UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM N-CSR
Investment Company Act file number: 811-05002
Deutsche Variable Series II
(Exact Name of Registrant as Specified in Charter)
345 Park Avenue
New York, NY 10154-0004
(Address of Principal Executive Offices) (Zip Code)
Registrant’s Telephone Number, including Area Code: (212) 250-3220
Paul Schubert
60 Wall Street
New York, NY 10005
(Name and Address of Agent for Service)
| Date of fiscal year end: | 12/31 |
| Date of reporting period: | 12/31/2016 |
| ITEM 1. | REPORT TO STOCKHOLDERS |
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Alternative Asset Allocation VIP
Contents
|
3 Performance Summary 5 Management Summary 6 Portfolio Summary 7 Investment Portfolio 8 Statement of Assets and Liabilities 9 Statement of Operations 9 Statements of Changes in Net Assets 11 Financial Highlights 12 Notes to Financial Statements 16 Report of Independent Registered Public Accounting Firm 17 Information About Your Fund's Expenses 18 Tax Information 18 Proxy Voting 19 Advisory Agreement and Sub-Advisory Agreement Board Considerations and Fee Evaluation 22 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Although allocation among different asset categories generally limits risk, portfolio management may favor an asset category that underperforms other assets or markets as a whole. The Fund expects to invest in underlying funds that emphasize alternatives or non-traditional asset categories or investment strategies, and as a result, it is subject to the risk factors of those underlying funds. Some of those risks include: stock market risk; the political, general economic, liquidity and currency risks of foreign investments, which may be particularly significant for emerging markets; credit and interest rate risk; floating rate loan risk; volatility in commodity prices, infrastructure and high-yield debt securities; market direction risk (market advances when short, market declines when long); and short sales risk. Because Exchange Traded Funds (ETFs) trade on a securities exchange, their shares may trade at a premium or discount to their net asset value. ETFs also incur fees and expenses so they may not fully match the performance of the indexes they are designed to track. The Fund may use derivatives, including as part of its currency and interest-rate strategies. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The success of the Fund’s currency and interest-rate strategies are dependent, in part, on the effectiveness and implementation of portfolio management’s proprietary models. As part of these strategies, the Fund’s exposure to foreign currencies could cause lower returns or even losses because foreign currency rates may fluctuate significantly over short periods of time for a number of reasons. The risk of loss is heightened during periods of rapid rises in interest rates. In addition, the notional amount of the Fund’s aggregate currency and interest-rate exposure resulting from these strategies may significantly exceed the net assets of the Fund. See the prospectus for additional risks and specific details regarding the Fund's risk profile.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 1.65% and 1.95% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report. These expense ratios include net expenses of the underlying funds in which the Fund invests.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Alternative Asset Allocation VIP from 2/2/09 to 12/31/16 | ||
|
■ Deutsche Alternative Asset Allocation VIP — Class A ■ MSCI World Index ■ Bloomberg Barclays U.S. Aggregate Bond Index ■ Blended Index |
|
The Morgan Stanley Capital International (MSCI) World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The index consists of 23 developed market country indices. The index is calculated using closing local market prices and translates into U.S. dollars using the London close foreign exchange rates. The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index representing domestic taxable investment-grade bonds, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities with an average maturity of one year or more. The Blended Index is calculated using the performance of two unmanaged indices, representative of stocks (the MSCI World Index (70%)) and bonds (the Bloomberg Barclays U.S. Aggregate Bond Index (30%)). These results are summed to produce the aggregate benchmark. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Alternative Asset Allocation VIP | 1-Year | 3-Year | 5-Year | Life of Fund* | |
| Class A | Growth of $10,000 | $10,530 | $10,212 | $11,310 | $15,604 |
| Average annual total return | 5.30% | 0.70% | 2.49% | 5.78% | |
| MSCI World Index | Growth of $10,000 | $10,751 | $11,184 | $16,409 | $24,680 |
| Average annual total return | 7.51% | 3.80% | 10.41% | 12.10% | |
| Bloomberg Barclays U.S. Aggregate Bond Index | Growth of $10,000 | $10,265 | $10,937 | $11,167 | $13,713 |
| Average annual total return | 2.65% | 3.03% | 2.23% | 4.07% | |
| Blended Index | Growth of $10,000 | $10,618 | $11,155 | $14,729 | $21,161 |
| Average annual total return | 6.18% | 3.71% | 8.05% | 9.93% | |
The growth of $10,000 is cumulative.
* The Fund commenced offering Class A shares on February 2, 2009. The performance shown for each index is for the time period of January 31, 2009 through December 31, 2016, which is based on the performance period of the life of the Fund.
| Deutsche Alternative Asset Allocation VIP | 1-Year | 3-Year | 5-Year | Life of Class** | |
| Class B | Growth of $10,000 | $10,499 | $10,130 | $11,161 | $14,068 |
| Average annual total return | 4.99% | 0.43% | 2.22% | 4.58% | |
| MSCI World Index | Growth of $10,000 | $10,751 | $11,184 | $16,409 | $22,236 |
| Average annual total return | 7.51% | 3.80% | 10.41% | 11.05% | |
| Bloomberg Barclays U.S. Aggregate Bond Index | Growth of $10,000 | $10,265 | $10,937 | $11,167 | $13,397 |
| Average annual total return | 2.65% | 3.03% | 2.23% | 3.91% | |
| Blended Index | Growth of $10,000 | $10,618 | $11,155 | $14,729 | $18,760 |
| Average annual total return | 6.18% | 3.71% | 8.05% | 8.65% | |
The growth of $10,000 is cumulative.
** The Fund commenced offering Class B shares on May 18, 2009. The performance shown for each index is for the time period of May 31, 2009 through December 31, 2016, which is based on the performance period of the life of Class B.
Management Summary December 31, 2016 (Unaudited)
The Fund returned 5.30% (Class A shares, unadjusted for contract charges) during 2016, slightly behind the 6.18% gain of its blended benchmark.1
The backdrop was generally positive for the Fund in 2016, but its best performance occurred in the first half of the year. During that time, the sharp drop in global bond yields fueled a rally in rate-sensitive and income-producing assets, aiding the Fund’s allocations to real estate investment trusts (REITs) and global infrastructure stocks. In contrast, the second half brought an improvement in global growth and a corresponding rise in bond yields, which weighed heavily on both categories. Still, they combined for a net positive contribution to performance in 2016. As the year progressed, our effort to lessen the Fund’s interest-rate exposure led us to reduce our allocation to REITs and infrastructure stocks to 14.7% by the end of December, well off of the peak level of 29.0% reached in April.
SPDR Bloomberg Barclays Convertible Securities ETF, which benefited from both the stock market rally and the continued demand for assets with above-average yields, also made a healthy contribution to returns.2 We added further value from our allocation to commodities. Not only did the asset class perform very well after some weakness to start the year, but our underlying investment — Deutsche Enhanced Commodity Strategy Fund — outpaced the broader category. We continue to see commodities as a crucial component of alternative investing, in part due to their ability to offset the effects of inflation.
The Fund’s allocation to emerging-markets bonds, with includes Deutsche Enhanced Emerging Markets Fixed Income Fund and positions in two exchanged-traded funds invested in local-currency debt, generated a robust return. After starting the year on a down note, the emerging debt markets recovered strongly behind the improving outlook for global growth in general, and for China and Latin America in particular.
The other components of the fixed-income portfolio — floating-rate securities and global inflation-protected bonds — gained ground but finished behind the benchmark. Still, both provided ballast to the Fund during the instances of financial-market volatility that occurred throughout the course of the year. In addition, floating-rate debt benefited from the general strength in the bond market’s credit sectors.
Deutsche Diversified Market Neutral Fund and Deutsche Strategic Equity Long/Short Fund declined in value and failed to keep pace with the rally in the broader stock and fixed-income indices. The funds closed in November and August, respectively, and they were removed from the portfolio. We have not yet invested all of the proceeds of these sales, which is the reason for the Fund’s above-average cash weighting at year-end. We believe this patient strategy gives us greater flexibility to capitalize on potential market volatility in the months ahead.
We think the Fund’s current structure provides diversified exposure to the various factors that are influencing the global economy. While alternative assets, as a group, have underperformed traditional investments in recent years, we believe these market segments offer an increasingly compelling risk-and-return profile and a continued opportunity for investors to add diversification to their portfolios.
Pankaj Bhatnagar, PhD
Darwei Kung
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The Blended Index is calculated using the performance of two unmanaged indices, representative of stocks (the Morgan Stanley Capital International (MSCI) World Index (70%) and bonds (the Bloomberg Barclays U.S. Aggregate Bond Index (30%). These results are summed to produce the aggregate benchmark. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
2 An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
Portfolio Summary (Unaudited)
| Asset Allocation* (As a % of Investment Portfolio excluding Cash Equivalents) | 12/31/16 | 12/31/15 |
| Real Asset | 34% | 41% |
| Deutsche Enhanced Commodity Strategy Fund | 17% | 12% |
| Deutsche Global Infrastructure Fund | 11% | 18% |
| Deutsche Global Real Estate Securities Fund | 0% | 3% |
| Deutsche Real Estate Securities Fund | 6% | 7% |
| Deutsche Real Estate Securities Income Fund | — | 1% |
| Fixed Income — Nontraditional | 39% | 22% |
| Deutsche Enhanced Emerging Markets Fixed Income Fund | 18% | 13% |
| SPDR Bloomberg Barclays Convertible Securities ETF | 12% | 9% |
| VanEck Vectors JPMorgan EM Local Currency Bond ETF | 7% | — |
| WisdomTree Emerging Markets Local Debt ETF | 2% | — |
| Fixed Income — Real-Return | 27% | 23% |
| Deutsche Floating Rate Fund | 11% | 13% |
| Deutsche Global Inflation Fund | 16% | 10% |
| Absolute Return | — | 14% |
| Deutsche Diversified Market Neutral Fund | — | 13% |
| Deutsche Strategic Equity Long/Short Fund | — | 1% |
| 100% | 100% | |
* During the periods indicated, asset categories and investment strategies represented in the fund's portfolio fell into the following general themes; Real Asset, Fixed Income – Nontraditional, Fixed Income – Real Return and Absolute Return. Real asset investments have a tangible or physical aspect such as real estate or commodities. Fixed income – nontraditional investments seek to provide diversification but may not be held in traditional portfolios. Fixed income – real return investments seek to provide a measure of inflation protection. Absolute return is the return, expressed as a percentage, which an asset achieves over a certain period of time.
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 7.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
Shares |
Value ($) | |
| Mutual Funds 68.5% | ||
| Deutsche Enhanced Commodity Strategy Fund "Institutional" (a) | 1,593,611 | 18,836,483 |
| Deutsche Enhanced Emerging Markets Fixed Income Fund "Institutional" (a) | 2,262,362 | 20,632,739 |
| Deutsche Floating Rate Fund "Institutional" (a) | 1,490,211 | 12,592,284 |
| Deutsche Global Inflation Fund "Institutional" (a) | 1,853,428 | 18,478,680 |
| Deutsche Global Infrastructure Fund "Institutional" (a) | 906,967 | 12,207,777 |
| Deutsche Global Real Estate Securities Fund "Institutional" (a) | 49,271 | 422,249 |
| Deutsche Real Estate Securities Fund "Institutional" (a) | 330,542 | 6,637,281 |
| Total Mutual Funds (Cost $94,200,355) | 89,807,493 | |
| Equity — Exchange-Traded Fund 10.1% | ||
| SPDR Bloomberg Barclays Convertible Securities (Cost $12,629,614) | 290,821 | 13,275,978 |
Shares |
Value ($) | |
| Fixed Income — Exchange-Traded Funds 7.4% | ||
| VanEck Vectors JPMorgan EM Local Currency Bond | 429,786 | 7,564,234 |
| WisdomTree Emerging Markets Local Debt | 61,430 | 2,197,351 |
| Total Fixed Income — Exchange-Traded Funds (Cost $10,432,008) | 9,761,585 | |
| Cash Equivalents 13.9% | ||
| Deutsche Central Cash Management Government Fund, 0.50% (a) (b) (Cost $18,239,998) | 18,239,998 | 18,239,998 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $135,501,975)† | 99.9 | 131,085,054 |
| Other Assets and Liabilities, Net | 0.1 | 106,691 |
| Net Assets | 100.0 | 131,191,745 |
† The cost for federal income tax purposes was $137,301,399. At December 31, 2016, net unrealized depreciation for all securities based on tax cost was $6,216,345. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $3,422,370 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $9,638,715.
(a) Affiliated fund managed by Deutsche Investment Management Americas Inc.
(b) The rate shown is the annualized seven-day yield at period end.
EM: Emerging Markets
SPDR: Standard & Poor's Depositary Receipt
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total |
| Mutual Funds | $89,807,493 | $ — | $ — | $89,807,493 |
| Exchange-Traded Fund | 23,037,563 | — | — | 23,037,563 |
| Short-Term Investment | 18,239,998 | — | — | 18,239,998 |
| Total | $131,085,054 | $ — | $ — | $131,085,054 |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in affiliated Underlying Funds, at value (cost $112,440,353) |
$108,047,491 |
| Investments in non-affiliated Underlying Funds, at value (cost $23,061,622) | 23,037,563 |
| Total investments in securities, at value (cost $135,501,975) | 131,085,054 |
| Cash | 2,142 |
| Receivable for Fund shares sold | 154,909 |
| Dividends receivable | 165,589 |
| Interest receivable | 6,874 |
| Other assets | 2,109 |
| Total assets | 131,416,677 |
| Liabilities | |
| Payable for Fund shares redeemed | 76,744 |
| Accrued management fee | 14,183 |
| Accrued Trustees' fees | 2,123 |
| Other accrued expenses and payables | 131,882 |
| Total liabilities | 224,932 |
| Net assets, at value | $131,191,745 |
| Net Assets Consist of | |
| Undistributed net investment income | 3,070,645 |
| Net unrealized appreciation (depreciation) on investments | (4,416,921) |
| Accumulated net realized gain (loss) | (3,663,836) |
| Paid-in capital | 136,201,857 |
| Net assets, at value | $131,191,745 |
|
Class A Net Asset Value, offering and redemption price per share ($24,213,623 ÷ 1,866,984 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 12.97 |
|
Class B Net Asset Value, offering and redemption price per share ($106,978,122 ÷ 8,257,413 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 12.96 |
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Income distributions from affiliated Underlying Funds |
$ 2,811,718 |
| Dividends | 636,737 |
| Other income | 16,536 |
| Total income | 3,464,991 |
|
Expenses: Management fee |
377,467 |
| Administration fee | 115,201 |
| Record keeping fees (Class B) | 42,962 |
| Services to shareholders | 2,956 |
| Distribution service fee (Class B) | 231,266 |
| Custodian fee | 5,643 |
| Professional fees | 64,455 |
| Reports to shareholders | 63,730 |
| Registration fees | 26 |
| Trustees' fees and expenses | 6,485 |
| Other | 5,657 |
| Total expenses before expense reductions | 915,848 |
| Expense reductions | (324,999) |
| Total expenses after expense reductions | 590,849 |
| Net investment income (loss) | 2,874,142 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Sale of affiliated Underlying Funds |
(1,874,966) |
| Sale of non-affiliated Underlying Funds | (156,613) |
| Capital gain distributions from affiliated Underlying Funds | 586,860 |
| (1,444,719) | |
| Change in net unrealized appreciation (depreciation) on investments | 3,861,095 |
| Net gain (loss) | 2,416,376 |
| Net increase (decrease) in net assets resulting from operations | $ 5,290,518 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 2,874,142 | $ 2,153,147 |
| Net realized gain (loss) | (1,444,719) | (134,096) |
| Change in net unrealized appreciation (depreciation) | 3,861,095 | (9,619,966) |
| Net increase (decrease) in net assets resulting from operations | 5,290,518 | (7,600,915) |
|
Distributions to shareholders from: Net investment income: Class A |
(500,963) | (610,326) |
| Class B | (1,722,118) | (2,547,011) |
|
Net realized gains: Class A |
— | (44,846) |
| Class B | — | (205,010) |
| Total distributions | (2,223,081) | (3,407,193) |
|
Fund share transactions: Class A Proceeds from shares sold |
4,188,144 | 4,707,272 |
| Reinvestment of distributions | 500,963 | 655,172 |
| Payments for shares redeemed | (2,114,144) | (2,020,383) |
| Net increase (decrease) in net assets from Class A share transactions | 2,574,963 | 3,342,061 |
|
Class B Proceeds from shares sold |
27,389,957 | 12,671,502 |
| Reinvestment of distributions | 1,722,118 | 2,752,021 |
| Payments for shares redeemed | (12,422,361) | (12,115,711) |
| Net increase (decrease) in net assets from Class B share transactions | 16,689,714 | 3,307,812 |
| Increase (decrease) in net assets | 22,332,114 | (4,358,235) |
| Net assets at beginning of period | 108,859,631 | 113,217,866 |
| Net assets at end of period (including undistributed net investment income of $3,070,645 and $2,181,836, respectively) | $131,191,745 | $108,859,631 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
1,666,853 | 1,416,911 |
| Shares sold | 325,638 | 354,455 |
| Shares issued to shareholders in reinvestment of distributions | 39,415 | 47,893 |
| Shares redeemed | (164,922) | (152,406) |
| Net increase (decrease) in Class A shares | 200,131 | 249,942 |
| Shares outstanding at end of period | 1,866,984 | 1,666,853 |
|
Class B Shares outstanding at beginning of period |
6,979,222 | 6,744,084 |
| Shares sold | 2,113,626 | 947,455 |
| Shares issued to shareholders in reinvestment of distributions | 135,280 | 201,024 |
| Shares redeemed | (970,715) | (913,341) |
| Net increase (decrease) in Class B shares | 1,278,191 | 235,138 |
| Shares outstanding at end of period | 8,257,413 | 6,979,222 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 12.60 | $ 13.88 | $ 13.75 | $ 13.90 | $ 13.24 | |
|
Income (loss) from investment operations: Net investment incomea |
.35 | .29 | .36 | .26 | .33 | |
| Net realized and unrealized gain (loss) | .31 | (1.13) | .13 | (.13) | .93 | |
| Total from investment operations | .66 | (.84) | .49 | .13 | 1.26 | |
|
Less distributions from: Net investment income |
(.29) | (.41) | (.27) | (.28) | (.49) | |
| Net realized gains | — | (.03) | (.09) | — | (.11) | |
| Total distributions | (.29) | (.44) | (.36) | (.28) | (.60) | |
| Net asset value, end of period | $ 12.97 | $ 12.60 | $ 13.88 | $ 13.75 | $ 13.90 | |
| Total Return (%)b,c | 5.30 | (6.29) | 3.50 | .93 | 9.72 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 24 | 21 | 20 | 15 | 10 | |
| Ratio of expenses before expense reductions (%)d | .56 | .53 | .56 | .64 | .63 | |
| Ratio of expenses after expense reductions (%)d | .27 | .33 | .32 | .27 | .30 | |
| Ratio of net investment income (%) | 2.70 | 2.19 | 2.54 | 1.86 | 2.46 | |
| Portfolio turnover rate (%) | 51 | 21 | 28 | 40 | 22 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. c Total return would have been lower if the Advisor had not reduced some Underlying Deutsche Funds' expenses. d The Fund invests in other Funds and indirectly bears its proportionate share of fees and expenses incurred by the Underlying Funds in which the Fund is invested. This ratio does not include these indirect fees and expenses. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 12.59 | $ 13.87 | $ 13.74 | $ 13.88 | $ 13.23 | |
|
Income (loss) from investment operations: Net investment incomea |
.31 | .25 | .31 | .22 | .30 | |
| Net realized and unrealized gain (loss) | .31 | (1.12) | .14 | (.11) | .91 | |
| Total from investment operations | .62 | (.87) | .45 | .11 | 1.21 | |
|
Less distributions from: Net investment income |
(.25) | (.38) | (.23) | (.25) | (.45) | |
| Net realized gains | — | (.03) | (.09) | — | (.11) | |
| Total distributions | (.25) | (.41) | (.32) | (.25) | (.56) | |
| Net asset value, end of period | $ 12.96 | $ 12.59 | $ 13.87 | $ 13.74 | $ 13.88 | |
| Total Return (%)b,c | 4.99 | (6.54) | 3.24 | .75 | 9.36 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 107 | 88 | 94 | 84 | 62 | |
| Ratio of expenses before expense reductions (%)d | .85 | .83 | .86 | .93 | .88 | |
| Ratio of expenses after expense reductions (%)d | .57 | .62 | .57 | .52 | .55 | |
| Ratio of net investment income (%) | 2.45 | 1.84 | 2.22 | 1.57 | 2.25 | |
| Portfolio turnover rate (%) | 51 | 21 | 28 | 40 | 22 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. c Total return would have been lower if the Advisor had not reduced some Underlying Deutsche Funds' expenses. d The Fund invests in other Funds and indirectly bears its proportionate share of fees and expenses incurred by the Underlying Funds in which the Fund is invested. This ratio does not include these indirect fees and expenses. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Alternative Asset Allocation VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust. The Fund mainly invests in other affiliated Deutsche funds (i.e., mutual funds, exchange-traded funds and other pooled investment vehicles managed by Deutsche Investment Management Americas Inc. or one of its affiliates, together the "Underlying Deutsche Funds"), non-affiliated exchange-traded funds ("Non-affiliated ETFs") and derivative investments. Non-affiliated ETFs and Underlying Deutsche Funds are collectively referred to as "Underlying Funds." During the year ended December 31, 2016, the Fund primarily invested in underlying Deutsche Funds and non-affiliated ETFs. Each Underlying Deutsche Fund's accounting policies and investment holdings are outlined in the Underlying Deutsche Funds' financial statements and are available upon request.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets of the Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Investments in mutual funds are valued at the net asset value per share of each class of the Underlying Deutsche Funds and are categorized as Level 1.
ETFs are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. ETFs for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. ETF securities are generally categorized as Level 1.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Federal Income Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
At December 31, 2016, the Fund had approximately $1,864,000 of long-term tax basis capital loss carryforwards, which may be applied against realized net taxable capital gains indefinitely.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to certain securities sold at a loss and capital gain distributions from Underlying Funds. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 3,070,645 |
| Capital loss carryforward | $ (1,864,000) |
| Unrealized appreciation (depreciation) on investments | $ (6,216,345) |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 2,223,081 | $ 3,164,682 |
| Distributions from long-term capital gains | $ — | $ 242,511 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend Income is recorded on the ex-dividend date. Distributions of income and capital gains from the Underlying Funds are recorded on the ex-dividend date. Realized gains and losses from investment transactions are recorded on an identified cost basis.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of affiliated Underlying Funds (excluding money market funds) aggregated $34,449,237 and $42,341,210, respectively. Purchases and sales of Non-affiliated ETFs aggregated $26,922,964 and $12,414,438, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments in Underlying Funds to be purchased, sold or entered into by the Fund or delegates such responsibility to the Fund's subadvisors.
RREEF America L.L.C. ("RREEF"), an indirect, wholly owned subsidiary of Deutsche Bank AG, acts as an investment subadvisor to the Fund. As an investment subadvisor to the Fund, RREEF provides investment management services to the portions of the Fund's portfolio allocated to direct investments in global real estate and global infrastructure securities. RREEF is paid by the Advisor for the services RREEF provides to the Fund. As of the date of this report, the Fund obtained its exposure to global real estate and global infrastructure securities indirectly through investments in other Underlying Deutsche Funds.
The Fund does not invest in the Underlying Deutsche Funds for the purpose of exercising management or control; however, investments within the set limits may represent 5% or more of an Underlying Deutsche Fund's outstanding shares. At December 31, 2016, the Fund held approximately 21% of Deutsche Global Inflation Fund, and 17% of Deutsche Enhanced Emerging Markets Fixed Income Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| On assets invested in other Deutsche Funds | .20% |
| On assets invested in all other assets not considered Deutsche Funds | 1.20% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.33% of the Fund's average daily net assets.
In addition, the Advisor will receive management fees from managing the Underlying Deutsche Funds in which the Fund invests.
For the period from January 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage, interest expense and Underlying Funds) of each class as follows:
| Class A | .29% |
| Class B | .59% |
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage, interest expense and Underlying Funds) of each class as follows:
| Class A | .23% |
| Class B | .53% |
For the year ended December 31, 2016, the Advisor agreed to waive 0.15% of the monthly management fee based on average daily net assets for the Fund.
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 64,130 |
| Class B | 260,869 |
| $ 324,999 |
The Fund indirectly bears its proportionate share of fees and expenses incurred by the Underlying Funds in which it is invested.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $115,201, of which $10,834 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Services to Shareholders | Total Aggregated | Unpaid at December 31, 2016 |
| Class A | $ 131 | $ 33 |
| Class B | 236 | 58 |
| $ 367 | $ 91 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plans, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee aggregated $231,266, of which $22,002 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $10,589, of which $4,064 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee.
D. Ownership of the Fund
At December 31, 2016, one participating insurance company was the owner of record of 10% or more of the total outstanding Class A shares of the Fund, owning 95%. Three participating insurance companies were the owner of record of 10% or more of the total outstanding Class B shares of the Fund, each owning 52%, 21% and 19%, respectively.
E. Transactions with Affiliates
The Fund mainly invests in Underlying Deutsche Funds and Non-affiliated ETFs. The Underlying Deutsche Funds in which the Fund invests are considered to be affiliated investments. A summary of the Fund's transactions with affiliated Underlying Deutsche Funds during the year ended December 31, 2016 is as follows:
| Affiliate | Value ($) at 12/31/2015 | Purchases Cost ($) | Sales Cost ($) |
Realized Gain/ (Loss) ($) |
Income Distributions ($) | Capital Gain Distributions ($) | Value ($) at 12/31/2016 |
| Deutsche Diversified Market Neutral Fund | 13,155,393 | 200,000 | 12,587,796 | (1,661,148) | — | — | — |
| Deutsche Enhanced Commodity Strategy Fund | 12,646,150 | 5,956,353 | — | — | 1,131,354 | — | 18,836,483 |
| Deutsche Enhanced Emerging Markets Fixed Income Fund | 13,296,026 | 8,171,631 | 1,220,000 | (176,533) | 646,913 | — | 20,632,739 |
| Deutsche Floating Rate Fund | 14,073,424 | 6,903,235 | 8,330,000 | (970,731) | 503,235 | — | 12,592,284 |
| Deutsche Global Inflation Fund | 10,993,719 | 9,150,223 | 1,974,000 | (10,402) | 91,223 | — | 18,478,680 |
| Deutsche Global Infrastructure Fund | 18,584,170 | 1,176,217 | 9,369,000 | 571,012 | 176,217 | — | 12,207,777 |
| Deutsche Global Real Estate Securities Fund | 3,340,604 | 870,174 | 3,943,000 | 545,214 | 17,174 | — | 422,249 |
| Deutsche Real Estate Securities Fund | 7,700,878 | 1,677,619 | 2,648,000 | 43,791 | 212,670 | 586,860 | 6,637,281 |
| Deutsche Real Estate Securities Income Fund | 581,940 | 3,785 | 616,579 | (62,687) | 3,785 | — | — |
| Deutsche Strategic Equity Long/Short Fund | 1,362,596 | 340,000 | 1,652,835 | (153,482) | — | — | — |
| Deutsche Central Cash Management Government Fund | 3,850,877 | 58,804,099 | 44,414,978 | — | 29,147 | — | 18,239,998 |
| Total | 99,585,777 | 93,253,336 | 86,756,188 | (1,874,966) | 2,811,718 | 586,860 | 108,047,491 |
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Alternative Asset Allocation VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Alternative Asset Allocation VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Alternative Asset Allocation VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In addition to the ongoing expenses which the Fund bears directly, the Fund's shareholders indirectly bear the expense of the Underlying Funds in which the Fund invests. These expenses are not included in the Fund's annualized expense ratios used to calculate the expense estimate in the tables. In the most recent six-month period, the Fund limited the ongoing expenses the Fund bears directly; had it not done so, expenses would have been higher. The examples in the table are based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $ 990.10 | $ 988.60 | ||
| Expenses Paid per $1,000* | $ 1.30 | $ 2.80 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,023.83 | $1,022.32 | ||
| Expenses Paid per $1,000* | $ 1.32 | $ 2.85 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios** | Class A | Class B | |||
| Deutsche Variable Series II — Deutsche Alternative Asset Allocation VIP | .26% | .56% |
** The Fund invests in other funds and indirectly bears its proportionate share of fees and expenses incurred by the Underlying Funds in which the Fund is invested. These ratios do not include these indirect fees and expenses.
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
For corporate shareholders, 11% of income dividends paid during the Fund's fiscal year ended December 31, 2016 qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement and Sub-Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Alternative Asset Allocation VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") and sub-advisory agreement (the "Sub-Advisory Agreement" and together with the Agreement, the "Agreements") between DIMA and RREEF America L.L.C. ("RREEF"), an affiliate of DIMA, in September 2016.
In terms of the process that the Board followed prior to approving the Agreements, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreements, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA has managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund. DIMA and RREEF are part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s and RREEF’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreements, including the scope of advisory services provided under the Agreements. The Board noted that, under the Agreements, DIMA and RREEF provide portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board also requested and received information regarding DIMA’s oversight of sub-advisers, including RREEF. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 4th quartile, 3rd quartile and 4th quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board observed that the Fund had experienced improved relative performance during the first seven months of 2016. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, sub-advisory fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were higher than the median (4th quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that DIMA agreed to voluntarily waive a portion (0.15%) of the Fund’s management fee. With respect to the sub-advisory fee paid to RREEF, the Board noted that the fee is paid by DIMA out of its fee and not directly by the Fund. The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA and RREEF.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA from advising the Deutsche Funds along with the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality. The Board did not receive profitability information with respect to the Fund, but did receive such information with respect to the funds in which the Fund invests. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. In this regard, the Board observed that while the Fund’s current investment management fee schedule does not include breakpoints, the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreements is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreements.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2AAA-2 (R-025824-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Global Equity VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 10 Statement of Assets and Liabilities 11 Statement of Operations 11 Statements of Changes in Net Assets 13 Financial Highlights 14 Notes to Financial Statements 18 Report of Independent Registered Public Accounting Firm 19 Information About Your Fund's Expenses 20 Tax Information 20 Proxy Voting 21 Advisory Agreement Board Considerations and Fee Evaluation 24 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Stocks may decline in value. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Emerging markets tend to be more volatile and less liquid than the markets of more mature economies, and generally have less diverse and less mature economic structures and less stable political systems than those of developed countries. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns.
The gross expense ratio of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 is 1.00% for Class A shares and may differ from the expense ratio disclosed in the Financial Highlights table in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Global Equity VIP | ||
|
■ Deutsche Global Equity VIP — Class A ■ MSCI All Country World Index |
The MSCI All Country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The index consists of 46 country indices comprising 23 developed and 23 emerging market country indices. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Global Equity VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,611 | $10,544 | $14,762 | $11,128 |
| Average annual total return | 6.11% | 1.78% | 8.10% | 1.07% | |
| MSCI All Country World Index | Growth of $10,000 | $10,786 | $10,970 | $15,644 | $14,191 |
| Average annual total return | 7.86% | 3.13% | 9.36% | 3.56% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
Global equities performed well during 2016, with strength in the United States and the Asia-Pacific region offsetting the weaker performance in Europe. The Fund’s benchmark, the MSCI AC World Index, returned 7.86% during the year, while the Class A shares of the Fund returned 6.11% (unadjusted for contract charges).1
Sector allocations were the primary reason for the Fund’s underperformance, while the effect of stock selection was largely flat. With regard to the former, we were hurt by holding a significant overweight position in health care.2 We averaged an allocation to the sector that was approximately twice that of its weighting in the index, which proved to be a meaningful detractor given that health care was the only sector to finish the year in negative territory.
In terms of stock selection, we generated strong performance in both health care and telecommunications services, but this was counterbalanced by a weaker showing in consumer staples, information technology and industrials.3 Several of our top individual contributors were companies that were taken over in 2016, including Medivation, Inc.,* Meda AB* and Press Ganey Holdings, Inc.*4 We believe the takeover of multiple Fund holdings illustrates how our emphasis on companies with strong organic growth can lead us to the types of stocks that may also be attractive to corporate buyers. Applied Materials, Inc., Amphenol Corp. and Marine Harvest ASA were also key contributors in 2016. On the negative side, the Fund’s largest detractors were Galenica AG,* Acadia Healthcare Company, Inc. and Alliance Data Systems Corp.
We continued to focus our efforts on identifying stocks positioned for sustainable, above-average growth that were trading below what we believed were their intrinsic values. As always, we remained focused on delivering outperformance through the quality of our stock-picking rather than making large "macro" bets or taking excessive risk.
Our search for reasonably valued growth companies led us to make several shifts in the portfolio during the past year. At the regional level, our individual-stock moves prompted us to boost the Fund’s allocation to the United States and add modestly to Japan. In the former, the positive economic outlook has created numerous opportunities in companies with a domestic focus. Japan, for its part, has become more fertile ground to identify growing companies due to the favorable combination of accommodative monetary policy and substantial fiscal stimulus. We funded these additions by reducing the portfolio’s weighting in Europe, where it became somewhat more challenging to find attractive growth stocks due to the structural challenges faced by the region’s economies. The Fund’s weighting in the emerging markets held steady at approximately 3% of assets, but we remained on the lookout for opportunities in this segment. More broadly speaking, we think companies that can deliver both top- and bottom-line growth in excess of the overall market should benefit from steady investor demand at a time of sluggish global economic conditions.
Brendan O'Neill, CFA
Mark Schumann, CFA
Sebastian P. Werner, PhD
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The MSCI All Country World Index tracks the performance of stocks in select developed markets around the world, including the United States. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
2 "Overweight" means the Fund holds a lower weighting in a given sector or security than the benchmark.
3 Consumer staples are the industries that manufacture and sell products such as food and beverages, prescription drugs and household products.
4 Contribution and detraction incorporate both an investment's total return and its weighting in the Fund.
* Not held in the portfolio as of December 31, 2016.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Common Stocks | 98% | 100% |
| Cash Equivalents | 1% | 0% |
| Preferred Stock | 1% | — |
| 100% | 100% |
| Sector Diversification (As a % of Common Stocks and Preferred Stock) | 12/31/16 | 12/31/15 |
| Information Technology | 21% | 15% |
| Health Care | 20% | 25% |
| Financials | 13% | 13% |
| Consumer Staples | 12% | 16% |
| Consumer Discretionary | 9% | 9% |
| Industrials | 8% | 10% |
| Materials | 7% | 6% |
| Energy | 6% | 5% |
| Telecommunication Services | 2% | 1% |
| Real Estate | 2% | — |
| 100% | 100% |
| Geographical Diversification (As a % of Investment Portfolio excluding Cash Equivalents and Securities Lending Collateral) |
12/31/16 | 12/31/15 |
| United States | 55% | 50% |
| Switzerland | 7% | 7% |
| Canada | 7% | 6% |
| Germany | 6% | 6% |
| United Kingdom | 6% | 5% |
| Sweden | 3% | 6% |
| Japan | 3% | — |
| Finland | 2% | 2% |
| Ireland | 2% | 3% |
| Other | 9% | 15% |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Shares | Value ($) | |
| Common Stocks 97.7% | ||
| Australia 1.0% | ||
| Australia & New Zealand Banking Group Ltd. (Cost $434,670) | 19,800 | 434,520 |
| Canada 7.1% | ||
| Agnico Eagle Mines Ltd. | 25,500 | 1,071,000 |
| Alimentation Couche-Tard, Inc. "B" | 16,600 | 752,697 |
| Brookfield Asset Management, Inc. "A" | 38,000 | 1,253,789 |
| (Cost $2,189,276) | 3,077,486 | |
| China 1.0% | ||
| Tencent Holdings Ltd. (Cost $427,910) | 18,400 | 450,066 |
| Finland 1.8% | ||
| Sampo Oyj "A" (Cost $824,246) | 17,500 | 787,320 |
| Germany 5.7% | ||
| Allianz SE (Registered) | 4,400 | 727,456 |
| BASF SE | 5,000 | 464,542 |
| Fresenius Medical Care AG & Co. KGaA | 15,000 | 1,270,150 |
| (Cost $2,056,985) | 2,462,148 | |
| Ireland 1.6% | ||
| Kerry Group PLC "A" (a) | 1,579 | 112,567 |
| Kerry Group PLC "A" (a) | 7,921 | 566,050 |
| (Cost $660,575) | 678,617 | |
| Israel 0.7% | ||
| Mobileye NV* (b) (Cost $317,737) | 8,000 | 304,960 |
| Japan 2.6% | ||
| Asics Corp. | 15,000 | 299,680 |
| Japan Tobacco, Inc. | 20,000 | 657,818 |
| LINE Corp. (ADR)* (c) | 5,400 | 183,654 |
| (Cost $1,151,870) | 1,141,152 | |
| Luxembourg 1.5% | ||
| Eurofins Scientific (Cost $331,302) | 1,500 | 639,438 |
| Malaysia 0.7% | ||
| IHH Healthcare Bhd. (Cost $277,346) | 213,000 | 301,610 |
| Mexico 0.8% | ||
| Fomento Economico Mexicano SAB de CV (ADR) (Cost $434,833) | 4,800 | 365,808 |
| Netherlands 0.5% | ||
| Patheon NV* (b) (Cost $212,555) | 8,200 | 235,422 |
| Norway 0.8% | ||
| Marine Harvest ASA* (Cost $209,110) | 18,300 | 330,142 |
| Philippines 0.8% | ||
| Universal Robina Corp. (Cost $459,003) | 100,000 | 329,294 |
| Sweden 3.5% | ||
| Assa Abloy AB "B" | 32,000 | 594,245 |
| Hennes & Mauritz AB "B" | 14,800 | 411,962 |
| Shares | Value ($) | |
| Svenska Cellulosa AB "B" | 18,400 | 519,878 |
| (Cost $1,474,346) | 1,526,085 | |
| Switzerland 7.2% | ||
| Comet Holding AG (Registered)* | 260 | 256,604 |
| Lonza Group AG (Registered)* | 3,700 | 640,862 |
| Nestle SA (Registered) | 12,015 | 862,157 |
| Roche Holding AG (Genusschein) | 3,900 | 890,750 |
| u-blox Holding AG* | 2,500 | 469,741 |
| (Cost $2,522,904) | 3,120,114 | |
| United Kingdom 5.8% | ||
| Aon PLC (b) | 8,000 | 892,240 |
| Compass Group PLC | 40,000 | 740,929 |
| Halma PLC | 43,000 | 476,011 |
| Spirax-Sarco Engineering PLC | 8,300 | 428,440 |
| (Cost $2,239,428) | 2,537,620 | |
| United States 54.6% | ||
| A.O. Smith Corp. | 7,000 | 331,450 |
| Acadia Healthcare Co., Inc.* | 12,000 | 397,200 |
| Activision Blizzard, Inc. | 18,500 | 668,035 |
| Allergan PLC* | 2,700 | 567,027 |
| Alliance Data Systems Corp. | 2,000 | 457,000 |
| Alphabet, Inc. "A"* | 820 | 649,809 |
| AMETEK, Inc. | 8,500 | 413,100 |
| Amphenol Corp. "A" | 19,300 | 1,296,960 |
| Apple, Inc. | 6,500 | 752,830 |
| Applied Materials, Inc. | 23,900 | 771,253 |
| Biogen, Inc.* | 850 | 241,043 |
| Bristol-Myers Squibb Co. | 8,000 | 467,520 |
| CBRE Group, Inc. "A"* | 10,300 | 324,347 |
| Celgene Corp.* | 8,500 | 983,875 |
| CVS Health Corp. | 4,500 | 355,095 |
| Danaher Corp. | 9,500 | 739,480 |
| Dollar General Corp. | 4,000 | 296,280 |
| Ecolab, Inc. | 5,000 | 586,100 |
| EOG Resources, Inc. | 6,100 | 616,710 |
| EPAM Systems, Inc.* | 4,900 | 315,119 |
| Evolent Health, Inc. "A"* | 13,600 | 201,280 |
| Exxon Mobil Corp. | 6,200 | 559,612 |
| Facebook, Inc. "A"* | 3,600 | 414,180 |
| Fidelity National Information Services, Inc. | 4,500 | 340,380 |
| General Electric Co. | 16,500 | 521,400 |
| JPMorgan Chase & Co. | 10,300 | 888,787 |
| L Brands, Inc. | 3,000 | 197,520 |
| LKQ Corp.* | 14,000 | 429,100 |
| Marcus & Millichap, Inc.* | 15,000 | 400,800 |
| Mastercard, Inc. "A" | 10,500 | 1,084,125 |
| Mead Johnson Nutrition Co. | 4,600 | 325,496 |
| NIKE, Inc. "B" | 5,500 | 279,565 |
| Noble Energy, Inc. | 14,700 | 559,482 |
| PPG Industries, Inc. | 4,500 | 426,420 |
| Progressive Corp. | 20,600 | 731,300 |
| Rollins, Inc. | 6,500 | 219,570 |
| Schlumberger Ltd. | 8,500 | 713,575 |
| Scotts Miracle-Gro Co. "A" | 5,000 | 477,750 |
| T-Mobile U.S., Inc.* | 13,000 | 747,630 |
| Time Warner, Inc. | 8,500 | 820,505 |
| TJX Companies, Inc. | 8,100 | 608,553 |
| Union Pacific Corp. | 4,200 | 435,456 |
| United Technologies Corp. | 4,000 | 438,480 |
| Shares | Value ($) | |
| Zoetis, Inc. | 13,200 | 706,596 |
| (Cost $21,027,982) | 23,757,795 | |
| Total Common Stocks (Cost $37,252,078) | 42,479,597 | |
| Preferred Stock 0.6% | ||
| Germany | ||
| Draegerwerk AG & Co. KGaA (Cost $214,962) | 3,000 | 251,251 |
| Securities Lending Collateral 0.4% | ||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.41% (d) (e) (Cost $184,920) | 184,920 | 184,920 |
| Shares | Value ($) | |
| Cash Equivalents 1.3% | ||
| Deutsche Central Cash Management Government Fund, 0.50% (d) (Cost $579,159) | 579,159 | 579,159 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $38,231,119)† | 100.0 | 43,494,927 |
| Other Assets and Liabilities, Net | 0.0 | (3,065) |
| Net Assets | 100.0 | 43,491,862 |
* Non-income producing security.
† The cost for federal income tax purposes was $38,332,815. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $5,162,112. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $6,558,921 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $1,396,809.
(a) Securities with the same description are the same corporate entity but trade on different stock exchanges.
(b) Listed on the New York Stock Exchange.
(c) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $182,294, which is 0.4% of net assets.
(d) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(e) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
ADR: American Depositary Receipt
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Common Stocks | |||||
| Australia | $ — | $ 434,520 | $ — | $ 434,520 | |
| Canada | 3,077,486 | — | — | 3,077,486 | |
| China | — | 450,066 | — | 450,066 | |
| Finland | — | 787,320 | — | 787,320 | |
| Germany | — | 2,462,148 | — | 2,462,148 | |
| Ireland | — | 678,617 | — | 678,617 | |
| Israel | 304,960 | — | — | 304,960 | |
| Japan | 183,654 | 957,498 | — | 1,141,152 | |
| Luxembourg | — | 639,438 | — | 639,438 | |
| Malaysia | — | 301,610 | — | 301,610 | |
| Mexico | 365,808 | — | — | 365,808 | |
| Netherlands | 235,422 | — | — | 235,422 | |
| Norway | — | 330,142 | — | 330,142 | |
| Philippines | — | 329,294 | — | 329,294 | |
| Sweden | — | 1,526,085 | — | 1,526,085 | |
| Switzerland | — | 3,120,114 | — | 3,120,114 | |
| United Kingdom | 892,240 | 1,645,380 | — | 2,537,620 | |
| United States | 23,757,795 | — | — | 23,757,795 | |
| Preferred Stock | — | 251,251 | — | 251,251 | |
| Short-Term Investments (f) | 764,079 | — | — | 764,079 | |
| Total | $29,581,444 | $13,913,483 | $ — | $43,494,927 | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(f) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $37,467,040) — including $182,294 of securities loaned |
$ 42,730,848 |
| Investment in Government & Agency Securities Portfolio (cost $184,920)* | 184,920 |
| Investment in Deutsche Central Cash Management Government Fund (cost $579,159) | 579,159 |
| Total investments in securities, at value (cost $38,231,119) | 43,494,927 |
| Foreign currency, at value (cost $150,581) | 146,538 |
| Receivable for Fund shares sold | 85,360 |
| Dividends receivable | 38,268 |
| Interest receivable | 1,656 |
| Foreign taxes recoverable | 28,403 |
| Other assets | 993 |
| Total assets | 43,796,145 |
| Liabilities | |
| Payable upon return of securities loaned | 184,920 |
| Payable for Fund shares redeemed | 4,520 |
| Accrued management fee | 29,045 |
| Accrued Trustees' fees | 1,025 |
| Other accrued expenses and payables | 84,773 |
| Total liabilities | 304,283 |
| Net assets, at value | $ 43,491,862 |
| Net Assets Consist of | |
| Undistributed net investment income | 215,993 |
|
Net unrealized appreciation (depreciation) on: Investments |
5,263,808 |
| Foreign currency | (6,729) |
| Accumulated net realized gain (loss) | (39,265,983) |
| Paid-in capital | 77,284,773 |
| Net assets, at value | $ 43,491,862 |
|
Class A Net Asset Value, offering and redemption price per share ($43,491,862 ÷ 4,587,493 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 9.48 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $38,721) |
$ 627,999 |
| Income distributions — Deutsche Central Cash Management Government Fund | 4,933 |
| Securities lending income, including income from Government & Agency Securities Portfolio, net of borrower rebates | 8,673 |
| Total income | 641,605 |
|
Expenses: Management fee |
290,902 |
| Administration fee | 44,754 |
| Services to shareholders | 680 |
| Custodian fee | 21,351 |
| Professional fees | 72,339 |
| Reports to shareholders | 23,022 |
| Trustees' fees and expenses | 4,011 |
| Other | 3,309 |
| Total expenses before expense reductions | 460,368 |
| Expense reductions | (37,258) |
| Total expenses after expense reductions | 423,110 |
| Net investment income | 218,495 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
878,217 |
| Foreign currency | 22,189 |
| Payment by affiliates (see Note F) | 140,394 |
| 1,040,800 | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
1,217,338 |
| Foreign currency | (4,079) |
| 1,213,259 | |
| Net gain (loss) | 2,254,059 |
| Net increase (decrease) in net assets resulting from operations | $ 2,472,554 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 218,495 | $ 363,204 |
| Net realized gain (loss) | 1,040,800 | 904,730 |
| Change in net unrealized appreciation (depreciation) | 1,213,259 | (2,104,278) |
| Net increase (decrease) in net assets resulting from operations | 2,472,554 | (836,344) |
|
Distributions to shareholders from: Net investment income: Class A |
(336,718) | (365,100) |
|
Fund share transactions: Class A Proceeds from shares sold |
1,414,193 | 1,395,898 |
| Reinvestment of distributions | 336,718 | 365,100 |
| Payments for shares redeemed | (9,403,270) | (19,468,680) |
| Net increase (decrease) in net assets from Class A share transactions | (7,652,359) | (17,707,682) |
| Increase (decrease) in net assets | (5,516,523) | (18,909,126) |
| Net assets at beginning of period | 49,008,385 | 67,917,511 |
| Net assets at end of period (including undistributed net investment income of $215,993 and $312,027, respectively) | $ 43,491,862 | $ 49,008,385 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
5,446,357 | 7,372,593 |
| Shares sold | 152,025 | 147,455 |
| Shares issued to shareholders in reinvestment of distributions | 36,640 | 37,523 |
| Shares redeemed | (1,047,529) | (2,111,214) |
| Net increase (decrease) in Class A shares | (858,864) | (1,926,236) |
| Shares outstanding at end of period | 4,587,493 | 5,446,357 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 9.00 | $ 9.21 | $ 9.27 | $ 7.96 | $ 6.98 | |
|
Income (loss) from investment operations: Net investment incomea |
.04 | .05 | .06 | .14 | .18 | |
| Net realized and unrealized gain (loss) | .51 | (.21) | .04 | 1.37 | 1.01 | |
| Total from investment operations | .55 | (.16) | .10 | 1.51 | 1.19 | |
|
Less distributions from: Net investment income |
(.07) | (.05) | (.16) | (.20) | (.21) | |
| Net asset value, end of period | $ 9.48 | $ 9.00 | $ 9.21 | $ 9.27 | $ 7.96 | |
| Total Return (%) | 6.11b,c | (1.75)b | 1.14 | 19.31b | 17.34 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 43 | 49 | 68 | 73 | 67 | |
| Ratio of expenses before expense reductions (%) | 1.03 | 1.00 | .95 | 1.06 | 1.02 | |
| Ratio of expenses after expense reductions (%) | .95 | .91 | .95 | .99 | 1.02 | |
| Ratio of net investment income (%) | .49 | .58 | .59 | 1.69 | 2.46 | |
| Portfolio turnover rate (%) | 46 | 79 | 78 | 139 | 18 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reimbursed. c Includes a reimbursement by the Advisor for a realized loss on a trade executed incorrectly, which otherwise would have reduced total return by 0.31%. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Global Equity VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities are generally categorized as Level 1. For certain international equity securities, in order to adjust for events which may occur between the close of the foreign exchanges and the close of the New York Stock Exchange, a fair valuation model may be used. This fair valuation model takes into account comparisons to the valuation of American Depository Receipts (ADRs), futures contracts and certain indices and these securities are categorized as Level 2.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as common stocks in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end. As of period end, the remaining contractual maturity of the collateral agreements were overnight and continuous.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies, and to distribute all of its taxable income to its shareholders.
Additionally, the Fund may be subject to taxes imposed by the governments of countries in which it invests and are generally based on income and/or capital gains earned or repatriated, a portion of which may be recoverable. Based upon the current interpretation of the tax rules and regulations, estimated tax liabilities and recoveries on certain foreign securities are recorded on an accrual basis and are reflected as components of interest income or net change in unrealized gain/loss on investments. Tax liabilities realized as a result of security sales are reflected as a component of net realized gain/loss on investments.
Under the Regulated Investment Company Modernization Act of 2010, net capital losses incurred post-enactment may be carried forward indefinitely, and their character is retained as short-term and/or long-term. Previously, net capital losses were carried forward for eight years and treated as short-term losses. As a transition rule, the Act requires that post-enactment net capital losses be used before pre-enactment net capital losses.
At December 31, 2016, the Fund had a net tax basis capital loss carryforward of approximately $39,164,000 of pre-enactment losses, which may be applied against any realized net taxable capital gains of each succeeding year until fully utilized or until December 31, 2017 ($39,164,000), the expiration date, whichever occurs first.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in foreign denominated investments, expiration of capital loss carryforward and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 215,993 |
| Capital loss carryforwards | $ (39,164,000) |
| Unrealized appreciation (depreciation) on investments | $ 5,162,112 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 336,718 | $ 365,100 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Certain dividends from foreign securities may be recorded subsequent to the ex-dividend date as soon as the Fund is informed of such dividends. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments) aggregated $20,133,209 and $27,444,466, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $1.5 billion | .650% |
| Next $1.75 billion | .635% |
| Next $1.75 billion | .620% |
| Over $5 billion | .605% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.65% of the Fund's average daily net assets.
For the period from January 1, 2016 through April 30, 2016, the Advisor had contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A shares at 0.91%.
For the period from May 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A shares at 0.97%.
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A shares at 0.95%.
For the year ended December 31, 2016, fees waived and/or expenses reimbursed were $37,258.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $44,754, of which $3,687 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC aggregated $83, of which $20 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $11,925, of which $4,278 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Securities Lending Fees. Deutsche Bank AG serves as lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred lending agent fees to Deutsche Bank AG in the amount of $725.
D. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 74% and 25%.
E. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
F. Payment by Affiliates
During the year ended December 31, 2016, the Advisor agreed to reimburse the Fund $140,394 for a loss incurred on a trade executed incorrectly. The amount of the loss was 0.31% of the Fund's average net assets.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Global Equity VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Global Equity VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Global Equity VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||
| Actual Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,030.40 | |
| Expenses Paid per $1,000* | $ 4.90 | |
| Hypothetical 5% Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,020.31 | |
| Expenses Paid per $1,000* | $ 4.88 | |
* Expenses are equal to the Fund's annualized expense ratio, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratio | Class A | |
| Deutsche Variable Series II — Deutsche Global Equity VIP | .96% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
For corporate shareholders, 91% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Global Equity VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 3rd quartile, 4th quartile and 4th quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has outperformed its benchmark in the three- and five-year periods and has underperformed its benchmark in the one-year period ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board observed that the Fund had experienced improved relative performance during the first seven months of 2016. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were equal to the median (2nd quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board noted that the expense limitation agreed to by DIMA was expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience,seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2GE-2 (R-025828-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Global Growth VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 11 Statement of Assets and Liabilities 12 Statement of Operations 12 Statements of Changes in Net Assets 14 Financial Highlights 15 Notes to Financial Statements 20 Report of Independent Registered Public Accounting Firm 21 Information About Your Fund's Expenses 22 Tax Information 22 Proxy Voting 23 Advisory Agreement Board Considerations and Fee Evaluation 26 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Stocks may decline in value. Smaller company stocks tend to be more volatile than medium-sized or large company stocks. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Emerging markets tend to be more volatile and less liquid than the markets of more mature economies, and generally have less diverse and less mature economic structures and less stable political systems than those of developed countries. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 1.44% and 1.76% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Global Growth VIP | ||
|
■ Deutsche Global Growth VIP — Class A ■ MSCI World Index |
The Morgan Stanley Capital International (MSCI) World Index is an unmanaged index that tracks the performance of stocks in select developed markets around the world, including the U.S. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
The growth of $10,000 is cumulative.
| Comparative Results | |||||
| Deutsche Global Growth VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,372 | $10,256 | $14,848 | $11,541 |
| Average annual total return | 3.72% | 0.85% | 8.23% | 1.44% | |
| MSCI World Index | Growth of $10,000 | $10,751 | $11,184 | $16,409 | $14,557 |
| Average annual total return | 7.51% | 3.80% | 10.41% | 3.83% | |
| Deutsche Global Growth VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class B | Growth of $10,000 | $10,338 | $10,153 | $14,591 | $11,142 |
| Average annual total return | 3.38% | 0.51% | 7.85% | 1.09% | |
| MSCI World Index | Growth of $10,000 | $10,751 | $11,184 | $16,409 | $14,557 |
| Average annual total return | 7.51% | 3.80% | 10.41% | 3.83% | |
Management Summary December 31, 2016 (Unaudited)
The Fund’s Class A shares returned 3.72% during 2016 (unadjusted for contract charges), underperforming the 7.51% return of the MSCI World Index.1 We are disappointed that the Fund underperformed in the past year, but it’s important to keep in mind that we employ a bottom-up stock selection process that emphasizes companies with strong organic growth and reasonable valuations. Although this may lead to differences in portfolio composition relative to the benchmark, we believe stock-by-stock analysis — rather than an effort to match the benchmark’s performance over short-term intervals — is the best way to achieve consistent exposure to the most compelling growth stories in the world markets.
Both sector allocations and individual stock selection contributed to the Fund’s underperformance. With regard to the former, the Fund was hurt by holding a significant overweight position in health care.2 The Fund averaged an allocation to the sector that was approximately twice that of its weighting in the index, which proved to be a meaningful detractor given that health care was the only sector to finish the year in negative territory.
In terms of stock selection, the Fund's favorable performance in health care was outweighed by its weaker showing in information technology, industrials and financials. The health care stock Meda AB, which was taken over at a premium, was the strongest individual contributor.3 Agnico Eagle Mines Ltd., Marine Harvest ASA and Amphenol Corp. also provided a substantial boost to returns. On the negative side, Galenica AG,* Acadia Healthcare Company, Inc. and Alliance Data Systems Corp. were the Fund’s largest detractors.
As is typically the case, the Fund's portfolio activity was characterized by a steady rotation out of holdings that had become fully valued in favor of growth companies that were more attractively priced. Our most notable reduction occurred in the consumer staples sector, where we found it increasingly difficult to identify reasonably valued growth stocks.4 In addition, the continued weakness in the global economy prompted us to shift from more cyclical growers to those with company-specific profit drivers. Our stock-level decisions also led us to rotate a portion of the Fund's allocation to higher-growth companies into those with more stable cash flows. We believe these shifts help illustrate how our flexible approach enables the Fund to capitalize on the broad range of potential opportunities within the growth category.
We maintained geographic diversification and balanced exposure across the global market capitalization spectrum, as we sought to invest in the most compelling growth ideas regardless of a company’s size or location. We continued to identify attractively valued growth stocks in Europe and the Pacific Rim, but we modestly reduced the Fund’s allocations to these areas during the second half of the period in favor of a higher weighting in the United States. At the sector level, we found health care to be home to a relatively high representation of investment ideas. Conversely, the Fund was underweight in slower-growing areas such as financials, energy, utilities and telecommunications services.
Sebastian P. Werner, PhD
Mark Schumann, CFA
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The MSCI World Index tracks the performance of stocks in select developed markets around the world, including the United States. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index.
2 "Underweight" means the Fund holds a lower weighting in a given sector or security than the benchmark. "Overweight" means it holds a higher weighting.
3 Contribution and detraction incorporate both a stock's total return and its weighting in the fund.
4 Consumer staples are the industries that manufacture and sell products such as food and beverages, prescription drugs and household products.
* Not held in the portfolio as of December 31, 2016.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Common Stocks | 97% | 97% |
| Cash Equivalents | 2% | 3% |
| Preferred Stock | 1% | 0% |
| Warrants | 0% | 0% |
| 100% | 100% |
| Sector Diversification (As a % of Investment Portfolio excluding Cash Equivalents and Securities Lending Collateral) |
12/31/16 | 12/31/15 |
| Health Care | 20% | 21% |
| Information Technology | 20% | 15% |
| Financials | 18% | 12% |
| Consumer Discretionary | 13% | 12% |
| Industrials | 10% | 13% |
| Consumer Staples | 9% | 14% |
| Materials | 5% | 6% |
| Energy | 3% | 5% |
| Telecommunication Services | 2% | 2% |
| Real Estate | 0% | 0% |
| 100% | 100% |
| Geographical Diversification (As a % of Investment Portfolio excluding Cash Equivalents and Securities Lending Collateral) |
12/31/16 | 12/31/15 |
| United States | 56% | 46% |
| Germany | 6% | 7% |
| Japan | 6% | 2% |
| Switzerland | 5% | 6% |
| Canada | 5% | 6% |
| United Kingdom | 5% | 6% |
| Sweden | 3% | 6% |
| Singapore | 2% | 0% |
| Hong Kong | 2% | 1% |
| Ireland | 1% | 3% |
| Netherlands | 1% | 2% |
| Norway | 1% | 2% |
| France | 1% | 2% |
| Luxembourg | 1% | 2% |
| Finland | 1% | 2% |
| Other | 4% | 7% |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Shares | Value ($) | |
| Common Stocks 97.0% | ||
| Australia 1.1% | ||
| Australia & New Zealand Banking Group Ltd. (Cost $290,405) | 13,000 | 285,291 |
| Canada 4.6% | ||
| Agnico Eagle Mines Ltd. | 9,000 | 378,393 |
| Alimentation Couche-Tard, Inc. "B" | 7,500 | 340,074 |
| Brookfield Asset Management, Inc. "A" | 15,734 | 519,135 |
| (Cost $859,274) | 1,237,602 | |
| China 1.1% | ||
| Minth Group Ltd. | 38,870 | 121,018 |
| Tencent Holdings Ltd. | 7,500 | 183,451 |
| ZTO Express Cayman, Inc. (ADR)* | 459 | 5,540 |
| (Cost $285,699) | 310,009 | |
| Finland 1.0% | ||
| Cramo Oyj | 2,641 | 66,100 |
| Sampo Oyj "A" | 4,500 | 202,454 |
| (Cost $272,658) | 268,554 | |
| France 0.8% | ||
| Flamel Technologies SA (ADR)* | 6,494 | 67,472 |
| LVMH Moet Hennessy Louis Vuitton SE | 750 | 143,271 |
| (Cost $236,872) | 210,743 | |
| Germany 5.5% | ||
| Allianz SE (Registered) | 2,100 | 347,195 |
| BASF SE | 2,800 | 260,144 |
| Continental AG | 850 | 163,784 |
| Fresenius Medical Care AG & Co. KGaA | 4,730 | 400,521 |
| Siemens AG (Registered) | 2,400 | 295,314 |
| VIB Vermoegen AG | 1,198 | 24,836 |
| (Cost $1,371,983) | 1,491,794 | |
| Hong Kong 1.5% | ||
| AIA Group Ltd. | 25,000 | 141,153 |
| Techtronic Industries Co., Ltd. | 72,097 | 258,660 |
| (Cost $398,925) | 399,813 | |
| Indonesia 0.6% | ||
| PT Arwana Citramulia Tbk | 621,918 | 24,044 |
| PT Bank Rakyat Indonesia Persero Tbk | 150,000 | 129,952 |
| (Cost $187,898) | 153,996 | |
| Ireland 0.9% | ||
| Kerry Group PLC "A" (Cost $225,191) | 3,300 | 235,824 |
| Japan 5.4% | ||
| Asics Corp. | 6,200 | 123,868 |
| Bandai Namco Holdings, Inc. | 4,700 | 129,732 |
| FANUC Corp. | 1,100 | 186,638 |
| Hoya Corp. | 7,000 | 293,880 |
| KDDI Corp. | 8,200 | 207,601 |
| MISUMI Group, Inc. | 7,511 | 123,588 |
| Murata Manufacturing Co., Ltd. | 1,200 | 160,594 |
| Shares | Value ($) | |
| Syuppin Co., Ltd. | 3,100 | 39,688 |
| Unicharm Corp. | 8,300 | 181,343 |
| (Cost $1,473,138) | 1,446,932 | |
| Korea 0.5% | ||
| Vieworks Co., Ltd.* (Cost $132,359) | 2,500 | 123,779 |
| Luxembourg 0.9% | ||
| Eurofins Scientific (Cost $130,977) | 600 | 255,775 |
| Malaysia 0.5% | ||
| IHH Healthcare Bhd. (Cost $125,729) | 92,000 | 130,273 |
| Netherlands 1.4% | ||
| Core Laboratories NV (a) (b) | 1,268 | 152,211 |
| ING Groep NV | 15,400 | 216,738 |
| (Cost $327,651) | 368,949 | |
| Norway 0.6% | ||
| Marine Harvest ASA* (Cost $97,944) | 8,500 | 153,345 |
| Philippines 0.3% | ||
| Universal Robina Corp. (Cost $126,280) | 27,000 | 88,909 |
| Singapore 1.6% | ||
| Broadcom Ltd. (c) (Cost $433,038) | 2,500 | 441,925 |
| Spain 0.1% | ||
| Telepizza Group SA 144A* (Cost $50,971) | 6,546 | 31,111 |
| Sweden 3.1% | ||
| Assa Abloy AB "B" | 15,000 | 278,552 |
| Hennes & Mauritz AB "B" | 9,500 | 264,435 |
| Nobina AB 144A | 9,892 | 55,257 |
| Svenska Cellulosa AB "B" | 8,000 | 226,034 |
| (Cost $787,624) | 824,278 | |
| Switzerland 5.2% | ||
| Lonza Group AG (Registered)* | 1,500 | 259,809 |
| Nestle SA (Registered) | 4,200 | 301,378 |
| Novartis AG (Registered) | 4,100 | 298,052 |
| Roche Holding AG (Genusschein) | 2,400 | 548,154 |
| (Cost $1,368,499) | 1,407,393 | |
| Taiwan 0.8% | ||
| Taiwan Semiconductor Manufacturing Co., Ltd. (Cost $230,034) | 38,000 | 213,922 |
| United Kingdom 4.5% | ||
| Aon PLC (b) | 4,300 | 479,579 |
| Arrow Global Group PLC | 11,587 | 42,424 |
| Babcock International Group PLC | 7,500 | 88,127 |
| Clinigen Healthcare Ltd. | 5,959 | 52,315 |
| Compass Group PLC | 12,400 | 229,688 |
| Halma PLC | 11,000 | 121,770 |
| Reckitt Benckiser Group PLC | 2,450 | 208,278 |
| (Cost $1,133,548) | 1,222,181 | |
| Shares | Value ($) | |
| United States 55.0% | ||
| A.O. Smith Corp. | 4,300 | 203,605 |
| Acadia Healthcare Co., Inc.* | 4,500 | 148,950 |
| Activision Blizzard, Inc. | 8,500 | 306,935 |
| Allergan PLC* | 1,600 | 336,016 |
| Alliance Data Systems Corp. | 1,200 | 274,200 |
| Alphabet, Inc. "A"* | 900 | 713,205 |
| Ameriprise Financial, Inc. | 1,700 | 188,598 |
| AMETEK, Inc. | 7,200 | 349,920 |
| Amgen, Inc. | 1,800 | 263,178 |
| Amphenol Corp. "A" | 7,000 | 470,400 |
| Apple, Inc. | 4,700 | 544,354 |
| Biogen, Inc.* | 950 | 269,401 |
| Celgene Corp.* | 4,200 | 486,150 |
| Citigroup, Inc. | 4,900 | 291,207 |
| Colgate-Palmolive Co. | 4,700 | 307,568 |
| Costco Wholesale Corp. | 1,500 | 240,165 |
| Danaher Corp. | 3,700 | 288,008 |
| Ecolab, Inc. | 2,400 | 281,328 |
| EOG Resources, Inc. | 3,400 | 343,740 |
| EPAM Systems, Inc.* | 2,800 | 180,068 |
| Facebook, Inc. "A"* | 1,800 | 207,090 |
| Fiserv, Inc.* | 2,800 | 297,584 |
| General Electric Co. | 9,700 | 306,520 |
| Home Depot, Inc. | 2,100 | 281,568 |
| Jack in the Box, Inc. | 2,500 | 279,100 |
| JPMorgan Chase & Co. | 5,300 | 457,337 |
| L Brands, Inc. | 2,900 | 190,936 |
| Marsh & McLennan Companies, Inc. | 4,300 | 290,637 |
| Mastercard, Inc. "A" | 3,700 | 382,025 |
| Mead Johnson Nutrition Co. | 2,600 | 183,976 |
| Microsoft Corp. | 3,600 | 223,704 |
| Middleby Corp.* | 1,000 | 128,810 |
| Moody's Corp. | 2,600 | 245,102 |
| NIKE, Inc. "B" | 4,000 | 203,320 |
| NVIDIA Corp. | 1,400 | 149,436 |
| PNC Financial Services Group, Inc. | 1,600 | 187,136 |
| PPG Industries, Inc. | 2,200 | 208,472 |
| Praxair, Inc. | 1,200 | 140,628 |
| Progressive Corp. | 8,500 | 301,750 |
| QUALCOMM, Inc. | 3,409 | 222,267 |
| Retrophin, Inc.* | 2,821 | 53,402 |
| S&P Global, Inc. | 2,300 | 247,342 |
| Schlumberger Ltd. | 1,900 | 159,505 |
| T-Mobile U.S., Inc.* | 6,000 | 345,060 |
| The Priceline Group, Inc.* | 280 | 410,497 |
| Thermo Fisher Scientific, Inc. | 2,600 | 366,860 |
| Time Warner, Inc. | 2,800 | 270,284 |
| Shares | Value ($) | |
| TJX Companies, Inc. | 4,300 | 323,059 |
| TriState Capital Holdings, Inc.* | 4,035 | 89,173 |
| Union Pacific Corp. | 1,600 | 165,888 |
| United Technologies Corp. | 2,600 | 285,012 |
| Wabtec Corp. | 1,800 | 149,436 |
| WEX, Inc.* | 1,300 | 145,080 |
| Zoetis, Inc. | 8,000 | 428,240 |
| (Cost $13,485,390) | 14,813,232 | |
| Total Common Stocks (Cost $24,032,087) | 26,115,630 | |
| Warrant 0.0% | ||
| France | ||
| Parrot SA Expiration Date 12/15/2022* | 924 | 375 |
| Parrot SA Expiration Date 12/22/2022* | 924 | 454 |
| Total Warrant (Cost $0) | 829 | |
| Preferred Stock 0.7% | ||
| Germany 0.6% | ||
| Draegerwerk AG & Co. KGaA (Cost $145,724) | 2,000 | 167,501 |
| United States 0.1% | ||
| Providence Service Corp. (Cost $13,600) | 136 | 12,976 |
| Total Preferred Stock (Cost $159,324) | 180,477 | |
| Securities Lending Collateral 0.1% | ||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.41% (d) (e) (Cost $37,088) | 37,088 | 37,088 |
| Cash Equivalents 1.7% | ||
| Deutsche Central Cash Management Government Fund, 0.50% (d) (Cost $467,912) | 467,912 | 467,912 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $24,696,411)† | 99.5 | 26,801,936 |
| Other Assets and Liabilities, Net | 0.5 | 137,789 |
| Net Assets | 100.0 | 26,939,725 |
* Non-income producing security.
† The cost for federal income tax purposes was $24,735,562. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $2,066,374. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $2,884,746 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $818,372.
(a) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $36,612, which is 0.1% of net assets.
(b) Listed on the New York Stock Exchange.
(c) Listed on the NASDAQ Stock Market, Inc.
(d) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(e) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
144A: Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration, normally to qualified institutional buyers.
ADR: American Depositary Receipt
S&P: Standard & Poor's
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Common Stocks | |||||
| Australia | $ — | $ 285,291 | $ — | $ 285,291 | |
| Canada | 1,237,602 | — | — | 1,237,602 | |
| China | 5,540 | 304,469 | — | 310,009 | |
| Finland | — | 268,554 | — | 268,554 | |
| France | 67,472 | 143,271 | — | 210,743 | |
| Germany | — | 1,491,794 | — | 1,491,794 | |
| Hong Kong | — | 399,813 | — | 399,813 | |
| Indonesia | — | 153,996 | — | 153,996 | |
| Ireland | — | 235,824 | — | 235,824 | |
| Japan | — | 1,446,932 | — | 1,446,932 | |
| Korea | — | 123,779 | — | 123,779 | |
| Luxembourg | — | 255,775 | — | 255,775 | |
| Malaysia | — | 130,273 | — | 130,273 | |
| Netherlands | 152,211 | 216,738 | — | 368,949 | |
| Norway | — | 153,345 | — | 153,345 | |
| Philippines | — | 88,909 | — | 88,909 | |
| Singapore | 441,925 | — | — | 441,925 | |
| Spain | — | 31,111 | — | 31,111 | |
| Sweden | — | 824,278 | — | 824,278 | |
| Switzerland | — | 1,407,393 | — | 1,407,393 | |
| Taiwan | — | 213,922 | — | 213,922 | |
| United Kingdom | 479,579 | 742,602 | — | 1,222,181 | |
| United States | 14,813,232 | — | — | 14,813,232 | |
| Warrants | — | — | 829 | 829 | |
| Preferred Stock (f) | — | 167,501 | 12,976 | 180,477 | |
| Short-Term Investments (f) | 505,000 | — | — | 505,000 | |
| Total | $17,702,561 | $9,085,570 | $ 13,805 | $26,801,936 | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(f) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $24,191,411) — including $36,612 of securities loaned |
$ 26,296,936 |
| Investment in Government & Agency Securities Portfolio (cost $37,088)* | 37,088 |
| Investment in Deutsche Central Cash Management Government Fund (cost $467,912) | 467,912 |
| Total investments in securities, at value (cost $24,696,411) | 26,801,936 |
| Foreign currency, at value (cost $160,507) | 156,487 |
| Receivable for investments sold | 153,708 |
| Receivable for Fund shares sold | 1,673 |
| Dividends receivable | 12,751 |
| Interest receivable | 377 |
| Foreign taxes recoverable | 11,755 |
| Other assets | 1,100 |
| Total assets | 27,139,787 |
| Liabilities | |
| Cash overdraft | 78 |
| Payable upon return of securities loaned | 37,088 |
| Payable for Fund shares redeemed | 56,124 |
| Accrued management fee | 9,669 |
| Accrued Directors' fees | 1,222 |
| Other accrued expenses and payables | 95,881 |
| Total liabilities | 200,062 |
| Net assets, at value | 26,939,725 |
| Net Assets Consist of | |
| Undistributed net investment income | 93,056 |
|
Net unrealized appreciation (depreciation) on: Investments |
2,105,525 |
| Foreign currency | (5,425) |
| Accumulated net realized gain (loss) | (17,823,821) |
| Paid-in capital | 42,570,390 |
| Net assets, at value | 26,939,725 |
|
Class A Net Asset Value, offering and redemption price per share ($26,869,894 ÷ 2,417,159 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 11.12 |
|
Class B Net Asset Value, offering and redemption price per share ($69,831 ÷ 6,272 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 11.13 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $28,982) |
$ 409,876 |
| Income distributions — Deutsche Central Cash Management Government Fund | 3,361 |
| Securities lending income, net of borrower rebates | 8,125 |
| Total income | 421,362 |
|
Expenses: Management fee |
264,035 |
| Administration fee | 28,856 |
| Services to shareholders | 1,201 |
| Distribution service fee (Class B) | 151 |
| Custodian fee | 68,342 |
| Professional fees | 78,517 |
| Reports to shareholders | 30,910 |
| Directors' fees and expenses | 3,420 |
| Other | 3,564 |
| Total expenses before expense reductions | 478,996 |
| Expense reductions | (204,617) |
| Total expenses after expense reductions | 274,379 |
| Net investment income (loss) | 146,983 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
1,344,526 |
| Foreign currency | (8,208) |
| 1,336,318 | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
(703,170) |
| Foreign currency | 1,343 |
| (701,827) | |
| Net gain (loss) | 634,491 |
| Net increase (decrease) in net assets resulting from operations | $ 781,474 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income (loss) |
$ 146,983 | $ 289,213 |
| Net realized gain (loss) | 1,336,318 | 153,277 |
| Change in net unrealized appreciation (depreciation) | (701,827) | (828,051) |
| Net increase (decrease) in net assets resulting from operations | 781,474 | (385,561) |
|
Distributions to shareholders from: Net investment income: Class A |
(243,128) | (371,824) |
| Class B | (285) | (513) |
| Total distributions | (243,413) | (372,337) |
|
Fund share transactions: Class A Proceeds from shares sold |
1,028,197 | 1,554,080 |
| Reinvestment of distributions | 243,128 | 371,824 |
| Payments for shares redeemed | (8,614,441) | (14,574,128) |
| Net increase (decrease) in net assets from Class A share transactions | (7,343,116) | (12,648,224) |
|
Class B Proceeds from shares sold |
14,771 | 8,017 |
| Reinvestment of distributions | 285 | 513 |
| Payments for shares redeemed | (11,122) | (52,359) |
| Net increase (decrease) in net assets from Class B share transactions | 3,934 | (43,829) |
| Increase (decrease) in net assets | (6,801,121) | (13,449,951) |
| Net assets at beginning of period | 33,740,846 | 47,190,797 |
| Net assets at end of period (including undistributed net investment income of $93,056 and $155,039, respectively) | $ 26,939,725 | $ 33,740,846 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
3,116,107 | 4,265,093 |
| Shares sold | 95,060 | 137,321 |
| Shares issued to shareholders in reinvestment of distributions | 22,163 | 31,944 |
| Shares redeemed | (816,171) | (1,318,251) |
| Net increase (decrease) in Class A shares | (698,948) | (1,148,986) |
| Shares outstanding at end of period | 2,417,159 | 3,116,107 |
|
Class B Shares outstanding at beginning of period |
6,040 | 10,038 |
| Shares sold | 1,328 | 716 |
| Shares issued to shareholders in reinvestment of distributions | 26 | 44 |
| Shares redeemed | (1,122) | (4,758) |
| Net increase (decrease) in Class B shares | 232 | (3,998) |
| Shares outstanding at end of period | 6,272 | 6,040 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 10.81 | $ 11.04 | $ 11.13 | $ 9.24 | $ 7.90 | |
|
Income (loss) from investment operations: Net investment incomea |
.06 | .07 | .08 | .10 | .12 | |
| Net realized and unrealized gain (loss) | .34 | (.21) | (.06) | 1.92 | 1.34 | |
| Total from investment operations | .40 | (.14) | .02 | 2.02 | 1.46 | |
|
Less distributions from: Net investment income |
(.09) | (.09) | (.11) | (.13) | (.12) | |
| Net asset value, end of period | $ 11.12 | $ 10.81 | $ 11.04 | $ 11.13 | $ 9.24 | |
| Total Return (%)b | 3.72 | (1.32) | .21 | 22.08 | 18.60 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 27 | 34 | 47 | 51 | 54 | |
| Ratio of expenses before expense reductions (%) | 1.66 | 1.44 | 1.41 | 1.45 | 1.42 | |
| Ratio of expenses after expense reductions (%) | .95 | .90 | .82 | .88 | .99 | |
| Ratio of net investment income (%) | .51 | .65 | .71 | 1.00 | 1.40 | |
| Portfolio turnover rate (%) | 70 | 64 | 63 | 171 | 107 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 10.82 | $ 11.05 | $ 11.14 | $ 9.25 | $ 7.91 | |
|
Income (loss) from investment operations: Net investment incomea |
.02 | .05 | .02 | .07 | .09 | |
| Net realized and unrealized gain (loss) | .35 | (.23) | (.04) | 1.92 | 1.34 | |
| Total from investment operations | .37 | (.18) | (.02) | 1.99 | 1.43 | |
|
Less distributions from: Net investment income |
(.06) | (.05) | (.07) | (.10) | (.09) | |
| Net asset value, end of period | $ 11.13 | $ 10.82 | $ 11.05 | $ 11.14 | $ 9.25 | |
| Total Return (%)b | 3.38 | (1.64) | (.15) | 21.62 | 18.16 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | .07 | .1 | .1 | 3 | 3 | |
| Ratio of expenses before expense reductions (%) | 1.98 | 1.76 | 1.76 | 1.81 | 1.76 | |
| Ratio of expenses after expense reductions (%) | 1.24 | 1.22 | 1.15 | 1.23 | 1.34 | |
| Ratio of net investment income (%) | .17 | .40 | .14 | .66 | 1.04 | |
| Portfolio turnover rate (%) | 70 | 64 | 63 | 171 | 107 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Global Growth VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets for Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee and recordkeeping fees). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities are generally categorized as Level 1. For certain international equity securities, in order to adjust for events which may occur between the close of the foreign exchanges and the close of the New York Stock Exchange, a fair valuation model may be used. This fair valuation model takes into account comparisons to the valuation of American Depository Receipts (ADRs), exchange-traded funds, futures contracts and certain indices and these securities are categorized as Level 2.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Brown Brothers Harriman & Co., as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as common stock in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end. As of period end, the remaining contractual maturity of the collateral agreements were overnight and continuous.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
Additionally, the Fund may be subject to taxes imposed by the governments of countries in which it invests and are generally based on income and/or capital gains earned or repatriated, a portion of which may be recoverable. Based upon the current interpretation of the tax rules and regulations, estimated tax liabilities and recoveries on certain foreign securities are recorded on an accrual basis and are reflected as components of interest income or net change in unrealized gain/loss on investments. Tax liabilities realized as a result of security sales are reflected as a component of net realized gain/loss on investments.
Under the Regulated Investment Company Modernization Act of 2010, net capital losses incurred post-enactment may be carried forward indefinitely, and their character is retained as short-term and/or long-term. Previously, net capital losses were carried forward for eight years and treated as short-term. As a transition rule, the Act requires that post-enactment net capital losses be used before pre-enactment net capital losses.
At December 31, 2016, the Fund had a net tax basis capital loss carryforward of approximately $17,790,000 of pre-enactment losses, which may be applied against any realized net taxable capital gains of each succeeding year until fully utilized or until December 31, 2017, the expiration date, whichever occurs first.
From November 1, 2016 through December 31, 2016, the Fund elects to defer qualified late year losses of approximately $360 of net short-term realized capital losses and treat them as arising in the fiscal year ending December 31, 2017.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in foreign denominated investments, income received from Passive Foreign Investment Companies and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 98,245 |
| Capital loss carryforwards | $(17,790,000) |
| Unrealized appreciation (depreciation) on investments | $ 2,066,374 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 243,413 | $ 372,337 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments) aggregated $19,521,874 and $26,285,877, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .915% |
| Next $500 million | .865% |
| Next $750 million | .815% |
| Next $1.5 billion | .765% |
| Over $3 billion | .715% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annualized rate (exclusive of any applicable waivers/reimbursements) of 0.915% of the Fund's average daily net assets.
For the period from January 1, 2016 through April 30, 2016, the Advisor had contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .90% |
| Class B | 1.25% |
For the period from May 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive all or a portion of its fees and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest) of each class as follows:
| Class A | .99% |
| Class B | 1.25% |
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive all or a portion of its fee and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .95% |
| Class B | 1.20% |
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 204,171 |
| Class B | 446 |
| $ 204,617 |
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $28,856, of which $2,313 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Services to Shareholders | Total Aggregated | Unpaid at December 31, 2016 |
| Class A | $ 244 | $ 62 |
| Class B | 41 | 10 |
| $ 285 | $ 72 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plan, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee aggregated $151, of which $15 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $13,374, of which $4,879 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
D. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 66% and 27%. Two participating insurance companies were owners of record of 10% or more of the total outstanding Class B shares of the Fund, owning 68% and 32%.
E. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Global Growth VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Global Growth VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Global Growth VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,032.50 | $1,031.50 | ||
| Expenses Paid per $1,000* | $ 4.96 | $ 6.26 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,020.31 | $1,018.97 | ||
| Expenses Paid per $1,000* | $ 4.93 | $ 6.22 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios | Class A | Class B | ||
| Deutsche Variable Series II — Deutsche Global Growth VIP | .97% | 1.23% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
For corporate shareholders, 65% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Global Growth VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 3rd quartile, 4th quartile and 4th quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board considered that effective on or about October 3, 2016, the Fund would change its investment strategy and portfolio managers. The Board observed that the Fund had experienced improved relative performance during the first seven months of 2016. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were higher than the median (4th quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2GG-2 (R-025830-7 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Global Income Builder VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 29 Statement of Assets and Liabilities 30 Statement of Operations 31 Statements of Changes in Net Assets 32 Financial Highlights 33 Notes to Financial Statements 41 Report of Independent Registered Public Accounting Firm 42 Information About Your Fund's Expenses 42 Tax Information 43 Proxy Voting 44 Advisory Agreement Board Considerations and Fee Evaluation 46 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Although allocation among different asset categories generally limits risk, fund management may favor an asset category that underperforms other assets or markets as a whole. Stocks may decline in value. Smaller company stocks tend to be more volatile than medium-sized or large company stocks. Dividends are not guaranteed. If the dividend-paying stocks held by the Fund reduce or stop paying dividends, the Fund’s ability to generate income may be adversely affected. Preferred stocks, a type of dividend-paying stock, present certain additional risks. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Emerging markets tend to be more volatile and less liquid than the markets of more mature economies, and generally have less diverse and less mature economic structures and less stable political systems than those of developed countries. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Bond investments are subject to interest-rate, credit, liquidity and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Because Exchange Traded Funds (ETFs) trade on a securities exchange, their shares may trade at a premium or discount to their net asset value. ETFs also incur fees and expenses so they may not fully match the performance of the indexes they are designed to track. The Fund may lend securities to approved institutions. Any fund that focuses in a particular segment of the market or region of the world will generally be more volatile than a fund that invests more broadly. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns.
The gross expense ratio of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 is 0.63% for Class A shares and may differ from the expense ratio disclosed in the Financial Highlights table in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Global Income Builder VIP | ||
|
■ Deutsche Global Income Builder VIP — Class A ■ S&P® Target Risk Moderate Index ■ Blended Index |
||
 |
||
| Yearly periods ended December 31 | ||
The S&P Target Risk Moderate Index is designed to measure the performance of S&P's proprietary moderate target risk allocation model. The S&P Target Risk Moderate Index seeks to provide significant exposure to fixed income, while also allocating a smaller portion of exposure to equities in order to seek current income, some capital preservation, and an opportunity for moderate to low capital appreciation.
The Blended Index consists of an equally weighted blend (50%/50%) of the MSCI World High Dividend Yield Index and Bloomberg Barclays U.S. Universal Index
MSCI World High Dividend Yield Index includes securities that offer a meaningfully higher-than-average dividend yield relative to the MSCI World Index and pass dividend sustainability and persistence screens. The index offers broad market coverage, and is free-float market capitalization-weighted to ensure that its performance can be replicated in institutional and retail portfolios. The index is calculated using closing local market prices and translates into US dollars using the London close foreign exchange rates.
Bloomberg Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index.
Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index.
| Comparative Results | |||||
| Deutsche Global Income Builder VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,681 | $10,931 | $14,402 | $14,850 |
| Average annual total return | 6.81% | 3.01% | 7.57% | 4.03% | |
| S&P® Target Risk Moderate Index | Growth of $10,000 | $10,563 | $10,920 | $13,099 | $14,569 |
| Average annual total return | 5.63% | 2.98% | 5.55% | 3.83% | |
| Blended Index | Growth of $10,000 | $10,666 | $10,970 | $13,133 | $14,848 |
| Average annual total return | 6.66% | 3.13% | 5.60% | 4.03% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
The Fund returned 6.81% during the 12 months ended December 31, 2016 (Class A shares, unadjusted for contract charges), outperforming the 5.63% return of S&P® Target Risk Moderate Index.1 Its other benchmark — the Blended Index — returned 6.66%.2
The Fund closed the period with allocations of 58% to equities and 41% to bonds, vs. 59% and 35% on December 31, 2015. Although the final numbers appear to indicate only a moderate change, we were active in managing these allocations throughout the period. For instance, we sought to take advantage of the sell-off that followed the "Brexit" vote by increasing the weighting in equities in late June and early July. This decision added value, given that stocks quickly rebounded as investors grew increasingly comfortable with the outlook for global growth. We subsequently pared back the position in stocks in the wake of the rally, reducing the equity weighting to a level that was in line with our longer-term target. We believe this active approach can help us use market volatility to our advantage by capitalizing on values as they emerge. On balance, the Fund’s tilt toward equities was well suited to a period characterized by significant outperformance for stocks.
Both the equity and fixed-income portfolios finished the year with positive returns. In the former, we added value through effective stock selection in the materials sector, but this was offset by a weaker showing in telecommunications services and industrials. Among individual stocks, Navient Corp., Vermilion Energy, Inc.* and Newmont Mining Corp. were the leading contributors to performance, while the largest detraction came from underweight positions in JPMorgan Chase & Co. and Bank of America Corp.3 We held a somewhat cautious view at year-end given the unusually large gains that followed the November election, leading us to maintain a focus on higher-quality companies.
On the fixed-income side, the portfolio’s overall positioning had a mixed impact on performance. We entered the period with a defensive posture, as we were very conscious of the risks associated with falling energy prices and slowing global growth. This cautious approach was expressed in a below-average credit exposure and an emphasis on higher-quality issues. Our defensive strategy served us well until the market low in mid-February, but it subsequently cost us some relative performance over the next four to six weeks by preventing the Fund from fully participating in the initial stages of the rally. We began to rebuild the portfolio’s credit exposure in early April, a process that we continued throughout the remainder of the period. The bond portfolio performed well vs. the benchmark in the second half as a result of these moves, enabling it to provide competitive returns for the full year. In terms of allocations, the portfolio was aided by its overweight positions in high-yield bonds and the emerging markets, together with its corresponding underweight in investment-grade issues.4
The Fund employed derivatives to manage its currency, interest-rate and asset-class exposures. In some cases, derivatives were used to hedge existing positions; in others, they were used to take opportunistic positions in a more efficient manner than buying securities outright. On balance, the Fund’s use of derivatives contributed positively to performance during the past 12 months.
|
Di Kumble, CFA Portfolio Managers |
John D. Ryan Darwei Kung |
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The S&P Target Risk Moderate Index is designed to measure the performance of S&P’s proprietary moderate target risk allocation model. The S&P Target Risk Moderate Index seeks to provide significant exposure to fixed income, while also allocating a smaller portion of exposure to equities in order to seek current income, some capital preservation and an opportunity for moderate-to-low capital appreciation.
2 The Blended Index consists of an equally weighted blend (50%/50%) of the MSCI World High Dividend Yield Index and Bloomberg Barclays U.S. Universal Index.
MSCI World High Dividend Yield Index includes securities that offer a meaningfully higher-than-average dividend yield relative to the MSCI World Index and pass dividend sustainability and persistence screens. The index offers broad market coverage, and is free-float market-capitalization-weighted to ensure that its performance can be replicated in institutional and retail portfolios. The index is calculated using closing local market prices and translates into U.S. dollars using the London close foreign exchange rates. Bloomberg Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index and the non-ERISA portion of the CMBS Index.
Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index.
3 Contribution and detraction incorporate both a stock's total return and its weighting in the Fund.
4 "Overweight" means the Fund holds a higher weighting in a given sector or security than the benchmark. "Underweight" means the Fund holds a lower weighting.
Credit quality measures a bond issuer's ability to repay interest and principal in a timely manner.
* Not held in the portfolio as of December 31, 2016.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Equity | 58% | 59% |
| Common Stocks | 58% | 59% |
| Fixed Income | 41% | 35% |
| Corporate Bonds | 14% | 20% |
| Government & Agency Obligations | 13% | 8% |
| Exchange-Traded Funds | 10% | — |
| Collateralized Mortgage Obligations | 1% | 2% |
| Commercial Mortgage-Backed Securities | 1% | 1% |
| Mortgage-Backed Securities Pass-Throughs | 1% | 3% |
| Asset-Backed | 1% | 1% |
| Municipal Bonds and Notes | 0% | 0% |
| Cash Equivalents | 1% | 6% |
| 100% | 100% |
| Sector Diversification (As a % of Equities, Corporate Bonds, Preferred Securities and Convertible Bonds) |
12/31/16 | 12/31/15 |
| Financials | 20% | 29% |
| Information Technology | 13% | 19% |
| Energy | 13% | 4% |
| Consumer Discretionary | 12% | 9% |
| Industrials | 10% | 8% |
| Health Care | 8% | 7% |
| Consumer Staples | 7% | 7% |
| Telecommunication Services | 6% | 6% |
| Materials | 5% | 3% |
| Real Estate | 3% | 1% |
| Utilities | 3% | 7% |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
Shares |
Value ($) | ||
| Common Stocks 57.6% | |||
| Consumer Discretionary 7.5% | |||
| Auto Components 0.4% | |||
| Aisin Seiki Co., Ltd. | 2,464 | 106,795 | |
| Bridgestone Corp. | 4,505 | 162,442 | |
| Cie Generale des Etablissements Michelin | 224 | 24,956 | |
| Denso Corp. | 3,579 | 154,981 | |
| Magna International, Inc. | 3,100 | 134,607 | |
| Nokian Renkaat Oyj | 444 | 16,548 | |
| Sumitomo Electric Industries Ltd. | 8,005 | 115,517 | |
| Sumitomo Rubber Industries Ltd. | 2,993 | 47,471 | |
| Toyota Industries Corp. | 79 | 3,763 | |
| 767,080 | |||
| Automobiles 1.2% | |||
| Bayerische Motoren Werke (BMW) AG | 1,599 | 149,521 | |
| Daimler AG (Registered) | 3,109 | 231,733 | |
| Ford Motor Co. | 27,315 | 331,331 | |
| Fuji Heavy Industries Ltd. | 5,200 | 212,339 | |
| General Motors Co. | 9,423 | 328,297 | |
| Honda Motor Co., Ltd. | 5,950 | 173,844 | |
| Isuzu Motors Ltd. | 4,100 | 51,923 | |
| Nissan Motor Co., Ltd. | 32,085 | 322,751 | |
| Renault SA | 1,453 | 129,438 | |
| Toyota Motor Corp. | 3,700 | 217,580 | |
| Volkswagen AG | 965 | 139,127 | |
| 2,287,884 | |||
| Distributors 0.1% | |||
| Genuine Parts Co. | 1,400 | 133,756 | |
| Diversified Consumer Services 0.1% | |||
| H&R Block, Inc. | 5,300 | 121,847 | |
| Hotels, Restaurants & Leisure 1.3% | |||
| Carnival Corp. | 4,488 | 233,645 | |
| Carnival PLC | 2,097 | 106,712 | |
| Compass Group PLC | 6,932 | 128,403 | |
| Crown Resorts Ltd. | 17,625 | 147,400 | |
| Darden Restaurants, Inc. | 2,200 | 159,984 | |
| Hilton Worldwide Holdings, Inc. | 5,800 | 157,760 | |
| Las Vegas Sands Corp. | 4,400 | 235,004 | |
| Marriott International, Inc. "A" | 2,000 | 165,360 | |
| McDonald's Corp. | 2,823 | 343,616 | |
| Royal Caribbean Cruises Ltd. | 738 | 60,546 | |
| Sands China Ltd. | 25,200 | 109,501 | |
| Starbucks Corp. | 2,533 | 140,632 | |
| TUI AG | 9,017 | 129,484 | |
| Wyndham Worldwide Corp. | 1,600 | 122,192 | |
| Yum! Brands, Inc. | 1,810 | 114,627 | |
| 2,354,866 | |||
| Household Durables 0.6% | |||
| Barratt Developments PLC | 18,660 | 106,472 | |
| D.R. Horton, Inc. | 4,200 | 114,786 | |
| Garmin Ltd. | 2,400 | 116,376 | |
| Leggett & Platt, Inc. | 2,400 | 117,312 | |
| Mohawk Industries, Inc.* | 224 | 44,728 | |
| Newell Brands, Inc. | 3,400 | 151,810 | |
| Persimmon PLC | 5,683 | 124,624 | |
| PulteGroup, Inc. | 5,700 | 104,766 | |
| Sekisui House Ltd. | 12,454 | 207,455 | |
Shares |
Value ($) | ||
| Whirlpool Corp. | 412 | 74,889 | |
| 1,163,218 | |||
| Internet & Direct Marketing Retail 0.2% | |||
| Amazon.com, Inc.* | 200 | 149,974 | |
| The Priceline Group, Inc.* | 100 | 146,606 | |
| 296,580 | |||
| Leisure Products 0.1% | |||
| Hasbro, Inc. | 851 | 66,199 | |
| Mattel, Inc. | 4,500 | 123,975 | |
| Sankyo Co., Ltd. | 2,300 | 74,266 | |
| 264,440 | |||
| Media 1.7% | |||
| CBS Corp. "B" | 1,086 | 69,091 | |
| Charter Communications, Inc. "A"* | 517 | 148,855 | |
| Comcast Corp. "A" | 4,444 | 306,858 | |
| Eutelsat Communications SA | 7,460 | 144,355 | |
| Interpublic Group of Companies, Inc. | 4,900 | 114,709 | |
| Lagardere SCA | 4,492 | 124,900 | |
| News Corp. "A" | 5,067 | 58,068 | |
| Omnicom Group, Inc. | 3,079 | 262,054 | |
| Pearson PLC | 10,783 | 108,884 | |
| ProSiebenSat.1 Media SE | 2,546 | 98,161 | |
| RTL Group SA* | 14 | 1,029 | |
| Scripps Networks Interactive, Inc. "A" | 700 | 49,959 | |
| SES SA | 6,436 | 141,895 | |
| Shaw Communications, Inc. "B" | 6,877 | 137,986 | |
| Singapore Press Holdings Ltd. | 38,400 | 93,659 | |
| Sirius XM Holdings, Inc. (a) | 49,900 | 222,055 | |
| Sky PLC | 9,730 | 119,049 | |
| Time Warner, Inc. | 2,527 | 243,931 | |
| Twenty-First Century Fox, Inc. "A" | 2,823 | 79,157 | |
| Twenty-First Century Fox, Inc. "B" | 4,343 | 118,347 | |
| Viacom, Inc. "B" | 5,700 | 200,070 | |
| Walt Disney Co. | 2,109 | 219,800 | |
| WPP PLC | 4,192 | 93,891 | |
| 3,156,763 | |||
| Multiline Retail 0.4% | |||
| Canadian Tire Corp., Ltd. "A" | 145 | 15,041 | |
| Dollar General Corp. | 1,810 | 134,067 | |
| Harvey Norman Holdings Ltd. | 36,814 | 136,836 | |
| Kohl's Corp. | 3,040 | 150,115 | |
| Macy's, Inc. | 2,027 | 72,587 | |
| Target Corp. | 3,402 | 245,726 | |
| 754,372 | |||
| Specialty Retail 0.7% | |||
| AutoZone, Inc.* | 90 | 71,081 | |
| Bed Bath & Beyond, Inc. | 869 | 35,316 | |
| Best Buy Co., Inc. | 1,834 | 78,257 | |
| Foot Locker, Inc. | 1,002 | 71,032 | |
| Hennes & Mauritz AB "B" | 5,107 | 142,155 | |
| Home Depot, Inc. | 1,883 | 252,472 | |
| Industria de Diseno Textil SA | 481 | 16,429 | |
| L Brands, Inc. | 2,956 | 194,623 | |
| Lowe's Companies, Inc. | 2,231 | 158,669 | |
| Staples, Inc. | 16,536 | 149,651 | |
| The Gap, Inc. | 796 | 17,862 | |
| TJX Companies, Inc. | 1,448 | 108,788 | |
| 1,296,335 | |||
Shares |
Value ($) | ||
| Textiles, Apparel & Luxury Goods 0.7% | |||
| Cie Financiere Richemont SA (Registered) | 2,214 | 146,612 | |
| Coach, Inc. | 3,300 | 115,566 | |
| HUGO BOSS AG | 2,524 | 154,576 | |
| Li & Fung Ltd. | 238,000 | 104,846 | |
| NIKE, Inc. "B" | 4,242 | 215,621 | |
| Swatch Group AG (Bearer) | 189 | 58,758 | |
| Swatch Group AG (Registered) | 1,593 | 97,406 | |
| VF Corp. | 2,441 | 130,227 | |
| Yue Yuen Industrial (Holdings) Ltd. | 52,476 | 190,992 | |
| 1,214,604 | |||
| Consumer Staples 4.8% | |||
| Beverages 1.0% | |||
| Anheuser-Busch InBev SA | 2,306 | 244,031 | |
| Asahi Group Holdings Ltd. | 3,500 | 110,578 | |
| Brown-Forman Corp. "B" | 2,586 | 116,163 | |
| Coca-Cola Co. | 8,285 | 343,496 | |
| Constellation Brands, Inc. "A" | 640 | 98,118 | |
| Diageo PLC | 7,054 | 183,566 | |
| Dr. Pepper Snapple Group, Inc. | 1,189 | 107,807 | |
| Heineken Holding NV | 91 | 6,345 | |
| Heineken NV | 295 | 22,157 | |
| Kirin Holdings Co., Ltd. | 2,800 | 45,596 | |
| Molson Coors Brewing Co. "B" | 1,309 | 127,379 | |
| Monster Beverage Corp.* | 500 | 22,170 | |
| PepsiCo, Inc. | 3,295 | 344,756 | |
| Suntory Beverage & Food Ltd. | 1,000 | 41,563 | |
| 1,813,725 | |||
| Food & Staples Retailing 0.9% | |||
| Casino Guichard-Perrachon SA | 484 | 23,261 | |
| Colruyt SA | 754 | 37,317 | |
| Costco Wholesale Corp. | 1,231 | 197,095 | |
| CVS Health Corp. | 2,611 | 206,034 | |
| George Weston Ltd. | 307 | 25,973 | |
| ICA Gruppen AB | 1,223 | 37,332 | |
| J Sainsbury PLC | 13,467 | 41,459 | |
| Koninklijke Ahold Delhaize NV | 2,076 | 43,792 | |
| Kroger Co. | 848 | 29,265 | |
| Lawson, Inc. | 400 | 28,093 | |
| Loblaw Companies Ltd. | 1,622 | 85,579 | |
| Seven & I Holdings Co., Ltd. | 967 | 36,860 | |
| Sysco Corp. | 3,474 | 192,355 | |
| Wal-Mart Stores, Inc. | 4,146 | 286,572 | |
| Walgreens Boots Alliance, Inc. | 2,074 | 171,644 | |
| Wesfarmers Ltd. | 3,522 | 107,049 | |
| Woolworths Ltd. | 3,923 | 68,169 | |
| 1,617,849 | |||
| Food Products 1.5% | |||
| Archer-Daniels-Midland Co. | 4,922 | 224,689 | |
| Bunge Ltd. | 1,545 | 111,611 | |
| Campbell Soup Co. | 2,120 | 128,196 | |
| Conagra Brands, Inc. | 4,126 | 163,183 | |
| General Mills, Inc. | 4,416 | 272,776 | |
| Hormel Foods Corp. | 5,254 | 182,892 | |
| Kellogg Co. | 2,756 | 203,145 | |
| Kraft Heinz Co. | 2,864 | 250,084 | |
| McCormick & Co., Inc. | 1,047 | 97,717 | |
| Mondelez International, Inc. "A" | 4,794 | 212,518 | |
| Nestle SA (Registered) | 4,357 | 312,644 | |
| Tate & Lyle PLC | 5,637 | 49,236 | |
| The Hershey Co. | 1,853 | 191,656 | |
| The JM Smucker Co. | 1,448 | 185,431 | |
Shares |
Value ($) | ||
| Tyson Foods, Inc. "A" | 2,200 | 135,696 | |
| Wilmar International Ltd. | 31,912 | 79,117 | |
| 2,800,591 | |||
| Household Products 0.5% | |||
| Church & Dwight Co., Inc. | 818 | 36,147 | |
| Clorox Co. | 1,118 | 134,182 | |
| Colgate-Palmolive Co. | 2,244 | 146,847 | |
| Henkel AG & Co. KGaA | 108 | 11,258 | |
| Kimberly-Clark Corp. | 1,883 | 214,888 | |
| Procter & Gamble Co. | 4,218 | 354,650 | |
| Reckitt Benckiser Group PLC | 1,463 | 124,372 | |
| 1,022,344 | |||
| Personal Products 0.1% | |||
| Unilever PLC | 3,225 | 130,946 | |
| Tobacco 0.8% | |||
| Altria Group, Inc. | 4,998 | 337,965 | |
| British American Tobacco PLC | 4,239 | 241,556 | |
| Imperial Brands PLC | 4,374 | 191,137 | |
| Japan Tobacco, Inc. | 5,477 | 180,143 | |
| Philip Morris International, Inc. | 3,619 | 331,102 | |
| Reynolds American, Inc. | 4,392 | 246,128 | |
| 1,528,031 | |||
| Energy 4.8% | |||
| Energy Equipment & Services 0.4% | |||
| Baker Hughes, Inc. | 2,100 | 136,437 | |
| Halliburton Co. | 1,700 | 91,953 | |
| Helmerich & Payne, Inc. | 600 | 46,440 | |
| Petrofac Ltd. | 12,492 | 133,900 | |
| Schlumberger Ltd. | 3,400 | 285,430 | |
| 694,160 | |||
| Oil, Gas & Consumable Fuels 4.4% | |||
| AltaGas Ltd. | 6,700 | 169,165 | |
| BP PLC | 70,450 | 442,815 | |
| Caltex Australia Ltd. | 7,357 | 161,860 | |
| Canadian Natural Resources Ltd. | 3,200 | 101,983 | |
| Chevron Corp. | 3,915 | 460,796 | |
| ConocoPhillips | 2,900 | 145,406 | |
| Enbridge, Inc. | 4,500 | 189,364 | |
| Eni SpA | 12,513 | 203,700 | |
| Exxon Mobil Corp. | 6,043 | 545,441 | |
| HollyFrontier Corp. | 4,332 | 141,916 | |
| Idemitsu Kosan Co., Ltd. | 4,400 | 116,823 | |
| Imperial Oil Ltd. | 5,300 | 184,384 | |
| Inter Pipeline Ltd. | 7,100 | 156,738 | |
| JX Holdings, Inc. | 38,985 | 165,008 | |
| Kinder Morgan, Inc. | 6,900 | 142,899 | |
| Marathon Petroleum Corp. | 4,500 | 226,575 | |
| Neste Oyj | 3,895 | 149,555 | |
| Occidental Petroleum Corp. | 5,349 | 381,009 | |
| OMV AG | 3,812 | 134,555 | |
| ONEOK, Inc. | 2,400 | 137,784 | |
| Pembina Pipeline Corp. | 5,900 | 184,385 | |
| Phillips 66 | 3,765 | 325,334 | |
| Plains GP Holdings LP "A" | 4,919 | 170,591 | |
| Repsol SA | 13,891 | 196,459 | |
| Royal Dutch Shell PLC "A" | 14,223 | 393,236 | |
| Royal Dutch Shell PLC "B" | 12,716 | 369,014 | |
| Snam SpA | 59,442 | 245,034 | |
| Spectra Energy Corp. | 6,585 | 270,578 | |
| Statoil ASA | 5,548 | 101,732 | |
| Suncor Energy, Inc. | 6,700 | 219,067 | |
| Targa Resources Corp. | 3,600 | 201,852 | |
Shares |
Value ($) | ||
| Tesoro Corp. | 1,655 | 144,730 | |
| TonenGeneral Sekiyu KK | 6,000 | 63,193 | |
| TOTAL SA | 7,525 | 385,580 | |
| TransCanada Corp. | 6,600 | 297,594 | |
| Valero Energy Corp. | 4,617 | 315,433 | |
| 8,241,588 | |||
| Financials 10.5% | |||
| Banks 5.4% | |||
| Aozora Bank Ltd. | 31,174 | 110,145 | |
| Australia & New Zealand Banking Group Ltd. | 9,097 | 199,638 | |
| Banco Bilbao Vizcaya Argentaria SA | 21,877 | 147,784 | |
| Banco Santander SA | 36,176 | 189,130 | |
| Bank Hapoalim BM | 34,026 | 202,598 | |
| Bank of America Corp. | 8,700 | 192,270 | |
| Bank of Montreal | 2,982 | 214,480 | |
| Bank of Nova Scotia | 5,798 | 322,838 | |
| Barclays PLC | 56,954 | 156,863 | |
| BB&T Corp. | 5,718 | 268,860 | |
| BNP Paribas SA | 2,864 | 182,732 | |
| BOC Hong Kong (Holdings) Ltd. | 50,927 | 182,060 | |
| CaixaBank SA | 20,420 | 67,569 | |
| Canadian Imperial Bank of Commerce | 2,194 | 179,030 | |
| Citigroup, Inc. | 3,400 | 202,062 | |
| Commonwealth Bank of Australia | 3,767 | 224,061 | |
| Credit Agricole SA | 11,561 | 143,493 | |
| Danske Bank AS | 6,374 | 193,447 | |
| DBS Group Holdings Ltd. | 9,671 | 115,801 | |
| Fifth Third Bancorp. | 3,790 | 102,216 | |
| Hang Seng Bank Ltd. | 10,200 | 189,862 | |
| HSBC Holdings PLC | 44,178 | 357,953 | |
| Huntington Bancshares, Inc. | 7,505 | 99,216 | |
| ING Groep NV | 9,966 | 140,261 | |
| Intesa Sanpaolo SpA | 59,462 | 151,961 | |
| Intesa Sanpaolo SpA (RSP) | 85,802 | 201,997 | |
| Japan Post Bank Co., Ltd. | 14,000 | 167,748 | |
| JPMorgan Chase & Co. | 3,849 | 332,130 | |
| KBC Group NV | 2,881 | 178,582 | |
| KeyCorp | 186 | 3,398 | |
| Lloyds Banking Group PLC | 171,766 | 132,251 | |
| M&T Bank Corp. | 1,110 | 173,637 | |
| Mebuki Financial Group, Inc. | 28,400 | 105,217 | |
| Mitsubishi UFJ Financial Group, Inc. | 23,300 | 143,560 | |
| Mizuho Financial Group, Inc. | 122,173 | 219,206 | |
| National Australia Bank Ltd. | 10,460 | 231,672 | |
| National Bank of Canada | 5,100 | 207,130 | |
| Nordea Bank AB | 27,976 | 311,202 | |
| Oversea-Chinese Banking Corp., Ltd. | 23,855 | 146,934 | |
| People's United Financial, Inc. | 7,356 | 142,412 | |
| PNC Financial Services Group, Inc. | 1,367 | 159,884 | |
| Resona Holdings, Inc. | 16,256 | 83,421 | |
| Royal Bank of Canada | 4,488 | 303,746 | |
| Skandinaviska Enskilda Banken AB "A" | 13,055 | 137,003 | |
| Societe Generale SA | 3,753 | 184,855 | |
| Sumitomo Mitsui Financial Group, Inc. | 4,300 | 163,985 | |
| SunTrust Banks, Inc. | 2,505 | 137,399 | |
| Svenska Handelsbanken AB "A" | 12,389 | 172,122 | |
| Swedbank AB "A" | 7,769 | 187,924 | |
| Toronto-Dominion Bank | 4,831 | 238,267 | |
| U.S. Bancorp. | 5,355 | 275,086 | |
Shares |
Value ($) | ||
| United Overseas Bank Ltd. | 8,702 | 122,670 | |
| Wells Fargo & Co. | 5,916 | 326,031 | |
| Westpac Banking Corp. | 9,287 | 218,490 | |
| 9,944,289 | |||
| Capital Markets 0.7% | |||
| Aberdeen Asset Management PLC | 3,603 | 11,440 | |
| Bank of New York Mellon Corp. | 3,112 | 147,447 | |
| BlackRock, Inc. | 290 | 110,357 | |
| CME Group, Inc. | 983 | 113,389 | |
| Credit Suisse Group AG (Registered)* | 7,499 | 107,650 | |
| Intercontinental Exchange, Inc. | 1,450 | 81,809 | |
| Morgan Stanley | 3,500 | 147,875 | |
| Nasdaq, Inc. | 1,086 | 72,892 | |
| NEX Group PLC | 9,993 | 57,205 | |
| The Goldman Sachs Group, Inc. | 600 | 143,670 | |
| Thomson Reuters Corp. | 3,909 | 171,074 | |
| TP ICAP PLC | 8,166 | 43,628 | |
| UBS Group AG (Registered) | 8,715 | 136,319 | |
| 1,344,755 | |||
| Consumer Finance 0.2% | |||
| American Express Co. | 507 | 37,558 | |
| Capital One Financial Corp. | 2,200 | 191,928 | |
| Discover Financial Services | 1,810 | 130,483 | |
| Navient Corp. | 1,056 | 17,350 | |
| 377,319 | |||
| Diversified Financial Services 0.3% | |||
| Berkshire Hathaway, Inc. "B"* | 1,417 | 230,943 | |
| Groupe Bruxelles Lambert SA | 1,079 | 90,520 | |
| Investor AB "B" | 2,094 | 78,399 | |
| Pargesa Holding SA (Bearer) | 2,110 | 137,331 | |
| 537,193 | |||
| Insurance 3.8% | |||
| Admiral Group PLC | 6,047 | 136,319 | |
| Aflac, Inc. | 2,429 | 169,058 | |
| Ageas | 3,955 | 156,632 | |
| Alleghany Corp.* | 35 | 21,284 | |
| Allianz SE (Registered) | 1,207 | 199,554 | |
| Allstate Corp. | 2,548 | 188,858 | |
| American International Group, Inc. | 2,875 | 187,766 | |
| Aon PLC | 435 | 48,516 | |
| Arch Capital Group Ltd.* | 689 | 59,454 | |
| Assicurazioni Generali SpA | 10,604 | 157,730 | |
| Assurant, Inc. | 495 | 45,966 | |
| Aviva PLC | 15,029 | 90,250 | |
| AXA SA | 10,123 | 255,912 | |
| Axis Capital Holdings Ltd. | 2,509 | 163,762 | |
| Baloise Holding AG (Registered) | 900 | 113,362 | |
| Chubb Ltd. | 1,731 | 228,700 | |
| Cincinnati Financial Corp. | 1,800 | 136,350 | |
| Everest Re Group Ltd. | 600 | 129,840 | |
| Fairfax Financial Holdings Ltd. | 170 | 82,110 | |
| FNF Group | 4,342 | 147,454 | |
| Great-West Lifeco, Inc. | 4,126 | 108,078 | |
| Hannover Rueck SE | 979 | 106,077 | |
| Hartford Financial Services Group, Inc. | 1,321 | 62,946 | |
| Japan Post Holdings Co., Ltd. | 13,000 | 162,013 | |
| Legal & General Group PLC | 48,724 | 148,835 | |
| Manulife Financial Corp. | 9,700 | 172,738 | |
| Marsh & McLennan Companies, Inc. | 1,013 | 68,469 | |
| MetLife, Inc. | 2,900 | 156,281 | |
Shares |
Value ($) | ||
| MS&AD Insurance Group Holdings, Inc. | 3,600 | 111,671 | |
| Muenchener Rueckversicherungs- Gesellschaft AG (Registered) |
1,203 | 227,504 | |
| NN Group NV | 6,297 | 213,690 | |
| Poste Italiane SpA 144A | 16,016 | 106,298 | |
| Power Corp. of Canada | 6,400 | 143,239 | |
| Power Financial Corp. | 8,500 | 212,460 | |
| Principal Financial Group, Inc. | 1,013 | 58,612 | |
| Progressive Corp. | 4,560 | 161,880 | |
| Prudential Financial, Inc. | 2,563 | 266,706 | |
| Sampo Oyj "A" | 3,223 | 145,002 | |
| SCOR SE | 1,635 | 56,530 | |
| Sompo Holdings, Inc. | 500 | 16,930 | |
| Standard Life PLC | 25,210 | 115,654 | |
| Sun Life Financial, Inc. | 2,200 | 84,467 | |
| Suncorp Group Ltd. | 19,025 | 185,534 | |
| Swiss Life Holding AG (Registered)* | 520 | 147,324 | |
| Swiss Re AG | 2,808 | 266,096 | |
| The Travelers Companies, Inc. | 1,495 | 183,018 | |
| Tokio Marine Holdings, Inc. | 1,600 | 65,686 | |
| Torchmark Corp. | 806 | 59,451 | |
| Willis Towers Watson PLC | 800 | 97,824 | |
| XL Group Ltd. | 3,308 | 123,256 | |
| Zurich Insurance Group AG* | 1,074 | 295,912 | |
| 7,049,058 | |||
| Thrifts & Mortgage Finance 0.1% | |||
| New York Community Bancorp., Inc. | 8,036 | 127,853 | |
| Health Care 4.8% | |||
| Biotechnology 1.3% | |||
| AbbVie, Inc. | 6,826 | 427,444 | |
| Actelion Ltd. (Registered)* | 658 | 142,328 | |
| Alexion Pharmaceuticals, Inc.* | 900 | 110,115 | |
| Alkermes PLC* | 400 | 22,232 | |
| Amgen, Inc. | 2,109 | 308,357 | |
| Biogen, Inc.* | 541 | 153,417 | |
| BioMarin Pharmaceutical, Inc.* | 300 | 24,852 | |
| Celgene Corp.* | 1,700 | 196,775 | |
| CSL Ltd. | 2,121 | 153,726 | |
| Gilead Sciences, Inc. | 4,540 | 325,109 | |
| Incyte Corp.* | 600 | 60,162 | |
| Regeneron Pharmaceuticals, Inc.* | 400 | 146,836 | |
| Shire PLC | 2,739 | 158,285 | |
| United Therapeutics Corp.* | 1,300 | 186,459 | |
| Vertex Pharmaceuticals, Inc.* | 100 | 7,367 | |
| 2,423,464 | |||
| Health Care Equipment & Supplies 0.6% | |||
| Abbott Laboratories | 5,212 | 200,193 | |
| Baxter International, Inc. | 2,461 | 109,121 | |
| Becton, Dickinson & Co. | 1,076 | 178,132 | |
| Danaher Corp. | 2,461 | 191,564 | |
| Medtronic PLC | 3,402 | 242,325 | |
| Stryker Corp. | 1,099 | 131,671 | |
| Zimmer Biomet Holdings, Inc. | 507 | 52,322 | |
| 1,105,328 | |||
| Health Care Providers & Services 0.6% | |||
| Aetna, Inc. | 1,411 | 174,978 | |
| AmerisourceBergen Corp. | 1,303 | 101,882 | |
| Anthem, Inc. | 1,358 | 195,240 | |
| Cardinal Health, Inc. | 1,810 | 130,266 | |
| Cigna Corp. | 501 | 66,828 | |
Shares |
Value ($) | ||
| Express Scripts Holding Co.* | 1,195 | 82,204 | |
| Humana, Inc. | 326 | 66,514 | |
| McKesson Corp. | 241 | 33,848 | |
| Quest Diagnostics, Inc. | 953 | 87,581 | |
| UnitedHealth Group, Inc. | 1,457 | 233,178 | |
| 1,172,519 | |||
| Life Sciences Tools & Services 0.1% | |||
| Thermo Fisher Scientific, Inc. | 1,183 | 166,921 | |
| Pharmaceuticals 2.2% | |||
| Allergan PLC* | 781 | 164,018 | |
| Astellas Pharma, Inc. | 8,400 | 116,814 | |
| AstraZeneca PLC | 4,399 | 240,747 | |
| Bayer AG (Registered) | 1,056 | 110,202 | |
| Bristol-Myers Squibb Co. | 3,112 | 181,865 | |
| Daiichi Sankyo Co., Ltd. | 6,100 | 124,768 | |
| Eisai Co., Ltd. | 1,700 | 97,578 | |
| Eli Lilly & Co. | 2,968 | 218,296 | |
| GlaxoSmithKline PLC | 16,150 | 311,365 | |
| Johnson & Johnson | 3,330 | 383,649 | |
| Merck & Co., Inc. | 5,139 | 302,533 | |
| Mitsubishi Tanabe Pharma Corp. | 8,900 | 174,672 | |
| Novartis AG (Registered) | 3,436 | 249,782 | |
| Novo Nordisk AS ''B" | 3,560 | 128,417 | |
| Orion Oyj "B" | 3,170 | 141,014 | |
| Otsuka Holdings Co., Ltd. | 2,900 | 126,392 | |
| Pfizer, Inc. | 12,522 | 406,715 | |
| Roche Holding AG (Genusschein) | 1,027 | 234,564 | |
| Sanofi | 1,414 | 114,532 | |
| Takeda Pharmaceutical Co., Ltd. | 4,100 | 169,570 | |
| UCB SA | 1,078 | 69,130 | |
| 4,066,623 | |||
| Industrials 6.9% | |||
| Aerospace & Defense 0.8% | |||
| BAE Systems PLC | 11,050 | 80,619 | |
| Boeing Co. | 1,376 | 214,216 | |
| Cobham PLC | 49,602 | 100,152 | |
| General Dynamics Corp. | 986 | 170,243 | |
| L3 Technologies, Inc. | 260 | 39,549 | |
| Lockheed Martin Corp. | 709 | 177,207 | |
| Northrop Grumman Corp. | 867 | 201,647 | |
| Raytheon Co. | 1,352 | 191,984 | |
| Rockwell Collins, Inc. | 869 | 80,608 | |
| Singapore Technologies Engineering Ltd. | 13,900 | 31,000 | |
| United Technologies Corp. | 2,389 | 261,882 | |
| 1,549,107 | |||
| Air Freight & Logistics 0.3% | |||
| FedEx Corp. | 724 | 134,809 | |
| Royal Mail PLC | 22,113 | 126,049 | |
| United Parcel Service, Inc. "B" | 2,086 | 239,139 | |
| 499,997 | |||
| Airlines 0.1% | |||
| Japan Airlines Co., Ltd. | 3,600 | 105,112 | |
| Singapore Airlines Ltd. | 5,974 | 39,907 | |
| Southwest Airlines Co. | 46 | 2,293 | |
| 147,312 | |||
| Building Products 0.1% | |||
| Johnson Controls International PLC | 3,586 | 147,707 | |
| Commercial Services & Supplies 0.5% | |||
| Cintas Corp. | 1,200 | 138,672 | |
| Dai Nippon Printing Co., Ltd. | 11,000 | 108,733 | |
Shares |
Value ($) | ||
| G4S PLC | 28 | 81 | |
| Quad Graphics, Inc. | 13 | 349 | |
| Republic Services, Inc. | 4,777 | 272,528 | |
| Secom Co., Ltd. | 1,500 | 109,729 | |
| Waste Connections, Inc. | 1,900 | 149,321 | |
| Waste Management, Inc. | 2,027 | 143,735 | |
| 923,148 | |||
| Construction & Engineering 0.3% | |||
| Bouygues SA | 2,434 | 87,312 | |
| Kajima Corp. | 15,000 | 103,866 | |
| Obayashi Corp. | 10,900 | 104,245 | |
| Taisei Corp. | 15,000 | 104,996 | |
| VINCI SA | 2,646 | 180,281 | |
| 580,700 | |||
| Electrical Equipment 0.6% | |||
| ABB Ltd. (Registered)* | 7,980 | 168,325 | |
| AMETEK, Inc. | 1,231 | 59,827 | |
| Eaton Corp. PLC | 3,889 | 260,913 | |
| Emerson Electric Co. | 4,600 | 256,450 | |
| Mitsubishi Electric Corp. | 11,300 | 157,474 | |
| Rockwell Automation, Inc. | 1,300 | 174,720 | |
| Schneider Electric SE | 1,113 | 77,513 | |
| 1,155,222 | |||
| Industrial Conglomerates 1.0% | |||
| 3M Co. | 1,961 | 350,176 | |
| CK Hutchison Holdings Ltd. | 15,701 | 177,795 | |
| General Electric Co. | 12,449 | 393,389 | |
| Honeywell International, Inc. | 2,606 | 301,905 | |
| Jardine Matheson Holdings Ltd. | 2,900 | 160,099 | |
| Keppel Corp., Ltd. | 19,400 | 77,582 | |
| NWS Holdings Ltd. | 87,171 | 142,241 | |
| Roper Technologies, Inc. | 796 | 145,732 | |
| Sembcorp Industries Ltd. | 20,238 | 39,882 | |
| Siemens AG (Registered) | 1,153 | 141,874 | |
| 1,930,675 | |||
| Machinery 1.6% | |||
| Atlas Copco AB "B" | 3,116 | 85,034 | |
| Caterpillar, Inc. | 2,296 | 212,931 | |
| Cummins, Inc. | 1,100 | 150,337 | |
| Deere & Co. | 2,173 | 223,906 | |
| Dover Corp. | 2,200 | 164,846 | |
| FANUC Corp. | 900 | 152,704 | |
| Fortive Corp. | 2,800 | 150,164 | |
| Illinois Tool Works, Inc. | 1,907 | 233,531 | |
| Ingersoll-Rand PLC | 2,400 | 180,096 | |
| Komatsu Ltd. | 6,300 | 142,580 | |
| Kone Oyj "B" | 3,407 | 152,787 | |
| MAN SE | 1,694 | 168,096 | |
| Mitsubishi Heavy Industries Ltd. | 1,000 | 4,556 | |
| PACCAR, Inc. | 1,158 | 73,996 | |
| Parker-Hannifin Corp. | 1,200 | 168,000 | |
| Schindler Holding AG (Registered) | 767 | 134,051 | |
| SKF AB "B" | 27 | 497 | |
| Stanley Black & Decker, Inc. | 1,231 | 141,183 | |
| Volvo AB "B" | 16,093 | 188,004 | |
| Wartsila Oyj | 1,838 | 82,573 | |
| Yangzijiang Shipbuilding Holdings Ltd. | 126,907 | 71,355 | |
| 2,881,227 | |||
| Marine 0.1% | |||
| Kuehne + Nagel International AG (Registered) | 866 | 114,592 | |
Shares |
Value ($) | ||
| Professional Services 0.4% | |||
| Adecco Group AG (Registered) | 2,241 | 146,777 | |
| Capita PLC | 17,783 | 116,503 | |
| Equifax, Inc. | 1,300 | 153,699 | |
| Nielsen Holdings PLC | 3,829 | 160,627 | |
| SGS SA (Registered) | 70 | 142,409 | |
| 720,015 | |||
| Road & Rail 0.4% | |||
| Canadian National Railway Co. | 218 | 14,671 | |
| CSX Corp. | 3,547 | 127,444 | |
| East Japan Railway Co. | 997 | 86,124 | |
| MTR Corp., Ltd. | 25,695 | 124,995 | |
| Norfolk Southern Corp. | 796 | 86,024 | |
| Union Pacific Corp. | 2,027 | 210,159 | |
| West Japan Railway Co. | 1,161 | 71,180 | |
| 720,597 | |||
| Trading Companies & Distributors 0.5% | |||
| Fastenal Co. | 3,600 | 169,128 | |
| ITOCHU Corp. | 12,139 | 161,251 | |
| Marubeni Corp. | 21,849 | 123,897 | |
| Mitsubishi Corp. | 4,328 | 92,199 | |
| Mitsui & Co., Ltd. | 10,651 | 146,452 | |
| Sumitomo Corp. | 9,666 | 113,736 | |
| W.W. Grainger, Inc. | 579 | 134,473 | |
| 941,136 | |||
| Transportation Infrastructure 0.2% | |||
| Atlantia SpA | 4,329 | 101,747 | |
| Macquarie Infrastructure Corp. | 2,200 | 179,740 | |
| Transurban Group (Units) | 6,095 | 45,450 | |
| 326,937 | |||
| Information Technology 9.3% | |||
| Communications Equipment 0.9% | |||
| Cisco Systems, Inc. | 13,235 | 399,961 | |
| F5 Networks, Inc.* | 700 | 101,304 | |
| Harris Corp. | 2,249 | 230,455 | |
| Juniper Networks, Inc. | 3,172 | 89,641 | |
| Motorola Solutions, Inc. | 2,630 | 218,001 | |
| Nokia Oyj | 68,785 | 332,590 | |
| Palo Alto Networks, Inc.* | 400 | 50,020 | |
| Telefonaktiebolaget LM Ericsson "B" | 51,614 | 303,299 | |
| 1,725,271 | |||
| Electronic Equipment, Instruments & Components 0.6% | |||
| Amphenol Corp. "A" | 1,449 | 97,373 | |
| Avnet, Inc. | 1,253 | 59,655 | |
| Corning, Inc. | 8,721 | 211,659 | |
| Hitachi Ltd. | 18,485 | 99,970 | |
| Keyence Corp. | 200 | 137,192 | |
| Kyocera Corp. | 2,500 | 124,335 | |
| Murata Manufacturing Co., Ltd. | 606 | 81,100 | |
| TE Connectivity Ltd. | 2,554 | 176,941 | |
| 988,225 | |||
| Internet Software & Services 1.0% | |||
| Alphabet, Inc. "A"* | 400 | 316,980 | |
| Alphabet, Inc. "C"* | 500 | 385,910 | |
| eBay, Inc.* | 7,060 | 209,612 | |
| Facebook, Inc. "A"* | 3,100 | 356,655 | |
| Mixi, Inc. | 3,100 | 113,224 | |
| Yahoo Japan Corp. | 60,300 | 231,510 | |
| Yahoo!, Inc.* | 5,400 | 208,818 | |
| 1,822,709 | |||
Shares |
Value ($) | ||
| IT Services 2.2% | |||
| Accenture PLC "A" | 2,286 | 267,759 | |
| Amadeus IT Group SA | 2,405 | 109,405 | |
| Atos SE | 413 | 43,701 | |
| Automatic Data Processing, Inc. | 2,986 | 306,901 | |
| Broadridge Financial Solutions, Inc. | 2,000 | 132,600 | |
| Cognizant Technology Solutions Corp. "A"* | 3,300 | 184,899 | |
| Computer Sciences Corp. | 2,800 | 166,376 | |
| Fidelity National Information Services, Inc. | 2,201 | 166,484 | |
| Fiserv, Inc.* | 1,996 | 212,135 | |
| Fujitsu Ltd. | 24,000 | 133,308 | |
| International Business Machines Corp. | 2,823 | 468,590 | |
| Mastercard, Inc. "A" | 2,700 | 278,775 | |
| Nomura Research Institute Ltd. | 3,410 | 103,758 | |
| NTT Data Corp. | 2,000 | 96,713 | |
| Paychex, Inc. | 4,623 | 281,448 | |
| PayPal Holdings, Inc.* | 3,300 | 130,251 | |
| Sabre Corp. | 5,200 | 129,740 | |
| Total System Services, Inc. | 2,079 | 101,933 | |
| Vantiv, Inc. "A"* | 1,312 | 78,222 | |
| Visa, Inc. "A" | 3,865 | 301,547 | |
| Western Union Co. | 11,509 | 249,976 | |
| Xerox Corp. | 20,974 | 183,103 | |
| 4,127,624 | |||
| Semiconductors & Semiconductor Equipment 1.6% | |||
| Analog Devices, Inc. | 2,389 | 173,489 | |
| Applied Materials, Inc. | 3,800 | 122,626 | |
| ASML Holding NV | 222 | 24,893 | |
| Broadcom Ltd. | 1,551 | 274,170 | |
| Intel Corp. | 9,860 | 357,622 | |
| KLA-Tencor Corp. | 2,021 | 159,012 | |
| Lam Research Corp. | 1,259 | 133,114 | |
| Linear Technology Corp. | 2,500 | 155,875 | |
| Marvell Technology Group Ltd. | 4,271 | 59,239 | |
| Maxim Integrated Products, Inc. | 4,054 | 156,363 | |
| Microchip Technology, Inc. | 2,538 | 162,813 | |
| NVIDIA Corp. | 1,300 | 138,762 | |
| QUALCOMM, Inc. | 5,515 | 359,578 | |
| Skyworks Solutions, Inc. | 1,400 | 104,524 | |
| Texas Instruments, Inc. | 3,621 | 264,224 | |
| Tokyo Electron Ltd. | 2,000 | 189,329 | |
| Xilinx, Inc. | 2,800 | 169,036 | |
| 3,004,669 | |||
| Software 1.9% | |||
| Activision Blizzard, Inc. | 5,383 | 194,380 | |
| Adobe Systems, Inc.* | 1,200 | 123,540 | |
| ANSYS, Inc.* | 724 | 66,963 | |
| CA, Inc. | 6,685 | 212,382 | |
| CDK Global, Inc. | 2,000 | 119,380 | |
| Dell Technologies, Inc. "V"* | 4,829 | 265,450 | |
| Electronic Arts, Inc.* | 1,426 | 112,312 | |
| Intuit, Inc. | 1,400 | 160,454 | |
| Microsoft Corp. | 6,974 | 433,364 | |
| Nice Ltd. | 1,927 | 131,358 | |
| Nintendo Co., Ltd. | 500 | 104,940 | |
| Oracle Corp. | 8,901 | 342,243 | |
| Oracle Corp. | 2,000 | 100,708 | |
| Red Hat, Inc.* | 1,500 | 104,550 | |
| salesforce.com, Inc.* | 2,000 | 136,920 | |
| SAP SE | 2,741 | 238,291 | |
| Symantec Corp. | 7,428 | 177,455 | |
Shares |
Value ($) | ||
| Synopsys, Inc.* | 1,295 | 76,224 | |
| The Sage Group PLC | 13,235 | 106,970 | |
| Trend Micro, Inc. | 2,800 | 99,646 | |
| VMware, Inc. "A"* (a) | 3,024 | 238,079 | |
| 3,545,609 | |||
| Technology Hardware, Storage & Peripherals 1.1% | |||
| Apple, Inc. | 4,783 | 553,967 | |
| Canon, Inc. | 11,174 | 314,921 | |
| FUJIFILM Holdings Corp. | 3,600 | 136,568 | |
| Hewlett Packard Enterprise Co. | 10,400 | 240,656 | |
| HP, Inc. | 12,754 | 189,269 | |
| NetApp, Inc. | 2,389 | 84,260 | |
| Ricoh Co., Ltd. | 12,647 | 106,794 | |
| Seagate Technology PLC | 3,600 | 137,412 | |
| Seiko Epson Corp. | 2,800 | 59,222 | |
| Western Digital Corp. | 2,700 | 183,465 | |
| 2,006,534 | |||
| Materials 1.3% | |||
| Chemicals 0.8% | |||
| Air Products & Chemicals, Inc. | 900 | 129,438 | |
| BASF SE | 1,393 | 129,422 | |
| Celanese Corp. "A" | 732 | 57,638 | |
| Dow Chemical Co. | 3,496 | 200,041 | |
| E.I. du Pont de Nemours & Co. | 1,376 | 100,998 | |
| Ecolab, Inc. | 362 | 42,434 | |
| EMS-Chemie Holding AG (Registered) | 110 | 55,977 | |
| GEO Specialty Chemicals, Inc.* | 19,324 | 7,588 | |
| Israel Chemicals Ltd. | 15,855 | 65,079 | |
| Kuraray Co., Ltd. | 900 | 13,529 | |
| LyondellBasell Industries NV "A" | 2,654 | 227,660 | |
| Mitsubishi Chemical Holdings Corp. | 600 | 3,892 | |
| Monsanto Co. | 941 | 99,003 | |
| Praxair, Inc. | 507 | 59,415 | |
| Solvay SA | 911 | 107,017 | |
| Syngenta AG (Registered) | 281 | 111,059 | |
| 1,410,190 | |||
| Construction Materials 0.0% | |||
| Fletcher Building Ltd. | 8,134 | 59,836 | |
| Containers & Packaging 0.1% | |||
| International Paper Co. | 2,655 | 140,875 | |
| WestRock Co. | 404 | 20,511 | |
| 161,386 | |||
| Metals & Mining 0.3% | |||
| Franco-Nevada Corp. | 2,000 | 119,584 | |
| Newmont Mining Corp. | 3,188 | 108,615 | |
| Nucor Corp. | 2,065 | 122,909 | |
| Rio Tinto PLC | 4,820 | 187,793 | |
| 538,901 | |||
| Paper & Forest Products 0.1% | |||
| Stora Enso Oyj "R" | 12,231 | 131,916 | |
| UPM-Kymmene Oyj | 5,018 | 123,738 | |
| 255,654 | |||
| Real Estate 1.9% | |||
| Equity Real Estate Investment Trusts (REITs) 1.6% | |||
| American Tower Corp. | 800 | 84,544 | |
| AvalonBay Communities, Inc. | 739 | 130,914 | |
| Crown Castle International Corp. | 1,478 | 128,246 | |
| Dexus Property Group | 11,978 | 83,124 | |
| Equity Residential | 2,500 | 160,900 | |
| General Growth Properties, Inc. | 3,800 | 94,924 | |
Shares |
Value ($) | ||
| H&R Real Estate Investment Trust (Units) | 5,712 | 95,168 | |
| HCP, Inc. | 6,559 | 194,933 | |
| Host Hotels & Resorts, Inc. | 9,200 | 173,328 | |
| Iron Mountain, Inc. | 3,100 | 100,688 | |
| Kimco Realty Corp. | 4,900 | 123,284 | |
| Prologis, Inc. | 2,200 | 116,138 | |
| Public Storage | 700 | 156,450 | |
| Realty Income Corp. | 2,125 | 122,145 | |
| RioCan Real Estate Investment Trust | 5,400 | 107,103 | |
| Scentre Group | 43,783 | 146,612 | |
| Simon Property Group, Inc. | 700 | 124,369 | |
| The Macerich Co. | 1,000 | 70,840 | |
| UDR, Inc. | 2,500 | 91,200 | |
| Ventas, Inc. | 2,000 | 125,040 | |
| VEREIT, Inc. | 11,640 | 98,474 | |
| Vicinity Centres | 40,703 | 87,887 | |
| Welltower, Inc. | 2,864 | 191,688 | |
| Weyerhaeuser Co. | 2,400 | 72,216 | |
| 2,880,215 | |||
| Real Estate Management & Development 0.3% | |||
| Henderson Land Development Co., Ltd. | 16,514 | 87,812 | |
| New World Development Co., Ltd. | 44,151 | 46,694 | |
| Sun Hung Kai Properties Ltd. | 11,536 | 145,856 | |
| Swire Pacific Ltd. "A" | 12,305 | 117,610 | |
| Swiss Prime Site AG (Registered)* | 1,553 | 127,142 | |
| Wharf Holdings Ltd. | 6,835 | 45,454 | |
| 570,568 | |||
| Telecommunication Services 3.7% | |||
| Diversified Telecommunication Services 2.7% | |||
| AT&T, Inc. | 12,573 | 534,730 | |
| BCE, Inc. | 6,804 | 294,072 | |
| Bezeq Israeli Telecommunication Corp., Ltd. | 189,510 | 360,202 | |
| BT Group PLC | 51,995 | 235,764 | |
| Deutsche Telekom AG (Registered) | 9,327 | 160,594 | |
| Elisa Oyj | 3,142 | 102,487 | |
| HKT Trust & HKT Ltd. "SS", (Units) | 145,683 | 178,511 | |
| Inmarsat PLC | 13,209 | 122,380 | |
| Nippon Telegraph & Telephone Corp. | 8,400 | 352,774 | |
| Orange SA | 7,544 | 114,715 | |
| PCCW Ltd. | 369,183 | 199,941 | |
| Proximus SA | 10,168 | 293,152 | |
| Singapore Telecommunications Ltd. | 70,245 | 176,107 | |
| Spark New Zealand Ltd. | 98,244 | 232,795 | |
| Swisscom AG (Registered) | 492 | 220,482 | |
| Telecom Italia SpA (RSP)* | 217,970 | 157,944 | |
| Telefonica Deutschland Holding AG | 29,696 | 127,297 | |
| Telenor ASA | 9,475 | 141,664 | |
| Telstra Corp., Ltd. | 89,735 | 330,473 | |
| TELUS Corp. | 6,732 | 214,347 | |
| Verizon Communications, Inc. | 10,071 | 537,590 | |
| 5,088,021 | |||
| Wireless Telecommunication Services 1.0% | |||
| KDDI Corp. | 11,000 | 278,489 | |
| Millicom International Cellular SA (SDR) | 2,271 | 97,057 | |
| NTT DoCoMo, Inc. | 14,969 | 341,244 | |
| Rogers Communications, Inc. "B" | 3,207 | 123,704 | |
| SoftBank Group Corp. | 1,900 | 126,386 | |
| StarHub Ltd. | 103,900 | 201,527 | |
Shares |
Value ($) | ||
| T-Mobile U.S., Inc.* | 3,200 | 184,032 | |
| Tele2 AB "B" | 17,137 | 137,595 | |
| Vodafone Group PLC | 127,480 | 314,493 | |
| 1,804,527 | |||
| Utilities 2.1% | |||
| Electric Utilities 1.3% | |||
| Alliant Energy Corp. | 1,634 | 61,912 | |
| American Electric Power Co., Inc. | 2,254 | 141,912 | |
| CLP Holdings Ltd. | 1,690 | 15,542 | |
| Duke Energy Corp. | 3,695 | 286,806 | |
| Edison International | 2,079 | 149,667 | |
| Endesa SA | 2,489 | 52,806 | |
| Entergy Corp. | 1,991 | 146,279 | |
| Eversource Energy | 2,723 | 150,391 | |
| Exelon Corp. | 6,600 | 234,234 | |
| FirstEnergy Corp. | 3,900 | 120,783 | |
| HK Electric Investments & HK Electric Investments Ltd. "SS", 144A (Units) | 89,000 | 73,446 | |
| NextEra Energy, Inc. | 900 | 107,514 | |
| PG&E Corp. | 2,325 | 141,290 | |
| Pinnacle West Capital Corp. | 960 | 74,909 | |
| Power Assets Holdings Ltd. | 3,243 | 28,586 | |
| PPL Corp. | 5,646 | 192,246 | |
| Southern Co. | 5,079 | 249,836 | |
| SSE PLC | 6,377 | 122,257 | |
| Xcel Energy, Inc. | 3,125 | 127,188 | |
| 2,477,604 | |||
| Independent Power & Renewable Electricity Producers 0.1% | |||
| Meridian Energy Ltd. | 59,474 | 107,446 | |
| Multi-Utilities 0.7% | |||
| Ameren Corp. | 1,301 | 68,250 | |
| CenterPoint Energy, Inc. | 1,689 | 41,617 | |
| CMS Energy Corp. | 2,461 | 102,427 | |
| Consolidated Edison, Inc. | 2,582 | 190,242 | |
| Dominion Resources, Inc. | 3,040 | 232,834 | |
| DTE Energy Co. | 927 | 91,319 | |
| DUET Group (Units) | 9,497 | 18,781 | |
| National Grid PLC | 9,911 | 116,309 | |
| Public Service Enterprise Group, Inc. | 2,784 | 122,162 | |
| SCANA Corp. | 1,930 | 141,430 | |
| Sempra Energy | 1,300 | 130,832 | |
| WEC Energy Group, Inc. | 1,671 | 98,004 | |
| 1,354,207 | |||
| Total Common Stocks (Cost $95,386,336) | 106,543,869 | ||
| Preferred Stock 0.2% | |||
| Consumer Discretionary | |||
| Bayerische Motoren Werke (BMW) AG | 3,157 | 241,945 | |
| Volkswagen AG | 984 | 138,220 | |
| Total Preferred Stock (Cost $374,243) | 380,165 | ||
| Rights 0.0% | |||
| Consumer Staples | |||
| Safeway Casa Ley, Expiration Date 1/30/2018* | 7,499 | 7,611 | |
| Safeway PDC LLC, Expiration Date 1/30/2017* | 7,499 | 366 | |
| Total Rights (Cost $7,977) | 7,977 | ||
Shares |
Value ($) | ||
| Warrant 0.0% | |||
| Materials | |||
| Hercules Trust II, Expiration Date 3/31/2029* (Cost $30,283) | 170 | 772 | |
| Principal Amount ($)(b) | Value ($) | |||
| Corporate Bonds 13.5% | ||||
| Consumer Discretionary 1.2% | ||||
| 21st Century Fox America, Inc., 144A, 3.375%, 11/15/2026 | 536,000 | 525,429 | ||
| Charter Communications Operating LLC: | ||||
| 3.579%, 7/23/2020 | 40,000 | 40,809 | ||
| 4.908%, 7/23/2025 | 30,000 | 31,618 | ||
| Churchill Downs, Inc., 5.375%, 12/15/2021 | 28,000 | 29,050 | ||
| Cox Communications, Inc., 144A, 3.35%, 9/15/2026 | 30,000 | 28,648 | ||
| CVS Health Corp., 5.125%, 7/20/2045 | 50,000 | 55,722 | ||
| Ford Motor Co., 5.291%, 12/8/2046 | 35,000 | 35,455 | ||
| Ford Motor Credit Co., LLC, 5.875%, 8/2/2021 | 750,000 | 828,276 | ||
| General Motors Co., 6.6%, 4/1/2036 | 30,000 | 34,290 | ||
| General Motors Financial Co., Inc.: | ||||
| 2.4%, 5/9/2019 | 55,000 | 54,854 | ||
| 3.2%, 7/13/2020 | 100,000 | 100,301 | ||
| 3.2%, 7/6/2021 | 60,000 | 59,500 | ||
| The Gap, Inc., 5.95%, 4/12/2021 (a) | 160,000 | 168,375 | ||
| Time Warner, Inc., 3.8%, 2/15/2027 | 110,000 | 109,375 | ||
| Walgreens Boots Alliance, Inc., 4.8%, 11/18/2044 | 40,000 | 41,112 | ||
| 2,142,814 | ||||
| Consumer Staples 0.5% | ||||
| Anheuser-Busch InBev Finance, Inc., 4.9%, 2/1/2046 | 70,000 | 75,661 | ||
| Kellogg Co., 2.65%, 12/1/2023 | 515,000 | 498,208 | ||
| Kraft Heinz Foods Co., 4.375%, 6/1/2046 | 35,000 | 32,934 | ||
| Minerva Luxembourg SA, 144A, 12.25%, 2/10/2022 | 250,000 | 268,750 | ||
| Molson Coors Brewing Co., 4.2%, 7/15/2046 | 40,000 | 37,293 | ||
| 912,846 | ||||
| Energy 4.1% | ||||
| Anadarko Petroleum Corp.: | ||||
| 4.85%, 3/15/2021 (a) | 15,000 | 16,083 | ||
| 5.55%, 3/15/2026 (a) | 50,000 | 55,963 | ||
| ConocoPhillips Co., 4.15%, 11/15/2034 | 35,000 | 34,210 | ||
| Delek & Avner Tamar Bond Ltd., 144A, 5.082%, 12/30/2023 | 350,000 | 358,750 | ||
| Empresa Nacional del Petroleo, 144A, 3.75%, 8/5/2026 | 400,000 | 373,936 | ||
| Enbridge, Inc., 5.5%, 12/1/2046 | 115,000 | 123,052 | ||
| Encana Corp., 5.15%, 11/15/2041 | 150,000 | 136,120 | ||
| Energy Transfer Partners LP, 5.95%, 10/1/2043 | 30,000 | 30,919 | ||
| Halliburton Co., 4.85%, 11/15/2035 | 45,000 | 47,458 | ||
| KazMunayGas National Co. JSC, 144A, 9.125%, 7/2/2018 | 800,000 | 869,280 | ||
| Principal Amount ($)(b) | Value ($) | |||
| Kinder Morgan Energy Partners LP: | ||||
| 4.7%, 11/1/2042 | 40,000 | 37,268 | ||
| 6.375%, 3/1/2041 | 10,000 | 10,848 | ||
| Lukoil International Finance BV, 144A, 6.656%, 6/7/2022 | 750,000 | 834,375 | ||
| Marathon Oil Corp., 5.2%, 6/1/2045 | 140,000 | 131,957 | ||
| Noble Holding International Ltd., 5.25%, 3/16/2018 | 10,000 | 9,975 | ||
| Pertamina Persero PT, 144A, 5.25%, 5/23/2021 | 800,000 | 841,828 | ||
| Petrobras Global Finance BV, 8.375%, 5/23/2021 | 1,600,000 | 1,724,000 | ||
| Petroleos Mexicanos: | ||||
| 144A, 4.625%, 9/21/2023 | 540,000 | 525,312 | ||
| 144A, 5.375%, 3/13/2022 | 171,000 | 175,101 | ||
| Plains All American Pipeline LP: | ||||
| 2.85%, 1/31/2023 | 55,000 | 51,994 | ||
| 4.3%, 1/31/2043 | 15,000 | 12,428 | ||
| 4.5%, 12/15/2026 | 490,000 | 497,078 | ||
| Regency Energy Partners LP, 4.5%, 11/1/2023 | 40,000 | 40,589 | ||
| Reliance Industries Ltd., 144A, 4.125%, 1/28/2025 | 500,000 | 498,332 | ||
| Shell International Finance BV, 4.0%, 5/10/2046 | 40,000 | 38,250 | ||
| Sunoco Logistics Partners Operations LP, 5.3%, 4/1/2044 | 40,000 | 38,620 | ||
| Valero Energy Corp., 3.4%, 9/15/2026 | 105,000 | 100,591 | ||
| Valero Energy Partners LP, 4.375%, 12/15/2026 | 35,000 | 35,314 | ||
| 7,649,631 | ||||
| Financials 3.6% | ||||
| Akbank TAS, 144A, 5.0%, 10/24/2022 | 750,000 | 712,500 | ||
| Apollo Investment Corp., 5.25%, 3/3/2025 | 60,000 | 58,390 | ||
| Ares Capital Corp., 3.625%, 1/19/2022 | 60,000 | 58,166 | ||
| Bank of America Corp.: | ||||
| 3.5%, 4/19/2026 | 50,000 | 49,334 | ||
| 3.875%, 8/1/2025 | 750,000 | 762,623 | ||
| Barclays Bank PLC, 144A, 6.05%, 12/4/2017 | 220,000 | 227,279 | ||
| BBVA Bancomer SA, 144A, 6.008%, 5/17/2022 | 500,000 | 500,000 | ||
| Blackstone Holdings Finance Co., LLC, 144A, 5.0%, 6/15/2044 | 20,000 | 19,728 | ||
| Branch Banking & Trust Co., 1.45%, 5/10/2019 | 50,000 | 49,443 | ||
| Citigroup, Inc., 3.3%, 4/27/2025 | 750,000 | 734,792 | ||
| Corp. Financiera de Desarrollo SA, 144A, 4.75%, 2/8/2022 | 250,000 | 261,250 | ||
| Credito Real SAB de CV SOFOM ER, 144A, 7.25%, 7/20/2023 | 250,000 | 255,000 | ||
| Everest Reinsurance Holdings, Inc., 4.868%, 6/1/2044 | 50,000 | 48,495 | ||
| FS Investment Corp., 4.75%, 5/15/2022 | 70,000 | 69,800 | ||
| HSBC Holdings PLC: | ||||
| 4.375%, 11/23/2026 | 200,000 | 201,485 | ||
| 6.375%, 12/29/2049 (a) | 200,000 | 199,000 | ||
| JPMorgan Chase & Co., 2.95%, 10/1/2026 | 190,000 | 181,353 | ||
| KKR Group Finance Co. III LLC, 144A, 5.125%, 6/1/2044 | 30,000 | 28,325 | ||
| Principal Amount ($)(b) | Value ($) | |||
| Legg Mason, Inc., 5.625%, 1/15/2044 | 50,000 | 48,690 | ||
| Loews Corp., 4.125%, 5/15/2043 | 40,000 | 38,375 | ||
| Manulife Financial Corp., 5.375%, 3/4/2046 | 55,000 | 62,746 | ||
| Massachusetts Mutual Life Insurance Co., 144A, 4.5%, 4/15/2065 | 10,000 | 9,172 | ||
| Morgan Stanley: | ||||
| 3.125%, 7/27/2026 | 50,000 | 47,769 | ||
| 6.25%, 8/9/2026 | 600,000 | 717,037 | ||
| Nationwide Financial Services, Inc., 144A, 5.3%, 11/18/2044 | 40,000 | 41,654 | ||
| Societe Generale SA, 144A, 2.625%, 9/16/2020 | 100,000 | 100,051 | ||
| Standard Chartered PLC, 144A, 4.05%, 4/12/2026 | 200,000 | 198,288 | ||
| Swiss Re Treasury U.S. Corp., 144A, 4.25%, 12/6/2042 | 30,000 | 29,297 | ||
| The Goldman Sachs Group, Inc.: | ||||
| 2.64%**, 10/28/2027 | 750,000 | 764,546 | ||
| 3.5%, 11/16/2026 | 20,000 | 19,540 | ||
| 3.75%, 2/25/2026 | 50,000 | 50,147 | ||
| Voya Financial, Inc., 4.8%, 6/15/2046 | 45,000 | 43,742 | ||
| Wells Fargo & Co., 3.0%, 10/23/2026 | 80,000 | 76,192 | ||
| 6,664,209 | ||||
| Health Care 0.5% | ||||
| Abbott Laboratories: | ||||
| 2.9%, 11/30/2021 | 170,000 | 169,515 | ||
| 4.9%, 11/30/2046 | 175,000 | 179,609 | ||
| AbbVie, Inc., 4.7%, 5/14/2045 | 60,000 | 58,868 | ||
| Actavis Funding SCS, 4.75%, 3/15/2045 | 25,000 | 24,543 | ||
| Aetna, Inc., 4.375%, 6/15/2046 | 40,000 | 40,166 | ||
| Celgene Corp., 5.0%, 8/15/2045 | 30,000 | 31,192 | ||
| Gilead Sciences, Inc., 4.15%, 3/1/2047 | 40,000 | 37,992 | ||
| Mylan NV, 144A, 5.25%, 6/15/2046 | 55,000 | 50,726 | ||
| Pfizer, Inc.: | ||||
| 4.0%, 12/15/2036 | 40,000 | 40,982 | ||
| 4.125%, 12/15/2046 | 20,000 | 20,345 | ||
| Shire Acquisitions Investments Ireland DAC, 3.2%, 9/23/2026 | 110,000 | 102,777 | ||
| Stryker Corp., 4.625%, 3/15/2046 | 40,000 | 40,787 | ||
| UnitedHealth Group, Inc.: | ||||
| 3.45%, 1/15/2027 | 50,000 | 50,792 | ||
| 4.2%, 1/15/2047 | 80,000 | 80,920 | ||
| 929,214 | ||||
| Industrials 0.1% | ||||
| CSX Corp., 4.25%, 11/1/2066 | 25,000 | 22,815 | ||
| FedEx Corp., 4.55%, 4/1/2046 | 30,000 | 30,231 | ||
| Molex Electronic Technologies LLC, 144A, 3.9%, 4/15/2025 | 30,000 | 29,511 | ||
| Roper Technologies, Inc., 3.8%, 12/15/2026 | 55,000 | 55,424 | ||
| Transurban Finance Co. Pty Ltd., 144A, 3.375%, 3/22/2027 | 40,000 | 37,795 | ||
| 175,776 | ||||
| Principal Amount ($)(b) | Value ($) | |||
| Information Technology 0.2% | ||||
| Activision Blizzard, Inc., 144A, 3.4%, 9/15/2026 | 50,000 | 47,456 | ||
| Diamond 1 Finance Corp.: | ||||
| 144A, 4.42%, 6/15/2021 | 200,000 | 206,949 | ||
| 144A, 8.1%, 7/15/2036 | 30,000 | 35,688 | ||
| NVIDIA Corp.: | ||||
| 2.2%, 9/16/2021 | 40,000 | 39,044 | ||
| 3.2%, 9/16/2026 | 40,000 | 38,458 | ||
| Seagate HDD Cayman, 5.75%, 12/1/2034 | 50,000 | 42,625 | ||
| 410,220 | ||||
| Materials 2.0% | ||||
| CF Industries, Inc.: | ||||
| 144A, 3.4%, 12/1/2021 | 180,000 | 178,108 | ||
| 144A, 4.5%, 12/1/2026 | 20,000 | 19,658 | ||
| Equate Petrochemical BV, 144A, 4.25%, 11/3/2026 | 690,000 | 658,453 | ||
| Glencore Funding LLC, 144A, 4.625%, 4/29/2024 | 20,000 | 20,450 | ||
| GTL Trade Finance, Inc., 144A, 5.893%, 4/29/2024 (a) | 570,000 | 567,150 | ||
| Potash Corp. of Saskatchewan, Inc., 4.0%, 12/15/2026 | 85,000 | 85,538 | ||
| St. Marys Cement, Inc., 144A, 5.75%, 1/28/2027 | 805,000 | 772,800 | ||
| UPL Corp., Ltd., 144A, 3.25%, 10/13/2021 | 600,000 | 583,883 | ||
| Vale Overseas Ltd., 5.875%, 6/10/2021 | 800,000 | 838,000 | ||
| 3,724,040 | ||||
| Real Estate 0.5% | ||||
| CBL & Associates LP: | ||||
| (REIT), 4.6%, 10/15/2024 | 50,000 | 46,867 | ||
| (REIT), 5.25%, 12/1/2023 | 70,000 | 68,829 | ||
| (REIT), 5.95%, 12/15/2026 | 120,000 | 120,793 | ||
| Hospitality Properties Trust, (REIT), 5.0%, 8/15/2022 | 220,000 | 232,256 | ||
| Omega Healthcare Investors, Inc., (REIT), 4.95%, 4/1/2024 | 60,000 | 60,797 | ||
| Select Income REIT, (REIT), 4.15%, 2/1/2022 | 60,000 | 59,416 | ||
| Trust F/1401, 144A, (REIT), 5.25%, 1/30/2026 | 355,000 | 339,912 | ||
| 928,870 | ||||
| Telecommunication Services 0.6% | ||||
| AT&T, Inc., 4.5%, 5/15/2035 | 80,000 | 77,293 | ||
| Bharti Airtel International Netherlands BV, 144A, 5.35%, 5/20/2024 | 1,000,000 | 1,047,435 | ||
| Verizon Communications, Inc., 4.672%, 3/15/2055 | 60,000 | 56,347 | ||
| 1,181,075 | ||||
| Utilities 0.2% | ||||
| Adani Transmission Ltd., 144A, 4.0%, 8/3/2026 | 200,000 | 188,855 | ||
| Electricite de France SA, 144A, 4.75%, 10/13/2035 | 95,000 | 95,313 | ||
| Southern Power Co., Series F, 4.95%, 12/15/2046 | 29,000 | 28,259 | ||
| 312,427 | ||||
| Total Corporate Bonds (Cost $25,361,513) | 25,031,122 | |||
| Principal Amount ($)(b) | Value ($) | |||
| Asset-Backed 0.3% | ||||
| Miscellaneous | ||||
| Hilton Grand Vacations Trust, "B", Series 2014-AA, 144A, 2.07%, 11/25/2026 | 232,725 | 229,785 | ||
| PennyMac LLC, "A1", Series 2015-NPL1, 144A, 4.0%, 3/25/2055 | 271,641 | 273,222 | ||
| Total Asset-Backed (Cost $504,086) | 503,007 | |||
| Mortgage-Backed Securities Pass-Throughs 0.7% | ||||
| Federal Home Loan Mortgage Corp., 6.0%, 3/1/2038 | 5,656 | 6,403 | ||
| Federal National Mortgage Association: | ||||
| 3.5%, 3/1/2046 | 1,316,611 | 1,340,530 | ||
| 4.5%, 9/1/2035 | 14,282 | 15,435 | ||
| 6.0%, 1/1/2024 | 17,533 | 19,835 | ||
| 6.5%, 5/1/2017 | 893 | 896 | ||
| Total Mortgage-Backed Securities Pass-Throughs (Cost $1,401,908) | 1,383,099 | |||
| Commercial Mortgage-Backed Securities 1.0% | ||||
| Credit Suisse First Boston Mortgage Securities Corp., "G", Series 2005-C6, 144A, 5.191%**, 12/15/2040 | 250,000 | 249,687 | ||
| CSAIL Commercial Mortgage Trust, "A4", Series 2015-C4, 3.808%, 11/15/2048 | 300,000 | 312,387 | ||
| FHLMC Multifamily Structured Pass-Through Certificates, "X1", Series K043, Interest Only, 0.548%***, 12/25/2024 | 4,975,774 | 182,684 | ||
| GMAC Commercial Mortgage Securities, Inc., "G", Series 2004-C1, 144A, 5.455%, 3/10/2038 | 502,681 | 494,094 | ||
| JPMBB Commercial Mortgage Securities Trust: | ||||
| "A4", Series 2015-C28, 3.227%, 10/15/2048 | 450,000 | 452,522 | ||
| "A3", Series 2014-C19, 3.669%, 4/15/2047 | 125,000 | 130,023 | ||
| Total Commercial Mortgage-Backed Securities (Cost $1,827,152) | 1,821,397 | |||
| Collateralized Mortgage Obligations 1.2% | ||||
| Fannie Mae Connecticut Avenue Securities, "1M1", Series 2016-C02, 2.734%**, 9/25/2028 | 596,332 | 602,533 | ||
| Federal Home Loan Mortgage Corp.: | ||||
| "HI", Series 3979, Interest Only, 3.0%, 12/15/2026 | 348,679 | 30,064 | ||
| "IK", Series 4048, Interest Only, 3.0%, 5/15/2027 | 467,735 | 43,234 | ||
| "LI", Series 3720, Interest Only, 4.5%, 9/15/2025 | 680,909 | 78,269 | ||
| "PI", Series 3843, Interest Only, 4.5%, 5/15/2038 | 343,018 | 31,488 | ||
| "C31", Series 303, Interest Only, 4.5%, 12/15/2042 | 1,483,032 | 294,944 | ||
| "H", Series 2278, 6.5%, 1/15/2031 | 127 | 132 | ||
| Principal Amount ($)(b) | Value ($) | |||
| Federal National Mortgage Association: | ||||
| "WO", Series 2013-27, Principal Only, Zero Coupon, 12/25/2042 | 220,000 | 127,593 | ||
| "4", Series 406, Interest Only, 4.0%, 9/25/2040 | 125,927 | 24,894 | ||
| "I", Series 2003-84, Interest Only, 6.0%, 9/25/2033 | 147,143 | 27,160 | ||
| Government National Mortgage Association: | ||||
| "QI", Series 2011-112, Interest Only, 4.0%, 5/16/2026 | 273,215 | 26,635 | ||
| "PI", Series 2015-40, Interest Only, 4.0%, 4/20/2044 | 369,117 | 55,490 | ||
| "NI", Series 2011-80, Interest Only, 4.5%, 5/16/2038 | 183,917 | 2,573 | ||
| "BI", Series 2010-30, Interest Only, 4.5%, 7/20/2039 | 55,462 | 6,729 | ||
| "ND", Series 2010-130, 4.5%, 8/16/2039 | 600,000 | 635,931 | ||
| "PI", Series 2014-108, Interest Only, 4.5%, 12/20/2039 | 92,303 | 15,395 | ||
| "IP", Series 2014-11, Interest Only, 4.5%, 1/20/2043 | 252,844 | 41,293 | ||
| "IQ", Series 2011-18, Interest Only, 5.5%, 1/16/2039 | 119,250 | 12,653 | ||
| "IV", Series 2009-69, Interest Only, 5.5%, 8/20/2039 | 263,212 | 52,110 | ||
| "IN", Series 2009-69, Interest Only, 5.5%, 8/20/2039 | 273,554 | 49,052 | ||
| "AI", Series 2007-38, Interest Only, 5.753%***, 6/16/2037 | 50,144 | 7,255 | ||
| "IJ", Series 2009-75, Interest Only, 6.0%, 8/16/2039 | 209,804 | 36,123 | ||
| Total Collateralized Mortgage Obligations (Cost $1,980,041) | 2,201,550 | |||
| Government & Agency Obligations 13.0% | ||||
| Other Government Related (c) 1.4% | ||||
| Novatek OAO, 144A, 4.422%, 12/13/2022 | 216,000 | 213,132 | ||
| Novolipetsk Steel, 144A, 4.5%, 6/15/2023 | 800,000 | 795,533 | ||
| Perusahaan Penerbit SBSN, 144A, 4.325%, 5/28/2025 | 200,000 | 199,240 | ||
| Rosneft Oil Co., 144A, 4.199%, 3/6/2022 | 750,000 | 739,417 | ||
| Vnesheconombank, 144A, 6.902%, 7/9/2020 | 500,000 | 540,150 | ||
| 2,487,472 | ||||
| Sovereign Bonds 2.8% | ||||
| Dominican Republic, 144A, 6.875%, 1/29/2026 | 100,000 | 103,957 | ||
| Export-Import Bank of India, 144A, 3.375%, 8/5/2026 | 1,000,000 | 933,271 | ||
| Government of Indonesia, Series FR56, 8.375%, 9/15/2026 | IDR | 1,340,000,000 | 102,147 | |
| Mexican Udibonos, Series S, 2.0%, 6/9/2022 | MXN | 8,363,295 | 389,589 | |
| Republic of Angola, 144A, 9.5%, 11/12/2025 | 450,000 | 434,376 | ||
| Republic of Hungary, Series 19/A, 6.5%, 6/24/2019 | HUF | 16,900,000 | 65,567 | |
| Republic of Namibia, 144A, 5.25%, 10/29/2025 | 250,000 | 244,775 | ||
| Principal Amount ($)(b) | Value ($) | |||
| Republic of Panama, 3.875%, 3/17/2028 | 200,000 | 195,500 | ||
| Republic of Portugal, 144A, 5.125%, 10/15/2024 | 400,000 | 387,000 | ||
| Republic of Sri Lanka, 144A, 5.125%, 4/11/2019 | 200,000 | 202,063 | ||
| United Mexican States, Series M, 5.75%, 3/5/2026 | MXN | 51,025,200 | 2,184,024 | |
| 5,242,269 | ||||
| U.S. Government Sponsored Agency 0.4% | ||||
| Tennessee Valley Authority, 4.25%, 9/15/2065 | 778,000 | 800,888 | ||
| U.S. Treasury Obligations 8.0% | ||||
| U.S. Treasury Bonds: | ||||
| 2.25%, 8/15/2046 | 30,000 | 25,225 | ||
| 3.625%, 2/15/2044 | 170,000 | 188,428 | ||
| 5.375%, 2/15/2031 | 571,000 | 760,501 | ||
| U.S. Treasury Notes: | ||||
| 0.75%, 10/31/2017 (e) (f) | 2,556,000 | 2,553,705 | ||
| 0.75%, 4/30/2018 (e) | 6,000,000 | 5,980,314 | ||
| 0.75%, 7/15/2019 | 60,000 | 59,128 | ||
| 1.25%, 1/31/2020 | 180,000 | 178,678 | ||
| 1.625%, 2/15/2026 | 4,875,000 | 4,555,078 | ||
| 1.625%, 5/15/2026 | 375,000 | 349,687 | ||
| 14,650,744 | ||||
| Total Government & Agency Obligations (Cost $23,554,845) | 23,181,373 | |||
| Short-Term U.S Treasury Obligations 0.4% | ||||
| U.S. Treasury Bills: | ||||
| 0.4%****, 2/9/2017 (d) | 658,000 | 657,697 | ||
| 0.56%****, 6/1/2017 (d) | 156,000 | 155,597 | ||
| Total Short-Term U.S. Treasury Obligations (Cost $813,348) | 813,294 | |||
| Municipal Bonds and Notes 0.1% | ||||
| Kentucky, Asset/Liability Commission, General Fund Revenue, 3.165%, 4/1/2018 (Cost $142,644) | 142,644 | 144,179 | ||
| Principal Amount ($)(b) | Value ($) | |||
| Convertible Bond 0.1% | ||||
| Materials | ||||
| GEO Specialty Chemicals, Inc., 144A, 7.5%, 10/30/2018 (PIK) (Cost $227,653) | 230,026 | 235,294 | ||
Shares |
Value ($) | |||
| Exchange-Traded Funds 9.9% | ||||
| iShares iBoxx $ High Yield Corporate Bond ETF | 60,000 | 5,193,000 | ||
| SPDR Bloomberg Barclays High Yield Bond ETF (a) | 235,800 | 8,594,910 | ||
| VanEck Vectors JPMorgan EM Local Currency Bond ETF | 253,324 | 4,458,501 | ||
| Total Exchange-Traded Funds (Cost $17,700,207) | 18,246,411 | |||
| Securities Lending Collateral 5.0% | ||||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.42% (g) (h) (Cost $9,315,773) | 9,315,773 | 9,315,773 | ||
| Cash Equivalents 1.4% | ||||
| Deutsche Central Cash Management Government Fund, 0.49% (g) (Cost $2,593,226) | 2,593,226 | 2,593,226 | ||
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $181,221,235)† | 104.0 | 192,402,508 |
| Other Assets and Liabilities, Net | (4.0) | (7,382,463) |
| Net Assets | 100.0 | 185,020,045 |
* Non-income producing security.
** Floating rate securities' yields vary with a designated market index or market rate, such as the coupon-equivalent of the U.S. Treasury Bill rate. These securities are shown at their current rate as of December 31, 2016.
*** These securities are shown at their current rate as of December 31, 2016.
**** Annualized yield at time of purchase; not a coupon rate.
† The cost for federal income tax purposes was $181,705,030. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $10,697,478. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $15,920,452 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $5,222,974.
(a) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $9,099,320, which is 4.9% of net assets.
(b) Principal amount stated in U.S. dollars unless otherwise noted.
(c) Government-backed debt issued by financial companies or government sponsored enterprises.
(d) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open futures contracts.
(e) At December 31, 2016, this security has been pledged, in whole or in part, as collateral for open over-the-counter derivatives.
(f) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open centrally cleared swap contracts.
(g) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(h) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
144A: Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration, normally to qualified institutional buyers.
EM: Emerging Markets
Interest Only: Interest Only (IO) bonds represent the "interest only" portion of payments on a pool of underlying mortgages or mortgage-backed securities. IO securities are subject to prepayment risk of the pool of underlying mortgages.
JSC: Joint Stock Company
PIK: Denotes that all or a portion of the income is paid in-kind in the form of additional principal.
Principal Only: Principal Only (PO) bonds represent the "principal only" portion of payments on a pool of underlying mortgages or mortgage-backed securities.
REIT: Real Estate Investment Trust
RSP: Risparmio (Convertible Savings Shares)
SBSN: Surat Berharga Syariah Negara (Islamic Based Government Securities)
SDR: Swedish Depositary Receipt
SPDR: Standard & Poor's Depositary Receipt
At December 31, 2016, open futures contracts purchased were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Appreciation/ (Depreciation) ($) |
| 3 Month Euro Euribor Interest Rate Futures | EUR | 12/18/2017 | 10 | 2,638,600 | 116 |
| 3 Month Euro Swiss Franc (Euroswiss) Interest Rate Futures | CHF | 12/18/2017 | 11 | 2,720,294 | (1,906) |
| 3 Month Euroyen Futures | JPY | 12/18/2017 | 12 | 2,565,305 | (162) |
| 90 Day Eurodollar | USD | 12/18/2017 | 11 | 2,708,200 | (3,606) |
| 90 Day Sterling Interest Rate Futures | GBP | 12/20/2017 | 17 | 2,606,541 | 1,536 |
| ASX 90 Day Bank Accepted Bills | AUD | 12/7/2017 | 15 | 10,771,368 | (2,937) |
| S&P 500 E-Mini Index | USD | 3/17/2017 | 35 | 3,913,350 | (55,542) |
| Ultra Long U.S. Treasury Bond | USD | 3/22/2017 | 73 | 11,698,250 | (212,309) |
| Total net unrealized depreciation | (274,810) | ||||
At December 31, 2016, open futures contracts sold were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Appreciation ($) |
| 10 Year U.S. Treasury Note | USD | 3/22/2017 | 23 | 2,858,469 | 19,717 |
| U.S. Treasury Long Bond | USD | 3/22/2017 | 16 | 2,410,500 | 33,465 |
| Ultra 10 Year U.S. Treasury Note | USD | 3/22/2017 | 5 | 670,313 | 6,357 |
| Total unrealized appreciation | 59,539 | ||||
At December 31, 2016, open credit default swap contracts sold were as follows:
| Centrally Cleared Swaps | |||||
| Expiration Date | Notional Amount ($) (i) | Fixed Cash Flows Received | Underlying Reference Obligation | Value ($) | Unrealized Appreciation ($) |
| 6/20/2021 | 7,700,000 | 5.0% | Markit CDX North America High Yield Index | 551,832 | 246,366 |
(i) The maximum potential amount of future undiscounted payments that the Fund could be required to make under a credit default swap contract would be the notional amount of the contract. These potential amounts would be partially offset by any recovery values of the referenced debt obligation or net amounts received from the settlement of buy protection credit default swap contracts entered into by the Fund for the same referenced debt obligation, if any.
At December 31, 2016, open interest rate swap contracts were as follows:
| Centrally Cleared Swaps | |||||
| Effective/ Expiration Dates |
Notional Amount ($) | Cash Flows Paid by the Fund |
Cash Flows Received by the Fund |
Value ($) | Unrealized Appreciation/ (Depreciation) ($) |
| 12/16/2015 9/16/2020 |
17,900,000 | Floating — 3-Month LIBOR | Fixed — 2.214% | 375,371 | 381,561 |
| 12/16/2015 9/17/2035 |
400,000 | Fixed — 2.938% | Floating — 3-Month LIBOR | (25,723) | (18,146) |
| 12/4/2015 12/4/2045 |
4,900,000 | Fixed — 2.615% | Floating — 3-Month LIBOR | (55,899) | 46,607 |
| 5/9/2016 5/9/2026 |
2,100,000 | Fixed — 2.48% | Floating — 3-Month LIBOR | (40,132) | (18,089) |
| 7/13/2016 7/13/2046 |
3,400,000 | Fixed — 2.22% | Floating — 3-Month LIBOR | 230,200 | 293,122 |
| 12/21/2016 12/21/2046 |
2,940,000 | Fixed — 2.25% | Floating — 3-Month LIBOR | 234,561 | 514,387 |
| Total net unrealized appreciation | 1,199,442 | ||||
LIBOR: London Interbank Offered Rate; 3-Month LIBOR rate at December 31, 2016 is 1.00%.
As of December 31, 2016, the Fund had the following open forward foreign currency exchange contracts:
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Appreciation ($) | Counterparty | |||||
| EUR | 9,370,000 | USD | 10,501,081 | 1/11/2017 | 632,593 | Societe Generale | |||
| JPY | 1,196,000,000 | USD | 11,547,302 | 1/11/2017 | 1,308,808 | Morgan Stanley | |||
| USD | 1,614,528 | ZAR | 23,000,000 | 1/17/2017 | 56,252 | Goldman Sachs & Co. | |||
| CAD | 3,745,200 | USD | 2,799,775 | 1/25/2017 | 9,589 | Barclays Bank PLC | |||
| MXN | 22,200,000 | USD | 1,186,341 | 1/26/2017 | 118,745 | Barclays Bank PLC | |||
| MXN | 22,200,000 | USD | 1,091,258 | 2/14/2017 | 26,333 | Barclays Bank PLC | |||
| JPY | 1,061,000,000 | USD | 9,716,340 | 2/17/2017 | 617,958 | Goldman Sachs & Co. | |||
| USD | 739,667 | MXN | 15,470,000 | 2/21/2017 | 1,786 | JPMorgan Chase Securities, Inc. | |||
| MXN | 46,418,196 | USD | 2,252,137 | 2/21/2017 | 27,384 | JPMorgan Chase Securities, Inc. | |||
| KRW | 4,300,000,000 | USD | 3,668,472 | 3/2/2017 | 108,028 | Australia & New Zealand Banking Group Ltd. | |||
| JPY | 409,128,200 | USD | 3,572,917 | 3/2/2017 | 62,696 | Morgan Stanley | |||
| USD | 5,506,778 | EUR | 5,250,000 | 3/20/2017 | 40,570 | Barclays Bank PLC | |||
| USD | 2,025,092 | GBP | 1,640,000 | 4/4/2017 | 718 | Barclays Bank PLC | |||
| Total unrealized appreciation | 3,011,460 | ||||||||
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Depreciation ($) | Counterparty | |||||
| USD | 5,019,409 | EUR | 4,686,000 | 1/11/2017 | (84,112) | Goldman Sachs & Co. | |||
| USD | 5,006,142 | EUR | 4,684,000 | 1/11/2017 | (72,951) | Toronto-Dominion Bank | |||
| USD | 11,221,682 | JPY | 1,196,000,000 | 1/11/2017 | (983,188) | State Street Bank & Trust Co. | |||
| ZAR | 23,000,000 | USD | 1,578,489 | 1/17/2017 | (92,291) | Citigroup, Inc. | |||
| USD | 2,792,718 | CAD | 3,745,172 | 1/25/2017 | (2,553) | Toronto-Dominion Bank | |||
| USD | 1,156,967 | MXN | 22,200,000 | 1/26/2017 | (89,371) | Citigroup, Inc. | |||
| USD | 1,110,469 | MXN | 22,200,000 | 2/14/2017 | (45,544) | Citigroup, Inc. | |||
| USD | 4,688,075 | JPY | 530,390,000 | 2/17/2017 | (139,827) | JPMorgan Chase Securities, Inc. | |||
| USD | 4,551,846 | JPY | 530,610,000 | 2/17/2017 | (1,712) | Goldman Sachs & Co. | |||
| MXN | 8,060,000 | USD | 385,445 | 2/28/2017 | (527) | Toronto-Dominion Bank | |||
| USD | 3,641,085 | JPY | 409,128,200 | 3/2/2017 | (130,864) | Goldman Sachs & Co. | |||
| KRW | 14,492,000 | USD | 11,976 | 3/2/2017 | (428) | Australia & New Zealand Banking Group Ltd. | |||
| USD | 3,692,966 | KRW | 4,314,492,000 | 3/2/2017 | (120,094) | Barclays Bank PLC | |||
| EUR | 5,250,000 | USD | 5,489,857 | 3/20/2017 | (57,490) | Bank of America | |||
| Total unrealized depreciation | (1,820,952) | ||||||||
| Currency Abbreviations |
|
AUD Australian Dollar CAD Canadian Dollar CHF Swiss Franc EUR Euro GBP British Pound HUF Hungarian Forint IDR Indonesian Rupiah JPY Japanese Yen KRW South Korean Won MXN Mexican Peso USD United States Dollar ZAR South African Rand |
For information on the Fund's policy and additional disclosures regarding futures contracts, credit default swaps, interest rate swap contracts and forward foreign currency exchange contracts, please refer to Note B in the accompanying Notes to Financial Statements.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Common Stocks | |||||
| Consumer Discretionary | $ 8,442,266 | $ 5,369,479 | $ — | $ 13,811,745 | |
| Consumer Staples | 6,515,909 | 2,397,577 | — | 8,913,486 | |
| Energy | 5,673,284 | 3,262,464 | — | 8,935,748 | |
| Financials | 9,173,263 | 10,207,204 | — | 19,380,467 | |
| Health Care | 6,070,969 | 2,863,886 | — | 8,934,855 | |
| Industrials | 7,443,956 | 5,194,416 | — | 12,638,372 | |
| Information Technology | 13,696,896 | 3,523,745 | — | 17,220,641 | |
| Materials | 1,429,121 | 989,258 | 7,588 | 2,425,967 | |
| Real Estate | 2,562,592 | 888,191 | — | 3,450,783 | |
| Telecommunication Services | 1,888,475 | 5,004,073 | — | 6,892,548 | |
| Utilities | 3,404,084 | 535,173 | — | 3,939,257 | |
| Preferred Stock | — | 380,165 | — | 380,165 | |
| Rights | — | — | 7,977 | 7,977 | |
| Warrants | — | — | 772 | 772 | |
| Fixed Income Investments (j) | |||||
| Corporate Bonds | — | 25,031,122 | — | 25,031,122 | |
| Asset-Backed | — | 503,007 | — | 503,007 | |
| Mortgage-Backed Securities Pass-Throughs | — | 1,383,099 | — | 1,383,099 | |
| Commercial Mortgage-Backed Securities | — | 1,821,397 | — | 1,821,397 | |
| Collateralized Mortgage Obligations | — | 2,201,550 | — | 2,201,550 | |
| Government & Agency Obligations | — | 23,181,373 | — | 23,181,373 | |
| Short-Term U.S. Treasury Obligations | — | 813,294 | — | 813,294 | |
| Municipal Bonds and Notes | — | 144,179 | — | 144,179 | |
| Convertible Bond | — | — | 235,294 | 235,294 | |
| Exchange-Traded Funds | 18,246,411 | — | — | 18,246,411 | |
| Short-Term Investments (j) | 11,908,999 | — | — | 11,908,999 | |
| Derivatives (k) | |||||
| Futures Contracts | 61,191 | — | — | 61,191 | |
| Credit Default Swap Contracts | — | 246,366 | — | 246,366 | |
| Interest Rate Swap Contracts | — | 1,235,677 | — | 1,235,677 | |
| Forward Foreign Currency Exchange Contracts | — | 3,011,460 | — | 3,011,460 | |
| Total | $96,517,416 | $100,188,155 | $ 251,631 | $196,957,202 | |
| Liabilities | Level 1 | Level 2 | Level 3 | Total | |
| Derivatives (k) | |||||
| Futures Contracts | $ (276,462) | $ — | $ — | $ (276,462) | |
| Interest Rate Swap Contracts | — | (36,235) | — | (36,235) | |
| Forward Foreign Currency Exchange Contracts | — | (1,820,952) | — | (1,820,952) | |
| Total | $ (276,462) | $ (1,857,187) | $ — | $ (2,133,649) | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(j) See Investment Portfolio for additional detailed categorizations.
(k) Derivatives include value of unrealized appreciation (depreciation) on open futures contracts, credit default swap contracts, interest rate swap contracts and forward foreign currency exchange contracts.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $169,312,236) — including $9,099,320 of securities loaned |
$180,493,509 |
| Investment in Government & Agency Securities Portfolio (cost $9,315,773)* | 9,315,773 |
| Investments in Deutsche Central Cash Management Government Fund (cost $2,593,226) | 2,593,226 |
| Total investments in securities, at value (cost $181,221,235) | 192,402,508 |
| Foreign currency, at value (cost $621,227) | 619,456 |
| Deposit from broker on bilateral swap contracts | 2,110,000 |
| Receivable for investments sold | 760 |
| Receivable for Fund shares sold | 178,819 |
| Dividends receivable | 236,575 |
| Interest receivable | 526,677 |
| Receivable for variation margin on futures contracts | 37,581 |
| Unrealized appreciation on forward foreign currency exchange contracts | 3,011,460 |
| Foreign taxes recoverable | 77,658 |
| Other assets | 8,654 |
| Total assets | 199,210,148 |
| Liabilities | |
| Cash overdraft | 181,684 |
| Payable upon return of securities loaned | 9,315,773 |
| Payable for investments purchased | 388,488 |
| Payable for Fund shares redeemed | 14,509 |
| Payable for variation margin on centrally cleared swaps | 116,501 |
| Payable upon return of deposit for bilateral swap contracts | 2,110,000 |
| Unrealized depreciation on forward foreign currency exchange contracts | 1,820,952 |
| Accrued management fee | 58,130 |
| Accrued Trustees' fees | 2,860 |
| Other accrued expenses and payables | 181,206 |
| Total liabilities | 14,190,103 |
| Net assets, at value | $185,020,045 |
| Net Assets Consist of | |
| Undistributed net investment income | 4,038,796 |
|
Net unrealized appreciation (depreciation) on: Investments |
11,181,273 |
| Swap contracts | 1,445,808 |
| Futures | (215,271) |
| Foreign currency | 1,181,058 |
| Accumulated net realized gain (loss) | (6,246,463) |
| Paid-in capital | 173,634,844 |
| Net assets, at value | $185,020,045 |
|
Class A Net Asset Value, offering and redemption price per share ($185,020,045 ÷ 7,873,905 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 23.50 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $176,266) |
$ 4,532,750 |
| Interest (net of foreign taxes withheld of $606) | 1,456,701 |
| Income distributions — Deutsche Central Cash Management Government Fund | 39,912 |
| Securities lending income, net of borrower rebates | 60,245 |
| Other income | 143,738 |
| Total income | 6,233,346 |
|
Expenses: Management fee |
702,468 |
| Administration fee | 189,856 |
| Services to shareholders | 1,443 |
| Custodian fee | 50,480 |
| Professional fees | 98,128 |
| Reports to shareholders | 59,668 |
| Trustees' fees and expenses | 9,416 |
| Other | 63,140 |
| Total expenses | 1,174,599 |
| Net investment income | 5,058,747 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
3,615 |
| Swap contracts | 45,729 |
| Futures | (438,677) |
| Written options | 3,245 |
| Foreign currency | 186,043 |
| (200,045) | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
6,028,993 |
| Swap contracts | 965,618 |
| Futures | (278,669) |
| Written options | (102,473) |
| Foreign currency | 726,030 |
| 7,339,499 | |
| Net gain (loss) | 7,139,454 |
| Net increase (decrease) in net assets resulting from operations | $ 12,198,201 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 5,058,747 | $ 6,650,199 |
| Net realized gain (loss) | (200,045) | (5,329,330) |
| Change in net unrealized appreciation (depreciation) | 7,339,499 | (4,092,770) |
| Net increase (decrease) in net assets resulting from operations | 12,198,201 | (2,771,901) |
|
Distributions to shareholders from: Net investment income: Class A |
(7,851,269) | (7,355,308) |
| Net realized gains: Class A | — | (6,214,133) |
| Total distributions | (7,851,269) | (13,569,441) |
|
Fund share transactions: Class A Proceeds from shares sold |
3,626,943 | 5,276,855 |
| Shares issued to shareholders in reinvestment of distributions | 7,851,269 | 13,569,441 |
| Payments for shares redeemed | (32,401,979) | (48,078,303) |
| Net increase (decrease) in net assets from Class A share transactions | (20,923,767) | (29,232,007) |
| Increase (decrease) in net assets | (16,576,835) | (45,573,349) |
| Net assets at beginning of period | 201,596,880 | 247,170,229 |
| Net assets at end of period (including undistributed net investment income of $4,038,796 and $7,214,311, respectively) | $185,020,045 | $201,596,880 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
8,792,358 | 10,040,081 |
| Shares sold | 157,470 | 219,508 |
| Shares issued to shareholders in reinvestment of distributions | 348,017 | 562,580 |
| Shares redeemed | (1,423,940) | (2,029,811) |
| Net increase (decrease) in Class A shares | (918,453) | (1,247,723) |
| Shares outstanding at end of period | 7,873,905 | 8,792,358 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 22.93 | $ 24.62 | $ 27.30 | $ 23.90 | $ 21.49 | |
|
Income (loss) from investment operations: Net investment incomea |
.61 | .68 | .72 | .78 | .57 | |
| Net realized and unrealized gain (loss) | .91 | (.97) | .25 | 3.14 | 2.20 | |
| Total from investment operations | 1.52 | (.29) | .97 | 3.92 | 2.77 | |
|
Less distributions from: Net investment income |
(.95) | (.76) | (.85) | (.52) | (.36) | |
| Net realized gains | — | (.64) | (2.80) | — | — | |
| Total distributions | (.95) | (1.40) | (3.65) | (.52) | (.36) | |
| Net asset value, end of period | $ 23.50 | $ 22.93 | $ 24.62 | $ 27.30 | $ 23.90 | |
| Total Return (%) | 6.81 | (1.44)b | 3.83 | 16.63 | 12.98 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 185 | 202 | 247 | 269 | 260 | |
| Ratio of expenses before expense reductions (%) | .62 | .60 | .62 | .60 | .59 | |
| Ratio of expenses after expense reductions (%) | .62 | .58 | .62 | .60 | .59 | |
| Ratio of net investment income (loss) (%) | 2.66 | 2.85 | 2.83 | 3.07 | 2.48 | |
| Portfolio turnover rate (%) | 135 | 92 | 88 | 182 | 188 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Global Income Builder VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities and Exchange-Traded Funds ("ETFs") are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Equity securities or ETFs for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities and ETFs are generally categorized as Level 1. For certain international equity securities, in order to adjust for events which may occur between the close of the foreign exchanges and the close of the New York Stock Exchange, a fair valuation model may be used. This fair valuation model takes into account comparisons to the valuation of American Depository Receipts (ADRs), exchange-traded funds, futures contracts and certain indices and these securities are categorized as Level 2.
Debt securities are valued at prices supplied by independent pricing services approved by the Fund's Board. Such services may use various pricing techniques which take into account appropriate factors such as yield, quality, coupon rate, maturity, type of issue, trading characteristics, prepayment speeds and other data, as well as broker quotes. If the pricing services are unable to provide valuations, debt securities are valued at the average of the most recent reliable bid quotations or evaluated prices, as applicable, obtained from broker-dealers. These securities are generally categorized as Level 2.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Futures contracts are generally valued at the settlement prices established each day on the exchange on which they are traded and are categorized as Level 1.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and are categorized as Level 2.
Swap contracts are valued daily based upon prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer. Swap contracts are generally categorized as Level 2.
Exchange-traded options are valued at the last sale price or, in the absence of a sale, the mean between the closing bid and asked prices or at the most recent asked price (bid for purchased options) if no bid or asked price are available. Exchange-traded options are categorized as Level 1. Over-the-counter written or purchased options are valued at prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer with which the option was traded. Over-the-counter written or purchased options are generally categorized as Level 2.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as common stocks, corporate bonds and exchange-traded funds in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end.
| Remaining Contractual Maturity of the Agreements As of December 31, 2016 | |||||
| Overnight and Continuous | <30 days | Between 30 & 90 days | >90 days | Total | |
| Securities Lending Transactions | |||||
| Common Stocks | $ 281,865 | $ — | $ — | $ — | $ 281,865 |
| Corporate Bonds | 995,395 | — | — | — | 995,395 |
| Exchange-Traded Fund | 8,038,513 | — | — | — | 8,038,513 |
| Total Borrowings | $9,315,773 | $ — | $ — | $ — | $9,315,773 |
| Gross amount of recognized liabilities for securities lending transactions | $9,315,773 | ||||
When-Issued/Delayed Delivery Securities. The Fund may purchase or sell securities with delivery or payment to occur at a later date beyond the normal settlement period. At the time the Fund enters into a commitment to purchase or sell a security, the transaction is recorded and the value of the transaction is reflected in the net asset value. The price of such security and the date when the security will be delivered and paid for are fixed at the time the transaction is negotiated. The value of the security may vary with market fluctuations. At the time the Fund enters into a purchase transaction it is required to segregate cash or other liquid assets at least equal to the amount of the commitment.
Additionally, the Fund may be required to post securities and/or cash collateral in accordance with the terms of the commitment.
Certain risks may arise upon entering into when-issued or delayed delivery transactions from the potential inability of counterparties to meet the terms of their contracts or if the issuer does not issue the securities due to political, economic or other factors. Additionally, losses may arise due to changes in the value of the underlying securities.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
At December 31, 2016, the Fund had $6,015,000 of tax basis capital loss carryforwards, which may be applied against realized net taxable capital gains indefinitely, including short-term losses ($3,135,000) and long-term losses ($2,880,000).
Additionally, the Fund may be subject to taxes imposed by the governments of countries in which it invests and are generally based on income and/or capital gains earned or repatriated, a portion of which may be recoverable based upon the current interpretation of the tax rules and regulations. Estimated tax liabilities and recoveries on certain foreign securities are recorded on an accrual basis and are reflected as components of interest income or net change in unrealized gain/loss on investments. Tax liabilities realized as a result of security sales are reflected as a component of net realized gain/loss on investments.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in foreign denominated investments, forward currency contracts, futures contracts, swap contracts and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 5,621,922 |
| Capital loss carryforwards | $ (6,015,000) |
| Unrealized appreciation (depreciation) on investments | $ 10,697,478 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 7,851,269 | $ 11,705,848 |
| Distributions from long-term capital gains | $ — | $ 1,863,593 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Certain dividends from foreign securities may be recorded subsequent to the ex-dividend date as soon as the Fund is informed of such dividends. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments. All discounts and premiums are accreted/amortized for both tax and financial reporting purposes, with the exception of securities in default of principal.
B. Derivative Instruments
Swaps. A swap is a contract between two parties to exchange future cash flows at periodic intervals based on the notional amount of the swap. A bilateral swap is a transaction between the fund and a counterparty where cash flows are exchanged between the two parties. A centrally cleared swap is a transaction executed between the fund and a counterparty, then cleared by a clearing member through a central clearinghouse. The central clearinghouse serves as the counterparty, with whom the fund exchanges cash flows.
The value of a swap is adjusted daily, and the change in value, if any, is recorded as unrealized appreciation or depreciation in the Statement of Assets and Liabilities. Gains or losses are realized when the swap expires or is closed. Certain risks may arise when entering into swap transactions including counterparty default; liquidity; or unfavorable changes in interest rates or the value of the underlying reference security, commodity or index. In connection with bilateral swaps, securities and/or cash may be identified as collateral in accordance with the terms of the swap agreement to provide assets of value and recourse in the event of default. The maximum counterparty credit risk is the net present value of the cash flows to be received from or paid to the counterparty over the term of the swap, to the extent that this amount is beneficial to the Fund, in addition to any related collateral posted to the counterparty by the Fund. This risk may be partially reduced by a master netting arrangement between the Fund and the counterparty. Upon entering into a centrally cleared swap, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the notional amount of the swap. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value of the swap. In a cleared swap transaction, counterparty risk is minimized as the central clearinghouse acts as the counterparty.
An upfront payment, if any, made by the Fund is recorded as an asset in the Statement of Assets and Liabilities. An upfront payment, if any, received by the Fund is recorded as a liability in the Statement of Assets and Liabilities. Payments received or made at the end of the measurement period are recorded as realized gain or loss in the Statement of Operations.
Interest Rate Swaps. Interest rate swaps are agreements in which the Fund agrees to pay to the counterparty a fixed rate payment in exchange for the counterparty agreeing to pay to the Fund a variable rate payment, or the Fund agrees to receive from the counterparty a fixed rate payment in exchange for the counterparty agreeing to receive from the Fund a variable rate payment. The payment obligations are based on the notional amount of the swap. For the year ended December 31, 2016, the Fund entered into interest rate swap agreements to gain exposure to different parts of the yield curve while managing overall duration.
A summary of the open interest rate swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in interest rate swap contracts had a total notional amount generally indicative of a range from $23,200,000 to $31,640,000.
Credit Default Swaps. Credit default swaps are agreements between a buyer and a seller of protection against predefined credit events for the reference entity. The Fund may enter into credit default swaps to gain exposure to an underlying issuer's credit quality characteristics without directly investing in that issuer or to hedge against the risk of a credit event on debt securities. As a seller of a credit default swap, the Fund is required to pay the par (or other agreed-upon) value of the referenced entity to the counterparty with the occurrence of a credit event by a third party, such as a U.S. or foreign corporate issuer, on the reference entity, which would likely result in a loss to the Fund. In return, the Fund receives from the counterparty a periodic stream of payments over the term of the swap provided that no credit event has occurred. If no credit event occurs, the Fund keeps the stream of payments with no payment obligations. The Fund may also buy credit default swaps, in which case the Fund functions as the counterparty referenced above. This involves the risk that the swap may expire worthless. It also involves counterparty risk that the seller may fail to satisfy its payment obligations to the Fund with the occurrence of a credit event. When the Fund sells a credit default swap, it will cover its commitment. This may be achieved by, among other methods, maintaining cash or liquid assets equal to the aggregate notional value of the reference entities for all outstanding credit default swaps sold by the Fund. For the year ended December 31, 2016, the Fund entered into credit default swap agreements to gain exposure to the underlying issuer's credit quality characteristics or to hedge the risk of default or other specified credit events on portfolio assets.
Under the terms of a credit default swap, the Fund receives or makes periodic payments based on a specified interest rate on a fixed notional amount. These payments are recorded as a realized gain or loss in the Statement of Operations. Payments received or made as a result of a credit event or termination of the swap are recognized, net of a proportional amount of the upfront payment, as realized gains or losses in the Statement of Operations.
A summary of the open credit default swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in credit default swap contracts purchased had a total notional value generally indicative of a range from $0 to approximately $16,300,000, and the investment on the credit default swap contracts sold had a total notional value of generally indicative of a range from $0 to approximately $7,700,000.
Futures Contracts. A futures contract is an agreement between a buyer or seller and an established futures exchange or its clearinghouse in which the buyer or seller agrees to take or make a delivery of a specific amount of a financial instrument at a specified price on a specific date (settlement date). For the year ended December 31, 2016, the Fund entered into interest rate futures to gain exposure to different parts of the yield curve while managing overall duration. The Fund also entered into interest rate futures contracts for non-hedging purposes to seek to enhance potential gains and entered into equity index futures as a means of gaining exposure to the equity asset class without investing directly into such asset class.
Upon entering into a futures contract, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the face value indicated in the futures contract. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value and are recorded for financial reporting purposes as unrealized gains or losses by the Fund. Gains or losses are realized when the contract expires or is closed. Since all futures contracts are exchange-traded, counterparty risk is minimized as the exchange's clearinghouse acts as the counterparty, and guarantees the futures against default.
Certain risks may arise upon entering into futures contracts, including the risk that an illiquid market will limit the Fund's ability to close out a futures contract prior to the settlement date and the risk that the futures contract is not well correlated with the security, index or currency to which it relates. Risk of loss may exceed amounts disclosed in the Statement of Assets and Liabilities.
A summary of the open futures contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in futures contracts purchased had a total notional value generally indicative of a range from approximately $14,228,000 to $39,622,000, and the investment in futures contracts sold had a total notional value generally indicative of a range from $0 to approximately $20,120,000.
Options. An option contract is a contract in which the writer (seller) of the option grants the buyer of the option, upon payment of a premium, the right to purchase from (call option), or sell to (put option), the writer a designated instrument at a specified price within a specified period of time. The Fund may write or purchase interest rate swaption agreements which are options to enter into a pre-defined swap agreement. The interest rate swaption agreement will specify whether the buyer of the swaption will be a fixed-rate receiver or a fixed-rate payer upon exercise. Certain options, including options on indices and interest rate options, will require cash settlement by the Fund if exercised. For the year ended December 31, 2016, the Fund entered into options on interest rate swaps in order to hedge against potential adverse interest rate movements of portfolio assets.
If the Fund writes a covered call option, the Fund foregoes, in exchange for the premium, the opportunity to profit during the option period from an increase in the market value of the underlying security above the exercise price. If the Fund writes a put option it accepts the risk of a decline in the value of the underlying security below the exercise price. Over-the-counter options have the risk of the potential inability of counterparties to meet the terms of their contracts. For exchange traded contracts, the counterparty risk is minimized as the exchange's clearinghouse acts as the counterparty, and guarantees the futures against default. The Fund's maximum exposure to purchased options is limited to the premium initially paid. In addition, certain risks may arise upon entering into option contracts including the risk that an illiquid secondary market will limit the Fund's ability to close out an option contract prior to the expiration date and that a change in the value of the option contract may not correlate exactly with changes in the value of the securities or currencies hedged.
There were no open written or purchased option contracts as of December 31, 2016. For the year ended December 31, 2016, the investment in written option contracts had a total value generally indicative of a range from $0 to $19,400,000.
Forward Foreign Currency Exchange Contracts. A forward foreign currency exchange contract ("forward currency contract") is a commitment to purchase or sell a foreign currency at the settlement date at a negotiated rate. For the year ended December 31, 2016, the Fund entered into forward currency contracts in order to hedge its exposure to changes in foreign currency exchange rates on its foreign currency denominated portfolio holdings, to facilitate transactions in foreign currency denominated securities and for non-hedging purposes to seek to enhance potential gains.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and unrealized gain (loss) is recorded daily. On the settlement date of the forward currency contract, the Fund records a realized gain or loss equal to the difference between the value of the contract at the time it was opened and the value of the contract at the time it was closed. Certain risks may arise upon entering into forward currency contracts from the potential inability of counterparties to meet the terms of their contracts. The maximum counterparty credit risk to the Fund is measured by the unrealized gain on appreciated contracts. Additionally, when utilizing forward currency contracts to hedge, the Fund gives up the opportunity to profit from favorable exchange rate movements during the term of the contract.
A summary of the open forward currency contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in forward currency contracts short vs. U.S. dollars had a total contract value generally indicative of a range from approximately $5,584,000 to $101,877,000, and the investment in forward currency contracts long vs. U.S. dollars had a total contract value generally indicative of a range from approximately $1,067,000 to $99,446,000. The investment in forward currency contracts long vs. other foreign currencies sold had a total contract value generally indicative of a range from $0 to approximately $1,251,000.
The following tables summarize the value of the Fund's derivative instruments held as of December 31, 2016 and the related location in the accompanying Statement of Assets and Liabilities, presented by primary underlying risk exposure:
| Asset Derivatives | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) | $ — | $ 1,235,677 | $ 61,191 | $ 1,296,868 |
| Credit Contracts (a) | — | 246,366 | — | 246,366 |
| Foreign Exchange Contracts (b) | 3,011,460 | — | — | 3,011,460 |
| $ 3,011,460 | $ 1,482,043 | $ 61,191 | $ 4,554,694 | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Includes cumulative appreciation of futures and centrally cleared swap contracts as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (b) Unrealized appreciation on forward foreign currency exchange contracts | ||||
| Liability Derivatives | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Equity Contracts (a) | $ — | $ — | $ (55,542) | $ (55,542) |
| Interest Rate Contracts (a) | — | (36,235) | (220,920) | (257,155) |
| Foreign Exchange Contracts (b) | (1,820,952) | — | — | (1,820,952) |
| $(1,820,952) | $ (36,235) | $ (276,462) | $(2,133,649) | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Includes cumulative depreciation of futures and centrally cleared swap contracts as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (b) Unrealized depreciation on forward foreign currency exchange contracts | ||||
Additionally, the amount of unrealized and realized gains and losses on derivative instruments recognized in Fund earnings during the year ended December 31, 2016 and the related location in the accompanying Statement of Operations is summarized in the following tables by primary underlying risk exposure:
| Realized Gain (Loss) | Written Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) | $ 3,245 | $ — | $ (147,880) | $ (438,677) | $ (583,312) |
| Credit Contracts (a) | — | — | 193,609 | — | 193,609 |
| Foreign Exchange Contracts (b) | — | 198,087 | — | — | 198,087 |
| $ 3,245 | $ 198,087 | $ 45,729 | $ (438,677) | $ (191,616) | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Net realized gain (loss) from written options, swap contracts and futures, respectively (b) Net realized gain (loss) from foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | |||||
| Change in Net Unrealized Appreciation (Depreciation) | Written Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Equity Contracts (a) | $ — | $ — | $ — | $ (55,542) | $ (55,542) |
| Interest Rate Contracts (a) | (102,473) | — | 361,028 | (223,127) | 35,428 |
| Credit Contracts (a) | — | — | 604,590 | — | 604,590 |
| Foreign Exchange Contracts (b) | — | 725,458 | — | — | 725,458 |
| $ (102,473) | $ 725,458 | $ 965,618 | $ (278,669) | $ 1,309,934 | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Change in net unrealized appreciation (depreciation) on written options, swap contracts and futures, respectively (b) Change in net unrealized appreciation (depreciation) on foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | |||||
As of December 31, 2016, the Fund has transactions subject to enforceable master netting agreements. A reconciliation of the gross amounts on the Statement of Assets and Liabilities to the net amounts by counterparty, including any collateral exposure, is included in the following tables:
| Counterparty | Gross Amounts of Assets Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Cash Collateral Received (a) |
Non-Cash Collateral Received | Net Amount of Derivative Assets |
| Australia & New Zealand Banking Group Ltd. | $ 108,028 | $ (428) | $ — | $ — | $ 107,600 |
| Barclays Bank PLC | 195,955 | (120,094) | — | — | 75,861 |
| Goldman Sachs & Co. | 674,210 | (216,688) | — | — | 457,522 |
| JPMorgan Chase Securities, Inc. | 29,170 | (29,170) | — | — | — |
| Morgan Stanley | 1,371,504 | — | (1,371,504) | — | — |
| Societe Generale | 632,593 | — | (550,000) | — | 82,593 |
| $ 3,011,460 | $ (366,380) | $ (1,921,504) | $ — | $ 723,576 | |
| Counterparty | Gross Amounts of Liabilities Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Cash Collateral Pledged |
Non-Cash Collateral Pledged (a) | Net Amount of Derivative Liabilities |
| Australia & New Zealand Banking Group Ltd. | $ 428 | $ (428) | $ — | $ — | $ — |
| Bank of America | 57,490 | — | — | (36,879) | 20,611 |
| Barclays Bank PLC | 120,094 | (120,094) | — | — | — |
| Citigroup, Inc | 227,206 | — | — | (135,878) | 91,328 |
| Goldman Sachs & Co. | 216,688 | (216,688) | — | — | — |
| JPMorgan Chase Securities, Inc. | 139,827 | (29,170) | — | — | 110,657 |
| State Street Bank & Trust Co. | 983,188 | — | — | (983,188) | — |
| Toronto-Dominion Bank | 76,031 | — | — | — | 76,031 |
| $ 1,820,952 | $ (366,380) | $ — | $ (1,155,945) | $ 298,627 |
(a) The actual collateral pledged may be more than the amount shown.
C. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments and U.S. Treasury obligations) aggregated $208,353,997 and $236,259,650, respectively. Purchases and sales of U.S. Treasury obligations aggregated $33,400,444 and $20,452,114, respectively.
For the year ended December 31, 2016, transactions for written options on interest rate swap contracts were as follows:
| Contract Amount | Premium | |
| Outstanding, beginning of period | 19,400,000 | $ 236,825 |
| Options closed | (5,500,000) | (88,852) |
| Options exercised | (3,400,000) | (63,920) |
| Options expired | (10,500,000) | (84,053) |
| Outstanding, end of period | — | $ — |
D. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Under the Investment Management Agreement, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .370% |
| Next $750 million | .345% |
| Over $1 billion | .310% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.37% of the Fund's average daily net assets.
For the period from January 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A shares at 0.73%.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $189,856, of which $15,711 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC aggregated $405, of which $103 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $17,490, of which $8,025 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Securities Lending Agent Fees. Deutsche Bank AG serves as securities lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred securities lending agent fees to Deutsche Bank AG in the amount of $5,038.
E. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding shares of the Fund, each owning 49% and 20%.
F. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and the Shareholders of Deutsche Global Income Builder VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Global Income Builder VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards
of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement.
We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration
of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances,
but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting.
Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities
owned as of December 31, 2016, by correspondence with the custodian and brokers or by other appropriate auditing procedures where
replies from brokers were not received. We believe that our audits provide
a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Global Income Builder VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||
| Actual Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,034.80 | |
| Expenses Paid per $1,000* | $ 3.02 | |
| Hypothetical 5% Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,022.17 | |
| Expenses Paid per $1,000* | $ 3.00 | |
* Expenses are equal to the Fund's annualized expense ratio, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratio | Class A | |
| Deutsche Variable Series II — Deutsche Global Income Builder VIP | .59% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
For corporate shareholders, 17% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016 qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Global Income Builder VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 1st quartile of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has outperformed its benchmark in the three- and five-year periods and has underperformed its benchmark in the one-year period ended December 31, 2015.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were lower than the median (1st quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board noted that the expense limitation agreed to by DIMA was expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to a comparable Deutsche U.S. registered fund ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Fund. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
Notes
VS2GIB-2 (R-025825-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Government & Agency Securities VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 11 Statement of Assets and Liabilities 12 Statement of Operations 13 Statements of Changes in Net Assets 14 Financial Highlights 15 Notes to Financial Statements 23 Report of Independent Registered Public Accounting Firm 24 Information About Your Fund's Expenses 25 Tax Information 25 Proxy Voting 26 Advisory Agreement Board Considerations and Fee Evaluation 29 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Bond investments are subject to interest-rate, credit, liquidity and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. The "full faith and credit" guarantee of the US government applies to the timely repayment of interest, and does not eliminate market risk. Because of the rising US government debt burden, it is possible that the US government may not be able to meet its financial obligations or that securities issued by the US government may experience credit downgrades. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 0.74% and 1.09% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Government & Agency Securities VIP | ||
|
■ Deutsche Government & Agency Securities VIP — Class A ■ Bloomberg Barclays GNMA Index |
The Bloomberg Barclays GNMA Index is an unmanaged, market-value-weighted measure of all fixed-rate securities backed by mortgage pools of the Government National Mortgage Association. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Government & Agency Securities VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,115 | $10,648 | $10,626 | $14,629 |
| Average annual total return | 1.15% | 2.11% | 1.22% | 3.88% | |
| Bloomberg Barclays GNMA Index | Growth of $10,000 | $10,156 | $10,912 | $10,940 | $15,311 |
| Average annual total return | 1.56% | 2.95% | 1.81% | 4.35% | |
| Deutsche Government & Agency Securities VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class B | Growth of $10,000 | $10,079 | $10,539 | $10,450 | $14,129 |
| Average annual total return | 0.79% | 1.77% | 0.88% | 3.52% | |
| Bloomberg Barclays GNMA Index | Growth of $10,000 | $10,156 | $10,912 | $10,940 | $15,311 |
| Average annual total return | 1.56% | 2.95% | 1.81% | 4.35% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
Following the U.S. Federal Reserve Board’s (the Fed) 25-basis-point rate hike (one percent equals 100 basis points) in December of 2015, markets were expecting a series of additional, modest rate increases to be enacted at upcoming Fed meetings. However, this outlook was upended as 2016 opened with a resurgence of concerns around slowing growth in China and weakness in energy prices, sending interest rates and credit-based assets lower. Sentiment would rally from mid-February on, as investors were encouraged by the outlook for even more gradual Fed policy normalization and increased efforts by overseas central banks to stimulate growth, along with a rebound in oil prices off their January lows. In late June, markets were surprised by the results of a U.K. referendum which resulted in a vote to leave the European Union, leading to an investor flight to safety which pushed U.S. Treasury yields down to historical lows. However, credit-sensitive areas of the market would quickly resume their outperformance against a backdrop of supportive central banks and continued strength in commodity prices. Bond returns would turn negative in the wake of the November 8th U.S. elections, as interest rates moved up in anticipation of higher growth and inflation under unified Republican control of the government.
During the 12-month period ended December 31, 2016, the Fund provided a total return of 1.15% (Class A shares, unadjusted for contract charges) compared with the 1.56% return of its benchmark, the Bloomberg Barclays GNMA Index.1
Within the Fund’s core mortgage-backed securities (MBS) allocation, we have maintained a significant position in older-vintage, higher-coupon mortgage pools, with a focus on characteristics that suggest a muted outlook for prepayments in most environments. While lagging the broader MBS market for much of the period, these higher-coupon holdings ultimately benefited performance, as their shorter duration profile was preferred as interest rates spiked post-election. In order to balance the allocation to higher-coupon, lower-duration MBS, we maintained a long stance with respect to the Fund’s Treasury yield curve exposure, which acted as a constraint on returns as rates rose late in the period. The Fund had an allocation to higher-yielding, collateralized mortgage obligations (CMOs) structured to provide different risk/reward trade-offs in a shifting rate environment as compared to pass-through MBS. Security selection within this position benefited from exposure to interest-only and longer-duration instruments. The managers used derivatives as part of implementing the Fund’s positioning along the yield curve as well to hedge against certain risks, with a modest negative impact on performance. We remain constructive on the outlook for MBS relative to many other areas of the bond market, and are maintaining above-benchmark MBS exposure entering 2017. We continue to favor higher-coupon, shorter-duration MBS, and have an overall preference for pass-through securities over CMOs.
Gregory M. Staples, CFA
Scott Agi, CFA
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The Bloomberg Barclays GNMA Index is an unmanaged, market-value-weighted measure of all fixed-rate securities backed by mortgage pools of the Government National Mortgage Association. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Net Assets) | 12/31/16 | 12/31/15 |
| Mortgage-Backed Securities Pass-Throughs | 94% | 76% |
| Collateralized Mortgage Obligations | 16% | 22% |
| Government & Agency Obligations | 7% | 5% |
| Corporate Bond | 2% | — |
| Commercial Mortgage-Backed Securities | 1% | 2% |
| Cash Equivalents and Other Assets and Liabilities, net | –20% | –5% |
| 100% | 100% |
| Coupons* | 12/31/16 | 12/31/15 |
| Less than 3.5% | 27% | 9% |
| 3.5%–4.49% | 35% | 39% |
| 4.5%–5.49% | 20% | 32% |
| 5.5%–6.49% | 17% | 18% |
| 6.5%–7.49% | 1% | 2% |
| 7.5% and Greater | 0% | 0% |
| 100% | 100% |
| Interest Rate Sensitivity | 12/31/16 | 12/31/15 |
| Effective Maturity | 9.9 years | 6.9 years |
| Effective Duration | 4.2 years | 3.7 years |
* Excludes Cash Equivalents and U.S. Treasury Bills.
Effective maturity is the weighted average of the maturity date of bonds held by the Fund taking into consideration any available maturity shortening features.
Effective duration is an approximate measure of the Fund's sensitivity to interest rate changes taking into consideration any maturity shortening features.
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Principal Amount ($)(a) | Value ($) | |||
| Mortgage-Backed Securities Pass-Throughs 93.8% | ||||
| Federal Home Loan Mortgage Corp.: | ||||
| 3.0%, 7/1/2044 (b) | 6,200,000 | 6,156,441 | ||
| 3.5%, with various maturities from 2/1/2044 until 6/1/2046 (b) | 4,979,035 | 5,099,505 | ||
| Federal National Mortgage Association: | ||||
| 3.0%, 4/1/2044 (b) | 300,000 | 298,024 | ||
| 3.5%, 3/1/2045 | 1,698,814 | 1,750,081 | ||
| 4.0%, with various maturities from 3/1/2042 until 4/1/2046 (b) | 2,150,628 | 2,263,874 | ||
| Government National Mortgage Association: | ||||
| 3.0%, 11/1/2044 (b) | 5,300,000 | 5,366,353 | ||
| 3.5%, with various maturities from 4/15/2042 until 10/15/2046 (b) | 7,475,448 | 7,794,304 | ||
| 4.0%, with various maturities from 9/20/2040 until 6/20/2043 | 3,519,844 | 3,774,809 | ||
| 4.5%, with various maturities from 6/20/2033 until 10/15/2041 | 3,669,647 | 3,994,125 | ||
| 4.55%, 1/15/2041 | 225,334 | 244,510 | ||
| 4.625%, 5/15/2041 | 101,924 | 110,574 | ||
| 5.0%, with various maturities from 12/15/2032 until 4/15/2042 | 3,635,702 | 4,014,588 | ||
| 5.5%, with various maturities from 10/15/2032 until 7/20/2040 | 4,189,143 | 4,699,669 | ||
| 6.0%, with various maturities from 2/15/2034 until 2/15/2039 | 3,982,615 | 4,623,935 | ||
| 6.5%, with various maturities from 9/15/2036 until 2/15/2039 | 440,488 | 500,934 | ||
| 7.0%, with various maturities from 2/20/2027 until 11/15/2038 | 107,360 | 111,117 | ||
| 7.5%, 10/20/2031 | 4,159 | 4,760 | ||
| Total Mortgage-Backed Securities Pass-Throughs (Cost $50,113,940) | 50,807,603 | |||
| Collateralized Mortgage Obligations 15.7% | ||||
| Federal Home Loan Mortgage Corp.: | ||||
| "OA", Series 3179, Principal Only, Zero Coupon, 7/15/2036 | 104,427 | 93,641 | ||
| "YI", Series 3936, Interest Only, 3.0%, 6/15/2025 | 38,161 | 1,387 | ||
| "AI", Series 4016, Interest Only, 3.0%, 9/15/2025 | 601,009 | 35,424 | ||
| "WI", Series 3939, Interest Only, 3.0%, 10/15/2025 | 195,749 | 9,736 | ||
| "EI", Series 3953, Interest Only, 3.0%, 11/15/2025 | 289,999 | 16,200 | ||
| "IO", Series 3974, Interest Only, 3.0%, 12/15/2025 | 107,739 | 7,396 | ||
| "DI", Series 4010, Interest Only, 3.0%, 2/15/2027 | 87,490 | 7,418 | ||
| "IK", Series 4048, Interest Only, 3.0%, 5/15/2027 | 935,470 | 86,469 | ||
| "CZ", Series 4113, 3.0%, 9/15/2042 | 341,266 | 311,423 | ||
| Principal Amount ($)(a) | Value ($) | |||
| "PL", Series 4627, 3.0%, 10/15/2046 | 500,000 | 477,445 | ||
| "IK", Series 3754, Interest Only, 3.5%, 6/15/2025 | 446,273 | 26,457 | ||
| "22", Series 243, Interest Only, 3.852%*, 6/15/2021 | 63,080 | 1,380 | ||
| "PI", Series 3940, Interest Only, 4.0%, 2/15/2041 | 356,840 | 52,648 | ||
| "C1", Series 329, Interest Only, 4.0%, 12/15/2041 | 1,053,922 | 189,072 | ||
| "UA", Series 4298, 4.0%, 2/15/2054 | 164,595 | 165,824 | ||
| "C32", Series 303, Interest Only, 4.5%, 12/15/2042 | 1,086,946 | 229,588 | ||
| "C28", Series 303, Interest Only, 4.5%, 1/15/2043 | 1,311,361 | 278,087 | ||
| "MI", Series 3871, Interest Only, 6.0%, 4/15/2040 | 64,427 | 6,456 | ||
| "IJ", Series 4472, Interest Only, 6.0%, 11/15/2043 | 453,057 | 108,288 | ||
| "DS", Series 3199, Interest Only, 6.446%*, 8/15/2036 | 1,210,732 | 236,653 | ||
| "A", Series 172, Interest Only, 6.5%, 1/1/2024 | 10,166 | 1,572 | ||
| "C22", Series 324, Interest Only, 6.5%, 4/15/2039 | 605,485 | 149,735 | ||
| "S", Series 2416, Interest Only, 7.396%*, 2/15/2032 | 150,582 | 31,815 | ||
| "ST", Series 2411, Interest Only, 8.046%*, 6/15/2021 | 41,468 | 1,878 | ||
| "KS", Series 2064, Interest Only, 9.446%*, 5/15/2022 | 143,346 | 24,031 | ||
| Federal National Mortgage Association: | ||||
| "DI", Series 2011-136, Interest Only, 3.0%, 1/25/2026 | 94,427 | 5,729 | ||
| "IB", Series 2013-35, Interest Only, 3.0%, 4/25/2033 | 609,532 | 97,520 | ||
| "Z", Series 2013-44, 3.0%, 5/25/2043 | 99,822 | 92,661 | ||
| "HI", Series 2010-123, Interest Only, 3.5%, 3/25/2024 | 85,264 | 1,713 | ||
| "KI", Series 2011-72, Interest Only, 3.5%, 3/25/2025 | 246,671 | 3,915 | ||
| ''IO", Series 2012-146, Interest Only, 3.5%, 1/25/2043 | 1,323,029 | 256,077 | ||
| "4", Series 406, Interest Only, 4.0%, 9/25/2040 | 251,853 | 49,789 | ||
| "25", Series 351, Interest Only, 4.5%, 5/25/2019 | 41,089 | 1,465 | ||
| "21", Series 334, Interest Only, 5.0%, 3/25/2018 | 9,130 | 168 | ||
| "20", Series 334, Interest Only, 5.0%, 3/25/2018 | 14,483 | 262 | ||
| ''23", Series 339, Interest Only, 5.0%, 6/25/2018 | 20,462 | 400 | ||
| "26", Series 381, Interest Only, 5.0%, 12/25/2020 | 18,678 | 1,099 | ||
| "IO", Series 2016-26, Interest Only, 5.0%, 5/25/2046 | 1,189,891 | 236,425 | ||
| "PJ", Series 2004-46, Interest Only, 5.244%*, 3/25/2034 | 184,804 | 22,166 | ||
| "30", Series 381, Interest Only, 5.5%, 11/25/2019 | 90,203 | 4,869 | ||
| "PI", Series 2009-14, Interest Only, 5.5%, 3/25/2024 | 2,029,376 | 155,587 | ||
| Principal Amount ($)(a) | Value ($) | |||
| "UI", Series 2010-126, Interest only, 5.5%, 10/25/2040 | 489,379 | 102,852 | ||
| "IO", Series 2014-70, Interest Only, 5.5%, 10/25/2044 | 637,807 | 158,345 | ||
| "BI", Series 2015-97, Interest Only, 5.5%, 1/25/2046 | 534,507 | 119,769 | ||
| "WI", Series 2011-59, Interest Only, 6.0%, 5/25/2040 | 113,408 | 7,439 | ||
| "SJ", Series 2007-36, Interest Only, 6.014%*, 4/25/2037 | 92,379 | 13,788 | ||
| "101", Series 383, Interest Only, 6.5%, 9/25/2022 | 452,889 | 50,467 | ||
| "SA", Series G92-57, IOette, 78.551%*, 10/25/2022 | 17,633 | 27,102 | ||
| Government National Mortgage Association: | ||||
| "PB", Series 2012-90, 2.5%, 7/20/2042 | 515,988 | 454,279 | ||
| "JI", Series 2013-10, Interest Only, 3.5%, 1/20/2043 | 589,625 | 104,575 | ||
| "ID", Series 2013-70, Interest only, 3.5%, 5/20/2043 | 286,248 | 50,674 | ||
| "BI", Series 2014-22, Interest Only, 4.0%, 2/20/2029 | 572,305 | 58,863 | ||
| "IP", Series 2015-50, Interest Only, 4.0%, 9/20/2040 | 1,269,035 | 125,760 | ||
| "PI", Series 2015-40, Interest Only, 4.0%, 4/20/2044 | 369,117 | 55,490 | ||
| "LI", Series 2009-104, Interest Only, 4.5%, 12/16/2018 | 46,401 | 1,490 | ||
| "NI", Series 2010-44, Interest Only, 4.5%, 10/20/2037 | 99,092 | 2,595 | ||
| "CI", Series 2010-87, Interest Only, 4.5%, 11/20/2038 | 1,251,588 | 153,405 | ||
| "PI", Series 2014-108, Interest Only, 4.5%, 12/20/2039 | 285,327 | 47,588 | ||
| "MI", Series 2010-169, Interest Only, 4.5%, 8/20/2040 | 364,978 | 45,955 | ||
| "IP", Series 2014-115, Interest Only, 4.5%, 2/20/2044 | 195,534 | 35,218 | ||
| "GZ", Series 2005-24, 5.0%, 3/20/2035 | 602,092 | 678,852 | ||
| "ZA", Series 2005-75, 5.0%, 10/16/2035 | 677,344 | 761,290 | ||
| "MZ", Series 2009-98, 5.0%, 10/16/2039 | 1,215,396 | 1,410,770 | ||
| "BS", Series 2011-93, Interest Only, 5.393%*, 7/16/2041 | 740,865 | 123,467 | ||
| "AI", Series 2008-46, Interest Only, 5.5%, 5/16/2023 | 46,037 | 1,883 | ||
| "GI", Series 2003-19, Interest Only, 5.5%, 3/16/2033 | 414,961 | 80,029 | ||
| "IB", Series 2010-130, Interest Only, 5.5%, 2/20/2038 | 105,198 | 18,834 | ||
| "IA", Series 2012-64, Interest Only, 5.5%, 5/16/2042 | 245,425 | 55,999 | ||
| "SA", Series 2012-84, Interest Only, 5.561%*, 12/20/2038 | 708,320 | 64,865 | ||
| "QA", Series 2007-57, Interest Only, 5.761%*, 10/20/2037 | 159,230 | 27,688 | ||
| Principal Amount ($)(a) | Value ($) | |||
| "DI", Series 2009-10, Interest Only, 6.0%, 4/16/2038 | 170,217 | 28,278 | ||
| "IP", Series 2009-118, Interest Only, 6.5%, 12/16/2039 | 42,776 | 10,605 | ||
| "SK", Series 2003-11, Interest Only, 6.993%*, 2/16/2033 | 273,983 | 43,229 | ||
| "IC", Series 1997-4, Interest Only, 7.5%, 3/16/2027 | 327,656 | 74,384 | ||
| Total Collateralized Mortgage Obligations (Cost $7,701,470) | 8,475,695 | |||
| Commercial Mortgage-Backed Security 1.1% | ||||
| FHLMC Multifamily Structured Pass-Through Certificates, "A2", Series K050, 3.334%, 8/25/2025 (Cost $597,399) | 580,000 | 600,922 | ||
| Corporate Bond 1.8% | ||||
| Financials | ||||
| National Australia Bank Ltd., 144A, 2.4%, 12/7/2021 (Cost $997,710) | 1,000,000 | 994,654 | ||
| Government & Agency Obligations 6.0% | ||||
| Other Government Related (c) 1.2% | ||||
| Province of New Brunswick Canada, 3.8%, 8/14/2045 | CAD | 800,000 | 621,446 | |
| U.S. Government Sponsored Agency 1.1% | ||||
| Federal Home Loan Mortgage Corp., 6.25%, 7/15/2032 | 450,000 | 619,263 | ||
| U.S. Treasury Obligation 3.7% | ||||
| U.S. Treasury Note, 0.75%, 10/31/2017 (d) | 2,000,000 | 1,998,204 | ||
| Total Government & Agency Obligations (Cost $3,280,828) | 3,238,913 | |||
| Short-Term U.S. Treasury Obligation 1.6% | ||||
| U.S. Treasury Bill, 0.4%**, 2/9/2017 (e) (Cost $879,619) | 880,000 | 879,595 | ||
Shares |
Value ($) | ||
| Cash Equivalents 16.7% | |||
| Deutsche Central Cash Management Government Fund, 0.49% (f) (Cost $9,017,503) | 9,017,503 | 9,017,503 | |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $72,588,469)† | 136.7 | 74,014,885 |
| Other Assets and Liabilities, Net | (36.7) | (19,879,518) |
| Net Assets | 100.0 | 54,135,367 |
* These securities are shown at their current rate as of December 31, 2016.
** Annualized yield at time of purchase; not a coupon rate.
† The cost for federal income tax purposes was $72,588,469. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $1,426,416. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $2,103,989 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $677,573.
(a) Principal amount stated in U.S. dollars unless otherwise noted.
(b) When-issued or delayed delivery securities included.
(c) Government-backed debt issued by financial companies or government sponsored enterprises.
(d) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open centrally cleared swap contracts.
(e) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open futures contracts.
(f) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
144A: Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration, normally to qualified institutional buyers.
Interest Only: Interest Only (IO) bonds represent the "interest only" portion of payments on a pool of underlying mortgages or mortgage-backed securities. IO securities are subject to prepayment risk of the pool of underlying mortgages.
IOettes: These securities represent the right to receive interest payments on an underlying pool of mortgages with similar features as those associated with IO securities. Unlike IO's, a nominal amount of principal is assigned to an IOette which is small in relation to the interest flow that constitutes almost all of the IOette cash flow. The effective yield of this security is lower than the stated interest rate.
Principal Only: Principal Only (PO) bonds represent the "principal only" portion of payments on a pool of underlying mortgages or mortgage-backed securities.
Included in the portfolio are investments in mortgage- or asset-backed securities which are interests in separate pools of mortgages or assets. Effective maturities of these investments may be shorter than stated maturities due to prepayments. Some separate investments in the Federal Home Loan Mortgage Corp., Federal National Mortgage Association and Government National Mortgage Association issues which have similar coupon rates have been aggregated for presentation purposes in this investment portfolio.
At December 31, 2016, open futures contracts purchased were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Appreciation ($) |
| Ultra 10 Year U.S. Treasury Note | USD | 3/22/2017 | 13 | 1,742,813 | 23,235 |
At December 31, 2016, open futures contracts sold were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Appreciation/ (Depreciation) ($) |
| 10 Year U.S. Treasury Note | USD | 3/22/2017 | 6 | 745,688 | (591) |
| 2 Year U.S. Treasury Note | USD | 3/31/2017 | 22 | 4,767,125 | 3,394 |
| Federal Republic of Germany Euro-Bund | EUR | 3/8/2017 | 13 | 2,246,303 | (23,828) |
| U.S. Treasury Long Bond | USD | 3/22/2017 | 11 | 1,657,219 | 17,250 |
| Ultra Long U.S. Treasury Bond | USD | 3/22/2017 | 10 | 1,602,500 | (11,265) |
| Total net unrealized depreciation | (15,040) | ||||
At December 31, 2016, open interest rate swap contracts were as follows:
| Centrally Cleared Swaps | ||||||
| Effective/ Expiration Dates |
Notional Amount | Currency | Cash Flows Paid by the Fund | Cash Flows Received by the Fund | Value ($) | Unrealized Depreciation ($) |
| 9/16/2015 9/17/2017 |
7,500,000 | USD | Fixed — 1.0% | Floating — 3-Month LIBOR | (13,117) | (24,449) |
| 3/15/2017 3/15/2027 |
200,000 | USD | Fixed — 1.75% | Floating — 3-Month LIBOR | 11,022 | (533) |
| 3/15/2017 3/15/2047 |
300,000 | USD | Fixed — 2.25% | Floating — 3-Month LIBOR | 22,067 | (5,177) |
| 12/14/2016 12/14/2046 |
640,000 | CAD | Fixed — 2.386% | Floating — 3-Month CDOR | (4,994) | (4,994) |
| 6/15/2016 6/15/2026 |
1,000,000 | USD | Floating — 3-Month LIBOR | Fixed — 2.25% | (5,709) | (57,332) |
| Total unrealized depreciation | (92,485) | |||||
| Bilateral Swaps | |||||||
| Effective/Expiration Dates | Notional Amount | Currency | Cash Flows Paid by the Fund | Cash Flows Received by the Fund | Value ($) | Upfront Payments Paid/ (Received) ($) |
Unrealized Depreciation ($) |
| 12/23/2016 12/23/2026 |
13,500,0001 | SEK | Fixed — 1.173% | Floating — 3-Month STIBOR | (12,823) | — | (12,823) |
CDOR: Canadian Dollar Offered Rate; 3-Month CDOR rate at December 31, 2016 is 0.95%.
LIBOR: London Interbank Offered Rate; 3-Month LIBOR rate at December 31, 2016 is 1.00%.
STIBOR: Stockholm Interbank Offered Rates; 3-Month STIBOR rate at December 31, 2016 is –0.59%.
At December 31, 2016, open total return swap contracts were as follows:
| Bilateral Swaps | ||||||
| Expiration Date | Notional Amount ($) | Fixed Cash Flows Received | Pay/Receive Return of the Reference Index |
Value ($) | Upfront Payments Paid/(Received) ($) | Unrealized Depreciation ($) |
| 1/12/2041 | 481,4452 | 4.0% | Markit IOS INDEX FN30.400.10 | (152) | — | (152) |
| 1/12/2041 | 481,4453 | 4.0% | Markit IOS INDEX FN30.400.10 | (152) | — | (152) |
| Total unrealized depreciation | (304) | |||||
Counterparties:
1 Danske Bank AS
2 Credit Suisse
3 Goldman Sachs & Co.
As of December 31, 2016, the Fund had the following open forward foreign currency exchange contracts:
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Appreciation ($) | Counterparty | |||||
| EUR | 898,955 | USD | 967,842 | 2/17/2017 | 19,305 | Nomura International PLC | |||
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Depreciation ($) | Counterparty | |||||
| USD | 962,487 | EUR | 898,955 | 2/17/2017 | (13,950) | Barclays Bank PLC | |||
| CAD | 910,714 | USD | 678,079 | 2/17/2017 | (600) | Merrill Lynch & Co., Inc. | |||
| Total unrealized depreciation | (14,550) | ||||||||
| Currency Abbreviations |
|
CAD Canadian Dollar USD United States Dollar EUR Euro SEK Swedish Krona |
For information on the Fund's policy and additional disclosures regarding futures contracts, interest rate swap contracts, total return swap contracts and forward foreign currency exchange contracts, please refer to the Derivatives section of Note B in the accompanying Notes to Financial Statements.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Fixed-Income Investments (g) | |||||
| Mortgage-Backed Securities Pass-Throughs | $ — | $50,807,603 | $ — | $50,807,603 | |
| Collateralized Mortgage Obligations | — | 8,475,695 | — | 8,475,695 | |
| Commercial Mortgage-Backed Securities | — | 600,922 | — | 600,922 | |
| Corporate Bond | — | 994,654 | — | 994,654 | |
| Government & Agency Obligations | — | 3,238,913 | — | 3,238,913 | |
| Short-Term U.S. Treasury Obligations | — | 879,595 | — | 879,595 | |
| Short-Term Investments | 9,017,503 | — | — | 9,017,503 | |
| Derivatives (h) | |||||
| Futures Contracts | 43,879 | — | — | 43,879 | |
| Forward Foreign Currency Exchange Contracts | — | 19,305 | — | 19,305 | |
| Total | $9,061,382 | $65,016,687 | $ — | $74,078,069 | |
| Liabilities | Level 1 | Level 2 | Level 3 | Total | |
| Derivatives (h) | |||||
| Futures Contracts | $ (35,684) | $ — | $ — | $ (35,684) | |
| Interest Rate Swap Contracts | — | (105,308) | — | (105,308) | |
| Total Return Swap Contracts | — | (304) | — | (304) | |
| Forward Foreign Currency Exchange Contracts | — | (14,550) | — | (14,550) | |
| Total | $ (35,684) | $ (120,162) | $ — | $ (155,846) | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(g) See Investment Portfolio for additional detailed categorizations.
(h) Derivatives include unrealized appreciation (depreciation) on open futures contracts, interest rate swap contracts, total return swap contracts and forward foreign currency exchange contracts.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments Investments in non-affiliated securities, at value (cost $63,570,966) |
$ 64,997,382 |
| Investment in Deutsche Central Cash Management Government Fund (cost $9,017,503) | 9,017,503 |
| Total investments in securities, at value (cost $72,588,469) | 74,014,885 |
| Cash | 7,502 |
| Foreign currency, at value (cost $42,010) | 42,156 |
| Receivable for investments sold | 2,498 |
| Receivable for investments sold — when-issued/delayed delivery securities | 3,045,342 |
| Receivable for Fund shares sold | 3,035 |
| Interest receivable | 283,011 |
| Receivable for variation margin on centrally cleared swaps | 4,686 |
| Unrealized appreciation on forward foreign currency exchange contracts | 19,305 |
| Other assets | 1,748 |
| Total assets | 77,424,168 |
| Liabilities | |
| Payable for investments purchased — when-issued/delayed delivery securities | 23,041,258 |
| Payable for Fund shares redeemed | 49,857 |
| Payable for variation margin on futures contracts | 15,683 |
| Unrealized depreciation on bilateral swap contracts | 13,127 |
| Unrealized depreciation on forward foreign currency exchange contracts | 14,550 |
| Accrued management fee | 31,846 |
| Accrued Trustees' fees | 1,576 |
| Other accrued expenses and payables | 120,904 |
| Total liabilities | 23,288,801 |
| Net assets, at value | $ 54,135,367 |
| Net Assets Consist of | |
| Undistributed net investment income | 1,284,868 |
|
Unrealized appreciation (depreciation) on: Investments |
1,426,416 |
| Swap contracts | (105,612) |
| Futures | 8,195 |
| Foreign currency | 4,885 |
| Accumulated net realized gain (loss) | (850,765) |
| Paid-in capital | 52,367,380 |
| Net assets, at value | $ 54,135,367 |
|
Class A Net Asset Value, offering and redemption price per share ($51,740,865 ÷ 4,598,638 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 11.25 |
|
Class B Net Asset Value, offering and redemption price per share ($2,394,502 ÷ 213,112 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 11.24 |
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Interest (net of foreign taxes withheld of $71) |
$ 1,658,916 |
| Income distributions — Deutsche Central Cash Management Government Fund | 36,035 |
| Securities lending income, net of borrower rebates | 1,344 |
| Other income | 28,966 |
| Total income | 1,725,261 |
|
Expenses: Management fee |
276,720 |
| Administration fee | 61,493 |
| Services to shareholders | 1,339 |
| Record keeping fees (Class B) | 2,553 |
| Distribution service fees (Class B) | 6,570 |
| Custodian fee | 30,639 |
| Professional fees | 81,943 |
| Reports to shareholders | 25,338 |
| Trustees' fees and expenses | 4,519 |
| Other | 48,682 |
| Total expenses before expense reductions | 539,796 |
| Expense reductions | (173,536) |
| Total expenses after expense reductions | 366,260 |
| Net investment income | 1,359,001 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
693,234 |
| Swap contracts | (247,778) |
| Futures | (854,282) |
| Written options | 28,320 |
| Foreign currency | 584 |
| Payment by affiliate (see Note G) | 9,350 |
| (370,572) | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
(885,000) |
| Swap contracts | 637,779 |
| Futures | 100,175 |
| Written options | (28,320) |
| Foreign currency | 4,885 |
| (170,481) | |
| Net gain (loss) | (541,053) |
| Net increase (decrease) in net assets resulting from operations | $ 817,948 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 1,359,001 | $ 1,915,259 |
| Net realized gain (loss) | (370,572) | 360,503 |
| Change in net unrealized appreciation (depreciation) | (170,481) | (2,269,736) |
| Net increase (decrease) in net assets resulting from operations | 817,948 | 6,026 |
|
Distributions to shareholders from: Net investment income: Class A |
(1,846,498) | (2,287,159) |
| Class B | (72,152) | (68,234) |
| Total distributions | (1,918,650) | (2,355,393) |
|
Fund share transactions: Class A Proceeds from shares sold |
2,898,041 | 7,621,170 |
| Reinvestment of distributions | 1,846,498 | 2,287,159 |
| Payments for shares redeemed | (18,364,955) | (27,899,252) |
| Net increase (decrease) in net assets from Class A share transactions | (13,620,416) | (17,990,923) |
|
Class B Proceeds from shares sold |
226,087 | 247,684 |
| Reinvestment of distributions | 72,152 | 68,234 |
| Payments for shares redeemed | (503,123) | (610,489) |
| Net increase (decrease) in net assets from Class B share transactions | (204,884) | (294,571) |
| Increase (decrease) in net assets | (14,926,002) | (20,634,861) |
| Net assets at beginning of period | 69,061,369 | 89,696,230 |
| Net assets at end of period (including undistributed net investment income of $1,284,868 and $1,956,284, respectively) | $ 54,135,367 | $ 69,061,369 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
5,786,470 | 7,344,193 |
| Shares sold | 253,037 | 659,618 |
| Shares issued to shareholders in reinvestment of distributions | 163,697 | 199,403 |
| Shares redeemed | (1,604,566) | (2,416,744) |
| Net increase (decrease) in Class A shares | (1,187,832) | (1,557,723) |
| Shares outstanding at end of period | 4,598,638 | 5,786,470 |
|
Class B Shares outstanding at beginning of period |
231,100 | 256,223 |
| Shares sold | 19,740 | 21,476 |
| Shares issued to shareholders in reinvestment of distributions | 6,391 | 5,944 |
| Shares redeemed | (44,119) | (52,543) |
| Net increase (decrease) in Class B shares | (17,988) | (25,123) |
| Shares outstanding at end of period | 213,112 | 231,100 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 11.48 | $ 11.80 | $ 11.47 | $ 12.69 | $ 13.12 | |
|
Income (loss) from investment operations: Net investment incomea |
.25 | .27 | .29 | .24 | .34 | |
| Net realized and unrealized gain (loss) | (.13) | (.26) | .31 | (.59) | .03 | |
| Total from investment operations | .12 | .01 | .60 | (.35) | .37 | |
|
Less distributions from: Net investment income |
(.35) | (.33) | (.27) | (.37) | (.52) | |
| Net realized gains | — | — | — | (.50) | (.28) | |
| Total distributions | (.35) | (.33) | (.27) | (.87) | (.80) | |
| Net asset value, end of period | $ 11.25 | $ 11.48 | $ 11.80 | $ 11.47 | $ 12.69 | |
| Total Return (%)b | 1.06 | .06 | 5.29 | (3.04) | 2.93 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 52 | 66 | 87 | 96 | 121 | |
| Ratio of expenses before expense reductions (%) | .86 | .74 | .72 | .71 | .68 | |
| Ratio of expenses after expense reductions (%) | .58 | .68 | .70 | .67 | .66 | |
| Ratio of net investment income (%) | 2.22 | 2.33 | 2.49 | 2.05 | 2.65 | |
| Portfolio turnover rate (%) | 521 | 376 | 393 | 794 | 796 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 11.46 | $ 11.79 | $ 11.46 | $ 12.67 | $ 13.10 | |
|
Income (loss) from investment operations: Net investment incomea |
.21 | .23 | .25 | .20 | .29 | |
| Net realized and unrealized gain (loss) | (.12) | (.27) | .31 | (.59) | .03 | |
| Total from investment operations | .09 | (.04) | .56 | (.39) | .32 | |
|
Less distributions from: Net investment income |
(.31) | (.29) | (.23) | (.32) | (.47) | |
| Net realized gains | — | — | — | (.50) | (.28) | |
| Total distributions | (.31) | (.29) | (.23) | (.82) | (.75) | |
| Net asset value, end of period | $ 11.24 | $ 11.46 | $ 11.79 | $ 11.46 | $ 12.67 | |
| Total Return (%)b | .79 | (.36) | 4.95 | (3.25) | 2.48 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 2 | 3 | 3 | 4 | 5 | |
| Ratio of expenses before expense reductions (%) | 1.21 | 1.09 | 1.06 | 1.06 | 1.03 | |
| Ratio of expenses after expense reductions (%) | .93 | 1.03 | 1.03 | .99 | 1.01 | |
| Ratio of net investment income (%) | 1.88 | 1.99 | 2.16 | 1.71 | 2.29 | |
| Portfolio turnover rate (%) | 521 | 376 | 393 | 794 | 796 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Government & Agency Securities VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets of the Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee and recordkeeping fees). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Debt securities are valued at prices supplied by independent pricing services approved by the Fund's Board. Such services may use various pricing techniques which take into account appropriate factors such as yield, quality, coupon rate, maturity, type of issue, trading characteristics, prepayment speeds and other data, as well as broker quotes. If the pricing services are unable to provide valuations, debt securities are valued at the average of the most recent reliable bid quotations or evaluated prices, as applicable, obtained from broker-dealers. These securities are generally categorized as Level 2.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Futures contracts are generally valued at the settlement prices established each day on the exchange on which they are traded and are categorized as Level 1.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and are categorized as Level 2.
Swap contracts are valued daily based upon prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer. Swap contracts are generally categorized as Level 2.
Exchange-traded options are valued at the last sale price or, in the absence of a sale, the mean between the closing bid and asked prices or at the most recent asked price (bid for purchased options) if no bid or asked price are available. Exchange-traded options are categorized as Level 1. Over-the-counter written or purchased options are valued at prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer with which the option was traded. Over-the-counter written or purchased options are generally categorized as Level 2.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds, including Government & Agency Securities Portfolio, managed by Deutsche Investment Management Americas Inc. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had no securities on loan.
When-Issued/Delayed Delivery Securities. The Fund may purchase or sell securities with delivery or payment to occur at a later date beyond the normal settlement period. At the time the Fund enters into a commitment to purchase or sell a security, the transaction is recorded and the value of the transaction is reflected in the net asset value. The price of such security and the date when the security will be delivered and paid for are fixed at the time the transaction is negotiated. The value of the security may vary with market fluctuations. At the time the Fund enters into a purchase transaction it is required to segregate cash or other liquid assets at least equal to the amount of the commitment. Additionally, the Fund or the counterparty may be required to post securities and/or cash collateral in accordance with the terms of the commitment.
Certain risks may arise upon entering into when-issued or delayed delivery transactions from the potential inability of counterparties to meet the terms of their contracts or if the issuer does not issue the securities due to political, economic or other factors. Additionally, losses may arise due to changes in the value of the underlying securities.
Federal Income Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
At December 31, 2016, the Fund had net tax basis capital loss carryforwards of approximately $843,000 of short-term losses, which may be applied against realized net taxable capital gains indefinitely.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in futures contracts, investments in swap contracts and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 1,270,530 |
| Capital loss carryforward | $ (843,000) |
| Unrealized appreciation (depreciation) on investments | $ 1,426,416 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 1,918,650 | $ 2,355,393 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Realized gains and losses from investment transactions are recorded on an identified cost basis. All discounts and premiums are accreted/amortized for both tax and financial reporting purposes for the Fund.
B. Derivative Instruments
Swaps. A swap is a contract between two parties to exchange future cash flows at periodic intervals based on the notional amount of the swap. A bilateral swap is a transaction between the Fund and a counterparty where cash flows are exchanged between the two parties. A centrally cleared swap is a transaction executed between the Fund and a counterparty, then cleared by a clearing member through a central clearinghouse. The central clearinghouse serves as the counterparty, with whom the Fund exchanges cash flows.
The value of a swap is adjusted daily, and the change in value, if any, is recorded as unrealized appreciation or depreciation in the Statement of Assets and Liabilities. Gains or losses are realized when the swap expires or is closed. Certain risks may arise when entering into swap transactions including counterparty default; liquidity; or unfavorable changes in interest rates or the value of the underlying reference security, commodity or index. In connection with bilateral swaps, securities and/or cash may be identified as collateral in accordance with the terms of the swap agreement to provide assets of value and recourse in the event of default. The maximum counterparty credit risk is the net present value of the cash flows to be received from or paid to the counterparty over the term of the swap, to the extent that this amount is beneficial to the Fund, in addition to any related collateral posted to the counterparty by the Fund. This risk may be partially reduced by a master netting arrangement between the Fund and the counterparty. Upon entering into a centrally cleared swap, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the notional amount of the swap. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value of the swap. In a cleared swap transaction, counterparty risk is minimized as the central clearinghouse acts as the counterparty.
An upfront payment, if any, made by the Fund is recorded as an asset in the Statement of Assets and Liabilities. An upfront payment, if any, received by the Fund is recorded as a liability in the Statement of Assets and Liabilities. Payments received or made at the end of the measurement period are recorded as realized gain or loss in the Statement of Operations.
Total Return Swap Contracts. Total return swaps involve commitments to pay interest in exchange for a market-linked return based on a notional amount. One counterparty pays out the total return of the reference security or index underlying the total return swap, and in return receives a fixed or variable rate. As a receiver, the Fund would receive payments based on any positive total return and would owe payments in the event of a negative total return. As the payer, the Fund would owe payments on any net positive total return, and would receive payments in the event of a negative total return. For the year ended December 31, 2016, the Fund entered into total return swap transactions as a means of gaining exposure to a particular asset class without investing directly in such asset class.
A summary of the open total return swap contracts as of December 31, 2016 is included in a table following the Fund’s Investment Portfolio. For the year ended December 31, 2016, the investment in total return swap contracts had a total notional amount generally indicative of a range from $0 to approximately $2,357,000.
Interest Rate Swaps. Interest rate swaps are agreements in which the Fund agrees to pay to the counterparty a fixed rate payment in exchange for the counterparty agreeing to pay to the Fund a variable rate payment, or the Fund agrees to receive from the counterparty a fixed rate payment in exchange for the counterparty agreeing to receive from the Fund a variable rate payment. The payment obligations are based on the notional amount of the swap. For the year ended December 31, 2016, the Fund entered into interest rate swap agreements to gain exposure to different parts of the yield curve while managing overall duration.
A summary of the open interest rate swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in interest rate swap contracts had a total notional amount generally indicative of a range from $8,500,000 to $45,034,000.
Options. An option contract is a contract in which the writer (seller) of the option grants the buyer of the option, upon payment of a premium, the right to purchase from (call option), or sell to (put option), the writer a designated instrument at a specified price within a specified period of time. The Fund may write or purchase interest rate swaption agreements which are options to enter into a pre-defined swap agreement. The interest rate swaption agreement will specify whether the buyer of the swaption will be a fixed-rate receiver or a fixed-rate payer upon exercise. Certain options, including options on indices and interest rate options, will require cash settlement by the Fund if exercised. For the year ended December 31, 2016, the Fund entered into options on interest rate swap contracts in order to hedge against potential adverse interest rate movements of portfolio assets.
If the Fund writes a covered call option, the Fund foregoes, in exchange for the premium, the opportunity to profit during the option period from an increase in the market value of the underlying security above the exercise price. If the Fund writes a put option it accepts the risk of a decline in the value of the underlying security below the exercise price. Over-the-counter options have the risk of the potential inability of counterparties to meet the terms of their contracts. For exchange-traded contracts, the counterparty risk is minimized as the exchange's clearinghouse acts as the counterparty, and guarantees the futures against default. The Fund's maximum exposure to purchased options is limited to the premium initially paid. In addition, certain risks may arise upon entering into option contracts, including the risk that an illiquid secondary market will limit the Fund's ability to close out an option contract prior to the expiration date and that a change in the value of the option contract may not correlate exactly with changes in the value of the securities or currencies hedged.
There were no purchased or written option contracts as of December 31, 2016. For the year ended December 31, 2016, the investment in written option contracts had a total value of $0.
Futures Contracts. A futures contract is an agreement between a buyer or seller and an established futures exchange or its clearinghouse in which the buyer or seller agrees to take or make a delivery of a specific amount of a financial instrument at a specified price on a specific date (settlement date). For the year ended December 31, 2016, the Fund entered into interest rate futures to gain exposure to different parts of the yield curve while managing overall duration and for non-hedging purposes to seek to enhance potential gains.
Upon entering into a futures contract, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the face value indicated in the futures contract. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value and are recorded for financial reporting purposes as unrealized gains or losses by the Fund. Gains or losses are realized when the contract expires or is closed. Since all futures contracts are exchange-traded, counterparty risk is minimized as the exchange's clearinghouse acts as the counterparty, and guarantees the futures against default.
Certain risks may arise upon entering into futures contracts, including the risk that an illiquid market will limit the Fund's ability to close out a futures contract prior to the settlement date and the risk that the futures contract is not well correlated with the security, index or currency to which it relates. Risk of loss may exceed amounts disclosed in the Statement of Assets and Liabilities.
A summary of the open futures contracts as of December 31, 2016, is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in futures contracts purchased had a total notional value generally indicative of a range from $0 to approximately $12,578,000, and the investment in futures contracts sold had a total notional value generally indicative of a range from $6,231,000 to approximately $16,972,000.
Forward Foreign Currency Exchange Contracts. A forward foreign currency exchange contract ("forward currency contract") is a commitment to purchase or sell a foreign currency at the settlement date at a negotiated rate. For the year ended December 31, 2016, the Fund entered into forward currency contracts in order to hedge its exposure to changes in foreign currency exchange rates on its foreign currency denominated portfolio holdings and for non-hedging purposes to seek to enhance potential gains.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and unrealized gain (loss) is recorded daily. On the settlement date of the forward currency contract, the Fund records a realized gain or loss equal to the difference between the value of the contract at the time it was opened and the value of the contract at the time it was closed. Certain risks may arise upon entering into forward currency contracts from the potential inability of counterparties to meet the terms of their contracts. The maximum counterparty credit risk to the Fund is measured by the unrealized gain on appreciated contracts. Additionally, when utilizing forward currency contracts to hedge, the Fund gives up the opportunity to profit from favorable exchange rate movements during the term of the contract.
A summary of the open forward currency contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in forward currency contracts short vs. U.S. dollars had a total contract value generally indicative of a range from $0 to approximately $1,646,000, and the investment in forward currency contracts long vs. U.S. dollars had a total contract value generally indicative of a range from $0 to approximately $962,000.
The following tables summarize the value of the Fund's derivative instruments held as of December 31, 2016 and the related location in the accompanying Statement of Assets and Liabilities, presented by primary underlying risk exposure:
| Asset Derivatives | Forward Contracts |
Futures Contracts |
Total |
| Interest Rate Contracts (a) | $ — | $ 43,879 | $ 43,879 |
| Foreign Exchange Contracts (b) | 19,305 | — | 19,305 |
| $ 19,305 | $ 43,879 | $ 63,184 | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Includes cumulative appreciation of futures contracts as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (b) Unrealized appreciation on forward foreign currency exchange contracts | |||
| Liability Derivatives | Forward Contracts |
Swap Contracts |
Futures Contracts |
Total |
| Interest Rate Contracts (a) (b) | $ — | $ (105,612) | $ (35,684) | $ (141,296) |
| Foreign Exchange Contracts (c) | (14,550) | — | — | (14,550) |
| $ (14,550) | $ (105,612) | $ (35,684) | $ (155,846) | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Includes cumulative depreciation of futures and centrally cleared swap contracts as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (b) Unrealized depreciation on bilateral swap contracts (c) Unrealized depreciation on forward foreign currency exchange contracts | ||||
Additionally, the amount of unrealized and realized gains and losses on derivative instruments recognized in Fund earnings during the year ended December 31, 2016 and the related location in the accompanying Statement of Operations is summarized in the following tables by primary underlying risk exposure:
| Realized Gain (Loss) | Written Options |
Swap Contracts |
Futures Contracts | Total |
| Interest Rate Contracts (a) | $ 28,320 | $ (247,778) | $ (854,282) | $ (1,073,740) |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Net realized gain (loss) on written options, swap contracts and futures, respectively | ||||
| Change in Net Unrealized Appreciation (Depreciation) | Written Options |
Forward Contracts |
Swap Contracts |
Futures Contracts | Total |
| Interest Rate Contracts (a) | $ (28,320) | $ — | $ 637,779 | $ 100,175 | $ 709,634 |
| Foreign Exchange Contracts (b) | — | 4,755 | — | — | 4,755 |
| $ (28,320) | $ 4,755 | $ 637,779 | $ 100,175 | $ 714,389 | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Change in net unrealized appreciation (depreciation) from written options, swap contracts and futures, respectively (b) Change in net unrealized appreciation (depreciation) on foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | |||||
As of December 31, 2016, the Fund has transactions subject to enforceable master netting agreements. A reconciliation of the gross amounts on the Statement of Assets and Liabilities to the net amounts by counterparty, including any collateral exposure, is included in the following tables:
| Counterparty | Gross Amounts of Assets Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Received | Net Amount of Derivative Assets |
| Nomura International PLC | $ 19,305 | $ — | $ — | $ 19,305 |
| Counterparty | Gross Amounts of Liabilities Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Pledged | Net Amount of Derivative Liabilities |
| Barclays Bank PLC | $ 13,950 | $ — | $ — | $ 13,950 |
| Credit Suisse | 152 | — | — | 152 |
| Danske Bank AS | 12,823 | — | — | 12,823 |
| Goldman Sachs & Co. | 152 | — | — | 152 |
| Merrill Lynch & Co., Inc. | 600 | — | — | 600 |
| $ 27,677 | $ — | $ — | $ 27,677 |
C. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment securities (excluding short-term investments and U.S. Treasury securities) aggregated $356,216,507 and $362,548,280, respectively. Purchases and sales of U.S. Treasury securities aggregated $16,670,360 and $17,575,479, respectively.
For the year ended December 31, 2016, transactions for written options on interest rate swap contracts were as follows:
| Contract Amount | Premiums | |
| Outstanding, beginning of period | 2,400,000 | $ 28,320 |
| Options expired | (2,400,000) | (28,320) |
| Outstanding, end of period | — | $ — |
D. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .450% |
| Next $750 million | .430% |
| Next $1.5 billion | .410% |
| Next $2.5 billion | .400% |
| Next $2.5 billion | .380% |
| Next $2.5 billion | .360% |
| Next $2.5 billion | .340% |
| Over $12.5 billion | .320% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.45% of the Fund's average daily net assets.
For the period from January 1, 2016 through April 30, 2017, the Advisor has contractually agreed to waive all or a portion of its fees and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest) of each class as follows:
| Class A | .58% |
| Class B | .93% |
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 166,135 |
| Class B | 7,401 |
| $ 173,536 |
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $61,493, of which $4,649 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Total Aggregated | Unpaid at December 31, 2016 | |
| Class A | $ 272 | $ 68 |
| Class B | 52 | 13 |
| $ 324 | $ 81 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plan, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee aggregated $6,570, of which $507 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $12,996, of which $5,241 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Security Lending Fees. Deutsche Bank AG serves as securities lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred securities lending agent fees to Deutsche Bank AG in the amount of $116.
E. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 54% and 34%. One participating insurance company was the owner of record of 10% or more of the total outstanding Class B shares of the Fund, owning 95%.
F. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
G. Payment by Affiliate
During the year ended December 31, 2016, the Advisor agreed to reimburse the Fund $9,350 for a loss incurred on a trade executed incorrectly. The amount of the loss was 0.015% of the Fund's average net assets.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Government & Agency Securities VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Government & Agency Securities VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers or by other appropriate auditing procedures where replies from brokers were not received. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Government & Agency Securities VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $ 990.30 | $ 989.40 | ||
| Expenses Paid per $1,000* | $ 2.90 | $ 4.65 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,022.22 | $1,020.46 | ||
| Expenses Paid per $1,000* | $ 2.95 | $ 4.72 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios | Class A | Class B | ||
| Deutsche Variable Series II — Deutsche Government & Agency Securities VIP | .58% | .93% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Government & Agency Securities VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 4th quartile, 3rd quartile and 2nd quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were higher than the median (4th quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be higher than the median (3rd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to a comparable Deutsche U.S. registered fund ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Fund. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2GAS-2 (R-025831-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Government Money Market VIP
(formerly Deutsche Money Market VIP)
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 8 Statement of Assets and Liabilities 9 Statement of Operations 9 Statements of Changes in Net Assets 11 Financial Highlights 12 Notes to Financial Statements 15 Report of Independent Registered Public Accounting Firm 16 Information About Your Fund's Expenses 17 Tax Information 17 Other Information 18 Advisory Agreement Board Considerations and Fee Evaluation 20 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
An investment in this Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or by any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund. The share price of money market funds can fall below the $1.00 share price. You should not rely on or expect the Advisor to enter into support agreements or take other actions to maintain the Fund’s $1.00 share price. The credit quality of the Fund’s holdings can change rapidly in certain markets, and the default of a single holding could have an adverse impact on the Fund’s share price. The Fund’s share price can also be negatively affected during periods of high redemption pressures and/or illiquid markets. The actions of a few large investors in the Fund may have a significant adverse effect on the share price of the Fund. See the prospectus for specific details regarding the Fund’s risk profile.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
All performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. The yield quotation more closely reflects the current earnings of the Fund than the total return quotation.
You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund's sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| 7-Day Current Yield | |
| December 31, 2016 | .04%* |
| December 31, 2015 | .01%* |
* The investment advisor has agreed to waive fees/reimburse expenses. Without such fee waivers/expense reimbursements, the 7-day current yield would have been lower.
Yields are historical, will fluctuate and do not guarantee future performance. The 7-day current yield refers to the income paid by the Fund over a 7-day period expressed as an annual percentage rate of the Fund's shares outstanding.
Management Summary December 31, 2016 (Unaudited)
During the 12-month period ended December 31, 2016, the Fund provided a total return of 0.05% (Class A shares, unadjusted for contract charges). All performance is historical and does not guarantee future results. Yields fluctuate and are not guaranteed. On May 2, 2016, the fund changed its name to Deutsche Government Money Market VIP. The Fund now operates as a government money market fund and invests most of its assets in short-term government securities, repurchase agreements that are collateralized by government securities, and cash investments.
Over the past 12 months, rate levels within the money market yield curve — including short-term money market rates — fluctuated based on varying economic reports, investors’ interest rate expectations, geopolitical uncertainty and evolving U.S. Federal Reserve Board (the Fed) statements.1 In December 2015, the Fed had taken its first step in the normalization of U.S. short-term rates as the central bank raised the federal funds rate by 25 basis points. In May 2016, comments from Fed officials were seen as hawkish, and at least two rate hikes in 2016 seemed imminent. However, in June, the government’s non-farm payroll jobs report was extremely weak and short-term rates that had risen in anticipation of a federal funds rate increase came back down. In late June, the decision by British voters to leave the European Union shocked investors and rattled global markets. However, reassurances from central banks and the swift installation of a new British prime minister calmed investment markets. By the end of the third quarter, improved economic data had paved the way for an eventual Fed rate hike in December. Uncertainty regarding the U.S. presidential election rattled investment markets in the lead-up to November 8, but did not have a strong impact on short-term debt instruments. In the lead-up to the SEC’s money market reform, enacted in mid-October, a gradual transfer of approximately $1 trillion in assets from prime money market funds to government money funds took place, which caused the money market yield curve to steepen dramatically. The transfer, although orderly, created a squeeze on short-term government money market supply and drove down the yields of short-term government securities.
We were able to maintain a competitive yield for the Fund during the annual period ended December 31, 2016. With government money market yields at increasingly low levels, the Fund held a large percentage of portfolio assets in agency and Treasury floating-rate securities linked to LIBOR in order to take advantage of an incremental rise in those rates.2 At the same time, the Fund invested in overnight agency repurchase agreements for liquidity and looked for yield opportunities from six-month agency and Treasury securities.3
Within government money markets, we believe that heavy demand will persist and that near-term supply will be variable. In the weeks leading up to the March 15, 2017 deadline for the U.S. government's debt ceiling to be raised, short-term Treasury supply could potentially be reduced by $200 billion if an increase in the debt ceiling is not passed by Congress. In anticipation of the deadline, the Treasury Department has been scaling back its Treasury bill auctions to investors. We think that Congress will likely raise the debt ceiling, and that following the deadline, the Treasury Department will ramp up short-term Treasury supply and relieve some of the downward pressure on government money market yields. In addition, our current forecast is for the federal funds rate to be raised two to three additional times during 2017, which should create some upward pressure on short-term rates.
A group of investment professionals is responsible for the day-to-day management of the Fund. These investment professionals have a broad range of experience managing money market funds.
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The yield curve is a graphical representation of how yields on bonds of different maturities compare. Normally, yield curves slant up, as bonds with longer maturities typically offer higher yields than short-term bonds.
2 Floating-rate securities are debt instruments with floating-rate coupons that generally reset every 30 to 90 days. While floating-rate loans are senior to equity and fixed-income securities, there is no guaranteed return of principal in case of default. Floating-rate loans often have less interest-rate risk than other fixed-income investments. Floating-rate loans are most often secured assets, generally senior to a company's secured debt and can be transferred to debt holders, providing potential downside potential.
3 A repurchase agreement, or "overnight repo," is an agreement between a seller and a buyer, usually of government securities, where the seller agrees to repurchase the securities at a given price and usually at a stated time. Repos are widely used money market instruments that serve as an interest-bearing, short-term "parking place" for large sums of money.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio) | 12/31/16 | 12/31/15 |
| Government & Agency Obligations | 58% | 6% |
| Repurchase Agreements | 42% | 9% |
| Commercial Paper | — | 40% |
| Certificates of Deposit and Bank Notes | — | 23% |
| Municipal Bonds and Notes | — | 13% |
| Short-Term Notes | — | 5% |
| Time Deposits | — | 4% |
| 100% | 100% |
| Weighted Average Maturity | 12/31/16 | 12/31/15 |
| Deutsche Variable Series II — Deutsche Government Money Market VIP | 29 days | 29 days |
| Government & Agency Retail Money Fund Average* | 36 days | 33 days |
* The Fund is compared to its respective iMoneyNet Category: Government & Agency Retail Money Fund Average — Category includes the most broadly based of the government retail funds. These funds may invest in U.S. Treasury securities, securities issued or guaranteed by the U.S. Government or its agencies or instrumentalities.
Weighted average maturity, also known as effective maturity, is the weighted average of the maturity date of bonds held by the Fund taking into consideration any available maturity shortening features.
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Prior to May 2, 2016, this fund was known as Deutsche Money Market VIP. The Fund's strategy also changed at that time.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. In addition, each month, information about the Fund and its portfolio holdings is filed with the SEC on Form N-MFP. The SEC delays the public availability of the information filed on Form N-MFP for 60 days after the end of the reporting period included in the filing. These forms will be available on the SEC's Web site at sec.gov, and they may also be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Principal Amount ($) | Value ($) | ||
| Government & Agency Obligations 57.2% | |||
| U.S. Government Sponsored Agencies 42.9% | |||
| Federal Farm Credit Bank: | |||
| 0.801%*, 8/29/2017 | 2,000,000 | 2,001,024 | |
| 0.824%*, 3/22/2017 | 1,500,000 | 1,499,983 | |
| 0.854%*, 9/21/2017 | 500,000 | 500,000 | |
| Federal Home Loan Bank: | |||
| 0.3%**, 1/5/2017 | 2,000,000 | 1,999,934 | |
| 0.356%**, 1/18/2017 | 1,500,000 | 1,499,752 | |
| 0.455%*, 5/4/2017 | 1,750,000 | 1,750,000 | |
| 0.458%**, 2/2/2017 | 2,500,000 | 2,499,000 | |
| 0.458%**, 2/10/2017 | 1,000,000 | 999,500 | |
| 0.554%**, 3/22/2017 | 1,500,000 | 1,498,183 | |
| 0.554%**, 3/23/2017 | 2,500,000 | 2,496,934 | |
| 0.569%**, 4/5/2017 | 1,500,000 | 1,497,807 | |
| 0.585%**, 3/16/2017 | 1,000,000 | 998,818 | |
| 0.59%**, 5/12/2017 | 1,500,000 | 1,496,834 | |
| 0.624%*, 3/8/2018 | 750,000 | 750,000 | |
| 0.661%**, 5/23/2017 | 500,000 | 498,718 | |
| 0.671%*, 5/18/2017 | 1,000,000 | 1,000,000 | |
| 0.771%*, 5/30/2018 | 1,000,000 | 1,000,000 | |
| 0.839%*, 2/22/2017 | 2,000,000 | 2,000,679 | |
| Federal Home Loan Mortgage Corp.: | |||
| 0.376%**, 2/14/2017 | 2,500,000 | 2,498,869 | |
| 0.396%*, 4/11/2017 | 1,500,000 | 1,500,000 | |
| 0.397%**, 1/19/2017 | 1,500,000 | 1,499,708 | |
| 0.478%**, 3/1/2017 | 3,000,000 | 2,997,689 | |
| 0.483%**, 3/3/2017 | 1,500,000 | 1,498,793 | |
| 0.488%**, 5/1/2017 | 1,000,000 | 998,400 | |
| 0.489%*, 5/8/2017 | 1,500,000 | 1,500,000 | |
| 0.508%**, 5/17/2017 | 1,000,000 | 998,111 | |
| 0.567%*, 5/16/2017 | 1,200,000 | 1,200,000 | |
| 0.716%*, 2/22/2018 | 1,000,000 | 1,000,000 | |
| 0.914%*, 12/21/2017 | 4,500,000 | 4,500,000 | |
| Federal National Mortgage Association: | |||
| 0.417%**, 1/3/2017 | 1,500,000 | 1,499,966 | |
| 0.417%**, 2/1/2017 | 1,000,000 | 999,647 | |
| 0.442%**, 2/1/2017 | 2,000,000 | 1,999,251 | |
| Financing Corp., 0.797%**, 10/6/2017 | 1,816,000 | 1,805,011 | |
| 52,482,611 | |||
| Principal Amount ($) | Value ($) | ||
| U.S. Treasury Obligations 14.3% | |||
| U.S. Treasury Bills: | |||
| 0.4%**, 2/2/2017 | 2,000,000 | 1,999,301 | |
| 0.428%**, 1/19/2017 | 500,000 | 499,895 | |
| 0.437%**, 1/19/2017 | 500,000 | 499,893 | |
| 0.498%**, 3/23/2017 | 1,000,000 | 998,898 | |
| U.S. Treasury Floating Rate Notes: | |||
| 0.63%*, 4/30/2017 | 4,000,000 | 3,998,668 | |
| 0.633%*, 7/31/2017 | 2,500,000 | 2,499,066 | |
| 0.746%*, 4/30/2018 | 2,500,000 | 2,500,083 | |
| 0.828%*, 1/31/2018 | 2,500,000 | 2,501,008 | |
| U.S. Treasury Note, 0.875%, 2/28/2017 | 2,000,000 | 2,001,187 | |
| 17,497,999 | |||
| Total Government & Agency Obligations (Cost $69,980,610) | 69,980,610 | ||
| Repurchase Agreements 41.7% | |||
| Merrill Lynch & Co., Inc., 0.5%, dated 12/30/2016, to be repurchased at $20,101,117 on 1/3/2017 (a) | 20,100,000 | 20,100,000 | |
| Nomura Securities International, 0.51%, dated 12/30/2016, to be repurchased at $8,000,453 on 1/3/2017 (b) | 8,000,000 | 8,000,000 | |
| Wells Fargo Bank, 0.5%, dated 12/30/2016, to be repurchased at $23,001,278 on 1/3/2017 (c) | 23,000,000 | 23,000,000 | |
| Total Repurchase Agreements (Cost $51,100,000) | 51,100,000 | ||
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $121,080,610)† | 98.9 | 121,080,610 |
| Other Assets and Liabilities, Net | 1.1 | 1,325,074 |
| Net Assets | 100.0 | 122,405,684 |
* Floating rate securities' yields vary with a designated market index or market rate, such as the coupon-equivalent of the U.S. Treasury Bill rate. These securities are shown at their current rate as of December 31, 2016.
** Annualized yield at time of purchase; not a coupon rate.
† The cost for federal income tax purposes was $121,080,610.
(a) Collateralized by $19,400,000 U.S. Treasury Inflation-Indexed Note, 0.125%, maturing on 4/15/2018 with a value of $20,502,052.
(b) Collateralized by $7,504,142 Federal National Mortgage Association with the various coupon rates from 2.39%–6.5%, with various maturity dates on 11/1/2026–12/1/2046 with a value of $8,160,000.
(c) Collateralized by $22,300,000 Federal National Mortgage Association, 4.0%, maturing on 1/1/2047 with a value of $23,460,001.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities. Securities held by the Fund are reflected as Level 2 because the securities are valued at amortized cost (which approximates fair value) and, accordingly, the inputs used to determine value are not quoted prices in an active market.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total |
| Investments in Securities (d) | $ — | $69,980,610 | $ — | $69,980,610 |
| Repurchase Agreements | — | 51,100,000 | — | 51,100,000 |
| Total | $ — | $121,080,610 | $ — | $121,080,610 |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(d) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in securities, valued at amortized cost |
$ 69,980,610 |
| Repurchase agreements, valued at amortized cost | 51,100,000 |
| Total investments in securities, valued at amortized cost | 121,080,610 |
| Cash | 1,536,210 |
| Receivable for Fund shares sold | 146,118 |
| Interest receivable | 26,795 |
| Due from Advisor | 1,177 |
| Other assets | 2,665 |
| Total assets | 122,793,575 |
| Liabilities | |
| Payable for Fund shares redeemed | 243,397 |
| Distributions payable | 2,029 |
| Accrued management fee | 2,704 |
| Accrued Trustees' fees | 2,391 |
| Other accrued expenses and payables | 137,370 |
| Total liabilities | 387,891 |
| Net assets, at value | $122,405,684 |
| Net Assets Consist of | |
| Undistributed net investment income | 14,915 |
| Paid-in capital | 122,390,769 |
| Net assets, at value | $122,405,684 |
|
Class A Net Asset Value, offering and redemption price per share ($122,405,684 ÷ 122,474,485 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 1.00 |
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Interest |
$ 565,955 |
| Other income | 45,964 |
| Total income | 611,919 |
|
Expenses: Management fee |
316,027 |
| Administration fee | 125,502 |
| Services to shareholders | 3,079 |
| Custodian fee | 12,397 |
| Professional fees | 51,426 |
| Reports to shareholders | 110,231 |
| Trustees' fee and expenses | 6,814 |
| Other | 15,638 |
| Total expenses before expense reductions | 641,114 |
| Expense reductions | (92,895) |
| Total expenses after expense reductions | 548,219 |
| Net investment income | 63,700 |
| Net realized gain (loss) from investments | 14,243 |
| Net increase (decrease) in net assets resulting from operations | $ 77,943 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 63,700 | $ 15,996 |
| Net realized gain (loss) | 14,243 | (122) |
| Net increase (decrease) in net assets resulting from operations | 77,943 | 15,874 |
|
Distributions to shareholders from: Net investment income Class A |
(63,706) | (15,989) |
|
Fund share transactions: Class A Proceeds from shares sold |
122,352,015 | 150,185,171 |
| Reinvestment of distributions | 62,278 | 16,193 |
| Cost of shares redeemed | (134,243,063) | (193,027,682) |
| Net increase (decrease) in net assets from Class A share transactions | (11,828,770) | (42,826,318) |
| Increase (decrease) in net assets | (11,814,533) | (42,826,433) |
| Net assets at beginning of period | 134,220,217 | 177,046,650 |
| Net assets at end of period (including undistributed net investment income of $14,915 and $800, respectively) | $122,405,684 | $134,220,217 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
134,303,255 | 177,129,573 |
| Shares sold | 122,352,015 | 150,185,171 |
| Shares issued to shareholders in reinvestment of distributions | 62,278 | 16,193 |
| Shares redeemed | (134,243,063) | (193,027,682) |
| Net increase (decrease) in Class A shares | (11,828,770) | (42,826,318) |
| Shares outstanding at end of period | 122,474,485 | 134,303,255 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 1.00 | $ 1.00 | $ 1.00 | $ 1.00 | $ 1.00 | |
|
Income from investment operations: Net investment income |
.001b | .000* | .000* | .000* | .000* | |
| Net realized gain (loss) | .000* | (.000)* | .000* | .000* | .000* | |
| Total from investment operations | .001 | .000* | .000* | .000* | .000* | |
|
Less distributions from: Net investment income |
(.001) | (.000)* | (.000)* | (.000)* | (.000)* | |
| Net asset value, end of period | $ 1.00 | $ 1.00 | $ 1.00 | $ 1.00 | $ 1.00 | |
| Total Return (%)a | .05b | .01 | .01 | .01 | .01 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 122 | 134 | 177 | 174 | 196 | |
| Ratio of expenses before expense reductions (%) | .51 | .49 | .49 | .49 | .45 | |
| Ratio of expenses after expense reductions (%) | .44 | .25 | .18 | .20 | .31 | |
| Ratio of net investment income (%) | .05b | .01 | .01 | .01 | .01 | |
|
a Total return would have been lower had certain expenses not been reduced. b Includes a non-recurring payment for overbilling of prior years' custodian out-of-pocket fees. Excluding this payment, net investment income per share, total return, and ratio of net investment income to average net assets would have been reduced by $0.0004, 0.04%, and 0.04%, respectively. * Amount is less than $.0005. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Government Money Market VIP (formerly Deutsche Money Market VIP) (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The Fund values all securities utilizing the amortized cost method permitted in accordance with Rule 2a-7 under the 1940 Act and certain conditions therein. Under this method, which does not take into account unrealized capital gains or losses on securities, an instrument is initially valued at its cost and thereafter assumes a constant accretion/amortization rate to maturity of any discount or premium. Securities held by the Fund are reflected as Level 2 because the securities are valued at amortized cost (which approximates fair value) and, accordingly, the inputs used to determine value are not quoted prices in an active market.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Repurchase Agreements. The Fund may enter into repurchase agreements, under the terms of a Master Repurchase Agreement, with certain banks and broker/dealers whereby the Fund, through its custodian or a sub-custodian bank, receives delivery of the underlying securities, the amount of which at the time of purchase and each subsequent business day is required to be maintained at such a level that the value is equal to at least the principal amount of the repurchase price plus accrued interest. The custodian bank or another designated sub-custodian holds the collateral in a separate account until the agreement matures. If the value of the securities falls below the principal amount of the repurchase agreement plus accrued interest, the financial institution deposits additional collateral by the following business day. If the financial institution either fails to deposit the required additional collateral or fails to repurchase the securities as agreed, the Fund has the right to sell the securities and recover any resulting loss from the financial institution. If the financial institution enters into bankruptcy, the Fund's claim on the collateral may be subject to legal proceedings.
As of December 31, 2016, the Fund held repurchase agreements with a gross value of $51,100,000. The value of the related collateral exceeded the value of the repurchase agreements at period end. The detail of the related collateral is included in the footnotes following the Fund's Investment Portfolio.
Federal Income Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Net investment income of the Fund is declared as a daily dividend and is distributed to shareholders monthly. The Fund may take into account capital gains and losses in its daily dividend declarations. The Fund may also make additional distributions for tax purposes if necessary.
Permanent book and tax differences relating to shareholder distributions will result in reclassifications to paid-in capital. Temporary book and tax differences will reverse in a subsequent period. There were no significant book to tax differences for the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income | $ 14,915 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income | $ 63,706 | $ 15,989 |
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date. Interest income is recorded on the accrual basis. Realized gains and losses from investment transactions are recorded on an identified cost basis. All discounts and premiums are accreted/amortized for both tax and financial reporting purposes.
B. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Prior to May 1, 2016, under the Investment Management Agreement, the Fund paid the Advisor a monthly management fee based on its average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $500 million | .285% |
| Next $500 million | .270% |
| Next $1.0 billion | .255% |
| Over $2.0 billion | .240% |
Effective May 1, 2016, under the Investment Management Agreement, the Fund pays the Advisor a monthly management fee based on its average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $500 million | .235% |
| Next $500 million | .220% |
| Next $1.0 billion | .205% |
| Over $2.0 billion | .190% |
For the period from January 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) at 0.51%.
In addition, the Advisor has agreed to voluntarily waive additional expenses. The waiver may be changed or terminated at any time without notice. Under this arrangement, the Advisor waived certain expenses of the Fund.
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement aggregated $316,027, of which $90,577 was waived, resulting in an annual effective rate of 0.18% of the Fund's average daily net assets.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $125,502, of which $9,994 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC aggregated $2,318, all of which was waived.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $11,431, of which $4,617 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Transactions with Affiliates. The Fund may purchase securities from, or sell securities to, an affiliated fund provided the affiliation is solely due to having a common investment adviser, common officers, or common trustees. During the year ended December 31, 2016, the Fund engaged in securities sales of $1,500,000 with an affiliated fund in compliance with Rule 17a-7 under the 1940 Act.
C. Ownership of the Fund
At December 31, 2016, three participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 46%, 21% and 14%.
D. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate, plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and the Shareholders of Deutsche Government Money Market VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Government Money Market VIP (formerly: Deutsche Money Market VIP) (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Government Money Market VIP (formerly: Deutsche Money Market VIP) (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||
| Actual Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,000.46 | |
| Expenses Paid per $1,000* | $ 2.11 | |
| Hypothetical 5% Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,023.03 | |
| Expenses Paid per $1,000* | $ 2.14 | |
* Expenses are equal to the Fund's annualized expense ratio, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratio | Class A | |
| Deutsche Variable Series II — Deutsche Government Money Market VIP | .42% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Other Information
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Government Money Market VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including a peer universe compiled using information supplied by iMoneyNet, an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one- and three-year periods ended December 31, 2015, the Fund’s gross performance (Class A shares) was in the 1st quartile and 2nd quartile, respectively, of the applicable iMoneyNet universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board noted that the Fund’s strategy was changed during the year in order to permit the Fund to operate as a "government money market fund" under applicable Securities and Exchange Commission rules.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were lower than the median (2nd quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board considered that the Fund’s management fee was reduced by 0.05% at all breakpoint levels in connection with the restructuring of the Fund into a government money market fund. The Board noted that the Fund’s Class A shares total (net) operating expenses were higher than the median (4th quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board noted the expense limitation agreed to by DIMA. The Board also noted the significant voluntary fee waivers implemented by DIMA to ensure the Fund maintained a positive yield. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2GMM-2 (R-025834-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche High Income VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 17 Statement of Assets and Liabilities 18 Statement of Operations 19 Statements of Changes in Net Assets 20 Financial Highlights 21 Notes to Financial Statements 29 Report of Independent Registered Public Accounting Firm 30 Information About Your Fund's Expenses 31 Tax Information 31 Proxy Voting 32 Advisory Agreement Board Considerations and Fee Evaluation 35 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Bond investments are subject to interest-rate, credit, liquidity and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality ("junk bonds") and non-rated securities present greater risk of loss than investments in higher-quality securities. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 0.75% and 1.14% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche High Income VIP | ||
|
■ Deutsche High Income VIP — Class A ■ BofA Merrill Lynch US High Yield Master II Constrained Index ■ Credit Suisse High Yield Index |
BofA Merrill Lynch US High Yield Master II Constrained Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. The Credit Suisse High Yield Index tracks the performance of the global high-yield debt market. On June 1, 2016, the BofA Merrill Lynch US High Yield Master II Constrained Index replaced the Credit Suisse High Yield Index as the fund's comparative broad-based securities market index because the Advisor believes the BofA Merrill Lynch US High Yield Master II Constrained Index more closely reflects the fund's investment strategies. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche High Income VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $11,287 | $10,945 | $13,572 | $17,270 |
| Average annual total return | 12.87% | 3.05% | 6.30% | 5.62% | |
| BofA Merrill Lynch US High Yield Master II Constrained Index | Growth of $10,000 | $11,749 | $11,488 | $14,258 | $20,510 |
| Average annual total return | 17.49% | 4.73% | 7.35% | 7.45% | |
| Credit Suisse High Yield Index | Growth of $10,000 | $11,826 | $11,452 | $14,126 | $19,923 |
| Average annual total return | 18.26% | 4.62% | 7.15% | 7.14% | |
| Deutsche High Income VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class B | Growth of $10,000 | $11,267 | $10,841 | $13,359 | $16,748 |
| Average annual total return | 12.67% | 2.73% | 5.96% | 5.29% | |
| BofA Merrill Lynch US High Yield Master II Constrained Index | Growth of $10,000 | $11,749 | $11,488 | $14,258 | $20,510 |
| Average annual total return | 17.49% | 4.73% | 7.35% | 7.45% | |
| Credit Suisse High Yield Index | Growth of $10,000 | $11,826 | $11,452 | $14,126 | $19,923 |
| Average annual total return | 18.26% | 4.62% | 7.15% | 7.14% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
High-yield bonds gained 17.49% in 2016 based on the performance of the BofA Merrill Lynch US High Yield Master II Constrained Index, as the combination of recovering energy prices, improving economic growth and low global bond yields fueled hearty demand for higher-risk, income-producing securities.1 Additionally, the market benefited from the combination of robust investment inflows and a decline in new issuance. While the Fund produced a strong absolute return of 12.87% during 2016 (Class A shares, unadjusted for contract charges), it nonetheless finished behind the benchmark.
The Fund’s shortfall vs. the index stemmed from a mixture of sector allocation and individual security selection. The substantial gain of the high-yield market was largely driven by a recovery in higher-risk market segments, particularly the commodity-related energy and mining industries. While Fund performance was helped by selective exposure in the energy exploration and production industry, an underweight in the more speculative oil field equipment and services industry detracted.2 The prices of many bonds rated CCC and below also surged during 2016, so the Fund’s underweight in these lower-rated, higher-risk issues contributed to its underperformance.
The bonds of the mining company Teck Resources, Ltd. — which gained ground behind the rally in commodity prices and favorable moves by Teck’s management to reduce debt — was one of our largest individual contributors.3 The bonds of the energy exploration and production company Continental Resources, Inc. traded stronger, thanks to the improvement in oil prices and the company’s effort to improve its credit quality by reducing debt. Bonds of the cable and satellite operator Cequel Communications Holdings I LLC, which reported improving financial results, also outperformed. On the negative side, the largest detractors were our underweight positions in ArcelorMittal SA* and Chesapeake Energy Corp., together with a zero weighting in the energy services company Transocean, Inc.
We believe the U.S. high-yield market was on a solid footing at the close of the year. The use of new-issue proceeds was dominated by refinancing during 2016, which substantially reduced concerns about near-term maturities for high-yield issuers and contributed to decreasing default expectations. In addition, we believe the backdrop of modest global growth can support commodity prices and drive a search for yield that helps risk assets. Although it appears the U.S. Federal Reserve Board (the Fed) is likely to begin tightening policy, we also think that well-communicated, measured and data-driven Fed rate moves can provide a favorable backdrop for high yield when accompanied by accelerating growth. Not least, we anticipate that absolute yields will remain attractive enough to fuel continued investor demand. Possible disruptions to this favorable outlook include more aggressive Fed actions, volatility in U.S. Treasuries and lingering geopolitical/macroeconomic issues.
The Fund employed derivatives during the period to manage its currency exposure and overall positioning. We used derivatives in order to hedge the Fund's exposure to the euro back into U.S. dollars, a positive given the relative weakness in the European currency. In addition, we used derivatives as a means to gain market exposure in a more liquid and efficient manner than buying securities outright.
Gary Russell, CFA
Thomas R. Bouchard
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The BofA Merrill Lynch US High Yield Master II Constrained Index tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
2 "Underweight" means the Fund holds a lower weighting in a given sector or security than the benchmark. "Overweight" means it holds a higher weighting.
3 Contribution and detraction incorporate both an investment’s total return and its weighting in the Fund.
* Not held in the portfolio as of December 31, 2016.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Corporate Bonds | 93% | 92% |
| Cash Equivalents | 5% | 4% |
| Convertible Bond | 1% | 1% |
| Government & Agency Obligations | 1% | 1% |
| Common Stocks | 0% | 0% |
| Warrant | 0% | 0% |
| Preferred Security | — | 1% |
| Loan Participations and Assignments | — | 1% |
| Preferred Stock | — | 0% |
| 100% | 100% |
| Sector Diversification (As a % of Investment Portfolio excluding Government & Agency Obligations, Cash Equivalents and Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Consumer Discretionary | 27% | 29% |
| Energy | 18% | 10% |
| Materials | 16% | 9% |
| Telecommunication Services | 13% | 14% |
| Industrials | 7% | 12% |
| Health Care | 6% | 9% |
| Utilities | 4% | 3% |
| Information Technology | 3% | 5% |
| Consumer Staples | 2% | 4% |
| Real Estate | 2% | 1% |
| Financials | 2% | 4% |
| 100% | 100% |
| Quality (As a % of Investment Portfolio excluding Cash Equivalents and Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| AAA | 1% | 1% |
| BBB | 9% | 3% |
| BB | 57% | 50% |
| B | 30% | 41% |
| CCC | 3% | 4% |
| Not Rated | 0% | 1% |
| 100% | 100% |
The quality ratings represent the higher of Moody's Investors Service, Inc. ("Moody's"), Fitch Ratings, Inc. ("Fitch") or Standard & Poor's Corporation ("S&P") credit ratings. The ratings of Moody's, Fitch and S&P represent their opinions as to the quality of the securities they rate. Credit quality measures a bond issuer's ability to repay interest and principal in a timely manner. Ratings are relative and subjective and are not absolute standards of quality. Credit quality does not remove market risk and is subject to change.
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Principal Amount ($)(a) | Value ($) | |||
| Corporate Bonds 91.3% | ||||
| Consumer Discretionary 24.9% | ||||
| Adient Global Holdings Ltd., 144A, 4.875%, 8/15/2026 | 340,000 | 333,200 | ||
| Allison Transmission, Inc., 144A, 5.0%, 10/1/2024 | 240,000 | 242,400 | ||
| Ally Financial, Inc., 4.125%, 3/30/2020 | 285,000 | 287,850 | ||
| Altice Financing SA: | ||||
| 144A, 6.5%, 1/15/2022 | 200,000 | 208,500 | ||
| 144A, 7.5%, 5/15/2026 | 785,000 | 816,400 | ||
| Altice U.S. Finance I Corp., 144A, 5.5%, 5/15/2026 | 480,000 | 489,600 | ||
| AMC Entertainment Holdings, Inc., 5.875%, 2/15/2022 | 220,000 | 230,175 | ||
| Asbury Automotive Group, Inc., 6.0%, 12/15/2024 | 885,000 | 904,912 | ||
| Ashton Woods U.S.A. LLC, 144A, 6.875%, 2/15/2021 | 360,000 | 346,500 | ||
| Beacon Roofing Supply, Inc., 6.375%, 10/1/2023 | 160,000 | 170,701 | ||
| Block Communications, Inc., 144A, 7.25%, 2/1/2020 | 375,000 | 379,687 | ||
| Boyd Gaming Corp., 6.875%, 5/15/2023 | 140,000 | 150,500 | ||
| CalAtlantic Group, Inc., 5.25%, 6/1/2026 | 573,000 | 558,675 | ||
| Caleres, Inc., 6.25%, 8/15/2023 | 110,000 | 115,500 | ||
| Carlson Travel, Inc.: | ||||
| 144A, 6.75%, 12/15/2023 | 400,000 | 416,000 | ||
| 144A, 9.5%, 12/15/2024 | 400,000 | 418,500 | ||
| CCO Holdings LLC: | ||||
| 144A, 5.125%, 5/1/2023 | 385,000 | 396,550 | ||
| 144A, 5.5%, 5/1/2026 | 1,330,000 | 1,356,600 | ||
| 144A, 5.875%, 4/1/2024 | 235,000 | 250,862 | ||
| 144A, 5.875%, 5/1/2027 | 480,000 | 498,000 | ||
| Cequel Communications Holdings I LLC: | ||||
| 144A, 5.125%, 12/15/2021 | 602,000 | 612,535 | ||
| 144A, 6.375%, 9/15/2020 | 940,000 | 968,200 | ||
| Churchill Downs, Inc., 5.375%, 12/15/2021 | 135,000 | 140,063 | ||
| Clear Channel Worldwide Holdings, Inc.: | ||||
| Series A, 6.5%, 11/15/2022 | 250,000 | 250,000 | ||
| Series B, 6.5%, 11/15/2022 | 365,000 | 373,212 | ||
| Series A, 7.625%, 3/15/2020 | 110,000 | 105,600 | ||
| Cogeco Communications, Inc., 144A, 4.875%, 5/1/2020 | 20,000 | 20,575 | ||
| CSC Holdings LLC: | ||||
| 5.25%, 6/1/2024 (b) | 585,000 | 571,837 | ||
| 144A, 5.5%, 4/15/2027 | 755,000 | 764,437 | ||
| 144A, 10.125%, 1/15/2023 | 400,000 | 462,000 | ||
| 144A, 10.875%, 10/15/2025 | 275,000 | 327,250 | ||
| Dana, Inc., 5.5%, 12/15/2024 | 180,000 | 183,600 | ||
| DISH DBS Corp.: | ||||
| 5.875%, 7/15/2022 | 200,000 | 210,500 | ||
| 6.75%, 6/1/2021 | 450,000 | 488,250 | ||
| 7.875%, 9/1/2019 | 270,000 | 299,700 | ||
| Dollar Tree, Inc., 5.25%, 3/1/2020 | 420,000 | 432,600 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Fiat Chrysler Automobiles NV: | ||||
| 4.5%, 4/15/2020 | 645,000 | 657,900 | ||
| 5.25%, 4/15/2023 (b) | 245,000 | 249,483 | ||
| Goodyear Tire & Rubber Co.: | ||||
| 5.0%, 5/31/2026 | 165,000 | 164,248 | ||
| 5.125%, 11/15/2023 | 165,000 | 169,950 | ||
| Group 1 Automotive, Inc.: | ||||
| 5.0%, 6/1/2022 | 455,000 | 449,312 | ||
| 144A, 5.25%, 12/15/2023 | 545,000 | 539,550 | ||
| HD Supply, Inc.: | ||||
| 144A, 5.25%, 12/15/2021 | 275,000 | 290,125 | ||
| 144A, 5.75%, 4/15/2024 | 120,000 | 126,684 | ||
| Hertz Corp., 6.75%, 4/15/2019 | 110,000 | 110,000 | ||
| Hot Topic, Inc., 144A, 9.25%, 6/15/2021 | 140,000 | 147,350 | ||
| Lennar Corp., 4.75%, 11/15/2022 | 400,000 | 410,000 | ||
| Live Nation Entertainment, Inc., 144A, 5.375%, 6/15/2022 | 50,000 | 51,750 | ||
| MDC Partners, Inc., 144A, 6.5%, 5/1/2024 | 195,000 | 175,500 | ||
| Mediacom Broadband LLC, 6.375%, 4/1/2023 | 225,000 | 236,250 | ||
| NCL Corp., Ltd.: | ||||
| 144A, 4.625%, 11/15/2020 | 235,000 | 239,113 | ||
| 144A, 4.75%, 12/15/2021 | 160,000 | 159,901 | ||
| Nielsen Finance LLC, 144A, 5.0%, 4/15/2022 | 155,000 | 157,906 | ||
| Penske Automotive Group, Inc.: | ||||
| 5.375%, 12/1/2024 | 310,000 | 309,225 | ||
| 5.5%, 5/15/2026 | 225,000 | 222,188 | ||
| Quebecor Media, Inc., 5.75%, 1/15/2023 | 205,000 | 212,688 | ||
| Rivers Pittsburgh Borrower LP, 144A, 6.125%, 8/15/2021 | 70,000 | 71,575 | ||
| Sabre GLBL, Inc.: | ||||
| 144A, 5.25%, 11/15/2023 | 55,000 | 56,478 | ||
| 144A, 5.375%, 4/15/2023 | 25,000 | 25,500 | ||
| Sally Holdings LLC, 5.625%, 12/1/2025 | 195,000 | 202,800 | ||
| Seminole Hard Rock Entertainment, Inc., 144A, 5.875%, 5/15/2021 | 125,000 | 123,750 | ||
| SFR Group SA, 144A, 7.375%, 5/1/2026 | 840,000 | 861,000 | ||
| Springs Industries, Inc., 6.25%, 6/1/2021 | 295,000 | 305,325 | ||
| Suburban Propane Partners LP, 5.75%, 3/1/2025 | 145,000 | 147,175 | ||
| Toll Brothers Finance Corp., 4.875%, 11/15/2025 | 520,000 | 510,900 | ||
| TRI Pointe Group, Inc., 4.375%, 6/15/2019 | 145,000 | 147,538 | ||
| Unitymedia Hessen GmbH & Co., KG, 144A, 5.5%, 1/15/2023 | 945,000 | 983,981 | ||
| UPCB Finance IV Ltd., 144A, 5.375%, 1/15/2025 | 955,000 | 962,162 | ||
| Viking Cruises Ltd.: | ||||
| 144A, 6.25%, 5/15/2025 | 240,000 | 223,200 | ||
| 144A, 8.5%, 10/15/2022 | 205,000 | 212,688 | ||
| Virgin Media Secured Finance PLC: | ||||
| 144A, 5.25%, 1/15/2026 | 200,000 | 197,500 | ||
| 144A, 5.5%, 8/15/2026 | 215,000 | 214,463 | ||
| Principal Amount ($)(a) | Value ($) | |||
| WMG Acquisition Corp., 144A, 5.0%, 8/1/2023 | 105,000 | 105,525 | ||
| 25,212,154 | ||||
| Consumer Staples 2.1% | ||||
| Cott Beverages, Inc.: | ||||
| 5.375%, 7/1/2022 | 445,000 | 452,787 | ||
| 6.75%, 1/1/2020 | 180,000 | 186,525 | ||
| FAGE International SA, 144A, 5.625%, 8/15/2026 | 420,000 | 421,050 | ||
| JBS Investments GmbH, 144A, 7.25%, 4/3/2024 | 496,000 | 518,320 | ||
| JBS U.S.A. LUX SA: | ||||
| 144A, 5.75%, 6/15/2025 | 290,000 | 293,625 | ||
| 144A, 8.25%, 2/1/2020 | 160,000 | 164,000 | ||
| Post Holdings, Inc., 144A, 6.75%, 12/1/2021 | 110,000 | 117,425 | ||
| Smithfield Foods, Inc., 6.625%, 8/15/2022 | 9,000 | 9,484 | ||
| 2,163,216 | ||||
| Energy 16.9% | ||||
| Antero Midstream Partners LP, 144A, 5.375%, 9/15/2024 | 170,000 | 171,700 | ||
| Antero Resources Corp.: | ||||
| 5.125%, 12/1/2022 | 330,000 | 333,300 | ||
| 5.375%, 11/1/2021 | 250,000 | 255,625 | ||
| 5.625%, 6/1/2023 | 205,000 | 209,869 | ||
| Blue Racer Midstream LLC, 144A, 6.125%, 11/15/2022 | 405,000 | 405,000 | ||
| Carrizo Oil & Gas, Inc., 6.25%, 4/15/2023 (b) | 235,000 | 240,875 | ||
| Cheniere Corpus Christi Holdings LLC: | ||||
| 144A, 5.875%, 3/31/2025 | 225,000 | 229,570 | ||
| 144A, 7.0%, 6/30/2024 | 400,000 | 433,000 | ||
| Chesapeake Energy Corp., 6.625%, 8/15/2020 (b) | 400,000 | 404,000 | ||
| Concho Resources, Inc., 4.375%, 1/15/2025 | 125,000 | 124,751 | ||
| Continental Resources, Inc.: | ||||
| 3.8%, 6/1/2024 | 200,000 | 184,500 | ||
| 4.5%, 4/15/2023 | 200,000 | 196,000 | ||
| 5.0%, 9/15/2022 (b) | 568,000 | 573,334 | ||
| Crestwood Midstream Partners LP, 6.25%, 4/1/2023 | 400,000 | 408,000 | ||
| Diamondback Energy, Inc., 144A, 4.75%, 11/1/2024 | 340,000 | 333,200 | ||
| EP Energy LLC, 144A, 8.0%, 11/29/2024 | 100,000 | 107,470 | ||
| Gulfport Energy Corp.: | ||||
| 144A, 6.0%, 10/15/2024 | 85,000 | 86,488 | ||
| 144A, 6.375%, 5/15/2025 | 140,000 | 141,778 | ||
| 6.625%, 5/1/2023 | 95,000 | 99,275 | ||
| Hilcorp Energy I LP: | ||||
| 144A, 5.0%, 12/1/2024 | 195,000 | 193,538 | ||
| 144A, 5.75%, 10/1/2025 | 335,000 | 339,187 | ||
| Holly Energy Partners LP: | ||||
| 144A, 6.0%, 8/1/2024 | 215,000 | 224,138 | ||
| 6.5%, 3/1/2020 | 105,000 | 108,413 | ||
| Laredo Petroleum, Inc.: | ||||
| 5.625%, 1/15/2022 (b) | 100,000 | 100,750 | ||
| 6.25%, 3/15/2023 (b) | 295,000 | 305,325 | ||
| MEG Energy Corp.: | ||||
| 144A, 6.375%, 1/30/2023 | 755,000 | 671,950 | ||
| 144A, 6.5%, 3/15/2021 | 100,000 | 92,500 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Murphy Oil Corp., 6.875%, 8/15/2024 | 145,000 | 154,425 | ||
| Newfield Exploration Co., 5.375%, 1/1/2026 | 655,000 | 667,838 | ||
| Noble Holding International Ltd., 7.75%, 1/15/2024 | 435,000 | 409,161 | ||
| Oasis Petroleum, Inc.: | ||||
| 6.5%, 11/1/2021 | 55,000 | 56,031 | ||
| 6.875%, 3/15/2022 | 445,000 | 456,125 | ||
| 6.875%, 1/15/2023 | 80,000 | 82,000 | ||
| Parsley Energy LLC, 144A, 5.375%, 1/15/2025 | 120,000 | 120,408 | ||
| PDC Energy, Inc., 144A, 6.125%, 9/15/2024 | 210,000 | 214,725 | ||
| Precision Drilling Corp., 144A, 7.75%, 12/15/2023 | 100,000 | 105,500 | ||
| Range Resources Corp.: | ||||
| 4.875%, 5/15/2025 | 340,000 | 329,375 | ||
| 144A, 5.0%, 8/15/2022 | 350,000 | 347,812 | ||
| 144A, 5.875%, 7/1/2022 | 195,000 | 202,800 | ||
| Rice Energy, Inc., 7.25%, 5/1/2023 | 250,000 | 265,000 | ||
| Rowan Companies, Inc., 7.375%, 6/15/2025 | 150,000 | 153,000 | ||
| Sabine Pass Liquefaction LLC: | ||||
| 144A, 5.0%, 3/15/2027 | 360,000 | 363,150 | ||
| 5.625%, 2/1/2021 | 1,190,000 | 1,273,300 | ||
| 5.625%, 4/15/2023 | 200,000 | 212,500 | ||
| 5.625%, 3/1/2025 | 390,000 | 417,300 | ||
| 144A, 5.875%, 6/30/2026 | 355,000 | 382,512 | ||
| Sunoco LP: | ||||
| 5.5%, 8/1/2020 | 130,000 | 132,600 | ||
| 6.375%, 4/1/2023 | 140,000 | 141,750 | ||
| Tesoro Corp.: | ||||
| 144A, 4.75%, 12/15/2023 | 340,000 | 342,337 | ||
| 144A, 5.125%, 12/15/2026 | 485,000 | 490,529 | ||
| Tesoro Logistics LP: | ||||
| 5.25%, 1/15/2025 | 715,000 | 730,194 | ||
| 6.375%, 5/1/2024 | 180,000 | 192,600 | ||
| Weatherford International Ltd., 144A, 9.875%, 2/15/2024 | 415,000 | 442,232 | ||
| Whiting Petroleum Corp.: | ||||
| 5.0%, 3/15/2019 | 165,000 | 165,645 | ||
| 5.75%, 3/15/2021 (b) | 560,000 | 557,670 | ||
| WPX Energy, Inc.: | ||||
| 5.25%, 9/15/2024 (b) | 100,000 | 97,000 | ||
| 6.0%, 1/15/2022 | 100,000 | 102,500 | ||
| 7.5%, 8/1/2020 | 150,000 | 161,250 | ||
| 8.25%, 8/1/2023 | 295,000 | 329,663 | ||
| 17,072,468 | ||||
| Financials 1.5% | ||||
| CIT Group, Inc.: | ||||
| 5.0%, 8/15/2022 | 400,000 | 417,000 | ||
| 5.0%, 8/1/2023 | 200,000 | 206,500 | ||
| CNO Financial Group, Inc., 5.25%, 5/30/2025 | 140,000 | 139,825 | ||
| Dana Financing Luxembourg Sarl, 144A, 6.5%, 6/1/2026 | 385,000 | 402,325 | ||
| Lincoln Finance Ltd., 144A, 7.375%, 4/15/2021 | 105,000 | 111,825 | ||
| Seminole Tribe of Florida, Inc., 144A, 7.804%, 10/1/2020 | 220,000 | 218,900 | ||
| 1,496,375 | ||||
| Principal Amount ($)(a) | Value ($) | |||
| Health Care 5.9% | ||||
| Alere, Inc., 144A, 6.375%, 7/1/2023 | 185,000 | 183,844 | ||
| Concordia International Corp., 144A, 9.0%, 4/1/2022 (b) | 120,000 | 101,700 | ||
| Endo Finance LLC, 144A, 5.75%, 1/15/2022 | 220,000 | 194,150 | ||
| Endo Ltd.: | ||||
| 144A, 6.0%, 7/15/2023 | 195,000 | 170,869 | ||
| 144A, 6.5%, 2/1/2025 | 150,000 | 125,625 | ||
| HCA, Inc.: | ||||
| 4.5%, 2/15/2027 | 1,020,000 | 1,002,150 | ||
| 4.75%, 5/1/2023 | 500,000 | 511,875 | ||
| 5.25%, 6/15/2026 | 385,000 | 397,994 | ||
| 5.875%, 2/15/2026 | 530,000 | 545,900 | ||
| Hologic, Inc., 144A, 5.25%, 7/15/2022 | 90,000 | 94,725 | ||
| LifePoint Health, Inc.: | ||||
| 144A, 5.375%, 5/1/2024 | 170,000 | 166,515 | ||
| 5.5%, 12/1/2021 | 275,000 | 286,000 | ||
| 5.875%, 12/1/2023 | 230,000 | 232,875 | ||
| Mallinckrodt International Finance SA: | ||||
| 144A, 4.875%, 4/15/2020 (b) | 80,000 | 80,300 | ||
| 144A, 5.625%, 10/15/2023 | 135,000 | 125,887 | ||
| Tenet Healthcare Corp.: | ||||
| 4.463%**, 6/15/2020 | 180,000 | 181,350 | ||
| 144A, 7.5%, 1/1/2022 | 135,000 | 140,737 | ||
| Valeant Pharmaceuticals International, Inc.: | ||||
| 144A, 5.375%, 3/15/2020 | 365,000 | 308,425 | ||
| 144A, 5.875%, 5/15/2023 | 235,000 | 177,425 | ||
| 144A, 6.125%, 4/15/2025 | 405,000 | 304,256 | ||
| 144A, 7.5%, 7/15/2021 | 750,000 | 635,625 | ||
| 5,968,227 | ||||
| Industrials 6.2% | ||||
| ADT Corp.: | ||||
| 3.5%, 7/15/2022 | 150,000 | 142,875 | ||
| 6.25%, 10/15/2021 | 395,000 | 428,575 | ||
| Allegion PLC, 5.875%, 9/15/2023 | 85,000 | 90,100 | ||
| Artesyn Embedded Technologies, Inc., 144A, 9.75%, 10/15/2020 | 240,000 | 219,600 | ||
| Belden, Inc., 144A, 5.5%, 9/1/2022 | 355,000 | 365,650 | ||
| Bombardier, Inc.: | ||||
| 144A, 5.75%, 3/15/2022 | 315,000 | 296,100 | ||
| 144A, 6.0%, 10/15/2022 | 265,000 | 249,100 | ||
| 144A, 8.75%, 12/1/2021 | 63,000 | 66,859 | ||
| Covanta Holding Corp., 5.875%, 3/1/2024 | 220,000 | 211,750 | ||
| EnerSys, 144A, 5.0%, 4/30/2023 | 45,000 | 45,225 | ||
| Florida East Coast Holdings Corp., 144A, 6.75%, 5/1/2019 | 155,000 | 160,425 | ||
| FTI Consulting, Inc., 6.0%, 11/15/2022 | 205,000 | 213,200 | ||
| Garda World Security Corp., 144A, 7.25%, 11/15/2021 | 290,000 | 269,700 | ||
| IHO Verwaltungs GmbH, 144A, 4.5%, 9/15/2023 (PIK) | 200,000 | 195,500 | ||
| Kenan Advantage Group, Inc., 144A, 7.875%, 7/31/2023 | 220,000 | 222,200 | ||
| Manitowoc Foodservice, Inc., 9.5%, 2/15/2024 | 93,000 | 107,183 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Masonite International Corp., 144A, 5.625%, 3/15/2023 | 220,000 | 227,150 | ||
| Moog, Inc., 144A, 5.25%, 12/1/2022 | 165,000 | 168,300 | ||
| Novelis Corp.: | ||||
| 144A, 5.875%, 9/30/2026 | 415,000 | 419,150 | ||
| 144A, 6.25%, 8/15/2024 | 195,000 | 206,700 | ||
| Oshkosh Corp., 5.375%, 3/1/2025 | 25,000 | 25,500 | ||
| Ply Gem Industries, Inc., 6.5%, 2/1/2022 | 506,000 | 521,001 | ||
| Prime Security Services Borrower LLC, 144A, 9.25%, 5/15/2023 | 25,000 | 27,219 | ||
| Ritchie Bros Auctioneers, Inc., 144A, 5.375%, 1/15/2025 | 130,000 | 132,600 | ||
| Summit Materials LLC: | ||||
| 6.125%, 7/15/2023 | 275,000 | 282,216 | ||
| 8.5%, 4/15/2022 | 95,000 | 104,975 | ||
| Titan International, Inc., 6.875%, 10/1/2020 | 170,000 | 166,387 | ||
| United Rentals North America, Inc.: | ||||
| 5.5%, 5/15/2027 | 150,000 | 148,875 | ||
| 6.125%, 6/15/2023 | 25,000 | 26,500 | ||
| WESCO Distribution, Inc., 144A, 5.375%, 6/15/2024 | 190,000 | 190,475 | ||
| XPO Logistics, Inc., 144A, 6.125%, 9/1/2023 | 85,000 | 88,825 | ||
| ZF North America Capital, Inc., 144A, 4.75%, 4/29/2025 | 210,000 | 213,675 | ||
| 6,233,590 | ||||
| Information Technology 2.6% | ||||
| Cardtronics, Inc., 5.125%, 8/1/2022 | 145,000 | 146,087 | ||
| Diamond 1 Finance Corp., 144A, 5.875%, 6/15/2021 | 150,000 | 159,589 | ||
| EarthLink Holdings Corp., 7.375%, 6/1/2020 | 245,000 | 258,475 | ||
| Entegris, Inc., 144A, 6.0%, 4/1/2022 | 160,000 | 166,400 | ||
| First Data Corp., 144A, 7.0%, 12/1/2023 | 275,000 | 292,875 | ||
| Match Group, Inc., 6.375%, 6/1/2024 | 120,000 | 126,600 | ||
| Micron Technology, Inc.: | ||||
| 5.5%, 2/1/2025 | 100,000 | 99,500 | ||
| 144A, 7.5%, 9/15/2023 | 390,000 | 431,925 | ||
| Netflix, Inc., 5.875%, 2/15/2025 | 165,000 | 177,994 | ||
| Riverbed Technology, Inc., 144A, 8.875%, 3/1/2023 | 155,000 | 163,525 | ||
| Western Digital Corp.: | ||||
| 144A, 7.375%, 4/1/2023 | 350,000 | 385,000 | ||
| 144A, 10.5%, 4/1/2024 | 168,000 | 198,660 | ||
| 2,606,630 | ||||
| Materials 13.6% | ||||
| AK Steel Corp.: | ||||
| 7.5%, 7/15/2023 | 200,000 | 222,000 | ||
| 7.625%, 5/15/2020 (b) | 320,000 | 326,400 | ||
| Anglo American Capital PLC: | ||||
| 144A, 4.125%, 9/27/2022 (b) | 400,000 | 403,004 | ||
| 144A, 4.875%, 5/14/2025 | 600,000 | 608,250 | ||
| Ardagh Packaging Finance PLC, 144A, 7.25%, 5/15/2024 | 290,000 | 305,587 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Axalta Coating Systems LLC, 144A, 4.875%, 8/15/2024 | 150,000 | 150,000 | ||
| Ball Corp., 4.375%, 12/15/2020 | 110,000 | 114,950 | ||
| Berry Plastics Corp., 5.5%, 5/15/2022 | 435,000 | 452,400 | ||
| Cascades, Inc., 144A, 5.5%, 7/15/2022 | 145,000 | 147,175 | ||
| Chemours Co.: | ||||
| 6.625%, 5/15/2023 | 265,000 | 262,350 | ||
| 7.0%, 5/15/2025 | 80,000 | 78,800 | ||
| Clearwater Paper Corp., 144A, 5.375%, 2/1/2025 | 175,000 | 173,250 | ||
| Constellium NV: | ||||
| 144A, 4.625%, 5/15/2021 | EUR | 150,000 | 152,335 | |
| 144A, 5.75%, 5/15/2024 | 250,000 | 233,750 | ||
| 144A, 7.875%, 4/1/2021 | 500,000 | 537,500 | ||
| Eagle Materials, Inc., 4.5%, 8/1/2026 | 130,000 | 129,675 | ||
| Freeport-McMoRan, Inc.: | ||||
| 3.55%, 3/1/2022 | 350,000 | 325,500 | ||
| 3.875%, 3/15/2023 | 300,000 | 275,250 | ||
| 4.0%, 11/14/2021 | 250,000 | 243,750 | ||
| 4.55%, 11/14/2024 | 400,000 | 375,000 | ||
| 144A, 6.5%, 11/15/2020 | 610,000 | 626,775 | ||
| 144A, 6.875%, 2/15/2023 | 200,000 | 210,000 | ||
| Graphic Packaging International, Inc., 4.125%, 8/15/2024 | 495,000 | 472,725 | ||
| Hexion, Inc., 6.625%, 4/15/2020 | 270,000 | 238,950 | ||
| HudBay Minerals, Inc.: | ||||
| 144A, 7.25%, 1/15/2023 | 45,000 | 46,575 | ||
| 144A, 7.625%, 1/15/2025 | 70,000 | 72,757 | ||
| Huntsman International LLC, 4.25%, 4/1/2025 | EUR | 290,000 | 307,024 | |
| Kaiser Aluminum Corp., 5.875%, 5/15/2024 | 200,000 | 207,000 | ||
| Plastipak Holdings, Inc., 144A, 6.5%, 10/1/2021 | 250,000 | 261,250 | ||
| Platform Specialty Products Corp.: | ||||
| 144A, 6.5%, 2/1/2022 (b) | 230,000 | 231,725 | ||
| 144A, 10.375%, 5/1/2021 | 350,000 | 387,625 | ||
| Reynolds Group Issuer, Inc.: | ||||
| 144A, 5.125%, 7/15/2023 | 400,000 | 408,500 | ||
| 144A, 7.0%, 7/15/2024 | 45,000 | 47,841 | ||
| Sealed Air Corp.: | ||||
| 144A, 4.875%, 12/1/2022 | 115,000 | 118,163 | ||
| 144A, 5.125%, 12/1/2024 | 55,000 | 56,513 | ||
| Teck Resources Ltd.: | ||||
| 3.75%, 2/1/2023 | 400,000 | 378,000 | ||
| 4.5%, 1/15/2021 | 1,565,000 | 1,572,825 | ||
| 4.75%, 1/15/2022 | 165,000 | 165,412 | ||
| 6.125%, 10/1/2035 | 450,000 | 437,625 | ||
| 6.25%, 7/15/2041 | 450,000 | 433,656 | ||
| Tronox Finance LLC: | ||||
| 6.375%, 8/15/2020 | 500,000 | 467,500 | ||
| 144A, 7.5%, 3/15/2022 | 245,000 | 228,462 | ||
| United States Steel Corp., 144A, 8.375%, 7/1/2021 | 510,000 | 563,820 | ||
| Valvoline, Inc., 144A, 5.5%, 7/15/2024 | 90,000 | 93,150 | ||
| WR Grace & Co-Conn: | ||||
| 144A, 5.125%, 10/1/2021 | 90,000 | 93,825 | ||
| 144A, 5.625%, 10/1/2024 | 45,000 | 47,250 | ||
| 13,691,874 | ||||
| Principal Amount ($)(a) | Value ($) | |||
| Real Estate 2.0% | ||||
| CyrusOne LP, (REIT), 6.375%, 11/15/2022 | 310,000 | 326,275 | ||
| Equinix, Inc.: | ||||
| (REIT), 5.375%, 1/1/2022 | 225,000 | 236,250 | ||
| (REIT), 5.375%, 4/1/2023 | 725,000 | 752,187 | ||
| (REIT), 5.75%, 1/1/2025 | 170,000 | 177,650 | ||
| (REIT), 5.875%, 1/15/2026 | 135,000 | 142,088 | ||
| MPT Operating Partnership LP: | ||||
| (REIT), 5.25%, 8/1/2026 | 50,000 | 49,000 | ||
| (REIT), 6.375%, 3/1/2024 | 235,000 | 245,869 | ||
| VEREIT Operating Partnership LP, (REIT), 4.875%, 6/1/2026 | 85,000 | 86,092 | ||
| 2,015,411 | ||||
| Telecommunication Services 11.9% | ||||
| CenturyLink, Inc.: | ||||
| Series T, 5.8%, 3/15/2022 | 380,000 | 388,409 | ||
| Series S, 6.45%, 6/15/2021 | 545,000 | 573,612 | ||
| Series W, 6.75%, 12/1/2023 | 250,000 | 255,625 | ||
| Series Y, 7.5%, 4/1/2024 | 635,000 | 666,750 | ||
| Digicel Ltd.: | ||||
| 144A, 6.75%, 3/1/2023 | 390,000 | 351,636 | ||
| 144A, 7.0%, 2/15/2020 | 200,000 | 188,328 | ||
| Frontier Communications Corp.: | ||||
| 6.25%, 9/15/2021 (b) | 540,000 | 511,650 | ||
| 7.125%, 1/15/2023 | 605,000 | 547,525 | ||
| 10.5%, 9/15/2022 | 615,000 | 646,549 | ||
| 11.0%, 9/15/2025 | 430,000 | 443,975 | ||
| Hughes Satellite Systems Corp., 7.625%, 6/15/2021 | 230,000 | 252,425 | ||
| Intelsat Jackson Holdings SA, 144A, 8.0%, 2/15/2024 (b) | 452,000 | 464,430 | ||
| Sprint Communications, Inc.: | ||||
| 144A, 7.0%, 3/1/2020 | 745,000 | 808,325 | ||
| 7.0%, 8/15/2020 | 350,000 | 371,039 | ||
| Sprint Corp.: | ||||
| 7.125%, 6/15/2024 | 1,345,000 | 1,385,350 | ||
| 7.625%, 2/15/2025 | 250,000 | 262,813 | ||
| T-Mobile U.S.A., Inc.: | ||||
| 6.0%, 4/15/2024 | 899,000 | 947,321 | ||
| 6.125%, 1/15/2022 | 110,000 | 116,050 | ||
| 6.375%, 3/1/2025 | 497,000 | 531,169 | ||
| 6.5%, 1/15/2026 | 15,000 | 16,219 | ||
| Telesat Canada, 144A, 8.875%, 11/15/2024 | 180,000 | 187,650 | ||
| Wind Acquisition Finance SA, 144A, 6.5%, 4/30/2020 | 195,000 | 202,800 | ||
| Windstream Services LLC: | ||||
| 7.75%, 10/15/2020 | 450,000 | 462,600 | ||
| 7.75%, 10/1/2021 (b) | 500,000 | 514,000 | ||
| Zayo Group LLC: | ||||
| 6.0%, 4/1/2023 | 530,000 | 551,200 | ||
| 6.375%, 5/15/2025 | 386,000 | 403,370 | ||
| 12,050,820 | ||||
| Utilities 3.7% | ||||
| AmeriGas Partners LP, 5.5%, 5/20/2025 | 325,000 | 328,250 | ||
| Calpine Corp.: | ||||
| 5.375%, 1/15/2023 | 240,000 | 234,600 | ||
| 5.75%, 1/15/2025 | 240,000 | 231,600 | ||
| Dynegy, Inc., 7.625%, 11/1/2024 | 475,000 | 438,187 | ||
| Principal Amount ($)(a) | Value ($) | |||
| NGL Energy Partners LP, 5.125%, 7/15/2019 | 190,000 | 188,575 | ||
| NRG Energy, Inc.: | ||||
| 6.25%, 7/15/2022 | 1,000,000 | 1,002,500 | ||
| 6.25%, 5/1/2024 | 770,000 | 748,825 | ||
| 144A, 6.625%, 1/15/2027 | 110,000 | 103,950 | ||
| 144A, 7.25%, 5/15/2026 | 385,000 | 383,075 | ||
| 7.875%, 5/15/2021 | 30,000 | 31,275 | ||
| Talen Energy Supply LLC, 144A, 4.625%, 7/15/2019 | 95,000 | 90,013 | ||
| 3,780,850 | ||||
| Total Corporate Bonds (Cost $90,160,488) | 92,291,615 | |||
| Government & Agency Obligation 1.1% | ||||
| U.S. Treasury Obligation | ||||
| U.S. Treasury Note, 0.75%, 10/31/2017 (Cost $1,100,429) | 1,100,000 | 1,099,012 | ||
| Convertible Bonds 1.5% | ||||
| Energy 0.0% | ||||
| Chesapeake Energy Corp., 2.5%, 5/15/2037 | 19,000 | 19,071 | ||
| Materials 1.5% | ||||
| GEO Specialty Chemicals, Inc., 144A, 7.5%, 10/30/2018 (PIK) | 1,426,438 | 1,459,104 | ||
| Total Convertible Bonds (Cost $1,422,510) | 1,478,175 | |||
|
Shares |
Value ($) | |||
| Common Stocks 0.1% | ||||
| Industrials 0.0% | ||||
| Quad Graphics, Inc. | 249 | 6,693 | ||
|
Shares |
Value ($) | |||
| Materials 0.1% | ||||
| GEO Specialty Chemicals, Inc.* | 144,027 | 56,560 | ||
| GEO Specialty Chemicals, Inc. 144A* | 2,206 | 866 | ||
| 57,426 | ||||
| Total Common Stocks (Cost $292,150) | 64,119 | |||
| Warrant 0.0% | ||||
| Materials | ||||
| Hercules Trust II, Expiration Date 3/31/2029* (Cost $244,286) | 1,100 | 4,994 | ||
| Securities Lending Collateral 4.6% | ||||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.42% (c) (d) (Cost $4,663,795) | 4,663,795 | 4,663,795 | ||
| Cash Equivalents 4.5% | ||||
| Deutsche Central Cash Management Government Fund, 0.49% (c) (Cost $4,597,237) | 4,597,237 | 4,597,237 | ||
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $102,480,895)† | 103.1 | 104,198,947 |
| Other Assets and Liabilities, Net | (3.1) | (3,086,949) |
| Net Assets | 100.0 | 101,111,998 |
* Non-income producing security.
** Floating rate securities' yields vary with a designated market index or market rate, such as the coupon-equivalent of the U.S. Treasury Bill rate. These securities are shown at their current rate as of December 31, 2016.
† The cost for federal income tax purposes was $102,480,895. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $1,718,052. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $3,337,205 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $1,619,153.
(a) Principal amount stated in U.S. dollars unless otherwise noted.
(b) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $4,496,490, which is 4.4% of net assets.
(c) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(d) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
144A: Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration, normally to qualified institutional buyers.
PIK: Denotes that all or a portion of the income is paid in-kind in the form of additional principal.
REIT: Real Estate Investment Trust
At December 31, 2016, open credit default swap contracts sold were as follows:
| Bilateral Swaps | ||||||
| Expiration Dates | Notional Amount ($) (e) | Fixed Cash Flows Received | Underlying Debt Obligation/ Quality Rating (f) |
Value ($) | Upfront Payments Paid ($) | Unrealized Appreciation ($) |
| 3/20/2019 | 1,500,0001 | 5.0% | Sprint Communications, Inc., 7.0%, 8/15/2020, B |
105,416 | 68,900 | 36,516 |
(e) The maximum potential amount of future undiscounted payments that the Fund could be required to make under a credit default swap contract would be the notional amount of the contract. These potential amounts would be partially offset by any recovery values of the referenced debt obligation or net amounts received from the settlement of buy protection credit default swap contracts entered into by the Fund for the same referenced debt obligation, if any.
(f) The quality ratings represent the higher of Moody's Investors Service, Inc. ("Moody's") or Standard & Poor's Corporation ("S&P") credit ratings and are unaudited.
Counterparty:
1 Goldman Sachs & Co.
As of December 31, 2016, the Fund had the following open forward foreign currency exchange contracts:
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Depreciation ($) | Counterparty | |||||
| USD | 216,529 | EUR | 204,955 | 1/31/2017 | (427) | Merrill Lynch & Co., Inc. | |||
| EUR | 653,509 | USD | 684,923 | 1/31/2017 | (4,130) | Merrill Lynch & Co., Inc. | |||
| Total unrealized depreciation | (4,557) | ||||||||
| Currency Abbreviations |
|
EUR Euro USD United States Dollar |
For information on the Fund's policy and additional disclosures regarding credit default swap contracts and forward foreign currency exchange contracts, please refer to Note B in the accompanying Notes to Financial Statements.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Fixed Income Investments (g) | |||||
| Corporate Bonds | $ — | $92,291,615 | $ — | $92,291,615 | |
| Government & Agency Obligation | — | 1,099,012 | — | 1,099,012 | |
| Convertible Bonds | — | 19,071 | 1,459,104 | 1,478,175 | |
| Common Stocks (g) | 6,693 | — | 57,426 | 64,119 | |
| Warrant | — | — | 4,994 | 4,994 | |
| Short-Term Investments (g) | 9,261,032 | — | — | 9,261,032 | |
| Derivatives (h) | |||||
| Credit Default Swap Contracts | — | 36,516 | — | 36,516 | |
| Total | $9,267,725 | $93,446,214 | $1,521,524 | $104,235,463 | |
| Liabilities | Level 1 | Level 2 | Level 3 | Total | |
| Derivatives (h) | |||||
| Forward Foreign Currency Exchange Contracts | $ — | $ (4,557) | $ — | $ (4,557) | |
| Total | $ — | $ (4,557) | $ — | $ (4,557) | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(g) See Investment Portfolio for additional detailed categorizations.
(h) Derivatives include unrealized appreciation (depreciation) on credit default swap contracts and forward foreign currency exchange contracts.
Level 3 Reconciliation
The following is a reconciliation of the Fund's Level 3 investments for which significant unobservable inputs were used in determining value:
| Loan Participations and Assignments | Convertible Bonds | Common Stocks | Warrants | Total | |
| Balance as of December 31, 2015 | $ 0 | $1,551,885 | $ 93,597 | $ 1,879 | $1,647,361 |
| Realized gains (loss) | (700,000) | — | 31,908 | — | (668,092) |
| Change in unrealized appreciation (depreciation) | 700,000 | (204,903) | 17,182 | 3,115 | 515,394 |
| Amortization of premium/accretion of discount | — | 8,620 | — | — | 8,620 |
| Purchases | — | 103,502 | — | — | 103,502 |
| (Sales) | 0 | — | (85,261) | — | (85,261) |
| Transfer into Level 3 | — | — | — | — | — |
| Transfer (out) of Level 3 | — | — | — | — | — |
| Balance as of December 31, 2016 | $ — | $1,459,104 | $ 57,426 | $ 4,994 | $1,521,524 |
| Net change in unrealized appreciation (depreciation) from investments still held as of December 31, 2016 | $ — | $ (204,903) | $ (9,637) | $ 3,115 | $(211,425) |
| Quantitative Disclosure About Significant Unobservable Inputs | ||||
| Asset Class | Fair Value at 12/31/16 | Valuation Technique(s) | Unobservable Input | Range (Weighted Average) |
| Common Stocks | ||||
| Materials | $ 57,426 | Market Approach | EV/EBITDA Multiple | 6.13% |
| Discount to public comparables | 20% | |||
| Discount for lack of marketability | 20% | |||
| Warrants | ||||
| Materials | $ 4,994 | Black Scholes Option Pricing Model | Implied Volatility | 27.0% |
| Illiquidity Discount | 20% | |||
| Convertible Bonds | ||||
| Materials | $1,459,104 | Convertible Bond Methodology | EV/EBITDA Multiple | 6.13% |
| Discount to public comparables | 20% | |||
| Discount for lack of marketability | 20% | |||
Qualitative Disclosure About Unobservable Inputs
Significant unobservable inputs developed by the Pricing Committee and used in the fair value measurement of the Fund’s equity and convertible bond investments include enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) ratio with a discount for lack of marketability. A significant change in the EV to EBITDA ratio may result in a significant change in the fair value measurement, while a significant change in the discount for lack of marketability is unlikely to result in a materially higher or lower fair value measurement.
Significant unobservable inputs developed by the Pricing Committee and used in the fair value measurement of the Fund’s warrants include volatility and discount for lack of marketability. A change in the volatility of the underlying asset as an input to the Black-Scholes model may have a significant change in the fair value measurement. A significant change in the discount for lack of marketability is unlikely to have a material impact to the fair value measurement.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $93,219,863) — including $4,496,490 of securities loaned |
$ 94,937,915 |
| Investment in Government & Agency Securities Portfolio (cost $4,663,795)* | 4,663,795 |
| Investment in Deutsche Central Cash Management Government Fund (cost $4,597,237) | 4,597,237 |
| Total investments in securities, at value (cost $102,480,895) | 104,198,947 |
| Cash | 9,999 |
| Foreign currency, at value (cost $227,008) | 226,428 |
| Receivable for investments sold | 4,800 |
| Receivable for Fund shares sold | 18,951 |
| Interest receivable | 1,486,311 |
| Unrealized appreciation on bilateral swap contracts | 36,516 |
| Upfront payments paid on bilateral swap contracts | 68,900 |
| Foreign taxes recoverable | 979 |
| Other assets | 1,750 |
| Total assets | 106,053,581 |
| Liabilities | |
| Payable upon return of securities loaned | 4,663,795 |
| Payable for Fund shares redeemed | 111,312 |
| Unrealized depreciation on forward foreign currency exchange contracts | 4,557 |
| Accrued management fee | 26,673 |
| Accrued Trustees' fees | 1,989 |
| Other accrued expenses and payables | 133,257 |
| Total liabilities | 4,941,583 |
| Net assets, at value | $101,111,998 |
| Net Assets Consist of | |
| Undistributed net investment income | 5,781,669 |
|
Net unrealized appreciation (depreciation) on: Investments |
1,718,052 |
| Swap contracts | 36,516 |
| Foreign currency | (3,986) |
| Accumulated net realized gain (loss) | (26,965,433) |
| Paid-in capital | 120,545,180 |
| Net assets, at value | $101,111,998 |
|
Class A Net Asset Value, offering and redemption price per share ($99,511,676 ÷ 15,845,238 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 6.28 |
|
Class B Net Asset Value, offering and redemption price per share ($1,600,322 ÷ 254,095 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 6.30 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
| Interest | $ 6,073,275 |
| Dividends | 284 |
| Income distributions — Deutsche Central Cash Management Government Fund | 19,176 |
| Securities lending income, net of borrower rebates | 45,660 |
| Other income | 33,497 |
| Total income | 6,171,892 |
|
Expenses: Management fee |
506,207 |
| Administration fee | 101,241 |
| Distribution service fee (Class B) | 2,364 |
| Recordkeeping fees (Class B) | 1,376 |
| Services to shareholders | 1,622 |
| Custodian fee | 17,118 |
| Professional fees | 92,509 |
| Reports to shareholders | 34,772 |
| Trustees' fees and expenses | 6,080 |
| Other | 49,148 |
| Total expenses before expense reductions | 812,437 |
| Expense reductions | (80,908) |
| Total expenses after expense reductions | 731,529 |
| Net investment income (loss) | 5,440,363 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
(3,049,451) |
| Swap contracts | (135,510) |
| Foreign currency | 21,196 |
| (3,163,765) | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
9,300,523 |
| Swap contracts | 593,956 |
| Foreign currency | (3,986) |
| 9,890,493 | |
| Net gain (loss) | 6,726,728 |
| Net increase (decrease) in net assets resulting from operations | $ 12,167,091 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 5,440,363 | $ 6,638,151 |
| Net realized gain (loss) | (3,163,765) | (4,223,311) |
| Change in net unrealized appreciation (depreciation) | 9,890,493 | (7,046,460) |
| Net increase (decrease) in net assets resulting from operations | 12,167,091 | (4,631,620) |
|
Distributions to shareholders from: Net investment income: Class A |
(6,259,405) | (8,457,661) |
| Class B | (122,558) | (6,469) |
| Total distributions | (6,381,963) | (8,464,130) |
|
Fund share transactions: Class A Proceeds from shares sold |
15,011,086 | 17,956,787 |
| Reinvestment of distributions | 6,259,405 | 8,457,661 |
| Payments for shares redeemed | (28,525,830) | (47,358,324) |
| Net increase (decrease) in net assets from Class A share transactions | (7,255,339) | (20,943,876) |
|
Class B Proceeds from shares sold |
5,848,785 | 29,829,991 |
| Reinvestment of distributions | 122,558 | 6,469 |
| Payments for shares redeemed | (7,539,910) | (26,867,647) |
| Net increase (decrease) in net assets from Class B share transactions | (1,568,567) | 2,968,813 |
| Increase (decrease) in net assets | (3,038,778) | (31,070,813) |
| Net assets at beginning of period | 104,150,776 | 135,221,589 |
| Net assets at end of period (including undistributed net investment income of $5,781,669 and $6,775,642, respectively) | $101,111,998 | 104,150,776 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
17,025,372 | 20,495,541 |
| Shares sold | 2,525,843 | 2,794,697 |
| Shares issued to shareholders in reinvestment of distributions | 1,081,072 | 1,315,344 |
| Shares redeemed | (4,787,049) | (7,580,210) |
| Net increase (decrease) in Class A shares | (1,180,134) | (3,470,169) |
| Shares outstanding at end of period | 15,845,238 | 17,025,372 |
|
Class B Shares outstanding at beginning of period |
530,185 | 3,764 |
| Shares sold | 990,197 | 4,790,954 |
| Shares issued to shareholders in reinvestment of distributions | 21,094 | 998 |
| Shares redeemed | (1,287,381) | (4,265,531) |
| Net increase (decrease) in Class B shares | (276,090) | 526,421 |
| Shares outstanding at end of period | 254,095 | 530,185 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 5.93 | $ 6.60 | $ 6.96 | $ 6.93 | $ 6.56 | |
|
Income (loss) from investment operations: Net investment incomea |
.32 | .32 | .36 | .39 | .45 | |
| Net realized and unrealized gain (loss) | .41 | (.58) | (.25) | .14 | .48 | |
| Total from investment operations | .73 | (.26) | .11 | .53 | .93 | |
|
Less distributions from: Net investment income |
(.38) | (.41) | (.47) | (.50) | (.56) | |
| Net asset value, end of period | $ 6.28 | $ 5.93 | $ 6.60 | $ 6.96 | $ 6.93 | |
| Total Return (%) | 12.87b | (4.44)b | 1.47b | 7.91b | 14.91 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 100 | 101 | 135 | 165 | 178 | |
| Ratio of expenses before expense reductions (%) | .80 | .75 | .75 | .73 | .72 | |
| Ratio of expenses after expense reductions (%) | .72 | .72 | .73 | .72 | .72 | |
| Ratio of net investment income (%) | 5.38 | 5.09 | 5.21 | 5.69 | 6.68 | |
| Portfolio turnover rate (%) | 77 | 47 | 52 | 58 | 58 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 5.94 | $ 6.63 | $ 6.99 | $ 6.97 | $ 6.59 | |
|
Income (loss) from investment operations: Net investment incomea |
.31 | .32 | .35 | .36 | .43 | |
| Net realized and unrealized gain (loss) | .41 | (.61) | (.26) | .15 | .49 | |
| Total from investment operations | .72 | (.29) | .09 | .51 | .92 | |
|
Less distributions from: Net investment income |
(.36) | (.40) | (.45) | (.49) | (.54) | |
| Net asset value, end of period | $ 6.30 | $ 5.94 | $ 6.63 | $ 6.99 | $ 6.97 | |
| Total Return (%)b | 12.67 | (4.95) | 1.22 | 7.44 | 14.70 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 2 | 3 | .03 | .32 | .09 | |
| Ratio of expenses before expense reductions (%) | 1.21 | 1.14 | 1.13 | 1.10 | .99 | |
| Ratio of expenses after expense reductions (%) | .98 | 1.02 | .97 | .97 | .99 | |
| Ratio of net investment income (%) | 5.15 | 4.86 | 5.09 | 5.29 | 6.42 | |
| Portfolio turnover rate (%) | 77 | 47 | 52 | 58 | 58 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche High Income VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets of the Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee and recordkeeping fees). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Debt securities and loan participations and assignments are valued at prices supplied by independent pricing services approved by the Fund's Board. Such services may use various pricing techniques which take into account appropriate factors such as yield, quality, coupon rate, maturity, type of issue, trading characteristics, prepayment speeds and other data, as well as broker quotes. If the pricing services are unable to provide valuations, debt securities are valued at the average of the most recent reliable bid quotations or evaluated prices, as applicable, obtained from broker-dealers and loan participations and assignments are valued at the mean of the most recent bid and ask quotations or evaluated prices, as applicable, obtained from broker-dealers. Certain securities may be valued on the basis of a price provided by a single source or broker-dealer. No active trading market may exist for some senior loans and they may be subject to restrictions on resale. The inability to dispose of senior loans in a timely fashion could result in losses. These securities are generally categorized as Level 2.
Equity securities are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities are generally categorized as Level 1 securities.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and are categorized as Level 2.
Swap contracts are valued daily based upon prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer. Swap contracts are generally categorized as Level 2.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. That portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as corporate bonds in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end. As of period end, the remaining contractual maturity of the collateral agreements were overnight and continuous.
Loan Participations and Assignments. Loan Participations and Assignments are portions of loans originated by banks and sold in pieces to investors. These floating-rate loans ("Loans") in which the Fund invests are arranged between the borrower and one or more financial institutions ("Lenders"). These Loans may take the form of Senior Loans, which are corporate obligations often issued in connection with recapitalizations, acquisitions, leveraged buy outs and refinancing. The Fund invests in such Loans in the form of participations in Loans ("Participations") or assignments of all or a portion of Loans from third parties ("Assignments"). Participations typically result in the Fund having a contractual relationship with only the Lender, not with the borrower. The Fund has the right to receive payments of principal, interest and any fees to which it is entitled from the Lender selling the Participation and only upon receipt by the Lender of the payments from the borrower. In connection with purchasing Participations, the Fund generally has no right to enforce compliance by the borrower with the terms of the loan agreement relating to the Loan, or any rights of set off against the borrower, and the Fund will not benefit directly from any collateral supporting the Loan in which it has purchased the Participation. As a result, the Fund assumes the credit risk of both the borrower and the Lender that is selling the Participation. Assignments typically result in the Fund having a direct contractual relationship with the borrower, and the Fund may enforce compliance by the borrower with the terms of the loan agreement. Loans held by the Fund are generally in the form of Assignments, but the Fund may also invest in Participations. If affiliates of the Advisor participate in the primary and secondary market for senior loans, legal limitations may restrict the Fund's ability to participate in restructuring or acquiring some senior loans. All Loans involve interest rate risk, liquidity risk and credit risk, including the potential default or insolvency of the borrower.
When-Issued/Delayed Delivery Securities. The Fund may purchase securities with delivery or payment to occur at a later date beyond the normal settlement period. At the time the Fund enters into a commitment to purchase a security, the transaction is recorded and the value of the transaction is reflected in the net asset value. The price of such security and the date when the security will be delivered and paid for are fixed at the time the transaction is negotiated. The value of the security may vary with market fluctuations. At the time the Fund enters into a purchase transaction it is required to segregate cash or other liquid assets at least equal to the amount of the commitment. Additionally, the Fund may be required to post securities and/or cash collateral in accordance with the terms of the commitment.
Certain risks may arise upon entering into when-issued or delayed delivery transaction from the potential inability of counterparties to meet the terms of their contracts or if the issuer does not issue the securities due to political, economic, or other factors. Additionally, losses may arise due to changes in the value of the underlying securities.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
Under the Regulated Investment Company Modernization Act of 2010, net capital losses incurred post-enactment may be carried forward indefinitely, and their character is retained as short-term and/or long-term. Previously, net capital losses were carried forward for eight years and treated as short-term losses. As a transition rule, the Act requires that post-enactment net capital losses be used before pre-enactment net capital losses.
At December 31, 2016, the Fund had a net tax basis capital loss carryforward of approximately $26,966,000, including $17,232,000 of pre-enactment losses, which may be applied against any realized net taxable capital gains of each succeeding year until fully utilized or until December 31, 2017, the expiration date, whichever occurs first; and approximately $9,734,000 of post-enactment long-term losses, which may be applied against realized net taxable capital gains indefinitely, including short-term losses ($1,843,000) and long-term losses ($7,891,000).
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in swap contracts, expiration of capital loss carryforward and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 5,813,628 |
| Capital loss carryforwards | $(26,966,000) |
| Unrealized appreciation (depreciation) on investments | $ 1,718,052 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 6,381,963 | $ 8,464,130 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on ex-dividend date. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments. All discounts and premiums are accreted/amortized for both tax and financial reporting purposes for the Fund, with the exception of securities in default of principal.
B. Derivative Instruments
Swaps. A swap is a contract between two parties to exchange future cash flows at periodic intervals based on the notional amount of the swap. A bilateral swap is a transaction between the fund and a counterparty where cash flows are exchanged between the two parties. A centrally cleared swap is a transaction executed between the fund and a counterparty, then cleared by a clearing member through a central clearinghouse. The central clearinghouse serves as the counterparty, with whom the fund exchanges cash flows.
The value of a swap is adjusted daily, and the change in value, if any, is recorded as unrealized appreciation or depreciation in the Statement of Assets and Liabilities. Gains or losses are realized when the swap expires or is closed. Certain risks may arise when entering into swap transactions including counterparty default; liquidity; or unfavorable changes in interest rates or the value of the underlying reference security, commodity or index. In connection with bilateral swaps, securities and/or cash may be identified as collateral in accordance with the terms of the swap agreement to provide assets of value and recourse in the event of default. The maximum counterparty credit risk is the net present value of the cash flows to be received from or paid to the counterparty over the term of the swap, to the extent that this amount is beneficial to the Fund, in addition to any related collateral posted to the counterparty by the Fund. This risk may be partially reduced by a master netting arrangement between the Fund and the counterparty. Upon entering into a centrally cleared swap, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the notional amount of the swap. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value of the swap. In a cleared swap transaction, counterparty risk is minimized as the central clearinghouse acts as the counterparty.
An upfront payment, if any, made by the Fund is recorded as an asset in the Statement of Assets and Liabilities. An upfront payment, if any, received by the Fund is recorded as a liability in the Statement of Assets and Liabilities. Payments received or made at the end of the measurement period are recorded as realized gain or loss in the Statement of Operations.
Credit default swaps are agreements between a buyer and a seller of protection against predefined credit events for the reference entity. The Fund may enter into credit default swaps to gain exposure to an underlying issuer's credit quality characteristics without directly investing in that issuer or to hedge against the risk of a credit event on debt securities. As a seller of a credit default swap, the Fund is required to pay the par (or other agreed-upon) value of the referenced entity to the counterparty with the occurrence of a credit event by a third party, such as a U.S. or foreign corporate issuer, on the reference entity, which would likely result in a loss to the Fund. In return, the Fund receives from the counterparty a periodic stream of payments over the term of the swap provided that no credit event has occurred. If no credit event occurs, the Fund keeps the stream of payments with no payment obligations. The Fund may also buy credit default swaps, in which case the Fund functions as the counterparty referenced above. This involves the risk that the swap may expire worthless. It also involves counterparty risk that the seller may fail to satisfy its payment obligations to the Fund with the occurrence of a credit event. When the Fund sells a credit default swap, it will cover its commitment. This may be achieved by, among other methods, maintaining cash or liquid assets equal to the aggregate notional value of the reference entities for all outstanding credit default swaps sold by the Fund. For the year ended December 31, 2016, the Fund entered into credit default swap agreements to gain exposure to the underlying issuer's credit quality characteristics.
Under the terms of a credit default swap, the Fund receives or makes periodic payments based on a specified interest rate on a fixed notional amount. These payments are recorded as a realized gain or loss in the Statement of Operations. Payments received or made as a result of a credit event or termination of the swap are recognized, net of a proportional amount of the upfront payment, as realized gains or losses in the Statement of Operations.
A summary of the open credit default swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the Fund's investment in credit default swap contracts sold had a total notional value generally indicative of a range from $1,500,000 to $9,570,000.
Forward Foreign Currency Exchange Contracts. A forward foreign currency exchange contract ("forward currency contract") is a commitment to purchase or sell a foreign currency at the settlement date at a negotiated rate. For the year ended December 31, 2016, the Fund entered into forward currency contracts in order to hedge its exposure to changes in foreign currency exchange rates on its foreign currency denominated portfolio holdings and to facilitate transactions in foreign currency denominated securities. Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and unrealized gain (loss) is recorded daily. On the settlement date of the forward currency contract, the Fund records a realized gain or loss equal to the difference between the value of the contract at the time it was opened and the value of the contract at the time it was closed. Certain risks may arise upon entering into forward currency contracts from the potential inability of counterparties to meet the terms of their contracts. The maximum counterparty credit risk to the Fund is measured by the unrealized gain on appreciated contracts. Additionally, when utilizing forward currency contracts to hedge, the Fund gives up the opportunity to profit from favorable exchange rate movements during the term of the contract.
A summary of the open forward currency contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in forward currency contracts short vs. U.S. dollars had a total contract value generally indicative of a range from $0 to approximately $685,000, and the investment in forward currency contracts long vs. U.S. dollars had a total contract value generally indicative of a range from $0 to approximately $217,000.
The following tables summarize the value of the Fund's derivative instruments held as of December 31, 2016 and the related location in the accompanying Statement of Assets and Liabilities, presented by primary underlying risk exposure:
| Asset Derivative | Swap Contracts |
| Credit Contracts (a) | $ 36,516 |
|
The above derivative is located in the following Statement of Assets and Liabilities account: (a) Unrealized appreciation on bilateral swap contracts | |
| Liability Derivative | Forward Contracts |
| Foreign Exchange Contracts (a) | $ (4,557) |
|
The above derivatives is located in the following Statement of Assets and Liabilities account: (a) Unrealized depreciation on foreign forward currency exchange contracts | |
Additionally, the amount of unrealized and realized gains and losses on derivative instruments recognized in Fund earnings during the year ended December 31, 2016 and the related location in the accompanying Statement of Operations is summarized in the following tables by primary underlying risk exposure:
| Realized Gain (Loss) | Forward Contracts | Swap Contracts |
Total |
| Credit Contracts (a) | $ — | $ (135,510) | $ (135,510) |
| Foreign Exchange Contracts (b) | 24,078 | — | 24,078 |
| $ 24,078 | $ (135,510) | $ (111,432) | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Net realized gain (loss) from swap contracts (b) Net realized gain (loss) from foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | |||
| Change in Net Unrealized Appreciation (Depreciation) | Forward Contracts | Swap Contracts |
Total |
| Credit Contracts (a) | $ — | $ 593,956 | $ 593,956 |
| Foreign Exchange Contracts (b) | (4,557) | — | (4,557) |
| $ (4,557) | $ 593,956 | $ 589,399 | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Change in net unrealized appreciation (depreciation) on swap contracts (b) Change in net unrealized appreciation (depreciation) on foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | |||
As of December 31, 2016, the Fund has transactions subject to enforceable master netting agreements. A reconciliation of the gross amounts on the Statement of Assets and Liabilities to the net amounts by counterparty, including any collateral exposure, is included in the following table:
| Counterparty | Gross Amounts of Assets Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Received | Net Amount of Derivative Assets |
| Goldman Sachs & Co. | $ 36,516 | $ — | $ — | $ 36,516 |
| Counterparty | Gross Amounts of Liabilities Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Pledged | Net Amount of Derivative Liabilities |
| Merrill Lynch & Co., Inc. | $ 4,557 | $ — | $ — | $ 4,557 |
C. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments and U.S. Treasury securities) aggregated $72,373,524 and $82,108,986, respectively. Purchases and sales of U.S. Treasury obligations aggregated $1,100,605 and $550,021, respectively.
D. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .500% |
| Next $750 million | .470% |
| Next $1.5 billion | .450% |
| Next $2.5 billion | .430% |
| Next $2.5 billion | .400% |
| Next $2.5 billion | .380% |
| Next $2.5 billion | .360% |
| Over $12.5 billion | .340% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.50% of the Fund's average daily net assets.
For the period from January 1, 2016 through April 30, 2017, the Advisor has contractually agreed to waive all or a portion of its fees and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .72% |
| Class B | .98% |
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 78,771 |
| Class B | 2,137 |
| $ 80,908 |
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $101,241, of which $8,561 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Services to Shareholders | Total Aggregated | Unpaid at December 31, 2016 |
| Class A | $ 284 | $ 71 |
| Class B | 58 | 15 |
| $ 342 | $ 86 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plans, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee was $2,364, of which 339 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $15,162, of which $5,913 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Security Lending Fees. Deutsche Bank AG serves as lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred lending agent fees to Deutsche Bank AG for the amount of $3,910.
E. Investing in High-Yield Debt Securities
High-yield debt securities or junk bonds are generally regarded as speculative with respect to the issuer’s continuing ability to meet principal and interest payments. The Fund’s performance could be hurt if an issuer of a debt security suffers an adverse change in financial condition that results in the issuer not making timely payments of interest or principal, a security downgrade or an inability to meet a financial obligation. High-yield debt securities’ total return and yield may generally be expected to fluctuate more than the total return and yield of investment-grade debt securities. A real or perceived economic downturn or an increase in market interest rates could cause a decline in the value of high-yield debt securities, result in increased redemptions and/or result in increased portfolio turnover, which could result in a decline in net asset value of the fund, reduce liquidity for certain investments and/or increase costs. High-yield debt securities are often thinly traded and can be more difficult to sell and value accurately than investment-grade debt securities as there may be no established secondary market. Investments in high yield debt securities could increase liquidity risk for the fund. In addition, the market for high-yield debt securities can experience sudden and sharp volatility which is generally associated more with investments in stocks.
F. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 54% and 31%. One participating insurance company was the owner of record of 10% or more of the total outstanding Class B shares of the Fund, owning 94%.
G. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche High Income VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche High Income VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers or by other appropriate auditing procedures where replies from brokers were not received. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche High Income VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,068.00 | $1,067.80 | ||
| Expenses Paid per $1,000* | $ 3.74 | $ 5.09 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,021.52 | $1,020.21 | ||
| Expenses Paid per $1,000* | $ 3.66 | $ 4.98 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios | Class A | Class B | ||
| Deutsche Variable Series II — Deutsche High Income VIP | .72% | .98% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
For corporate shareholders, 1% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche High Income VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 3rd quartile of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has outperformed its benchmark in the one- and three-year periods and has underperformed its benchmark in the five-year period ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were lower than the median (1st quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be higher than the median (3rd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2HI-2 (R-025832-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Large Cap Value VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 9 Statement of Assets and Liabilities 10 Statement of Operations 10 Statements of Changes in Net Assets 12 Financial Highlights 13 Notes to Financial Statements 18 Report of Independent Registered Public Accounting Firm 19 Information About Your Fund's Expenses 20 Tax Information 20 Proxy Voting 21 Advisory Agreement Board Considerations and Fee Evaluation 24 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Stocks may decline in value. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 0.78% and 1.10% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Large Cap Value VIP | ||
|
■ Deutsche Large Cap Value VIP — Class A ■ Russell 1000® Value Index ■ S&P 500 Index |
The Russell 1000® Value Index is an unmanaged index that consists of those stocks in the Russell 1000® Index with less-than-average growth orientation. The Russell 1000® Index is an unmanaged price-only index of the 1,000 largest capitalized companies that are domiciled in the U.S. and whose common stocks are traded. Effective on or about October 3, 2016, the Standard & Poor’s (S&P) 500 Index replaced the Russell 1000® Value Index as the comparative broad-based securities market index because the Advisor believes that the Standard & Poor’s (S&P) 500 Index more closely reflects the fund’s overall investments. The Standard & Poor’s 500 Index (S&P 500) is an unmanaged, capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Large Cap Value VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $9,561 | $9,858 | $14,167 | $14,149 |
| Average annual total return | –4.39% | –0.47% | 7.21% | 3.53% | |
|
Russell 1000® Value Index
|
Growth of $10,000 | $11,734 | $12,803 | $19,938 | $17,445 |
| Average annual total return | 17.34% | 8.59% | 14.80% | 5.72% | |
| S&P 500® Index | Growth of $10,000 | $11,196 | $12,905 | $19,818 | $19,572 |
| Average annual total return | 11.96% | 8.87% | 14.66% | 6.95% | |
| Deutsche Large Cap Value VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class B | Growth of $10,000 | $9,538 | $9,772 | $13,959 | $13,714 |
| Average annual total return | –4.62% | –0.77% | 6.90% | 3.21% | |
| Russell 1000® Value Index | Growth of $10,000 | $11,734 | $12,803 | $19,938 | $17,445 |
| Average annual total return | 17.34% | 8.59% | 14.80% | 5.72% | |
| S&P 500® Index | Growth of $10,000 | $11,196 | $12,905 | $19,818 | $19,572 |
| Average annual total return | 11.96% | 8.87% | 14.66% | 6.95% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
Deutsche Large Cap Value VIP returned –4.39% in 2016 (Class A shares, unadjusted for contract charges), compared with the 11.96% return of its benchmark the S&P 500® Index. The Russell 1000™ Value Index returned 17.34%.1
At the start of 2016, stocks performed poorly due to lingering concerns regarding global growth, but favorable actions by the world’s central banks provided the spark for a rebound in mid-February. Stocks continued to rally through the spring and summer, as better-than-expected economic data fueled a steady recovery in market sentiment. During the period, the U.S. Federal Reserve Board reaffirmed its commitment to a gradual, data-dependent approach to its interest-rate policy. At the same time, investors grew more comfortable with the growth picture, as rebounding commodity prices, an improving outlook for China and steady economic data from developed markets allayed fears that the world economy would slip into a recession. Macroeconomic concerns returned in October, when the market rally lost steam amid growing uncertainty about the U.S. election. While stocks paused in the weeks leading up to the election, they staged a powerful relief rally in the final three weeks of November due to investors’ favorable response to the removal of political uncertainty.
For the 12-month period, the Fund significantly underperformed the benchmark, and the largest detractor from performance was the Fund's tilt toward growth companies, as stocks with the biggest growth orientation underperformed, while more value-oriented stocks outperformed. High-dividend and low-volatility stocks also outperformed, and the Fund was underweighted in those areas as well. With regard to sectors, the Fund's overweight in health care and underweight in financials subtracted from returns. In terms of specific holdings, the timing of the Fund's position in Bank of America Corp.* detracted significantly from performance. Holdings in the generic drug maker Endo International plc* also detracted as the company lowered its earnings outlook. Conversely, the Fund's holdings in Darden Restaurants, Inc.* contributed to returns as the company has benefited from the excellent execution of core strategies within its restaurant chains. Additionally, the Fund's out-of-benchmark position in Southwest Airlines Co.* added to performance as the airline has enjoyed healthy earnings.2
In October 2016, Deutsche Large Cap Value VIP adopted the CROCI® (Cash Return on Capital Invested) strategy as its underlying investment thesis. Portfolio management will select stocks of companies that they believe offer economic value from among the largest U.S. companies, utilizing the CROCI® strategy as one factor, among other factors. The belief underpinning the CROCI® investment philosophy is that reported financial statement data is incomplete and often not comparable across industries, sectors, countries and regions. Furthermore, it is not adjusted for inflation, nor does it always reflect all information relevant to valuation calculations. The managers believe that a systematic adjustment of reported financial statement data can provide a more accurate assessment of corporate valuation, financial risk and cash returns, thereby leading to superior long-term investment performance. The team will also take additional measures to attempt to reduce portfolio turnover, market impact and transaction costs in connection with implementation of the strategy, by applying liquidity and trading controls, and managing the portfolio with tax efficiency in mind.
Di Kumble, CFA
John Moody
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The Standard & Poor’s 500 Index (S&P 500) is an unmanaged, capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S&P 500 Index became the fund's benchmark as of October 3, 2016. The Russell 1000 Value Index is an unmanaged index that consists of those stocks in the Russell 1000® Index with less-than-average growth orientation. The Russell 1000 Index is an unmanaged price-only index of the 1,000 largest capitalized companies that are domiciled in the U.S. and whose common stocks are traded. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
2 "Underweight" means the Fund holds a lower weighting in a given sector or security than the benchmark. "Overweight" means the Fund holds a higher weighting.
* Not held in the portfolio as of December 31, 2016.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Common Stocks | 99% | 99% |
| Cash Equivalents | 1% | 1% |
| 100% | 100% |
| Sector Diversification (As a % of Common Stocks and Master Limited Partnership) | 12/31/16 | 12/31/15 |
| Utilities | 21% | 4% |
| Consumer Staples | 17% | 8% |
| Health Care | 17% | 31% |
| Consumer Discretionary | 15% | 16% |
| Industrials | 12% | 8% |
| Information Technology | 12% | 6% |
| Telecommunication Services | 3% | — |
| Materials | 3% | 1% |
| Financials | — | 17% |
| Energy | — | 9% |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
Shares |
Value ($) | |
| Common Stocks 99.1% | ||
| Consumer Discretionary 14.4% | ||
| Auto Components 2.5% | ||
| Goodyear Tire & Rubber Co. | 187,572 | 5,790,348 |
| Household Durables 2.3% | ||
| D.R. Horton, Inc. | 195,619 | 5,346,267 |
| Leisure Products 2.2% | ||
| Hasbro, Inc. | 65,902 | 5,126,516 |
| Media 5.1% | ||
| Time Warner, Inc. | 61,550 | 5,941,422 |
| Twenty-First Century Fox, Inc. "A" | 202,631 | 5,681,773 |
| 11,623,195 | ||
| Multiline Retail 2.3% | ||
| Target Corp. | 73,013 | 5,273,729 |
| Consumer Staples 17.3% | ||
| Beverages 7.5% | ||
| Coca-Cola Co. | 136,424 | 5,656,139 |
| Dr. Pepper Snapple Group, Inc. | 65,687 | 5,955,841 |
| PepsiCo, Inc. | 55,016 | 5,756,324 |
| 17,368,304 | ||
| Food & Staples Retailing 2.4% | ||
| Wal-Mart Stores, Inc. | 80,861 | 5,589,112 |
| Household Products 5.0% | ||
| Kimberly-Clark Corp. | 49,591 | 5,659,325 |
| Procter & Gamble Co. | 68,188 | 5,733,247 |
| 11,392,572 | ||
| Personal Products 2.4% | ||
| Estee Lauder Companies, Inc. "A" | 72,788 | 5,567,554 |
| Health Care 17.1% | ||
| Biotechnology 4.8% | ||
| Amgen, Inc. | 38,649 | 5,650,870 |
| Gilead Sciences, Inc. | 75,160 | 5,382,208 |
| 11,033,078 | ||
| Health Care Equipment & Supplies 5.0% | ||
| Medtronic PLC | 76,605 | 5,456,574 |
| Stryker Corp. | 51,657 | 6,189,025 |
| 11,645,599 | ||
| Pharmaceuticals 7.3% | ||
| Johnson & Johnson | 49,617 | 5,716,375 |
| Merck & Co., Inc. | 90,716 | 5,340,451 |
| Pfizer, Inc. | 179,702 | 5,836,721 |
| 16,893,547 | ||
| Industrials 12.3% | ||
| Aerospace & Defense 4.9% | ||
| Raytheon Co. | 38,561 | 5,475,662 |
| United Technologies Corp. | 52,840 | 5,792,321 |
| 11,267,983 | ||
| Industrial Conglomerates 5.0% | ||
| General Electric Co. | 182,486 | 5,766,557 |
| Honeywell International, Inc. | 50,248 | 5,821,231 |
| 11,587,788 | ||
Shares |
Value ($) | |
| Machinery 2.4% | ||
| Illinois Tool Works, Inc. | 45,773 | 5,605,362 |
| Information Technology 12.2% | ||
| Communications Equipment 2.5% | ||
| Cisco Systems, Inc. | 187,608 | 5,669,514 |
| IT Services 2.5% | ||
| International Business Machines Corp. | 34,737 | 5,765,995 |
| Semiconductors & Semiconductor Equipment 2.3% | ||
| KLA-Tencor Corp. | 69,045 | 5,432,461 |
| Software 2.4% | ||
| Oracle Corp. | 141,548 | 5,442,520 |
| Technology Hardware, Storage & Peripherals 2.5% | ||
| Apple, Inc. | 50,522 | 5,851,458 |
| Materials 2.5% | ||
| Chemicals | ||
| LyondellBasell Industries NV "A" | 66,129 | 5,672,545 |
| Telecommunication Services 2.7% | ||
| Diversified Telecommunication Services | ||
| Verizon Communications, Inc. | 116,589 | 6,223,521 |
| Utilities 20.6% | ||
| Electric Utilities 10.2% | ||
| American Electric Power Co., Inc. | 95,788 | 6,030,812 |
| Edison International | 81,791 | 5,888,134 |
| NextEra Energy, Inc. | 49,621 | 5,927,725 |
| PG&E Corp. | 95,723 | 5,817,087 |
| 23,663,758 | ||
| Multi-Utilities 10.4% | ||
| Consolidated Edison, Inc. | 80,892 | 5,960,122 |
| Dominion Resources, Inc. | 78,335 | 5,999,678 |
| DTE Energy Co. | 60,972 | 6,006,352 |
| Public Service Enterprise Group, Inc. | 137,989 | 6,054,957 |
| 24,021,109 | ||
| Total Common Stocks (Cost $227,137,671) | 228,853,835 | |
| Cash Equivalents 0.8% | ||
| Deutsche Central Cash Management Government Fund, 0.50% (a) (Cost $1,823,475) | 1,823,475 | 1,823,475 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $228,961,146)† | 99.9 | 230,677,310 |
| Other Assets and Liabilities, Net | 0.1 | 159,514 |
| Net Assets | 100.0 | 230,836,824 |
† The cost for federal income tax purposes was $229,050,047. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $1,627,263. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $7,354,677 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $5,727,414.
(a) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total |
| Common Stocks (b) | $228,853,835 | $ — | $ — | $228,853,835 |
| Short-Term Investment | 1,823,475 | — | — | 1,823,475 |
| Total | $230,677,310 | $ — | $ — | $230,677,310 |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(b) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $227,137,671) |
$228,853,835 |
| Investment in Deutsche Central Cash Management Government Fund (cost $1,823,475) | 1,823,475 |
| Total investments in securities, at value (cost $228,961,146) | 230,677,310 |
| Receivable for Fund shares sold | 42,249 |
| Dividends receivable | 508,655 |
| Interest receivable | 380 |
| Other assets | 3,517 |
| Total assets | 231,232,111 |
| Liabilities | |
| Payable for Fund shares redeemed | 174,543 |
| Accrued management fee | 111,380 |
| Accrued Trustees' fees | 4,091 |
| Other accrued expenses and payables | 105,273 |
| Total liabilities | 395,287 |
| Net assets, at value | $230,836,824 |
| Net Assets Consist of | |
| Undistributed net investment income | 3,845,993 |
| Net unrealized appreciation (depreciation) on investments | 1,716,164 |
| Accumulated net realized gain (loss) | (22,950,201) |
| Paid-in capital | 248,224,868 |
| Net assets, at value | $230,836,824 |
|
Class A Net Asset Value, offering and redemption price per share ($227,325,587 ÷ 16,529,732 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 13.75 |
|
Class B Net Asset Value, offering and redemption price per share ($3,511,237 ÷ 254,820 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 13.78 |
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $6,912) |
$ 5,674,829 |
| Income distributions — Deutsche Central Cash Management Government Fund | 16,482 |
| Securities lending income, net of borrower rebates | 56,072 |
| Other income | 47,515 |
| Total income | 5,794,898 |
|
Expenses: Management fee |
1,572,759 |
| Administration fee | 242,022 |
| Services to shareholders | 4,306 |
| Record keeping fees (Class B) | 2,468 |
| Distribution and service fees (Class B) | 9,481 |
| Custodian fee | 8,404 |
| Professional fees | 72,832 |
| Reports to shareholders | 32,842 |
| Trustees' fees and expenses | 12,674 |
| Other | 15,740 |
| Total expenses before expense reductions | 1,973,528 |
| Expense reductions | (179,874) |
| Total expenses after expense reductions | 1,793,654 |
| Net investment income | $ 4,001,244 |
| Realized and Unrealized Gain (Loss) | |
| Net realized gain (loss) from investments | (20,531,633) |
| Change in net unrealized appreciation (depreciation) on investments | 1,399,099 |
| Net gain (loss) | (19,132,534) |
| Net increase (decrease) in net assets resulting from operations | (15,131,290) |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 4,001,244 | $ 2,553,436 |
| Net realized gain (loss) | (20,531,633) | 10,078,803 |
| Change in net unrealized appreciation (depreciation) | 1,399,099 | (38,128,300) |
| Net increase (decrease) in net assets resulting from operations | (15,131,290) | (25,496,061) |
|
Distributions to shareholders from: Net investment income: Class A |
(2,434,486) | (5,899,426) |
| Class B | (25,893) | (54,717) |
|
Net realized gains: Class A |
(12,035,759) | (17,852,466) |
| Class B | (185,570) | (214,368) |
| Total distributions | (14,681,708) | (24,020,977) |
|
Fund share transactions: Class A Proceeds from shares sold |
5,510,987 | 6,111,736 |
| Reinvestment of distributions | 14,470,245 | 23,751,892 |
| Payments for shares redeemed | (56,264,127) | (118,444,533) |
| Net increase (decrease) in net assets from Class A share transactions | (36,282,895) | (88,580,905) |
|
Class B Proceeds from shares sold |
525,700 | 538,133 |
| Reinvestment of distributions | 211,463 | 269,085 |
| Payments for shares redeemed | (1,258,566) | (881,598) |
| Net increase (decrease) in net assets from Class B share transactions | (521,403) | (74,380) |
| Increase (decrease) in net assets | (66,617,296) | (138,172,323) |
| Net assets at beginning of period | 297,454,120 | 435,626,443 |
| Net assets at end of period (including undistributed net investment income of $3,845,993 and $2,410,518, respectively) | $230,836,824 | $297,454,120 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
19,157,658 | 24,769,255 |
| Shares sold | 405,203 | 372,428 |
| Shares issued to shareholders in reinvestment of distributions | 1,079,869 | 1,389,812 |
| Shares redeemed | (4,112,998) | (7,373,837) |
| Net increase (decrease) in Class A shares | (2,627,926) | (5,611,597) |
| Shares outstanding at end of period | 16,529,732 | 19,157,658 |
|
Class B Shares outstanding at beginning of period |
291,996 | 297,108 |
| Shares sold | 38,734 | 32,072 |
| Shares issued to shareholders in reinvestment of distributions | 15,722 | 15,690 |
| Shares redeemed | (91,632) | (52,874) |
| Net increase (decrease) in Class B shares | (37,176) | (5,112) |
| Shares outstanding at end of period | 254,820 | 291,996 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 15.29 | $ 17.38 | $ 15.97 | $ 12.45 | $ 11.56 | |
|
Income (loss) from investment operations: Net investment income (loss)a |
.23 | .11 | .24 | .26 | .25 | |
| Net realized and unrealized gain (loss) | (.93) | (1.20) | 1.45 | 3.54 | .87 | |
| Total from investment operations | (.70) | (1.09) | 1.69 | 3.80 | 1.12 | |
|
Less distributions from: Net investment income |
(.14) | (.25) | (.28) | (.28) | (.23) | |
| Net realized gains on investment transactions | (.70) | (.75) | — | — | — | |
| Total distributions | (.84) | (1.00) | (.28) | (.28) | (.23) | |
| Net asset value, end of period | $ 13.75 | $ 15.29 | $ 17.38 | $ 15.97 | $ 12.45 | |
| Total Return (%)b | (4.39) | (6.87) | 10.72 | 30.89 | 9.79 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 227 | 293 | 430 | 432 | 377 | |
| Ratio of expenses before expense reductions (%) | .81 | .78 | .78 | .78 | .78 | |
| Ratio of expenses after expense reductions (%) | .74 | .73 | .73 | .74 | .77 | |
| Ratio of net investment income (loss) (%) | 1.66 | .65 | 1.43 | 1.82 | 2.04 | |
| Portfolio turnover rate (%) | 293 | 121 | 133 | 54 | 63 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 15.31 | $ 17.40 | $ 15.99 | $ 12.46 | $ 11.57 | |
|
Income (loss) from investment operations: Net investment income (loss)a |
.19 | .06 | .18 | .22 | .21 | |
| Net realized and unrealized gain (loss) | (.92) | (1.21) | 1.46 | 3.55 | .88 | |
| Total from investment operations | (.73) | (1.15) | 1.64 | 3.77 | 1.09 | |
|
Less distributions from: Net investment income |
(.10) | (.19) | (.23) | (.24) | (.20) | |
| Net realized gains on investment transactions | (.70) | (.75) | — | — | — | |
| Total distributions | (.80) | (.94) | (.23) | (.24) | (.20) | |
| Net asset value, end of period | $ 13.78 | $ 15.31 | $ 17.40 | $ 15.99 | $ 12.46 | |
| Total Return (%)b | (4.62) | (7.16) | 10.36 | 30.54 | 9.44 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 4 | 4 | 5 | 5 | 4 | |
| Ratio of expenses before expense reductions (%) | 1.13 | 1.10 | 1.09 | 1.09 | 1.09 | |
| Ratio of expenses after expense reductions (%) | 1.05 | 1.04 | 1.04 | 1.05 | 1.08 | |
| Ratio of net investment income (loss) (%) | 1.37 | .35 | 1.10 | 1.52 | 1.73 | |
| Portfolio turnover rate (%) | 293 | 121 | 133 | 54 | 63 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Large Cap Value VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets of the Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee and recordkeeping fees). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities are generally categorized as Level 1.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds including Government & Agency Securities Portfolio managed by Deutsche Investment Management Americas Inc. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had no securities on loan.
Federal Income Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
At December 31, 2016, the Fund had a net tax basis capital loss carryforward of approximately $22,862,000, which may be applied against realized net taxable capital gains indefinitely, including short-term losses ($20,822,000) and long-term losses ($2,040,000).
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, is declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 3,845,993 |
| Capital loss carryforward | $(22,862,000) |
| Unrealized appreciation (depreciation) on investments | $ 1,627,263 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 2,525,931 | $ 5,954,143 |
| Distribution from long-term capital gains | $ 12,155,777 | $ 18,066,834 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments) aggregated $703,333,478 and $748,194,540, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Under the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .650% |
| Next $750 million | .625% |
| Next $1.5 billion | .600% |
| Next $2.5 billion | .575% |
| Next $2.5 billion | .550% |
| Next $2.5 billion | .525% |
| Next $2.5 billion | .500% |
| Over $12.5 billion | .475% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.65% of the Fund's average daily net assets.
For the period from January 1, 2016 through April 30, 2016, the Advisor had contractually agreed to waive all or a portion of its fees and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .73% |
| Class B | 1.04% |
For the period from May 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive all or a portion of its fee and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .75% |
| Class B | 1.06% |
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive all or a portion of its fee and/or reimburse certain operating expenses of the Fund to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .72% |
| Class B | 1.03% |
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 176,640 |
| Class B | 3,234 |
| $ 179,874 |
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $242,022, of which $19,742 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Services to Shareholders | Total Aggregated | Unpaid at December 31, 2016 |
| Class A | $ 392 | $ 99 |
| Class B | 222 | 56 |
| $ 614 | $ 155 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plan, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee aggregated $9,481, of which $769 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $12,086, of which $4,197 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Securities Lending Agent Fees. Deutsche Bank AG serves as securities lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred securities lending agent fees to Deutsche Bank AG in the amount of $4,876.
D. Ownership of the Fund
At December 31, 2016, three participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 50%, 29% and 16%. Two participating insurance companies were owners of record of 10% or more of the total outstanding Class B shares of the Fund, each owning 64% and 15%.
E. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and the Shareholders of Deutsche Large Cap Value VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Large Cap Value VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Large Cap Value VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,044.80 | $1,043.90 | ||
| Expenses Paid per $1,000* | $ 3.80 | $ 5.34 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,021.42 | $1,019.91 | ||
| Expenses Paid per $1,000* | $ 3.76 | $ 5.28 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios | Class A | Class B | ||
| Deutsche Variable Series II — Deutsche Large Cap Value VIP | .74% | 1.04% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
The Fund paid distributions of $0.70 per share from net long-term capital gains during its year ended December 31, 2016.
For corporate shareholders, 100% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Large Cap Value VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 4th quartile of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board considered that on or about October 3, 2016, the Fund would change its investment strategy and portfolio managers. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were equal to the median of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
Notes
VS2LCV-2 (R-025833-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Small Mid Cap Growth VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 10 Statement of Assets and Liabilities 11 Statement of Operations 11 Statements of Changes in Net Assets 13 Financial Highlights 14 Notes to Financial Statements 18 Report of Independent Registered Public Accounting Firm 19 Information About Your Fund's Expenses 19 Tax Information 20 Proxy Voting 21 Advisory Agreement Board Considerations and Fee Evaluation 23 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Stocks may decline in value. Smaller and medium company stocks tend to be more volatile than large company stocks. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns.
The gross expense ratio of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 is 0.72% for Class A shares and may differ from the expense ratio disclosed in the Financial Highlights table in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Small Mid Cap Growth VIP | ||
|
■ Deutsche Small Mid Cap Growth VIP — Class A ■ Russell 2500™ Growth Index |
The Russell 2500™ Growth Index is an unmanaged index that measures the performance of the small- to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500 companies with higher price-to-book ratios and higher forecasted growth values. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Small Mid Cap Growth VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,908 | $11,426 | $18,655 | $17,497 |
| Average annual total return | 9.08% | 4.54% | 13.28% | 5.75% | |
| Russell 2500 Growth Index | Growth of $10,000 | $10,973 | $11,725 | $19,151 | $22,078 |
| Average annual total return | 9.73% | 5.45% | 13.88% | 8.24% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
For the 12-month period ended December 31, 2016, the Fund returned 9.08% (Class A shares, unadjusted for contract charges) in comparison to the 9.73% return of the Russell 2500™ Growth Index.1
As 2016 began, we saw heightened volatility after China’s accelerated yuan depreciation rekindled worries regarding capital outflows. However, the market staged a significant rally beginning on February 12 as oil prices rallied strongly. The second quarter also proved quite volatile, as investors struggled with tepid U.S. growth and Britain's "Brexit" referendum vote in late June to leave the European Union. Immediately following the vote, a massive equity sell-off was unleashed worldwide. However, stocks rallied by the end of June, as global markets displayed surprising resilience. Stocks rallied during the third quarter as better-than-expected earnings reports bolstered sentiment. OPEC’s announcement that it planned to trim oil production beginning in January 2017 then prompted a rally across markets. The fourth quarter represented one of the most interesting market periods in recent history. Following November 8, equities, especially small caps, rallied strongly in light of the presidential election results. Market sentiment was energized by the prospects for above-trend economic growth going forward.
Portfolio underperformance was derived primarily from unfavorable sector allocation, based on overweights in health care and financials, and an underweight to materials.2 Overweights in consumer staples and energy, coupled with an underweight in real estate, contributed positively to returns.3 Stock selection was positive across materials, consumer discretionary and financials.4 In contrast, selection within health care and industrials detracted.
We continue to position the Fund for sustained economic recovery and remain focused on our bottom-up stock selection process. We maintain a long-term perspective, investing in quality small- and mid-cap growth stocks that trade at attractive valuations and are likely to benefit from a strong merger & acquisition cycle.
Joseph Axtell, CFA
Rafaelina M. Lee
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The Russell 2500 Growth Index is an unmanaged index that measures the performance of the small- to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500 companies with higher price-to-book ratios and higher forecasted growth values. Index returns do not reflect fees or expenses and it is not possible to invest directly in an index.
2 "Overweight" means that the Fund holds a higher weighting in a given sector or security than the benchmark. "Underweight" means that the Fund holds a lower weighting.
3 Consumer staples are the industries that manufacture and sell products such as food and beverages, prescription drugs and household products.
4 Consumer discretionary is the sector of the economy that includes companies (such as apparel and automobile companies) that sell nonessential goods and services.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Common Stocks | 97% | 98% |
| Cash Equivalents | 3% | 2% |
| Convertible Preferred Stock | 0% | 0% |
| 100% | 100% |
| Sector Diversification (As a % of Common Stocks and Convertible Preferred Stock) | 12/31/16 | 12/31/15 |
| Consumer Discretionary | 20% | 20% |
| Industrials | 20% | 17% |
| Information Technology | 20% | 20% |
| Health Care | 18% | 23% |
| Financials | 7% | 9% |
| Materials | 7% | 5% |
| Consumer Staples | 4% | 4% |
| Energy | 3% | 2% |
| Real Estate | 1% | — |
| Telecommunication Services | 0% | — |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
Shares |
Value ($) | |
| Common Stocks 97.4% | ||
| Consumer Discretionary 19.4% | ||
| Auto Components 2.5% | ||
| Gentherm, Inc.* | 38,010 | 1,286,638 |
| Tenneco, Inc.* | 27,182 | 1,698,060 |
| 2,984,698 | ||
| Diversified Consumer Services 1.6% | ||
| Bright Horizons Family Solutions, Inc.* | 12,300 | 861,246 |
| ServiceMaster Global Holdings, Inc.* | 26,100 | 983,187 |
| 1,844,433 | ||
| Hotels, Restaurants & Leisure 3.3% | ||
| Jack in the Box, Inc. | 16,552 | 1,847,865 |
| La Quinta Holdings, Inc.* | 49,849 | 708,355 |
| Panera Bread Co. "A"* | 6,468 | 1,326,522 |
| 3,882,742 | ||
| Household Durables 2.9% | ||
| Helen of Troy Ltd.* | 11,200 | 945,840 |
| iRobot Corp.* | 29,393 | 1,718,021 |
| Newell Brands, Inc. | 16,958 | 757,175 |
| 3,421,036 | ||
| Leisure Products 1.0% | ||
| Polaris Industries, Inc. (a) | 14,619 | 1,204,459 |
| Media 1.3% | ||
| Cinemark Holdings, Inc. | 39,218 | 1,504,403 |
| Specialty Retail 5.1% | ||
| Burlington Stores, Inc.* | 22,300 | 1,889,925 |
| The Children's Place, Inc. | 18,041 | 1,821,239 |
| Ulta Salon, Cosmetics & Fragrance, Inc.* | 5,969 | 1,521,737 |
| Urban Outfitters, Inc.* | 30,305 | 863,086 |
| 6,095,987 | ||
| Textiles, Apparel & Luxury Goods 1.7% | ||
| Carter's, Inc. | 12,586 | 1,087,304 |
| Hanesbrands, Inc. | 42,994 | 927,381 |
| 2,014,685 | ||
| Consumer Staples 3.6% | ||
| Food & Staples Retailing 1.4% | ||
| Casey's General Stores, Inc. | 14,482 | 1,721,620 |
| Food Products 1.1% | ||
| Hain Celestial Group, Inc.* | 32,043 | 1,250,638 |
| Household Products 1.1% | ||
| Spectrum Brands Holdings, Inc. | 10,800 | 1,321,164 |
| Energy 3.3% | ||
| Energy Equipment & Services 2.0% | ||
| Core Laboratories NV (a) | 7,974 | 957,199 |
| Dril-Quip, Inc.* | 7,284 | 437,404 |
| Patterson-UTI Energy, Inc. | 37,400 | 1,006,808 |
| 2,401,411 | ||
| Oil, Gas & Consumable Fuels 1.3% | ||
| Diamondback Energy, Inc.* | 10,820 | 1,093,470 |
| Gulfport Energy Corp.* | 17,430 | 377,185 |
| 1,470,655 | ||
Shares |
Value ($) | |
| Financials 7.1% | ||
| Banks 5.6% | ||
| Chemical Financial Corp. | 17,001 | 920,944 |
| FCB Financial Holdings, Inc. "A"* | 24,721 | 1,179,192 |
| Pinnacle Financial Partners, Inc. | 19,461 | 1,348,647 |
| Signature Bank* | 6,291 | 944,908 |
| South State Corp. | 12,713 | 1,111,116 |
| SVB Financial Group* | 6,741 | 1,157,160 |
| 6,661,967 | ||
| Capital Markets 1.5% | ||
| Lazard Ltd. "A" | 23,866 | 980,654 |
| Moelis & Co. "A" | 22,802 | 772,988 |
| 1,753,642 | ||
| Health Care 17.4% | ||
| Biotechnology 6.1% | ||
| Alkermes PLC* | 19,068 | 1,059,799 |
| Bluebird Bio, Inc.* (a) | 8,876 | 547,649 |
| Ligand Pharmaceuticals, Inc.* (a) | 11,809 | 1,199,913 |
| Neurocrine Biosciences, Inc.* | 14,801 | 572,799 |
| Retrophin, Inc.* | 87,925 | 1,664,420 |
| Spectrum Pharmaceuticals, Inc.* | 132,070 | 585,070 |
| TESARO, Inc.* | 4,700 | 632,056 |
| United Therapeutics Corp.* | 6,200 | 889,266 |
| 7,150,972 | ||
| Health Care Equipment & Supplies 0.7% | ||
| Cynosure, Inc. "A"* | 18,800 | 857,280 |
| Health Care Providers & Services 6.9% | ||
| BioScrip, Inc.* | 513,500 | 534,040 |
| Centene Corp.* | 31,422 | 1,775,657 |
| Healthways, Inc.* | 26,800 | 609,700 |
| Kindred Healthcare, Inc. | 80,458 | 631,596 |
| Molina Healthcare, Inc.* | 26,781 | 1,453,137 |
| Providence Service Corp.* | 41,245 | 1,569,372 |
| RadNet, Inc.* | 107,600 | 694,020 |
| Teladoc, Inc.* (a) | 55,200 | 910,800 |
| 8,178,322 | ||
| Life Sciences Tools & Services 1.4% | ||
| PAREXEL International Corp.* | 18,053 | 1,186,443 |
| VWR Corp.* | 20,000 | 500,600 |
| 1,687,043 | ||
| Pharmaceuticals 2.3% | ||
| Akorn, Inc.* | 28,330 | 618,444 |
| Flamel Technologies SA (ADR)* | 140,644 | 1,461,291 |
| Pacira Pharmaceuticals, Inc.* | 19,083 | 616,381 |
| 2,696,116 | ||
| Industrials 19.1% | ||
| Aerospace & Defense 1.9% | ||
| DigitalGlobe, Inc.* | 37,813 | 1,083,343 |
| HEICO Corp. | 15,722 | 1,212,952 |
| 2,296,295 | ||
| Building Products 2.8% | ||
| A.O. Smith Corp. | 28,752 | 1,361,407 |
| Fortune Brands Home & Security, Inc. | 21,743 | 1,162,381 |
| Gibraltar Industries, Inc.* | 19,400 | 808,010 |
| 3,331,798 | ||
| Commercial Services & Supplies 0.6% | ||
| Advanced Disposal Services, Inc.* | 34,500 | 766,590 |
Shares |
Value ($) | |
| Construction & Engineering 1.3% | ||
| Primoris Services Corp. | 66,842 | 1,522,661 |
| Electrical Equipment 2.7% | ||
| Acuity Brands, Inc. | 5,162 | 1,191,699 |
| AZZ, Inc. | 22,843 | 1,459,668 |
| Thermon Group Holdings, Inc.* | 28,935 | 552,369 |
| 3,203,736 | ||
| Machinery 7.4% | ||
| IDEX Corp. | 12,700 | 1,143,762 |
| John Bean Technologies Corp. | 20,100 | 1,727,595 |
| Manitowoc Foodservice, Inc.* | 57,400 | 1,109,542 |
| Middleby Corp.* | 13,560 | 1,746,664 |
| WABCO Holdings, Inc.* | 20,122 | 2,135,950 |
| Watts Water Technologies, Inc. "A" | 14,395 | 938,554 |
| 8,802,067 | ||
| Marine 0.6% | ||
| Kirby Corp.* | 10,100 | 671,650 |
| Professional Services 0.9% | ||
| On Assignment, Inc.* | 23,482 | 1,036,965 |
| Trading Companies & Distributors 0.9% | ||
| HD Supply Holdings, Inc.* | 24,184 | 1,028,062 |
| Information Technology 19.1% | ||
| Electronic Equipment, Instruments & Components 4.2% | ||
| Belden, Inc. | 9,300 | 695,361 |
| Cognex Corp. | 39,216 | 2,494,922 |
| IPG Photonics Corp.* | 17,928 | 1,769,673 |
| 4,959,956 | ||
| Internet Software & Services 2.4% | ||
| CoStar Group, Inc.* | 7,327 | 1,381,066 |
| WebMD Health Corp.* (a) | 29,833 | 1,478,822 |
| 2,859,888 | ||
| IT Services 6.6% | ||
| Broadridge Financial Solutions, Inc. | 23,570 | 1,562,691 |
| Cardtronics PLC "A"* | 37,408 | 2,041,354 |
| Euronet Worldwide, Inc.* | 13,000 | 941,590 |
| MAXIMUS, Inc. | 23,134 | 1,290,646 |
| WEX, Inc.* | 9,098 | 1,015,337 |
| WNS Holdings Ltd. (ADR)* | 34,828 | 959,511 |
| 7,811,129 | ||
| Semiconductors & Semiconductor Equipment 2.2% | ||
| Advanced Energy Industries, Inc.* | 32,293 | 1,768,042 |
| Mellanox Technologies Ltd.* | 19,200 | 785,280 |
| 2,553,322 | ||
Shares |
Value ($) | |
| Software 3.7% | ||
| Aspen Technology, Inc.* | 32,083 | 1,754,298 |
| Proofpoint, Inc.* | 11,700 | 826,605 |
| Tyler Technologies, Inc.* | 12,892 | 1,840,591 |
| 4,421,494 | ||
| Materials 6.4% | ||
| Chemicals 3.8% | ||
| Huntsman Corp. | 72,512 | 1,383,529 |
| Minerals Technologies, Inc. | 20,978 | 1,620,550 |
| Trinseo SA | 24,825 | 1,472,123 |
| 4,476,202 | ||
| Construction Materials 1.5% | ||
| Eagle Materials, Inc. | 17,856 | 1,759,352 |
| Metals & Mining 1.1% | ||
| United States Steel Corp. | 42,000 | 1,386,420 |
| Real Estate 1.5% | ||
| Equity Real Estate Investment Trusts (REITs) | ||
| National Storage Affiliates Trust | 28,375 | 626,236 |
| Urban Edge Properties | 40,000 | 1,100,400 |
| 1,726,636 | ||
| Telecommunication Services 0.5% | ||
| Diversified Telecommunication Services | ||
| SBA Communications Corp. "A"* | 6,155 | 635,565 |
| Total Common Stocks (Cost $84,684,845) | 115,353,061 | |
| Convertible Preferred Stock 0.2% | ||
| Health Care | ||
| Providence Service Corp., 5.5% (Cost $283,300) | 2,833 | 270,300 |
| Securities Lending Collateral 3.6% | ||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.42% (b) (c) (Cost $4,211,603) | 4,211,603 | 4,211,603 |
| Cash Equivalents 2.5% | ||
| Deutsche Central Cash Management Government Fund, 0.49% (b) (Cost $2,937,543) | 2,937,543 | 2,937,543 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $92,117,291)† | 103.7 | 122,772,507 |
| Other Assets and Liabilities, Net | (3.7) | (4,395,414) |
| Net Assets | 100.0 | 118,377,093 |
* Non-income producing security.
† The cost for federal income tax purposes was $92,730,623. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $30,041,884. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $34,424,235 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $4,382,351.
(a) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $4,136,348, which is 3.5% of net assets.
(b) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(c) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
ADR: American Depositary Receipt
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total |
| Common Stocks (d) | $115,353,061 | $ — | $ — | $115,353,061 |
| Convertible Preferred Stock | — | — | 270,300 | 270,300 |
| Short-Term Investments (d) | 7,149,146 | — | — | 7,149,146 |
| Total | $122,502,207 | $ — | $ 270,300 | $122,772,507 |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(d) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $84,968,145) — including $4,136,348 of securities loaned |
$115,623,361 |
| Investment in Government & Agency Securities Portfolio (cost $4,211,603)* | 4,211,603 |
| Investment in Deutsche Central Cash Management Government Fund (cost $2,937,543) | 2,937,543 |
| Total investments in securities, at value (cost $92,117,291) | 122,772,507 |
| Receivable for investments sold | 354,091 |
| Receivable for Fund shares sold | 2,499 |
| Dividends receivable | 46,766 |
| Interest receivable | 14,845 |
| Other assets | 2,032 |
| Total assets | 123,192,740 |
| Liabilities | |
| Payable upon return of securities loaned | 4,211,603 |
| Payable for investments purchased | 359,864 |
| Payable for Fund shares redeemed | 91,173 |
| Accrued management fee | 55,835 |
| Accrued Trustees' fees | 2,185 |
| Other accrued expenses and payables | 94,987 |
| Total liabilities | 4,815,647 |
| Net assets, at value | $118,377,093 |
| Net Assets Consist of | |
| Undistributed net investment income | 115,705 |
| Net unrealized appreciation (depreciation) on investments | 30,655,216 |
| Accumulated net realized gain (loss) | 5,767,616 |
| Paid-in capital | 81,838,556 |
| Net assets, at value | $118,377,093 |
|
Class A Net Asset Value, offering and redemption price per share ($118,377,093 ÷ 6,244,931 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 18.96 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $2,318) |
$ 796,494 |
| Interest | 688 |
| Income distributions — Deutsche Central Cash Management Government Fund | 11,138 |
| Securities lending income, net of borrower rebates | 143,458 |
| Other income | 49,703 |
| Total income | 1,001,481 |
|
Expenses: Management fee |
639,301 |
| Administration fee | 116,236 |
| Services to shareholders | 1,794 |
| Custodian fee | 5,199 |
| Professional fees | 73,887 |
| Reports to shareholders | 24,607 |
| Trustees' fees and expenses | 7,229 |
| Other | 8,953 |
| Total expenses | 877,206 |
| Net investment income (loss) | 124,275 |
| Realized and Unrealized Gain (Loss) | |
| Net realized gain (loss) from investments | 6,541,357 |
| Change in net unrealized appreciation (depreciation) on investments | 1,718,283 |
| Net gain (loss) | 8,259,640 |
| Net increase (decrease) in net assets resulting from operations | $ 8,383,915 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income (loss) |
$ 124,275 | $ (327,026) |
| Net realized gain (loss) | 6,541,357 | 21,100,175 |
| Change in net unrealized appreciation (depreciation) | 1,718,283 | (21,155,273) |
| Net increase (decrease) in net assets resulting from operations | 8,383,915 | (382,124) |
|
Distributions to shareholders from: Net realized gains Class A |
(20,264,895) | (13,914,292) |
|
Fund share transactions: Class A Proceeds from shares sold |
2,382,262 | 9,710,776 |
| Reinvestment of distributions | 20,264,895 | 13,914,292 |
| Payments for shares redeemed | (27,583,809) | (46,020,854) |
| Net increase (decrease) in net assets from Class A share transactions | (4,936,652) | (22,395,786) |
| Increase (decrease) in net assets | (16,817,632) | (36,692,202) |
| Net assets at beginning of period | 135,194,725 | 171,886,927 |
| Net assets at end of period (including undistributed net investment income $115,705 and $0, respectively) | $118,377,093 | $135,194,725 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
6,467,679 | 7,527,702 |
| Shares sold | 129,160 | 422,288 |
| Shares issued to shareholders in reinvestment of distributions | 1,137,838 | 604,706 |
| Shares redeemed | (1,489,746) | (2,087,017) |
| Net increase (decrease) in Class A shares | (222,748) | (1,060,023) |
| Shares outstanding at end of period | 6,244,931 | 6,467,679 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 20.90 | $ 22.83 | $ 21.59 | $ 15.14 | $ 13.24 | |
|
Income (loss) from investment operations: Net investment income (loss)a |
.02 | (.04) | (.02) | (.04) | .02 | |
| Net realized and unrealized gain (loss) | 1.64 | (.00) | 1.26 | 6.51 | 1.88 | |
| Total from investment operations | 1.66 | (.04) | 1.24 | 6.47 | 1.90 | |
|
Less distributions from: Net investment income |
— | — | — | (.02) | — | |
| Net realized gains | (3.60) | (1.89) | — | — | — | |
| Total distributions | (3.60) | (1.89) | — | (.02) | — | |
| Net asset value, end of period | $ 18.96 | $ 20.90 | $ 22.83 | $ 21.59 | $ 15.14 | |
| Total Return (%) | 9.08 | (.90) | 5.74 | 42.78 | 14.35 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 118 | 135 | 172 | 187 | 145 | |
| Ratio of expenses (%) | .75 | .72 | .73 | .72 | .74 | |
| Ratio of net investment income (loss) (%) | .11 | (.19) | (.11) | (.22) | .11 | |
| Portfolio turnover rate (%) | 28 | 42 | 44 | 56 | 57 | |
| a Based on average shares outstanding during the period. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Small Mid Cap Growth VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities and exchange-trade funds ("ETFs") are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities and ETFs are generally categorized as Level 1.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as common stock in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end. As of period end, the remaining contractual maturity of the collateral agreements were overnight and continuous.
Federal Income Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies, and to distribute all of its taxable income to its shareholders.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 115,705 |
| Undistributed long-term capital gains | $ 6,380,949 |
| Net unrealized appreciation (depreciation) on investments | $ 30,041,884 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 239,535 | $ — |
| Distributions from long-term capital gains* | $ 20,025,360 | $ 13,914,292 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments) aggregated $32,257,962 and $56,994,883, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .550% |
| Next $750 million | .525% |
| Over $1 billion | .500% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.55% of the Fund's average daily net assets.
For the period from January 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A at 0.86%.
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of Class A at 0.88%.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $116,236, of which $10,152 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC aggregated $397, of which $106 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $10,474, of which $4,211 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Securities Lending Agent Fees. Deutsche Bank AG serves as securities lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred securities lending agent fees to Deutsche Bank AG in the amount of $12,149.
D. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 71% and 25%.
E. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Small Mid Cap Growth VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Small Mid Cap Growth VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers or by other appropriate auditing procedures where replies from brokers were not received. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Small Mid Cap Growth VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||
| Actual Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,094.10 | |
| Expenses Paid per $1,000* | $ 3.90 | |
| Hypothetical 5% Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,021.42 | |
| Expenses Paid per $1,000* | $ 3.76 | |
* Expenses are equal to the Fund's annualized expense ratio, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratio | Class A | |
| Deutsche Variable Series II — Deutsche Small Mid Cap Growth VIP | .74% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
The Fund paid distributions of $3.56 per share from net long-term capital gains during its year ended December 31, 2016.
Pursuant to Section 852 of the Internal Revenue Code, the Fund designates $7,036,000 as capital gain dividends for its year ended December 31, 2016.
For corporate shareholders, 100% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Small Mid Cap Growth VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 3rd quartile, 2nd quartile and 2nd quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were lower than the median (1st quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (1st quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board noted that the expense limitation agreed to by DIMA was expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to a comparable Deutsche U.S. registered fund ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Fund. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2SMCG-2 (R-025835-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Small Mid Cap Value VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 9 Statement of Assets and Liabilities 10 Statement of Operations 10 Statements of Changes in Net Assets 12 Financial Highlights 13 Notes to Financial Statements 17 Report of Independent Registered Public Accounting Firm 18 Information About Your Fund's Expenses 19 Tax Information 19 Proxy Voting 20 Advisory Agreement Board Considerations and Fee Evaluation 23 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Stocks may decline in value. Smaller and medium company stocks tend to be more volatile than large company stocks. Any fund that focuses in a particular segment of the market or region of the world will generally be more volatile than a fund that invests more broadly. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns. While all share classes have the same underlying portfolio, their performance will differ.
The gross expense ratios of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 are 0.80% and 1.16% for Class A and Class B shares, respectively, and may differ from the expense ratios disclosed in the Financial Highlights tables in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Small Mid Cap Value VIP | ||
|
■ Deutsche Small Mid Cap Value VIP — Class A ■ Russell 2500™ Value Index |
The Russell 2500™ Value Index is an unmanaged Index of those securities in the Russell 3000® Index with lower price-to-book ratios and lower forecasted growth values. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
||
| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Small Mid Cap Value VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $11,689 | $12,099 | $18,615 | $19,149 |
| Average annual total return | 16.89% | 6.56% | 13.23% | 6.71% | |
| Russell 2500 Value Index | Growth of $10,000 | $12,520 | $12,674 | $20,145 | $19,566 |
| Average annual total return | 25.20% | 8.22% | 15.04% | 6.94% | |
| Deutsche Small Mid Cap Value VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class B | Growth of $10,000 | $11,647 | $11,969 | $18,280 | $18,490 |
| Average annual total return | 16.47% | 6.18% | 12.82% | 6.34% | |
| Russell 2500 Value Index | Growth of $10,000 | $12,520 | $12,674 | $20,145 | $19,566 |
| Average annual total return | 25.20% | 8.22% | 15.04% | 6.94% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
The Class A shares of Deutsche Small Mid Cap Value VIP returned 16.89% in 2016 (unadjusted for contract charges), trailing the 25.20% return of its benchmark, the Russell 2500™ Value Index.1
While the overall asset class finished with strong returns, the Fund did not fully participate in the gains. We recognize that the shortfall is disappointing for our investors, but our goal is to invest in stocks we believe are positioned for outperformance over a multiyear time frame. Although this can lead to swings in short-term performance relative to the benchmark, we are focused on making sure the Fund is invested in fundamentally sound, undervalued companies with the potential for market-beating returns. Moreover, the Fund holds a number of companies that we believe are creating shareholder value by paying above-average dividends and buying back shares. We therefore see the portfolio as being well positioned from a longer-term perspective, notwithstanding its underperformance of the past year.
Both sector allocations and stock selection contributed to the deficit of the past 12 months. We held an underweight allocation to utilities and real estate investment trusts, which proved to be a headwind given that both groups registered robust gains in the first half of the period.2 We began to reduce the extent of these underweights as the year progressed, but we put the money to work gradually as opportunities permitted rather than establishing the positions all at once. The Fund therefore had an above-average cash weighting for much of the year, which was an additional drag on returns in the rising market.
Stock selection also played a role in the Fund’s underperformance, with our weakest relative results occurring in the industrials, materials and consumer discretionary sectors.3 Conversely, we outperformed in the health care and consumer staples sectors.4 Among individual stocks, the largest detractors were Pitney Bowes, Inc., Hanesbrands, Inc. and Verint Systems, Inc., while the most significant contributors were OFG Bancorp. and Dolby Laboratories, Inc.
The Fund’s management team changed during the first calendar quarter, but we maintained the same disciplined, value-oriented and research-driven style the Fund employed in the past. We continued to manage the portfolio with a lower valuation than the small-and-mid-cap market as a whole, and we retained a focus on companies with robust fundamentals, high free cash flows and healthy balance sheets. With that said, we did make two shifts of note. First, the Fund now strives to maintain sector weightings that are more closely in line with the benchmark, which we believe can help reduce the impact of sector allocations on the Fund’s relative performance. Second, we began to place a larger emphasis on higher-quality companies that are trading below their intrinsic values due to factors that have caused their stocks to fall temporarily out of favor. At a time in which market performance has been driven largely by liquidity flows and momentum factors, we saw a growing opportunity set among these types of companies. In total, we believe the Fund’s value-driven approach, together with these important shifts, can help us identify the most compelling investment ideas in the small-and-mid-cap space.
Richard Hanlon, CFA
Mary Schafer
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The Russell 2500 Value Index is an unmanaged index of those securities in the Russell 3000® Index with lower price-to-book ratios and lower forecasted growth values. Index returns do not reflect fees or expenses and it is not possible to invest directly into an index.
2 "Underweight" means the Fund holds a lower weighting in a given sector or security than the benchmark. "Overweight" means the Fund holds a higher weighting.
3 Consumer discretionary represents industries that produce goods and services that are not necessities in everyday life.
4 The consumer staples sector represents companies that produce essential items such as food, beverages and household items.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Common Stocks | 95% | 97% |
| Cash Equivalents | 5% | 3% |
| 100% | 100% |
| Sector Diversification (As a % of Common Stocks) | 12/31/16 | 12/31/15 |
| Financials | 24% | 23% |
| Industrials | 15% | 26% |
| Information Technology | 15% | 19% |
| Consumer Discretionary | 14% | 10% |
| Energy | 7% | 5% |
| Real Estate | 7% | 2% |
| Consumer Staples | 6% | 2% |
| Utilities | 5% | — |
| Health Care | 4% | 4% |
| Materials | 3% | 9% |
| 100% | 100% |
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Shares | Value ($) | |
| Common Stocks 95.0% | ||
| Consumer Discretionary 13.5% | ||
| Auto Components 3.2% | ||
| Standard Motor Products, Inc. | 47,104 | 2,506,875 |
| Visteon Corp. | 36,937 | 2,967,519 |
| 5,474,394 | ||
| Leisure Products 1.7% | ||
| Polaris Industries, Inc. (a) | 34,849 | 2,871,209 |
| Media 4.2% | ||
| AMC Entertainment Holdings, Inc. "A" (a) | 53,628 | 1,804,582 |
| Scripps Networks Interactive, Inc. "A" | 36,800 | 2,626,416 |
| TEGNA, Inc. | 124,067 | 2,653,793 |
| 7,084,791 | ||
| Specialty Retail 2.8% | ||
| Hibbett Sports, Inc.* (a) | 66,984 | 2,498,503 |
| Staples, Inc. | 243,600 | 2,204,580 |
| 4,703,083 | ||
| Textiles, Apparel & Luxury Goods 1.6% | ||
| Hanesbrands, Inc. | 123,173 | 2,656,842 |
| Consumer Staples 5.2% | ||
| Food Products 4.0% | ||
| Conagra Brands, Inc. | 68,928 | 2,726,102 |
| Lamb Weston Holdings, Inc.* | 53,576 | 2,027,852 |
| Pinnacle Foods, Inc. | 36,800 | 1,966,960 |
| 6,720,914 | ||
| Household Products 1.2% | ||
| Central Garden & Pet Co.* | 61,700 | 2,041,653 |
| Energy 6.9% | ||
| Oil, Gas & Consumable Fuels | ||
| Cimarex Energy Co. | 23,476 | 3,190,389 |
| Matador Resources Co.* | 105,815 | 2,725,794 |
| Noble Energy, Inc. | 66,700 | 2,538,602 |
| QEP Resources, Inc. | 170,841 | 3,145,183 |
| 11,599,968 | ||
| Financials 22.9% | ||
| Banks 10.8% | ||
| Capital Bank Financial Corp. "A" | 91,849 | 3,605,073 |
| Great Western Bancorp., Inc. | 83,802 | 3,652,929 |
| KeyCorp | 260,854 | 4,765,803 |
| OFG Bancorp. (a) | 244,782 | 3,206,644 |
| Sterling Bancorp. | 124,554 | 2,914,564 |
| 18,145,013 | ||
| Capital Markets 2.8% | ||
| Lazard Ltd. "A" | 114,128 | 4,689,519 |
| Consumer Finance 2.9% | ||
| Synchrony Financial | 133,865 | 4,855,283 |
| Insurance 4.6% | ||
| CNO Financial Group, Inc. | 206,155 | 3,947,868 |
| Reinsurance Group of America, Inc. | 30,449 | 3,831,398 |
| 7,779,266 | ||
| Thrifts & Mortgage Finance 1.8% | ||
| Walker & Dunlop, Inc.* | 100,033 | 3,121,030 |
| Shares | Value ($) | |
| Health Care 3.8% | ||
| Health Care Providers & Services 2.9% | ||
| Aceto Corp. | 50,409 | 1,107,486 |
| HealthSouth Corp. | 55,335 | 2,282,015 |
| MEDNAX, Inc.* | 22,100 | 1,473,186 |
| 4,862,687 | ||
| Life Sciences Tools & Services 0.9% | ||
| PerkinElmer, Inc. | 31,743 | 1,655,397 |
| Industrials 14.6% | ||
| Air Freight & Logistics 0.5% | ||
| Forward Air Corp. | 18,642 | 883,258 |
| Commercial Services & Supplies 4.9% | ||
| Pitney Bowes, Inc. | 169,363 | 2,572,624 |
| Steelcase, Inc. "A" | 171,020 | 3,061,258 |
| The Brink's Co. | 65,533 | 2,703,236 |
| 8,337,118 | ||
| Construction & Engineering 0.7% | ||
| Aegion Corp.* | 48,700 | 1,154,190 |
| Machinery 5.4% | ||
| Hillenbrand, Inc. | 74,467 | 2,855,809 |
| Snap-on, Inc. | 17,985 | 3,080,291 |
| Stanley Black & Decker, Inc. | 26,959 | 3,091,928 |
| 9,028,028 | ||
| Professional Services 0.8% | ||
| FTI Consulting, Inc.* | 29,205 | 1,316,562 |
| Trading Companies & Distributors 2.3% | ||
| AerCap Holdings NV* | 93,358 | 3,884,626 |
| Information Technology 14.0% | ||
| Communications Equipment 2.6% | ||
| Harris Corp. | 43,493 | 4,456,728 |
| Electronic Equipment, Instruments & Components 5.4% | ||
| Dolby Laboratories, Inc. "A" | 38,058 | 1,719,841 |
| Insight Enterprises, Inc.* | 22,400 | 905,856 |
| Keysight Technologies, Inc.* | 83,952 | 3,070,125 |
| Rogers Corp.* | 43,635 | 3,351,604 |
| 9,047,426 | ||
| IT Services 2.9% | ||
| Convergys Corp. | 114,260 | 2,806,226 |
| NeuStar, Inc. "A"* | 63,680 | 2,126,912 |
| 4,933,138 | ||
| Software 1.2% | ||
| Verint Systems, Inc.* | 57,732 | 2,035,053 |
| Technology Hardware, Storage & Peripherals 1.9% | ||
| NetApp, Inc. | 89,001 | 3,139,065 |
| Materials 2.8% | ||
| Chemicals | ||
| Celanese Corp. "A" | 36,129 | 2,844,797 |
| CF Industries Holdings, Inc. | 59,200 | 1,863,616 |
| 4,708,413 | ||
| Real Estate 6.4% | ||
| Equity Real Estate Investment Trusts (REITs) | ||
| Agree Realty Corp. | 56,902 | 2,620,337 |
| Gaming and Leisure Properties, Inc. | 96,421 | 2,952,411 |
| Pebblebrook Hotel Trust | 63,939 | 1,902,185 |
| Shares | Value ($) | |
| Physicians Realty Trust | 128,508 | 2,436,512 |
| STAG Industrial, Inc. | 36,100 | 861,707 |
| 10,773,152 | ||
| Utilities 4.9% | ||
| Electric Utilities 1.7% | ||
| IDACORP, Inc. | 36,983 | 2,978,981 |
| Gas Utilities 1.2% | ||
| ONE Gas, Inc. | 30,900 | 1,976,364 |
| Multi-Utilities 2.0% | ||
| DTE Energy Co. | 34,000 | 3,349,340 |
| Total Common Stocks (Cost $132,723,798) | 160,262,491 | |
| Securities Lending Collateral 3.9% | ||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.41% (b) (c) (Cost $6,521,525) | 6,521,525 | 6,521,525 |
| Shares | Value ($) | |
| Cash Equivalents 5.1% | ||
| Deutsche Central Cash Management Government Fund, 0.50% (b) (Cost $8,640,301) | 8,640,301 | 8,640,301 |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $147,885,624)† | 104.0 | 175,424,317 |
| Other Assets and Liabilities, Net |
4.0 |
(6,730,608) |
| Net Assets | 100.0 | 168,693,709 |
* Non-income producing security.
† The cost for federal income tax purposes was $148,072,883. At December 31, 2016, net unrealized appreciation for all securities based on tax cost was $27,351,434. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $31,244,828 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $3,893,394.
(a) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $6,358,065, which is 3.8% of net assets.
(b) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(c) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total |
| Common Stocks (d) | $160,262,491 | $ — | $ — | $160,262,491 |
| Short-Term Investments (d) | 15,161,826 | — | — | 15,161,826 |
| Total | $175,424,317 | $ — | $ — | $175,424,317 |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(d) See Investment Portfolio for additional detailed categorizations.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $132,723,798) — including $6,358,065 of securities loaned |
$160,262,491 |
| Investment in Government & Agency Securities Portfolio (cost $6,521,525)* | 6,521,525 |
| Investment in Deutsche Central Cash Management Government Fund (cost $8,640,301) | 8,640,301 |
| Total investments in securities, at value (cost $147,885,624) | 175,424,317 |
| Receivable for Fund shares sold | 55,315 |
| Dividends receivable | 197,632 |
| Interest receivable | 7,051 |
| Other assets | 2,682 |
| Total assets | 175,686,997 |
| Liabilities | |
| Payable upon return of securities loaned | 6,521,525 |
| Payable for Fund shares redeemed | 271,847 |
| Accrued management fee | 93,442 |
| Accrued Trustees' fees | 2,578 |
| Other accrued expenses and payables | 103,896 |
| Total liabilities | 6,993,288 |
| Net assets, at value | $168,693,709 |
| Net Assets Consist of | |
| Undistributed net investment income | 1,465,989 |
| Net unrealized appreciation (depreciation) on investments | 27,538,693 |
| Accumulated net realized gain (loss) | 3,281,308 |
| Paid-in capital | 136,407,719 |
| Net assets, at value | $168,693,709 |
|
Class A Net Asset Value, offering and redemption price per share ($153,332,198 ÷ 9,208,579 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 16.65 |
|
Class B Net Asset Value, offering and redemption price per share ($15,361,511 ÷ 923,852 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 16.63 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Dividends (net of foreign taxes withheld of $7,070) |
$ 2,744,870 |
| Income distributions — Deutsche Central Cash Management Government Fund | 41,849 |
| Securities lending income, net of borrower rebates | 72,548 |
| Other income | 32,130 |
| Total income | 2,891,397 |
|
Expenses: Management fee |
1,039,718 |
| Administration fee | 159,957 |
| Services to shareholders | 4,203 |
| Record keeping fees (Class B) | 14,575 |
| Distribution service fee (Class B) | 33,836 |
| Custodian fee | 3,491 |
| Professional fees | 68,831 |
| Reports to shareholders | 37,341 |
| Trustees' fees and expenses | 8,696 |
| Other | 9,506 |
| Total expenses before expense reductions | 1,380,154 |
| Expense reductions | (13,962) |
| Total expenses after expense reductions | 1,366,192 |
| Net investment income (loss) | 1,525,205 |
| Realized and Unrealized Gain (Loss) | |
| Net realized gain (loss) from investments | 3,137,095 |
| Change in net unrealized appreciation (depreciation) on investments | 19,608,211 |
| Net gain (loss) | 22,745,306 |
| Net increase (decrease) in net assets resulting from operations | $ 24,270,511 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income (loss) |
$ 1,525,205 | $ 1,012,706 |
| Net realized gain (loss) | 3,137,095 | 17,066,350 |
| Change in net unrealized appreciation (depreciation) | 19,608,211 | (20,852,678) |
| Net increase (decrease) in net assets resulting from operations | 24,270,511 | (2,773,622) |
|
Distributions to shareholders from: Net investment income: Class A |
(888,084) | (593,081) |
| Class B | (31,217) | — |
|
Net realized gains: Class A |
(15,665,658) | (17,173,555) |
| Class B | (1,422,898) | (1,373,376) |
| Total distributions | (18,007,857) | (19,140,012) |
|
Fund share transactions: Class A Proceeds from shares sold |
8,157,267 | 11,088,951 |
| Reinvestment of distributions | 16,553,742 | 17,766,636 |
| Payments for shares redeemed | (37,741,593) | (52,858,262) |
| Net increase (decrease) in net assets from Class A share transactions | (13,030,584) | (24,002,675) |
|
Class B Proceeds from shares sold |
2,712,137 | 2,463,269 |
| Reinvestment of distributions | 1,454,115 | 1,373,376 |
| Payments for shares redeemed | (3,082,291) | (5,621,076) |
| Net increase (decrease) in net assets from Class B share transactions | 1,083,961 | (1,784,431) |
| Increase (decrease) in net assets | (5,683,969) | (47,700,740) |
| Net assets at beginning of period | 174,377,678 | 222,078,418 |
| Net assets at end of period (including undistributed net investment income of $1,465,989 and $973,558, respectively) | $168,693,709 | $174,377,678 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
10,068,570 | 11,531,437 |
| Shares sold | 525,679 | 646,274 |
| Shares issued to shareholders in reinvestment of distributions | 1,110,244 | 1,025,787 |
| Shares redeemed | (2,495,914) | (3,134,928) |
| Net increase (decrease) in Class A shares | (859,991) | (1,462,867) |
| Shares outstanding at end of period | 9,208,579 | 10,068,570 |
|
Class B Shares outstanding at beginning of period |
852,173 | 953,703 |
| Shares sold | 176,025 | 143,164 |
| Shares issued to shareholders in reinvestment of distributions | 97,461 | 79,203 |
| Shares redeemed | (201,807) | (323,897) |
| Net increase (decrease) in Class B shares | 71,679 | (101,530) |
| Shares outstanding at end of period | 923,852 | 852,173 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 15.97 | $ 17.79 | $ 17.08 | $ 12.78 | $ 11.36 | |
|
Income (loss) from investment operations: Net investment incomea |
.15 | .09 | .05 | .12 | .14 | |
| Net realized and unrealized gain (loss) | 2.34 | (.31) | .88 | 4.35 | 1.42 | |
| Total from investment operations | 2.49 | (.22) | .93 | 4.47 | 1.56 | |
|
Less distributions from: Net investment income |
(.10) | (.05) | (.14) | (.17) | (.14) | |
| Net realized gains | (1.71) | (1.55) | (.08) | — | — | |
| Total distributions | (1.81) | (1.60) | (.22) | (.17) | (.14) | |
| Net asset value, end of period | $ 16.65 | $ 15.97 | $ 17.79 | $ 17.08 | $ 12.78 | |
| Total Return (%) | 16.89b | (1.91) | 5.53 | 35.24 | 13.77 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 153 | 161 | 205 | 240 | 219 | |
| Ratio of expenses before expense reductions (%) | .83 | .80 | .82 | .82 | .82 | |
| Ratio of expenses after expense reductions (%) | .82 | .80 | .82 | .82 | .82 | |
| Ratio of net investment income (%) | .99 | .51 | .32 | .81 | 1.18 | |
| Portfolio turnover rate (%) | 53 | 25 | 34 | 115 | 11 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
| Class B | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 15.95 | $ 17.77 | $ 17.07 | $ 12.78 | $ 11.36 | |
|
Income (loss) from investment operations: Net investment incomea |
.09 | .02 | (.01) | .07 | .10 | |
| Net realized and unrealized gain (loss) | 2.34 | (.29) | .87 | 4.34 | 1.42 | |
| Total from investment operations | 2.43 | (.27) | .86 | 4.41 | 1.52 | |
|
Less distributions from: Net investment income |
(.04) | — | (.08) | (.12) | (.10) | |
| Net realized gains | (1.71) | (1.55) | (.08) | — | — | |
| Total distributions | (1.75) | (1.55) | (.16) | (.12) | (.10) | |
| Net asset value, end of period | $ 16.63 | $ 15.95 | $ 17.77 | $ 17.07 | $ 12.78 | |
| Total Return (%) | 16.47b | (2.21) | 5.09 | 34.70 | 13.38 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 15 | 14 | 17 | 20 | 17 | |
| Ratio of expenses before expense reductions (%) | 1.19 | 1.16 | 1.17 | 1.17 | 1.16 | |
| Ratio of expenses after expense reductions (%) | 1.18 | 1.16 | 1.17 | 1.17 | 1.16 | |
| Ratio of net investment income (loss) (%) | .57 | .14 | (.04) | .45 | .81 | |
| Portfolio turnover rate (%) | 53 | 25 | 34 | 115 | 11 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Small Mid Cap Value VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
Multiple Classes of Shares of Beneficial Interest. The Fund offers two classes of shares (Class A shares and Class B shares). Sales of Class B shares are subject to recordkeeping fees up to 0.15% and Rule 12b-1 fees under the 1940 Act equal to an annual rate of 0.25% of the average daily net assets of the Class B shares of the Fund. Class A shares are not subject to such fees.
Investment income, realized and unrealized gains and losses, and certain fund-level expenses and expense reductions, if any, are borne pro rata on the basis of relative net assets by the holders of all classes of shares except that each class bears certain expenses unique to that class (including the applicable Rule 12b-1 fee and recordkeeping fees). Differences in class-level expenses may result in payment of different per share dividends by class. All shares have equal rights with respect to voting subject to class-specific arrangements.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Equity securities are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Securities for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities are generally categorized as Level 1.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Brown Brothers Harriman & Co., as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period.. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as common stocks in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end. As of period end, the remaining contractual maturity of the collateral agreements were overnight and continuous.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to income received from Real Estate Investment Trusts and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 1,444,846 |
| Undistributed long-term capital gains | $ 3,468,567 |
| Unrealized appreciation (depreciation) on investments | $ 27,351,434 |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 1,718,093 | $ 9,435,762 |
| Distributions from long-term capital gains | $ 16,289,764 | $ 9,704,250 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Real Estate Investment Trusts. The Fund at its fiscal year end recharacterizes distributions received from a Real Estate Investment Trust ("REIT") investment based on information provided by the REIT into the following categories: ordinary income, long-term and short-term capital gains, and return of capital. If information is not available timely from a REIT, the recharacterization will be estimated for financial reporting purposes and a recharacterization will be made to the accounting records in the following year when such information becomes available. Distributions received from REITs in excess of income are recorded as either a reduction of cost of investments or realized gains.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments.
B. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments) aggregated $79,356,801 and $110,034,868, respectively.
C. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .650% |
| Next $750 million | .620% |
| Next $1.5 billion | .600% |
| Next $2.5 billion | .580% |
| Next $2.5 billion | .550% |
| Next $2.5 billion | .540% |
| Next $2.5 billion | .530% |
| Over $12.5 billion | .520% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.65% of the Fund's average daily net assets.
For the period from January 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .82% |
| Class B | 1.18% |
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fees and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) of each class as follows:
| Class A | .84% |
| Class B | 1.20% |
For the year ended December 31, 2016, fees waived and/or expenses reimbursed for each class are as follows:
| Class A | $ 12,660 |
| Class B | 1,302 |
| $ 13,962 |
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $159,957, of which $14,376 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC were as follows:
| Service to Shareholders | Total Aggregated | Unpaid at December 31, 2016 |
| Class A | $ 592 | $ 151 |
| Class B | 476 | 114 |
| $ 1,068 | $ 265 |
Distribution Service Agreement. Under the Fund's Class B 12b-1 plan, Deutsche AM Distributors, Inc. ("DDI") received a fee ("Distribution Service Fee") of 0.25% of average daily net assets of Class B shares. For the year ended December 31, 2016, the Distribution Service Fee aggregated $33,836, of which $3,243 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $12,025, of which $4,343 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
D. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 53% and 22%. Four participating insurance companies were owners of record of 10% or more of the total outstanding Class B shares of the Fund, each owning 28%, 22%, 19% and 15%.
E. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Small Mid Cap Value VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Small Mid Cap Value VIP (one of the funds constituting Deutsche Variable series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Small Mid Cap Value VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees, distribution and service (12b-1) fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||||
| Actual Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,163.50 | $1,161.30 | ||
| Expenses Paid per $1,000* | $ 4.51 | $ 6.47 | ||
| Hypothetical 5% Fund Return | Class A | Class B | ||
| Beginning Account Value 7/1/16 | $1,000.00 | $1,000.00 | ||
| Ending Account Value 12/31/16 | $1,020.96 | $1,019.15 | ||
| Expenses Paid per $1,000* | $ 4.22 | $ 6.04 | ||
* Expenses are equal to the Fund's annualized expense ratio for each share class, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratios | Class A | Class B | ||
| Deutsche Variable Series II — Deutsche Small Mid Cap Value VIP | .83% | 1.19% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
The Fund paid distributions of $1.63 per share from net long-term capital gains during its year ended December 31, 2016.
Pursuant to Section 852 of the Internal Revenue Code, the Fund designates $3,846,000 as capital gain dividends for its year ended December 31, 2016.
For corporate shareholders, 100% of the ordinary dividends (i.e., income dividends plus short-term capital gains) paid during the Fund's fiscal year ended December 31, 2016, qualified for the dividends received deduction.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Small Mid Cap Value VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s Rule 12b-1 plan, distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 2nd quartile, 4th quartile and 4th quartile, respectively, of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has outperformed its benchmark in the one- and three-year periods and has underperformed its benchmark in the five-year period ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in some past periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were lower than the median (1st quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board also reviewed data comparing each share class’s total (net) operating expenses to the applicable Broadridge Universe Expenses. The Board noted that the expense limitations agreed to by DIMA were expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to a comparable Deutsche U.S. registered fund ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Fund. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund and any fees received by an affiliate of DIMA for distribution services. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2SMCV-2 (R-025829-6 2/17)
December 31, 2016
Annual Report
Deutsche Variable Series II
Deutsche Unconstrained Income VIP
Contents
|
3 Performance Summary 4 Management Summary 5 Portfolio Summary 6 Investment Portfolio 15 Statement of Assets and Liabilities 15 Statement of Operations 17 Statements of Changes in Net Assets 18 Financial Highlights 19 Notes to Financial Statements 28 Report of Independent Registered Public Accounting Firm 29 Information About Your Fund's Expenses 30 Tax Information 30 Proxy Voting 31 Advisory Agreement Board Considerations and Fee Evaluation 34 Board Members and Officers |
This report must be preceded or accompanied by a prospectus. To obtain an additional prospectus or summary prospectus, if available, call (800) 728-3337 or your financial representative. We advise you to consider the Fund's objectives, risks, charges and expenses carefully before investing. The summary prospectus and prospectus contain this and other important information about the Fund. Please read the prospectus carefully before you invest.
Bond investments are subject to interest-rate, credit, liquidity and market risks to varying degrees. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality ("junk bonds") and non-rated securities present greater risk of loss than investments in higher-quality securities. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Emerging markets tend to be more volatile and less liquid than the markets of more mature economies, and generally have less diverse and less mature economic structures and less stable political systems than those of developed countries. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. The Fund may lend securities to approved institutions. See the prospectus for details.
Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries.
Deutsche AM Distributors, Inc., 222 South Riverside Plaza, Chicago, IL 60606, (800) 621-1148
NOT FDIC/NCUA INSURED NO BANK GUARANTEE MAY
LOSE VALUE NOT A DEPOSIT
NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
Performance Summary December 31, 2016 (Unaudited)
Fund performance shown is historical, assumes reinvestment of all dividend and capital gain distributions and does not guarantee future results. Investment return and principal value fluctuate with changing market conditions so that, when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Please contact your participating insurance company for the Fund's most recent month-end performance. Performance doesn't reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option. These charges and fees will reduce returns.
The gross expense ratio of the Fund, as stated in the fee table of the prospectus dated May 1, 2016 is 1.16% for Class A shares and may differ from the expense ratio disclosed in the Financial Highlights table in this report.
Generally accepted accounting principles require adjustments to be made to the net assets of the Fund at period end for financial reporting purposes only, and as such, the total return based on the unadjusted net asset value per share may differ from the total return reported in the financial highlights.
| Growth of an Assumed $10,000 Investment in Deutsche Unconstrained Income VIP | ||
|
■ Deutsche Unconstrained Income VIP — Class A ■ Bloomberg Barclays U.S. Universal Index |
The unmanaged Bloomberg Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index and the non-ERISA portion of the CMBS Index. Index returns do not reflect any fees or expenses and it is not possible to invest directly into an index. | |
 |
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| Yearly periods ended December 31 | ||
| Comparative Results | |||||
| Deutsche Unconstrained Income VIP | 1-Year | 3-Year | 5-Year | 10-Year | |
| Class A | Growth of $10,000 | $10,050 | $9,964 | $11,149 | $15,424 |
| Average annual total return | 0.50% | –0.12% | 2.20% | 4.43% | |
| Bloomberg Barclays U.S. Universal Index | Growth of $10,000 | $10,391 | $11,016 | $11,469 | $15,631 |
| Average annual total return | 3.91% | 3.28% | 2.78% | 4.57% | |
The growth of $10,000 is cumulative.
Management Summary December 31, 2016 (Unaudited)
The Class A shares of the Fund returned 0.50% (unadjusted for contract charges) in 2016, underperforming the 3.91% return of the Bloomberg Barclays U.S. Universal Index.1
The Fund’s overall positioning had a mixed impact on performance in the past 12 months. We entered the period with a defensive posture, as we were very conscious of the risks associated with falling energy prices and slowing global growth. This cautious approach was expressed in a below-average credit exposure and a focus on higher-quality issues. Our defensive strategy served us well until the market low in mid-February, but it subsequently cost us some relative performance over the next four to six weeks by preventing the Fund from fully participating in the initial stages of the rally. We began to add back to the portfolio’s credit exposure in early April, a process that we continued throughout the remainder of the period. The Fund performed well vs. the benchmark in the second half as a result of these moves, enabling it to provide competitive returns for the full year.
Overall, the Fund benefited from its sizable position in high-yield bonds given that the category finished with a total return well above the index. We could have generated even better performance by taking a more aggressive stance in high yield, but we preferred to maintain a focus on higher-quality bonds within the category. We took a similarly risk-conscious approach in the emerging markets by favoring more stable countries over those with higher risk. We therefore missed the majority of the rally in Argentina and Venezuela, which cost us some relative performance. However, our investments in Russia, Indonesia and Brazil made significant contributions. An allocation to emerging-markets corporate bonds, which delivered returns in excess of government securities amid investors’ reach for yield, also provided a meaningful boost to results.
The Fund maintained a lower weighting in the investment-grade category due to its minimal position in corporate bonds. We continue to find better opportunities elsewhere, especially with corporates’ yield spreads having narrowed over the course of 2016. The majority of the investment-grade portfolio was allocated to structured securities, where we saw a more favorable trade-off of risk and return potential. This portion of the Fund made a modest contribution and provided a measure of stability early in the year.
The Fund also held small positions in developed-market international bonds, but our focus was primarily on one-off opportunities. Our investments in Portugal and France contributed positively, but a position in Australia detracted.
The Fund employed derivatives to manage its currency, interest-rate and asset-class exposures. In some cases, derivatives were used to hedge existing positions; in others, they were used to take opportunistic positions in a more efficient manner than buying securities outright. On balance, the use of derivatives contributed positively to performance during the past 12 months.
At the close of the period, we continued to identify the most attractive opportunities in high-yield and emerging-markets debt. With investors receiving little in the way of yield on developed-market government bonds, we think both asset classes can continue to benefit from robust demand. We are very conscious of the potential risks, however, particularly now that yield spreads have fallen to more normalized levels from their first-quarter highs. Accordingly, we have taken steps to maintain liquidity and manage the risks inherent in the underlying portfolio. We believe this yield-focused, but cautious, strategy is the appropriate positioning in the current environment.
Gary Russell, CFA
John D. Ryan
Darwei Kung
Portfolio Managers
The views expressed reflect those of the portfolio management team only through the end of the period of the report as stated on the cover. The management team's views are subject to change at any time based on market and other conditions and should not be construed as a recommendation. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk.
1 The unmanaged Bloomberg Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index and the non-ERISA portion of the CMBS Index. Index returns do not reflect fees or expenses and it is not possible to invest directly in an index.
Portfolio Summary (Unaudited)
| Asset Allocation (As a % of Investment Portfolio excluding Securities Lending Collateral) | 12/31/16 | 12/31/15 |
| Government & Agency Obligations | 41% | 18% |
| Corporate Bonds | 20% | 47% |
| Exchange-Traded Funds | 11% | — |
| Collateralized Mortgage Obligations | 10% | 13% |
| Loan Participations and Assignments | 5% | 4% |
| Cash Equivalents | 5% | 3% |
| Commercial Mortgage-Backed Securities | 5% | 2% |
| Short-Term U.S. Treasury Obligations | 2% | 2% |
| Asset-Backed | 1% | 2% |
| Common Stocks | 0% | 1% |
| Convertible Bond | 0% | 0% |
| Put Options Purchased | 0% | 0% |
| Mortgage-Backed Security Pass-Throughs | — | 8% |
| 100% | 100% |
| Quality (Excludes Cash Equivalents, Securities Lending Collateral and Exchange-Traded Funds) | 12/31/16 | 12/31/15 |
| AAA | 41% | 32% |
| AA | 1% | 0% |
| A | 9% | 4% |
| BBB | 31% | 14% |
| BB | 9% | 29% |
| B | 3% | 16% |
| CCC or Below | 6% | 3% |
| Not Rated | — | 2% |
| 100% | 100% |
| Interest Rate Sensitivity | 12/31/16 | 12/31/15 |
| Effective Maturity | 7.2 years | 7.6 years |
| Effective Duration | 4.6 years | 3.5 years |
The quality ratings represent the higher of Moody's Investors Service, Inc. ("Moody's"), Fitch Ratings, Inc. ("Fitch") or Standard & Poor's Corporation ("S&P") credit ratings. The ratings of Moody's, Fitch and S&P represent their opinions as to the quality of the securities they rate. Credit quality measures a bond issuer's ability to repay interest and principal in a timely manner. Ratings are relative and subjective and are not absolute standards of quality. Credit quality does not remove market risk and is subject to change.
Effective maturity is the weighted average of the maturity date of bonds held by the Fund taking into consideration any available maturity shortening features.
Effective duration is an approximate measure of the Fund's sensitivity to interest rate changes taking into consideration any maturity shortening features.
Portfolio holdings and characteristics are subject to change.
For more complete details about the Fund's investment portfolio, see page 6.
Following the Fund's fiscal first and third quarter-end, a complete portfolio holdings listing is filed with the SEC on Form N-Q. The form will be available on the SEC's Web site at sec.gov, and it also may be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the SEC's Public Reference Room may be obtained by calling (800) SEC-0330. The Fund's portfolio holdings are also posted on deutschefunds.com from time to time. Please see the Fund's current prospectus for more information.
Investment Portfolio December 31, 2016
| Principal Amount ($)(a) | Value ($) | |||
| Corporate Bonds 19.7% | ||||
| Consumer Discretionary 1.6% | ||||
| Ally Financial, Inc., 5.75%, 11/20/2025 | 30,000 | 29,925 | ||
| Charter Communications Operating LLC: | ||||
| 3.579%, 7/23/2020 | 20,000 | 20,405 | ||
| 4.908%, 7/23/2025 | 10,000 | 10,539 | ||
| Churchill Downs, Inc., 5.375%, 12/15/2021 | 15,000 | 15,563 | ||
| Cox Communications, Inc., 144A, 3.35%, 9/15/2026 | 10,000 | 9,549 | ||
| CVS Health Corp., 5.125%, 7/20/2045 | 30,000 | 33,434 | ||
| Ford Motor Co., 5.291%, 12/8/2046 | 15,000 | 15,195 | ||
| General Motors Co., 6.6%, 4/1/2036 | 15,000 | 17,145 | ||
| General Motors Financial Co., Inc.: | ||||
| 2.4%, 5/9/2019 | 15,000 | 14,960 | ||
| 3.2%, 7/13/2020 | 50,000 | 50,150 | ||
| 3.2%, 7/6/2021 | 25,000 | 24,792 | ||
| The Gap, Inc., 5.95%, 4/12/2021 | 80,000 | 84,187 | ||
| Time Warner, Inc., 3.8%, 2/15/2027 | 40,000 | 39,773 | ||
| Walgreens Boots Alliance, Inc., 4.8%, 11/18/2044 | 20,000 | 20,556 | ||
| 386,173 | ||||
| Consumer Staples 1.6% | ||||
| Anheuser-Busch InBev Finance, Inc., 4.9%, 2/1/2046 | 30,000 | 32,426 | ||
| Kraft Heinz Foods Co., 4.375%, 6/1/2046 | 140,000 | 131,737 | ||
| Minerva Luxembourg SA, 144A, 12.25%, 2/10/2022 | 200,000 | 215,000 | ||
| Molson Coors Brewing Co., 4.2%, 7/15/2046 | 15,000 | 13,985 | ||
| 393,148 | ||||
| Energy 5.3% | ||||
| Anadarko Petroleum Corp.: | ||||
| 4.85%, 3/15/2021 (b) | 10,000 | 10,722 | ||
| 5.55%, 3/15/2026 (b) | 10,000 | 11,193 | ||
| ConocoPhillips Co., 4.15%, 11/15/2034 | 20,000 | 19,549 | ||
| Enbridge, Inc., 5.5%, 12/1/2046 | 35,000 | 37,451 | ||
| Encana Corp., 5.15%, 11/15/2041 | 50,000 | 45,373 | ||
| Energy Transfer Partners LP, 5.95%, 10/1/2043 | 10,000 | 10,306 | ||
| Halliburton Co., 4.85%, 11/15/2035 | 10,000 | 10,546 | ||
| Kinder Morgan Energy Partners LP: | ||||
| 4.7%, 11/1/2042 | 20,000 | 18,634 | ||
| 6.375%, 3/1/2041 | 10,000 | 10,848 | ||
| Lukoil International Finance BV, 144A, 6.656%, 6/7/2022 | 250,000 | 278,125 | ||
| Marathon Oil Corp., 5.2%, 6/1/2045 | 50,000 | 47,128 | ||
| Noble Holding International Ltd., 5.25%, 3/16/2018 | 10,000 | 9,975 | ||
| Pertamina Persero PT, 144A, 5.25%, 5/23/2021 | 200,000 | 210,457 | ||
| Petroleos Mexicanos: | ||||
| 144A, 4.625%, 9/21/2023 | 215,000 | 209,152 | ||
| 144A, 5.375%, 3/13/2022 | 86,000 | 88,062 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Plains All American Pipeline LP: | ||||
| 2.85%, 1/31/2023 | 25,000 | 23,633 | ||
| 4.3%, 1/31/2043 | 5,000 | 4,143 | ||
| 4.5%, 12/15/2026 | 165,000 | 167,384 | ||
| Regency Energy Partners LP, 4.5%, 11/1/2023 | 20,000 | 20,294 | ||
| Shell International Finance BV, 4.0%, 5/10/2046 | 15,000 | 14,344 | ||
| Sunoco Logistics Partners Operations LP, 5.3%, 4/1/2044 | 20,000 | 19,310 | ||
| Valero Energy Corp., 3.4%, 9/15/2026 | 25,000 | 23,950 | ||
| Valero Energy Partners LP, 4.375%, 12/15/2026 | 10,000 | 10,090 | ||
| 1,300,669 | ||||
| Financials 5.0% | ||||
| Akbank TAS, 144A, 5.0%, 10/24/2022 | 200,000 | 190,000 | ||
| Apollo Investment Corp., 5.25%, 3/3/2025 | 30,000 | 29,195 | ||
| Ares Capital Corp., 3.625%, 1/19/2022 | 20,000 | 19,389 | ||
| Bank of America Corp., 3.5%, 4/19/2026 | 20,000 | 19,733 | ||
| Barclays Bank PLC, 144A, 6.05%, 12/4/2017 | 120,000 | 123,970 | ||
| Blackstone Holdings Finance Co., LLC, 144A, 5.0%, 6/15/2044 | 10,000 | 9,864 | ||
| Branch Banking & Trust Co., 1.45%, 5/10/2019 | 20,000 | 19,777 | ||
| Corp. Financiera de Desarrollo SA, 144A, 4.75%, 2/8/2022 | 250,000 | 261,250 | ||
| Credito Real SAB de CV SOFOM ER, 144A, 7.25%, 7/20/2023 | 250,000 | 255,000 | ||
| Everest Reinsurance Holdings, Inc., 4.868%, 6/1/2044 | 30,000 | 29,097 | ||
| FS Investment Corp., 4.75%, 5/15/2022 | 40,000 | 39,886 | ||
| KKR Group Finance Co. III LLC, 144A, 5.125%, 6/1/2044 | 20,000 | 18,883 | ||
| Legg Mason, Inc., 5.625%, 1/15/2044 | 20,000 | 19,476 | ||
| Loews Corp., 4.125%, 5/15/2043 | 20,000 | 19,188 | ||
| Manulife Financial Corp., 5.375%, 3/4/2046 | 25,000 | 28,521 | ||
| Massachusetts Mutual Life Insurance Co., 144A, 4.5%, 4/15/2065 | 10,000 | 9,172 | ||
| Morgan Stanley, 3.125%, 7/27/2026 | 20,000 | 19,107 | ||
| Nationwide Financial Services, Inc., 144A, 5.3%, 11/18/2044 | 20,000 | 20,827 | ||
| Swiss Re Treasury U.S. Corp., 144A, 4.25%, 12/6/2042 | 20,000 | 19,531 | ||
| The Goldman Sachs Group, Inc.: | ||||
| 3.5%, 11/16/2026 | 10,000 | 9,770 | ||
| 3.75%, 2/25/2026 | 20,000 | 20,059 | ||
| Voya Financial, Inc., 4.8%, 6/15/2046 | 15,000 | 14,581 | ||
| Wells Fargo & Co., 3.0%, 10/23/2026 | 35,000 | 33,334 | ||
| 1,229,610 | ||||
| Principal Amount ($)(a) | Value ($) | |||
| Health Care 1.2% | ||||
| Abbott Laboratories: | ||||
| 2.9%, 11/30/2021 | 60,000 | 59,829 | ||
| 4.9%, 11/30/2046 | 60,000 | 61,580 | ||
| AbbVie, Inc., 4.7%, 5/14/2045 | 5,000 | 4,906 | ||
| Actavis Funding SCS, 4.75%, 3/15/2045 | 10,000 | 9,817 | ||
| Aetna, Inc., 4.375%, 6/15/2046 | 15,000 | 15,062 | ||
| Celgene Corp., 5.0%, 8/15/2045 | 10,000 | 10,397 | ||
| Gilead Sciences, Inc., 4.15%, 3/1/2047 | 15,000 | 14,247 | ||
| Mylan NV, 144A, 5.25%, 6/15/2046 | 25,000 | 23,057 | ||
| Pfizer, Inc.: | ||||
| 4.0%, 12/15/2036 | 15,000 | 15,368 | ||
| 4.125%, 12/15/2046 | 5,000 | 5,086 | ||
| Shire Acquisitions Investments Ireland DAC, 3.2%, 9/23/2026 | 39,000 | 36,439 | ||
| Stryker Corp., 4.625%, 3/15/2046 | 10,000 | 10,197 | ||
| UnitedHealth Group, Inc.: | ||||
| 3.45%, 1/15/2027 | 15,000 | 15,238 | ||
| 4.2%, 1/15/2047 | 25,000 | 25,288 | ||
| 306,511 | ||||
| Industrials 0.3% | ||||
| CSX Corp., 4.25%, 11/1/2066 | 10,000 | 9,126 | ||
| FedEx Corp., 4.55%, 4/1/2046 | 15,000 | 15,116 | ||
| Molex Electronic Technologies LLC, 144A, 3.9%, 4/15/2025 | 20,000 | 19,674 | ||
| Roper Technologies, Inc., 3.8%, 12/15/2026 | 20,000 | 20,154 | ||
| Transurban Finance Co. Pty Ltd., 144A, 3.375%, 3/22/2027 | 15,000 | 14,173 | ||
| 78,243 | ||||
| Information Technology 0.8% | ||||
| Activision Blizzard, Inc., 144A, 3.4%, 9/15/2026 | 20,000 | 18,982 | ||
| Diamond 1 Finance Corp.: | ||||
| 144A, 4.42%, 6/15/2021 | 100,000 | 103,474 | ||
| 144A, 8.1%, 7/15/2036 | 20,000 | 23,792 | ||
| NVIDIA Corp.: | ||||
| 2.2%, 9/16/2021 | 15,000 | 14,642 | ||
| 3.2%, 9/16/2026 | 15,000 | 14,422 | ||
| Seagate HDD Cayman, 5.75%, 12/1/2034 | 30,000 | 25,575 | ||
| 200,887 | ||||
| Materials 2.7% | ||||
| CF Industries, Inc., 144A, 4.5%, 12/1/2026 | 5,000 | 4,914 | ||
| Equate Petrochemical BV, 144A, 4.25%, 11/3/2026 | 200,000 | 190,856 | ||
| Glencore Funding LLC, 144A, 4.625%, 4/29/2024 | 10,000 | 10,225 | ||
| GTL Trade Finance, Inc., 144A, 5.893%, 4/29/2024 (b) | 150,000 | 149,250 | ||
| Potash Corp. of Saskatchewan, Inc., 4.0%, 12/15/2026 | 30,000 | 30,190 | ||
| St. Marys Cement, Inc., 144A, 5.75%, 1/28/2027 | 295,000 | 283,200 | ||
| 668,635 | ||||
| Real Estate 1.0% | ||||
| CBL & Associates LP: | ||||
| (REIT), 4.6%, 10/15/2024 | 20,000 | 18,747 | ||
| (REIT), 5.25%, 12/1/2023 | 40,000 | 39,331 | ||
| (REIT), 5.95%, 12/15/2026 | 40,000 | 40,264 | ||
| Crown Castle International Corp., (REIT), 5.25%, 1/15/2023 | 15,000 | 16,144 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Hospitality Properties Trust, (REIT), 5.0%, 8/15/2022 | 60,000 | 63,343 | ||
| Omega Healthcare Investors, Inc., (REIT), 4.95%, 4/1/2024 | 30,000 | 30,398 | ||
| Select Income REIT, (REIT), 4.15%, 2/1/2022 | 30,000 | 29,708 | ||
| 237,935 | ||||
| Telecommunication Services 0.1% | ||||
| AT&T, Inc., 4.5%, 5/15/2035 | 25,000 | 24,154 | ||
| Verizon Communications, Inc., 4.672%, 3/15/2055 | 15,000 | 14,087 | ||
| 38,241 | ||||
| Utilities 0.1% | ||||
| Electricite de France SA, 144A, 4.75%, 10/13/2035 | 25,000 | 25,082 | ||
| Southern Power Co., Series F, 4.95%, 12/15/2046 | 7,000 | 6,821 | ||
| 31,903 | ||||
| Total Corporate Bonds (Cost $4,882,336) | 4,871,955 | |||
| Asset-Backed 1.0% | ||||
| Home Equity Loans 0.1% | ||||
| CIT Group Home Equity Loan Trust, "AF6", Series 2002-1, 6.2%, 2/25/2030 | 27,496 | 27,416 | ||
| Miscellaneous 0.9% | ||||
| Domino's Pizza Master Issuer LLC, "A2", Series 2012-1A, 144A, 5.216%, 1/25/2042 | 87,300 | 89,043 | ||
| Hilton Grand Vacations Trust, "B", Series 2014-AA, 144A, 2.07%, 11/25/2026 | 139,635 | 137,871 | ||
| 226,914 | ||||
| Total Asset-Backed (Cost $259,285) | 254,330 | |||
| Commercial Mortgage-Backed Securities 4.7% | ||||
| Credit Suisse First Boston Mortgage Securities Corp., "G", Series 2005-C6, 144A, 5.191%**, 12/15/2040 | 250,000 | 249,687 | ||
| CSAIL Commercial Mortgage Trust, "A4", Series 2015-C4, 3.808%, 11/15/2048 | 110,000 | 114,542 | ||
| GMAC Commercial Mortgage Securities, Inc., "G", Series 2004-C1, 144A, 5.455%, 3/10/2038 | 502,681 | 494,094 | ||
| JPMBB Commercial Mortgage Securities Trust: | ||||
| "A4", Series 2015-C28, 3.227%, 10/15/2048 | 170,000 | 170,953 | ||
| "A3", Series 2014-C19, 3.669%, 4/15/2047 | 125,000 | 130,023 | ||
| Total Commercial Mortgage-Backed Securities (Cost $1,163,650) | 1,159,299 | |||
| Collateralized Mortgage Obligations 10.0% | ||||
| Banc of America Mortgage Securities, "2A2", Series 2004-A, 2.984%**, 2/25/2034 | 55,240 | 54,509 | ||
| Bear Stearns Adjustable Rate Mortgage Trust, "2A1", Series 2005-11, 3.516%**, 12/25/2035 | 74,644 | 75,469 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Countrywide Home Loans, "2A5", Series 2004-13, 5.75%, 8/25/2034 | 45,936 | 45,530 | ||
| Fannie Mae Connecticut Avenue Securities, "1M1", Series 2016-C02, 2.734%**, 9/25/2028 | 178,900 | 180,760 | ||
| Federal Home Loan Mortgage Corp.: | ||||
| "AI", Series 4016, Interest Only, 3.0%, 9/15/2025 | 601,009 | 35,424 | ||
| "PI", Series 3843, Interest Only, 4.5%, 5/15/2038 | 217,399 | 19,956 | ||
| "C31", Series 303, Interest Only, 4.5%, 12/15/2042 | 562,529 | 111,875 | ||
| "DZ", Series 4253, 4.75%, 9/15/2043 | 1,152,557 | 1,185,407 | ||
| "HI", Series 2934, Interest Only, 5.0%, 2/15/2020 | 40,246 | 2,204 | ||
| "WI", Series 3010, Interest Only, 5.0%, 7/15/2020 | 64,284 | 3,301 | ||
| "JS", Series 3572, Interest Only, 6.096%***, 9/15/2039 | 350,891 | 49,897 | ||
| Federal National Mortgage Association: | ||||
| "4", Series 406, Interest Only, 4.0%, 9/25/2040 | 125,927 | 24,894 | ||
| "BI", Series 2010-13, Interest Only, 5.0%, 12/25/2038 | 7,630 | 73 | ||
| "SI", Series 2007-23, Interest Only, 6.014%***, 3/25/2037 | 170,282 | 25,803 | ||
| Government National Mortgage Association: | ||||
| "GI", Series 2014-146, Interest Only, 3.5%, 9/20/2029 | 1,404,147 | 177,530 | ||
| "PI", Series 2015-40, Interest Only, 4.0%, 4/20/2044 | 184,558 | 27,745 | ||
| "HI", Series 2015-77, Interest Only, 4.0%, 5/20/2045 | 343,946 | 65,454 | ||
| "IP", Series 2014-115, Interest Only, 4.5%, 2/20/2044 | 55,867 | 10,062 | ||
| "IV", Series 2009-69, Interest Only, 5.5%, 8/20/2039 | 175,475 | 34,740 | ||
| "IN", Series 2009-69, Interest Only, 5.5%, 8/20/2039 | 182,369 | 32,701 | ||
| "AI", Series 2007-38, Interest Only, 5.753%***, 6/16/2037 | 50,144 | 7,255 | ||
| "IJ", Series 2009-75, Interest Only, 6.0%, 8/16/2039 | 175,711 | 30,253 | ||
| JPMorgan Mortgage Trust, "2A1", Series 2006-A2, 2.912%**, 4/25/2036 | 185,825 | 170,922 | ||
| Merrill Lynch Mortgage Investors Trust, "2A", Series 2003-A6, 3.264%**, 10/25/2033 | 41,713 | 41,549 | ||
| Wells Fargo Mortgage-Backed Securities Trust, "2A3",Series 2004-EE, 3.035%**, 12/25/2034 | 57,693 | 57,032 | ||
| Total Collateralized Mortgage Obligations (Cost $2,380,371) | 2,470,345 | |||
| Government & Agency Obligations 39.9% | ||||
| Other Government Related (c) 5.6% | ||||
| Novolipetsk Steel, 144A, 4.5%, 6/15/2023 | 400,000 | 397,766 | ||
| Perusahaan Penerbit SBSN, 144A, 4.325%, 5/28/2025 | 200,000 | 199,240 | ||
| Rosneft Oil Co., 144A, 4.199%, 3/6/2022 | 250,000 | 246,473 | ||
| Principal Amount ($)(a) | Value ($) | |||
| Vnesheconombank, 144A, 6.902%, 7/9/2020 | 500,000 | 540,150 | ||
| 1,383,629 | ||||
| Sovereign Bonds 9.8% | ||||
| Dominican Republic, 144A, 6.875%, 1/29/2026 | 100,000 | 103,957 | ||
| Government of Indonesia, Series FR56, 8.375%, 9/15/2026 | IDR | 1,340,000,000 | 102,147 | |
| KazAgro National Management Holding JSC, 144A, 4.625%, 5/24/2023 | 700,000 | 655,844 | ||
| Mexican Udibonos, Series S, 2.0%, 6/9/2022 | MXN | 2,683,951 | 125,696 | |
| Republic of Argentina- Inflation Linked Bond, 5.83%, 12/31/2033 | ARS | 375 | 170 | |
| Republic of Hungary, Series 19/A, 6.5%, 6/24/2019 | HUF | 11,600,000 | 45,004 | |
| Republic of Portugal, 144A, 5.125%, 10/15/2024 | 100,000 | 96,750 | ||
| Republic of Slovenia, 144A, 5.5%, 10/26/2022 | 100,000 | 110,498 | ||
| Republic of Sri Lanka, 144A, 5.75%, 1/18/2022 | 500,000 | 492,383 | ||
| United Mexican States, Series M, 5.75%, 3/5/2026 | MXN | 16,345,600 | 699,638 | |
| 2,432,087 | ||||
| U.S. Treasury Obligations 24.5% | ||||
| U.S. Treasury Bond, 2.25%, 8/15/2046 | 10,000 | 8,408 | ||
| U.S. Treasury Notes: | ||||
| 0.75%, 10/31/2017 (d) | 730,000 | 729,344 | ||
| 0.75%, 7/15/2019 | 25,000 | 24,637 | ||
| 1.5%, 5/31/2019 | 232,600 | 233,672 | ||
| 1.625%, 12/31/2019 | 109,000 | 109,537 | ||
| 1.625%, 2/15/2026 | 5,130,000 | 4,793,344 | ||
| 1.625%, 5/15/2026 | 155,000 | 144,537 | ||
| 6,043,479 | ||||
| Total Government & Agency Obligations (Cost $10,167,833) | 9,859,195 | |||
| Short-Term U.S. Treasury Obligations 1.5% | ||||
| U.S. Treasury Bills: | ||||
| 0.4%****, 2/9/2017 (e) | 15,000 | 14,993 | ||
| 0.56%****, 6/1/2017 (e) | 365,000 | 364,058 | ||
| Total Short-Term U.S. Treasury Obligations (Cost $379,136) | 379,051 | |||
| Loan Participations and Assignments 5.1% | ||||
| Senior Loans** | ||||
| American Rock Salt Holdings LLC, First Lien Term Loan, 4.75%, 5/20/2021 | 102,375 | 102,503 | ||
| Calpine Corp., Term Loan B5, 3.75%, 1/15/2024 | 192,075 | 193,287 | ||
| DaVita HealthCare Partners, Inc., Term Loan B, 3.52%, 6/24/2021 | 68,250 | 69,052 | ||
| Goodyear Tire & Rubber Co., Second Lien Term Loan, 3.75%, 4/30/2019 | 73,333 | 74,403 | ||
| Level 3 Financing, Inc., Term Loan B2, 3.5%, 5/31/2022 | 60,000 | 60,812 | ||
| Principal Amount ($)(a) | Value ($) | |||
| MacDermid, Inc., Term Loan, 5.0%, 6/7/2023 | 74,113 | 75,206 | ||
| MEG Energy Corp., Term Loan, 3.75%, 3/31/2020 | 250,130 | 244,034 | ||
| NRG Energy, Inc., Term Loan B, 3.749%, 6/30/2023 | 115,160 | 116,497 | ||
| Quebecor Media, Inc., Term Loan B1, 3.402%, 8/17/2020 | 87,075 | 87,365 | ||
| Valeant Pharmaceuticals International, Inc.: | ||||
| Term Loan B, 5.0%, 2/13/2019 | 132,992 | 133,125 | ||
| Term Loan B, 5.25%, 12/11/2019 | 112,212 | 112,222 | ||
| Total Loan Participations and Assignments (Cost $1,267,176) | 1,268,506 | |||
| Convertible Bond 0.6% | ||||
| Materials | ||||
| GEO Specialty Chemicals, Inc., 144A, 7.5%, 10/30/2018 (PIK) (Cost $130,558) | 132,085 | 135,110 | ||
Shares |
Value ($) | ||
| Common Stocks 0.0% | |||
| Industrials 0.0% | |||
| Quad Graphics, Inc. | 26 | 699 | |
| Materials 0.0% | |||
| GEO Specialty Chemicals, Inc.* | 13,196 | 5,182 | |
| Total Common Stocks (Cost $19,933) | 5,881 | ||
| Warrant 0.0% | |||
| Materials | |||
| Hercules Trust II, Expiration Date 3/31/2029* (Cost $17,432) | 85 | 386 | |
| Exchange-Traded Funds 10.4% | |||
| iShares iBoxx $ High Yield Corporate Bond ETF | 15,000 | 1,298,250 | |
| SPDR Bloomberg Barclays High Yield Bond ETF (b) | 35,000 | 1,275,750 | |
| Total Exchange-Traded Funds (Cost $2,514,600) | 2,574,000 | ||
| Contract Amount | Value ($) | |||
| Call Options Purchased 0.0% | ||||
| Options on Interest Rate Swap Contracts | ||||
| Pay Fixed Rate — 4.19% – Receive Floating — 3-Month LIBOR, Swap Expiration Date 2/3/2027, Option Expiration Date 2/1/20171 | 1,500,000 | 0 | ||
| Pay Fixed Rate — 4.32% – Receive Floating — 3-Month LIBOR, Swap Expiration Date 2/3/2027, Option Expiration Date 2/1/20172 | 1,400,000 | 0 | ||
| Total Call Options Purchased (Cost $127,165) | 0 | |||
| Put Options Purchased 0.1% | ||||
| Options on Interest Rate Swap Contracts | ||||
| Receive Fixed Rate — 2.19% – Pay Floating — 3-Month LIBOR, Swap Expiration Date 2/3/2027, Option Expiration Date 2/1/20171 | 1,500,000 | 4,655 | ||
| Receive Fixed Rate — 2.32% – Pay Floating — 3-Month LIBOR, Swap Expiration Date 2/3/2027, Option Expiration Date 2/1/20172 | 1,400,000 | 10,603 | ||
| Total Put Options Purchased (Cost $98,573) | 15,258 | |||
Shares |
Value ($) | ||
| Securities Lending Collateral 5.9% | |||
| Government & Agency Securities Portfolio "Deutsche Government Cash Institutional Shares", 0.42% (f) (g) (Cost $1,464,323) | 1,464,323 | 1,464,323 | |
| Cash Equivalents 4.8% | |||
| Deutsche Central Cash Management Government Fund, 0.49% (f) (Cost $1,190,393) | 1,190,393 | 1,190,393 | |
| % of Net Assets | Value ($) | |
| Total Investment Portfolio (Cost $26,062,764)† | 103.7 | 25,648,032 |
| Other Assets and Liabilities, Net | (3.7) | (924,557) |
| Net Assets | 100.0 | 24,723,475 |
* Non-income producing security.
** Floating rate securities' yields vary with a designated market index or market rate, such as the coupon-equivalent of the U.S. Treasury Bill rate. These securities are shown at their current rate as of December 31, 2016.
*** These securities are shown at their current rate as of December 31, 2016.
**** Annualized yield at time of purchase; not a coupon rate.
† The cost for federal income tax purposes was $26,064,148. At December 31, 2016, net unrealized depreciation for all securities based on tax cost was $416,116. This consisted of aggregate gross unrealized appreciation for all securities in which there was an excess of value over tax cost of $402,684 and aggregate gross unrealized depreciation for all securities in which there was an excess of tax cost over value of $818,800.
(a) Principal amount stated in U.S. dollars unless otherwise noted.
(b) All or a portion of these securities were on loan. In addition, "Other Assets and Liabilities, Net" may include pending sales that are also on loan. The value of securities loaned at December 31, 2016 amounted to $1,430,865, which is 5.8% of net assets.
(c) Government-backed debt issued by financial companies or government-sponsored enterprises.
(d) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open centrally cleared swap contracts.
(e) At December 31, 2016, this security has been pledged, in whole or in part, to cover initial margin requirements for open futures contracts.
(f) Affiliated fund managed by Deutsche Investment Management Americas Inc. The rate shown is the annualized seven-day yield at period end.
(g) Represents collateral held in connection with securities lending. Income earned by the Fund is net of borrower rebates.
144A: Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration, normally to qualified institutional buyers.
Interest Only: Interest Only (IO) bonds represent the "interest only" portion of payments on a pool of underlying mortgages or mortgage-backed securities. IO securities are subject to prepayment risk of the pool of underlying mortgages.
JSC: Joint Stock Company
LIBOR: London Interbank Offered Rate; 3-Month LIBOR rate at December 31, 2016 is 1.00%.
PIK: Denotes that all or a portion of the income is paid in-kind in the form of additional principal.
REIT: Real Estate Investment Trust
SBSN: Surat Berharga Syariah Negara (Islamic Based Government Securities)
SPDR: Standard & Poor's Depositary Receipt
At December 31, 2016, open futures contracts purchased were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Depreciation ($) |
| 10 Year U.S. Treasury Note | USD | 3/22/2017 | 32 | 3,977,000 | (26,568) |
| Ultra Long U.S. Treasury Bond | USD | 3/22/2017 | 26 | 4,166,500 | (75,658) |
| Total unrealized depreciation | (102,226) | ||||
At December 31, 2016, open futures contracts sold were as follows:
| Futures | Currency | Expiration Date | Contracts | Notional Value ($) | Unrealized Appreciation ($) |
| Ultra 10 Year U.S. Treasury Note | USD | 3/22/2017 | 1 | 134,063 | 1,271 |
At December 31, 2016, open written options contracts were as follows:
| Options on Interest Rate Swap Contracts | Swap Effective/ Expiration Date |
Contract Amount | Option Expiration Date | Premiums Received ($) | Value ($) (h) |
|
Call Options Receive Fixed — 3.19% – Pay Floating — 3-Month LIBOR |
2/3/2017 2/3/2027 |
700,0001 | 2/1/2017 | 50,400 | (8) |
| Receive Fixed — 3.32% – Pay Floating — 3-Month LIBOR | 2/3/2017 2/3/2027 |
700,0002 | 2/1/2017 | 50,631 | (2) |
| Total Call Options | 101,031 | (10) | |||
|
Put Options Pay Fixed — 3.19% – Receive Floating — 3-Month LIBOR |
2/3/2017 2/3/2027 |
700,0001 | 2/1/2017 | 50,400 | (53,696) |
| Pay Fixed — 3.32% – Receive Floating — 3-Month LIBOR | 2/3/2017 2/3/2027 |
700,0002 | 2/1/2017 | 50,631 | (61,851) |
| Total Put Options | 101,031 | (115,547) | |||
| Total | 202,062 | (115,557) | |||
(h) Unrealized appreciation on written options on interest rate swap contracts at December 31, 2016 was $86,505.
At December 31, 2016, open credit default swap contracts sold were as follows:
| Centrally Cleared Swap | ||||||
| Expiration Date | Notional Amount ($) (i) | Currency | Fixed Cash Flows Received | Underlying Reference Obligation | Value ($) | Unrealized Appreciation ($) |
| 6/20/2021 | 2,800,000 | USD | 5.0% | Markit CDX North America High Yield Index | 200,667 | 89,749 |
(i) The maximum potential amount of future undiscounted payments that the Fund could be required to make under a credit default swap contract would be the notional amount of the contract. These potential amounts would be partially offset by any recovery values of the referenced debt obligation or net amounts received from the settlement of buy protection credit default swap contracts entered into by the Fund for the same referenced debt obligation, if any.
At December 31, 2016, open interest rate swap contracts were as follows:
| Centrally Cleared Swaps | |||||
| Effective/ Expiration Date |
Notional Amount ($) | Cash Flows Paid by the Fund | Cash Flows Received by the Fund | Value ($) | Unrealized Appreciation/ (Depreciation) ($) |
| 3/16/2016 3/16/2017 |
1,000,000 | Floating — 3-Month LIBOR | Fixed — 1.0% | 2,544 | 2,389 |
| 12/16/2015 9/18/2017 |
3,600,000 | Fixed — 1.557% | Floating — 3-Month LIBOR | (26,408) | (27,563) |
| 12/16/2015 9/16/2020 |
2,000,000 | Floating — 3-Month LIBOR | Fixed — 2.214% | 41,940 | 42,632 |
| 3/16/2016 3/16/2025 |
4,100,000 | Fixed — 2.25% | Floating — 3-Month LIBOR | (25,038) | (9,962) |
| 12/16/2015 9/16/2025 |
3,000,000 | Fixed — 2.64% | Floating — 3-Month LIBOR | (108,473) | (94,059) |
| 12/16/2015 9/17/2035 |
200,000 | Fixed — 2.938% | Floating — 3-Month LIBOR | (12,863) | (9,074) |
| 12/16/2015 9/18/2045 |
500,000 | Floating — 3-Month LIBOR | Fixed — 2.998% | 44,942 | 29,389 |
| 7/13/2016 7/13/2046 |
1,500,000 | Fixed — 2.22% | Floating — 3-Month LIBOR | 101,559 | 129,319 |
| 12/21/2016 12/21/2046 |
1,300,000 | Fixed — 2.25% | Floating — 3-Month LIBOR | 103,717 | 227,450 |
| Total net unrealized appreciation | 290,521 | ||||
Counterparties:
1 JPMorgan Chase Securities, Inc.
2 BNP Paribas
As of December 31, 2016, the Fund had the following open forward foreign currency exchange contracts:
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Appreciation ($) | Counterparty | |||||
| USD | 547,536 | ZAR | 7,800,000 | 1/17/2017 | 18,503 | Goldman Sachs & Co. | |||
| MXN | 7,500,000 | USD | 400,791 | 1/26/2017 | 40,478 | Barclays Bank PLC | |||
| MXN | 7,500,000 | USD | 368,668 | 2/14/2017 | 9,143 | Barclays Bank PLC | |||
| USD | 237,153 | MXN | 4,960,000 | 2/21/2017 | 430 | JPMorgan Chase Securities, Inc. | |||
| MXN | 14,869,812 | USD | 721,460 | 2/21/2017 | 9,200 | JPMorgan Chase Securities, Inc. | |||
| Total unrealized appreciation | 77,754 | ||||||||
| Contracts to Deliver | In Exchange For | Settlement Date | Unrealized Depreciation ($) | Counterparty | |||||
| ZAR | 7,800,000 | USD | 535,314 | 1/17/2017 | (30,725) | Citigroup, Inc. | |||
| USD | 390,867 | MXN | 7,500,000 | 1/26/2017 | (30,554) | Citigroup, Inc. | |||
| USD | 375,158 | MXN | 7,500,000 | 2/14/2017 | (15,633) | Citigroup, Inc. | |||
| MXN | 2,590,000 | USD | 123,859 | 2/28/2017 | (79) | Toronto-Dominion Bank | |||
| Total unrealized depreciation | (76,991) | ||||||||
| Currency Abbreviations |
|
ARS Argentine Peso HUF Hungarian Forint IDR Indonesian Rupiah MXN Mexican Peso USD United States Dollar ZAR South African Rand |
For information on the Fund's policy and additional disclosures regarding options purchased, futures contracts, credit default swap contracts, interest rate swap contracts, forward foreign currency exchange contracts and written option contracts, please refer to Note B in the accompanying Notes to Financial Statements.
Fair Value Measurements
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
The following is a summary of the inputs used as of December 31, 2016 in valuing the Fund's investments. For information on the Fund's policy regarding the valuation of investments, please refer to the Security Valuation section of Note A in the accompanying Notes to Financial Statements.
| Assets | Level 1 | Level 2 | Level 3 | Total | |
| Fixed Income Investments (j) | |||||
| Corporate Bonds | $ — | $ 4,871,955 | $ — | $ 4,871,955 | |
| Asset-Backed | — | 254,330 | — | 254,330 | |
| Commercial Mortgage-Backed Securities | — | 1,159,299 | — | 1,159,299 | |
| Collateralized Mortgage Obligations | — | 2,470,345 | — | 2,470,345 | |
| Government & Agency Obligations | — | 9,859,195 | — | 9,859,195 | |
| Short-Term U.S. Treasury Obligations | — | 379,051 | — | 379,051 | |
| Loan Participations and Assignments | — | 1,268,506 | — | 1,268,506 | |
| Convertible Bond | — | — | 135,110 | 135,110 | |
| Common Stocks | 699 | — | 5,182 | 5,881 | |
| Warrant | — | — | 386 | 386 | |
| Exchange-Traded Funds | 2,574,000 | — | — | 2,574,000 | |
| Short-Term Investments (j) | 2,654,716 | — | — | 2,654,716 | |
|
Derivatives (k) Purchased Options |
— | 15,258 | — | 15,258 | |
| Futures Contracts | 1,271 | — | — | 1,271 | |
| Credit Default Swap Contracts | — | 89,749 | — | 89,749 | |
| Interest Rate Swap Contracts | — | 431,179 | — | 431,179 | |
| Forward Foreign Currency Exchange Contracts | — | 77,754 | — | 77,754 | |
| Total | $ 5,230,686 | $ 20,876,621 | $ 140,678 | $ 26,247,985 | |
| Liabilities | Level 1 | Level 2 | Level 3 | Total | |
|
Derivatives (k) Futures Contracts |
$ (102,226) | $ — | $ — | $ (102,226) | |
| Written Options | — | (115,557) | — | (115,557) | |
| Interest Rate Swap Contracts | — | (140,658) | — | (140,658) | |
| Forward Foreign Currency Exchange Contracts | — | (76,991) | — | (76,991) | |
| Total | $ (102,226) | $ (333,206) | $ — | $ (435,432) | |
There have been no transfers between fair value measurement levels during the year ended December 31, 2016.
(j) See Investment Portfolio for additional detailed categorizations.
(k) Derivatives include value of options purchased, unrealized appreciation (depreciation) on futures contracts, credit default swap contracts, interest rate swap contracts and forward foreign currency exchange contracts, and written options, at value.
The accompanying notes are an integral part of the financial statements.
Statement of Assets and Liabilities
| as of December 31, 2016 | |
| Assets | |
|
Investments: Investments in non-affiliated securities, at value (cost $23,408,048) — including $1,430,865 of securities loaned |
$ 22,993,316 |
| Investments in Government & Agency Securities Portfolio (cost $1,464,323)* | 1,464,323 |
| Investment in Deutsche Central Cash Management Government Fund (cost $1,190,393) | 1,190,393 |
| Total investments in securities, at value (cost $26,062,764) | 25,648,032 |
| Cash | 12,359 |
| Foreign currency, at value (cost $739,089) | 708,130 |
| Receivable for investments sold | 860 |
| Receivable for Fund shares sold | 3,504 |
| Dividends receivable | 6,357 |
| Interest receivable | 191,549 |
| Receivable for variation margin on futures | 37,605 |
| Unrealized appreciation on forward foreign currency exchange contracts | 77,754 |
| Foreign taxes recoverable | 560 |
| Other assets | 857 |
| Total assets | $ 26,687,567 |
| Liabilities | |
| Payable upon return of securities loaned | 1,464,323 |
| Payable for investments purchased | 125,070 |
| Payable for Fund shares redeemed | 95 |
| Payable for variation margin on centrally cleared swaps | 53,515 |
| Options written, at value (premiums received $202,062) | 115,557 |
| Unrealized depreciation on forward foreign currency exchange contracts | 76,991 |
| Accrued management fee | 10,922 |
| Accrued Trustees' fees | 1,132 |
| Other accrued expenses and payables | 116,487 |
| Total liabilities | 1,964,092 |
| Net assets, at value | $ 24,723,475 |
| Net Assets Consist of | |
| Undistributed net investment income | 148,268 |
|
Net unrealized appreciation (depreciation) on: Investments |
(414,732) |
| Swap contracts | 380,270 |
| Futures | (100,955) |
| Foreign currency | (30,549) |
| Written options | 86,505 |
| Accumulated net realized gain (loss) | (4,975,337) |
| Paid-in capital | 29,630,005 |
| Net assets, at value | $ 24,723,475 |
|
Class A Net Asset Value, offering and redemption price per share ($24,723,745 ÷ 2,560,974 outstanding shares of beneficial interest, no par value, unlimited number of shares authorized) |
$ 9.65 |
* Represents collateral on securities loaned.
The accompanying notes are an integral part of the financial statements.
Statement of Operations
| for the year ended December 31, 2016 | |
| Investment Income | |
|
Income: Interest (net of foreign taxes withheld of $605) |
$ 678,099 |
| Dividends | 95,073 |
| Income distributions — Deutsche Central Cash Management Government Fund | 17,290 |
| Securities lending income, net of borrower rebates | 8,298 |
| Other income | 15,727 |
| Total income | 814,487 |
|
Expenses: Management fee |
156,092 |
| Administration fee | 28,380 |
| Services to shareholders | 709 |
| Custodian fee | 27,778 |
| Professional fees | 81,043 |
| Reports to shareholders | 22,596 |
| Trustees' fees and expenses | 3,116 |
| Pricing service fee | 28,901 |
| Other | 21,951 |
| Total expenses before expense reductions | 370,566 |
| Expense reductions | (177,038) |
| Total expenses after expense reductions | 193,528 |
| Net investment income | 620,959 |
| Realized and Unrealized Gain (Loss) | |
|
Net realized gain (loss) from: Investments |
(1,372,990) |
| Swap contracts | (259,273) |
| Futures | (272,260) |
| Written options | 295 |
| Foreign currency | 178,192 |
| (1,726,036) | |
|
Change in net unrealized appreciation (depreciation) on: Investments |
1,272,709 |
| Swap contracts | 542,144 |
| Futures | (59,307) |
| Written options | (63,342) |
| Foreign currency | (399,876) |
| 1,292,328 | |
| Net gain (loss) | (433,708) |
| Net increase (decrease) in net assets resulting from operations | $ 187,251 |
The accompanying notes are an integral part of the financial statements.
Statements of Changes in Net Assets
| Increase (Decrease) in Net Assets | Years Ended December 31, | |
| 2016 | 2015 | |
|
Operations: Net investment income |
$ 620,959 | $ 1,762,667 |
| Net realized gain (loss) | (1,726,036) | (2,050,038) |
| Change in net unrealized appreciation (depreciation) | 1,292,328 | (941,379) |
| Net increase (decrease) in net assets resulting from operations | 187,251 | (1,228,750) |
|
Distributions to shareholders from: Net investment income: Class A |
(2,341,380) | (2,026,151) |
| Total distributions | (2,341,380) | (2,026,151) |
|
Fund share transactions: Class A Proceeds from shares sold |
1,180,584 | 1,567,297 |
| Reinvestment of distributions | 2,341,380 | 2,026,151 |
| Payments for shares redeemed | (9,433,108) | (21,135,428) |
| Net increase (decrease) in net assets from Class A share transactions | (5,911,144) | (17,541,980) |
| Increase (decrease) in net assets | (8,065,273) | (20,796,881) |
| Net assets at beginning of period | 32,788,748 | 53,585,629 |
| Net assets at end of period (including undistributed net investment income of $148,268 and $1,922,375, respectively) | $ 24,723,475 | $ 32,788,748 |
| Other Information | ||
|
Class A Shares outstanding at beginning of period |
3,142,272 | 4,786,192 |
| Shares sold | 115,644 | 142,362 |
| Shares issued to shareholders in reinvestment of distributions | 245,171 | 184,028 |
| Shares redeemed | (942,113) | (1,970,310) |
| Net increase (decrease) in Class A shares | (581,298) | (1,643,920) |
| Shares outstanding at end of period | 2,560,974 | 3,142,272 |
The accompanying notes are an integral part of the financial statements.
Financial Highlights
| Class A | Years Ended December 31, | |||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||
| Selected Per Share Data | ||||||
| Net asset value, beginning of period | $ 10.43 | $ 11.20 | $ 11.53 | $ 12.60 | $ 11.90 | |
|
Income (loss) from investment operations: Net investment incomea |
.22 | .40 | .49 | .49 | .57 | |
| Net realized and unrealized gain (loss) | (.17) | (.72) | (.23) | (.59) | .92 | |
| Total from investment operations | .05 | (.32) | .26 | (.10) | 1.49 | |
|
Less distributions from: Net investment income |
(.83) | (.45) | (.59) | (.62) | (.76) | |
| Net realized gains | — | — | — | (.35) | (.03) | |
| Total distributions | (.83) | (.45) | (.59) | (.97) | (.79) | |
| Net asset value, end of period | $ 9.65 | $ 10.43 | $ 11.20 | $ 11.53 | $ 12.60 | |
| Total Return (%)b | .50 | (3.02) | 2.23 | (1.04) | 13.08 | |
| Ratios to Average Net Assets and Supplemental Data | ||||||
| Net assets, end of period ($ millions) | 25 | 33 | 54 | 61 | 73 | |
| Ratio of expenses before expense reductions (%) | 1.31 | 1.15 | 1.08 | 1.02 | .99 | |
| Ratio of expenses after expense reductions (%) | .68 | .70 | .77 | .74 | .77 | |
| Ratio of net investment income (%) | 2.19 | 3.67 | 4.23 | 4.16 | 4.72 | |
| Portfolio turnover rate (%) | 159 | 185 | 185 | 183 | 164 | |
|
a Based on average shares outstanding during the period. b Total return would have been lower had certain expenses not been reduced. | ||||||
Notes to Financial Statements
A. Organization and Significant Accounting Policies
Deutsche Unconstrained Income VIP (the "Fund") is a diversified series of Deutsche Variable Series II (the "Trust"), which is registered under the Investment Company Act of 1940, as amended (the "1940 Act"), as an open-end management investment company organized as a Massachusetts business trust.
The Fund's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") which require the use of management estimates. Actual results could differ from those estimates. The Fund qualifies as an investment company under Topic 946 of Accounting Standards Codification of U.S. GAAP. The policies described below are followed consistently by the Fund in the preparation of its financial statements.
Security Valuation. Investments are stated at value determined as of the close of regular trading on the New York Stock Exchange on each day the exchange is open for trading.
Various inputs are used in determining the value of the Fund's investments. These inputs are summarized in three broad levels. Level 1 includes quoted prices in active markets for identical securities. Level 2 includes other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds and credit risk). Level 3 includes significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments). The level assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities.
Debt securities and loan participations and assignments are valued at prices supplied by independent pricing services approved by the Fund's Board. Such services may use various pricing techniques which take into account appropriate factors such as yield, quality, coupon rate, maturity, type of issue, trading characteristics, prepayment speeds and other data, as well as broker quotes. If the pricing services are unable to provide valuations, debt securities are valued at the average of the most recent reliable bid quotations or evaluated prices, as applicable, obtained from broker-dealers and loan participations and assignments are valued at the mean of the most recent bid and ask quotations or evaluated prices, as applicable, obtained from one or more broker-dealers. Certain securities may be valued on the basis of a price provided by a single source or broker-dealer. No active trading market may exist for some senior loans and they may be subject to restrictions on resale. The inability to dispose of senior loans in a timely fashion could result in losses. These securities are generally categorized as Level 2.
Equity securities and exchange-traded funds ("ETFs") are valued at the most recent sale price or official closing price reported on the exchange (U.S. or foreign) or over-the-counter market on which they trade. Equity securities or ETFs for which no sales are reported are valued at the calculated mean between the most recent bid and asked quotations on the relevant market or, if a mean cannot be determined, at the most recent bid quotation. Equity securities and ETFs are generally categorized as Level 1.
Investments in open-end investment companies are valued at their net asset value each business day and are categorized as Level 1.
Futures contracts are generally valued at the settlement prices established each day on the exchange on which they are traded and are categorized as Level 1.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and are categorized as Level 2.
Swap contracts are valued daily based upon prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer. Swap contracts are generally categorized as Level 2.
Exchange-traded options are valued at the last sale price or, in the absence of a sale, the mean between the closing bid and asked prices or at the most recent asked price (bid for purchased options) if no bid or asked price are available. Exchange-traded options are categorized as Level 1. Over-the-counter written or purchased options are valued at prices supplied by a Board approved pricing vendor, if available, and otherwise are valued at the price provided by the broker-dealer with which the option was traded. Over-the-counter written or purchased options are generally categorized as Level 2.
Securities and other assets for which market quotations are not readily available or for which the above valuation procedures are deemed not to reflect fair value are valued in a manner that is intended to reflect their fair value as determined in accordance with procedures approved by the Board and are generally categorized as Level 3. In accordance with the Fund's valuation procedures, factors considered in determining value may include, but are not limited to, the type of the security; the size of the holding; the initial cost of the security; the existence of any contractual restrictions on the security's disposition; the price and extent of public trading in similar securities of the issuer or of comparable companies; quotations or evaluated prices from broker-dealers and/or pricing services; information obtained from the issuer, analysts, and/or the appropriate stock exchange (for exchange-traded securities); an analysis of the company's or issuer's financial statements; an evaluation of the forces that influence the issuer and the market(s) in which the security is purchased and sold; and with respect to debt securities, the maturity, coupon, creditworthiness, currency denomination and the movement of the market in which the security is normally traded. The value determined under these procedures may differ from published values for the same securities.
Disclosure about the classification of fair value measurements is included in a table following the Fund's Investment Portfolio.
Foreign Currency Translations. The books and records of the Fund are maintained in U.S. dollars. Investment securities and other assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the prevailing exchange rates at period end. Purchases and sales of investment securities, income and expenses are translated into U.S. dollars at the prevailing exchange rates on the respective dates of the transactions.
Net realized and unrealized gains and losses on foreign currency transactions represent net gains and losses between trade and settlement dates on securities transactions, the acquisition and disposition of foreign currencies, and the difference between the amount of net investment income accrued and the U.S. dollar amount actually received. The portion of both realized and unrealized gains and losses on investments that results from fluctuations in foreign currency exchange rates is not separately disclosed but is included with net realized and unrealized gain/appreciation and loss/depreciation on investments.
Securities Lending. Deutsche Bank AG, as lending agent, lends securities of the Fund to certain financial institutions under the terms of its securities lending agreement. During the term of the loans, the Fund continues to receive interest and dividends generated by the securities and to participate in any changes in their market value. The Fund requires the borrowers of the securities to maintain collateral with the Fund consisting of either cash or liquid, unencumbered assets having a value at least equal to the value of the securities loaned. When the collateral falls below specified amounts, the lending agent will use its best effort to obtain additional collateral on the next business day to meet required amounts under the securities lending agreement. As of period end, any securities on loan were collateralized by cash. During the year ended December 31, 2016, the Fund invested the cash collateral into a joint trading account in affiliated money market funds managed by Deutsche Investment Management Americas Inc. As of December 31, 2016, the Fund invested the cash collateral in Government & Agency Securities Portfolio. Deutsche Investment Management Americas Inc. receives a management/administration fee (0.09% annualized effective rate as of December 31, 2016) on the cash collateral invested in Government & Agency Securities Portfolio. The Fund receives compensation for lending its securities either in the form of fees or by earning interest on invested cash collateral net of borrower rebates and fees paid to a lending agent. Either the Fund or the borrower may terminate the loan at any time, and the borrower, after notice, is required to return borrowed securities within a standard time period. There may be risks of delay and costs in recovery of securities or even loss of rights in the collateral should the borrower of the securities fail financially. If the Fund is not able to recover securities lent, the Fund may sell the collateral and purchase a replacement investment in the market, incurring the risk that the value of the replacement security is greater than the value of the collateral. The Fund is also subject to all investment risks associated with the reinvestment of any cash collateral received, including, but not limited to, interest rate, credit and liquidity risk associated with such investments.
As of December 31, 2016, the Fund had securities on loan, which were classified as corporate bonds and exchange-traded funds in the Investment Portfolio. The value of the related collateral exceeded the value of the securities loaned at period end.
| Remaining Contractual Maturity of the Agreements as of December 31, 2016 | |||||
| Overnight and Continuous | <30 days | Between 30 & 90 days | >90 days | Total | |
| Securities Lending Transactions | |||||
| Corporate Bonds | $ 164,223 | $ — | $ — | $ — | $ 164,223 |
| Exchange-Traded Funds | 1,300,100 | — | — | — | 1,300,100 |
| Total Borrowings | $1,464,323 | $ — | $ — | $ — | $1,464,323 |
| Gross amount of recognized liabilities for securities lending transactions | $1,464,323 | ||||
Loan Participations and Assignments. Loan Participations and Assignments are portions of loans originated by banks and sold in pieces to investors. These floating-rate loans ("Loans") in which the Fund invests are arranged between the borrower and one or more financial institutions ("Lenders"). These Loans may take the form of Senior Loans, which are corporate obligations often issued in connection with recapitalizations, acquisitions, leveraged buy outs and refinancing. The Fund invests in such Loans in the form of participations in Loans ("Participations") or assignments of all or a portion of Loans from third parties ("Assignments"). Participations typically result in the Fund having a contractual relationship with only the Lender, not with the borrower. The Fund has the right to receive payments of principal, interest and any fees to which it is entitled from the Lender selling the Participation and only upon receipt by the Lender of the payments from the borrower. In connection with purchasing Participations, the Fund generally has no right to enforce compliance by the borrower with the terms of the loan agreement relating to the Loan, or any rights of set off against the borrower, and the Fund will not benefit directly from any collateral supporting the Loan in which it has purchased the Participation. As a result, the Fund assumes the credit risk of both the borrower and the Lender that is selling the Participation. Assignments typically result in the Fund having a direct contractual relationship with the borrower, and the Fund may enforce compliance by the borrower with the terms of the loan agreement. Loans held by the Fund are generally in the form of Assignments, but the Fund may also invest in Participations. If affiliates of the Advisor participate in the primary and secondary market for senior loans, legal limitations may restrict the Fund's ability to participate in restructuring or acquiring some senior loans. All Loans involve interest rate risk, liquidity risk and credit risk, including the potential default or insolvency of the borrower.
When-Issued/Delayed Delivery Securities. The Fund may purchase or sell securities with delivery or payment to occur at a later date beyond the normal settlement period. At the time the Fund enters into a commitment to purchase or sell a security, the transaction is recorded and the value of the transaction is reflected in the net asset value. The price of such security and the date when the security will be delivered and paid for are fixed at the time the transaction is negotiated. The value of the security may vary with market fluctuations. At the time the Fund enters into this type of transaction, it is required to segregate cash or other liquid assets at least equal to the amount of the commitment. Additionally, the Fund may be required to post securities and/or cash collateral in accordance with the terms of the commitment.
Certain risks may arise upon entering into when-issued or delayed delivery transactions from the potential inability of counterparties to meet the terms of their contracts or if the issuer does not issue the securities due to political, economic, or other factors. Additionally, losses may arise due to changes in the value of the underlying securities.
Taxes. The Fund's policy is to comply with the requirements of the Internal Revenue Code, as amended, which are applicable to regulated investment companies and to distribute all of its taxable income to its shareholders.
Additionally, the Fund may be subject to taxes imposed by the governments of countries in which it invests and are generally based on income and/or capital gains earned or repatriated, a portion of which may be recoverable. Based upon the current interpretation of the tax rules and regulations, estimated tax liabilities and recoveries on certain foreign securities are recorded on an accrual basis and are reflected as components of interest income or net change in unrealized gain/loss on investments. Tax liabilities realized as a result of security sales are reflected as a component of net realized gain/loss on investments.
At December 31, 2016, the Fund had net tax basis capital loss carryforwards of approximately $5,075,000, which may be applied against realized net taxable capital gains indefinitely, including short-term losses ($2,624,000) and long-term losses ($2,451,000).
The Fund has reviewed the tax positions for the open tax years as of December 31, 2016 and has determined that no provision for income tax and/or uncertain tax provisions is required in the Fund's financial statements. The Fund's federal tax returns for the prior three fiscal years remain open subject to examination by the Internal Revenue Service.
Distribution of Income and Gains. Distributions from net investment income of the Fund, if any, are declared and distributed to shareholders annually. Net realized gains from investment transactions, in excess of available capital loss carryforwards, would be taxable to the Fund if not distributed and, therefore, will be distributed to shareholders at least annually. The Fund may also make additional distributions for tax purposes if necessary.
The timing and characterization of certain income and capital gain distributions are determined annually in accordance with federal tax regulations which may differ from accounting principles generally accepted in the United States of America. These differences primarily relate to investments in foreign denominated investments, forward currency contracts, futures contracts, swap contracts and certain securities sold at a loss. As a result, net investment income (loss) and net realized gain (loss) on investment transactions for a reporting period may differ significantly from distributions during such period. Accordingly, the Fund may periodically make reclassifications among certain of its capital accounts without impacting the net asset value of the Fund.
At December 31, 2016, the Fund's components of distributable earnings on a tax basis were as follows:
| Undistributed ordinary income* | $ 180,712 |
| Capital loss carryforwards | $ (5,075,000) |
| Unrealized appreciation (depreciation) on investments | $ (416,116) |
In addition, the tax character of distributions paid by the Fund is summarized as follows:
| Years Ended December 31, | ||
| 2016 | 2015 | |
| Distributions from ordinary income* | $ 2,341,380 | $ 2,026,151 |
* For tax purposes, short-term capital gain distributions are considered ordinary income distributions.
Expenses. Expenses of the Trust arising in connection with a specific fund are allocated to that fund. Other Trust expenses which cannot be directly attributed to a fund are apportioned among the funds in the Trust based upon the relative net assets or other appropriate measures.
Contingencies. In the normal course of business, the Fund may enter into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet been made. However, based on experience, the Fund expects the risk of loss to be remote.
Other. Investment transactions are accounted for on a trade date plus one basis for daily net asset value calculations. However, for financial reporting purposes, investment transactions are reported on trade date. Interest income is recorded on the accrual basis. Dividend income is recorded on the ex-dividend date net of foreign withholding taxes. Realized gains and losses from investment transactions are recorded on an identified cost basis. Proceeds from litigation payments, if any, are included in net realized gain (loss) from investments. All discounts and premiums are accreted/amortized for both tax and financial reporting purposes for the Fund, with the exception of securities in default of principal.
B. Derivative Instruments
Swaps. A swap is a contract between two parties to exchange future cash flows at periodic intervals based on the notional amount of the swap. A bilateral swap is a transaction between the fund and a counterparty where cash flows are exchanged between the two parties. A centrally cleared swap is a transaction executed between the fund and a counterparty, then cleared by a clearing member through a central clearinghouse. The central clearinghouse serves as the counterparty, with whom the fund exchanges cash flows.
The value of a swap is adjusted daily, and the change in value, if any, is recorded as unrealized appreciation or depreciation in the Statement of Assets and Liabilities. Gains or losses are realized when the swap expires or is closed. Certain risks may arise when entering into swap transactions including counterparty default; liquidity; or unfavorable changes in interest rates or the value of the underlying reference security, commodity or index. In connection with bilateral swaps, securities and/or cash may be identified as collateral in accordance with the terms of the swap agreement to provide assets of value and recourse in the event of default. The maximum counterparty credit risk is the net present value of the cash flows to be received from or paid to the counterparty over the term of the swap, to the extent that this amount is beneficial to the Fund, in addition to any related collateral posted to the counterparty by the Fund. This risk may be partially reduced by a master netting arrangement between the Fund and the counterparty. Upon entering into a centrally cleared swap, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the notional amount of the swap. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value of the swap. In a cleared swap transaction, counterparty risk is minimized as the central clearinghouse acts as the counterparty.
An upfront payment, if any, made by the Fund is recorded as an asset in the Statement of Assets and Liabilities. An upfront payment, if any, received by the Fund is recorded as a liability in the Statement of Assets and Liabilities. Payments received or made at the end of the measurement period are recorded as realized gain or loss in the Statement of Operations.
Interest Rate Swaps. Interest rate swaps are agreements in which the Fund agrees to pay to the counterparty a fixed rate payment in exchange for the counterparty agreeing to pay to the Fund a variable rate payment, or the Fund agrees to receive from the counterparty a fixed rate payment in exchange for the counterparty agreeing to receive from the Fund a variable rate payment. The payment obligations are based on the notional amount of the swap. For the year ended December 31, 2016, the Fund entered into interest rate swap agreements to gain exposure to different parts of the yield curve while managing overall duration.
A summary of the open interest rate swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in interest rate swap contracts had a total notional amount generally indicative of a range from $14,400,000 to $17,200,000.
Credit Default Swaps. Credit default swaps are agreements between a buyer and a seller of protection against predefined credit events for the reference entity. The Fund may enter into credit default swaps to gain exposure to an underlying issuer's credit quality characteristics without directly investing in that issuer or to hedge against the risk of a credit event on debt securities. As a seller of a credit default swap, the Fund is required to pay the par (or other agreed-upon) value of the referenced entity to the counterparty with the occurrence of a credit event by a third party, such as a U.S. or foreign corporate issuer, on the reference entity, which would likely result in a loss to the Fund. In return, the Fund receives from the counterparty a periodic stream of payments over the term of the swap provided that no credit event has occurred. If no credit event occurs, the Fund keeps the stream of payments with no payment obligations. The Fund may also buy credit default swaps, in which case the Fund functions as the counterparty referenced above. This involves the risk that the swap may expire worthless. It also involves counterparty risk that the seller may fail to satisfy its payment obligations to the Fund with the occurrence of a credit event. When the Fund sells a credit default swap, it will cover its commitment. This may be achieved by, among other methods, maintaining cash or liquid assets equal to the aggregate notional value of the reference entities for all outstanding credit default swaps sold by the Fund. For the year ended December 31, 2016, the Fund entered into credit default swap agreements to gain exposure to the underlying issuer's credit quality characteristics and to hedge the risk of default on fund securities.
Under the terms of a credit default swap, the Fund receives or makes periodic payments based on a specified interest rate on a fixed notional amount. These payments are recorded as a realized gain or loss in the Statement of Operations. Payments received or made as a result of a credit event or termination of the swap are recognized, net of a proportional amount of the upfront payment, as realized gains or losses in the Statement of Operations.
A summary of the open credit default swap contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in credit default swap contracts purchased had a total notional value generally indicative of a range from $0 to $7,618,000, and the investment in credit default swap contracts sold had a total notional value generally indicative of a range from $0 to $2,800,000.
Options. An option contract is a contract in which the writer (seller) of the option grants the buyer of the option, upon payment of a premium, the right to purchase from (call option), or sell to (put option), the writer a designated instrument at a specified price within a specified period of time. The Fund may write or purchase interest rate swaption agreements which are options to enter into a pre-defined swap agreement. The interest rate swaption agreement will specify whether the buyer of the swaption will be a fixed-rate receiver or a fixed-rate payer upon exercise. Certain options, including options on indices, will require cash settlement by the Fund if the option is exercised. For the year ended December 31, 2016, the Fund entered into options on interest rate swaps in order to hedge against potential adverse interest rate movements of portfolio assets.
If the Fund writes a covered call option, the Fund foregoes, in exchange for the premium, the opportunity to profit during the option period from an increase in the market value of the underlying security above the exercise price. If the Fund writes a put option it accepts the risk of a decline in the value of the underlying security below the exercise price. Over-the-counter options have the risk of the potential inability of counterparties to meet the terms of their contracts. The Fund's maximum exposure to purchased options is limited to the premium initially paid. In addition, certain risks may arise upon entering into option contracts including the risk that an illiquid secondary market will limit the Fund's ability to close out an option contract prior to the expiration date and that a change in the value of the option contract may not correlate exactly with changes in the value of the securities.
A summary of the open purchased option contracts as of December 31, 2016 is included in the Fund's Investment Portfolio. A summary of open written option contracts is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in purchased option contracts had a total value generally indicative of a range from approximately $15,000 to $223,000, and written option contracts had a total value generally indicative of a range from approximately $116,000 to $438,000.
Futures Contracts. A futures contract is an agreement between a buyer or seller and an established futures exchange or its clearinghouse in which the buyer or seller agrees to take or make a delivery of a specific amount of a financial instrument at a specified price on a specific date (settlement date). For the year ended December 31, 2016, the Fund entered into interest rate futures to gain exposure to different parts of the yield curve while managing overall duration and for non-hedging purposes to seek to enhance potential gains.
Upon entering into a futures contract, the Fund is required to deposit with a financial intermediary cash or securities ("initial margin") in an amount equal to a certain percentage of the face value indicated in the futures contract. Subsequent payments ("variation margin") are made or received by the Fund dependent upon the daily fluctuations in the value and are recorded for financial reporting purposes as unrealized gains or losses by the Fund. Gains or losses are realized when the contract expires or is closed. Since all futures contracts are exchange-traded, counterparty risk is minimized as the exchange's clearinghouse acts as the counterparty, and guarantees the futures against default.
Certain risks may arise upon entering into futures contracts, including the risk that an illiquid market will limit the Fund's ability to close out a futures contract prior to the settlement date and the risk that the futures contract is not well correlated with the security, index or currency to which it relates. Risk of loss may exceed amounts disclosed in the Statement of Assets and Liabilities.
A summary of the open futures contracts as of December 31, 2016 is included in a table following the Fund's Investment Portfolio. For the year ended December 31, 2016, the investment in futures contracts purchased had a total notional value generally indicative of a range from approximately $8,144,000 to $14,004,000, and the investment in futures contracts sold had a total notional value generally indicative of a range from $0 to approximately $4,285,000.
Forward Foreign Currency Exchange Contracts. A forward foreign currency exchange contract ("forward currency contract") is a commitment to purchase or sell a foreign currency at the settlement date at a negotiated rate. For the year ended December 31, 2016, the Fund entered into forward currency contracts in order to hedge against anticipated currency market changes and for non-hedging purposes to seek to enhance potential gains.
Forward currency contracts are valued at the prevailing forward exchange rate of the underlying currencies and unrealized gain (loss) is recorded daily. On the settlement date of the forward currency contract, the Fund records a realized gain or loss equal to the difference between the value of the contract at the time it was opened and the value of the contract at the time it was closed. Certain risks may arise upon entering into forward currency contracts from the potential inability of counterparties to meet the terms of their contracts. The maximum counterparty credit risk to the Fund is measured by the unrealized gain on appreciated contracts. Additionally, when utilizing forward currency contracts to hedge, the Fund gives up the opportunity to profit from favorable exchange rate movements during the term of the contract.
A summary of the open forward currency contracts as of December 31, 2016, is included in a table following the Fund’s Investment Portfolio. For the year ended December 31, 2016, the investment in forward currency contracts short vs. U.S. dollars had a total contract value generally indicative of a range from approximately $1,516,000 to $11,487,000, and the investment in forward currency contracts long vs. U.S. dollars had a total contract value generally indicative of a range from approximately $427,000 to $11,598,000. The investment in forward currency contracts long vs. other foreign currencies sold had a total contract value generally indicative of a range from $0 to approximately $618,000.
The following tables summarize the value of the Fund's derivative instruments held as of December 31, 2016 and the related location in the accompanying Statement of Assets and Liabilities, presented by primary underlying risk exposure:
| Asset Derivatives | Purchased Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) (b) | $ 15,258 | $ — | $ 431,179 | $ 1,271 | $ 447,708 |
| Credit Contracts (b) | — | — | 89,749 | — | 89,749 |
| Foreign Exchange Contracts (c) | — | 77,754 | — | — | 77,754 |
| $ 15,258 | $ 77,754 | $ 520,928 | $ 1,271 | $ 615,211 | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Investments in securities, at value (includes purchased options) (b) Includes cumulative appreciation of futures and centrally cleared swap contracts as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (c) Unrealized appreciation on forward foreign currency exchange contracts | |||||
| Liability Derivatives | Written Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) (b) | $ (115,557) | $ — | $ (140,658) | $ (102,226) | $ (358,441) |
| Foreign Exchange Contracts (c) | — | (76,991) | — | — | (76,991) |
| $ (115,557) | $ (76,991) | $ (140,658) | $ (102,226) | $ (435,432) | |
|
Each of the above derivatives is located in the following Statement of Assets and Liabilities accounts: (a) Options written, at value (b) Includes cumulative depreciation of futures and centrally cleared swaps as disclosed in the Investment Portfolio. Unsettled variation margin is disclosed separately within the Statement of Assets and Liabilities. (c) Unrealized depreciation on forward foreign currency exchange contracts | |||||
Additionally, the amount of unrealized and realized gains and losses on derivative instruments recognized in Fund earnings during the year ended December 31, 2016 and the related location in the accompanying Statement of Operations is summarized in the following tables by primary underlying risk exposure:
| Realized Gain (Loss) | Purchased Options | Written Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) | $ (64,155) | $ 295 | $ — | $ (143,507) | $ (272,260) | $ (479,627) |
| Credit Contracts (a) | — | — | — | (115,766) | — | (115,766) |
| Foreign Exchange Contracts (b) | — | — | 177,785 | — | — | 177,785 |
| $ (64,155) | $ 295 | $ 177,785 | $ (259,273) | $ (272,260) | $ (417,608) | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Net realized gain (loss) from investments (includes purchased options), written options, swap contracts and futures, respectively (b) Net realized gain (loss) from foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | ||||||
| Change in Net Unrealized Appreciation (Depreciation) | Purchased Options | Written Options | Forward Contracts | Swap Contracts | Futures Contracts | Total |
| Interest Rate Contracts (a) | $ 12,405 | $ (63,342) | $ — | $ 420,114 | $ (59,307) | $ 309,870 |
| Credit Contracts (a) | — | — | — | 122,030 | — | 122,030 |
| Foreign Exchange Contracts (b) | — | — | (401,250) | — | — | (401,250) |
| $ 12,405 | $ (63,342) | $ (401,250) | $ 542,144 | $ (59,307) | $ 30,650 | |
|
Each of the above derivatives is located in the following Statement of Operations accounts: (a) Change in net unrealized appreciation (depreciation) on investments (includes purchased options), written options, swap contracts and futures, respectively (b) Change in net unrealized appreciation (depreciation) on foreign currency (Statement of Operations includes both forward currency contracts and foreign currency transactions) | ||||||
As of December 31, 2016, the Fund has transactions subject to enforceable master netting agreements. A reconciliation of the gross amounts on the Statement of Assets and Liabilities to the net amounts by counterparty, including any collateral exposure, is included in the following tables:
| Counterparty | Gross Amounts of Assets Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Received | Net Amount of Derivative Assets |
| Barclays Bank PLC | $ 49,621 | $ — | $ — | $ 49,621 |
| BNP Paribas | 10,603 | (10,603) | — | — |
| JPMorgan Chase Securities, Inc. | 14,285 | (14,285) | — | — |
| Goldman Sachs & Co. | 18,503 | — | — | 18,503 |
| $ 93,012 | $ (24,888) | $ — | $ 68,124 | |
| Counterparty | Gross Amounts of Liabilities Presented in the Statement of Assets and Liabilities | Financial Instruments and Derivatives Available for Offset | Collateral Pledged | Net Amount of Derivative Liabilities |
| BNP Paribas | $ 61,853 | $ (10,603) | $ — | $ 51,250 |
| Citigroup, Inc. | 76,912 | — | — | 76,912 |
| JPMorgan Chase Securities, Inc. | 53,704 | (14,285) | — | 39,419 |
| Toronto-Dominion Bank | 79 | — | — | 79 |
| $ 192,548 | $ (24,888) | $ — | $ 167,660 |
C. Purchases and Sales of Securities
During the year ended December 31, 2016, purchases and sales of investment transactions (excluding short-term investments and U.S. Treasury obligations) aggregated $30,753,055 and $43,011,995, respectively. Purchases and sales of U.S. Treasury obligations aggregated $7,101,469 and $4,061,054, respectively.
For the year ended December 31, 2016, transactions for written options on interest rate swap contracts were as follows:
| Contract Amount | Premiums | |
| Outstanding, beginning of period | 7,100,000 | $ 305,407 |
| Options bought back | (1,500,000) | (28,800) |
| Options exercised | (1,500,000) | (28,200) |
| Options expired | (1,300,000) | (46,345) |
| Outstanding, end of period | 2,800,000 | $ 202,062 |
D. Related Parties
Management Agreement. Under the Investment Management Agreement with Deutsche Investment Management Americas Inc. ("DIMA" or the "Advisor"), an indirect, wholly owned subsidiary of Deutsche Bank AG, the Advisor directs the investments of the Fund in accordance with its investment objectives, policies and restrictions. The Advisor determines the securities, instruments and other contracts relating to investments to be purchased, sold or entered into by the Fund.
Pursuant to the Investment Management Agreement with the Advisor, the Fund pays a monthly management fee based on the Fund's average daily net assets, computed and accrued daily and payable monthly, at the following annual rates:
| First $250 million | .550% |
| Next $750 million | .520% |
| Next $1.5 billion | .500% |
| Next $2.5 billion | .480% |
| Next $2.5 billion | .450% |
| Next $2.5 billion | .430% |
| Next $2.5 billion | .410% |
| Over $12.5 billion | .390% |
Accordingly, for the year ended December 31, 2016, the fee pursuant to the Investment Management Agreement was equivalent to an annual rate (exclusive of any applicable waivers/reimbursements) of 0.55% of the Fund's average daily net assets.
For the period from January 1, 2016 through September 30, 2016, the Advisor had contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) at 0.68%.
Effective October 1, 2016 through September 30, 2017, the Advisor has contractually agreed to waive its fee and/or reimburse certain operating expenses to the extent necessary to maintain the total annual operating expenses (excluding certain expenses such as extraordinary expenses, taxes, brokerage and interest expense) at 0.67%.
For the year ended December 31, 2016, fees waived and/or expenses reimbursed amounted to $177,038.
Administration Fee. Pursuant to an Administrative Services Agreement, DIMA provides most administrative services to the Fund. For all services provided under the Administrative Services Agreement, the Fund pays DIMA an annual fee ("Administration Fee") of 0.10% of the Fund's average daily net assets, computed and accrued daily and payable monthly. For the year ended December 31, 2016, the Administration Fee was $28,380, of which $2,107 is unpaid.
Service Provider Fees. Deutsche AM Service Company ("DSC"), an affiliate of the Advisor, is the transfer agent, dividend-paying agent and shareholder service agent for the Fund. Pursuant to a sub-transfer agency agreement between DSC and DST Systems, Inc. ("DST"), DSC has delegated certain transfer agent, dividend-paying agent and shareholder service agent functions to DST. DSC compensates DST out of the shareholder servicing fee it receives from the Fund. For the year ended December 31, 2016, the amounts charged to the Fund by DSC aggregated $131, of which $33 is unpaid.
Typesetting and Filing Service Fees. Under an agreement with DIMA, DIMA is compensated for providing typesetting and certain regulatory filing services to the Fund. For the year ended December 31, 2016, the amount charged to the Fund by DIMA included in the Statement of Operations under "Reports to shareholders" aggregated $15,217, of which $7,122 is unpaid.
Trustees' Fees and Expenses. The Fund paid retainer fees to each Trustee not affiliated with the Advisor, plus specified amounts to the Board Chairperson and Vice Chairperson and to each committee Chairperson.
Affiliated Cash Management Vehicles. The Fund may invest uninvested cash balances in Deutsche Central Cash Management Government Fund and Deutsche Variable NAV Money Fund, affiliated money market funds which are managed by the Advisor. Each affiliated money market fund is managed in accordance with Rule 2a-7 under the 1940 Act, which governs the quality, maturity, diversity and liquidity of instruments in which a money market fund may invest. Deutsche Central Cash Management Government Fund seeks to maintain a stable net asset value, and Deutsche Variable NAV Money Fund maintains a floating net asset value. The Fund indirectly bears its proportionate share of the expenses of each affiliated money market fund in which it invests. Deutsche Central Cash Management Government Fund does not pay the Advisor an investment management fee. To the extent that Deutsche Variable NAV Money Fund pays an investment management fee to the Advisor, the Advisor will waive an amount of the investment management fee payable to the Advisor by the Fund equal to the amount of the investment management fee payable on the Fund's assets invested in Deutsche Variable NAV Money Fund.
Security Lending Fees. Deutsche Bank AG serves as securities lending agent for the Fund. For the year ended December 31, 2016, the Fund incurred securities lending agent fees to Deutsche Bank AG in the amount of $682.
E. Investing in High-Yield Securities
High-yield debt securities or junk bonds are generally regarded as speculative with respect to the issuer’s continuing ability to meet principal and interest payments. The Fund’s performance could be hurt if an issuer of a debt security suffers an adverse change in financial condition that results in the issuer not making timely payments of interest or principal, a security downgrade or an inability to meet a financial obligation. High-yield debt securities’ total return and yield may generally be expected to fluctuate more than the total return and yield of investment-grade debt securities. A real or perceived economic downturn or an increase in market interest rates could cause a decline in the value of high-yield debt securities, result in increased redemptions and/or result in increased portfolio turnover, which could result in a decline in net asset value of the Fund, reduce liquidity for certain investments and/or increase costs. High-yield debt securities are often thinly traded and can be more difficult to sell and value accurately than investment-grade debt securities as there may be no established secondary market. Investments in high yield debt securities could increase liquidity risk for the Fund. In addition, the market for high-yield debt securities can experience sudden and sharp volatility which is generally associated more with investments in stocks.
F. Investing in Emerging Markets
Investing in emerging markets may involve special risks and considerations not typically associated with investing in developed markets. These risks include revaluation of currencies, high rates of inflation or deflation, repatriation restrictions on income and capital, and future adverse political, social and economic developments. Moreover, securities issued in these markets may be less liquid, subject to government ownership controls or delayed settlements, and may have prices that are more volatile or less easily assessed than those of comparable securities of issuers in developed markets.
G. Ownership of the Fund
At December 31, 2016, two participating insurance companies were owners of record of 10% or more of the total outstanding Class A shares of the Fund, each owning 54% and 42%.
H. Line of Credit
The Fund and other affiliated funds (the "Participants") share in a $400 million revolving credit facility provided by a syndication of banks. The Fund may borrow for temporary or emergency purposes, including the meeting of redemption requests that otherwise might require the untimely disposition of securities. The Participants are charged an annual commitment fee which is allocated based on net assets, among each of the Participants. Interest is calculated at a rate per annum equal to the sum of the Federal Funds Rate plus 1.25 percent plus if the one-month LIBOR exceeds the Federal Funds Rate, the amount of such excess. The Fund may borrow up to a maximum of 33 percent of its net assets under the agreement. The Fund had no outstanding loans at December 31, 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Trustees of Deutsche Variable Series II and Shareholders of Deutsche Unconstrained Income VIP:
We have audited the accompanying statement of assets and liabilities, including the investment portfolio, of Deutsche Unconstrained Income VIP (one of the funds constituting Deutsche Variable Series II) (the Fund) as of December 31, 2016, and the related statement of operations for the year then ended, the statements of changes in net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Fund's management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. We were not engaged to perform an audit of the Fund's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Fund's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2016, by correspondence with the custodian and brokers, or by other appropriate auditing procedures where replies from brokers were not received. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Deutsche Unconstrained Income VIP (one of the funds constituting Deutsche Variable Series II) at December 31, 2016, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended, and the financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles.
 | ||
| Boston, Massachusetts February 14, 2017 |
Information About Your Fund's Expenses (Unaudited)
As an investor of the Fund, you incur two types of costs: ongoing expenses and transaction costs. Ongoing expenses include management fees and other Fund expenses. Examples of transaction costs include contract charges, which are not shown in this section. The following tables are intended to help you understand your ongoing expenses (in dollars) of investing in the Fund and to help you compare these expenses with the ongoing expenses of investing in other mutual funds. In the most recent six-month period, the Fund limited these expenses; had it not done so, expenses would have been higher. The example in the table is based on an investment of $1,000 invested at the beginning of the six-month period and held for the entire period (July 1, 2016 to December 31, 2016).
The tables illustrate your Fund's expenses in two ways:
— Actual Fund Return. This helps you estimate the actual dollar amount of ongoing expenses (but not transaction costs) paid on a $1,000 investment in the Fund using the Fund's actual return during the period. To estimate the expenses 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 "Expenses Paid per $1,000" line under the share class you hold.
— Hypothetical 5% Fund Return. This helps you to compare your Fund's ongoing expenses (but not transaction costs) with those of other mutual funds using the Fund's actual expense ratio and a hypothetical rate of return of 5% per year before expenses. Examples using a 5% hypothetical Fund return may be found in the shareholder reports of other mutual 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.
Please note that the expenses shown in these tables are meant to highlight your ongoing expenses only and do not reflect any transaction costs. The "Expenses Paid per $1,000" line of the tables is useful in comparing ongoing expenses only and will not help you determine the relative total expense of owning different funds. If these transaction costs had been included, your costs would have been higher.
| Expenses and Value of a $1,000 Investment for the six months ended December 31, 2016 | ||
| Actual Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $ 992.80 | |
| Expenses Paid per $1,000* | $ 3.41 | |
| Hypothetical 5% Fund Return | Class A | |
| Beginning Account Value 7/1/16 | $1,000.00 | |
| Ending Account Value 12/31/16 | $1,021.72 | |
| Expenses Paid per $1,000* | $ 3.46 | |
* Expenses are equal to the Fund's annualized expense ratio, multiplied by the average account value over the period, multiplied by 184 (the number of days in the most recent six-month period), then divided by 366.
| Annualized Expense Ratio | Class A | |
| Deutsche Variable Series II — Deutsche Unconstrained Income VIP | .68% |
For more information, please refer to the Fund's prospectus.
These tables do not reflect charges and fees ("contract charges") associated with the separate account that invests in the Fund or any variable life insurance policy or variable annuity contract for which the Fund is an investment option.
For an analysis of the fees associated with an investment in the fund or similar funds, please refer to the current and hypothetical expense calculators for Variable Insurance Products which can be found at deutschefunds.com/EN/resources/calculators.jsp.
Tax Information (Unaudited)
Please consult a tax advisor if you have questions about federal or state income tax laws, or on how to prepare your tax returns. If you have specific questions about your account, please contact your insurance provider.
Proxy Voting
The Trust's policies and procedures for voting proxies for portfolio securities and information about how the Trust voted proxies related to its portfolio securities during the most recent 12-month period ended June 30 are available on our Web site — deutschefunds.com (click on "proxy voting" at the bottom of the page) — or on the SEC's Web site — sec.gov. To obtain a written copy of the Trust's policies and procedures without charge, upon request, call us toll free at (800) 728-3337.
Advisory Agreement Board Considerations and Fee Evaluation
The Board of Trustees (hereinafter referred to as the "Board" or "Trustees") approved the renewal of Deutsche Unconstrained Income VIP’s (the "Fund") investment management agreement (the "Agreement") with Deutsche Investment Management Americas Inc. ("DIMA") in September 2016.
In terms of the process that the Board followed prior to approving the Agreement, shareholders should know that:
— During the entire process, all of the Fund’s Trustees were independent of DIMA and its affiliates (the "Independent Trustees").
— The Board met frequently during the past year to discuss fund matters and dedicated a substantial amount of time to contract review matters. Over the course of several months, the Board’s Contract Committee reviewed extensive materials received from DIMA, independent third parties and independent counsel. These materials included an analysis of the Fund’s performance, fees and expenses, and profitability from a fee consultant retained by the Fund’s Independent Trustees (the "Fee Consultant"). The Board also received extensive information throughout the year regarding performance of the Fund.
— The Independent Trustees regularly meet privately with counsel to discuss contract review and other matters. In addition, the Independent Trustees were advised by the Fee Consultant in the course of their review of the Fund’s contractual arrangements and considered a comprehensive report prepared by the Fee Consultant in connection with their deliberations.
— In connection with reviewing the Agreement, the Board also reviewed the terms of the Fund’s distribution agreement, administrative services agreement, transfer agency agreement and other material service agreements.
— Based on its evaluation of the information provided, the Contract Committee presented its findings and recommendations to the Board. The Board then reviewed the Contract Committee’s findings and recommendations.
In connection with the contract review process, the Contract Committee and the Board considered the factors discussed below, among others. The Board also considered that DIMA and its predecessors have managed the Fund since its inception, and the Board believes that a long-term relationship with a capable, conscientious advisor is in the best interests of the Fund. The Board considered, generally, that shareholders chose to invest or remain invested in the Fund knowing that DIMA managed the Fund, and that the Agreement was approved by the Fund’s shareholders. DIMA is part of Deutsche Bank AG’s ("Deutsche Bank") Asset Management ("Deutsche AM") division. Deutsche AM is a global asset management business that offers a wide range of investing expertise and resources, including research capabilities in many countries throughout the world. Deutsche Bank has advised the Board that the U.S. asset management business continues to be a critical and integral part of Deutsche Bank, and that Deutsche Bank will continue to invest in Deutsche AM and seek to enhance Deutsche AM’s investment platform. Deutsche Bank also has confirmed its commitment to maintaining strong legal and compliance groups within the Deutsche AM division.
As part of the contract review process, the Board carefully considered the fees and expenses of each Deutsche fund overseen by the Board in light of the fund’s performance. In many cases, this led to the negotiation and implementation of expense caps. As part of these negotiations, the Board indicated that it would consider relaxing these caps in future years following sustained improvements in performance, among other considerations.
While shareholders may focus primarily on fund performance and fees, the Fund’s Board considers these and many other factors, including the quality and integrity of DIMA’s personnel and such other issues as back-office operations, fund valuations, and compliance policies and procedures.
Nature, Quality and Extent of Services. The Board considered the terms of the Agreement, including the scope of advisory services provided under the Agreement. The Board noted that, under the Agreement, DIMA provides portfolio management services to the Fund and that, pursuant to a separate administrative services agreement, DIMA provides administrative services to the Fund. The Board considered the experience and skills of senior management and investment personnel and the resources made available to such personnel. The Board reviewed the Fund’s performance over short-term and long-term periods and compared those returns to various agreed-upon performance measures, including market index(es) and a peer universe compiled using information supplied by Morningstar Direct ("Morningstar"), an independent fund data service. The Board also noted that it has put into place a process of identifying "Focus Funds" (e.g., funds performing poorly relative to a peer universe), and receives additional reporting from DIMA regarding such funds and, where appropriate, DIMA’s plans to address underperformance. The Board believes this process is an effective manner of identifying and addressing underperforming funds. Based on the information provided, the Board noted that for the one-, three- and five-year periods ended December 31, 2015, the Fund’s performance (Class A shares) was in the 4th quartile of the applicable Morningstar universe (the 1st quartile being the best performers and the 4th quartile being the worst performers). The Board also observed that the Fund has underperformed its benchmark in the one-, three- and five-year periods ended December 31, 2015. The Board noted the disappointing investment performance of the Fund in recent periods and continued to discuss with senior management of DIMA the factors contributing to such underperformance and actions being taken to improve performance. The Board recognized the efforts by DIMA in recent years to enhance its investment platform and improve long-term performance across the Deutsche fund complex.
Fees and Expenses. The Board considered the Fund’s investment management fee schedule, operating expenses and total expense ratios, and comparative information provided by Broadridge Financial Solutions, Inc. ("Broadridge") and the Fee Consultant regarding investment management fee rates paid to other investment advisors by similar funds (1st quartile being the most favorable and 4th quartile being the least favorable). With respect to management fees paid to other investment advisors by similar funds, the Board noted that the contractual fee rates paid by the Fund, which include a 0.10% fee paid to DIMA under the Fund’s administrative services agreement, were equal to the median (2nd quartile) of the applicable Broadridge peer group (based on Broadridge data provided as of December 31, 2015). The Board noted that the Fund’s Class A shares total (net) operating expenses were expected to be lower than the median (2nd quartile) of the applicable Broadridge expense universe (based on Broadridge data provided as of December 31, 2015, and analyzing Broadridge expense universe Class A (net) expenses less any applicable 12b-1 fees) ("Broadridge Universe Expenses"). The Board noted that the expense limitation agreed to by DIMA was expected to help the Fund’s total (net) operating expenses remain competitive. The Board considered the Fund’s management fee rate as compared to fees charged by DIMA to comparable Deutsche U.S. registered funds ("Deutsche Funds") and considered differences between the Fund and the comparable Deutsche Funds. The information requested by the Board as part of its review of fees and expenses also included information about institutional accounts (including any sub-advised funds and accounts) and funds offered primarily to European investors ("Deutsche Europe funds") managed by Deutsche AM. The Board noted that DIMA indicated that Deutsche AM does not manage any institutional accounts or Deutsche Europe funds comparable to the Fund.
On the basis of the information provided, the Board concluded that management fees were reasonable and appropriate in light of the nature, quality and extent of services provided by DIMA.
Profitability. The Board reviewed detailed information regarding revenues received by DIMA under the Agreement. The Board considered the estimated costs and pre-tax profits realized by DIMA from advising the Deutsche Funds, as well as estimates of the pre-tax profits attributable to managing the Fund in particular. The Board also received information regarding the estimated enterprise-wide profitability of DIMA and its affiliates with respect to all fund services in totality and by fund. The Board and the Fee Consultant reviewed DIMA’s methodology in allocating its costs to the management of the Fund. Based on the information provided, the Board concluded that the pre-tax profits realized by DIMA in connection with the management of the Fund were not unreasonable. The Board also reviewed certain publicly available information regarding the profitability of certain similar investment management firms. The Board noted that while information regarding the profitability of such firms is limited (and in some cases is not necessarily prepared on a comparable basis), DIMA and its affiliates’ overall profitability with respect to the Deutsche Funds (after taking into account distribution and other services provided to the funds by DIMA and its affiliates) was lower than the overall profitability levels of most comparable firms for which such data was available.
Economies of Scale. The Board considered whether there are economies of scale with respect to the management of the Fund and whether the Fund benefits from any economies of scale. The Board noted that the Fund’s investment management fee schedule includes fee breakpoints. The Board concluded that the Fund’s fee schedule represents an appropriate sharing between the Fund and DIMA of such economies of scale as may exist in the management of the Fund at current asset levels.
Other Benefits to DIMA and Its Affiliates. The Board also considered the character and amount of other incidental benefits received by DIMA and its affiliates, including any fees received by DIMA for administrative services provided to the Fund. The Board also considered benefits to DIMA related to brokerage and soft-dollar allocations, including allocating brokerage to pay for research generated by parties other than the executing broker dealers, which pertain primarily to funds investing in equity securities, along with the incidental public relations benefits to DIMA related to Deutsche Funds advertising and cross-selling opportunities among DIMA products and services. The Board considered these benefits in reaching its conclusion that the Fund’s management fees were reasonable.
Compliance. The Board considered the significant attention and resources dedicated by DIMA to documenting and enhancing its compliance processes in recent years. The Board noted in particular (i) the experience, seniority and time commitment of the individuals serving as DIMA’s and the Fund’s chief compliance officers; (ii) the large number of DIMA compliance personnel; and (iii) the substantial commitment of resources by DIMA and its affiliates to compliance matters.
Based on all of the information considered and the conclusions reached, the Board unanimously determined that the continuation of the Agreement is in the best interests of the Fund. In making this determination, the Board did not give particular weight to any single factor identified above. The Board considered these factors over the course of numerous meetings, certain of which were in executive session with only the Independent Trustees and counsel present. It is possible that individual Independent Trustees may have weighed these factors differently in reaching their individual decisions to approve the continuation of the Agreement.
Board Members and Officers
The following table presents certain information regarding the Board Members and Officers of the fund. Each Board Member's year of birth is set forth in parentheses after his or her name. Unless otherwise noted, (i) each Board Member has engaged in the principal occupation(s) noted in the table for at least the most recent five years, although not necessarily in the same capacity; and (ii) the address of each Independent Board Member is c/o Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. Except as otherwise noted below, the term of office for each Board Member is until the election and qualification of a successor, or until such Board Member sooner dies, resigns, is removed or as otherwise provided in the governing documents of the fund. Because the fund does not hold an annual meeting of shareholders, each Board Member will hold office for an indeterminate period. The Board Members may also serve in similar capacities with other funds in the fund complex.
| Independent Board Members | |||
| Name, Year of Birth, Position with the Fund and Length of Time Served1 | Business Experience and Directorships During the Past Five Years | Number of Funds in Deutsche Fund Complex Overseen | Other Directorships Held by Board Member |
|
Keith R. Fox, CFA (1954) Chairperson since 2017,2 and Board Member since 1996 |
Managing General Partner, Exeter Capital Partners (a series of private investment funds) (since 1986). Directorships: Progressive International Corporation (kitchen goods importer and distributor); The Kennel Shop (retailer); former Chairman, National Association of Small Business Investment Companies; former Directorships: BoxTop Media Inc. (advertising); Sun Capital Advisers Trust (mutual funds) (2011–2012) | 98 | — |
|
Kenneth C. Froewiss (1945) Vice Chairperson since 2017,2 Board Member since 2001, and Chairperson (2013–December 31, 2016) |
Retired Clinical Professor of Finance, NYU Stern School of Business (1997–2014); Member, Finance Committee, Association for Asian Studies (2002–present); Director, Mitsui Sumitomo Insurance Group (US) (2004–present); prior thereto, Managing Director, J.P. Morgan (investment banking firm) (until 1996) | 98 | — |
|
John W. Ballantine (1946) Board Member since 1999 |
Retired; formerly, Executive Vice President and Chief Risk Management Officer, First Chicago NBD Corporation/The First National Bank of Chicago (1996–1998); Executive Vice President and Head of International Banking (1995–1996); former Directorships: Director and former Chairman of the Board, Healthways, Inc.3 (population well-being and wellness services) (2003–2014); Stockwell Capital Investments PLC (private equity); First Oak Brook Bancshares, Inc. and Oak Brook Bank; Prisma Energy International
|
98 | Portland General Electric3 (utility company) (2003– present) |
|
Henry P. Becton, Jr. (1943) Board Member since 1990 |
Vice Chair and former President, WGBH Educational Foundation. Directorships: Public Radio International; Public Radio Exchange (PRX); The Pew Charitable Trusts (charitable organization); former Directorships: Becton Dickinson and Company3 (medical technology company); Belo Corporation3 (media company); The PBS Foundation; Association of Public Television Stations; Boston Museum of Science; American Public Television; Concord Academy; New England Aquarium; Mass. Corporation for Educational Telecommunications; Committee for Economic Development; Public Broadcasting Service; Connecticut College; North Bennett Street School (Boston) | 98 | — |
|
Dawn-Marie Driscoll (1946) Board Member since 1987 |
Emeritus Executive Fellow, Center for Business Ethics, Bentley University; formerly: President, Driscoll Associates (consulting firm); Partner, Palmer & Dodge (law firm) (1988–1990); Vice President of Corporate Affairs and General Counsel, Filene's (retail) (1978–1988). Directorships: Advisory Board, Center for Business Ethics, Bentley University; Trustee and former Chairman of the Board, Southwest Florida Community Foundation (charitable organization); former Directorships: ICI Mutual Insurance Company (2007–2015); Sun Capital Advisers Trust (mutual funds) (2007–2012), Investment Company Institute (audit, executive, nominating committees) and Independent Directors Council (governance, executive committees) | 98 | — |
|
Paul K. Freeman (1950) Board Member since 1993 |
Consultant, World Bank/Inter-American Development Bank; Chair, Independent Directors Council; Investment Company Institute (executive and nominating committees); formerly, Chairman of Education Committee of Independent Directors Council; Project Leader, International Institute for Applied Systems Analysis (1998–2001); Chief Executive Officer, The Eric Group, Inc. (environmental insurance) (1986–1998); Directorships: Denver Zoo Foundation (December 2012–present); former Directorships: Prisma Energy International | 98 | — |
|
Richard J. Herring (1946) Board Member since 1990 |
Jacob Safra Professor of International Banking and Professor, Finance Department, The Wharton School, University of Pennsylvania (since July 1972); Co-Director, Wharton Financial Institutions Center; formerly: Vice Dean and Director, Wharton Undergraduate Division (July 1995–June 2000); Director, Lauder Institute of International Management Studies (July 2000–June 2006) | 98 | Director, Aberdeen Singapore and Japan Funds (since 2007); Independent Director of Barclays Bank Delaware (since September 2010) |
|
William McClayton (1944) Board Member since 2004, and Vice Chairperson (2013–December 31, 2016) |
Private equity investor (since October 2009); previously, Managing Director, Diamond Management & Technology Consultants, Inc. (global consulting firm) (2001–2009); Directorship: Board of Managers, YMCA of Metropolitan Chicago; formerly: Senior Partner, Arthur Andersen LLP (accounting) (1966–2001); Trustee, Ravinia Festival | 98 | — |
|
Rebecca W. Rimel (1951) Board Member since 1995 |
President, Chief Executive Officer and Director, The Pew Charitable Trusts (charitable organization) (1994–present); formerly: Executive Vice President, The Glenmede Trust Company (investment trust and wealth management) (1983–2004); Board Member, Investor Education (charitable organization) (2004–2005); Trustee, Executive Committee, Philadelphia Chamber of Commerce (2001–2007); Director, Viasys Health Care3 (January 2007–June 2007); Trustee, Thomas Jefferson Foundation (charitable organization) (1994–2012) | 98 | Director, Becton Dickinson and Company3 (medical technology company) (2012– present); Director, BioTelemetry Inc.3 (health care) (2009– present) |
|
William N. Searcy, Jr. (1946) Board Member since 1993 |
Private investor since October 2003; formerly: Pension & Savings Trust Officer, Sprint Corporation3 (telecommunications) (November 1989–September 2003); Trustee, Sun Capital Advisers Trust (mutual funds) (1998–2012) | 98 | — |
|
Jean Gleason Stromberg (1943) Board Member since 1997 |
Retired. Formerly, Consultant (1997–2001); Director, Financial Markets U.S. Government Accountability Office (1996–1997); Partner, Norton Rose Fulbright, L.L.P. (law firm) (1978–1996); former Directorships: The William and Flora Hewlett Foundation (charitable organization) (2000–2015); Service Source, Inc. (nonprofit), Mutual Fund Directors Forum (2002–2004), American Bar Retirement Association (funding vehicle for retirement plans) (1987–1990 and 1994–1996) | 98 | — |
| Officers5 | |
| Name, Year of Birth, Position with the Fund and Length of Time Served6 | Business Experience and Directorships During the Past Five Years |
|
Brian E. Binder9 (1972) President and Chief Executive Officer, 2013–present |
Managing Director4 and Head of US Product and Fund Administration, Deutsche Asset Management (2013–present); Director and President, Deutsche AM Service Company (since 2016); Director and Vice President, Deutsche AM Distributors, Inc. (since 2016); Director and President, DB Investment Managers, Inc. (since 2016); formerly, Head of Business Management and Consulting at Invesco, Ltd. (2010–2012) |
|
John Millette8 (1962) Vice President and Secretary, 1999–present |
Director,4 Deutsche Asset Management; Chief Legal Officer and Secretary, Deutsche Investment Management Americas Inc. (2015–present); and Director and Vice President, Deutsche AM Trust Company (since 2016) |
|
Hepsen Uzcan7 (1974) Vice President, since 2016 Assistant Secretary, 2013–present |
Director,4 Deutsche Asset Management |
|
Paul H. Schubert7 (1963) Chief Financial Officer, 2004–present Treasurer, 2005–present |
Managing Director,4 Deutsche Asset Management, and Chairman, Director and President, Deutsche AM Trust Company (since 2013); Vice President, Deutsche AM Distributors, Inc. (since 2016); formerly, Director, Deutsche AM Trust Company (2004–2013) |
|
Caroline Pearson8 (1962) Chief Legal Officer, 2010–present |
Managing Director,4 Deutsche Asset Management; Secretary, Deutsche AM Distributors, Inc.; and Secretary, Deutsche AM Service Company |
|
Scott D. Hogan8 (1970) Chief Compliance Officer, since 2016 |
Director,4 Deutsche Asset Management |
|
Wayne Salit7 (1967) Anti-Money Laundering Compliance Officer, 2014–present |
Director,4 Deutsche Asset Management; AML Compliance Officer, Deutsche AM Distributors, Inc.; formerly: Managing Director, AML Compliance Officer at BNY Mellon (2011–2014); and Director, AML Compliance Officer at Deutsche Bank (2004–2011) |
|
Paul Antosca8 (1957) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
|
Diane Kenneally8 (1966) Assistant Treasurer, 2007–present |
Director,4 Deutsche Asset Management |
1 The length of time served represents the year in which the Board Member joined the board of one or more Deutsche funds currently overseen by the Board.
2 Effective as of January 1, 2017.
3 A publicly held company with securities registered pursuant to Section 12 of the Securities Exchange Act of 1934.
4 Executive title, not a board directorship.
5 As a result of their respective positions held with the Advisor, these individuals are considered "interested persons" of the Advisor within the meaning of the 1940 Act. Interested persons receive no compensation from the fund.
6 The length of time served represents the year in which the officer was first elected in such capacity for one or more Deutsche funds.
7 Address: 60 Wall Street, New York, NY 10005.
8 Address: One Beacon Street, Boston, MA 02108.
9 Address: 222 South Riverside Plaza, Chicago, IL 60606.
The fund's Statement of Additional Information ("SAI") includes additional information about the Board Members. The SAI is available, without charge, upon request. If you would like to request a copy of the SAI, you may do so by calling the following toll-free number: (800) 728-3337.
VS2UI-2 (R-025836-6 2/17)
| ITEM 2. | CODE OF ETHICS |
As of the end of the period covered by this report, the registrant has adopted a code of ethics, as defined in Item 2 of Form N-CSR that applies to its Principal Executive Officer and Principal Financial Officer.
There have been no amendments to, or waivers from, a provision of the code of ethics during the period covered by this report that would require disclosure under Item 2.
A copy of the code of ethics is filed as an exhibit to this Form N-CSR. | |
| ITEM 3. | AUDIT COMMITTEE FINANCIAL EXPERT |
| The fund’s audit committee is comprised solely of trustees who are "independent" (as such term has been defined by the Securities and Exchange Commission ("SEC") in regulations implementing Section 407 of the Sarbanes-Oxley Act (the "Regulations")). The fund’s Board of Trustees has determined that there are several "audit committee financial experts" (as such term has been defined by the Regulations) serving on the fund’s audit committee including Mr. Paul K. Freeman, the chair of the fund’s audit committee. An “audit committee financial expert” is not an “expert” for any purpose, including for purposes of Section 11 of the Securities Act of 1933 and the designation or identification of a person as an “audit committee financial expert” does not impose on such person any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such person as a member of the audit committee and board of directors in the absence of such designation or identification. | |
| ITEM 4. | PRINCIPAL ACCOUNTANT FEES AND SERVICES |
Deutsche variable
Series II
form n-csr disclosure re: AUDIT FEES
The following table shows the amount of fees that Ernst & Young LLP (“EY”), the Fund’s Independent Registered Public Accounting Firm, billed to the Fund during the Fund’s last two fiscal years. The Audit Committee approved in advance all audit services and non-audit services that EY provided to the Fund.
Services that the Fund’s Independent Registered Public Accounting Firm Billed to the Fund
| Fiscal Year Ended December 31, |
Audit Fees Billed to Fund | Audit-Related Fees Billed to Fund |
Tax Fees Billed to Fund | All Other Fees Billed to Fund |
| 2016 | $644,583 | $0 | $73,288 | $0 |
| 2015 | $644,583 | $0 | $73,288 | $0 |
The above “Tax Fees” were billed for professional services rendered for tax return preparation.
Services that the Fund’s Independent Registered Public Accounting Firm Billed to the Adviser and Affiliated Fund Service Providers
The following table shows the amount of fees billed by EY to Deutsche Investment Management Americas, Inc. (“DIMA” or the “Adviser”), and any entity controlling, controlled by or under common control with DIMA (“Control Affiliate”) that provides ongoing services to the Fund (“Affiliated Fund Service Provider”), for engagements directly related to the Fund’s operations and financial reporting, during the Fund’s last two fiscal years.
| Fiscal Year Ended December 31, |
Audit-Related Fees Billed to Adviser and Affiliated Fund Service Providers |
Tax Fees Billed to Adviser and Affiliated Fund Service Providers | All Other Fees Billed to Adviser and Affiliated Fund Service Providers |
| 2016 | $0 | $449,529 | $0 |
| 2015 | $0 | $563,986 | $1,789,233 |
The above “Tax Fees” were billed in connection with tax compliance services and agreed upon procedures. All other engagement fees were billed for services in connection with agreed upon procedures for DIMA and other related entities.
Non-Audit Services
The following table shows the amount of fees that EY billed during the Fund’s last two fiscal years for non-audit services. The Audit Committee pre-approved all non-audit services that EY provided to the Adviser and any Affiliated Fund Service Provider that related directly to the Fund’s operations and financial reporting. The Audit Committee requested and received information from EY about any non-audit services that EY rendered during the Fund’s last fiscal year to the Adviser and any Affiliated Fund Service Provider. The Committee considered this information in evaluating EY’s independence.
| Fiscal Year Ended December 31, |
Total (A) |
Total Non-Audit Fees billed to Adviser and Affiliated Fund Service Providers (engagements related directly to the operations and financial reporting of the Fund) (B) |
Total Non-Audit Fees billed to Adviser and Affiliated Fund Service Providers (all other engagements) (C) |
Total of (A), (B) and (C) |
| 2016 | $73,288 | $449,529 | $595,469 | $1,118,286 |
| 2015 | $73,288 | $2,353,219 | $880,336 | $3,306,843 |
All other engagement fees were billed for services in connection with agreed upon procedures and tax compliance for DIMA and other related entities.
Audit Committee Pre-Approval Policies and Procedures. Generally, each Fund’s Audit Committee must pre approve (i) all services to be performed for a Fund by a Fund’s Independent Registered Public Accounting Firm and (ii) all non-audit services to be performed by a Fund’s Independent Registered Public Accounting Firm for the DIMA Entities with respect to operations and financial reporting of the Fund, except that the Chairperson or Vice Chairperson of each Fund’s Audit Committee may grant the pre-approval for non-audit services described in items (i) and (ii) above for non-prohibited services for engagements of less than $100,000. All such delegated pre approvals shall be presented to each Fund’s Audit Committee no later than the next Audit Committee meeting.
There were no amounts that were approved by the Audit Committee pursuant to the de minimis exception under Rule 2-01 of Regulation S-X.
According to the registrant’s principal Independent Registered Public Accounting Firm, substantially all of the principal Independent Registered Public Accounting Firm's hours spent on auditing the registrant's financial statements were attributed to work performed by full-time permanent employees of the principal Independent Registered Public Accounting Firm.
***
In connection with the audit of the 2015 financial statements, the Fund entered into an engagement letter with EY. The terms of the engagement letter required by EY, and agreed to by the Audit Committee, included provisions in which the parties consent to the sole jurisdiction of federal courts in New York, Boston or the Northern District of Illinois, as well as a waiver of right to a trial by jury.
In connection with the audit of the 2016 financial statements, the Fund entered into an engagement letter with EY. The terms of the engagement letter required by EY, and agreed to by the Audit Committee, include a provision mandating the use of mediation and arbitration to resolve any controversy or claim between the parties arising out of or relating to the engagement letter or services provided thereunder.
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1.) In various communications beginning on April 20, 2016, EY advised the Fund’s Audit Committee that EY had identified the following matters that it determined to be inconsistent with the SEC’s auditor independence rules.
| · | EY advised the Fund’s Audit Committee of financial relationships held by covered persons within EY and its affiliates that were in violation of the Rule 2-01(c)(1) of Regulation S-X. EY advised the Audit Committee that after consideration of the facts and circumstances and the applicable independence rules, EY concluded that the independence breaches did not and do not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements of the Fund and that a reasonable investor would reach the same conclusion. In assessing this matter, EY indicated that upon detection the breaches were corrected promptly and that none of the breaches (i) related to financial relationships directly in the Fund, (ii) involved professionals who were part of the audit engagement team for the Fund or in a position to influence the audit engagement team, or (iii) were for services directly for the Fund. |
| · | EY advised the Fund’s Audit Committee that, in 2016, a pension plan for the Ernst & Young Global Limited (“EYG”) member firm in Germany (“EY Germany”), through one of its investment advisors, purchased an investment in an entity that may be deemed to be under common control with the Fund. EY informed the Audit Committee that this investment was inconsistent with Rule 2-01(c)(1)(i) of Regulation S-X. EY advised the Audit Committee that in assessing the impact of the independence breach, in fact and appearance, EY considered all relevant facts and circumstances to assess whether a reasonable investor would conclude that EY was and is capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement. EY advised the Audit Committee that after consideration of the facts and circumstances and the applicable independence rules, EY concluded that the independence breach did not and does not impair EY’s ability to exercise objective and impartial judgment in connection with the audit of the financial statements of the Fund and that a reasonable investor would reach the same conclusion. In reaching this conclusion, EY noted a number of factors, including that the purchase was by EY Germany’s investment advisor without EY Germany’s permission, authorization or knowledge and EY Germany instructed its investment advisor to sell the shares of the entity that may be deemed to be under common control with the Fund immediately upon detection of the purchase and the breach did not involve any professionals who were part of the audit engagement team for the Fund or in a position to influence the audit engagement team. In addition, EY noted that the independence breach did not (i) create a mutual or conflicting interest with the Fund, (ii) place EY in the position of auditing its own work, (iii) result in EY acting as management or an employee of the Fund, or (iv) place EY in a position of being an advocate of the Fund. |
| · | EY advised the Fund’s Audit Committee that, in 2014, the EYG member firm in Spain (“EY Spain”) completed an acquisition of a small consulting firm that had a deposit account with an overdraft line of credit at the time of the acquisition with Deutsche Bank SA Espanola, which EY Spain acquired. EY informed the Audit Committee that having this line of credit with an entity that may be deemed to be under common control with the Fund was inconsistent with Rule 2-01(c)(1)(ii) of Regulation S-X. EY advised the Audit Committee that in assessing the impact of the independence breach, in fact and appearance, EY considered all relevant facts and circumstances to assess whether a reasonable investor would conclude that EY was and is capable of exercising objective and impartial judgment on all issues encompassed within the audit engagements. EY advised the Audit Committee that after consideration of the facts and circumstances and the applicable independence rules, EY concluded that the independence breach did not and does not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements of the Fund and that a reasonable investor would reach the same conclusion. In reaching this conclusion, EY noted a number of factors, including that that the credit line was terminated and the breach did not involve any professionals who were part of the audit engagement team for the Fund or in a position to influence the audit engagement team. In addition, EY noted that the independence breach did not (i) create a mutual or conflicting interest with the Fund, (ii) place EY in the position of auditing its own work, (iii) result in EY acting as management or an employee of the Fund, or (iv) place EY in a position of being an advocate of the Fund. |
EY advised the Audit Committee that the above described matters, individually and in the aggregate, do not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements for the Fund and a reasonable investor with knowledge of all relevant facts and circumstances would conclude that EY has been and is capable of objective and impartial judgment on all issues encompassed within EY’s audit engagements, and that EY can continue to act as the Independent Registered Public Accounting Firm.
Management and the Audit Committee considered these matters and, based solely upon EY’s description of the facts and the representations made by EY, believe that (1) these matters did not impact EY’s application of objective and impartial judgment with respect to all issues encompassed within EY’s audit engagements; and (2) a reasonable investor with knowledge of all relevant facts and circumstances would reach the same conclusion.
2.) In various communications beginning on June 27, 2016, EY also informed the Audit Committee that EY had identified independence breaches where EY and covered persons maintain lending relationships with owners of greater than 10% of the shares of certain investment companies within the “investment company complex” as defined under Rule 2-01(f)(14) of Regulation S-X. EY informed the Audit Committee that these lending relationships are inconsistent with Rule 2-01(c)(l)(ii)(A) of Regulation S-X (referred to as the “Loan Rule”).
The Loan Rule specifically provides that an accounting firm would not be independent if it receives a loan from a lender that is a record or beneficial owner of more than ten percent of an audit client’s equity securities. For purposes of the Loan Rule, audit clients include the Fund as well as all registered investment companies advised by the Deutsche Investment Management Americas Inc. (the “Adviser”), the Fund’s investment adviser, and its affiliates, including other subsidiaries of the Adviser’s parent company, Deutsche Bank AG (collectively, the “Deutsche Funds Complex”). EY’s lending relationships affect EY’s independence under the Loan Rule with respect to all investment companies in the Deutsche Funds Complex.
EY informed the Audit Committee that, after evaluating the facts and circumstances and the applicable independence rules, EY has concluded that the lending relationships described above do not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements for the Fund and a reasonable investor with knowledge of all relevant facts and circumstances would conclude that EY has been and is capable of objective and impartial judgment on all issues encompassed within EY’s audit engagements. EY informed the Audit Committee that its conclusion was based on a number of factors, including, among others, EY’s belief that the lenders are not able to impact the impartiality of EY or assert any influence over the investment companies in the Deutsche Funds Complex whose shares the lenders own or the applicable investment company’s investment adviser. In addition, the individuals at EY who arranged EY’s lending relationships have no oversight of, or ability to influence, the individuals at EY who conducted the audits of the Fund’s financial statements.
On June 20, 2016, the SEC Staff issued a “no-action” letter to another mutual fund complex (see Fidelity Management & Research Company et al., No-Action Letter) related to similar Loan Rule issues as those described above. In that letter, the SEC Staff confirmed that it would not recommend enforcement action against an investment company that relied on the audit services performed by an audit firm that was not in compliance with the Loan Rule in certain specified circumstances. The circumstances described in the no-action letter appear to be substantially similar to the circumstances that effected EY’s independence under the Loan Rule with respect to the Fund. EY confirmed to the Audit Committee that it meets the conditions of the no-action letter. In the no-action letter, the SEC Staff stated that the relief under the letter is temporary and will expire 18 months after the issuance of the letter.
3.) In various communications beginning on January 25, 2017, EY advised the Fund’s Audit Committee that EY had identified the following matters that it determined to be inconsistent with the SEC’s auditor independence rules.
| · | EY advised the Fund’s Audit Committee of financial relationships held by covered persons within EY and its affiliates that were in violation of the Rule 2-01(c)(1) of Regulation S-X. EY advised the Audit Committee that after consideration of the facts and circumstances and the applicable independence rules, EY concluded that the independence breaches do not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements of the Fund and that a reasonable investor would reach the same conclusion. In assessing this matter, EY indicated that upon detection the breaches were corrected promptly and that none of the breaches (i) related to financial relationships directly in the Fund, (ii) involved professionals who were part of the audit engagement team for the Fund or in a position to influence the audit engagement team, or (iii) were for services directly for the Fund. |
| · | EY advised the Fund’s Audit Committee that, in 2015, the Ernst & Young Global Limited (“EYG”) member firm in Spain (“EY Spain”) provided a loaned staff service to Deutsche Bank AG, where a manager from EY Spain analyzed investment opportunities in Spain under the supervision of Deutsche Bank AG personnel. EY informed the Audit Committee that this loaned staff service where the EY professional temporarily acted as an employee of Deutsche Bank AG was inconsistent with Rule 2-01(c)(4)(vi) of Regulation S-X. EY advised the Audit Committee that in assessing the impact of the independence breach, in fact and appearance, EY considered all relevant facts and circumstances to assess whether a reasonable investor would conclude that EY was and is capable of exercising objective and impartial judgment on all issues encompassed within the audit engagements. EY advised the Audit Committee that after consideration of the facts and circumstances and the applicable independence rules, EY concluded that the independence breach did not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements of the Fund and that a reasonable investor would reach the same conclusion. In reaching this conclusion, EY noted a number of factors, including that the breach did not involve any professionals who were part of the audit engagement team for the Fund or in a position to influence the audit engagement team and did not involve services provided directly for the Fund. In addition, EY noted that the independence breach did not (i) create a mutual or conflicting interest with the Fund, (ii) place EY in the position of auditing its own work, (iii) result in EY acting as management or an employee of the Fund, or (iv) place EY in a position of being an advocate of the Fund. |
EY advised the Audit Committee that the above described matters, individually and in the aggregate, do not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements for the Fund and a reasonable investor with knowledge of all relevant facts and circumstances would conclude that EY has been and is capable of objective and impartial judgment on all issues encompassed within EY’s audit engagements, and that EY can continue to act as the Independent Registered Public Accounting Firm.
4.) In various communications beginning on January 25, 2017, EY informed the Audit Committee that EY had identified an independence breach where a covered person maintains a lending relationship with an owner of greater than 10% of the shares of certain investment companies within the “investment company complex” as defined under Rule 2-01(f)(14) of Regulation S-X. EY informed the Audit Committee that this lending relationship is inconsistent with Rule 2-01(c)(l)(ii)(A) of Regulation S-X (referred to as the “Loan Rule”).
The Loan Rule specifically provides that an accounting firm would not be independent if it receives a loan from a lender that is a record or beneficial owner of more than ten percent of an audit client’s equity securities. For purposes of the Loan Rule, audit clients include the Fund as well as all registered investment companies advised by the Deutsche Investment Management Americas Inc. (the “Adviser”), the Fund’s investment adviser, and its affiliates, including other subsidiaries of the Adviser’s parent company, Deutsche Bank AG (collectively, the “Deutsche Funds Complex”). The covered person’s lending relationship affects EY’s independence under the Loan Rule with respect to all investment companies in the Deutsche Funds Complex.
EY informed the Audit Committee that, after evaluating the facts and circumstances and the applicable independence rules, EY has concluded that the lending relationship described above does not and will not impair EY’s ability to exercise objective and impartial judgment in connection with the audits of the financial statements for the Fund and a reasonable investor with knowledge of all relevant facts and circumstances would conclude that EY has been and is capable of objective and impartial judgment on all issues encompassed within EY’s audit engagements. EY informed the Audit Committee that its conclusion was based on a number of factors, including, among others, EY’s belief that the lender is not able to impact the impartiality of EY or assert any influence over the investment companies in the Deutsche Funds Complex whose shares the lenders own or the applicable investment company’s investment adviser.
On June 20, 2016, the SEC Staff issued a “no-action” letter to another mutual fund complex (see Fidelity Management & Research Company et al., No-Action Letter) related to similar Loan Rule issues as those described above. In that letter, the SEC Staff confirmed that it would not recommend enforcement action against an investment company that relied on the audit services performed by an audit firm that was not in compliance with the Loan Rule in certain specified circumstances. The circumstances described in the no-action letter appear to be substantially similar to the circumstances that effected EY’s independence under the Loan Rule with respect to the Fund. EY confirmed to the Audit Committee that it meets the conditions of the no-action letter. In the no-action letter, the SEC Staff stated that the relief under the letter is temporary and will expire 18 months after the issuance of the letter.
| ITEM 5. | AUDIT COMMITTEE OF LISTED REGISTRANTS | |
| Not applicable | ||
| ITEM 6. | SCHEDULE OF INVESTMENTS | |
| Not applicable | ||
| ITEM 7. | DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END MANAGEMENT INVESTMENT COMPANIES | |
| Not applicable | ||
| ITEM 8. | PORTFOLIO MANAGERS OF CLOSED-END MANAGEMENT INVESTMENT COMPANIES | |
| Not applicable | ||
| ITEM 9. | PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT INVESTMENT COMPANY AND AFFILIATED PURCHASERS | |
| Not applicable | ||
| ITEM 10. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS | |
| There were no material changes to the procedures by which shareholders may recommend nominees to the Fund’s Board. The primary function of the Nominating and Governance Committee is to identify and recommend individuals for membership on the Board and oversee the administration of the Board Governance Guidelines. Shareholders may recommend candidates for Board positions by forwarding their correspondence by U.S. mail or courier service to Keith R. Fox, Deutsche Funds Board Chair, c/o Thomas R. Hiller, Ropes & Gray LLP, Prudential Tower, 800 Boylston Street, Boston, MA 02199-3600. | ||
| ITEM 11. | CONTROLS AND PROCEDURES | |
| (a) | The Chief Executive and Financial Officers concluded that the Registrant’s Disclosure Controls and Procedures are effective based on the evaluation of the Disclosure Controls and Procedures as of a date within 90 days of the filing date of this report. | |
| (b) | There have been no changes in the registrant’s internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant’s internal controls over financial reporting. | |
| ITEM 12. | EXHIBITS | |
| (a)(1) | Code of Ethics pursuant to Item 2 of Form N-CSR is filed and attached hereto as EX-99.CODE ETH. | |
| (a)(2) | Certification pursuant to Rule 30a-2(a) under the Investment Company Act of 1940 (17 CFR 270.30a-2(a)) is filed and attached hereto as Exhibit 99.CERT. | |
| (b) | Certification pursuant to Rule 30a-2(b) under the Investment Company Act of 1940 (17 CFR 270.30a-2(b)) is furnished and attached hereto as Exhibit 99.906CERT. | |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| Registrant: | Deutsche Variable Series II |
| By: | /s/Brian E. Binder Brian E. Binder President |
| Date: | February 14, 2017 |
Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| By: | /s/Brian E. Binder Brian E. Binder President |
| Date: | February 14, 2017 |
| By: | /s/Paul Schubert Paul Schubert Chief Financial Officer and Treasurer |
| Date: | February 14, 2017 |