or diplomatic developments.
The economies of emerging countries may differ unfavorably from the U.S. economy in such respects as growth of gross domestic product,
rate of inflation, capital reinvestment, resources, self-sufficiency and balance of payments. Many emerging countries have experienced in the past, and continue to experience, high rates of inflation. In certain countries inflation has at times
accelerated rapidly to hyperinflationary levels, creating a negative interest rate environment and sharply eroding the value of outstanding financial assets in those countries. Other emerging countries, on the other hand, have recently experienced
deflationary pressures and are in economic recessions. The economies of many emerging countries are heavily dependent upon international trade and are accordingly affected by protective trade barriers and the economic conditions of their trading
partners. In addition, the economies of some emerging countries are vulnerable to weakness in world prices for their commodity exports.
An Underlying Funds income and, in some cases, capital gains from foreign stocks and securities will be subject to applicable taxation in certain of the countries in which it invests, and treaties
between the U.S. and such countries may not be available in some cases to reduce the otherwise applicable tax rates. See TAXATION.
From time to time, certain of the companies in which an Underlying Fund may invest may operate in, or have dealings with, countries subject to sanctions or embargos imposed by the U.S. Government and the
United Nations and/or countries identified by the U.S. Government as state sponsors of terrorism. A company may suffer damage to its reputation if it is identified as a company which operates in, or has dealings with, countries subject to sanctions
or embargoes imposed by the U.S. Government as state sponsors of terrorism. As an investor in such companies, the Underlying Fund will be indirectly subject to those risks. Iran is subject to several United Nations sanctions and is an embargoed
country by the Office of Foreign Assets Control (OFAC) of the US Department of Treasury.
Restrictions on Investment and
Repatriation. Certain emerging countries require governmental approval prior to investments by foreign persons or limit investments by foreign persons to only a specified
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percentage of an issuers outstanding securities or a specific class of securities which may have less advantageous terms (including price) than securities of the issuer available for
purchase by nationals. Repatriation of investment income and capital from certain emerging countries is subject to certain governmental consents. Even where there is no outright restriction on repatriation of capital, the mechanics of repatriation
may affect the operation of an Underlying Fund.
Sovereign Debt Obligations.
Investment in sovereign debt can involve a
high degree of risk. The governmental entity that controls the repayment of sovereign debt may not be able or willing to repay the principal and/or interest when due in accordance with the terms of such debt. A governmental entitys willingness
or ability to repay principal and interest due in a timely manner may be affected by, among other factors, its cash flow situation, the extent of its foreign reserves, the availability of sufficient foreign exchange on the date a payment is due, the
relative size of the debt service burden to the economy as a whole, the governmental entitys policy towards the International Monetary Fund and the political constraints to which a governmental entity may be subject. Governmental entities may
also be dependent on expected disbursements from foreign governments, multilateral agencies and others abroad to reduce principal and interest on their debt. The commitment on the part of these governments, agencies and others to make such
disbursements may be conditioned on a governmental entitys implementation of economic reforms and/or economic performance and the timely service of such debtors obligations. Failure to implement such reforms, achieve such levels of
economic performance or repay principal or interest when due may result in the cancellation of such third parties commitments to lend funds to the governmental entity, which may further impair such debtors ability or willingness to
service its debts in a timely manner. Consequently, governmental entities may default on their sovereign debt. Holders of sovereign debt (including an Underlying Fund) may be requested to participate in the rescheduling of such debt and to extend
further loans to governmental agencies.
Emerging country governmental issuers are among the largest debtors to commercial
banks, foreign governments, international financial organizations and other financial institutions. Certain emerging country governmental issuers have not been able to make payments of interest on or principal of debt obligations as those payments
have come due. Obligations arising from past restructuring agreements may affect the economic performance and political and social stability of those issuers.
The ability of emerging country governmental issuers to make timely payments on their obligations is likely to be influenced strongly by the issuers balance of payments, including export
performance, and its access to international credits and investments. An emerging country whose exports are concentrated in a few commodities could be vulnerable to a decline in the international prices of one or more of those commodities. Increased
protectionism on the part of an emerging countrys trading partners could also adversely affect the countrys exports and tarnish its trade account surplus, if any. To the extent that emerging countries receive payment for their exports in
currencies other than dollars or non-emerging country currencies, the emerging country issuers ability to make debt payments denominated in dollars or non-emerging market currencies could be affected.
To the extent that an emerging country cannot generate a trade surplus, it must depend on continuing loans from foreign governments,
multilateral organizations or private commercial banks, aid payments from foreign governments and on inflows of foreign investment. The access of emerging countries to these forms of external funding may not be certain, and a withdrawal of external
funding could adversely affect the capacity of emerging country governmental issuers to make payments on their obligations. In addition, the cost of servicing emerging country debt obligations can be affected by a change in international interest
rates since the majority of these obligations carry interest rates that are adjusted periodically based upon international rates.
Another factor bearing on the ability of emerging countries to repay debt obligations is the level of international reserves of a country. Fluctuations in the level of these reserves affect the amount of
foreign exchange readily available for external debt payments and thus could have a bearing on the capacity of emerging countries to make payments on these debt obligations.
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As a result of the foregoing or other factors, a governmental obligor, especially in an
emerging country, may default on its obligations. If such an event occurs, an Underlying Fund may have limited legal recourse against the issuer and/or guarantor. Remedies must, in some cases, be pursued in the courts of the defaulting party itself,
and the ability of the holder of foreign sovereign debt securities to obtain recourse may be subject to the political climate in the relevant country. In addition, no assurance can be given that the holders of commercial bank debt will not contest
payments to the holders of other foreign sovereign debt obligations in the event of default under the commercial bank loan agreements.
Brady Bonds.
Certain foreign debt obligations, customarily referred to as Brady Bonds, are created through the exchange of existing commercial bank loans to foreign entities for new
obligations in connection with debt restructuring under a plan introduced by former U.S. Secretary of the Treasury, Nicholas F. Brady (the Brady Plan). Brady Bonds may be fully or partially collateralized or uncollateralized and issued
in various currencies (although most are U.S. dollar denominated). In the event of a default on collateralized Brady Bonds for which obligations are accelerated, the collateral for the payment of principal will not be distributed to investors, nor
will such obligations be sold and the proceeds distributed. The collateral will be held by the collateral agent to the scheduled maturity of the defaulted Brady Bonds, which will continue to be outstanding, at which time the face amount of the
collateral will equal the principal payments which would have then been due on the Brady Bonds in the normal course. In light of the residual risk of the Brady Bonds and, among other factors, the history of default with respect to commercial bank
loans by public and private entities of countries issuing Brady Bonds, investments in Brady Bonds may be speculative.
Investing in Central and South American Countries.
A significant portion of certain Underlying Funds portfolios may be
invested in issuers located in Central and South American countries. The economies of Central and South American countries have experienced considerable difficulties in the past decade, including high inflation rates, high interest rates and
currency devaluations. As a result, Central and South American securities markets have experienced great volatility. In addition, a number of Central and South American countries are among the largest emerging country debtors. There have been
moratoria on, and reschedulings of, repayment with respect to these debts. Such events can restrict the flexibility of these debtor nations in the international markets and result in the imposition of onerous conditions on their economies.
In the past, many Central and South American countries have experienced substantial, and in some periods extremely high,
rates of inflation for many years. High inflation rates have also led to high interest rates. Inflation and rapid fluctuations in inflation rates have had, and could, in the future, have very negative effects on the economies and securities markets
of certain Central and South American countries. Many of the currencies of Central and South American countries have experienced steady devaluation relative to the U.S. dollar, and major devaluations have historically occurred in certain countries.
Any devaluations in the currencies in which an Underlying Funds portfolio securities are denominated may have a detrimental impact on the Underlying Fund. There is also a risk that certain Central and South American countries may restrict the
free conversion of their currencies into other currencies. Some Central and South American countries may have managed currencies which are not free floating against the U.S. dollar. This type of system can lead to sudden and large adjustments in the
currency that, in turn, can have a disruptive and negative effect on foreign investors. Certain Central and South American currencies may not be internationally traded and it would be difficult for an Underlying Fund to engage in foreign currency
transactions designed to protect the value of the Underlying Funds interests in securities denominated in such currencies.
In addition, substantial limitations may exist in certain countries with respect to an Underlying Funds ability to repatriate investment income, capital or the proceeds of sales of securities
by foreign investors. An Underlying Fund could be adversely affected by delays in, or a refusal to grant, any required governmental approval for repatriation of capital, as well as by the application to the Underlying Fund of any restrictions on
investments.
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The emergence of the Central and South American economies and securities markets will
require continued economic and fiscal discipline that has been lacking at times in the past, as well as stable political and social conditions. Governments of many Central and South American countries have exercised and continue to exercise
substantial influence over many aspects of the private sector. The political history of certain Central and South American countries has been characterized by political uncertainty, intervention by the military in civilian and economic spheres and
political corruption. Such developments, if they were to recur, could reverse favorable trends toward market and economic reform, privatization and removal of trade barriers.
International economic conditions, particularly those in the United States, as well as world prices for oil and other commodities may also influence the recovery of the Central and South American
economies. Because commodities such as oil, gas, minerals and metals represent a significant percentage of the regions exports, the economies of Central and South American countries are particularly sensitive to fluctuations in commodity
prices. As a result, the economies in many of these countries can experience significant volatility.
Certain Central and
South American countries have entered into regional trade agreements that would, among other things, reduce barriers among countries, increase competition among companies and reduce government subsidies in certain industries. No assurance can be
given that these changes will result in the economic stability intended. There is a possibility that these trade arrangements will not be implemented, will be implemented but not completed or will be completed but then partially or completely
unwound. It is also possible that a significant participant could choose to abandon a trade agreement, which could diminish its credibility and influence. Any of these occurrences could have adverse effects on the markets of both participating and
non-participating countries, including share appreciation or depreciation of participants national currencies and a significant increase in exchange rate volatility, a resurgence in economic protectionism, an undermining of confidence in the
Central and South American markets, an undermining of Central and South American economic stability, the collapse or slowdown of the drive toward Central and South American economic unity, and/or reversion of the attempts to lower government debt
and inflation rates that were introduced in anticipation of such trade agreements. Such developments could have an adverse impact on an Underlying Funds investments in Central and South America generally or in specific countries participating
in such trade agreements.
Investing in Australia.
The Australian economy is dependent on the economies of Asia, Europe
and the U.S. as key trading partners and, in particular, on the price and demand for agricultural products and natural resources. Asia includes countries in all stages of economic development, although most Asian economies are characterized by
over-extension of credit, currency devaluations and restrictions, rising unemployment, high inflation, decreased exports and economic recessions. Currency devaluations in any one country can have a significant effect on the entire Asian region.
Recently, the economies in the Asian region have suffered significant downturns as well as significant volatility. Increased political and social unrest in any Asian country could cause further economic and market uncertainty in the region. Europe
includes both developed and emerging economies. Most developed countries in Western Europe are members of the European Union (EU), and many are also members of the European Monetary Union (EMU). The EMU requires compliance
with restrictions on inflation rates, deficits, and debt levels, and the tight fiscal and monetary controls necessary to join the EMU may significantly affect every country in Europe. The U.S. is Australias single largest trade and investment
partner and is susceptible to sustained increases in energy prices, weakness in the labor market, and rising long-term interest rates.
Australias stock exchanges are members of The Australian Stock Exchange. Trading is done by a computerized system that enables all exchanges to quote uniform prices. The exchanges are subject to
oversight by both The Australian Stock Exchange and the Australian Securities and Investments Commission, which work
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together to regulate the major aspects of stock exchange operations. Australian reporting, accounting and auditing standards differ substantially from U.S. standards. In general, Australian
corporations do not provide all of the disclosure required by U.S. law and accounting practice, and such disclosure may be less timely and less frequent than that required of U.S. companies.
The total market capitalization of the Australian stock market is small relative to the U.S. stock market. Australias chief
industries are mining, industrial and transportation equipment, food processing, chemicals and steel. Australias chief imports consist of machinery and transport equipment, computers and office machines, telecommunications equipment and parts,
crude oil, and petroleum products. Australias chief exports consist of coal, gold, meat, wool, aluminum, iron ore, wheat, machinery, and transport equipment.
Investing in Hong Kong.
The Hong Kong economy is dependent on the U.S. economy and the economies of other Asian countries and can be significantly affected by currency fluctuations and increasing
competition from Asias other emerging economies. The willingness and ability of the Chinese government to support the Hong Kong economy and market is uncertain, and changes in the Chinese governments position could significantly affect
Hong Kongs economy. Asia includes countries in all stages of economic development, although most Asian economies are characterized by over-extension of credit, currency devaluations and restrictions, rising unemployment, high inflation,
decreased exports and economic recessions. Currency devaluations in any one country can have a significant effect on the entire Asian region. In the late 1990s, the economies in the Asian region suffered significant downturns and significant
volatility increased. Heightened political and social unrest in any Asian country could cause further economic and market uncertainty in the region.
In 1997, Great Britain handed over control of Hong Kong to the Chinese mainland government. Since that time, Hong Kong has been governed by a semi-constitution known as the Basic Law, which guarantees a
high degree of autonomy in certain matters until 2047, while defense and foreign affairs are the responsibility of the central government in Beijing. The chief executive of Hong Kong is appointed by the Chinese government. Hong Kong is able to
participate in international organizations and agreements and it continues to function as an international financial center, with no exchange controls, free convertibility of the Hong Kong dollar and free inward and outward movement of capital. The
Basic Law guarantees existing freedoms, including free speech and assembly, press, religion, and the right to strike and travel. Business ownership, private property, the right of inheritance and foreign investment are also protected by law. China
has committed by treaty to preserve Hong Kongs autonomy until 2047. However, if China were to exert its authority so as to alter the economic, political or legal structures of existing social policy of Hong Kong, investor and business
confidence in Hong Kong could be negatively affected, which in turn could negatively affect markets and business performance.
Trading on Hong Kongs stock exchange is conducted in the post trading method, matching buyers and sellers through public outcry.
Securities are denominated in the official unit of currency, the Hong Kong dollar. Foreign investment in Hong Kong is generally unrestricted and proper regulatory oversight is administered by the Hong Kong Securities and Futures Commission.
Investors are subject to a small stamp duty and a stock exchange levy, but capital gains are tax-exempt. Despite significant upgrades in the required presentation of financial information in the past decade, reporting, accounting and auditing
practices remain significantly less rigorous than U.S. standards. In general, Hong Kong corporations are not required to provide all the disclosure required by U.S. law and accounting practice, and such disclosure may be less timely and less
frequent than that required of U.S. corporations.
The total market capitalization of the Hong Kong stock market is small
relative to the U.S. stock market. Hong Kongs chief industries are textiles, clothing, tourism, banking, shipping, electronics, plastics, toys, watches and clocks. Hong Kongs chief imports consist of electrical machinery and appliances,
textiles, foodstuffs, transport equipment, raw materials, semi manufactures, petroleum and plastics. Hong Kongs chief exports consist of electrical machinery and appliances, textiles, apparel footwear, watches and clocks, toys, plastics, and
precious stones.
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Investing in Japan
. Japans economy grew substantially after World War II. The
boom in Japans equity and property markets during the expansion of the late 1980s supported high rates of investment and consumer spending on durable goods, but both of these components of demand subsequently retreated sharply following
a decline in asset prices. More recently, Japans economic growth has been substantially below the levels of earlier decades. The banking sector has continued to suffer from non-performing loans and the economy generally has been subject to
deflationary pressures. Many Japanese banks have required public funds to avert insolvency, and large amounts of bad debt have prevented banks from expanding their loan portfolios despite low discount rates. In 2003, Japans Financial Services
Agency established the Industrial Revitalization Corporation Japan (IRCJ) to assist in cleaning up the non-performing loans of the Japanese banking sector. The IRCJ is modeled after the Resolution Trust Corporation, which was created in
the United States to address the savings and loans crisis, and is scheduled to complete its work and be dissolved in 2008. However, several banks paid back all their public money in 2006. Recent economic performance has shown improvements with
positive growth in gross domestic product in 2004 and 2005 and a reduction in non-performing loans since 2002.
Like many
European countries, Japan is experiencing a deterioration of its competitiveness. Factors contributing to this include high wages, a generous pension and universal health care system, an aging populace and structural rigidities. Japan is reforming
its political process and deregulating its economy to address this situation. Among other things, the Japanese labor market is moving from a system of lifetime company employment in response to the need for increased labor mobility, and corporate
governance systems are being introduced to new accounting rules, decision-making mechanisms and managerial incentives. Internal conflict over the proper way to reform the financial system will continue as Japan Posts banking, insurance and
delivery service undergoes privatization between 2007 and 2017. Japans huge government debt which currently totals 170% of GDP is also a major long-run problem.
The conservative Liberal Democratic Party has been in power since 1955, except for a short-lived coalition government formed from opposition parties in 1993 following the economic crisis of 1990-1992.
Former Prime Minister Junichiro Koizumi focused on stabilizing the Japanese banking system to allow for sustained economic recovery. It is too soon to know where current Prime Minister Shinzo Abe, elected in September 2006, will focus. However, he
has placed reformers on the Council of Economic and Fiscal Policy and indicated an interest in foreign policy. Future political developments may lead to changes in policy that might adversely affect an Underlying Funds investments.
Japans heavy dependence on international trade has been adversely affected by trade tariffs and other protectionist measures
as well as the economic condition of its trading partners. While Japan subsidizes its agricultural industry, only approximately 12% of its land is suitable for cultivation and the country must import 60% of its requirements for grains (other than
rice) and fodder crops. In addition, its export industry, its most important economic sector, depends on imported raw materials and fuels, including iron ore, copper, oil and many forest products. As a result, Japan is sensitive to fluctuations in
commodity prices. Japans high volume of exports, such as automobiles, machine tools and semiconductors, have caused trade tensions, particularly with the United States. Some trade agreements, however, have been implemented to reduce these
tensions and members of the Council on Economic and Fiscal Policy have indicated an interest in seeking more free trade agreements. The relaxing of official and de facto barriers to imports, or hardships created by any pressures brought by trading
partners, could adversely affect Japans economy. A substantial rise in world oil or commodity prices could also have a negative effect. The Japanese yen has fluctuated widely during recent periods. A weak yen is disadvantageous to U.S.
shareholders investing in yen-denominated securities. A strong yen, however, could be an impediment to strong continued exports and economic recovery, because it makes Japanese goods sold in other countries more expensive and reduces the value of
foreign earnings repatriated to Japan. Because the Japanese economy is so dependent on exports, any fall-off in exports may be seen as a sign of economic weakness, which may adversely affect the market.
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Reporting, accounting, and auditing practices for the Japanese market are similar to those
in the United States, for the most part, with certain exceptions. In particular, the Japanese government does not require companies to provide the same depth and frequency of disclosure required by U.S. law.
Geologically, Japan is located in a volatile area of the world, and has historically been vulnerable to earthquakes, volcanoes and other
natural disasters. As demonstrated by the Kobe earthquake in January of 1995, in which 5,000 people were killed and billions of dollars of damage was sustained, these natural disasters can be significant enough to affect the countrys economy.
Investing in the United Kingdom.
The economies of the United Kingdom may be significantly affected by the economies of
other European countries. Europe includes both developed and emerging economies. Most developed countries in Western Europe are members of the EU, and many are also members of the EMU. The EMU requires compliance with restrictions on inflation
rates, deficits, and debt levels, and the tight fiscal and monetary controls necessary to join the EMU may significantly affect every country in Europe. Many Eastern European countries continue to move toward market economies. However, Eastern
European markets remain relatively undeveloped and can be particularly sensitive to political and economic developments.
The
United Kingdom is Europes largest equity market in terms of aggregate market capitalization. Despite having a great deal of common purpose and common concepts, the accounting principles in the United Kingdom and the U.S. can lead to markedly
different financial statements. In the global market for capital, investors may want to know about a companys results and financial position under their own principles. This is particularly so in the U.S. capital markets. The overriding
requirement for a United Kingdom companys financial statements is that they give a true and fair view. Accounting standards are an authoritative source as to what is and is not a true and fair view, but do not define it
unequivocally. Ad hoc adaptations to specific circumstances may be required. In the U.S., financial statements are more conformed because they must be prepared in accordance with generally accepted accounting principles.
The United Kingdoms chief industries are machine tools, electric power equipment, automation equipment, railroad equipment,
shipbuilding, aircraft, motor vehicles and parts, electronics and communications equipment, metals, chemicals, coal, petroleum, paper and paper products, food processing, textiles, clothing and other consumer goods. The United Kingdoms chief
imports consist of manufactured goods, machinery, fuels and foodstuffs. Chief exports consist of manufactured goods, fuels, chemicals, food, beverages and tobacco.
Forward Foreign Currency Exchange Contracts.
Certain of the Underlying
Funds may enter into forward foreign currency exchange contracts for hedging purposes and to seek to protect against anticipated changes in future foreign currency exchange rates. Certain of the Underlying Funds may also enter into forward foreign
currency exchange contracts to seek to increase total return. A forward foreign currency exchange contract involves an obligation to purchase or sell a specific currency at a future date, which may be any fixed number of days from the date of the
contract agreed upon by the parties, at a price set at the time of the contract. These contracts are traded in the interbank market between currency traders (usually large commercial banks) and their customers. A forward contract generally has no
deposit requirement, and no commissions are generally charged at any stage for trades.
At the maturity of a forward contract
an Underlying Fund may either accept or make delivery of the currency specified in the contract or, at or prior to maturity, enter into a closing purchase transaction involving the purchase or sale of an offsetting contract. Closing purchase
transactions with respect to forward contracts are often, but not always, effected with the currency trader who is a party to the original forward contract.
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An Underlying Fund may enter into forward foreign currency exchange contracts in several
circumstances. First, when an Underlying Fund enters into a contract for the purchase or sale of a security denominated or quoted in a foreign currency, or when an Underlying Fund anticipates the receipt in a foreign currency of dividend or interest
payments on such a security which it holds, the Underlying Fund may desire to lock in the U.S. dollar price of the security or the U.S. dollar equivalent of such dividend or interest payment, as the case may be. By entering into a
forward contract for the purchase or sale, for a fixed amount of U.S. dollars, of the amount of foreign currency involved in the underlying transactions, the Underlying Fund will attempt to protect itself against an adverse change in the
relationship between the U.S. dollar and the subject foreign currency during the period between the date on which the security is purchased or sold, or on which the dividend or interest payment is declared, and the date on which such payments are
made or received.
Additionally, when an Underlying Funds investment adviser believes that the currency of a particular
foreign country may suffer a substantial decline against the U.S. dollar, it may enter into a forward contract to sell, for a fixed amount of U.S. dollars, the amount of foreign currency approximating the value of some or all of an Underlying
Funds portfolio securities quoted or denominated in such foreign currency. The precise matching of the forward contract amounts and the value of the securities involved will not generally be possible because the future value of such securities
in foreign currencies will change as a consequence of market movements in the value of those securities between the date on which the contract is entered into and the date it matures. Using forward contracts to protect the value of an Underlying
Funds portfolio securities against a decline in the value of a currency does not eliminate fluctuations in the underlying prices of the securities. It simply establishes a rate of exchange which an Underlying Fund can achieve at some future
point in time. The precise projection of short-term currency market movements is not possible, and short-term hedging provides a means of fixing the U.S. dollar value of only a portion of an Underlying Funds foreign assets.
Certain of the Underlying Funds may engage in cross-hedging by using forward contracts in one currency to hedge against fluctuations in
the value of securities quoted or denominated in a different currency if the Underlying Funds investment adviser determines that there is a pattern of correlation between the two currencies. In addition, certain Underlying Funds may enter into
foreign currency transactions to seek a closer correlation between an Underlying Funds overall currency exposures and the currency exposures of the Underlying Funds performance benchmark.
Certain Underlying Funds are not required to post cash collateral with their non-U.S. counterparties in certain foreign currency
transactions. Accordingly, such an Underlying Fund may remain more fully invested (and more of the Underlying Funds assets may be subject to investment and market risk) than if it were required to post cash collateral with its counterparties
(which is the case with U.S. counterparties). Because such an Underlying Funds non-U.S. counterparties are not required to post cash collaterial with the Underlying Fund, the Underlying Fund will be subject to additional counterparty risk.
Certain of the Underlying Funds will not enter into a forward contract with a term of greater than one year.
As an investment
company registered with the SEC, an Underlying Fund must identify on its books liquid assets, or engage in other appropriate measures, to cover open positions with respect to its transactions in forward contracts. In the case of forward
contracts that do not cash settle, for example, an Underlying Fund must identify on its books liquid assets equal to the full notional amount of the forward contracts while the positions are open. With respect to forward contracts that do cash
settle, however, an Underlying Fund is permitted to identify liquid assets in an amount equal to the Underlying Funds daily marked-to-market net obligations (i.e., the Underlying Funds daily net liability) under the forward contracts, if
any, rather than their full notional amount. Each Underlying Fund reserves the right to modify its asset segregation policies in the future in its discretion. By identifying assets equal to only its net obligations under cash-settled forward
contracts, the Underlying Fund will have the ability to employ leverage to a greater extent than if the Underlying Fund were required to identify assets equal to the full notional amount of the forward contracts.
While an Underlying Fund may enter into forward contracts to reduce currency exchange rate risks, transactions in such contracts involve
certain other risks. Thus, while an Underlying Fund may benefit from such transactions, unanticipated changes in currency prices may result in a poorer overall performance for the Underlying Fund than if it had not engaged in any such transactions.
Moreover, there may be imperfect correlation between an Underlying Funds portfolio holdings of securities quoted or denominated in a particular currency and forward contracts entered into by such Underlying Fund. Such imperfect correlation may
cause an Underlying Fund to sustain losses which will prevent the Underlying Fund from achieving a complete hedge or expose the Underlying Fund to risk of foreign exchange loss.
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Markets for trading foreign forward currency contracts offer less protection against
defaults than is available when trading in currency instruments on an exchange. Forward contracts are subject to the risk that the counterparty to such contract will default on its obligations. Because a forward foreign currency exchange contract is
not guaranteed by an exchange or clearinghouse, a default on the contract would deprive an Underlying Fund of unrealized profits, transaction costs or the benefits of a currency hedge or force the Underlying Fund to cover its purchase or sale
commitments, if any, at the current market price. In addition, the institutions that deal in forward currency contracts are not required to make markets in the currencies they trade and these markets can experience periods of illiquidity.
Forward contracts are subject to the risk that the counterparty to such contract will default on its obligations. Because a
forward foreign currency exchange contract is not guaranteed by an exchange or clearinghouse, a default on the contract would deprive an Underlying Fund of unrealized profits, transaction costs or the benefits of a currency hedge or force the
Underlying Fund to cover its purchase or sale commitments, if any, at the current market price. An Underlying Fund will not enter into such transactions unless the credit quality of the unsecured senior debt or the claims-paying ability of the
counterparty is considered to be investment grade by its investment adviser. To the extent that a substantial portion of an Underlying Funds total assets, adjusted to reflect the Underlying Funds net position after giving effect to
currency transactions, is denominated or quoted in the currencies of foreign countries, the Underlying Fund will be more susceptible to the risk of adverse economic and political developments within those countries.
Writing and Purchasing Currency Call and Put Options.
Certain of the Underlying Funds may, to the extent they invest in foreign securities, write covered put and call options and purchase put and call options on foreign currencies for the purpose of
protecting against declines in the U.S. dollar value of foreign portfolio securities and against increases in the U.S. dollar cost of foreign securities to be acquired. As with other kinds of option transactions, however, the writing of an option on
foreign currency will constitute only a partial hedge, up to the amount of the premium received. If an option that an Underlying Fund has written is exercised, the Underlying Fund seeks to close out an option, the Underlying Fund could be required
to purchase or sell foreign currencies at disadvantageous exchange rates, thereby incurring losses. The purchase of an option on foreign currency may constitute an effective hedge against exchange rate fluctuations; however, in the event of exchange
rate movements adverse to an Underlying Funds position, the Underlying Fund may forfeit the entire amount of the premium plus related transaction costs. Options on foreign currencies may be traded on U.S. and foreign exchanges or
over-the-counter. Certain of the Underlying Funds may purchase call options on currency to seek to increase total return.
Options on currency may also be used for cross-hedging purposes, which involves writing or purchasing options on one currency to seek to
hedge against changes in exchange rates for a different currency with a pattern of correlation, or to seek to increase total return when an Underlying Funds investment adviser anticipates that the currency will appreciate or depreciate in
value, but the securities quoted or denominated in that currency do not present attractive investment opportunities and are not included in the Underlying Funds portfolio.
A currency call option written by an Underlying Fund obligates an Underlying Fund to sell a specified currency to the holder of the
option at a specified price if the option is exercised before the expiration date. A currency put option written by an Underlying Fund obligates the Underlying Fund to purchase a specified currency from the option holder at a specified price if the
option is exercised before the expiration date. The writing of currency options involves a risk that an Underlying Fund will, upon exercise of the option, be required to sell currency subject to a call at a price that is less than the
currencys market value or be required to purchase currency subject to a put at a price that exceeds the currencys market value. Written put and call options on foreign currencies may be covered in a manner similar to written put and call
options on securities and securities indices described under Options on Securities and Securities IndicesWriting Covered Options above.
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An Underlying Fund may terminate its obligations under a written call or put option by
purchasing an option identical to the one it has written. Such purchases are referred to as closing purchase transactions. An Underlying Fund may enter into closing sale transactions in order to realize gains or minimize losses on
options purchased by the Underlying Fund.
An Underlying Fund may purchase call options on foreign currency in anticipation of
an increase in the U.S. dollar value of currency in which securities to be acquired by an Underlying Fund are quoted or denominated. The purchase of a call option would entitle the Underlying Fund, in return for the premium paid, to purchase
specified currency at a specified price during the option period. An Underlying Fund would ordinarily realize a gain if, during the option period, the value of such currency exceeded the sum of the exercise price, the premium paid and transaction
costs; otherwise the Underlying Fund would realize either no gain or a loss on the purchase of the call option.
An Underlying
Fund may purchase put options in anticipation of a decline in the U.S. dollar value of the currency in which securities in its portfolio are quoted or denominated (protective puts). The purchase of a put option would entitle an
Underlying Fund, in exchange for the premium paid, to sell specified currency at a specified price during the option period. The purchase of protective puts is usually designed to offset or hedge against a decline in the U.S. dollar value of an
Underlying Funds portfolio securities due to currency exchange rate fluctuations. An Underlying Fund would ordinarily realize a gain if, during the option period, the value of the underlying currency decreased below the exercise price
sufficiently to more than cover the premium and transaction costs; otherwise the Underlying Fund would realize either no gain or a loss on the purchase of the put option. Gains and losses on the purchase of protective put options would tend to be
offset by countervailing changes in the value of underlying currency or portfolio securities.
In addition to using options
for the hedging purposes described above, certain Underlying Funds may use options on currency to seek to increase total return. These Underlying Funds may write (sell) covered put and call options on any currency in an attempt to realize greater
income than would be realized on portfolio securities transactions alone. However, in writing covered call options for additional income, an Underlying Fund may forego the opportunity to profit from an increase in the market value of the underlying
currency. Also, when writing put options, an Underlying Fund accepts, in return for the option premium, the risk that it may be required to purchase the underlying currency at a price in excess of the currencys market value at the time of
purchase.
Special Risks Associated with Options on Currency.
An exchange traded options position may be closed out
only on an options exchange that provides a secondary market for an option of the same series. Although an Underlying Fund will generally purchase or write only those options for which there appears to be an active secondary market, there is no
assurance that a liquid secondary market on an exchange will exist for any particular option, or at any particular time. For some options, no secondary market on an exchange may exist. In such event, it might not be possible to effect closing
transactions in particular options, with the result that an Underlying Fund would have to exercise its options in order to realize any profit and would incur transaction costs upon the sale of underlying securities pursuant to the exercise of put
options. If an Underlying Fund as an option writer is unable to effect a closing purchase transaction in a secondary market, it may not be able to sell the underlying currency (or security quoted or denominated in that currency) or dispose of the
identified assets, until the option expires or it delivers the underlying currency upon exercise.
There is no assurance that
higher than anticipated trading activity or other unforeseen events might not, at times, render certain of the facilities of the Options Clearing Corporation inadequate, and thereby result in the institution by an exchange of special procedures
which may interfere with the timely execution of customers orders.
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An Underlying Fund may purchase and write over-the-counter options to the extent consistent
with its limitation on investments in illiquid securities. Trading in over-the-counter options is subject to the risk that the other party will be unable or unwilling to close out options purchased or written by an Underlying Fund.
The amount of the premiums which an Underlying Fund may pay or receive may be adversely affected as new or existing institutions,
including other investment companies, engage in or increase their option purchasing and writing activities.
Mortgage Dollar Rolls
Certain of the Underlying Funds may enter into mortgage dollar rolls in which an Underlying Fund sells
securities for delivery in the current month and simultaneously contracts with the same counterparty to repurchase similar, but not identical securities on a specified future date. During the roll period, an Underlying Fund loses the right to
receive principal and interest paid on the securities sold. However, an Underlying Fund would benefit to the extent of any difference between the price received for the securities sold and the lower forward price for the future purchase or fee
income plus the interest earned on the cash proceeds of the securities sold until the settlement date of the forward purchase. All cash proceeds will be invested in instruments that are permissible investments for the applicable Underlying Fund. An
Underlying Fund will, until the settlement date, identify cash or liquid assets on its books, as permitted by applicable law, in an amount equal to its forward purchase price.
For financial reporting and tax purposes, the Underlying Funds treat mortgage dollar rolls as two separate transactions; one involving the purchase of a security and a separate transaction involving a
sale. The Underlying Funds do not currently intend to enter into mortgage dollar rolls for financing and do not treat them as borrowings.
Mortgage dollar rolls involve certain risks including the following: if the broker-dealer to whom an Underlying Fund sells the security becomes insolvent, an Underlying Funds right to purchase or
repurchase the mortgage-related securities subject to the mortgage dollar roll may be restricted. Also the instrument which an Underlying Fund is required to repurchase may be worth less than an instrument which an Underlying Fund originally held.
Successful use of mortgage dollar rolls will depend upon the ability of an Underlying Funds investment adviser to manage an Underlying Funds interest rate and mortgage prepayments exposure. For these reasons, there is no assurance that
mortgage dollar rolls can be successfully employed. The use of this technique may diminish the investment performance of an Underlying Fund compared to what such performance would have been without the use of mortgage dollar rolls.
Convertible Securities
Certain of the Underlying Funds may invest in convertible securities. Convertible securities are bonds, debentures, notes, preferred
stocks or other securities that may be converted into or exchanged for a specified amount of common stock (or other securities) of the same or different issuer within a particular period of time at a specified price or formula. A convertible
security entitles the holder to receive interest that is generally paid or accrued on debt or a dividend that is paid or accrued on preferred stock until the convertible security matures or is redeemed, converted or exchanged. Convertible securities
have unique investment characteristics, in that they generally (i) have higher yields than common stocks, but lower yields than comparable non-convertible securities, (ii) are less subject to fluctuation in value than the underlying common
stock due to their fixed income characteristics and (iii) provide the potential for capital appreciation if the market price of the underlying common stock increases.
The value of a convertible security is a function of its investment value (determined by its yield in comparison with the yields of other securities of comparable maturity and quality that do
not have a conversion privilege) and its conversion value (the securitys worth, at market value, if converted into the underlying
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common stock). The investment value of a convertible security is influenced by changes in interest rates, with investment value normally declining as interest rates increase and increasing as
interest rates decline. The credit standing of the issuer and other factors may also have an effect on the convertible securitys investment value. The conversion value of a convertible security is determined by the market price of the
underlying common stock. If the conversion value is low relative to the investment value, the price of the convertible security is governed principally by its investment value. To the extent the market price of the underlying common stock approaches
or exceeds the conversion price, the price of the convertible security will be increasingly influenced by its conversion value. A convertible security generally will sell at a premium over its conversion value by the extent to which investors place
value on the right to acquire the underlying common stock while holding a fixed income security.
A convertible security may
be subject to redemption at the option of the issuer at a price established in the convertible securitys governing instrument. If a convertible security held by an Underlying Fund is called for redemption, the Underlying Fund will be required
to permit the issuer to redeem the security, convert it into the underlying common stock or sell it to a third party or permit the issuer to redeem the security. Any of these actions could have an adverse effect on an Underlying Funds ability
to achieve its investment objective, which, in turn, could result in losses to the Underlying Fund.
Index Swaps, Interest Rate Swaps,
Mortgage Swaps, Credit Swaps, Currency Swaps, Total Return Swaps, Options on Swaps, and Floors and Collars
Certain of the
Underlying Funds may enter into index, interest rate, mortgage, credit, currency and total return swaps and other interest rate swap arrangements such as rate caps, floors and collars, for hedging purposes or to seek to increase total return.
Certain of the Underlying Funds may also purchase and write (sell) options on swaps, commonly referred to as swaptions.
In a
standard swap transaction, two parties agree to exchange the returns differentials in rates of return or some other amount earned or realized on particular predetermined investments or instruments, which may be adjusted for an interest
factor. The gross returns to be exchanged or swapped between the parties are generally calculated with respect to a notional amount,
i.e.
, the return on or increase in value of a particular dollar amount invested at a
particular interest rate, in a particular foreign currency or security, or in a basket of securities representing a particular index. Bilateral swap agreements are two party contracts entered into primarily by institutional investors.
Cleared swaps are transacted through futures commission merchants (FCMs) that are members of central clearinghouses with the clearinghouse serving as a central counterparty similar to transactions in futures contracts. Funds post initial
and variation margin by making payments to their clearing member FCMs.
Currency swaps involve the exchange by an Underlying
Fund with another party of their respective rights to make or receive payments in specified currencies. Interest rate swaps involve the exchange by an Underlying Fund with another party of their respective commitments to pay or receive interest,
such as an exchange of fixed rate payments for floating rate payments. Mortgage swaps are similar to interest rate swaps in that they represent commitments to pay and receive interest. The notional principal amount, however, is tied to a reference
pool or pools of mortgages. Index swaps involve the exchange by an Underlying Fund with another party of the respective amounts payable with respect to a notional principal amount at interest rates equal to two specified indices. Total return swaps
are contracts that obligate a party to pay or receive interest in exchange for payment by the other party of the total return generated by a security, a basket of securities, an index, or an index component.
A swaption is an option to enter into a swap agreement. Like other types of options, the buyer of a swaption pays a non-refundable
premium for the option and obtains the right, but not the obligation, to enter into an underlying swap or to modify the terms of an existing swap on agreed-upon terms. The seller of a swaption, in exchange for the premium, becomes obligated (if the
option is exercised) to enter into or modify an
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underlying swap on agreed-upon terms, which generally entails a greater risk of loss than incurred in buying a swaption. The purchase of an interest rate cap entitles the purchaser, to the extent
that a specified index exceeds a predetermined interest rate, to receive payment of interest on a notional principal amount from the party selling such interest rate cap. The purchase of an interest rate floor entitles the purchaser, to the extent
that a specified index falls below a predetermined interest rate, to receive payments of interest on a notional principal amount from the party selling the interest rate floor. An interest rate collar is the combination of a cap and a floor that
preserves a certain return within a predetermined range of interest rates. Since interest rate, mortgage and currency swaps and interest rate caps, floors and collars are individually negotiated, each Underlying Fund expects to achieve an acceptable
degree of correlation between its portfolio investments and its swap, cap, floor and collar positions.
A great deal of
flexibility may be possible in the way swap transactions are structured. However, generally an Underlying Fund will enter into interest rate, total return, credit, mortgage and index swaps on a net basis, which means that the two payment streams are
netted out, with the Underlying Fund receiving or paying, as the case may be, only the net amount of the two payments. Interest rate, total return, credit, index and mortgage swaps do not normally involve the delivery of securities, other underlying
assets or principal. Accordingly, the risk of loss with respect to interest rate, total return, credit, index and mortgage swaps is normally limited to the net amount of interest payments that the Underlying Fund is contractually obligated to make.
If the other party to an interest rate, total return, credit, index or mortgage swap defaults, the Underlying Funds risk of loss consists of the net amount of interest payments that the Underlying Fund is contractually entitled to receive.
As a result of new rules adopted in 2012, certain standardized swaps are currently subject to mandatory central clearing.
Central clearing is expected to decrease counterparty risk and increase liquidity compared to bilateral swaps because central clearing interposes the central clearinghouse as the counterparty to each participants swap. However, central
clearing does not eliminate counterparty risk or illiquidity risk entirely. In addition, depending on the size of the Fund and other factors, the margin required under the rules of a clearinghouse and by a clearing member may be in excess of the
collateral required to be posted by the Fund to support its obligations under a similar bilateral swap. However, regulators are expected to adopt rules imposing certain margin requirements, including minimums, on uncleared swaps in the near future,
which could change this comparison.
In contrast, currency swaps usually involve the delivery of the entire principal amount
of one designated currency in exchange for the other designated currency. Therefore, the entire principal value of a currency swap is subject to the risk that the other party to the swap will default on its contractual delivery obligations. A credit
swap may have as reference obligations one or more securities that may, or may not, be currently held by an Underlying Fund. The protection buyer in a credit swap is generally obligated to pay the protection seller an upfront
or a periodic stream of payments over the term of the swap provided that no credit event, such as a default, on a reference obligation has occurred. If a credit event occurs, the seller generally must pay the buyer the par value (full
notional value) of the swap in exchange for an equal face amount of deliverable obligations of the reference entity described in the swap, or the seller may be required to deliver the related net cash amount, if the swap is cash settled. An
Underlying Fund may be either the protection buyer or seller in the transaction. If the Underlying Fund is a buyer and no credit event occurs, the Underlying Fund may recover nothing if the swap is held through its termination date. However, if a
credit event occurs, the buyer generally may elect to receive the full notional value of the swap in exchange for an equal face amount of deliverable obligations of the reference entity whose value may have significantly decreased. As a seller, an
Underlying Fund generally receives an upfront payment or a rate of income throughout the term of the swap provided that there is no credit event. As the seller, an Underlying Fund would effectively add leverage to its portfolio because, in addition
to its total net assets, an Underlying Fund would be subject to investment exposure on the notional amount of the swap. If a credit event occurs, the value of any deliverable obligation received by the Underlying Fund as seller, coupled with the
upfront
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or periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the Underlying Fund. To the extent that an Underlying
Funds exposure in a transaction involving a swap, a swaption or an interest rate floor, cap or collar is covered by identifying cash or liquid assets on the Underlying Funds books or is covered by other means in accordance with SEC
guidance or otherwise, the Underlying Funds and their investment advisers believe that the transactions do not constitute senior securities under the Act and, accordingly, will not treat them as being subject to an Underlying Funds borrowing
restrictions.
An Underlying Equity Fund, the Commodity Strategy Fund and the Dynamic Allocation Fund will not enter into swap
transactions unless the unsecured commercial paper, senior debt or claims paying ability of the other party thereto is considered to be investment grade by its investment adviser. To the extent that it is permitted to invest in the following, an
Underlying Fixed Income Fund will not enter into any bilateral transactions involving total return, interest rate, mortgage or credit swap transactions unless the unsecured commercial paper, senior debt or claims-paying ability of the other party is
rated either A or A-1 or better by Standard & Poors or A or P-1 or better by Moodys or their equivalent ratings. The Underlying Fixed Income Funds permitted to invest in currency swap transactions will do so only if the
unsecured commercial paper, senior debt or claims-paying ability of the other party thereto is rated investment grade by Standard & Poors or Moodys or their equivalent ratings or, if unrated by such rating agencies, determined
to be of comparable quality by the applicable investment adviser. If there is a default by the other party to such a transaction, an Underlying Fund will have contractual remedies pursuant to the agreements related to the transaction.
The use of interest rate, total return, mortgage, credit, index and currency swaps, as well as swaptions and interest rate caps, floors
and collars is a highly specialized activity which involves investment techniques and risks different from those associated with ordinary portfolio securities transactions. The use of a swap requires an understanding not only of the referenced
asset, reference rate, or index but also of the swap itself, without the benefit of observing the performance of the swap under all possible market conditions. If an Underlying Funds investment adviser is incorrect in its forecasts of market
values, credit quality, interest rates and currency exchange rates, the investment performance of an Underlying Fund would be less favorable than it would have been if this investment technique were not used.
In addition, these transactions can involve greater risks than if an Underlying Fund had invested in the reference obligation directly
because, in addition to general market risks, swaps are subject to illiquidity risk, counterparty risk, credit risk and pricing risk. Regulators also may impose limits on an entitys or group of entities positions in certain swaps.
However, certain risks are reduced (but not eliminated) if the Fund invests in cleared swaps. Because bilateral swap agreements are two party contracts and because they may have terms of greater than seven days, swap transactions these swaps may be
considered to be illiquid. Moreover, the Fund bears the risk of loss of the amount expected to be received under a swap agreement in the event of the default or bankruptcy of a swap counterparty. Many swaps are complex and often valued subjectively.
Swaps and other derivatives may also be subject to pricing or basis risk, which exists when the price of a particular derivative diverges from the price of corresponding cash market instruments. Under certain market conditions it may not
be economically feasible to imitate a transaction or liquidate a position in time to avoid a loss or take advantage of an opportunity. If a swap transaction is particularly large or if the relevant market is illiquid, it may not be possible to
initiate a transaction or liquidate a position at an advantageous time or price, which may result in significant losses.
Regulators are in the process of developing rules that would require trading and execution of most liquid swaps on trading facilities.
Moving trading to an exchange-type system may increase market transparency and liquidity but may require the Fund to incur increased expenses to access the same types of swaps.
Rules adopted in 2012 also require centralized reporting of detailed information about many types of cleared and uncleared swaps. This
information is available to regulators and, to a more limited extent and on an anonymous basis, to the public. Reporting of swap data may result in greater market transparency, which may be beneficial to funds that use swaps to implement trading
strategies. However, these rules place potential additional administrative obligations on these funds, and the safeguards established to protect anonymity may not function as expected.
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The swap market has grown substantially in recent years with a large number of banks and
investment banking firms acting both as principals and as agents utilizing standardized swap documentation. As a result, the swap market has become relatively liquid in comparison with the markets for other similar instruments which are traded in
the interbank market. The investment advisers for the Underlying Funds, under the supervision of the Board of Trustees, are responsible for determining and monitoring the liquidity of the Underlying Funds transactions in swaps, swaptions,
caps, floors and collars.
Equity Swaps
Each Underlying Equity Fund, Commodity Strategy Fund, and Dynamic Allocation Fund may enter into equity swap contracts to invest in a market without owning or taking physical custody of securities in
various circumstances, including circumstances where direct investment in the securities is restricted for legal reasons or is otherwise impracticable. Equity swaps may also be used for hedging purposes or to seek to increase total return. The
counterparty to an equity swap contract will typically be a bank, investment banking firm or broker/dealer. Equity swaps may be structured in different ways. For example, a counterparty may agree to pay the Underlying Fund the amount, if any, by
which the notional amount of the equity swap contract would have increased in value had it been invested in particular stocks (or an index of stocks), plus the dividends that would have been received on those stocks. In these cases, the Underlying
Fund may agree to pay to the counterparty a floating rate of interest on the notional amount of the equity swap contract plus the amount, if any, by which that notional amount would have decreased in value had it been invested in such stocks.
Therefore, the return to the Underlying Fund on the equity swap contract should be the gain or loss on the notional amount plus dividends on the stocks less the interest paid by the Underlying Fund on the notional amount. In other cases, the
counterparty and the Underlying Fund may each agree to pay the other the difference between the relative investment performances that would have been achieved if the notional amount of the equity swap contract had been invested in different stocks
(or indices of stocks).
An Underlying Fund will generally enter into equity swaps on a net basis, which means that the two
payment streams are netted out, with the Underlying Fund receiving or paying, as the case may be, only the net amount of the two payments. Payments may be made at the conclusion of an equity swap contract or periodically during its term. Equity
swaps normally do not involve the delivery of securities or other underlying assets. Accordingly, the risk of loss with respect to equity swaps is normally limited to the net amount of payments that an Underlying Fund is contractually obligated to
make. If the other party to an equity swap defaults, an Underlying Funds risk of loss consists of the net amount of payments that such Underlying Fund is contractually entitled to receive, if any. Inasmuch as these transactions are entered
into for hedging purposes or are offset by the cash or liquid assets identified on the Underlying Funds books to cover the Underlying Funds exposure, the Underlying Funds and their investment advisers believe that transactions do not
constitute senior securities under the Act and, accordingly, will not treat them as being subject to an Underlying Funds borrowing restrictions.
An Underlying Fund will enter into equity swap transactions only if the unsecured commercial paper, senior debt or claims paying ability of the other party thereto is considered to be investment grade by
the investment adviser. An Underlying Funds ability to enter into certain swap transactions may be limited by tax considerations.
Real Estate Investment Trusts
The Underlying Equity Funds, Dynamic Allocation Fund and Commodity Strategy Fund may invest in shares of REITs. REITs are pooled investment vehicles which invest primarily in real estate or real estate
related loans. REITs are generally classified as equity REITs, mortgage REITs or a combination of equity and mortgage REITs. Equity REITs invest the majority of their assets directly in real property and derive income
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primarily from the collection of rents. Equity REITs can also realize capital gains by selling properties that have appreciated in value. Mortgage REITs invest the majority of their assets in
real estate mortgages and derive income from the collection of interest payments. Like regulated investment companies such as the Underlying Funds, REITs are not taxed on income distributed to shareholders provided they comply with certain
requirements under the Code. An Underlying Fund will indirectly bear its proportionate share of any expenses paid by REITs in which it invests in addition to the expenses paid by an Underlying Fund.
Investing in REITs involves certain unique risks. Equity REITs may be affected by changes in the value of the underlying property owned
by such REITs, while mortgage REITs may be affected by the quality of any credit extended. REITs are dependent upon management skills, are not diversified (except to the extent the Code requires), and are subject to the risks of financing projects.
REITs are subject to heavy cash flow dependency, default by borrowers, self-liquidation, and the possibilities of failing to qualify for the exemption from tax for distributed income under the Code and failing to maintain their exemptions from the
Act. REITs (especially mortgage REITs) are also subject to interest rate risks.
Lending of Portfolio Securities
Certain of the Underlying Funds may lend their portfolio securities to brokers, dealers and other institutions, including Goldman Sachs.
By lending its securities, an Underlying Fund attempts to increase its net investment income.
Securities loans are required
to be secured continuously by collateral in cash, cash equivalents, letters of credit or U.S. Government securities equal to at least 100% of the value of the loaned securities. This collateral must be valued, or marked to market, daily.
Borrowers are required to furnish additional collateral to the Underlying Fund as necessary to fully cover their obligations.
With respect to loans that are collateralized by cash, the Underlying Fund may reinvest that cash in short-term investments and pay the
borrower a pre-negotiated fee or rebate from any return earned on the investment. Investing the collateral subjects it to market depreciation or appreciation, and the Underlying Fund is responsible for any loss that may result from its
investment of the borrowed collateral. Cash collateral may be invested in, among other things, other registered or unregistered funds, including private investing funds or money market funds that are managed by the Underlying Funds investment
adviser or its affiliates and which pay the Underlying Funds investment adviser or its affiliates for their services. If an Underlying Fund were to receive non-cash collateral, the Underlying Fund would receive a fee from the borrower equal to
a negotiated percentage of the market value of the loaned securities.
For the duration of any securities loan, the Underlying
Fund will continue to receive the equivalent of the interest, dividends or other distributions paid by the issuer on the loaned securities. The Underlying Fund will not have the right to vote its loaned securities during the period of the loan, but
the Underlying Fund may attempt to recall a loaned security in anticipation of a material vote if it desires to do so. An Underlying Fund will have the right to terminate a loan at any time and recall the loaned securities within the normal and
customary settlement time for securities transactions.
Securities lending involves certain risks. An Underlying Fund may lose
money on its investment of cash collateral, resulting in a loss of principal, or may fail to earn sufficient income on its investment to cover the fee or rebate it has agreed to pay the borrower. The Underlying Fund may incur losses in connection
with its securities lending activities that exceed the value of the interest income and fees received in connection with such transactions. Securities lending subjects an Underlying Fund to the risk of loss resulting from problems in the settlement
and accounting process, and to additional credit, counterparty and market risk. These risks could be greater with respect to non-U.S. securities. Engaging in securities lending could have a leveraging effect, which may intensify the other risks
associated with investments in the Underlying Fund. In addition, an Underlying Fund bears the risk that the price of the securities on loan will increase while they are on loan, or
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that the price of the collateral will decline in value during the period of the loan, and that the counterparty will not provide, or will delay in providing, additional collateral. An Underlying
Fund also bears the risk that a borrower may fail to return securities in a timely manner or at all, either because the borrower fails financially or for other reasons. If a borrower of securities fails financially, an Underlying Fund may also lose
its rights in the collateral. An Underlying Fund could experience delays and costs in recovering loaned securities or in gaining access to and liquidating the collateral, which could result in actual financial loss and which could interfere with
portfolio management decisions or the exercise of ownership rights in the loaned securities. If an Underlying Fund is not able to recover the loaned securities, the Underlying Fund may sell the collateral and purchase replacement securities in the
market. However, the Underlying Fund will incur transaction costs on the purchase of replacement securities. These events could trigger adverse tax consequences for the Underlying Fund. In determining whether to lend securities to a particular
borrower, and throughout the period of the loan, the creditworthiness of the borrower will be considered and monitored. Loans will only be made to firms deemed to be of good standing, and where the consideration that can be earned currently from
securities loans of this type is deemed to justify the attendant risk. It is intended that the value of securities loaned by an Underlying Fund will not exceed one-third of the value of an Underlying Funds total assets (including the loan
collateral).
An Underlying Fund will consider the loaned securities as assets of the Underlying Fund, but will not consider
any collateral as an Underlying Fund asset except when determining total assets for the purpose of the above one-third limitation. Loan collateral (including any investment of the collateral) is not subject to the percentage limitations stated
elsewhere in this SAI, the Prospectus or the Underlying Funds Prospectuses or SAIs regarding investing in fixed income securities and cash equivalents.
The Underlying Funds Board of Trustees has approved certain Underlying Funds participation in a securities lending program and has adopted policies and procedures relating thereto. Under the
current securities lending program, each participating Underlying Fund has retained an affiliate of its investment adviser to serve as its securities lending agent.
For its services, the securities lending agent may receive a fee from an Underlying Fund, including a fee based on the returns earned on the Underlying Funds investment of cash received as
collateral for the loaned securities. In addition, an Underlying Fund may make brokerage and other payments to Goldman Sachs and its affiliates in connection with the Underlying Funds portfolio investment transactions. An Underlying
Funds Board of Trustees periodically reviews securities loan transactions for which a Goldman Sachs affiliate has acted as lending agent for compliance with the Underlying Funds securities lending procedures. Goldman Sachs also has been
approved as a borrower under the Underlying Funds securities lending program, subject to certain conditions.
When-Issued Securities
and Forward Commitments
Each Underlying Fund may purchase securities on a when-issued basis or purchase or sell securities
on a forward commitment basis beyond the customary settlement time. These transactions involve a commitment by an Underlying Fund to purchase or sell securities at a future date beyond the customary settlement time. The price of the underlying
securities (usually expressed in terms of yield) and the date when the securities will be delivered and paid for (the settlement date) are fixed at the time the transaction is negotiated. When-issued purchases and forward commitment transactions are
negotiated directly with the other party, and such commitments are not traded on exchanges. An Underlying Fund will generally purchase securities on a when-issued basis or purchase or sell securities on a forward commitment basis only with the
intention of completing the transaction and actually purchasing or selling the securities. If deemed advisable as a matter of investment strategy, however, an Underlying Fund may dispose of or negotiate a commitment after entering into it. An
Underlying Fund may also sell securities it has committed to purchase before those securities are delivered to the Underlying Fund on the settlement date. The Underlying Funds may realize a capital gain or loss in
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connection with these transactions. For purposes of determining an Underlying Funds duration, the maturity of when-issued or forward commitment securities for fixed-rate obligations will be
calculated from the commitment date. Each Underlying Fund is generally required to identify on its books, until three days prior to the settlement date, cash and liquid assets in an amount sufficient to meet the purchase price unless the Underlying
Funds obligations are otherwise covered. Alternatively, each Underlying Fund may enter into offsetting contracts for the forward sale of other securities that it owns. Securities purchased or sold on a when-issued or forward commitment basis
involve a risk of loss if the value of the security to be purchased declines prior to the settlement date or if the value of the security to be sold increases prior to the settlement date.
Variable Amount Master Demand Notes
The Financial Square Prime Obligations
Fund may purchase variable amount master demand notes. These obligations permit the investment of fluctuating amounts at varying rates of interest pursuant to direct arrangements between the Financial Square Prime Obligations Fund, as lender, and
the borrower. Variable amount master demand notes are not generally transferable, and are not ordinarily rated. The Financial Square Prime Obligations Fund may invest in them only if the Financial Square Prime Obligations Funds investment
adviser believes that the notes are of comparable quality to the other obligations in which the Financial Square Prime Obligations Fund may invest.
Investment in Unseasoned Companies
Each Underlying Equity Fund and
Commodity Strategy Fund may invest in companies (including predecessors) which have operated less than three years. The securities of such companies may have limited liquidity, which can result in their being priced higher or lower than might
otherwise be the case. In addition, investments in unseasoned companies are more speculative and entail greater risk than do investments in companies with an established operating record.
Other Investment Companies
Each Underlying Fund may invest in securities
of other investment companies, including ETFs. An Underlying Fund will indirectly bear its proportionate share of any management fees and other expenses paid by investment companies in which it invests, in addition to the management fees (and other
expenses) paid by the Underlying Fund. An Underlying Funds investments in other investment companies are subject to statutory limitations prescribed by the Act, including in certain circumstances a prohibition on the Underlying Fund acquiring
more that 3% of the voting shares of any other investment company, and a prohibition on investing more than 5% of the Underlying Funds total assets in securities of any one investment company or more than 10% of its total assets in the
securities of all investment companies. Many ETFs, however, have obtained exemptive relief from the SEC to permit unaffiliated funds (such as the Underlying Funds) to invest in their shares beyond these statutory limits, subject to certain
conditions and pursuant to contractual arrangements between the ETFs and the investing funds. An Underlying Fund may rely on these exemptive orders in investing in ETFs. Moreover, pursuant to an exemptive order obtained from the SEC or under an
exemptive rule adopted by the SEC, the Underlying Funds may invest in investment companies and money market funds for which an Investment Adviser or any of its affiliates serves as investment adviser, administrator and/or distributor. However, to
the extent that an Underlying Fund invests in a money market fund for which an Investment Adviser or any of its affiliates acts as investment adviser, the management fees payable by the Underlying Fund to the Investment Adviser will, to the extent
required by the SEC, be reduced by an amount equal to the Underlying Funds proportionate share of the management fees paid by such money market fund to its investment adviser. Although the Underlying Funds do not expect to do so in the
foreseeable future, each Underlying Fund is authorized to invest substantially all of its assets in a single open-end investment company or series thereof that has substantially the same investment objective, policies and fundamental restrictions as
the Underlying Fund. Additionally, for so long as any Underlying Fund serves as an underlying fund to another Goldman Sachs Fund, including the Portfolios, that Underlying Fund may invest a percentage of its assets in other investment companies if
those investments are consistent with applicable law and/or exemptive relief obtained from the SEC.
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Certain of the Underlying Funds may purchase shares of investment companies investing
primarily in foreign securities, including country funds. Country funds have portfolios consisting primarily of securities of issuers located in specified foreign countries or regions.
ETFs are pooled investment vehicles issuing shares which are traded like traditional equity securities on a stock exchange. An ETF
represents a portfolio of securities, which is often designed to track a particular market segment or index. An investment in an ETF, like one in any investment vehicles, carries risks of its underlying securities. An ETF may fail to accurately
track the returns of the market segment or index that it is designed to track, and the price of an ETFs shares may fluctuate or lose money. In addition, because they, unlike other pooled investment vehicles, are traded on an exchange, ETFs are
subject to the following risks: (i) the market price of the ETFs shares may trade at a premium or discount to the ETFs net asset value; (ii) an active trading market for an ETF may not develop or be maintained; and
(iii) there is no assurance that the requirements of the exchange necessary to maintain the listing of the ETF will continue to be met or remain unchanged. In the event substantial market or other disruptions affecting ETFs should occur in the
future, the liquidity and value of an Underlying Funds shares could also be substantially and adversely affected.
Repurchase
Agreements
Each Underlying Fund may enter into repurchase agreements with banks, brokers, and dealers which furnish
collateral at least equal in value or market price to the amount of the repurchase obligation. Certain Underlying Funds may also enter into repurchase agreements involving certain foreign government securities. A repurchase agreement is an
arrangement under which an Underlying Fund purchases securities and the seller agrees to repurchase the securities within a particular time and at a specified price for the duration of the agreement. Custody of the securities is maintained by an
Underlying Funds custodian (or sub-custodian). The repurchase price may be higher than the purchase price, the difference being income to an Underlying Fund, or the purchase and repurchase prices may be the same, with interest at a stated rate
due to an Underlying Fund together with the repurchase price on repurchase. In either case, the income to an Underlying Fund is unrelated to the interest rate on the security subject to the repurchase agreement.
For purposes of the Act and generally for tax purposes, a repurchase agreement is deemed to be a loan from a Fund to the seller of the
security. For other purposes, it is not always clear whether a court would consider the security purchased by a Fund subject to a repurchase agreement as being owned by a Fund or as being collateral for a loan by a Fund to the seller. In the event
of commencement of bankruptcy or insolvency proceedings with respect to the seller of the security before repurchase of the security under a repurchase agreement, a Fund may encounter delay and incur costs before being able to sell the security.
Such a delay may involve loss of interest or a decline in price of the security. If the court characterizes the transaction as a loan and a Fund has not perfected a security interest in the security, a Fund may be required to return the security to
the sellers estate and be treated as an unsecured creditor of the seller. As an unsecured creditor, a Fund would be at risk of losing some or all of the principal and interest involved in the transaction.
Apart from the risk of bankruptcy or insolvency proceedings, there is also the risk that the seller may fail to repurchase the security.
However, if the market value of the security subject to the repurchase agreement becomes less than the repurchase price (including accrued interest), a Fund will direct the seller of the security to deliver additional securities so that the market
value of all securities subject to the repurchase agreement equals or exceeds the repurchase price. Certain repurchase agreements which provide for settlement in more than seven days can be liquidated before the nominal fixed term on seven days or
less notice. Such repurchase agreements will be regarded as liquid instruments.
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The Underlying Funds, together with other registered investment companies having advisory
agreements with the Investment Advisers or their affiliates, may transfer uninvested cash balances into a single joint account, the daily aggregate balance of which will be invested in one or more repurchase agreements.
Reverse Repurchase Agreements
Certain of the Underlying Funds may borrow money by entering into transactions called reverse repurchase agreements. Under these arrangements, an Underlying Fund will sell portfolio securities to banks
and other financial institutions, with an agreement to repurchase the security on an agreed date, price and interest payment. Certain of these Underlying Funds may also enter into reverse repurchase agreements involving certain foreign government
securities. Reverse repurchase agreements involve the possible risk that the value of portfolio securities an Underlying Fund relinquishes may decline below the price the Underlying Fund must pay when the transaction closes. Borrowings may magnify
the potential for gain or loss on amounts invested resulting in an increase in the speculative character of an Underlying Funds outstanding shares.
When an Underlying Fund enters into a reverse repurchase agreement, it identifies on its books cash or liquid assets that have a value equal to or greater than the repurchase price. The amount of cash or
liquid assets so identified is then monitored continuously by its investment adviser to make sure that an appropriate value is maintained. Reverse repurchase agreements are considered to be borrowings under the Act.
Restricted and Illiquid Securities
The Underlying Funds may not invest more than 15% (5% of total assets, in the case of Financial Square Prime Obligations Fund) of their net assets in illiquid investments, which include securities (both
foreign and domestic) that are not readily marketable, certain SMBS, certain municipal leases and participation interests, certain over-the-counter options, repurchase agreements and time deposits with a notice or demand period of more than seven
days, and certain restricted securities, unless it is determined, based upon a continuing review of the trading markets for the specific instrument, that such instrument is liquid. The Trustees have adopted guidelines under which the Underlying
Funds investment advisers determine and monitor the liquidity of the Underlying Funds portfolio securities. This investment practice could have the effect of increasing the level of illiquidity in an Underlying Fund to the extent that
qualified institutional buyers become for a time uninterested in purchasing these instruments.
The purchase price and
subsequent valuation of restricted securities may reflect a discount from the price at which such securities trade when they are not restricted, since the restriction may make them less liquid. The amount of the discount from the prevailing market
price is expected to vary depending upon the type of security, the character of the issuer, the party who will bear the expenses of registering the restricted securities and prevailing supply and demand conditions.
Short Sales
Certain of
the Underlying Funds may engage in short sales. Short sales are transactions in which an Underlying Fund sells a security it does not own in anticipation of a decline in the market value of that security. To complete such a transaction, the
Underlying Fund must borrow the security to make delivery to the buyer. The Underlying Fund then is obligated to replace the security borrowed by purchasing it at the market price at the time of replacement. The price at such time may be more or
less than the price at which the security was sold by the Underlying Fund. Until the security is replaced, the Underlying Fund is required to pay to the lender amounts equal to any dividend which accrues during the period of the loan. To borrow the
security, the Underlying Fund also may be required to pay a premium, which would increase the cost of the security sold. There will also be other costs associated with short sales.
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An Underlying Fund will incur a loss as a result of the short sale if the price of the
security increases between the date of the short sale and the date on which the Underlying Fund replaces the borrowed security. The Underlying Fund will realize a gain if the security declines in price between those dates. This result is the
opposite of what one would expect from a cash purchase of a long position in a security. The amount of any gain will be decreased, and the amount of any loss increased, by the amount of any premium or amounts in lieu of interest the Underlying Fund
may be required to pay in connection with a short sale, and will be also decreased by any transaction or other costs.
Until
an Underlying Fund replaces a borrowed security in connection with a short sale, the Underlying Fund will (a) identify on its books cash or liquid assets at such a level that the identified assets plus any amount deposited as collateral will
equal the current value of the security sold short or (b) otherwise cover its short position in accordance with applicable law.
There is no guarantee that an Underlying Fund will be able to close out a short position at any particular time or at an acceptable price. During the time that an Underlying Fund is short a security, it
is subject to the risk that the lender of the security will terminate the loan at a time when the Underlying Fund is unable to borrow the same security from another lender. If that occurs, the Underlying Fund may be bought in at the
price required to purchase the security needed to close out the short position, which may be a disadvantageous price.
Short Sales Against
the Box
Certain of the Underlying Funds may engage in short sales against the box. As noted above, a short sale is made by
selling a security the seller does not own. A short sale is against the box to the extent that the seller contemporaneously owns or has the right to obtain, at no added cost, securities identical to those sold short. It may be entered
into by an Underlying Fund, for example, to lock in a sales price for a security the Underlying Fund does not wish to sell immediately. If an Underlying Fund sells securities short against the box, it may protect itself from loss if the price of the
securities declines in the future, but will lose the opportunity to profit on such securities if the price rises.
If an
Underlying Fund effects a short sale of securities at a time when it has an unrealized gain on the securities, it may be required to recognize that gain as if it had actually sold the securities (as a constructive sale) on the date it
effects the short sale. However, such constructive sale treatment may not apply if an Underlying Fund closes out the short sale with securities other than the appreciated securities held at the time of the short sale and if certain other conditions
are satisfied. Uncertainty regarding the tax consequences of effecting short sales may limit the extent to which an Underlying Fund may effect short sales.
Temporary Investments
Each Underlying Fund (with the exception of
Financial Square Prime Obligations Fund) may, for temporary defensive purposes (and to the extent it is permitted to invest in the following), invest a certain percentage of its total assets in: U.S. Government securities; commercial paper rated at
least A-2 by Standard & Poors, P-2 by Moodys or having a comparable rating by another NRSRO (or, if unrated, determined by the Investment Adviser to be of comparable credit quality); certificates of deposit; bankers
acceptances; repurchase agreements; non-convertible preferred stocks and non-convertible corporate bonds with a remaining maturity of less than one year; ETFs; other investment companies; and cash items. When an Underlying Funds assets are
invested in such instruments, the Underlying Fund may not be achieving its investment objective.
Participation Notes
Certain of the Underlying Funds may invest in participation notes. Some countries, especially emerging markets countries, do not permit
foreigners to participate directly in their securities markets or otherwise present
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difficulties for efficient foreign investment. The Underlying Funds may use participation notes to establish a position in such markets as a substitute for direct investment. Participation notes
are issued by banks or broker-dealers and are designed to track the return of a particular underlying equity or debt security, currency or market. When a participation note matures, the issuer of the participation note will pay to, or receive from,
the Underlying Fund the difference between the nominal value of the underlying instrument at the time of purchase and that instruments value at maturity. Investments in participation notes involve the same risks associated with a direct
investment in the underlying security, currency or market that they seek to replicate. In addition, participation notes are generally traded over-the-counter and are subject to counterparty risk. Counterparty risk is the risk that the broker-dealer
or bank that issues them will not fulfill its contractual obligation to complete the transaction with an Underlying Fund. Participation notes constitute general unsecured contractual obligations of the banks or broker-dealers that issue them, and an
Underlying Fund would be relying on the creditworthiness of such banks or broker-dealers and would have no rights under a participation note against the issuer of the underlying assets. In addition, participation notes may trade at a discount to the
value of the underlying securities or markets that they seek to replicate.
Low Exercise Price Options
From time to time, certain Underlying Funds may use non-standard warrants, including low exercise price warrants or low exercise price
options (LEPOs), to gain exposure to issuers in certain countries. LEPOs are different from standard warrants in that they do not give their holders the right to receive a security of the issuer upon exercise. Rather, LEPOs pay the
holder the difference in price of the underlying security between the date the LEPO was purchased and the date it is sold. Additionally, LEPOs entail the same risks as other over-the-counter derivatives. These include the risk that the counterparty
or issuer of the LEPO may not be able to fulfill its obligations, that the holder and counterparty or issuer may disagree as to the meaning or application of contractual terms, or that the instrument may not perform as expected. Additionally, while
LEPOs may be listed on an exchange, there is no guarantee that a liquid market will exist or that the counterparty or issuer of a LEPO will be willing to repurchase such instrument when the Underlying Fund wishes to sell it.
Optimized Portfolio as Listed Securities
Certain Underlying Funds may invest in optimized portfolio as listed securities (OPALS). OPALS represent an interest in a basket of securities of companies primarily located in a specific
country generally designed to track an index for that country. Investments in OPALS are subject to the same risks inherent in directly investing in foreign securities and also have the risk that they will not track the underlying index. In addition,
because the OPALS are not registered under applicable securities laws, they may only be sold to certain classes of investors, and it may be more difficult for the Underlying Fund to sell OPALS than other types of securities. However, the OPALS may
generally be exchanged with the issuer for the underlying securities, which may be more readily tradable.
Equity-Linked Structured Notes
Certain Underlying Funds may invest in equity-linked structured notes. Equity-linked structured notes are derivatives that
are specifically designed to combine the characteristics of one or more underlying securities and their equity derivatives in a single note form. The return and/or yield or income component may be based on the performance of the underlying equity
securities, an equity index, and/or option positions. Equity-linked structured notes are typically offered in limited transactions by financial institutions in either registered or non-registered form. An investment in equity-linked notes creates
exposure to the credit risk of the issuing financial institution, as well as to the market risk of the underlying securities. There is no guaranteed return of principal with these securities and the appreciation potential of these securities may be
limited by a maximum payment or call right. In certain cases, equity-linked notes may be more volatile and less liquid than less complex securities or other types of fixed-income securities. Such securities may exhibit price behavior that does not
correlate with other fixed-income securities.
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Commodity-Linked Notes
Certain Underlying Funds may invest in commodity-linked notes. Commodity-linked notes are a type of structured note. Commodity-linked notes are privately negotiated structured debt securities indexed to
the return of an index such as the Dow Jones-UBS Commodity Index Total Return, which is representative of the commodities market. They are available from a limited number of approved counterparties, and all invested amounts are exposed to the
dealers credit risk. Commodity-linked notes may be leveraged. For example, if the Underlying Fund invests $100 in a three-times leveraged commodity-linked note, it will exchange $100 principal with the dealer to obtain $300 exposure to the
commodities market because the value of the note will change by a magnitude of three for every percentage change (positive or negative) in the value of the underlying index. This means a $100 note would be worth $70 if the commodity index decreased
by 10 percent. Structured notes also are subject to counterparty risk.
Currency-Linked Notes
Certain Underlying Funds may invest in currency-linked notes. Currency-linked notes are short- or intermediate-term debt securities whose
value at maturity or interest payments are linked to the change in value of the U.S. dollar against the performance of a currency index or one or more foreign currencies. In some cases, these securities pay an amount at maturity based on a multiple
of the amount of a currencys change against the dollar. If they are sold prior to their maturity, their price may be higher or lower than their purchase price as a result of market conditions or changes in the credit quality of the issuer.
Non-Diversified Status
Each of the International Real Estate Securities Fund, Real Estate Securities Fund, Local Emerging Markets Debt Fund, Commodity Strategy Fund, Dynamic Allocation Fund, Global Income Fund and Emerging
Markets Debt Fund is non-diversified under the Act and may invest more of its assets in fewer issuers than diversified mutual funds. These Underlying Funds are subject only to certain federal tax diversification requirements.
Under federal tax laws, each of these Underlying Funds may, with respect to 50% of its total assets, invest up to 25% of its total assets in the securities of any issuer. With respect to the remaining 50% of their respective total assets,
(i) each Underlying Fund may not invest more than 5% of its total assets in the securities of any one issuer, and (ii) each Underlying Fund may not acquire more than 10% of the outstanding voting securities of any one issuer. These tests
apply at the end of each quarter of the taxable year and are subject to certain conditions and limitations under the Code. These tests do not apply to investments in United States Government Securities and regulated investment companies.
Portfolio Maturity
Dollar-weighted average maturity is derived by multiplying the value of each investment by the time remaining to its maturity, adding
these calculations, and then dividing the total by the value of an Underlying Fixed Income Funds portfolio. An obligations maturity is typically determined on a stated final maturity basis, although there are some exceptions. For
example, if an issuer of an instrument takes advantage of a maturity-shortening device, such as a call, refunding, or redemption provision, the date on which the instrument is expected to be called, refunded, or redeemed may be considered to be its
maturity date. There is no guarantee that the expected call, refund or redemption will occur and an Underlying Fixed Income Funds average maturity may lengthen beyond an investment advisers expectations should the expected call refund or
redemption not occur. Similarly, in calculating its dollar-weighted average maturity, an Underlying Fund may determine the maturity of a variable or floating rate obligation according to the interest rate reset date, or the date principal can be
recovered on demand, rather than the date of ultimate maturity.
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Portfolio Turnover
Each Underlying Fund may engage in active short-term trading to benefit from price disparities among different issues of securities or among the markets for equity or fixed income securities, or for other
reasons. As a result of active management, it is anticipated that the portfolio turnover rate of each Underlying Fund may vary greatly from year to year as well as within a particular year, and may be affected by changes in the holdings of specific
issuers, changes in country and currency weightings, cash requirements for redemption of shares and by requirements which enable the Underlying Funds to receive favorable tax treatment. The Underlying Funds are not restricted by policy with regard
to portfolio turnover and will make changes in their investment portfolio from time to time as business and economic conditions as well as market prices may dictate.
The Balanced Strategy Portfolios experienced an increased portfolio turnover rate in 2012 driven by the fact the Dynamic Allocation Fund was added as an investment at the end of the second quarter.
Additionally, the Balanced Strategy Portfolios benchmark was changed at the same time to be more global in nature, which resulted in slightly higher turnover in the Funds optimization process. The Income Strategies Portfolio also
experienced an increased portfolio turnover in 2012, as it went through a restructuring in mid-December 2012 in which the portfolio moved from a 40/60 balanced portfolio across core and satellite asset classes, to a new structure where it only
invested in income-generating satellite asset classes.
Private Investments in Public Equity
Certain of the Underlying Funds may purchase equity securities in a private placement that are issued by issuers who have outstanding,
publicly-traded equity securities of the same class (private investments in public equity or PIPES). Shares in PIPES generally are not registered with the SEC until after a certain time period from the date the private sale
is completed. This restricted period can last many months. Until the public registration process is completed, PIPES are restricted as to resale and the Underlying Fund cannot freely trade the securities. Generally such restrictions cause the PIPES
to be illiquid during this time. PIPES may contain provisions that the issuer will pay specified financial penalties to the holder if the issuer does not publicly register the restricted equity securities within a specified period of time, but there
is no assurance that the restricted equity securities will be publicly registered, or that the registration will remain in effect.
Restructured Investments
Included among the issuers of emerging country debt securities are entities organized and operated solely for the purpose of restructuring
the investment characteristics of various securities. These entities are often organized by investment banking firms which receive fees in connection with establishing each entity and arranging for the placement of its securities. This type of
restructuring involves the deposit with or purchase by an entity, such as a corporation or trust, or specified instruments, such as Brady Bonds, and the issuance by the entity of one or more classes of securities (Restructured
Investments) backed by, or representing interests in, the underlying instruments. The cash flow on the underlying instruments may be apportioned among the newly issued Restructured Investments to create securities with different investment
characteristics such as varying maturities, payment priorities or investment rate provisions. Because Restructured Investments of the type in which an Underlying Fund may invest typically involve no credit enhancement, their credit risk will
generally be equivalent to that of the underlying instruments.
Certain of the Underlying Funds are permitted to invest in a
class of Restructured Investments that is either subordinated or unsubordinated to the right of payment of another class. Subordinated Restructured Investments typically have higher yields and present greater risks than unsubordinated Restructured
Investments. Although an Underlying Funds purchases of subordinated Restructured Investments would have a similar economic effect to that of borrowing against the underlying securities, such purchases will not be deemed to be borrowing for
purposes of the limitations placed on the extent of an Underlying Funds assets that may be used for borrowing.
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Certain issuers of Restructured Investments may be deemed to be investment
companies as defined in the Act. As a result, an Underlying Funds investments in these Restructured Investments may be limited by the restrictions contained in the Act. Restructured Investments are typically sold in private placement
transactions, and there currently is no active trading market for most Restructured Investments.
Combined Transactions
Certain of the Underlying Funds may enter into multiple transactions, including multiple options transactions, multiple futures
transactions, multiple currency transactions (as applicable) (including forward currency contracts) and multiple interest rate and other swap transactions and any combination of futures, options, currency and swap transactions (component
transactions) as part of a single or combined strategy when, in the opinion of the Underlying Funds investment adviser, it is in the best interests of an Underlying Fund to do so. A combined transaction will usually contain elements of risk
that are present in each of its component transactions. Although combined transactions are normally entered into based on an Underlying Funds investment advisers judgment that the combined strategies will reduce risk or otherwise more
effectively achieve the desired portfolio management goal, it is possible that the combination will instead increase such risks or hinder achievement of the portfolio management objective.
Special Note Regarding Market Events
Events in the financial sector over
the past several years have resulted in reduced liquidity in credit and fixed income markets and in an unusually high degree of volatility in the financial markets, both domestically and internationally. While entire markets have been impacted,
issuers that have exposure to the real estate, mortgage and credit markets have been particularly affected. These events and the potential for continuing market turbulence may have an adverse effect on the Underlying Funds investments. It is
uncertain how long these conditions will continue.
The instability in the financial markets led the U.S. Government to take a
number of unprecedented actions designed to support certain financial institutions and certain segments of the financial markets. Federal, state, and foreign governments, regulatory agencies, and self -regulatory organizations may take actions that
affect the regulation of the instruments in which the Underlying Funds invest, or the issuers of such instruments, in ways that are unforeseeable. Such legislation or regulation could limit or preclude the Portfolios ability to achieve their
investment objectives.
Governments or their agencies may also acquire distressed assets from financial institutions and
acquire ownership interests in those institutions. The implications of government ownership and disposition of these assets are unclear, and such ownership or disposition may have positive or negative effects on the liquidity, valuation and
performance of the Underlying Funds portfolio holdings.
INVESTMENT RESTRICTIONS
The investment restrictions set forth below have been adopted by the Trust as fundamental policies that cannot be changed
without the affirmative vote of the holders of a majority of the outstanding voting securities (as defined in the Act) of the affected Portfolio. The investment objective of each Portfolio and all other investment policies or practices of each
Portfolio are considered by the Trust not to be fundamental and accordingly may be changed without shareholder approval. For purposes of the Act, a majority of the outstanding voting securities means the lesser of the vote of
(i) 67% or more of the shares of a Portfolio present at a meeting, if the holders of more than 50% of the outstanding shares of a Portfolio are present or represented by proxy, or (ii) more than 50% of the shares of a Portfolio. For
purposes of the following limitations, any limitation which involves a maximum percentage will not be considered violated unless an excess over the percentage occurs immediately after, and is caused by, an acquisition or encumbrance of securities or
assets of, or borrowings by, a Portfolio. With respect to the Portfolios fundamental investment restriction number (3) below, asset coverage of at least 300% (as defined in the Act), inclusive of any amounts borrowed, must be maintained
at all times.
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As a matter of fundamental policy, a Portfolio may not:
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(1)
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Make any investment inconsistent with the Portfolios classification as a diversified company under the Act;
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Each Portfolio is classified as a diversified open-end management company under the Act.
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(2)
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Invest 25% or more of its total assets in the securities of one or more issuers conducting their principal business activities in the same industry (excluding
investment companies and the U.S. Government or any of its agencies or instrumentalities). (For the purposes of this restriction, state and municipal governments and their agencies, authorities and instrumentalities are not deemed to be industries;
telephone companies are considered to be a separate industry from water, gas or electric utilities; personal credit finance companies and business credit finance companies are deemed to be separate industries; and wholly-owned finance companies are
considered to be in the industry of their parents if their activities are primarily related to financing the activities of their parents.) This restriction does not apply to investments in Municipal Securities which have been pre-refunded by the use
of obligations of the U.S. Government or any of its agencies or instrumentalities;
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(3)
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Borrow money, except (a) the Portfolio may borrow from banks (as defined in the Act) or through reverse repurchase agreements in amounts up to 33-1/3% of its total
assets (including the amount borrowed), (b) the Portfolio may, to the extent permitted by applicable law, borrow up to an additional 5% of its total assets for temporary purposes, (c) the Portfolio may obtain such short-term credits as may
be necessary for the clearance of purchases and sales of portfolio securities, (d) the Portfolio may purchase securities on margin to the extent permitted by applicable law and (e) the Portfolio may engage transactions in mortgage dollar
rolls which are accounted for as financings;
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The following interpretation applies to, but is not part of, this
fundamental policy: In determining whether a particular investment in portfolio instruments or participation in portfolio transactions is subject to this borrowing policy, the accounting treatment of such instrument or participation shall be
considered, but shall not by itself be determinative. Whether a particular instrument or transaction constitutes a borrowing shall be determined by the Board, after consideration of all of the relevant circumstances.
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(4)
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Make loans, except through (a) the purchase of debt obligations in accordance with the Portfolios investment objective and policies, (b) repurchase
agreements with banks, brokers, dealers and other financial institutions and (c) loans of securities as permitted by applicable law;
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(5)
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Underwrite securities issued by others, except to the extent that the sale of portfolio securities by the Portfolio may be deemed to be an underwriting;
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(6)
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Purchase, hold or deal in real estate, although a Portfolio may purchase and sell securities that are secured by real estate or interests therein, securities of real
estate investment trusts and mortgage-related securities and may hold and sell real estate acquired by a Portfolio as a result of the ownership of securities;
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B-92
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(7)
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Invest in commodities or commodity contracts, except that the Portfolio may invest in currency and financial instruments and contracts that are commodities or commodity
contracts; and
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(8)
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Issue senior securities to the extent such issuance would violate applicable law.
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Notwithstanding any other fundamental investment restriction or policy, each Portfolio may invest some or all of its assets in a single
open-end investment company or series thereof with substantially the same investment objective, restrictions and policies as the Portfolio.
In addition to the fundamental policies mentioned above, the Trustees have adopted the following non-fundamental policies which can be changed or amended by action of the Trustees without approval of
shareholders. Again, for purposes of the following limitations, any limitation which involves a maximum percentage shall not be considered violated unless an excess over the percentage occurs immediately after, and is caused by, an acquisition of
securities by the Fund.
A Portfolio may not:
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(a)
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Invest in companies for the purpose of exercising control or management (but this does not prevent a Portfolio from purchasing a controlling interest in one or more of
the Underlying Funds consistent with its investment objective and policies).
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(b)
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Invest more than 15% of the Portfolios net assets in illiquid investments, including illiquid repurchase agreements with a notice or demand period of more than
seven days, securities which are not readily marketable and restricted securities not eligible for resale pursuant to Rule 144A under the Securities Act of 1933 (the 1933 Act).
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(c)
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Purchase additional securities if the Portfolios borrowings (excluding covered mortgage dollar rolls) exceed 5% of its net assets.
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(d)
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Make short sales of securities, except short sales against the box.
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The Underlying Funds in which the Portfolios may invest have adopted certain investment restrictions which may be more or less restrictive than those listed above, thereby allowing a Portfolio to
participate in certain investment strategies indirectly that are prohibited under the fundamental and non-fundamental investment restrictions and policies listed above. The investment restrictions of these Underlying Funds are set forth in their
respective SAIs.