-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, KYZVQ0pgWrLRpa2o3NK4w9tcUg6SHI/m7WyCbLCNs2omsl2hb8z8WMfFwuIgnHnj pteepsaHpahlaML2CCQ08g== 0000950169-98-000952.txt : 19980819 0000950169-98-000952.hdr.sgml : 19980819 ACCESSION NUMBER: 0000950169-98-000952 CONFORMED SUBMISSION TYPE: 497 PUBLIC DOCUMENT COUNT: 1 FILED AS OF DATE: 19980818 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: LM INSTITUTIONAL FUND ADVISORS II INC CENTRAL INDEX KEY: 0001052864 STANDARD INDUSTRIAL CLASSIFICATION: UNKNOWN SIC - 0000 [0000] STATE OF INCORPORATION: MD FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 497 SEC ACT: SEC FILE NUMBER: 333-44423 FILM NUMBER: 98693647 BUSINESS ADDRESS: STREET 1: 100 LIGHT ST 29TH FLOOR CITY: BALTIMORE STATE: MD ZIP: 21202 BUSINESS PHONE: 4104542744 497 1 LM/INSTITUTIONAL FUND ADVISORS - -------------------------------------------------------------------------------- LM INSTITUTIONAL FUND ADVISORS JUNE 30, 1998 - -------------------------------------------------------------------------------- IMPORTANT INFORMATION! - -------------------------------------------------------------------------------- This prospectus offers shares in six no-load mutual funds comprising LM Institutional Fund Advisors II, Inc. (each a "Portfolio"). The Portfolios, which are intended to serve as investment vehicles for institutional investors such as pension plans, endowments and foundations, offer two classes of shares: the Institutional Class and the Financial Intermediary Class. This prospectus explains concisely what you should know before investing in the Portfolios. Please read it carefully and keep it for future reference. You can find more detailed information in the June 30, 1998 statement of additional information (the "SAI"), as amended from time to time. For a free copy of the SAI or other information, call Legg Mason Wood Walker, Incorporated ("LMWW") at 1-800-822-5544. The SAI has been filed with the Securities and Exchange Commission ("SEC") and is incorporated into this prospectus by reference. THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. FUND SHARES ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED BY, ANY FINANCIAL INSTITUTION, ARE NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD OR ANY OTHER AGENCY, AND INVOLVE RISK, INCLUDING THE POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED. PORTFOLIO PAGE - -------------------------------------------------------------------------------- Legg Mason Fund Adviser Large Cap Value Portfolio 10 Legg Mason Fund Adviser Mid Cap Value Portfolio 11 Brandywine Small Cap Value Portfolio 13 Batterymarch Emerging Markets Portfolio 14 Batterymarch International Equity Portfolio 15 Legg Mason Fund Adviser Total Return Portfolio 17 THE LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO AND THE LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO EACH MAY INVEST UP TO 35% OF THEIR TOTAL ASSETS IN LOWER-RATED BONDS, COMMONLY KNOWN AS "JUNK BONDS." INVESTMENTS OF THIS TYPE ARE SUBJECT TO A GREATER RISK OF LOSS OF PRINCIPAL AND NONPAYMENT OF INTEREST. INVESTORS SHOULD CAREFULLY ASSESS THE RISKS ASSOCIATED WITH AN INVESTMENT IN THESE PORTFOLIOS. FOR MORE INFORMATION CONCERNING THESE RISKS, SEE "COMMON INVESTMENT POLICIES AND TECHNIQUES; RISK FACTORS." [LM INSTITUTIONAL FUND ADVISORS LOGO HERE] - -------------------------------------------------------------------------------- TABLE OF CONTENTS - -------------------------------------------------------------------------------- PROSPECTUS SUMMARY 4 EXPENSE INFORMATION 6 Legg Mason Fund Adviser Large Cap Value Portfolio 6 Legg Mason Fund Adviser Mid Cap Value Portfolio 7 Brandywine Small Cap Value Portfolio 7 Batterymarch Emerging Markets Portfolio 8 Batterymarch International Equity Portfolio 8 Legg Mason Fund Adviser Total Return Portfolio 9 DESCRIPTION OF EACH PORTFOLIO AND ITS INVESTMENT STRATEGY 10 Legg Mason Fund Adviser Large Cap Value Portfolio 10 Legg Mason Fund Adviser Mid Cap Value Portfolio 11 Brandywine Small Cap Value Portfolio 13 Batterymarch Emerging Markets Portfolio 14 Batterymarch International Equity Portfolio 15 Legg Mason Fund Adviser Total Return Portfolio 17 COMMON INVESTMENT POLICIES AND TECHNIQUES; RISK FACTORS 18 Foreign Securities 18 Options and Futures 21 Foreign Currency Exchange Transactions 23 Preferred Stocks and Convertible Securities 24 Debt and Fixed Income Securities 25 Commercial Paper and Other Short-term Investments 29 Indexed Securities and Structured Notes 30 Forward Commitments 30 Restricted and Illiquid Securities 31 Securities of Other Investment Companies 32 Repurchase Agreements 32 Reverse Repurchase Agreements and Other Borrowing 32 Loans of Portfolio Securities 33 Portfolio Turnover 34 Alternative Investment Strategies 35 New Investment Products 35 Investment Policies 35 PERFORMANCE DATA 36 MANAGEMENT OF THE PORTFOLIOS 37 Board of Directors 37 Manager, Advisers 37 The Distributor 40 -2- Portfolio Transactions 40 Expenses 41 ORGANIZATION AND HISTORY 41 PURCHASE OF SHARES 42 Initial Investment 42 Additional Investments 43 Other Purchase Information 44 Retirement Plans 44 Account Registration Changes 45 DISTRIBUTION PLANS 45 REDEMPTION OF SHARES 45 Signature Guarantee 47 EXCHANGE PRIVILEGE 47 NET ASSET VALUE 48 DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS 49 TAX INFORMATION 50 APPENDICES APPENDIX A -- SECURITIES RATINGS A-1 APPENDIX B -- PRIOR PERFORMANCE OF ADVISERS' OTHER ACCOUNTS B-1 -3- - -------------------------------------------------------------------------------- PROSPECTUS SUMMARY - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- GENERAL - -------------------------------------------------------------------------------- LM Institutional Fund Advisors II, Inc. is an open-end management investment company ("mutual fund") comprised of a variety of separate investment portfolios. LM Institutional Fund Advisors II, Inc. was organized as a Maryland corporation on January 13, 1998. - -------------------------------------------------------------------------------- COMPARISON OF THE PORTFOLIOS - -------------------------------------------------------------------------------- The following chart provides general information about each Portfolio. It is qualified in its entirety by the more complete descriptions of the Portfolios appearing elsewhere in this prospectus.
- ---------------------------------- ------------------------------------ -------------------------------------------- Equity Portfolios Investment Objectives Primary Investments - ---------------------------------- ------------------------------------ -------------------------------------------- Legg Mason Fund Adviser Large Long-term growth of capital Large cap equity securities that are Cap Value Portfolio undervalued - ---------------------------------- ------------------------------------ -------------------------------------------- Legg Mason Fund Adviser Mid Cap Capital appreciation Mid cap equity securities that are Value Portfolio undervalued - ---------------------------------- ------------------------------------ -------------------------------------------- Brandywine Small Cap Value Long-term capital appreciation Small cap equity securities that are Portfolio undervalued - ---------------------------------- ------------------------------------ -------------------------------------------- Batterymarch Emerging Markets Long-term capital appreciation Emerging market equity securities Portfolio - ---------------------------------- ------------------------------------ -------------------------------------------- Batterymarch International Long-term total return Foreign equity securities Equity Portfolio - ---------------------------------- ------------------------------------ -------------------------------------------- Legg Mason Fund Adviser Total Capital appreciation and current Dividend-paying common stocks, debt Return Portfolio income in order to achieve an securities and securities convertible into attractive total investment return common stocks which, in the opinion of consistent with reasonable risk Legg Mason Fund Adviser, Inc., offer potential for attractive total return - ---------------------------------- ------------------------------------ --------------------------------------------
-4- - -------------------------------------------------------------------------------- MANAGER AND ADVISERS - -------------------------------------------------------------------------------- LM Institutional Advisors, Inc. (the "Manager") serves as the investment manager to each Portfolio. Legg Mason Fund Adviser, Inc. ("LMFA"") is the investment adviser to each of the Legg Mason Fund Adviser Large Cap Value Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the Legg Mason Fund Adviser Total Return Portfolio. Brandywine Asset Management, Inc. ("Brandywine") is the investment adviser to the Brandywine Small Cap Value Portfolio. Batterymarch Financial Management, Inc. ("Batterymarch") is the investment adviser to the Batterymarch Emerging Markets Portfolio and the Batterymarch International Equity Portfolio. Collectively LMFA, Brandywine and Batterymarch are referred to herein as "Advisers" and individually as the "Adviser." - -------------------------------------------------------------------------------- CERTAIN RISK FACTORS - -------------------------------------------------------------------------------- In addition to the typical risks of investing in securities, and in equity securities in particular, the Portfolios may be subject to certain special risks. These risks include the risks associated with investing in: foreign markets and the securities of foreign issuers (these risks increase to the extent a Portfolios invests in emerging markets); small cap securities (which tend to be less liquid, more difficult to value and more volatile); and fixed income securities (in particular, junk bonds). See "Description of Each Portfolio and Its Investment Strategy" and "Common Investment Policies and Techniques; Risk Factors" for more information about which Portfolios are likely to be subject to the foregoing risks and a description of other risks to which the Portfolios are subject. - -------------------------------------------------------------------------------- PURCHASE OF SHARES - -------------------------------------------------------------------------------- The Portfolios offer two classes of shares: Institutional Class and Financial Intermediary Class. Shares in the Financial Intermediary Class bear a 12b-1 fee. See "Distribution Plans" below for more information. The minimum initial investment is $1 million, subject to certain exceptions. See "Purchase of Shares." - -------------------------------------------------------------------------------- REDEMPTIONS AND EXCHANGES - -------------------------------------------------------------------------------- Shares of each Portfolio may be redeemed without cost at the relevant net asset value per share next determined after receipt of the redemption request. The redemption price may be more or less than the purchase price. See "Redemption of Shares." Shares of any Portfolio may be exchanged on the basis of relative net asset values for shares of the same class of any other Portfolio or of any portfolio of LM Institutional Fund Advisors I, Inc. See "Exchange Privilege." -5- - -------------------------------------------------------------------------------- DIVIDENDS AND DISTRIBUTIONS - -------------------------------------------------------------------------------- The Legg Mason Fund Adviser Large Cap Value Portfolio and the Legg Mason Total Return Portfolio declare and pay dividends quarterly out of their net investment income for that quarter. All other Portfolios declare and pay dividends annually out of their net investment income for that year. Distributions of net realized capital gains are made annually. All dividends and distributions will be reinvested automatically at net asset value in additional shares of the same class of the same Portfolio, unless cash payment is requested. See "Dividends and Distributions to Shareholders." - -------------------------------------------------------------------------------- EXPENSE INFORMATION - -------------------------------------------------------------------------------- Expenses are one of several factors to consider when investing. The following tables contain expense information about the Portfolios based on the amounts expected to be incurred in the current fiscal year. The examples show the cumulative expenses attributable to a hypothetical $1,000 investment over specified periods, assuming 5% annual return and redemption at the end of each period. The paragraph following the tables and examples contains additional information about the tables, the examples and the Portfolios' expenses. - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $ 8 TRANSACTION EXPENSES None None 3 years $24 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .50% .50% (REFLECTING EXPENSE LIMITATION) 12b-1 Fees None .25% 1 year $10 Other Expenses .25% .25% 3 years $32 ---- ---- Total Operating Expenses .75% 1.00% ==== ===== (REFLECTING EXPENSE LIMITATION)
-6- - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $ 8 TRANSACTION EXPENSES None None 3 years $24 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .50% .50% (REFLECTING EXPENSE LIMITATION) 12b-1 Fees None .25% 1 year $10 Other Expenses .25% .25% 3 years $32 ---- ---- Total Operating Expenses .75% 1.00% ==== ===== (REFLECTING EXPENSE LIMITATION)
- -------------------------------------------------------------------------------- BRANDYWINE SMALL CAP VALUE PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $ 9 TRANSACTION EXPENSES None None 3 years $27 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .60% .60% (REFLECTING EXPENSE LIMITATION) 12b-1 Fees None .25% 1 year $11 Other Expenses .25% .25% 3 years $35 ---- ---- Total Operating Expenses .85% 1.10% ==== ===== (REFLECTING EXPENSE LIMITATION)
-7- - -------------------------------------------------------------------------------- BATTERYMARCH EMERGING MARKETS PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $15 TRANSACTION EXPENSES None None 3 years $46 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .60% .60% (REFLECTING EXPENSE LIMITATION) 1 year $17 12b-1 Fees None .25% 3 years $54 Other Expenses .85% .85% ---- ---- Total Operating Expenses 1.45% 1.70% ===== ===== (REFLECTING EXPENSE LIMITATION)
- -------------------------------------------------------------------------------- BATTERYMARCH INTERNATIONAL EQUITY PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $10 TRANSACTION EXPENSES None None 3 years $32 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .60% .60% (REFLECTING EXPENSE LIMITATION) 12b-1 Fees None .25% 1 year $13 Other Expenses .40% .40% 3 years $40 ---- ---- Total Operating Expenses 1.00% 1.25% ===== ===== (REFLECTING EXPENSE LIMITATION)
-8- - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER TOTAL RETURN PORTFOLIO - --------------------------------------------------------------------------------
Institutional Financial Institutional Class Example Class Intermediary Class --------------------------- -------------- ------------------- SHAREHOLDER 1 year $ 8 TRANSACTION EXPENSES None None 3 years $24 ANNUAL FUND OPERATING EXPENSES (AS A PERCENTAGE OF Financial Intermediary AVERAGE NET ASSETS) Class Example ---------------------- Management Fees .50% .50% (REFLECTING EXPENSE LIMITATION) 1 year $10 12b-1 Fees None .25% 3 years $32 Other Expenses .25% .25% ---- ---- Total Operating Expenses .75% 1.00% ==== ===== (REFLECTING EXPENSE LIMITATION)
The tables are provided to help you understand the expenses of investing in a Portfolio and your share of the Portfolio's operating expenses. The management fees shown in the table for each Portfolio reflect voluntary expense limitations currently in effect which are expected to continue for the current fiscal year. In the absence of such limitations, management fees and total operating expenses for each Portfolio would be:
TOTAL OPERATING MANAGEMENT FEE EXPENSES PORTFOLIO CLASS WITHOUT LIMITATION WITHOUT LIMITATION --------- ----- ------------------ ------------------ Legg Mason Fund Adviser Large Cap Value Institutional 0.60% 0.85% Portfolio Financial Intermediary 0.60% 1.10% Legg Mason Fund Adviser Mid Cap Value Institutional 0.60% 0.85% Portfolio Financial Intermediary 0.60% 1.10% Brandywine Small Cap Value Portfolio Institutional 0.65% 0.90% Financial Intermediary 0.65% 1.15% Batterymarch Emerging Markets Portfolio Institutional 0.65% 1.50% Financial Intermediary 0.65% 1.75% Batterymarch International Equity Portfolio Institutional 0.65% 1.05% Financial Intermediary 0.65% 1.30% Legg Mason Fund Adviser Total Return Portfolio Institutional 0.60% 0.85% Financial Intermediary 0.60% 1.10%
-9- "Other expenses" are based on estimated amounts for the current fiscal year. The 12b-1 fees shown in the tables reflect the amount to which the Directors have currently limited payments under the Portfolios' Distribution Plans. Pursuant to each Portfolio's Distribution Plan, the Directors may increase the 12b-1 fees to 0.40% of average net assets without shareholder approval. The examples do not represent past or future expense levels. Actual expenses may be greater or less than those shown. Federal regulations require the examples to assume a 5% annual return, but actual annual returns will vary. As a result of the 12b-1 fees, long-term shareholders of the Financial Intermediary Class may pay more than the economic equivalent of the maximum sales charge permitted by the National Association of Securities Dealers, Inc. - -------------------------------------------------------------------------------- DESCRIPTION OF EACH PORTFOLIO AND ITS INVESTMENT STRATEGY - -------------------------------------------------------------------------------- The investment objective and policies for each Portfolio are stated below. The Portfolios are not intended to be a complete investment program, and there is no assurance that any Portfolio will achieve its investment objective. Please see "Common Investment Policies and Techniques; Risk Factors" below and the SAI for additional information concerning the Portfolios' investment programs and the risks associated with investing in the Portfolios. Each of the Portfolios may from time to time depart from the policies described below for temporary "defensive" purposes. See "Common Investment Policies and Techniques; Risk Factors -- Alternative Investment Strategies" for more information. - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO - -------------------------------------------------------------------------------- Adviser: LMFA - -------------------------------------------------------------------------------- Objective: long-term growth of capital - -------------------------------------------------------------------------------- Under normal market conditions, the Portfolio will invest at least 65% of its total assets in equity securities that LMFA believes are undervalued in relation to the long-term earning power or asset value of the issuer and therefore offer above average potential for capital appreciation. The Portfolio will also invest at least 65% of its total assets in "large cap" equity securities. Large cap equity securities are securities of companies that, at the time of purchase, have an equity market capitalization of more than $5 billion. Equity securities include common stock, preferred stock, securities convertible into common stock, rights and warrants to acquire such securities and substantially similar forms of equity with comparable risk characteristics. The Portfolio may invest in securities that pay no dividends or interest, and current dividend income is not a prerequisite in the selection of securities. Securities may be undervalued because of many factors, including not being closely followed by investors, being out of favor with investors, or because the issuer is experiencing -10- unusual circumstances suggesting the possibility that the market value of the securities may increase. Other factors that may contribute to a security being undervalued include an overall market decline, poor economic conditions, tax-loss selling and actual or anticipated unfavorable developments affecting the issuer. LMFA believes that the securities of sound, well-managed companies that may be undervalued for these reasons are likely to provide a greater opportunity for long-term growth of capital than securities with prices that appear to reflect anticipated favorable developments and that are therefore subject to correction should any unfavorable developments occur. Equity securities are normally the Portfolio's main investments. However, the Portfolio may invest up to 35% of its total assets in any type of debt or fixed income security, including securities that, at the time of purchase, are not rated investment grade by a nationally recognized statistical rating organization (an "NRSRO"), if LMFA believes they would help achieve the Portfolio's investment objective. Lower-rated securities (and unrated securities determined by LMFA to be of comparable quality) are considered to be primarily speculative and may be in default. The Portfolio may also invest up to 25% of its total assets in securities principally traded in foreign markets, engage in foreign currency exchange transactions and transactions in futures contracts and options, enter into repurchase agreements, purchase shares of other investment companies, invest in real estate investment trusts ("REITs"), purchase restricted and illiquid securities, loan its portfolio securities, borrow money for temporary or emergency purposes, and purchase or sell securities on a forward commitment basis. See "Common Investment Policies and Techniques; Risk Factors" below for more information. The Portfolio may also hold a portion of its assets in cash or money market instruments. - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO - -------------------------------------------------------------------------------- Adviser: LMFA - -------------------------------------------------------------------------------- Objective: capital appreciation - -------------------------------------------------------------------------------- Under normal market conditions, the Portfolio will invest at least 65% of its total assets in equity securities of companies that have an equity market capitalization at the time of purchase within the range used from time to time for inclusion in the S&P Midcap 400 Index (currently, approximately $500 million to $5 billion). Equity securities include common stock, preferred stock, securities convertible into common stock, rights and warrants to acquire such securities and substantially similar forms of equity with comparable risk characteristics. Issuers in which the Portfolio will invest will typically exhibit one or more of the following characteristics: -11- 1. The companies generally are not closely followed by, or are out of favor with, investors, and appear to be undervalued in relation to their long-term earning power or asset values. 2. The companies are experiencing unusual and possibly non-repetitive developments which, in LMFA's opinion, may cause the market values of the securities to increase. Such developments may include: (a) a sale or termination of an unprofitable part of the company's business; (b) a change in the company's management or in management's philosophy; (c) a basic change in the industry in which the company operates; (d) the introduction of new products or technologies; or (e) the prospect or effect of acquisition or merger activities. 3. The companies are involved in actual or anticipated reorganizations or restructurings under the Bankruptcy Code. No more than 20% of the Portfolio's total assets at the time of purchase may be invested in such securities. Investments in securities with such characteristics may involve greater risks of loss than investments in securities of larger, well-established companies which typically have a history of consistent operating patterns and greater financial resources. In addition, the prices of securities of mid-sized companies generally are more volatile than those of larger companies, the securities of mid-sized companies generally are less liquid and may, at times, be more difficult to value, and mid-sized companies generally are more likely to be adversely affected by poor economic or market conditions. Investments in securities of companies involved in actual or anticipated reorganizations or restructurings involve special risks, including difficulty in obtaining information as to the financial condition of such issuers and the fact that the market prices of such securities are subject to sudden and erratic market movements and above-average price volatility. Subject to the 65% test described above, the Portfolio may also invest in larger, more highly capitalized companies when circumstances warrant such investments. The Portfolio may invest in securities that pay no dividends or interest, and current dividend income is not a prerequisite in the selection of securities. Equity securities are normally the Portfolio's main investments. However, the Portfolio may invest up to 35% of its total assets in any type of debt or fixed income security, including securities that, at the time of purchase, are not rated investment grade by an NRSRO, if LMFA believes they would help achieve the Portfolio's investment objective. Lower-rated securities (and unrated securities determined by LMFA to be of comparable quality) are considered to be primarily speculative and may be in default. The Portfolio may also invest up to 25% of its total assets in securities principally traded in foreign markets, engage in foreign currency exchange transactions and transactions in futures contracts and -12- options, purchase restricted and illiquid securities, enter into repurchase agreements, purchase shares of other investment companies, invest in REITs, loan its portfolio securities, borrow money for temporary or emergency purposes, and purchase or sell securities on a forward commitment basis. See "Common Investment Policies and Techniques; Risk Factors" below for more information. The Portfolio may also hold a portion of its assets in cash or money market instruments. - -------------------------------------------------------------------------------- BRANDYWINE SMALL CAP VALUE PORTFOLIO - -------------------------------------------------------------------------------- Adviser: Brandywine - -------------------------------------------------------------------------------- Objective: long-term capital appreciation - -------------------------------------------------------------------------------- Under normal market conditions, the Portfolio will invest at least 65% of its total assets in equity securities of "small cap" companies (generally defined as companies at the time of initial investment with an equity market capitalization not in excess of the 40th percentile of the capitalization of issuers traded on the New York Stock Exchange). A company that was a "small cap" company at the time of the Portfolio's initial investment will continue to be treated as such for purposes of the 65% test, even if the equity capitalization exceeds the 40th percentile at the time of subsequent investment. Equity securities include common stock, preferred stock, securities convertible into common stock, rights and warrants to acquire such securities and substantially similar forms of equity with comparable risk characteristics. Securities of "small cap" companies entail special risks. Such companies often have limited operating histories and may have more restricted product lines or more limited financial resources than larger, more established companies. For these and other reasons, they may be more severely affected by economic downturns or other adverse developments than are larger, more established companies. Securities of "small cap" companies may be traded "over-the-counter" and often trade less frequently and in more limited volume, may be subject to greater volatility and may be more difficult to value than securities of larger, more established companies. "Small cap" companies are often involved in actual or anticipated reorganizations or restructurings, which involve special risks, including difficulty in obtaining information as to the financial condition of such companies and the fact that market prices of such companies' securities are subject to sudden and erratic price volatility. Although the Portfolio expects to remain substantially fully invested in equity securities, the Portfolio may invest in cash and money market instruments, including repurchase agreements. For temporary defensive purposes, the Portfolio may also invest in investment grade debt and fixed income investments. The Portfolio may also engage in reverse repurchase agreement transactions and other borrowings, purchase restricted and illiquid securities, loan its portfolio securities, and invest in securities of other investment -13- companies. For more information, see "Common Investment Policies and Techniques; Risk Factors." - -------------------------------------------------------------------------------- BATTERYMARCH EMERGING MARKETS PORTFOLIO - -------------------------------------------------------------------------------- Adviser: Batterymarch - -------------------------------------------------------------------------------- Objective: long-term capital appreciation - -------------------------------------------------------------------------------- Under normal market conditions, the Portfolio will invest substantially all of its assets, but in any event at least 65% of its total assets, in "emerging market" equity securities. Emerging markets include any country: (i) having an "emerging stock market" or considered a "frontier market" as defined by the International Finance Corporation; (ii) with low- to middle-income economies according to the International Bank for Reconstruction and Development ("World Bank"); (iii) listed in World Bank publications as developing; or (iv) included in the Morgan Stanley Capital International (MSCI) Emerging Markets published index. Emerging market equity securities include common stock, preferred stock, securities convertible into common stock, rights and warrants to acquire such securities and substantially similar forms of equity with comparable risk characteristics that are: (1) publicly traded on emerging market stock exchanges, or whose principal trading market is over-the-counter (i.e., off-exchange) in an emerging market country; (2) securities denominated in any currency if issued by companies to finance operations in an emerging market country; (3) securities of companies that derive a substantial portion (i.e., in excess of 50%) of their total revenues from goods or services produced in, or sales made in, emerging market countries; (4) securities of companies organized under the laws of an emerging market country or region, which are publicly traded in securities markets elsewhere; or (5) American depositary receipts ("ADRs") (or similar instruments) with respect to the foregoing. Investing in foreign issuers, and in particular in emerging market equity securities, involves special risks. See "Common Investment Policies and Techniques; Risk Factors -- Foreign Securities." The Portfolio intends to invest in Asia, Latin America, the Indian Sub-continent, Southern and Eastern Europe, the Middle East, and Africa, although it may not invest in all these markets at all times and may not invest in any particular market when it deems such an investment to be inadvisable. The Portfolio will normally diversify its investments among a number of different countries, although more than 25% of its total assets may be invested in securities denominated in a single currency. The concentration of the Portfolio's assets in this manner will increase the Portfolio's exposure to adverse developments affecting the value of that currency, subjecting the Portfolio to greater risk. For more information concerning the risks associated with investments denominated in foreign currencies, see "Common Investment Policies and Techniques; Risk Factors -- Foreign Securities." An issuer of -14- securities purchased by the Portfolio may be domiciled in a country other than the country in whose currency the securities are denominated. Assets not invested in emerging market equity securities may be invested in any combination of debt securities or equity securities, including securities of issuers located in developed countries, cash, money market instruments and repurchase agreements. In addition, the Portfolio may invest up to 10% of its total assets in lower-rated fixed income securities (i.e., securities rated below investment grade at the time of purchase or unrated securities of comparable quality at the time of purchase). Lower-rated securities (and unrated securities determined by Batterymarch to be of comparable quality) are considered to be primarily speculative and may be in default. The Portfolio may also invest in securities of other investment companies, invest in indexed securities and structured notes, purchase restricted and illiquid securities, borrow money for temporary or emergency purposes, engage in futures and options transactions, and engage in foreign currency exchange transactions. For more information, see "Common Investment Policies and Techniques; Risk Factors." Although the Portfolio has the ability to hedge its foreign currency risk, appropriate hedging instruments are not available with respect to most emerging market currencies, and it is therefore unlikely that the Portfolio will be able to employ such hedging strategies to a significant extent, if at all. - -------------------------------------------------------------------------------- BATTERYMARCH INTERNATIONAL EQUITY PORTFOLIO - -------------------------------------------------------------------------------- Adviser: Batterymarch - -------------------------------------------------------------------------------- Objective: long-term total return - -------------------------------------------------------------------------------- Under normal market conditions, the Portfolio will invest substantially all of its assets, but in any event at least 65% of its total assets, in equity securities of issuers located in at least three different countries other than the United States. Equity securities include common stock, preferred stock, securities convertible into common stock, rights and warrants to acquire such securities and substantially similar forms of equity with comparable risk characteristics. When selecting securities for the Portfolio, Batterymarch examines securities from over 20 international stock markets, with emphasis on several of the largest -- Japan, the United Kingdom, France, Canada and Germany. Securities are chosen using Batterymarch's model for identifying securities it believes to be undervalued. The weighting of the Portfolio's assets among individual countries will reflect an assessment of the attractiveness of individual securities. The Portfolio also may invest up to 35% of its total assets in emerging market equity securities (as defined above under "Batterymarch Emerging Markets Portfolio"). Investing in foreign issuers, and in particular in emerging market equity securities, involves special risks. See "Common Investment Policies and Techniques; Risk Factors -- Foreign Securities." -15- The Portfolio's investments will normally be diversified across a broad range of industries and across a number of countries, consistent with the objective of long-term total return. However, the Portfolio currently expects that it may invest more than 25% of its total assets in securities of Japanese and United Kingdom ("UK") issuers. As a result, the value of its shares will be especially affected by Japanese and UK political, economic, market and exchange rate conditions, and may fluctuate more widely than the value of shares of other equity funds. The Japanese economy is dependent to a significant extent on foreign trade, and the relationships between Japan and its trading partners and between the yen and other currencies are expected to have a significant impact on the Japanese economy generally and therefore are expected to influence the Portfolio's performance. Japan has in the past experienced difficult relations with its trading partners, particularly the United States. It is possible that trade sanctions or other protectionist measures could impact the Japanese economy and markets, and have an adverse effect on the value of the Portfolio's assets, in both the short and long term. Japan is currently experiencing a recession, including a decline in real estate values, that has adversely affected the balance sheets of many financial institutions. Certain Japanese financial institutions have experienced extreme financial difficulties, including bankruptcy. On the other hand, a strong Japanese currency may adversely affect industries engaged substantially in export. Japan's economy is heavily dependent on foreign oil. Japan is located in a seismically active area, and severe earthquakes may damage important elements of the country's infrastructure. Japanese economic prospects may be affected by the economic, political and military situations of its neighbors, notably North and South Korea, Thailand, China, and Russia. The UK is the world's sixth largest economy and is home to one of the oldest, most established, and most active stock markets. Trade remains a very key component of the UK economy, with over $520 billion in goods passing through its borders last year. Strong domestic sectors are services, natural energy resources, and heavy industry, including steel, autos, and machinery. Imports generally emphasize food and manufacturing components. Their trading partners are predominately established market economies, such as the US, Japan, and other member countries of the European Union. The UK, via the North Sea, also has substantial petroleum resources. Healthy relations with its trading partners is an important factor in determining the UK's economic outlook. In addition, the UK's nonparticipation in the European Monetary Union could have a negative impact on certain UK issuers and on the UK's short term and long term economic prospects. Although the Portfolio expects to remain substantially fully invested in equity securities, the Portfolio may invest in any type of debt or fixed income security (including securities issued by U.S. issuers), cash and money market instruments, including repurchase agreements. The Portfolio may invest up to 5% of its total assets in lower-rated fixed income securities (i.e., securities rated below investment grade at the time of purchase or unrated securities of comparable quality at the time of purchase). Lower-rated securities (and unrated -16- securities determined by Batterymarch to be of comparable quality) are considered to be primarily speculative and may be in default. The Portfolio may also purchase restricted and illiquid securities, invest in securities of other investment companies, invest in indexed securities and structured notes, borrow money for temporary or emergency purposes, engage in futures and options transactions, and engage in foreign currency exchange transactions. For more information, see "Common Investment Policies and Techniques; Risk Factors." - -------------------------------------------------------------------------------- LEGG MASON FUND ADVISER TOTAL RETURN PORTFOLIO - -------------------------------------------------------------------------------- Adviser: LMFA - -------------------------------------------------------------------------------- Objective: capital appreciation and current income in order to achieve an attractive total investment return consistent with reasonable risk
- -------------------------------------------------------------------------------- The Portfolio attempts to meet its objective by investing primarily in dividend-paying common stocks, debt securities and securities convertible into common stocks which, in the opinion of LMFA, offer potential for attractive total return. The Portfolio also invests in common stocks and securities convertible into common stocks which do not pay current dividends but which, in LMFA's opinion, offer prospects for capital appreciation or future income. The Portfolio may invest in debt securities of any maturity of both foreign and domestic issuers without regard to a percentage limit or any limits on credit quality. LMFA currently anticipates that under normal market conditions the Portfolio will invest no more than 50% of its total assets in intermediate-term and long-term debt securities, and no more than 5% of its total assets in the aggregate in debt securities not rated investment grade, i.e., not rated at least BBB by S&P or Baa by Moody's, or in unrated securities if determined by LMFA to be of comparable quality. Lower-rated securities (and unrated securities determined by LMFA to be of comparable quality) are considered to be primarily speculative and may be in default. For more information, see "Common Investment Policies and Techniques; Risk Factors -- Debt and Fixed Income Securities -- Lower-Rated Securities." The Portfolio may also invest up to 25% of its total assets in securities principally traded in foreign markets, purchase preferred stock, engage in foreign currency exchange transactions and transactions in futures contracts and options, enter into repurchase agreements, purchase shares of other investment companies, invest in REITs, purchase restricted and illiquid securities, loan its portfolio securities, borrow money for temporary or emergency purposes, and purchase or sell securities on a forward commitment basis. For more information, see "Common Investment Policies and Techniques; Risk Factors." The Portfolio may also hold a portion of its assets in cash or money market instruments. -17- - -------------------------------------------------------------------------------- COMMON INVESTMENT POLICIES AND TECHNIQUES; RISK FACTORS - -------------------------------------------------------------------------------- Some or all of the Portfolios may engage in the following investment practices and techniques to the extent described in this Prospectus. See the SAI for a further description of the uses, risks and costs of these practices. - -------------------------------------------------------------------------------- FOREIGN SECURITIES - -------------------------------------------------------------------------------- Investing in the securities of issuers in any foreign country, or in securities denominated in a foreign currency, involves special risks and considerations not typically associated with investing in U.S. issuers or U.S. dollar-denominated securities. These include risks resulting from differences in accounting, auditing and financial reporting standards; lower liquidity than U.S. securities; the possibility of nationalization, expropriation or confiscatory taxation; adverse changes in investment or exchange control regulations (which may include suspension of the ability to transfer currency out of a country); and political instability. In many cases, there is less publicly available information concerning foreign issuers than is available concerning U.S. issuers. Additionally, purchases and sales of foreign securities and dividends and interest payable on those securities may be subject to foreign taxes and tax withholding. Foreign securities generally exhibit greater price volatility and a greater risk of illiquidity. To the extent a Portfolio purchases securities denominated in a foreign currency, a change in the value of any such currency against the U.S. dollar will result in a change in the U.S. dollar value of the Portfolio's assets and the Portfolio's income available for distribution. In addition, a Portfolio is required to compute and distribute its income in U.S. dollars. Therefore, if the exchange rate for a foreign currency declines after a Portfolio's income has been earned and translated into U.S. dollars (but before payment), the Portfolio could be required to liquidate portfolio securities to make such distributions. Similarly, if an exchange rate declines between the time a Portfolio incurs expenses in U.S. dollars and the time such expenses are paid, the amount of such currency required to be converted into U.S. dollars in order to pay such expenses in U.S. dollars will be greater than the equivalent amount in any such currency of such expenses at the time they were incurred. The relative performance of various countries' securities markets historically has reflected wide variations relating to the unique characteristics of each country's economy. Individual foreign economies may differ favorably or unfavorably from the U.S. economy in such respects as growth of gross domestic product, rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments position. Bank deposit insurance, if any, may be subject to widely varying regulations and limits in foreign countries. -18- Foreign securities purchased by a Portfolio may be listed on foreign exchanges, traded over-the-counter or purchased in private transactions. Transactions on foreign exchanges are usually subject to mark-ups or commissions higher than negotiated commissions on U.S. transactions. There is less government supervision and regulation of exchanges and brokers in many foreign countries than in the United States. Additional costs associated with an investment in foreign securities may include higher custodial fees than apply to domestic custodial arrangements and transaction costs of foreign currency conversions. Certain of the foregoing risks may also apply to some extent to securities of U.S. issuers that are denominated in foreign currencies or that are traded in foreign markets, or to securities of U.S. issuers having significant foreign operations. EMERGING MARKET ISSUERS. The risks of foreign investment, described above, are greater for investments in emerging market issuers, and such investments should therefore be considered speculative. Debt securities of governmental and other issuers in emerging market countries will typically be rated below investment grade or be of comparable quality. For more information about lower-rated securities, see "Debt and Fixed Income Securities -- Lower-Rated Securities" below. Investors are strongly advised to consider carefully the special risks involved in emerging markets, which are in addition to the usual risks of investing in developed markets around the world. Emerging market countries may experience substantial rates of inflation or deflation. Inflation, deflation and rapid fluctuations in such rates have had, and may continue to have, very negative effects on the economies and securities markets of certain emerging market countries. While some emerging market countries have sought to develop a number of corrective mechanisms to reduce inflation or deflation or mitigate their effects, inflation and deflation may continue to have significant effects both on emerging market countries and their securities markets. In addition, many of the currencies of emerging market countries have experienced steady devaluations relative to the U.S. dollar, and major devaluations have occurred in certain countries. Economies in emerging market countries generally are dependent heavily upon international trade and, accordingly, have been and may continue to be affected adversely by economic conditions, trade barriers, exchange controls, managed adjustments in relative currency values and other protectionist measures imposed or negotiated by the countries with which they trade. Because of the high levels of foreign-denominated debt owed by many emerging market countries, fluctuating exchange rates can significantly affect the debt service obligations of those countries. This could, in turn, affect local interest rates, profit margins and exports, which are a major source of foreign exchange earnings. Hedging instruments are not typically available with respect to investments in emerging market countries and, to the extent they are available, the ongoing and indeterminate nature of the foregoing risks (and the -19- costs associated with hedging transactions) would make it virtually impossible to hedge effectively against such risks. To the extent an emerging market country faces a liquidity crisis with respect to its foreign exchange reserves, it may increase restrictions on the outflow of any foreign exchange. Repatriation is ultimately dependent on the ability of a Portfolio to liquidate its investments and convert the local currency proceeds obtained from such liquidation into U.S. dollars. Where this conversion must be done through official channels (usually the central bank or certain authorized commercial banks), the ability to obtain U.S. dollars is dependent on the supply of such U.S. dollars through those channels and, if available, upon the willingness of those channels to allocate those U.S. dollars to the Portfolio. In such a case, a Portfolio's ability to obtain U.S. dollars may be adversely affected by any increased restrictions imposed on the outflow of foreign exchange. If the Portfolio is unable to repatriate any amounts due to exchange controls, it may be required to accept an obligation payable at some future date by the central bank or other governmental entity of the jurisdiction involved. If such conversion can legally be done outside official channels, either directly or indirectly, a Portfolio's ability to obtain U.S. dollars may not be affected as much by any increased restrictions except to the extent of the price which may be required to be paid for the U.S. dollars. Many emerging market countries have little experience with the corporate form of business organization, and may not have well developed corporation and business laws or concepts of fiduciary duty in the business context. The securities markets of emerging market countries are substantially smaller, less developed, less liquid and more volatile than the securities markets of the U.S. and other more developed countries. Disclosure and regulatory standards in many respects are less stringent than in the U.S. and other major markets. There also may be a lower level of monitoring and regulation of an emerging market country's securities markets and the activities of investors in such markets; enforcement of existing regulations has been extremely limited. Some emerging markets have different settlement and clearance procedures, which, for example, may not call for delivery of a security to a Portfolio until well after the Portfolio has paid for such security. 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. The inability of a Portfolio to make intended securities purchases due to settlement problems could cause that Portfolio to miss attractive investment opportunities. Inability to dispose of a portfolio security caused by settlement problems could result either in losses to the Portfolio due to subsequent declines in value of the portfolio security or, if the Portfolio has entered into a contract to sell the security, in possible liability to the purchaser. The risk also exists that an emergency situation may arise in one or more emerging market countries as a result of which trading of securities may cease or may be substantially -20- curtailed and prices for a Portfolio's portfolio securities in such markets may not be readily available. SOVEREIGN DEBT SECURITIES. Sovereign debt is subject to risks in addition to those relating to foreign investments generally. As a sovereign entity, the issuing government may be immune from lawsuits in the event of its failure or refusal to pay the obligations when due. The debtor's willingness or ability to repay 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 sovereign debtor's policy toward principal international lenders and the political constraints to which the sovereign debtor may be subject. Sovereign debtors also may be dependent on expected disbursements from foreign governments or multinational agencies, the country's access to trade and other international credits, and the country's balance of trade. Some emerging market sovereign debtors have in the past rescheduled their debt payments or declared moratoria on payments, and similar occurrences may happen in the future. DEPOSITARY RECEIPTS. American Depositary Receipts, or "ADRs," are securities issued by a U.S. depositary (usually a bank) and represent a specified quantity of underlying non-U.S. securities on deposit with a custodian bank as collateral. A foreign issuer of the security underlying an ADR is generally not subject to the same reporting requirements in the United States as a domestic issuer. Accordingly, the information available to a U.S. investor will be limited to the information the foreign issuer is required to disclose in its own country and the market value of an ADR may not reflect undisclosed material information concerning the issuer or the underlying security. ADRs may also be subject to exchange rate risks if the underlying securities are denominated in foreign currency. The Portfolios may also invest in similar non-U.S. instruments issued by foreign banks or trust companies such as "GDRs" and "EDRs." For purposes of its investment policies, each Portfolio will treat ADRs and similar instruments as equivalent to investment in the underlying securities. - -------------------------------------------------------------------------------- OPTIONS AND FUTURES - -------------------------------------------------------------------------------- A futures contract is an agreement between the parties to buy or sell a specified amount of one or more securities, units of an index or currencies at a specified price and date; futures contracts are generally closed out by the parties in advance of that date for a cash settlement. Under an option contract, one party generally has the right to require the other to buy or sell a specified amount of securities, units of an index, currencies or futures contracts, and may exercise that right if the market price of the underlying instrument moves in a direction advantageous to the holder of the option. Options with respect to securities indices typically call for cash settlement instead of delivery of the securities that comprise the index. Options and futures are generally considered to be "derivatives." -21- The Portfolios may buy and sell (i.e., write) options and futures for hedging purposes and, to the extent permitted by applicable law, for non-hedging purposes, such as to earn additional income. Futures contracts and options may also be used for other non-hedging purposes, such as to simulate full investment in underlying securities while retaining a cash balance for Portfolio management purposes, as a substitute for direct investment in a security, to facilitate trading, to reduce transaction costs, or to seek higher investment returns when a futures contract or option is priced more attractively than the underlying security or index. The use of options and futures involves certain investment risks and transaction costs. These risks include (1) difficulty in predicting movements in the prices of individual securities or an index, fluctuations in the general securities markets or in market sectors and movements in interest rates and currency markets; (2) imperfect correlation, or no correlation at all, between movements in the price of options and futures contracts, movements in the price of the underlying instruments, index or currencies and movements in the securities or currencies that are the subject of a hedge; (3) the fact that skills needed to use these instruments are different from those needed to select a Portfolio's other investments; (4) the possible lack of a liquid secondary market for any particular instrument at any particular time; (5) the possibility that the use of cover or segregation involving a large percentage of a Portfolio's assets could impede portfolio management or the Portfolio's ability to meet redemption requests or other short-term obligations; and (6) the fact that, although use of these instruments for hedging purposes can reduce the risk of loss, they can also reduce the opportunity for gain, or even result in losses, by offsetting favorable price movements in hedged investments. There can be no assurance that a Portfolio's use of futures contracts or options will be successful. Moreover, in the event that an anticipated change in the price of the instruments, index or currencies that are the subject of the strategy does not occur, the Portfolio might have been in a better position had it not used that strategy at all. Options and futures traded on U.S. or other exchanges may be subject to position and daily fluctuation limits, which may limit the ability of a Portfolio to reduce risk using such options and futures and may limit their liquidity. The use of options and futures contracts for speculative purposes, e.g., to enhance income or to increase a Portfolio's exposure to a particular security or type of security or a particular foreign currency, subjects the Portfolio to additional risk. The use of options and futures to hedge an anticipated purchase also subjects a Portfolio to additional risk until the purchase is completed or the position is closed out. Many options on securities are traded primarily on the over-the-counter ("OTC") market. OTC options are two-party contracts with price and other terms negotiated between buyer and seller and generally do not have as much, if any, liquidity. Thus, when a Portfolio purchases an OTC option, it relies on the dealer from which it has purchased the option to make or take delivery of the instruments or currencies underlying the option or otherwise fulfill its obligations under the contract. Failure by the dealer to do so would result in the loss of the premium paid by that Portfolio as well as the loss of the expected benefit of the -22- transaction. OTC options may be considered "illiquid securities" for purposes of each Portfolio's investment limitations. - -------------------------------------------------------------------------------- FOREIGN CURRENCY EXCHANGE TRANSACTIONS - -------------------------------------------------------------------------------- Each Portfolio that may invest in securities that are denominated in foreign currencies may engage in a variety of foreign currency exchange transactions to protect against uncertainty in the level of future exchange rates. These transactions may be engaged in connection with the purchase and sale of portfolio securities ("transaction hedging") and to protect the value of specific portfolio positions ("position hedging"). A Portfolio may engage in transaction hedging to protect against a change in the foreign currency exchange rates between the date on which the Portfolio contracts to purchase or sell the security and the settlement date, or to "lock in" the U.S. dollar equivalent of a dividend or interest payment in a foreign currency. A Portfolio may purchase or sell a foreign currency on a spot (or cash) basis at the prevailing spot rate. If conditions warrant, for transaction hedging purposes, a Portfolio may also enter into contracts to purchase or sell foreign currencies at a future date ("forward contracts") and may purchase and sell foreign currency futures contracts. A foreign currency forward contract is a negotiated agreement to exchange currency at a future time at a rate or rates that may be higher or lower than the spot rate. Foreign currency futures contracts are standardized exchange-traded contracts and have margin requirements. Each Portfolio may also purchase and sell (i.e., write) exchange-listed and over-the-counter call and put options on foreign currency futures contracts and on foreign currencies. A Portfolio may engage in "position hedging" to protect against a decline in the value relative to the U.S. dollar of the currencies in which its portfolio securities are denominated or quoted (or an increase in the value of the currency in which securities the Portfolio intends to buy are denominated). For position hedging purposes, each Portfolio may purchase and sell (i.e., write) foreign currency futures contracts, foreign currency forward contracts, and options on exchanges or over-the-counter markets. In connection with position hedging, a Portfolio may also purchase or sell foreign currency on a spot basis. A Portfolio's currency hedging transactions may call for the delivery of one foreign currency in exchange for another foreign currency and may at times involve currencies other than those in which its portfolio securities are then denominated. "Cross hedging" activities will be used when a Portfolio's Adviser believes that such transactions provide significant hedging opportunities for the Portfolio. Cross hedging transactions by a Portfolio involve the further risk of imperfect correlation between changes in the values of the currencies to which such transactions relate and changes in the values of such currencies and of the currency or other asset or liability which is the subject of the hedge. -23- The decision as to whether and to what extent a Portfolio will engage in foreign currency exchange transactions will depend on a number of factors, including prevailing market conditions, the composition of a Portfolio's investments and the availability of suitable transactions. Accordingly, there can be no assurance that a Portfolio will engage in foreign currency exchange transactions at any given time or from time to time. For a further discussion of the risks associated with purchasing and selling futures contracts and options, see "Options and Futures" above. A Portfolio may also use other foreign currency exchange instruments and techniques when available and deemed appropriate by its Adviser. - -------------------------------------------------------------------------------- PREFERRED STOCKS AND CONVERTIBLE SECURITIES - -------------------------------------------------------------------------------- A preferred stock pays dividends at a specified rate and has preference over common stock in the payment of dividends and the liquidation of an issuer's assets but is junior to the debt securities of the issuer in those same respects. The market prices of preferred stocks are subject to changes in interest rates and are more sensitive to changes in an issuer's creditworthiness than are the prices of debt securities. Shareholders of preferred stock may suffer a loss of value if dividends are not paid. Under ordinary circumstances, preferred stock does not carry voting rights. A convertible security is a bond, debenture, note, preferred stock or other security that may be converted into or exchanged for a prescribed amount of common stock (or another equity security) of the same or a different issuer within a particular period of time at a specified price or formula. A convertible security entitles the holder to receive interest paid or accrued on debt or the dividend paid or accrued on preferred stock until the convertible security matures or is redeemed, converted or exchanged. Before conversion, convertible securities have characteristics similar to nonconvertible debt securities in that they ordinarily provide a stream of income with generally higher yields than those of common stocks of the same or similar issuers. Convertible securities are usually subordinated to comparable-tier nonconvertible securities but rank senior to common stock in a corporation's capital structure. The value of a convertible security is a function of (1) its yield in comparison with the yields of other securities of comparable maturity and quality that do not have a conversion privilege and (2) its worth, at market value, if converted into the underlying common stock. A convertible security may be subject to redemption at the option of the issuer at a price established in the convertible security's governing instrument. If a convertible security held by a Portfolio is called for redemption, the Portfolio will be required to (1) permit the issuer to redeem the security, (2) convert it into the underlying common stock or (3) sell it to a third party. Any of these actions could have an adverse effect on a Portfolio's ability to achieve its investment objective. -24- - -------------------------------------------------------------------------------- DEBT AND FIXED INCOME SECURITIES - -------------------------------------------------------------------------------- The Portfolios may invest in a variety of debt and fixed income securities. These securities share one principal risk: their values fluctuate with changes in interest rates. Thus, a decrease in interest rates will generally result in an increase in the value of a Portfolio's fixed income investments. Conversely, during periods of rising interest rates, the value of a Portfolio's fixed income investments will generally decline. The magnitude of these fluctuations will generally be greater when a security's duration or average maturity is longer. Changes in the value of portfolio securities will not affect interest income from those securities, but will be reflected in a Portfolio's net asset value. The most common types of these instruments, and the associated risks, are described below. Subject to its investment policies and applicable law, each of the Portfolios may invest in these and other instruments. U.S. GOVERNMENT OBLIGATIONS. U.S. Government securities include (1) U.S. Treasury bills (maturity of one year or less), U.S. Treasury notes (maturity of one to ten years) and U.S. Treasury bonds (maturities generally greater than ten years) and (2) obligations issued or guaranteed by U.S. Government agencies or instrumentalities. In the case of obligations not backed by the full faith and credit of the United States, a Portfolio must look principally to the agency or instrumentality issuing or guaranteeing the obligation for ultimate repayment and may not be able to assert a claim against the United States itself in the event the agency or instrumentality does not meet its commitments. Neither the U.S. Government nor any of its agencies or instrumentalities guarantees the market value of the securities they issue. Therefore, the market value of such securities will fluctuate in response to changes in interest rates. MORTGAGE-RELATED SECURITIES. Mortgage-related securities represent an interest in a pool of mortgages made by lenders such as commercial banks, savings and loan institutions, mortgage bankers and others. Mortgage-related securities may be issued by governmental, government-related or non-governmental entities, and provide regular payments which consist of interest and, in most cases, principal. In contrast, other forms of debt securities normally provide for periodic payment of interest in fixed amounts with principal payments at maturity or specified call dates. In effect, payments on mortgage-related securities are a "pass-through" of the payments made by the individual borrowers on their mortgage loans, net of any fees paid to the issuer or guarantor of such securities. Additional payments to holders of mortgage-related securities are caused by repayments resulting from the sale of the underlying property, refinancing or foreclosure, net of fees or costs which may be incurred. As prepayment rates of individual pools of mortgage loans vary widely, it is not possible to predict accurately the average life of a particular security. Although mortgage-related securities are issued with stated maturities of up to forty years, unscheduled or early payments of principal and interest on the underlying mortgages may shorten -25- considerably the securities' effective maturities. The volume of prepayments of principal on a pool of mortgages underlying a particular mortgage-related security will influence the yield of that security, and the principal returned to a Portfolio may be reinvested in instruments whose yield may be higher or lower than that which might have been obtained had such prepayments not occurred. When interest rates are declining, such prepayments usually increase, and reinvestments of such principal prepayments will be at a lower rate than that on the original mortgage-related security. An increase in mortgage prepayments could cause the Portfolio to incur a loss on a mortgage-related security that was purchased at a premium. On the other hand, a decrease in the rate of prepayments, resulting from an increase in market interest rates or other causes, may extend the effective maturities of mortgage-related securities, increasing their sensitivity to changes in market interest rates and potentially increasing the volatility of a Portfolio's shares. The rate of prepayment may also be affected by general economic conditions, the location and age of the mortgages, and other social and demographic conditions. In determining the average maturity or duration of a mortgage-related security, a Portfolio's Adviser must apply certain assumptions and projections about the maturity and prepayment of such security; actual prepayment rates may differ. Because of prepayments, mortgage-related securities may have less potential for capital appreciation during periods of declining interest rates than other securities of comparable maturities, although they may have a similar risk of decline in market value during periods of rising interest rates. ASSET-BACKED SECURITIES. Asset-backed securities refer to securities that directly or indirectly represent a participation 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 and receivables from revolving credit (credit card) agreements. Such assets are securitized through the use of trusts or special purpose corporations. Asset-backed securities are backed by a pool of assets representing the obligations often of a number of different parties. Certain of such securities may be illiquid. The principal on asset-backed securities, like that on mortgage-backed securities, may be prepaid at any time. As a result, if such securities are purchased at a premium, a prepayment rate that is faster than expected will reduce yield to maturity, while a prepayment rate that is slower than expected will have the opposite effect. Conversely, if the securities are purchased at a discount, prepayments faster than expected will increase yield to maturity and prepayments slower than expected will decrease it. Accelerated prepayments also reduce the certainty of the yield because the Portfolio must reinvest the assets at the then-current rates. Accelerated prepayments on securities purchased at a premium also impose a risk of loss of principal. On the other hand, a decrease in the rate of prepayments may extend the effective maturities of the securities, increasing their sensitivity to changes in market interest rates and potentially increasing the volatility of a Portfolio's shares. The rate of prepayment may also be affected by general economic conditions and other social and demographic conditions. -26- Each type of asset-backed security also entails unique risks depending on the type of assets involved and the legal structure used. For example, credit card receivables are generally unsecured obligations of the credit card holder and the debtors 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. There have also been proposals to cap the interest rate that a credit card issuer may charge. In some transactions, the value of the asset-backed security is dependent on the performance of a third party acting as credit enhancer or servicer. Furthermore, in some transactions (such as those involving the securitization of vehicle loans or leases) it may be administratively burdensome to perfect the interest in the underlying collateral, and the underlying collateral may become damaged or stolen. CORPORATE DEBT SECURITIES. A Portfolio may invest in debt securities (i.e., bonds, debentures, notes and other similar debt instruments) of domestic or foreign non-governmental issuers which meet the minimum credit quality criteria, if any, set forth for the Portfolio. Corporate debt securities may pay fixed or variable rates of interest, or interest at a rate contingent upon some other factor, such as the price of some commodity. These securities may include warrants, may be convertible into preferred or common equity, or may be bought as part of a unit containing common stock. LOWER-RATED SECURITIES. Non-investment grade securities, i.e., securities rated below Baa by Moody's or BBB by S&P or unrated securities of comparable quality, are described as "speculative" by Moody's and S&P and may be subject to greater market fluctuations and greater risk of loss of income or principal, including a greater possibility of default or bankruptcy of the issuer of such securities, than are more highly rated debt securities. Such securities are commonly referred to as "junk bonds." A Portfolio's Adviser seeks to minimize the risks of investing in all securities through diversification, in-depth credit analysis and attention to current developments in interest rates and market conditions and will monitor the ratings of securities held by the Portfolios and the creditworthiness of their issuers. See the Appendix to this Prospectus for a description of the ratings assigned to fixed income securities by the rating agencies. A debt security may be callable, i.e., subject to redemption at the option of the issuer at a price established in the security's governing instrument. If a debt security held by a Portfolio is called for redemption, the Portfolio will be required to permit the issuer to redeem the security or sell it to a third party. Either of these actions could have an adverse effect on a Portfolio's ability to achieve its investment objective because, for example, the Portfolio may be able to reinvest the proceeds only in securities with lower yields or may receive a price upon sale that is lower than it would have received in the absence of the redemption. The prices of debt securities fluctuate in response to perceptions of the issuer's creditworthiness. Generally, lower-rated securities offer a higher current yield than that provided by higher grade issues, but also involve higher risks. Debt securities rated C by -27- Moody's and S&P are bonds on which no interest is being paid and which can be regarded as having extremely poor prospects of ever attaining any real investment standing. Debt securities rated D by an NRSRO are bonds that are in default or arrears and have questionable value. Lower-rated securities are especially affected by adverse changes in the industries in which the issuers are engaged and by changes in the financial condition of the issuers. Highly leveraged issuers may also experience financial stress during periods of rising interest rates. The market for lower-rated securities has expanded rapidly in recent years. This growth has paralleled a long economic expansion. At certain times in the past, the prices of many lower-rated securities declined, indicating concerns that issuers of such securities might experience financial difficulties. At those times, the yields on lower-rated securities rose dramatically, reflecting the risk that holders of such securities could lose a substantial portion of their value as a result of the issuers' financial restructuring or default. There can be no assurance that such declines will not recur. The market for lower-rated securities is generally thinner and less active than that for higher quality debt securities, which may make it difficult for a Portfolio to value its securities or may limit a Portfolio's ability to sell such securities at fair value. As a result, judgment plays a greater role in pricing such securities than is the case for securities having more active markets. Adverse publicity and investor perceptions, whether or not based on fundamental analysis, may also decrease the values and liquidity of lower-rated securities, especially in a thinly traded market. The ratings of Moody's and S&P represent the opinions of those agencies as to the quality of the debt securities which they rate. Such ratings are relative and subjective, and are not absolute standards of quality. Unrated debt securities are not necessarily of lower quality than rated securities, but they may not be attractive to as many buyers. If securities are rated investment grade by one rating organization and below investment grade by the other, a Portfolio's Adviser may rely on the rating that it believes is more accurate. Each Portfolio's Adviser will consider a security's quality and credit rating when determining whether such security is an appropriate investment. Subject to its investment objective, policies and applicable law, a Portfolio may purchase a security with the lowest rating (or an unrated security of comparable quality). STRIPPED SECURITIES. Stripped securities are created by separating bonds into their principal and interest components and selling each piece separately (commonly referred to as IOs and POs). The yield to maturity on an IO or PO class of stripped mortgage-backed securities is extremely sensitive not only to changes in prevailing interest rates but also to the rate of principal payments (including prepayments) on the underlying assets. A rapid rate of principal prepayments may have a measurably adverse effect on a Portfolio's yield to maturity to the extent it invests in IOs. If the assets underlying the IOs experience greater than anticipated prepayments of principal, the fund may fail to recoup fully its initial investment in these securities. Conversely, POs tend to increase in value if prepayments are greater than -28- anticipated and decline if prepayments are slower than anticipated. The secondary market for stripped mortgage-backed securities may be more volatile and less liquid than that for other mortgage-backed securities, potentially limiting a Portfolio's ability to buy or sell those securities at any particular time. The Board has approved guidelines for determining a security's liquidity and has delegated to each Portfolio's Adviser the responsibility for determining whether a particular security eligible for trading is "liquid" pursuant to such guidelines. ZERO COUPON AND PAY-IN-KIND SECURITIES. A zero coupon bond is a security that makes no fixed interest payments but instead is sold at a discount from its face value. The bond is redeemed at its face value on the specified maturity date. Zero coupon bonds may be issued as such, or they may be created by a broker who strips the coupons from a bond and separately sells the rights to receive principal and interest. The prices of zero coupon bonds tend to fluctuate more in response to changes in market interest rates than do the prices of interest-paying debt securities with similar maturities. A Portfolio investing in zero coupon bonds generally accrues income on such securities prior to the receipt of cash payments. Since each Portfolio must distribute substantially all of its income to shareholders to qualify as a regulated investment company under federal income tax law, a Portfolio investing in zero coupon bonds may have to dispose of other securities to generate the cash necessary for the distribution of income attributable to its zero coupon bonds. Pay-in-kind securities have characteristics similar to those of zero coupon securities, but interest on such securities may be paid in the form of obligations of the same type rather than cash. - -------------------------------------------------------------------------------- COMMERCIAL PAPER AND OTHER SHORT-TERM INVESTMENTS - -------------------------------------------------------------------------------- Each of the Portfolios may invest and hold cash or other short-term investments, including commercial paper. Commercial paper represents short-term unsecured promissory notes issued in bearer form by banks or bank holding companies, corporations and finance companies. The Portfolios may purchase commercial paper issued pursuant to the private placement exemption in Section 4(2) of the Securities Act of 1933. Section 4(2) paper is restricted as to disposition under federal securities laws in that any resale must similarly be made in an exempt transaction. The Portfolios may or may not regard such securities as illiquid, depending on the circumstances of each case. Any Portfolio may also invest in obligations (including certificates of deposit, demand and time deposits and bankers' acceptances) of U.S. banks and savings and loan institutions. While domestic bank deposits are insured by an agency of the U.S. Government, the Portfolios will generally assume positions considerably in excess of the insurance limits. -29- - -------------------------------------------------------------------------------- INDEXED SECURITIES AND STRUCTURED NOTES - -------------------------------------------------------------------------------- The values of indexed securities and structured notes are linked to currencies, other securities, interest rates, commodities, indices or other financial indicators ("reference instruments"). These instruments differ from other types of debt securities in several respects. The interest rate or principal amount payable at maturity may vary based on changes in one or more specified reference instruments, such as a floating interest rate compared with a fixed interest rate or the currency exchange rates between two currencies (neither of which need be the currency in which the instrument is denominated). An indexed security or structured note may be positively or negatively indexed; that is, its value or interest rate may increase or decrease if the value of the reference instrument increases. Further, the change in the principal amount payable with respect to, or the interest rate of, an indexed security or structured note may be a multiple of the percentage change (positive or negative) in the value of the underlying reference instrument(s). Investment in indexed securities and structured notes involves certain risks, including the credit risk of the issuer and the normal risks of price changes in response to changes in interest rates. Further, in the case of certain indexed securities or structured notes, a decline in the reference instrument may cause the interest rate to be reduced to zero, and any further declines in the reference instrument may then reduce the principal amount payable on maturity. Finally, these securities may be less liquid than other types of securities, and may be more volatile than their underlying reference instruments. - -------------------------------------------------------------------------------- FORWARD COMMITMENTS - -------------------------------------------------------------------------------- Each Portfolio may enter into commitments to purchase securities on a "forward commitment" basis, including purchases on a "when-issued" basis or a "to be announced" basis. When such transactions are negotiated, certain terms may be fixed at the time the commitment is made, but delivery and payment for the securities takes place at a later date. Such securities are often the most efficiently priced and have the best liquidity in the bond market. During the period between a commitment and settlement, no payment is made by the purchaser for the securities purchased and, thus, no interest accrues to the purchaser from the transaction. In a "to be announced" transaction, a Portfolio commits to purchase securities for which all specific information is not yet known at the time of the trade, particularly the exact face amount in forward commitment mortgage-backed securities transactions. A Portfolio may sell the securities subject to a forward commitment purchase, which may result in a gain or loss. When a Portfolio purchases securities on a forward commitment basis, it assumes the risks of ownership, including the risk of price fluctuation, at the time of purchase, not at the time of receipt. Purchases of forward commitment securities also involve -30- a risk of loss if the seller fails to deliver after the value of the securities has risen. Depending on market conditions, a Portfolio's forward commitment purchases could cause its net asset value to be more volatile. Each Portfolio may also enter into a forward commitment to sell securities it owns and will generally do so only with the intention of actually delivering the securities. The use of forward commitments enables a Portfolio to hedge against anticipated changes in interest rates and prices. In a forward sale, a Portfolio does not participate in gains or losses on the security occurring after the commitment date. Forward commitments to sell securities also involve a risk of loss if the seller fails to take delivery after the value of the securities has declined. Forward commitment transactions involve additional risks similar to those associated with investments in options and futures contracts. See "Options and Futures Contracts." It is not expected that any Portfolio's purchases of forward commitments will at any time exceed, in the aggregate, 20% of that Portfolio's total assets. - -------------------------------------------------------------------------------- RESTRICTED AND ILLIQUID SECURITIES - -------------------------------------------------------------------------------- Restricted securities are securities subject to legal or contractual restrictions on their resale, such as private placements. Such restrictions might prevent the sale of restricted securities at a time when the sale would otherwise be desirable. No securities for which there is not a readily available market ("illiquid securities") will be acquired by any Portfolio if such acquisition would cause the aggregate value of illiquid securities to exceed 15% of the Portfolio's net assets. Under SEC regulations, certain securities acquired through private placements can be traded freely among qualified purchasers. The SEC has stated that an investment company's board of directors, or its investment adviser acting under authority delegated by the board, may determine that a security eligible for trading under this rule is "liquid." The Portfolios intend to rely on this rule, to the extent appropriate, to deem specific securities acquired through private placements as "liquid." The Board has approved guidelines for determining such securities' liquidity and has delegated to each Portfolio's Adviser the responsibility for determining whether a particular security eligible for trading under this rule is "liquid" pursuant to such guidelines. Investing in these restricted securities could have the effect of increasing a Portfolio's illiquidity if qualified purchasers become, for a time, uninterested in buying these securities. Illiquid securities may be difficult to value, and a Portfolio may have difficulty disposing of such securities promptly. The Portfolios do not consider foreign securities to be restricted if they can be freely sold in the principal markets in which they are traded, even if they are not registered for sale in the U.S. -31- - -------------------------------------------------------------------------------- SECURITIES OF OTHER INVESTMENT COMPANIES - -------------------------------------------------------------------------------- Investments in other investment companies may involve the payment of substantial premiums above the net asset value of such issuers' portfolio securities, and the total return on such investments will be reduced by the operating expenses and fees of such investment companies, including advisory fees. The Portfolios may invest in both closed-end and open-end investment companies. - -------------------------------------------------------------------------------- REPURCHASE AGREEMENTS - -------------------------------------------------------------------------------- A repurchase agreement is an agreement under which securities are acquired from a securities dealer or bank subject to resale at an agreed upon price and date. The securities are held by a Portfolio as collateral until retransferred and will be supplemented by additional collateral if necessary to maintain a total market value equal to or in excess of the value of the repurchase agreement. The Portfolio bears a risk of loss in the event that the other party to a repurchase agreement defaults on its obligations and the Portfolio is delayed or prevented from exercising its rights to dispose of the collateral securities. A Portfolio also bears the risk that the proceeds from any sale of collateral will be less than the repurchase price. - -------------------------------------------------------------------------------- REVERSE REPURCHASE AGREEMENTS AND OTHER BORROWING - -------------------------------------------------------------------------------- A reverse repurchase agreement is a portfolio management technique in which a Portfolio temporarily transfers possession of a portfolio instrument to another person, such as a financial institution or broker-dealer, in return for cash. At the same time, the Portfolio agrees to repurchase the instrument at an agreed upon time (normally within seven days) and price, including interest payment. While engaging in reverse repurchase agreements, each Portfolio will maintain cash or securities in a segregated account with a value at least equal to the Portfolio's obligation under the agreements, adjusted daily. Reverse repurchase agreements may expose a Portfolio to greater fluctuations in the value of its assets and renders the segregated assets unavailable for sale or other disposition. The Portfolios may also enter into dollar roll transactions in which a Portfolio sells a fixed income security for delivery in the current month and simultaneously contracts to purchase substantially similar (same type, coupon and maturity) securities at an agreed upon future time. By engaging in the dollar roll transaction the Portfolio foregoes principal and interest paid on the security that is sold, but receives the difference between the current sales price and the forward price for the future purchase. The Portfolio would also be able to earn interest on the income that is received from the initial sale. The obligation to purchase securities on a specified future date involves the risk that the market value of the securities that a Portfolio is obligated to purchase may decline below the -32- purchase price. In addition, in the event the other party to the transaction files for bankruptcy, becomes insolvent or defaults on its obligation, a Portfolio may be adversely affected. Each Portfolio will limit its investments in reverse repurchase agreements and other borrowing (including dollar roll transactions) to no more than one-third of its total assets. To avoid potential leveraging effects of such borrowing (including reverse repurchase agreements and dollar rolls), a Portfolio will not make investments while its borrowing is in excess of 5% of its total assets. - -------------------------------------------------------------------------------- LOANS OF PORTFOLIO SECURITIES - -------------------------------------------------------------------------------- A Portfolio may lend its portfolio securities, provided that cash or equivalent collateral, equal to at least 100% of the market value of the securities loaned, is continuously maintained by the borrower with the Portfolio. During the time securities are on loan, the borrower will pay the Portfolio an amount equivalent to any dividends or interest paid on such securities, and the Portfolio may invest the cash collateral and earn additional income, or it may receive an agreed upon amount of interest income from the borrower who has delivered equivalent collateral. These loans are subject to termination at the option of the Portfolio or the borrower. A Portfolio may pay administrative and custodial fees in connection with a loan and may pay a negotiated portion of the interest earned on the cash or equivalent collateral to the borrower or placing broker. No Portfolio presently expects to have on loan at any given time securities totaling more than one-third of its net assets. A Portfolio runs the risk that the counterparty to a loan transaction will default on its obligation and that the value of the collateral received may decline before the Portfolio can dispose of it. - -------------------------------------------------------------------------------- REITs - -------------------------------------------------------------------------------- REITs pool investors' funds for investment primarily in income producing real estate or real estate related loans or interests. Under the Internal Revenue Code of 1986 (the "Code"), a REIT is not taxed on income it distributes to its shareholders if it complies with several requirements relating to its organization, ownership, assets, and income and a requirement that it generally distribute to its shareholders at least 95% of its taxable income (other than net capital gains) for each taxable year. REITs can generally be classified as Equity REITs, Mortgage REITs, and Hybrid REITs. Equity REITs, which invest the majority of their assets directly in real property, derive their income primarily from rents. Equity REITs can also realize capital gains by selling properties that have appreciated in value. Mortgage REITs, which invest the majority of their assets in real estate mortgages, derive their income primarily from interest payments. Hybrid REITS combine the characteristics of both Equity REITs and Mortgage REITs. -33- While a Portfolio will not generally invest in real estate directly, it may be subject to risks similar to those associated with the direct ownership of real estate. These risks include declines in the value of real estate, risks related to general and local economic conditions, dependency on management skill, heavy cash flow dependency, possible lack of availability of mortgage funds, overbuilding, extended vacancies of properties, increased competition, increases in property taxes and operating expenses, changes in zoning laws, losses due to costs resulting from the clean-up of environmental problems, liability to third parties for damages resulting from environmental problems, casualty or condemnation losses, limitations on rents, changes in neighborhood values and in the appeal of properties to tenants and changes in interest rates. In addition to these risks, REITs may be affected by changes in the value of the underlying property owned by the trusts, or by the quality of any credit they extend. Further, REITs are dependent upon management skills and generally may not be diversified. REITs are also subject to heavy cash flow dependency, defaults by borrowers and self-liquidation. In addition, REITs could possibly fail to qualify for tax-free pass-through of income under the Code or to maintain their exemptions from registration under the 1940 Act. The above factors may also adversely affect a borrower's or a lessee's ability to meet its obligations to the REIT. In the event of a default by a borrower or lessee, the REIT may experience delays in enforcing its rights as a mortgagee or lessor and may incur substantial costs associated with protecting its investments. In addition to the foregoing risks, certain "special purpose" REITs in which a Portfolio invests may invest their assets in specific real estate sectors, such as hotel REITs, nursing home REITs or warehouse REITs, and are therefore subject to the risks associated with adverse developments in any such sectors. - -------------------------------------------------------------------------------- PORTFOLIO TURNOVER - -------------------------------------------------------------------------------- While it is impossible to predict portfolio turnover rates, the Legg Mason Fund Adviser Large Cap Value Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio, the Brandywine Small Cap Value Portfolio, the Batterymarch Emerging Markets Portfolio, the Batterymarch International Equity Portfolio and the Legg Mason Fund Adviser Total Return Portfolio currently expect that their average turnover rate will not exceed 100%, 100%, 175%, 50%, 75% and 100% respectively. The length of time a Portfolio has held a particular security is not generally a consideration in investment decisions. A change in the securities held by a Portfolio is known as "portfolio turnover." As a result of a Portfolio's investment policies, under certain market conditions a Portfolio's portfolio turnover rate may be higher than that of other mutual funds. Portfolio turnover generally involves some expense to a Portfolio, including brokerage commissions or dealer mark-ups and other transaction costs on the sale of securities and reinvestment in other securities. These transactions may result in realization of taxable capital gains. Higher portfolio turnover rates, such as those above 100%, are likely to result in -34- higher brokerage commissions or other transactions costs and could give rise to a greater amount of taxable capital gains. - -------------------------------------------------------------------------------- ALTERNATIVE INVESTMENT STRATEGIES - -------------------------------------------------------------------------------- At times a Portfolio's Adviser may judge that conditions in the securities markets make pursuing the Portfolio's typical investment strategy inconsistent with the best interests of its shareholders. At such times, the Adviser may temporarily use alternative strategies, primarily designed to reduce fluctuations in the value of the Portfolio's assets. In implementing these defensive strategies, a Portfolio may invest without limit in securities that the Adviser believes present less risk to a Portfolio, including equity securities, debt and fixed income securities, preferred stocks, U.S. Government and agency obligations, cash or money market instruments, or in other securities the Adviser considers consistent with such defensive strategies. As a result of these strategies, the Batterymarch Emerging Markets Portfolio and the Batterymarch International Equity Portfolio may invest up to 100% of their assets in securities of U.S. issuers. It is impossible to predict when, or for how long, a Portfolio will use these alternative strategies. - -------------------------------------------------------------------------------- NEW INVESTMENT PRODUCTS - -------------------------------------------------------------------------------- New types of mortgage-backed and asset-backed securities, derivative instruments and hedging instruments are developed and marketed from time to time. Consistent with its investment limitations, each Portfolio expects to invest in those new types of securities and instruments that its Adviser believes may assist the Portfolio in achieving its investment objective. - -------------------------------------------------------------------------------- INVESTMENT POLICIES - -------------------------------------------------------------------------------- Except for investment policies designated as fundamental in this prospectus or the SAI, the investment policies described in this prospectus and in the SAI are not fundamental policies. Changes to fundamental investment policies require shareholder approval; the Directors may change any non-fundamental investment policy without shareholder approval. -35- - -------------------------------------------------------------------------------- PERFORMANCE DATA - -------------------------------------------------------------------------------- Advertisements and other communications to shareholders or prospective investors may include performance information about a Portfolio. "Yield" for each class of shares of a Portfolio is calculated by dividing the annualized net investment income per share during a recent 30-day period by the maximum public offering price per share of the class on the last day of that period. "Total return" is a measurement of the overall change in value, including changes in share price and assuming reinvestment of distributions, of an investment in a Portfolio. "Cumulative total return" shows a Portfolio's performance over a specific period of time. "Average annual total return" for the one-, five- and ten-year periods (or for the life of a class, if shorter) through the most recent calendar quarter represents the average annual compounded rate of return on an investment of $1,000 in a Portfolio invested at the maximum public offering price. Investment performance, which will vary, is based on many factors, including market conditions, portfolio composition, Portfolio operating expenses and the class of shares the investor purchases. Investment performance also often reflects the risks associated with a Portfolio's investment objective and policies. These factors should be considered when comparing a Portfolio's investment results with those of other mutual funds and other investment vehicles. Performance information is based on historical performance and should not be viewed as representative of a Portfolio's future performance. The investment return and principal value of an investment in a Portfolio will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Quotations of investment performance for any period when an expense limitation was in effect will be greater than if the limitation had not been in effect. Portfolio performance may be compared to that of various indexes. See the SAI. -36- - -------------------------------------------------------------------------------- MANAGEMENT OF THE PORTFOLIOS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- BOARD OF DIRECTORS - -------------------------------------------------------------------------------- The business affairs of LM Institutional Fund Advisors II, Inc. ("Corporation") are managed under the direction of a Board of Directors, and the Directors of the Corporation are responsible for generally overseeing the conduct of each Portfolio's business. Information about the Directors and executive officers of the Corporation may be found in the SAI. The Board of Directors has retained the Manager and the Advisers to manage the Portfolios' affairs, furnish a continuing investment program for the Portfolios and make investment decisions on their behalf, subject to such policies as the Directors may determine. - -------------------------------------------------------------------------------- MANAGER, ADVISERS AND PORTFOLIO MANAGERS - -------------------------------------------------------------------------------- The Portfolios are managed by the Manager. Each Portfolio pays the Manager a monthly fee based on the average net assets of the Portfolio at the following rates: ANNUAL PERCENTAGE OF PORTFOLIO AVERAGE NET ASSETS --------- -------------------- Legg Mason Fund Adviser Large Cap Value Portfolio 0.60% Legg Mason Fund Adviser Mid Cap Value Portfolio 0.60% Brandywine Small Cap Value Portfolio 0.65% Batterymarch Emerging Markets Portfolio 0.65% Batterymarch International Equity Portfolio 0.65% Legg Mason Fund Adviser Total Return Portfolio 0.60% The Manager is a Maryland corporation formed on February 20, 1998 and is a wholly owned subsidiary of Legg Mason, Inc., a financial services holding company. In order to assist in carrying out its investment advisory responsibilities, the Manager has retained the Advisers to render advisory services to the Portfolios. The Manager pays the fees of the Advisers. -37- The Manager pays a Portfolio's Adviser a monthly fee based on the average net assets of the Portfolio at the following rates:
- ------------------------------------------------------ ------------------------- -------------------------- Portfolio Adviser Adviser Fee - ------------------------------------------------------ ------------------------- -------------------------- Legg Mason Fund Adviser Large Cap Value LMFA .55% - ------------------------------------------------------ ------------------------- -------------------------- Legg Mason Fund Adviser Mid Cap Value LMFA .55% - ------------------------------------------------------ ------------------------- -------------------------- Brandywine Small Cap Value Brandywine .60% - ------------------------------------------------------ ------------------------- -------------------------- Batterymarch Emerging Markets Batterymarch .60% - ------------------------------------------------------ ------------------------- -------------------------- Batterymarch International Equity Batterymarch .60% - ------------------------------------------------------ ------------------------- -------------------------- Legg Mason Fund Adviser Total Return LMFA .55% - ------------------------------------------------------ ------------------------- --------------------------
LMFA. LMFA acts as adviser or manager to eighteen investment company portfolios which had aggregate assets under management of approximately $12 billion as of April 30, 1998. LMFA s address is 100 Light Street, Baltimore, Maryland 21202. LMFA is a subsidiary of Legg Mason, Inc. BRANDYWINE. Brandywine, a wholly owned subsidiary of Legg Mason, Inc., acts as investment adviser to institutional accounts, such as corporate pension plans, mutual funds and endowment funds, as well as to individual investors. Total assets under management by Brandywine were approximately $8.2 billion as of April 30, 1998. The address of Brandywine is Three Christina Centre, Suite 1200, 201 N. Walnut Street, Wilmington, Delaware 19801. BATTERYMARCH. Batterymarch, a wholly owned subsidiary of Legg Mason, Inc., acts as investment adviser to institutional accounts, such as corporate pension plans, mutual funds and endowment funds, as well as to individual investors. Total assets under management by Batterymarch were approximately $4.4 billion as of April 30, 1998. The address of Batterymarch is 200 Clarendon Street, Boston, Massachusetts 02116. -38- EXPENSE LIMITATIONS. The Manager and the Advisers have until July 31, 1999 voluntarily agreed to waive their fees and/or reimburse each Portfolio in any month to the extent a Portfolio's expenses (exclusive of taxes, interest, deferred organizational expenses, 12b-1 fees, brokerage and extraordinary expenses) exceed during that month the annual rate of that Portfolio's average net assets set forth below: Legg Mason Fund Adviser Large Cap Value Portfolio, Legg Mason Fund Adviser Mid Cap Value Portfolio and Legg Mason Fund Adviser Total Return Portfolio 0.75% Brandywine Small Cap Value Portfolio 0.85% Batterymarch International Equity Portfolio 1.00% Batterymarch Emerging Markets Portfolio 1.45% Any amounts waived or reimbursed in a particular fiscal year will be subject to repayment by a Portfolio to the Manager and the Advisers to the extent that from time to time during the next three fiscal years the repayment will not cause a Portfolio's expenses to exceed the limit, if any, imposed by the Manager and the Advisers at that time. These agreements are voluntary and may be terminated by the Manager and the Advisers at any time. PORTFOLIO MANAGERS. The names and business experience for the past five years for each portfolio manager are set forth in the following chart. -39-
- ------------------------------------------------ ------------------------------------------------------ Portfolio Portfolio Manager and Business Experience (past five years) - ------------------------------------------------ ------------------------------------------------------ Legg Mason Fund Adviser Large Cap Value William H. Miller, III is a portfolio manager Value Portfolio and President of LMFA. Mr. Miller has been employed by LMFA since 1982. - ------------------------------------------------ ------------------------------------------------------ Legg Mason Fund Adviser Mid Cap Value William H. Miller, III (see above) Portfolio - ------------------------------------------------ ------------------------------------------------------ Brandywine Small Cap Value Portfolio Henry F. Otto is a senior portfolio manager at Brandywine. Mr. Otto has been employed by Brandywine since 1987. Steven M. Tonkovich is a portfolio manager and analyst at Brandywine. Mr. Tonkovich has been employed by Brandywine since 1989. - ------------------------------------------------ ------------------------------------------------------ Batterymarch Emerging Markets Portfolio Batterymarch emerging markets team - ------------------------------------------------ ------------------------------------------------------ Batterymarch International Equity Portfolio Batterymarch developed markets (EAFE) team - ------------------------------------------------ ------------------------------------------------------ Legg Mason Fund Adviser Total Return Nancy T. Dennin is a portfolio manager and Portfolio Senior Vice President of LMFA. Ms. Dennin has been employed by LMFA since 1985. - ------------------------------------------------ ------------------------------------------------------
- -------------------------------------------------------------------------------- THE DISTRIBUTOR - -------------------------------------------------------------------------------- LMWW is the distributor of each Portfolio's shares. LMWW pays certain expenses in connection with the offering of shares of each Portfolio, including any compensation to its financial advisors, the printing and distribution of prospectuses, SAIs and periodic reports used in connection with the offering to prospective investors, and expenses relating to any supplementary sales literature or advertising. The Portfolios bear the expenses of preparing, setting in type and mailing the prospectuses, SAIs and periodic reports to existing shareholders. - -------------------------------------------------------------------------------- PORTFOLIO TRANSACTIONS - -------------------------------------------------------------------------------- Each Portfolio's Adviser places all orders for the purchase and sale of portfolio investments with brokers or dealers selected by it in its discretion. It will seek the best price and execution of each Portfolio's orders. However, the Adviser may pay higher commission rates than the lowest available when it believes it is reasonable to do so in light of the value of -40- brokerage and research services provided by the broker effecting the transaction. The Adviser may also consider sales of shares of the Portfolio (or other Portfolios or other funds managed by it or its affiliates, to the extent permitted by applicable law) in selecting broker-dealers to execute Portfolio transactions. The Portfolios may use LMWW, among others, as broker for agency transactions in listed and over-the-counter securities at commission rates and under circumstances consistent with the policy of best execution. Some securities considered by an Adviser for purchase by a Portfolio may also be appropriate for other clients served by the Adviser. Transactions in such securities will be allocated among the Portfolios and such other clients in a manner considered fair and reasonable by the Adviser. - -------------------------------------------------------------------------------- EXPENSES - -------------------------------------------------------------------------------- Each Portfolio pays its share of all expenses of the Corporation that are not assumed by the Manager, the Adviser or other parties, including Directors', auditing, legal, custodial, transfer agency and distribution fees (which are in turn allocated to the Financial Intermediary Class of shares). - -------------------------------------------------------------------------------- ORGANIZATION AND HISTORY - -------------------------------------------------------------------------------- The Corporation was incorporated in Maryland on January 13, 1998. Each Portfolio is an open-end, diversified management company. The Directors of the Corporation may, without shareholder approval, create, in addition to the Portfolios, other series of shares representing separate investment portfolios. Any such series may be divided without shareholder approval into two or more classes of shares having such terms as the Directors may determine. The Corporation has a total of seven billion shares of common stock at par value $0.001. Each share has one vote, with fractional shares voting proportionally. Voting on matters pertinent only to a particular Portfolio, such as the adoption of an investment advisory contract for that Portfolio, is limited to that Portfolio's shareholders. Shares of all classes of a Portfolio will vote together as a single class except when otherwise required by law or as determined by the Directors. Shares are freely transferable, are entitled to dividends as declared by the Directors, and, if a Portfolio were liquidated, would receive the net assets of that Portfolio. Voting rights are not cumulative, and all shares of the Portfolios are fully paid and nonassessable and have no preemptive or conversion rights. Although no Portfolio intends to hold annual shareholder meetings, it will hold a special meeting of shareholders when the Investment Company Act of 1940 (the "1940 Act") -41- requires a shareholder vote on certain matters (including the election of Directors in certain cases or approval of an advisory contract). - -------------------------------------------------------------------------------- PURCHASE OF SHARES - -------------------------------------------------------------------------------- The Portfolios offer two classes of shares: Institutional Class and Financial Intermediary Class. Shares in the Financial Intermediary Class bear a 12b-1 fee. See "Distribution Plans" below for more information. - -------------------------------------------------------------------------------- INITIAL INVESTMENT - -------------------------------------------------------------------------------- Prior to or concurrent with the initial purchase of shares in any Portfolio, each investor must open an account for that Portfolio by completing and signing an Application and mailing it to Boston Financial Data Services (the "Transfer Agent" or "BFDS") at the following address: P.O. Box 953, Boston, Massachusetts 02103. The Portfolios have established minimum investment criteria that vary depending upon which class of shares you wish to purchase. For Institutional Class shares, investors must have at least $50 million in assets and invest in the aggregate at least $1 million in the Portfolios and the portfolios of LM Institutional Fund Advisors I, Inc. For Financial Intermediary Class shares, investors must have at least $30 million in assets and invest in the aggregate at least $1 million in the Portfolios and the portfolios of LM Institutional Fund Advisors I, Inc. The Portfolios reserve the right to revise the minimum investment requirement and may waive it in their sole discretion. A purchase order, together with payment in proper form, received by the Transfer Agent prior to the close of regular trading on the Exchange (ordinarily 4:00 p.m., Eastern time) ("close of the Exchange") will be effected at that day's net asset value. An order received after the close of the Exchange will generally be effected at the net asset value determined on the next business day. However, orders received by certain retirement plans and other financial intermediaries by the close of the Exchange and communicated to the Transfer Agent by 9:00 a.m., Eastern time, on the following business day will be effected at the net asset value determined on the prior business day. Purchases of shares can be made by wiring federal funds to State Street Bank and Trust Company. Before wiring federal funds, the investor must first telephone the Portfolio at 888-42LMIFA to receive instructions for wire transfer. On the telephone, the following information will be required: shareholder name; name of the person authorizing the transaction; shareholder account number; name of the Portfolio and class of shares to be purchased; amount being wired; and name of the wiring bank. -42- Funds should be wired through the Federal Reserve System to: State Street Bank and Trust Company ABA # 011-000-028 LM Institutional Fund Advisors [insert name of Portfolio] [Insert your account name and number] The wire should state that the funds are for the purchase of shares of a specific Portfolio and include the account name and number. Shares may also be purchased and paid for by the contribution of eligible portfolio securities, subject in each case to approval by the Manager. Approval will depend on, among other things, the nature and quality of the securities offered and the current needs of the Portfolio in question. Securities offered in payment for shares will be valued in the same way and at the same time the Portfolio values it portfolio securities for purposes of determining net asset value. See "How Each Portfolio Values Its Shares," below. Investors who wish to purchase Portfolio shares through the contribution of securities should contact the Portfolio at 888-42LMIFA for instructions. Investors should also realize that at the time of contribution they may be required to recognize a gain or loss for tax purposes on securities contributed. The Portfolio has full discretion to reject any securities offered as payment for shares. As described below, each Portfolio may offer Financial Intermediary Class shares that are offered primarily through financial intermediaries. Each Portfolio may pay financial intermediaries for their services out of that class's assets pursuant to the class' distribution plan or otherwise. Legg Mason and its affiliates (including the Manager and the Advisers) may also from time to time, at their own expense, make payments to financial intermediaries that sell shares of the Portfolios or to other parties in connection with the sale of shares. If investors effect transactions through a broker or agent, investors may be charged a fee by that broker or agent. Any shares purchased or received as a distribution will be credited directly to the investor's account. - -------------------------------------------------------------------------------- ADDITIONAL INVESTMENTS - -------------------------------------------------------------------------------- Additional investments may be made at any time at the relevant net asset value for that class by following the procedures outlined above. Investors should always furnish a shareholder account number when making additional purchases. -43- - -------------------------------------------------------------------------------- OTHER PURCHASE INFORMATION - -------------------------------------------------------------------------------- Purchases will be made in full and fractional shares. In the interest of economy and convenience, certificates for shares will not be issued. Each Portfolio and LMWW reserves the right, in its sole discretion, to suspend the offering of shares or to reject any purchase order, in whole or in part, when, in the judgment of management, such suspension or rejection is in the best interests of the Portfolio; to waive the minimum initial investment for certain investors; and to redeem shares if information provided in the Application should prove to be incorrect in any manner judged by a Portfolio to be material (e.g., in a manner such as to render the shareholder ineligible to purchase shares of a Portfolio). A Portfolio may suspend the offering of shares at any time and resume it at any time thereafter. Shares of the Portfolios may not be qualified or registered for sale in all States. Prospective investors should inquire as to whether shares of a particular Portfolio are available for offer and sale in their State of residence. Shares of the Portfolio may not be offered or sold in any State unless registered or qualified in that jurisdiction or unless an exemption from registration or qualification is available. Purchases and sales of Portfolio shares should be made for long-term investment purposes only. Each Portfolio reserves the right to restrict purchases of shares (including exchanges) when a pattern of frequent purchases and sales made in response to short-term fluctuations in share price appears evident. - -------------------------------------------------------------------------------- RETIREMENT PLANS - -------------------------------------------------------------------------------- Shares of the Portfolios are available for purchase by retirement plans, including 401(k) plans, 403(b) plans and Individual Retirement Accounts ("IRAs"). The administrator of a plan or employee benefits office can provide participants or employees with detailed information on how to participate in the plan and how to elect a Portfolio as an investment option. Participants in a retirement or savings plan may be permitted to elect different investment options, alter the amounts contributed to the plan, or change how contributions are allocated among investment options in accordance with the plan's specific provisions. The plan administrator or employee benefits office should be consulted for details. For questions about participant accounts, participants should contact their employee benefits office, the plan administrator, or the organization that provides recordkeeping services for the plan. Investors who purchase shares through retirement plans should be aware that the plan administrator may aggregate purchase and redemption orders of participants in the plan. Therefore, there may be a delay between the time the investor places an order with the plan administrator and the time the order is forwarded to the Transfer Agent for execution. -44- - -------------------------------------------------------------------------------- ACCOUNT REGISTRATION CHANGES - -------------------------------------------------------------------------------- Changes in registration or account privileges may be made in writing to the Transfer Agent. Signature guarantees may be required. See "Signature Guarantee" below. All correspondence must include the account number and must be sent to: Boston Financial Data Services P.O. Box 953 Boston, Massachusetts, 02103 - -------------------------------------------------------------------------------- DISTRIBUTION PLANS - -------------------------------------------------------------------------------- The Board of Directors has adopted Distribution Plans pursuant to Rule 12b-1 under the 1940 Act with respect to shares of the Financial Intermediary Class of each Portfolio. Under the terms of each Plan, a Portfolio is permitted to pay, out of the assets of the Financial Intermediary Class of the Portfolio, in an amount up to 0.40% on an annual basis of the average daily net assets of that class, LMWW, financial intermediaries and other parties that provide services in connection with or are otherwise involved in the distribution of shares or administration of plans or programs that use Portfolio shares as their funding medium, and to reimburse certain other expenses and payments. Payments under the Plans are currently limited to 0.25% of average daily net assets. For more information regarding the Plans and their terms, see the SAI. - -------------------------------------------------------------------------------- REDEMPTION OF SHARES - -------------------------------------------------------------------------------- Portfolio shares may be redeemed through three methods: (1) by sending a written request for redemption to the Transfer Agent at P.O. Box 953, Boston, Massachusetts 02103; (2) by calling the Portfolio at 888-42LMIFA; or (3) by wire communication with the Transfer Agent. In each case, the investor should first notify the Portfolio at 888-42LMIFA of the intention to redeem. No charge is made for redemptions. Shareholders who wish to be able to redeem by telephone or wire communication must complete an authorization form in advance. Redemptions over $10,000,000 may be initiated by telephone, but must be confirmed in writing prior to processing. With respect to telephone redemptions or transfers, the Transfer Agent will process orders based on instructions from a shareholder, or any person claiming to act as his or her representative, who can provide it with his or her account registration and address as it appears on its records. The Transfer Agent will employ these and other reasonable procedures to confirm that instructions communicated by telephone are genuine; if it fails to employ reasonable procedures, the Transfer Agent may be liable for any losses due to unauthorized or fraudulent instructions. -45- Upon receipt of a request for redemption as described below (a request "in good order") before the close of the Exchange on any day when the Exchange is open, the Transfer Agent will redeem Portfolio shares at that day's net asset value per share. Requests for redemption received by the Transfer Agent after the close of the Exchange will be executed at the net asset value next determined. However, orders received by certain retirement plans and other financial intermediaries by the close of the Exchange and communicated to the Transfer Agent by 9:00 a.m., Eastern time, on the following business day will be effected at the net asset value determined on the prior business day. The Portfolios may refuse to effect redemption requests during periods permitted by federal securities laws. Requests for redemption should indicate: 1) The number of shares or dollar amount to be redeemed and the investor's shareholder account number; 2) The investor's name and the names of any co-owner of the account, using exactly the same name or names used in establishing the account; 3) Proof of authorization to request redemption on behalf of any co-owner of the account (please contact the Portfolio for further details); and 4) The name, address, and account number to which the redemption payment should be sent. Payment of the redemption price normally will be made by wire three business days after receipt of a redemption request in good order. However, each Portfolio reserves the right to postpone the payment date when the Exchange is closed, when trading is restricted, or during other periods as permitted by federal securities laws, or to take up to seven days to make payment upon redemption if the Portfolio involved could be adversely affected by immediate payment. Redemption proceeds may also be paid in kind at the discretion of the Portfolio. Shareholders who receive a redemption in kind may incur costs to dispose of such securities. Shareholders of some investment companies have experienced difficulty contacting their funds by telephone during periods of intense market activity. Shareholders who are unable to contact a Portfolio by telephone and wish to make a redemption should follow the instructions for redeeming by mail or by wire. Other supporting legal documents, such as copies of the trust instrument or power of attorney, may be required from corporations or other organizations, fiduciaries or persons other than the shareholder of record making the request for redemption or repurchase. If you have a question concerning the sale or redemption of shares, please contact the Portfolio or the Transfer Agent. -46- Any Portfolio may elect to close any shareholder account when the current value of the account is less than $1 million due to redemptions or exchanges by the shareholder by redeeming all of the shares in the account and mailing the proceeds to the investor. If a Portfolio elects to redeem the shares in an account, the shareholder will be notified that the account is below $1 million and will be allowed 30 days in which to make an additional investment in order to avoid having the account closed. Shares will be redeemed at the net asset value calculated on the day of redemption. Any Portfolio may change the $1 million minimum account balance from time to time without notice to shareholders. - -------------------------------------------------------------------------------- SIGNATURE GUARANTEE - -------------------------------------------------------------------------------- When a signature guarantee is called for, the shareholder should have "Signature Guaranteed" stamped under his signature and guaranteed by any of the following entities: U.S. banks, foreign banks having a U.S. correspondent bank, credit unions, savings associations, U.S. registered dealers and brokers, municipal securities dealers and brokers, government securities dealers and brokers, national securities exchanges, registered securities associations and clearing agencies (each an "Eligible Guarantor Institution"). Each Portfolio and its agents reserve the right to reject any signature guarantee pursuant to written signature guarantee standards or procedures, which may be revised in the future to permit them to reject signature guarantees from Eligible Guarantor Institutions that do not, based on credit guidelines, satisfy such written standards or procedures. Any Portfolio may change the signature guarantee requirements from time to time without prior notice to shareholders. - -------------------------------------------------------------------------------- EXCHANGE PRIVILEGE - -------------------------------------------------------------------------------- Shareholders in any Portfolio may exchange their shares for shares of the same class of any of the other Portfolios or of any of the portfolios offered by LM Institutional Fund Advisors I, Inc., provided that the shares of that class are being offered at the time of the proposed exchange. Investments by exchange among any of the Portfolios are made at the per share net asset values next determined after the order for exchange is received in good order. The exchange privilege is not intended as a vehicle for short-term trading. Excessive exchange activity may interfere with portfolio management and have an adverse effect on all shareholders. In order to limit excessive exchange activity and in other circumstances where a Portfolio believes doing so would be in its best interest, the Portfolio reserves the right to revise or terminate the exchange privilege, limit the amount or number of exchanges or reject any exchange. For further information concerning the exchange privilege, or to make an exchange, please contact the Portfolio at 888-42LMIFA. -47- - -------------------------------------------------------------------------------- NET ASSET VALUE - -------------------------------------------------------------------------------- Net asset value per share of each class of shares is determined daily for each Portfolio as of the close of regular trading on the Exchange (normally 4:00 p.m., Eastern time), on every day that the Exchange is open, by subtracting the Portfolio's liabilities attributable to a given class of shares from its total assets attributable to the class and dividing the result by the number of shares of that class outstanding. Net asset value will not be determined on days on which the Exchange is closed. Portfolio securities and other assets for which market quotations are readily available are valued at current market value. Current market value means the last sale price of the day for a comparable position, or, in the absence of any such sales, the mean between representative bid and asked prices obtained from a quotation reporting system. Securities with remaining maturities of 60 days or less are generally valued at amortized cost. Fixed income securities, including those to be purchased under firm commitment agreements, are normally valued on the basis of quotations obtained from brokers and dealers or pricing services which take into account appropriate factors such as institutional-size trading in similar groups of securities, yield, quality, coupon rate, maturity, type of issue, trading characteristics and other market data. Certain fixed income securities for which daily market quotations are not readily available may be valued with reference to fixed income securities whose prices are more readily available and whose durations are comparable to those of the securities being valued. Other assets and securities for which no quotations are readily available are valued at fair value as determined in good faith by the Directors or persons acting at their direction. The values of foreign securities quoted in foreign currencies are translated into U.S. dollars at current exchange rates or at such other rates as the Directors or persons acting at their direction may determine in computing net asset value. Because of time zone differences, foreign exchanges and securities markets will usually be closed prior to the time of the closing of the Exchange and values of foreign investments will be determined as of the earlier closing of such exchanges and securities markets. However, events affecting the values of such foreign securities may occasionally occur between the earlier closings of such exchanges and securities markets and the closing of the Exchange which will not be reflected in the computation of the net asset value. If an event materially affecting the value of such foreign securities occurs during such period, then such securities will be valued at fair value as determined in good faith by the Directors or persons acting at their direction. -48- - -------------------------------------------------------------------------------- DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS - -------------------------------------------------------------------------------- The Legg Mason Fund Adviser Large Cap Value Portfolio and the Legg Mason Fund Adviser Total Return Portfolio declare and pay dividends quarterly out of their net investment income for that quarter. All other Portfolios declare and pay dividends annually out of their net investment income for that year. Distributions of net realized capital gains are made annually. Shareholders may elect to receive dividends and distributions in one of four ways: 1) Receive both dividends and other distributions in shares of the same class of the distributing Portfolio; 2) Receive dividends in cash and other distributions in shares of the same class of the distributing Portfolio; 3) Receive dividends in shares of the same class of the distributing Portfolio and other distributions in cash; or 4) Receive both dividends and other distributions in cash. If no election is made, both dividends and other distributions are credited to a shareholder's Portfolio account in shares (of the same class as the shares already held) at the net asset value of the shares determined as of the close of the Exchange on the reinvestment date. Reinvestment of dividends and other distributions occurs on the ex-dividend date. An election to receive dividends or other distributions in cash rather than additional shares may be made by notifying the Transfer Agent in writing. If a shareholder has elected to receive dividends and/or other distributions in cash and the postal or other delivery service is unable to deliver checks to the shareholder's address of record, such shareholder's distribution option will automatically be converted to having all dividends and other distributions reinvested in additional shares. No interest will accrue on amounts represented by uncashed distribution or redemption checks. The Directors reserve the right to revise the dividend policy or postpone the payment of dividends if warranted in their judgment due to unusual circumstances, such as an unexpected large expense, loss or fluctuation in net asset value. -49- - -------------------------------------------------------------------------------- TAX INFORMATION - -------------------------------------------------------------------------------- Each Portfolio intends to qualify as a "regulated investment company" for federal income tax purposes and to meet all other requirements necessary for it to be relieved of federal taxes on income and gains it distributes to shareholders. Each Portfolio will distribute substantially all its net investment income and net realized capital gains to its shareholders on a current basis. Distributions from a Portfolio (whether paid in cash or reinvested in shares of the Portfolio) will be taxable to shareholders (other than IRAs, other qualified retirement plans and other tax-exempt investors) as ordinary income to the extent derived from the Portfolio's investment income and net short-term gains. Portfolio distributions of net capital gains (that is, the excess of net gains from capital assets held for more than one year over net losses from capital assets held for not more than one year) will be taxable as long-term capital gain. Special tax rules apply to investments through defined contributions plans and other tax-qualified plans. Shareholders should consult their tax adviser to determine the suitability of shares of a Portfolio as an investment through such plans and the precise effect of an investment on their particular tax situation. A Portfolio's investments in foreign securities may be subject to withholding taxes at the source on dividend or interest payments. In that case, a Portfolio's yield on those securities would be decreased. If at the end of a Portfolio's fiscal year more than 50% of the value of its total assets represents securities of foreign corporations, the Portfolio may make an election to treat any foreign taxes paid by it as paid by its shareholders. In this case, shareholders who are U.S. citizens, U.S. corporations and, in some cases, U.S. residents generally will be required to include in U.S. taxable income their pro rata share of such taxes, but may then generally be entitled to claim a foreign tax credit or deduction (but not both) for their share of such taxes. A shareholder's ability to claim a foreign tax credit or deduction in respect of foreign taxes paid by a Portfolio may be subject to certain limitations (including a holding period requirement, applicable to both a Portfolio and its shareholders, imposed by the Taxpayer Relief Act of 1997). A Portfolio's transactions in foreign currencies and hedging activities may give rise to ordinary income or loss to the extent such income or loss results from fluctuations in value of the foreign currency concerned. In addition, such activities will likely produce a difference between book income and taxable income. This difference may cause a portion of a Portfolio's income distributions to constitute a return of capital for tax purposes or require a Portfolio to make distributions exceeding book income to qualify as a regulated investment company for tax purposes. -50- Investment in an entity that qualifies as a "passive foreign investment company" under the Internal Revenue Code of 1986 could subject a Portfolio to a U.S. federal income tax or other charge on certain "excess distributions" with respect to the investment, and on the proceeds from disposition of the investment. A Portfolio may make an election to mark the gains (and to a limited extent losses) in such investments "to the market" as though it had sold and repurchased its holdings in those passive foreign investment companies on the last day of the Portfolio's taxable year. Early each year each Portfolio will notify its shareholders of the amount and tax status of distributions paid during that year. The foregoing is a summary of certain federal income tax consequences of investing in a Portfolio. Shareholders are urged to consult their tax advisers with respect to the effects of this investment on their particular tax situation (including possible liability for state and local taxes). -51- - -------------------------------------------------------------------------------- APPENDIX A -- SECURITIES RATINGS - -------------------------------------------------------------------------------- The following rating services describe rated securities as follows: MOODY'S INVESTORS SERVICE, INC. BONDS Aaa -- Bonds which are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edged." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa -- Bonds which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they compromise what are generally known as high grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities. A -- Bonds which are rated A possess many favorable investment attributes and are to be considered as upper-medium grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment sometime in the future. Baa -- Bonds which are rated Baa are considered as medium grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Ba -- Bonds which are rated Ba are judged to have speculative elements; their future cannot be considered as well-assured. Often the protection of interest and principal payments may be very moderate, and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B -- Bonds which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. A-1 Caa -- Bonds which are rated Caa are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest. Ca -- Bonds which are rated Ca represent obligations which are speculative in a high degree. Such issues are often in default or have other marked shortcomings. C -- Bonds which are rated C are the lowest rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. NOTES MIG 1/VMIG 1 -- This designation denotes best quality. There is present strong protection by established cash flows, superior liquidity support or demonstrated broad-based access to the market for refinancing. MIG 2/VMIG 2 -- This designation denotes high quality. Margins of protection are ample although not so large as in the preceding group. COMMERCIAL PAPER Issuers rated Prime-1 (or supporting institutions) have a superior ability for repayment of senior short-term debt obligations. Prime-1 repayment ability will often be evidenced by the following characteristics: - -- Leading market positions in well established industries. - -- High rates of return on funds employed. - -- Conservative capitalization structure with moderate reliance on debt and ample asset protection. - -- Broad margins in earnings coverage of fixed financial charges and high internal cash generation. - -- Well established access to a range of financial markets and assured sources of alternate liquidity. Issuers rated Prime-2 (or supporting institutions) have a strong ability for repayment of senior short-term debt obligations. This will normally be evidenced by many of the characteristics cited above to a lesser degree. Earnings trends and coverage ratios, while sound, may be more subject to variation. Capitalization characteristics, while still appropriate, may be more affected by external conditions. Ample alternate liquidity is maintained. A-2 STANDARD & POOR'S BONDS AAA -- Debt rated "AAA" has the highest rating assigned by Standard & Poor's. Capacity to pay interest and repay principal is extremely strong. AA -- Debt rated "AA" has a very strong capacity to pay interest and repay principal and differs from the higher rated issues only in small degree. A -- Debt rated "A" has a strong capacity to pay interest and repay principal although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in higher rated categories. BBB -- Debt rated "BBB" is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. BB-B-CCC-CC-C -- Debt rated "BB", "B", "CCC", "CC" and "C" is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. "BB" indicates the lowest degree of speculation and "C" the highest. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major exposures to adverse conditions. BB -- Debt rated "BB" has less near-term vulnerability to default than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments. The "BB" rating category is also used for debt subordinated to senior debt that is assigned an actual or implied "BBB" rating. B -- Debt rated "B" has a greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments. Adverse business, financial, or economic conditions will likely impair capacity or willingness to pay interest and repay principal. The "B" rating category is also used for debt subordinated to senior debt that is assigned as actual or implied "BB" or "BB-" rating. CCC -- Debt rated "CCC" has a currently identifiable vulnerability to default, and is dependent upon favorable business, financial, and economic conditions to meet timely payment of interest and repayment of principal. In the event of adverse business, financial, or economic conditions, it is not likely to have the capacity to pay interest and repay principal. A-3 The "CCC" rating category is also used for debt subordinated to senior debt that is assigned an actual or implied "B" or "B-" rating. CC -- The rating "CC" typically is applied to debt subordinated to senior debt that is assigned an actual or implied "CCC" rating. C -- The rating "C" typically is applied to debt subordinated to senior debt which is assigned an actual or implied "CCC-" debt rating. The "C" rating may be used to cover a situation where a bankruptcy petition has been filed, but debt service payments are continued. D -- Bonds rated "D" are in payment default. The "D" rating category is used when interest payments or principal payments are not made on the date due even if the applicable grace period has not expired, unless S&P believes that such payments will be made during such grace period. The "D" rating also will be used on the filing of a bankruptcy petition if debt service payments are jeopardized. NOTES SP-1 -- Strong capacity to pay principal and interest. Those issues determined to possess overwhelming safety characteristics are given a plus sign (+) designation. SP-2 -- Satisfactory capacity to pay principal and interest. SP-3 -- Speculative capacity to pay principal and interest. COMMERCIAL PAPER A-1 -- This highest category indicates that the degree of safety regarding timely payment is strong. Those issues determined to possess extremely strong safety characteristics are denoted with a plus sign (+) designation. A-2 -- Capacity for timely payment on issues with this designation is satisfactory. However, the relative degree of safety is not as high as for issues designated "A-1." A-3 -- Issues carrying this designation have adequate capacity for timely payment. They are, however, more vulnerable to the adverse effects of changes in circumstances than obligations carrying the higher designations. FITCH INVESTORS SERVICE, INC. AAA -- Bonds considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal, which is unlikely to be affected by reasonably foreseeable events. A-4 AA -- Bonds considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong, although not quite as strong as bonds rated AAA. A -- Bonds considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB -- Bonds considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered to be adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have adverse impact on these bonds, and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB -- Bonds considered to be speculative. The obligor's ability to pay interest and repay principal may be affected over time by adverse economic changes. However, business and financial alternatives can be identified which could assist the obligor in satisfying its debt service requirements. B -- Bonds are considered highly speculative. Bonds in this class are lightly protected as to the obligor's ability to pay interest over the life of the issue and repay principal when due. CCC -- Bonds have certain characteristics which, with passing of time, could lead to the possibility of default on either principal or interest payments. CC -- Bonds are minimally protected. Default in payment of interest and/or principal seems probable. C -- Bonds are in actual or imminent default in payment of interest or principal. DDD -- Bonds are in default and in arrears in interest and/or principal payments. Such bonds are extremely speculative and should be valued only on the basis of their value in liquidation or reorganization of the obligor. SHORT TERM RATINGS Fitch's short-term ratings apply to debt obligations that are payable on demand or have original maturities of generally up to three years, including commercial paper, certificates of deposit, medium-term notes, and municipal and investment notes. The short-term rating places greater emphasis than a long-term rating on the existence of liquidity necessary to meet the issuer's obligations in a timely manner. A-5 F-1+ -- Exceptionally Strong Credit Quality. Issues assigned this rating are regarded as having the strongest degree of assurance for timely payment. F-1 -- Very Strong Credit Quality. Issues assigned this rating reflect an assurance of timely payment only slightly less in degree than issues rated "F-1+". F-2 -- Good Credit Quality. Issues assigned this rating have a satisfactory degree of assurance for timely payment, but the margin of safety is not as great as for issues assigned "F-1+" and "F-1 " ratings. F-3 -- Fair Credit Quality. Issues assigned this rating have characteristics suggesting that the degree of assurance for timely payment is adequate; however, near-term adverse changes could cause these securities to be rated below investment grade. F-S -- Weak Credit Quality. Issues assigned this rating have characteristics suggesting a minimal degree of assurance for timely payment and are vulnerable to near-term adverse changes in financial and economic conditions. D -- Default. Issues assigned this rating are in actual or imminent payment default. LOC -- The symbol LOC indicates that the rating is based on a letter of credit issued by a commercial bank. A-6 - -------------------------------------------------------------------------------- APPENDIX B -- PRIOR PERFORMANCE OF ADVISERS' OTHER ACCOUNTS - -------------------------------------------------------------------------------- The Portfolios are newly organized, have not yet commenced operations and have no performance record of their own. However, the Advisers have managed other client accounts that have investment objectives and policies that are similar, but not necessarily identical to, those of the Portfolios. Representative investment performance for these accounts is stated below. The investment performance is shown on an annual total return basis, with returns for periods of less than one year not annualized, and on an average annual total return basis. The performance information is provided through June 30, 1998 The prior performance information shown is in two forms: (1) composites of certain of the Adviser's separately managed accounts and (2) SEC-registered, open-end investment companies. In each case, the account or accounts have investment objectives and policies substantially similar (although not necessarily identical) to those of the relevant Portfolio; were managed throughout the periods shown using investment styles and strategies substantially similar (although not necessarily identical) to those of the relevant Portfolio; and, to the extent a composite of accounts is shown, the composite includes all of the fully-discretionary, fee-paying accounts managed by such Adviser during the periods shown using investment objectives, policies and strategies substantially similar (although not necessarily identical) to those of the relevant Portfolio. The performance information for composites has been adjusted to give effect to the Portfolios' estimated fees and expenses, before waivers and reimbursements, for the Financial Intermediary Class shares as shown in the table on page 9. The performance information for composites assumes reinvestment of all dividends and proceeds from capital transactions and has been prepared in accordance with the Performance Presentation Standards established by the Association for Investment Management and Research ("AIMR standards"), except for the deduction of estimated fees and expenses as noted above. The performance results would be more favorable if they had been adjusted for estimated fees and expenses of the Institutional Class shares of the Portfolios. Accounts included in composites are generally not subject to the diversification requirements, specific tax restrictions and investment limitations imposed on each of the Portfolios by the 1940 Act or the Code. The performance results for these accounts might have been adversely affected had the accounts been subject to these requirements, restrictions and limitations. Performance for SEC-registered, open-end investment companies is calculated using the SEC's standardized total return formula, which is based upon the change in value of an assumed initial investment of $1,000 from the beginning through the end of a period and assumes reinvestment of all dividends and other distributions. For periods of more than one year, the result is then annualized and expressed as a percentage of the initial investment, and includes the effect of operating expenses, including advisory fees. Information about the investment objectives, policies, expenses and net assets of each of the investment companies follows the performance information. B-1 The method for calculating performance for the composites produces a different result than if the performance were calculated using the SEC's method for calculating the total return of an open-end investment company. A Portfolio's expenses, timing of purchases and sales of portfolio securities, timing and availability of cash flows, cash positions (which are typically greater for open-end investment companies than for separate accounts), and brokerage commissions are some of the reasons that might cause performance results of the Portfolio to vary from that of the accounts and/or investment companies shown below. In particular, the large infusions of cash that are typically associated with the commencement of operations of new mutual funds such as the Portfolios, as well as differences in the amount of assets, which can affect the ability and the manner in which security positions are accumulated or liquidated, may also cause a Portfolio's performance to vary from that of the accounts and/or investment companies shown below. As noted above, the investment objective, policies, styles and strategies of each Portfolio are not necessarily identical to those of the relevant accounts and/or investment companies shown below. Again, for these and other reasons, the performance of the Portfolios will vary from that of the accounts and/or investment companies. PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE LEGG MASON FUND ADVISER LARGE CAP VALUE PORTFOLIO. The investment performance for the period from July 1, 1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Value Trust ("Value Trust") is shown below. The benchmark index to which Value Trust is compared is the S&P 500 Index. The S&P 500 Index is an unmanaged index representing the performance of 500 companies selected by S&P. Although used as a benchmark, the Index's performance may not be comparable to Value Trust's performance because, unlike the performance of Value Trust, the Index's performance has not been adjusted for any fees or expenses. B-2
- ---------------------------------------- ------------------------------------- ------------------------------------- Yearly Total Return - ---------------------------------------- ------------------------------------- ------------------------------------- Year Ended June 30 Account Performance (%) S&P 500 Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1998 38.48 30.16 - ---------------------------------------- ------------------------------------- ------------------------------------- 1997 52.16 34.71 - ---------------------------------------- ------------------------------------- ------------------------------------- 1996 28.64 26.00 - ---------------------------------------- ------------------------------------- ------------------------------------- 1995 27.59 26.07 - ---------------------------------------- ------------------------------------- ------------------------------------- 1994 4.86 1.41 - ---------------------------------------- ------------------------------------- ------------------------------------- 1993 13.95 13.63 - ---------------------------------------- ------------------------------------- ------------------------------------- 1992 18.48 13.41 - ---------------------------------------- ------------------------------------- ------------------------------------- 1991 -5.20 7.39 - ---------------------------------------- ------------------------------------- ------------------------------------- 1990 4.80 16.49 - ---------------------------------------- ------------------------------------- ------------------------------------- 1989 16.67 20.55 - ---------------------------------------- ------------------------------------- -------------------------------------
- ------------------------------------ -------------------------------------------- ---------------------------------- AVERAGE ANNUAL RETURNS - ------------------------------------ -------------------------------------------- ---------------------------------- Period ended Account S&P 500 June 30 Performance (%) Performance (%) - ------------------------------------ -------------------------------------------- ---------------------------------- 1 Year 38.48 30.16 - ------------------------------------ -------------------------------------------- ---------------------------------- 3 Year 39.43 30.24 - ------------------------------------ -------------------------------------------- ---------------------------------- 5 Year 29.39 23.08 - ------------------------------------ -------------------------------------------- ---------------------------------- 10 Year 18.96 18.54 - ------------------------------------ -------------------------------------------- ----------------------------------
Value Trust, which commenced operations on April 16, 1982, is a diversified open-end investment company. Value Trust's investment objective is long-term growth of capital. Value Trust invests primarily in securities that appear to be undervalued in relation to the long-term earning power or asset value of their issuers. Value Trust invests primarily in companies with a record of earnings and dividends, reasonable return on equity, and sound finances. Value Trust may from time to time invest in securities that pay no dividends or interest. Current dividend income is not a prerequisite in the selection of equity securities. Value Trust normally invests primarily in equity securities. It may invest in debt securities for temporary defensive purposes and, consistent with its investment objective, during periods when or under circumstances where LMFA believes the return on certain debt securities may equal or exceed the return on equity securities. Value Trust may invest in debt securities of both foreign and domestic issuers of any maturity without regard to rating, and may invest its B-3 assets in such securities without regard to a percentage limit. LMFA currently anticipates that, under normal market conditions, Value Trust will invest no more than 25% of its total assets in long-term debt securities. Up to 10% of Value Trust's total assets may be invested in debt securities not rated investment grade, i.e., not rated at least BBB by S&P or Baa by Moody's or, if unrated by those entities, deemed by LMFA to be of comparable quality. Value Trust may purchase preferred stock, indexed securities, closed-end investment companies, foreign securities (25% or less of total assets), illiquid securities (10% or less of net assets) and when-issued securities; may invest in futures and options transactions, including puts and calls; and may enter into forward foreign currency contracts. As of June 30, 1998, Value Trust had approximately $5,753,938,809 in assets. For its fiscal year ended March 31, 1998, the Primary shares of Value Trust had a total expense ratio of 1.73%. Legg Mason Capital Management, Inc. ("LMCM"), an affiliate of LMFA (the Adviser to the Portfolio) that shares investment personnel with LMFA, manages separate accounts in a manner substantially similar (although not necessarily identical to) that of the Portfolio. The total return for the composite of these accounts for the year ended June 30, 1998 and the period from January 1, 1997 through June 30, 1997 was 35.52% and 22.30%, respectively, and the average annual total return for the composite for one year (July 1, 1997 to June 30, 1998) was 35.52% and since inception (January 1, 1997 to June 30, 1998) was 38.00%. The number of accounts included in the composite has ranged from 1 to 25 over the relevant period and the aggregate assets of the accounts has ranged from $4.4 million to $599.3 million over the period. All of the fully discretionary tax-exempt accounts of LMCM with assets greater than $3 million are included in the composite after a period of three months and after the account becomes fully invested. Taxable and non-fully discretionary accounts and accounts that hold large amounts of cash are not managed by LMCM in a manner that is substantially similar to the Portfolio. The inclusion of taxable accounts, non-fully discretionary accounts, or accounts that hold large amounts of cash might have adversely affected the performance of the composite. Accounts included in the composite are generally not subject to the diversification requirements, specific tax restrictions and investment limitations imposed on the Portfolio by the 1940 Act or the Code. The performance results for these accounts might have been adversely affected had the accounts been subject to these requirements, restrictions and limitations. These potential differences do not adversely affect the determination that the accounts included in this composite are managed in a substantially similar manner to the Portfolio. THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. PRIOR PERFORMANCE OF AN ACCOUNT SIMILAR TO THE LEGG MASON FUND ADVISER MID CAP VALUE PORTFOLIO. The investment performance for the period from July 1, 1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Special Investment Trust ("Special Investment Trust") is shown below. The benchmark index to which Special Investment Trust is compared is the Russell 2000 Index. The Russell 2000 Index is an unmanaged index representing the performance of the 2000 smallest of the 3000 largest U.S.-domiciled corporations, ranked by B-4 market capitalization. Although used as a benchmark, the Index's performance may not be comparable to Special Investment Trust's performance since, unlike the performance of Special Investment Trust, the Index's performance has not been adjusted for any fees or expenses.
- ---------------------------------------- ------------------------------------- ------------------------------------- Yearly Total Return - ---------------------------------------- ------------------------------------- ------------------------------------- Year Ended June 30 Account Performance (%) Russell 2000 Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1998 22.29 16.51 - ---------------------------------------- ------------------------------------- ------------------------------------- 1997 22.52 16.33 - ---------------------------------------- ------------------------------------- ------------------------------------- 1996 25.89 23.89 - ---------------------------------------- ------------------------------------- ------------------------------------- 1995 8.85 20.11 - ---------------------------------------- ------------------------------------- ------------------------------------- 1994 4.97 4.34 - ---------------------------------------- ------------------------------------- ------------------------------------- 1993 25.72 26.01 - ---------------------------------------- ------------------------------------- ------------------------------------- 1992 12.34 14.54 - ---------------------------------------- ------------------------------------- ------------------------------------- 1991 14.37 1.33 - ---------------------------------------- ------------------------------------- ------------------------------------- 1990 10.96 2.96 - ---------------------------------------- ------------------------------------- ------------------------------------- 1989 20.57 12.81 - ---------------------------------------- ------------------------------------- -------------------------------------
- ---------------------------------------- ------------------------------------- ------------------------------------- AVERAGE ANNUAL RETURNS - ---------------------------------------- ------------------------------------- ------------------------------------- Period ended Account Russell 2000 June 30 Performance (%) Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1 Year 22.29 16.51 - ---------------------------------------- ------------------------------------- ------------------------------------- 3 Year 23.56 18.86 - ---------------------------------------- ------------------------------------- ------------------------------------- 5 Year 16.60 16.04 - ---------------------------------------- ------------------------------------- ------------------------------------- 10 Year 16.63 13.58 - ---------------------------------------- ------------------------------------- -------------------------------------
Special Investment Trust, which commenced operations on December 30, 1985, is a diversified open-end investment company. Special Investment Trust's investment objective is capital appreciation. Current income is not a consideration. Special Investment Trust invests principally in equity securities, and securities convertible into equity securities, of companies with market capitalizations of less than $2.5 billion which LMFA believes have one or more of the following characteristics: they are not closely followed by, or are out of favor with, investors, and appear to be undervalued in relation to their long-term earning power or asset values; unusual developments have occurred which suggest the possibility that the market value of the securities will increase; or they are involved in actual or anticipated reorganizations or restructurings under the Bankruptcy Code (no more than 20% of Special Investment Trust's total B-5 assets may be invested in such securities). Special Investment Trust also invests in debt securities of companies having one or more of these characteristics. Special Investment Trust may invest in larger, more highly-capitalized companies when circumstances warrant such investments. Special Investment Trust may invest up to 20% of its total assets in securities of companies involved in actual or anticipated reorganizations or restructurings, and may purchase debt securities. Up to 35% of its net assets may be invested in debt securities not rated at least BBB by S&P, or Baa by Moody's, and securities unrated by those entities, deemed by LMFA to be of comparable quality. Special Investment Trust may purchase preferred stock, indexed securities, closed-end investment companies, foreign securities (25% or less of total assets), illiquid securities (10% or less of net assets) and when-issued securities; may invest in futures and options transactions, including puts and calls; and may enter into forward foreign currency contracts. When conditions warrant, for temporary defensive purposes, Special Investment Trust also may invest without limit in short-term debt instruments. As of June 30, 1998, Special Investment Trust had approximately $1,626,638,158 in assets. For its fiscal year ended June 30, 1998, the Primary shares of Special Investment Trust had a total expense ratio of 1.86%. THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BRANDYWINE SMALL CAP VALUE PORTFOLIO. The investment performance for the period from September 30, 1988 to June 30, 1998 of all accounts managed by Brandywine that are substantially similar to the Portfolio is shown below. The benchmark index to which the accounts are compared is the Russell 2000 Index. The Russell 2000 Index is an unmanaged index representing the performance of the 2000 smallest of the 3000 largest U.S.-domiciled corporations, ranked by market capitalization. Although used as a benchmark, the Index's performance may not be comparable to the accounts' performance since, unlike the performance of the accounts, the Index's performance has not been adjusted for any fees or expenses. B-6
- ----------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ----------------------------------------------------------------------------------------------------------------------- Composite Year Ended June 30 Performance (%) Russell 2000 Performance (%) - ------------------------------------------- -------------------------------- ------------------------------------------ 1998 23.16 16.51 - ------------------------------------------- -------------------------------- ------------------------------------------ 1997 32.65 16.33 - ------------------------------------------- -------------------------------- ------------------------------------------ 1996 19.21 23.89 - ------------------------------------------- -------------------------------- ------------------------------------------ 1995 16.87 20.11 - ------------------------------------------- -------------------------------- ------------------------------------------ 1994 6.26 4.34 - ------------------------------------------- -------------------------------- ------------------------------------------ 1993 22.53 26.01 - ------------------------------------------- -------------------------------- ------------------------------------------ 1992 18.01 14.54 - ------------------------------------------- -------------------------------- ------------------------------------------ 1991 13.21 1.33 - ------------------------------------------- -------------------------------- ------------------------------------------ 1990 -2.82 2.96 - ------------------------------------------- -------------------------------- ------------------------------------------ 1989 (beginning September 30, 12.88 12.81 1988) - ------------------------------------------- -------------------------------- ------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ---------------------------------------- ------------------------------------- ---------------------------------------- Period ended Composite Russell 2000 June 30 Performance (%) Performance (%) - ---------------------------------------- ------------------------------------- ---------------------------------------- 1 Year 23.16 16.51 - ---------------------------------------- ------------------------------------- ---------------------------------------- 3 Year 24.88 18.86 - ---------------------------------------- ------------------------------------- ---------------------------------------- 5 Year 19.32 16.04 - ---------------------------------------- ------------------------------------- ---------------------------------------- Since Inception 16.26 13.58 September 30, 1988 - ---------------------------------------- ------------------------------------- ----------------------------------------
The number of accounts included in the composite has ranged from 2 to 9 over the relevant period and the aggregate assets of the accounts has ranged from $21 million to $1 billion over the period. One of the accounts included in the composite is a registered open-end investment company. Accounts included in the composite are generally not subject to the diversification requirements, specific tax restrictions and investment limitations imposed on the Portfolio by the 1940 Act or the Code. The performance results for these accounts might have been adversely affected had the accounts been subject to these requirements, restrictions and limitations. In addition, the accounts included in the composite have invested in so-called "micro" cap stocks to a greater extent than the Portfolio is likely to. These potential differences B-7 do not adversely affect the determination that the accounts included in this composite are managed in a substantially similar manner to the Portfolio. THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BATTERYMARCH EMERGING MARKETS PORTFOLIO. The investment performance for the period from January 1, 1994 to June 30, 1998 of all accounts managed by Batterymarch that are substantially similar to the Portfolio is shown below. The benchmark index to which the accounts are compared is the MSCI Emerging Markets Free Index with Gross Dividends ("MSCI EMF"). The MSCI EMF is an unmanaged index representing the performance of a market weighted aggregate of 26 individual emerging country indices and takes into account local and market restrictions on share ownership by foreigners. Although used as a benchmark, the Index's performance may not be comparable to the accounts' performance since, unlike the performance of the accounts, the Index's performance has not been adjusted for any fees or expenses.
- -------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ---------------------------------------- ------------------------------------- ------------------------------------- Year Ended June 30 Composite Performance (%) MSCI EMF Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1998 -34.01 -39.08 - ---------------------------------------- ------------------------------------- ------------------------------------- 1997 19.99 12.82 - ---------------------------------------- ------------------------------------- ------------------------------------- 1996 10.61 8.47 - ---------------------------------------- ------------------------------------- ------------------------------------- 1995 -7.51 0.01 - ---------------------------------------- ------------------------------------- ------------------------------------- 1994 -10.82 -9.04 - ---------------------------------------- ------------------------------------- -------------------------------------
- ----------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ---------------------------------------- ------------------------------------- ---------------------------------------- Period ended Composite MSCI EMF June 30 Performance (%) Performance (%) - ---------------------------------------- ------------------------------------- ---------------------------------------- 1 Year -34.01 -39.08 - ---------------------------------------- ------------------------------------- ---------------------------------------- 3 Year -1.14 -5.93 - ---------------------------------------- ------------------------------------- ---------------------------------------- Since Inception -2.64 -4.44 (January 1, 1994) - ---------------------------------------- ------------------------------------- ----------------------------------------
The number of accounts included in the composite has ranged from 1 to 5 over the relevant period and the aggregate assets of the accounts has ranged from $65 million to $1 billion over the period. One of the accounts included in the composite is the mutual fund B-8 described below. Accounts included in the composite are generally not subject to the diversification requirements, specific tax restrictions and investment limitations imposed on the Portfolio by the 1940 Act or the Code. The performance results for these accounts might have been adversely affected had the accounts been subject to these requirements, restrictions and limitations. These potential differences do not adversely affect the determination that the accounts included in this composite are managed in a substantially similar manner to the Portfolio. The performance of the composite is calculated based on AIMR standards, including the performance of the "mutual fund account" included in the composite, while the separate performance of the mutual fund shown below is calculated according to the SEC's method for calculating performance. The investment performance for the period from May 28, 1996 to June 30, 1998 for the Primary shares of the Legg Mason Emerging Markets Trust ("Emerging Markets Trust"), which has been advised by Batterymarch since its inception, is shown below.
- ----------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ------------------------------------------------- --------------------------------------- ----------------------------- Year Ended June 30 Account Performance (%) MSCI EMF Performance (%) - ------------------------------------------------- --------------------------------------- ----------------------------- 1998 -34.42 -39.08 - ------------------------------------------------- --------------------------------------- ----------------------------- 1997 27.41 12.82 - ------------------------------------------------- --------------------------------------- ----------------------------- 1996 (Inception of May 28, 1996) 0.20 -0.45 - ------------------------------------------------- --------------------------------------- -----------------------------
- ----------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ------------------------------------------------- --------------------------------------- ----------------------------- Period ended Account Performance (%) MSCI EMF June 30 Performance (%) - ------------------------------------------------- --------------------------------------- ----------------------------- 1 Year -34.42 -39.08 - ------------------------------------------------- --------------------------------------- ----------------------------- Since Inception -8.13 -8.90 (May 28, 1996) - ------------------------------------------------- --------------------------------------- -----------------------------
Emerging Markets Trust, which commenced operations on May 28, 1996, is a diversified open-end investment company. Emerging Markets Trust's investment objective is long-term capital appreciation. Emerging Markets Trust normally invests at least 65% of its total assets in emerging market equity securities. Assets not invested in emerging market equity securities may be invested in any combination of debt securities of the U.S. Government, equity securities of issuers in developed countries, cash and money market instruments, including repurchase agreements. Batterymarch intends Emerging Markets Trust to be substantially fully invested in equity securities and convertible securities of emerging market issuers. Emerging Markets Trust may use options and stock index futures and may also enter into forward foreign currency exchange contracts in order to protect against fluctuations in exchange rates. More than 25% of B-9 Emerging Markets Trust's total assets may be denominated in a single currency. When abnormal market or economic situations warrant in the opinion of Batterymarch, Emerging Markets Trust may invest without limit for temporary defensive purposes in short-term debt instruments, including government, corporate and money market securities of domestic issuers, as well as repurchase agreements. Emerging Markets Trust also may purchase preferred stock, convertible securities, open- and closed-end investment companies, illiquid securities (15% or less of net assets) and when-issued securities; may invest in futures and options transactions, including puts and calls; and may borrow money, lend securities and enter into repurchase and reverse repurchase agreements. As of June 30, 1998, Emerging Markets Trust had approximately $57,604,878 in assets. For its fiscal year ended December 31, 1997, the Primary shares of Emerging Markets Trust had a total expense ratio of 2.50% (after fee waivers; 2.86% in the absence of such waivers). THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. PRIOR PERFORMANCE OF ACCOUNTS SIMILAR TO THE BATTERYMARCH INTERNATIONAL EQUITY PORTFOLIO. The investment performance for the period from July 1, 1988 to June 30, 1998 of all accounts managed by Batterymarch that are substantially similar to the Portfolio is shown below. The benchmark index to which the accounts are compared is the MSCI Europe Australia & Far East Index ("MSCI EAFE"). The MSCI EAFE is an unmanaged index representing the performance of share prices of approximately 1100 companies listed on stock exchanges around the world. Twenty countries are included in the Index. Although used as a benchmark, the Index's performance may not be comparable to the accounts' performance since, unlike the performance of the accounts, the Index's performance has not been adjusted for any fees or expenses. B-10
- -------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ---------------------------------------- ------------------------------------- ------------------------------------- Year Ended June 30 Composite Performance (%) MSCI EAFE Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1998 11.72 6.38 - ---------------------------------------- ------------------------------------- ------------------------------------- 1997 18.51 13.16 - ---------------------------------------- ------------------------------------- ------------------------------------- 1996 14.24 13.62 - ---------------------------------------- ------------------------------------- ------------------------------------- 1995 1.20 1.95 - ---------------------------------------- ------------------------------------- ------------------------------------- 1994 17.32 17.30 - ---------------------------------------- ------------------------------------- ------------------------------------- 1993 6.60 20.70 - ---------------------------------------- ------------------------------------- ------------------------------------- 1992 8.26 -0.31 - ---------------------------------------- ------------------------------------- ------------------------------------- 1991 -15.96 -11.23 - ---------------------------------------- ------------------------------------- ------------------------------------- 1990 25.04 3.53 - ---------------------------------------- ------------------------------------- ------------------------------------- 1989 11.49 9.79 - ---------------------------------------- ------------------------------------- -------------------------------------
- -------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ---------------------------------------- ------------------------------------- ------------------------------------- Period ended Composite MSCI EAFE June 30 Performance (%) Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1 Year 11.72 6.38 - ---------------------------------------- ------------------------------------- ------------------------------------- 3 Year 14.82 11.06 - ---------------------------------------- ------------------------------------- ------------------------------------- 5 Year 12.60 10.48 - ---------------------------------------- ------------------------------------- ------------------------------------- 10 Year 9.84 7.49 - ---------------------------------------- ------------------------------------- -------------------------------------
The number of accounts included in the composite has ranged from 4 to 11 over the relevant period and the aggregate assets of the accounts has ranged from $700 million to $1.8 billion over the period. One of the accounts included in the composite is the mutual fund described below. Accounts included in the composite are generally not subject to the diversification requirements, specific tax restrictions and investment limitations imposed on the Portfolio by the 1940 Act or the Code. The performance results for these accounts might have been adversely affected had the accounts been subject to these requirements, restrictions and limitations. These potential differences do not adversely affect the determination that the accounts included in this composite are managed in a substantially similar manner to the Portfolio. The performance of the composite is calculated based on AIMR standards, including the performance of the "mutual fund account" included in the composite, while the separate performance of the mutual fund shown below is calculated according to the SEC's method for calculating performance. B-11 The investment performance for the period from February 17, 1995 to December 31, 1997 for the Primary shares of the Legg Mason International Equity Trust ("International Equity Trust"), which has been advised by Batterymarch since its inception, is shown below.
- ----------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ------------------------------------------------- --------------------------------------- ----------------------------- Year Ended June 30 Account Performance (%) MSCI EAFE Performance (%) - ------------------------------------------------- --------------------------------------- ----------------------------- 1998 5.73 6.38 - ------------------------------------------------- --------------------------------------- ----------------------------- 1997 18.74 13.16 - ------------------------------------------------- --------------------------------------- ----------------------------- 1996 15.90 13.62 - ------------------------------------------------- --------------------------------------- ----------------------------- 1995 (Inception February 17, 1995) 4.00 6.08 - ------------------------------------------------- --------------------------------------- -----------------------------
- ----------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ------------------------------------------------- --------------------------------------- ----------------------------- Period ended Account Performance (%) MSCI EAFE Performance (%) June 30 - ------------------------------------------------- --------------------------------------- ----------------------------- 1 Year 5.73 6.38 - ------------------------------------------------- --------------------------------------- ----------------------------- 3 Years 13.32 11.06 - ------------------------------------------------- --------------------------------------- ----------------------------- Since Inception 13.08 9.81 (February 17, 1995) - ------------------------------------------------- --------------------------------------- -----------------------------
International Equity Trust, which commenced operations on February 17, 1995, is a diversified open-end investment company. International Equity Trust's investment objective is maximum long-term total return. International Equity Trust normally invests at least 65% of its assets in equity securities of companies located outside the United States, and Batterymarch currently intends to invest substantially all of International Equity Trust's assets in non-U.S. equity securities. International Equity Trust may invest up to 35% of its total assets in emerging market securities. When cash is temporarily available, or for temporary defensive purposes, when Batterymarch believes such action is warranted by abnormal market or economic situations, International Equity Trust may invest without limit in cash and U.S. dollar-denominated money market instruments, including repurchase agreements of domestic issuers. When Batterymarch believes such action is warranted by abnormal market or economic situations, for temporary defensive purposes, International Equity Trust also may invest without limit in short-term debt instruments, including government, corporate and money market securities of domestic issuers. International Equity Trust is authorized to invest in stock index futures and options. International Equity Trust may also enter into forward foreign currency exchange contracts in order to protect against fluctuations in exchange rates. International Equity Trust also may purchase securities other than common stock, such as debentures or preferred stock that may or may not be convertible into common stock. Some of these instruments may be rated below investment grade. International Equity Trust will not purchase B-12 securities rated below investment grade (or comparable unrated securities) if, as a result, more than 5% of its assets would be so invested. International Equity Trust may also invest in open- and closed-end investment companies, illiquid securities (15% or less of net assets) and when-issued securities; may invest in futures and options transactions, including puts and calls; and may borrow money, lend securities and enter into repurchase and reverse repurchase agreements. As of June 30, 1998, International Equity Trust had approximately $286,359,073 in assets. For its fiscal year ended December 31, 1997, the Primary shares of International Equity Trust had a total expense ratio of 2.17%. THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. PRIOR PERFORMANCE OF AN ACCOUNT SIMILAR TO THE LEGG MASON FUND ADVISER TOTAL RETURN PORTFOLIO. The investment performance for the period from July 1, 1988 to June 30, 1998 for the Primary class of shares of the Legg Mason Total Return Trust, Inc. ("Total Return Trust") is shown below. The benchmark index to which Total Return Trust is compared is the S&P 500 Index. The S&P 500 Index is an unmanaged index representing the performance of 500 companies selected by S&P. Although used as a benchmark, the Index's performance may not be comparable to Total Return Trust's performance since, unlike the performance of Total Return Trust, the Index's performance has not been adjusted for any fees or expenses.
- -------------------------------------------------------------------------------------------------------------------- Yearly Total Return - ------------------------------------- ------------------------------------- ---------------------------------------- Year Ended June 30 Account Performance (%) S&P 500 Index Performance (%) - ------------------------------------- ------------------------------------- ---------------------------------------- 1998 23.31 30.16 - ------------------------------------- ------------------------------------- ---------------------------------------- 1997 38.14 34.71 - ------------------------------------- ------------------------------------- ---------------------------------------- 1996 23.28 26.00 - ------------------------------------- ------------------------------------- ---------------------------------------- 1995 11.83 26.07 - ------------------------------------- ------------------------------------- ---------------------------------------- 1994 4.69 1.41 - ------------------------------------- ------------------------------------- ---------------------------------------- 1993 14.66 13.63 - ------------------------------------- ------------------------------------- ---------------------------------------- 1992 25.09 13.41 - ------------------------------------- ------------------------------------- ---------------------------------------- 1991 2.45 7.39 - ------------------------------------- ------------------------------------- ---------------------------------------- 1990 -0.84 16.49 - ------------------------------------- ------------------------------------- ---------------------------------------- 1989 14.16 20.55 - ------------------------------------- ------------------------------------- ----------------------------------------
B-13
- -------------------------------------------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS - ---------------------------------------- ------------------------------------- ------------------------------------- Period ended Account S&P 500 Index June 30 Performance (%) Performance (%) - ---------------------------------------- ------------------------------------- ------------------------------------- 1 Year 23.31 30.16 - ---------------------------------------- ------------------------------------- ------------------------------------- 3 Year 28.06 30.24 - ---------------------------------------- ------------------------------------- ------------------------------------- 5 Year 19.71 23.08 - ---------------------------------------- ------------------------------------- ------------------------------------- 10 Year 15.13 18.54 - ---------------------------------------- ------------------------------------- -------------------------------------
Total Return Trust, which commenced operations on November 21, 1985, is a diversified open-end investment company. Total Return Trust's investment objective is to obtain capital appreciation and current income in order to achieve an attractive total investment return consistent with reasonable risk. Total Return Trust invests in dividend-paying common stocks, debt securities and securities convertible into common stocks which, in the opinion of LMFA, offer potential for attractive total return. Total Return Trust also invests in common stocks and securities convertible into common stocks which do not pay current dividends but which, in LMFA's opinion, offer prospects for capital appreciation and future income. Total Return Trust may invest in debt securities, including government, corporate and money market securities, consistent with its investment objective, during periods when or under circumstances where LMFA believes the return on certain debt securities may equal or exceed the return on equity securities. Total Return Trust may invest in debt securities of any maturity of both foreign and domestic issuers without regard to rating and may invest its assets in such securities without regard to a percentage limit. LMFA currently anticipates that, under normal market conditions, Total Return Trust will invest no more than 50% of its total assets in intermediate-term and long-term debt securities, and no more than 5% of its total assets in debt securities not rated investment grade, i.e., not rated at least BBB by S&P or Baa by Moody's or, if unrated by those entities, deemed by LMFA to be of comparable quality. Total Return Trust also may purchase preferred stock, indexed securities, closed-end investment companies, foreign securities (25% or less of total assets), illiquid securities (10% or less of net assets) and when-issued securities; may invest in futures and options transactions, including puts and calls; and may enter into forward foreign currency contracts. As of June 30, 1998, Total Return Trust had approximately $728,661,319 in assets. For its fiscal year ended June 30, 1998, the Primary shares of Total Return Trust had a total expense ratio of 1.88%. THE PERFORMANCE INFORMATION DOES NOT REPRESENT THE PERFORMANCE OF THE PORTFOLIO, WHICH IS NEWLY-ORGANIZED, HAS NOT YET COMMENCED OPERATIONS AND HAS NO PERFORMANCE RECORD OF ITS OWN. THE PERFORMANCE INFORMATION SHOULD NOT BE CONSIDERED A PREDICTION OF FUTURE PERFORMANCE OF THE PORTFOLIO. THE PORTFOLIO'S PERFORMANCE MAY BE HIGHER OR LOWER THAN THAT SHOWN. B-14 LM INSTITUTIONAL FUND ADVISORS II, INC. CUSTODIAN: TRANSFER AND SHAREHOLDER STATE STREET BANK SERVICING AGENT: AND TRUST CO. BOSTON FINANCIAL DATA P.O. Box 1713 SERVICES Boston, Massachusetts 02105 P.O. Box 953 Boston, Massachusetts, 02103 [LM INSTITUTIONAL FUND ADVISORS LOGO HERE] COUNSEL: INDEPENDENT ACCOUNTANT: ROPES & GRAY ERNST & YOUNG LLP One International Place 2001 Market Street Boston, MA 02110 Philadelphia, PA 19103 (617) 951-7000 DISTRIBUTOR: Legg Mason Wood Walker, Incorporated 100 Light Street P.O. Box 1476 Baltimore, MD 21203-1476 410-539-0000 800-822-5544 - -------------------------------------------------------------------------------- LM INSTITUTIONAL FUND ADVISORS II, INC. June 30, 1998 - -------------------------------------------------------------------------------- STATEMENT OF ADDITIONAL INFORMATION LM Institutional Fund Advisors II, Inc. (the "Fund") is a no-load, open-end management investment company. LM Institutional Fund Advisors II, Inc. currently consists of six separate professionally managed investment portfolios which are described in this Statement of Additional Information ("SAI"). Each of these portfolios is referred to herein as a "Portfolio". This SAI is not a prospectus and should be read in conjunction with the Prospectus for the Portfolios, dated June 30, 1998, which has been filed with the Securities and Exchange Commission ("SEC"). Copies of the Portfolios' Prospectus are available without charge from Legg Mason Wood Walker, Incorporated at 1-800-822-5544. TABLE OF CONTENTS DEFINITIONS 1 ADDITIONAL INFORMATION ABOUT INVESTMENT LIMITATIONS AND POLICIES 2 ADDITIONAL INFORMATION ABOUT SECURITIES, INVESTMENT TECHNIQUES AND RELATED RISKS 4 Ratings of Debt Obligations 4 Mortgage-Related Securities 4 Private Mortgage-Related Securities 6 Asset-Backed Securities 6 Non-Governmental Fixed Income and Other Debt Securities 7 Restricted Securities 8 Borrowings 8 Options on Securities 9 Futures Contracts and Options on Futures Contracts 9 Risks Associated with Futures and Options 13 Additional Risks of Options on Securities, Futures Contracts and Options on Futures Contracts Traded on Foreign Exchanges 16 Cover for Hedging Strategies 16 VALUATION OF PORTFOLIO SHARES 17 MANAGEMENT OF THE PORTFOLIOS 17 Directors and Officers 17 Manager and Advisers 19 PURCHASES AND REDEMPTIONS 23 EXCHANGE PRIVILEGE 24 PORTFOLIO TRANSACTIONS AND BROKERAGE 24 ADDITIONAL TAX INFORMATION 25 OTHER INFORMATION 27 PERFORMANCE INFORMATION 27 -i- DEFINITIONS "Adviser" means the investment advisory firm that manages a Portfolio's assets. LMFA, Brandywine and Batterymarch are each Advisers. "Batterymarch" means Batterymarch Financial Management, Inc., 200 Clarendon Street, Boston, Massachusetts 02116. Batterymarch is the Adviser to the Batterymarch Emerging Markets Portfolio and the Batterymarch International Equity Portfolio. "Brandywine" means Brandywine Asset Management, Inc., Three Christina Centre, Suite 1200, 201 N. Walnut Street, Wilmington, Delaware 19801. Brandywine is the Adviser to the Brandywine Small Cap Value Portfolio. "Code" means the Internal Revenue Code of 1986, as amended. "Distributor" means the party that is responsible for the distribution or sale of the Fund's shares. Legg Mason is the Fund's Distributor. "Exchange" means the New York Stock Exchange. "Fundamental Investment Limitation" means an investment limitation of a Portfolio that may be changed only with the affirmative vote of the lesser of (a) more than 50% of the outstanding shares of the relevant Portfolio or (b) 67% or more of the shares of the relevant Portfolio present at a shareholders' meeting if more than 50% of the outstanding shares of that Portfolio are represented at the meeting in person or by proxy. Only those policies or limitations expressly designated as such are fundamental investment limitations. All other policies and restrictions may be changed without shareholder approval. "Independent Director" means a Director of the Fund who is not an "interested person" (as defined in the 1940 Act) of the Fund. "Legg Mason" means Legg Mason Wood Walker, Incorporated. "LMFA" means Legg Mason Fund Adviser, Inc., 100 Light Street, Baltimore, MD 21202. LMFA is the Adviser to the Legg Mason Fund Adviser Large Cap Value Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the Legg Mason Fund Adviser Total Return Portfolio. "Manager" means LM Institutional Advisors, Inc., 100 Light Street, Baltimore, MD 21202. "1940 Act" means the Investment Company Act of 1940, as amended. "NRSROs" means nationally recognized (or foreign) statistical rating organizations, including Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's ("S&P"). "Plan" means the Fund's Distribution and Shareholder Services Plans. "SEC" means the Securities and Exchange Commission. "12b-1 Director" means a Director of the Fund who is an Independent Director and who has no direct or indirect financial interest in the operation of the Fund's Plans or the Fund's Underwriting Agreement. ADDITIONAL INFORMATION ABOUT INVESTMENT LIMITATIONS AND POLICIES Each Portfolio has adopted certain fundamental investment limitations that are set forth below. Each Portfolio may: (1) make loans, borrow money or issue senior securities to the fullest extent permitted by the 1940 Act, the rules or regulations thereunder or applicable orders of the SEC, as such statute, rules, regulations or orders may be amended from time to time. (2) not concentrate investments in a particular industry or group of industries as concentration is defined under the 1940 Act, the rules or regulations thereunder or applicable orders of the SEC, as such statute, rules, regulations or orders may be amended from time to time. Securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities and repurchase agreements thereon will not be considered to represent an industry. (3) underwrite securities to the fullest extent permitted by the 1940 Act, the rules or regulations thereunder or applicable orders of the SEC, as such statute, rules, regulations or orders may be amended from time to time. (4) purchase or sell commodities, commodities contracts, futures contracts, options, forward contracts or real estate to the fullest extent permitted by the 1940 Act, the rules or regulations thereunder or applicable orders of the SEC, as such statute, rules, regulations or orders may be amended from time to time. -2- Additional Information The fundamental investment limitations set forth above limit a Portfolio's ability to engage in certain investment practices and purchase securities to the extent permitted by, or consistent with, the 1940 Act. Relevant limitations of the 1940 Act are described below, which are based either on the 1940 Act itself, the rules or regulations thereunder, or interpretations promulgated by the SEC. As such, these limitations of the 1940 Act are not "fundamental," that is, the limitations will change as the statute, rules, regulations or interpretations change, and no shareholder vote will be required or sought. Fundamental investment restriction (1). The 1940 Act presently limits a Portfolio's ability to borrow up to one-third of the value of its total assets. Borrowing by a Portfolio allows it to leverage its portfolio, which exposes it to certain risks. Leveraging increases the effect of any increase or decrease in the value of portfolio securities on a Portfolio's net asset value, and money borrowed will be subject to interest costs (which may include commitment fees and/or the cost of maintaining minimum average balances) which may or may not exceed the return from the securities purchased with borrowed funds. The 1940 Act also restricts the ability of any mutual fund to lend. Under the 1940 Act, a Portfolio may only make loans if expressly permitted to do so by the Portfolio's investment policies, and a Portfolio may not make loans to persons who control or are under common control with the Portfolio. Thus, the 1940 Act effectively prohibits a Portfolio from making loans to certain persons when conflicts of interest or undue influence are most likely present. The Portfolios may, however, make other loans which if made would expose shareholders to additional risks, such as the failure of the other party to repay the loan. The ability of a mutual fund to issue senior securities is severely circumscribed by complex regulatory constraints under the 1940 Act that restrict, for instance, the amount, timing, and form of senior securities that may be issued. Certain portfolio management techniques such as the purchase of securities on margin, short sales, or the writing of puts on portfolio securities, may be considered senior securities unless appropriate steps are taken to segregate a Portfolio's assets or otherwise cover its obligations. Fundamental investment restriction (2). "Concentration" is interpreted under the 1940 Act to mean investment of 25% or more of a Portfolio's total assets in a single industry. If a Portfolio were to "concentrate" its investments in a particular industry, investors would be exposed to greater risks because the Portfolio's performance would be largely dependent on that industry's performance. Fundamental investment restriction (3). The 1940 Act prohibits a diversified mutual fund from underwriting securities in excess of 25% of its total assets. -3- Fundamental investment restriction (4). This restriction would permit investment in commodities, commodities contracts (e.g., futures contracts or options), forward contracts or real estate to the extent permitted under the 1940 Act. However, it is unlikely that the Portfolios would make such investments, other than the use of futures contracts, options, forward contracts and certain real estate-related securities as explained in the Prospectus and this Statement of Additional Information. Each Portfolio, however, would like the ability to consider using these investment techniques in the future. Commodities, as opposed to commodity futures, represent the actual underlying bulk goods, such as grains, metals and food stuffs. Real estate-related securities include real estate investment trusts, commercial and residential mortgage-backed securities, and real estate financings, and such instruments are generally sensitive to factors such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, overbuilding, and the management skill and creditworthiness of the issuer. ADDITIONAL INFORMATION ABOUT SECURITIES, INVESTMENT TECHNIQUES AND RELATED RISKS RATINGS OF DEBT OBLIGATIONS Moody's, S&P and NRSROs are private organizations that provide ratings of the credit quality of debt obligations. A description of the ratings assigned to corporate debt obligations by Moody's and S&P is included as Appendix A to the Prospectus. A Portfolio may consider these ratings in determining whether to purchase, sell or hold a security. Ratings are not absolute assurances of quality. Consequently, securities with the same maturity, interest rate and rating may have different market prices. Credit rating agencies attempt to evaluate the safety of principal and interest payments and do not evaluate the risks of fluctuations in market value. Also, rating agencies may fail to make timely changes in credit ratings in response to subsequent events, so that an issuer's current financial condition may be better or worse than the rating indicates. MORTGAGE-RELATED SECURITIES Mortgage-related securities represent an ownership interest in a pool of residential mortgage loans. These securities are designed to provide monthly payments of interest and, in most instances, principal to the investor. The mortgagor's monthly payments to his/her lending institution are "passed-through" to investors such as the Portfolios. Most issuers or poolers provide guarantees of payments, regardless of whether the mortgagor actually makes the payment. The guarantees made by issuers or poolers are often backed by various forms of credit, insurance and collateral, although these may be in amounts less than the full obligation of the pool to its shareholders. Pools often consist of whole mortgage loans or participations in loans. The majority of these loans are made to purchasers of one- to four-family homes. The terms and -4- characteristics of the mortgage instruments are generally uniform within a pool but may vary among pools. For example, in addition to fixed-rate, fixed-term mortgages, the Portfolios may purchase pools of variable-rate mortgages, growing-equity mortgages, graduated-payment mortgages and other types. All poolers apply standards for qualification to lending institutions which originate mortgages for the pools. Poolers also establish credit standards and underwriting criteria for individual mortgages included in the pools. In addition, many mortgages included in pools are insured through private mortgage insurance companies. The average life of mortgage-related securities varies with the maturities and the nature of the underlying mortgage instruments. For example, securities issued by the Government National Mortgage Association ("GNMA") tend to have a longer average life than participation certificates ("PCs") issued by the Federal Home Loan Mortgage Corporation ("FHLMC") because there is a tendency for the conventional and privately-insured mortgages underlying FHLMC PCs to repay at faster rates than the Federal Housing Administration and Veterans Administration loans underlying GNMAs. In addition, the term of a security may be shortened by unscheduled or early payments of principal and interest on the underlying mortgages. The occurrence of mortgage prepayments is affected by factors including the level of interest rates, general economic conditions, the location and age of the mortgage and other social and demographic conditions. In determining the dollar-weighted average maturity of a Portfolio, the Portfolio's Adviser will follow industry practice in assigning an average life to the mortgage-related securities held by each Portfolio unless the interest rate on the mortgages underlying the securities is such that a different prepayment rate is likely. For example, if a GNMA has a high interest rate relative to the market, that GNMA is likely to have a shorter overall maturity than a GNMA with a market rate coupon. Moreover, LMFA may deem it appropriate to change the projected average life for a Portfolio's mortgage-related securities as a result of fluctuations in market interest rates and other factors. Yields on mortgage-related securities are typically quoted based on the maturity of the underlying instruments and the associated average life assumption. Actual prepayment experience may cause the yield to differ from the yield expected on the basis of average life. Reinvestment of the prepayments may occur at higher or lower interest rates than the original investment, thus affecting the yield of the Portfolio. The compounding effect from reinvestments of monthly payments received by each Portfolio will increase the yield to shareholders compared to bonds that pay interest semi-annually. -5- PRIVATE MORTGAGE-RELATED SECURITIES Certain private mortgage pools are organized in such a way that the SEC staff considers them to be closed-end investment companies. Each Portfolio's investment in such pools is constrained by federal statute, which restricts investments in the shares of other investment companies. The private mortgage-related securities in which the Portfolios may invest include foreign mortgage pass-through securities ("Foreign Pass-Throughs"), which are structurally similar to the pass-through instruments described above. Such securities are issued by originators of and investors in mortgage loans, including savings and loan associations, mortgage bankers, commercial banks, investment bankers, specialized financial institutions and special purpose subsidiaries of the foregoing. Foreign Pass-Throughs usually are backed by a pool of fixed rate or adjustable-rate mortgage loans. Certain Foreign Pass-Throughs in which the Portfolios invest typically are not guaranteed by an entity having the credit status of GNMA, but generally utilize various types of credit enhancement. ASSET-BACKED SECURITIES Asset-backed securities are structurally similar to mortgage-backed securities, but are secured by interests in a different type of receivable. Asset-backed securities therefore present certain risks that are not presented by mortgage-related debt securities or other securities in which the Portfolios may invest. Primarily, these securities do not have the benefit of the same security interest in the related collateral. Credit card receivables are generally unsecured and the debtors are entitled to the protection of a number of state and federal consumer credit laws, many of which give such debtors the right to set off certain amounts owed on the credit cards, thereby reducing the balance due. Most issuers of automobile receivables permit the servicers to retain possession of the underlying obligations. If the servicer were to sell these obligations to another party, there is a risk that the purchaser would acquire an interest superior to that of the holders of the related automobile receivables. In addition, because of the large number of vehicles involved in a typical issuance and technical requirements under state laws, the trustee for the holders of the automobile receivables may not have a proper security interest in all of the obligations backing such receivables. Therefore, there is the possibility that recoveries on repossessed collateral may not, in some cases, be available to support payments on these securities. Because asset-backed securities are relatively new, the market experience in these securities is limited and the market's ability to sustain liquidity through all phases of the market cycle is not certain. -6- NON-GOVERNMENTAL FIXED INCOME AND OTHER DEBT SECURITIES A Portfolio's investments in fixed income and other debt securities of non-governmental domestic or foreign issuers are limited to fixed income or other debt obligations (bonds, debentures, notes and other similar instruments) which meet the minimum ratings criteria set forth for the Portfolio or, if unrated, are determined by the Portfolio's Adviser to be of comparable quality to fixed income or other debt obligations in which the Portfolio may invest. Where one of the NRSROs has assigned an investment grade rating to an instrument and others have given it a lower rating, the Portfolios may consider the instrument to be investment grade. The market for lower-rated securities may be thinner and less active than that for higher-rated securities, which can adversely affect the prices at which these securities can be sold, and may make it difficult for a Portfolio to obtain market quotations daily. If market quotations are not available, these securities will be valued by a method that the Portfolios' Boards of Directors believe accurately reflects fair market value. Judgment may play a greater role in valuing lower-rated debt securities than is the case with respect to securities for which a broader range of dealer quotations and last-sale information is available. Although the prices of lower-rated bonds are generally less sensitive to interest rate changes than are higher-rated bonds, the prices of lower-rated bonds may be more sensitive to adverse economic changes and developments regarding the individual issuer. Although the market for lower-rated debt securities is not new, and the market has previously weathered economic downturns, there has been in recent years a substantial increase in the use of such securities to fund corporate acquisitions and restructurings. Accordingly, the past performance of the market for such securities may not be an accurate indication of its performance during future economic downturns or periods of rising interest rates. When economic conditions appear to be deteriorating, medium- to lower-rated securities may decline in value due to heightened concern over credit quality, regardless of the prevailing interest rates. Investors should carefully consider the relative risks of investing in high yield securities and understand that such securities are not generally meant for short-term investing. Adverse economic developments can disrupt the market for lower-rated securities, and severely affect the ability of issuers, especially highly leveraged issuers, to service their debt obligations or to repay their obligations upon maturity which may lead to a higher incidence of default on such securities. In addition, the secondary market for lower-rated securities, which is concentrated in relatively few market makers, may not be as liquid as the secondary market for more highly rated securities. As a result, a Portfolio could find it more difficult to sell these securities or may be able to sell the securities only at prices lower than if such securities were widely traded. Therefore, prices realized upon the sale of such lower rated or unrated securities, under these circumstances, may be less than the prices used in calculating a Portfolio's net asset value. -7- Lower-rated or unrated debt obligations also present risks based on payment expectations. If an issuer calls an obligation for redemption, the Portfolio may have to replace the security with a lower yielding security, resulting in a decreased return for investors. If a Portfolio experiences unexpected net redemptions, it may be forced to sell its higher-rated securities, resulting in a decline in the overall credit quality of the Portfolio's investment portfolio and increasing the exposure of the Portfolio to the risks of lower-rated securities. RESTRICTED SECURITIES Restricted securities may be sold only (1) pursuant to SEC Rule 144A or other exemption, (2) in privately negotiated transactions or (3) in public offerings with respect to which a registration statement is in effect under the Securities Act of 1933, as amended. Rule 144A securities, although not registered in the U.S., may be sold to qualified institutional buyers in accordance with Rule 144A under the Securities Act of 1933, as amended. Each Portfolio's Adviser, acting pursuant to guidelines established by its Board of Directors, may determine that some Rule 144A securities are liquid for purposes of limitations on the amount of illiquid investments a Portfolio may own. Where registration is required, a Portfolio may be obligated to pay all or part of the registration expenses and a considerable period may elapse between the time of the decision to sell and the time the Portfolio may be permitted to sell a security under an effective registration statement. If, during such a period, adverse market conditions were to develop, the Portfolio might obtain a less favorable price than prevailed when it decided to sell. BORROWINGS The 1940 Act requires a Portfolio to maintain continuous asset coverage (that is, total assets including borrowings, less liabilities exclusive of borrowings) of at least 300% of the amount borrowed. If the asset coverage should decline below 300% as a result of market fluctuations or for other reasons, a Portfolio may be required to sell some of its holdings within three days to reduce the debt and restore the 300% asset coverage, even though it may be disadvantageous from an investment standpoint to sell securities at that time. Borrowing may increase the effect on net asset value of any increase or decrease in the market value of the Portfolio. Money borrowed will be subject to interest costs which may or may not be recovered by appreciation of the securities purchased. A Portfolio also may be required to maintain minimum average balances in connection with such borrowing or to pay a commitment or other fee to maintain a line of credit; either of these requirements would increase the cost of borrowing over the stated interest rate. The Portfolios may enter into reverse repurchase agreements and dollar roll transactions as a method of borrowing. -8- OPTIONS ON SECURITIES A Portfolio may purchase call options on securities for any purpose. For example, a call option may be purchased by a Portfolio on a security that its Adviser intends to include in the Portfolio's investment portfolio in order to fix the cost of a future purchase. Call options also may be used as a means of participating in an anticipated price increase of a security on a more limited risk basis than would be possible if the security itself were purchased. In the event of a decline in the price of the underlying security, use of this strategy would serve to limit the Portfolio's potential loss to the option premium paid; conversely, if the market price of the underlying security increases above the exercise price and the Portfolio either sells or exercises the option, any profit realized would be reduced by the premium. A Portfolio may purchase put options on securities for any purpose. For example, a put option may be purchased by a Portfolio in order to hedge against a decline in the market value of securities held in its portfolio. The put option enables a Portfolio to sell the underlying security at the predetermined exercise price; thus the potential for loss to the Portfolio below the exercise price is limited to the option premium paid. If the market price of the underlying security is higher than the exercise price of the put option, any profit the Portfolio realizes on the sale of the security would be reduced by the premium paid for the put option less any amount for which the put option may be sold. A Portfolio may also write call and put options. FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS Each Portfolio will limit its use of futures contracts and futures options to hedging transactions or other circumstances permitted to registered investment companies by regulatory authorities. For example, a Portfolio might use futures contracts to attempt to hedge against anticipated changes in interest rates or the economy that might adversely affect either the value of the Portfolio's securities or the price of the securities which the Portfolio intends to purchase. A Portfolio's hedging may include sales of futures contracts as an offset against the effect of expected increases in interest rates, and purchases of futures contracts as an offset against the effect of expected declines in interest rates. Although other techniques could be used to reduce exposure to interest rate fluctuations, a Portfolio may be able to hedge its exposure more effectively and perhaps at a lower cost by using futures contracts and options on futures contracts. A futures contract on a security or foreign currency is a bilateral agreement pursuant to which one party agrees to make, and the other party agrees to accept, delivery of the specified type of security or foreign currency called for in the contract at a specified future time and at a specified price. A Portfolio may, for example, purchase a futures contract on a security or foreign currency when it intends to purchase securities or foreign currency but has not yet -9- done so. This strategy may minimize the effect of all or part of an increase in the market price of the security or the relative value of the foreign currency that a Portfolio intends to purchase in the future. A rise in the price of the security or foreign currency prior to its purchase may either be offset by an increase in the value of the futures contract purchased by a Portfolio or avoided by taking delivery of the security or foreign currency under the futures contract. Conversely, a fall in the market price of the underlying security or foreign currency may result in a corresponding decrease in the value of the futures position. A Portfolio may sell a futures contract on a security or foreign currency, for example, in order to continue to receive the income from a security or foreign currency, while endeavoring to avoid part or all of the decline in the market value of that security that would accompany an increase in interest rates. A Portfolio may also purchase a call option on a futures contract to hedge against a market advance in securities or foreign currency which the Portfolio plans to acquire at a future date. The purchase of a call option on a futures contract is analogous to the purchase of a call option on an individual security or foreign currency which can be used as a temporary substitute for a position in the security itself. A Portfolio also may write covered call options on futures contracts as a partial hedge against a decline in the price of securities or foreign currency held in the Portfolio's investment portfolio, or purchase put options on futures contracts in order to hedge against a decline in the value of securities or foreign currency held in the Portfolio's investment portfolio. A Portfolio may write a covered put option as a partial anticipatory hedge. A financial futures contract sale creates an obligation by the seller to deliver the type of financial instrument called for in the contract in a specified delivery month for a stated price. A financial futures contract purchase creates an obligation by the purchaser to take delivery of the type of financial instrument called for in the contract in a specified delivery month at a stated price. The specific instruments delivered or taken, respectively, at settlement date are not determined until on or near that date. The determination is made in accordance with the rules of the exchange on which the futures contract sale or purchase was made. Futures contracts are traded in the United States only on commodity exchanges or boards of trade -- known as "contract markets" -- approved for such trading by the Commodity Futures Trading Commission (the "CFTC"), and must be executed through a futures commission merchant or brokerage firm which is a member of the relevant contract market. When a purchase or sale of a futures contract is made by a Portfolio, the Portfolio is required to deposit with its custodian (or a broker, if legally permitted) a specified amount of cash or U.S. Government securities ("initial margin"). The margin required for a futures contract is set by the exchange on which the contract is traded and may be modified during the term of the contract. The initial margin is in the nature of a performance bond or good faith deposit on the futures contract which is returned to the Portfolio upon termination of the contract, assuming all contractual obligations have been satisfied. Under certain circumstances, such as during periods of high volatility, a Portfolio may be required by an exchange to increase the level of its initial margin payment. Additionally, initial margin -10- requirements may be increased generally in the future by regulatory action. Each Portfolio expects to earn interest income on its initial margin deposits. A futures contract held by a Portfolio is valued daily at the official settlement price of the exchange on which it is traded. Each day the Portfolio pays or receives cash, called "variation margin," equal to the daily change in value of the futures contract. This process is known as "marking to market." Variation margin does not represent a borrowing or loan by a Portfolio but is instead settlement between the Portfolio and the broker of the amount one would owe the other if the futures contract expired. In computing daily net asset value, each Portfolio will mark to market its open futures positions. A Portfolio is also required to deposit and maintain margin with respect to put and call options on futures contracts written by it. Such margin deposits will vary depending on the nature of the underlying futures contract (and the related initial margin requirements) and the current market value of the option and other futures positions held by the Portfolio. Although some futures contracts call for making or taking delivery of the underlying securities or currencies, generally those contracts are closed out prior to delivery by offsetting purchases or sales of matching futures contracts (involving the same currency or underlying security and delivery month). If an offsetting purchase price is less than the original sale price, the Portfolio realizes a gain, or if it is more, the Portfolio realizes a loss. If an offsetting sale price is more than the original purchase price, the Portfolio realizes a gain, or if it is less, the Portfolio realizes a loss. If the Portfolio is unable to enter into a closing transaction, the amount of the Portfolio's potential loss is unlimited. In general, 40% of the gain or loss arising from the closing out of a futures contract traded on an exchange approved by the CFTC is treated as short-term gain or loss, and 60% is treated as long- term gain or loss. The Portfolio will also bear transaction costs for each contract which will be included in these calculations. A Portfolio may purchase and write call and put options on futures contracts it may buy or sell and enter into closing transactions with respect to such options to terminate existing positions. In return for the premium paid, options on futures contracts give the purchaser the right to assume a position in a futures contract at the specified option exercise price at any time during the period of the option. The Portfolio may use options on futures contracts in lieu of writing or buying options directly on the underlying securities or purchasing and selling the underlying futures contracts. For example, to hedge against a possible decrease in the value of its portfolio securities, a Portfolio may purchase put options or write call options on futures contracts rather than selling futures contracts. Similarly, a Portfolio may purchase call options or write put options on futures contracts as a substitute for the purchase of futures contracts to hedge against a possible increase in the price of securities which the Portfolio expects to purchase. Such options generally operate in the same manner as options purchased or written directly on the underlying investments. -11- As with options on securities, the holder or writer of an option may terminate his position by selling or purchasing an offsetting option. There is no guarantee that such closing transactions can be effected. A Portfolio will be required to deposit initial margin and maintenance margin with respect to put and call options on futures contracts written by it pursuant to brokers' requirements similar to those described above in connection with the discussion of futures contracts. An index futures contract is a contract to buy or sell units of an index at a specified future date at a price agreed upon when the contract is made. Entering into a contract to buy units of an index is commonly referred to as buying or purchasing a contract or holding a long position in the index. Entering into a contract to sell units of an index is commonly referred to as selling a contract or holding a short position. A unit is the current value of the index. A Portfolio may enter into stock index futures contracts, debt index futures contracts, or other index futures contracts appropriate to its objective. A Portfolio may also purchase and sell options on index futures contracts. For example, the Standard & Poor's 500 Composite Stock Price Index ("S&P 500") is composed of 500 selected common stocks, most of which are listed on the New York Stock Exchange. The S&P 500 assigns relative weightings to the common stocks included in the Index, and the value fluctuates with changes in the market values of those common stocks. In the case of the S&P 500, contracts are to buy or sell 500 units. Thus, if the value of the S&P 500 were $150, one contract would be worth $75,000 (500 units x $150). The stock index futures contract specifies that no delivery of the actual stocks making up the index will take place. Instead, settlement in cash must occur upon the termination of the contract, with the settlement being the difference between the contract price and the actual level of the stock index at the expiration of the contract. For example, if a Portfolio enters into a futures contract to buy 500 units of the S&P 500 at a specified future date at a contract price of $150 and the S&P 500 is at $154 on that future date, the Portfolio will gain $2,000 (500 units x gain of $4). If the Portfolio enters into a futures contract to sell 500 units of the stock index at a specified future date at a contract price of $150 and the S&P 500 is at $152 on that future date, the Portfolio will lose $1,000 (500 units x loss of $2). A Portfolio will not enter into futures contracts or option positions if, immediately thereafter, the initial margin deposits plus premiums paid by it, less the amount by which any such options positions are "in-the-money" at the time of purchase, would exceed 5% of the fair market value of the Portfolio's total assets. A call option is "in-the-money" if the value of the futures contract that is the subject of the option exceeds the exercise price. A put option is "in-the-money" if the exercise price exceeds the value of the futures contract that is the subject of the option. -12- RISKS ASSOCIATED WITH FUTURES AND OPTIONS In considering the Portfolios' use of futures contracts and options, particular note should be taken of the following: (1) Positions in futures contracts and options may be closed out only on an exchange or board of trade which provides a secondary market for such futures contracts or options. Futures exchanges may limit the amount of fluctuation permitted in certain futures contract and option prices during a single trading day. The daily limit establishes the maximum amount that the price of a futures contract or option may vary either up or down from the previous day's settlement price at the end of the current trading session. Once the daily limit has been reached in a futures contract or option subject to the limit, no more trades may be made on that day at a price beyond that limit. The daily limit governs only price movements during a particular trading day and therefore does not limit potential losses because the limit may work to prevent the liquidation of unfavorable positions. For example, futures prices have occasionally moved to the daily limit for several consecutive trading days with little or no trading, thereby preventing prompt liquidation of positions and subjecting some holders of futures contracts to substantial losses. (2) The ability to establish and close out positions in either futures contracts or exchange-listed options is also subject to the maintenance of a liquid secondary market. Consequently, it may not be possible for a Portfolio to close a position and, in the event of adverse price movements, the Portfolio would have to make daily cash payments of variation margin (except in the case of purchased options). However, in the event futures contracts or options have been used to hedge portfolio securities, such securities generally will not be sold until the contracts can be terminated. In such circumstances, an increase in the price of the securities, if any, may partially or completely offset losses on the futures contract. However, there is no guarantee that the price of the securities will, in fact, correlate with the price movements in the contracts and thus provide an offset to losses on the contracts. The inability to close out a futures or option position may also restrict the Portfolio's ability to sell the underlying security or currency at a time when the Adviser might otherwise do so. Reasons for the absence of a liquid secondary market on an exchange include the following: (i) there may be insufficient trading interest in certain contracts or options; (ii) restrictions may be imposed by an exchange on opening transactions or closing transactions or both; (iii) trading halts, suspensions or other restrictions may be imposed with respect to particular classes or series of contracts or options, or underlying securities; (iv) unusual or unforeseen circumstances may interrupt normal operations on an exchange; (v) the facilities of an exchange or a 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 contracts or options (or a particular class or series of contracts or options), in which event the secondary market on that exchange for such contracts or options (or in the class or series of contracts or options) would cease to -13- exist, although outstanding contracts or options on the exchange that had been issued by a clearing corporation as a result of trades on that exchange would continue to be exercisable in accordance with their terms. (3) Successful use by a Portfolio of futures contracts and options will depend upon its Adviser's ability to predict market movements, which may require different skills and techniques than predicting changes in the prices of individual securities. Moreover, futures contracts relate not to the current level of the underlying instrument but to anticipated levels at some point in the future. There is, in addition, the risk that movements in the price of the futures contract or option will not correlate with movements in the prices of the securities or currencies being hedged. If the price of the securities or currencies being hedged has moved in a favorable direction, this advantage may be partially offset by losses in the futures or option position. For example, it is possible that, where a Portfolio has sold futures to hedge its portfolio against a decline in the market, the index on which the futures are written may advance and the value of securities held in the Portfolio's portfolio may decline. If this occurred, the Portfolio would lose money on the futures and also experience a decline in value in its portfolio securities. It is also possible that, if a Portfolio has hedged against the possibility of a decline in the market adversely affecting securities held in its portfolio and securities prices increase instead, the Portfolio will lose part or all of the benefit of the increased value of those securities it has hedged because it will have offsetting losses in its futures positions. In addition, if the Portfolio has insufficient cash, it may have to sell assets from its investment portfolio to meet daily variation margin requirements. Any such sale of assets may or may not be made at prices that reflect the rising market; consequently, a Portfolio may need to sell assets at a time when such sales are disadvantageous to the Portfolio. If the price of the futures or option contract moves more than the price of the underlying securities or currencies, the Portfolio will experience either a loss or a gain on the futures contract or option that may or may not be completely offset by movements in the price of the securities or currencies that are the subject of the hedge. (4) The value of an option position will reflect, among other things, the current market price of the underlying security, currency or futures contract, the time remaining until expiration, the relationship of the exercise price to the market price, the historical price volatility of the underlying security, currency or futures contract and general market conditions. For this reason, the successful use of options as a hedging strategy depends upon the Adviser's ability to forecast the direction of price fluctuations in the underlying market. (5) In addition to the possibility that there may be an imperfect correlation, or no correlation at all, between price movements in the futures and options position and the securities or currencies being hedged, movements in the prices of futures and options contracts may not correlate perfectly with movements in the prices of the hedged securities or currencies due to price distortions in the futures and options markets. There may be several reasons unrelated to the value of the underlying securities or currencies which cause this situation to occur. First, as noted above, all participants in the futures market are subject to initial and -14- variation margin requirements. If, to avoid meeting additional margin deposit requirements or for other reasons, investors choose to close a significant number of futures contracts through offsetting transactions, distortions in the normal price relationship between the securities or currencies and the futures markets may occur. Second, because the margin deposit requirements in the futures market are less onerous than margin requirements in the securities market, there may be increased participation by speculators in the futures market; such speculative activity in the futures market also may cause temporary price distortions. Third, participants could make or take delivery of the underlying securities or currencies instead of closing out their contracts. As a result, a correct forecast of general market trends may not result in successful hedging through the use of futures or options contracts over the short term. In addition, activities of large traders involving arbitrage and other investment strategies may result in temporary price distortions. (6) Options normally have expiration dates of up to nine months. The exercise price of the options may be below, equal to or above the current market value of the underlying security, currency or futures contract. Options that expire unexercised have no value, and the Portfolio will realize a loss in the amount paid and any transaction costs. (7) Like options on securities, options on futures contracts have a limited life. The ability to establish and close out options on futures will be subject to the development and maintenance of liquid secondary markets on the relevant exchanges or boards of trade. There can be no certainty that liquid secondary markets for all options on futures contracts will develop. (8) Purchasers of options on futures contracts pay a premium in cash at the time of purchase. This amount and the transaction costs are all that is at risk. Sellers of options on futures contracts, however, must post an initial margin and are subject to additional margin calls which could be substantial in the event of adverse price movements. In addition, although the maximum amount at risk when the Portfolio purchases an option is the premium paid for the option and the transaction costs, there may be circumstances when the purchase of an option on a futures contract would result in a loss to the Portfolio when the use of a futures contract would not, such as when there is no movement in the value of the securities or currencies being hedged. (9) A Portfolio's activities in the futures and options markets may result in a higher portfolio turnover rate and additional transaction costs in the form of added brokerage commissions; however, a Portfolio also may save on commissions by using such contracts as a hedge rather than buying or selling individual securities in anticipation or as a result of market movements. (10) A Portfolio may purchase and write both exchange-traded options and options traded on the OTC market. Exchange markets for options on debt securities exist but are relatively new, and the ability to establish and close out positions on the exchanges is subject to -15- the maintenance of a liquid secondary market. Although the Portfolios intend to purchase or write only those exchange-traded options for which there appears to be an active secondary market, there is no assurance that a liquid secondary market will exist for any particular option at any specific time. Closing transactions may be effected with respect to options traded in the OTC markets only by negotiating directly with the other party to the option contract, or in a secondary market for the option if such market exists. Although the Portfolios will enter into OTC options only with dealers which agree to enter into, and which are expected to be capable of entering into, closing transactions with the Portfolios, there can be no assurance that a Portfolio will be able to liquidate an OTC option at a favorable price at any time prior to expiration. In the event of insolvency of the contra-party, a Portfolio may be unable to liquidate an OTC option. Accordingly, it may not be possible to effect closing transactions with respect to certain options, with the result that the Portfolio would have to exercise those options which it has purchased in order to realize any profit. With respect to options written by a Portfolio, the inability to enter into a closing transaction may result in material losses to the Portfolio. For example, because a Portfolio must maintain a covered position with respect to any call option it writes on a security or futures contract the Portfolio may not sell the underlying security or futures contract or invest any cash, U.S. Government securities or short-term debt securities used as cover during the period it is obligated under such option. This requirement may impair a Portfolio's ability to sell a portfolio security or make an investment at a time when such a sale or investment might be advantageous. ADDITIONAL RISKS OF OPTIONS ON SECURITIES, FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS TRADED ON FOREIGN EXCHANGES Options on securities, options on currencies, futures contracts and options on futures contracts may be traded on foreign exchanges. Such transactions may not be regulated as effectively as similar transactions in the United States, may not involve a clearing mechanism and related guarantees and are subject to the risk of governmental actions affecting trading in, or the price of, foreign securities. The value of such positions also could be adversely affected by (1) other complex foreign political, legal and economic factors, (2) lesser availability than in the United States of data on which to make trading decisions, (3) delays in the Portfolios' ability to act upon economic events occurring in foreign markets during non-business hours in the United States, (4) the imposition of different exercise and settlement terms and procedures and margin requirements than in the United States and (5) lesser trading volume. COVER FOR HEDGING STRATEGIES Each Portfolio will comply with guidelines established by the SEC with respect to coverage of hedging strategies by mutual funds, and, if the guidelines so require, will set aside cash or liquid securities in a segregated account with its custodian in the amount prescribed, as marked to market daily. Securities, options or futures positions used for cover and securities held in a segregated account cannot be sold or closed out while the hedging strategy is outstanding, unless they are replaced with similar assets. As a result, there is a possibility that -16- the use of cover or segregation involving a large percentage of a Portfolio's assets could impede portfolio management or a Portfolio's ability to meet redemption requests or other current obligations. VALUATION OF PORTFOLIO SHARES As described in the Prospectus, securities owned by any of the Portfolios for which market quotations are readily available are valued at current market value. Securities are valued at the last sale price for a comparable position on the day the securities are being valued or, lacking any sales on such day, at the last available bid price. In cases where securities are traded on more than one market, the securities are generally valued on the market considered by the Adviser as the primary market. Occasionally, events affecting the value of foreign investments occur between the time at which they are determined and the close of trading on the Exchange, which events will not be reflected in a computation of a Portfolio's net asset value on that day. If events materially affecting the value of such investments occur during such time period, the investments will be valued at their fair value as determined in good faith by, or under the direction of, the Board of Directors. MANAGEMENT OF THE PORTFOLIOS DIRECTORS AND OFFICERS The Fund's officers are responsible for the operation of the Fund under the direction of its Board of Directors. The officers and Directors of the Fund and their principal occupations during the past five years are set forth below. An asterisk (*) indicates Interested Directors. The business address of Mr. Livingston is 117 Colorado Boulevard, Pasadena, California 91105. The business address of each officer and Director is 100 Light Street, Baltimore, Maryland 21202, unless otherwise indicated. Catherine H. Bray, 41, Director; Portfolio Manager, T. Rowe Price, June 1989-May 1996. *Edmund J. Cashman, 61, Director; Senior Executive Vice President and Director of Legg Mason, Inc.; Officer and/or Director of various other affiliates of Legg Mason, Inc.; President or Vice Chairman of the Board and Director/Trustee of four Legg Mason funds. *W. Curtis Livingston, III, 53, Director and Vice Chairman; President, Director and Chief Executive Officer of Western Asset Management Company (investment management firm) ("Western Asset"), December 1980-present; President, Pacific American Income Shares, -17- Inc.; Director, Legg Mason, Inc.; Director and President, LM Institutional Fund Advisors I, Inc.; Director and Vice Chairman of LM Institutional Advisors, Inc. Emmett J. Rice, 78, Director; Governor, Federal Reserve Central Bank, June 1979-February 1987; Director, Jardine-Fleming China Region Fund, July 1992-present; Director, Albermarle Corporation and Tredegar Industries, Inc. *Edward A. Taber, 54, Chairman, Director and President; Senior Executive Vice President of Legg Mason, Inc.; Director of the Legg Mason Value Trust, Inc., the Legg Mason Total Return Trust, Inc. and the Legg Mason Special Investment Trust, Inc.; Trustee of the Legg Mason Tax-Free Income Fund and the Legg Mason Cash Reserve Trust; President of the Legg Mason Income Trust, Inc., the Legg Mason Global Trust, Inc., LM Institutional Fund Advisors II, Inc. and the Legg Mason Investors Trust, Inc.; Director of Western Asset, Western Asset Global Management, Limited, Bartlett & Co., Batterymarch Financial Management, Inc., Gray, Seifert & Co., Inc. (investment adviser), GSH & Co. Inc. (investment adviser holding company), Fairfield Group, Inc. (investment adviser), LM Institutional Advisors, Inc., and Legg Mason Fund Adviser, Inc.; formerly director of Taxable Fixed Income Division of T. Rowe Price Associates, Inc. Robert M. Tarola, 48, Director; Senior Vice President and Chief Financial Officer, Helix Health, Inc., July 1996-present; Partner, Price Waterhouse LLP, May 1974-June 1996. Linda R. Taylor, 52, Director. Marie K. Karpinski, 49, Vice President and Treasurer; Vice President and Treasurer of twenty-one Legg Mason/Bartlett funds (open-end investment companies), 1986-present; Vice President and Treasurer of LM Institutional Fund Advisors I, Inc.; Assistant Treasurer of Pacific American Income Shares, Inc. (closed-end investment company), 1988-present; Treasurer of Legg Mason Fund Adviser, Inc., March 1986-present; Vice-President of Legg Mason Wood Walker, Incorporated., 1992-present; Assistant Vice-President of Legg Mason Wood Walker, Incorporated, 1989-1992. Kathi Bair, 33, Secretary; Secretary of nine Legg Mason Funds; Assistant Treasurer of three Legg Mason Funds. Officers and Directors of the Fund who are affiliated persons of the Manager, the Advisers, LMFA or Legg Mason receive no salary or fees from the Fund. Each Independent Director receives an annual retainer of $500 per Portfolio and a per meeting fee of $500 per Portfolio. The following table provides certain information relating to the compensation of the Fund's Directors and senior executive officers. -18-
- -------------------------------------------------------------------------------------------------------- Name of Person and Position Total Compensation From Aggregate Compensation the Fund* From the Fund and Complex Paid to Directors** - -------------------------------------------------------------------------------------------------------- Catherine H. Bray $17,500 -0- Director - -------------------------------------------------------------------------------------------------------- Edmund J. Cashman -0- -0- Director - -------------------------------------------------------------------------------------------------------- W. Curtis Livingston, III Director -0- -0- - -------------------------------------------------------------------------------------------------------- Emmett J. Rice $17,500 -0- Director - -------------------------------------------------------------------------------------------------------- Edward A. Taber III -0- -0- Director and President - -------------------------------------------------------------------------------------------------------- Robert M. Tarola $17,500 -0- Director - -------------------------------------------------------------------------------------------------------- Linda R. Taylor $17,500 -0- Director - -------------------------------------------------------------------------------------------------------- *Represents fees expected to be paid to each person during the fiscal year ended March 31, 1999. **Represents aggregate compensation paid to each person during the calendar year ended December 31, 1997. - --------------------------------------------------------------------------------------------------------
MANAGER AND ADVISERS THE MANAGER. The Manager serves as investment manager to the Portfolios of the Fund under separate Investment Management Agreements dated June 3, 1998 between the Manager and the Fund (the "Management Agreements"). The Management Agreements were most recently approved by the Board of Directors, including a majority of Independent Directors, on March 27, 1998, other than the Legg Mason Fund Adviser Total Return Portfolio, which was most recently approved by the Board of Directors, including a majority of Independent Directors, on May 29, 1998. Under the Management Agreement, the Manager is responsible, subject to the general supervision of the Fund's Board of Directors, for the actual management of the Fund's assets, including the responsibility for making decisions and placing orders to buy, sell or hold a particular security, consistent with the investment objectives and policies described in the Prospectus and this Statement of Additional Information. The Manager also is responsible for -19- the compensation of Directors and officers of the Fund who are employees of the Manager or its affiliates. The Manager receives for its services a fee as described in the Prospectus. As noted below, the Manager has delegated responsibility for the selection of the Fund's investments to the Advisers. Each Portfolio pays all of its other expenses which are not assumed by the Manager. These expenses include, among others, expenses of preparing and printing prospectuses, statements of additional information, proxy statements and reports and of distributing them to existing shareholders, custodian charges, transfer agency fees, organizational expenses, compensation of the Directors who are not "interested persons" of the Manager, or its affiliates, as that term is defined in the 1940 Act, legal and audit expenses, insurance expenses, expenses of registering and qualifying shares of the Portfolios for sale under federal and state law, Rule 12b-1 fees, governmental fees, expenses incurred in connection with membership in investment company organizations, interest expense, taxes and brokerage fees and commissions. The Portfolios also are liable for such nonrecurring expenses as may arise, including litigation to which a Portfolio or the Fund may be a party. The Fund may also have an obligation to indemnify its Directors and officers with respect to litigation. Under the Management Agreement, the Manager will not be liable for any error of judgment or mistake of law or for any loss suffered by the Portfolios in connection with the performance of the Management Agreement, except a loss resulting from a breach of fiduciary duty with respect to the receipt of compensation for services or a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or from reckless disregard by it of its obligations or duties thereunder. The Management Agreement terminates automatically upon assignment and is terminable with respect to any Portfolio at any time without penalty by vote of the Fund's Board of Directors, by vote of a majority of that Portfolio's outstanding voting securities, or by the Manager, on not less than 60 days' notice to the Fund, and may be terminated immediately upon the mutual written consent of the Manager and the Fund. ADVISERS LMFA. LMFA serves as Adviser to the Legg Mason Fund Adviser Large Cap Value Portfolio, the Legg Mason Fund Adviser Mid Cap Value Portfolio and the Legg Mason Fund Adviser Total Return Portfolio under separate Investment Advisory Agreements dated June 3, 1998 between LMFA and the Manager (the "LMFA Advisory Agreements"). The LMFA Advisory Agreements were most recently approved by the Board of Directors, including a majority of the Independent Directors, on March 27, 1998, other than for the Legg Mason Fund Adviser Total Return Portfolio, which was most recently approved by the Board of Directors, including a majority of Independent Directors, on May 29, 1998. -20- Under the LMFA Advisory Agreement, LMFA is responsible, subject to the general supervision of the Fund's Board of Directors and the Manager, for the actual management of the Portfolios' assets, including the responsibility for making decisions and placing orders to buy, sell or hold a particular security, consistent with the investment objectives and policies described in the Prospectus and this Statement of Additional Information. LMFA receives from the Manager for its services an advisory fee as described in the Prospectus. Under the LMFA Advisory Agreement, LMFA will not be liable for any error of judgment or mistake of law or for any loss suffered by the Portfolios in connection with the performance of the LMFA Advisory Agreement, except a loss resulting from a breach of fiduciary duty with respect to the receipt of compensation for services or a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or from reckless disregard by it of its obligations or duties thereunder. The LMFA Advisory Agreement terminates automatically upon assignment and is terminable with respect to any Portfolio at any time without penalty by vote of the Fund's Board of Directors, by vote of a majority of that Portfolio's outstanding voting securities, or by LMFA, on not less than 60 days' notice, and may be terminated immediately upon the mutual written consent of the parties. BRANDYWINE. Brandywine serves as the Adviser to the Brandywine Small Cap Value Portfolio under an Investment Advisory Agreement dated June 3, 1998 between Brandywine and the Manager (the "Brandywine Advisory Agreement"). The Brandywine Advisory Agreement was most recently approved by the Board of Directors, including a majority of the Independent Directors, on March 27, 1998. Under the Brandywine Advisory Agreement, Brandywine is responsible, subject to the general supervision of the Fund's Board of Directors and the Manager, for the actual management of the Portfolios' assets, including the responsibility for making decisions and placing orders to buy, sell or hold a particular security, consistent with the investment objectives and policies described in the Prospectus and this Statement of Additional Information. Brandywine also is responsible for the compensation of Directors and officers of the Fund who are employees of Brandywine or its affiliates. Brandywine receives from the Manager for its services to the Portfolios' an advisory fee as described in the Prospectus. Under the Brandywine Advisory Agreement, Brandywine will not be liable for any error of judgment or mistake of law or for any loss suffered by the Portfolios in connection with the performance of the Brandywine Advisory Agreement, except a loss resulting from a breach of fiduciary duty with respect to the receipt of compensation for services or a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or from reckless disregard by it of its obligations or duties thereunder. -21- The Brandywine Advisory Agreement terminates automatically upon assignment and is terminable with respect to the Portfolio at any time without penalty by vote of the Fund's Board of Directors, by vote of a majority of the Portfolio's outstanding voting securities, or by Brandywine, on not less than 60 days' notice, and may be terminated immediately upon the mutual written consent of the parties. BATTERYMARCH. Batterymarch serves as the Adviser to the Batterymarch Emerging Markets Portfolio and the Batterymarch International Equity Portfolio under separate Investment Advisory Agreements dated June 3, 1998 between Batterymarch and the Manager (the "Batterymarch Advisory Agreements"). The Batterymarch Advisory Agreements were most recently approved by the Board of Directors, including a majority of the Independent Directors, on March 27, 1998. Under the Batterymarch Advisory Agreement, Batterymarch is responsible, subject to the general supervision of the Fund's Board of Directors and the Manager, for the actual management of the Portfolios' assets, including the responsibility for making decisions and placing orders to buy, sell or hold a particular security, consistent with the investment objectives and policies described in the Prospectus and this Statement of Additional Information. Batterymarch also is responsible for the compensation of Directors and officers of the Fund who are employees of Batterymarch or its affiliates. Batterymarch receives from the Manager for its services to the Portfolios' an advisory fee as described in the Prospectus. Under the Batterymarch Advisory Agreement, Batterymarch will not be liable for any error of judgment or mistake of law or for any loss suffered by the Portfolios in connection with the performance of the Batterymarch Advisory Agreement, except a loss resulting from a breach of fiduciary duty with respect to the receipt of compensation for services or a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or from reckless disregard by it of its obligations or duties thereunder. The Batterymarch Advisory Agreement terminates automatically upon assignment and is terminable with respect to any Portfolio at any time without penalty by vote of the Fund's Board of Directors, by vote of a majority of that Portfolio's outstanding voting securities, or by Batterymarch, on not less than 60 days' notice, and may be terminated immediately upon the mutual written consent of the parties. DISTRIBUTOR Legg Mason acts as distributor of the Fund's shares pursuant to an Underwriting Agreement with the Fund dated June 3, 1998 (the "Underwriting Agreement"). Legg Mason is not obligated to sell any specific amount of Fund shares and receives no compensation pursuant to the Underwriting Agreement. The Underwriting Agreement is terminable with respect to any Portfolio without penalty, at any time, by vote of a majority of -22- the Fund's Independent Directors, or by vote of the holders of a majority of the shares of that Portfolio, or by Legg Mason upon 60 days' notice to the Fund. The Fund has adopted a Plan for each Portfolio which, among other things, permits the Fund to pay Legg Mason fees for its services related to sales and distribution of Financial Intermediary Class shares and the provision of ongoing services to Financial Intermediary Class shareholders. Payments are made only from assets attributable to Financial Intermediary Class shares. Under the Plan, the aggregate fees may not exceed an annual rate of 0.40% of each Portfolio's average daily net assets attributable to Financial Intermediary Class shares. Payments under the Plan are currently limited to 0.25% of average daily net assets. The Board of Directors may increase the limit up to 0.40% of average daily net assets as provided by the Plan without obtaining shareholder approval. Distribution activities for which such payments may be made include, but are not limited to, compensation to persons who engage in or support distribution and redemption of Shares, printing of prospectuses and reports for persons other than existing shareholders, advertising, preparation and distribution of sales literature, overhead, travel and telephone expenses, all with respect to Financial Intermediary Class shares only. The Plan was approved by the sole shareholder of the Financial Intermediary Class of each Portfolio on June 3, 1998. Legg Mason may pay all or a portion of the fee to its investment executives. The Plan will continue in effect only so long as it is approved at least annually by the vote of a majority of the Board of Directors, including a majority of the 12b-1 Directors, cast in person at a meeting called for the purpose of voting on the Plan. The Plan may be terminated by a vote of a majority of the 12b-1 Directors or by a vote of a majority of the outstanding voting securities of the Financial Intermediary Class shares. Any change in the Plan that would materially increase the distribution cost to a Portfolio requires shareholder approval; otherwise the Plan may be amended by the Directors, including a majority of the 12b-1 Directors, as previously described. In accordance with Rule 12b-1, the Plan provides that Legg Mason will submit to the Fund's Board of Directors, and the Directors will review, at least quarterly, a written report of any amounts expended pursuant to the Plan and the purposes for which expenditures were made. In addition, as long as the Plan is in effect, the selection and nomination of the Independent Directors will be committed to the discretion of such Independent Directors. PURCHASES AND REDEMPTIONS The Fund reserves the right to modify the mail, telephone or wire redemption services or to terminate the telephone or wire redemption services described in the Prospectus at any time without prior notice to shareholders. The Fund also reserves the right to suspend or postpone redemptions (1) for any period during which the Exchange is closed (other than for -23- customary weekend and holiday closings), (2) when trading in markets the Fund normally utilizes is restricted or an emergency, as defined by rules and regulations of the SEC, exists, making disposal of the Fund's investments or determination of its net asset value not reasonably practicable, or (3) for such other periods as the SEC by regulation or order may permit for the protection of the Fund's shareholders. The Fund agrees to redeem shares of each Portfolio solely in cash up to the lesser of $250,000 or 1% of the relevant Portfolio's net assets during any 90-day period for any one shareholder. In consideration of the best interests of the remaining shareholders, the Fund reserves the right to pay any redemption price exceeding this amount in whole or in part by a distribution in kind of readily marketable securities held by a Portfolio in lieu of cash. It is highly unlikely that shares would ever be redeemed in kind. If shares are redeemed in kind, however, the redeeming shareholder should expect to incur transaction costs upon the disposition of the securities received in the distribution. EXCHANGE PRIVILEGE Shareholders in any of the Portfolios are entitled to exchange their shares for shares of the other Portfolios or of the portfolios of LM Institutional Fund Advisors I, Inc., provided that such shares are eligible for sale in the shareholder's state of residence, and are being offered at the time. When a shareholder decides to exchange shares of a Portfolio, the Fund's transfer agent will redeem shares of the Portfolio and invest the proceeds in shares of the Portfolio selected. Redemptions of shares of the Portfolio will be made at their net asset value determined on the same day that the request is received in proper order, if received before the close of regular trading on the Exchange. If the request is received by the transfer agent after such close of regular trading, shares will be redeemed at their net asset value determined as of the close of the Exchange on the next day the Exchange is open. There is no charge for the exchange privilege and no sales charge imposed on an exchange, but the Portfolios reserve the right to modify or terminate the exchange privilege at any time. For more information concerning the exchange privilege, or to make an exchange, please contact the Portfolios. PORTFOLIO TRANSACTIONS AND BROKERAGE Under the various Management Agreements and Advisory Agreements, the Manager and the Advisers are responsible for the execution of the Portfolios' transactions. In selecting brokers or dealers, the Advisers must seek the most favorable price (including the applicable dealer spread) and execution for such transactions, subject to the possible payment as described below of higher brokerage commissions or spreads to brokers or dealers who provide research and analysis. The Portfolios may not always pay the lowest commission or spread available. -24- Rather, in placing orders on behalf of the Portfolios, the Advisers will also take into account such factors as size of the order, difficulty of execution, efficiency of the executing broker's or dealer's facilities (including the services described below) and any risk assumed by the executing broker or dealer. Consistent with the policy of obtaining most favorable price and execution, an Adviser may give consideration to research, statistical and other services furnished by brokers or dealers to the Adviser for its use, may place orders with brokers or dealers who provide supplemental investment and market research and securities and economic analysis, and may pay to those brokers or dealers a higher brokerage commission or spread than may be charged by other brokers or dealers. Such research, analysis and other services may be useful to an Adviser in connection with services to clients other than the Portfolios. An Adviser's fee is not reduced by reason of its receiving such brokerage and research services. The Portfolios may not buy securities from, or sell securities to, an Adviser or its affiliated persons as principal, except as permitted by the rules and regulations of the SEC. Subject to certain conditions, the Portfolios may purchase securities that are offered in underwritings in which an affiliate of an Adviser is a participant, although the Portfolios may not make such purchases directly from such affiliate. The Advisers will select brokers to execute portfolio transactions. In the over-the-counter market, the Portfolios generally will deal with responsible primary market-makers unless a more favorable execution can otherwise be obtained. Investment decisions for the Portfolios are made independently from those of other funds and accounts advised by the Advisers. However, the same security may be held in the portfolios of more than one fund or account. When two or more accounts simultaneously engage in the purchase or sale of the same security, the prices and amounts will be equitably allocated to each account. In some cases, this procedure may adversely affect the price or quantity of the security available to a particular account. In other cases, however, an account's ability to participate in larger volume transactions may produce better executions and prices. ADDITIONAL TAX INFORMATION GENERAL REQUIREMENTS FOR "PASS-THROUGH" TREATMENT In order to continue to qualify for treatment as a regulated investment company ("RIC") under the Code, each Portfolio must distribute annually to its shareholders at least 90% of its investment company taxable income (consisting generally of net investment income and net short-term capital gain, if any) and must meet several additional requirements. With respect to each Portfolio, these requirements include the following: (1) the Portfolio must derive at least 90% of its gross income each taxable year from dividends, interest, payments with respect to securities loans and gains from the sale or other disposition of securities or other income -25- (including but not limited to gains from options or futures ) derived with respect to its business of investing in securities ("Income Requirement"); (2) at the close of each quarter of the Portfolio's taxable year, at least 50% of the value of its total assets must be represented by cash and cash items, U.S. Government securities, securities of other regulated investment companies and other securities, with those other securities limited, in respect of any one issuer, to an amount that does not exceed 5% of the value of the Portfolio's total assets and not 10% of the outstanding voting securities of such issuer; and (3) at the close of each quarter of the Portfolio's taxable year, not more than 25% of its total assets may be invested in securities (other than U.S. Government securities and securities of other regulated investment companies) of any one issuer and two or more issuers which the Portfolio controls and which are engaged in the same, similar, or related trades or businesses. If a Portfolio fails to distribute in a calendar year substantially all of its ordinary income for such year and substantially all of its capital gain net income for the one-year period ending October 31 (or later if the Portfolio is permitted and so elects), plus any retained amount from the prior year, the Portfolio will be subject to a 4% excise tax on the undistributed amounts. A distribution declared by a Portfolio in October, November or December of any year and payable to shareholders of record on a date in such months will be deemed to have been paid by the Portfolio and received by the shareholders on December 31 if the distribution is paid by the Portfolio during the following January. Such a distribution, therefore, will be taxable to shareholders for the year in which that December 31 falls. Each Portfolio intends generally to make distributions sufficient to avoid imposition of the 4% excise tax. ORIGINAL ISSUE DISCOUNT A Portfolio may purchase debt securities issued with original issue discount. Original issue discount that accrues in a taxable year will be treated as income earned by the Portfolio and therefore an equivalent amount must be distributed to satisfy the distribution requirement and avoid imposition of the 4% excise tax. Because the original issue discount earned by a Portfolio in a taxable year may not be represented by cash income, the Portfolio may have to dispose of other securities and use the proceeds thereof to make distributions in amounts necessary to satisfy those distribution requirements. A Portfolio may realize capital gains or losses from such dispositions, which would increase or decrease the Portfolio's investment company taxable income and/or net capital gain. MISCELLANEOUS If a Portfolio invests in shares of preferred stock or otherwise holds dividend-paying securities as a result of exercising a conversion privilege, a portion of the dividends from the Portfolio's investment company taxable income (whether paid in cash or reinvested in additional shares) may be eligible for the dividends-received deduction allowed to corporations that meet certain holding period requirements. The eligible portion may not exceed the aggregate dividends received by the Portfolio from U.S. corporations. However, dividends -26- received by a corporate shareholder and deducted by it pursuant to the dividends-received deduction are subject indirectly to the alternative minimum tax. Dividends and interest received by a Portfolio, and gains realized by a Portfolio on foreign securities, may be subject to income, withholding or other taxes imposed by foreign countries and U.S. possessions that would reduce the yield on the Portfolio's securities. Tax conventions between certain countries and the United States may reduce or eliminate these foreign taxes, however, and foreign countries generally do not impose taxes on capital gains in respect of investments by foreign investors. OTHER INFORMATION LM Institutional Fund Advisors II, Inc. is a Maryland corporation, incorporated on January 13, 1998, and its capitalization consists of five billion shares of common stock with a par value of $0.001 each. The Board of Directors of the Fund may establish additional portfolios (with different investment objectives and fundamental policies) or classes of shares within a portfolio at any time in the future. Establishment and offering of additional portfolios or classes of shares of a portfolio will not alter the rights of the Fund's shareholders. When issued, shares are fully paid, non-assessable, redeemable and freely transferable. Shares do not have preemptive rights or subscription rights. In liquidation of a Portfolio, each shareholder is entitled to receive his or her pro rata share of the net assets of that Portfolio. PERFORMANCE INFORMATION Each Portfolio may, from time to time, include its total return in marketing materials or reports to shareholders or prospective investors. Quotations of average annual total return for a class of shares of a Portfolio will be expressed in terms of the average annual compounded rate of return of a hypothetical investment in that class of shares over periods of one, five and ten years (up to the life of the class), calculated pursuant to the following formula: P (1 + T)(exponent n) = ERV (where P = a hypothetical initial payment of $1,000, T = the average annual total return, n = number of years, and ERV = the ending redeemable value of a hypothetical $1,000 payment made at the beginning of the period). All total return figures reflect the deduction of a proportional share of Portfolio expenses on an annual basis and assume that all dividends and other distributions are reinvested when paid. The performance of each class of a Portfolio will differ because each class is subject to different expenses. Each Portfolio's performance may fluctuate daily depending upon such factors as the average maturity of its securities, changes in investments, changes in interest rates and variations in operating expenses. Therefore, current performance does not provide a basis for determining future performance. The fact that a Portfolio's performance will fluctuate and that shareholders' principal is not guaranteed or insured should be considered in comparing the Portfolio's performance with the performance of other investments. -27- From time to time each Portfolio may compare the performance of a class of shares in advertising and sales literature to the performance of other investment companies, groups of investment companies or various market indices. One such market index is the S&P 500, a widely recognized, unmanaged index composed of the capitalization-weighted average of the prices of 500 of the largest publicly traded stocks in the U.S. The S&P 500 includes reinvestment of all dividends. It takes no account of the costs of investing or the tax consequences of distributions. The Portfolios invest in many securities that are not included in the S&P 500. Each Portfolio may also cite rankings and ratings, and compare the return of a class of shares with data published by Lipper Analytical Services, Inc., CDA Investment Technologies, Inc., Wiesenberger Investment Company Services, Value Line, Morningstar, and other services or publications that monitor, compare and/or rank the performance of investment companies. Each Portfolio may also refer in such materials to mutual fund performance rankings, ratings, comparisons with funds having similar investment objectives, and other mutual funds reported in independent periodicals, including, but not limited to, Financial World, Money Magazine, Forbes, Business Week, Barron's, Fortune, the Kiplinger Letters, the Wall Street Journal, and the New York Times. Each Portfolio may compare the investment return of a class of shares to the return on certificates of deposit and other forms of bank deposits, and may quote from organizations that track the rates offered on such deposits. Bank deposits are insured by an agency of the federal government up to specified limits. In contrast, Portfolio shares are not insured, the value of Portfolio shares may fluctuate, and an investor's shares, when redeemed, may be worth more or less than the investor originally paid for them. Unlike the interest paid on many certificates of deposit, which remains at a specified rate for a specified period of time, the return of each class of shares will vary. Portfolio advertisements may reference the history of Legg Mason and its affiliates, the education and experience of the portfolio manager, and the fact that the portfolio manager engages in a particular style of investing (e.g., growth or value). In advertising, each Portfolio may illustrate hypothetical investment plans designed to help investors meet long-term financial goals, such as saving for a child's college education or for retirement. Sources such as the Internal Revenue Service, the Social Security Administration, the Consumer Price Index and Chase Global Data and Research may supply data concerning interest rates, college tuitions, the rate of inflation, Social Security benefits, mortality statistics and other relevant information. Each Portfolio may use other recognized sources as they become available. Each Portfolio may use data prepared by Ibbotson Associates of Chicago, Illinois ("Ibbotson") to compare the returns of various capital markets and to show the value of a hypothetical investment in a capital market. Ibbotson relies on different indices to calculate the performance of common stocks, corporate and government bonds and Treasury bills. -28- Each Portfolio may illustrate and compare the historical volatility of different portfolio compositions where the performance of stocks is represented by the performance of an appropriate market index, such as the S&P 500, and the performance of bonds is represented by a nationally recognized bond index, such as the Lehman Brothers Long-Term Government Bond Index. Each Portfolio may also include in advertising biographical information on key investment and managerial personnel. Each Portfolio may advertise examples of the potential benefits of periodic investment plans, such as dollar cost averaging, a long-term investment technique designed to lower average cost per share. Under such a plan, an investor invests in a mutual fund at regular intervals a fixed dollar amount thereby purchasing more shares when prices are low and fewer shares when prices are high. Although such a plan does not guarantee profit or guard against loss in declining markets, the average cost per share could be lower than if a fixed number of shares were purchased at the same intervals. Investors should consider their ability to purchase shares through low price levels. Each Portfolio may discuss Legg Mason's tradition of service. Since 1899, Legg Mason and its affiliated companies have helped investors meet their specific investment goals and have provided a full spectrum of financial services. Legg Mason affiliates serve as investment advisers for private accounts and mutual funds with assets of more than $71 billion as of March 31, 1998. In advertising, each Portfolio may discuss the advantages of saving through tax-deferred retirement plans or accounts, including the advantages and disadvantages of "rolling over" a distribution from a retirement plan into an IRA, factors to consider in determining whether you qualify for such a rollover, and the other options available. These discussions may include graphs or other illustrations that compare the growth of a hypothetical tax-deferred investment to the after-tax growth of a taxable investment. CUSTODIAN, TRANSFER AGENT AND DIVIDEND-DISBURSING AGENT State Street Bank and Trust Company, P.O. Box 1790, Boston, Massachusetts 02105, serves as custodian of the Fund's assets. Boston Financial Data Services, Inc., P.O. Box 953, Boston, Massachusetts 02103, serves as transfer and dividend-disbursing agent and administrator of various shareholder services. Shareholders who request an historical transcript of their account will be charged a fee based upon the number of years researched. The Fund reserves the right, upon 60 days' written notice, to make other charges to investors to cover administrative costs. -29- INDEPENDENT ACCOUNTANTS Ernst & Young, LLP have been selected to serve as the Fund's independent accountants. The statements of assets and liabilities of the Portfolios and related notes thereto included in this Statement of Additional Information have been so included in reliance upon the report of Ernst & Young, LLP, given on their authority as experts in auditing and accounting. LEGAL COUNSEL Ropes & Gray, Boston, MA, serves as legal counsel to the Fund. -30- LM INSTITUTIONAL FUND ADVISORS II, INC. STATEMENT OF ASSETS AND LIABILITIES MAY 20, 1998
- ---------------------------------------------------------------------------------------------------------------------------------- LMFA LMFA MID LMFA BRANDYWINE BATTERYMARCH BATTERYMARCH LMFA/WA LARGE CAP TOTAL SMALL CAP INTERNATIONAL EMERGING BALANCED CAP VALUE RETURN VALUE EQUITY MARKETS VALUE ASSETS - ---------------------------------------------------------------------------------------------------------------------------------- Cash $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 - ---------------------------------------------------------------------------------------------------------------------------------- Deferred organization $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 and initial offering costs - ---------------------------------------------------------------------------------------------------------------------------------- Total Assets $57,000 $57,000 $57,000 $57,000 $57,000 $57,000 $57,000 - ---------------------------------------------------------------------------------------------------------------------------------- LIABILITIES - ---------------------------------------------------------------------------------------------------------------------------------- Accrued organization $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 expenses and initial offering costs - ---------------------------------------------------------------------------------------------------------------------------------- Total liabilities $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000 - ---------------------------------------------------------------------------------------------------------------------------------- Net Assets - Offering and redemption price of $10.00 per share with 1,500 shares outstanding for each portfolio (6,000, 000,000) shares par value $.001 per share authorized $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 - ---------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------
NOTES TO STATEMENT OF ASSETS AND LIABILITIES A. LM Institutional Fund Advisors II, Inc. ("Corporation") was organized on January 13, 1998. The Portfolios have had no operations other than those matters related to their organization and registration as an investment company under the Investment Company Act of 1940 and the sale of their shares. LM Institutional Advisors, Inc. ("LMIA"), a wholly owned subsidiary of Legg Mason, Inc. (a financial services holding company), has provided the initial capital for the Portfolios by purchasing 1,500 shares each at $10.00 per share. Such shares were acquired for investment and can be disposed of only by redemption. Legg Mason Wood Walker, Incorporated ("Legg Mason"), a wholly owned subsidiary of Legg Mason, Inc. and a member of the New York Stock Exchange, acts as the distributor of the Portfolios' shares. -31- B. Deferred organization represent expenses incurred in connection with the Portfolios' organization and will be amortized on a straight line basis over five years commencing on the effective date of each Portfolio's initial sale of shares to the public. The Portfolios have agreed to reimburse LMIA for the organization expenses advanced by LMIA. The advanced are repayable on demand but must be fully repaid within five years from the commencement of operations. The proceeds realized by LMIA or any holder thereof upon redemption during the amortization period of any of the shares constituting initial capital will be reduced by a proportionate amount of unamortized deferred organization expenses which the number of initial shares redeemed bears to the number of initial shares then outstanding. Initial offering costs represent costs associated with the sale of shares of the Portfolios and will be amortized over a one year period. REPORT OF INDEPENDENT AUDITORS To the Shareholders and Board of Directors LM Institutional Fund Advisors II, Inc. We have audited the accompanying statements of assets and liabilities of LM Institutional Fund Advisors II, Inc., (the "Fund") (comprised of, respectively, the Legg Mason Fund Adviser Large Cap Value Portfolio, Legg Mason Fund Adviser Mid Cap Value Portfolio, Brandywine Small Cap Value Portfolio, Batterymarch Emerging Markets Portfolio, Batterymarch International Equity Portfolio, Legg Mason Fund Adviser/Western Asset Balanced Portfolio and Legg Mason Fund Adviser Total Return Portfolio (the "Portfolios")) as of May 27, 1998. These statements of assets and liabilities are the responsibility of the Fund's management. Our responsibility is to express an opinion on these statements of assets and liabilities based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the statements of assets and liabilities are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the statements of assets and liabilities. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. -32- In our opinion, the statements of assets and liabilities referred to above present fairly, in all material respects, the financial position of each of the respective portfolios of LM Institutional Fund Advisors II, Inc. at May 27, 1998, in conformity with generally accepted accounting principles. Ernst & Young LLP Philadelphia, Pennsylvania May 27, 1998 -33-
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