---------------------------
OMB APPROVAL
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OMB Number: 3235-0570
Expires: October 31, 2006
Estimated average burden
hours per response: 19.3
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT
INVESTMENT COMPANIES
Investment Company Act file number 811-098150
--------------------------------------------
THE ARBITRAGE FUNDS
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in charter)
650 Fifth Avenue, 5th Floor New York, New York 10019
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip code)
John S. Orrico
Water Island Capital, LLC 650 Fifth Avenue, 6th Floor New York, New York 10019
- --------------------------------------------------------------------------------
(Name and address of agent for service)
Registrant's telephone number, including area code: (212) 259-2655
---------------------
Date of fiscal year end: May 31, 2004
-------------------------
Date of reporting period: May 31, 2004
-------------------------
Form N-CSR is to be used by management investment companies to file reports with
the Commission not later than 10 days after the transmission to stockholders of
any report that is required to be transmitted to stockholders under Rule 30e-1
under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may
use the information provided on Form N-CSR in its regulatory, disclosure review,
inspection, and policymaking roles.
A registrant is required to disclose the information specified by Form N-CSR,
and the Commission will make this information public. A registrant is not
required to respond to the collection of information contained in Form N-CSR
unless the Form displays a currently valid Office of Management and Budget
("OMB") control number. Please direct comments concerning the accuracy of the
information collection burden estimate and any suggestions for reducing the
burden to Secretary, Securities and Exchange Commission, 450 Fifth Street, NW,
Washington, DC 20549-0609. The OMB has reviewed this collection of information
under the clearance requirements of 44 U.S.C. ss. 3507.
ITEM 1. REPORTS TO STOCKHOLDERS.
[GRAPHIC OMITTED]
THE ARBITRAGE FUND
A SERIES OF THE ARBITRAGE FUNDS
650 Fifth Avenue
New York, New York 10019
ANNUAL REPORT
MAY 31, 2004
INVESTMENT ADVISER ADMINISTRATOR
------------------ -------------
WATER ISLAND CAPITAL, LLC ULTIMUS FUND SOLUTIONS, LLC
650 Fifth Avenue P.O. Box 46707
6th Floor Cincinnati, Ohio 45246-0707
New York, New York 10019 1.800.295.4485
[GRAPHIC OMITTED]
THE ARBITRAGE FUND
Water Island Capital, LLC
650 Fifth Avenue, fifth avenue
New York, New York 10019
_______
TEL: 212.259.2656 FAX: 212.259.2698
July 2004
Dear Shareholder,
As the Arbitrage Fund caps its fourth full year of operations, we are proud of
the record we have built. From inception (September 17, 2000) through the end of
the fiscal year May 31, the Fund has produced an average annualized return of
8.77%, net of all fees and expenses, compared with a negative annualized return
of -5.54% for the S&P 500 during the same period. For the one year period ended
May 31, the Fund has generated a return of 6.66%, also net of all fees and
expenses, compared to a return of 18.33% for the S&P 500 during the same period.
An investor should expect this type of divergence in performance between the
Fund and an overall market indicator, like the S&P 500. The Fund is not designed
to track the performance of the overall market - rather it is designed to
provide an investor with a unique opportunity to diversify his portfolio.
Investors should expect the Fund to trail the overall market during a general
upturn while providing an opportunity for positive performance during a general
downswing in the market.
This year's performance was positively impacted by the improving mergers and
acquisitions (M&A) climate, fueled in part by an improving economy. A handful of
deals experiencing regulatory difficulties, such as the acquisition of Wellpoint
Health Networks by Anthem, or terminated transactions, such as Lockheed Martin's
proposed acquisition of Titan Corporation, slowed our otherwise positive
performance. In particular, the confluence of several of these events during the
last quarter of the Fund's fiscal year, primarily in April, created a
significant drag on returns. We view these events, however, as a bump on the
road to another positive year.
The past year's results are, in large part, due to the portfolio being well
positioned to take advantage of an increasingly solid mergers and acquisitions
environment. If the economic growth we've witnessed over the past year continues
to broaden, we expect deal activity to improve as well, providing us with ample
investment opportunities. Likewise, we expect return opportunities to improve as
interest rates move higher.
This year we added both a senior trader and a senior analyst to our team. These
additions will further enhance our skill set, as we seek greater investment and
diversification opportunities in both the US and global markets. As you are no
doubt aware, the closing of the Fund to new investors this year was, likewise,
part of our effort to generate maximum returns within our strategy.
A few additional facts about the portfolio may be of interest. As of May 31 the
Fund had assets under management of $409 million with gross long exposure of
approximately $397 million and gross short exposure of approximately $141
million. The Fund's portfolio included approximately 60 M&A transactions. A list
of the Fund's 10 largest positions, the greatest of which represents 5.0% of
assets, can be found below.
1
The Fund has seen several changes this past year. An institutional class of
shares was opened. As mentioned above, the Fund closed to new investors, but
remains open to current investors. The expansion of our portfolio management
team will allow us to look overseas to take advantage of the robust M&A activity
abroad. As we approach the completion of our fourth full year since inception,
we take stock of the portfolio, its performance and the Fund's growth in assets.
The success we have achieved to date can also be attributed to the improved M&A
market and the enhanced team we have assembled. We are well positioned to manage
the Fund's assets with the goal of delivering optimal returns to the
shareholder.
We at Water Island Capital, LLC strive to add value and diversification to your
investment portfolio. With your continued support, we are confident that we will
continue to do so for many years to come.
Sincerely,
/s/ John S. Orrico
John S. Orrico, CFA
President
The Arbitrage Fund
TOP 10 POSITIONS PERCENT
-------------------------------------- ---------
1 ILEX ONCOLOGY/ GENZYME 5.01%
2 NPTEST HOLDING/ CREDENCE 4.93%
3 WESTPORT RES/ KERR MCGEE 4.62%
4 MILLENNIUM CHEM/ LYONDELL 4.27%
5 XICOR/ INTERSIL 3.72%
6 APOGENT TECH/ FISHER SCIENTIFIC 3.63%
7 BANK ONE/ JP MORGAN 3.29%
8 TITAN/ LOCKHEED MARTIN 3.20%
9 AT&T WIRELESS/cingular wireless 3.12%
10 ADVANCED FIBRE/ TELLABS 2.70%
2
COMPARISON OF THE CHANGE IN VALUE OF A $10,000 INVESTMENT
IN THE ARBITRAGE FUND(a) VERSUS THE S&P 500 INDEX
[GRAPHIC OMITTED]
The Arbitrage Fund S&P 500 Index
------------------ -------------
09/17/00 10,000 09/17/00 10,000
11/30/00 -1.80% 9,820 11/30/00 -10.08% 8,992
02/28/01 28.88% 12,656 02/28/01 -5.43% 8,504
05/31/01 -7.61% 11,693 05/31/01 1.62% 8,641
08/31/01 -7.38% 10,831 08/31/01 -9.44% 7,826
11/30/01 -0.83% 10,740 11/30/01 0.86% 7,893
02/28/02 5.52% 11,333 02/28/02 -2.51% 7,695
05/31/02 2.29% 11,592 05/31/02 -3.25% 7,445
08/31/02 3.13% 11,955 08/31/02 -13.80% 6,417
11/30/2002 -0.26% 11,924 11/30/2002 2.68% 6,590
2/28/2003 3.89% 12,180 2/28/2003 -9.72% 5,949
5/31/2003 2.01% 12,799 5/31/2003 15.05% 6,845
8/31/2003 4.36% 13,008 8/31/2003 5.07% 7,192
11/30/2003 4.36% 13,753 11/30/2003 5.46% 7,584
2/29/2004 4.36% 14,207 2/29/2004 8.67% 8,241
5/31/2004 4.36% 13,651 5/31/2004 -1.72% 8,099
Past performance is not predictive of future performance.
AVERAGE ANNUAL TOTAL RETURNS(b)
(FOR PERIODS ENDED MAY 31, 2004)
1 YEAR SINCE INCEPTION(c)
-------- -------------------
The Arbitrage Fund - Class R 6.66% 8.77%
The Arbitrage Fund - Class I -- 1.35%(d)
Standard & Poor's 500 Index 18.33% (5.54%)
(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.
(c) Initial public offering of Class R shares was September 17, 2000.
Initial public offering of Class I shares was October 17, 2003.
(d) Not annualized.
3
THE ARBITRAGE FUND
STATEMENT OF ASSETS AND LIABILITIES
MAY 31, 2004
================================================================================
ASSETS
Investments in securities:
At acquisition cost $ 407,432,851
==============
At value (Note 1) $ 412,913,292
Deposits with brokers for securities
sold short (Note 1) 100,301,534
Dividends and interest receivable 346,161
Receivable for investment securities sold 32,310,471
Receivable for capital shares sold 612,854
Other assets 69,388
--------------
Total Assets 546,553,700
--------------
LIABILITIES
Written options, at value (Notes 1 and 4)
(premiums received $2,457,627) 2,690,403
Securities sold short, at value (Note 1)
(proceeds $104,701,885) 104,367,639
Payable for investment securities purchased 21,980,555
Payable for capital shares redeemed 7,786,522
Dividends payable on securities sold short (Note 1) 220,537
Payable to Adviser (Note 3) 488,706
Payable to Administrator (Note 3) 50,500
Other accrued expenses and liabilities 145,636
--------------
Total Liabilities 137,730,498
--------------
NET ASSETS $ 408,823,202
==============
NET ASSETS CONSIST OF:
Paid-in capital $ 404,792,430
Distributions in excess of net realized gains (1,551,112)
Net unrealized appreciation (depreciation) on:
Investments 5,480,441
Short positions 334,246
Written option contracts (232,776)
Translation of assets in foreign currencies (27)
--------------
Net Assets $ 408,823,202
==============
PRICING OF CLASS R SHARES
Net assets applicable to Class R shares $ 239,493,590
==============
Shares of beneficial interest outstanding (unlimited
number of shares authorized, no par value) 19,124,744
==============
Net asset value and offering price per share (a) $ 12.52
==============
PRICING OF CLASS I SHARES
Net assets applicable to Class I shares $ 169,329,612
==============
Shares of beneficial interest outstanding (unlimited
number of shares authorized, no par value) 13,500,445
==============
Net asset value and offering price per share (a) $ 12.54
==============
(a) Redemption price varies based on length of time held (Note 1).
See accompanying notes to financial statements.
4
THE ARBITRAGE FUND
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MAY 31, 2004
================================================================================
INVESTMENT INCOME
Dividends $ 1,687,650
Interest 288,120
--------------
Total Income 1,975,770
--------------
EXPENSES
Investment advisory fees (Note 3) 4,195,931
Dividend expense 1,250,859
Distribution expense, Class R (Note 3) 535,864
Administration fees (Note 3) 303,493
Custodian and bank service fees 107,528
Fund accounting fees (Note 3) 100,404
Registration and filing fees, Common 23,230
Registration and filing fees, Class R 20,178
Registration and filing fees, Class I 28,977
Transfer agent and shareholder services fees,
Class R (Note 3) 25,822
Transfer agent and shareholder services fees,
Class I (Note 3) 22,080
Professional fees 41,274
Postage and supplies 33,437
Insurance expense 29,000
Trustees' fees 26,500
Printing of shareholder reports 8,884
Other expenses 10,595
--------------
Total Expenses 6,764,056
Fees waived by the Adviser (Note 3) (102,297)
Class R expenses reimbursed by the Adviser (Note 3) ( 68,873)
Class I expenses reimbursed by the Adviser (Note 3) ( 51,079)
--------------
Net Expenses 6,541,807
--------------
NET INVESTMENT LOSS ( 4,566,037)
REALIZED AND UNREALIZED GAINS (LOSSES) ON INVESTMENTS AND
FOREIGN CURRENCIES (Note 6)
Net realized gains (losses) from:
Security transactions 925,201
Option contracts 10,514,976
Foreign currency transactions (35)
Net change in unrealized appreciation/depreciation on:
Investments (8,800,978)
Short positions 9,418,295
Written option contracts 503,950
Foreign currency translation (27)
--------------
NET REALIZED AND UNREALIZED GAINS ON INVESTMENTS
AND FOREIGN CURRENCIES 12,561,382
--------------
NET INCREASE IN NET ASSETS FROM OPERATIONS $ 7,995,345
==============
See accompanying notes to financial statements.
5
THE ARBITRAGE FUND
STATEMENTS OF CHANGES IN NET ASSETS
================================================================================
YEAR YEAR
ENDED ENDED
MAY 31, MAY 31,
2004 2003
- --------------------------------------------------------------------------------
FROM OPERATIONS
Net investment loss $ (4,566,037) $ (445,613)
Net realized gains (losses) from:
Security transactions 925,201 760,047
Option contracts 10,514,976 1,887,142
Foreign currency transactions (35) --
Net change in unrealized appreciation/
depreciation on:
Investments (8,800,978) 14,349,594
Short positions 9,418,295 (9,153,293)
Written option contracts 503,950 (761,696)
Foreign currency translation (27) --
------------ ------------
Net increase in net assets resulting
from operations 7,995,345 6,636,181
------------ ------------
FROM DISTRIBUTIONS TO SHAREHOLDERS
Distributions from net realized gains, Class R (7,829,264) ( 520,638)
Distributions from net realized gains, Class I (2,300,609) --
------------ ------------
Decrease in net assets from distributions
to shareholders ( 10,129,873) ( 520,638)
------------ ------------
FROM CAPITAL SHARE TRANSACTIONS (NOTE 5)
CLASS R
Proceeds from shares sold 252,248,398 135,245,212
Shares issued in reinvestment of distributions 7,709,210 489,049
Proceeds from redemption fees collected (Note 1) 77,063 --
Payments for shares redeemed (153,665,252) (23,284,533)
------------ ------------
Net increase in net assets from Class R
share transactions 106,369,419 112,449,728
------------ ------------
CLASS I
Proceeds from shares sold 191,327,000 --
Shares issued in reinvestment of distributions 2,176,251 --
Proceeds from redemption fees collected (Note 1) 18,074 --
Payments for shares redeemed (18,812,223) --
------------ ------------
Net increase in net assets from Class I
share transactions 174,709,102 --
------------ ------------
TOTAL INCREASE IN NET ASSETS 278,943,993 118,565,271
NET ASSETS
Beginning of year 129,879,209 11,313,938
------------ ------------
End of year $408,823,202 $129,879,209
============ ============
See accompanying notes to financial statements.
6
THE ARBITRAGE FUND - CLASS R
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,
2004 2003 2002 2001(a)
- -------------------------------------------------------------------------------------------------------
Net asset value at beginning of period $ 12.20 $ 11.19 $ 11.66 $ 10.00
Income (loss) from investment operations:
Net investment income (loss) (0.19) (0.04) (0.04) 0.22
Net realized and unrealized gains (losses)
on investments and foreign currencies 1.01 1.20 (0.08) 1.46
Total from investment operations 0.82 1.16 (0.12) 1.68
Less distributions:
From net investment income -- -- -- (0.02)
From net realized gains (0.50) (0.15) (0.35) --
Total distributions (0.50) (0.15) (0.35) (0.02)
Proceeds from redemption fees collected 0.00(b) -- -- --
Net asset value at end of period $ 12.52 $ 12.20 $ 11.19 $ 11.66
Total return 6.66% 10.41% (0.86%) 16.93%(c)
Net assets at end of period (000's) $ 239,494 $ 129,879 $ 11,314 $ 1,631
Ratio of expenses to average net assets:
Before advisory fees waived, expenses reimbursed
and dividends on securities sold short 2.46% 3.00% 6.19% 51.30%(e)
Before dividends on securities sold short 2.01% 2.54% 5.94% --
After advisory fees waived, expenses reimbursed
and dividends on securities sold short(d) 1.95% 1.95% 1.94% 1.95%(e)
Ratio of net investment loss to average net assets:
Before advisory fees waived and
expenses reimbursed (1.76%) (1.56%) ( 5.19%) (50.05%)(e)
After advisory fees waived and
expenses reimbursed (1.69%) ( 0.97%) ( 1.18%) (0.70%)(e)
Portfolio turnover rate 251% 511% 2,480% 2,952%
(a) Represents the period from the commencement of operations (September 17,
2000) through May 31, 2001.
(b) Amount rounds to less than $0.01 per share.
(c) Not annualized.
(d) Excludes dividend expense of 0.45%, 0.46% and 0.25% of average net assets
for the years ended May 31, 2004, 2003 and 2002, respectively.
(e) Annualized.
See accompanying notes to financial statements.
7
THE ARBITRAGE FUND - CLASS I
FINANCIAL HIGHLIGHTS
================================================================================
SELECTED PER SHARE DATA AND RATIOS FOR A SHARE OUTSTANDING THROUGHOUT THE PERIOD
PERIOD
ENDED
MAY 31,
2004(a)
- --------------------------------------------------------------------------------
Net asset value at beginning of period $ 12.86
---------
Income (loss) from investment operations:
Net investment loss (0.07)
Net realized and unrealized gains on
investments and foreign currencies 0.25
---------
Total from investment operations 0.18
---------
Less distributions:
From net realized gains (0.50)
---------
Proceeds from redemption fees collected 0.00(b)
---------
Net asset value at end of period $ 12.54
=========
Total return 1.35%(c)
=========
Net assets at end of period (000's) $ 169,330
=========
Ratio of expenses to average net assets:
Before advisory fees waived, expenses reimbursed
and dividends on securities sold short 2.27%(e)
Before dividends on securities sold short 1.82%(e)
After advisory fees waived, expenses reimbursed
and dividends on securities sold short(d) 1.70%(e)
Ratio of net investment loss to average net assets:
Before advisory fees waived and expenses reimbursed ( 1.56%)(e)
After advisory fees waived and expenses reimbursed ( 1.44%)(e)
Portfolio turnover rate 251%
(a) Represents the period from the commencement of operations (October 17,
2003) through May 31, 2004.
(b) Amount rounds to less than $0.01 per share.
(c) Not annualized.
(d) Excludes dividend expense of 0.45%(e) of average net assets. (e)
Annualized.
See accompanying notes to financial statements.
8
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 97.11% VALUE
- --------------------------------------------------------------------------------
AEROSPACE AND DEFENSE -- 3.20%
693,100 Titan Corp. (The)(a)(b) ..................... $13,092,659
-----------
AGRICULTURE -- 0.65%
220,200 Sylvan, Inc. (a) ............................ 2,653,410
-----------
APPAREL -- 2.24%
273,920 Maxwell Shoe Co., Inc. (a) .................. 6,116,634
148,939 Vans, Inc. (a) .............................. 3,039,845
-----------
9,156,479
-----------
AUTO PARTS AND EQUIPMENT -- 0.33%
917,100 AirBoss of America Corp. (a) ................ 1,367,652
-----------
BANKS -- 10.23%
277,246 Bank One Corp. (b) .......................... 13,432,569
132,658 BSB Bancorp, Inc. (b) ....................... 4,609,865
146,300 Charter One Financial, Inc. ................. 6,431,348
199,648 First Commonwealth Financial Corp. .......... 2,657,308
64,200 Franklin Bancorp, Inc. ...................... 1,277,580
298,000 Gold Banc Corp., Inc. (b) ................... 4,881,240
20,733 National Commerce Financial Corp. ........... 674,652
97,152 Provident Financial Group, Inc. (b) ......... 3,889,966
104,800 Regions Financial Corp. ..................... 3,984,496
-----------
41,839,024
-------------
BIOTECHNOLOGY -- 1.27%
361,552 Interpore International, Inc. (a) (b) ....... 5,217,195
-----------
CHEMICALS -- 6.12%
599,600 IMC Global, Inc. (b) ........................ 7,465,020
1,028,900 Millennium Chemicals, Inc. .................. 17,470,722
34,200 Phosphate Resource Partners L.P.(a) ......... 83,106
-----------
25,018,848
-------------
COMMERCIAL SERVICES -- 1.26%
404,200 Exult, Inc. (a) ............................. 2,497,956
646,637 Hall, Kinion & Associates, Inc.(a) .......... 2,677,077
-----------
5,175,033
-------------
DIVERSIFIED FINANCIALS -- 0.36%
2,384,456 Loring Ward International Ltd. (a)(c) ....... 1,485,261
-----------
ELECTRIC -- 1.90%
314,800 Unisource Energy Corp. (b) .................. 7,769,264
-----------
9
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS (CONTINUED)
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 97.11% (Continued) Value
- --------------------------------------------------------------------------------
ELECTRICAL COMPONENTS & Equipment-- 0.09%
127,213 Capstone Turbine Corp. (a) .................. $ 354,924
-----------
ELECTRONICS -- 1.49%
113,801 Invision Technologies, Inc. (a) ............. 5,672,980
26,000 Isco, Inc. .................................. 414,154
-----------
6,087,134
-------------
ENTERTAINMENT -- 0.06%
20,000 Metro-Goldwyn-Mayer, Inc. (a) ............... 237,800
-----------
HEALTHCARE SERVICES AND PRODUCTS -- 8.41%
173,300 ALARIS Medical Systems, Inc. (a) ............ 3,852,459
460,000 Apogent Technologies, Inc. (a) (b) .......... 14,821,200
167,900 MedSource Technologies, Inc. (a) ............ 1,168,584
171,250 Oxford Health Plans, Inc. ................... 9,721,863
329,106 U.S. Oncology, Inc. (a) ..................... 4,824,694
-----------
34,388,800
-------------
HOME FURNISHING-- 0.04%
20,000 TiVo, Inc. (a) .............................. 152,200
-----------
HOUSEHOLD PRODUCTS -- 1.26%
307,183 First Years, Inc. (The) (b) ................. 5,145,315
-----------
INSURANCE -- 0.34%
1,889,669 Gainsco, Inc. ............................... 1,379,458
-----------
INTERNET SERVICES -- 3.70%
467,901 FreeMarkets, Inc. (a) (b) ................... 3,191,085
125,000 Marimba, Inc. (a) ........................... 1,022,500
486,250 OneSource Information Services, Inc. (a) .... 4,288,725
854,752 Switchboard, Inc. (a) ....................... 6,607,233
-----------
15,109,543
-------------
LEISURE -- 0.32%
50,000 Huffy Corp. (a) ............................. 58,000
79,000 Hockey Co. Holdings, Inc. (a) ............... 1,233,977
-----------
1,291,977
MANUFACTURING -- 1.66%
40,000 B.W. Technologies Ltd. (a) .................. 1,049,392
348,800 Maax, Inc. .................................. 5,748,580
-----------
6,797,972
-------------
10
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS (CONTINUED)
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 97.11% (Continued) VALUE
- --------------------------------------------------------------------------------
MEDIA -- 2.03%
300,000 Liberty Media Corp. - Class A (a) ........... $ 3,294,000
676,744 UnitedGlobalCom, Inc. (a) (b) ............... 4,987,603
-----------
8,281,603
-------------
MINING -- 0.04%
25,000 Ivanhoe Mines Ltd. (a) ...................... 165,067
-----------
OFFICE & BUSINESS EQUIPMENT -- 2.45%
1,983,008 Danka Business Systems PLC - ADR (a) ........ 7,971,692
46,200 New England Business Service, Inc. .......... 2,026,794
-----------
9,998,486
-------------
OIL AND GAS -- 5.71%
118,700 Evergreen Resources, Inc. (a) ............... 4,492,795
545,300 Westport Resources Corp. (a) ................ 18,867,380
-----------
23,360,175
-------------
PACKAGING AND CONTAINERS -- 0.21%
130,100 Graphic Packaging Corp. (a) ................. 840,446
-----------
PHARMACEUTICALS -- 7.89%
247,383 Cima Labs, Inc. (a) ......................... 7,995,419
884,245 ILEX Oncology, Inc. (a) (b) ................. 20,470,272
153,600 Tularik, Inc. (a) ........................... 3,800,064
-----------
32,265,755
-------------
REAL ESTATE INVESTMENT TRUSTS -- 0.57%
75,000 Boardwalk Real Estate Investment Trust ...... 876,081
60,800 Keystone Property Trust ..................... 1,454,336
-----------
2,330,417
-------------
RETAIL -- 2.77%
48,100 Duane Reade, Inc. (a) ....................... 793,650
714,133 Hollywood Entertainment Corp. (a) ........... 9,483,686
45,455 Loehmann's Holdings, Inc. (a) ............... 1,035,010
-----------
11,312,346
-------------
SAVINGS AND LOANS -- 4.23%
77,261 GreenPoint Financial Corp. (b) .............. 3,098,166
87,612 Hawthorne Financial Corp. (a) ............... 3,086,571
246,569 Seacoast Financial Services Corp. (b) ....... 8,447,454
96,633 Waypoint Financial Corp. (b) ................ 2,647,744
-----------
17,279,935
-------------
SECURITY SERVICES -- 1.26%
141,300 Kroll, Inc. (a) ............................. 5,163,102
-----------
11
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS (Continued)
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 97.11% (Continued) VALUE
- --------------------------------------------------------------------------------
SEMICONDUCTORS -- 11.49%
1,837,623 Conexant Systems, Inc. (a) .................. $ 8,673,581
422,745 Mindspeed Technologies, Inc. (a) (b) ........ 2,185,592
105,778 Monolithic Systems Technology, Inc. (a) ..... 738,330
1,199,947 NPTest Holding Corp. (a) .................... 20,171,109
1,010,015 Xicor, Inc. (a) ............................. 15,200,726
-----------
46,969,338
SOFTWARE -- 2.43%
171,414 Group 1 Software, Inc. (a) .................. 3,918,524
399,453 Optika, Inc. (a) ............................ 1,450,014
513,539 Private Business, Inc. (a) .................. 1,181,140
122,359 Ross Systems, Inc. (a) (b) .................. 2,225,833
117,242 Skillsoft PLC - ADR (a) ..................... 1,172,420
-----------
9,947,931
TELECOMMUNICATIONS -- 11.10%
587,880 Advanced Fibre Communications, Inc.(a) ...... 11,052,144
900,900 AT&T Wireless Services, Inc. (a)(b) ......... 12,756,744
120,000 Microcell Telecommunications, Inc. - Class B (a) 2,831,599
117,447 PanAmSat Corp.(a) ........................... 2,728,294
31,221 SafeNet, Inc.(a) ............................ 727,449
1,796,679 Sorrento Networks Corp. (a) ................. 5,264,269
1,013,767 Time Warner Telecom, Inc.(a) ................ 4,318,647
366,100 Wireless Matrix Corp.(a) .................... 375,597
1,618,225 Zhone Technologies, Inc.(a) ................. 5,307,778
-----------
45,362,521
-------------
TOTAL COMMON STOCKS (Cost $390,943,191)...... $ 396,997,070
-------------
================================================================================
SHARES ESCROWED RIGHTS -- 0.18% VALUE
- --------------------------------------------------------------------------------
35,300 Hoenig Group, Inc. - contingent payment rights $ --
244,657 Information Resources, Inc. - contingent
value rights .............................. 733,971
247,200 PetroCorp, Inc. - escrow shares ............ --
-------------
TOTAL ESCROWED RIGHTS (Cost $419,002) ...... $ 733,971
-------------
12
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS (Continued)
MAY 31, 2004
================================================================================
CONTRACTS CALL OPTION CONTRACTS -- 0.30% VALUE
- --------------------------------------------------------------------------------
AT&T Wireless Services, Inc.,
1,250 01/22/05 at $12.5 ........................... $ 265,625
Exult, Inc.,
690 06/19/04 at $7.5 ............................ 13,800
New York Community Bancorp, Inc.,
750 06/19/04 at $22.5 ........................... 123,750
Monolithic System Technology, Inc.,
2,500 10/16/04 at $7.5 ............................ 237,500
Nasdaq-100 Index - Tracking Stock,
3,000 07/17/04 at $36 ............................. 435,000
Oxford Health Plans, Inc.,
250 06/19/04 at $55 ............................. 52,500
Walt Disney Co. (The),
500 07/17/04 at $22.5 ........................... 77,500
500 07/17/04 at $25 ............................. 20,000
-------------
TOTAL CALL OPTION CONTRACTS (Cost $1,322,190).. $ 1,225,675
-------------
================================================================================
CONTRACTS PUT OPTION CONTRACTS -- 0.10% VALUE
- --------------------------------------------------------------------------------
AT&T Wireless Services, Inc.,
2,500 01/22/05 at $12.5 ........................... $ 81,250
Cima Labs, Inc.,
2,300 06/19/04 at $30 ............................. 57,500
Credence System Corp.,
1,500 06/19/04 at $10 ............................. 3,750
Genzyme Corp.,
1,405 06/19/04 at $42.5 ........................... 126,450
450 07/17/04 at $42.5 ........................... 79,875
Intersil Corp. - Class A,
600 06/19/04 at $20 ............................. 22,500
Oxford Health Plans, Inc.,
250 06/19/04 at $55 ............................. 7,500
Nasdaq-100 Index - Tracking Stock,
1,500 07/17/04 at $32 ............................. 26,250
Sovereign Bancorp, Inc.,
2,000 06/19/04 at $20 ............................. 15,000
UnitedHealth Group, Inc.,
680 06/19/04 at $60 ............................. 11,900
-------------
Total Put Option Contracts (Cost $1,223,867) $ 431,975
-------------
13
THE ARBITRAGE FUND
PORTFOLIO OF INVESTMENTS (Continued)
MAY 31, 2004
================================================================================
SHARES MONEY MARKET SECURITIES -- 3.31% VALUE
- --------------------------------------------------------------------------------
13,524,601 Dreyfus Treasury Prime Cash Management Fund
(Cost $13,524,601) .......................... $ 13,524,601
------------
TOTAL INVESTMENTS AT VALUE-- 101.00%
(Cost $407,432,851)........................... $412,913,292
LIABILITIES IN EXCESS OF OTHER ASSETS--(1.00%). ( 4,090,090)
------------
NET ASSETS-- 100.00%........................... $408,823,202
============
(a) Non-income producing security.
(b) All or a portion of the shares have been committed as collateral for open
short positions.
(c) Security is fair valued following the procedures established by the Board
of Trustees. Represents 0.36% of net assets.
ADR - Amercian Depository Receipt
See accompanying notes to financial statements.
14
THE ARBITRAGE FUND
SCHEDULE OF SECURITIES SOLD SHORT
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 25.53% VALUE
- --------------------------------------------------------------------------------
BANKS -- 3.05%
49,100 First Commonwealth Financial Corp. .......... $ 653,521
110,451 National City Corp. ......................... 3,919,906
25,000 New York Community Bancorp, Inc. ............ 585,500
78,700 North Fork Bancorp, Inc. .................... 3,029,950
7,500 SunTrust Banks, Inc. ........................ 488,100
125,500 Union Planters Corp. ........................ 3,778,805
------------
12,455,782
------------
BIOTECHNOLOGY -- 0.79%
7,000 Amgen, Inc. ................................. 382,900
65,500 Genzyme Corp. ............................... 2,854,490
------------
3,237,390
------------
CHEMICALS -- 3.94%
974,300 Lyondell Chemical Co. ....................... 16,095,436
------------
CONSULTING SERVICES -- 0.03%
15,807 chinadotcom Corp. - Class A ................. 114,443
------------
COMMERCIAL SERVICES -- 0.40%
178,725 Kforce, Inc. ................................ 1,637,121
------------
DIVERSIFIED FINANCIALS -- 3.27%
363,600 J.P. Morgan Chase & Co. ..................... 13,395,024
------------
ELECTRONICS -- 2.19%
156,000 Fisher Scientific International, Inc. ....... 8,955,960
------------
HEALTHCARE SERVICES AND PRODUCTS-- 0.52%
32,500 UnitedHealth Group, Inc. .................... 2,120,625
------------
INTERNET SERVICES -- 0.66%
1,053,716 Ariba, Inc. ................................. 2,297,101
49,900 Stellent, Inc. .............................. 397,703
------------
2,694,804
OIL AND GAS -- 2.93%
224,900 Kerr-McGee Corp. ............................ 11,076,325
29,200 Pioneer Natural Resources Co. ............... 903,740
------------
11,980,065
------------
SAVINGS AND LOANS -- 2.58%
169,380 Commercial Capital Bancorp, Inc. ............ 3,113,204
36,439 First Place Financial Corp. ................. 599,057
314,400 Sovereign Bancorp, Inc. ..................... 6,838,200
------------
10,550,461
------------
15
THE ARBITRAGE FUND
SCHEDULE OF SECURITIES SOLD SHORT (Continued)
MAY 31, 2004
================================================================================
SHARES COMMON STOCKS -- 25.53% (Continued) VALUE
- --------------------------------------------------------------------------------
SEMICONDUCTORS -- 4.31%
810,137 Credence Systems Corp. ...................... $ 11,350,019
295,000 Intersil Corp. - Class A .................... 6,268,750
------------
17,618,769
------------
TELECOMMUNICATIONS -- 0.86%
442,287 Tellabs, Inc. ............................... 3,511,759
------------
TOTAL SECURITIES SOLD SHORT
(Proceeds $104,701,885)..................... $ 104,367,639
=============
See accompanying notes to financial statements.
16
THE ARBITRAGE FUND
SCHEDULE OF OPEN OPTIONS WRITTEN
MAY 31, 2004
================================================================================
OPTION VALUE OF
CONTRACTS WRITTEN CALL OPTIONS OPTIONS
- --------------------------------------------------------------------------------
AT&T Wireless Services, Inc.,
1,250 01/22/05 at $15 ............................. $ 3,125
Conexant Systems, Inc.,
275 06/19/04 at $5 .............................. 3,437
900 07/17/04 at $5 .............................. 29,250
Credence Systems Corp.,
1,500 06/19/04 at $12.5 ........................... 243,750
Fisher Scientific International, Inc.,
955 06/19/04 at $55 ............................. 286,500
150 06/19/04 at $60 ............................. 7,125
Genzyme Corp.,
150 06/19/04 at $45 ............................. 13,500
150 07/17/04 at $45 ............................. 27,000
300 07/17/04 at $47.5 ........................... 28,500
300 07/17/04 at $50 ............................. 13,500
IMC Global, Inc.,
2,303 06/19/04 at $12.5 ........................... 63,333
200 07/17/04 at $12.5 ........................... 12,000
Intersil Corp. - Class A,
600 06/19/04 at $20 ............................. 93,000
Kerr-McGee Corp.,
700 06/19/04 at $45 ............................. 301,000
775 06/19/04 at $50 ............................. 40,688
Lyondell Chemical Co.,
375 06/19/04 at $15 ............................. 58,125
400 06/19/04 at $17.5 ........................... 6,000
Metro-Goldwyn-Mayer, Inc.,
500 06/19/04 at $12 ............................. 18,750
Mindspeed Technologies, Inc.,
350 06/19/04 at $5 .............................. 15,750
Monolithic Systems Technology, Inc.,
1,750 06/19/04 at $7.5 ............................ 30,625
1,750 07/17/04 at $7.5 ............................ 91,875
Nasdaq-100 Index - Tracking Stock,
3,000 07/17/04 at $38 ............................. 142,500
Pioneer Natural Resources Co.,
550 06/19/04 at $30 ............................. 70,125
150 06/19/04 at $35 ............................. 1,500
SafeNet, Inc.,
250 06/19/04 at $22.5 ........................... 40,625
Sovereign Bancorp, Inc.,
577 06/19/04 at $20 ............................. 106,745
Stellent, Inc.,
500 06/19/04 at $7.5 ............................ 33,750
17
THE ARBITRAGE FUND
SCHEDULE OF OPEN OPTIONS WRITTEN (Continued)
MAY 31, 2004
================================================================================
OPTION VALUE OF
CONTRACTS WRITTEN CALL OPTIONS (Continued) OPTIONS
- --------------------------------------------------------------------------------
Tellabs, Inc.,
2,740 06/19/04 at $7.5 ............................ $ 164,400
TiVo, Inc.,
200 06/19/04 at $7.5 ............................ 10,500
UnitedGlobalCom, Inc. - Class A,
500 06/19/04 at $7.5 ............................ 16,250
UnitedHealth Group, Inc.,
575 06/19/04 at $60 ............................. 310,500
830 06/19/04 at $65 ............................. 116,200
190 07/17/04 at $60 ............................. 112,100
Walt Disney Co. (The),
1,000 07/17/04 at $27.5 ........................... 10,000
-----------
TOTAL WRITTEN CALL OPTIONS .................... $ 2,522,028
===========
================================================================================
OPTION VALUE OF
CONTRACTS WRITTEN PUT OPTIONS OPTIONS
- --------------------------------------------------------------------------------
AT&T Wireless Services, Inc.,
5,000 01/22/05 at $10 ............................. $ 87,500
Cima Labs, Inc.,
300 06/19/04 at $25 ............................. 5,250
New York Community Bancorp, Inc.,
750 06/19/04 at $22.5 ........................... 50,625
Oxford Health Plans, Inc.,
250 06/19/04 at $50 ............................. 1,250
Walt Disney Co. (The),
500 07/17/04 at $22.5 ........................... 23,750
-----------
TOTAL WRITTEN PUT OPTIONS...................... $ 168,375
-----------
TOTAL OPEN OPTIONS WRITTEN (Premiums
Received $2,457,627).......................... $ 2,690,403
===========
See accompanying notes to financial statements.
18
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS
MAY 31, 2004
================================================================================
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
The Arbitrage Funds (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 non-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 Funds two classes of shares, Class R and Class I, represent interests in the
same portfolio of investments and have the same rights, but differ primarily in
the expenses to which they are subject and the investment eligibility
requirements. Class R shares are subject to an annual distribution fee of up to
..25% of the Fund's average daily net assets allocable 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:
SECURITIES VALUATION - 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 equity-type
securities 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. Securities traded in the
over-the-counter market, and which are not quoted by NASDAQ, 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. 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.
REPURCHASE AGREEMENTS - The Fund may enter into repurchase agreements with
certain banks or non-bank dealers. The Adviser will monitor, on an ongoing
basis, the value of the underlying securities to ensure that the value always
equals or exceeds the repurchase price plus accrued interest.
19
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
MAY 31, 2004
================================================================================
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
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 the Fund is equal to the net asset value per share, except
that, effective October 1, 2003, 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, 2004, proceeds from redemption fees total $77,063 in Class R
and $18,074 in Class I.
INVESTMENT INCOME - Interest income is accrued as earned. Dividend income is
recorded on the ex-dividend date.
DISTRIBUTIONS TO SHAREHOLDERS - Dividends arising from net investment income and
net capital gain distributions, if any, are declared and paid at least annually
to shareholders of the Fund. The amount of distributions from net investment
income and net realized gains are determined in accordance with federal income
tax regulations which may differ from accounting principles generally accepted
in the United States of America. These "book/tax" differences are either
temporary or permanent in nature and are primarily due to losses deferred due to
wash sales.
The tax character of distributions paid during the years ended May 31, 2004 and
2003 was ordinary income.
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.
SECURITY TRANSACTIONS - Security transactions are accounted for on trade date.
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
20
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
MAY 31, 2004
================================================================================
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
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.
OPTION TRANSACTIONS - The Fund writes (sells) covered call options to hedge
portfolio investments. Put options can also be written by the Fund as part of a
merger arbitrage strategy involving a pending corporate reorganization. When the
Fund writes (sells) an option, an amount equal to the premium received by the
Fund is included in the Statement of Assets and Liabilities as an asset and an
equivalent liability. The amount of the liability is subsequently
marked-to-market to reflect the current value of the option written. By writing
an option, the Fund may become obligated during the term of the option to
deliver or purchase the securities underlying the option at the exercise price
if the option is exercised. Option contracts are valued at the 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).
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 income and expenses during the reporting period. Actual
results could differ from those estimates.
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.
21
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (Continued)
MAY 31, 2004
================================================================================
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
The following information is computed on a tax basis for each item as of May 31,
2004:
- --------------------------------------------------------------------------------
Cost of portfolio investments (including securities
sold short and written options) $ 313,748,475
==============
Gross unrealized appreciation $ 12,280,702
Gross unrealized depreciation ( 20,173,927)
--------------
Net unrealized appreciation ( 7,893,225)
Net unrealized depreciation on translation of assets
and liabilities in foreign currencies ( 27)
Undistributed long-term capital gains 1,146,280
Undistributed short-term capital gains 10,777,744
--------------
Total distributable earnings $ 4,030,772
==============
- --------------------------------------------------------------------------------
The difference between the federal income tax cost of portfolio investments and
the financial statement cost is due to the tax deferral of losses on wash sales.
2. INVESTMENT TRANSACTIONS
During the year ended May 31, 2004, 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 $959,647,922 and
$686,880,161, respectively.
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 allocable to Class R shares and 1.70% of the Fund's
average daily net assets allocable to Class I shares. Accordingly, for the year
ended May 31, 2004, the Adviser waived $102,297 of its advisory fee and
reimbursed the Fund for $68,873 and $51,079 of Class R and Class I expenses,
respectively.
22
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (Continued)
MAY 31, 2004
================================================================================
3. TRANSACTIONS WITH AFFILIATES (Continued)
Any waiver or reimbursement is subject to later adjustment to allow the Adviser
to recoup fees waived or expenses reimbursed to the extent actual fees and
expenses for a period are less than the expense limitation cap of each class,
provided, however, that the Adviser shall only be entitled to recoup 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, 2004, the Adviser may in the
future recoup from the Fund fees waived and expenses reimbursed totaling
$639,832, of which $222,249 expires May 31, 2007, $266,412 expires May 31, 2006
and $151,171 expires May 31, 2005.
Certain officers of the Trust are also officers of the Adviser.
ADMINISTRATION AGREEMENT
Under the terms of an Administration Agreement, Ultimus Fund Solutions, LLC
("Ultimus") supplies executive, administrative and regulatory services to the
Fund, supervises the preparation of tax returns, and coordinates the preparation
of reports to shareholders and reports to and filings with the Securities and
Exchange Commission and state securities authorities. For the performance of
these administrative services, Ultimus receives a monthly fee at an annual rate
of .15% of the Fund's average daily net assets up to $50 million; .125% of such
assets from $50 million to $100 million; .10% of such assets from $100 million
to $250 million; .075% of such assets from $250 to $500 million; and .05% of
such assets in excess of $500 million, subject to a minimum fee of $2,000 per
month. Certain officers of the Trust are also officers of Ultimus.
TRANSFER AGENT AND SHAREHOLDER SERVICES AGREEMENT
Under the terms of a Transfer Agent and Shareholder Services Agreement between
the Trust and Ultimus, Ultimus 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, Ultimus receives from the Fund a monthly fee at an annual rate of $20
per account, subject to a minimum fee of $1,500 per month for each class of
shares. In addition, the Fund pays out-of-pocket expenses including, but not
limited to, postage and supplies.
23
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (Continued)
MAY 31, 2004
================================================================================
3. TRANSACTIONS WITH AFFILIATES (Continued)
FUND ACCOUNTING AGREEMENT
Under the terms of a Fund Accounting Agreement between the Trust and Ultimus,
Ultimus calculates the daily net asset value per share and maintains the
financial books and records of the Fund. For these services, Ultimus receives
from the Fund a monthly fee of $3,500, plus an asset based fee equal to .01% of
the Fund's average daily net assets up to $500 million and .005% of such assets
in excess of $500 million. Additionally, on a monthly basis, Ultimus receives $5
per trade for accounting for portfolio trades in excess of two hundred. In
addition, the Fund reimburses certain out-of-pocket expenses incurred by Ultimus
in obtaining valuations of the Fund's portfolio securities.
DISTRIBUTION AGREEMENT
Under the terms of a Distribution Agreement between the Trust and Ultimus Fund
Distributors, LLC (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 Ultimus.
DISTRIBUTION PLAN
The Fund has adopted a plan of distribution pursuant to Rule 12b-1 under the
1940 Act (the "Plan") for Class R shares, which permits Class R to pay for
expenses incurred in the distribution and promotion of Class R shares. Under the
Plan, Class R may pay compensation to any broker-dealer with whom the
Distributor or the Fund, on behalf of Class R shares, has entered into a
contract to distribute Class R shares, or to any other qualified financial
services firm, for distribution and/or shareholder-related services with respect
to shares held or purchased by their respective customers in connection with the
purchase of shares attributable to their efforts. The amount of payments under
the Plan in any year shall not exceed .25% annually of the average daily net
assets allocable to Class R shares. During the year ended May 31, 2004, the Fund
paid Class R distribution expenses of $535,864 pursuant to the Plan.
4. OPTIONS CONTRACTS
A summary of option contracts written during the year ended May 31, 2004 is as
follows:
OPTION OPTION
CONTRACTS PREMIUMS
- --------------------------------------------------------------------------------
Options outstanding at beginning of year............... 11,404 $ 915,294
Options written........................................ 343,694 31,133,846
Options closed......................................... ( 59,578) ( 4,805,808)
Options exercised......................................( 111,410) ( 12,780,115)
Options expired........................................( 150,615) ( 12,005,590)
---------- -----------
Options outstanding at end of year..................... 33,495 $ 2,457,627
========== ===========
- --------------------------------------------------------------------------------
24
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (Continued)
MAY 31, 2004
================================================================================
5. 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 transactions for the years
shown:
- --------------------------------------------------------------------------------
YEAR YEAR
ENDED ENDED
MAY 31, MAY 31,
2004 2003
- --------------------------------------------------------------------------------
CLASS R
Shares sold ..................................... 19,944,187 11,593,800
Shares issued in reinvestment of distributions .. 607,024 42,674
Shares redeemed ................................. (12,071,428) (2,002,360)
----------- ----------
Net increase in shares outstanding .............. 8,479,783 9,634,114
Shares outstanding at beginning of year ......... 10,644,961 1,010,847
----------- ----------
Shares outstanding at end of year ............... 19,124,744 10,644,961
=========== ==========
CLASS I
Shares sold ..................................... 14,818,551 --
Shares issued in reinvestment of distributions .. 171,224
Shares redeemed ................................. (1,489,330) --
------------ ------------
Net increase in shares outstanding .............. 13,500,445 --
Shares outstanding at beginning of year ......... -- --
------------ ------------
Shares outstanding at end of year ............... 13,500,445 --
============ ============
- --------------------------------------------------------------------------------
25
THE ARBITRAGE FUND
NOTES TO THE FINANCIAL STATEMENTS (Continued)
MAY 31, 2004
================================================================================
6. FOREIGN CURRENCY TRANSLATION
Amounts denominated in or expected to settle in foreign currencies are
translated to U.S. dollars based on exchange rates on the following basis:
A. The market values of investment securities and other assets and liabilities
are translated at the closing rate of exchange each day.
B. Purchases and sales of investment securities and income and expenses are
translated at the rate of exchange prevailing on the respective dates of such
transactions.
C. The Fund does not isolate that portion of the results of operations caused by
changes in foreign exchange rates on investment 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.
7. 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.
26
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Trustees
The Arbitrage Funds
New York, New York
We have audited the accompanying statement of assets and liabilities of The
Arbitrage Fund (a series of The Arbitrage Funds), including the portfolio of
investments, as of May 31, 2004, and the related statement of operations for the
year then ended, the statement of changes in net assets for each of the two
years in the period then ended, and the financial highlights for each of the
three 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. The financial highlights for the period September 17, 2000
(commencement of operations) through May 31, 2001 have been audited by other
auditors, whose report dated July 10, 2001 expressed an unqualified opinion on
such financial highlights.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (US). 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. 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, 2004 by correspondence with the custodian and
brokers. Where brokers have not replied to our confirmation request we carried
out other appropriate procedures. 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, 2004, 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 three years in
the period then ended, in conformity with accounting principles generally
accepted in the United States of America.
TAIT, WELLER & BAKER
Philadelphia, Pennsylvania
July 16, 2004
27
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:
POSITION HELD LENGTH OF
TRUSTEE ADDRESS AGE WITH THE TRUST TIME SERVED
- --------------------------------------------------------------------------------------------------------
*John S. Orrico, CFA 650 Fifth Avenue 44 President, Secretary, Since May 2000
New York, NY 10019 Treasurer and Trustee
Joel C. Ackerman 295 Central Park West 59 Trustee Since May 2000
New York, NY 10024
John C. Alvardo 75 Spring Street 44 Trustee Since December 2003
New York, NY 10012
Jay N. Goldberg 660 Madison Avenue 63 Trustee Since May 2000
New York, NY 10021
Matthew Hemberger 650 Fifth Avenue 44 Vice President Since March 2004
New York, NY 10019
* Mr. Orrico is an "interested person" of the Trust within the meaning of
Section 2(a)(19) of the Investment Company Act of 1940.
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. (a financial management firm).
Joel C. Ackerman is currently a private investor. During 2003, he was a Partner
in Crossroads Investments LP and a Partner with LRL Capital (hedge fund). Prior
to September 2002, he was a Partner of Ardsley Partners (hedge fund).
John C. Alvardo is a Managing Member of Power Capital Partners, LLC which is a
financial advisory and consulting firm. From 1995 to 2000, he was senior Vice
President, Co-Founder and Partner of Stratum Group LP, which is private a equity
investment firm.
Jay N. Goldberg is General Partner of Hudson Ventures (a venture capital
company).
Matthew Hemberger is Chief Compliance Officer of the Adviser. Prior to March
2001, he was an Analyst, Assistant Portfolio Manager, and CFO at Lindemann
Capital Partners, L.P.
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.
28
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[GRAPHIC OMITTED]
THE ARBITRAGE FUND
A SERIES OF THE ARBITRAGE FUNDS
ADVISER WATER ISLAND CAPITAL, LLC
650 Fifth Avenue, 6th Floor
New York, NY 10019
DISTRIBUTOR ULTIMUS FUND DISTRIBUTORS, LLC
135 Merchant Street, Suite 230
Cincinnati, OH 45246
TRANSFER AGENT ULTIMUS FUND SOLUTIONS, LLC
135 Merchant Street, Suite 230
Cincinnati, OH 45246
CUSTODIAN MELLON BANK, N.A.
One Mellon Bank Center
Pittsburgh, PA 15258
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
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 Securities and Exchange Commission's website at
http:/www.sec.gov.
ITEM 2. CODE OF ETHICS.
As of the end of the period covered by this report, the registrant has adopted a
code of ethics that applies to the registrant's principal executive officer,
principal financial officer, principal accounting officer or controller, or
persons performing similar functions, regardless of whether these individuals
are employed by the registrant or a third party. Pursuant to Item 10(a)(1), a
copy of registrant's code of ethics is filed as an exhibit to this Form N-CSR.
During the period covered by this report, the code of ethics has not been
amended. The registrant has not granted any waivers, including implicit waivers,
from the provisions of the code of ethics.
ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT.
The registrant's board of trustees has determined that the registrant has at
least one audit committee financial expert serving on its audit committee. The
name of the audit committee financial expert is John C. Alvarado. Mr. Alvarado
is "independent" for purposes of this Item.
ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
(a) AUDIT FEES. The aggregate fees billed for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements or for services that are normally provided
by the accountant in connection with statutory and regulatory filings
or engagements were $15,500 with respect to the registrant's fiscal
year ended May 31, 2004. The aggregate fees billed for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements or for services that are
normally provided by the accountant in connection with the statutory
and regulatory filings or engagements were $11,000 with respect to the
registrant's fiscal year ended May 31, 2003.
(b) AUDIT-RELATED FEES. No fees were billed in either of the last two
fiscal years for assurance and related services by the principal
accountant that are reasonably related to the performance of the audit
of the registrant's financial statements and are not reported under
paragraph (a) of this Item.
(c) TAX FEES. No fees were billed in either of the last two fiscal years
for professional services rendered by the principal accountant for tax
compliance, tax advice, and tax planning.
(d) ALL OTHER FEES. No fees were billed in either of the last two fiscal
years for products and services provided by the principal accountant,
other than the services reported in paragraphs (a) through (c) of this
Item.
(e)(1)The audit committee has not adopted pre-approval policies and
procedures described in paragraph (c)(7) of Rule 2-01 of Regulation
S-X.
(e)(2)None of the services described in paragraph (b) through (d) of this
Item were approved by the audit committee pursuant to paragraph
(c)(7)(i)(C) of Rule 2-01 of Regulation S-X.
(f) Less than 50% of hours expended on the principal accountant's
engagement to audit the registrant's financial statements for the
most recent fiscal year were attributed to work performed by persons
other than the principal accountant's full-time, permanent employees.
(g) No non-audit fees were billed in either of the last two fiscal years
by the registrant's accountant for services rendered to the
registrant, and rendered to the registrant's investment adviser (not
including any sub-adviser whose role is primarily portfolio
management and is subcontracted with or overseen by another
investment adviser), and any entity controlling, controlled by, or
under common control with the adviser that provides ongoing services
to the registrant.
(h) The registrant's audit committee has not considered whether the
provision of non-audit services to the registrant's investment
adviser (not including any sub-adviser whose role is primarily
portfolio management and is subcontracted with or overseen by another
investment adviser), and any entity controlling, controlled by, or
under common control with the investment adviser that provides
ongoing services to the registrant, that were not pre-approved
pursuant to paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-X, is
compatible with maintaining the principal accountant's independence.
ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS.
Not applicable
ITEM 6. SCHEDULE OF INVESTMENTS.
Not applicable
ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END
MANAGEMENT INVESTMENT COMPANIES.
Not applicable
ITEM 8. PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT INVESTMENT
COMPANY AND AFFILIATED PURCHASERS.
Not applicable
ITEM 9. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
The registrant has not adopted procedures by which shareholders may recommend
nominees to the registrant's board of trustees.
ITEM 10. CONTROLS AND PROCEDURES.
(a)(1) Based on his evaluation of the registrant's disclosure controls and
procedures (as defined in Rule 301-2(c) under the Investment Company Act of
1940), the registrant's principal executive officer and principal financial
officer has concluded that such disclosure controls and procedures are
reasonably designed and are operating effectively to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to him by others within those entities, particularly during the
period in which this report is being prepared, and that the information required
in filings on Form N-CSR is recorded, processed, summarized, and reported on a
timely basis.
(a)(2) There were no significant changes in the registrant's internal control
over financial reporting that occurred during the registrant's most recent
fiscal half-year (the registrant's second fiscal half-year in the case of an
annual report) that have materially affected, or are reasonably likely to
materially affect, the registrant's internal control over financial reporting.
ITEM 11. EXHIBITS.
File the exhibits listed below as part of this Form. Letter or number the
exhibits in the sequence indicated.
(a)(1) Any code of ethics, or amendment thereto, that is the subject of the
disclosure required by Item 2, to the extent that the registrant intends to
satisfy the Item 2 requirements through filing of an exhibit: Attached hereto
(a)(2) A separate certification for each principal executive officer and
principal financial officer of the registrant as required by Rule 30a-2(a) under
the Act (17 CFR 270.30a-2(a)): Attached hereto
(a)(3) Any written solicitation to purchase securities under Rule 23c-1 under
the Act (17 CFR 270.23c-1) sent or given during the period covered by the report
by or on behalf of the registrant to 10 or more persons: Not applicable
(b) Certifications required by Rule 30a-2(b) under the Act (17 CFR
270.30a-2(b)): Attached hereto
Exhibit 99.CODE ETH Code of Ethics
Exhibit 99.CERT Certifications pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
Exhibit 99.906CERT Certifications pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant) The Arbitrage Funds
------------------------------------------------------------------
By (Signature and Title)* /s/ John S. Orrico
------------------------------------------
John S. Orrico, President and Treasurer
Date August 4, 2004
-----------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
By (Signature and Title)* /s/ John S. Orrico
------------------------------------------
John S. Orrico, President and Treasurer
Date August 4, 2004
-----------------------------------
* Print the name and title of each signing officer under his or her signature.