T. Rowe Price Spectrum Funds

N-CSRS 1 srspc.htm T. ROWE PRICE SPECTRUM FUND T. Rowe Price Spectrum Funds - June 30, 2010

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT OF REGISTERED

MANAGEMENT INVESTMENT COMPANIES

Investment Company Act File Number: 811-4998

T. Rowe Price Spectrum Fund, Inc.

(Exact name of registrant as specified in charter)

100 East Pratt Street, Baltimore, MD 21202

(Address of principal executive offices)

David Oestreicher

100 East Pratt Street, Baltimore, MD 21202

(Name and address of agent for service)

Registrant’s telephone number, including area code: (410) 345-2000

Date of fiscal year end: December 31

Date of reporting period: June 30, 2010

Item 1: Report to Shareholders

Spectrum Funds

June 30, 2010

The views and opinions in this report were current as of June 30, 2010. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.

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Manager’s Letter

Fellow Shareholders

After a year of fast-paced recovery, most global stock markets took a breather in the first half of 2010. A swarm of worrisome developments weighed on investor confidence—particularly in the second quarter—generating losses across sectors, styles, and regions. U.S. bonds generally fared well throughout the period, especially in the second quarter, as investors retreated toward Treasuries.

MARKET ENVIRONMENT

Global stocks declined in the first half of 2010, as gains through April were erased by a sharp correction—traditionally defined as a drop of at least 10%—in May and June. The remarkable rally that started in March 2009 was initially disrupted by the emergence of a severe Greek debt crisis. Investors worried that the crisis could spread to other highly indebted European nations and perhaps weigh down the wider global economy. Indeed, the U.S. reported disappointing economic news in May and June, including poor employment figures.

Losses accelerated late in the spring as more troubling news emerged. Efforts to tighten monetary policy and lending practices in China enhanced worries about the global economy. Rising military tensions between North and South Korea elevated geopolitical risk. U.S. financials sector reform efforts, on top of recently passed health care reforms, seemed to be shifting the ground under investors’ feet. Finally, the massive Gulf of Mexico oil spill also weighed on investor sentiment and generated uncertainty about local economies and the future of the energy sector.

The correction that ensued was widespread and affected virtually all global market sectors. Markets outside the U.S. posted the weakest results, particularly developed markets in Europe. A strong rise in the value of the U.S. dollar—triggered by a global flight to safety—further weighed down the international indexes.

Results for the U.S. stock market were somewhat better. For the first half of the period, U.S. mid- and small-cap shares significantly outperformed their large-cap peers due to stronger gains early in the year. Growth stocks remained largely out of favor as value stocks held up better across all market capitalizations. Despite dropping roughly 13% to 18% from late April through the end of June, most major indexes remain more than 50% above their March 2009 nadir as of June 30.

In the large-cap universe, as measured by the S&P 500 Index, all sectors declined. Based on total return data from S&P, energy and materials fared the worst as global macroeconomic uncertainty, lower commodity prices, and the Gulf oil spill dented investor sentiment toward natural resource stocks. Most remaining sectors fell moderately, but industrials and consumer discretionary companies held up best.

The U.S. bond market, in contrast, made solid gains for the half. Early in the year when investors were more confident in economic recovery, high yield bonds did well. When conditions turned sour in the spring, investors turned to the investment-grade universe. Long-term Treasuries produced the strongest returns for the period. High-quality corporate bonds, agency mortgage-backed securities (MBS), and asset-backed securities (ABS) did well but were less robust. Short-term U.S. government issues and municipal securities lagged. Outside the U.S., emerging market bonds fared considerably better than developed market bonds, which were hampered in the wake of the Greek financial crisis.

Spectrum Growth Fund
The Spectrum Growth Fund returned -7.00% for the six months ended June 30, 2010. In a challenging market environment, the fund modestly trailed the Russell 3000 Index and the Lipper Multi-Cap Core Funds Index.

The global stock market correction generated losses in all of the fund’s key investment segments.Losses were heaviest for U.S. large-caps and non-U.S. stocks. Positions in small- and mid-cap shares held up better, but these accounted for only about 25% of the total portfolio. Top holding Apple was among the portfolio’s best performers for the period, while number-two holding Google was a key detractor. (Please refer to the portfolio of investments for a complete listing of fund holdings and the amount each represents in the portfolio.)

Stocks remained reasonably valued, and while volatility increased, they have been supported by a favorable earnings environment and solid balance sheets as the economy has improved. Over time, we have moved away from a preference for value and now are about neutrally balanced between growth and value stocks. Broadly, valuations on growth stocks are highly attractive compared with historical levels.

Although volatility has increased, stocks continue to be supported by a favorable earnings environment and reasonable balance sheets in the context of a gradually improving economy.

While value stocks often do well as the economy and profits recover from trough levels, growth stocks are very attractively valued. We are underweighting small-cap stocks versus large-caps as strong small-cap performance in 2010 has made the small-cap sector’s valuations even richer. We have a neutral bias between U.S. and non-U.S. developed markets stocks because we believe better U.S. growth prospects are reflected in current valuations. We remain overweight to emerging markets stocks and believe that over the long term, higher growth prospects for emerging markets should offset greater short-term volatility. However, we reduced our overweight during the period in recognition that valuations had become less compelling following the recent strong performance of emerging markets equities.

Spectrum Income Fund
The Spectrum Income Fund returned 2.24% for the six months ended June 30, 2010. These results lagged behind those of its benchmarks, the Barclays Capital U.S. Aggregate Index and the Lipper General Bond Funds Average (see the Performance Comparison table).

While the fund is predominantly a fixed income portfolio, our third-largest holding is the Equity Income Fund, which invests in dividend-paying stocks. This positioning generally is advantageous when stocks are rising but can weaken results when stocks lose ground. Our underperformance for the period largely can be explained by our holdings in the Equity Income Fund, which underperformed as stocks trailed bonds over the period.

Most of our fixed income holdings gained ground throughout the period, but leadership rotated from one group to another. Signs of economic recovery early in the period prompted strong gains in high yield and investment-grade corporate bonds. The correction that occurred in the spring sent many investors rushing for the relative safety of Treasuries, which rallied in the second quarter. MBS and ABS—notably those with the least amount of credit risk—gained ground in the second quarter as well. Over the period, we reduced the fund’s exposure to investment-grade bonds in favor of high yield and emerging market bonds as yield spreads remain attractive in these sectors relative to their historical average.

We remain overweight in high yield bonds relative to investment-grade bonds. Despite recent concerns, these securities should improve with the economy over the long term. Even if U.S. economic growth slows in the second half of 2010, the majority of high yield issuers have already taken the necessary steps to improve liquidity, extend debt maturities, and rationalize cost structures. For this reason, defaults are expected to trend below 2% by the end of this year and remain at this low level in 2011.

Spectrum International Fund
The Spectrum International Fund returned -10.49% for the six months ended June 30, 2010. The fund slightly outperformed the MSCI All Country World ex-U.S.A. Index as well as the Lipper International Multi-Cap Core Funds Average.

The portfolio’s largest single area of exposure is the developed markets of Europe, a region that was hit hard during the period as a debt crisis in Greece threatened to spread to other indebted European nations. Smaller positions in emerging markets fared somewhat better, but no single segment of the portfolio was able to generate gains in the difficult market environment.

We are currently overweight to emerging market equities relative to the benchmark. Valuations are less compelling than they were early in 2009 following a strong recovery. However, these markets have had limited exposure to recent financial crises and have been enjoying strong improvements in domestic consumer spending. Over a longer investment horizon, we expect growth opportunities to offset the higher potential for day-to-day volatility. We reduced our allocation to emerging market stocks over the period as valuations are less compelling following strong performance in the sector relative to developed non-U.S. equities. We added to our allocation to the International Growth & Income Fund, which invests in established companies in developed markets that we believe are currently undervalued.

OUTLOOK

While investors have been rightly concerned about the sovereign debt crisis in Europe, such aftershocks are not out of the ordinary following financial crises. Indeed, this is the type of bad news one might expect as the global economy struggles to readjust—and one reason we and others have predicted a slow recovery even after the steep recession. Nonetheless, we believe the U.S. economy is regaining its footing, due in part to pent-up demand for long-lasting durable goods. Sharp increases in productivity as a result of cost-cutting appear to be coming to an end, setting the stage for an eventual improvement in job gains and household spending. Modest but continued growth would bode well for equity markets and corporate bonds but may lead to some decline in Treasury prices should risk aversion subside and yields turn higher once again.

Stock valuations are reasonable, especially in relation to today’s low interest rates. The difference between the earnings yield on large-cap stocks and the 10-year Treasury rate is attractive in any historical context. Nonetheless, volatility is likely to persist until the global economy shows legitimate signs of strong growth. We believe that shareholders will be well served over the long term by the funds’ fundamental commitment to diversification across asset classes, as well as our emphasis on strong fundamental research in seeking investment opportunities in the current market environment.

Respectfully submitted,

Edmund M. Notzon III
President of the Spectrum Funds and chairman of the Investment
Advisory Committee

July 16, 2010

The committee chairman has day-to-day responsibility for managing the portfolios and works with committee members in developing and executing the funds’ investment program.

RISKS OF INVESTING

As with all stock and bond mutual funds, each fund’s share price can fall because of weakness in the stock or bond markets, a particular industry, or specific holdings. Stock markets can decline for many reasons, including adverse political or economic developments, changes in investor psychology, or heavy institutional selling. The prospects for an industry or company may deteriorate because of a variety of factors, including disappointing earnings or changes in the competitive environment. In addition, the investment manager’s assessment of companies held in a fund may prove incorrect, resulting in losses or poor performance even in rising markets.

Bonds are subject to interest rate risk, the decline in bond prices that usually accompanies a rise in interest rates, and credit risk, the chance that any fund holding could have its credit rating downgraded or that a bond issuer will default (fail to make timely payments of interest or principal), potentially reducing the fund’s income level and share price. High yield corporate bonds could have greater price declines than funds that invest primarily in high-quality bonds. Companies issuing high yield bonds are not as strong financially as those with higher credit ratings, so the bonds usually are considered speculative investments.

Funds that invest overseas may carry more risk than funds that invest strictly in U.S. assets. Risks can result from varying stages of economic and political development; differing regulatory environments, trading days, and accounting standards; and higher transaction costs of non-U.S. markets. Non-U.S. investments are also subject to currency risk, or a decline in the value of a foreign currency versus the U.S. dollar, which reduces the dollar value of securities denominated in that currency.

GLOSSARY

Barclays Capital U.S. Aggregate Index: An unmanaged index that tracks investment-grade corporate and government bonds.

Duration: The average time (expressed in years) needed for an investor to receive the present value of the future cash flows on a fixed income investment. It is used to measure a bond or bond fund’s sensitivity to interest rate changes. For example, a fund with a five-year duration would fall about 5% in price in response to a one-percentage-point increase in interest rates, and vice versa.

J.P. Morgan Non-U.S. Dollar Government Bond Index: An unmanaged index that tracks the performance of major non-U.S. bond markets.

Lipper average: The average of available mutual fund performance returns in defined categories as tracked by Lipper Inc.

Lipper indexes: Fund benchmarks that consist of a small number of the largest mutual funds in a particular category as tracked by Lipper Inc.

MSCI All Country World Index ex-U.S.A.: An index that measures equity market performance of developed and emerging countries, excluding the U.S.

MSCI EAFE Index: An unmanaged index that tracks the stocks of about 1,000 companies in Europe, Australasia, and the Far East (EAFE).

MSCI Emerging Markets Index: An unmanaged index that tracks stocks in emerging market countries.

Russell 2000 Index: An unmanaged index that tracks the stocks of 2,000 small U.S. companies.

Russell 3000 Index: An index that tracks the performance of the 3,000 largest U.S. companies, representing approximately 98% of the investable U.S. equity market.

S&P 500 Index: An unmanaged index that tracks the stocks of 500 U.S. primarily large-cap companies.

30-day SEC yield: A method of calculating a fund’s yield that assumes all portfolio securities are held until maturity. Yield will vary and is not guaranteed.

Weighted average maturity: A measure of a fund’s interest rate sensitivity. In general, the longer the average maturity, the greater the fund’s sensitivity to interest rate changes. The weighted average maturity may take into account the interest rate readjustment dates for certain securities. Money funds must maintain a weighted average maturity of less than 60 days.

Performance and Expenses

GROWTH OF $10,000

This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.

GROWTH OF $10,000

FUND EXPENSE EXAMPLE

As a mutual fund shareholder, you may incur two types of costs: (1) transaction costs, such as redemption fees or sales loads, and (2) ongoing costs, including management fees, distribution and service (12b-1) fees, and other fund expenses. The following example is intended to help you understand your ongoing costs (in dollars) of investing in the fund and to compare these costs with the ongoing costs of investing in other mutual funds. The example is based on an investment of $1,000 invested at the beginning of the most recent six-month period and held for the entire period.

Actual Expenses
The first line of the following table (“Actual”) provides information about actual account values and expenses based on the fund’s actual returns. You may use the information in this line, together with your account balance, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During Period” to estimate the expenses you paid on your account during this period.

Hypothetical Example for Comparison Purposes
The information on the second line of the table (“Hypothetical”) is based on hypothetical account values and expenses derived from the fund’s actual expense ratio and an assumed 5% per year rate of return before expenses (not the fund’s actual return). You may compare the ongoing costs of investing in the fund with other funds by contrasting this 5% hypothetical example and the 5% hypothetical examples that appear in the shareholder reports of the other funds. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period.

Note: T. Rowe Price charges an annual small-account maintenance fee of $10, generally for accounts with less than $2,000 ($500 for UGMA/UTMA). The fee is waived for any investor whose T. Rowe Price mutual fund accounts total $25,000 or more, accounts employing automatic investing, and IRAs and other retirement plan accounts that utilize a prototype plan sponsored by T. Rowe Price (although a separate custodial or administrative fee may apply to such accounts). This fee is not included in the accompanying table. If you are subject to the fee, keep it in mind when you are estimating the ongoing expenses of investing in the fund and when comparing the expenses of this fund with other funds.

You should also be aware that the expenses shown in the table highlight only your ongoing costs and do not reflect any transaction costs, such as redemption fees or sales loads. Therefore, the second line of the table is useful in comparing ongoing costs only and will not help you determine the relative total costs of owning different funds. To the extent a fund charges transaction costs, however, the total cost of owning that fund is higher.

T. ROWE PRICE SPECTRUM GROWTH FUND

Unaudited