T. Rowe Price Spectrum Funds - December 31, 2010

N-CSR 1 arspc.htm T. ROWE PRICE SPECTRUM FUNDS T. Rowe Price Spectrum Funds - December 31, 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: December 31, 2010

Item 1: Report to Shareholders

Spectrum Funds

December 31, 2010

The views and opinions in this report were current as of December 31, 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

The global economy recovered in fits and starts in 2010, buffeted by disappointing job gains in the U.S. and the sovereign debt crisis in Europe. Unemployment remained stubbornly high across much of the developed world, and the U.S. housing market appeared to be tottering, after earlier signs of stabilization. The lackluster recovery prompted the Federal Reserve to engineer a second round of monetary stimulus and paved the way for the extension of federal tax cuts. These measures, in combination with continued solid corporate earnings growth, contributed to an environment of improving economic prospects and a strong finish to the year for the stock market.

MARKET ENVIRONMENT

Economic conditions seesawed between encouraging and unsettling throughout most of the year, showcasing the frailty of the post-recession climate following the worst financial crisis since World War II. There were clear improvements in manufacturing, private sector hiring, and even consumer spending. But the positive trends were far from robust, which made financial markets vulnerable to negative developments, such as the European debt crisis, the oil spill in the Gulf of Mexico, and investors’ concerns about health care and financial regulatory reform.

While the economy recovered slowly, the corporate environment showed signs of strength. Cost-cutting and improving demand led to strong profit growth in many industries, even among those companies hardest hit by the financial crisis. As a result, the broad stock indexes finished the year with gains, and all sectors in the S&P 500 Index advanced in the period.

Consumer discretionary and industrials and business services shares performed best, followed by materials, energy, and information technology (IT). Consumer staples and financials shares produced solid gains but lagged the broad market. Health care and utilities—two sectors that tend to have lower sensitivity to the health of the economy—produced modest results as equity investors favored riskier investments.

Broadly speaking, stocks gained ground globally. European markets were held back by a mounting debt crisis among the peripheral European states, which continues to threaten the health of many regional economies and markets. Developed markets in Asia performed well and emerging markets also advanced, posting strong returns supported by robust economic growth. While many emerging economies are contending with accelerating inflation, they continue to offer an attractive combination of economic health and growth potential over an intermediate- to longer-term horizon.

In November, the Federal Reserve introduced a second round of Treasury security purchases intended to increase borrowing and spending by lowering longer-term interest rates. But as the year progressed, bond investors became increasingly concerned about the long-term sustainability of ultra-low long-term rates, as well as their potential to generate inflation.

As investors shifted into higher-risk assets with higher return potential, higher-quality bonds suffered modest setbacks. Treasuries struggled most in this environment. However, corporate bonds fared well, especially high yield bonds. Non-U.S. dollar bonds, as well as emerging market bonds, also benefited. The favorable fiscal positioning of many emerging market sovereign issuers stands in contrast to the budget and funding challenges faced by a number of developed market governments.

SPECTRUM GROWTH FUND

The Spectrum Growth Fund returned 25.67% for the six months ended December 31, 2010, and 16.88% for the full year. The fund outperformed the Russell 3000 Index and the Lipper Multi-Cap Core Funds Index for the six-month period and slightly trailed the Russell index for the full year.

Each of Spectrum Growth’s underlying components advanced for the last year. The strongest absolute performers included the New Horizons Fund, the Small-Cap Stock Fund, and the Mid-Cap Growth Fund. The Mid-Cap Value Fund weighed on relative returns, underperforming its Russell Midcap Value Index.

Among domestic stocks, strong stock selection in IT and an overweight position in the consumer discretionary sector both aided performance as they benefited from a more favorable economic climate. Improved IT spending helped generate a cyclical rebound in the sector. Apple was a key contributor: Its IPhone and iMac personal computers continued to sell quite well, and its new iPad is selling at a rate well above initial projections. Internet giant Google faltered in the first half of the year due to a slowdown in advertising sales but perked up in the second half and should continue benefiting from display advertising and video-related revenues.

Financials, among the portfolio’s largest holdings, lagged the broader market. Continuing pressures from low interest rates, the European debt crisis, and questions about the handling of residential foreclosures put downward pressure on the sector.

We believe valuations continue to favor growth stocks, but we are neutral overall between growth and value as the attractive valuations in growth stocks look to be balanced against the case for value stocks based on the current economic and profit cycles. We are also neutral between U.S. and non-U.S. equities, though we are overweight to emerging markets (compared with developed overseas markets) given their greater growth opportunities.

SPECTRUM INCOME FUND

The Spectrum Income Fund returned 7.28% for the six months ended December 31, 2010, and 9.68% for the full year, outperforming its benchmarks, the Barclays Capital U.S. Aggregate Index and the Lipper General Bond Funds Average for both periods (see the accompanying performance table).

The Spectrum Income Fund’s allocations to diversifying sectors such as high yield bonds; dividend-paying stocks; and, to a lesser extent, emerging market bonds drove the fund’s outperformance relative to its Barclays Capital benchmark. Additionally, the fund was aided by strong relative performance by the underlying funds over the year, led by the New Income Fund’s significant outperformance versus the Barclays Capital U.S. Aggregate Index benchmark. The New Income Fund benefited from an underweight allocation to Treasuries, coupled with overweight allocations to high yield bonds and commercial mortgage-backed securities, which drove outperformance as investors sought higher yields and additional risk in a modestly improving economic environment.

We remain overweight to high yield bonds relative to investment-grade bonds as an improving economic climate and recent opportunities for issuers to refinance higher-coupon debt and extend maturities leave us anticipating continued strength in this sector. Additionally, the higher coupons offered by high yield bonds can help moderate the adverse impact from potentially rising interest rates. Likewise, we will remain overweight to nondollar bonds relative to U.S. investment-grade bonds and believe rising U.S. deficits could continue to weigh on the dollar. Emerging market debt prospects remain compelling thanks to strong fundamentals, including solid fiscal positioning relative to many developed countries and robust economic growth rates, which are increasingly supported by an expanding consumer class.

SPECTRUM INTERNATIONAL FUND

The Spectrum International Fund returned 26.82% for the six months ended December 31, 2010, and 13.52% for the full year. The fund outperformed the MSCI All Country World ex-U.S.A. Index as well as the Lipper International Multi-Cap Core Funds Average for both periods.

International markets saw strong results in the second half of the year, and each of the underlying funds in the Spectrum International Fund generated positive returns. The International Stock Fund and International Growth & Income Fund were strong positive contributors to both absolute and relative performance. Outside the U.S., the consumer discretionary, industrials, and materials sectors all saw solid gains for the year. From a regional perspective, Japan and Pacific ex Japan both experienced positive returns for the year. Emerging market stocks also enjoyed a strong year as the sector returned more than 19% for the 12-month period.

Relative to the MSCI All Country World ex-U.S.A. Index, we have maintained our high allocation to Europe, where holdings include solid consumer discretionary stocks, which could benefit from a gradually rebounding global economy. Additionally, we are overweight in emerging market stocks, given their healthy economic environment and strong growth potential. While we are mindful that accelerating inflation could impede growth in many emerging countries, our emerging market funds have exposure to stocks that should benefit over the long term from a burgeoning middle class and strong exports.

OUTLOOK

The global economy is recovering, but the residual effects of the financial crisis are likely to be with us for some time. We remain positive about the stock market’s direction over the medium term as equities are attractively valued compared with bonds and corporate fundamentals appear to be strong. In the short term, however, unexpected shocks to the equity markets cannot be ruled out.

Bond markets, however, may be vulnerable in the medium term. Economic improvement over the next six to 18 months could exert upward pressure on interest rates, and elevated levels of new Treasury supply may undermine prices. In addition, the strong returns for stocks could pull more investors out of the bond market. Nonetheless, bond holdings remain an important way to control risk in an uncertain climate.

These complex trends underscore the value of a well-diversified approach. The Spectrum Funds offer diversification combined with a disciplined security selection approach, which can help manage risks while still providing ample opportunity to take advantage of market gains. We remain committed to achieving these results for you.

Respectfully submitted,

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

January 20, 2011

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 are usually 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.

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 averages: The averages of all mutual funds in a particular category 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 ex-U.S.A. Index: 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 26 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.

Russell Midcap Value Index: Unmanaged index that measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values.

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

SEC yield (30-day): 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 effective duration (years): A measure of a security’s price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

Weighted average maturity: 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.

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.