-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RgRlgcpNOovYQZPQabJY/fMgiyN2h8vzXEsPFIxNlllfC9EMIdXRHTo53kayPWhO iRxX5AF4wxgudkJQZIbpGg== 0000922423-96-000214.txt : 19960503 0000922423-96-000214.hdr.sgml : 19960503 ACCESSION NUMBER: 0000922423-96-000214 CONFORMED SUBMISSION TYPE: 497 PUBLIC DOCUMENT COUNT: 2 FILED AS OF DATE: 19960502 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: FUNDAMENTAL FIXED INCOME FUND CENTRAL INDEX KEY: 0000811668 STANDARD INDUSTRIAL CLASSIFICATION: [] FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 497 SEC ACT: 1933 Act SEC FILE NUMBER: 033-12738 FILM NUMBER: 96555052 BUSINESS ADDRESS: STREET 1: 90 WASHINGTON ST - 19TH FL CITY: NEW YORK STATE: NY ZIP: 10006 BUSINESS PHONE: 2126353005 FORMER COMPANY: FORMER CONFORMED NAME: FUNDAMENTAL PORTFOLIO ADVISORS FIXED INCOME FUND DATE OF NAME CHANGE: 19870715 497 1 PROSPECTUS - U.S. GOVERNMENT STRATEGIC INCOME Rule 497(c) Registration No.:33-12738 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND 90 Washington Street * New York, N.Y. 10006 * 1 (800) 225-6864 Prospectus dated April 25, 1996 The objective of the Fundamental U.S. Government Strategic Income Fund (the "Fund"), a No-Load series of Fundamental Fixed-Income Fund (the "Trust"), is to provide you high current income with minimum risk of principal and relative stability of net asset value. Unlike bank deposits and certificates of deposit, the Fund does not offer a fixed rate of return or provide the same stability of principal. Although the Fund's investment manager attempts to maximize stability of net asset value, investment return and principal value will fluctuate with interest rate changes. The Fund is not a money market fund and the value of your shares when you redeem them may be more or less than your original cost. There can be no assurance that the Fund's investment objective will be attained. The Fund seeks to achieve its objective by investing primarily in U.S. Government Obligations. U.S. Government Obligations consist of marketable securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities (hereinafter collectively referred to as "Government Securities"). Direct obligations are issued by the United States Treasury and include bills, certificates of indebtedness, notes and bonds (hereinafter "Direct Obligations"). Obligations of U.S. Government agencies and instrumentalities ("Agencies") are issued by government-sponsored agencies and enterprises acting under authority of Congress. Shares of the Fund are not insured or guaranteed by the U.S. Government, its agencies or instrumentalities or by any other person or entity. References to Government guarantees apply to the timely payment of principal and interest on certain Government Securities in which the Fund may invest. The Fund may also invest in repurchase agreements secured by Government Securities and may engage in certain options and futures transactions only as a defensive measure (i.e., as a hedge and not for speculation) to improve the Fund's liquidity and stabilize the value of its portfolio. Under normal market conditions, the Fund will invest at least 65% of its total assets in Government Securities. The Fund may borrow money to purchase additional portfolio securities. Borrowing for investment increases both investment opportunity and investment risk (see "Certain Investment Techniques and Policies-Borrowing" for more information). The Fund seeks greater share price stability than longer-term investments by limiting the average weighted duration of its investment portfolio to three years or less. It is the policy of the Fund to limit the duration by the use of hedging techniques. Fundamental Portfolio Advisors, Inc. is the Fund's investment manager (the "Manager"). The Fund is designed for investors who seek higher yield than a money market fund and less fluctuation in net asset value than ordinary long-term bond funds. The Fund is a diversified series of Fundamental Fixed-Income Fund, a registered, open-end management investment company. Shares of the Fund are offered continuously at net asset value, without any sales charge, but the Fund does have a Rule 12b-1 Plan. Please read this Prospectus carefully and retain it for future reference. The Fund's Statement of Additional Information dated April 25, 1996 has been filed with the Securities and Exchange Commission and is incorporated herein by reference. It is available upon request to the Fund at (800) 225-6864. THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. 1 - -------------------------------------------------------------------------------- TABLE OF CONTENTS Page Page Highlights ................................. 2 Redemption of Shares ....................... 16 Fee Table .................................. 3 Brokerage Allocation ....................... 19 Financial Highlights ....................... 4 Distribution Agreement and Marketing Plan .. 19 Investment Objective and Policies .......... 5 Performance Information .................... 20 Certain Investment Techniques and Policies . 8 Tax Matters ................................ 21 The Manager and the Management Agreement ... 13 Other Information .......................... 22 Purchase of Shares ......................... 14 Shareholder Inquiries ...................... 23
- -------------------------------------------------------------------------------- HIGHLIGHTS The Fund's Objective. The Fund seeks to provide high current income with minimum risk of principal and relative stability of net asset value. The Fund Attempts to Achieve High Current Income With Relative Stability of Net Asset Value. By investing in a portfolio of Government Securities with high current yields and limiting the weighted average duration of the portfolio to three years or less, the Fund seeks to offer a higher yield than a money market fund and less fluctuation in net asset value than a longer-term bond fund. However, the Fund is not a money market fund and its net asset value will fluctuate. As with any bond investment, the Fund's yield and share price may be positively or negatively affected by changes in interest rates. The potential for such fluctuation is reduced, however, to the extent that hedging strategies used to manage the effect of interest rates on the Fund's investments are successful. For this reason, the Manager expects that under normal market conditions, the value of the Fund's portfolio will not fluctuate as significantly as a result of interest rate changes as an unhedged portfolio of long duration fixed-rate obligations would. However, a sudden and extreme increase in prevailing interest rates would likely cause a decline in the Fund's net asset value. Conversely, a sudden and extreme decline in interest rates would likely result in an increase in the Fund's net asset value. As with any mutual fund there is no assurance that the Fund will achieve its goal. Government Securities. The Fund will seek investment opportunities in obligations issued or guaranteed by the U.S. Government, its agencies or instrumentalities. It is anticipated that the portion of the distributions by the Fund which is derived from interest income received by the Fund on Direct Obligations will be exempt from state and local personal income taxes in many states (see "Tax Matters"). How to Buy and Sell Shares in the Fund. This is a No-Load Fund. Shares of the Fund are offered for sale on a continuous basis at the next determined net asset value per share (see "Purchase of Shares-How to Purchase Shares and Determination of Net Asset Value"). For your initial investment, there is a $2,500 minimum. The minimum initial investment for qualified pension plans (IRAs, Keoghs, etc.) is $2,000. The minimum subsequent investment is $100. (The foregoing minimum investments and charges may be modified or waived at any time at our discretion). There is no fee for purchasing shares directly from the Fund. However, you may be charged a fee for effecting transactions in the Fund's shares through securities dealers, banks or other financial institutions. Shares are redeemable at your option without charge at the next determined net asset value per share (see "Redemption of Shares"). The Fund reserves the right, however, to liquidate an account with a value of less than $100 on 60 days' notice. 2 Shareholder Services and Privileges. For shareholder convenience, the Fund provides certain services and privileges which may be suited to your particular needs, including Exchange, Check Redemption, Telephone Redemption and Expedited Redemption Privileges, an Automatic Investment Plan and various Tax-Sheltered Retirement Plans (see "Purchase of Shares" and "Redemption of Shares"). Monthly Dividends. The Fund declares dividends daily and pays them on a monthly basis, eliminating the need for you to hold your shares until quarter-end to receive dividend income. Dividends are automatically reinvested at net asset value in additional Fund shares without any charge. You may elect, however, to receive them in cash (see "Tax Matters"). Management and the Fundamental Family of Funds. Fundamental Portfolio Advisors, Inc., 90 Washington Street, 19th Floor, New York, New York 10006, the Fund's investment manager, (the "Manager") determines overall investment strategy for the Fund, including the selection of the Fund's portfolio securities, and provides the overall business management and administrative services necessary for the Fund's operations (see "The Manager and the Management Agreement"). Dr. Lance Brofman has been the Fund's portfolio manager since its inception in 1992. Dr. Brofman received an M.B.A. and a Ph.D. in Economics and Finance from New York University in 1978. He is currently the Chief Portfolio Strategist for the Fundamental Family of Funds. Exchange Privilege. The Manager also acts as investment manager to several other mutual fund portfolios in the Fundamental Family of Funds, including New York Muni Fund Series of Fundamental Funds, Inc., The California Muni Fund, and the High-Yield Municipal Bond and Tax-Free Money Market Series of Fundamental Fixed-Income Fund. Shares of such funds are exchangeable for shares of the Fund at the respective net asset value per share without any charge and may be exchanged by telephone (see "Redemption of Shares-Exchange Privilege"). Risk Factors. The Fund invests in a portfolio of U.S. Government securities, and is not limited as to the maturities of the securities in which it may invest. While U.S. Government debt obligations are generally considered to be of the highest credit quality, to the extent that there is credit risk in U.S. Government securities it would also affect the Fund's portfolio. Moreover, there are additional risk considerations which may be associated with certain investment policies of, and strategies employed by, the Fund including those relating to borrowing as well as those relating to U.S. Government guaranteed mortgage-related securities, futures and options transactions. Such risks may not be incurred by other mutual funds which have similar investment objectives, but which do not follow these policies or employ these strategies. See "Investment Objective and Policies" and "Certain Investment Techniques and Policies" in the Prospectus and "Investment Objective and Policies" in the Fund's Statement of Additional Information. FEE TABLE Shareholder Transaction Expenses Sales Commission on Purchase of Shares ................... NONE Sales Commission on Reinvestment of Dividends ............ NONE Redemption Fees .......................................... NONE Exchange Fees ............................................ NONE Annual Fund Expenses (As a percentage of average net assets) Management Fees .......................................... .75% 12b-1 Fees1 .............................................. .25% Other Expenses, net of reimbursement Interest ............................................. .20% Other ................................................ 2.05% Total Fund Expenses ...................................... 3.25% 1As a result of distribution fees of .25% per annum of the Fund's average daily net assets, a long-term shareholder may pay more than the economic equivalent of the maximum front-end sales charges permitted by the Rules of the National Association of Securities Dealers, Inc. 3 Example: You would pay the following expenses on a $1,000 investment, assuming (1) 5% annual return and (2) redemption at the end of the time period: 1 year 3 years 5 years 10 years ------ ------- ------- -------- $33 $100 $170 $355 This example should not be considered a representation of past or future expenses, and actual expenses may be greater or less than those shown. For a more complete description of the Fund's various costs and expenses, including management and distribution fees, see "The Manager and the Management Agreement", "Distribution Agreement and Marketing Plan" and the Financial Statements included at the end of the Fund's Statement of Additional Information. The Manager may, from time to time, waive or reduce its fees on assets held by the Fund. Fee waivers or reductions will cause the Fund's expenses to go down and its yield to increase. FINANCIAL HIGHLIGHTS (for a share outstanding throughout the period) The following per share income and capital changes has been audited by McGladrey & Pullen, LLP, independent certified public accountants, whose report thereon appears in the Statement of Additional Information.
Year Ended March 2, -------------------------------------------- 1992* to December 31, December 31, December 31, December 31, 1995 1994 1993 1992 ------ ------ ------ ------ Per share operating performance (for a share outstanding throughout the period) Net asset value, beginning of period $ 1.37 $ 2.01 $ 2.02 $ 2.01 ------ ------ ------ ------ Income from investment operations Net investment income 0.08 0.14 0.16 0.15 Net realized and unrealized gain/(loss) on investments 0.12 (0.64) - 0.01 ------ ------ ------ ------ Total from investment operations 0.20 (0.50) 0.16 0.16 ------ ------ ------ ------ Less distributions Dividends from net investment income (0.08) (0.14) (0.16) (0.15) Dividends from net realized gains - - (0.01) - ------ ------ ------ ------ Net asset value, end of period $ 1.49 $ 1.37 $ 2.01 $ 2.02 ====== ====== ====== ====== Total return (annualized) 15.43% (25.57%) 8.14% 10.76% Ratios/supplemental data: Net assets, end of period (000 omitted) 15,194 19,020 63,182 40,500 Ratios to average net assets (annualized): Interest expense 0.20% 0.12% 0.05% 0.09% Operating expenses 3.05% 2.16% 1.39% 0.96% ------ ------ ------ ------- Total expenses 3.25%+ 2.28%+ 1.44%+ 1.05%+ ====== ====== ====== ======= Net investment income 5.91% 8.94% 7.85% 8.50% Portfolio turnover rate 114.36% 60.66% 90.59% 115.39%
4
Year Ended March 2, -------------------------------------------- 1992* to December 31, December 31, December 31, December 31, 1995 1994 1993 1992 ------ ------ ------ ------ Borrowings Amount outstanding at end of period (000 omitted) 7,481 9,674 31,072 19,666 Average amount of debt outstanding during the period (000 omitted) 7,790 16,592 28,756 13,779 Average number of shares outstanding during the period (000 omitted) 11,571 21,436 28,922 12,683 Average amount of debt per share during the period .67 .77 .99 1.09
* Commencement of public offering of shares. + These ratios are after expense reimbursement of 1.0% for the year ended December 31, 1995, .13% for the year ended December 31, 1993, and 1.05% for the period March 2, 1992 to December 31, 1992. These ratios exclude 2.8%, 1.9% and 1.4% for the years ended December 31, 1995, 1994 and 1993, respectively, and 1.2% for the period March 2, 1992 to December 31, 1992 of interest expense on securities sold subject to repurchase which was netted against interest income. INVESTMENT OBJECTIVE AND POLICIES The Fund's objective is to provide high current income with minimum risk of principal and relative stability of net asset value. The Fund's investment objective is deemed fundamental and may not be changed without shareholder approval. There can, of course be no assurance that the Fund will achieve its investment objective. In seeking its objective, the Fund invests primarily in obligations issued or guaranteed by the U.S. Government, its agencies or instrumentalities (collectively "Government Securities"). Government Securities in which the Fund may invest include: Direct obligations of the U.S. Treasury, such as U.S. Treasury bills, certificates of indebtedness, notes and bonds ("Direct Obligations"); and obligations of U.S. Government agencies or instrumentalities, such as Federal Home Loan Banks, Farmers Home Administration, Federal Farm Credit Banks, Federal National Mortgage Association ("FNMA"), Government National Mortgage Association ("GNMA"), Resolution Funding Corp. ("RFCO"), Financing Corp. ("FICO") and Federal Home Loan Mortgage Association ("FHLMC") (hereinafter collectively referred to as "Agencies"). The obligations of Government Securities which the Fund may buy are backed in a variety of ways by the U.S. Government or its agencies or instrumentalities. While the U.S. Government provides financial support to such agencies and instrumentalities, no assurance can be given that it will always do so, since it is not obligated by law. The Fund will invest in such securities only when it is satisfied that the credit risk with respect to the issuer is minimal. Some of these obligations, such as GNMA mortgage-backed securities and obligations of the Farmers Home Administration which represent part ownership in a pool of mortgage loans, are backed by the full faith and credit of the U.S. Treasury. Obligations of the Farmers Home Administration are also backed by the issuer's right to borrow from the U.S. Treasury. Obligations of Federal Home Loan Banks and the Farmers Home Administration are backed by the discretionary authority of the U.S. Government to purchase certain obligations of agencies or instrumentalities. Obligations of Federal Home Loan Banks, Farmers Home Administration, Federal Farm Credit Banks, FNMA, RFCO, FICO and FHLMC are backed by the credit of the agency or instrumentality issuing the obligations. The Fund intends to minimize the risk of principal and provide relative stability of net asset value by limiting the average weighted duration of its investment portfolio to three years or less. It is the policy of the Fund to limit the 5 duration by the use of hedging techniques, so that the average weighted duration of the Fund's portfolio is three years or less. The Fund may engage in certain options and futures transactions only as a defensive measure (i.e., as a hedge and not for speculation) to improve the Fund's liquidity and stabilize the value of its portfolio. The Fund is not a money market fund and cannot guarantee that its share price will not fluctuate. Unlike bank deposits and certificates of deposit, the Fund does not offer a fixed rate of return or provide the same stability of principal. The value of your shares when you redeem them may be more or less than your original cost. The Fund may invest in repurchase agreements, cash or money market instruments or such other high quality debt instruments as is consistent with its investment objective. In addition, the Fund is authorized for the purpose of increasing its return or hedging its interest rate exposure, to engage in any one or more of the specialized investment techniques and strategies described below under the caption "Certain Investment Techniques and Policies". Securities issued by the U.S. Government differ with respect to maturity and modality of payment. The two types of payment modes are coupon paying and capital appreciation. Coupon paying bonds and notes pay a periodic interest payment, usually semi-annually, and a final principal payment at maturity. Capital appreciation bonds and Treasury bills accrue a daily amount of interest income, and pay a stated face amount at maturity. Most U.S. Government capital appreciation bonds were created as a result of the separation of coupon paying bonds into distinct securities representing the periodic coupon payments and the final principal payment. This is referred to as "stripping". The separate securities representing a specific payment to be made by the U.S. Government on a specific date are also called "zero coupon" bonds. Current Federal tax law requires the Fund daily to accrue as income a portion of the original issue discount at which each zero coupon bond was purchased. Amortization of this discount has the effect of increasing the Fund's income, although it receives no actual cash payments. The Fund distributes this income to its shareholders as income dividends and such income is reflected in the Fund's quoted yield. See below for additional discussion concerning the effects of the amortization of the discount. The U.S. Government facilitates the "stripping" of coupon bonds by providing for the periodic coupon payments and the principal payment to be kept separate in the Federal Reserve and Treasury bookkeeping systems, and allows stripped bonds to be reconstituted into coupon bonds by delivering all of the securities representing the coupons and principal payment to the system. Since the value of debt securities owned by the Fund will fluctuate depending upon market factors and generally inversely with prevailing interest rate levels, the net asset value of the Fund will fluctuate. The Fund is not limited as to the maturities of the securities in which it may invest. Debt securities with longer maturities generally tend to produce higher yields and are subject to greater market fluctuation as a result of changes in interest rates than debt securities with shorter maturities. The potential for such fluctuation may be reduced, however, to the extent that the Fund engages in hedging techniques. The Fund's current operating policy is to seek to achieve a weighted portfolio duration of three years or less. Duration is expressed in years and is that point in time representing the half-life of the present value of all cash flows expected from a bond over its life (from coupon payments, sinking fund, if any, principal at maturity, etc.). Duration provides a yardstick to bond price volatility with respect to changes in rates. As maturity lengthens or as the coupon rate or yield-to-maturity is reduced, volatility increases. Duration captures all three factors and expresses them in a single number. It should be noted that there are several methods of calculating the duration of a security or portfolio of securities. These methods may yield different results. The Fund applies different hedging techniques resulting in different outcomes depending on what duration is calculated. Any one method of calculating a security's duration will in turn give different results as interest rates change and the market value of the security changes. The duration equivalent of derivatives such as bond futures contracts and options futures contracts used by the Fund (see "Certain Investment Techniques and Policies-Futures Contracts and Options on Futures Contracts") can vary significantly with changes 6 in interest rates and market prices. Such variation can significantly affect the result of a portfolio duration calculation. For example: the Fund's management might use one set of assumptions and method of calculating duration that would indicate that the weighted average portfolio duration of the Fund was less than three years at a particular point in time, while other assumptions and/or methodology could indicate a substantially greater duration implying different steps to be taken by Fund management. (See "Basis Risk" and "Risks of Writing Options"). Certain U.S. Government securities such as Collateralzied Mortgage Obligations ("CMOs") have cash flows which can vary according to the rates of principal payments (including prepayments) on the related underlying mortgage assets. The coupon and therefore the cash flows of CMOs can also vary either directly or inversely according to moves of an applicable index such as LIBOR, or a multiple of the applicable index. Since the cash flows associated with CMOs can vary with principal payment speeds and changes in the applicable index, the calculation of duration of a CMO depends on the assumptions for future values of the index and/or speeds of principal payments. A particular assumption by Fund management concerning future interest rates and prepayment rates may cause it to calculate duration or employ a method to calculate duration that would result in a significantly different amount of futures and options being used for hedging purposes, than would be the case if other assumptions concerning future interest rates were employed. (See "U.S. Government Guaranteed Mortgage-Related Securities and the Risk Factors Relating to such Investments".) The Fund's current operating policy of attempting to achieve a weighted portfolio duration of three years or less through the investment policies and strategies described above and elsewhere involve risks which may not be incurred by other mutual funds which do not follow these policies or employ these strategies. Specifically, there may be other mutual funds which attempt to minimize fluctuations in net asset value by limiting the maturities of their portfolio securities, by not using leverage and not engaging in futures and options transactions. The policies and strategies employed by the Fund, including the various uncertainties associated with the various methods and assumptions required for the calculation of portfolio duration, may cause a decline in the Fund's net asset value greater than that of other mutual funds in response to an unanticipated change in prevailing interest rates. At any given time, there is a relationship between the yield of a U.S. Government obligation and its maturity. This is called the "yield curve." Since U.S. Government debt securities are assumed to have negligible credit risk, the main determinant of yield differential between individual securities is maturity. When the yield curve is such that longer maturities correspond to higher yields, the yield curve has a positive slope and is referred to as a "normal" yield curve. At certain times shorter maturities have higher yields and the yield curve is said to be "inverted." Even when the yield curve is "normal" (i.e. has a positive slope), the relationship between yield and maturity for some U.S. Government strip securities is such that yields increase with maturity up to some point and then, after peaking, decline so that the longest maturities are not the highest yielding. This is called a "humped" curve. The highest yielding point on the yield curve for such securities is referred to as the "strippers hump." Zero coupon Treasury securities do not entitle the holder to any periodic payments of interest prior to maturity. Accordingly, such securities usually trade at a deep discount from their face or par value and will be subject to greater fluctuations of market value in response to changing interest rates than debt obligations of comparable maturities which make periodic distributions of interest. On the other hand, because there are no periodic interest payments to be reinvested prior to maturity, zero coupon securities eliminate the reinvestment risk and lock in a rate of return to maturity. Current Federal tax law requires that a holder (such as the Fund) of a zero coupon security accrue a portion of the discount at which the security was purchased as income each year even though the Fund received no interest payment in cash on the security during the year. As an investment company, the Fund must pay out substantially all of its net investment income each year. Accordingly, the Fund may be required to pay out as an income distribution each year an amount which is greater than the total amount of cash interest the Fund actually received. Such distributions will be made from the cash assets of the Fund or by liquidation of portfolio securities, if necessary. If a distribution of cash necessitates the liquidation of portfolio securities, the Manager will select which securities to sell. The Fund may 7 realize a gain or loss from such sales. In the event the Fund realizes net capital gains from such transactions, its shareholders may receive a larger capital gain distribution, if any, than they would in the absence of such transactions. The Fund is diversified and, accordingly, may not purchase the securities of any one issuer, other than obligations issued or guaranteed by the U.S. Government or its agencies or instrumentalities, if, immediately after such purchase, (i) more than 5% of the value of the Fund's total assets would be invested in such issuer, or (ii) the Fund would own more than 10% of the outstanding voting securities of such issuer; except that up to 25% of the value of the Fund's total assets may be invested without regard to such limitations. Certain securities that may be purchased by the Fund, such as those with interest rates that flucutate directly or indirectly (inverse floaters) based on multiples of a stated index, are designed to be highly sensitive to changes in interest rates and can subject the holders thereof to extreme reductions of yield and possibly loss of principal. CERTAIN INVESTMENT TECHNIQUES AND POLICIES Futures Contracts and Options on Futures Contracts. The Fund may enter into contracts for the purchase or sale for future delivery of fixed-income securities or contracts based on a financial index of Government Securities ("futures contracts") and may purchase and write put and call options to buy or sell futures contracts ("options on futures contracts"). A "sale" of a futures contract means the acquisition of a contractual obligation to deliver the securities called for by the contract at a specified price on a specified date. A "purchase" of a futures contract means the incurring of a contractual obligation to acquire the securities called for by the contract at a specified date. The purchaser of a futures contract on an index agrees to take or make delivery of an amount of cash equal to the difference between a specified dollar multiple of the value of the index on the expiration date of the contract ("current contract value") and the price at which the contract was originally struck. Although most futures contracts call for actual delivery or acceptance of debt securities, the contracts usually are closed out before the settlement date without the making or taking of delivery. Options on futures contracts to be written or purchased by the Fund will be traded on an exchange or over-the-counter. Unlike a futures contract, which requires the parties to the contract to buy or sell a security on a set date, an option on a futures contract, for example, merely entitles its holder to decide on or before a future date whether to enter into such a contract. If the holder decides not to enter into the contract, all that is lost is the premium paid for the option. Because an option gives the buyer the right to enter into a contract at a set price for a fixed period of time, its value will change daily. That change will be reflected in the net asset value of the Fund. These investment techniques will be used to hedge against anticipated future changes in interest rates which otherwise might either adversely affect the value of the Fund's portfolio securities or adversely affect the price of securities which the Fund intends to purchase at a later date. Options and futures can be volatile investments and involve certain risks. If the Fund's Manager applies a hedge at an inappropriate time or judges interest rates incorrectly, options and futures strategies may lower the Fund's return. The Fund could also experience losses if the prices of its options and futures positions were poorly correlated with its other investments, or if it could not close out its positions because of an illiquid secondary market. See the Fund's Statement of Additional Information for further discussion of the use, risks and costs of futures contracts and options on futures contracts. In order to hedge against anticipated changes in interest rates, the Fund will engage in the use of futures contracts and related options solely for bona fide hedging purposes, as defined by the Commodity Futures Trading Commission, and not for speculation. Basis Risk. The use of futures contracts to shorten the weighted average duration of the Fund's portfolio, while reducing the exposure of the Fund's portfolio to interest rate risk does subject the Fund's portfolio to basis risk. Basis refers to the relationship between a futures contract and the underlying security. In the case of futures contracts on U.S. Treasury Bonds, the contract specifies delivery of a "bench-mark" 8% 20 year U.S. Treasury Bond. Any outstanding treasury with a maturity of more than 15 years is deliverable against the contract, with the principal amount per 8 contract adjusted according to a formula which takes into account the coupon and maturity of the treasury bond being delivered. This means that at any given time there is one treasury issue that is "the cheapest to deliver" against the contract. The supply and demand of the available float of treasury securities determines which treasury security is cheapest to deliver at any given time. This, combined with the supply and demand for futures relative to the underlying cash securities markets, causes the relationship between the cash security markets and the futures markets to exhibit perturbations of variance from an exact one-to-one correlation. The Fund could experience losses if the value of the prices of the futures positions the Fund has entered into are poorly correlated with the Fund's other investments. For example, on a day that the price on a treasury bond deliverable against the futures contract declined by ten points, the futures contract might decline by nine or eleven points. In this example, a nine point decline in the price of a futures contract would not fully offset the price decline in the cash security price. This would cause a downward fluctuation in the value of the Fund's portfolio. Likewise, a basis fluctuation whereby the futures prices fell more or rose less than the cash securities prices due to basis change would cause an upward fluctuation in the value of the Fund's portfolio. Options on Portfolio Securities. The Fund, in seeking to generate high current income, may write covered call options on certain of its portfolio securities at such time and from time to time as Fund management shall determine to be appropriate and consistent with the investment objective of the Fund. A covered call option means that the Fund owns the security on which the option is written. Generally, the Fund expects that options written by it will be conducted on recognized securities exchanges. In certain instances, however, the Fund may purchase and sell options in the over-the-counter market ("OTC Options"). The Fund's ability to close options positions established in the over-the-counter market may be more limited than in the case of exchange-traded options and may also involve the risk that securities dealers participating in such transactions will fail to meet their obligations to the Fund. In addition, the staff of the Securities and Exchange Commission has taken the position that OTC Options and the assets used as "cover" should be treated as illiquid securities. Accordingly, there is a current fixed limit of 10% of the Fund's assets upon which such options may be written. The Fund will receive a premium (less any commissions) from the writing of such contracts, and it is believed that the total return to the Fund can be increased through such premiums consistent with the Fund's investment objective. The writing of option contracts is a highly specialized activity which involves investment techniques and risks different from those ordinarily associated with investment companies, although the Fund believes that the writing of covered call options listed on an exchange or traded in the over-the-counter market, where the Fund owns the underlying security, tends to reduce such risks. The writer forgoes the opportunity to profit from an increase in the market price of the underlying security above the exercise price so long as the option remains open. See the Fund's Statement of Additional Information for more information. Risks of Writing Options The successful use of the foregoing investment techniques depends on the ability of Fund management to forecast interest rate movements correctly. Should interest rates move in an unexpected manner, the Fund may not achieve the anticipated benefits of futures or option contracts or may realize losses and be in a worse position than if such strategies had not been used. The correlation between movements in the price of such instruments and movements in the prices of the securities hedged or used for cover will not be perfect and could produce unanticipated losses. The Fund's ability to dispose of its positions in futures contracts and options will depend on the availability of liquid markets in such instruments. Markets in options and futures with respect to a number of Government Securities are relatively new and still developing. It is impossible to predict the amount of trading interest that may exist in various types of futures and options contracts. If a secondary market does not exist with respect to an option purchased or written by the Fund over-the-counter, it might not be possible to effect a closing transaction in the option (i.e. 9 dispose of the option) with the result that (i) an option purchased by the Fund would have to be exercised in order for the Fund to realize any profit and (ii) the Fund may not be able to sell portfolio securities covering an option written by the Fund until the option expires or it delivers the underlying futures contract upon exercise. Therefore, no assurance can be given that the Fund will be able to utilize these instruments effectively for the purposes set forth above. Furthermore, the Fund's ability to engage in options and futures transactions may be limited by tax considerations. See "Tax Matters". U.S. Government Guaranteed Mortgage-Related Securities and the Risk Factors Relating to such Investments. Included in the U.S. Government securities the Fund may purchase are pass-through sccurities, collateralized mortgage obligations, multi-class pass-through securities and stripped mortgage-backed securities, all of which are described below. Mortgages backing these securities purchased by the Fund include, among others, conventional 30-year fixed rate mortgages, graduated payment mortgages, 15-year mortgages and adjustable rate mortgages. All of these mortgages can be used to create pass-through securities. A pass-through security is formed when mortgages are pooled together and undivided interests in the pool or pools are sold. The cash flow from the mortgages is passed through to the holders of the securities in the form of periodic payments of interest, principal and prepayment (net of a service fee). Prepayments occur when the holder of an individual mortgage prepays the remaining principal before the mortgage's scheduled maturity date. As a result of the pass-through of prepayments of principal on the underlying securities, mortgage-backed securities are often subject to more rapid prepayment of principal than their stated maturity would indicate. Because the prepayment characteristics of the underlying mortgages vary, it is not possible to predict accurately the realized yield or average life of a particular issue of pass-through certificates. Prepayment rates are important because of their effect on the yield and price of the securities. Accelerated prepayments adversely impact yields for pass-throughs purchased at a premium (i.e., a price in excess of principal amount) and may involve additional risk of loss of principal because the premium may not have been fully amortized at the time the obligation is repaid. The opposite is true for pass-throughs purchased at a discount. The Fund may purchase mortgage-related securities at a premium or at a discount. Principal and interest payments on the mortgage-related securities are Government guaranteed to the extent described below. Such guarantees do not extend to the value or yield of the mortgage-related securities themselves or of the Fund's shares. (a) GNMA Pass-Through Securities. The Government National Mortgage Association ("GNMA") issues mortgage-backed securities ("GNMA Certificates") which evidence an undivided interest in a pool or pools of mortgages. GNMA Certificates that the Fund purchases are the "modified pass-through" type, which entitle the holder to receive timely payment of all interest and principal payments due on the mortgage pool, net of fees paid to the "issuer" and GNMA, regardless of whether the mortgagor actually makes the payment. The National Housing Act authorizes GNMA to guarantee the timely payment of principal and interest on securities backed by a pool of mortgages insured by the Federal Housing Administration ("FHA") or guaranteed by the Veterans Administration ("VA"). The GNMA guarantee is backed by the full faith and credit of the United States. GNMA is also empowered to borrow without limitation from the U.S. Treasury if necessary to make any payments required under its guarantee. The average life of a GNMA Certificate is likely to be substantially shorter than the original maturity of the mortgages underlying the securities. Prepayments of principal by mortgagors and mortgage foreclosures will usually result in the return of the greater part of principal investment long before the maturity of the mortgages in the pool. Foreclosures impose no risk to principal investment because of the GNMA guarantee, except to the extent that the Fund has purchased the certificates at a premium in the secondary market. 10 (b) FHLMC Pass-Through Securities. The Federal Home Loan Mortgage Corporation ("FHLMC") was created in 1970 through enactment of Title III of the Emergency Home Finance Act of 1970. Its purpose is to promote development of a nationwide secondary market in conventional residential mortgages. FHLMC issues two types of mortgage pass-through securities ("FHLMC Certificates"), mortgage participation certificates ("PCs") and guaranteed mortgage certificates ("GMCs"). PCs resemble GNMA Certificates in that each PC represents a pro rata share of all interest and principal payments made and owed on the underlying pool. FHLMC guarantees timely monthly payment of interest on PCs and the ultimate payment of principal. GMCs also represent a pro rata interest in a pool of mortgages. However, these instruments pay interest semiannually and return principal once a year in guaranteed minimum payments. The expected average life of these securities is approximately ten years. The FHLMC guarantee is not backed by the full faith and credit of the United States. (c) FNMA Pass-Through Securities. The Federal National Mortgage Association ("FNMA") was established in 1938 to create a secondary market in mortgages insured by the FHA. FNMA issues guaranteed mortgage pass-through certificates ("FNMA Certificates"). FNMA Certificates resemble GNMA Certificates in that each FNMA Certificate represents a pro rata share of all interest and principal payments made and owed on the underlying pool. FHMA guarantees timely payment of interest and principal on FNMA Certificates. The FNMA guarantee is not backed by the full faith and credit of the United States. (d) Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities. Collateralized mortgage obligations ("CMOs") are debt instruments issued by special purpose entities which are secured by pools of mortgage loans or other mortgage-backed securities. Multi-class pass-through securities are equity interests in a trust composed of mortgage loans or other mortgage-backed securities. Payments of principal and interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled distributions on the multi-class pass-through security. The Fund may invest in CMOs and multi-class pass-through securities (collectively CMOs unless the context indicates otherwise) issued by agencies or instrumentalities of the U.S. Government. In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often referred to as a "tranche," is issued at a specific coupon rate and has a stated maturity or final distribution date. Principal prepayments on collateral underlying a CMO may cause it to be retired substantially earlier than the stated maturities or final distribution dates. The principal and interest on the underlying mortgages may be allocated among the several classes of a series of a CMO in many ways. One or more tranches of a CMO may have coupon rates which reset periodically at a specified increment over an index such as the London Interbank Offered Rate ("LIBOR"). These floating rate CMOs are typically issued with lifetime caps on the coupon rate thereon. The Fund may also invest in inverse or reverse floating CMOs. Inverse or reverse floating CMOs constitute a tranche of a CMO with a coupon rate that moves in the reverse direction to an applicable index such as LIBOR. Accordingly, the coupon rate thereon will increase as interest rates decrease. Inverse or reverse floating CMOs are typically more volatile than fixed or floating rate tranches of CMOs. Investments in inverse or reverse floating CMOs would be purchased by the Fund to attempt to protect against a reduction in the income earned on the Fund investments due to a decline in interest rates. The Fund would be adversely affected by the purchase of such CMOs in the event of an increase in interest rates since the coupon rate thereon will decrease as interest rates increase, and, like other mortgage-related securities, the value will decrease as interest rates increase. Many inverse floating rate CMOs have coupons that move inversely to a multiple of an applicable index such as LIBOR. The effect of the coupon varying inversely to a multiple of an applicable index creates a leverage factor. This leverage factor magnifies the extent to which the successful use of hedging techniques depends on Fund management's ability to both correctly forecast interest movements and the relationship between long and short-term 11 interest rates. An accurate estimate of the amount of futures and options required to achieve a desired weighted average portfolio duration is also extremely sensitive to management's ability to forecast interest rate movements and relationships. Furthermore, the markets for inverse floating rate CMOs with highly leveraged characteristics may at times be very thin. The Fund's ability to dispose of its positions in such securities will depend on the degree of liquidity in the markets for such securities. Markets in such securities are relatively new and still developing. It is impossible to predict the amount of trading interest that may exist in such securities, and therefore the future degree of liquidity. It should be noted that inverse floaters based on multiples of a stated index are designed to be highly sensitive to changes in interest rates and can subject the holders thereof to extreme reductions of yield and loss of principal. (e) Stripped Mortgage-Backed Securities. Stripped Mortgage-Backed Securities ("SMBS") are derivative multi-class mortgage securities. The Fund may invest in SMBS issued by agencies or instrumentalities of the U.S. Government. There are generally two classes of SMBS, one of which (the "IO class") entitles the holders thereof to receive distributions consisting solely or primarily of all or a portion of the interest on the underlying pool of mortgage loans or mortgage-backed securities ("Mortgage Assets") and the other of which (the "PO class") entitles the holders thereof to receive distributions consisting solely or primarily of all or a portion of the principal of the underlying pool of Mortgage Assets. The cash flows and yields on IO and PO classes are extremely sensitive to the rate of principal payments (including prepayments) on the related underlying Mortgage Assets. For example, a rapid or slow rate of principal payments may have a material adverse effect on the yield to maturity of IOs or POs, respectively. If the underlying Mortgage Assets experience greater than anticipated prepayments of principal, an investor may incur substantial losses. Conversely, if the underlying Mortgage Assets experience slower than anticipated prepayments of principal, the yield on a PO class will be affected more severely than would be the case with a traditional mortgage-backed security. Repurchase Agreements. The Fund may enter into repurchase agreements involving Government Securities. Under a repurchase agreement, the Fund acquires a debt instrument for a relatively short period (usually not more that one week) subject to the obligation of the seller to repurchase and the Fund to resell such debt instrument at a fixed price. The resale price is in excess of the purchase price in that it reflects an agreed-upon market interest rate effective for the period of time during which the Fund's money is invested. The Fund's repurchase agreements will at all times be fully collateralized in an amount at least equal to the purchase price including accrued interest earned on the underlying Government Securities. The instruments held as collateral are valued daily, and as the value of instruments declines, the Fund will require additional collateral. If the seller defaults and the value of the collateral securing the repurchase agreement declines, the Fund may incur a loss. Reverse Repurchase Agreements. The Fund may enter into reverse repurchase agreement transactions. Such transactions involve the sale of Government Securities held by the Fund, with an agreement that the Fund will repurchase such securities at an agreed upon price and date. The Fund will employ reverse repurchase agreements when necessary to meet unanticipated net redemptions so as to avoid liquidating other portfolio investments during unfavorable market conditions, or as a technique to enhance income. At the time it enters into a reverse repurchase agreement, the Fund will place in a segregated custodial account high-quality liquid debt securities having a dollar value equal to the repurchase price. The Fund will utilize reverse repurchase agreements when the interest income to be earned from portfolio investments is greater than the interest expense incurred as a result of the reverse repurchase transactions. Lending of Portfolio Securities. In order to generate additional income, the Fund may lend its portfolio securities in an amount up to 33-1/3% of total assets to broker-dealers, major banks or other recognized domestic institutional borrowers of securities not affiliated with the Manager. The borrower at all times during the loan must maintain cash or cash equivalent collateral or provide to the Fund an irrevocable letter of credit equal in value to at 12 least 100% of the value of the securities loaned. During the time portfolio securities are on loan, the borrower pays the Fund any dividends or interest paid on such securities, and the Fund may invest the cash collateral and earn additional income, or it may receive an agreed-upon amount of interest income from the borrower who has delivered equivalent collateral or a letter of credit. Portfolio Turnover. The Fund has no fixed policy with respect to portfolio turnover. The Fund may engage in short-term trading to benefit from yield disparities among different issues of Government Securities, to seek short-term profits during periods of fluctuating interest rates, or for other reasons the Manager believes would be beneficial to the Fund. The Manager expects that, under normal circumstances, the Fund's annual portfolio turnover rate will not exceed 200%. The portfolio turnover rate is calculated by dividing the lesser of sales or purchases of portfolio securities by the average monthly value of the Fund's portfolio securities, excluding securities having a maturity at the date of purchase of one year or less. While the Fund will pay commissions in connection with its options and futures transactions, the other securities in which the Fund invests are generally traded on a "net" basis with dealers acting as principals for their own account without a stated commission. Nevertheless, high portfolio turnover may involve correspondingly greater brokerage commissions and other transaction costs which will be borne directly by the Fund. See "Portfolio Transactions" in the Statement of Additional Information. Borrowing. The Fund may borrow from banks and enter into reverse repurchase agreements up to 33-1/3% of the value of its total assets (computed at the time the loan is made) to take advantage of investment opportunities and for temporary, extraordinary or emergency purposes. See "Reverse Repurchase Agreements" above. The Fund may pledge up to 33-1/3% of its total assets to secure these borrowings. If the Fund's asset coverage for borrowings falls below 300%, the Fund will take prompt action to reduce its borrowings. If the Fund borrows to invest in securities, any investment gains made on the securities in excess of interest paid on the borrowing will cause the net asset value of the Fund's shares to rise faster than would otherwise be the case. On the other hand, if the investment performance of the additional securities purchased fails to cover their cost (including any interest paid on the money borrowed) to the Fund, the net asset value of the Fund's shares will decrease faster than would otherwise be the case. This is the speculative characteristic known as "leverage." As long as the interest rate paid by the Fund for borrowing via the use of reverse repurchase agreements is less than the interest rate the Fund can earn on its securities investments, these transactions will represent an essential element of the Fund's objective of achieving relatively high current income. As discussed above, this speculative characteristic known as leverage increases the amount of fluctuation in the Fund's price given any particular change in the value of its securities holdings. Thus, all of the sources of risk inherent in the Fund's strategy of reducing interest rate risk by the use of hedging with futures contracts (see the sub-heading "Basis Risk") to bring the weighted duration of the Fund's portfolio to three years or less, will be magnified to the extent that the borrowing done by the Fund results in leverage. THE MANAGER AND THE MANAGEMENT AGREEMENT The Manager. Fundamental Portfolio Advisors, Inc. (the "Manager"), which was organized in 1986, manages the Fund's investments pursuant to a management agreement dated January 31, 1992 (the "Agreement"). The Manager is an investment adviser registered with the Securities and Exchange Commission, and specializes in managing and advising mutual funds. The Management Agreement. Under the terms of the Management Agreement (the "Agreement"), the Manager serves as investment adviser and is responsible for the overall management of the business affairs and assets of the Fund, subject to the authority of the Trust's Board of Trustees. The Manager also is authorized under the Agreement to buy and sell securities for the account of the Fund, in its discretion, subject to the right of the Fund's trustees to disapprove any such purchase or sale. The Manager pays all of the ordinary operating expenses of the Fund, 13 including executive salaries and the rental of office space, with the exception of the following, which are to be paid by the Fund: (1) charges and expenses for determining from time-to-time the net asset value of the Fund and the keeping of its books and records, (2) the charges and expenses of any auditors, custodian, transfer agent, plan agent, dividend disbursing agent and registrar performing services for the Fund, (3) brokers' commissions, and issue and transfer taxes, chargeable to the Fund in connection with securities transactions, (4) insurance premiums, interest charges, dues and fees for membership in trade associations and all taxes and fees payable by the Fund to Federal, state or other governmental agencies, (5) fees and expenses involved in registering and maintaining registrations of the shares of the Fund with the Securities and Exchange Commission and under the securities laws or regulations of states and other jurisdictions, (6) all expenses of shareholders' and trustees' meetings, and of preparing, printing and distributing notices, proxy statements and all reports to shareholders and to governmental agencies, (7) charges and expenses of legal counsel to the Fund, (8) compensation of those trustees of the Fund as such who are not affiliated with or interested persons of the Manager or the Fund (other than as trustees), (9) fees and expenses incurred pursuant to the Marketing Plan and (10) such nonrecurring or extraordinary expenses as may arise, including litigation affecting the Fund and any indemnification by the Fund of its trustees, officers, employees or agents with respect thereto. To the extent any of the foregoing charges or expenses are incurred by the Trust for the benefit of each of its series, the Fund is responsible for payment of the portion of such charges or expenses which are properly allocable to the Fund. For the services it provides under the terms of the Agreement, the Manager receives a monthly fee of .75% per annum of the Fund's average daily net assets up to $500 million, .725% per annum on the next $500 million, and .70% per annum on assets over $1 billion. This fee is higher than that paid by most other mutual funds due to the complexity of managing the Fund. The Manager may, from time to time, voluntarily waive all or a portion of its fees payable under the Agreement. The Manager has agreed to reduce its fee for any fiscal year, or reimburse the Fund, to the extent required, so that the amount of the ordinary expenses of the Fund (excluding brokerage commissions and fees, taxes, interest and extraordinary expenses, such as litigation and certain other excludable expenses for which a waiver has been obtained) paid or incurred by the Fund do not exceed the most restrictive expense limitation applicable to the Fund imposed by the securities laws or regulations of those states or jurisdictions in which the Fund's shares are registered or qualified for sale. Currently, the most restrictive expense limitation would require the Manager to reduce its respective fees to the extent required or reimburse the Fund monthly so that ordinary expenses for the Fund (excluding brokerage commissions and fees, taxes, interest and extraordinary expenses, such as litigation, and certain other excludable expenses) for any fiscal year do not exceed 2.5% of the first $30 million of the Fund's average net assets, plus 2.0% of the next $70 million, plus 1.5% of the Fund's average net assets in excess of $100 million. PURCHASE OF SHARES How to Purchase Shares and Determination of Net Asset Value. This is a No-Load Fund. Shares of the Fund are offered for sale on a continuous basis at the next determined net asset value per share after your order is received and accepted. Orders received after the closing time of the New York Stock Exchange (currently 4:00 P.M. New York time) are purchased at the net asset value determined on the next business day. The Fund's net asset value per share is determined by dividing the value of the Fund's net assets by the total number of shares outstanding. The Fund determines the net asset value (NAV) of its shares on each day that both the New York Stock Exchange and the Fund's custodian bank are open for business and there is sufficient trading in the Fund's portfolio securities to affect materially its NAV per share. The Fund's portfolio securities are valued on the basis of prices provided by an independent pricing service when, in the opinion of persons designated by the Fund's trustees, such prices are believed to reflect the fair market 14 value of such securities. Prices of non-exchange traded portfolio securities provided by independent pricing services are generally determined without regard to bid or last sale prices but take into account institutional size trading in similar groups of securities, yield, quality, coupon rate, maturity, type of issue, trading characteristics and other market data. Securities traded or dealt in upon a securities exchange and not subject to restrictions against resale as well as options and futures contracts listed for trading on a securities exchange or board of trade are valued at the last quoted sales price, or, in the absence of a sale, at the mean of the last bid and asked prices. Options not listed for trading on a securities exchange or board of trade for which over-the-counter market quotations are readily available are valued at the mean of the current bid and asked prices. Money market and short-term debt instruments with a remaining maturity of 60 days or less will be valued on an amortized cost basis. Securities not priced in a manner described above and other assets are valued by persons designated by the Fund's trustees using methods which the trustees believe accurately reflects fair value. The prices realized from the sale of these securities could be less than those originally paid by the Fund or less than what may be considered the fair value of such securities. For your initial investment, there is a $2,500 minimum required. The minimum initial investment for qualified pension plans (IRAs, Keoghs, etc.) is $2,000. The minimum subsequent investment is $100. (The foregoing minimum investments may be modified or waived at any time at our discretion). You may be charged a fee for effecting transactions in the Fund's shares through securities dealers, banks or other financial institutions. We charge no redemption fee when you redeem your shares and there is no charge for reinvestment of dividends or exchanges made between funds. Conditions of Purchase. Shares of the Fund may be purchased either directly from the Fund or through securities dealers, banks or other financial institutions. The Fund has a minimum initial purchase requirement of $2,500 and a minimum subsequent purchase requirement of $100. Subsequent purchases are made in the same manner as initial purchases. After a purchase order becomes effective, confirmation of the purchase is sent to the investor, and the purchase is credited to the investor's account. The Fund reserves the right to reject any purchase order, including purchases by exchange. Shares of the Fund may be purchased only in states where the shares are qualified for sale. Investors can purchase shares without a sales charge if they purchase shares directly from the Fund. However, investors may be charged a fee if they purchase shares through securities dealers, banks, or other financial institutions. Investors opening a new account for the Fund must complete and submit an account application along with payment of the purchase price for their initial investment. Investors purchasing additional shares of the Fund should include their account number with payment of the purchase price for additional shares being purchased. Investors may reopen an account with a minimum investment of $100 and without filing a new account application during the year in which the account was closed or during the following calendar year if information on the original application is still applicable. The Fund may require the filing of a statement that all information on the original application remains applicable. Methods of Payment Payment of the purchase price for shares of the Fund may be made in any of the following manners: Payment by wire: An expeditious method of purchasing shares is the transmittal of Federal Funds by bank wire to The Chase Manhattan Bank, N.A. To purchase shares by wire transfer, instruct a commercial bank to wire money to The Chase Manhattan Bank, N.A. ABA #021000021, Credit to: United States Trust Company of New York, A/C #920-1-073195, Further credit to: Fundamental Family of Funds, A/C #2073919. The wire transfer should be accompanied by the name, address, and social security number (in the case of new investors) or account number (in the case of persons already owning shares of the Fund). 15 Payment by check: Shares may also be purchased by check. Checks should be made payable to Fundamental Family of Funds, and mailed to Fundamental Shareholder Services, Inc., Agent, P.O. Box 1013, Bowling Green Station, New York, N.Y. 10274-1013. If your check does not clear, Fundamental Shareholder Services Inc. will cancel your purchase and you could be liable for any losses or fees incurred. The Fund reserves the right to limit the number of checks processed at any one time and will notify investors prior to exercising this right. Automatic Investment Program: The Fundamental Automatic Investment Program offers a simple way to maintain a regular investment program. The Fund has waived the initial investment minimum for you when you open a new account and invest $100 or more per month through the Fundamental Automatic Investment Program. The Fundamental Automatic Investment Program allows you to purchase shares (minimum of $50 per transaction) at regular intervals. Investments are made by transferring funds directly from your checking, or bank money market account. At your option investments can be made, once a month on either the fifth or the twentieth day, or twice a month on both days. To establish a Fundamental Automatic Investment Program, or to add this option to your existing account simply complete an authorization form, which can be obtained by calling 1-800-322-6864. You may cancel this privilege or change the amount you invest at any time. Initial Program setup and any modifications may take up to ten days to take effect. There is currently no charge for this service, and the Fund may terminate or modify this privilege at any time. REDEMPTION OF SHARES Each investor in the Fund has the right to cause the Fund to redeem his or her shares by making a request to Fundamental Shareholder Services, Inc. in accordance with either the regular redemption procedure, the telephone redemption privilege, the expedited redemption privilege, or the check redemption privilege, as described below. If Fundamental Shareholder Services, Inc. receives a redemption request before the close of trading on any day the New York Stock Exchange is open for trading, the redemption will become effective on that day and be made at the net asset value per share of the Fund, as determined at the close of trading on that day, and payment will be made on the following business day. If Fundamental Shareholder Services, Inc. receives a redemption request following the close of trading on the New York Stock Exchange, or on any day the New York Stock Exchange is not open for business, the redemption will become effective on the next day the New York Stock Exchange is open for trading and be made at the net asset value per share of the Fund, as determined at the close of trading on that day, and payment will be made on the following business day. Investors are entitled to receive all dividends on shares being redeemed that are declared on or before the effective date of the redemption of such shares. The net asset value per share of the Fund received by an investor on redeeming shares may be more or less than the purchase price per share paid by such investor, depending on the market value of the portfolio of the Fund at the time of redemption. Regular Redemption Procedure. Investors may redeem their shares by sending a written redemption request to Fundamental Shareholder Services, Inc., which request must specify the number of shares to be redeemed and be signed by the investor of record. For redemptions exceeding $50,000 (and for all written redemptions, regardless of amount, made within 30 days following any change in account registration), the signature of the investor on the redemption request must be guaranteed by an eligible guarantor institution approved by Fundamental Shareholder Services, Inc. Signature guarantees in proper form generally will be accepted from domestic banks, a member of a national securities exchange, credit unions and savings associations, as well as from participants in the Securities Transfer Agents Medallion Program ("STAMP"). If you have any questions with respect to signature guarantees, please call the transfer agent at (800) 322-6864. Fundamental Shareholder Services, Inc. may, at its option, request further documentation from corporations, executors, administrators, trustees, or guardians. If a redemption request is 16 sent to the Fund, the Fund will forward it to Fundamental Shareholder Services, Inc. Redemption requests will not become effective until all proper documents have been received by Fundamental Shareholder Services, Inc. Requests for redemption that are subject to any special condition or specify an effective date other than as provided herein cannot be accepted and will be returned to the investor. Telephone Redemption Privilege. An investor may, by either completing the appropriate section of the purchase application or by making a later written request to Fundamental Shareholder Services, Inc. containing his or her signature guaranteed by an eligible guarantor (see above), obtain the telephone redemption privilege for any of his or her accounts. Provided that your account registration has not changed within the last 30 days, an investor may redeem up to $150,000 worth of shares per day from an account for which he or she has the telephone redemption privilege by making a telephone redemption request to Fundamental Shareholder Services, Inc., at (800) 322-6864. Telephone calls may be recorded. A check for the proceeds of such a redemption will be issued in the name of the investor of record and mailed to the investor's address as it appears on the records of the Fund. Both the Fund and Fundamental Shareholder Services, Inc. reserve the right to refuse or limit a telephone redemption request, and may modify the telephone redemption privilege upon the giving of 60 days' prior notice. Neither the Fund nor the transfer agent will be liable for following instructions communicated by telephone that they reasonably believe to be genuine. It is the Fund's policy to provide that a written confirmation statement of all telephone call transactions be mailed to shareholders at their address of record within three business days after the telephone call transaction. Since you will bear the risk of loss, you should verify the accuracy of telephone transactions immediately upon receipt of your confirmation statement. Expedited Redemption Privilege. An investor in any series of the Trust may, by either completing the appropriate section of the purchase application or by later making a written request to Fundamental Shareholder Services, Inc., containing his or her signature guaranteed by an eligible guarantor (see above), obtain the expedited redemption privilege for any of his or her accounts. The expedited redemption privilege allows the investor to have the proceeds from any redemption of shares in an amount of $5,000 or more transferred by wiring Federal Funds to the commercial bank or savings and loan institution specified in his or her purchase application or written request for the expedited redemption privilege. The commercial bank or savings and loan institution specified must be a member of the Federal Reserve System. Expedited redemption requests may be made either by mail to the address specified under the regular redemption procedure or by telephone to the number specified under the telephone redemption privilege. The proceeds from such a redemption may be subject to a deduction of the usual and customary charge. An investor may change the account or commercial bank designated to receive the redemption proceeds by sending a written request to Fundamental Shareholder Services, Inc., containing his or her signature guaranteed in the manner described above. Both the Fund and Fundamental Shareholder Services, Inc. reserve the right to refuse or limit an expedited redemption request and to modify the expedited redemption privilege at any time. Check Redemption Privilege. An investor may, by either completing the appropriate section of the purchase application or by later making a written request to the Fund, obtain redemption checks for any of his or her accounts. These checks may be used by the investor in any lawful manner and may be payable to the order of any person or company in an amount of $100 or more. When a check is presented to Fundamental Shareholder Services, Inc. for payment, Fundamental Shareholder Services, Inc., as agent for the investor, will cause the Fund to redeem a sufficient number of shares in the investor's account to cover the amount of the check. Investors using the check redemption privilege will be subject to the same rules and regulations that are applicable to other checking accounts at United States Trust Company of New York. There is no charge to the investor for using the check redemption privilege, except that a fee may be imposed by Fundamental Shareholder Services, Inc., if an investor requests that it stop payment of a Redemption Check or if it cannot honor a Redemption Check due to insufficient funds or other valid reasons. The 17 check redemption privilege may not be used to close an account. The check redemption privilege may be modified or terminated at any time by either the Fund or Fundamental Shareholder Services, Inc. At times, the Fund may be requested to redeem shares for which it has not yet received good payment. The Fund may delay, or cause to be delayed, payment or redemption proceeds until such time as it has assured itself that good payment has been received for the purchase of such shares, which may take up to 15 days. In the case of payment by check, determination of whether the check has been paid by the paying institution can generally be made within 7 days, but may take longer. Investors may avoid the possibility of any such delay by purchasing shares by wire. In the event of delays in paying redemption proceeds, the Fund will take all available steps to expedite collection of the investment check. If shares were purchased by check, you may write checks against such shares only after 15 days from the date the purchase was executed. Shareholders who draw against shares purchased fewer than 15 days from the date of original purchase, will be charged usual and customary bank fees. The Fund reserves the right to suspend the right of redemption or postpone the day of payment with respect to its shares (1) during any period when the New York Stock Exchange is closed (other than customary weekend and holiday closings), (2) during any period when trading markets that the Fund normally uses are restricted or an emergency exists as determined by the Securities and Exchange Commission, so that disposing of the Fund's investments or determining its net asset value is not reasonably practicable, or (3) for such other periods as the Securities and Exchange Commission by order may permit to protect investors. If an investor's account has an aggregate net asset value of less than $100, the Fund may redeem the shares held in such account if the net asset value of such account has not been increased to at least $100 within 60 days of notice by the Fund to such investor of its intention to redeem the shares in such account. The Fund will not redeem the shares of an account with a net asset value of less than $100 if the account was reduced from the initial minimum investment to below $100 as a result of market activity. Transfers. An investor may transfer shares of the Fund by submitting to Fundamental Shareholder Services, Inc. a written request for transfer, signed by the registered holder of the shares and indicating the name, social security or taxpayer identification number of and distribution and redemption options elected by the new registered holder. Such request must be signature guaranteed. Fundamental Shareholder Services, Inc. may, at its option, request further documentation from transferors that are corporations, executors, administrators, trustees, or guardians. Tax Sheltered Retirement Plans. We offer a Prototype Pension and Profit Sharing Plan, including Keogh plans, IRAs, SEP-IRA Plans, IRA Rollover Accounts and 403(b) plans. Check redemption and telephone redemption privileges are not available to Retirement account holders. Plan support services are available by calling us at (800)322-6864. Exchange Privilege. For your convenience, the Exchange Privilege permits you to purchase shares in any of the other funds for which Fundamental Portfolio Advisors, Inc. acts as the investment manager in exchange for shares of the Fund at respective net asset values per share. Exchange instructions may be given in writing to Fundamental Shareholder Services, Inc., Agent, P.O. Box 1013, Bowling Green Station, New York, New York 10274-1013, the Fund's transfer agent, and must specify the number of shares of the Fund to be exchanged and the fund into which the exchange is being made. The telephone exchange privilege will be made available to shareholders automatically. You may telephone exchange instructions by calling Fundamental Shareholder Services, Inc. at (800) 322-6864. Before any exchange, you must obtain, and should review, a copy of the current prospectus of the fund into which your exchange is being made. Prospectuses may be obtained by calling or writing the Fund. See also "Telephone Redemption Privilege" for a discussion of the Fund's policy with respect to losses resulting from unauthorized telephone transactions. 18 The Exchange Privilege is only available in those states where such exchanges can legally be made and exchanges may only be made between accounts with identical account registration and account numbers. Prior to effecting an exchange, you should consider the investment policies of the fund in which you are seeking to invest. Any exchange of shares is, in effect, a redemption of shares in one fund and a purchase of the other fund. You may realize a capital gain or loss for Federal income tax purposes in connection with an exchange. The Exchange Privilege may be modified or terminated by the Fund after giving 60 days prior notice. The Fund reserves the right to reject any specific order, including purchases by exchange. A Completed Purchase Application must be received by the Transfer Agent before the Exchange, Check Redemption, Telephone Redemption or Expedited Redemption Privileges may be used. BROKERAGE ALLOCATION It is the Fund's policy to seek execution of its purchases and sales at the most favorable prices through responsible broker-dealers and in agency transactions, at competitive commission rates. The Fund's brokerage allocation policy may permit the Fund to pay a broker-dealer which furnishes research services a higher commission than that which might be charged by another broker-dealer which does not furnish research services, provided that such commission is deemed reasonable in relation to the value of the services provided by such broker-dealer (see the Statement of Additional Information for a complete discussion of the Fund's brokerage allocation policy). It is not the Fund's practice to allocate principal business on the basis of sales of Fund shares which may be made through brokers or dealers, although broker-dealers effecting purchases of Fund shares for their customers may participate in principal transactions or brokerage allocation. The Fund may, however, allocate principal business or brokerage to obtain for the benefit of the Fund services that the Fund would otherwise have to pay for directly. The Fund's trustees have authorized the Manager to effect portfolio transactions on an agency basis with affiliated broker-dealers, and has adopted certain procedures incorporating the standards of Rule 17e-1 of the 1940 Act, which requires that the commissions paid to any affiliated broker-dealer must be "reasonable and fair compared to the commission, fee, or other remuneration received, or to be received, by other brokers in connection with comparable transactions involving similar securities during a comparable period of time." DISTRIBUTION AGREEMENT AND MARKETING PLAN Distribution Agreement. Fundamental Service Corporation, ("FSC") 90 Washington Street, New York, New York, the Distributor, a Delaware corporation, which is an affiliated company of the Manager, acts as principal distributor of Fund shares. The Distributor has the exclusive right to distribute Fund shares directly or through other broker-dealers. The Distributor is reimbursed for distribution expenses pursuant to a Distribution and Marketing Plan (the "Marketing Plan"), adopted pursuant to Rule 12b-1 under the 1940 Act, which allows it to finance activities that are primarily intended to result in the sale of the Fund's shares, including but not limited to advertising, commissions, and salaries paid to registered representatives and marketing personnel of the Distributor, printing of prospectuses and reports for other than existing shareholders, preparation and distribution of advertising material and sales literature, and payments to dealers, banks and shareholder servicing agents who enter into agreements with the Manager or the Distributor for providing administrative and account maintenance services. Such services may include, without limitation, some or all of the following: answering Fund inquiries; assistance in changing dividend options, account registration and addresses; performance of sub-accounting; maintenance of shareholder accounts and records; assistance in processing purchase and redemption transactions; providing periodic statements showing a shareholder's account balance and the integration of such statements with those of other transactions and balances in the 19 shareholder's other accounts serviced by the Manager or the Distributor, if any; and such other information and services as the Fund reasonably may request, to the extent the Manager or Distributor is permitted by applicable statute, rule or regulation to provide such information or services. Marketing Plan. Pursuant to the Marketing Plan, the Fund may incur distribution expenses not to exceed .25% per annum of its average daily net assets. The Marketing Plan will only permit payments for expenses actually incurred by the Distributor or the Manager. The Marketing Plan allows for the carry-over of expenses from year to year and, if the Marketing Plan is terminated or not continued in accordance with its terms, the Fund's obligation to make payments to the Distributor (or Manager) pursuant to the Plan will cease and the Fund will not be required to make any payments past the date the Marketing Plan terminates. The Fund records all accruals made under the Marketing Plan as expenses in the calculation of its net investment income. The Fund may not accrue the amount of distribution expenses incurred by the Distributor that may be paid pursuant to the Marketing Plan in future periods as a liability, because it is believed that the standards for the accrual of a liability under generally accepted accounting principles will not have been satisfied. Such distribution expenses are recorded as an expense in future periods as they are accrued. Certain overhead expenses of the Distributor are also provided for under the Marketing Plan. During the year ended December 31, 1995, FSC waived all its fees earned under the marketing plan in the amount of $40,618. See "Distribution Agreement and Marketing Plan" in the Fund's Statement of Additional Information. PERFORMANCE INFORMATION Advertisements and communications to investors regarding the Fund may cite certain performance and ranking information and make performance comparisons to other funds or to relevant indices, as described below. The Fund's performance may be calculated both in terms of total return and also on the basis of current yield over any period of time and may include a computation of the Fund's distribution rate. Comparative Results. From time to time, the Fund may use hypothetical investment examples and performance information in advertisements, shareholder reports or other communications to shareholders. Because such performance information is based on historical earnings, it should not be considered as an indication or representation of the performance of the Fund in the future. From time to time, the performance and yield of the Fund may be quoted and compared to those of other mutual funds with similar investment objectives, unmanaged investment accounts, including savings accounts, money market funds, (or accounts), certificates of deposit, or other similar products and to stock or other relevant indices or to rankings prepared by independent services or other financial or industry publications that monitor the performance of mutual funds. For example, the performance of the Fund may be compared to data prepared by Lipper Analytical Services, Inc., Morningstar, Inc., and Value Line, widely recognized independent services which monitor the performance of mutual funds. Performance and yield data as reported in national financial publications including, but not limited to, Money Magazine, Forbes, Barron's, The Wall Street Journal, The New York Times, Businessweek and The Bond Buyer, or in local or regional publications, may also be used in comparing the performance and yield of the Fund. Additionally, the Fund may, with proper authorization, reprint articles written about the Fund and provide them to prospective shareholders. If a comparison of the Fund's performance to other similar funds or to relevant indices is made, the Fund's performance will be stated in the same terms in which such comparative data and indices are stated. Performance information will vary from time to time and past results are not necessarily representative of future results. The Fund's performance is a function of portfolio management in selecting the type and quality of portfolio securities, and is affected by operating, distribution and marketing expenses. Yield Information. The term "yield" refers to the income generated by an investment over a one-month or 30 day period. The income is computed by dividing the net investment income per share earned during such period by the 20 maximum public offering price per share on the last day of the period, and then annualizing such 30-day (or one month) yield in accordance with a formula prescribed by the Securities and Exchange Commission which provides for compounding on a semi-annual basis. Total Return. The Fund's performance information may also be calculated quarterly on a total return basis. All advertisements in which such information is included will show the average annual total return of an assumed initial investment of $1,000, reduced by the pro rata share of the account opening fee, at the end of one, five and ten year periods or, if such periods have not yet elapsed, at the end of a shorter period corresponding to the life of the Fund. These values will be calculated by multiplying the compounded average annual total return for each time period by the amount of the assumed initial investment, reduced by the pro rata share of the account opening fee. The total return basis combines principal and dividend income changes for the period shown. For purposes of computing total return, income dividends and capital gains distributions paid on shares of the Fund are assumed to have been reinvested when received. The Fund may also publish annual and cumulative total return figures from time to time. Distribution Rate. The Fund may also quote its distribution rate and/or its effective distribution rate in sales literature or other shareholder communications. The Fund's distribution rate is computed by dividing the most recent monthly distribution per share annualized by the current net asset value per share. The Fund's effective distribution rate is computed by dividing the distribution rate by the ratio used to annualize the distribution and reinvesting the resulting amount for a full year on the basis of such ratio. The effective distribution rate will be higher than the assumed reinvestment. The Fund's distribution rate may differ from its yield because the distribution rate may contain items of capital gain and other items of income. TAX MATTERS The Fund intends to qualify as a regulated investment company by satisfying the requirements under Subchapter M of the Internal Revenue Code of 1986, as amended (the "Code"), including the requirements with respect to diversification of assets, distribution of income and sources of income. It is the Fund's policy to distribute to shareholders all of its investment income (net of expenses) and any capital gains (net of capital losses) in accordance with the timing requirements imposed by the Code, so that the Fund will satisfy the distribution requirement of Subchapter M and not be subject to Federal income taxes or the 4% excise tax. If the Fund fails to satisfy any of the Code requirements for qualification as a regulated investment company, it will be taxed at regular corporate tax rates on all its taxable income (including capital gains) without any deduction for its distributions to shareholders, and distributions will be taxable to you as ordinary dividends (even if derived from the Fund's net long-term capital gains) to the extent of the Fund's current and accumulated earnings and profits. Distributions by the Fund of its net investment income and the excess, if any, of its net short-term capital gain over its net long-term capital loss are taxable to you as ordinary income. The distributions are treated as dividends for Federal income tax purposes, but will not qualify for the 70% dividends-received deduction for corporate shareholders. Distributions by the Fund of the excess, if any, of its net long-term capital gain over its net short-term capital loss are designated as capital gain dividends and are taxable to you as long-term capital gains, regardless of the length of time you have held your shares. Distributions to you will be treated in the same manner for Federal income tax purposes whether you elect to receive them in cash or reinvest them in additional shares. In general, you take distributions into account in the year in which they are made. However, you are required to treat certain distributions made during January as having been paid by the Fund and received by you on December 31 of the preceding year. A statement setting forth the Federal income tax status of all distributions made (or deemed made) during the year will be sent to you promptly after the end of each year. 21 If you are a non-resident alien or a foreign entity shareholder, ordinary income dividends paid to you generally will be subject to United States withholding tax at a rate of 30% (or a lower rate under an applicable treaty). If you are a non-U.S. shareholder we urge you to consult your own tax advisor concerning the applicability of the United States withholding tax. Under the back-up withholding rules of the Code, you may be subject to 31% withholding of Federal income tax on ordinary income dividends, capital gain dividends and redemption payments made by the Fund. In order to avoid this back-up withholding, you must provide the Fund with a correct taxpayer identification number (which if you are an individual is usually your Social Security number) and certify that you are a corporation or otherwise exempt from, or not subject to, back-up withholding. The foregoing discussion of Federal income tax consequences is based on tax laws and regulations in effect on the date of this Prospectus, and is subject to change by legislation or administrative action. As the foregoing discussion is for general information only, you should also review the more detailed discussion of Federal income tax considerations relevant to the Fund contained in the Fund's Statement of Additional Information. In addition, you should consult with your own tax advisor as to the tax consequences of an investment in the Fund. Ordinary income dividends paid by the Fund which are derived from interest income received by the Fund on Direct Obligations and certain Agency obligations are either fully or partially exempt from state and local personal income taxes in many states. The year-end tax information which the Fund will send to you will contain the percentage of ordinary income dividends paid by the Fund which were derived from interest received by the Fund on Direct Obligations and certain Agency obligations and which therefore may be exempt from state and local personal income taxes. You are advised to consult with your own tax advisors concerning the application of state and local income taxes to an investment in the Fund. OTHER INFORMATION Description of Shares The Fund is a diversified series of Fundamental Fixed-Income Fund, a Massachusetts business trust organized on March 19, 1987. Fundamental Fixed-Income Fund's Declaration of Trust permits its Board of Trustees to authorize the issuance of an unlimited number of full and fractional shares of beneficial interests (without par value), which may be divided into such separate series as the Trustees may establish. The Trustees have currently established three series of shares: the Fund, the High-Yield Municipal Bond Series and the Tax-Free Money Market Series. The Trustees may establish additional series of shares, and may divide or combine the shares of a series of the Fund into a greater or lesser number of shares without thereby changing the proportionate beneficial interests in such series. Each share of a series of the Trust represents an equal proportionate interest in such series with each other share of such series. The shares of any additional series would participate equally in the earnings, dividends and assets of the particular series, and would be entitled to vote separately to approve investment advisory agreements or changes in investment restrictions, but shareholders of all series would vote together in the election of trustees and selection of accountants. Upon liquidation of the Fund, each shareholder of the Fund would be entitled to share pro rata in the net assets available for distribution to shareholders of the Fund. Shareholders are entitled to one vote for each share held and may vote in the election of trustees and on other matters submitted to meetings of shareholders. Although trustees are not elected annually by the shareholders, shareholders have, under certain circumstances, the right to remove one or more trustees. No material amendment may be made to the Declaration of Trust without the affirmative vote of a majority of its shares. Shares have no preemptive or conversion rights. Shares are fully paid and non-assessable, except as set forth in the Fund's Statement of Additional Information. 22 Declaration of Trust-Certain Liabilities As a Massachusetts business trust, Fundamental Fixed-Income Fund's operations are governed by its Declaration of Trust, a copy of which is on file with the office of the Secretary of The Commonwealth of Massachusetts. See "Certain Liabilities" in the Fund's Statement of Additional Information. Litigation The Fund was named as a defendant in two class action lawsuits: Schur v. Fundamental U.S. Government Strategic Income Fund, et al., United States District Court, Southern District of New York; Vandyke, et al. v. Fundamental U.S. Government Strategic Income Fund, et al., United States District Court, Southern District of California (which has been transferred to the United States District Court, Southern District of New York). Also named as defendants in one or both of these actions were the Trust, the Manager, the Distributor, and alleged control persons of the Fund. The suits were filed in July and August of 1994, respectively, and alleged that the Fund invested in certain financial instruments, primarily "derivatives," that were inconsistent with the Fund's stated objectives as set forth in its prospectus. The suits claimed that defendants are liable under Sections 11 and/or 12 of the Securities Act of 1933 because there existed material misstatements or omissions in the prospectus that rendered it misleading. They also claimed that defendants are liable under Section 10(b) of the Securities and Exchange Act of 1934 (and Rule 10b-5 promulgated thereunder) for making material misstatements or omissions in connection with the purchase or sale of securities. The Vandyke action also alleged common law claims, including fraud. By Stipulation of Settlement dated April 5, 1996, a settlement requiring court approval was reached with the plaintiffs. If approved by the Court, the settlement will require a payment of approximately $500,000 or more under certain future circumstances by the Fund's investment adviser to the class members as set forth in the Stipulation of Settlement. Under no circumstances will the settlement result in any liability or cost to the Fund or its shareholders. The settlement will, however, result in the dismissal of the lawsuits and a release from liability issuing in favor of all defendants including the Fund. The Stipulation of Settlement also expressly states that the settlement does not constitute an admission of wrongdoing by the Fund or any of the other defendants. By Class Action Settlement Notice Order entered by the Court on April 15, 1996, the Court ordered, among other things, that a hearing on the settlement will occur on July 17, 1996. If the settlement is not successfully concluded, the Fund intends to contest the litigation vigorously. In addition, Management is cooperating in an investigation being conducted by the Securities and Exchange Commission concerning the Fund, the Manager and affiliated entities. Among other things, the investigation concerns the sufficiency of disclosures set forth in the Fund's prior advertising and prospectus, the consistency of the Fund's practices with those disclosures, the Fund's investment in inverse floating rate notes between 1993 and 1995, the valuation of the Fund's portfolio securities, and the Manager's designation of brokerage commissions or fees on portfolio transactions effected on behalf of the Fund and its affiliates in consideration of the receipt of research services. Code of Ethics The Code of Ethics of Fundamental Portfolio Advisors, Inc. and the Fund prohibits all affiliated personnel from engaging in personal investment activities which compete with or attempt to take advantage of the Fund's planned portfolio transactions. The objective of the Code of Ethics of both the Fund and Fundamental Portfolio Advisors, Inc. is that their operations be carried out for the exclusive benefit of the Fund's shareholders. Both organizations maintain careful monitoring of compliance with the Code of Ethics. 23 Transfer Agent and Shareholder Services Fundamental Shareholder Services, Inc. (also known as FSSI) is the transfer and dividend paying agent for shares of the Fund. Inquiries regarding the Fund should be addressed to FSSI. FSSI maintains an account for each shareholder in the Fund and all of the shareholder's transactions are recorded in this account. Confirmation statements showing details of transactions are sent to shareholders following each transaction, and each shareholder is sent a monthly account summary. Annual and semi-annual reports of the Fund together with the list of securities held by the Fund in its portfolio are mailed to each shareholder in the Fund. Shareholders whose shares are held in the name of an investment broker-dealer or other party will not normally have an account with the Fund and may not be able to use some of the services available. Custodian and Independent Accountants The Chase Manhattan Bank, N.A., 114 West 47th Street, New York, New York, acts as Custodian of the Fund's cash and securities. The Chase Manhattan Bank, N.A. also acts as bookkeeping agent for the Fund, and in that capacity, monitors the Fund's accounting records and calculates its net asset value. McGladrey & Pullen, LLP, 555 Fifth Avenue, New York, New York, acts as independent public accountants for the Fund, performing an annual audit of the Fund's financial statements and preparing its tax returns. Counsel Kramer, Levin, Naftalis, Nessen, Kamin & Frankel, 919 Third Avenue, New York, New York, act as counsel to the Fund. SHAREHOLDER INQUIRIES Shareholder inquiries concerning the status of an account should be directed to your securities dealer or to the Fund at (800) 322-6864. 24 Left Col. FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND 90 Washington Street New York NY 10006 1-800-225-6864 Transfer Agent Fundamental Shareholder Services, Inc. P.O. Box 1013 New York, NY 10274 1-800-322-6864 Counsel to the Fund Kramer, Levin, Naftalis, Nessen Kamin &Frankel New York, New York Independent Auditors McGladrey &Pullen, LLP New York, New York No person has been authorized to give any information or to make any representations other than those contained in this Prospectus and in the Funds official sales literature in connection with the offer of the Funds shares, and, if given or made, such other information or representations must not be relied upon as having been authorized by the Fund. This Prospectus does not constitute an offer in any State in which, or to any person to whom, such offering may not lawfully be made. USPR 042194 Right Col. FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND Prospectus April 25, 1996 FUNDAMENTAL Family of Funds FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND FUNDAMENTAL Family of Funds EX-99 2 STATEMENT OF ADDITIONAL INFORMATION Rule 497(c) Registration No.:33-12738 FUNDAMENTAL FIXED-INCOME FUND FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND 90 Washington Street 19th Floor New York, New York 10006 STATEMENT OF ADDITIONAL INFORMATION April 25, 1996 This Statement of Additional Information provides certain detailed information concerning the Fundamental U.S. Government Strategic Income Fund (the "U.S. Government Series"), a series of Fundamental Fixed-Income Fund (the "Fund"). The U.S. Government Series' objective is to provide you high current income with minimum risk of principal and relative stability of net asset value. Unlike bank deposits and certificates of deposit, the U.S. Government Series does not offer a fixed rate of return or provide the same stability of principal. Although the U.S. Government Series' investment manager attempts to maximize stability of net asset value, investment return and principal value will fluctuate with interest rate changes. The U.S. Government Series is not a money market fund and the value of your shares when you redeem them may be more or less than your original cost. The U.S. Government Series seeks to achieve its objective by investing primarily in U.S. Government obligations. U.S. Government obligations consist of marketable securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities. Direct obligations are issued by the United States Treasury and include bills, certificates of indebtedness, notes and bonds (hereinafter "Direct Obligations"). Obligations of U.S. Government agencies and instrumentalities ("Agencies") are issued by government sponsored agencies and enterprises acting under authority of Congress. The U.S. Government Series may also invest in repurchase agreements, may engage in certain options and futures transactions only as a defensive measure (i.e., as a hedge and not for speculation) to improve its liquidity and stabilize the value of its portfolio and may borrow money to purchase additional portfolio securities. Under normal market conditions, the U.S. Government Series will invest at least 65% of its total assets in Government Securities. Of course, there can be no assurance that the U.S. Government Series' investment objective will be achieved. This Statement of Additional Information is not a Prospectus and should be read in conjunction with the U.S. Government Series' current Prospectus, a copy of which may be obtained by writing to Fundamental Service Corporation at 90 Washington Street, 19th Floor, New York, New York 10006, or by calling 1 (800) 322-6864. This Statement of Additional Information relates to the U.S. Government Series' Prospectus dated April 25, 1996. THIS STATEMENT OF ADDITIONAL INFORMATION IS NOT A PROSPECTUS AND IS AUTHORIZED FOR DISTRIBUTION TO PROSPECTIVE INVESTORS ONLY IF PRECEDED OR ACCOMPANIED BY AN EFFECTIVE PROSPECTUS. -2- TABLE OF CONTENTS INVESTMENT OBJECTIVE AND POLICIES.......................................... 4 INVESTMENT LIMITATIONS..................................................... 13 MANAGEMENT OF THE FUND..................................................... 15 MARKETING PLAN............................................................. 19 INVESTMENT MANAGER......................................................... 21 PORTFOLIO TRANSACTIONS..................................................... 23 CUSTODIAN, INDEPENDENT ACCOUNTANTS and COUNSEL............................. 25 TAXES...................................................................... 25 DESCRIPTION OF SHARES...................................................... 32 CERTAIN LIABILITIES........................................................ 33 DETERMINATION OF NET ASSET VALUE........................................... 34 PERFORMANCE INFORMATION.................................................... 34 OTHER INFORMATION.......................................................... 37 FINANCIAL STATEMENTS....................................................... 37 -3- INVESTMENT OBJECTIVE AND POLICIES The Prospectus of the U.S. Government Series dated April 25, 1996 (the "Prospectus") identifies the investment objective and the principal investment policies of the U.S. Government Series. Other investment policies, investment limitations and a further description of certain of the policies described in the Prospectus are set forth below. Portfolio Turnover. Pursuit by the U.S. Government Series of its investment objective may lead to frequent changes in the securities held in its portfolio, which is known as "portfolio turnover." Portfolio turnover may involve payments by the U.S. Government Series of brokerage commissions, dealer spreads and other transaction costs relating to the purchase and the sale of securities. Portfolio turnover rate for a given fiscal year is calculated by dividing the lesser of the amount of the purchases or the amount of the sales of portfolio securities during the year by the monthly average of the value of the portfolio securities during the year. OPTIONS, FUTURES CONTRACTS AND RELATED OPTIONS CALL AND PUT OPTIONS Call and put options on various U.S. Treasury notes and U.S. Treasury bonds are listed and traded on Exchanges, and are written in over-the-counter transactions. Call and put options on Agencies are currently written or purchased only in over-the-counter transactions. WRITING CALL AND PUT OPTIONS PURPOSE. The principal reason for writing options is to obtain, through receipt of premiums, a greater current return than would be realized on the underlying securities alone. Such current return can be expected to fluctuate because premiums earned from an option writing program and interest income yields on portfolio securities vary as economic and market conditions change. Actively writing options on portfolio securities is likely to result in the U.S. Government Series having a substantially higher portfolio turnover rate than that of most other investment companies. Higher portfolio involves correspondingly greater brokerage commissions and other transaction costs, which are borne directly by the U.S. Government Series. WRITING OPTIONS. The purchaser of a call option pays a premium to the writer (i.e., the seller) for the right to buy the underlying security from the writer at a specified price during a -4- certain period. The U.S. Government Series writes call options either on a covered basis, or for cross-hedging purposes. A call option is covered if the U.S. Government Series owns or has the right to acquire the underlying securities subject to the call option at all times during the option period. Thus the U.S. Government Series may write options on Government Securities. An option is for cross-hedging purposes if it is not covered, but is designed to provide a hedge against a security which the U.S. Government Series owns or has the right to acquire. In such circumstances, the U.S. Government Series will collateralize the option by maintaining in a segregated account with the U.S. Government Series' Custodian, cash or Government Securities in an amount not less than the market value of the underlying security, marked to market daily, while the option is outstanding. The purchaser of a put option pays a premium to the writer (i.e., the seller) for the right to sell the underlying security to the writer at a specified price during a certain period. The U.S. Government Series would write put options only on a secured basis, which means that, at all times during the option period, the U.S. Government Series would maintain in a segregated account with its Custodian, cash, money market instruments or high grade liquid debt securities in an amount of not less than the exercise price of the option, or would hold a put on the same underlying security at an equal or greater exercise price. CLOSING PURCHASE TRANSACTIONS AND OFFSETTING TRANSACTIONS. In order to terminate its position as a writer of a call or put option, the U.S. Government Series could enter into a "closing purchase transaction," which is the purchase of a call (put) on the same underlying security and having the same exercise price and expiration date as the call (put) previously written by the U.S. Government Series. The U.S. Government Series would realize a gain (loss) if the premium plus commission paid in the closing purchase transaction is less (greater) than the premium it received on the sale of the option. The U.S. Government Series would also realize a gain if an option it has written lapses unexercised. The U.S. Government Series can write options that are listed on an Exchange as well as options which are privately negotiated in over-the-counter transactions. The U.S. Government Series can close out its position as a writer of an option only if a liquid secondary market exists for options of that series, but there is no assurance that such a market will exist, particularly in the case of over-the-counter options, since they can be closed out only with the other party to the transaction. Alternatively, the U.S. Government Series could purchase an offsetting option, which would not close out its position as a writer, but would provide an asset of equal value to its obligation under the option written. If the U.S. Government Series is not able to enter into a closing purchase transaction or to purchase an offsetting option -5- with respect to an option it has written, it will be required to maintain the securities subject to the call or the collateral securing the option until a closing purchase transaction can be entered into (or the option is exercised or expires), even though it might not be advantageous to do so. RISKS OF WRITING OPTIONS. By writing a call option, the U.S. Government Series loses the potential for gain on the underlying security above the exercise price while the option is outstanding; by writing a put option, the U.S. Government Series might become obligated to purchase the underlying security at an exercise price that exceeds the then current market price. PURCHASING CALL AND PUT OPTIONS The U.S. Government Series may purchase either listed or over-the-counter options. The U.S. Government Series may purchase call options to protect (i.e., hedge) against anticipated increases in the price of securities it wishes to acquire. Since the premium paid for a call option is typically a small fraction of the price of the underlying security, a given amount of funds will purchase call options covering a much larger quantity of such security than could be purchased directly. By purchasing call options, the U.S. Government Series could benefit from any significant increase in the price of the underlying security to a greater extent than if it had invested the same amount in the security directly. However, because of the very high volatility of option premiums, the U.S. Government Series would bear a significant risk of losing the entire premium if the price of the underlying security did not rise sufficiently, or if it did not do so before the option expired. Conversely, put options may be purchased to protect (i.e., hedge) against anticipated declines in the market value of either specific portfolio securities or of the U.S. Government Series' assets generally. The U.S. Government Series will not purchase call or put options on securities if as a result, more than ten percent of its net assets would be invested in premiums on such options. INTEREST RATE FUTURES CONTRACTS The U.S. Government Series may engage in transactions involving futures contracts and related options in accordance with the rules and interpretations of the Commodity Futures Trading Commission ("CFTC") under which the U.S. Government Series would be exempt from registering as a "commodity pool." An interest rate futures contract is an agreement pursuant to which a party agrees to take or make delivery of a specified -6- debt security (such as U.S. Treasury bonds, U.S. Treasury notes, U.S. Treasury bills and GNMA Certificates) at a specified future time and at a specified price. Interest rate futures contracts also include cash settlement contracts based upon a specified interest rate such as the London Interbank Offering Rate for dollar deposits ("LIBOR"). INITIAL AND VARIATION MARGIN. In contrast to the purchase or sale of a security, no price is paid or received upon the purchase or sale of a futures contract. Initially, the U.S. Government Series will be required to deposit with its Custodian in an account in the broker's name an amount of cash, money market instruments or liquid high-grade debt securities equal to not more than five percent of the contract amount. This amount is known as "initial margin." The nature of initial margin in futures transactions is different from that of margin in securities transactions in that futures contract margin does not involve the borrowing of funds by the customer to finance the transaction. Rather, the initial margin is in the nature of a performance bond or good faith deposit on the contract, which is returned to the U.S. Government Series upon termination of the futures contract and satisfaction of its contractual obligations. Subsequent payments to and from the broker, called "variation margin," will be made on a daily basis as the price of the underlying security fluctuates, making the long and short positions in the futures contract more or less valuable, a process known as "marking to market." For example, when the U.S. Government Series has purchased a futures contract and the price of the underlying security has risen, that position will have increased in value, and the U.S. Government Series will receive from the broker a variation margin payment equal to that increase in value. Conversely, when the U.S. Government Series has purchased a futures contract and the value of the underlying security has declined, the position would be less valuable, and the U.S. Government Series would be required to make a variation payment to the broker. At any time prior to expiration of the futures contract, the U.S. Government Series may elect to terminate the position by taking an opposite position. A final determination of variation margin is then made, additional cash is required to be paid by or released to the U.S. Government Series, and the U.S. Government Series realizes a loss or a gain. FUTURES STRATEGIES. When the U.S. Government Series anticipates a significant market or market sector advance, the purchase of a futures contract affords a hedge against not participating in the advance at a time when the U.S. Government Series is not fully invested ("anticipatory hedge"). Such purchase of a futures contract would serve as a temporary substitute for the purchase of individual securities, which may be purchased in an -7- orderly fashion once the market is established. As individual securities are purchased, an equivalent amount of futures contracts can then be terminated by offsetting sales. The U.S. Government Series may sell futures contracts in anticipation of, or during, a general market or market sector decline that may adversely affect the market value of the U.S. Government Series' securities ("defensive hedge"). To the extent that the U.S. Government Series' portfolio of securities changes in value in correlation with the underlying security, the sale of futures contracts would substantially reduce the risk to the U.S. Government Series of a market decline and, by so doing, provide an alternative to the liquidation of securities positions in the U.S. Government Series. Ordinarily, commissions on futures transactions are lower than transaction costs incurred in the purchase and sale of Government Securities. Transactions will be entered into by the U.S. Government Series only with brokers or financial institutions deemed creditworthy by the Manager. However, in the event of the bankruptcy of a broker through which the U.S. Government Series engages in transactions in listed options, futures or related options, the U.S. Government Series might experience delays and/or losses in liquidating open positions purchased and/or incur a loss of all or part of its margin deposits with the broker. SPECIAL RISKS ASSOCIATED WITH FUTURES TRANSACTIONS. There are several risks connected with the use of futures contracts as a hedging device. These include the risk of imperfect correlation between movements in the price of the futures contracts and of the underlying securities, the risk of market distortion, the illiquidity risk and the risk of error in anticipating price movement. There may be an imperfect correlation (or no correlation) between movements in the price of the futures contracts and the securities being hedged. The risk of imperfect correlation increases as the composition of the securities being hedged diverges from the securities upon which the futures contract is based. If the price of the futures contract moves less than the price of the securities being hedged, the hedge will not be fully effective. To compensate for the imperfect correlation, the U.S. Government Series could buy or sell futures contracts in a greater dollar amount than the dollar amount of securities being hedged if the historical volatility of the securities being hedged is greater than the historical volatility of the securities underlying the futures contract. Conversely, the U.S. Government Series could buy or sell futures contracts in a lesser dollar amount than the dollar amount of securities being hedged if the historical volatility of the securities being hedged is less than the historical volatility of the securities underlying the futures contract. It is also possible that the value of futures contracts held by the U.S. -8- Government Series could decline at the same time as portfolio securities being hedged; if this occurred, the U.S. Government Series would lose money on the futures contract in addition to suffering a decline in value in the portfolio securities being hedged. There is also the risk that the price of a futures contract may not correlate perfectly with movements in the securities underlying the futures contract due to certain market distortions. First, all participants in the futures market are subject to margin depository and maintenance requirements. Rather than meet additional margin depository requirements, investors may close futures contracts through offsetting transactions, which could distort the normal relationship between the futures market and the securities underlying the futures contract. Second, from the point of view of speculators, the deposit requirements in the futures markets are less onerous than margin requirements in the securities markets. Therefore, increased participation by speculators in the futures markets may cause temporary price distortions. Due to the possibility of price distortion in the futures markets and because of the imperfect correlation between movements in futures contracts and movements in the securities underlying them, a correct forecast of general market trends by the Manager may still not result in a successful hedging transaction judged over a very short time frame. There is also the risk that futures markets may not be sufficiently liquid. Futures contracts may be closed out only on an Exchange or board of trade that provides a market for such futures contracts. Although the U.S. Government Series intends to purchase or sell futures only on Exchanges and boards of trade where there appears to be an active secondary market, there can be no assurance that an active secondary market will exist for any particular contract or at any particular time. In the event of such illiquidity, it may not be possible to close a futures position and, in the event of adverse price movement, the U.S. Government Series would continue to be required to make daily payments of variation margin. Since the securities being hedged would not be sold until the related futures contract is sold, an increase, if any, in the price of the securities may to some extent offset losses on the related futures contract. In such event, the U.S. Government Series would lose the benefit of the appreciation in value of the securities. Successful use of futures is also subject to the Manager's ability to correctly predict the direction of movements in the market. For example, if the U.S. Government Series hedges against a decline in the market and market prices instead advance, the U.S. Government Series will lose part or all of the benefit of the increase in value of its securities holdings because it will have offsetting losses in futures contracts. In such cases, if the U.S. -9- Government Series has insufficient cash, it may have to sell portfolio securities at a time when it is disadvantageous to do so in order to meet the daily variation margin. The use of futures contracts to shorten the weighted average duration of the U.S. Government Series' portfolio, while reducing the exposure of the U.S. Government Series' portfolio to interest rate risk does subject the U.S. Government Series' portfolio to basis risk. Basis refers to the relationship between a futures contract and the underlying security. In the case of futures contracts on U.S. Treasury Bonds, the contract specifies delivery of a "bench-mark" 8% 20 year U.S. Treasury Bond. Any outstanding treasury with a maturity of more than 15 years is deliverable against the contract, with the principal amount per contract adjusted according to a formula which takes into account the coupon and maturity of the treasury bond being delivered. This means that at any given time there is one treasury issue that is "the cheapest to deliver" against the contract. The supply and demand of the available float of treasury securities determines which treasury security is cheapest to deliver at any given time. This, combined with the supply and demand for futures relative to the underlying cash securities markets, causes the relationship between the cash security markets and the futures markets to exhibit perturbations of variance from an exact one-to-one correlation. The U.S. Government Series could experience losses if the value of the prices of the futures positions the U.S. Government Series has entered into are poorly correlated with the U.S. Government Series' other investments. For example, on a day that the price on a treasury bond deliverable against the futures contract declined by ten points, the futures contract might decline by nine or eleven points. In this example, a nine point decline in the price of a futures contract would not fully offset the price decline in the cash security price. This would cause a downward fluctuation in the value of the U.S. Government Series' portfolio. Likewise, a basis fluctuation whereby the futures prices fell more or rose less than the cash securities prices due to basis change would cause an upward fluctuation in the value of the U.S. Government Series' portfolio. CFTC regulations require, among other things, (i) that futures and related options be used solely for bona fide hedging purposes (or that the underlying commodity value of the U.S. Government Series' long futures positions not exceed the sum of certain identified liquid investments) and (ii) that the U.S. Government Series not enter into futures and related options for which the aggregate initial margin and premiums exceed five percent of the fair market value of the U.S. Government Series' assets. In order to minimize leverage in connection with the purchase of futures contracts by the U.S. Government Series, an amount of cash, -10- money market instruments or liquid high grade debt securities equal to the market value of the obligations under the futures contracts (less any related margin deposits) will be maintained in a segregated account with the Custodian. OPTIONS ON FUTURES CONTRACTS The U.S. Government Series may also purchase and write options on futures contracts. An option on a futures contract gives the purchaser the right, in return for the premium paid, to assume a position in a futures contract (a long position if the option is a call and a short position if the option is a put), at a specified exercise price at any time during the option period. As a writer of an option on a futures contract, the U.S. Government Series would be subject to initial margin and maintenance requirements similar to those applicable to futures contracts. In addition, net option premiums received by the U.S. Government Series are required to be included as initial margin deposits. When an option on a futures contract is exercised, delivery of the futures position is accompanied by cash representing the difference between the current market price of the futures contract and the exercise price of the option. The U.S. Government Series can purchase put options on futures contracts in lieu of, and for the same purpose as selling a futures contract. The purchase of call options on futures contracts would be intended to serve the same purpose as the actual purchase of the futures contract. RISKS OF TRANSACTIONS IN OPTIONS ON FUTURES CONTRACTS. In addition to the risks described above which apply to all options transactions, there are several special risks relating to options on futures. The Manager will not purchase options on futures on any Exchange unless in the Manager's opinion, a liquid secondary Exchange market for such options exists. Compared to the use of futures, the purchase of options on futures involves less potential risk to the U.S. Government Series because the maximum amount at risk is the premium paid for the options (plus transaction costs). However, there may be circumstances, such as when there is no movement in the price of the underlying security, where the use of an option on a future would result in a loss to the U.S. Government Series whereas the use of a future would not. ADDITIONAL RISKS TO OPTIONS AND FUTURES TRANSACTIONS Each of the Exchanges has established limitations governing the maximum number of call or put options on the same underlying security or futures contract (whether or not covered) which may be written by a single investor, whether acting alone or in concert with others (regardless of whether such options are written on the same or different Exchanges or are held or written -11- on one or more accounts or through one or more brokers). Option positions of all investment companies advised by the Manager are combined for purposes of these limits. An Exchange may order the liquidation of positions found to be in violation of these limits and it may impose other sanctions or restrictions. These position limits may restrict the number of listed options which the U.S. Government Series may write. Although the U.S. Government Series intends to enter into futures contracts only if there is an active market for such contracts, there is no assurance that an active market will exist for the contracts at any particular time. Most U.S. futures exchanges and boards of trade limit the amount of fluctuation permitted in futures contract prices during a single trading day. Once the daily limit has been reached in a particular contract, no trades may be made that day at a price beyond that limit. It is possible that futures contract prices would move to the daily limit for several consecutive trading days with little or no trading, thereby preventing prompt liquidation of futures positions and subjecting some futures traders to substantial losses. In such event, and in the event of adverse price movements, the U.S. Government Series would be required to make daily cash payments of variation margin. In such circumstances, an increase in the value of the portion of the portfolio being hedged, if any, may partially or completely offset losses on the futures contract. However, there is no guarantee that the price of the securities being hedged will, in fact, correlate with the price movements in a futures contract and thus provide an offset to losses on the futures contract. Certain additional risks relate to the fact that the U.S. Government Series might purchase and sell options on mortgage-related securities. Since the remaining principal balance of mortgage-related securities declines each month as a result of mortgage payments, if the U.S. Government Series has written a call and is holding such securities as "cover" to satisfy its delivery obligation in the event of exercise, it may find that the securities it holds no longer have a sufficient remaining principal balance for this purpose. Should this occur, the U.S. Government Series would purchase additional mortgage-related securities from the same pool (if obtainable) or replacements in the cash market in order to maintain its cover. A mortgage-related security held by the U.S. Government Series to cover an option position in any but the nearest expiration month may cease to represent cover for the option in the event of a decrease in the coupon rate at which new pools are originated. If this should occur, the option would no longer be covered, and the U.S. Government Series would either enter into a closing purchase transaction or replace the mortgage-related security with one which represents cover. In either case, the U.S. Government Series may realize an unanticipated loss and incur additional transactions costs. -12- INVESTMENT LIMITATIONS The U.S. Government Series has adopted the following policies as "fundamental policies," which cannot be changed without the approval of the holders of a majority of the shares of the U.S. Government Series (which, as used in this Statement of Additional Information, means the lesser of (i) more than 50% of the outstanding shares, or (ii) 67% or more of the shares present at a meeting at which holders of more than 50% of the outstanding shares are represented in person or by proxy). The U.S. Government Series may not: 1. Purchase the securities of any one issuer, other than obligations issued or guaranteed by the U.S. Government or its agencies or instrumentalities, if, immediately after such purchase, (i) more than 5% of the value of its total assets would be invested in such issuer, or (ii) it would own more than 10% of the outstanding voting securities of such issuer; except that up to 25% of the value of its total assets may be invested without regard to such limitations. 2. Invest 25% or more of its total assets in a single industry; provided, however, that such limitation shall not be applicable to obligations issued or guaranteed by the U.S. Government, its agencies or instrumentalities. 3. Issue senior securities, as defined in the Investment Company Act of 1940 (the "1940 Act"), except to the extent such issuance might be involved with borrowings described under subparagraph (4) below or with respect to hedging and risk management transactions or the writing of options within limits described in the U.S. Government Series' current Prospectus. 4. Borrow money, except for temporary or emergency purposes, or by engaging in reverse repurchase transactions, and then only in an amount not exceeding one-third of the U.S. Government Series' total assets, including the amount borrowed. The U.S. Government Series will not mortgage, pledge or hypothecate any assets except to secure permitted borrowings and reverse repurchase transactions. Collateral arrangements with respect to the U.S. Government Series' permissible futures and options transactions, including initial and variation margin, are not considered to be a pledge of assets for purposes of this restriction. 5. Make loans of money or property to any person, other than by entering into repurchase agreements, and except to the extent the securities in which the U.S. Government Series may invest are considered to be loans. -13- 6. Buy any securities "on margin". Neither the deposit of initial or variation margin in connection with hedging and risk management transactions nor short-term credits as may be necessary for the clearance of transactions is considered the purchase of a security on margin. 7. Sell any securities "short", write, purchase or sell puts, calls or combinations thereof, or purchase or sell financial futures or options, except as described under the heading "Certain Investment Techniques and Policies" in the U.S. Government Series' current Prospectus. 8. Act as an underwriter of securities, except to the extent the U.S. Government Series may be deemed to be an underwriter in connection with the sale of securities held in its portfolio. 9. Make investments for the purpose of exercising control or participation in management. 10. Invest in securities of other investment companies in an amount exceeding the limitations set forth in the 1940 Act and the rules thereunder, except as part of a merger, consolidation or other acquisition. 11. Invest in equity interests in oil, gas or other mineral exploration or development programs. 12. Purchase or sell real estate (but this shall not prevent investments in securities secured by real estate or interests therein), commodities or commodity contracts, except to the extent that financial futures and related options that the U.S. Government Series may invest in are considered to be commodities or commodities contracts. 13. Invest more than 10% of the U.S. Government Series' total assets in illiquid securities and repurchase agreements with remaining maturities in excess of seven days. Operating Policies. The U.S. Government Series has adopted the following operating policies which are not fundamental and which may be changed without shareholder approval: To comply with certain state statutes, the U.S. Government Series will not: (1) make investments in oil, gas or other mineral leases; (2) make investments in real estate limited partnerships; (3) purchase or retain securities of an issuer when one or more officers and trustees of the Fund or the Fund's Manager, or a person owning more than 10% of the shares of either, own beneficially more than 1/2 of 1% of the securities of such issuer and such persons owning more than 1/2 of 1% of such securities together own beneficially more than 5% of the securities of such issuer; -14- (4) purchase securities of other investment companies, except in connection with a merger, consolidation, acquisition or reorganization, or by purchase in the open market of securities of open-end or closed-end investment companies where no underwriter or dealer's commission or profit, other than customary broker's commission, is involved; or (5) invest more than 15% of its total assets in the securities of issuers which together with any predecessors have a record of less than three years continuous operation or securities of issuers which are restricted as to disposition. Percentage Restrictions. If a percentage restriction on investment or utilization of assets set forth above is adhered to at the time an investment is made or assets are so utilized, a later change in percentage resulting from changes in the value of the portfolio securities of the U.S. Government Series will not be considered a violation of such policy. MANAGEMENT OF THE FUND The Fund's Board of Trustees provides broad supervision over the affairs of the Fund and of the U.S. Government Series. The officers of the Fund are responsible for the operations of the U.S. Government Series. The Trustees and executive officers of the Fund are listed below, together with their principal occupations for at least the last five years. Each Trustee who is considered to be an "interested person" of the Fund, as defined by the 1940 Act, is indicated by an asterisk (*). JAMES C. ARMSTRONG: Trustee of the Fund. Mr. Armstrong is a partner in Armstrong/Seltzer Communications Inc., a New York management, consulting, and public relations firm. He was formerly Executive Director, Global Public Affairs Institute at New York University and Professor, Bell of Pennsylvania Chair in Telecommunications, Temple University, and is a management consultant. He was with American Telephone and Telegraph Company for 15 years. His last position with AT&T was Director, Corporate Policy Analysis. Mr. Armstrong previously held positions at the Institute for Defense Analysis, the Office of the Postmaster General, and on the faculty of the University of Maryland. He has been a consultant to government, academic and business organizations, and has served on various government-industry task forces and committees. Mr. Armstrong was an Officer in the United States Navy and holds a Ph.D. in nuclear physics. Mr. Armstrong's address is 51 Mt. Pleasant Road, Morristown, New Jersey 07960. JAMES A. BOWERS: Trustee of the Fund. Mr. Bowers is a consultant for Prototypes (formerly, Director of Finance and Administration), The American Telephone and Telegraph Company, The RAND Corporation and CogniTech Services Corporation. He was -15- employed at AT&T for 23 years. His latest position with AT&T was in the Treasury Department as District Manager-Securities and Exchange Commission Reporting. Mr. Bowers holds Bachelor of Science and Master of Arts degrees in Economics from Florida Atlantic University. Mr. Bowers' address is 60 East Eighth Street, New York, N.Y. 10003. CLARK L. BULLOCK: Trustee of the Fund. Mr. Bullock is Chairman of the Board of Shelter Rock Investors Services Corp., a privately-held, New York-based investment company. Mr. Bullock received a Masters of Science degree in Mathematical Economics from Purdue University in 1972 and a Bachelor of Arts degree in International Relations from the University of Arizona. Mr. Bullock's address is c/o Shelter Rock Investors, 150 Hopper Avenue, Waldwick, New Jersey 07463. L. GREG FERRONE: Trustee of the Fund. Mr. Ferrone is a consultant with IntraNet, Inc., a provider of computer systems to the domestic and international banking industry. Previously he was the Director of Sales & Marketing for RAV Communications Inc., Vice President/Regional Manager with National Westminster Bank USA and an officer at Security Pacific Bank. Mr. Ferrone received a Bachelor of Science degree from Rensselaer Polytechnic Institute in 1972 and studied at the Stonier Graduate School of Banking. Mr. Ferrone's address is 83 Ronald Court, Ramsey, New Jersey 07446. *VINCENT J. MALANGA: Chairman of the Board, Chief Executive Officer, President and Treasurer of the Fund, The California Muni Fund and Fundamental Funds, Inc. Mr. Malanga is President, Treasurer and a Director of Fundamental Portfolio Advisors, Inc., Executive Vice President, Secretary and a Director of Fundamental Service Corporation, and President of LaSalle Economics Inc., an economic consulting firm. Mr. Malanga is Vice President, Secretary and a 50% shareholder of LaSalle Portfolio Management, Inc., the general partner of both LPM Financial Futures Fund I, Limited Partnership and LPM Equities Fund Limited Partnership. Prior thereto, he was a Vice President and Senior Economist at A. Gary Shilling & Company, Inc., an economic consulting and brokerage firm. He previously served as an Economist at White, Weld & Co. (an investment banking and brokerage firm) from 1976 to 1978. Prior thereto, Mr. Malanga, who holds a Ph.D. in Economics from Fordham University, was an Economist at the Federal Reserve Bank of New York. Mr. Malanga's address is 90 Washington Street, 19th Floor, New York, New York 10006. DAVID P. WIEDER: Vice President of the Fund. Secretary of Fundamental Portfolio Advisors, Inc., and President and a Director of Fundamental Shareholder Services, Inc. Mr. Wieder holds a Bachelor of Science degree in Economics from Cornell -16- University. Mr. Wieder's address is 90 Washington Street, 19th Floor, New York, New York 10006. CAROLE M. LAIBLE: Secretary of the Fund. Treasurer and Secretary of Fundamental Shareholder Services, Inc. She was formerly a General Service Manager for McGladrey & Pullen. Ms. Laible received a Bachelor of Science degree from St. John's University in 1986. Ms. Laible's address is 90 Washington Street, 19th Floor, New York, New York 10006. All of the Trustees of the Fund are also Directors of New York Muni Fund, Inc. and Trustees of The California Muni Fund. All of the officers of the Fund hold similar offices with Fundamental Funds, Inc. and The California Muni Fund. The U.S. Government Series does not pay any salary or compensation to any of its officers, all of whom are officers or employees of Fundamental Portfolio Advisors, Inc. (the "Manager"). For services and attendance at board meetings and meetings of committees which are common to the Fund, Fundamental Funds, Inc. and The California Muni Fund (other affiliated mutual funds for which the Manager acts as the investment advisor), each Trustee of the Fund who is not affiliated with the Manager is compensated at the rate of $6,500 per quarter prorated among the three funds based on their respective net assets at the end of each quarter. Each such Trustee is also reimbursed by the three funds, on the same basis, for actual out-of-pocket expenses relating to his attendance at meetings. The Manager pays the compensation of the Fund's officers and of the one Trustee that is affiliated with the Manager. For the fiscal year ended December 31, 1995, trustees' fees totalling $25,164 were paid by the Fund to the Trustees as a group ($468 for the High-Yield Municipal Bond Series, $18,072 for the Tax Free Money Market Series and $6,624 for the U.S. Government Series). -17- COMPENSATION TABLE (FOR EACH CURRENT BOARD MEMBER RECEIVING COMPENSATION FROM A FUNDAMENTAL FUND FOR THE MOST RECENTLY COMPLETED FISCAL YEAR) AGGREGATE COMPENSATION FROM FUND AGGREGATE COMPENSATION PAID BY ALL HIGH- U.S. FUNDS MANAGED YIELD TAX- GOV'T BY CALI- MUNI- FREE STRA- FUNDAMENTAL FORNIA CIPAL MONEY TEGIC PORTFOLIO NAME NY MUNI MUNI BOND MARKET INCOME ADVISORS, INC. - ---- ------- ---- ---- ------ ------ -------------- James C. Armstrong $18,333 $1,376 $117 $4,518 $1,656 $26,000 James A. Bowers 18,333 1,376 117 4,518 1,656 26,000 Clark L. Bullock 18,333 1,376 117 4,518 1,656 26,000 L. Greg Ferrone 18,333 1,376 117 4,518 1,656 26,000 Transfer Agent Fundamental Shareholder Services, Inc., P.O. Box 1013, Bowling Green Station, New York, New York 10274-1013, an affiliate of Fundamental Portfolio Advisors, Inc. and Fundamental Service Corporation, performs all services in connection with the transfer of shares of the U.S. Government Series, acts as its dividend disbursing agent, and as administrator of the exchange, check redemption, telephone redemption and expedited redemption privileges of the U.S. Government Series pursuant to a Transfer Agency and Service Agreement dated January 31, 1992. During the fiscal year ended December 31, 1995, fees paid to the Transfer Agent by the U.S. Government Series amounted to $62,540. -18- MARKETING PLAN As discussed in the Prospectus, the Fund has entered into a Distribution Agreement with Fundamental Service Corporation ("FSC"). FSC is a Delaware corporation which is owned approximately 43.7% by each of Messrs. Thomas W. Buckingham, a consultant to the Manager, and Vincent J. Malanga, a Trustee and officer of the Fund and a director and officer of the Manager, and 9.8% by Dr. Lance M. Brofman, an employee of the Manager. The Trustees who are not, and were not at the time they voted, interested persons of the Fund, as defined in the 1940 Act (the "Independent Trustees"), have approved the Distribution Agreement. The Distribution Agreement provides that FSC will bear the distribution expenses of the U.S. Government Series not borne by the U.S. Government Series. The Distribution Agreement was last approved by the Board of Trustees of the Fund on October 18, 1995. FSC bears all expenses it incurs in providing services under the Distribution Agreement. Such expenses include compensation to it and to securities dealers and other financial institutions and organizations such as banks, trust companies, savings and loan associations and investment advisors for distribution related and/or administrative services performed for the U.S. Government Series. FSC also pays certain expenses in connection with the distribution of the U.S. Government Series' shares, including the cost of preparing, printing and distributing advertising or promotional materials, and the cost of printing and distributing prospectuses and supplements thereto to prospective shareholders. The U.S. Government Series bears the cost of registering its shares under Federal and state securities laws. The Fund and FSC have agreed to indemnify each other against certain liabilities, including liabilities under the Securities Act of 1933, as amended. Under the Distribution Agreement, FSC will use its best efforts in rendering services to the Fund. The Fund has adopted a plan of distribution pursuant to Rule 12b-1 under the 1940 Act (the "Plan") pursuant to which the U.S. Government Series pays FSC compensation accrued daily and paid monthly at the annual rate of .25% of the U.S. Government Series' average daily net assets. The Plan was adopted by a majority vote of the Board of Trustees, including all of the Independent Trustees (none of whom had or have any direct or indirect financial interest in the operation of the Plan), cast in person at a meeting called for the purpose of voting on the Plan on January 31, 1992 and by the shareholders of the U.S. Government Series on February 18, 1992. Pursuant to the Plan, FSC provides the Fund, for review by the Trustees, and the Trustees review, at least quarterly, a -19- written report of the amounts expended under the Plan and the purpose for which such expenditures were made. No interested person of the Fund nor any Trustee of the Fund who is not an interested person of the Fund, as defined in the 1940 Act, has any direct financial interest in the operation of the Plan except to the extent that FSC and certain of its employees may be deemed to have such an interest as a result of receiving a portion of the amounts expended thereunder by the Fund. The Plan will continue in effect until December 31, 1996. The Plan will continue in effect from year-to-year thereafter, provided such continuance is approved annually by vote of the Trustees in the manner described above. It may not be amended to increase materially the amount to be spent for the services described therein without approval of the shareholders of the Fund, and material amendments of the Plan must also be approved by the Trustees in the manner described above. The Plan may be terminated at any time, without payment of any penalty, by vote of the majority of the Trustees who are not interested persons of the Fund, and with no direct or indirect financial interest in the operations of the Plan, or by a vote of a majority of the outstanding voting securities of the Fund (as defined in the 1940 Act). The Plan will automatically terminate in the event of its assignment (as defined in the 1940 Act). So long as the Plan is in effect, the election and nomination of the Independent Trustees shall be committed to the discretion of the Independent Trustees. In the Trustees' quarterly review of the Plan, they will consider its continued appropriateness and the level of compensation provided therein. During the year ended December 31, 1995, amounts incurred by the Fund under the plan aggregated $40,695 for advertising, and printing and mailing of prospectuses to other than current shareholders. The Glass-Steagall Act prohibits banks from engaging in the business of underwriting, selling or distributing securities. Although the scope of this prohibition under the Glass-Steagall Act has not been clearly defined by the courts or appropriate regulatory agencies, FSC believes that the Glass-Steagall Act should not preclude a bank from performing shareholder support services, servicing and recordkeeping functions. FSC intends to engage banks only to perform such functions. However, changes in Federal or state statutes and regulations pertaining to the permissible activities of banks and their affiliates or subsidiaries, as well as further judicial or administrative decisions or interpretations, could prevent a bank from continuing to perform all or a part of the contemplated services. If a bank were prohibited from so acting, the Trustees would consider what actions, if any, would be necessary to continue to provide -20- efficient and effective shareholder services. In such event, changes in the operation of the U.S. Government Series might occur, including possible termination of any automatic investment or redemption or other services then provided by a bank. It is not expected that shareholders would suffer any adverse financial consequences as a result of any of these occurrences. The U.S. Government Series may execute portfolio transactions with and purchase securities issued by depository institutions that indirectly receive payments under the Plan. No preference will be shown in the selection of investments for the instruments of such depository institutions. INVESTMENT MANAGER The Fund has entered into an agreement (the "Management Agreement") with Fundamental Portfolio Advisers, Inc. (the "Manager"), 90 Washington Street, 19th Floor, New York, New York 10006, to act as its investment adviser. The Management Agreement has been approved to continue in effect for an initial two year period, and will continue in effect from year to year thereafter if it is specifically approved, at least annually, by the vote of a majority of the Board of Trustees of the Fund (including a majority of the Board of Trustees who are not parties to the Management Agreement or interested persons of any such parties) cast in person at a meeting called for the purpose of voting on such renewal. The Management Agreement terminates if assigned and may be terminated without penalty by either party by vote of its Board of Directors or Trustees or a majority of its outstanding voting securities and the giving of sixty days' written notice. Under the terms of the Management Agreement, the Manager serves as investment adviser to the U.S. Government Series and is responsible for the overall management of the business affairs and assets of the U.S. Government Series, subject to the authority of the Fund's Board of Trustees. The Manager also is authorized under the Management Agreement to buy and sell securities for the account of the U.S. Government Series, in its discretion, subject to the right of the Fund's Trustees to disapprove any such purchase or sale. The Manager pays all of the ordinary operating expenses of the U.S. Government Series, including executive salaries and the rental of office space, with the exception of the following, which are to be paid by the U.S. Government Series: (1) charges and expenses for determining from time-to-time the net asset value of the U.S. Government Series and the keeping of its books and records, (2) the charges and expenses of any auditors, custodian, transfer agent, plan agent, dividend disbursing agent and registrar performing services for the U.S. Government Series, (3) brokers' commissions, and issue and transfer taxes, chargeable to the U.S. Government Series in connection with securities transactions, (4) insurance premiums, interest charges, dues and fees for -21- membership in trade associations and all taxes and fees payable by the U.S. Government Series to Federal, state or other governmental agencies, (5) fees and expenses involved in registering and maintaining registrations of the shares of the U.S. Government Series with the Securities and Exchange Commission and under the securities laws or regulations of states and other jurisdictions, (6) all expenses of shareholders' and Trustees' meetings and of preparing, printing and distributing notices, proxy statements and all reports to shareholders and to governmental agencies, (7) charges and expenses of legal counsel to the Fund, (8) compensation of those Trustees of the Fund as such who are not affiliated with or interested persons of the Manager or the Fund (other than as Trustees), (9) fees and expenses incurred pursuant to the 12b-1 Plan and (10) such nonrecurring or extraordinary expenses as may arise, including litigation affecting the Fund or the U.S. Government Series and any indemnification by the Fund of its Trustees, officers, employees or agents with respect thereto. To the extent any of the foregoing charges or expenses are incurred by the Fund for the benefit of each of the Fund's series, the U.S. Government Series is responsible for payment of the portion of such charges or expenses which are properly allocable to the U.S. Government Series. As compensation for the performance of its management services and the assumption of certain expenses of the U.S. Government Series and the Fund, the Manager is entitled under the Management Agreement to an annual management fee (which is computed daily and paid monthly) from the U.S. Government Series equal to the percentage of the average daily net asset value of the U.S. Government Series as follows: .75% per annum of the U.S. Government Series' average daily net assets up to $500 million, .725% per annum of the U.S. Government Series' average daily net assets for the next $500 million, and .70% per annum of the U.S. Government Series' average daily net assets above $1 billion. However, if for any fiscal year in which the aggregate operating expenses of the U.S. Government Series (including the management fee but exclusive of taxes, interest expenses, brokerage fees and commissions, fees and expenses paid pursuant to the Plan and extraordinary expenses beyond the control of, and not caused by bad faith, negligence or malfeasance of the Manager, if any), are in excess of the expense limitation of any state having jurisdiction over the U.S. Government Series, the Manager will reimburse the U.S. Government Series on a monthly basis for the amount of such excess. -22- PORTFOLIO TRANSACTIONS All orders for the purchase or sale of portfolio securities are placed on behalf of the U.S. Government Series by the Manager pursuant to authority contained in the Management Agreement (subject to the right of the Trustees to reverse any such transaction). The Manager is and may in the future also be responsible for the placement of transaction orders for the other series of the Fund and other funds for which the Manager acts as investment adviser. Securities purchased and sold on behalf of the U.S. Government Series will be traded on a net basis (i.e. without commission) through dealers acting for their own account and not as brokers or otherwise involve transactions directly with the issuer of the instrument. In selecting brokers or dealers, the Manager will consider various relevant factors, including, but not limited to, the size and type of the transaction; the nature and character of the markets for the security to be purchased or sold; the execution efficiency, settlement capability, and financial condition of the dealer; the dealer's execution services rendered on a continuing basis; and the reasonableness of any dealer spreads. Dealers may be selected who provide brokerage and/or research services to the Fund or U.S. Government Series and/or other investment companies over which the Manager exercises investment discretion. Such services may include advice concerning the value of securities; the advisability of investing in, purchasing or selling securities; the availability of securities or the purchasers or sellers of securities; furnishing analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy and performance of accounts; and effecting securities transactions and performing functions incidental thereto (such as clearance and settlement). The Manager maintains a listing of dealers who provide such services on a regular basis. However, because it is anticipated that many transactions on behalf of the U.S. Government Series, other series of the Fund and other funds over which the Manager exercises investment discretion are placed with dealers (including dealers on the list) without regard to the furnishing of such services, it is not possible to estimate the proportion of such transactions directed to such dealers solely because such services were provided. The receipt of research from dealers may be useful to the Manager in rendering investment management services to the U.S. Government Series and/or other series of the Fund and other funds over which the Manager exercises investment discretion, and conversely, such information provided by brokers or dealers who have executed transaction orders on behalf of such other clients of the Manager may be useful to the Manager in carrying out its obligations to the U.S. Government Series. The receipt of such -23- research has not reduced the Manager's normal independent research activities; however, it enables the Manager to avoid the additional expenses which might otherwise be incurred if it were to attempt to develop comparable information through its own staff. Dealers who execute portfolio transactions on behalf of the U.S. Government Series may receive spreads or commissions which are in excess of the amount of spreads or commissions which other brokers or dealers would have charged for effecting such transactions. In order to cause the U.S. Government Series to pay such higher spreads or commissions, the Manager must determine in good faith that such spreads or commissions are reasonable in relation to the value of the brokerage and/or research services provided by such executing broker or dealers viewed in terms of a particular transaction or the Manager's overall responsibilities to the U.S. Government Series, the Fund or the Manager's other clients. In reaching this determination, the Manager will not attempt to place a specific dollar value on the brokerage and/or research services provided or to determine what portion of the compensation should be related to those services. The Manager is authorized to place portfolio transactions with dealer firms that have provided assistance in the distribution of shares of the U.S. Government Series or shares of other series of the Fund or other funds for which the Manager acts as investment adviser if it reasonably believes that the quality of the transaction and the amount of the spread are comparable to what they would be with other qualified dealers. The Funds' Trustees and brokerage allocation committee (comprised solely of non-interested Trustees) periodically review the Manager's performance of its responsibilities in connection with the placement of portfolio transactions on behalf of the U.S. Government Series and the Fund and review the dealer spreads paid by the U.S. Government Series and the Fund over representative periods of time to determine if they are reasonable in relation to the benefits to the Fund and its portfolios. The Fund's Trustees have authorized the Manager to effect the U.S. Government Series' portfolio transactions on an agency basis with affiliated broker-dealers pursuant to certain procedures incorporating the standards of Rule 17e-1 of the 1940 Act. For the years ended December 31, 1995 and 1994, the U.S. Government Series' portfolio turnover rate was approximately 114% and 61%, respectively. -24- CUSTODIAN, INDEPENDENT ACCOUNTANTS AND COUNSEL The Chase Manhattan Bank, N.A. (the "Bank"), 114 West 47th Street, New York, New York, acts as Custodian of the Fund's cash and securities. The Bank also acts as bookkeeping agent for the Fund, and in that capacity monitors the Fund's accounting records and calculates its net asset value. McGladrey & Pullen, LLP, 555 Fifth Avenue, New York, New York, acts as independent public accountants for the Fund, performing an annual audit of the Fund's financial statements and preparing its tax returns. Kramer, Levin, Naftalis, Nessen, Kamin & Frankel, 919 Third Avenue, New York, New York, serves as counsel to the Fund. TAXES The following is only a summary of certain additional tax considerations generally affecting the U.S. Government Series and its shareholders that are not described in the Prospectus. No attempt is made to present a detailed explanation of the tax treatment of the U.S. Government Series or its shareholders, and the discussions here and in the Prospectus are not intended as substitutes for careful tax planning. QUALIFICATION AS A REGULATED INVESTMENT COMPANY The U.S. Government Series has elected to be taxed as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986, as amended (the "Code"). As a regulated investment company, the U.S. Government Series is not subject to federal income tax on the portion of its net investment income (i.e., taxable interest, dividends and other taxable ordinary income, net of expenses) and capital gain net income (i.e., the excess of capital gains over capital losses) that it distributes to shareholders, provided that it distributes at least 90% of its investment company taxable income (i.e., net investment income and the excess of net short-term capital gain over net long-term capital loss) for the taxable year (the "Distribution Requirement"), and satisfies certain other requirements of the Code that are described below. Distributions by the U.S. Government Series made during the taxable year or, under specified circumstances, within twelve months after the close of the taxable year, will be considered distributions of income and gains of the taxable year and can therefore satisfy the Distribution Requirement. -25- In addition to satisfying the Distribution Requirement, a regulated investment company must: (1) derive at least 90% of its gross income from dividends, interest, certain payments with respect to securities loans, gains from the sale or other disposition of stock or securities or foreign currencies (to the extent such currency gains are directly related to the regulated investment company's principal business of investing in stock or securities) and other income (including but not limited to gains from options, futures or forward contracts) derived with respect to its business of investing in such stock, securities or currencies (the "Income Requirement"); and (2) derive less than 30% of its gross income (exclusive of certain gains on designated hedging transactions that are offset by realized or unrealized losses on offsetting positions) from the sale or other disposition of stock, securities or foreign currencies (or options, futures or forward contracts thereon) held for less than three months (the "ShortShort Gain Test"). However, foreign currency gains, including those derived from options, futures and forwards, will not in any event be characterized as Short-Short Gain if they are directly related to the regulated investment company's investments in stock or securities (or options or futures thereon). Because of the Short-Short Gain Test, the U.S. Government Series may have to limit the sale of appreciated securities that it has held for less than three months. However, the Short-Short Gain Test will not prevent the U.S. Government Series from disposing of investments at a loss, since the recognition of a loss before the expiration of the three-month holding period is disregarded for this purpose. Interest (including original issue discount) received by the U.S. Government Series at maturity or upon the disposition of a security held for less than three months will not be treated as gross income derived from the sale or other disposition of such security within the meaning of the Short-Short Gain Test. However, income that is attributable to realized market appreciation will be treated as gross income from the sale or other disposition of securities for this purpose. In general, gain or loss recognized by the U.S. Government Series on the disposition of an asset will be a capital gain or loss. However, gain recognized on the disposition of a debt obligation purchased by the U.S. Government Series at a market discount (generally, at a price less than its principal amount) will be treated as ordinary income to the extent of the portion of the market discount which accrued during the period of time the U.S. Government Series held the debt obligation. In general, for purposes of determining whether capital gain or loss recognized by the U.S. Government Series on the disposition of an asset is long-term or short-term, the holding period of the asset may be affected if (1) the asset is used to close a "short sale" (which includes for certain purposes the acquisition of a put option) or is substantially identical to -26- another asset so used, or (2) the asset is otherwise held by the U.S. Government Series as part of a "straddle" (which term generally excludes a situation where the asset is stock and the U.S. Government Series grants a qualified covered call option (which, among other things, must not be deep-in-the-money) with respect thereto). However, for purposes of the Short-Short Gain Test, the holding period of the asset disposed of may be reduced only in the case of clause (1) above. In addition, the U.S. Government Series may be required to defer the recognition of a loss on the disposition of an asset held as part of a straddle to the extent of any unrecognized gain on the offsetting position. Any gain recognized by the U.S. Government Series on the lapse of, or any gain or loss recognized by the U.S. Government Series from a closing transaction with respect to, an option written by the U.S. Government Series will be treated as a short-term capital gain or loss. For purposes of the Short-Short Gain Test, the holding period of an option written by the U.S. Government Series will commence on the date it is written and end on the date it lapses or the date a closing transaction is entered into. Accordingly, the U.S. Government Series may be limited in its ability to write options which expire within three months and to enter into closing transactions at a gain within three months of the writing of options. Transactions that may be engaged in by the U.S. Government Series (such as regulated futures contracts, certain foreign currency contracts, and options on stock indexes and futures contracts) will be subject to special tax treatment as "Section 1256 contracts." Section 1256 contracts are treated as if they are sold for their fair market value on the last business day of the taxable year, even though a taxpayer's obligations (or rights) under such contracts have not terminated (by delivery, exercise, entering into a closing transaction or otherwise) as of such date. Any gain or loss recognized as a consequence of the year-end deemed disposition of Section 1256 contracts is taken into account for the taxable year together with any other gain or loss that was previously recognized upon the termination of Section 1256 contracts during that taxable year. Any capital gain or loss for the taxable year with respect to Section 1256 contracts (including any capital gain or loss arising as a consequence of the year-end deemed sale of such contracts) is generally treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. The U.S. Government Series, however, may elect not to have this special tax treatment apply to Section 1256 contracts that are part of a "mixed straddle" with other investments of the U.S. Government Series that are not Section 1256 contracts. The IRS has held in several private rulings (and Treasury Regulations now provide) that gains arising from Section 1256 contracts will be treated for -27- purposes of the Short-Short Gain Test as being derived from securities held for not less than three months if the gains arise as a result of a constructive sale under Code Section 1256. Treasury Regulations permit a regulated investment company, in determining its investment company taxable income and net capital gain (i.e., the excess of net long-term capital gain over net short-term capital loss) for any taxable year, to elect (unless it has made a taxable year election for excise tax purposes as discussed below) to treat all or any part of any net capital loss, any net long-term capital loss or any net foreign currency loss incurred after October 31 as if it had been incurred in the succeeding year. In addition to satisfying the requirements described above, the U.S. Government Series must satisfy an asset diversification test in order to qualify as a regulated investment company. Under this test, at the close of each quarter of the U.S. Government Series' taxable year, at least 50% of the value of the U.S. Government Series' assets must consist of cash and cash items, U.S. Government securities, securities of other regulated investment companies, and securities of other issuers (as to which the U.S. Government Series has not invested more than 5% of the value of the U.S. Government Series' total assets in securities of such issuer and as to which the U.S. Government Series does not hold more than 10% of the outstanding voting securities of such issuer), and no more than 25% of the value of its total assets may be invested in the securities of any one issuer (other than U.S. Government securities and securities of other regulated investment companies), or in two or more issuers which the U.S. Government Series controls and which are engaged in the same or similar trades or businesses. Generally, an option (call or put) with respect to a security is treated as issued by the issuer of the security, not the issuer of the option. However, with regard to forward currency contracts, there does not appear to be any formal or informal authority which identifies the issuer of such instrument. For purposes of asset diversification testing, obligations issued or guaranteed by agencies or instrumentalities of the U.S. Government such as the Federal Agricultural Mortgage Corporation, the Farm Credit System Financial Assistance Corporation, a Federal Home Loan Bank, the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, the Government National Mortgage Corporation, and the Student Loan Marketing Association are treated as U.S. Government securities. If for any taxable year the U.S. Government Series does not qualify as a regulated investment company, all of its taxable income (including its net capital gain) will be subject to tax at regular corporate rates without any deduction for distributions to shareholders, and such distributions will be taxable to the shareholders as ordinary dividends to the extent of the U.S. -28- Government Series' current and accumulated earnings and profits. Such distributions generally will be eligible for the dividends-received deduction in the case of corporate shareholders. EXCISE TAX ON REGULATED INVESTMENT COMPANIES A 4% non-deductible excise tax is imposed on a regulated investment company that fails to distribute in each calendar year an amount equal to 98% of ordinary taxable income for the calendar year and 98% of capital gain net income for the one-year period ended on October 31 of such calendar year (or, at the election of a regulated investment company having a taxable year ending November 30 or December 31, for its taxable year (a "taxable year election")). The balance of such income must be distributed during the next calendar year. For the foregoing purposes, a regulated investment company is treated as having distributed any amount on which it is subject to income tax for any taxable year ending in such calendar year. For purposes of the excise tax, a regulated investment company shall: (1) reduce its capital gain net income (but not below its net capital gain) by the amount of any net ordinary loss for the calendar year; and (2) exclude foreign currency gains and losses incurred after October 31 of any year (or after the end of its taxable year if it has made a taxable year election) in determining the amount of ordinary taxable income for the current calendar year (and, instead, include such gains and losses in determining ordinary taxable income for the succeeding calendar year). The U.S. Government Series intends to make sufficient distributions or deemed distributions of its ordinary taxable income and capital gain net income prior to the end of each calendar year to avoid liability for the excise tax. However, investors should note that the U.S. Government Series may in certain circumstances be required to liquidate portfolio investments to make sufficient distributions to avoid excise tax liability. U.S. GOVERNMENT SERIES DISTRIBUTIONS The U.S. Government Series anticipates distributing substantially all of its investment company taxable income for each taxable year. Such distributions will be taxable to shareholders as ordinary income and treated as dividends for federal income tax purposes, but they will not qualify for the 70% dividends-received deduction for corporate shareholders. The U.S. Government Series may either retain or distribute to shareholders its net capital gain for each taxable year. The U.S. Government Series currently intends to distribute any such -29- amounts. Net capital gain that is distributed and designated as a capital gain dividend, will be taxable to shareholders as long-term capital gain, regardless of the length of time the shareholder has held his shares or whether such gain was recognized by the U.S. Government Series prior to the date on which the shareholder acquired his shares. Distributions by the U.S. Government Series that do not constitute ordinary income dividends or capital gain dividends will be treated as a return of capital to the extent of (and in reduction of) the shareholder's tax basis in his shares; any excess will be treated as gain from the sale of his shares, as discussed below. Distributions by the U.S. Government Series will be treated in the manner described above regardless of whether such distributions are paid in cash or reinvested in additional shares of the U.S. Government Series (or of another fund). Shareholders receiving a distribution in the form of additional shares will be treated as receiving a distribution in an amount equal to the fair market value of the shares received, determined as of the reinvestment date. In addition, if the net asset value at the time a shareholder purchases shares of the U.S. Government Series reflects undistributed net investment income or recognized capital gain net income, or unrealized appreciation in the value of the assets of the U.S. Government Series, distributions of such amounts will be taxable to the shareholder in the manner described above, although such distributions economically constitute a return of capital to the shareholder. Shareholders purchasing shares of the U.S. Government Series just prior to the ex-dividend date will be taxed on the entire amount of the dividend received, even though the net asset value per share on the date of such purchase reflected the amount of such dividend. Ordinarily, shareholders are required to take distributions by the U.S. Government Series into account in the year in which they are made. However, dividends declared in October, November or December of any year and payable to shareholders of record on a specified date in such a month will be deemed to have been received by the shareholders (and made by the U.S. Government Series) on December 31 of such calendar year if such dividends are actually paid in January of the following year. Shareholders will be advised annually as to the U.S. federal income tax consequences of distributions made (or deemed made) to them during the year. The U.S. Government Series will be required in certain cases to withhold and remit to the U.S. Treasury 31% of ordinary income dividends and capital gain dividends, and the proceeds of -30- redemption of shares, paid to any shareholder (1) who has provided either an incorrect tax identification number or no number at all, (2) who is subject to backup withholding by the IRS for failure to report the receipt of interest or dividend income properly, or (3) who has failed to certify to the U.S. Government Series that it is not subject to backup withholding or that it is a corporation or other "exempt recipient." SALE OR REDEMPTION OF SHARES A shareholder will recognize gain or loss on the sale or redemption of shares of the U.S. Government Series in an amount equal to the difference between the proceeds of the sale or redemption and the shareholder's adjusted tax basis in the shares. All or a portion of any loss so recognized may be disallowed if the shareholder purchases other shares of the U.S. Government Series within 30 days before or after the sale or redemption. In general, any gain or loss arising from (or treated as arising from) the sale or redemption of shares of the U.S. Government Series will be considered capital gain or loss and will be long-term capital gain or loss if the shares were held for longer than one year. However, any capital loss arising from the sale or redemption of shares held for six months or less will be treated as a long-term capital loss to the extent of the amount of capital gain dividends received on such shares. For this purpose, the special holding period rules of Code Section 246(c)(3) and (4) generally will apply in determining the holding period of shares. Long-term capital gains of noncorporate taxpayers are currently taxed at a maximum rate 11.6% lower than the maximum rate applicable to ordinary income. Capital losses in any year are deductible only to the extent of capital gains plus, in the case of a noncorporate taxpayer, $3,000 of ordinary income. FOREIGN SHAREHOLDERS Taxation of a shareholder who, as to the United States, is a nonresident alien individual, foreign trust or estate, foreign corporation, or foreign partnership ("foreign shareholder"), depends on whether the income from the U.S. Government Series is "effectively connected" with a U.S. trade or business carried on by such shareholder. If the income from the U.S. Government Series is not effectively connected with a U.S. trade or business carried on by a foreign shareholder, ordinary income dividends paid to a foreign shareholder will be subject to U.S. withholding tax at the rate of 30% (or lower applicable treaty rate) upon the gross amount of the dividend. Such a foreign shareholder would generally be exempt from U.S. federal income tax on gains realized on the sale of shares of the U.S. Government Series, capital gain dividends and amounts retained by the U.S. Government Series that are designated -31- as undistributed capital gains. If the income from the U.S. Government Series is effectively connected with a U.S. trade or business carried on by a foreign shareholder, then ordinary income dividends, capital gain dividends, and any gains realized upon the sale of shares of the U.S. Government Series will be subject to U.S. federal income tax at the rates applicable to U.S. citizens or domestic corporations. In the case of a noncorporate foreign shareholder, the U.S. Government Series may be required to withhold U.S. federal income tax at a rate of 31% on distributions that are otherwise exempt from withholding (or taxable at a reduced treaty rate), unless the shareholder furnishes the U.S. Government Series with proper notification of its foreign status. The tax consequences to a foreign shareholder entitled to claim the benefits of an applicable tax treaty may be different from those described herein. Foreign shareholders are urged to consult their own tax advisers with respect to the particular tax consequences to them of an investment in the U.S. Government Series, including the applicability of foreign taxes. EFFECT OF FUTURE LEGISLATION; LOCAL TAX CONSIDERATIONS The foregoing general discussion of U.S. federal income tax consequences is based on the Code and Treasury Regulations issued thereunder as in effect on the date of this Statement. Future legislative or administrative changes or court decisions may significantly change the conclusions expressed herein, and any such changes or decisions may have a retroactive effect. Rules of state and local taxation of ordinary income dividends and capital gain dividends from regulated investment companies often differ from the rules for U.S. federal income taxation described above. Shareholders are urged to consult their tax advisers as to the consequences of federal, state and local tax rules with respect to an investment in the U.S. Government Series. DESCRIPTION OF SHARES The Fund's Declaration of Trust permits its Board of Trustees to authorize the issuance of an unlimited number of full and fractional shares of beneficial interest (without par value), which may be divided into such separate series as the Trustees may establish. The Fund currently has three series of shares: the U.S. Government Series, the Tax-Free Money Market Series and the High-Yield Municipal Bond Series. The Trustees may establish additional series of shares, and may divide or combine the shares into a greater or lesser number of shares without thereby changing -32- the proportionate beneficial interests of each series. Each share represents an equal proportionate interest in a series with each other share. The shares of any additional series would participate equally in the earnings, dividends and assets of the particular series, and would be entitled to vote separately to approve investment advisory agreements or changes in investment restrictions, but shareholders of all series would vote together in the election and selection of Trustees and accountants. Upon liquidation of the Fund, the shareholders of each series are entitled to share pro rata in the net assets available for distribution to shareholders of such series. Shareholders are entitled to one vote for each share held and may vote in the election of Trustees and on other matters submitted to meetings of shareholders. Although Trustees are not elected annually by the shareholders, shareholders have under certain circumstances the right to remove one or more Trustees. No material amendment may be made to the Fund's Declaration of Trust without the affirmative vote of a majority of its shares. Shares have no preemptive or conversion rights. Shares are fully paid and non-assessable, except as set forth below. See "Certain Liabilities." CERTAIN LIABILITIES As a Massachusetts business trust, the Fund's operations are governed by its Declaration of Trust dated March 19, 1987, a copy of which is on file with the office of the Secretary of The Commonwealth of Massachusetts. Theoretically, shareholders of a Massachusetts business trust may, under certain circumstances, be held personally liable for the obligations of the trust. However, the Declaration of Trust contains an express disclaimer of shareholder liability for acts or obligations of the Fund or any series of the Fund and requires that notice of such disclaimer be given in each agreement, obligation or instrument entered into or executed by the Fund or its Trustees. Moreover, the Declaration of Trust provides for the indemnification out of Fund property of any shareholders held personally liable for any obligations of the Fund or any series of the Fund. The Declaration of Trust also provides that the Fund shall, upon request, assume the defense of any claim made against any shareholder for any act or obligation of the Fund and satisfy any judgment thereon. Thus, the risk of a shareholder incurring financial loss beyond his or her investment because of shareholder liability would be limited to circumstances in which the Fund itself will be unable to meet its obligations. In light of the nature of the Fund's business, the possibility of the Fund's liabilities exceeding its assets, and therefore a shareholder's risk of personal liability, is extremely remote. The Declaration of Trust further provides that the Fund -33- shall indemnify each of its Trustees and officers against liabilities and expenses reasonably incurred by them, in connection with, or arising out of, any action, suit or proceeding, threatened against or otherwise involving such Trustee or officer, directly or indirectly, by reason of being or having been a Trustee or officer of the Fund. The Declaration of Trust does not authorize the Fund to indemnify any Trustee or officer against any liability to which he or she would otherwise be subject by reason of willful misfeasance, bad faith, gross negligence or reckless disregard of such person's duties. DETERMINATION OF NET ASSET VALUE The net asset value per share of the U.S. Government Series is determined as of the close of trading on the New York Stock Exchange (currently 4:00 P.M., New York time) on each day that both the New York Stock Exchange and the Fund's custodian bank are open for business. The net asset value per share of the U.S. Government Series is also determined on any other day in which the level of trading in its portfolio securities is sufficiently high that the current net asset value per share might be materially affected by changes in the value of its portfolio securities. On any day in which no purchase orders for the shares of the U.S. Government Series become effective and no shares are tendered for redemption, the net asset value per share is not determined. PERFORMANCE INFORMATION For purposes of quoting and comparing the performance of the U.S. Government Series to that of other mutual funds and to stock or other relevant indices in advertisements or in reports to shareholders, performance will be stated both in terms of total return and in terms of yield. The total return basis combines principal and dividend income changes for the periods shown. Principal changes are based on the difference between the beginning and closing net asset values for the period and assume reinvestment of dividends and distributions paid by the U.S. Government Series. Dividends and distributions are comprised of net investment income and net realized capital gains. Under the rules of the Securities and Exchange Commission, funds advertising performance must include total return quotes calculated according to the following formula: P(1 + T)n = ERV Where P = a hypothetical initial payment of $1,000 T = average annual total return n = number of years (1, 5 or 10) -34- ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1, 5 or 10 year periods or at the end of the 1, 5 or 10 year periods (or fractional portion thereof) Under the foregoing formula the time periods used in advertising will be based on rolling calendar quarters, updated to the last day of the most recent quarter prior to submission of the advertising for publication, and will cover one, five, and ten year periods or a shorter period dating from the effectiveness of the U.S. Government Series' registration statement. In calculating the ending redeemable value, the pro rata share of the account opening fee is deducted from the initial $1,000 investment and all dividends and distributions by the U.S. Government Series are assumed to have been reinvested at net asset value as described in the prospectus on the reinvestment dates during the period. Total return, or "T" in the formula above, is computed by finding the average annual compounded rates of return over the 1, 5 and 10 year periods (or fractional portion thereof) that would equate the initial amount invested to the ending redeemable value. The U.S. Government Series' aggregate unannualized total rate of return, reflecting the initial investment and reinvestment of all dividends and distributions, for the period from March 2, 1992 (commencement of public offering of shares) to December 31, 1995, was 0.12%. The U.S. Government Series may also from time to time include in such advertising a total return figure that is not calculated according to the formula set forth above in order to compare more accurately the U.S. Government Series' performance with other measures of investment return. For example, in comparing the U.S. Government Series's total return with data published by Lipper Analytical Services, Inc. or similar independent services or financial publications, the U.S. Government Series calculates its aggregate total return for the specified periods of time by assuming the reinvestment of each dividend or other distribution at net asset value on the reinvestment date. Percentage increases are determined by subtracting the initial net asset value of the investment from the ending net asset value and by dividing the remainder by the beginning net asset value. The U.S. Government Series does not, for these purposes, deduct the pro rata share of the account opening fee from the initial value invested. The U.S. Government Series will, however, disclose the pro rata share of the account opening fee and will disclose that the performance data does not reflect such non-recurring charge and that inclusion of such charge would reduce the performance quoted. Such alternative total return information will be given no greater prominence in such advertising than the information prescribed under the Securities and Exchange Commission's rules. -35- In addition to the total return quotations discussed above, the U.S. Government Series may advertise its yield based on a 30-day (or one month) period ended on the date of the most recent balance sheet included in the U.S. Government Series' Post-Effective Amendment to its Registration Statement, computed by dividing the net investment income per share earned during the period by the maximum offering price per share on the last day of the period, according to the following formula: a-b YIELD 2[( ----- +1)6-1] cd Where: a = dividends and interest earned during the period. b = expenses accrued for the period (net of reimbursements). c = the average daily number of shares outstanding during the period that were entitled to receive dividends. d = the maximum offering price per share on the last day of the period. Under this formula, interest earned on debt obligations for purposes of "a" above, is calculated by (1) computing the yield to maturity of each obligation held by the U.S. Government Series based on the market value of the obligation (including actual accrued interest) at the close of business on the last day of each month, or, with respect to obligations purchased during the month, the purchase price (plus actual accrued interest), (2) dividing that figure by 360 and multiplying the quotient by the market value of the obligation (including actual accrued interest as referred to above) to determine the interest income on the obligation for each day of the subsequent month that the obligation is in the U.S. Government Series' portfolio (assuming a month of 30 days) and (3) computing the total of the interest earned on all debt obligations and all dividends accrued on all equity securities during the 30-day or one month period. In computing dividends accrued, dividend income is recognized by accruing 1/360 of the stated dividend rate of a security each day that the security is in the U.S. Government Series' portfolio. For purposes of "b" above, Rule 12b-1 expenses are included among the expenses accrued for the period. Any amounts representing sales charges will not be included among these expenses; however, the U.S. Government Series will disclose the pro rata share of the account opening fee. Undeclared earned income, computed in accordance with generally accepted accounting principles, may be subtracted from the maximum offering price calculation required pursuant to "d" above. -36- Any quotation of performance stated in terms of yield will be given no greater prominence than the information prescribed under the Securities and Exchange Commission's rules. In addition, all advertisements containing performance data of any kind will include a legend disclosing that such performance data represents past performance and that the investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. The U.S. Government Series' yield as of December 31, 1995, based on a 30-day period, was 7.20% OTHER INFORMATION As of April 22, 1996, the Trustees and officers of the Fund as a group beneficially owned less than 1% of the outstanding shares of the U.S. Government Series. As of such date, no persons were known by Fund management to have owned beneficially, directly or indirectly, 5% or more of the outstanding shares of the U.S. Government Series. FINANCIAL STATEMENTS Audited financial statements of the U.S. Government Series for the year ended December 31, 1995 are attached hereto. -37- FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND (left column) STATEMENT OF ASSETS AND LIABILITIES December 31, 1995 - -------------------------------------------------------------------------------- ASSETS Investment in securities, at value (cost $19,364,775) (Notes 5 and 6) ......... $22,828,137 Interest receivable .................... 110,989 ----------- Total assets ..................... 22,939,126 ----------- LIABILITIES Notes payable .......................... 63,000 Options written at value (premiums received $62,325) (Note 5) ........... 93,360 Securities sold subject to repurchase (Note 6) ............................. 7,431,045 Payables: Capital stock redeemed ............... 7,962 Dividends declared ................... 23,784 Accrued expenses ..................... 99,265 Variation margin ..................... 26,481 ----------- Total liabilities ................ 7,744,897 ----------- NET ASSETS consisting of: Accumulated net realized loss ......... $(18,337,748) Unrealized appreciation of securities . 3,463,362 Unrealized depreciation of options written .............................. (31,035) Unrealized depreciation of open future contracts ............................ (183,771) Paid-in-capital applicable to 10,191,431 shares of beneficial interest ............................. 30,283,421 ------------ $15,194,229 =========== NET ASSET VALUE PER SHARE ................ $1.49 ===== (Right Column) STATEMENT OF OPERATIONS Year Ended December 31, 1995 - -------------------------------------------------------------------------------- INVESTMENT INCOME Interest income, net of $455,877 of interest expense ..................... $ 1,491,430 EXPENSES (Notes 2, 3 and 6) Investment advisory fees ............... $ 121,770 Custodian and accounting fees .......... 47,886 Transfer agent fees .................... 62,540 Professional fees ...................... 305,365 Trustees' fees ......................... 16,893 Printing and postage ................... 2,393 Interest on bank borrowing ............. 32,761 Distribution expenses .................. 40,695 Other .................................. 60,789 Less: Expenses waived or reimbursed by manager and affiliate ............. (162,388) ----------- Total expenses 528,704 ----------- Net investment income ............ 962,726 REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS Net realized loss on: Investments .......................... (10,482,851) Future and options on futures ........ (3,905,275) (14,388,126) ----------- Change in unrealized appreciation (depreciation) of investments, options and futures contracts for the year: Investments ........................ 15,547,752 Open option contracts written ...... (12,178) Open futures contracts ............. 127,400 15,662,974 ----------- ----------- Net gain on investments ................ 1,274,848 ----------- NET INCREASE IN NET ASSETS FROM OPERATIONS ........................ $ 2,237,574 =========== (Bottom) STATEMENT OF CHANGES IN NET ASSETS - --------------------------------------------------------------------------------
Year Ended Year Ended December December 31, 1995 31, 1994 -------- -------- INCREASE (DECREASE) IN NET ASSETS FROM: OPERATIONS Net investment income ................................................................... $ 962,726 $ 3,223,702 Net realized gain (loss) on investments ................................................. (14,388,126) 6,321,524 Unrealized appreciation (depreciation) on investments, options and futures contracts .... 15,662,974 (21,438,948) ------------ ------------ Net increase (decrease) in net assets from operations ............................. 2,237,574 (11,893,722) DIVIDENDS PAID TO SHAREHOLDERS FROM Investment income ....................................................................... (962,726) (3,223,702) CAPITAL SHARE TRANSACTIONS (Note 4) ....................................................... (5,170,959) (28,974,362) ------------ ------------ Total decrease .................................................................... (3,896,111) (44,091,786) NET ASSETS Beginning of year ....................................................................... 19,090,340 63,182,126 ------------ ------------ End of year ............................................................................. $ 15,194,229 $ 19,090,340 ============ ============
See Notes to Financial Statements. 3 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND STATEMENT OF OPTIONS WRITTEN December 31, 1995 - --------------------------------------------------------------------------------
Number of Expiration Contracts++ Options Written Month Value - ----------- --------------- ---------- -------- 25 U.S. Treasury Bonds, Call @ $122 February 1996 $ 20,703 50 U.S. Treasury Bonds, Call @ $122 March 1996 72,657 -------- $ 93,360 ======== ++Each contract represents $100,000 face value of U.S. Treasury Bond Futures.
STATEMENT OF CASH FLOWS Year Ended December 31, 1995 - -------------------------------------------------------------------------------- INCREASE (DECREASE) IN CASH CASH FLOWS FROM OPERATING ACTIVITIES Net increase in net assets from operations ............................... $ 2,237,574 Adjustments to reconcile net increase in net assets from operations to net cash provided by operating activities: Purchase of investment securities ........................................ (30,993,645) Proceeds on sale of securities ........................................... 42,446,029 Premiums received for options written .................................... 1,043,355 Premiums paid to close options written ................................... (2,410,864) Decrease in interest receivable .......................................... 372,942 Decrease in variation margin receivable .................................. 59,294 Decrease in accrued expenses ............................................. (63,798) Net accretion of discount on securities .................................. (337,697) Net realized (gain) loss: Investments ............................................................ 10,482,161 Options written ........................................................ 1,016,659 Unrealized appreciation on securities and options written for the period . (15,535,574) ----------- Total adjustments .................................................... 6,078,862 ----------- Net cash provided by operating activities ............................ 8,316,436 ----------- CASH FLOWS FROM FINANCING ACTIVITIES:* Net repayments of note payable and securities sold subject to repurchase ... (2,177,075) Proceeds on shares sold .................................................... 1,819,736 Payment on shares repurchased .............................................. (7,761,803) Cash dividends paid ........................................................ (237,526) ----------- Net cash provided by financing activities ............................ (8,356,668) ----------- Net decrease in cash ................................................. (40,232) CASH AT BEGINNING OF YEAR .................................................... 40,232 ----------- CASH AT END OF YEAR .......................................................... $ 0 =========== *Non-cash financing activities not included herein consist of reinvestment of dividends of $779,070. Cash payments for interest expense totaled $488,706 for the period.
See Notes to Financial Statements. 4 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND STATEMENT OF INVESTMENTS December 31, 1995 - -------------------------------------------------------------------------------- Principal Interest Maturity Amount Rate Date Value ------ ---- ---- ----- United States Treasury Securities-43.21% United States Treasury Bonds 5,500,000 9.00% 11/15/18 $ 7,497,173 4,300,000* 0.00% 11/15/11 2,312,411 85,000* 0.00% 11/15/03 54,455 ----------- (Cost $8,098,571) 9,864,039 ----------- United States Agency Backed Securities-56.79% Federal Home Loan Mortgage Corporation 843,718+ 9.25% 08/15/23 914,505 250,454+ 6.50% 12/15/23 223,308 FNMA-Federal National Mortgage Assoc. Collateralized Mortgage Obligations 3,671,204+ TTIB** 03/25/23 3,821,099 356,450+ 15.50% 03/25/23 362,239 490,760+ TTIB** 05/25/23 528,882 1,519,480+ TTIB** 11/25/23 1,478,879 980,392 TTIB** 11/25/23 1,088,706 1,000,000(beta) 8.75% 12/25/23 1,112,230 465,436+ 12.50% 08/25/23 470,700 953,000 9.00% 02/25/24 957,470 Department of Navy, FNMA Guaranteed 100,000+ 0.00% 04/01/09 43,189 REFCO-Resolution Funding Corporation 600,000 0.00% 07/15/10 248,994 ----------- (Cost $10,120,746) 11,250,201 ----------- FICO-Financing Corporation (U.S. Government Agency) Zero Coupon Securities 100,000* 11/02/12 34,024 100,000* 05/02/14 30,580 125,000 05/02/15 35,565 200,000+ 11/02/18 44,613 148,000* 05/11/12 52,068 99,000* 11/11/13 31,321 119,000* 11/11/14 35,042 320,000+ 11/11/17 76,269 281,000* 05/30/14 85,455 261,000* 11/30/15 71,232 164,000* 11/30/16 41,666 167,000* 08/08/17 40,477 100,000* 08/03/18 22,669 182,000* 06/06/15 51,431 109,000+ 12/06/17 25,848 137,000* 08/03/15 38,267 5 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND PORTFOLIO OF INVESTMENTS (continued) December 31, 1995 - -------------------------------------------------------------------------------- Principal Interest Maturity Amount Rate Date Value ------ ---- ---- ----- FICO-Financing Corporation (U.S. Government Agency) Zero Coupon Securities (continued) 208,000 02/03/16 $ 56,114 138,000* 02/03/11 53,055 250,000 10/06/14 74,140 205,000+* 04/06/17 50,811 259,000* 10/05/15 71,453 100,000+ 10/05/17 23,991 217,000+ 04/05/18 50,272 375,000* 04/05/19 81,349 74,000 04/05/15 21,171 100,000 10/05/16 25,692 240,000* 10/06/17 60,300 135,000 04/06/04 83,230 444,000+ 08/08/16 115,387 100,000+ 02/08/17 25,050 200,000* 04/06/17 49,572 129,000 10/06/17 30,943 108,000+ 11/30/17 25,644 100,000+ 02/03/12 35,855 118,000* 08/03/16 30,698 144,000 08/03/18 32,643 ----------- (Cost $1,145,458) $ 1,713,897 ----------- Total investments (Cost $19,364,775++) $22,828,137 =========== ** Two-Tiered Index Floating Rate Bonds (TTIB) are instruments whose interest rate is fixed over various ranges of the interest rate on another security or the value of an index, but variable within certain ranges of the same security or index. + Collateral or partial collateral for securities sold subject to repurchase (Note 6) * Segregated, in whole or part, as initial margin for futures contracts (Note 5) ++ Cost is the same for Federal income tax purposes (beta) Security valued in good faith under procedures approved by the Fund's Board of Trustees. See Notes to Financial Statements. 6 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND NOTES TO FINANCIAL STATEMENTS December 31, 1995 - -------------------------------------------------------------------------------- 1. Significant Accounting Policies Fundamental Fixed-Income Fund (the Fund) is an open-end management investment company registered under the Investment Company Act of 1940. The Fund operates as a series company currently issuing three classes of shares of beneficial interest, the Tax-Free Money Market Series, the High-Yield Municipal Bond Series and the U.S. Government Strategic Income Fund (the Series). Each series is considered a separate entity for financial reporting and tax purposes. The Fund seeks to provide high current income with minimum risk of principal and relative stability of net asset value. Valuation of Securities-Investments are stated at value based on prices provided by a pricing service which takes into account appropriate factors such as institution-size trading in similar groups of securities, yield, quality, coupon rate, maturity, type of issue, trading characteristics and other market data, without exclusive reliance upon exchange or over-the-counter prices, because such valuations are believed to reflect more accurately the fair value of such securities. Securities not priced in this manner are valued at the mean between the most recently quoted bid and ask prices provided by dealers. Securities for which quotations are not readily available are valued in good faith under methods approved by the Board of Trustees. Futures Contracts-Initial margin deposits with respect to these contracts are maintained by the Fund's custodian in segregated asset accounts. Subsequent changes in the daily valuation of open contracts are recognized as unrealized gains or losses. Variation margin payments are made or received as daily appreciation or depreciation in the value of these contracts occurs. Realized gains or losses are recorded when a contract is closed. Repurchase Agreements-The Series may invest in repurchase agreements, which are agreements pursuant to which securities are acquired from a third party with the commitment that they will be repurchased by the seller at a fixed price on an agreed upon date. The Series may enter into repurchase agreements with banks or lenders meeting the creditworthiness standards established by the Board of Trustees. The resale price reflects the purchase price plus an agreed upon market rate of interest which is unrelated to the coupon rate or date of maturity of the purchased security. It is the Fund's policy that its custodian take possession of the underlying collateral securities the value of which exceeds the purchase price including accrued interest earned on the underlying security. If the seller defaults, and the value of the collateral declines, realization of the collateral by the Fund may be delayed or limited. Reverse Repurchase Agreements-The Series may enter into reverse repurchase agreements with the same parties with whom it may enter into repurchase agreements. Under a reverse repurchase agreement, the Series sells securities and agrees to repurchase them at a mutually agreed upon date and price. Under the Investment Company Act of 1940 reverse repurchase agreements are generally regarded as a form of borrowing. At the time the Series enters into a reverse repurchase agreement it will establish and maintain a segregated account with its custodian containing securities from its portfolio having a value not less than the repurchase price including accrued interest. Federal Income Taxes-It is the Series' policy to comply with the requirements of the Internal Revenue Code applicable to "regulated investment companies" and to distribute all of its taxable and tax exempt income to its shareholders. Therefore, no provision for federal income tax is required. Distributions-The Series declares dividends daily from its net investment income and pays such dividends on the last business day of each month. Distributions to shareholders, which are determined in accordance with income tax regulations, are recorded on the ex-dividend date. Distributions of net capital gain, if any, realized on sales of investments are anticipated to be made before the close of the Series' fiscal year, as declared by the Board of Trustees. Dividends are reinvested at the net asset value unless shareholders request payment in cash. General-Securities transactions are accounted for on a trade date basis. Interest income is accrued as earned. Realized gain and loss from the sale of securities are recorded on an identified cost basis. Original issue discounts and premiums are amortized over the life of the respective securities. Premiums are charged against interest income and original issue discounts are accreted to interest income. Accounting Estimates-The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of increases and decreases in net assets from operations during the reporting period. Actual results could differ from those estimates. 7 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND NOTES TO FINANCIAL STATEMENTS (continued) December 31, 1995 - -------------------------------------------------------------------------------- 2. Investment Advisory Fees and Other Transactions With Affiliates The Series has a Management Agreement with Fundamental Portfolio Advisors, Inc. (the Manager). Pursuant to the agreement the Manager serves as investment adviser to the Series and is responsible for the overall management of the business affairs and assets of the Series subject to the authority of the Fund's Board of Trustees. In compensation for the services provided by the Manager, the Series will pay an annual management fee in an amount equal to .75% of the Series' average daily net assets up to $500 million, .725% on the next $500 million, and .70% per annum on assets over $1 billion. The Manager is required to reimburse the Series for its expenses (excluding interest, taxes, brokerage fees and extraordinary expenses) to the extent that such expenses, including the management fees, exceed the limits on investment company expenses prescribed in any state in which the Series' shares are qualified for sale. The manager voluntarily waived fees and reimbursed expenses of $121,770 for the year ended December 31, 1995. The Series has adopted a Distribution and Marketing Plan, pursuant to Rule 12b-1, promulgated under the Investment Company Act of 1940, under which the Series pays to Fundamental Service Corporation (FSC), an affiliate of the Manager, a fee which is accrued daily and paid monthly at an annual rate of 0.25% of the Series' average daily net assets. Amounts paid under the plan are to compensate FSC for the services it provides and the expenses it bears in distributing the Series' shares to investors. The amount incurred by the Series pursuant to the agreement for the year ended December 31, 1995 is set forth in the statement of operations. FSC has waived fees in the amount of $40,618. The Fund compensates Fundamental Shareholders Services, Inc. (FSSI), an affiliate of the Manager, for services it provides under a Transfer Agent and Service Agreement. The amount incurred by the Series pursuant to the agreement for the year ended December 31, 1995 is set forth in the Statement of Operations. 3. Trustees' Fees All of the Trustees of the Fund are also directors or trustees of two other affiliated mutual funds for which the Manager acts as investment adviser. For services and attendance at board meetings and meetings of committees which are common to each fund, each Trustee who is not affiliated with the Manager is compensated at the rate of $6,500 per quarter pro rated among the funds based on their respective average net assets. 4. Shares of Beneficial Interest As of December 31, 1995 there were an unlimited number of shares of beneficial interest (no par value) authorized and capital paid-in amounted to $30,283,421. Transactions in shares of beneficial interest were as follows:
Year Ended Year Ended December 31, 1995 December 31, 1994 ----------------------------- ------------------------------- Shares Amount Shares Amount ------ ------ ------ ------ Shares sold 1,300,415 $1,819,736 7,503,044 $13,099,717 Shares issued on reinvestment of dividends 554,101 779,070 1,398,152 2,335,836 Shares redeemed (5,559,992) (7,769,765) (26,452,420) (44,409,915) ---------- ----------- ----------- ------------ Net decrease (3,705,476) $(5,170,959) (17,551,224) $(28,974,362) ========== =========== =========== ============
5. Complex Services, Off Balance Sheet Risks and Investment Transactions Collaterialized Mortgage Obligations and Multi-Class Pass-Through Securities: The Fund invests in collateralized mortgage obligations ("CMOs") which are debt instruments issued by special purpose entities which are secured by pools of mortgage loans or other mortgage-backed securities. Multi-class pass-through securities are equity interests in a trust composed of mortgage loans or other mortgage-backed securities. Payments of principal and interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled distributions on the multi-class pass-through security. The Fund may invest in CMOs and multi-class pass-through securities issued by agencies or instrumentalities of the U.S. Government. 8 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND NOTES TO FINANCIAL STATEMENTS (continued) December 31, 1995 - -------------------------------------------------------------------------------- Two-Tiered Index Floating Rate Bonds (TTIB): The Fund invests in variable rate securities commonly called "TTIBs" which are collateralized mortgage obligations. The interest rate on these securities are fixed over various ranges of the interest rate on another security or the value of an index, but variable within certain ranges of the same security or index. Changes in interest rate on the other security or index affect the rate paid on the TTIB, and the TTIB's price will be more volatile than that of a fixed-rate bond. Futures Contracts and Options on Futures Contracts: The Fund invests in futures contracts consisting primarily of US Treasury Bond Futures. A futures contract is an agreement between two parties to buy and sell a security for a set price on a future date. Futures contracts are traded on designated "contract markets" which through their clearing corporations, guarantee performance of the contracts. In addition the fund invests in options on US Treasury Bond Futures which gives the holder a right to buy or sell futures contracts in the future. Unlike a futures contract which requires the parties to the contract to buy and sell a security on a set date, an option on a futures contract entitles its holder to decide before a future date whether to enter into such a futures contract. Both types of contracts are marked to market daily and changes in valuation will affect the net asset value of the Fund. The Fund's principal objective in holding or issuing derivative financial instruments is as a hedge against interest-rate fluctuations in its bond portfolio, and to enhance its total return. The Fund's principal investment objective is to maximize the level of interest income while maintaining acceptable levels of interest-rate and liquidity risk. To achieve this objective, the Fund uses a combination of derivative financial instruments principally consisting of US Treasury Bond Futures and Options on US Treasury Bond Futures. Typically the Fund sells treasury bond futures contracts or writes treasury bond option contracts. These activities create off balance sheet risk since the Fund may be unable to enter into an offsetting position and under the terms of the contract deliver the security at a specified time at a specified price. The cost to the Fund of acquiring the security to deliver may be in excess of recorded amounts and result in a loss to the Fund. For the year ended December 31, 1995, the Fund had daily average notional amounts outstanding of approximately $6,687,000 and $10,787,000 of short positions on US Treasury Bond Futures and Options Written on US Treasury Bond Futures respectively. Realized gains and losses from these transactions are stated separately in the Statement of Operations. The Fund had the following open futures contracts at December 31, 1995. Principal Expiration Unrealized Type Amount Position Month Gain ---- ------ -------- ----- ----- U.S. Treasury Bond ....... $6,500,000 Short March 1996 $183,771 Portfolio securities with an aggregate value of approximately $3,250,000 have been segregated as collateral for this contract as of December 31, 1995. In addition, the following table summarizes option contracts written by the Series for the year ended December 31, 1995: Number of Premiums Realized Contracts Received Cost Loss --------- -------- ---- ---- Contracts outstanding December 31, 1994 ....... 375 $ 413,175 Options written ........... 1,230 1,043,354 Contracts closed or expired (1,530) (1,394,204) $2,410,863 $(1,016,659) ------ ---------- Contracts outstanding December 31, 1995 ....... 75 $ 62,325 ===== ========= Other Investment Transactions For the year ended December 31, 1995, the cost of purchases and proceeds from sales of investment securities, other than short-term obligations, were $28,242,059 and $39,141,080, respectively. 9 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND NOTES TO FINANCIAL STATEMENTS (continued) December 31, 1995 - -------------------------------------------------------------------------------- As of December 31, 1995, net unrealized appreciation of portfolio securities amounted to $3,463,362 comprised entirely of unrealized appreciation. As of December 31, 1995, the Fund has available for federal income tax purposes an unused capital loss carryover of approximately $15,000,000 which expires in 2002. 6. Borrowing The Fund has a line of credit agreement with its custodian bank collateralized by cash and portfolio securities to the extent of the amounts borrowed. Borrowings under this agreement bear interest linked to the bank's prime rate. The Series enters into reverse repurchase agreements collateralized by portfolio securities equal in value to the repurchase price. Portfolio securities with an aggregate value of approximately $8,290,000 have been segregated as collateral for securities sold subject to repurchase as of December 31, 1995. 7. Selected Financial Information
Year Year February 18, Year Ended Ended Ended 1992 to December 31, December 31, December 31, December 31, Per share operating performance 1995 1994 1993 1992 (for a share outstanding throughout the period) ------ ------ ------ ------- Net asset value, beginning of period ....................... $ 1.37 $ 2.01 $ 2.02 $ 2.00 ------ ------ ------ ------ Income from investment operations Net investment income ...................................... 0.08 0.14 0.16 0.15 Net realized and unrealized gain/(loss) on investments ..... 0.12 (0.64) - 0.02 ------ ------ ------ ------ Total from investment operations ................... 0.20 (0.50) 0.16 0.17 ------ ------ ------ ------ Less distributions Dividends from net investment income ....................... (0.08) (0.14) (0.16) (0.15) Dividends from net realized gains .......................... - - (0.01) - ------ ------ ------ ------ Net asset value, end of period ............................. $ 1.49 $ 1.37 $ 2.01 $ 2.02 ====== ====== ====== ====== Total return ............................................... 15.43% (25.57%) 8.14% 10.76%** Ratios/supplemental data: Net assets, end of period (000 omitted) .................... 15,194 19,090 63,182 40,500 Ratios to average net aset (annualized): Interest expense ......................................... 0.20% 0.12% 0.05% 0.09% Operating expenses ....................................... 3.05% 2.16% 1.39% 0.96% ------ ------ ------ ------ Total expenses ..................................... 3.25%+ 2.28% 1.44%+ 1.05%+ ====== ====== ====== ====== Net investment income .................................... 5.91% 8.94% 7.85% 8.50% Portfolio turnover rate .................................... 114.36% 60.66% 90.59% 115.39% Borrowings Amount outstanding at end of period (000 omitted) .......... 7,481 9,674 31,072 19,666 Average amount of debt outstanding during the period (000 omitted) ............................................ 7,790 16,592 28,756 13,779 Average number of shares outstanding during the period (000 omitted) ............................................ 11,571 21,436 28,922 12,683 Average amount of debt per share during the period ......... .67 .77 .99 1.09 *Commencement of operations. **Annualized. +These ratios are after expense reimbursement of 1.0% for the year ended December 31, 1995, .13% for the year ended December 31, 1993, and 1.05% for the period of February 18, 1992 to December 31, 1992.
10 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND NOTES TO FINANCIAL STATEMENTS (continued) December 31, 1995 - -------------------------------------------------------------------------------- 8. Contingencies The Fund has been named as a defendant in two related class action lawsuits alleging that the Fund invested in certain derivitive financial instruments that were inconsistent with the Fund's stated investment objectives. The suits claim that the defendants, which include the Fund's investment adviser, distributor, and certain control persons, are liable for damages because there existed material misstatements or omissions in the prospectuses that rendered them misleading. Management has entered into negotiations with the plaintiffs who have consented to a series of adjournments of all operative dates in the litigation. These negotiations have resulted in a settlement in principle with the plaintiffs that, if consummated, would require a payment of approximately $500,000 or more under certain future circumstances by the Fund's investment adviser and no liability or cost to the Fund or its shareholders. The contemplated stipulation of settlement expressly states that the settlement does not constitute an admission of wrongdoing by the Fund or any of the other defendants. The settlement remains subject to final documentation and agreement by the parties and approval by the Court. If the settlement is not successfully concluded, the Fund intends to contest the litigation vigorously. If this litigation ever goes forward, it would involve significant complexities that preclude a present determination of whether any liability to the Fund ultimately would result and, if so, whether any such liability would be material to the financial position of the Fund. Accordingly, and because the contemplated settlement does not require any payment by the Fund, no amount has been accrued in the financial statements with respect to this matter. In addition, Management is cooperating in a formal investigation being conducted by the Securities and Exchange Commission concerning the Fund, the Fund's adviser and affiliated entities. Among other things, the investigation concerns the sufficiency of disclosures set forth in the Fund's prior advertising and prospectus, the consistency of the Fund's practices with those disclosures, and the Fund's investment in inverse floating rate notes between 1993 and 1995. Currently, the Fund has no inverse floating rate notes in its portfolio. 11 INDEPENDENT AUDITOR'S REPORT The Board of Trustees and Shareholders Fundamental U.S. Government Strategic Income Fund We have audited the accompanying statement of assets and liabilities including the statement of investments and statement of options written, of the Fundamental U.S. Government Strategic Income Fund Series of Fundamental Fixed-lncome Fund as of December 31, 1995 and the related statements of operations and cash flows for the year then ended, and the statement of changes in net assets for the two years then ended and selected financial information for the three years then ended and the period from February 18, 1992 (date of inception) to December 31, 1992. These financial statements and selected financial information are the responsibility of the Fund's management. Our responsibility is to express an opinion on these financial statements and selected financial information based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and selected financial information are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our procedures included confirmation of securities owned as of December 31, 1995 by correspondence with the custodian and brokers. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements and selected financial information referred to above present fairly, in all material respects, the financial position of the Fundamental U.S. Government Strategic Income Fund of Fundamental Fixed-lncome Fund as of December 31, 1995, the results of its operations, changes in its net assets, cash flows, and selected financial information for the periods indicated, in conformity with generally accepted accounting principles. S I G N A T U R E New York, New York February 13, 1996 12 Left Col. FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND 90 Washington Street New York, New York 10006 1-800-322-6864 Independent Auditors McGladrey & Pullen, LLP New York, NY 10017 Attorney Kramer, Levin, Naftalis, Nessen, Kamin & Frankel 919 Third Avenue New York, NY 10022 This report and the financial statements contained herein are submitted for the general information of the shareholders of the Fund. The report is not authorized for distribution to prospective investors in the Fund unless preceded or accompanied by an effective prospectus. Right Col. Annual Report December 31, 1995 FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND FUNDAMENTAL -----END PRIVACY-ENHANCED MESSAGE-----