UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM N-CSR
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CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT
INVESTMENT COMPANIES
INVESTMENT COMPANY ACT FILE NUMBER 811-09815
THE ARBITRAGE FUNDS
(Exact name of Registrant as specified in charter)
--------
650 Fifth Avenue
6th Floor
New York, NY 10019
(Address of principal executive offices) (Zip code)
John S. Orrico
Water Island Capital, LLC
650 Fifth Avenue
6th Floor
New York, NY 10019
(Name and address of agent for service)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 212-259-2655
DATE OF FISCAL YEAR END: MAY 31, 2006
DATE OF REPORTING PERIOD: MAY 31, 2006
ITEM 1. REPORTS TO STOCKHOLDERS.
[Arbitrage Logo Omitted]
THE ARBITRAGE FUND
A SERIES OF THE ARBITRAGE FUNDS
650 Fifth Avenue
New York, New York 10019
ANNUAL REPORT
MAY 31, 2006
WWW.THEARBFUND.COM
[Arbitrage Logo Omitted]
THE ARBITRAGE FUND
Water Island Capital, LLC
650 Fifth Avenue
New York, New York 10019
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TEL: 212.259.2656 FAX: 212.259.2698
July 10, 2006
Dear Shareholder:
As The Arbitrage Fund operates on a May 31 fiscal year, we are pleased to
present this year's Annual Report covering the period from June 1, 2005 through
May 31, 2006. Looking back at the letter enclosed in last year's Annual Report,
one cannot help but observe what a difference a year makes. In that letter, we
noted that signs of a healthy merger arbitrage market were at hand and that
although the widening of spreads might provide a minor or temporary drag on
returns, the situation of negligible dealflow and low interest rates was rapidly
reversing itself to the benefit of merger arbitrage. In fact, it was and, as a
result, the Fund's Class R Shares generated a return of 7.15% for the 12 months
ending May 31, 2006.
Since our last Annual Report to you, the two key drivers of profits in merger
arbitrage: (1) higher interest rates and (2) normalized dealflow (in that order)
have indeed improved substantially. Short term rates are double what they were
in June 2004, and more than quadruple where they stood in January 2004. Since
profit margins (i.e. spreads) in merger arbitrage track short term rates, we
believe the profit potential in merger arbitrage is considerably greater than it
has been at any time since 2000.
Similarly, though less critically, dealflow is at record levels. In fact, during
the past 12 months we have witnessed a greater level of merger transactions
(both in number of transactions and dollar value) than we have seen in half a
decade. We expect this trend to continue through the balance of this year,
driven in large part by globalization of the world's major economies. We say,
however, that record dealflow, while clearly a boon for arbitrageurs, is "less
critical" because whether or not deal volume breaks records or continues at
current levels, The Arbitrage Fund is well positioned to profit from the wider
spreads that result from higher short term interest rates as long as deal volume
remains within historical norms.
It is also worth noting in the current volatile market that mergers occur in
both up markets and down ones and that some of the best acquisition
opportunities may frequently appear in difficult or volatile markets.
For these reasons, we are pleased to report to you that our predictions
regarding an improved merger arbitrage environment have proven accurate and our
efforts have borne fruit in the form of improved returns. We strongly believe
that the merger market remains in the first stage of an extended recovery both
at home and abroad and that that recovery will continue for several years to
come. Record dealflow or not, we believe higher and more stable short term
interest rates are here to stay, and that should bode well for the Fund's
performance.
1
We thank you for your continued support and renew again our commitment to
provide our shareholders with capital appreciation consistent with the
overriding principle of capital preservation. Please also know that, as always,
we welcome your calls.
Sincerely,
/s/ John S. Orrico
John S. Orrico, CFA
Portfolio Manager
President, Water Island Capital, LLC
THE MATERIAL ABOVE REFLECTS THE MANAGER'S OPINION OF THE MARKET AS OF A CERTAIN
DATE AND SHOULD NOT BE RELIED UPON AS INVESTMENT ADVICE. THE FUND USES
INVESTMENT TECHNIQUES THAT ARE DIFFERENT FROM THE RISKS ORDINARILY ASSOCIATED
WITH EQUITY INVESTMENTS. SUCH TECHNIQUES AND STRATEGIES INCLUDE MERGER ARBITRAGE
RISKS, HIGH PORTFOLIO RISKS, OPTION RISKS, BORROWING RISKS, SHORT SALE RISKS,
AND FOREIGN INVESTMENT RISKS, WHICH MAY INCREASE VOLATILITY AND MAY INCREASE
COSTS AND LOWER PERFORMANCE.
THE ARBITRAGE FUND IS DISTRIBUTED BY SEI INVESTMENTS DISTRIBUTION CO., WHICH IS
NOT AFFILIATED WITH THE ADVISOR OR ANY AFFILIATE.
THIS REPORT IS INTENDED FOR THE FUND'S SHAREHOLDERS. IT MAY NOT BE DISTRIBUTED
TO PROSPECTIVE INVESTORS UNLESS IT IS PRECEDED OR ACCOMPANIED BY A CURRENT
PROSPECTUS.
2
Comparison of the Change in Value of a $10,000 Investment
in The Arbitrage Fund(c) versus the S&P 500 Index
[Line Graph Omitted]
Plot Points are as follows:
The Arbitrage Fund S&P 500 Index
9/00 10,000 10,000
9,820 9,128
12,656 8,632
5/01 11,733 8,772
10,831 7,944
10,741 8,012
11,334 7,811
5/02 11,594 7,557
11,957 6,514
11,925 6,689
12,182 6,039
5/03 12,801 6,948
13,011 7,300
13,756 7,698
14,210 8,366
5/04 13,654 8,221
13,142 8,136
13,612 8,688
13,726 8,950
5/05 13,510 8,898
13,886 9,158
13,772 9,422
14,170 9,701
5/06 14,478 9,667
AVERAGE ANNUAL TOTAL RETURNS(B)
(FOR PERIODS ENDED MAY 31, 2006)
1 YEAR 5 YEAR SINCE INCEPTION
---------- ---------- ----------------
The Arbitrage Fund - Class R 7.15% 4.29% 6.70% (c)
The Arbitrage Fund - Class I 7.38% n/a 2.95% (d)
S&P 500 Index 8.64% 1.96% (0.59%)(c)
(a) The line graph above represents performance of Class R shares only, which
will vary from the performance of Class I shares based on the difference in
fees paid by shareholders in the different classes.
(b) The returns shown do not reflect the deduction of taxes a shareholder would
pay on Fund distributions or the redemption of Fund shares. Fee waivers are in
effect. If they had not been in effect, performance would have been lower.
(c) Represents the period from the commencement of operations of Class R shares
(September 17, 2000) through May 31, 2006.
(d) Represents the period from the commencement of operations of Class I shares
(October 17, 2003) through May 31, 2006.
3
THE ARBITRAGE FUND
Portfolio Information
May 31, 2006 (Unaudited)
- --------------------------------------------------------------------------------
ASSET ALLOCATION (as a percentage of total investments)
- --------------------------------------------------------------------------------
The following chart shows the Fund's asset composition as of the report date.
[Pie Chart Omitted] Plot points are as follows:
Common Stocks - 91.80%
Equity Swaps - 4.74%
Real Estate Investment Trusts - 3.20%
Other - 0.26%
4
THE ARBITRAGE FUND
Statement of Assets and Liabilities
May 31, 2006
- --------------------------------------------------------------------------------
ASSETS
Investments:
At acquisition cost $ 183,132,254
=============
At value (Note 1) $ 184,557,327
Deposits with brokers for securities sold short (Note 1 19,931,679
Receivable for investment securities sold 3,574,963
Receivable for capital shares sold 375,626
Dividends and interest receivable 115,881
Unrealized appreciation on
forward currency exchange contracts (Note 8) 30,649
Prepaid expenses 46,320
-------------
Total Assets 208,632,445
-------------
LIABILITIES
Securities sold short, at value (Note 1
(proceeds $19,346,846) 18,179,652
Bank overdraft 4,139,979
Bank overdraft denominated in foreign currency
(cost $1,717,298) 1,729,136
Written options, at value (Notes 1 and 2
(premiums received $663,271) 581,708
Unrealized depreciation on
forward currency exchange contracts (Note 8) 574,692
Payable for investment securities purchased 7,222,517
Payable for capital shares redeemed 157,884
Dividends payable on securities sold short (Note 1) 47,573
Payable to Adviser (Note 3) 217,348
Payable to Distributor (Note 3) 16,981
Payable to Administrator (Note 3) 14,686
Payable to Trustees 12,000
Payable to Chief Compliance Officer 3,598
Other accrued expenses and liabilities 81,137
-------------
Total Liabilities 32,978,891
-------------
NET ASSETS $ 175,653,554
=============
NET ASSETS CONSIST OF:
Paid-in capital $ 172,972,738
Accumulated net investment loss (1,317,045)
Accumulated net realized gains on investment transactions 1,880,143
Net unrealized appreciation (depreciation) on:
Investments 1,425,073
Securities sold short 1,167,194
Written option contracts 81,563
Translation of assets and liabilities
denominated in foreign currencies (556,112)
-------------
Net Assets $ 175,653,554
=============
CLASS R SHARES
Net assets applicable to Class R shares $ 87,642,672
=============
Shares of beneficial interest outstanding
(unlimited number of shares authorized, no par value) 6,885,427
=============
Net assets value and offering price per share (a) $ 12.73
=============
CLASS I SHARES
Net assets applicable to Class I shares $ 88,010,882
=============
Shares of beneficial interest outstanding
(unlimited number of shares authorized, no par value) 6,869,014
=============
Net assets value and offering price per share (a) $ 12.81
=============
(a) Redemption price varies based on length of time held (Note 1).
See accompanying notes to financial statements.
5
THE ARBITRAGE FUND
Statement of Operations
For the Year Ended May 31, 2006
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Dividends (net of withholding taxes of $49,010) $ 2,642,513
Interest 1,065,459
Other (Note 7) 1,778
-------------
Total Income 3,709,750
-------------
EXPENSES
Investment advisory fees (Note 3) 2,885,534
Distribution expense, Class R (Note 3) 273,965
Administration fees (Note 3) 197,501
Dividend expense 566,682
Transfer agent fees (Note 3) 102,091
Transfer agent and shareholder service fees, Class R (Note 3) 3,695
Transfer agent, account maintenance and shareholder service
fees, Class I (Note 3) 5,161
Custodian and bank service fees 67,476
Registration and filing fees, Common 66,134
Registration and filing fees, Class R 1,195
Registration and filing fees, Class I 1,090
Professional fees 57,899
Trustees' fees 48,860
Insurance expense 46,256
Printing of shareholder reports 45,411
Chief Compliance Officer fees (Note 3) 20,400
Fund accounting fees (Note 3) 13,975
Postage and supplies 3,181
Other expenses 25,424
-------------
Total Expenses 4,431,930
Fees waived by the Adviser (Note 3) (318,096)
Class R expenses reimbursed by the Adviser (Note 3) (1,740)
Class I expenses reimbursed by the Adviser (Note 3) (1,161)
-------------
Net Expenses 4,110,933
-------------
NET INVESTMENT LOSS (401,183)
-------------
REALIZED AND UNREALIZED GAINS (LOSSES) ON INVESTMENTS AND
FOREIGN CURRENCIES (NOTE 5)
Net realized gains (losses) from:
Investments 30,327,309
Securities sold short (13,506,076)
Written option contracts 1,261,386
Foreign currency transactions (458,202)
Net change in unrealized appreciation (depreciation) on:
Investments (6,988,743)
Securities sold short 4,528,444
Written option contracts 226,294
Foreign currency transactions (1,724,192)
-------------
NET REALIZED AND UNREALIZED GAINS ON INVESTMENTS
AND FOREIGN CURRENCIES 13,666,220
-------------
NET INCREASE IN NET ASSETS FROM OPERATIONS $ 13,265,037
=============
See accompanying notes to financial statements.
6
THE ARBITRAGE FUND
Statements of Changes in Net Assets
- -----------------------------------------------------------------------------------------------
YEAR YEAR
ENDED ENDED
MAY 31, MAY 31,
2006 2005
FROM OPERATIONS
Net investment loss $ (401,183) $ (3,340,794)
Net realized gains (losses) from:
Investments 30,327,309 (2,877,488)
Securities sold short (13,506,076) --
Written option contracts 1,261,386 867,279
Foreign currency transactions (458,202) (267,246)
Net change in unrealized appreciation (depreciation) on:
Investments (6,988,743) 2,933,375
Securities sold short 4,528,444 (3,695,496)
Written option contracts 226,294 88,045
Foreign currency transactions (1,724,192) 1,168,107
------------- -------------
Net increase (decrease) in net assets resulting from operations 13,265,037 (5,124,218)
------------- -------------
FROM DISTRIBUTIONS TO SHAREHOLDERS
Distributions from net realized gains, Class R -- (7,254,491)
Distributions from net realized gains, Class I -- (4,670,105)
------------- -------------
Decrease in net assets from distributions to shareholders -- (11,924,596)
------------- -------------
FROM CAPITAL SHARE TRANSACTIONS (NOTE 4)
CLASS R
Proceeds from shares sold 24,876,671 43,128,832
Shares issued in reinvestment of distributions -- 7,011,970
Proceeds from redemption fees collected (Note 1) 27,885 25,653
Payments for shares redeemed (78,607,975) (145,366,395)
------------- -------------
Net decrease in net assets from
Class R share transactions (53,703,419) (95,199,940)
------------- -------------
CLASS I
Proceeds from shares sold 28,645,078 54,421,439
Shares issued in reinvestment of distributions -- 4,413,952
Proceeds from redemption fees collected (Note 1) 147 10,556
Payments for shares redeemed (41,005,110) (126,968,574)
------------- -------------
Net decrease in net assets from
Class I share transactions (12,359,885) (68,122,627)
------------- -------------
TOTAL DECREASE IN NET ASSETS (52,798,267) (180,371,381)
NET ASSETS
Beginning of year 228,451,821 408,823,202
------------- -------------
End of year $ 175,653,554 $ 228,451,821
============= =============
ACCUMULATED NET INVESTMENT LOSS $ (1,317,045) $ --
============= =============
See accompanying notes to financial statements.
7
THE ARBITRAGE FUND - CLASS R
Financial Highlights
- ------------------------------------------------------------------------------------------------------
SELECTED PER SHARE DATA AND RATIOS FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD
- ------------------------------------------------------------------------------------------------------
YEAR YEAR YEAR YEAR YEAR
ENDED ENDED ENDED ENDED ENDED
MAY 31, MAY 31, MAY 31, MAY 31, MAY 31,
2006 2005 2004 2003 2002
- ------------------------------------------------------------------------------------------------------
Net asset value at beginning of year $ 11.88 $ 12.52 $ 12.20 $ 11.19 $ 11.66
-------- --------- --------- --------- --------
Income (loss) from investment operations:
Net investment loss (0.10) (0.19) (0.19) (0.04) (0.04)
Net realized and unrealized gains (losses)
on investments and foreign currencies 0.95 0.07 1.01 1.20 (0.08)
-------- --------- --------- --------- --------
Total from investment operations 0.85 (0.12) 0.82 1.16 (0.12)
-------- --------- --------- --------- --------
Less distributions:
From net realized gains -- (0.52) (0.50) (0.15) (0.35)
-------- --------- --------- --------- --------
Proceeds from redemption fees collected 0.00(a) 0.00(a) 0.00(a) -- --
-------- --------- --------- --------- --------
Net asset value at end of year $ 12.73 $ 11.88 $ 12.52 $ 12.20 $ 11.19
======== ========= ========= ========= ========
Total return (b) 7.15% (1.07%) 6.66% 10.41% (0.86%)
======== ========= ========= ========= ========
Net assets at end of year (000's) $ 87,643 $ 134,035 $ 239,494 $ 129,879 $ 11,314
======== ========= ========= ========= ========
Ratio of gross expenses to average
net assets 2.41% 2.36% 2.46% 3.00% 6.19%
Ratio of gross expenses to average net
assets excluding dividend expense (c) 2.12% 2.06% 2.01% 2.54% 5.94%
Ratio of net expenses to average net assets
excluding dividend expense (c) (d) 1.95% 1.95% 1.95% 1.95% 1.94%
Ratio of net investment loss to
average net assets:
Before advisory fees waived and
expenses reimbursed (0.44%) (1.27%) (1.76%) (1.56%) (5.19%)
After advisory fees waived and
expenses reimbursed (0.28%) (1.16%) (1.69%) (0.97%) (1.18%)
Portfolio turnover rate 394% 387% 251% 511% 2,480%
(a) Amount rounds to less than $0.01 per share.
(b) Total return is a measure of the change in the value of an investment in the Fund over the periods
covered, which assumes any dividends or capital gains distributions are reinvested in shares of the
Fund. Returns shown do not reflect the deduction of taxes a shareholder would pay on Fund distributions
or the redemption of Fund shares.
(c) Dividend expense totaled 0.29%, 0.30%, 0.45%, 0.46% and 0.25% of average net assets for the years ended
May 31, 2006, 2005, 2004, 2003 and 2002, respectively.
(d) Ratios were determined based on net assets after advisory fees waived and expenses reimbursed.
Amounts designated as "--" are either $0 or round to $0.
See accompanying notes to financial statements.
8
THE ARBITRAGE FUND - CLASS I
Financial Highlights
- ---------------------------------------------------------------------------------------
SELECTED PER SHARE DATA AND RATIOS FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD
- ---------------------------------------------------------------------------------------
YEAR YEAR PERIOD
ENDED ENDED ENDED
MAY 31, MAY 31, MAY 31,
2006 2005 2004(A)
- ---------------------------------------------------------------------------------------
Net asset value at beginning of period $ 11.93 $ 12.54 $ 12.86
-------- --------- ---------
Income (loss) from investment operations:
Net investment loss (0.10) (0.15) (0.07)
Net realized and unrealized gains on
investments and foreign currencies 0.98 0.06 0.25
-------- --------- ---------
Total from investment operations 0.88 (0.09) 0.18
-------- --------- ---------
Less distributions:
From net realized gains -- (0.52) (0.50)
-------- --------- ---------
Proceeds from redemption fees collected 0.00(b) 0.00(b) 0.00(b)
-------- --------- ---------
Net asset value at end of period $ 12.81 $ 11.93 $ 12.54
======== ========= =========
Total return (d) 7.38% (0.82%) 1.35%(c)
======== ========= =========
Net assets at end of period (000's) $ 88,011 $ 94,417 $ 169,330
======== ========= =========
Ratio of gross expenses to average net assets 2.16% 2.14% 2.27%(e)
Ratio of gross expenses to average net assets
excluding dividend expense (f) 1.87% 1.84% 1.82%(e)
Ratio of net expenses to average net assets excluding
dividend expense (f)(g) 1.70% 1.70% 1.70%(e)
Ratio of net investment loss to average net assets:
Before advisory fees waived and expenses reimbursed (0.29%) (1.05%) (1.56%)(e)
After advisory fees waived and expenses reimbursed (0.12%) (0.91%) (1.44%)(e)
Portfolio turnover rate 394% 387% 251%(e)
(a) Represents the period from the commencement of operations (October 17, 2003) through
May 31, 2004.
(b) Amount rounds to less than $0.01 per share.
(c) Not annualized.
(d) Total return is a measure of the change in the value of an investment in the Fund over
the periods covered, which assumes any dividends or capital gains distributions are
reinvested in shares of the Fund. Returns shown do not reflect the deduction of taxes
a shareholder would pay on Fund distributions or the redemption of Fund shares.
(e) Annualized.
(f) Dividend expense totaled 0.29%, 0.30% and 0.45%(e) of average net assets for the periods
ended May 31, 2006, 2005 and 2004, respectively.
(g) Ratios were determined based on net assets after advisory fees waived and expenses
reimbursed.
Amounts designated as "--" are either $0 or round to $0.
See accompanying notes to financial statements.
9
THE ARBITRAGE FUND
Portfolio of Investments
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 96.45% VALUE
- -------------------------------------------------------------------------------------
APPAREL/TEXTILES -- 1.71%
354,439 Mossimo, Inc. (a) ........................................... $ 2,729,180
15,000 Russell Corp. ............................................... 273,750
------------
3,002,930
------------
BANKS -- 4.47%
50,000 Banco BPI SA ................................................ 367,997
70,000 Commercial Capital Bancorp, Inc. ............................ 1,099,000
65,294 Interchange Financial Services Corp. (b) .................... 1,467,809
100,000 North Fork Bancorporation, Inc. (b) ......................... 2,947,000
95,000 Sound Federal Bancorp, Inc. (b) ............................. 1,964,600
------------
7,846,406
------------
BEVERAGES -- 2.36%
125,000 Vincor International, Inc. .................................. 4,139,607
------------
BIOTECHNOLOGY -- 0.16%
292,100 Oragenics, Inc. (a) ......................................... 286,258
------------
BROADCASTING, NEWSPAPERS & ADVERTISING -- 1.07%
117,500 Emmis Communications Corp., Cl A (a) ........................ 1,887,050
------------
CHEMICALS -- 0.55%
25,000 Engelhard Corp. ............................................. 973,250
------------
COMPUTERS & SERVICES -- 5.82%
275,144 Advanced Digital Information Corp. (a)(b) ................... 3,265,959
60,000 Fargo Electronics, Inc. (a) ................................. 1,489,800
109,500 Lipman Electronic Engineering Ltd. (a) ...................... 3,220,395
133,037 SBS Technologies, Inc. (a)(b) ............................... 2,192,450
2,005 Seagate Technology .......................................... 46,814
------------
10,215,418
------------
CONSUMER PRODUCTS -- 0.00%
10,000 Oneida Ltd. (a) ............................................. 2,200
------------
CONTAINERS & PACKAGING -- 0.98%
50,000 Airspray NV ................................................. 1,717,959
------------
ELECTRICAL EQUIPMENT -- 2.09%
123,310 Excel Technology, Inc. (a) .................................. 3,677,104
------------
ELECTRICAL SERVICES -- 0.06%
4,000 Duke Energy Corp. ........................................... 112,880
------------
ENVIRONMENTAL SERVICES -- 4.86%
274,838 Duratek, Inc. (a)(b) ........................................ 6,029,946
115,000 Zenon Environmental, Inc. (a) ............................... 2,501,703
------------
8,531,649
------------
10
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 96.45% (Continued) VALUE
- -------------------------------------------------------------------------------------
FINANCIAL SERVICES -- 4.83%
21,770 Athlon Holding NV ........................................... $ 839,437
11,000 Capital One Financial Corp. (c) ............................. 910,470
60,000 Euronext NV ................................................. 5,163,511
196,696 Loring Ward International Ltd. (a) .......................... 803,971
65,000 SFE Corp. Ltd. .............................................. 763,709
------------
8,481,098
------------
GAS/NATURAL GAS -- 3.26%
75,000 KeySpan Corp. (b) ........................................... 3,002,250
10,000 Kinder Morgan, Inc. ......................................... 1,004,800
150,000 Transmontaigne, Inc. (a)(b) ................................. 1,725,000
------------
5,732,050
------------
HOTELS & LODGING -- 3.01%
50,000 Aztar Corp. (a) ............................................. 2,593,000
600,400 Jameson Inns, Inc. (a) ...................................... 1,741,160
64,900 Sands Regent (a) ............................................ 947,540
------------
5,281,700
------------
HOUSEHOLD PRODUCTS -- 0.01%
230 Whirlpool Corp. ............................................. 20,682
------------
INSURANCE -- 2.64%
369,400 Capital Title Group, Inc. (b) ............................... 2,766,806
311,097 Ceres Group Inc (a) ......................................... 1,863,471
------------
4,630,277
------------
LABORATORY EQUIPMENT -- 2.11%
50,000 Fisher Scientific International, Inc. (a)(c) ................ 3,712,500
------------
MEASURING DEVICES -- 2.24%
44,745 Amazys Holding AG ........................................... 3,938,422
------------
MEDIA -- 0.00%
5,000 TVSL SA ..................................................... --
------------
MEDICAL PRODUCTS & SERVICES -- 6.80%
165,000 Andrx Corp. (a)(b)(c) ....................................... 3,854,400
5,095 Boston Scientific Corp. (a) ................................. 105,365
30,000 Diagnostic Products Corp. ................................... 1,731,600
162,293 Encore Medical Corp. (a) .................................... 808,219
7,000 Schering AG ................................................. 765,150
150,000 Serologicals Corp. (a) ...................................... 4,675,500
------------
11,940,234
------------
11
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 96.45% (Continued) VALUE
- -------------------------------------------------------------------------------------
METALS & MINING -- 1.01%
10,000 Falconbridge Ltd. ........................................... $ 500,700
20,000 Falconbridge Ltd. ........................................... 994,596
2,720 Inco Ltd. (c) ............................................... 179,357
69,900 Western Copper Corp. (a) .................................... 91,426
------------
1,766,079
------------
MISCELLANEOUS BUSINESS SERVICES -- 4.20%
167,506 Alderwoods Group, Inc. (a)(b) ............................... 3,239,566
40,000 Aramark Corp., Cl B ......................................... 1,310,000
818,671 Goldleaf Financial Solutions, Inc. (a) ...................... 1,440,861
83,657 Remedytemp, Inc., Cl A (a) .................................. 1,381,177
------------
7,371,604
------------
MISCELLANEOUS MANUFACTURING -- 2.80%
70,000 Applied Films Corp. (a) ..................................... 1,984,500
496,278 Identix, Inc. (a)(b) ........................................ 2,928,040
------------
4,912,540
------------
PETROLEUM EXPLORATION & PRODUCTION -- 9.14%
70 ConocoPhillips .............................................. 4,430
110,500 KCS Energy, Inc. (a) ........................................ 3,113,890
125,000 Producers Oilfield Services, Inc. (a) ....................... 1,664,472
150,000 Remington Oil & Gas Corp. (a)(b) ............................ 6,351,000
98,700 Stone Energy Corp. (a)(c) ................................... 4,920,195
------------
16,053,987
------------
PHOTOGRAPHIC EQUIPMENT & SUPPLIES -- 1.61%
300,000 Lexar Media, Inc. (a) ....................................... 2,829,000
------------
PRINTING & PUBLISHING -- 1.79%
95,600 Thomas Nelson, Inc. ......................................... 2,844,100
10,000 Tribune Co. ................................................. 298,400
------------
3,142,500
------------
PROFESSIONAL SERVICES -- 1.96%
80,000 Education Management Corp. (a) .............................. 3,436,000
------------
RETAIL -- 3.79%
165,000 Albertson's, Inc. ........................................... 4,225,650
63,899 Sportsman's Guide, Inc. (a) ................................. 1,947,642
150,000 Telepizza ................................................... 491,304
1 Woolworths Ltd. ............................................. 14
------------
6,664,610
------------
12
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 96.45% (Continued) VALUE
- -------------------------------------------------------------------------------------
RETIREMENT SERVICES -- 1.10%
60,000 American Retirement Corp. (a) ............................... $ 1,932,600
------------
SEMICONDUCTORS -- 4.24%
183,900 ADE Corp. (a) ............................................... 5,923,419
450,000 Conexant Systems, Inc. (a) .................................. 1,318,500
2,224 Microsemi Corp. (a) ......................................... 53,332
55,000 Mindspeed Technologies, Inc. (a) ............................ 157,850
------------
7,453,101
------------
SOFTWARE -- 5.59%
1,131,500 Manugistics Group, Inc. (a) ................................. 2,817,435
230,951 NetIQ Corp. (a) ............................................. 2,810,673
510,000 Portal Software, Inc. (a) ................................... 2,499,000
88,099 SSA Global Technologies, Inc. (a)(b) ........................ 1,687,096
------------
9,814,204
------------
TELEPHONES & TELECOMMUNICATIONS -- 6.33%
85,000 Andrew Corp. (a) ............................................ 860,200
775,000 Lucent Technologies, Inc. (a) ............................... 1,976,250
625,000 Mpower Holding Corp. (a) .................................... 1,150,000
178,753 Nextel Partners, Inc., Cl A (a)(b) .......................... 5,076,585
35,000 Portugal Telecom SGPS SA .................................... 411,797
150,000 Ubiquitel, Inc. (a) ......................................... 1,561,500
175,000 Wireless Matrix Corp. (a) ................................... 89,014
------------
11,125,346
------------
TESTING LABORATORIES -- 0.74%
418,538 Xenogen Corp. (a) ........................................... 1,301,653
------------
TRAVEL SERVICES -- 1.11%
120,154 Navigant International, Inc. (a) ............................ 1,951,301
------------
WHOLESALE -- 2.01%
75,000 Aviall, Inc. (a)(b) ......................................... 3,536,250
------------
TOTAL COMMON STOCK (Cost $168,297,408) $169,420,449
------------
- -------------------------------------------------------------------------------------
SHARES EQUITY SWAPS -- 4.98% VALUE
- -------------------------------------------------------------------------------------
153,029 Aegis Group Plc ............................................. $ 394,464
50,000 Alliance UniChem Plc ........................................ 865,941
10,000 BAA Plc ..................................................... 163,270
90,000 BOC Group Plc ............................................... 2,639,084
100,000 Body Shop International Plc ................................. 552,967
13
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES EQUITY SWAPS -- 4.98% (Continued) VALUE
- -------------------------------------------------------------------------------------
20,000 Cambridge Antibody Technology Group Plc (a) ................. $ 488,407
65,000 Enodis Plc .................................................. 228,064
100,000 nCipher Plc (a) ............................................. 390,164
400,000 Pilkington Plc .............................................. 1,225,697
150,000 Systems Union Group Plc ..................................... 588,755
100,000 Virgin Mobile Holdings (UK) Plc ............................. 697,056
50,000 Wyevale Garden Centres Plc .................................. 512,734
------------
TOTAL EQUITY SWAPS (Cost $8,342,213) $ 8,746,603
------------
- -------------------------------------------------------------------------------------
SHARES REAL ESTATE INVESTMENT TRUSTS -- 3.36% VALUE
- -------------------------------------------------------------------------------------
200,000 Boykin Lodging Co. (a) ...................................... $ 2,138,000
85,000 CarrAmerica Realty Corp. (b) ................................ 3,768,050
------------
TOTAL REAL ESTATE INVESTMENT TRUSTS (Cost $5,940,044) $ 5,906,050
------------
- -------------------------------------------------------------------------------------
SHARES WARRANTS -- 0.06% VALUE
- -------------------------------------------------------------------------------------
250,000 Oragenics, Inc., Expires 12/07 (a) .......................... $ 95,000
85,000 Oragenics, Inc., Expires 11/08 (a) .......................... --
------------
TOTAL WARRANTS (Cost $--) $ 95,000
------------
- -------------------------------------------------------------------------------------
SHARES ESCROWED RIGHTS -- 0.00% VALUE
- -------------------------------------------------------------------------------------
35,300 Hoenig Group, Inc. - contingent payment rights (a)(d) ....... $ --
247,200 PetroCorp, Inc. - escrow shares (a)(d) ...................... --
------------
TOTAL ESCROWED RIGHTS (Cost $--) $ --
------------
- -------------------------------------------------------------------------------------
CONTRACTS PUT OPTION CONTRACTS -- 0.18% VALUE
- -------------------------------------------------------------------------------------
Andrx Corp.,
40 09/19/06 at $22.5 ......................................... $ 3,600
Archipelago Holdings, Inc.,
250 07/25/06 at $60 ........................................... 117,500
Capital One Financial Corp.,
100 06/20/06 at $80 ........................................... 6,000
Energy Partners Ltd.,
250 07/25/06 at $20 ........................................... 21,250
Fisher Scientific International, Inc.,
200 07/25/06 at $70 ........................................... 21,500
14
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
CONTRACTS PUT OPTION CONTRACTS -- 0.18% (Continued) VALUE
- -------------------------------------------------------------------------------------
Inco Ltd.,
100 07/25/06 at $45 ........................................... $ 1,000
100 07/25/06 at $65 ........................................... 39,000
KLA-Tencor Corp.,
400 07/25/06 at $37.5 ......................................... 35,000
LandAmerica Financial Group, Inc.,
75 06/20/06 at $65 ........................................... 4,500
Maytag Corp.,
500 07/25/06 at $17.5 ......................................... --
Plains Exploration & Production Co.,
210 08/22/06 at $35 ........................................... 39,375
Stone Energy Corp.,
500 07/25/06 at $45 ........................................... 17,500
VeriFone Holdings, Inc.,
100 07/25/06 at $30 ........................................... 9,500
------------
TOTAL PUT OPTION CONTRACTS (Cost $471,039) $ 315,725
------------
- -------------------------------------------------------------------------------------
CONTRACTS CALL OPTION CONTRACTS -- 0.04% VALUE
- -------------------------------------------------------------------------------------
Fisher Scientific International, Inc.,
200 07/25/06 at $75 ........................................... $ 51,000
KLA-Tencor Corp.,
100 06/20/06 at $42.5 ......................................... 6,500
100 07/22/06 at $42.5 ......................................... 16,000
------------
TOTAL CALL OPTION CONTRACTS (Cost $81,550) $ 73,500
------------
TOTAL INVESTMENTS AT VALUE -- 105.07% (Cost $183,132,254)... $184,557,327
============
Percentages are based on net assets of $175,653,554.
(a) Non-income producing security.
(b) All or a portion of the shares have been pledged as collateral for open short
positions.
(c) Underlying security for a written/purchased call/put option.
(d) This security was issued for possible settlement of pending litigation and does
not have an expiration date.
Cl -- Class
Ltd. -- Limited
Plc -- Public Limited Company
UK -- United Kingdom
Amounts designated as "--" are either $0 or have been rounded to $0.
See accompanying notes to financial statements.
15
THE ARBITRAGE FUND
Schedule of Securities Sold Short
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 9.86% VALUE
- -------------------------------------------------------------------------------------
APPAREL/TEXTILES -- 0.48%
53,000 Iconix Brand Group, Inc. (a)(b) ............................. $ 846,410
------------
ELECTRICAL EQUIPMENT -- 1.41%
184,600 Viisage Technology, Inc. (a)(b) ............................. 2,473,640
------------
FINANCIAL SERVICES -- 0.94%
33,150 Australian Stock Exchange Ltd. .............................. 761,994
15,000 NYSE Group, Inc. (a)(b) ..................................... 897,000
------------
1,658,994
------------
FOOD -- 0.00%
528 Metcash Ltd. ................................................ 1,663
------------
INSURANCE -- 0.40%
10,500 LandAmerica Financial Group, Inc. (b) ....................... 702,660
------------
MEASURING DEVICES -- 0.88%
20,000 Thermo Electron Corp. (a)(b) ................................ 734,800
69,000 X-Rite, Inc. ................................................ 805,920
------------
1,540,720
------------
MEDICAL PRODUCTS & SERVICES -- 0.16%
54,000 Caliper Life Sciences, Inc. (a) ............................. 277,560
------------
METALS & MINING -- 0.00%
89 Glamis Gold Ltd. (a) ........................................ 3,456
------------
PETROLEUM EXPLORATION & PRODUCTION -- 1.68%
60,000 Helix Energy Solutions Group, Inc. (a) ...................... 2,127,600
40,000 PetroHawk Energy Corp. (a)(b) ............................... 469,200
10,000 Plains Exploration & Production Co. (a)(b) .................. 357,000
------------
2,953,800
------------
PRINTING & PUBLISHING -- 0.00%
8 RH Donnelley Corp. .......................................... 439
------------
SEMICONDUCTORS -- 1.12%
119,050 Micron Technology, Inc. (a)(b) .............................. 1,971,468
------------
SOFTWARE -- 0.99%
55,000 VeriFone Holdings, Inc. (a)(b) .............................. 1,740,200
------------
16
THE ARBITRAGE FUND
Schedule of Securities Sold Short (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 9.86% (Continued) VALUE
- -------------------------------------------------------------------------------------
TELEPHONES & TELECOMMUNICATIONS -- 0.69%
87,600 Alcatel SA ADR .............................................. $ 1,162,452
1,500 NTL, Inc. (a) ............................................... 40,020
------------
1,202,472
------------
TRUCKING -- 0.76%
44,500 Mullen Group Income Fund .................................... 1,331,423
------------
WHOLESALE -- 0.35%
20,900 Supervalu, Inc. ............................................. 609,444
------------
TOTAL COMMON STOCK (Proceeds $18,518,563) $ 17,314,349
------------
- -------------------------------------------------------------------------------------
SHARES EQUITY SWAP -- 0.49% VALUE
- -------------------------------------------------------------------------------------
65,590 Boots Group Plc (Proceeds $828,283) ......................... $ 865,303
------------
TOTAL SECURITIES SOLD SHORT -- 10.35% (Proceeds $19,346,846) $ 18,179,652
============
Percentages are based on net assets of $175,653,554.
(a) Non-income producing security.
(b) Underlying security for a written/purchased call/put option.
ADR -- American Depositary Receipt
Ltd. -- Limited
Plc -- Public Limited Company
See accompanying notes to financial statements.
17
THE ARBITRAGE FUND
Schedule of Open Options Written
May 31, 2006
- -------------------------------------------------------------------------------------
CONTRACTS WRITTEN CALL OPTIONS -- 0.32% VALUE
- -------------------------------------------------------------------------------------
Andrx Corp.,
40 09/19/06 at $25 ........................................... $ 800
Archipelago Holdings, Inc.,
150 07/25/06 at $60 ........................................... 69,750
175 07/25/06 at $65 ........................................... 46,375
250 07/25/06 at $70 ........................................... 35,625
Capital One Financial Corp.,
150 06/20/06 at $85 ........................................... 10,125
Energy Partners Ltd.,
100 06/20/06 at $22.5 ......................................... 4,500
250 07/25/06 at $22.5 ......................................... 24,375
Fisher Scientific International, Inc.,
400 07/25/06 at $80 ........................................... 37,000
Iconix Brand Group, Inc.,
35 06/20/06 at $17.5 ......................................... 787
50 08/22/06 at $15 ........................................... 11,250
125 08/22/06 at $17.5 ......................................... 12,500
Inco Ltd.,
100 07/25/06 at $55 ........................................... 117,000
150 07/25/06 at $75 ........................................... 8,250
KLA-Tencor Corp.,
400 07/25/06 at $45 ........................................... 32,000
LandAmerica Financial Group, Inc.,
75 06/20/06 at $70 ........................................... 2,063
Micron Technology, Inc.,
407 06/20/06 at $16 ........................................... 34,595
NYSE Group, Inc.,
125 06/20/06 at $60 ........................................... 31,250
75 06/20/06 at $65 ........................................... 6,563
PetroHawk Energy Corp.,
600 06/20/06 at $12.5 ......................................... 9,000
Plains Exploration & Production Co.,
210 08/22/06 at $45 ........................................... 5,775
Stone Energy Corp.,
500 07/25/06 at $55 ........................................... 25,000
Thermo Electron Corp.,
200 06/20/06 at $35 ........................................... 38,500
50 06/20/06 at $40 ........................................... --
VeriFone Holdings, Inc.,
100 07/25/06 at $35 ........................................... 6,500
Viisage Technology, Inc.,
50 07/25/06 at $15 ........................................... 1,625
------------
TOTAL WRITTEN CALL OPTIONS (Premiums Received $653,571) $ 571,208
------------
18
THE ARBITRAGE FUND
Schedule of Open Options Written (Continued)
May 31, 2006
- -------------------------------------------------------------------------------------
CONTRACTS WRITTEN PUT OPTION -- 0.01% VALUE
- -------------------------------------------------------------------------------------
Inco Ltd.,
150 07/25/06 at $55 (Premiums Received $9,700) ................ $ 10,500
------------
TOTAL OPEN OPTIONS WRITTEN -- 0.33%
(Premiums Received $663,271) $ 581,708
============
Percentages are based on net assets of $175,653,554.
Ltd. -- Limited
Amounts designated as "--" are either $0 or have been rounded to $0.
As of May 31, 2006, the Fund had forward foreign currency exchange contracts
outstanding as follows:
- ------------------------------------------------------------------------------------
NET UNREALIZED
TO RECEIVE APPRECIATION
SETTLEMENT DATE (TO DELIVER) INITIAL VALUE MARKET VALUE (DEPRECIATION)
- -------------------------------------------------------------------------------------
Contracts to Sell
08/02/06 (17,650,000) CAD $15,826,758 $16,061,576 $ (234,818)
08/02/06 (3,550,000) CHF 2,890,644 2,942,574 (51,930)
08/02/06 (4,370,000) EUR 5,565,274 5,635,265 (69,991)
08/02/06 (4,650,000) GBP 8,504,184 8,709,366 (205,182)
----------- ----------- ----------
Total Sell Contracts $32,786,860 $33,348,781 $ (561,921)
------------ ----------- ----------
Contracts to Buy
06/05/06 170,796 EUR $ (219,131) $ (219,420) $ 289
06/05/06 28,286 GBP (52,976) (52,932) (44)
08/02/06 7,320,000 CAD (6,638,202) (6,661,231) 23,029
08/02/06 350,000 GBP (660,940) (655,544) (5,396)
----------- ----------- ----------
Total Buy Contracts $(7,571,249) $(7,589,127) $ 17,878
----------- ----------- ----------
Net Contracts $25,215,611 $25,759,654 $ (544,043)
=========== =========== ==========
CAD -- Canadian Dollar EUR -- Euro Dollar
CHF -- Swiss Franc GPB -- British Pound Sterling
See accompanying notes to financial statements.
19
THE ARBITRAGE FUND
Notes to the Financial Statements
May 31, 2006
- --------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
The Arbitrage Fund (the "Trust") was organized as a Delaware business trust on
December 22, 1999 and is registered under the Investment Company Act of 1940, as
amended (the "1940 Act"), as an open-end management investment company issuing
its shares in series, each series representing a distinct portfolio with its own
investment objective and policies. The one series presently authorized is The
Arbitrage Fund (the "Fund"), a diversified series, which offers two classes of
shares. Class R shares and Class I shares commenced operations on September 17,
2000 and October 17, 2003, respectively.
The investment objective of the Fund is to achieve capital growth by engaging in
merger arbitrage.
The Fund's two classes of shares, Class R and Class I, represent interests in
the same portfolio of investments and have the same rights, but differ primarily
in the expenses to which they are subject and the investment eligibility
requirements. Class R shares are subject to an annual distribution fee of up to
..25% of the Fund's average daily net assets attributable to Class R shares,
whereas Class I shares are not subject to any distribution fees.
The following is a summary of the Fund's significant accounting policies:
USE OF ESTIMATES - The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements and
the reported amounts of increases and decreases in net assets from operations
during the reporting period. Actual results could differ from those estimates.
VALUATION OF INVESTMENTS - The Fund's portfolio securities are valued as of the
close of business of the regular session of the New York Stock Exchange ("NYSE")
(normally 4:00 p.m., Eastern time). Common stocks and other securities,
including open short positions, that are traded on a securities exchange are
valued at the last quoted sales price at the close of regular trading on the day
the valuation is made. Securities which are quoted by NASDAQ are valued at the
NASDAQ Official Closing Price. Price information on listed stocks is taken from
the exchange where the security is primarily traded. Securities which are listed
on an exchange but which are not traded on the valuation date are valued at the
mean of the most recent bid and asked prices. Put and call options and
securities traded in the over-the-counter market are valued at the mean of the
most recent bid and asked prices. Unlisted securities for which market
quotations are readily available are valued at the latest quoted bid price.
Other assets and securities for which no quotations are readily available are
valued at fair value as determined in good faith under the supervision of the
Board of Trustees of the Trust. Some of the more common reasons that may
necessitate that a security be valued at fair value include: the security's
trading has been halted or suspended; the security has been delisted from a
national exchange; the
20
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
security's primary trading market is temporarily closed at a time when under
normal conditions it would be open; or the security's primary pricing source is
not able or willing to provide a price. Such methods of fair valuation may
include, but are not limited to: multiple of earnings, multiple of book value,
discount from market of a similar freely traded security, purchase price of a
security, subsequent private transactions in the security or related securities,
or a combination of these and other factors. Foreign securities are translated
from the local currency into U.S. dollars using currency exchange rates supplied
by a quotation service (see Note 6).
SHARE VALUATION - The net asset value per share of each class of shares of the
Fund is calculated daily by dividing the total value of the Fund's assets
attributable to that class, less liabilities attributable to that class, by the
number of shares of that class outstanding. The offering price and redemption
price per share of each class of the Fund is equal to the net asset value per
share, except that, shares of each class are subject to a redemption fee of 2%
if redeemed within 90 days of the date of purchase. For the year ended May 31,
2006, proceeds from redemption fees were $27,885 in Class R and $147 in Class I.
INVESTMENT INCOME - Interest income is accrued as earned. Dividend income and
expense are recorded on the ex-dividend date.
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS - Dividends arising from net
investment income and net capital gain distributions, if any, are declared and
paid at least annually to shareholders of the Fund. The amount of distributions
from net investment income and net realized gains are determined in accordance
with Federal income tax regulations which may differ from accounting principles
generally accepted in the United States of America. These "book/tax" differences
are either temporary or permanent in nature and are primarily due to losses
deferred due to wash sales.
The tax character of distributions declared during the years ended May 31, 2006
and May 31, 2005 was as follows:
- --------------------------------------------------------------------------------
Year Ordinary Long-Term Total
Ended Income Capital Gains Distributions
- --------------------------------------------------------------------------------
5/31/06 $ -- $ -- $ --
5/31/05 $ 10,778,315 $ 1,146,281 $ 11,924,596
- --------------------------------------------------------------------------------
ALLOCATION BETWEEN CLASSES - Investment income earned, realized capital gains
and losses, and unrealized appreciation and depreciation are allocated daily to
each class of shares based upon its proportionate shares of total net assets of
the Fund. Class specific expenses are charged directly to the class incurring
the expense. Common expenses which are not attributable to a specific class are
allocated daily to each class of shares based upon its proportionate share of
total net assets of the Fund.
21
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
SECURITY TRANSACTIONS - Security transactions are accounted for on trade date.
Gains and losses on securities sold are determined on a specific identification
basis.
SHORT POSITIONS - The Fund may sell securities short for economic 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 sold, but not yet purchased, may
require purchasing the securities 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. The amount of the collateral is required to be adjusted daily to
reflect changes in the value of the securities sold short.
WRITTEN OPTION TRANSACTIONS - The Fund may write (sell) covered call options to
hedge portfolio investments. Put options may 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 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).
EQUITY SWAP CONTRACTS - The Fund may invest in swaps for the purpose of managing
its exposure to interest rate, credit or market risk. An 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. 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. Collateral, in the form of cash or securities, may be required
to be held in segregated accounts with the Fund's custodian and/or
counterparty's broker. Risks may exceed amounts recognized on the Statements of
Assets and Liabilities. These risks include changes in the returns of the
underlying instruments, failure of the counterparties to perform under the
contracts' terms and the possible lack of liquidity with respect to the swap
22
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
agreements. Details of swap agreements open at May 31, 2006 are included in the
Fund's Portfolio of Investments and Schedule of Securities Sold Short. As of May
31, 2006, the Fund had long and short equity swap contracts outstanding of
$8,746,603 and $865,303, respectively.
FEDERAL INCOME TAX - It is the Fund's policy to comply with the special
provisions of Subchapter M of the Internal Revenue Code applicable to regulated
investment companies. As provided therein, in any fiscal year in which a Fund so
qualifies and distributes at least 90% of its taxable net income, the Fund (but
not the shareholders) will be relieved of Federal income tax on the income
distributed. Accordingly, no provision for income taxes has been made.
In order to avoid imposition of the excise tax applicable to regulated
investment companies, it is also the Fund's intention to declare as dividends in
each calendar year at least 98% of its net investment income (earned during the
calendar year) and 98% of its net realized capital gains (earned during the
twelve months ended October 31) plus undistributed amounts from prior years.
The following information is computed on a tax basis for each item as of May 31,
2006:
- --------------------------------------------------------------------------------
Cost of portfolio investments (including securities sold
short and written options) $164,010,164
============
Gross unrealized appreciation $ 6,742,792
Gross unrealized depreciation (4,956,989)
Net unrealized appreciation 1,785,803
Net unrealized depreciation on translation of assets and
liabilities in foreign currencies (12,069)
Undistributed ordinary income 6,724,077
Undistributed long-term capital gain 89,346
Post October losses (4,041,193)
Post October currency losses (1,861,087)
Other temporary differences (4,061)
------------
Total distributable earnings $ 2,680,816
============
- --------------------------------------------------------------------------------
The difference between the Federal income tax cost of portfolio investments and
the cost reported on the Statement of Assets and Liabilities is due to the tax
deferral of losses on wash sales.
For the fiscal year ended May 31, 2006, the fund utilized capital loss
carryforwards of $1,501,235 to offset net realized capital gains.
For the year ended May 31, 2006, the Fund reclassified net investment losses of
$915,862 and accumulated net realized losses of $258,357 to paid-in-capital on
the Statement of Assets and Liabilities. Such reclassification, the result of
permanent differences between financial statement and income tax reporting
requirements primarily attributable to reclassification of long term capital
gain distributions on Real Estate Investment Trust securities, gains and losses
on certain foreign currency related transactions and net
23
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
operating loss and reclassification of short sale related dividend expense to
capital loss, have no effect on the Fund's net assets or net asset value per
share.
2. INVESTMENT TRANSACTIONS
During the year ended May 31, 2006, cost of purchases and proceeds from sales
and maturities of investment securities, other than short-term investments, U.S.
government securities, options and short positions, amounted to $882,137,360 and
$756,576,849, respectively.
A summary of put and call option contracts written during the year ended May 31,
2006 is as follows:
- --------------------------------------------------------------------------------
OPTION OPTION
CONTRACTS PREMIUMS
- --------------------------------------------------------------------------------
Options outstanding at beginning of year 3,730 $ 463,871
Options written 69,933 8,961,085
Options canceled in a closing purchase transaction (18,780) (2,922,207)
Options exercised (25,368) (3,499,941)
Options expired (24,598) (2,339,537)
----------- -----------
Options outstanding at end of year 4,917 $ 663,271
=========== ===========
- --------------------------------------------------------------------------------
3. TRANSACTIONS WITH AFFILIATES
INVESTMENT ADVISORY AGREEMENT
The Fund's investments are managed by Water Island Capital, LLC (the "Adviser")
under the terms of an Investment Advisory Agreement. Under the Investment
Advisory Agreement, the Fund pays the Adviser a fee, which is computed and
accrued daily and paid monthly, at the annual rate of 1.50% of the Fund's
average daily net assets.
Until August 31, 2012, the Adviser has contractually agreed to waive its
advisory fee and/or reimburse the Fund's other expenses to the extent that total
operating expenses (exclusive of interest, taxes, dividends on short positions,
brokerage commissions and other costs incurred in connection with the purchase
or sale of portfolio securities) exceed the annual rate of 1.95% of the Fund's
average daily net assets attributable to Class R shares and 1.70% of the Fund's
average daily net assets attributable to Class I shares. Accordingly, for the
year ended May 31, 2006, the Adviser waived $318,096 of its advisory fee and
reimbursed the Fund for $1,740 and $1,161 of Class R and Class I expenses,
respectively.
The Adviser is permitted to recapture fees waived or expenses reimbursed to the
extent actual fees and expenses for a period are less than the expense
limitation of each class, provided, however, that the Adviser shall only be
entitled to recapture such amounts for a period of three years from the end of
the fiscal year during which such amount was waived or reimbursed. As of May 31,
2006, the Adviser may in the future recapture from the Fund
24
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
fees waived and expenses reimbursed totaling $940,941 of which $320,997 expires
May 31, 2009, $397,695 expires May 31, 2008, and $222,249 expires May 31, 2007.
Certain officers of the Trust are also officers of the Adviser. Effective
October 1, 2004, the Vice President of the Trust also serves as Chief Compliance
Officer ("CCO") of the Trust and of the Adviser. The Fund pays the Adviser 15%
of the CCO's salary for providing CCO services.
ADMINISTRATION AGREEMENT
Under the terms of an Administration Agreement, SEI Investments Global Funds
Services ("SIGFS") supplies administrative and regulatory services to the Fund,
supervises the preparation of tax returns, and coordinates the preparation of
reports to shareholders and filings with the Securities and Exchange Commission
and state securities authorities. For the performance of these administrative
services including fund accounting services, SIGFS receives a monthly fee at an
annual rate of .10% of the Fund's average daily net assets up to $500 million;
and .08% of such assets in excess of $500 million, subject to a minimum fee of
$150,000 per year. For the period July 25, 2005 through May 31, 2006, SIGFS was
paid $161,218 under the administration agreement. Certain officers of the Trust
are also officers of SIGFS. Such officers are paid no fees by the Trust for
serving as officers of the Trust.
Prior to July 25, 2005, Ultimus Fund Solutions, LLC ("Ultimus") served as the
Fund's administrator. For the performance of administrative services by Ultimus,
the Fund paid Ultimus a fee at the annual rate of .15% of the average value of
its daily net assets up to $50 million, .125% of such assets from $50 million to
$100 million, .10% of such assets from $100 million to $250 million, .075% of
such assets from $250 million to $500 million and .05% of such assets in excess
of $500 million, subject to a minimum fee of $2,000 per month. For the period
June 1, 2005 through July 24, 2005, Ultimus was paid $36,283 under the
administration agreement.
TRANSFER AGENT AND SHAREHOLDER SERVICES AGREEMENT
Under the terms of a Transfer Agent and Shareholder Services Agreement between
the Trust and DST Systems, Inc. ("DST"), DST maintains the records of each
shareholder's account, answers shareholders' inquiries concerning their
accounts, processes purchases and redemptions of Fund shares, acts as dividend
and distribution disbursing agent and performs other shareholder service
functions. For these services, DST receives from the Fund a monthly fee at an
annual rate of $50,000 per account, subject to a minimum fee of $17,500 per year
for each class of shares. For the period July 25, 2005 through May 31, 2006, DST
was paid $102,091 under the transfer agent agreement. In addition, the Fund pays
out-of-pocket expenses including, but not limited to, postage and supplies.
25
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
Prior to July 25, 2005, Ultimus served as the Fund's transfer agent. For these
services Ultimus received from the Fund a monthly fee at an annual rate of $20
per account, subject to a minimum fee of $1,500 per month for each class of
shares. For the period June 1, 2005 through July 24, 2005, Ultimus was paid
$6,357 under the transfer agent agreement.
Prior to July 25, 2005, for shareholder accounts held through financial
intermediaries, Class I may have, in some cases, compensated these
intermediaries for providing account maintenance services to their customers at
an annual rate of not more than $20 per account. For the period June 1, 2005
through July 24, 2005, Class I paid $2,500 to financial intermediaries for
account maintenance services.
FUND ACCOUNTING AGREEMENT
Prior to July 25, 2005, under the terms of a Fund Accounting Agreement between
the Trust and Ultimus, Ultimus calculated the daily net asset value per share
and maintained the financial books and records of the Fund. For these services,
Ultimus received from the Fund a monthly fee of $3,500, plus an asset based fee
equal to .01% of the Fund's average daily net assets up to $500 million and
..005% of such assets in excess of $500 million. Additionally, on a monthly
basis, Ultimus received $5 per trade for accounting for portfolio trades in
excess of two hundred. For the period June 1, 2005 through July 24, 2005,
Ultimus was paid $13,975 under the fund accounting agreement. In addition, the
Fund reimbursed certain out-of-pocket expenses incurred by Ultimus in obtaining
valuations of the Fund's portfolio securities.
DISTRIBUTION AGREEMENT
The Fund has adopted a plan of distribution pursuant to Rule 12b-1 under the
1940 Act (the "Plan") for Class R shares, which permits Class R to pay for
expenses incurred in the distribution and promotion of Class R shares. Under the
Plan, Class R may pay compensation to any broker-dealer with whom the
Distributor or the Fund, on behalf of Class R shares, has entered into a
contract to distribute Class R shares, or to any other qualified financial
services firm, for distribution and/or shareholder-related services with respect
to shares held or purchased by their respective customers in connection with the
purchase of shares attributable to their efforts. The amount of payments under
the Plan in any year shall not exceed .25% annually of the average daily net
assets allocable to Class R shares. During the year ended May 31, 2006, the Fund
paid Class R distribution expenses of $273,965 pursuant to the Plan.
Under the terms of a Distribution Agreement between the Trust and SEI
Investments Distribution, Co. (the "Distributor"), the Distributor serves as
principal underwriter and national distributor for the shares of the Fund. The
Fund's shares are sold on a no-load basis and, therefore, the Distributor
receives no sales commissions or sales loads for providing services to the Fund.
The Distributor is an affiliate of SEI Investments Global Funds Services. Prior
to July 25, 2005 Ultimus Fund Distributors, LLC served as the Fund's principal
underwriter and distributor.
26
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
4. CAPITAL SHARE TRANSACTIONS
Proceeds and payments on capital shares as shown in the Statement of Changes in
Net Assets are the result of the following capital share transactions for the
years shown:
- --------------------------------------------------------------------------------
YEAR YEAR
ENDED ENDED
MAY 31, MAY 31,
2006 2005
- --------------------------------------------------------------------------------
CLASS R
Shares sold 2,018,023 3,553,278
Shares issued in reinvestment of distributions -- 572,406
Shares redeemed (6,414,977) (11,968,047)
------------ -------------
Net decrease in shares outstanding (4,396,954) (7,842,363)
Shares outstanding at beginning of year 11,282,381 19,124,744
------------ -------------
Shares outstanding at end of year 6,885,427 11,282,381
============ =============
CLASS I
Shares sold 2,334,068 4,445,038
Shares issued in reinvestment of distributions -- 359,150
Shares redeemed (3,379,310) (10,390,377)
------------ -------------
Net decrease in shares outstanding (1,045,242) (5,586,189)
Shares outstanding at beginning of year 7,914,256 13,500,445
------------ -------------
Shares outstanding at end of year 6,869,014 7,914,256
============ =============
- --------------------------------------------------------------------------------
5. FOREIGN CURRENCY TRANSLATION
Amounts denominated in or expected to settle in foreign currencies are
translated to U.S. dollars based on exchange rates on the following basis:
A. The market values of investment securities and other assets and liabilities
are translated at the closing rate of exchange each day.
B. Purchases and sales of investment securities and income and expenses are
translated at the rate of exchange prevailing on the respective dates of such
transactions.
C. The Fund does not isolate that portion of the results of operations caused by
changes in foreign exchange rates on investments from those caused by changes in
market prices of securities held. Such fluctuations are included with the net
realized and unrealized gains or losses on investments.
Reported net realized foreign exchange gains or losses arise from 1) purchases
and sales of foreign currencies, 2) currency gains or losses realized between
the trade and settlement dates on securities transactions and 3) the difference
between the amounts of
27
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
dividends, interest and foreign withholding taxes recorded on the Fund's books,
and the U.S. dollar equivalent of the amounts actually received or paid.
Reported net unrealized foreign exchange gains and losses arise from changes in
the value of assets and liabilities, other than investment securities, resulting
from changes in exchange rates.
6. CONTINGENCIES AND COMMITMENTS
The Fund indemnifies the Trust's officers and trustees for certain liabilities
that might arise from their performance of their duties to the Fund.
Additionally, in the normal course of business the Fund enters into contracts
that contain a variety of representations and warranties and which provide
general indemnifications. The Fund's maximum exposure under these arrangements
is unknown, as this would involve future claims that may be made against the
Fund that have not yet occurred. However, based on experience, the Fund expects
the risk of loss to be remote.
7. SECURITIES LENDING
In order to generate additional income, the Fund may, from time to time, lend
its portfolio securities to broker-dealers, banks or institutional borrowers of
securities. The Fund must receive 100% collateral in the form of cash or U.S.
government securities. This collateral must be valued daily and, should the
market value of the loaned securities increase, the borrower must furnish
additional collateral to the Fund. During the time portfolio securities are on
loan, the borrower pays the Fund any dividends or interest paid on such
securities. Loans are subject to termination by the Fund or the borrower at any
time. While the Fund does not have the right to vote securities on loan, it has
the right to terminate the loan and regain the right to vote if that is
considered important with respect to the investment. In the event the borrower
defaults in its obligation to the Fund, the Fund bears the risk of delay in the
recovery of its portfolio securities and the risk of loss of rights in the
collateral. The Fund will only enter into loan arrangements with broker-dealers,
banks or other institutions which the Adviser has determined are creditworthy
under guidelines established by the Trustees. There were no securities on loan
as of May 31, 2006.
During the year ended May 31, 2006, the Fund earned $1,778 in securities lending
income.
8. FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
The Fund enters into forward foreign currency exchange contracts as a way of
managing foreign exchange rate risk. The Fund may enter into these contracts for
the purchase or sale of a specific foreign currency at a fixed price on a future
date as a hedge or cross-hedge against either specific transactions or portfolio
positions. The objective of the Fund's foreign currency hedging transactions is
to reduce risk that the U.S. dollar value of the Fund's securities denominated
in foreign currency will decline in value due to changes in
28
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2006
- --------------------------------------------------------------------------------
foreign currency exchange rates. All foreign currency exchange contracts are
"marked-to market" daily at the applicable translation rates resulting in
unrealized gains or losses. Risks may arise upon entering into these contracts
from the potential inability of counterparties to meet the terms of their
contracts and from unanticipated movements in the value of a foreign currency
relative to the U.S. dollar.
29
THE ARBITRAGE FUND
Report of Independent Registered Public Accounting Firm
- --------------------------------------------------------------------------------
TO THE BOARD OF TRUSTEES AND SHAREHOLDERS
THE ARBITRAGE FUND
We have audited the accompanying statement of assets and liabilities of The
Arbitrage Fund (the "Fund"), including the schedules of investments as of May
31, 2006, and the related statement of operations for the year then ended, the
statement of changes in net assets for each of the two years in the period then
ended, and the financial highlights for each of the five years in the period
then ended. These financial statements and financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and financial highlights based on our
audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and financial highlights are free of material misstatement. We were
not engaged to perform an audit of the Trust's internal control over financial
reporting. Our audits included consideration of internal control over financial
reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Trust's internal control over financial reporting.
Accordingly, we express no such opinion. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of securities owned as of May
31, 2006 by correspondence with the custodian and brokers. An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of The
Arbitrage Fund as of May 31, 2006, the results of its operations for the year
then ended, the changes in its net assets for each of the two years in the
period then ended, and the financial highlights for each of the five years in
the period then ended, in conformity with accounting principles generally
accepted in the United States of America.
TAIT, WELLER & BAKER
PHILADELPHIA, PENNSYLVANIA
JULY 10, 2006
30
THE ARBITRAGE FUND
About Your Fund's Expenses (Unaudited)
- --------------------------------------------------------------------------------
We believe it is important for you to understand the impact of costs on your
investment. As a shareholder of a mutual fund, you incur two types of costs: (1)
transaction costs, including redemption fees; and (2) ongoing costs, including
management fees, distribution (12b-1) fees, and other fund expenses. The
following examples are intended to help you understand your ongoing costs (in
dollars) of investing in the Fund and to compare these costs with the ongoing
costs of investing in other mutual funds.
A mutual fund's expenses are expressed as a percentage of its average net
assets. This figure is known as the expense ratio. The following examples are
intended to help you understand the ongoing costs (in dollars) of investing in
the Fund and to compare these costs with the ongoing costs of investing in other
mutual funds. The examples below are based on an investment of $1,000 made at
the beginning of the period shown and held for the entire period.
The table on the next page illustrates the Fund's costs in two ways:
ACTUAL FUND RETURN - This section helps you to estimate the actual expenses that
you paid over the period. The "Ending Account Value" shown is derived from the
Fund's actual return, and the third column shows the dollar amount of operating
expenses that would have been paid by an investor who started with $1,000 in the
Fund. You may use the information here, together with the amount you invested,
to estimate the expenses that you paid over the period.
To do so, simply divide your account value by $1,000 (for example, an $8,600
account value divided by $1,000 = 8.6), then multiply the result by the number
given for the Fund under the heading "Expenses Paid During Period."
HYPOTHETICAL 5% RETURN - This section is intended to help you compare the Fund's
costs with those of other mutual funds. It assumes that the Fund had an annual
return of 5% before expenses during the period shown, but that the expense ratio
is unchanged. In this case, because the return used is not the Fund's actual
return, the results do not apply to your investment. The example is useful in
making comparisons because the Securities and Exchange Commission requires all
mutual funds to calculate expenses based on a 5% return. You can assess the
Fund's costs by comparing this hypothetical example with the hypothetical
examples that appear in shareholder reports of other mutual funds.
Note that expenses shown in the table are meant to highlight and help you
compare ongoing costs only. The Fund does not charge a front-end sales load.
However, a redemption fee of 2% is applied on the sale of shares held within 90
days of the date of purchase and does not apply to the redemption of shares
acquired through reinvestment of dividends and other distributions.
The calculations assume no shares were bought or sold during the period. Your
actual costs may have been higher or lower, depending on the amount of your
investment and the timing of any purchases or redemptions.
More information about the Fund's expenses, including annual expense ratios
since inception, can be found in this report. For additional information on
operating expenses and other shareholder costs, please refer to the Fund's
prospectus.
31
THE ARBITRAGE FUND
About Your Fund's Expenses (Unaudited) (Continued)
- --------------------------------------------------------------------------------
THE ARBITRAGE FUND - CLASS R
- --------------------------------------------------------------------------------
BEGINNING ENDING
ACCOUNT VALUE ACCOUNT VALUE EXPENSES PAID
DECEMBER 1, 2005 MAY 31, 2006 DURING PERIOD*
- --------------------------------------------------------------------------------
Based on Actual Fund Return $1,000.00 $1,051.20 $11.46
Based on Hypothetical 5% Return
(before expenses) $1,000.00 $1,013.76 $11.25
- --------------------------------------------------------------------------------
* Expenses are equal to the Arbitrage Fund - Class R annualized expense ratio of
2.24% for the period, multiplied by the average account value over the period,
multiplied by 182/365 (to reflect the one-half year period).
THE ARBITRAGE FUND - CLASS I
- --------------------------------------------------------------------------------
BEGINNING ENDING
ACCOUNT VALUE ACCOUNT VALUE EXPENSES PAID
DECEMBER 1, 2005 MAY 31, 2006 DURING PERIOD*
- --------------------------------------------------------------------------------
Based on Actual Fund Return $1,000.00 $1,051.70 $10.18
Based on Hypothetical 5% Return
(before expenses) $1,000.00 $1,015.01 $10.00
- --------------------------------------------------------------------------------
* Expenses are equal to the Arbitrage Fund - Class I annualized expense ratio of
1.99% for the period, multiplied by the average account value over the period,
multiplied by 182/365 (to reflect the one-half year period).
32
THE ARBITRAGE FUND
Other Information (Unaudited)
- --------------------------------------------------------------------------------
A description of the policies and procedures that the Fund uses to vote proxies
relating to portfolio securities is available without charge upon request by
calling toll-free 1-800-295-4485, or on the Securities and Exchange Commission's
("SEC") website at http://www.sec.gov. Information regarding how the Fund voted
proxies relating to portfolio securities during the most recent 12-month period
ended June 30 is available without charge upon request by calling toll-free
1-800-295-4485, or on the SEC's website at http://www.sec.gov.
The Trust files a complete listing of portfolio holdings for the Fund with the
SEC as of the first and third quarters of each fiscal year on Form N-Q. The
filings are available upon request, by calling 1-800-295-4485. Furthermore, you
may obtain a copy of the filing on the SEC's website at http://www.sec.gov. The
Trust's Forms N-Q may also be reviewed and copied at the SEC's Public Reference
Room in Washington, D.C., and information on the operation of the Public
Reference Room may be obtained by calling 1-800-SEC-0330.
33
THE ARBITRAGE FUND
Trustees' Renewal Of Advisory Agreement (Unaudited)
- --------------------------------------------------------------------------------
The Board of Trustees (the "Board") of The Arbitrage Fund (the "Fund"),
including a majority of its independent Trustees, approved the continuance of
the Fund's investment advisory agreement with Water Island Capital, LLC, the
Fund's investment adviser (hereafter referred to as the "Adviser"). The board
determined that continuance of the investment advisory agreement was in the best
interests of the Fund and its shareholders.
The Board based its decision upon its most recent review of the Adviser's
investment personnel, portfolio management process, and performance. The Board
discussed the factors below, among others. However, no single factor determined
whether the Board approved the continuation of the investment advisory
agreement. Rather, it was the totality of the factors that led to the decision.
NATURE, EXTENT, AND QUALITY OF SERVICES
The Board considered the experience of the personnel managing the Fund's assets
as well as the quality of the Fund's investment management over both short- and
long-term periods. The Board concluded the Adviser has provided high quality
consistent service to the Fund and its shareholders.
COST
The Board considered the Fund's overall expense ratio, comparing it to other
similarly managed mutual funds. In its consideration of the Fund's overall
expense ratio, the Board also considered the Adviser's long term commitment to
cap operating expenses by waiving a portion of its advisory fee. The Board
during its review of costs considered the Fund's advisory fee, comparing the fee
to other funds offering similar investment strategies.
The Board concluded even though the Fund's overall expense ratio is higher than
the average of comparably managed funds, they believe shareholders are receiving
a quality investment option for a reasonable price. The Board also concluded
that although the advisory fees payable to the Adviser are in the higher range
of fees for other comparably managed funds, they believe the fees to be
reasonable given the quality of services provided by the Adviser and the
complexity of investment strategies implemented by the Adviser.
PROFITABILITY OF ADVISER
The Board considered the Adviser's profitability with regards to its management
of the Fund, concluding that the Adviser's profitability was not excessive and
therefore was a secondary factor in connection with the evaluation of advisory
fees paid by the Fund.
34
ARBITRAGE FUND
Trustees' Renewal Of Advisory Agreement (Unaudited) (Continued)
- --------------------------------------------------------------------------------
INVESTMENT PERFORMANCE
The Board considered the Fund's short- and long-term performance, including any
periods of outperformance or underperformance of relevant benchmarks and peer
groups. The Board concluded that the Fund has performed consistent with its
investment strategy. The Fund's returns have trailed the average performance of
its peer group as well the broad U.S. stock market (as measured by the S&P 500
Index) over the short-term (1 year) while performance when measured over a
longer term (4 + years) has exceeded the average performance of its peer group
as well the broad U.S. stock market. Information about the Fund's historical
performance can be found on page 3 of this Annual Report.
ECONOMIES OF SCALE AND ANCILLARY BENEFITS
The Board concluded that as a result of the significant decrease in Fund assets
over the past year, at the present time it would not be relevant to consider the
extent to which economies of scale would be realized as the Fund grows, and
whether fee levels reflect potential future economies of scale.
The Board also considered the "ancillary benefits" to the Adviser, viewing these
as secondary factors in connection with the evaluation of the reasonableness of
the advisory fees paid by the Fund. The Board did consider the level of soft
dollar activity, concluding that as a result of the Fund being the Adviser's
only client, benefits derived from these trades are going directly to the Fund
and its shareholders.
35
THE ARBITRAGE FUND
Board of Trustees and Officers (Unaudited)
- ------------------------------------------------------------------------------------------------------
Overall responsibility for management of the Fund rests with the Board of Trustees. The Trustees serve
during the lifetime of the Trust and until its termination, or until death, resignation, retirement or
removal. The Trustees, in turn, elect the officers of the Fund to actively supervise its day-to-day
operations. The officers have been elected for an annual term. The following are the Trustees and
executive officers of the Fund:
TRUSTEE/ POSITION HELD LENGTH OF
EXECUTIVE OFFICER ADDRESS AGE WITH THE TRUST TIME SERVED
- ------------------------------------------------------------------------------------------------------
*John S. Orrico, CFA 650 Fifth Avenue 46 President, Secretary, Since May 2000
New York, NY 10019 Treasurer and Trustee
*Joel C. Ackerman 295 Central Park West 61 Trustee Since May 2000
New York, NY 10024
John C. Alvarado 575 Madison Ave, 10th Floor 46 Trustee Since December 2003
New York, NY10022
Burtt R. Ehrlich One Landmark Square, 22nd Floor 67 Trustee Since March 2005
Stanford, CT 06901
Jay N. Goldberg 535 Fifth Avenue 65 Trustee Since May 2000
New York, NY 10017
Matthew Hemberger 650 Fifth Avenue 47 Vice President, Since May 2000
New York, NY 10019 Chief Compliance
Officer and
Anti-Money Laundering
Compliance Officer
Eric Kleinschmidt One Freedom Valley Drive 38 Chief Financial Since July 2005
Oaks, PA 19456 Officer
James Ndiaye One Freedom Valley Drive 37 Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
Philip T. Masterson One Freedom Valley Drive 42 Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
Michael T. Pang One Freedom Valley Drive 34 Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
Sofia A. Rosala One Freedom Valley Drive 32 Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
* Messrs Orrico and Ackerman are "interested persons" of the Trust within the
meaning of Section 2(a)(19) of the Investment Company Act of 1940.
36
THE ARBITRAGE FUND
Board of Trustees and Officers (Unaudited) (Continued)
- --------------------------------------------------------------------------------
Each Trustee oversees one portfolio of the Trust. The principal occupations of
the Trustees and executive officers of the Fund during the past five years and
public directorships held by the Trustees are set forth below:
John S. Orrico is General Partner of the Adviser. Prior to January 2000, he was
Portfolio Manager to private trusts and entities at Lindemann Capital Partners,
L.P. and Gruss and Co. (financial management firms).
Joel C. Ackerman is currently a consultant to the Fund's Adviser. During 2003,
he was a Partner in Crossroads Investments LP and a Partner with LRL Capital
(hedge fund). Prior to September 2002, he was a Partner of Ardsley Partners
(hedge fund).
John C. Alvarado is a Managing Member of Power Capital Partners, LLC which is a
financial advisory and consulting firm. He is currently Chief Financial Officer
of Wax Inc. (men's retail apparel), a Managing Director of Energy Finance
Merchants, LLC, and Managing Member of Gordon Alvarado LLC. From 1995 to 2000,
he was senior Vice President, Co-Founder and Partner of Stratum Group LP, which
is private a equity investment firm.
Burtt R. Ehrlich has served as director of Armor Holdings, Inc. since January
1996, director of Clarus Corp. since June 2002, and as a member of the Board of
Directors of Langer, Inc. since February 2001. Mr. Ehrlich served as Chairman
and Chief Operating Officer of Ehrlich Bober Financial Corp. (the predecessor of
Benson Eyecare Corporation) from December 1986 until October 1992, and as a
director of Benson Eyecare Corporation from October 1992 until November 1995.
Jay N. Goldberg is Senior Managing Director of Hudson Ventures (a venture
capital company).
Matthew Hemberger is Chief Compliance Officer of the Adviser,
Chief Compliance Officer to the Trust, and Anti-Money Laundering Compliance
Officer to the Trust. Prior to March 2001, he was an Analyst, Assistant
Portfolio Manager, and CFO at Lindemann Capital Partners, L.P.
Eric Kleinschmidt is Chief Financial Officer to the Trust. He has been employed
by SEI Investments since 1995 and is Director of SEI Investments Fund Accounting
since 2004, after serving as Manager from 1999 to 2004.
James Ndiaye is Vice President and Assistant Secretary to the Trust. Prior to
October 2004, he was Vice President of Deutsche Asset Management. From 2000 to
2003, he was an Associate at Morgan, Lewis & Bockius LLP. From 1999 to 2000, he
was Assistant Vice President of ING Variable Annuities Group.
37
THE ARBITRAGE FUND
Board of Trustees and Officers (Unaudited) (Continued)
- --------------------------------------------------------------------------------
Philip T. Masterson is Vice President and Assistant Secretary to the Trust.
Prior to August 2004, he was General Counsel of Citco Mutual Fund Services. From
2001 to 2003 he was Vice President and Associate Counsel for the Oppenheimer
Funds. He was also Vice President and Assistant Counsel of the Oppenheimer Funds
from 1997 to 2001.
Michael T. Pang is Vice President and Assistant Secretary to the Trust. Prior to
January 2005, he was Counsel for Caledonian Bank & Trust's Mutual Funds Group.
From 2001 to 2004 he was Counsel for Permal Asset Management. From 2000 to 2001,
he was an Associate at Schulte, Roth & Zabel's Investment Management Group. From
1997 to 2000, he was a Staff Attorney for the U.S. SEC's Division of
Enforcement, Northeast Regional Office.
Sofia A. Rosala is Vice President and Assistant Secretary to the Trust. She is
also Corporate Counsel of the Administrator. Prior to 2004, she was Compliance
Officer of SEI Investments Company. From 1998 to 2001, she was an Account and
Product Consultant for SEI Private Trust Company. Additional information about
members of the Board of Trustees and Officers is available in the Statement of
Additional Information (SAI). To obtain a free copy of the SAI, please call
1-800-295-4485.
38
[Arbitrage Logo Omitted]
THE ARBITRAGE FUND
A SERIES OF THE ARBITRAGE FUNDS
ADVISER WATER ISLAND CAPITAL, LLC
650 Fifth Avenue, 6th Floor
New York, NY 10019
DISTRIBUTOR SEI INVESTMENTS DISTRIBUTION CO.
One Freedom Valley Drive
Oaks, PA 19456
TRANSFER AGENT DST SYSTEMS, INC.
P.O. Box 219842
Kansas City, MO 64121-9842
CUSTODIAN MELLON BANK, N.A.
One Mellon Bank Center
Pittsburgh, PA 15258
ARB (7/06)
ITEM 2. CODE OF ETHICS.
The Registrant has adopted a code of ethics that applies to the Registrant's
Principal Executive and Senior Financial Officers.
ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT.
(a)(1) The Registrant's board of trustees has determined that the Registrant has
at least one audit committee financial expert serving on the audit committee.
(a)(2) The audit committee financial experts is John C. Alvarado, who is
independent as defined in Form N-CSR Item 3(a)(2).
ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Fees billed by Tait, Weller & Baker LLP Related to the Trust
Tait, Weller & Baker LLP billed the Trust aggregate fees for services rendered
to the Trust for the last two fiscal years as follows:
- ------------------------------------------------------------------------------------------------------------------------------
2006 2005
- ------- ---------- ----------------- ----------------- ----------------- ----------------- ----------------- -----------------
All fees and All fees and All other fees All fees and All fees and All other fees
services to the services to and services to services to the services to and services to
Trust that were service service Trust that were service service
pre-approved affiliates that affiliates that pre-approved affiliates that affiliates that
were pre- did not require were pre- did not require
approved pre-approval approved pre-approval
- ------- ---------- ----------------- ----------------- ----------------- ----------------- ----------------- -----------------
(a) Audit $18,500 $0 $0 $16,500 $0 $0
Fees(1)
- ------- ---------- ----------------- ----------------- ----------------- ----------------- ----------------- -----------------
(b) Audit- $0 $0 $0 $0 $0 $0
Related
Fees
- ------- ---------- ----------------- ----------------- ----------------- ----------------- ----------------- -----------------
(c) Tax $0 $0 $0 $0 $0 $0
Fees
- ------- ---------- ----------------- ----------------- ----------------- ----------------- ----------------- -----------------
(d) All $0 $0 $0 $0 $0 $0
Other
Fees
- ------------------------------------------------------------------------------------------------------------------------------
Notes:
(1) Audit fees include amounts related to the audit of the Registrant's
annual financial statements and services normally provided by the
accountant in connection with statutory and regulatory filings.
(e)(1) Registrant's full audit committee is responsible for any required
pre-approval of audit or non-audit services, and pre-approves audit or
non-audit services pursuant to policies and procedures as described in
paragraph (c)(7) of Rule 2-01 of Regulation S-X.
(e)(2) Percentage of fees billed applicable to non-audit services pursuant to
waiver of pre-approval requirement were as follows:
----------------------------------------------------------------
2006 2005
---------------------------- ----------------- ----------------
Audit-Related Fees 0.00% 0.00%
---------------------------- ----------------- ----------------
Tax Fees 0.00% 0.00%
---------------------------- ----------------- ----------------
All Other Fees 0.00% 0.00%
---------------------------------------------------------------
(f) Not applicable.
(g) The aggregate non-audit fees and services billed by Tait, Weller &
Baker LLP for the last two fiscal years were $0 and $0 for 2006 and
2005, respectively.
(h) During the past fiscal year, all non-audit services provided by
Registrant's principal accountant to either Registrant's investment
adviser or to any entity controlling, controlled by or under common
control with Registrant's investment adviser that provides ongoing
services to Registrant were pre-approved by the audit committee of
Registrant's Board of Trustees. Included in the audit committee's
pre-approval was the review and consideration as to whether the
provision of these non-audit services is compatible with maintaining
the principal accountant's independence.
ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS.
Not applicable to open-end management investment companies.
ITEM 6. SCHEDULE OF INVESTMENTS
Not applicable.
ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END
MANAGEMENT INVESTMENT COMPANIES.
Not applicable to open-end management investment companies.
ITEM 8. PORTFOLIO MANAGERS OF CLOSED-END MANAGEMENT INVESTMENT COMPANIES
Not applicable to open-end management investment companies.
ITEM 9. PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT COMPANY AND
AFFILIATED PURCHASERS.
Not applicable to open-end management investment companies.
ITEM 10. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM 11. CONTROLS AND PROCEDURES.
(a) The certifying officers, whose certifications are included herewith, have
evaluated the Registrant's disclosure controls and procedures within 90 days of
the filing date of this report. In their opinion, based on their evaluation, the
Registrant's disclosure controls and procedures are adequately designed, and are
operating effectively to ensure, that information required to be disclosed by
the Registrant in the reports it files or submits under the Securities Exchange
Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms.
(b) There were no significant changes in the Registrant's internal control over
financial reporting that occurred during the Registrant's last fiscal half-year
that have materially affected, or are reasonably likely to materially affect,
the Registrant's internal control over financial reporting.
ITEMS 12. EXHIBITS.
(a)(1) Code of Ethics attached hereto.
(a)(2) A separate certification for the principal executive officer and the
principal financial officer of the Registrant as required by Rule 30a-2(a) under
the Investment Company Act of 1940, as amended (17 CFR 270.30a-2(a)), are filed
herewith.
(b) Officer certifications as required by Rule 30a-2(b) under the Investment
Company Act of 1940, as amended (17 CFR 270.30a-2(b)) also accompany this filing
as an Exhibit.
- --------------------------------------------------------------------------------
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 Arbitrage Funds
By (Signature and Title)* /s/ John S. Orrico
-----------------------
John S. Orrico
President and Treasurer
Date: August 7, 2006
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/ John S. Orrico
-----------------------
John S. Orrico
President and Treasurer
Date: August 7, 2006
By (Signature and Title)* /s/ Eric Kleinschmidt
-----------------------
Eric Kleinschmidt
Chief Financial Officer
Date: August 7, 2006
* Print the name and title of each signing officer under his or her signature.