Notes to Financial Statements |
JUNE 30, 2012 (UNAUDITED)
1. Organization
American Century Variable Portfolios II, Inc. (the corporation) is registered under the Investment Company Act of 1940, as amended (the 1940 Act), as an open-end management investment company and is organized as a Maryland corporation. VP Inflation Protection Fund (the fund) is the sole fund issued by the corporation. The fund is diversified as defined under the 1940 Act. The fund’s investment objective is to pursue long-term total return using a strategy that seeks to protect against U.S. inflation. The fund pursues its investment objective by investing substantially all of its assets in investment-grade debt securities. The fund normally invests over 50% of its assets in inflation-adjusted debt securities that are designed to protect the future purchasing power of the money invested in them.
The fund offers Class I and Class II. The share classes differ principally in their respective distribution and shareholder servicing expenses and arrangements.
2. Significant Accounting Policies
The following is a summary of significant accounting policies consistently followed by the fund in preparation of its financial statements. The financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, which may require management to make certain estimates and assumptions at the date of the financial statements. Actual results could differ from these estimates.
Investment Valuations — The fund determines the fair value of its investments and computes its net asset value per share as of the close of regular trading (usually 4 p.m. Eastern time) on the New York Stock Exchange (NYSE) on each day the NYSE is open.
Debt securities maturing in greater than 60 days at the time of purchase are valued at the evaluated mean as provided by independent pricing services or at the mean of the most recent bid and asked prices as provided by investment dealers. Debt securities maturing within 60 days at the time of purchase may be valued at cost, plus or minus any amortized discount or premium or at the evaluated mean as provided by an independent pricing service. Evaluated mean prices are commonly derived through utilization of market models, which may consider, among other factors, trade data, quotations from dealers and active market makers, relevant yield curve and spread data, related sector levels, creditworthiness, and other relevant market information on the same or comparable securities.
Investments in open-end management investment companies are valued at the reported net asset value per share. Exchange-traded futures contracts are valued at the settlement price as provided by the appropriate clearing corporation. Swap agreements are valued at an evaluated price as provided by independent pricing services or investment dealers. Forward foreign currency exchange contracts are valued at the mean of the latest bid and asked prices of the forward currency rates as provided by an independent pricing service.
The value of investments initially expressed in foreign currencies is translated into U.S. dollars at prevailing exchange rates.
If the fund determines that the market price for a portfolio security is not readily available or the valuation methods mentioned above do not reflect a security’s fair value, such security is valued as determined in good faith by the Board of Directors or its designee, in accordance with procedures adopted by the Board of Directors. Circumstances that may cause the fund to use these procedures to value a security include, but are not limited to: a security has been declared in default; trading in a security has been halted during the trading day; there is a foreign market holiday and no trading occurred; or an event occurred between the close of a foreign exchange and the NYSE that may affect the value of a security.
Security Transactions — Security transactions are accounted for as of the trade date. Net realized gains and losses are determined on the identified cost basis, which is also used for federal income tax purposes.
Investment Income — Interest income is recorded on the accrual basis and includes paydown gain (loss) and accretion of discounts and amortization of premiums. Inflation adjustments related to inflation-linked debt securities are reflected as interest income.
Segregated Assets — In accordance with the 1940 Act, the fund segregates assets on its books and records to cover certain types of investments, including, but not limited to, futures contracts, forward commitments, when-issued securities, swap agreements and certain forward foreign currency exchange contracts. American Century Investment Management, Inc. (ACIM) (the investment advisor) monitors, on a daily basis, the securities segregated to ensure the fund designates a sufficient amount of liquid assets, marked-to-market daily. The fund may also receive assets or be required to pledge assets at the custodian bank or with a broker for margin requirements on futures contracts and swap agreements.
Foreign Currency Translations — All assets and liabilities initially expressed in foreign currencies are translated into U.S. dollars at prevailing exchange rates at period end. The fund may enter into spot foreign currency exchange contracts to facilitate transactions denominated in a foreign currency. Purchases and sales of investment securities, dividend and interest income, spot foreign currency exchange contracts, and expenses are translated at the rates of exchange prevailing on the respective dates of such transactions. Net realized and unrealized foreign currency exchange gains or losses related to investment securities are a component of net realized gain (loss) on investment transactions and change in net unrealized appreciation (depreciation) on investments, respectively.
Income Tax Status — It is the fund’s policy to distribute substantially all net investment income and net realized gains to shareholders and to otherwise qualify as a regulated investment company under provisions of the Internal Revenue Code. The fund is no longer subject to examination by tax authorities for years prior to 2008. At this time, management believes there are no uncertain tax positions which, based on their technical merit, would not be sustained upon examination and for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next twelve months. Accordingly, no provision has been made for federal or state income taxes.
Multiple Class — All shares of the fund represent an equal pro rata interest in the net assets of the class to which such shares belong, and have identical voting, dividend, liquidation and other rights and the same terms and conditions, except for class specific expenses and exclusive rights to vote on matters affecting only individual classes. Income, non-class specific expenses, and realized and unrealized capital gains and losses of the fund are allocated to each class of shares based on their relative net assets.
Distributions to Shareholders — Distributions from net investment income, if any, are generally declared and paid quarterly. Distributions from net realized gains, if any, are generally declared and paid annually.
Indemnifications — Under the corporation’s organizational documents, its officers and directors are indemnified against certain liabilities arising out of the performance of their duties to the fund. In addition, in the normal course of business, the fund enters into contracts that provide general indemnifications. The maximum exposure under these arrangements is unknown as this would involve future claims that may be made against a fund. The risk of material loss from such claims is considered by management to be remote.
3. Fees and Transactions with Related Parties
Management Fees — The corporation has entered into a management agreement with ACIM, under which ACIM provides the fund with investment advisory and management services in exchange for a single, unified management fee (the fee) per class. The agreement provides that all expenses of managing and operating the fund, except distribution fees, brokerage expenses, taxes, interest, fees and expenses of the independent directors (including legal counsel fees), and extraordinary expenses, will be paid by ACIM. The fee is computed and accrued daily based on each class’s daily net assets and paid monthly in arrears. The fee consists of (1) an Investment Category Fee based on the daily net assets of the fund and certain other accounts managed by the investment advisor that are in the same broad investment category as the fund and (2) a Complex Fee based on the assets of all the funds in the American Century Investments family of funds. The rates for the Investment Category Fee range from 0.1625% to 0.2800%. The rates for the Complex Fee range from 0.2500% to 0.3100%. The effective annual management fee for each class for the six months ended June 30, 2012 was 0.47%.
Distribution Fees — The Board of Directors has adopted the Master Distribution Plan (the plan) for Class II, pursuant to Rule 12b-1 of the 1940 Act. The plan provides that Class II will pay American Century Investment Services, Inc. (ACIS) an annual distribution fee equal to 0.25%. The fee is computed and accrued daily based on the Class II daily net assets and paid monthly in arrears. The distribution fee provides compensation for expenses incurred in connection with distributing shares of Class II including, but not limited to, payments to brokers, dealers, and financial institutions that have entered into sales agreements with respect to shares of the fund. Fees incurred under the plan during the six months ended June 30, 2012 are detailed in the Statement of Operations.
Related Parties — Certain officers and directors of the corporation are also officers and/or directors of American Century Companies, Inc., the parent of the corporation’s investment advisor, ACIM, the distributor of the corporation, ACIS, and the corporation’s transfer agent, American Century Services, LLC.
4. Investment Transactions
Purchases of investment securities, excluding short-term investments, for the six months ended June 30, 2012 totaled $201,713,308, of which $184,646,893 represented U.S. Treasury and Government Agency obligations.
Sales of investment securities, excluding short-term investments, for the six months ended June 30, 2012 totaled $272,222,126, of which $238,906,756 represented U.S. Treasury and Government Agency obligations.
5. Capital Share Transactions
Transactions in shares of the fund were as follows:
| | | | | | |
| | Six months ended June 30, 2012 | | | Year ended December 31, 2011 | |
| | Shares | | | Amount | | | Shares | | | Amount | |
| Class I/Shares Authorized | | 250,000,000 | | | | | | | 250,000,000 | | | | |
| Sold | | 1,086,253 | | | | $12,947,492 | | | | 4,661,705 | | | | $53,920,141 | |
| Issued in reinvestment of distributions | | 435,131 | | | | 5,074,981 | | | | 613,260 | | | | 6,880,771 | |
| Redeemed | | (9,165,361 | ) | | | (110,091,084 | ) | | | (1,648,002 | ) | | | (18,777,732 | ) |
| | | (7,643,977 | ) | | | (92,068,611 | ) | | | 3,626,963 | | | | 42,023,180 | |
| Class II/Shares Authorized | | 250,000,000 | | | | | | | | 250,000,000 | | | | | |
| Sold | | 8,384,396 | | | | 99,227,277 | | | | 19,385,683 | | | | 221,209,198 | |
| Issued in reinvestment of distributions | | 4,227,212 | | | | 49,367,602 | | | | 5,747,175 | | | | 64,149,347 | |
| Redeemed | | (7,871,611 | ) | | | (93,413,975 | ) | | | (24,254,659 | ) | | | (277,563,013 | ) |
| | | 4,739,997 | | | | 55,180,904 | | | | 878,199 | | | | 7,795,532 | |
| Net increase (decrease) | | (2,903,980 | ) | | | $(36,887,707 | ) | | | 4,505,162 | | | | $49,818,712 | |
6. Fair Value Measurements
The fund’s securities valuation process is based on several considerations and may use multiple inputs to determine the fair value of the positions held by the fund. In conformity with accounting principles generally accepted in the United States of America, the inputs used to determine a valuation are classified into three broad levels as follows:
| • | Level 1 valuation inputs consist of unadjusted quoted prices in an active market for identical securities; |
| Level 2 valuation inputs consist of direct or indirect observable market data (including quoted prices for similar securities, evaluations of subsequent market events, interest rates, prepayment speeds, credit risk, etc.); or |
| Level 3 valuation inputs consist of unobservable data (including a fund’s own assumptions). |
The level classification is based on the lowest level input that is significant to the fair valuation measurement. The valuation inputs are not necessarily an indication of the risks associated with investing in these securities or other financial instruments.
The following is a summary of the level classifications as of period end. The Schedule of Investments provides additional information on the fund’s portfolio holdings.
| | | | | | | | | |
| | Level 1 | | | Level 2 | | | Level 3 | |
| Investment Securities | |
| U.S. Treasury Securities | | — | | | | $732,762,952 | | | | — | |
| Sovereign Governments and Agencies | | — | | | | 254,142,402 | | | | — | |
| Corporate Bonds | | — | | | | 155,287,670 | | | | — | |
| U.S. Government Agency Mortgage-Backed Securities | | — | | | | 138,593,982 | | | | — | |
| U.S. Government Agency Securities | | — | | | | 44,972,252 | | | | — | |
| Commercial Mortgage-Backed Securities | | — | | | | 35,426,127 | | | | — | |
| Collateralized Mortgage Obligations | | — | | | | 22,453,144 | | | | — | |
| Municipal Securities | | — | | | | 882,907 | | | | — | |
| Temporary Cash Investments | | $427 | | | | 948,990 | | | | — | |
| Total Value of Investment Securities | | $427 | | | | $1,385,470,426 | | | | — | |
| | | | | | | | | | | | |
| Other Financial Instruments | |
| Forward Foreign Currency Exchange Contracts | | — | | | | $4,856,010 | | | | — | |
| Futures Contracts | | $(113,006 | ) | | | — | | | | — | |
| Swap Agreements | | — | | | | (15,279,794 | ) | | | — | |
| Total Unrealized Gain (Loss) on Other Financial Instruments | | $(113,006 | ) | | | $(10,423,784 | ) | | | — | |
7. Derivative Instruments
Foreign Currency Risk — The fund is subject to foreign currency exchange rate risk in the normal course of pursuing its investment objectives. The value of foreign investments held by a fund may be significantly affected by changes in foreign currency exchange rates. The dollar value of a foreign security generally decreases when the value of the dollar rises against the foreign currency in which the security is denominated and tends to increase when the value of the dollar declines against such foreign currency. A fund may enter into forward foreign currency exchange contracts to reduce a fund’s exposure to foreign currency exchange rate fluctuations, or to shift exposure to the fluctuations in the value of foreign currencies from one foreign currency to another foreign currency. The net U.S. dollar value of foreign currency underlying all contractual commitments held by a fund and the resulting unrealized appreciation or depreciation are determined daily. Realized gain or loss is recorded upon the termination of the contract. Net realized and unrealized
gains or losses occurring during the holding period of forward foreign currency exchange contracts are a component of net realized gain (loss) on foreign currency transactions and change in net unrealized appreciation (depreciation) on translation of assets and liabilities in foreign currencies, respectively. A fund bears the risk of an unfavorable change in the foreign currency exchange rate underlying the forward contract. Additionally, losses, up to the fair value, may arise if the counterparties do not perform under the contract terms. The foreign currency risk derivative instruments held at period end as disclosed on the Schedule of Investments are indicative of the fund’s typical volume during the period.
Interest Rate Risk — The fund is subject to interest rate risk in the normal course of pursuing its investment objectives. The value of bonds generally declines as interest rates rise. A fund may enter into futures contracts based on a bond index or a specific underlying security. A fund may purchase futures contracts to gain exposure to increases in market value or sell futures contracts to protect against a decline in market value. Upon entering into a futures contract, a fund will segregate cash, cash equivalents or other appropriate liquid securities on its records in amounts sufficient to meet requirements. Subsequent payments (variation margin) are made or received daily, in cash, by a fund. The variation margin is equal to the daily change in the contract value and is recorded as unrealized gains and losses. A fund recognizes a realized gain or loss when the futures contract is closed or expires. Net realized and unrealized gains or losses occurring during the holding period of futures contracts are a component of net realized gain (loss) on futures contract transactions and change in net unrealized appreciation (depreciation) on futures contracts, respectively. One of the risks of entering into futures contracts is the possibility that the change in value of the contract may not correlate with the changes in value of the underlying securities. The interest rate risk derivative instruments held at period end as disclosed on the Schedule of Investments are indicative of the fund’s typical volume during the period.
Other Contracts — A fund may enter into total return swap agreements in order to attempt to obtain or preserve a particular return or spread at a lower cost than obtaining a return or spread through purchases and/or sales of instruments in other markets or gain exposure to certain markets in the most economical way possible. A fund will segregate cash, cash equivalents or other appropriate liquid securities on its records in amounts sufficient to meet requirements. Changes in value, including the periodic amounts of interest to be paid or received on swap agreements, are recorded as unrealized appreciation (depreciation) on swap agreements. Realized gain or loss is recorded upon receipt or payment of a periodic settlement or termination of swap agreements. Net realized and unrealized gains or losses occurring during the holding period of swap agreements are a component of net realized gain (loss) on swap agreement transactions and change in net unrealized appreciation (depreciation) on swap agreements, respectively. The risks of entering into swap agreements include the possible lack of liquidity, failure of the counterparty to meet its obligations, and that there may be unfavorable changes in the underlying investments or instruments. The other contracts derivative instruments held at period end as disclosed on the Schedule of Investments are indicative of the fund’s typical volume during the period.
| Value of Derivative Instruments as of June 30, 2012 | |
| | Asset Derivatives | | | Liability Derivatives | |
| Type of Risk Exposure | Location on Statement of Assets and Liabilities | | Value | | | Location on Statement of Assets and Liabilities | | Value | |
| Foreign Currency Risk | Unrealized gain on forward foreign currency exchange contracts | | | $5,735,485 | | | Unrealized loss on forward foreign currency exchange contracts | | | $879,475 | |
| Interest Rate Risk | Receivable for variation margin on futures contracts* | | | — | | | Payable for variation margin on futures contracts* | | | 123,047 | |
| Other Contracts | Swap agreements | | | 14,416 | | | Swap agreements | | | 15,294,210 | |
| | | | | $5,749,901 | | | | | | $16,296,732 | |
*Included in the unrealized gain (loss) on futures contracts as reported in the Schedule of Investments.
| Effect of Derivative Instruments on the Statement of Operations for the Six Months Ended June 30, 2012 | |
| | Net Realized Gain (Loss) | | | Change in Net Unrealized Appreciation (Depreciation) | |
| Type of Risk Exposure | Location on Statement of Operations | | Value | | | Location on Statement of Operations | | Value | |
| Foreign Currency Risk | Net realized gain (loss) on foreign currency transactions | | | $6,927,299 | | | Change in net unrealized appreciation (depreciation) on translation of assets and liabilities in foreign currencies | | | $(4,646,462 | ) |
| Interest Rate Risk | Net realized gain (loss) on futures contract transactions | | | (399,079 | ) | | Change in net unrealized appreciation (depreciation) on futures contracts | | | (305,824 | ) |
| Other Contracts | Net realized gain (loss) on swap agreement transactions | | | (784,725 | ) | | Change in net unrealized appreciation (depreciation) on swap agreements | | | 2,482,984 | |
| | | | | $5,743,495 | | | | | | $(2,469,302 | ) |
8. Risk Factors
There are certain risks involved in investing in foreign securities. These risks include those resulting from future adverse political, social and economic developments, fluctuations in currency exchange rates, the possible imposition of exchange controls, and other foreign laws or restrictions.
9. Federal Tax Information
The book-basis character of distributions made during the year from net investment income or net realized gains may differ from their ultimate characterization for federal income tax purposes. These differences reflect the differing character of certain income items and net realized gains and losses for financial statement and tax purposes, and may result in reclassification among certain capital accounts on the financial statements.
As of June 30, 2012, the components of investments for federal income tax purposes were as follows:
| | | | | |
| Federal tax cost of investments | | | $1,231,952,503 | |
| Gross tax appreciation of investments | | | $157,907,048 | |
| Gross tax depreciation of investments | | | (4,388,698 | ) |
| Net tax appreciation (depreciation) of investments | | | $153,518,350 | |
The difference between book-basis and tax-basis cost and unrealized appreciation (depreciation) is attributable primarily to the tax deferral of losses on wash sales.
| For a Share Outstanding Throughout the Years Ended December 31 (except as noted) |
| Per-Share Data | Ratios and Supplemental Data |
| | | Income From Investment Operations: | Distributions From: | | | Ratio to Average Net Assets of: | | |
| | Net Asset Value, Beginning of Period | Net Investment Income (Loss) | Net Realized and Unrealized Gain (Loss) | Total From Investment Operations | Net Investment Income | Net Realized Gains | Tax Return of Capital | Total Distributions | Net Asset Value, End of Period | Total Return(1) | Operating Expenses | Net Investment Income (Loss) | Portfolio Turnover Rate | Net Assets, End of Period (in thousands) |
| Class I |
2012(2) | $11.78 | 0.18(3) | 0.30 | 0.48 | (0.19) | (0.28) | — | (0.47) | $11.79 | 4.13% | 0.48%(4) | 3.14%(4) | 14% | $71,394 |
| 2011 | $11.11 | 0.40(3) | 0.90 | 1.30 | (0.49) | (0.14) | — | (0.63) | $11.78 | 12.09% | 0.48% | 3.61% | 63% | $161,320 |
| 2010 | $10.74 | 0.30(3) | 0.27 | 0.57 | (0.20) | — | — | (0.20) | $11.11 | 5.39% | 0.49% | 2.70% | 44% | $111,872 |
| 2009 | $9.91 | 0.26(3) | 0.77 | 1.03 | (0.20) | — | — | (0.20) | $10.74 | 10.43% | 0.49% | 2.61% | 43% | $101,956 |
| 2008 | $10.55 | 0.49(3) | (0.60) | (0.11) | (0.50) | — | (0.03) | (0.53) | $9.91 | (1.26)% | 0.49% | 4.62% | 49% | $90,845 |
| 2007 | $10.09 | 0.49 | 0.46 | 0.95 | (0.49) | — | — | (0.49) | $10.55 | 9.66% | 0.50% | 4.75% | 109% | $55,277 |
| Class II |
2012(2) | $11.75 | 0.17(3) | 0.31 | 0.48 | (0.18) | (0.28) | — | (0.46) | $11.77 | 4.10% | 0.73%(4) | 2.89%(4) | 14% | $1,311,797 |
| 2011 | $11.09 | 0.38(3) | 0.88 | 1.26 | (0.46) | (0.14) | — | (0.60) | $11.75 | 11.74% | 0.73% | 3.36% | 63% | $1,254,452 |
| 2010 | $10.73 | 0.27(3) | 0.27 | 0.54 | (0.18) | — | — | (0.18) | $11.09 | 5.12% | 0.74% | 2.45% | 44% | $1,173,585 |
| 2009 | $9.91 | 0.25(3) | 0.75 | 1.00 | (0.18) | — | — | (0.18) | $10.73 | 10.22% | 0.74% | 2.36% | 43% | $1,058,286 |
| 2008 | $10.55 | 0.45(3) | (0.59) | (0.14) | (0.47) | — | (0.03) | (0.50) | $9.91 | (1.59)% | 0.74% | 4.37% | 49% | $756,501 |
| 2007 | $10.08 | 0.46 | 0.47 | 0.93 | (0.46) | — | — | (0.46) | $10.55 | 9.49% | 0.75% | 4.50% | 109% | $551,066 |
Notes to Financial Highlights
| (1) | Total returns are calculated based on the net asset value of the last business day. Total returns for periods less than one year are not annualized. |
| (2) | Six months ended June 30, 2012 (unaudited). |
| (3) | Computed using average shares outstanding throughout the period. |
See Notes to Financial Statements.
| Approval of Management Agreement |
At a meeting held on June 14, 2012, the Fund’s Board of Directors/Trustees unanimously approved the renewal of the management agreement pursuant to which American Century Investment Management, Inc. (the “Advisor”) acts as the investment advisor for the Fund. Under Section 15(c) of the Investment Company Act, contracts for investment advisory services are required to be reviewed, evaluated, and approved by a majority of a fund’s independent directors/trustees (the “Directors”) each year.
As a part of the approval process, the Board requested and reviewed extensive data and information compiled by the Advisor and certain independent providers of evaluation data concerning the Fund and the services provided to the Fund by the Advisor. This review was in addition to the oversight and evaluation undertaken by the Board and its committees on a continuous basis throughout the year and included, but was not limited to the following:
| • | the nature, extent, and quality of investment management, shareholder services, and other services provided by the Advisor to the Fund; |
| • | the wide range of other programs and services the Advisor provides to the Fund and its shareholders on a routine and non-routine basis; |
| • | the investment performance of the fund, including data comparing the Fund’s performance to appropriate benchmarks and/or a peer group of other mutual funds with similar investment objectives and strategies; |
| • | data comparing the cost of owning the Fund to the cost of owning similar funds; |
| • | the Advisor’s compliance policies, procedures, and regulatory experience; |
| • | financial data showing the cost of services provided to the Fund, the profitability of the Fund to the Advisor, and the overall profitability of the Advisor; |
| • | data comparing services provided and charges to other investment management clients of the Advisor; and |
| • | consideration of collateral benefits derived by the Advisor from the management of the Fund and any potential economies of scale relating thereto. |
In keeping with its practice, the Board held two in-person meetings to review and discuss the information provided. The Board also had the benefit of the advice of its independent counsel throughout the period.
Factors Considered
The Directors considered all of the information provided by the Advisor, the independent data providers, and the Board’s independent counsel, and evaluated such information for the Fund. In connection with their review, the Directors did not identify any single factor as being all-important or controlling, and each Director may have attributed different levels of importance to different factors. In deciding to renew the management agreement, the Board based its decision on a number of factors, including the following:
Nature, Extent and Quality of Services - Generally. Under the management agreement, the Advisor is responsible for providing or arranging for all services necessary for the operation of the Fund. The Board noted that under the management agreement, the Advisor provides or arranges at its own expense a wide variety of services including:
| • | constructing and designing the Fund |
| • | portfolio research and security selection |
| • | initial capitalization/funding |
| • | daily valuation of the Fund’s portfolio |
| • | shareholder servicing and transfer agency, including shareholder confirmations, recordkeeping, and communications |
| • | regulatory and portfolio compliance |
| • | marketing and distribution |
The Board noted that many of these services have expanded over time both in terms of quantity and complexity in response to shareholder demands, competition in the industry, changing distribution channels, and the changing regulatory environment.
Investment Management Services. The nature of the investment management services provided to the Fund is quite complex and allows Fund shareholders access to professional money management, instant diversification of their investments within an asset class, the opportunity to easily diversify among asset classes by investing in or exchanging among various American Century Investments funds, and liquidity. In evaluating investment performance, the Board expects the Advisor to manage the Fund in accordance with its investment objectives and approved strategies. Further, the Directors recognize that the Advisor has an obligation to seek the best execution of fund trades. In providing these services, the Advisor utilizes teams of investment professionals (portfolio managers, analysts, research assistants, and securities traders) who require extensive information technology, research, training, compliance and other systems to conduct their business. The Board, directly and through its Portfolio Committee, regularly reviews investment performance information for the Fund, together with comparative information for appropriate benchmarks and/or peer groups of
similarly-managed funds, over different time horizons. The Directors also review detailed performance information during the management agreement approval process. If performance concerns are identified, the Fund receives special reviews until performance improves, during which the Board discusses with the Advisor the reasons for such results (e.g., market conditions, security selection) and any efforts being undertaken to improve performance. The Board found the investment management services provided by the Advisor to the Fund to meet or exceed industry standards. More detailed information about the Fund’s performance can be found in the Performance section of this report.
Shareholder and Other Services. Under the management agreement, the Advisor provides the Fund with a comprehensive package of transfer agency, shareholder, and other services. The Board, directly and through various committees of the Board, regularly reviews reports and evaluations of such services at its regular meetings. These reports include, but are not limited to, information regarding the operational efficiency and accuracy of the shareholder and transfer agency services provided, staffing levels, shareholder satisfaction (as measured by external as well as internal sources), technology support, new products and services offered to Fund shareholders, securities trading activities, portfolio valuation services, auditing services, and legal and operational compliance activities. Certain aspects of shareholder and transfer agency service level efficiency and the quality of securities trading activities are measured by independent third party providers and are presented in comparison to other fund groups not managed by the Advisor. The Board found the services provided by the Advisor to the Fund under the management agreement to be competitive and of high quality.
Costs of Services and Profitability. The Advisor provides detailed information concerning its cost of providing various services to the Fund, its profitability in managing the Fund, its overall profitability, and its financial condition. The Directors have reviewed with the Advisor the methodology used to prepare this financial information. The financial information regarding the Advisor is considered in evaluating the Advisor’s financial condition, ability to continue to provide services under the management agreement, and the reasonableness of the current management fee. The Board concluded that the Advisor’s profits were reasonable in light of the services provided to the Fund.
Ethics. The Board generally considers the Advisor’s commitment to providing quality services to shareholders and to conducting its business ethically. They noted that the Advisor’s practices generally meet or exceed industry best practices.
Economies of Scale. The Board also reviewed information provided by the Advisor regarding the possible existence of economies of scale in connection with the management of the Fund. The Board concluded that economies of scale are difficult to measure and predict with precision, especially on a fund-by-fund basis. The Board concluded that the Advisor is appropriately sharing economies of scale through its competitive fee structure, offering competitive fees from fund inception, and through reinvestment in its business to provide shareholders additional content and services.
Comparison to Other Funds’ Fees. The management agreement provides that the Fund pay the Advisor a single, all-inclusive (or unified) management fee for providing all services necessary for the management and operation of the Fund, other than brokerage expenses, taxes, interest, extraordinary expenses, and the fees and expenses of the Fund’s independent directors (including their independent legal counsel) and expenses incurred in connection with the provision of shareholder services and distribution services under a plan adopted pursuant to Rule 12b-1 under the 1940 Act. Under the unified fee structure, the Advisor is responsible for providing all investment advisory, custody, audit, administrative, compliance, recordkeeping, marketing and shareholder services, or arranging and supervising third parties to provide such services. By contrast, most other funds are charged a variety of fees, including an investment advisory fee, a transfer agency fee, an administrative fee, distribution charges and other expenses. Other than their investment advisory fees and any applicable Rule 12b-1 distribution fees, all other components of the total fees charged by these other funds may be increased without shareholder approval. The Board believes the unified fee structure is a benefit to Fund shareholders because it clearly discloses to shareholders the cost of owning Fund shares, and, since the unified fee cannot be increased without a vote of Fund shareholders, it shifts to the Advisor the risk of increased costs of operating the Fund and provides a direct incentive to minimize administrative inefficiencies. Part of the Board’s analysis of fee levels involves reviewing certain evaluative data compiled by an independent provider and comparing the Fund’s unified fee to the total expense ratio of other funds in the Fund’s peer group. The Board concluded that the management fee paid by the Fund to the Advisor under the management agreement is reasonable in light of the services provided to the Fund.
Comparison to Fees and Services Provided to Other Clients of the Advisor. The Board also requested and received information from the Advisor concerning the nature of the services, fees, costs and profitability of its advisory services to advisory clients other than the Fund. They observed that these varying types of client accounts require different services and involve different regulatory and entrepreneurial risks than the management of the Fund. The Board analyzed this information and concluded that the fees charged and services provided to the Fund were reasonable by comparison.
Collateral or “Fall-Out” Benefits Derived by the Advisor. The Board considered the existence of collateral benefits the Advisor may receive as a result of its relationship with the Fund. They concluded that the Advisor’s primary business is managing mutual funds and it generally does not use fund or shareholder information to generate profits in other lines of business, and therefore does not derive any significant collateral benefits from them. The Board noted that the Advisor receives proprietary research from broker-dealers that execute fund portfolio transactions and concluded that this research is likely to benefit Fund shareholders. The Board also determined that the Advisor is able to provide investment management services to certain clients other than the Fund, at least in part, due to its existing infrastructure built to serve the fund complex. The Board concluded, however, that the assets of those other clients are not material to the analysis and, where applicable, may be included with the assets of the Fund to determine breakpoints in the management fee schedule.
Existing Relationship. The Board also considered whether there was any reason for not continuing the existing arrangement with the Advisor. In this regard, the Board was mindful of the potential disruptions of the Fund’s operations and various risks, uncertainties, and other effects that could occur as a result of a decision not to continue such relationship. In particular, the Board recognized that most shareholders have invested in the Fund on the strength of the Advisor’s industry standing and reputation and in the expectation that the Advisor will have a continuing role in providing advisory services to the Fund.
Conclusion of the Directors. As a result of this process, the Board, including all of the independent directors and assisted by the advice of independent legal counsel, taking into account all of the factors discussed above and the information provided by the Advisor and others, concluded that the management agreement between the Fund and the Advisor is fair and reasonable in light of the services provided and should be renewed.
