UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------
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)
--------
41 Madison Avenue
28th Floor
New York, NY 10010
(Address of principal executive offices) (Zip code)
John S. Orrico
Water Island Capital, LLC
41 Madison Avenue
28th Floor
New York, NY 10010
(Name and address of agent for service)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 212-259-2655
DATE OF FISCAL YEAR END: MAY 31, 2007
DATE OF REPORTING PERIOD: MAY 31, 2007
ITEM 1. REPORTS TO STOCKHOLDERS.
[LOGO OMITTED]
THE ARBITRAGE FUND
41 Madison Avenue
28th Floor
New York, New York 10010
800-295-4485
www.thearbfund.com
ANNUAL REPORT
MAY 31, 2007
[LOGO OMITTED]
THE ARBITRAGE FUND
WATER ISLAND CAPITAL, LLC
41 MADISON AVENUE
28TH FLOOR
NEW YORK, NEW YORK 10010
-------
800-295-4485
www.thearbfund.com
July 7, 2007
Dear Shareholder:
The Arbitrage Fund (the "Fund") generated a gain of 5.64% in Class R (and a gain
of 5.92% in Class I) for the fiscal year ended May 31, 2007.
This positive performance was delivered in the context of strong global merger
activity, fueled by strengthening economies in Europe, Asia, and South America.
In North America, merger activity in both the U.S. and Canada remains
particularly robust, and continues to account for a majority of the deals in
which we have invested over the past year. Deal spreads, the return potential
associated with each of the transactions in which we invest, have continued to
improve over the past 12 months, driven in large part by an uptrend, though
slight, in short-term interest rates. Additionally, the large pool of merger
transactions announced globally allows us to invest opportunistically in those
transactions that offer the best risk-adjusted returns, based on our research.
We expect interest rates to remain relatively stable over the months ahead,
supported by continued strong growth in the world's major economies.
ACCELERATING GLOBAL CONSOLIDATION
While most of today's headlines focus on the impact of the large private equity
firms and, up until recently, the abundance of inexpensive financing available
to finance "going private" transactions, the trends underlying global
consolidation among strategic operators are the more important story, in our
opinion. The underlying factors that fuel consolidation among strategic
operators across the economic spectrum from energy and commodities, to
financial, technology and healthcare industries are taking hold in Europe and
Asia at an accelerating pace. Legal and regulatory hurdles to cross border
mergers continue to ease, accompanied by less nationalistic resistance to
foreign buyers from the governments of countries within the European community.
Booming economies in China, India, as well as many of the emerging markets are
forcing both state-owned and private firms to look beyond their borders to meet
their needs for energy, commodities, and building related materials in order to
maintain infrastructure growth. We expect these trends to continue, and with it,
further consolidation opportunities in the years ahead. We're excited about the
opportunities that we're witnessing outside of North America, and expect that
the Fund's portfolio will reflect these trends as we invest a greater portion of
assets overseas.
HOSTILE BIDDING
Over the past year we've witnessed an increase in the level of hostile bidding
(buyers going directly to shareholders with offers without first reaching
agreement with the target's board of directors) taking place in the marketplace.
Topping bidders (buyers that offer shareholders a
1
higher price in an attempt to break up an already existing deal between the
target and a different buyer) are also showing up with greater frequency as
well. We attribute this in part to the competitive aspects of consolidation, as
operators within an industry become aggressive bidders to avoid being "left
behind" in a marketplace where their competitors are gaining scale. Strategic
operators are also moving more aggressively in order to pre-empt the private
equity buyers that are ever more present in today's environment, in an attempt
to acquire a strategic asset before they fall prey to a leveraged buyout
transaction.
The upside for arbitrageurs, such as the Arbitrage Fund, is the opportunity to
benefit from the potentially greater returns associated with such activity. Thus
far in 2007, the Fund has witnessed close to a dozen of the transactions in
which we have invested become the subject of higher bids. In many instances, the
presence of a hostile bidder will many times force the target company into the
hands of a friendly buyer or "white knight". While difficult to predict which
targets might attract additional expressions of interest, we expect this trend
to continue, fueled in part by the fact that in a global environment, potential
bidders can surface from anywhere on the globe.
THE ROLE OF PRIVATE EQUITY
As mentioned above, the role of the large private equity firms in today's merger
environment continues to be significant. With relatively low interest rates and
capital markets around the globe receptive to financing these leveraged buyouts,
the number and dollar value of transactions involving private equity firms
continues to hit record levels. These "going private" transactions have taken
place across all industries, from utilities to gaming, from hospitals to
semiconductors, and every industry in between. The deals have gotten larger as
well. During the past 6 months, we've witnessed ever larger deals involving
private equity: Equity Office Properties by Blackstone Group ($36 billion),
Clear Channel Communications by Bain Capital and Thomas H. Lee Partners ($27
billion), First Data Corp. and TXU Corp by KKR & Co. ($29 billion and $30
billion respectively), Harrah's Entertainment by Apollo and Texas Pacific Group
($16 billion), and BCE Inc. by Providence Equity ($30 billion), among others.
The high level of activity driven by these private equity shops creates
opportunities for the Fund to profit. On many occasions, we've witnessed
strategic buyers enter into a competitive process with these private buyers to
purchase assets. These bidding wars can pay off handsomely for investors. As
long as the credit markets remain receptive to financing deals and interest
rates remain stable, we expect private equity to play a continued role in
consolidation going forward. There are some clouds on the horizon however.
The risks associated with private equity deals can be substantial. In those
instances where private equity has no existing businesses in the field related
to the target, the driving force behind the deal is primarily geared toward
generating financial gains through leverage. In the event the target company
stumbles or experiences deteriorating fundamentals prior to the deal closing,
the private equity buyer may terminate the deal, thus leaving investors with
considerable financial downside. Likewise, factors out of the target company's
control, such as rising interest rates or difficult credit markets, may prevent
the buyer from obtaining the financing necessary to close the transaction. Thus,
when investing in a private equity deal, investors generally face elevated
risks. The Fund approaches these deals with caution, paying great attention to
the level of leverage
2
inherent in the transaction and strategic rationale behind the deal. The returns
may appear attractive relative to deals involving strategic buyers, but the
risks may not be worth taking.
LOOKING AHEAD
As we enter the second half of 2007, our outlook remains upbeat. The
opportunities for investment across the globe are attractive. Economic growth
and the factors driving consolidation across Europe and Asia remain strong. Thus
far in 2007, over $2 trillion deals have been announced worldwide, and we expect
volumes to remain healthy over the balance of the year.We remain focused on
achieving the best risk-adjusted returns available in the marketplacefor our
investors, with an emphasis on capital preservation. As always, we appreciate
your continued support.
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 ADVISER 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.
3
COMPARISON OF THE CHANGE IN VALUE OF A $10,000 INVESTMENT
IN THE ARBITRAGE FUND(C) VERSUS THE S&P 500 INDEX
[GRAPH OMITTED]
PLOT POINTS ARE AS FOLLOWS:
The Arbitrage Fund(a) 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
14,557 9,972
14,626 10,762
15,045 10,861
5/07 15,294 11,869
AVERAGE ANNUAL TOTAL RETURNS(B)
(FOR PERIODS ENDED MAY 31, 2007)
1 YEAR 5 YEARS SINCE INCEPTION
---------- ---------- ----------------
The Arbitrage Fund - Class R 5.64% 5.69% 6.54%(c)
The Arbitrage Fund - Class I 5.92% n/a 3.76%(d)
S&P 500 Index 22.79% 9.45% 2.58%(e)
(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, 2007.
(d) Represents the period from the commencement of operations of Class I shares
(October 17, 2003) through May 31, 2007.
(e) Represents the period from September 18, 2000 through May 31, 2007.
4
THE ARBITRAGE FUND
Portfolio Information
May 31, 2007 (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 OMIITED]
Common Stocks - 89.66%
Real Estate Invesment Trusts - 4.48%
Money Market Security - 3.69%
Equity Swaps - 1.97%
Other - 0.12%
Option Contracts - 0.08%
5
THE ARBITRAGE FUND
Statement of Assets and Liabilities
May 31, 2007
- ----------------------------------------------------------------------------------------
ASSETS
Investments:
At acquisition cost $172,871,022
============
At value (Note 1) $177,872,111
Deposits with brokers for securities sold short (Note 1) 29,494,525
Receivable for investment securities sold 4,782,876
Receivable for capital shares sold 356,492
Dividends receivable 158,814
Unrealized appreciation on forward currency exchange contracts (Note 8) 102,179
Unrealized appreciation on spot currency exchange contracts 7,052
Prepaid expenses 47,515
Reclaims receivable 36,072
------------
Total Assets 212,857,636
------------
LIABILITIES
Securities sold short, at value (Note 1) (proceeds $27,341,041) 29,141,532
Bank overdraft denominated in foreign currency (proceeds $2,610,025) 2,664,938
Written options, at value (Notes 1 and 2) (premiums received $170,705) 176,868
Unrealized depreciation on forward currency exchange contracts (Note 8) 540,097
Unrealized depreciation on spot currency exchange contracts 182
Payable for investment securities purchased 12,646,072
Payable for capital shares redeemed 166,091
Dividends payable on securities sold short (Note 1) 6,531
Payable to Adviser (Note 3) 191,920
Payable to Distributor (Note 3) 46,523
Payable to Administrator (Note 3) 14,260
Payable to Trustees 14,000
Payable to Chief Compliance Officer (Note 3) 7,227
Other accrued expenses and liabilities 99,368
------------
Total Liabilities 45,715,609
------------
NET ASSETS $167,142,027
============
NET ASSETS CONSIST OF:
Paid-in capital $161,926,947
Accumulated net investment loss (1,272,299)
Accumulated net realized gains on investments, securties sold short,
written option contracts and foreign currencies 3,784,299
Net unrealized appreciation (depreciation) on:
Investments 5,001,089
Securities sold short (1,800,491)
Written option contracts (6,163)
Translation of assets and liabilities denominated in foreign currencies (491,355)
------------
NET ASSETS $167,142,027
============
CLASS R SHARES
Net assets applicable to Class R shares $ 75,207,267
============
Shares of beneficial interest outstanding (unlimited number of
shares authorized, no par value) 5,825,094
============
Net asset value, offering and redemption price per share(a) $ 12.91
============
CLASS I SHARES
Net assets applicable to Class I shares $ 91,934,760
============
Shares of beneficial interest outstanding (unlimited number of
shares authorized, no par value) 7,055,332
============
Net asset value, offering and redemption price per share(a) $ 13.03
============
(a) Redemption price varies based on length of time held (Note 1).
See accompanying notes to financial statements.
6
THE ARBITRAGE FUND
Statement of Operations
For the Year Ended May 31, 2007
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Dividends (net of withholding taxes of $40,864) $ 4,111,527
-----------
Total Income 4,111,527
-----------
EXPENSES
Investment advisory fees (Note 3) 2,540,481
Distibution expense, Class R (Note 3) 203,890
Administration fees (Note 3) 169,364
Trustees' fees 50,500
Chief Compliance Officer fees (Note 3) 20,338
Dividend expense 438,971
Transfer agent fees (Note 3) 106,929
Professional fees 72,591
Custodian and bank service fees 64,009
Insurance expense 52,473
Printing of shareholder reports 45,119
Registration and filing fees 42,119
Other expenses 8,959
-----------
Total Expenses 3,815,743
Fees waived by the Adviser (Note 3) (294,255)
-----------
Net Expenses 3,521,488
-----------
NET INVESTMENT INCOME 590,039
-----------
REALIZED AND UNREALIZED GAINS (LOSSES) ON INVESTMENTS
AND FOREIGN CURRENCIES
Net realized gains (losses) from:
Investments 12,521,961
Securities sold short (4,239,076)
Written option contracts 1,618,731
Foreign currency transactions (Note 5) (1,730,058)
Net change in unrealized appreciation (depreciation) on:
Investments 3,576,016
Securities sold short (2,967,685)
Written option contracts (87,726)
Foreign currency transactions (Note 5) 64,757
-----------
NET REALIZED AND UNREALIZED GAINS ON INVESTMENTS
AND FOREIGN CURRENCIES 8,756,920
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $ 9,346,959
===========
See accompanying notes to financial statements.
7
THE ARBITRAGE FUND
Statement of Changes in Net Assets
- --------------------------------------------------------------------------------------
YEAR YEAR
ENDED ENDED
MAY 31, MAY 31,
2007 2006
- --------------------------------------------------------------------------------------
FROM OPERATIONS
Net investment income (loss) $ 590,039 $ (401,183)
Net realized gains (losses) from:
Investments 12,521,961 30,327,309
Securities sold short (4,239,076) (13,506,076)
Written option contracts 1,618,731 1,261,386
Foreign currency transactions (1,730,058) (458,202)
Net change in unrealized appreciation
(depreciation) on:
Investments 3,576,016 (6,988,743)
Securities sold short (2,967,685) 4,528,444
Written option contracts (87,726) 226,294
Foreign currency transactions 64,757 (1,724,192)
------------- -------------
Net increase in net assets resulting from operations 9,346,959 13,265,037
------------- -------------
FROM DISTRIBUTIONS TO SHAREHOLDERS
Distributions from net realized gains, Class R (3,275,506) --
Distributions from net realized gains, Class I (3,537,189) --
------------- -------------
Decrease in net assets from distributions
to shareholders (6,812,695) --
------------- -------------
FROM CAPITAL SHARE TRANSACTIONS (NOTE 4)
CLASS R
Proceeds from shares sold 33,076,805 24,876,671
Shares issued in reinvestment of distributions 3,122,426 --
Proceeds from redemption fees collected (Note 1) 3,514 27,885
Payments for shares redeemed (49,670,593) (78,607,975)
------------- -------------
Net decrease in net assets from
Class R share transactions (13,467,848) (53,703,419)
------------- -------------
CLASS I
Proceeds from shares sold 26,893,015 28,645,078
Shares issued in reinvestment of distributions 3,035,110 --
Proceeds from redemption fees collected (Note 1) 3,761 147
Payments for shares redeemed (27,509,829) (41,005,110)
------------- -------------
Net increase (decrease) in net assets from
Class I share transactions 2,422,057 (12,359,885)
------------- -------------
TOTAL DECREASE IN NET ASSETS (8,511,527) (52,798,267)
NET ASSETS
Beginning of year 175,653,554 228,451,821
------------- -------------
End of year $ 167,142,027 $ 175,653,554
============= =============
ACCUMULATED NET INVESTMENT LOSS $ (1,272,299) $ (1,317,045)
============= =============
See accompanying notes to financial statements.
8
THE ARBITRAGE FUND -- CLASS R
Financial Highlights
- ------------------------------------------------------------------------------------------------------
SELECTED PER SHARE DATA AND RATIOS FOR A SHARE OUTSTANDING THROUGHOUT EACH YEAR
- ------------------------------------------------------------------------------------------------------
YEAR YEAR YEAR YEAR YEAR
ENDED ENDED ENDED ENDED ENDED
MAY 31, MAY 31, MAY 31, MAY 31, MAY 31,
2007 2006 2005 2004 2003
- ------------------------------------------------------------------------------------------------------
Net asset value at beginning of year $ 12.73 $ 11.88 $ 12.52 $ 12.20 $ 11.19
-------- -------- --------- --------- ---------
Income (loss) from investment operations:
Net investment income (loss) 0.03(e) (0.10) (0.19) (0.19) (0.04)
Net realized and unrealized gains on
investments and foreign currencies 0.67(e) 0.95 0.07 1.01 1.20
-------- -------- --------- --------- ---------
Total from investment operations 0.70 0.85 (0.12) 0.82 1.16
-------- -------- --------- --------- ---------
Less distributions:
From net realized gains (0.52) -- (0.52) (0.50) (0.15)
-------- -------- --------- --------- ---------
Proceeds from redemption fees collected 0.00(a) 0.00(a) 0.00(a) 0.00(a) --
-------- -------- --------- --------- ---------
Net asset value at end of year $ 12.91 $ 12.73 $ 11.88 $ 12.52 $ 12.20
======== ======== ========= ========= =========
Total return(b) 5.64% 7.15% (1.07%) 6.66% 10.41%
======== ======== ========= ========= =========
Net assets at end of year (000's) $ 75,207 $ 87,643 $ 134,035 $ 239,494 $ 129,879
======== ======== ========= ========= =========
Ratio of gross expenses to average
net assets 2.38% 2.41% 2.36% 2.46% 3.00%
Ratio of gross expenses to average net
assets excluding dividend expense(c) 2.12% 2.12% 2.06% 2.01% 2.54%
Ratio of net expenses to average net assets
excluding dividend expense(c)(d) 1.95% 1.95% 1.95% 1.95% 1.95%
Ratio of net investment income (loss) to
average net assets:
Before advisory fees waived and
expenses reimbursed 0.06% (0.44%) (1.27%) (1.76%) (1.56%)
After advisory fees waived and
expenses reimbursed 0.23% (0.28%) (1.16%) (1.69%) (0.97%)
Portfolio turnover rate 383% 394% 387% 251% 511%
(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 0.26%, 0.29%, 0.30%, 0.45% and 0.46% of average
net assets for the years ended May 31, 2007, 2006, 2005, 2004 and 2003,
respectively.
(d) Ratios were determined based on net assets after advisory fees waived and
expenses reimbursed.
(e) Per share amounts were calculated using average shares for the period.
Amounts designated as "--" are either $0 or have been rounded to $0.
See accompanying notes to financial statements.
9
THE ARBITRAGE FUND -- CLASS I
Financial Highlights
- -----------------------------------------------------------------------------------------------------------
SELECTED PER SHARE DATA AND RATIOS FOR A SHARE OUTSTANDING THROUGHOUT EACH PERIOD
- -----------------------------------------------------------------------------------------------------------
YEAR YEAR YEAR PERIOD
ENDED ENDED ENDED ENDED
MAY 31, MAY 31, MAY 31, MAY 31,
2007 2006 2005 2004(a)
- -----------------------------------------------------------------------------------------------------------
Net asset value at beginning of period $ 12.81 $ 11.93 $ 12.54 $ 12.86
---------- --------- --------- ---------
Income (loss) from investment operations:
Net investment income (loss) 0.06(h) (0.10) (0.15) (0.07)
Net realized and unrealized gains on
investments and foreign currencies 0.68(h) 0.98 0.06 0.25
---------- --------- --------- ---------
Total from investment operations 0.74 0.88 (0.09) 0.18
---------- --------- --------- ---------
Less distributions:
From net realized gains (0.52) -- (0.52) (0.50)
---------- --------- --------- ---------
Proceeds from redemption fees collected 0.00(b) 0.00(b) 0.00(b) 0.00(b)
---------- --------- --------- ---------
Net asset value at end of period $ 13.03 $ 12.81 $ 11.93 $ 12.54
========== ========= ========= =========
Total return(c) 5.92% 7.38% (0.82%) 1.35%(d)
========== ========= ========= =========
Net assets at end of period (000's) $ 91,935 $ 88,011 $ 94,417 $ 169,330
========== ========= ========= =========
Ratio of gross expenses to average net assets 2.13% 2.16% 2.14% 2.27%(e)
Ratio of gross expenses to average net assets
excluding dividend expense(f) 1.87% 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% 1.70%(e)
Ratio of net investment income (loss)
to average net assets:
Before advisory fees waived and
expenses reimbursed 0.28% (0.29%) (1.05%) (1.56%)(e)
After advisory fees waived and
expenses reimbursed 0.46% (0.12%) (0.91%) (1.44%)(e)
Portfolio turnover rate 383% 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) 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.
(d) Not annualized.
(e) Annualized.
(f) Dividend expense totaled 0.26%, 0.29%, 0.30% and 0.45%(e) of average net
assets for the periods ended May 31, 2007, 2006, 2005 and 2004,
respectively.
(g) Ratios were determined based on net assets after advisory fees waived and
expenses reimbursed.
(h) Per share amounts were calculated using average shares for the period.
Amounts designated as "--" are either $0 or have been rounded to $0.
See accompanying notes to financial statements.
10
THE ARBITRAGE FUND
Portfolio of Investments
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 95.41% VALUE
- -------------------------------------------------------------------------------------
AEROSPACE & DEFENSE -- 2.34%
45,600 Armor Holdings, Inc.(a)(c).................................. $ 3,918,408
-----------
AGRICULTURE -- 0.52%
99,273 Queensland Cotton Holdings Ltd. ............................ 483,942
42,900 Saskatchewan Wheat Pool, Inc.(a)............................ 385,221
-----------
869,163
-----------
APPAREL/TEXTILES -- 0.96%
3,600 Puma Rudolf Dassler Sport .................................. 1,605,259
-----------
BANKS -- 11.64%
65,000 Bank of New York Co., Inc.(b)............................... 2,636,400
40,000 Greater Bay Bancorp ........................................ 1,116,400
45,418 Investors Financial Services Corp.(b)....................... 2,794,115
82,400 MAF Bancorp, Inc. .......................................... 4,439,712
17 New York Community Bancorp, Inc. ........................... 297
97,500 Placer Sierra Bancshares ................................... 2,741,700
106,400 Sky Financial Group, Inc.(b)................................ 2,926,000
89,388 TierOne Corp. .............................................. 2,796,951
-----------
19,451,575
-----------
BIOTECHNOLOGY -- 0.06%
278,600 Oragenics, Inc.(a).......................................... 91,938
-----------
BROADCASTING, NEWSPAPERS & ADVERTISING -- 3.71%
124,600 24/7 Real Media, Inc.(a).................................... 1,462,804
48,800 Alliance Atlantis Communications, Inc., Cl B(a)............. 2,369,021
25,200 aQuantive, Inc.(a)(b)(c).................................... 1,607,508
20,000 Clear Channel Communications, Inc.(b)....................... 768,000
-----------
6,207,333
-----------
BUILDING & CONSTRUCTION SUPPLIES -- 5.67%
64,900 Florida Rock Industries, Inc.(b)............................ 4,417,094
71,000 Infrasource Services, Inc.(a)(b)............................ 2,570,200
130,000 Rinker Group Ltd. .......................................... 2,066,891
5,001 Washington Group International, Inc.(a)..................... 420,084
-----------
9,474,269
-----------
COAL -- 0.34%
139,000 Gloucester Coal Ltd. ....................................... 570,615
-----------
11
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 95.41% (Continued) VALUE
- -------------------------------------------------------------------------------------
COMMUNICATION EQUIPMENT -- 3.04%
358,990 Aeroflex, Inc.(a)........................................... $ 5,076,119
-----------
COMPUTERS & COMPUTER SERVICES -- 9.89%
112,000 BISYS Group, Inc.(a)(b)..................................... 1,316,000
28,000 CDW Corp. .................................................. 2,383,920
30,000 Ceridian Corp.(a)(c)........................................ 1,061,100
134,893 Covansys Corp.(a)(b)........................................ 4,558,035
95,600 Kronos, Inc.(a)(b).......................................... 5,237,924
65,000 Paxar Corp.(a)(b)........................................... 1,966,250
-----------
16,523,229
-----------
ELECTRICAL SERVICES -- 2.07%
131,200 Fortis, Inc. ............................................... 3,461,932
-----------
ENTERTAINMENT -- 1.13%
80,000 Gateway Casinos Income Fund ................................ 1,883,453
-----------
FINANCIAL SERVICES -- 2.35%
128,565 Loring Ward International Ltd. ............................. 1,611,422
30,000 SLM Corp.(c)................................................ 1,686,300
213,700 Veda Advantage Ltd. ........................................ 627,884
-----------
3,925,606
-----------
GAS/NATURAL GAS -- 4.12%
122,500 KeySpan Corp.(b)............................................ 5,104,575
229,700 SEMCO Energy, Inc.(a)(b).................................... 1,773,284
-----------
6,877,859
-----------
HOTELS & LODGING -- 1.52%
29,000 Station Casinos, Inc. ...................................... 2,547,650
-----------
INSURANCE -- 3.46%
67,600 21st Century Insurance Group(b)............................. 1,473,680
88,500 Bristol West Holdings, Inc. ................................ 1,953,195
54,795 Ohio Casualty Corp.(b)...................................... 2,359,473
-----------
5,786,348
-----------
LEISURE PRODUCTS -- 1.96%
214,670 K2, Inc.(a)(b).............................................. 3,275,864
-----------
MEDIA -- 0.00%
5,000 TVSL SA(a).................................................. --
-----------
12
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 95.41% (Continued) VALUE
- -------------------------------------------------------------------------------------
MEDICAL PRODUCTS & SERVICES -- 13.00%
67,000 Bioenvision, Inc.(a)........................................ $ 378,550
33,217 Biosite, Inc.(a)............................................ 3,053,306
76,486 BioVeris Corp.(a)(b)........................................ 1,635,271
92,393 Cytyc Corp.(a)(c)........................................... 3,906,376
180,500 Enpath Medical, Inc.(a)..................................... 2,588,370
64,400 Medimmune, Inc.(a)(c)....................................... 3,727,472
99,400 Pediatric Services of America, Inc.(a)...................... 1,575,490
17,500 Sierra Health Services, Inc.(a)............................. 729,400
201,690 Stratagene Corp.(a)......................................... 2,190,353
40,143 Symbion, Inc.(a)............................................ 878,329
25,000 Viasys Healthcare, Inc.(a).................................. 1,073,750
-----------
21,736,667
-----------
METALS & MINING -- 0.77%
48,000 LionOre Mining International Ltd.(a)........................ 1,290,356
-----------
MISCELLANEOUS BUSINESS SERVICES -- 7.27%
247,913 Agile Software Corp.(a)..................................... 1,988,262
15,000 Alliance Data Systems Corp.(a)(c)........................... 1,168,800
115,600 Electronic Clearing House, Inc.(a).......................... 1,420,724
30,000 First Data Corp.(b)......................................... 981,000
300,236 Goldleaf Financial Solutions, Inc.(a)....................... 1,768,390
60,000 Netratings, Inc.(a)......................................... 1,257,600
123,300 Versacold Income Fund ...................................... 1,400,114
175,000 VOXCOM Income Fund ......................................... 2,163,970
-----------
12,148,860
-----------
PETROLEUM EXPLORATION & PRODUCTION -- 4.64%
71,400 Houston Exploration Co.(a)(b)............................... 4,286,856
70,000 Todco(a)(b)................................................. 3,462,200
-----------
7,749,056
-----------
PETROLEUM FIELD MACHINERY & EQUIPMENT -- 1.61%
40,000 Lone Star Technologies, Inc.(a)............................. 2,695,200
-----------
PUBLIC THOROUGHFARES -- 0.51%
122,807 Transurban Group ........................................... 852,770
-----------
REAL ESTATE -- 0.40%
75,000 Investa Property Group ..................................... 192,428
8,000 Riofisa SA(a)............................................... 473,666
-----------
666,094
-----------
13
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 95.41% (Continued) VALUE
- -------------------------------------------------------------------------------------
RETAIL -- 3.30%
64,100 Coles Group Ltd. ........................................... $ 876,956
158,600 Pathmark Stores, Inc.(a)(b)................................. 2,061,800
22,500 Sobeys, Inc. ............................................... 1,209,078
43,300 Stride Rite Corp. .......................................... 872,495
28,858 Wild Oats Markets, Inc.(a)(b)............................... 496,357
------------
5,516,686
------------
SCHOOLS -- 0.67%
140,212 Educate, Inc.(a)(b)......................................... 1,113,283
------------
SEMICONDUCTORS -- 0.09%
119,485 Conexant Systems, Inc.(a)................................... 154,136
------------
SOFTWARE -- 2.86%
170,697 Mobius Management Systems, Inc.(a)(b)....................... 1,706,970
156,600 webMethods, Inc.(a)......................................... 1,440,720
140,000 Workbrain Corp.(a).......................................... 1,632,962
------------
4,780,652
------------
STEEL & STEEL WORKS -- 0.20%
3,500 Boehler-Uddeholm ........................................... 340,326
------------
TELEPHONES & TELECOMMUNICATIONS -- 3.64%
144,210 Eschelon Telecom, Inc.(a)(b)................................ 4,265,732
52,077 Inter-tel, Inc. ............................................ 1,361,814
10,000 TeleCorp PCS, Inc., Cl A(a)................................. --
258,100 Terayon Communication Systems, Inc.(a)...................... 455,546
------------
6,083,092
------------
WHOLESALE -- 1.67%
120,000 Van Houtte, Inc. ........................................... 2,799,364
------------
TOTAL COMMON STOCK (Cost $154,661,197) $159,473,162
------------
- -------------------------------------------------------------------------------------
SHARES REAL ESTATE INVESTMENT TRUSTS -- 4.77% VALUE
- -------------------------------------------------------------------------------------
75,000 Crescent Real Estate EQT Co. ............................... $ 1,677,000
74,300 Highland Hospitality Corp. ................................. 1,431,761
107,500 Innkeepers USA Trust(b)..................................... 1,895,225
42,800 Legacy Hotels Real Estate Investment Trust ................. 558,470
167,500 Spirit Finance Corp. ....................................... 2,405,300
------------
TOTAL REAL ESTATE INVESTMENT TRUSTS (Cost $7,918,174) $ 7,967,756
------------
14
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES EQUITY SWAPS -- 2.09% VALUE
- -------------------------------------------------------------------------------------
10,000 ABN AMRO Holding ........................................... $ 479,452
150,000 Baggeridge Brick Plc ....................................... 674,548
75,000 Enodis Plc ................................................. 307,468
25,000 Hanson Plc ................................................. 531,857
384,900 La Tasca Group Plc ......................................... 1,507,501
-----------
TOTAL EQUITY SWAPS (Cost $3,415,928) $ 3,500,826
-----------
- -------------------------------------------------------------------------------------
SHARES WARRANTS -- 0.13% VALUE
- -------------------------------------------------------------------------------------
153,646 Caliper Life Sciences, Inc. Expires 09/11(a) (Cost $86,516) $ 223,152
-----------
- -------------------------------------------------------------------------------------
SHARES ESCROWED RIGHTS -- 0.00% VALUE
- -------------------------------------------------------------------------------------
247,200 PetroCorp, Inc. - escrow shares(a)(d) (Cost $--)............ $ --
-----------
- -------------------------------------------------------------------------------------
CONTRACTS PUT OPTION CONTRACTS (a) -- 0.07% VALUE
- -------------------------------------------------------------------------------------
Alliance Data Systems Corp.,
100 09/22/07 at $75 ........................................... $ 9,500
aQuantive, Inc.,
20 09/22/07 at $50 ........................................... 750
152 09/22/07 at $55............................................ 10,260
80 09/22/07 at $60............................................ 8,000
CapitalSource, Inc.,
200 10/20/07 at $25 ........................................... 24,500
Cytyc Corp.,
220 07/21/07 at $40 ........................................... 18,150
Hercules Offshore, Inc.,
250 07/21/07 at $25 ........................................... 2,500
50 07/21/07 at $30............................................ 1,750
Medimmune, Inc.,
426 06/16/07 at $50 ........................................... 2,130
SLM Corp.,
300 10/20/07 at $50 ........................................... 33,750
-----------
TOTAL PUT OPTION CONTRACTS (Cost $193,557) $ 111,290
-----------
15
THE ARBITRAGE FUND
Portfolio of Investments (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
CONTRACTS CALL OPTION CONTRACTS(a) -- 0.02% VALUE
- -------------------------------------------------------------------------------------
Hologic, Inc.,
350 07/21/07 at $60 (Cost $32,975) ........................... $ 33,250
------------
- -------------------------------------------------------------------------------------
SHARES MONEY MARKET SECURITY -- 3.93% VALUE
- -------------------------------------------------------------------------------------
6,562,675 Dreyfus Treasury Prime Cash
Management Fund, Institutional Shares, 4.710%(e)
(Cost $6,562,675)......................................... $ 6,562,675
------------
TOTAL INVESTMENTS AT VALUE -- 106.42% (Cost $172,871,022) $177,872,111
============
Percentages are based on net assets of $167,142,027.
(a) Non-income producing security.
(b) All or a portion of the shares have been committed 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.
(e) Rate shown is the 7-day effective yield as of May 31, 2007.
Cl -- Class
Ltd. -- Limited
Plc -- Public Limited Company
Amounts designated as "--" are either $0 or have been rounded to $0.
See accompanying notes to financial statements.
As of May 31, 2007, the Fund had forward foreign currency exchange contracts
outstanding as follows:
- ------------------------------------------------------------------------------------------
UNREALIZED
APPRECIATION
SETTLEMENT DATE TO DELIVER INITIAL VALUE MARKET VALUE (DEPRECIATION)
- ------------------------------------------------------------------------------------------
Contracts to Sell
07/30/07 ........... (2,944,450) AUD $ 2,439,771 $ 2,432,203 $ 7,568
07/30/07 ........... (15,950,425) CAD 14,409,736 14,949,833 (540,097)
07/30/07 ........... (2,645,000) EUR 3,620,476 3,566,565 53,911
07/30/07 ........... (1,440,000) GBP 2,877,480 2,846,581 30,899
07/30/07 ........... (54,800,000) JPY 463,394 453,593 9,801
------------ ------------ ----------
Total Sell Contracts .. $ 23,810,857 $ 24,248,775 $ (437,918)
------------ ------------ ----------
Net Contracts ......... $ 23,810,857 $ 24,248,775 $ (437,918)
============ ============ ==========
AUD -- Australian Dollar GBP -- British Pound Sterling
CAD -- Canadian Dollar JPY -- Japanese Yen
EUR -- Euro
16
THE ARBITRAGE FUND
Schedule of Securities Sold Short
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 16.25% VALUE
- -------------------------------------------------------------------------------------
AGRICULTURE -- 0.23%
42,900 Saskatchewan Wheat Pool, Inc.(a)............................ $ 385,221
-----------
BANKS -- 5.25%
116,900 Huntington Bancshares, Inc. ................................ 2,625,574
56,336 Mellon Financial Corp.(b)................................... 2,441,039
27,210 State Street Corp........................................... 1,857,627
51,300 Wells Fargo & Co. .......................................... 1,851,417
-----------
8,775,657
-----------
BUILDING & CONSTRUCTION SUPPLIES -- 0.87%
12,190 Vulcan Materials Co. ....................................... 1,459,021
-----------
CONSUMER PRODUCTS -- 0.36%
14,062 Jarden Corp.(a)............................................. 599,322
-----------
ELECTRICAL SERVICES -- 3.64%
131,200 Fortis, Inc. ............................................... 3,461,933
87,130 Quanta Services, Inc.(a).................................... 2,614,771
-----------
6,076,704
-----------
FINANCIAL SERVICES -- 1.70%
60,000 NASDAQ-100 Trust, Ser 1 .................................... 2,844,600
-----------
MEDICAL PRODUCTS & SERVICES -- 0.97%
30,000 Hologic, Inc.(a)(b)......................................... 1,622,700
-----------
METALS & MINING -- 0.00%
100 Agnico-Eagle Mines Ltd. .................................... 3,631
-----------
MISCELLANEOUS BUSINESS SERVICES -- 0.02%
772 URS Corp.(a)(b)............................................. 38,816
-----------
PETROLEUM EXPLORATION & PRODUCTION -- 2.27%
59,975 Forest Oil Corp.(a)......................................... 2,434,385
38,700 Hercules Offshore, Inc.(a)(b)............................... 1,351,791
-----------
3,786,176
-----------
PRINTING & PUBLISHING -- 0.00%
150 Fairfax Media Ltd. ......................................... 605
-----------
PUBLIC THOROUGHFARES -- 0.51%
123,344 Transurban Group ........................................... 856,499
-----------
17
THE ARBITRAGE FUND
Schedule of Securities Sold Short (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
SHARES COMMON STOCK -- 16.25% (Continued) VALUE
- -------------------------------------------------------------------------------------
RETAIL -- 0.43%
20,500 Great Atlantic & Pacific Tea Co.(a) ........................ $ 707,455
-----------
SEMICONDUCTORS -- 0.00%
48 LSI Corp.(a)................................................ 417
-----------
TELEPHONES & TELECOMMUNICATIONS -- 0.00%
36 Citizens Communications Co. ................................ 571
-----------
TOTAL COMMON STOCK (Proceeds $25,439,878) $27,157,395
-----------
- -------------------------------------------------------------------------------------
SHARES REAL ESTATE INVESTMENT TRUST -- 1.06% VALUE
- -------------------------------------------------------------------------------------
67,297 CapitalSource, Inc.(b) (Proceeds $1,685,832)................ $ 1,769,911
-----------
- -------------------------------------------------------------------------------------
SHARES EQUITY SWAP -- 0.13% VALUE
- -------------------------------------------------------------------------------------
15,000 Barclays Plc (Proceeds $215,331)............................ $ 214,226
-----------
TOTAL SECURITIES SOLD SHORT -- 17.44% (Proceeds $27,341,041) $29,141,532
===========
Percentages are based on net assets of $167,142,027.
(a) Non-income producing security.
(b) Underlying security for a written/purchased call/put option.
Ltd. -- Limited
Plc -- Public Limited Company
Ser -- Series
See accompanying notes to financial statements.
18
THE ARBITRAGE FUND
Schedule of Open Options Written
May 31, 2007
- -------------------------------------------------------------------------------------
CONTRACTS WRITTEN CALL OPTIONS(a) -- 0.09% VALUE
- -------------------------------------------------------------------------------------
Alliance Data Systems Corp.,
75 06/16/07 at $80............................................. $ 1,125
25 09/22/07 at $80............................................. 2,438
aQuantive, Inc.,
83 06/16/07 at $65............................................. 830
219 07/21/07 at $65............................................. 6,570
Armor Holdings, Inc.,
250 06/16/07 at $90............................................. 3,750
Ceridian Corp.,
150 08/18/07 at $35............................................. 16,500
Hercules Offshore, Inc.,
200 07/21/07 at $35............................................. 35,000
Hologic, Inc.,
50 07/21/07 at $55............................................. 12,625
Medimmune, Inc.,
10 06/16/07 at $57.5........................................... 525
1 09/22/07 at $60............................................. 5
415 12/22/07 at $60............................................. 2,075
Mellon Financial Corp.,
50 06/16/07 at $42.5........................................... 6,375
Novelis, Inc.,
150 06/16/07 at $45............................................. --
SLM Corp.,
300 06/16/07 at $55............................................. 47,250
URS Corp.,
30 07/21/07 at $50............................................. 6,000
---------
TOTAL WRITTEN CALL OPTIONS (Premiums Received $124,419) $ 141,068
---------
19
THE ARBITRAGE FUND
Schedule of Open Options Written (Continued)
May 31, 2007
- -------------------------------------------------------------------------------------
CONTRACTS WRITTEN PUT OPTIONS(a) -- 0.02% VALUE
- -------------------------------------------------------------------------------------
aQuantive, Inc.,
8 06/16/07 at $60 ........................................ $ 100
Hologic, Inc.,
85 06/16/07 at $50 ........................................ 2,125
170 06/16/07 at $55 ........................................ 33,575
---------
TOTAL WRITTEN PUT OPTIONS (Premiums Received $46,286) $ 35,800
---------
TOTAL OPEN OPTIONS WRITTEN -- 0.11%
(Premiums Received $170,705) $ 176,868
=========
Percentages are based on net assets of $167,142,027.
(a) Non-income producing security.
Amounts designated as "--" are either $0 or have been rounded to $0.
See accompanying notes to financial statements.
20
THE ARBITRAGE FUND
Notes to the Financial Statements
May 31, 2007
- --------------------------------------------------------------------------------
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
0.25% 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 security's primary trading market is temporarily closed
at a time when under normal
21
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
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 5).
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,
2007, proceeds from redemption fees were $3,514 in Class R and $3,761 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 deferred
wash sale losses, deferred post October foreign currency loss and constructive
gain from sale of securities.
The tax character of dividends and distributions declared during the years ended
May 31, 2007 and May 31, 2006 was as follows:
- --------------------------------------------------------------------------------
Year Ordinary Long-Term Total
Ended Income Capital Gains Distributions
- --------------------------------------------------------------------------------
5/31/07 $6,723,349 $89,346 $6,812,695
5/31/06 -- -- --
- --------------------------------------------------------------------------------
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.
22
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
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 Statement 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
agreements.
23
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
Details of swap agreements open at May 31, 2007 are included in the Fund's
Portfolio of Investments and Schedule of Securities Sold Short. As of May 31,
2007, the Fund had long and short equity swap contracts outstanding of
$3,500,826 and $214,226, 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,
2007:
- --------------------------------------------------------------------------------
Cost of portfolio investments (including securities sold short
and written options) $146,491,671
============
Gross unrealized appreciation $ 6,410,733
Gross unrealized depreciation (4,348,693)
------------
Net unrealized appreciation 2,062,040
Net unrealized depreciation on translation of assets and
liabilities in foreign currencies (491,355)
Undistributed ordinary income 6,350,051
Post October losses (336,519)
Post October currency losses (1,357,326)
Other temporary differences (1,011,811)
------------
Total distributable earnings $ 5,215,080
============
- --------------------------------------------------------------------------------
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, mark-to-market on open forwards, disallowed
losses on tax straddles and gains on the constructive sale of securities.
For the year ended May 31, 2007, the Fund reclassified net investment losses of
$545,293 to accumulated net realized gain (loss) 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 operating loss and reclassification of short sale
related dividend expense to capital loss, has no effect on the Fund's net assets
or net asset value per share.
24
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
2. INVESTMENT TRANSACTIONS
During the year ended May 31, 2007, 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 $720,165,885 and
$655,684,099, respectively.
A summary of put and call option contracts written during the year ended May 31,
2007 is as follows:
- --------------------------------------------------------------------------------
OPTION OPTION
CONTRACTS PREMIUMS
- --------------------------------------------------------------------------------
Options outstanding at beginning of year 4,917 $ 663,271
Options written 29,603 5,315,206
Options canceled in a closing purchase transaction (4,382) (556,386)
Options exercised (14,434) (3,580,712)
Options expired (13,433) (1,670,674)
------------- -------------
Options outstanding at end of year 2,271 $ 170,705
============= =============
- --------------------------------------------------------------------------------
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, 2007, the Adviser waived $294,255 of its advisory fee.
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,
2007, the Adviser may in the future recapture from the Fund fees waived and
expenses reimbursed totaling $1,012,947 of which $294,255 expires May 31, 2010,
$320,997 expires May 31, 2009, and $397,695 expires May 31, 2008.
25
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
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 0.10% of the Fund's average daily net assets up to $500 million;
and 0.08% of such assets in excess of $500 million, subject to a minimum fee of
$150,000 per year. For the year ended May 31, 2007, SIGFS was paid $169,364
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.
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 complex
minimum fee, including two CUSIPs, at an annual rate of $50,000 per year. For
each CUSIP thereafter, an additional fee is applied at a minimum fee of $17,500
per CUSIP per year. For the year ended May 31, 2007, DST was paid $106,929 under
the transfer agent and shareholder services agreement.
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 0.25% annually of the average daily net
assets allocable to Class R shares. During the year ended May 31, 2007, the Fund
paid Class R distribution expenses of $203,890 pursuant to the Plan.
26
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
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.
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,
2007 2006
- --------------------------------------------------------------------------------
CLASS R
Shares sold 2,579,669 2,018,023
Shares issued in reinvestment of distributions 251,399 --
Shares redeemed (3,891,401) (6,414,977)
------------ ------------
Net decrease in shares outstanding (1,060,333) (4,396,954)
Shares outstanding at beginning of year 6,885,427 11,282,381
------------ ------------
Shares outstanding at end of year 5,825,094 6,885,427
============ ============
CLASS I
Shares sold 2,093,615 2,334,068
Shares issued in reinvestment of distributions 242,227 --
Shares redeemed (2,149,524) (3,379,310)
------------ ------------
Net increase (decrease) in shares outstanding 186,318 (1,045,242)
Shares outstanding at beginning of year 6,869,014 7,914,256
------------ ------------
Shares outstanding at end of year 7,055,332 6,869,014
============ ============
- --------------------------------------------------------------------------------
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.
27
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
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 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, 2007.
28
THE ARBITRAGE FUND
Notes to the Financial Statements (Continued)
May 31, 2007
- --------------------------------------------------------------------------------
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 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.
9. NEW ACCOUNTING PRONOUNCEMENTS
On July 13, 2006, the Financial Accounting Standards Board ("FASB") released
FASB INTERPRETATION NO. 48, "ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES" ("FIN
48"). FIN 48 provides guidance for how uncertain tax positions should be
recognized, measured, presented and disclosed in the financial statements. FIN
48 requires the evaluation of tax positions taken or expected to be taken in the
course of preparing the Fund's tax returns to determine whether the tax
positions are "more-likely-than-not" of being sustained by the applicable tax
authority. Tax positions not deemed to meet the more-likely-than-not threshold
would be recorded as a tax benefit or expense in the current year. Adoption of
FIN 48 is required for fiscal years beginning after December 15, 2006 and is to
be applied to all open tax years as of the effective date. The Fund will not be
required to adopt FIN 48 until November 30, 2007. As of May 31, 2007, the Fund
has not evaluated the impact that will result from adopting FIN 48.
In September 2006, FASB issued STATEMENT ON FINANCIAL ACCOUNTING STANDARDS
("SFAS") NO. 157, "FAIR VALUE MEASUREMENTS." This standard establishes a single
authoritative definition of fair value, sets out a framework for measuring fair
value and requires additional disclosures about fair value measurements. SFAS
No. 157 applies to fair value measurements already required or permitted by
existing standards. SFAS No. 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007 and interim periods within
those fiscal years. The changes to current generally accepted accounting
principles from the application of this Statement relate to the definition of
fair value, the methods used to measure fair value, and the expanded disclosures
about fair value measurements. As of May 31, 2007, the Fund does not believe the
adoption of SFAS No. 157 will impact the amounts reported in the financial
statements, however, additional disclosures may be required about the inputs
used to develop the measurements and the effect of certain of the measurements
reported on the Statement of Changes in Net Assets for a fiscal period.
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 portfolio of investments as of May
31, 2007, and the related statement of operations for the year then ended, the
statements of changes in net assets for each of the two years in the period then
ended, and the financial highlights for each of the five years in the period
then ended. These financial statements and financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and financial highlights based on our
audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and financial highlights are free of material misstatement. The Trust
is not required to have, nor were we 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, 2007 by correspondence with the custodian and brokers or by
other appropriate auditing procedures where brokers have not replied to our
confirmation requests. 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, 2007, 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 LLP
PHILADELPHIA, PENNSYLVANIA
JULY 13, 2007
30
THE ARBITRAGE FUND
Disclosure of Fund Expenses (Unaudited)
- --------------------------------------------------------------------------------
All mutual funds have operating expenses. As a shareholder of a mutual fund,
your investment is affected by these ongoing costs, which include (among others)
costs for portfolio management, administrative services, and shareholder reports
like this one. It is important for you to understand the impact of these costs
on your investment returns.
Operating expenses such as these are deducted from a mutual fund's gross income
and directly reduce its final investment return. These expenses are expressed as
a percentage of a mutual fund's average net assets; this percentage is known as
a mutual fund's expense ratio.
The following examples use the expense ratio and are intended to help you
understand the ongoing costs (in dollars) of investing in your Fund and to
compare these costs with those of other mutual funds. The examples 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 following page illustrates your Fund's costs in two ways.
o ACTUAL FUND RETURN. This section helps you to estimate the actual expenses
after fee waivers that your Fund incurred over the period. The "Expenses Paid
During Period" column shows the actual dollar expense cost incurred by a $1,000
investment in the Fund, and the "Ending Account Value" number is derived from
deducting that expense cost from the Fund's gross investment return.
You can use this information, together with the actual amount you invested in
the Fund, to estimate the expenses you paid over that period. Simply divide your
actual account value by $1,000 to arrive at a ratio (for example, an $8,600
account value divided by $1,000 = 8.6), then multiply that ratio by the number
shown for your Fund under "Expenses Paid During Period."
o HYPOTHETICAL 5% RETURN. This section helps you compare your Fund's costs with
those of other mutual funds. It assumes that the Fund had an annual 5% return
before expenses during the year, but that the expense ratio (Column 3) for the
period is unchanged. This example is useful in making comparisons because the
Securities and Exchange Commission requires all mutual funds to make this 5%
calculation. You can assess your Fund's comparative cost by comparing the
hypothetical result for your Fund in the "Expenses Paid During Period" column
with those that appear in the same charts in the shareholder reports for other
mutual funds.
Note: Because the return is set at 5% for comparison purposes -- NOT your Fund's
actual return -- the account values shown may not apply to your specific
investment.
31
THE ARBITRAGE FUND
Disclosure of Fund Expenses (Unaudited) (Continued)
- --------------------------------------------------------------------------------
THE ARBITRAGE FUND -- CLASS R
- -------------------------------------------------------------------------------------------
BEGINNING ENDING ANNUALIZED
ACCOUNT VALUE ACCOUNT VALUE EXPENSE EXPENSES PAID
DECEMBER 1, 2006 MAY 31, 2007 RATIOS DURING PERIOD*
- -------------------------------------------------------------------------------------------
Based on Actual Fund Return $1,000.00 $1,045.70 2.43% $12.39
Based on Hypothetical 5% Return
(before expenses) $1,000.00 $1,012.81 2.43% $12.19
- -------------------------------------------------------------------------------------------
* Expenses are equal to the Fund's Class R annualized expense ratio 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 ANNUALIZED
ACCOUNT VALUE ACCOUNT VALUE EXPENSE EXPENSES PAID
DECEMBER 1, 2006 MAY 31, 2007 RATIOS DURING PERIOD*
- -------------------------------------------------------------------------------------------
Based on Actual Fund Return $1,000.00 $1,046.90 2.18% $11.13
Based on Hypothetical 5% Return
(before expenses) $1,000.00 $1,014.06 2.18% $10.95
- -------------------------------------------------------------------------------------------
* Expenses are equal to the Fund's Class I annualized expense ratio 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
Fund'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)
- --------------------------------------------------------------------------------
On March 27, 2007 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 recognized that the Fund's overall expense ratio is higher than the
average of comparably managed funds but concluded 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, the fees are 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.
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's performance warranted continuation
of the investment advisory agreement.
34
THE ARBITRAGE FUND
Trustees' Renewal of Advisory Agreement (Unaudited) (Continued)
- --------------------------------------------------------------------------------
ECONOMIES OF SCALE AND ANCILLARY BENEFITS
The Board concluded, given the size of the Fund's assets 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 research derived from these trades was useful
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 47 President, Secretary, Since May 2000
New York, NY 10019 Treasurer and Trustee
*Joel C. Ackerman 295 Central Park West 62 Trustee Since May 2000
New York, NY 10024
John C. Alvarado 75 Sprint Street, 8th Floor 47 Trustee Since December 2003
New York, NY 10012
Burtt R. Ehrlich One Landmark Square, 22nd Floor 68 Trustee Since March 2005
Stanford, CT 06901
Jay N. Goldberg Hudson Venture Partners 66 Trustee Since May 2000
660 Madison Avenue
New York, NY 10012
Matthew Hemberger 650 Fifth Avenue 48 Vice President, Since May 2000
New York, NY 10019 Chief Compliance
Officer and
Anti-Money Laundering
Compliance Officer
Eric Kleinschmidt One Freedom Valley Drive 39 Chief Financial Since July 2005
Oaks, PA 19456 Officer
James Ndiaye One Freedom Valley Drive 38 Assistant Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
Michael T. Pang One Freedom Valley Drive 35 Assistant Vice President and Since October 2005
Oaks, PA 19456 Assistant Secretary
Sofia A. Rosala One Freedom Valley Drive 33 Assistant 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 with 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 a private 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 General Partner 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 Assistant 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)
- --------------------------------------------------------------------------------
Michael T. Pang is Assistant 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 Assistant 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
THE ARBITRAGE FUND
Notice to Shareholders (Unaudited)
- --------------------------------------------------------------------------------
For shareholders that do not have a May 31, 2007 tax year end, this notice is
for informational purposes only. For shareholders with a May 31, 2007 tax year
end, please consult your tax advisor as to the pertinence of this notice. For
the fiscal year ended May 31, 2007, the Fund is designating the following items
with regard to distributions paid during the year.
LONG TERM ORDINARY QUALIFYING QUALIFYING QUALIFYING
CAPITAL GAIN INCOME TOTAL QUALIFYING DIVIDEND INTEREST SHORT-TERM
DISTRIBUTIONS DISTRIBUTIONS DISTRIBUTIONS DIVIDENDS(1) INCOME(2) INCOME(3) CAPITAL GAIN(4)
- -------------- ------------- ------------- ------------- ---------- ---------- ---------------
1.31% 98.69% 100.00% 100.00% 100.00% 0.00% 100.00%
(1) QUALIFYING DIVIDENDS REPRESENT DIVIDENDS WHICH QUALIFY FOR THE CORPORATE
DIVIDENDS RECEIVED DEDUCTION AND ARE REFLECTED AS A PERCENTAGE OF "ORDINARY
INCOME DISTRIBUTIONS" (THE TOTAL OF SHORT-TERM CAPITAL GAIN AND NET INVESTMENT
INCOME DISTRIBUTIONS).
(2) THE PERCENTAGE IN THIS COLUMN REPRESENTS THE AMOUNT OF "QUALIFYING DIVIDEND
INCOME" AS CREATED BY THE JOBS AND GROWTH TAX RELIEF RECONCILIATION ACT OF 2003
AND IS REFLECTED AS A PERCENTAGE OF "ORDINARY INCOME DISTRIBUTIONS" (THE TOTAL
OF SHORT-TERM CAPITAL GAIN AND NET INVESTMENT INCOME DISTRIBUTIONS). IT IS THE
INTENTION OF THE AFOREMENTIONED FUND TO DESIGNATE THE MAXIMUM AMOUNT PERMITTED
BY LAW.
(3) THE PERCENTAGE IN THIS COLUMN REPRESENTS THE AMOUNT OF "QUALIFYING INTEREST
INCOME" AS CREATED BY THE AMERICAN JOBS CREATION ACT OF 2004 AND IS REFLECTED AS
A PERCENTAGE OF NET INVESTMENT INCOME DISTRIBUTIONS THAT IS EXEMPT FROM U.S.
WITHHOLDING TAX WHEN PAID TO FOREIGN INVESTORS.
(4) THE PERCENTAGE IN THIS COLUMN REPRESENTS THE AMOUNT OF "QUALIFYING
SHORT-TERM CAPITAL GAIN" AS CREATED BY THE AMERICAN JOBS CREATION ACT OF 2004
AND IS REFLECTED AS A PERCENTAGE OF SHORT-TERM CAPITAL GAIN DISTRIBUTIONS THAT
IS EXEMPT FROM U.S. WITHHOLDING TAX WHEN PAID TO FOREIGN INVESTORS.
THE INFORMATION REPORTED HEREIN MAY DIFFER FROM THE INFORMATION AND
DISTRIBUTIONS TAXABLE TO THE SHAREHOLDERS FOR THE CALENDAR YEAR ENDING DECEMBER
31, 2007. COMPLETE INFORMATION WILL BE COMPUTED AND REPORTED IN CONJUNCTION WITH
YOUR FORM 1099-DIV.
39
NOTES
- --------------------------------------------------------------------------------
NOTES
- --------------------------------------------------------------------------------
[LOGO OMITTED]
THE ARBITRAGE FUND
800-295-4485
www.thearbfund.com
ADVISER WATER ISLAND CAPITAL, LLC
41 Madison Avenue
28th Floor
New York, NY 10010
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 (7/07)
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:
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2007 2006
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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 did not require were did not require
pre-approved pre-approval pre-approved pre-approval
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(a) Audit $19,500 $0 $0 $18,500 $0 $0
Fees(1)
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(b) Audit- $0 $0 $0 $0 $0 $0
Related
Fees
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(c) Tax $0 $0 $0 $0 $0 $0
Fees
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(d) All $0 $0 $0 $0 $0 $0
Other
Fees
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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:
------------------------ --------------- ---------------
2007 2006
------------------------ --------------- ---------------
Audit-Related Fees 0.00% 0.00%
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Tax Fees 0.00% 0.00%
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All Other Fees 0.00% 0.00%
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(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 2007 and
2006, 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.
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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
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John S. Orrico
President and Treasurer
Date: August 8, 2007
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
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John S. Orrico
President and Treasurer
Date: August 8, 2007
By (Signature and Title)* /s/ Eric Kleinschmidt
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Eric Kleinschmidt
Chief Financial Officer
Date: August 8, 2007
* Print the name and title of each signing officer under his or her signature.