UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT INVESTMENT COMPANIES
Investment Company Act file number 811-3445
--------
THE MERGER FUND
---------------
(Exact name of registrant as specified in charter)
100 SUMMIT LAKE DRIVE
VALHALLA, NEW YORK 10595
-------------------------
(Address of principal executive offices) (Zip code)
FREDERICK W. GREEN
THE MERGER FUND
100 SUMMIT LAKE DRIVE
VALHALLA, NEW YORK 10595
-------------------------
(Name and address of agent for service)
1-800-343-8959
--------------
Registrant's telephone number, including area code
Date of fiscal year end: SEPTEMBER 30, 2003
------------------
Date of reporting period: SEPTEMBER 30, 2003
------------------
ITEM 1. REPORT TO STOCKHOLDERS.
- ------------------------------
THE
MERGER
FUND(R)
ANNUAL REPORT
SEPTEMBER 30, 2003
November 18, 2003
Dear Fellow Shareholder:
The Merger Fund(R) met its investment objectives in fiscal 2003. As
previously reported, the Fund's NAV rose 11.9% in the 12 months ended September.
Not only was this gain at the high end of our rate-of-return targets, but it was
also achieved with little volatility and without a material decline in any
month. The Fund's strong performance-much improved over fiscal 2002-was not
fueled by an upturn in merger activity; total domestic M&A volume was actually
down more than 30% from year-earlier levels. Our deal selection, however, was
significantly better. In contrast to fiscal 2002, when The Merger Fund(R) held
positions in six transactions that were ultimately abandoned, we experienced
only one broken deal last year, out of over 90 new arbitrage investments. Maybe
our analytical skills are getting better or perhaps we were just luckier, but
failed mergers are the bane of arbitrageurs, and it helps immensely when we can
dodge these bullets. The Fund's fixed-income holdings, which had weighed on our
results the prior year, showed a dramatic recovery in fiscal 2003. We also were
able to take advantage of trading opportunities that were created when arbitrage
spreads showed wide fluctuations, sometimes for no good reason.
As is customary in these annual reports, we have included a series of charts
which reflect the nature of the arbitrage opportunities in which the Fund has
recently invested. Chart 1 shows that as of September 30, friendly transactions
represented slightly more than 93% of the dollar value of our equity holdings,
while unsolicited, or hostile, takeover attempts accounted for about 6%. The
latter figure, which is up from just 2% a year earlier, indicates that hostile
deals continue to represent a relatively small percentage of M&A activity. As
we have often noted, the scarcity of unsolicited takeover attempts is due
principally to the fact that the odds of success are low. Courts have blessed
the "just-say-no" defense, allowing companies to hide behind poison pills. And
the prevalence of staggered boards means that waging a successful proxy battle
can take over two years, too long for all but the most committed acquirers.
Even when the target company eventually loses its independence, it may well end
up in the hands of a "white knight," not the original bidder. Not all hostile
offers are created equal, however. Some have a much better chance of
succeeding, as illustrated by Alcan's recent $4.5 billion takeover of French
aluminum-maker Pechiney. To begin with, it helped that Alcan is a world-class
player. A target company's directors have a harder time dismissing an
unsolicited bid launched by a well-respected strategic acquirer with deep
pockets. It also helped that Alcan was the most logical buyer of Pechiney.
Potential rival bidders either didn't want the whole company, faced antitrust
obstacles or had other reasons for not getting involved. In the absence of a
competing offer, Pechiney had few defenses against Alcan. Poison pills are rare
allowed in France, and the French government decided to remain out of the fray,
depriving Pechiney of the opportunity to play the nationalism card against a
foreign acquirer. In the end, Pechiney agreed to Alcan's sweetened offer, and
the deal was done. We wish more hostile bidders had such a clear path to
victory.
Chart 2 shows that all of the proposed acquisitions in which the Fund has
recently invested are strategic in nature, meaning combinations that involve a
corporate buyer-typically operating in the same industry as the target-whose
objective in doing the transaction is to enhance shareholder value on a longer-
term basis. Financial deals, in contrast, are usually structured as going-
private transactions, in which an investor group that often includes the
target's management uses large amounts of borrowed money to buy out the public
shareholders. In most cases, the goal in such highly leveraged deals is to pay
down debt and either sell or IPO the company, ideally within a relatively short
time frame of just a few years. Where have all the LBOs goneo Clearly, the
pronounced recovery in the equity markets over the past year or so hasn't been
helpful to financial buyers. Valuations have moved up from bargain-basement
levels, taking the "juice" out of many potential deals. At the same time,
corporate acquirers have seen their shares rally, giving them a more valuable
currency and a competitive edge when bidding against LBO firms. Of course, even
in the second half of 2002, when stock prices were significantly lower than they
are now, there wasn't much LBO activity. It's possible that the same factors
that put a damper on strategic deal-making-economic and geopolitical worries and
a crisis of confidence in the executive suite-prevented many potential LBOs from
happening. A year later, the window of opportunity for financial buyers may
have closed, leaving LBO groups to focus their efforts on buying parts of public
companies, not the whole enterprise.
Chart 3 shows the type of consideration to be received by the selling
company's shareholders in transactions in which The Merger Fund(R) held
positions at the end of its fiscal year. As might be expected given that
managements are naturally reluctant to issue new shares at what they consider to
be depressed levels, the percentage of our deals that involve at least some
stock has risen to 64%, up from 54% a year ago. Within the all-stock category,
roughly three-quarters of the transactions have fixed exchange ratios, while the
balance have flexible exchange ratios, meaning that the number of shares to be
issued by the acquirer will fluctuate with the price of its stock-the higher the
price, the fewer shares issued, and vice versa. When investing in mergers and
acquisitions with fixed exchange ratios, the Fund typically attempts to lock in
the arbitrage spread by selling short the acquirer's shares at the same time the
long position in the target is established. In this way, the Fund is hedged
against a decline in the acquirer's stock price prior to the close of the
transaction. The use of such hedging strategies helps explain why the
performance of The Merger Fund(R) is largely uncorrelated with moves in the
market averages.
Chart 4 shows our investments grouped by economic sector. A couple of things
are noteworthy about this year's chart. First, the Fund's sector exposure has
changed considerably over the past 12 months. Whereas deals in the telecom,
multi-sector and energy categories accounted for 48% of our long equity
positions at the end of fiscal 2002, these same three sectors now represent just
9% of our investments. Returning to the top spot this year is the financial
services sector, which over time has been the leading source of arbitrage
opportunities for the Fund. As we have explained before, however, sector
classifications are less important to us than the many other factors which are
likely to have a greater bearing on the outcome of a pending corporate
reorganization. Stated another way, an arb-friendly merger agreement or an
obvious fix to a potential antitrust problem are more relevant to our decision-
making than the fact that the parties to a deal operate in a particular economic
sector. Nonetheless, we do attempt to manage the Fund's industry exposure so as
to limit the risk that an industry-specific development could threaten multiple
deals in the portfolio. In this regard, Chart 4 shows that our holdings at the
end of September were well diversified by economic sector.
Chart 5 is new this year. It shows the Fund's arbitrage investments grouped
by the geographic region in which the target company is domiciled.
Approximately 79% of the deals in our portfolio at the end of fiscal 2003
involved U.S.-based targets, while another 5% involved acquisitions of Canadian
companies. Although The Merger Fund(R) has historically focused on North
American transactions, in recent years we have found an increasing number of
attractive opportunities in Europe. At the end of September, nearly 15% of our
arbitrage situations involved European targets. When investing outside of the
U.S., we may face different political, governance or regulatory issues, and we
are careful not to get involved in a foreign deal unless our research makes us
comfortable that we understand how the game is played. We also routinely hedge
the currency risk in cross-border deals, so that fluctuations in exchange rates
don't have an adverse impact on our returns.
Chart 6 shows the total dollar value of mergers and acquisitions in the U.S.,
by quarter, since 1991. M&A activity, which plateaued at an average annual rate
of close to $1.5 trillion in 1998, 1999 and 2000, has since fallen to much more
subdued levels. As noted earlier, the year ended September 2003 failed to bring
an upturn in deal volume. October, however, saw over $100 billion in new
transactions, more than were announced in the prior three months combined.
Although it is too soon to say that takeover activity has begun a robust,
sustainable recovery, it appears that the worst of the merger drought is behind
us. Buoyed by an improving business climate and a rising stock market,
corporate confidence seems to be taking a turn for the better. And as it does,
more deal-making should follow.
Finally, a few words about the market-timing and late-trading scandals that
have cast a cloud over the mutual-fund industry. The Merger Fund(R) has never
entered into market-timing or late-trading arrangements with any investor.
Moreover, since the Fund's inception in 1989, co-manager Bonnie Smith and I
have chosen not to do any personal trading, either in mutual funds or individual
stocks and bonds. Virtually all of our investable assets, including 100% of our
retirement plans, are committed to long-term holdings in The Merger Fund(R) or
one of the other investment vehicles that we manage. In other words, we only
eat our own cooking.
Sincerely,
/s/Frederick W. Green
Frederick W. Green
President
CHART 1 CHART 2
PORTFOLIO COMPOSITION PORTFOLIO COMPOSITION
BY TYPE OF DEAL*<F1> BY TYPE OF BUYER*<F1>
-------------------- ---------------------
FRIENDLY 93.5% STRATEGIC 100.0%
HOSTILE 6.5% FINANCIAL 0.0%
CHART 3
PORTFOLIO COMPOSITION
BY DEAL TERMS*<F1>
------------------
STOCK WITH FIXED EXCHANGE RATIO 24.1%
STOCK WITH FLEXIBLE EXCHANGE RATIO 8.5%
CASH & STOCK 30.9%
CASH 23.1%
UNDETERMINED 13.4%
*<F1> Data as of September 30, 2003
CHART 4
PORTFOLIO COMPOSITION
BY SECTOR*<2>
-------------
FINANCIAL SERVICES 20.3%
BASIC INDUSTRIES 13.4%
HEALTHCARE 12.1%
CONSUMER NON-DURABLES 10.9%
BUSINESS SERVICES 8.8%
TECHNOLOGY 8.8%
TELECOMMUNICATIONS 7.5%
TRANSPORTATION 5.1%
MEDIA 4.6%
CONSUMER DURABLES 4.2%
CONSUMER SERVICES 2.5%
MULTI-SECTOR 1.8%
CHART 5
PORTFOLIO COMPOSITION
BY REGION*<F2>
--------------
UNITED STATES 79.4%
EUROPE 14.6%
CANADA 5.1%
OTHER 0.9%
*<F2> Data as of September 30, 2003
CHART 6
MERGER ACTIVITY
1991 - 2003
Date First Quarter Second Quarter Third Quarter Fourth Quarter
- ---- ------------- -------------- ------------- --------------
1991 $19.9516 $20.5286 $27.3834 $16.3747
1992 $16.6579 $30.7912 $16.1062 $20.9834
1993 $20.3626 $30.0446 $72.4562 $64.2678
1994 $43.9419 $41.2508 $79.3201 $58.3516
1995 $63.2519 $109.5822 $138.6244 $92.8259
1996 $81.5836 $147.5119 $114.5835 $180.8346
1997 $157.8150 $135.3298 $146.4147 $247.8092
1998 $207.8147 $667.8133 $273.4782 $271.3921
1999 $344.2760 $473.5610 $227.3533 $495.8469
2000 $495.6549 $238.7511 $432.3114 $264.6629
2001 $161.5246 $138.7080 $154.2153 $121.5994
2002 $45.7014 $60.8711 $95.8875 $44.3849
2003 $36.7571 $57.2983 $68.9329
Source: Securities Data Corp.
COMPARISON OF CHANGE IN VALUE OF $10,000 INVESTMENT
IN THE MERGER FUND AND THE S&P 500
Date The Merger Fund S&P 500
---- --------------- -------
9/93 $10,000 $10,000
9/94 $11,255 $10,369
9/95 $12,472 $13,453
9/96 $13,870 $16,188
9/97 $15,372 $22,735
9/98 $15,498 $24,792
9/99 $18,801 $31,685
9/00 $22,402 $35,895
9/01 $23,281 $26,339
9/02 $21,327 $20,943
9/03 $23,861 $26,052
AVERAGE
ANNUAL TOTAL RETURN
------------------------------------
1 YR. 3 YR. 5 YR. 10 YR.
----- ----- ----- ------
The Merger Fund 11.9% 2.1% 9.0% 9.1%
The Standard & Poor's 500 Index (S&P 500) is a capital weighted index,
representing the aggregate market value of the common equity of 500 stocks
primarily traded on the New York Stock Exchange. This chart assumes an initial
gross investment of $10,000 made on September 30, 1993. Returns shown include
the reinvestment of all dividends. Past performance is not predictive of future
performance. The graph and table do not reflect the deduction of taxes that a
shareholder would pay on fund distributions or the redemption of fund shares.
Investment return and principal value will fluctuate, so that your shares, when
redeemed, may be worth more or less than the original cost.
THE MERGER FUND
SCHEDULE OF INVESTMENTS
SEPTEMBER 30, 2003
SHARES VALUE
------ -----
COMMON AND PREFERRED STOCKS -- 74.32%*<F3>
AIRLINES -- 0.38%*<F3>
253,331 Koninklijke Luchtvaart
Maatschappij NV(1)<F7>(5)<F11> $ 3,970,923
23,100 Koninklijke Luchtvaart
Maatschappij NV -- NYS(5)<F11> 359,898
--------------
4,330,821
--------------
ALUMINUM -- 4.68%*<F3>
918,831 Pechiney(1)<F7>(5)<F11> 50,558,652
118,600 Pechiney -- ADR(5)<F11> 3,243,710
--------------
53,802,362
--------------
AUTOMOTIVE PARTS & EQUIPMENT -- 2.97%*<F3>
2,212,900 Dana Corporation 34,145,047
--------------
BANKS -- 0.37%*<F3>
121,000 Pacific Northwest Bancorp(3)<F9> 4,313,650
--------------
COMPUTER HARDWARE -- 0.00%*<F3>
39,158 Hewlett-Packard Company
Contingent Value Rights**<F4>(6)<F12> 0
--------------
COMPUTER SOFTWARE -- 2.13%*<F3>
550,000 Legato Systems, Inc.**<F4> 6,165,500
1,004,300 PeopleSoft, Inc.**<F4>(3)<F9> 18,268,217
--------------
24,433,717
--------------
CONSULTING SERVICES -- 0.08%*<F3>
50,000 Right Management
Consultants, Inc.**<F4>(3)<F9> 904,000
--------------
DIAGNOSTIC TESTING -- 3.38%*<F3>
672,900 IGEN International, Inc.**<F4> 38,893,620
--------------
FOOD & BEVERAGES -- 6.19%*<F3>
915,103 Dreyer's Grand Ice Cream Holdings, Inc.(3)<F9> 71,158,409
--------------
HOME IMPROVEMENT -- 1.43%*<F3>
971,600 MAAX Inc.(3)<F9>(5)<F11> 16,451,932
--------------
INFORMATION TECHNOLOGY -- 3.02%*<F3>
1,667,600 The Titan Corporation**<F4>(1)<F7> 34,752,784
--------------
INSURANCE -- 4.13%*<F3>
66,335 Great-West Lifeco Inc., Series E(5)<F11>(8)<F14> 1,297,746
21,627 Great-West Lifeco Inc., Series F(5)<F11>(8)<F14> 417,491
837,300 John Hancock Financial Services, Inc.(1)<F7> 28,300,740
536,000 The MONY Group Inc.(1)<F7> 17,446,800
--------------
47,462,777
--------------
INTERNET SERVICES -- 0.98%*<F3>
427,300 Overture Services, Inc.**<F4> 11,319,177
--------------
INVESTMENT MANAGEMENT -- 2.70%*<F3>
742,600 Neuberger Berman Inc.(3)<F9> 31,092,662
--------------
MEDICAL DEVICES -- 6.88%*<F3>
173,000 Centerpulse -- ADR**<F4>(1)<F7>(5)<F11>(6)<F12> 5,124,779
116,588 Centerpulse AG**<F4>(3)<F9>(5)<F11>(6)<F12> 34,536,657
941,950 Instrumentarium Oyj(2)<F8>(5)<F11> 39,490,113
--------------
79,151,549
--------------
MEDICAL INFORMATION SYSTEMS -- 0.57%*<F3>
306,300 PracticeWorks, Inc.**<F4>(2)<F8> 6,576,261
--------------
METALS & MINING -- 1.32%*<F3>
683,500 Ashanti Goldfields Company Ltd.**<F4>(5)<F11> 7,142,575
350,000 Randgold Resources Limited _
ADR**<F4>(4)<F10>(5)<F11> 8,050,000
--------------
15,192,575
--------------
MULTI-INDUSTRY -- 1.29%*<F3>
309,566 Groupe Bruxelles Lambert S.A.(1)<F7>(5)<F11> 14,834,781
--------------
NETWORKING EQUIPMENT -- 0.01%*<F3>
115,000 Redback Networks Inc.**<F4> 70,150
--------------
OFFICE PRODUCTS & SERVICES -- 2.84%*<F3>
3,490,000 OfficeMax, Inc.**<F4>(2)<F8> 32,701,300
--------------
PAPER & FOREST PRODUCTS -- 3.79%*<F3>
1,072,500 Rayonier Inc.(2)<F8> 43,543,500
--------------
PHARMACEUTICALS -- 1.80%*<F3>
210,000 Abbott Laboratories(4)<F10> 8,935,500
241,500 Biogen, Inc.**<F4> 9,232,545
90,000 CIMA Labs Inc.**<F4>(2)<F8> 2,515,500
--------------
20,683,545
--------------
PHARMACY SERVICES -- 2.69%*<F3>
678,700 AdvancePCS**<F4> 30,928,359
--------------
REAL ESTATE DEVELOPMENT -- 1.98%*<F3>
576,900 Newhall Land & Farming Company 22,793,319
--------------
REAL ESTATE INVESTMENT TRUSTS -- 1.27%*<F3>
421,800 Chateau Communities, Inc. 12,552,768
100,000 Mid-Atlantic Realty Trust 2,100,000
--------------
14,652,768
--------------
SATELLITE COMMUNICATIONS -- 2.88%*<F3>
2,312,000 General Motors Corporation _
Class H**<F4>(4)<F10> 33,084,720
--------------
SAVINGS & LOANS -- 0.83%*<F3>
286,500 Bank United Corp. Litigation Contingent
Payment Rights Trust**<F4>(7)<F13> 14,325
186,118 First Essex Bancorp, Inc.(2)<F8> 9,471,545
--------------
9,485,870
--------------
SPECIALTY RENTALS -- 1.33%*<F3>
544,959 McGrath Rentcorp 15,231,604
--------------
TELEPHONY -- 5.22%*<F3>
3,176,850 NextWave Telecom Inc. _
Class B**<F4>(4)<F10>(6)<F12> 9,689,393
2,475,800 Price Communications Corporation**<F4>(1)<F7> 30,699,920
1,254,000 Telus Corporation(3)<F9>(5)<F11> 19,653,942
--------------
60,043,255
--------------
TITLE INSURANCE -- 0.77%*<F3>
355,000 Fidelity National Information Solutions,
Inc.**<F4>(4)<F10>(6)<F12> 8,857,250
--------------
TRANSACTION PROCESSING -- 3.25%*<F3>
2,737,000 Concord EFS, Inc.**<F4>(1)<F7> 37,414,790
--------------
TRUCKING -- 3.16%*<F3>
745,200 Roadway Corporation 36,343,404
--------------
TOTAL COMMON AND PREFERRED STOCKS
(Cost $843,258,902) 854,649,958
--------------
CONTRACTS (100 SHARES PER CONTRACT)
- -----------------------------------
PUT OPTIONS PURCHASED -- 0.00%*<F3>
Concord EFS, Inc.:
210 Expiration December 20, 2003,
Exercise Price $14.00 36,750
--------------
TOTAL PUT OPTIONS
(Cost $41,657) 36,750
--------------
PRINCIPAL AMOUNT
- ----------------
CONVERTIBLE BONDS -- 2.18%*<F3>
Adelphia Communications Corporation
$15,702,000 3.25%, 5/01/2021 D<F5>(6)<F12> 5,495,700
Enron Corp.
21,900,000 0.00%, 2/07/2021 D<F5>(6)<F12> 2,901,750
Redback Networks Inc.
13,537,000 5.00%, 4/01/2007 D<F5>(6)<F12> 5,465,564
Tyco International Ltd.
14,525,000 0.00%, 11/17/2020(5)<F11>(6)<F12> 11,193,401
--------------
TOTAL CONVERTIBLE BONDS (Cost $18,254,554) 25,056,415
--------------
CORPORATE BONDS -- 6.12%*<F3>
Adelphia Communications Corporation:
9,779,000 9.38%, 11/15/2009 D<F5>(6)<F12> 7,040,880
3,188,000 10.25%, 6/15/2011 D<F5>(6)<F12> 2,295,360
18,065,000 9.25%, 10/01/2022 D<F5>(6)<F12> 12,555,175
Roadway Corporation
26,670,000 8.25%, 12/01/2008(6)<F12> 30,620,627
Williams Holdings of Delaware, Inc.
8,250,000 6.13%, 12/01/2003(6)<F12> 8,250,000
WorldCom, Inc. - WorldCom Group:
7,000,000 7.50%, 5/15/2011 D<F5>(6)<F12> 2,301,250
22,330,000 7.88%, 5/15/2049 D<F5>(6)<F12> 7,340,988
--------------
TOTAL CORPORATE BONDS (Cost $63,770,836) 70,404,280
--------------
U.S. GOVERNMENT AGENCY OBLIGATIONS -- 1.14%*<F3>
Freddie Mac
13,000,000 7.16%, 12/18/2015 13,151,827
--------------
TOTAL U.S. GOVERNMENT AGENCY OBLIGATIONS
(Cost $13,591,026) 13,151,827
--------------
SHORT-TERM INVESTMENTS -- 15.59%*<F3>
COMMERCIAL PAPER -- 3.48%*<F3>
ConAgra Foods, Inc.
10,000,000 0.95%, 10/01/2003(3)<F9> 10,000,000
Gannett Co., Inc.
10,000,000 0.95%, 10/03/2003 9,999,472
Kinder Morgan Energy Partners, L.P.
10,000,000 1.05%, 10/10/2003 9,997,375
V.F. Corporation
10,000,000 1.05%, 10/02/2003 9,999,708
--------------
39,996,555
--------------
U.S. GOVERNMENT AGENCY OBLIGATIONS -- 8.69%*<F3>
Federal Home Loan Bank:
25,000,000 0.88%, 10/06/2003 24,996,944
25,000,000 0.88%, 10/07/2003(1)<F7> 24,996,333
25,005,000 0.91%, 10/08/2003(3)<F9> 25,000,575
25,009,000 0.93%, 10/14/2003 25,000,601
--------------
99,994,453
--------------
VARIABLE RATE DEMAND NOTES #<F6> -- 3.42%*<F3>
4,890,826 American Family Financial Services, Inc., 0.74% 4,890,826
27,020,675 U.S. Bank, 0.87% 27,020,675
7,426,252 Wisconsin Corporate Central Credit Union, 0.79% 7,426,252
--------------
39,337,753
--------------
TOTAL SHORT-TERM INVESTMENTS (Cost $179,328,761) 179,328,761
--------------
TOTAL INVESTMENTS (Cost $1,118,245,736) $1,142,627,991
--------------
--------------
ADR - American Depository Receipt
NYS - New York Shares
*<F3> Calculated as a percentage of net assets.
**<F4> Non-income producing security.
D<F5> Security in default.
#<F6> Variable rate demand notes are considered short-term obligations and
are payable on demand. Interest rates change periodically on
specified dates. The rates listed above are as of September 30,
2003.
(1)<F7> All or a portion of the shares have been committed as collateral for
open short positions.
(2)<F8> All or a portion of the shares have been committed as collateral for
short foreign currency contracts.
(3)<F9> All or a portion of the shares have been committed as collateral for
written option contracts.
(4)<F10> All or a portion of the shares have been committed as collateral for
equity swap contracts.
(5)<F11> Foreign security.
(6)<F12> Fair-valued security.
(7)<F13> Litigation settlement rights.
(8)<F14> Preferred stock.
See notes to the financial statements.
THE MERGER FUND
SCHEDULE OF SECURITIES SOLD SHORT
SEPTEMBER 30, 2003
SHARES VALUE
------ -----
117,470 Alcan Inc. $ 4,494,402
758,430 Boise Cascade Corporation 20,932,668
1,459,500 Caremark Rx, Inc. 32,984,700
495,000 EMC Corporation 6,251,850
292,400 Fidelity National Financial, Inc. 8,789,544
1,094,760 First Data Corporation 43,746,609
277,600 IDEC Pharmaceuticals Corporation 9,202,440
34,675 Lehman Brothers Holdings Inc. 2,395,349
83,300 Lockheed Martin Corporation 3,844,295
177,800 Manulife Financial Corporation 5,138,420
60,000 Pixelworks, Inc. 517,200
465,000 Randgold Resources Limited - ADR 10,695,000
1,393,300 Redback Networks Inc. 849,913
271,990 Sovereign Bancorp, Inc. 5,045,415
162,254 Suez SA 2,575,427
1,254,000 Telus Corporation 21,438,201
52,810 Total SA 7,970,383
144,000 Verizon Communications Inc. 4,671,360
84,265 Wells Fargo & Company 4,339,647
163,300 Yahoo! Inc. 5,777,554
585,945 Yellow Corporation 17,508,037
508,065 Zimmer Holdings, Inc. 27,994,382
------------
TOTAL SECURITIES SOLD SHORT
(Proceeds $243,119,475) $247,162,796
------------
------------
ADR - American Depository Receipt
See notes to the financial statements.
THE MERGER FUND
SCHEDULE OF OPTIONS WRITTEN
SEPTEMBER 30, 2003
CONTRACTS (100 SHARES PER CONTRACT) VALUE
- ----------------------------------- -----
CALL OPTIONS
Abbott Laboratories:
100 Expiration October 18, 2003, Exercise Price $40.00 $ 26,250
2,000 Expiration November 22, 2003, Exercise Price $40.00 620,000
Ashanti Goldfields Company Ltd.:
500 Expiration October 18, 2003, Exercise Price $10.00 56,250
4,035 Expiration December 20, 2003, Exercise Price $10.00 524,550
CIMA Labs Inc.:
900 Expiration December 20, 2003, Exercise Price $30.00 36,000
Dana Corporation:
2,750 Expiration October 18, 2003, Exercise Price $15.00 158,125
8,837 Expiration January 17, 2004, Exercise Price $15.00 905,793
Dreyer's Grand Ice Cream Holdings, Inc.:
250 Expiration January 17, 2004, Exercise Price $80.00 2,500
General Motors Corporation -- Class H:
22,120 Expiration December 20, 2003, Exercise Price $12.50 4,755,800
1,000 Expiration January 17, 2004, Exercise Price $12.50 217,500
IGEN International, Inc.:
2,229 Expiration October 18, 2003, Exercise Price $55.00 718,853
4,500 Expiration December 20, 2003, Exercise Price $60.00 630,000
John Hancock Financial Services, Inc.:
6,873 Expiration December 20, 2003, Exercise Price $30.00 2,817,930
The MONY Group Inc.:
5,360 Expiration January 17, 2004, Exercise Price $30.00 1,608,000
Neuberger Berman Inc.:
2,490 Expiration October 18, 2003, Exercise Price $40.00 498,000
Overture Services, Inc.:
1,600 Expiration October 18, 2003, Exercise Price $22.50 624,000
PeopleSoft, Inc.:
10,043 Expiration October 18, 2003, Exercise Price $17.50 1,104,730
Rayonier Inc.:
10,725 Expiration November 22, 2003, Exercise Price $40.00 1,581,937
Right Management Consultants, Inc.:
500 Expiration November 22, 2003, Exercise Price $17.50 50,000
The Titan Corporation
2,500 Expiration April 17, 2004, Exercise Price $22.50 75,000
-----------
TOTAL OPTIONS WRITTEN
(Premiums received $19,058,882) $17,011,218
-----------
-----------
See notes to the financial statements.
THE MERGER FUND
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 30, 2003
ASSETS:
Investments, at value (Cost $1,118,245,736) $1,142,627,991
Cash 31,189
Deposit at brokers for short sales 68,308,582
Receivable from brokers for proceeds on securities sold short 238,844,160
Receivable for investments sold 17,951,244
Receivable for fund shares issued 7,527,698
Receivable for written options 4,252,545
Receivable from custodian 190,182
Dividends and interest receivable 1,323,431
Prepaid expenses 68,875
--------------
Total Assets 1,481,125,897
--------------
LIABILITIES:
Securities sold short, at value (Proceeds of $243,119,475) $247,162,796
Options written, at value (Premiums received $19,058,882) 17,011,218
See accompanying schedule
Payable for investment securities purchased 61,125,706
Payable for fund shares redeemed 849,655
Payable for forward currency exchange contracts 2,862,100
Payable for equity swap contracts 532,838
Investment advisory fee payable 946,008
Distribution fees payable 338,374
Accrued expenses and other payables 306,970
------------
Total Liabilities 331,135,665
--------------
NET ASSETS $1,149,990,232
--------------
--------------
NET ASSETS Consist Of:
Accumulated undistributed net investment loss ($10,681,814)
Accumulated undistributed net realized loss on investments
sold, foreign currencies, securities sold short, equity swaps,
and option contracts expired or closed (85,661,552)
Net unrealized appreciation (depreciation) on:
Investments $ 24,382,255
Short positions (4,043,321)
Written options 2,047,664
Equity swap contracts (668,147)
Foreign currency translation 15,392
Forward currency exchange contracts (2,862,100)
------------
Net unrealized appreciation 18,871,743
Paid-in capital 1,227,461,855
--------------
Total Net Assets $1,149,990,232
--------------
--------------
NET ASSET VALUE, offering price and redemption price per share
($1,149,990,232 / 77,513,471 shares of beneficial
interest outstanding) $14.84
------
------
See notes to the financial statements.
THE MERGER FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 2003
INVESTMENT INCOME:
Interest $ 11,713,464
Dividend income on long positions
(net of foreign withholding taxes of $488,738) 10,944,439
------------
Total investment income 22,657,903
------------
EXPENSES:
Investment advisory fee $ 8,937,429
Distribution fees 1,774,700
Transfer agent and shareholder servicing agent fees 336,675
Federal and state registration fees 92,833
Professional fees 178,306
Trustees' fees and expenses 33,056
Custody fees 207,400
Administration fee 446,992
Reports to shareholders 166,400
Other 97,508
------------
Total operating expenses before interest expense
and dividends on short positions 12,271,299
Interest expense on equity swap contracts 2,600,427
Dividends on short positions 4,760,216
------------
Total expenses 19,631,942
------------
NET INVESTMENT INCOME 3,025,961
------------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Realized gain (loss) on:
Long transactions (43,502,368)
Short transactions 4,039,535
Option contracts expired or closed 5,115,453
Equity swap contracts 7,663,515
Foreign currencies (11,683,742)
------------
Net realized loss (38,367,607)
Change in unrealized appreciation / depreciation on:
Investments 167,476,117
Short positions (31,256,149)
Written options 1,484,546
Equity swap contracts (721,023)
Foreign currency translation 10,261
Forward currency exchange contracts (2,837,347)
------------
Net unrealized gain 134,156,405
------------
NET REALIZED AND UNREALIZED GAIN ON INVESTMENTS 95,788,798
------------
NET INCREASE IN NET ASSETS RESULTING FROM
OPERATIONS $ 98,814,759
------------
------------
See notes to the financial statements.
THE MERGER FUND
STATEMENT OF CHANGES IN NET ASSETS
YEAR ENDED YEAR ENDED
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
------------------ ------------------
Net investment income $ 3,025,961 $ 13,646,427
Net realized loss on investments sold, foreign
currency translations, forward currency exchange
contracts, securities sold short, equity swap contracts,
and option contracts expired or closed (38,367,607) (49,059,869)
Change in unrealized appreciation / depreciation on
investments, foreign currencies, forward currency
exchange contracts, short positions, equity swap
contracts and written options 134,156,405 (52,822,278)
-------------- -------------
Net increase (decrease) in net assets
resulting from operations 98,814,759 (88,235,720)
-------------- -------------
Distributions to shareholders from:
Net investment income (11,728,173) (12,365,528)
Net realized gains -- (50,198,621)
-------------- -------------
Total dividends and distributions (11,728,173) (62,564,149)
-------------- -------------
Net increase in net assets from capital
share transactions (Note 4) 208,946,909 21,863,116
-------------- -------------
Net increase (decrease) in net assets 296,033,495 (128,936,753)
NET ASSETS:
Beginning of period 853,956,737 982,893,490
-------------- -------------
End of period (including accumulated undistributed net
investment income (loss) of ($10,681,814) and $9,672,479
respectively) $1,149,990,232 $ 853,956,737
-------------- -------------
-------------- -------------
See notes to the financial statements.
THE MERGER FUND
FINANCIAL HIGHLIGHTS
Selected per share data is based on a share of beneficial interest outstanding
throughout each period.
YEAR YEAR YEAR YEAR YEAR
ENDED ENDED ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2001 2000 1999
------------- ------------- ------------- ------------- -------------
Net Asset Value,
beginning of period $13.46 $15.74 $16.90 $15.37 $13.90
Income from investment
operations:
Net investment income(2)<F16> 0.06(4) 0.23(4) 0.36(3) 0.25(3) 0.08(3)
<F18> <F18> <F17> <F17> <F17>
Net realized and unrealized
gain (loss) on investments 1.52 (1.45) 0.27 2.50 2.71
------ ------ ------ ------ ------
Total from investment
operations 1.58 (1.22) 0.63 2.75 2.79
Less distributions:
Dividends from net
investment income (0.20) (0.21) (0.14) (0.07) (0.22)
Distributions from net
realized gains -- (0.85) (1.65) (1.15) (1.10)
------ ------ ------ ------ ------
Total distributions (0.20) (1.06) (1.79) (1.22) (1.32)
------ ------ ------ ------ ------
Net Asset Value,
end of period $14.84 $13.46 $15.74 $16.90 $15.37
------ ------ ------ ------ ------
------ ------ ------ ------ ------
Total Return 11.88% (8.39)% 3.86% 19.08% 21.39%
Supplemental Data and Ratios:
Net assets, end
of period (000's) $1,149,990 $853,957 $982,893 $1,078,958 $575,449
Ratio of operating expenses
to average net assets(1)<F15> 1.37% 1.38% 1.34% 1.34% 1.38%
Ratio of interest expense and
dividends on short positions
to average net assets 0.82% 0.27% 0.67% 0.86% 1.07%
Ratio of net investment income
to average net assets 0.34% 1.36% 2.23% 1.57% 0.54%
Portfolio turnover rate(5)<F19> 309.18% 258.37% 383.74% 419.24% 386.52%
(1)<F15> For the years ended September 30, 2003, 2002, 2001, 2000 and 1999,
the operating expense ratio excludes interest expense and dividends
on short positions. The ratios including interest expense and
dividends on short positions for the years ended September 2003,
2002, 2001, 2000 and 1999, were 2.19%, 1.65%, 2.01%, 2.20% and
2.45%, respectively.
(2)<F16> Net investment income before interest expense and dividends on short
positions for the years ended September 30, 2003, 2002, 2001, 2000
and 1999, was $0.16, $0.27, $0.47, $0.38 and $0.23, respectively.
(3)<F17> Net investment income per share represents net investment income for
the respective period divided by the monthly average shares of
beneficial interest outstanding throughout each period.
(4)<F18> Net investment income per share is calculated using ending balances
prior to consideration of adjustments for permanent book and tax
differences.
(5)<F19> The numerator for the portfolio turnover rate includes the lesser of
purchases or sales (excluding short positions). The denominator
includes the average long positions throughout the period.
See notes to the financial statements.
THE MERGER FUND
NOTES TO THE FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
NOTE 1 -- ORGANIZATION
The Merger Fund (the "Fund") is a no-load, open-end, non-diversified
investment company organized as a trust under the laws of the Commonwealth of
Massachusetts on April 12, 1982, and registered under the Investment Company Act
of 1940 (the "1940 Act"), as amended. The Fund was formerly known as the Risk
Portfolio of The Ayco Fund. In January of 1989, the Fund's fundamental policies
were amended to permit the Fund to engage exclusively in merger arbitrage. At
the same time, Westchester Capital Management, Inc. became the Fund's investment
adviser, and the Fund began to do business as The Merger Fund. Merger arbitrage
is a highly specialized investment approach generally designed to profit from
the successful completion of proposed mergers, takeovers, tender offers,
leveraged buyouts, liquidations and other types of corporate reorganizations.
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. These
policies are in conformity with generally accepted accounting principles.
A. Investment Valuation
Securities listed on the NASDAQ National Market are valued at the NASDAQ
Official Closing Price ("NOCP"). Other investments in securities and
commodities (including options) are valued at the last sales price on the
securities or commodities exchange on which such financial instruments are
primarily traded. Securities not listed on an exchange or securities for which
there were no transactions are valued at the average of the current bid and
asked prices. Securities for which there are no such valuations are valued at
fair value as determined in good faith by management under the supervision of
the Board of Trustees. The investment adviser reserves the right to value
securities, including options, at prices other than last-sale prices or the
average of current bid and asked prices when such prices are believed
unrepresentative of fair market value as determined in good faith by the
adviser. At September 30, 2003 fair valued long securities represent 13.45% of
investments, at value. Investments in United States government securities (other
than short-term securities) are valued at the average of the quoted bid and
asked prices in the over-the-counter market. Short-term investments are carried
at amortized cost, which approximates market value.
B. Short Positions
The Fund may sell securities or currencies short for hedging purposes. For
financial statement purposes, an amount equal to the settlement amount is
included in the Statement of Assets and Liabilities as an asset and an
equivalent liability. The amount of the liability is subsequently marked-to-
market to reflect the current value of the short position. Subsequent
fluctuations in the market prices of securities or currencies sold, but not yet
purchased, may require purchasing the securities or currencies at prices which
may differ from the market value reflected on the Statement of Assets and
Liabilities. The Fund is liable for any dividends payable on securities while
those securities are in a short position. As collateral for its short positions,
the Fund is required under the 1940 Act to maintain assets consisting of cash,
cash equivalents or liquid securities. These assets are required to be adjusted
daily to reflect changes in the value of the securities or currencies sold
short.
C. Transactions with Brokers for Short Sales
The Fund's receivable from brokers for proceeds on securities sold short and
deposit at brokers for short sales are with three major securities dealers. The
Fund does not require the brokers to maintain collateral in support of the
receivable from the broker for proceeds on securities sold short.
D. Federal Income Taxes
No provision for federal income taxes has been made since the Fund has
complied to date with the provisions of the Internal Revenue Code applicable to
regulated investment companies and intends to continue to so comply in future
years and to distribute investment company net taxable income and net capital
gains to shareholders. Additionally, the Fund intends to make all required
distributions to avoid federal excise tax.
E. Written Option Accounting
The Fund writes (sells) covered call options to hedge portfolio investments.
Uncovered put options can also be written by the Fund as part of a merger
arbitrage strategy involving a pending corporate reorganization. When the Fund
writes (sells) an option, an amount equal to the premium received by the Fund is
included in the Statement of Assets and Liabilities as an asset and an
equivalent liability. The amount of the liability is subsequently marked-to-
market to reflect the current value of the option written. By writing an option,
the Fund may become obligated during the term of the option to deliver or
purchase the securities underlying the option at the exercise price if the
option is exercised. Option contracts are valued at the last sales price
reported on the date of valuation. If no sale is reported, the option contract
written is valued at the average of the current bid and asked price reported on
the day of valuation. When an option expires on its stipulated expiration date
or the Fund enters into a closing purchase transaction, the Fund realizes a gain
or loss if the cost of the closing purchase transaction differs from the premium
received when the option was sold without regard to any unrealized gain or loss
on the underlying security, and the liability related to such option is
eliminated. When an option is exercised, the premium originally received
decreases the cost basis of the security (or increases the proceeds on a sale of
the security), and the Fund realizes a gain or loss from the sale of the
underlying security.
F. Purchased Option Accounting
The Fund purchases put options to hedge portfolio investments. Call options
may be purchased only for the purpose of closing out previously written covered
call options. Premiums paid for option contracts purchased are included in the
Statement of Assets and Liabilities as an asset. Option contracts are valued at
the last sales price reported on the date of valuation. If no sale is reported,
the option contract purchased is valued at the average of the current bid and
asked price reported on the day of valuation. When option contracts expire or
are closed, realized gains or losses are recognized without regard to any
unrealized gains or losses on the underlying securities.
G. Forward Currency Exchange Contracts
The Fund may enter into forward currency exchange contracts obligating the
Fund to deliver and receive a currency at a specified future date. Forward
contracts are valued daily and unrealized appreciation or depreciation is
recorded daily as the difference between the contract exchange rate and the
closing forward rate applied to the face amount of the contract. A realized gain
or loss is recorded at the time the forward contract is closed.
H. Distributions to Shareholders
Dividends from net investment income and net realized capital gains, if any,
are declared and paid annually. Income and capital gain distributions are
determined in accordance with income tax regulations which may differ from
generally accepted accounting principles. These differences are due primarily to
wash loss deferrals, constructive sales, straddle loss deferrals, adjustments on
equity swaps, and unrealized gains or losses on Section 1256 contracts, which
are realized, for tax purposes, at September 30, 2003. Accordingly,
reclassifications are made within the net asset accounts for such amounts, as
well as amounts related to permanent differences in the character of certain
income and expense items for income tax and financial reporting purposes. The
Fund may utilize earnings and profits distributed to shareholders on redemption
of shares as part of the dividends paid deduction.
I. Use of 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 revenues and expenses during the reporting period.
Actual results could differ from those estimates.
J. Foreign Securities
Investing in securities of foreign companies and foreign governments involves
special risks and considerations not typically associated with investing in U.S.
companies and the U.S. government. These risks include revaluation of currencies
and future adverse political and economic developments. Moreover, securities of
many foreign companies and foreign governments and their markets may be less
liquid and their prices more volatile than those of securities of comparable
U.S. companies and the U.S. government.
K. Foreign Currency Translations
The books and records of the Fund are maintained in U.S. dollars. Foreign
currency transactions are translated into U.S. dollars on the following basis:
(i) market value of investment securities, assets and liabilities at the daily
rates of exchange, and (ii) purchases and sales of investment securities,
dividend and interest income and certain expenses at the rates of exchange
prevailing on the respective dates of such transactions. For financial reporting
purposes, the Fund does not isolate changes in the exchange rate of investment
securities from the fluctuations arising from changes in the market prices of
securities. However, for federal income tax purposes the Fund does isolate and
treat as ordinary income the effect of changes in foreign exchange rates on
realized gain or loss from the sale of investment securities and payables and
receivables arising from trade date and settlement date differences.
L. When-Issued Securities
The Fund may sell securities on a when-issued or delayed delivery basis.
Although the payment and interest terms of these securities are established at
the time the Fund enters into the agreement, these securities may be delivered
for cash proceeds at a future date. The Fund records sales of when-issued
securities and reflects the values of such securities in determining net asset
value in the same manner as other open short sale positions. The Fund segregates
and maintains at all times cash, cash equivalents, or other liquid securities in
an amount at least equal to the market value for when-issued securities.
M. Other
Investment and shareholder transactions are recorded on the trade date.
Realized gains and losses from security transactions are recorded on the
identified cost basis. Dividend income and distributions to shareholders are
recorded on the ex-dividend date. Interest is accounted for on the accrual
basis. Investment income includes $669,199 of interest earned on receivables
from brokers for proceeds on securities sold short and deposits. The Fund may
utilize derivative instruments including options, forward currency exchange
contracts and other instruments with similar characteristics to the extent that
they are consistent with the Fund's investment objectives and limitations. The
use of these instruments may involve additional investment risks including the
possibility of illiquid markets or imperfect correlation between the value of
the instruments and the underlying securities.
NOTE 3 -- AGREEMENTS
The Fund's investment adviser is Westchester Capital Management, Inc. (the
"Adviser") pursuant to an investment advisory agreement dated January 31, 1989.
Under the terms of this agreement, the Adviser is entitled to receive a fee,
calculated daily and payable monthly, at the annual rate of 1.00% of the Fund's
average daily net assets. Certain officers of the Fund are also officers of the
Adviser.
U.S. Bancorp Fund Services, LLC, a subsidiary of U.S. Bancorp, a publicly
held bank holding company, serves as transfer agent, administrator and
accounting services agent for the Fund. U.S. Bank, N.A. serves as custodian for
the Fund.
Distribution services are performed pursuant to distribution contracts with
broker-dealers and other qualified institutions. Prior to its resignation on
June 30, 2003, Mercer Allied Company, L.P. served as the Fund's principal
underwriter. The Fund has not had a principal underwriter since such date.
NOTE 4 -- SHARES OF BENEFICIAL INTEREST
The Trustees have the authority to issue an unlimited amount of shares of
beneficial interest without par value.
Changes in shares of beneficial interest were as follows:
YEAR ENDED YEAR ENDED
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
---------------------------- ---------------------------
SHARES AMOUNT SHARES AMOUNT
----------- ------------- ----------- ------------
Sold 50,925,065 $ 724,702,611 62,705,294 $939,169,175
Issued as reinvestment
of dividends 819,393 11,250,262 4,068,906 60,016,356
Redeemed (37,670,473) (527,005,964) (65,762,532) (977,322,415)
----------- ------------- ----------- ------------
Net increase 14,073,985 $ 208,946,909 1,011,668 $ 21,863,116
----------- ------------- ----------- ------------
----------- ------------- ----------- ------------
For the period August 9, 1999 through October 4, 2001, The Merger Fund was
closed to new investors. Effective October 5, 2001, The Merger Fund reopened to
new investors.
NOTE 5 -- INVESTMENT TRANSACTIONS
Purchases and sales of securities for the year ended September 30, 2003
(excluding short-term investments, options and short positions) aggregated
$2,334,652,143 and $2,092,950,696, respectively. There were no purchases or
sales of U.S. Government Securities.
At September 30, 2003, the components of accumulated losses on a tax basis
were as follows:
Cost of Investments $1,159,962,529
--------------
--------------
Gross unrealized appreciation $ 40,687,057
Gross unrealized depreciation (58,021,595)
--------------
Net unrealized depreciation $ (17,334,538)
--------------
--------------
Undistributed ordinary income $ 3,130,135
Undistributed long-term capital gain --
--------------
Total distributable earnings $ 3,130,135
--------------
--------------
Other accumulated losses $ (80,601,758)
--------------
Total accumulated losses $ (77,471,623)
--------------
--------------
The tax components of capital loss carryovers as of September 30, 2003, and
tax-basis post-October loss deferrals (recognized for tax purposes on October 1,
2003) are as follows:
NET CAPITAL CAPITAL LOSS
LOSS CARRYOVER POST-OCTOBER
CARRYOVER*<F20> EXPIRATION LOSS
--------------- ------------ ------------
$17,185,725 2010 $36,613,632
$ 6,619,041 2011
-----------
$23,804,766
*<F20> Capital gain distributions will resume in the future to the extent
gains are realized in excess of the available carryforwards.
The tax components of dividends paid during the years ended September 30,
2003 and 2002 were as follows:
2003 2002
---- ----
Ordinary Income $11,728,173 $62,564,149
Long-Term Capital Gains $ -- $ --
NOTE 6 -- OPTION CONTRACTS WRITTEN
The premium amount and the number of option contracts written during the year
ended September 30, 2003, were as follows:
PREMIUM NUMBER OF
AMOUNT CONTRACTS
------------ ---------
Options outstanding at September 30, 2002 $ 3,209,068 17,181
Options written 104,789,434 470,646
Options closed (10,307,773) (65,398)
Options exercised (70,566,437) (266,563)
Options expired (8,065,410) (66,554)
------------ --------
Options outstanding at September 30, 2003 $ 19,058,882 89,312
------------ --------
------------ --------
NOTE 7 -- DISTRIBUTION PLAN
The Fund has adopted a Plan of Distribution (the "Plan") dated July 1, 1993,
as amended, pursuant to Rule 12b-1 under the 1940 Act. Under the Plan, the Fund
will compensate broker-dealers or qualified institutions with whom the Fund has
entered into a contract to distribute Fund shares ("Dealers"). Under the Plan,
the amount of such compensation paid in any one year shall not exceed 0.25%
annually of the average daily net assets of the Fund, which may be payable as a
service fee for providing record keeping, subaccounting, subtransfer agency
and/or shareholder liaison services. For the year ended September 30, 2003, the
Fund incurred $1,774,700 pursuant to the Plan.
The Plan will remain in effect from year to year provided such continuance is
approved at least annually by a vote either of a majority of the Trustees,
including a majority of the non-interested Trustees, or a majority of the Fund's
outstanding shares.
NOTE 8 -- CREDIT FACILITY
Custodial Trust Company has made available to the Fund a $230 million credit
facility (subject to increase under certain conditions) pursuant to a Loan and
Security Agreement ("Agreement") dated March 18, 1992 (subsequently amended) for
the purpose of purchasing portfolio securities. The Agreement can be terminated
by either the Fund or Custodial Trust Company with three months' prior notice.
As collateral for the loan, the Fund is required under the 1940 Act to maintain
assets consisting of cash, cash equivalents or liquid securities. The assets are
required to be adjusted daily to reflect changes in the amount of the loan
outstanding. During the year ended September 30, 2003 the Fund did not have any
borrowings outstanding under the Agreement.
NOTE 9 -- FORWARD CURRENCY EXCHANGE CONTRACTS
At September 30, 2003, the Fund had entered into "position hedge" forward
currency exchange contracts that obligated the Fund to deliver and receive
currencies at a specified future date. The net unrealized depreciation of
$2,862,100 is included in the net unrealized appreciation (depreciation) section
of the accompanying financial statements. The terms of the open contracts are as
follows:
SETTLEMENT CURRENCY TO U.S. $ VALUE AT CURRENCY TO U.S. $ VALUE AT
DATE BE DELIVERED SEPTEMBER 30, 2003 BE RECEIVED SEPTEMBER 30, 2003
---------- ------------ ------------------ ----------- ------------------
10/31/03 21,375,200 Canadian Dollars $ 15,821,470 15,576,963 U.S. Dollars $ 15,576,963
11/28/03 8,077,570 Canadian Dollars 5,972,039 5,803,061 U.S. Dollars 5,803,061
10/17/03 33,910,200 Euros 39,466,513 38,878,044 U.S. Dollars 38,878,044
11/28/03 2,649,542 Euros 3,079,751 2,902,573 U.S. Dollars 2,902,573
12/19/03 46,805,503 Euros 54,373,652 53,094,004 U.S. Dollars 53,094,004
1/30/04 3,404,475 Euros 3,962,311 3,958,093 U.S. Dollars 3,958,093
10/31/03 15,106,583 Swiss Francs 11,453,165 11,054,063 U.S. Dollars 11,054,063
------------ ------------
$134,128,901 $131,266,801
------------ ------------
------------ ------------
NOTE 10 -- EQUITY SWAP CONTRACTS
The Fund has entered into both long and short equity swap contracts with
multiple broker/dealers. A long equity swap contract entitles the Fund to
receive from the counterparty any appreciation and dividends paid on an
individual security, while obligating the Fund to pay the counterparty any
depreciation on the security as well as interest on the notional amount of the
contract at a rate equal to LIBOR plus 50 to 100 basis points. A short equity
swap contract obligates the Fund to pay the counterparty any appreciation and
dividends paid on an individual security, while entitling the Fund to receive
from the counterparty any depreciation on the security as well as interest on
the notional value of the contract at a rate equal to LIBOR less 50 to 100 basis
points.
The Fund may also enter into equity swap contracts whose value is determined
by the spread between a long equity position and a short equity position. This
type of swap contract obligates the Fund to pay the counterparty an amount tied
to any increase in the spread between the two securities over the term of the
contract. The Fund is also obligated to pay the counterparty any dividends paid
on the short equity holding as well as any net financing costs. This type of
swap contract entitles the Fund to receive from the counterparty any gains based
on a decrease in the spread as well as any dividends paid on the long equity
holding and any net interest income.
Fluctuations in the value of an open contract are recorded daily as a net
unrealized gain or loss. The Fund will realize a gain or loss upon termination
or reset of the contract. Either party, under certain conditions, may terminate
the contract prior to the contract's expiration date.
Credit risk may arise as a result of the failure of the counterparty to
comply with the terms of the contract. The Fund considers the creditworthiness
of each counterparty to a contract in evaluating potential credit risk. The
counterparty risk to the Fund is limited to the net unrealized gain, if any, on
the contract, along with dividends receivable on long equity contracts and
interest receivable on short equity contracts. Additionally, risk may arise from
unanticipated movements in interest rates or in the value of the underlying
securities. At September 30, 2003, the Fund had the following open equity swap
contracts:
UNREALIZED APPRECIATION
TERMINATION DATE SECURITY SHARES (DEPRECIATION)
- ---------------- -------- ------ --------------
9/30/04 BHP Billiton plc 161,000 $ (24,472)
2/28/04 Canary Wharf Group 4,395,601 278,951
4/30/04 Fording Canadian Coal Trust 128,552 (39,723)
1/16/04 KLM Jan 16 Call (200,000) 112
9/30/04 Pechiney Sept 45 Call (181,100) (45,746)
6/30/04 Reed Elsevier NV 333,691 (164,391)
9/30/04 Reed International (475,825) 146,816
6/30/04 Safeway plc 4,609,861 208,575
6/30/04 William Morrison (5,059,033) (1,028,269)
-----------
$ (668,147)
-----------
-----------
For the year ended September 30, 2003, the Fund realized gains of $7,663,515
upon the termination of equity swap contracts.
NOTE 11 -- FEDERAL TAX DISCLOSURE (UNAUDITED)
For the year ended September 30, 2003, 37% of ordinary distributions paid
qualifies for the dividends received deduction available to corporate
shareholders. Shareholders should consult their tax advisers.
REPORT OF INDEPENDENT AUDITORS
To the Board of Trustees and Shareholders of
The Merger Fund
In our opinion, the accompanying statement of assets and liabilities, including
the schedules of investments, of securities sold short and of options written,
and the related statements of operations, of changes in net assets and the
financial highlights present fairly, in all material respects, the financial
position of The Merger Fund (the "Fund") at September 30, 2003, the results of
its operations, the changes in its net assets and the financial highlights for
each of the periods indicated, in conformity with accounting principles
generally accepted in the United States of America. These financial statements
and financial highlights (hereafter referred to as "financial statements") are
the responsibility of the Fund's management; our responsibility is to express an
opinion on these financial statements based on our audit. We conducted our
audit of these financial statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits, which included confirmation of securities at
September 30, 2003 by correspondence with the custodian and brokers, provide a
reasonable basis for our opinion.
/s/PricewaterhouseCoopers LLP
Milwaukee, Wisconsin
November 14, 2003
INFORMATION ABOUT TRUSTEES AND OFFICERS
The business and affairs of the Fund are managed under the direction of the
Fund's Board of Trustees. Information pertaining to the Officers and Trustees of
the Fund is set forth below. The SAI includes additional information about the
Fund's Officers and Trustees and is available, without charge, upon request by
calling 1-800-343-8959.
TERM OF # OF PORTFOLIOS OTHER
POSITIONS(S) OFFICE AND IN FUND COMPLEX DIRECTORSHIPS
HELD WITH LENGTH OF PRINCIPAL OCCUPATION OVERSEEN BY HELD BY OFFICER
NAME, ADDRESS AND AGE THE FUND TIME SERVED DURING PAST FIVE YEARS OFFICER OR TRUSTEE OR TRUSTEE
- --------------------- ------------ ----------- ---------------------- ------------------ ---------------
Frederick W. Green*<F21> President One-year President of 2 None
Westchester Capital and term; Westchester Capital
Management, Inc. Trustee since 1989 Management, Inc.,
100 Summit Lake Drive the Fund's Adviser.
Valhalla, NY 10595
Age: 56
Bonnie L. Smith Vice One-year Vice President of 2 None
Westchester Capital President, term; Westchester Capital
Management, Inc. Secretary since 1989 Management, Inc.,
100 Summit Lake Drive and the Fund's Adviser.
Valhalla, NY 10595 Treasurer
Age: 55
James P. Logan, III Independent One-year President of Logan, 2 None
Logan, Chace LLC Trustee term; Chace LLC, an
420 Lexington Avenue since 1989 executive search firm.
New York, NY 10170 Chairman of J.P.
Age: 67 Logan & Company.
Michael J. Downey Independent One-year Managing Partner of 2 Chairman and
2 Parsons Lane Trustee term; Lexington Capital Director of The
Rochester, NY 14610 since 1995 Investments. Asia Pacific
Age: 59 Consultant and Fund, Inc.
independent financial
adviser since July
1993.
*<F21> Denotes a trustee who is an "interested person" as that term is defined
in Section 2 (a)(19) of the Investment Company Act of 1940, as amended
(the "1940 Act").
INVESTMENT ADVISER
Westchester Capital Management, Inc.
100 Summit Lake Drive
Valhalla, NY 10595
(914) 741-5600
ADMINISTRATOR, TRANSFER AGENT, DIVIDEND PAYING
AGENT, AND SHAREHOLDER SERVICING AGENT
U.S. Bancorp Fund Services, LLC
615 East Michigan Street
P.O. Box 701
Milwaukee, WI 53201-0701
(800) 343-8959
CUSTODIAN
U.S. Bank, N.A.
P.O. Box 701
Milwaukee, WI 53201-0701
(800) 343-8959
TRUSTEES
Frederick W. Green
Michael J. Downey
James P. Logan, III
EXECUTIVE OFFICERS
Frederick W. Green, President
Bonnie L. Smith, Vice President,
Treasurer and Secretary
COUNSEL
Fulbright & Jaworski L.L.P.
666 Fifth Avenue
New York, NY 10103
INDEPENDENT AUDITORS
PricewaterhouseCoopers LLP
100 East Wisconsin Avenue
Milwaukee, WI 53202
ITEM 2. CODE OF ETHICS.
- ----------------------
The registrant has adopted a code of ethics that applies to the registrant's
principal executive officer and principal financial officer. The registrant has
not made any amendments to its code of ethics during the covered period. The
registrant has not granted any waivers from any provisions of the code of ethics
during the covered period. The registrant undertakes to provide to any person
without charge, upon request, a copy of its code of ethics by mail when they
call the registrant at 1-800-343-8959.
ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT.
- ----------------------------------------
The registrant's board of trustees has determined that there is at least one
audit committee financial expert serving on its audit committee. Michael J.
Downey and James P. Logan, III are audit committee financial experts and are
considered to be independent.
ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
- -----------------------------------------------
Not required for annual reports filed for periods ending before December 15,
2003.
ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS.
- ----------------------------------------------
Not applicable to open-end investment companies.
ITEM 6. [RESERVED]
- ------------------
ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END
- -------------------------------------------------------------------------
MANAGEMENT INVESTMENT COMPANIES.
- --------------------------------
Not applicable to open-end investment companies.
ITEM 8. [RESERVED]
- ------------------
ITEM 9. CONTROLS AND PROCEDURES.
- --------------------------------
(a) The Registrant's President/Chief Executive Officer and Treasurer/Chief
Financial Officer have concluded that the registrant's disclosure controls
and procedures (as defined in Rule 30a-3(c) under the Investment Company
Act of 1940 (the "Act")) are effective as of a date within 90 days of the
filing date of the report that includes the disclosure required by this
paragraph, based on the evaluation of these controls and procedures
required by Rule 30a-3(b) under the Act.
(b) There were no changes in the Registrant's internal control over financial
reporting (as defined in Rule 30a-3(d) under the Act) that occurred during
the registrant's last fiscal half-year that has materially affected, or is
reasonably likely to materially affect, the registrant's internal control
over financial reporting.
ITEM 10. EXHIBITS.
- -----------------
(a)(1) Any code of ethics or amendment thereto. Filed herewith.
(a)(2) Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Filed herewith.
(b) Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Furnished herewith.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant) The Merger Fund
----------------------------------------
By (Signature and Title) /s/ Frederick W. Green
------------------------------
Frederick W. Green, President
Date December 3, 2003
-----------------------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
By (Signature and Title) /s/ Frederick W. Green
-----------------------------
Frederick W. Green, President
Date December 3, 2003
------------------------------------------------
By (Signature and Title) /s/ Bonnie Smith
-----------------------------
Bonnie Smith, Treasurer
Date December 3, 2003
------------------------------------------------